Unofficial Guide to Finance Basics

This guide will take you through the basics of finance and is intended for non-finance background guys to help you become familiar with the terminology and what it all means. Although this is very basic but even if you do not get it at all, dont worry. In addition to the professors, Cashonova, the finance club, will take sessions for you where you can clear any doubts you may have. Besides that, all the fin gurus (we have a lot of them ;) ) in senior batch are always there. Contents: Financial Markets Basics of Stocks Common Terms used in Accounting Understanding Basics of Accounting

Disclaimer: IIFT and various student bodies including IMF & Cashonova are not associated with this document. This is just a personal attempt to help out the incoming batch.

P.S. No copyright is claimed. Information has been taken from publicly available sources
Compiled by Rohit Mittal

Financial Markets
In general terms financial market is a mechanism of delivering savings from the households, governments, and corporations to the users of these funds. Financial markets and financial assets exist in an economy because the savings of various individuals and institutions during a period of time differ from their investment in real assets. By real assets, we mean things such as houses, buildings, equipments, inventories, and durable goods. If savings equaled investment in real assets for all economic units in an economy over all periods of time, there would be no external financing, no financial assets, and no money and no financial markets. In this case each economic unit would be self sufficient. A financial asset is created only when the investment of an economic unit in real assets exceeds its savings, and it finances this excess by borrowing or issuing equity securities. Of course, another economic unit must be willing to lend. This as a whole, savingssurplus economic units provide funds to savings deficit units. This exchange of funds is evidenced by pieces of paper representing a financial asset to the holder and a financial liability to the issuer. The purpose of financial markets in an economy is to allocate savings efficiently during a period of time to parties who use funds for investment in real assets or for consumption. If those parties that saved were the same as those that engaged in capital formation the economy can prosper without financial markets. In modern economies, however, the economic units most responsible for capital formation-non financial corporations- use more than their total savings for investing in real assets. Household, on the other hand, have total savings in excess of total investment. The more diverse the pattern of desired savings and investment among economic units the greater the need for efficient financial markets to distribute savings to ultimate users. The investor in real assets and ultimate saver should be brought together at the least possible cost and inconvenience. Efficient financial markets are essential to ensure adequate capital formation and economic growth in an economy. With financial intermediaries in an economy, the flow of savings from savers to users of funds can be indirect. Financial intermediaries include institutions such as commercial banks, life insurance companies and pension and profit sharing funds. These intermediates come between ultimate borrowers and lenders by transforming direct claims into indirect ones. Financial intermediary transforms the funds in such a way as to make them more attractive. On one hand, the indirect security issued to ultimate lenders is more attractive than is a direct or primary security. In particular, these indirect claims are well suited to the small saver. On the other hand,

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the ultimate borrower is able to sell its primary securities to financial intermediary on more attractive terms than it could if the securities were sold directly to ultimate lenders. Financial intermediaries provide a variety of services and economies that make them quite attractive. Transaction costs and costs associated with locating potential borrowers and savers are lowered The risk of unreliable information is reduced. Due to the pool of large of amount savings and investment opportunity it provides a flexible and divisible forum to both saver and borrower. By investing in different securities and an intermediary actually spreads the risk. Intermediary provides expert services to both saver and borrower.

Some times intermediation process becomes cumbersome and there is a reversion towards direct loans and security issues. This process is called disintermediation. In other words when financial intermediations no longer makes the market efficient than the process of disintermediation occurs. Components of Financial Markets There are two components of financial markets: Money market: refers to a mechanism where short term securities mainly with maturity period of one year are traded. A large number of buyers and sellers run the market with securities relatively short term in nature and of small denominations. Trading in the money markets involves Treasury bills, commercial paper, bankers acceptances, certificates of deposit, government funds, and short term mortgageand asset-backed securities. It provides liquidity to the firms. Capital Market: Capital market is a place where sale and purchase of shares and bonds take place aiming to invest or lend and borrow funds for the longer term use usually more than one year. A large number of investors provide funds to a large number of companies, corporations, and firms willing to raise funds. The capital market includes stock market (equity securities) and bond market (debt securities).

