• Finance is the management of money and other valuables, which can be easily converted into cash.
• Finance is a simple task of providing the necessary funds (money) required by the business of entities like companies, firms, individuals and others on the terms that are most favourable to achieve their economic objectives.
• Finance is concerned with cash. It is so, since, every business transaction involves cash directly or indirectly.
• Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilisation of funds. It also deals with profits that adequately compensate for the cost and risks borne by the business.

The evolution of financial markets has been particularly significant in the last decades with regard to intermediaries, capital markets and financial instruments. Structural changes have mainly involved the more traditional financial operators in banking, but have also involved investment firms and insurance companies.

Personal Finance

Personal finance is the process of effectively managing assets in the possession of an individual or a family. The approach dictates that attention is given to the generation of income for the household, allotting specific amounts of that income to cover all expenses associated with the household, and take action to create reserves of cash and other assets for ongoing financial security. A wide variety of resources can be called upon to aid in the process of personal finance.

Basic to the task of personal finance is having a firm grasp on the flow of income into the household. The income is usually in the form of wages or salary from a job, although other forms on income may apply. Interest earned from investments, alimony or child support payments and other forms of compensation all qualify as income.

Along with identifying the sources and total amount of income, effective personal finance also requires a clear understanding of the fixed and variable expenses associated with the household. Fixed expenses will often include rent or mortgage payments, car payments and any outstanding loans. Variable payments may include food, monthly utility costs or monthly bank service charges.

• Consider putting extra money into paying off loans with the highest interest rate first, then using the freed money after the first loan or credit card is paid off to increase payments on the next debt. Living within means is another extremely important tip for personal finance management. With the easy availability of credit, many people exceed their income on a regular basis, even before putting money into paying down debt or saving.
• Individuals who are focused on investing, managing their personal finances, or planning for special financial goals should be searching for a personal finance adviser to handle these matters.

Instruments and Transactions

1. Common and Preferred stock
2. Bonds and Loan
3. Investment Funds
4. Derivatives and Insurance
5. Corporate Finance

• Common and Preferred stock

Common stock

Shares of stock are given to owners of corporations as evidence of their ownership interests. The ownership of common shares allows common stockholders to vote for the board of directors, receive dividends, and receive assets when the corporations go out of business. The sale of common stock to owners is a source of resources for a corporation. In return for the common shares, the corporation receives resources from the buyer, who becomes an owner.

Preferred stock

A second major class of stockholders owns preferred stock. Owners of preferred stock have specific rights (or preferences) over those of common stockholders. For example, preferred stockholders have a right to receive dividends before common stockholders. Usually, when a company goes out of business, preferred stockholders also have a right to receive their share of the company’s assets before any assets are distributed to common stockholders. In return for preferred shares, the corporation receives resources from the buyer, who becomes an owner.

• Bonds and Loan

A bond is a type of debt instrument. It is a way for a company or government to raise money by selling, in effect, IOUs.

Bonds work by firms selling a bond for say $1,000. In return the firm agrees to pay back the bond in 10, 20 or 30 years’ time. In the meantime, it will pay interest on this bond of say 5%. The purchaser of the bond gives the firm $1,000 and in return gets interest payments for the duration of the bond term.

The main difference between a bond and loan is that a bond is highly tradeable. If you buy a bond, there is usually a market where you can trade bonds. This means you can sell the bond, rather than wait to the end of the 30 year period. In practice people buy bonds when they wish to increase their portfolio in that way.

Loans tend to be agreements between banks and customers. Loans are usually non trade-able and the bank is obliged to see out the term of the loan.

However, instruments such as derivatives and securitisation have made loans more tradeable. Banks are able to pass on the risk of loans to other financial bodies willing to take on the risk.

• Investment Funds

An investment fund is a firm that pools funds from a number of retail investors and invests the same for a fee. Thus, an investment fund enables investors to gain exposure to a broad range of options. Moreover, the investment fund is able to achieve economies of scale, bringing down the trading costs.

Investment funds are suitable for investors who wish to invest in securities without studying the characteristics of the various options. Private bankers, trust managers or other advisers often direct some or all of the assets of their clients towards fund investments.

In terms of risk and reward, an investment fund can range from being ultra-safe, low-yielding bond funds to being highly-leveraged derivative hedge funds.

