BASIC FINANCE

Understanding Finance.
What is Finance?
Finance is defined as the management of money and includes activities such as investing, borrowing,
lending, budgeting, saving, and forecasting. There are three main types of finance: (1) personal, (2)
corporate, and (3) public/government.

Lesson 2 . Types of Finance

Types of Finance

Finance is majorly divided into three segments:

● Personal Finance
● Corporate Finance
● Public Finance.

What is Personal Finance?

Personal Finance

- is managing the finance or funds of an individual and helping them achieve the desired goals
in terms of savings and investments.
- Personal Finance is specific to individuals and the strategies depend on the individuals
earning potential, requirements, goals, time frame, etc.
- Personal finance includes investment in education, assets like real estate, cars, life insurance
policies, medical and other insurance, saving and expense management.

Personal Finance includes:

● Protection against unforeseen and uncertain personal events

● Transfer of wealth across generations of the family
● Managing taxes and complying with tax policies (tax subsidies or penalties)
● Preparing for retirement
● Preparing for long term expenses or purchases involving a huge amount
● Paying for a loan or debt obligations
● Investment and wealth accumulation goals

What is Corporate Finance?

Corporate Finance

- is about funding the company expenses and building the capital structure of the company. It
deals with the source of funds and the channelization of those funds like the allocation of
funds for resources and increasing the value of the company by improving the financial
position.
- Corporate finance focuses on maintaining a balance between the risk and opportunities and
increasing the asset value.
Corporate Finance Includes:

● Capital budgeting
● Employing standard business valuation techniques or real options valuation
● Identifying the source of funding in the form of equity, shareholders’ funds, creditors, debts
● Determining the utility of unappropriated profits for future investment, operational utilization,
or distribution to the shareholders
● Acquisition and investment in stock or other assets
● Identifying relevant objectives, opportunities, and constraints
● Risk management and tax considerations
● Stock issuance while going public and listing on the Stock exchange

What is Public Finance?

- This type of finance is related to states, municipalities, provinces in short government
required finances.
- It includes long term investment decisions related to public entities. Public finance takes
factors like distribution of income, resource allocation, economic stability in consideration.
- Funds are obtained majorly from taxes, borrowing from banks or insurance companies.

Public Finance includes:

● Identifying the expenditure required by the public entity

● The sources of revenue for the public entity
● Determining the budgeting process and source of funds
● Issuing debts for public projects
● Tax management

The other two famous terms in Finance are the Microfinance and Trade Finance

What Is Microfinance?
Microfinance

- is also known as microcredit. This type of finance is specifically designed for individuals
who do not have easy access to financial services.
- These individuals include unemployed and lower-income group individuals.
- Banks may even offer additional services like saving accounts, microinsurance, and trainings.
- The main motive behind providing microfinance is to provide an opportunity for these
individuals to become self-reliant.
- Lenders often grant loans after pooling borrowers to ensure better repayment probability. The
repayment amount on such microloans is higher than that of conventional financing due to the
risk involved.

Microfinance includes:

● Bank checking and savings account

● Educational programs on the principles of investing
 ● Training on skills like accounting and bookkeeping including cash flow management, profit
and loss statements, etc.
● Basic money management training
● Lessons on financial terms and concepts like interest rate, cash flow, budget, debt, etc.

What is Trade Finance?

Trade Finance

- includes financial services and instruments that enable and facilitate trade internationally.
- Trade finance is ideal for importers and exporters to carry on smooth international
transactions by reducing risk in global trade.
- Trade finance can help reduce the risk associated with global trade by reconciling the
divergent needs of an exporter and importer.

- Unlike conventional finance, trade finance is used to protect the two parties from the various
risks involved in international trade and does not mean that the parties lack funds or liquidity.
The risks involved in international trade are currency fluctuations, non-payment by the party,
political instability, creditworthiness of the parties, etc.
- Trade finance involves a third party for conducting a transaction thus eliminating the risk of
supply and payment.
- In trade finance, the exporter is provided with the payment as per the agreement and the
importer can avail of a credit facility to fulfill the trade order.
Apart from protecting against the risks, non-payment, and non-receipt of goods, trade finance
also improves the efficiency and revenue.