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Basics of Stocks
Definition of a Stock -Plain and simple, stock is a share in the ownership of a company. Stock represents a claim on the company's assets and earnings. As you acquire more stock, your ownership stake in the company becomes greater. Whether you say shares, equity, or stock, it all means the same thing. Holding a company's stock means that you are one of the many owners (shareholders) of a company and, as such, you have a claim (albeit usually very small) to everything the company owns. Yes, this means that technically you own a tiny sliver of every piece of furniture, every trademark, and every contract of the company. As an owner, you are entitled to your share of the company's earnings as well as any voting rights attached to the stock. Being a shareholder of a public company does not mean you have a say in the day-to-day running of the business. Instead, one vote per share to elect the board of directors at annual meetings is the extent to which you have a say in the company. For instance, being a Microsoft shareholder doesn't mean you can call up Bill Gates and tell him how you think the company should be run. The management of the company is supposed to increase the value of the firm for shareholders. If this doesn't happen, the shareholders can vote to have the management removed, at least in theory. The importance of being a shareholder is that you are entitled to a portion of the companys profits and have a claim on assets. Profits are sometimes paid out in the form of dividends. The more shares you own, the larger the portion of the profits you get. Your claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll receive what's left after all the creditors have been paid. This last point is worth repeating: the importance of stock ownership is your claim on assets and earnings. Another extremely important feature of stock is its limited liability, which means that, as an owner of a stock, you are not personally liable if the company is not able to pay its debts. Other companies such as partnerships are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell off their house, car, furniture, etc. Owning stock means that, no matter what, the maximum value you can lose is the value of your investment. Debt vs. Equity - Why does a company issue stock? Why would the founders share the profits with thousands of people when they could keep

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profits to themselves? The reason is that at some point every company needs to raise money. To do this, companies can either borrow it from somebody or raise it by selling part of the company, which is known as issuing stock. A company can borrow by taking a loan from a bank or by issuing bonds. Both methods fit under the umbrella of debt financing. Issuing stock is advantageous for the company because it does not require the company to pay back the money or make interest payments along the way. All that the shareholders get in return for their money is the hope that the shares will someday be worth more than what they paid for them. The first sale of a stock, which is issued by the private company itself, is called the IPO. It is important that you understand the distinction between a company financing through debt and financing through equity. When you buy a debt investment such as a bond, you are guaranteed the return of your money (the principal) along with promised interest payments. This isn't the case with an equity investment. By becoming an owner, you assume the risk of the company not being successful - just as a small business owner isn't guaranteed a return, neither is a shareholder. As an owner, your claim on assets is less than that of creditors. This means that if a company goes bankrupt and liquidates, you, as a shareholder, don't get any money until the banks and bondholders have been paid out. Different Types Of Stocks There are two main types of stocks: common stock and preferred stock. Common Stock -Common stock is, well, common. When people talk about stocks they are usually referring to this type. In fact, the majority of stock is issued is in this form. We basically went over features of common stock in the last section. Common shares represent ownership in a company and a claim (dividends) on a portion of profits. Investors get one vote per share to elect the board members, who oversee the major decisions made by management. Over the long term, common stock, by means of capital growth, yields higher returns than almost every other investment. This higher return comes at a cost since common stocks entail the most risk. If a company goes bankrupt and liquidates, the common shareholders will not receive money until the creditors, bondholders and preferred shareholders are paid. Preferred Stock -Preferred stock represents some degree of ownership in a company but usually doesn't come with the same voting rights. (This may vary depending on the company.) With preferred shares, investors are usually guaranteed a fixed dividend forever. This is different than common

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stock, which has variable dividends that are never guaranteed. Another advantage is that in the event of liquidation, preferred shareholders are paid off before the common shareholder (but still after debt holders). Preferred stock may also be callable, meaning that the company has the option to purchase the shares from shareholders at anytime. How Stocks Trade -Most stocks are traded on exchanges, which are places where buyers and sellers meet and decide on a price. Some exchanges are physical locations where transactions are carried out on a trading floor. You've probably seen pictures of a trading floor, in which traders are wildly throwing their arms up, waving, yelling, and signaling to each other. The other type of exchange is virtual, composed of a network of computers where trades are made. The purpose of a stock market is to facilitate the exchange of securities between buyers and sellers, reducing the risks of investing. Before we go on, we should distinguish between the primary market and the secondary market. The primary market is where securities are created (by means of an IPO) while, in the secondary market, investors trade previously-issued securities without the involvement of the issuing-companies. The secondary market is what people are referring to when they talk about the stock market. It is important to understand that the trading of a company's stock does not directly involve that company. What Causes Stock Prices To Change? Stock prices change every day as a result of market forces. By this we mean that share prices change because of supply and demand. If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall. Understanding supply and demand is easy. What is difficult to comprehend is what makes people like a particular stock and dislike another stock. This comes down to figuring out what news is positive for a company and what news is negative. There are many answers to this problem and just about any investor you ask has their own ideas and strategies. That being said, the principal theory is that the price movement of a stock indicates what investors feel a company is worth. Don't equate a company's value with the stock price. The value of a company is its market capitalization, which is the stock price multiplied by the number of shares outstanding. For example, a company that trades at $100 per share and has 1 million shares outstanding has a lesser value than a company that trades at $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5 million = $250 million).

