The Building Blocks of Financial Theory PDF

The Building Blocks of Financial Theory Module 1 Content What is Money? What is Finance? Difference Between Stock and Flow (Income, Wealth, Black Money, Investment) Monetary Assets Vs Financial Assets Financial Intermediaries Financial Systems Interface of Financ...

The Building Blocks of Financial Theory Module 1 Content What is Money? What is Finance? Difference Between Stock and Flow (Income, Wealth, Black Money, Investment) Monetary Assets Vs Financial Assets Financial Intermediaries Financial Systems Interface of Financial Management with Other Functional Areas Basic Financial Statement Analysis: Balance Sheet Analysis, P&L Account Ratio Analysis: Liquidity, Leverage, Turnover and Profitability Ratios What is Money? - A medium of exchange that is centralized, generally accepted, recognized, and facilitates transactions of goods and services, is known as money. - The use of money eliminates the problem of bartering where both parties must have something the other wants or needs. How did it evolve? Limitations of Barter Metallic Money Electronic System Money Commodity Money Paper Money Limitations of Barter System - Double Coincidence of Wants: For a transaction to occur, both parties needed to desire what the other possessed. Imagine having a surplus of apples but needing shoes – you might not find someone who has shoes and wants apples! - Indivisibility: Certain goods like cows were difficult to divide for smaller transactions. How would you barter half a cow for a basket of berries? - Perishability: Barter goods like food could spoil over time, reducing their value as a store of wealth. Why was metallic money the best option then? - Durability: They wouldn't rot or spoil. - Divisibility: They could be easily divided into smaller units (coins) for varied transactions. - Scarcity: Their limited availability maintained their value. Paper Money! What was the highest denomination note ever printed? What is currency paper made up of? How many languages appear in the language panel of Indian banknotes? Is it possible to have two or more banknotes with the same serial number? Paper Money! What was the highest denomination note ever printed? - 10000! What is currency paper made up of? - 100% Cotton How many languages appear in the language panel of Indian banknotes? - 15 Is it possible to have two or more banknotes with the same serial number? - Yes! ( Inset letter different, year of printing different, sign different) Paper Money/ Fiat Currency Fiat money is government-issued currency that is not backed by a physical commodity like gold or silver. Its value is derived from the trust in the issuing government and the stability of the economy. The Reserve Bank of India (RBI) has the authority to print Rupees. The value of the Rupee is not directly tied to the value of any particular commodity. Electronic Money Unified Payments Interface (UPI): This dominant player allows instant money transfers between bank accounts using a virtual payment address (VPA). Apps like PhonePe, Google Pay, and Paytm leverage UPI for seamless peer-to-peer (P2P) and merchant transactions. Mobile Wallets: Similar to digital wallets globally, these store e-money linked to your bank account or credit card. Popular examples include PhonePe Wallet, Paytm Wallet, and MobiKwik. Prepaid Cards: Reloadable cards like those issued by RuPay or Visa are widely used for online shopping and digital transactions. They offer convenience and can help manage spending budgets. Functions of Money Medium of Money eliminates the need for bartering. You can use it to buy things, regardless of whether the seller wants what you have. This facilitates Exchange trade and economic activity. Money provides a common way to measure the value of goods and Unit of Account services. Everything has a price tag in a specific currency, allowing for easy comparison across different products. Store of Money allows you to save purchasing power over time. The money you earn today can be used to buy things in the future. Value This enables saving, investment, and delayed consumption. Characteristics of Money - Durability: Money should be able to stand up under constant use. - Portability: Money needs to be small enough so it can be conveniently carried in clothes, pockets, or purses. - Divisibility: Money must be made in various units. You should be able to make change. By having various units of money, goods of various value can be paid for, and change for larger units of money can be made. - Uniformity: Every bill and coin of the same value needs to look the same. Money must be uniform in that one 100 rupee note and another 100 rupee note must be able to buy the same thing. - Acceptable: Money needs to be easily recognizable. We should also be able to recognize genuine money from counterfeit. - Relative Scarcity: Money needs to be hard to manufacture. If it were possible to manufacture money as easily as any other good, we would be flooded with counterfeit currency. Our money is a hard-to manufacture special paper and metal coins that have proven to be very difficult to duplicate.  