- It enables the company to receive a cash payment based on the accounts receivables as the
buyer’s bank guarantees payment. This also ensures timely payments and assured shipment of
goods. The different parties involved in trade finance are importer, exporter, banks, insurers,
credit agencies, trade finance companies.

Lesson 3. Importance of Finance & Its Role Within Business

Finance

- is the elixir that assists in the formation of new businesses, and allows businesses to take
advantage of opportunities to grow, employ local workers and in turn support other businesses
and local, state and federal government through the remittance of income taxes.
- The strategic use of financial instruments, such as loans and investments, is key to the success
of every business. Financial trends also define the state of the economy on a global level, so
central banks can plan appropriate monetary policies.

Functions in Finance
- Finance is the process of creating, moving and using money, enabling the flow of money
through a company in much the same way it facilitates global money flow.
 - Money is created by the sales force when they sell the goods or services the company
produces; it then flows into production where it is spent to manufacture more products to sell.
What remains is used to pay salaries and fund the administrative expenses of the company.

Benefits of Finance
- The flow of finance starts on Wall Street with the creation of capital used to fund business
through the issuance of common stock to provide capital, bonds to lend capital and
derivatives (packaged groups of securities that help to hedge against financial risk and replace
the money banks lend out to borrowers).
- Public companies and municipalities use this capital to help fund their operations, and banks
use it to lend to companies, municipalities and individuals to finance the purchase of goods
and services.

Significance of Finance
- When some element of the finance process breaks down companies go out of business and the
economy moves into recession. For example, if a major bank loses a significant amount of
money and faces the risk of insolvency, other banks and corporate customers will stop lending
or depositing money to the problem bank.
- It will then stop lending to its customers and they will not be able to purchase the goods or
pay the bills for which they were seeking funding.
- The flow of money throughout the financial system slows down or stops as a result.
- All facets of the global economy depend upon an orderly process of finance. Capital markets
provide the money to support business, and business provides the money to support
individuals.
- Income taxes support federal, state and local governments. Even the arts benefit from the
financial process because they draw their money from corporate sponsors and individual
patrons.
- Capital markets create money, businesses distribute it, and individuals and institutions spend
it.

Income and Expenses

Where Does Income Come From?
Income[1] is what is earned or received in a given period. There are various terms for income because
there are various ways of earning income. Income from employment or self-employment is wages or
salary. Deposit accounts, like savings accounts, earn interest, which could also come from lending.
Owning stock entitles the shareholder to a dividend, if there is one. Owning a piece of a partnership or
a privately held corporation entitles one to a draw.

The two fundamental ways of earning income in a market-based economy are by selling labor or
selling capital. Selling labor means working, either for someone else or for yourself. Income comes in
the form of a paycheck. Total compensation may include other benefits, such as retirement
contributions, health insurance, or life insurance. Labor is sold in the labor market.

Selling capital means investing: taking excess cash and selling it or renting it to someone who needs
liquidity[2] (access to cash). Lending is renting out capital; the interest is the rent. You can lend
privately by direct arrangement with a borrower, or you can lend through a public debt exchange by
buying corporate, government, or government agency bonds. Investing in or buying corporate stock is
an example of selling capital in exchange for a share of the company’s future value.

You can invest in many other kinds of assets, like antiques, art, coins, land, or commodities such as
soybeans, live cattle, platinum, or light crude oil. The principle is the same: investing is renting capital
or selling it for an asset that can be resold later, or that can create future income, or both. Capital is
sold in the capital market and lent in the credit market—a specific part of the capital market (just like
the dairy section is a specific part of the supermarket).

In the labor market, the price of labor is the wage that an employer (buyer of labor) is willing to pay to
the employee (seller of labor). For any given job, that price is determined by many factors. The nature
of the work defines the education and skills required, and the price may reflect other factors as well,
such as the status or desirability of the job.

In turn, the skills needed and the attractiveness of the work determine the supply of labor for that
particular job—the number of people who could and would want to do the job. If the supply of labor
is greater than the demand, if there are more people to work at a job than are needed, then employers
will have more hiring choices. That labor market is a buyers’ market, and the buyers can hire labor at
lower prices. If there are fewer people willing and able to do a job than there are jobs, then that labor
market is a sellers’ market, and workers can sell their labor at higher prices.