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To further complicate things, the price of a stock doesn't only reflect a company's current value, it also reflects the growth that investors expect in the future. The most important factor that affects the value of a company is its earnings. Earnings are the profit a company makes, and in the long run no company can survive without them. It makes sense when you think about it. If a company never makes money, it isn't going to stay in business.

The important things to grasp about this subject are the following: 1. At the most fundamental level, supply and demand in the market determines stock price. 2. Price times the number of shares outstanding (market capitalization) is the value of a company. Comparing just the share price of two companies is meaningless. 3. Theoretically, earnings are what affect investors' valuation of a company, but there are other indicators that investors use to predict stock price. Remember, it is investors' sentiments, attitudes and expectations that ultimately affect stock prices. 4. There are many theories that try to explain the way stock prices move the way they do. Unfortunately, there is no one theory that can explain everything. The Bulls, The Bears And The Farm The Bulls -A bull market is when everything in the economy is great, people are finding jobs, gross domestic product (GDP) is growing, and stocks are rising. Things are just plain rosy! Picking stocks during a bull market is easier because everything is going up. Bull markets cannot last forever though, and sometimes they can lead to dangerous situations if stocks become overvalued. If a person is optimistic and believes that stocks will go up, he or she is called a "bull" and is said to have a "bullish outlook". The Bears -A bear market is when the economy is bad, recession is looming and stock prices are falling. Bear markets make it tough for investors to pick profitable stocks. One solution to this is to make money when stocks are falling using a technique called short selling. Another strategy is to wait on the sidelines until you feel that the bear market is nearing its end, only starting to buy in anticipation of a bull market. If a person is pessimistic, believing that stocks are going to drop, he or she is called a "bear" and said to have a "bearish outlook".

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The Other Animals on the Farm - Chickens and Pigs Chickens are afraid to lose anything. Their fear overrides their need to make profits and so they turn only to money-market securities or get out of the markets entirely. While it's true that you should never invest in something over which you lose sleep, you are also guaranteed never to see any return if you avoid the market completely and never take any risk. Pigs are high-risk investors looking for the one big score in a short period of time. Pigs buy on hot tips and invest in companies without doing their due diligence. They get impatient, greedy, and emotional about their investments, and they are drawn to high-risk securities without putting in the proper time or money to learn about these investment vehicles. Professional traders love the pigs, as it's often from their losses that the bulls and bears reap their profits. "Bulls make money, bears make money, but pigs just get slaughtered!"

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Common Terms used in Accounting

Accounts Payable - Accounts payable is the total amount of money that is owed by a business to pay for all outstanding services and goods provided by outside sources. A majority of accounts payable transactions include invoices from vendors, bills necessary to run the business, and funds owed for services. In other words, accounts payable is the amount of money that is owed to cover regular monthly and yearly expenses. Accounts Receivable - Accounts receivable is basically the opposite of accounts payable. Accounts receivable is the amount of money that your business is due from others. All income that the business is expecting to receive should be included in accounts receivable. This includes money that is being paid to you for both goods and/or services. Accrued Expenses - According to Alpine Guild, an accrued expense is an expense that has been incurred but has not yet been paid. One example of an accrual is salaries owed to employees. According to that same site, salaries continue to accrue until payday, when the accrued expense of the salaries is eliminated. Assets - Assets cover a broad range of valuable items owned by a business. An asset could be physical property such as a building, a boat or a storage area. Additionally, an asset could be a stock certificate or the ownership of a patent. Current assets are those items of ownership that will turn into cash over the next year. According to Alpine Guild, some examples of assets include cash, marketable securities, accounts receivable and inventory. Fixed assets are those items of ownership that cannot quickly be liquidated into cash, and include land, buildings, machinery, equipment, furniture, and long-term investments. Balance Sheet -Balance sheet is one of the most important basic financial accounting terms. According to Alpine Guild, a balance sheet is a statement of the financial position of a company at a specific time. Typically, a balance sheet is created at the close of business on the last day of the month, on the final day of the quarter, or at the end of the year. In most cases, a balance sheet is created to list all of a company's assets on the left side of the page. On the right side of the page or near the bottom of the page, liabilities and capital are recorded. According to Nolo.com, the total of all assets and the total of all liabilities should balance. More simply stated, assets should always equal liabilities plus capital. Capital -Capital is the money that is invested in a business by its owner or owners. Sometimes the word equity is used synonymously with capital to signify the financial investment that is part of the business. Capital is also a

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basic financial accounting term that includes equipment, buildings and fixed assets that are owned by the business. Cash Flow -Cash flow is a simple but important accounting term that represents the actual amount of cash that is generated by a company. Cash flow can often be determined by looking at the company's current bank statement and comparing it to outstanding expenses. The cash flow does not show the entire profit for the year, but reflects a current cash standing at a particular point in time.

