Principles of Finance/History
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Introduction to Finance
Finance is a field of study of the relationship of three things; time, risk and money.
The Time Value of Money is one of three fundamental ideas that shape finance.
The Time Value of Money explains why, "A dollar today is worth more than a dollar tomorrow". This is primarily due to the market for loanable funds and inflation. If someone has a dollar today then they also have the opportunity to loan/invest that dollar at some interest rate. Therefore, a dollar today in time t, would be worth $1.00 plus some interest rate, i. That is more than a dollar by itself in the future. An example for inflation would be, let's say you have $1 and you can buy 10 candies today. For the same 10 candies tomorrow you have to pay $1.20. So, due to inflation for the same 10 candies today you pay less than you would pay tomorrow
Inflation refers to the decrease in the purchasing power. Deflation refers to the increase in the purchasing power. In layman terms, inflation causes not the value of money to decrease but the amount of consumables/items that you can now purchase to decline in quantity. Look at the example above. $1 is still $1 but after inflation the individual can probably buy only 8 candies for the same $1 amount.
There are two values of money. One is the Present Value of Money and the other is the Future Value of Money.
Second is the concept of "opportunity cost"; i.e. if a person deploys his money on one item or investment then he has given up the opportunity to do something else with it.
Third is the concept of risk. Let us say, I have earmarked $10,000 towards investments and I decide that I will invest in Microsoft. I put all my money in Microsoft(MSFT) all $10,000 of it. As on 5th Oct., 2006 each share of Microsoft trades at $27.94. So, I would be able to purchase 357.91 shares of MSFT. My returns are completely dependent on how MSFT stock performs in the market and this means that if a Microsoft product(i.e. Vista), fails in the marketplace, MSFT stock goes tumbling down and reduces my investment in MSFT.
Thus, Risk can be defined as the probability of my investment eroding its own self.
In equity, the risk factor is higher than in debt financing and hence as an investor I look for equity to give me higher returns as I have taken higher risk. If I buy US Treasury notes for that value, the investment is almost risk free as the US Govt. stands to guarantee it and hence the return (typically, expressed as the rate of interest) is low. The difference between the returns from equity and from debt(US Treasury, etc) is the Risk Premium.
Risk Premium is the reward given to an investor to take more risk.
Return on Investments
The concept of a return on investment is designed to balance all three perils. In finance there are actually two returns: the return of investment and the return on investment. If the investment loses money, you may be able to recover a portion of what you risked. A return on investment (hereafter "ROI", or "return") is the return that finance is primarily concerned with although the other cannot be overlooked. It implies first and foremost a 100% return of investment. In order to do so, the return must therefore
- replace the buying power lost to inflation,
- make up for and exceed the losses from other financing activities, and
- make the investment more attractive to someone than any other option, including spending the money.
Item 3 can be as objective as selecting the best ROI among many or it can be as subjective and personal as whether or not to give up the satisfaction of having dessert every night for a month. Regardless if the investor does not perceive sufficient potential for gain, the money will never change hands.
Debt Finance and Equity Finance - The Two Pillars of Modern Finance
Financing activity for most ventures are either debt financing or equity financing.
Once an investor has decided to engage in financing any business venture or project, he has three concerns to address: risk, protective claim, and return.
These three concerns are essentially hierarchical. The latter two depend on and counterbalance with the first. Higher risk is only attractive when associated with higher returns. The protective claim then acts like a fulcrum to fine tune the balance between risk and return.
Debt financing. In this mode money is borrowed, and usually the borrower (debtor) gives the lender (creditor) a promisory note. This, usually, obligated the debtor to pay back a certain defined amount at a particular and defined time in the future.
Forms of debt financing can include credit cards, mortgages, signature loans, bonds, IOUs, and HELOCs (Home Equity Lines of Credit) as examples. Treasury debt, savings bonds, corporate bonds are also forms of debt financing.
With debt financing, the creditor's return is fixed and understandable. It is, quite simply, the agreed upon interest rate for the debt. This rate can vary from a single digit rate to 25% or perhaps even 30% depending on the debtor. Risk is determined by a handful of factors the most significant usually being one's credit history. The protective claim offered to creditors in debt financing is a claim on the debtor's assets. Should the debtor fail to repay, the creditor may forcibly take possession of other debtor property and sell it, using the money to offset the loss of the loan. The claim of creditors takes priority over the claim of those who participate in equity financing.
Equity financing is generally considered less certain than debt financing. Equity financing is also typically where non-cash assets such as equipment, skills, and land are invested alongside regular cash. This is the category in which we also find venture capital, shares of stock, angel investors, and more. The terms that are used to describe the equity financing relationship are more varied and, as such, will be simply dubbed equity investors. Later on, more proper names will be provided which, for the time being, are immaterial.
The return of equity financing is the claim on a business's profits; not just today's profits, but in modern companies that issue stock, all future potential profits as well. For this reason, i.e. because most personal finance does not involve the debtor making a profit, almost all of personal finance is debt financing. The exceptions will be noted shortly.
While it's true that in equity financing, the equity investor still has some claim on the business' assets, the creditor's prior claim renders this point moot from a practical standpoint. What protection, then, is offered for equity financing? The claim to management rights. As an equity investor, with a few notable exceptions, you are granted the right to do everything in your personal power along with the other equity investors to make sure that the business goes in a profitable direction.
Ratio analysis is one core theme of business finance. To understand the concept of ratio analysis we must know that there are five basic types of ratio analysis.
- Liquidity Ratio
- Activity Ratio
- Debt Ratio
- Profitability Ratio
- Markets Ratio.
Now we discuss one by one the impacts of these ratios on the business and their implementation in the business environment.
In liquidity ratio analysis there are two types of ratios:
- Current Ratio
- Quick (Acid-Test) Ratio.
Current Ratio shows how many $1 of current assets are available for paying $1 of current liabilities of the company, firm or organization. As some financial analysts suggests that the more current assets that are available to the company, the better. But in some cases, a high current ratio may indicate too much inventory or too much in prepaid or other current assets. It could also indicate idle cash, and as a result, a poor investment strategy. A current ratio that is high is not as bad as one that is low, however a high current ratio is an indication that financial policies either do not exist or are not being implemented. A low or declining current ratio is always bad. It is an indicator of rising current liabilities and declining current assets. A current ratio of 1 or less is an indication of insolvency. Further declines in the ratio could trigger collection actions on the part of creditors and send the company into bankruptcy.
Quick (Acid-Test) Ratio
The quick ratio is calculated by dividing cash by current liabilities. This is the true test of a companies ability to pay its debts. A high current ratio and a low quick ratio could indicate too much is invested in inventory or other current assets, assets that are not very liquid and therefore could not be depended on to pay current liabilities. An increase in inventory could be a signal that sales have fallen, production has slowed and management should take action to prevent any damage to the financial condition of the company. Both ratios should be analyzed together to get the correct picture of the companies financial health.