Similarly, the fewer skills required for the job, the more people there will be who are able to do it,
creating a buyers’ market. The more skills required for a job, the fewer people there will be to do it,
and the more leverage or advantage the seller has in negotiating a price. People pursue education to
make themselves more highly skilled and therefore able to compete in a sellers’ labor market.

When you are starting your career, you are usually in a buyers’ market (unless you have some unusual
gift or talent), if only because of your lack of experience. As your career progresses, you have more,
and perhaps more varied, experience and presumably more skills, and so can sell your labor in more
of a sellers’ market. You may change careers or jobs more than once, but you would hope to be doing
so to your advantage, that is, always to be gaining bargaining power in the labor market.

Many people love their work for many reasons other than the pay, however, and choose it for those
rewards. Labor is more than a source of income; it is also a source of many intellectual, social, and
other personal gratifications. Your labor nevertheless is also a tradable commodity and has a market
value. The personal rewards of your work may ultimately determine your choices, but you should be
aware of the market value of those choices as you make them.

Your ability to sell labor and earn income reflects your situation in your labor market. Earlier in your
career, you can expect to earn less than you will as your career progresses. Most people would like to
reach a point where they don’t have to sell labor at all. They hope to retire someday and pursue other
hobbies or interests. They can retire if they have alternative sources of income—if they can earn
income from savings and from selling capital.

Capital markets exist so that buyers can buy capital. Businesses always need capital and have limited
ways of raising it. Sellers and lenders (investors), on the other hand, have many more choices of how
to invest their excess cash in the capital and credit markets, so those markets are much more like
sellers’ markets. The following are examples of ways to invest in the capital and credit markets:
 ● Buying stocks
● Buying government or corporate bonds
● Lending a mortgage

The market for any particular investment or asset may be a sellers’ or buyers’ market at any particular
time, depending on economic conditions. For example, the market for real estate, modern art, sports
memorabilia, or vintage cars can be a buyers’ market if there are more sellers than buyers. Typically,
however, there is as much or more demand for capital as there is supply. The more capital you have to
sell, the more ways you can sell it to more kinds of buyers, and the more those buyers may be willing
to pay. At first, however, for most people, selling labor is their only practical source of income.

Where Does Income Go?

Expenses[3] are costs for items or resources that are used up or consumed in the course of daily
living. Expenses recur (i.e., they happen over and over again) because food, housing, clothing, energy,
and so on are used up on a daily basis.

When income is less than expenses, you have a budget deficit[4]—too little cash to provide for your
wants or needs. A budget deficit is not sustainable; it is not financially viable. The only choices are to
eliminate the deficit by (1) increasing income, (2) reducing expenses, or (3) borrowing to make up the
difference. Borrowing may seem like the easiest and quickest solution, but borrowing also increases
expenses, because it creates an additional expense: interest. Unless income can also be increased,
borrowing to cover a deficit will only increase it.

When income for a period is greater than expenses, there is a budget surplus[5]. That situation is
sustainable and remains financially viable. You could choose to decrease income by, say, working
less. More likely, you would use the surplus in one of two ways: consume more or save it. If
consumed, the income is gone, although presumably you enjoyed it.

If saved, however, the income can be stored, perhaps in a piggy bank or cookie jar, and used later. A
more profitable way to save is to invest it in some way—deposit in a bank account, lend it with
interest, or trade it for an asset, such as a stock or a bond or real estate. Those ways of saving are ways
of selling your excess capital in the capital markets to increase your wealth. The following are
examples of savings:

1. Depositing into a statement savings account at a bank

2. Contributing to a retirement account
3. Purchasing a certificate of deposit (CD)
4. Purchasing a government savings bond
5. Depositing into a money market account

Opportunity Costs and Sunk Costs

There are two other important kinds of costs aside from expenses that affect your financial life.
Suppose you can afford a new jacket or new boots, but not both, because your resources—the income
you can use to buy clothing—are limited. If you buy the jacket, you cannot also buy the boots. Not
getting the boots is an opportunity cost[6] of buying the jacket; it is cost of sacrificing your next best
choice.
In personal finance, there is always an opportunity cost. You always want to make a choice that will
create more value than cost, and so you always want the opportunity cost to be less than the benefit
from trade. You bought the jacket instead of the boots because you decided that having the jacket
would bring more benefit than the cost of not having the boots. You believed your benefit would be
greater than your opportunity cost.