Types of Investment Funds

Investment funds can be open-ended or closed-ended. An open-ended fund is an investment fund that allows investors to sell their share in the fund whenever they want, whereas closed-ended investment funds require the investment to be kept locked up for a fixed period.

Investment funds can be either of the two types:

Private funds: This type of fund involves up to 50 investors, with each contributing a significant amount of money (not less than $1 million per investor). The money is then invested into a particular class of assets. Private funds are usually closed-ended funds and are selected by people who have a long-term investment horizon. In this type of investment fund, money managers use their specialized knowledge of the selected asset class to obtain higher returns than that expected from public funds.

Public funds: Public funds offer high flexibility, liquidity and transparency. These funds are required by law to declare their net asset value (NAV) on a regular basis. Most of these funds have an open-ended structure.

• Derivatives and Insurance 

An insurance contract can be viewed as a derivative contract where the underlying asset is the value of losses experienced by the insured.

There are both similarities and important differences.

Basis risk and extent or risk reduction, basis risk is the uncertainty about effectiveness of a hedge.

• Corporate Finance

Corporate finance deals with the strategic financial issues associated with achieving this goal, such as how the corporation should raise and manage its capital, what investments the firm should make, what portion of profits should be returned to shareholders in the form of dividends, and whether it makes sense to merge with or acquire another firm.

Balance Sheet Approach to Valuation

If the role of management is to increase the shareholder value, then managers can make better decisions if they can predict the impact of those decisions on the firm’s value. By observing the difference in the firm’s equity value at different points in time, one can better evaluate the effectiveness of financial decisions. A rudimentary way of valuing the equity of a company is simply to take its balance sheet and subtract liabilities from assets to arrive at the equity value. However, this book value has little resemblance to the real value of the company. First, the assets are recorded at historical costs, which may be much greater than or much less their present market values. Second, assets such as patents, trademarks, loyal customers, and talented managers do not appear on the balance sheet but may have a significant impact on the firm’s ability to generate future profits. So while the balance sheet method is simple, it is not accurate; there are better ways of accomplishing the task of valuation.

Cash vs. Profits

Another way to value the firm is to consider the future flow of cash. Since cash today is worth more than the same amount of cash tomorrow, a valuation model based on cash flow can discount the value of cash received in future years, thus providing a more accurate picture of the true impact of financial decisions.

Decisions about finances affect operations and vice versa; a company’s finances and operations are interrelated. The firm’s working capital flows in a cycle, beginning with cash that may be converted into equipment and raw materials. Additional cash is used to convert the raw materials into inventory, which then is converted into accounts receivable and eventually back to cash, completing the cycle. The goal is to have more cash at the end of the cycle than at the beginning.

The change in cash is different from accounting profits. A company can report consistent profits but still become insolvent. For example, if the firm extends customers increasingly longer periods of time to settle their accounts, even though the reported earnings do not change, the cash flow will decrease. As another example, take the case of a firm that produces more product than it sells, a situation that results in the accumulation of inventory. In such a situation, the inventory will appear as an asset on the balance sheet, but does not result in profit or loss. Even though the inventory was not sold, cash nonetheless was consumed in producing it.

Note also the distinction between cash and equity. Shareholders’ equity is the sum of common stock at par value, additional paid-in capital, and retained earnings. Some people have been known to picture retained earnings as money sitting in a shoe box or bank account. But shareholders’ equity is on the opposite side of the balance sheet from cash. In fact, retained earnings represent shareholders’ claims on the assets of the firm, and do not represent cash that can be used if the cash balance gets too low. In this regard, one can say that retained earnings represent cash that already has been spent.

Shareholder equity changes due to three things:

• net income or losses
• payment of dividends
• share issuance or repurchase.

Changes in cash are reported by the cash flow statement, which organizes the sources and uses of cash into three categories: operating activities, investing activities, and financing activities.

Cash Cycle

The duration of the cash cycle is the time between the date the inventory (or raw materials) is paid for and the date the cash is collected from the sale of the inventory. A company’s cash cycle is important because it affects the need for financing. The cash cycle is calculated as:

days in inventory + days in receivables – days in payables

Financing requirements will increase if either of the following occurs:

• Sales increase while the cash cycle remains fixed in duration. Increased sales increase the value of assets in the cycle.
• Sales remain flat but the cash cycle increases in duration.