The Payments System - The payments system is the set of institutional arrangements through which purchasing power is transferred from one transactor’s exchange to another. - A common medium of exchange is what we call money. Thus the payments system is organized around the use.of money. - For making small local payments. currency has proved to be the best means of payment. For making large and out~of-town payments. the use of chequing deposits and bank drafts are more popular. For faster payments. telegraphic transfers of money are also made  Deposits Deposits Post-Office Bank Deposits Deposits Time Deposits Demand Deposits Savings Deposits Time Deposits  Deposits are moneys accepted by various agencies from others to be held under stipulated terms and conditions. Deposits in current account are payable on demand. They can be drawn upon by cheque without any restriction. These deposits are Bank Deposits Current mostly held by business firms, wh1ch use them for making business payments. No interest is paid on these deposits. Fixed Fixed Deposits are for a fixed term and are not payable on demand. Money deposited becomes payable only upon maturity but doesn’t really happen in reality. Savings Savings deposits combine features of both current account deposits and fixed deposits. Are interest earning and have restrictions on chequing. Demand Deposits Time Deposits Demand deposits are defined as All other deposits which are not payable deposits payable on demand.through on demand and on which cheques cannot cheque or otherwise. be drawn have a fixed term to maturity. They are, therefore, called time deposits. Among deposits it is demand deposits which serve as a medium of exchange. for their ownership can be transferred from one person to another ·through cheques and clearing arrangement Post-Office Deposits Savings deposits Time deposits Deposits withdrawable on Includes recurring deposits and demand, only with withdrawal cumulative time deposits. slip Similar to Commercial Banks’ Chequeable portion is very small. TD. Large withdrawals need notice. Encashablity is difficult Does not serve as a medium of exchange. Not used for transferring purchasing power. Measurement of Money Supply The total stock of money in circulation among the public at a particular point in time is called money supply or supply of money. Measurement of Money Supply Measu In Commercial Banks Post Office res Circulation Currency + Demand Time Demand/Savings Time Coins Mo M1 M2 M3 M4  Measurement of Money Supply M1 includes all the currency notes being held by the public on any given day. It also includes all the demand deposits with all the banks in the country, both savings as well as current account deposits. It also includes all the other deposits of the banks kept with the RBI. So M1 = CC + DD + Other Deposits M2, also narrow money, includes all the inclusions of M1 and additionally also includes the saving deposits of the post office banks. So M2 = M1 + Savings Deposits of Post Office Savings M3 consists of all currency notes held by the public, all demand deposits with the bank, deposits of all the banks with the RBI and the net Time Deposits of all the banks in the country. So M3 = M1 + time deposits of banks. M4 is the widest measure of money supply that the RBI uses. It includes all the aspects of M3 and also includes the savings of the post office banks of the country. It is the least liquid measure of all of them. M4 = M3 + Post office savings What is Finance Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting. Types of Finance Finance can be classified into three main categories. Personal Finance Corporate Finance Public Finance Personal Finance Personal finance concerns all aspects of a person's budgeting, saving, investing, and strategizing given his or her current financial constraints and abilities. Personal finance emphasizes the financial choices that individuals make and the impact those decisions have on their lives. Personal finance is very specific to each individual's unique financial situation, but typically it depends on annual earnings or salaries, living requirements and expenses, goals, and lifestyle preferences. Public Finance The central government is responsible for safeguarding markets and controlling the economy. Funds for its programs are derived from a variety of sources, including taxation and borrowing from banks, insurance companies, and other governments such as state and local. Dividends from the government's own companies also help finance programs. Public finance is constrained to the government and it involves stabilizing the economy by managing inflation, unemployment rate, interest rates, and more. The government either increases or decreases the cash flow in the market depending on the economy. Corporate Finance Corporate finance is the activity of managing all financial activities for a corporation. Its activities include budgeting current capital and future investments, refinancing projects and assets, raising additional funds through certain loans and bond issues, and using its other resources to ensure the company is making the best deals in the current market. The main focus of corporate finance is to maximize shareholder value by long and short-term financial planning and by implementing different strategies. Corporate financing activities range from decisions on capital investment to investment banking. Corporate Finance Corporate finance departments are responsible for governing and supervising the financial activities of their companies and the decisions on investing capital. These include whether the proposed investment should be undertaken and whether the investment should be paid for with equities, debt, or both. In addition to investments in capital, corporate finance deals with capital procurement. It also includes the need to obtain dividends for shareholders. The Finance Division also administers current