In personal finance, opportunity costs affect not only consumption decisions but also financing
decisions, such as whether to borrow or to pay cash. Borrowing has obvious costs, whereas paying
with your own cash or savings seems costless. Using your cash does have an opportunity cost,
however. You lose whatever interest you may have had on your savings, and you lose liquidity—that
is, if you need cash for something else, like a better choice or an emergency, you no longer have it and
may even have to borrow it at a higher cost.

When buyers and sellers make choices, they weigh opportunity costs, and sometimes regret them,
especially when the benefits from trade are disappointing. Regret can color future choices. Sometimes
regret can keep us from recognizing sunk costs[7].

Sunk costs are costs that have already been spent; that is, whatever resources you traded are gone, and
there is no way to recover them. Decisions, by definition, can be made only about the future, not about
the past. A trade, when it’s over, is over and done, so recognizing that sunk costs are truly sunk can
help you make better decisions.

For example, the money you spent on your jacket is a sunk cost. If it snows next week and you decide
you really do need boots, too, that money is gone, and you cannot use it to buy boots. If you really
want the boots, you will have to find another way to pay for them.

Unlike a price tag, opportunity cost is not obvious. You tend to focus on what you are getting in the
trade, not on what you are not getting. This tendency is a cheerful aspect of human nature, but it can
be a weakness in the kind of strategic decision making that is so essential in financial planning.
Human nature also may make you focus too much on sunk costs, but all the relish or regret in the
world cannot change past decisions. Learning to recognize sunk costs is important in making good
financial decisions.

Assets
As defined earlier in this chapter, an asset is any item with economic value that can be converted to
cash. Assets are resources that can be used to create income or reduce expenses and to store value.
The following are examples of tangible (material) assets:

● Car
● Savings account
● Wind-up toy collection
● Money market account
● Shares of stock
● Forty acres of farmland
● Home

When you sell excess capital in the capital markets in exchange for an asset, it is a way of storing
wealth, and hopefully of generating income as well. The asset is your investment—a use of your
liquidity. Some assets are more liquid than others. For example, you can probably sell your car more
quickly than you can sell your house. As an investor, you assume that when you want your liquidity
back, you can sell the asset. This assumes that it has some liquidity and market value (some use and
value to someone else) and that it trades in a reasonably efficient market. Otherwise, the asset is not
an investment, but merely a possession, which may bring great happiness but will not serve as a store
of wealth.

Assets may be used to store wealth, create income, and reduce future expenses.

Assets Store Wealth

If the asset is worth more when it is resold than it was when it was bought, then you have earned a
capital gain[1]: the investment has not only stored wealth but also increased it. Of course, things can
go the other way too: the investment can decrease in value while owned and be worth less when
resold than it was when bought. In that case, you have a capital loss[2]. The investment not only did
not store wealth, it lost some.

The better investment asset is the one that increases in value—creates a capital gain—during the time
you are storing it.

Assets Create Income

Some assets not only store wealth but also create income. An investment in an apartment house stores
wealth and creates rental income, for example. An investment in a share of stock stores wealth and
also perhaps creates dividend income. A deposit in a savings account stores wealth and creates interest
income.

Some investors care more about increasing asset value than about income. For example, an investment
in a share of corporate stock may produce a dividend, which is a share of the corporation’s profit, or
the company may keep all its profit rather than pay dividends to shareholders. Reinvesting that profit
in the company may help the company to increase in value. If the company increases in value, the
stock increases in value, increasing investors’ wealth. Further, increases in wealth through capital
gains are taxed differently than income, making capital gains more valuable than an increase in
income for some investors.

On the other hand, other investors care more about receiving income from their investments. For
example, retirees who no longer have employment income may be relying on investments to provide
income for living expenses. Being older and having a shorter horizon, retirees may be less concerned
with growing wealth than with creating income.

Assets Reduce Expenses

Some assets are used to reduce living expenses. Purchasing an asset and using it may be cheaper than
arranging for an alternative. For example, buying a car to drive to work may be cheaper, in the long
run, than renting one or using public transportation. The car typically will not increase in value, so it
cannot be expected to be a store of wealth; its only role is to reduce future expenses.

