Finance is one of the most technical subjects. It includes mathematical training and skills in economics and accounting. At first, finance seems the most difficult subject for students. But by knowing some basic finance concepts, one can better understand this discipline. This article aims to describe some most frequently used finance concepts. Let us start by defining finance first.
- What is finance?
Finance is a diverse field that deals with a number of activities like raising funds, banking, leverage, debt, money, capital market, credit, and investment. In simple, financing is the process of money management and acquiring needed funds. It is the study of basic elements of the financial system, including lenders and borrowers, money creation, financial instruments, financial intermediaries, financial market, and price discovery. The strong financial system aims to improve the efficiency of financing decisions. It also helps in the better allocation of resources that ensure better economic growth of a country. The core finance concepts are based on macroeconomic and microeconomic theories. The following section will describe some important finance concepts.
Budgeting is one of the most important finance concepts. It is simply a plan that explains how to spend money. In finance, budgeting is important as it allows us to know in advance whether we have enough money to arrange all resources for a project. If yes, we can conveniently execute our plans. In contrast, if we fall short of the required money, the next step must be to make effective funding raising plans. Thus, for budgeting, an individual needs a proactive approach to managing the resources.
- Tax planning
Tax planning is the financial situation analysis of a company that ensures the working of all elements to allow you to pay as lowest taxes as possible. Tax planning is vital for the smooth functioning of the financial planning process. It saves organizations from legal hassles regarding tax payments. Thus, a finance manager must know the five D’s of tax planning that involves deduction, dividing, disguising, deferring, and dodging to save tax. Moreover, some processes that help in saving tax include fixed deposit, investing in PPF (Public Provident Fund) accounts, provident funds and mutual funds, and national saving certificates.
- Debt services
Debt services are the cash or funds that a borrower needs to pay for the interest and principal payment on particular types of debts or loans after a certain time period. For example, if an individual takes a student loan and mortgage, then the debtor must need to calculate debt services on each loan, either monthly or annually. Basically, the debt services measure how much cash a company generates against every dollar of debt. Thus, the formula for calculating the debt service coverage ratio is:
- Cash flow management
As the name suggests, cash flow management is the process that estimates how much money comes into and moves out of a business. It helps in estimating the amount of money that will be available for your business in the future. It also calculates the money you will need to pay debts, employees’ salaries, and service charges to the suppliers or vendors. If done properly, it allows an organization to make informed decisions after knowing the cost versus revenue ratio and estimating the availability of funds required for paying bills and bearing other expenditures. It can be done in three potential ways, including cash flow from financing activities, operating activities and investing activities. All these types of cash flow management deal with an organization’s cash flow statement. As a whole, cash flow management is the art of collecting and managing cash which is a vital component of a company’s financial stability.
- Financial Reporting
Financial reporting consists of four important documents, including balance sheets, cash flow statements, income statements, and statements of stakeholder’s equity. These reports provide detailed information that is important for developing good marketing, budgeting and investment plans. It helps in estimating the trends, calculating the growth or progress and investigating any irregularities that need to be monitored. Moreover, the four vital components of financial reports include profitability measurements, shareholders’ equity analysis, cash flow data, and asset and liability evaluation.
- Net worth
Net financial worth is the value of an organization’s assets after subtracting liabilities it owes from it. It is an important thing to measure the company’s financial health and present a clear-cut picture of a company’s current financial problems. In other words, you can find the net financial worth by finding the difference between the stock of liabilities and the stock of financial assets.
A high positive value of the net financial worth of a company reflects the good financial health of an organization. Likewise, the negative value net worth depicts that the organization is bearing a loss.
- Bear market
The bear market is the one that faces a prolonged decline in prices. It represents a condition where the securities prices fall up to 20% for more than two months and often occurs during a period of high unemployment. In such conditions, investors often feel pessimistic. In contrast, the bull market is reciprocal to the bear market; it represents the state when the economy is on the rise. The fluctuation in stocks and prices is also common in bull markets. But shifts in trends often occur for a very short period of time, representing that the market is performing healthily activities. Thus, by knowing about the bear market and bull market, one can easily understand the role of the ever-changing economic landscape in finance management, especially while making investment plans.
- Financial risk tolerance
Risk tolerance refers to the amount of loss that an investor is ready to withstand while investing in a particular project. Based on the degree of loss an investor can bear, the investors are classified into three categories, namely, conservative, moderate and aggressive. In more simple words, risk tolerance is the ability of an investor to accept the decline in his investment. The most practical approach to risk tolerance is to ask a series of business-oriented questions from the investors. These questions may include information about available assets, time horizon, capabilities to sustain in an ever-changing economic landscape in bear and bull markets, and many more.
