Finance Overview: Key Concepts and Terms

 

Finance is the study of money management, investments, and financial systems. 

It involves the processes of acquiring, investing, and using funds to achieve economic objectives. 

Understanding the basic concepts and terminology in finance is essential for making informed financial decisions. 

Here’s an introduction to key concepts and terms in finance:

#1 Fundamental Principles of Finance:

Money: Anything that is widely accepted as a medium of exchange for goods and services. 

It is a store of value, a unit of account, and a means of deferred payment.

Investment: Investment involves the reallocation of financial capital to new asset, enterprise, or project with the expectation to earn some future income or profit.

Return on Investment (ROI): ROI serves as an indicator of the profitability associated with an investment, determined by subtracting the investment cost from the gains generated by the investment and subsequently dividing this figure by the initial investment cost.

Risk: Risk encompasses the uncertainty of an investment's eventual outcomes, including the loss potential. 

There is, in general, a positive relationship between return and level of risk.

Interest: It is essentially the cost of borrowing money or the return one gets from investing, usually expressed as a percentage of the principal amount involved.

Inflation: Refers to the rate at which the overall price level of goods and services increases, subsequently diminishing purchasing power over time.

Liquidity: Is an asset's ability to get liquidated into cash quickly with a minimum loss in value.

#2 Basic Financial Terms:

Assets: Things owned by a person, business, or other organization that have economic value. Examples include cash, stocks, real estate, and equipment.

Liabilities: The debts or financial obligations of a person to someone else. Examples include loans, credit card debts, and mortgages.

Equity: The interest owning the organization, and it is reflected through stock of an entity. It is the value of the asset that remains upon deduction of liabilities.

Capital: Money that can be used productively or invested, and can be divided further by debt capital and equity capital - borrowed money, owners' money.

Net worth: the value of what a person or business owns minus what it owes. An indication of the owners' interest in the entity.

#3 Financial Reports:

Balance Sheet: A statement that outlines what an organization has and owes, comprised of assets, liabilities, and equity, providing a snapshot at any given moment in time.

Income Statement or Profit and Loss Statement: A financial statement that represents the income and expenses of an organization over an interval of time and culminates in a net profit or loss.

Cash Flow Statement: A financial document that delineates the specifics of cash inflows and outflows within a specified timeframe, organized into three categories: operating, investing, and financing activities.

#4 Time Value of Money (TVM):

The concept is based on the idea that a sum of money has a different value in time due to its earning potential. 

The whole basis is that receiving money today is worth more than receiving a similar amount sometime in the future, simply because today's money can earn interest.

Present value: Refers to the value the money will have in the future after some interest rate is applied through discounting.

FV-Future Value: The future value of a current sum of money at some future date, based on a given basic interest rate.

#5 Types of Finance:

Personal Finance: Management of individual or household financial activities, including budgeting, saving, investment, and retirement planning.

Corporate Finance involves the management of a company's financial resources that focuses on shareholders' wealth maximization through both long-run and short-run financial decisions.

Public Finance: Refers to the management of the country's revenue, expenditure, and debt. 

This branch deals with the allocation of resources, taxation, and governmental expenditures.

Investment Finance: investing in financial assets such as stocks, bonds, and real estate with the view to earning returns.

#6 Types of Investments:

Stock represents the ownership interests in a corporation. 

Investors purchase stocks with expectations of dividends-income or capital appreciation-increase in the stock value.

Bonds: These are debt securities issued by corporations or governments. 

Here in, bond holders virtually lend money to the issuer in exchange for periodic interest payments, as well as the return of the principal at maturity.

Mutual Funds: These are investment means that pool money from many investors to buy a diversified portfolio of stocks, bonds, or other securities.

Real Estate: A property investment for residential, commercial, or industrial uses, usually for rental income or capital gains.

Commodities: Refer to tangible assets such as gold, silver, oil, and agricultural products that are exchanged within financial markets.

#7 Interest Rates and Compounding:

Simple Interest: It is interest calculated only on the principal amount.

Compound Interest: The interest earned on both the principal invested and interest accrued based on exponential growth.

APR: Annual interest rate on a loan earned on an investment. 

The rate is expressed without considering the effect of compounding.

APY: stands for Annual Percentage Yield, meaning the effective annual rate of return in consideration of the impact from compounding.

#8 Financial Markets and Institutions:

Stock Market: The market in which the shares of the public company are being traded.

Bond Market: A financial market in which participants are able to create, buy, and trade debt securities.

Banks: An institution which lends credit, receives deposits or offers a variety of allied services.

Investment Companies: Those firms that manage investments for both individuals and institutional clients.

Central Banks: set monetary policy and regulate money supply at a national level; supervise the operation of the financial system. Examples include: Bank of Canada.

#9 Common Financial Ratios:

Debt-to-Equity Ratio: Measures a company’s financial leverage by comparing total liabilities to shareholders' equity.

Price-to-Earnings Ratio: The ratio between a firm's share price and its earnings per share, used in determining valuation.

Current Ratio: Shows the ability of a firm to pay its current liabilities by its current assets.

#10 Financial Risk Management:

Diversification: Reducing risk by spreading investments across various asset classes or sectors.

Hedging: Using financial instruments like derivatives to offset potential losses in investments.

Insurance involves a risk management approach through which monetary compensation is allowed on the occurrence of unfortunate events. 

Understanding these basic concepts and words lays the ground for more complicated financial topics and informed decisions about finances.