Money is a short term store of value, in the form of a promise to pay the
bearer on demand. While money used to be backed by silver or gold, modern
money has no inherent value. Its value derives instead from the trust and the
confidence that its users have toward issuer of the promise to pay – usually a
central government.
Financial capital is a longer term store of value, usually in the form of a
promise to pay later. Financial capital may be backed by other assets, but not
always. Whether or not the financial capital is backed by other assets, trust
toward its issuer is a fundamentally important component of its value. High
levels of well-founded confidence are essential in a modern economy.
Financial capital means long term financial resources, held in the form of
financial assets including bonds and shares.
Capital also has a much wider range of meanings (including financial capital)
depending on the context.
For example, it may include capital goods such as transport infrastructure,
and human capital including knowledge, skills and relationships.
Factors of production are resources which are used in production, classically
being land, labour, capital and enterprise.
Capitalism is a relatively free market system based on the concept that the
owners of capital are entitled to a reward for putting their capital at risk.
More about economic structures
A free market is an economy - or part of an economy - where resources are
allocated by the market by means of the market mechanism.
The market mechanism is the interaction of demand and supply, resulting in
an equilibrium quantity and price being set by the market.
When demand exceeds supply, market prices are likely to rise.
When supply exceeds demand, market prices are likely to fall.
When demand and supply are equal, market prices are likely to remain stable.
Regulation is the official control of markets (or of other activities) usually by a
system of rules, often including primary or secondary legislation.
A mixed economy is an economy where resources are allocated by both the
government and by the market mechanism.
The private sector is the part of the economy which is not owned or controlled
by the government, and consists of organisations established to make a profit.
The public sector is the part of the economy comprising the government, and
other governmental organisations.
The third sector is the part of the economy comprising non-governmental
non-profit-making organisations. The other two sectors being the government
(public sector) and business (private sector).
Nationalisation is the transfer of a business from private ownership to national
public ownership.
Privatisation can mean either
(1) The transfer of a business or an activity from state ownership and control
into ownership by the private sector.
(2) A corporate privatisation, which is a transfer of ownership from public
equity markets (the stock exchange) to private equity ownership.
Share capital is money invested by the owners of the company
(shareholders).
For the protection of the creditors of the company, the company is not
normally allowed to pay out the share capital to the shareholders.
This is an expression of the principle of mandatory capital conservation by
companies, for the protection of their creditors.
Stakeholders are all the people who have a legitimate interest in an
organisation's activities, including shareholders but also covering a much
wider group of interest holders.
One important group of stakeholders are lenders - also known as debt
investors.
Debt investors in organisations
A loan is a borrowing (liability) for the borrower, and an investment (asset) for
the lender.
A bond is a formal debt investment, usually tradeable, issued by a borrowing
organisation and bought by a lender (= debt investor).
Documentation is the formal written contract for the debt investment.
Default is (i) part of the documentation of a bond or other debt investment
(such as a bank loan) that protects the investor (lender) against the borrower
failing to honour the terms of the borrowing - for example, failing to pay
interest or principal when it falls due; and also (ii) the failure itself by the
borrower, for instance not making repayments when they're contractually
committed to.
Covenants are another part of lending and borrowing documentation that
protects the lender-investor.
Breach of a covenant by a borrower is normally an event of default that gives
additional rights to the lender-investor, for example acceleration.
Credit ratings are an assessment of creditworthiness, made by a separate
organisation from the one issuing bonds (or other securities).
Credit rating agencies are specialist bodies that evaluate creditworthiness and
publish credit ratings, for example Moody's and Standard & Poor's (S&P).
Responsibilities of companies and their directors
Corporate social responsibility (CSR) is the acceptance by commercial
organisations that they have wider ranging and longer term responsibilities,
beyond the short and medium term financial interests of financial
stakeholders.
Sustainability considers the long term environmental and other effects of an
organisation's activities, seeking to ensure that they do not degrade the
physical environment or other necessary conditions for well being.
A fiduciary duty is a legal duty to act solely in another party's interests.
A fiduciary is a person who occupies a position of trust in relation to someone
else and is required to act for the latter's benefit within the scope of that
relationship.
Examples include trustees and company directors.
Stewardship is the fundamental fiduciary duty of company directors, to
safeguard and administer the property belonging to a company, on behalf of
its shareholders.
Cash is an enormously important asset for most organsiations and
individuals, most of the time. The less cash we have, the more important it
becomes. If we run out of short term cash to pay our liabilities we can go
bust, even if we still have value tied up in our longer term assets.
Cash flows are the changes in our reserves of cash. Cash flow forecasting
is making projections of our cash flows and available cash balances, and
taking timely action to cover potential shortfalls. Related cash flow statements
are a key building block of financial reporting.
Formulae you may find helpful:
Net receipts/(payments) = Receipts – payments
[Receipts – Payments] + Opening cash/(overdraft) = Closing cash/(overdraft)
Net receipts/(payments) + Opening cash/(overdraft) = Closing cash/(overdraft)
Definitions:
NET means after making deductions, or before adding things on.