assets, existing liabilities, and stock controls. Functions of Finance The functions of finance involve three major decisions a company must make – the investment decisions, the financing decisions, and the dividend / share repurchase decisions. The Investment Decisions Capital investment is the allocation of capital to investment proposals whose benefits are to be realized in the future. The assets which can be acquired fall into two groups i) long term assets – which yield a return over a period of time in future. ii) short term assets – those assets which in normal course of business are convertible into cash without any loss in value, usually within a year. The decisions regarding long term assets are known as capital budgeting and regarding short term assets as working capital management. Financing Decisions The second function of financial management deals with financing pattern of the firm. The financing decision is mainly concerned with identification of sources of finance and determining financing mix and cultivating sources of funds and raising funds. The two main sources of funds are shareholders funds (owners’ equity) and borrowed funds. The cost of funds, determination of debt equity mix, impact of tax, depreciation, consideration of control and financial strain, interest rate and inflation are some of the factors that affect the financing decision. A balance is to be maintained between owners’ funds and outsiders’ funds and long term and short term funds. A firm usually makes use of both internal and external funds. The employment of these sources in various combinations is called ‘financial leverage’. Different types of analysis are required for this decision e.g., leverage analysis, EBIT – EPS analysis. Dividend Policy Decisions This decision relates to disposition of distributable profit between dividends and retained earnings. Retained earnings being a source of funding, dividend decision is concerned as part of financing decision of the firm. The impact of levels of dividends and retention of earnings on market value of share and future earnings of the firm, funds required for future expansion, impact of legal and cash flow constraints and the future boom or recession are some factors that affect this decision. Retention of earnings depends upon reinvestment opportunities available and the opportunity to generate satisfactory rate of return for the shareholders. Dividends may be paid in cash or in the form of bonus shares. These and other aspects of dividend decision will be explained in detail later in this course. Financial Management ―Financial management deals with how the corporations obtain the funds and how it uses them.—Hoagland ―Financial Management is the application of planning and control functions to the finance function.—Archer and Ambrosio ―Financial management may be considered to be the management of the finance function. —Raymond Chambers Financial management is the area of business management devoted to a judicious use of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals. —J.F. Bradley Objectives of Financial Management Financial management evaluates how funds are used and procured. The core of financial policy is to maximize earnings in the long run and optimize them in the short run. Financial management is an improved resource, mainly capital funds. The firm‘s investment and financing decisions are unavoidable and continuous. In order to make them rationally, the firm must have a goal. A firm‘s financial management may have the following as their objective: Maximization of firm‘s profit Maximization of firm‘s wealth Profit Maximization The maximization of profit is often considered as an implied objective of a firm. To achieve the aforesaid objective various types of financial decisions may be taken. Firms producing goods and services may function in a market economy. In a market economy prices of goods and services are determined in competitive markets. Firms in the market economy are expected to produce goods and services desired by society as efficiently as possible. Price system is the most important aspect of market economy which indicates what goods and services society wants. Profit Maximization Higher demand for goods and services leads to higher prices resulting in higher profit for firms. It attracts other producers due to which competition in the market increases. An equilibrium price is reached when the supply of goods in a market matches the demand for those goods. The prices and profits of those goods and services tend to fall which has no demand by the society. Prices are determined by the demand and supply conditions as well as the competitive forces and they guide the allocation of resources for various productive activities. Profit Maximization Profit maximization implies that a firm either produces maximum output for a given amount of input or uses minimum input for producing a given output. It is assumed that profit maximization causes the efficient allocation of resources under competitive market conditions and profit is considered as the most appropriate measure of a firm‘s performance. Criticism to profit maximization In the new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate and immoral. There is a possibility of production of goods and services that are wasteful and unnecessary from the society‘s point of view. Also, it might lead to inequality of income and wealth. Firms producing same goods and services differ substantially in terms of technology, costs and capital. In such