Sometimes an asset may be expected to both store wealth and reduce future expenses. For example,
buying a house to live in may be cheaper, in the long run, than renting one. In addition, real estate
may appreciate in value, allowing you to realize a gain when you sell the asset. In this case, the house
has effectively stored wealth. Appreciation in value depends on the real estate market and demand for
housing when the asset is sold, however, so you cannot count on it. Still, a house usually can reduce
living expenses and be a potential store of wealth.

The choice of investment asset, then, depends on your belief in its ability to store and increase wealth,
create income, or reduce expenses. Ideally, your assets will store and increase wealth while increasing
income or reducing expenses. Otherwise, acquiring the asset will not be a productive use of liquidity.
Also, in that case the opportunity cost will be greater than the benefit from the investment, since there
are many assets to choose from.

Debt and Equity

Buying capital, that is, borrowing enables you to invest without first owning capital. By using other
people’s money to finance the investment, you get to use an asset before actually owning it, free and
clear, assuming you can repay out of future earnings.

Borrowing capital has costs, however, so the asset will have to increase wealth, increase earnings, or
decrease expenses enough to compensate for its costs. In other words, the asset will have to be more
productive to earn enough to cover its financing costs—the cost of buying or borrowing capital to buy
the asset.

Buying capital gives you equity, borrowing capital gives you debt, and both kinds of financing have
costs and benefits. When you buy or borrow liquidity or cash, you become a buyer in the capital
market.

The Costs of Debt and Equity

You can buy capital from other investors in exchange for an ownership share or equity[1], which
represents your claim on any future gains or future income. If the asset is productive in storing wealth,
generating income, or reducing expenses, the equity holder or shareholder or owner enjoys that
benefit in proportion to the share of the asset owned. If the asset actually loses value, the owner bears
a portion of the loss in proportion to the share of the asset owned. The cost of equity[2] is in having to
share the benefits from the investment.

For example, in 2004 Google, a company that produced a very successful Internet search engine,
decided to buy capital by selling shares of the company (shares of stock or equity securities) in
exchange for cash. Google sold over 19 million shares for a total of $1.67 billion. Those who bought
the shares were then owners or shareholders of Google, Inc. Each shareholder has equity in Google,
and as long as they own the shares they will share in the profits and value of Google, Inc. The original
founders and owners of Google, Larry Page and Sergey Brin, have since had to share their company’s
gains (or income) or losses with all those shareholders. In this case, the cost of equity is the minimum
rate of return Google must offer its shareholders to compensate them for waiting for their returns and
for bearing some risk[3] that the company might not do as well in the future.

Borrowing is renting someone else’s money for a period of time, and the result is debt[4] During that
period of time, rent or interest[5] must be paid, which is a cost of debt[6]. When that period of time
expires, all the capital (the principal[7] amount borrowed) must be given back. The investment’s
earnings must be enough to cover the interest, and its growth in value must be enough to return the
principal. Thus, debt is a liability, an obligation for which the borrower is liable.
In contrast, the cost of equity may need to be paid only if there is an increase in income or wealth, and
even then can be deferred. So, from the buyer’s point of view, purchasing liquidity by borrowing
(debt) has a more immediate effect on income and expenses. Interest must be added as an expense,
and repayment must be anticipated.

The Uses of Debt and Equity

Debt is a way to make an investment that could not otherwise be made, to buy an asset (e.g., house,
car, corporate stock) that you couldn’t buy without borrowing. If that asset is expected to provide
enough benefit (i.e., increase value or create income or reduce expense) to compensate for its
additional costs, then the debt is worth it. However, if debt creates additional expense without enough
additional benefit, then it is not worth it. The trouble is, while the costs are usually known up front,
the benefits are not. That adds a dimension of risk to debt, which is another factor in assessing
whether it’s desirable.

For example, after the housing boom began to go bust in 2008, homeowners began losing value in
their homes as housing prices dropped. Some homeowners are in the unfortunate position of owing
more on their mortgage than their house is currently worth. The costs of their debt were knowable
upfront, but the consequences—the house losing value and becoming worth less than the debt—were
not.