GROSS means before deductions.
Conventions:
So long as the financial numbers we’re combining and comparing are in the
same currency and the same units, we can ignore the currency units in our
calculations. It doesn’t matter whether they’re thousands of pounds, euro,
dollars or any other consistent currency.
Numbers to be subtracted, are sometimes shown in brackets, and sometimes
not. It's a good to establish for yourself, and stick with, a consistent sign
convention. Similarly some people and situations show liabilities – such as
any overdrafts – in brackets, and others don’t. Again, aim to be consistent,
without getting grumpy when others aren’t so consistent.
Overview of financial reporting
Financial reporting - to owners & others
Accounts - internal & external
Annual report - external
Management accounting
Management accounting - internal
Five primary financial statements
Primary financial statements - external
Notes - rest of external financial statements
Balance sheet - reported externally by all organisations
Assets - In financial reporting, assets are defined as 'present economic
resources controlled by a reporting entity as a result of past events'.
An economic resource is a right that has the potential to produce economic
benefits.
Examples include cash, trade receivables, inventory, tangible fixed assets and
some intangible assets.
Assets are represented in the balance sheet by debit balances.
Liabilities - In financial reporting, liabilities are amounts or obligations of a
reporting entity arising from past transactions or events, the settlement of
which may result in:
● The transfer or use of assets, for example payments of money
● The provision of services or
● Other yielding of economic benefits in the future.
Examples include overdrafts, trade payables, accruals and provisions.
Liabilities are represented in the balance sheet by credit balances.
Net assets = Assets - Liabilities
Equity = Net Assets
Balance sheet Assets - Liabilities = Equity
Statement of financial position = Balance sheet
Current assets are assets likely to be converted into cash in less than a year.
Current liabilities are liabilities likely to be settled in less than a year -
Non-current applies to assets or liabilities of more than a year.
Cash flow statements and Income statements - reported externally by
most organisations
Cash flow statement: Receipts - Payments = Increase or Decrease in cash
Income statement: Revenue - Costs = Profit or Loss
Profit and loss account = Income statement
Comprehensive income and Changes in equity - reported externally by
the largest organisations
Other comprehensive income - revaluations of assets etc
Other changes in equity - dividends paid & new shares issued
Shareholders and other stakeholders
Shareholders = owners
Stakeholders = all with legitimate interests
Members = shareholders
Directors = most senior managers
Directors' responsibilities statement - including preparing accounts
Capital
Capital - long-term funding
Capitalisation - accounting as an asset
Capital adequacy - sufficiency of stable capital
Capitalised costs & Intangible assets
Intangible assets are the most important assets for the majority of
organisations. Intangible assets include know how, goodwill, patents, and
many others. Some intangible assets are recorded in organisations' balance
sheets. But many are not.
Intellectual property is a subset of intangible assets, including copyrights,
patents and trademarks. Intellectual property law focuses on giving creators
exclusive rights, for a limited period of time and to legally prevent others from
using intellectual property, without permission.
Goodwill is an intangible asset representing the additional premium - in
excess of the value of net assets - paid to acquire control of a business. Also
known as positive goodwill.
Capitalising costs, putting them onto the balance sheet as assets
Expensing costs, charging them to the income statement as expenses.
Research and development is concerned with discovering new knowledge
about products, processes, services and applying this knowledge to create
new and improved products, processes, and services to fulfill market needs.
Interest, return and compounding
Interest amount is the charge made for a borrowing, or the surplus returned
on an investment.
Rate of interest is interest expressed as a percentage of the starting amount
borrowed or invested
Starting amount is the initial amount of money invested or borrowed, at the
start of a period.
End amount is the total accumulated amount of money at the end of period,
including both the starting amount and the return or interest amount on top.
Return amount. The surplus returned on an investment, additional to the
starting amount.
Rate of return per period. For single periods, return expressed as a
percentage of the starting amount invested.
Interest
Interest is an example of return, for an amount invested or deposited.
Interest is also a charge made for borrowing money.
Compound interest
Compound interest is based on interest on interest, as well as interest on the
original amount borrowed or invested.
Compound growth and return are similarly based on growth on growth, not
just growth on the original starting amount.
Understanding compounding (article)
De-compounding is the reverse process to compounding.
It calculates a compound rate per period for a shorter period of time, based on
a total rate of growth for a longer period.
Financial returns
Financial returns are surpluses enjoyed on investments.
Financial returns include income and capital gains.
Financial returns can be negative.
Interest income is an example of a financial return.
Yield is the rate of return (or cost) on the current market value of an asset (or
liability), usually expressed as a percentage per annum.
For example, today’s yield to maturity of a bond measures the total return to
an investor in the bond, reflecting both
● The interest income over the remaining life of the bond and
● Any capital gain (or loss) from today’s market value to the redemption
amount payable at maturity
References for compounding and de-compounding - different bases of
comparison
Annual Percentage Rate (APR)
Annual Effective Rate (AER)
Effective Annual Rate (EAR)
Nominal annual rate
Retail markets deal in smaller volumes, and include non-professional
participants
Wholesale markets deal in larger volumes, mainly for professional specialists
Key points
One person’s interest income is another person’s interest expense.