conditions, it is difficult to have a truly competitive price system and thus, it is doubtful if the profit maximizing behaviour will lead to optimum social welfare. Wealth Maximization Wealth maximization objective is as important as profit maximization. The operating objective of financial management is to maximize wealth or NPV (Net Present Value) of a firm. The wealth of owners of a corporation is maximized by raising the price of the common stock. This is achieved when the management of a firm operates efficiently and makes optimal decisions in areas of capital investment, financing, dividend and current assets management. Wealth Maximization The market price of a firm‘s stock represents the focal judgment of all market participants as to what the value of a particular firm is. It takes into account present and prospective future earnings per share, the timing and risk of these earnings, the dividend policy of the firm and many other factors that bear upon the market price of the stock. Wealth Maximization The value/wealth maximization objective of a firm is superior to profit maximization objective due to the following reasons: The value maximization objective of a firm considers all future cash flows, dividends, EPS, risk of a decision etc. whereas profit maximization objective does not consider the effect of EPS, dividend paid or any other returns to shareholders. A firm that wishes to maximize the shareholders’ wealth may pay regular dividends, whereas a firm that wishes to maximize profit may refrain from paying dividend payment to its shareholders. Wealth Maximization Shareholders would prefer an increase in the firm‘s wealth against its generation of increasing flow of its profits. The market price of a share reflects the shareholder‘s expected return considering the long term prospects of the firm, reflects the differences in timings of the returns, considers risk and recognizes the importance of distribution or returns. The maximization of a firm‘s value as reflected in the market price of a share is viewed as a proper goal of the firm. The profit maximization can be considered as a part of wealth maximization. Techniques of Financial Management Ratio Analysis - This is an important tool in analysis of financial statements. Ratios are used as an index or yardstick for evaluating the financial position and performance of a firm. Ratio is the expression of one figure in terms of another. It is the expression of the relationship between mutually independent figures. Ratio analysis makes use of financial report and data and summarizes the key relationship in order to appraise financial performance. It is used by the analysts to make quantitative judgment about the financial position and performance of the firm. There are various ratios which are used by different parties for different purposes and can be calculated from the information given in financial statements. The comparison of past ratios with future ratios shows the firm‘s relative strength and weaknesses. Techniques of Financial Management Capital Budgeting Techniques - Investment in long-term assets for increasing the revenue of firm is called as ̳capital budgeting‘. It is a decision to invest funds in long-term activities for future benefits to increase the wealth of the firm, hence that of the owners. Capital budgeting refers to long-term planning for proposed capital outlays and their financing. The future growth of a firm depends on capital expenditure decisions. Capital budgeting involves large amount of funds, risk and uncertainty and they are of an irreversible nature. Estimation of cash flow is very important for evaluating the investment proposals. Capital budgeting results the exchange of current fund for future benefits which will occur over a series of years to come. Techniques of Financial Management The important techniques used in capital investment appraisal are as follows: Payback period method, Accounting rate of return method, Net present value method, Internal rate of return method, Profitability index method, Discounted payback period method, etc. Techniques of Financial Management Working Capital Management - Techniques like economic order quantity, ABC analysis, fixation of inventory levels, cash management models, etc are adopted in the efficient working capital management. Capital Structure - The finance manager has to decide an optimum capital structure to maximize the wealth of shareholders. In capital structure decisions - analysis of operating and financial leverages, cost of different components of capital, EPS - EBIT analysis, ascertainment of EPS and different financing alternatives, determination of financial breakeven point, indifference point analysis and other mathematical models are used. Stock and Flow Stock refers to any quantity that is measured at a particular point in time, while flow is referred to as the quantity that can be measured over a period of time. Both the stock and flow are interdependent on each other. The concept of stock and flow is very essential in Economics, as it helps to understand the development of economic variables.  