While financially it makes sense to reduce the length of the cash cycle, such a reduction should not be done without considering the impact on operations. For example, one must consider the impact on customer and supplier relations as well as the impact on order fill rates.

Revenue, Expenses, and Inventory

A firm’s income is calculated by subtracting its expenses from its revenue. However, not all costs are considered expenses; accounting standards and tax laws prohibit the expensing of costs incurred in the production of inventory. Rather, these costs must be allocated to inventory accounts and appear as assets on the balance sheet. Once the finished goods are drawn from inventory and sold, these costs are reported on the income statement as the cost of goods sold (COGS). If one wishes to know how much product the firm actually produced, the cost of goods produced in an accounting period is determined by adding the change in inventory to the COGS.

Assets

Assets can be classified as current assets and long-term assets. It is useful to know the number of days of certain assets and liabilities that a firm has on hand. These numbers are easily calculated from the financial statements as follows:

Accounts Receivable (A/R)

Number of days of A/R = ( accounts receivable / annual credit sales ) ( 365 ).
This also is known as the collection period.

Inventory

Number of days of inventory = ( inventory / annual COGS ) ( 365 ).
This also is known as the inventory period.

On the liabilities side:

Payables

Number of days of accounts payable = ( accounts payable / COGS ) ( 365 ), assuming that all accounts payable are for the production of goods. This also is known as the payables period.

Financial Ratios

A firm’s performance can be evaluated using various financial ratios. Ratios are used to measure leverage, margins, turnover rates, return on assets, return on equity, and liquidity. Additional insight can be gained by comparing ratios among firms in the industry.

Bank Loans

Bank loans can be classified according to their durations. There are short-term loans (one year or less), long-term loans (also known as term loans), and revolving loans that allow one to borrow up to a specified credit level at any time over the duration of the loan. Some revolving loans automatically renew at maturity; these loans are said to be “evergreen.”

Sources and Uses of Cash

It can be worthwhile to know where a firm’s cash is originating and how it is being used. There are two sources of cash: reducing assets or increasing liabilities or equity. Similarly, a company uses cash either by increasing assets or decreasing liabilities or equity.

Sustainable Growth

A company’s sustainable growth rate is calculated by multiplying the ROE by the earnings retention rate.

Firm Value, Equity Value, and Debt Value

The value of the firm is the value of its assets, or rather, the present value of the unlevered free cash flow resulting from the use of those assets. In the case of an all-equity financed firm, the equity value is equal to the firm value. When the firm has issued debt, the debt holders have a priority claim on their interest and principal, and the equity holders have a residual claim on what remains after the debt obligations are met. The sum of the value of the debt and the value of the equity then is equal to the value of the firm, ignoring the tax benefits from the interest paid on the debt. Considering taxes, the effective value of the firm will be higher since a levered firm has a tax benefit from the interest paid on the debt. If there is outstanding preferred stock, the firm value is the sum of the equity value, debt value, and preferred stock value, plus the value of the interest tax shield.

The debt holders and stock holders each have a claim on the cash flows of the firm. In a given time period, the debt holders have a claim equal to the interest payments during that period plus any principal payments that are due. The stock holders then have a claim equal to the unlevered free cash flow in that period plus the cash generated by the interest tax shield, minus the claims of the debt holders.

Capital Structure

The proportion of a firm’s capital structure supplied by debt and by equity is reported as either the debt to equity ratio (D/E) or as the debt to value ratio (D/V), the latter of which is equal to the debt divided by the sum of the debt and the equity.

One can quickly convert between the D/E ratio and the D/V ratio by using the following relationships:

D / V = ( D / E ) / ( 1 + D / E )

D / E = ( D / V ) / ( 1 – D / V )

Optimal Capital Structure

The total value of a firm is the sum of the value of its equity and the value of its debt. The optimal capital structure is the amount of debt and equity that maximizes the value of the firm.

Share Buyback

If a firm has extra cash on hand it may choose to buy back some of its outstanding shares. One interesting aspect of such transactions is that they can be based on information that the firm has that the market does not have. Therefore, a share buyback could serve as a signal that the share price has potential to rise at above average rates.

Mergers and Acquisitions

Companies may combine for direct financial reasons or for non-financial ones such as expanding a product line. The target firm usually is acquired at a premium to its market value, with the hope that synergies from the merger will exceed the price premium. Mergers and acquisitions do not always achieve their goals, as promised syngeries may fail to materialize.