Debt may also be used to cover a budget deficit, or the excess of expenses over income. As mentioned
previously, however, in the long run the cost of the debt will increase expenses that are already too
big, which is what created the deficit in the first place. Unless income can also be increased, debt can
only aggravate a deficit.

The Value of Debt

The value of debt includes the benefits of having the asset sooner rather than later, something that
debt financing enables. For example, many people want to buy a house when they have children,
perhaps because they want bedrooms and bathrooms and maybe a yard for their children. Not far into
adulthood, would-be homebuyers may not have had enough time to save enough to buy the house
outright, so they borrow to make up the difference. Over the length of their mortgage (real estate
loan), they pay the interest.

The alternative would be to rent a living space. If the rent on a comparable home were more than the
mortgage interest (which it often is, because a landlord usually wants the rent to cover the mortgage
and create a profit), it would make more sense, if possible, to borrow and buy a home and be able to
live in it. And, extra bedrooms and bathrooms and a yard are valuable while children are young and
live at home. If you wait until you have saved enough to buy a home, you may be much older, and
your children may be off on their own.

Another example of the value of debt is using debt to finance an education. Education is valuable
because it has many benefits that can be enjoyed over a lifetime. One benefit is an increase in
potential earnings in wages and salaries. Demand for the educated or more skilled employee is
generally greater than for the uneducated or less-skilled employee. So education creates a more
valuable and thus higher-priced employee.

It makes sense to be able to maximize value by becoming educated as soon as possible so that you
have as long as possible to benefit from increased income. It even makes sense to invest in an
education before you sell your labor because your opportunity cost of going to school—in this case,
the “lost” wages of not working—is lowest. Without income or savings (or very little) to finance your
education, typically, you borrow. Debt enables you to use the value of the education to enhance your
income, out of which you can pay back the debt.

The alternative would be to work and save and then get an education, but you would be earning
income less efficiently until you completed your education, and then you would have less time to earn
your return. Waiting decreases the value of your education, that is, its usefulness, over your lifetime.

Income and Risk

Personal finance is not just about getting what you want; it is also about protecting what you have.
Since the way to accumulate assets is to create surplus capital by having an income larger than
expenses, and since you rely on income to provide for living expenses, you also need to think about
protecting your income. One way to do so is through diversification[1], or spreading the risk.

You already know not to put all your eggs in one basket, because if something happens to that basket,
all the eggs are gone. If the eggs are in many baskets, on the other hand, the loss of any one basket
would mean the loss of just a fraction of the eggs. The more baskets, the smaller your proportional
loss would be. Then if you put many different baskets in many different places, your eggs are
diversified even more effectively, because all the baskets aren’t exposed to the same environmental or
systematic risks.

Diversification is more often discussed in terms of investment decisions, but diversification of sources
of income works the same way and makes the same kind of sense for the same reasons. If sources of
income are diverse—in number and kind—and one source of income ceases to be productive, then
you still have others to rely on.

If you sell your labor to only one buyer, then you are exposed to more risk than if you can generate
income by selling your labor to more than one buyer. You have only so much time you can devote to
working, however. Having more than one employer could be exhausting and perhaps impossible.
Selling your labor to more than one buyer also means that you are still dependent on the labor market,
which could suffer from an economic cycle such as a recession affecting many buyers (employers).

Mark, for example, works as a school counselor, tutors on the side, paints houses in the summers, and
buys and sells sports memorabilia on the Internet. If he got laid off from his counseling job, he would
lose his paycheck but still be able to create income by tutoring, painting, and trading memorabilia.

Similarly, if you sell your capital to only one buyer—invest in only one asset—then you are exposed
to more risk than if you generate income by investing in a variety of assets. Diversifying investments
means you are dependent on trade in the capital markets, however, which likewise could suffer from
unfavorable economic conditions.

Mark has a checking account, an online money market account, and a balanced portfolio of stocks. If
his stock portfolio lost value, he would still have the value in his money market account.

A better way to diversify sources of income is to sell both labor and capital. Then you are trading in
different markets, and are not totally exposed to risks in either one. In Mark’s case, if all his incomes
dried up, he would still have his investments, and if all his investments lost value, he would still have
his paycheck and other incomes. To diversify to that extent, you need surplus capital to trade. This
brings us full circle to Adam Smith, quoted at the beginning of this chapter, who said, essentially, “It
takes money to make money.”