Monetary Assets Vs. Financial Assets A financial asset is an asset that has no physical characteristics, but rather derives its value from a monetary basis, a contractual claim, or a contract whose settlement may affect the holder’s own equity, whether it is a derivative contract or non-derivative contract. Examples of financial assets whose value is derived from a monetary basis include monetary assets such as cash or cash equivalent and bank deposit. The contractual claim gives a holder the right to receive an amount of money (cash or otherwise) or another financial asset from another party or to exchange financial assets/ financial liabilities with another party under favorable conditions. Financial assets mainly include cash,accounts receivable (A/Rs),loans receivable; and investment securities (common shares, fixed income investments).  Monetary Assets Vs. Financial Assets On the other hand, a monetary asset is a type of financial asset that constitutes money (cash) held in, and assets whose value can be converted into, a fixed or determinable amount of money (cash). For example, a cash amount is a monetary asset and it will maintain its monetary value/ numerical value over time. However, under accounting principles, a monetary asset doesn’t gain or lose value over some time. In reality monetary assets may be impacted by inflation or deflation, and as a result their real value doesn’t remain fixed over the long run, and even over the short run in specific cases. Monetary assets include cash, investments, accounts receivable, and notes receivable. Financial Intermediaries Financial intermediaries are institutions or individuals that act as a middleman between two parties to facilitate a financial transaction. They help to channel funds indirectly between lenders and borrowers.  Functions of Financial Intermediaries Asset Protection: One of the most crucial roles played by financial intermediaries may be asset storage. Commercial banking institutions provide the safekeeping of currency, whether it be in the manner of coins or paper money, as well as other valuables like gold or silver. A range of instruments is made available to people who make deposits to assist them in both securing their money and facilitating 24/7 access to it. These consist of credit cards, cheques, debit cards, and ATM cards. Additionally, depositors have access to information about the deposits, withdrawals, and direct payments they have authorized through the bank.  Functions of Financial Intermediaries Loans: Loans are another crucial role that financial intermediaries play. The majority of the work that financial intermediaries do is to advance both immediate and long-term loan transactions. They serve as a go-between for customers wishing to borrow money from depositors who have extra funds and the depositors themselves. Loans are typically obtained by borrowers to buy capital-intensive items like commercial real estate, cars, and manufacturing equipment. In addition to charging interest on the loans, intermediaries often distribute a percentage of the proceeds to the depositors whose funding was used to fund the loans. The interest earned on the remaining principle is retained as a profit. A credit check is performed on borrowers to determine their creditworthiness and ability to repay the loan.  Functions of Financial Intermediaries Investments: Financial intermediaries also perform essential investment-related tasks. The knowledge of in-house investment specialists who help customers of financial intermediaries like mutual funds and investment banks increase their investments may be advantageous. The companies discover the most suitable assets that maximize returns while lowering risk using their substantial industry expertise and countless of investment portfolios. As an individual investor, you have access to a variety of assets, including securities, real estate, treasury notes, and derivatives of financial markets. In certain circumstances, such as with certificates of deposit, intermediaries make an investment of the money of their clients and pay them an annual interest rate over a certain period of time. Some intermediaries may offer financial and investment advice alongside or in addition to managing the assets of clients to help customers make the best investment choices.  Types of Financial Intermediaries Commercial Banks: These are the most common type of financial intermediaries that offer various banking services including deposits, loans, and other financial products to individuals and businesses. Non-Banking Financial Companies (NBFCs): NBFCs offer similar services to banks but do not hold a banking license. They play a crucial role in providing credit to underserved segments of the economy. Cooperative Banks: These types of banks are owned and operated by their members and serve their members' financial interests. They are particularly important in rural areas for providing credit to small farmers and businesses. Insurance Companies: These entities provide risk management through various insurance products, covering life, health, property, and more.  Types of Financial Intermediaries Mutual Funds: This is an investment method where experts pool money from investors to purchase securities like stocks, bonds, and other assets. Pension Funds: These funds manage retirement savings and invest in different types of financial instruments to ensure returns for their beneficiaries. Stock Exchanges and Brokerage Firms: They facilitate stock trading, bonds, and other financial securities. These act as intermediaries between investors and the financial markets. Microfinance Institutions (MFIs): These financial institutions provide small loans and other financial services to small businesses and individuals in underserved markets. Housing Finance Companies: Specialized financial intermediaries that provide loans for purchasing or constructing residential properties.