- Asset allocation and diversification
Asset allocation is the process of determining the right place for investing money in markets. In simple terms, asset allocation is the division of investments among assets like cash, bond and stock. It is an investment strategy that works to balance risk and rewards by taking into account any investor’s goals, investment horizon and risk tolerance. Moreover, there is no simple formula that can calculate the right asset allocation for everyone. Three main assets, equities, cash, and equivalent or fixed income have different risk and return levels, thus, resulting in different values over time.
Diversification is another important finance concept that suggests that people diversify their portfolios. Diversification in finance simply means that investors should invest in different types of assets instead of putting all resources into a single one. In common risk management strategies, diversification aims to reduce risk and increase yield over term. Thus, both asset allocation and diversification are key terms in most investment strategies and are important finance concepts as well.
Inflation is a relatively common concept. It aims to explain the increase in the price of goods, services and overall cost of living over time. In other words, inflation is simply the measure of the purchasing power of an individual. It measures the overall impact of price change for different types of products and services. A common indicator of inflation is the Consumer Price Index (CPI). CPI calculates the change in retail prices of household purchases that a nation consumes on daily bases. The formula for calculating CPI is:
CPI= consumer price index in the current period
Ct = Current cost of a market basket
Co = Cost of the market basket in the base period
The increase in CPI value represents more inflation while negative values reflect deflation (increase in purchasing power of people).
Liquidity refers to the process through which the security or asset needs to be converted into ready cash. The tangible things are the least, while the cash is the most liquid type of asset. The three most important type of liquidity ratio often used in finance and management includes Cash ratio, Current ratio and Quick ratio. All these types of liquidity ratios aim to increase the availability of cash, so it can be used whenever an organization needs it. It further includes the activities like the conversion of tangible assets into cash and measurement of the debt capacity of an organization. The most common way to find liquidity in finance is by measuring the current ratio. The formula for measuring the current ratio involves:
- Simple and Compound interest
Interest is simply a fixed amount of cash that the debtor has to pay on money he/she borrowed. The amount of interest one has to pay depends on the creditworthiness and type of debt. It may be high, moderate or low. Commonly, interests are of two types namely simple and compound. The simple interests are those that we calculate on the principle, type and total amount of the loan. At the same time, the compound interest is the one that we calculate based on the amount of the loan and the accumulated interest of the past year.
The formula for calculating simple interest includes:
Where P= Principle amount = the original amount someone lends
R = Interest rate = often fixed and expressed in the form of decimal
N = number of time periods = usually a period of one year
While the formula for calculating the compound interest (CI) is:
Where P = Principal balance
r = Interest rate
n = number of times the interest is compound after certain time periods
t = number of time periods
1.13 Capital Asset Pricing Model (CAPM)
Among the list of most important finance concepts, the capital asset pricing model (CAPM) is a common model used in corporate finance. It allows the entrepreneurs to price investment based on return rate. Basically, CAPM is a sophisticated way to determine whether security is fairly valued. Mostly, it relies on the investor behaviours, market fundaments and risk and returns’ distribution. You can find the CAPM by having capital asset expected return E (Ri), sensitivity (βi ), risk-free rate of interest (Rf), and expected rate of the market E (Rm).
E (Ri) = (Rf) + βi ( E (Rm ) – Rf)
- Finance Statement analysis
Before discussing finance statement analysis, it is important to know about the financial statement. Briefly, financial statements are the formal documents that explain the financial activities and performance of an individual, company and other entities. Thus, the financial statement analysis is the process of reviewing a company’s financial statement for the sake of making informed decisions. Broadly, the financial statement analysis can be performed by using the five techniques: trend analysis, cost volume profit analysis, benchmarking analysis, financial ratio analysis, and common-size financial analysis. Besides, the horizontal, vertical and ratio analyses are important tools for analysing the financial statement of an organization.
- Working capital management
Working capital management is the corporate business strategy and one of the most popular finance concepts. It aims to ensure whether a company is functioning as effectively as possible by estimating the liquidity available for managing day-to-day business tasks. Effective working capital management is the multi-tasking phenomenon that involves managing short-term investments, managing inventory or payables, and granting credits to customers. It can be calculated by using the following formula:
Consequently, no matter what type of finance sector you are dealing with (public, personal, private, or corporate), these basic finance concepts are vital to understanding the financial management techniques which are important to take your business to the next level. Starting from these basic finance concepts and learning their vital formulae by heart can help you in solving almost all basic level questions in finance assignments and examinations. Also, the time value of money is the fundamental concept behind all the above mentioned finance concepts. It explains that the sum of money today is more than the sum of the same amount of money in the future because of its earning potential in the interim period.
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