Finance: The Basics

Erik Banks

• Publisher: Routledge
• Year: 2015
• ISBN:
  9781317418849
• Edition: 3
• Topic: Business
• Subtopic: Finance
• Index: Business

Now in its third edition, Finance: The Basics is a clear and practical introduction to the world of finance. It thoroughly explains essential financial statements, tools and concepts; fundamental financial instruments and transactions; and global financial participants, markets and systems. This fully revised third edition captures the most important aspects of a changing financial landscape, including:

• Updates on key areas of the financial system, including default experience, corporate finance trends, growth in dark pools, hedge funds, foreign exchange and derivatives, and changes to the international regulatory and central banking framework.

• Further real-world examples/studies that introduce, or expand upon, a range of practical topics; 12 updated studies are supplemented by new cases related to reinsurance, central bank quantitative easing and digital currency and payments.

• A comprehensive glossary containing key terms discussed in the book.

Each chapter is accompanied by an overview and summary, illustrations and tables, real life case studies, and recommended readings. Finance: The Basics is essential reading for anyone interested in the fascinating world of finance.

Part 1 Concepts and Tools

The World of Finance

DOI: 10.4324/9781315687674-1

Chapter Overview

In this chapter we will consider the basic definitions and concepts of the financial world, the meaning and scope of finance, and how it impacts daily activities. We will then consider the goals of finance, which center on how a firm maximizes value, ensures proper liquidity and solvency, and manages risks. With this background in hand we will then discuss the financial process, a cycle based on financial reporting, planning, and decision-making, and consider how market factors can impact the cycle. We will conclude with a brief overview of the book, describing in general terms the concepts/tools, instruments/transactions, and markets/participants discussed in subsequent chapters.

Definition and Scope of Finance

Finance is the study of concepts, applications, and systems that affect the value (or wealth) of individuals, companies, and countries over the short and long term. The study is both qualitative and quantitative, and we shall consider both dimensions in this book. Once we understand the essential elements of finance, we can identify the motivations and goals that drive specific actions and decisions.

Finance affects the daily activities of people, organizations, and entire nations. Though financial dealings have existed for centuries, their presence and importance have become even more apparent in an era characterized by growing wealth accumulation, consumption, and investment. Indeed, the penetration of finance is so thorough that we needn’t look far to see its impact: consider that on any given day many of us are likely to be aware of economic growth, unemployment and inflation estimates, stock prices and deposit quotes, oil and gold price trends, credit and mortgage loan offers, corporate earnings announcements, and takeovers and bankruptcies. A financial transaction occurs every time we place savings into a deposit account or the stock market, make a purchase with a credit card, or take out a loan to buy a car or a house. A financial transaction also occurs when a company borrows money from its bankers or issues bonds to investors or acquires a competitor. And a financial transaction occurs when a government agency issues bonds to finance its budget requirements, sells state-owned assets to the private sector, or changes its interest rate or tax policies. It’s easy to imagine that, when each one of these individual transactions is multiplied by thousands or millions of similar transactions, asset prices and capital flows can change and affect the fortunes of individuals, companies, and countries.

While finance can obviously affect a whole range of participants – from countries to companies, to individuals – we will focus our discussion on companies. The corporate focus is useful because companies drive much of the financial activity that impacts all other participants.

The Goals of Finance

A company exists to produce goods and services, and doing so successfully leads to the creation of an enterprise with value. In fact, a company operating in a capitalistic free market economy aims to maximize the value of its operation. Naturally, this is just one primary goal – we can easily imagine that a company may also try to pursue other goals, such as building market share, delivering top quality customer service, establishing competitive leadership, creating an international presence, developing brand name recognition, introducing new and exciting products, promoting employee/community support, and so forth. Ultimately, however, a company seeks to create a maximum level of enduring enterprise value. As we shall see, this overarching goal can be accomplished by maximizing profits, managing liquidity and solvency, and taking proper account of financial and operating risks.

Maximizing Profits

Companies seek to maximize value (wealth) while adhering to certain social, legal, and regulatory constraints. When markets are left to their own devices – under a laissez faire system, where free markets dominate and government involvement is at an absolute minimum – companies can produce goods/services at will, and consumers can freely select which ones to buy. In such free market systems companies try to attract consumers in order to produce and sell more goods/services as efficiently as possible. How can a company become stronger and increase its wealth? The obvious answer is by increasing its profits, or the income that remains after expenses have been paid: a company that makes more money is more valuable than one that makes less money, all other things being equal, and if it can do so continuously, over a long period of time, it becomes stronger.

Let’s consider a simple example to help frame the discussion. Assume that a hypothetical company, ABC Co. (which we shall revisit throughout the book), produces certain goods, which it sells to its customers. In order to produce these goods it has a staff of workers, sources raw materials locally, and owns a factory (which it depreciates, or reduces in value, on a regular basis as a result of normal “wear and tear”). The purchase price of the factory is paid by taking out a loan from a local bank. The rest of the company’s assets (i.e. items that it owns) are kept in a short-term bank deposit. The revenues earned by selling the goods are used to buy raw materials from abroad, repay the interest and principal on the loan, and pay the salaries of the employees, the rent on the office space, and taxes to the government. The remaining balance, net income (or net profit), is then reinvested in the business or paid out to the owners. This simple example raises a number of important questions about how the company operates and how it attempts to maximize its profits. For instance, does the company maximize profits by:

• Buying raw materials from abroad rather than locally?
• Borrowing from the local bank rather than issuing bonds or stock?
• Purchasing the factory instead of leasing it?
• Depreciating the factory on an accelerated basis rather than a straight-line basis?
• Renting the office space instead of buying it?
• Keeping its remaining assets in short-term bank deposits rather than long-term securities?
• Reinvesting net profits rather than paying them out to the owners?

The correct answers are not immediately apparent, mainly because we need to understand more about the company, its financial structure, its operating environment, and the competitive marketplace. And, of course, we need a proper suite of financial concepts and tools so that we can evaluate the issues and alternatives; we shall consider these concepts and tools in subsequent chapters.

Let’s now extend the example one step further, to demonstrate that the scope of finance is very broad. Assume that ABC Co. wants to expand its operations and decides to buy a competing firm. To arrange the acquisition, it borrows from its local bankers. Once the acquired company is fully integrated, the firm invests in factories located around the world, which allows it to source raw materials in each local marketplace, produce goods in a local setting, and then sell them to the local consumer base. Half of any profits it earns are reinvested in the local operations, while the other half is repatriated to the...

Table of contents

• Cover Page
• Half Title Page
• Title Page
• Copyright Page
• Contents
• List of “Finance in action” cases
• List of illustrations
• Preface to the third edition
• List of abbreviations
• PART 1 Concepts and Tools
• PART 2 Instruments and Transactions
• PART 3 Participants and Marketplaces
• Appendix: Internet resources
• Glossary
• Bibliography
• Index