Compounding is interest on interest.
Successful financial choices incorporate context and time, as well as raw
money amounts.
Compound interest definition
Compound interest is based on interest on interest, as well as interest on the
original amount borrowed or invested.
Compound growth and return are similarly based on growth on growth, not
just growth on the original starting amount.
Example
An example of compound growth would be an amount that doubles every
period, for example:
1, 2, 4, 8, 16, 32...
Contrasted with simple growth, increasing by a fixed amount every period, for
example:
1, 2, 3, 4, 5....
Notes about compounding:
● When rates of interest, growth and return are positive, compounding
results in greater total values.
● The greater the rates of interest, growth or return, the larger the
compounding effects.
● The more periods that compounding is applied for, the greater the
compounding effects.
● When relatively low rates are applied for small numbers of periods,
compounding effects are relatively small.
● Compounding effects become greater when rates are higher, or the
number of periods is higher, or both.
Risk in this context, generally means both the possibility of adverse events
and their related effects.
Risk management means recognising relevant significant (material) risks, and
addressing them appropriately.
Risk identification and management
Materiality is the threshold at which insignificant risks become significant.
Immaterial risks are ones that do not require active risk management,
because of one or more of their small size or low likelihood.
Sources and affected areas
Financial risk refers - among other things - to the adverse financial
implications arising from all types of risk.
Operational risk includes the risks of adverse effects resulting from (1)
Inadequate or failed internal processes, people and systems; (2) External
events such as adverse changes to the economic environment; and (3) Both
of these in combination.
Reputational risk is the risk of adverse consequences resulting from a
worsening of the reputation of a business or other organisation, for example,
as a result of adverse publicity.
Benchmark is a measure stated on a standardised basis, to enable
comparison. For example, an effective annual rate.
Futures are exchange traded contracts used for either hedging or speculating
in relation to outturn market rates on a prespecified date in the future.
Variation margin in futures markets, is a potentially refundable amount
payable by a 'losing' market participant, to protect other participants in the
market against the risk of a default.
Default in relation to contracts is a failure to honour the terms of an
agreement. For example a loan agreement, or an obligation under a futures
contract.
Collateral is an asset provided as security for a debt.
Derivative instrument or contract is one whose value and other characteristics
are derived from those of another asset or instrument (sometimes known as
the Underlying Asset).
Hedging is a risk management technique that generally involves adding an
opposite exposure to an existing risk, in the expectation that variations in the
two items will cancel out - in whole or in part - to reduce the net variability in
the overall hedged position.
Speculation is any risk taking activity or decision which depends for its
favourable result on market rates or prices.
Impairment is a reduction in the recoverable amount of an asset below its
carrying amount.
For example, physical damage would be a common reason for recognising an
impairment.
Risks evaluation means prioritising risks for management according to their
Severity and Likelihood.
This matrix is one model for prioritising risks for management.
Transferable and non-transferable risks
Risks can be classified as 'transferable' or 'non-transferable'.
Transferable risks are those which can be transferred to someone else, at a
price.
Ways of transferring these risks include hedging with risk management
products, or passing the risk to an insurer.
In these ways and others, we can remove transferable risks from our
organisation, if we choose to.
We can only transfer risks that there's a market for and not all risks are
transferable.
Transferable risk - Transferable risks are those which can be transferred to
another organisation or person, at a price.
Non-transferable risk - Non-transferable risks are risks which must be borne
by an organisation.
Ways of transferring these risks include hedging with risk management
products, or passing the risk to an insurer.
In these ways and others, we can remove transferable risks from our
organisation, if we choose to.
We can only transfer risks that there's a market for.
Not all risks are transferable.
Example: Hedging foreign exchange risk - a transferable risk
Say we're a UK-based business importing French food and wine that we pay
for in EUR. We sell it all in the UK, with all our revenues being in GBP.
We're due to pay a large liability to our suppliers, in EUR, in a month's time.
We've got a foreign exchange risk on the EUR/GBP exchange rate in a
month's time.
If the EUR were to strengthen, we'd need to pay more GBP for the same
amount of EUR (that we'll need in order to settle the liability to our suppliers).
So our costs would increase in GBP terms.
This is a transferable risk, because there's a well-developed market that
allows us to strike a deal with a bank TODAY, to exchange GBP for EUR in a
MONTH'S TIME, at a rate agreed today.
Now the bank has the foreign exchange risk.
While our GBP cost is effectively locked-in.
We can only transfer risks that there's a market for, such as foreign exchange
rates in major currencies like GBP & EUR.
The bank that's taking the risk from us will charge us for taking the risk away,
by quoting us a price that's favourable to them, and slightly unfavourable for
us.
The deal with the bank is a standardised product known as a foreign
exchange forward contract.