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Understanding Basics of Accounting

Financial management is a crucial aspect of any thriving business. Profit maximization, or stockholder wealth maximization, are two real concerns for any organization and they depend on solid financial decisions. To make good decisions, management needs good information. And that information comes from the accounting system. From the accounting system come the financial statements. These statements contain important information about the organization's operating results. This information is important for effective management, and financial control. As a manager, or any other person with financial responsibility, you have to be able to interpret this information yourself. Financial statements contain important information about your company's operating results and financial position. The relationship between certain items of financial data can be used to identify areas where your firm excels and, more importantly, where there are opportunities for improvement. Using, understanding, and interpreting these statements will help you make much better business decisions. Businesses record their performance in standard formats called financial statements. The most common of these are: Balance Sheet (also known as a Statement of Financial Position, or a Statement of Financial Condition). Income Statement (Statement of Profit and Loss, Statement of Earnings, Statement of Operations). Cash Flow Statement

While these statements look at different aspects of the company, they are interrelated and dependent on each other, as information from one is needed to prepare the others. The key to understanding accounts is to have a good grasp of what the basic statements are there to do: how they are prepared, what they tell you, and what they don't. The Bookkeeping Process Every time your organization conducts a business transaction, the status of the accounts changes. In a retail company, for example, when a sale is made, the cash account increases, and the inventory decreases. The bookkeeping process keeps track of these changes in various ledgers and journals. The financial statements are then prepared using this information. Accounting is based on the fundamental accounting equation:

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Total Assets = Total Liabilities + Equity This essentially means that the difference between what the business owns and what it owes represents the equity the company's owners have. To keep this equation in balance means that, with each transaction, at least two accounts and the balances in those accounts will change. Accounting is the process of keeping track of those changes, and recording and then reporting them. Transaction Example: If a company purchases a computer for $1500 with $500 cash deposit, and the remainder on a store credit program, there are three accounts affected: * The asset account 'Equipment.' * The asset account 'Cash.' * The liability account 'Accounts Payable.' These specific accounts can be found in what is called the Chart of Accounts. The titles Equipment, Cash, and Accounts Payable are not random; these are specific accounts that were identified as relevant to the company before it began operating as a business. To keep track of transactions efficiently, a General Journal (Original Book of Entry) is used. The journal records what happened, the accounts affected, and the amounts. Once you've identified the accounts that are involved, you need to apply the rules of what accountants call 'transaction analysis.' This involves the following: * Asset and Expense accounts are increased by a debit, and decreased by a credit. * Liabilities, Equity, and Revenue accounts are increased by a credit, and decreased by a debit. Having a chronological record of the business' transactions is very useful, should you need to go back and review a particular transaction at a later date. The problem with keeping information in this format, though, is that there is no way to determine what the actual balance in each account is after each transaction. For example, you may need to know how much cash is actually in the cash account, and thus in the bank account, at any given time. To keep track of account balances, accountants use what is called a General Ledger.

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The General Ledger consists of ledger accounts, one for each account set up in the Chart of Accounts. Debits and credits to each account are posted to the ledger from the journal, and the balance is kept current. Posting is the process of transferring amounts from the general journal to specific general ledger accounts. Because entries are recorded in the ledger after the journal, the general ledger is often called the Book of Final Entry. Balance Sheet -A Balance Sheet indicates the financial position of a business at one point in time; it shows what the business owns and owes. The general journal captures day-to-day account balances. At the end of an accounting period, a Balance Sheet is prepared. The Balance Sheet has three sections: Assets the things of value that the company owns. Liabilities obligations to pay or provide goods or services at some later date. Equity the amount of net assets (assets - liabilities) owing to the owners of the business.

The Balance Sheet is named as such because the total of the assets must equal the total of the liabilities and equity. What a company owns equals what it owes to its creditors and owners. Income Statement -At certain points during the year, each business wants to know how well it is doing. Is it earning a profit? Is it losing money? Just how well is it doing compared to other firms? Is it likely to be able to earn a profit in the future? To answer these questions, it uses an Income Statement. The Income Statement communicates the inflow of revenue, and the outflow of expenses, over a given period of time. Revenue is the inflow of assets (i.e. cash or accounts receivable) to a company in return for services performed, or goods sold. Expenses are the outflow or consumption of assets (i.e. cash, inventory, supplies), or obligations incurred (i.e. accounts payable, taxes payable) while generating revenue. The difference between these two is the Net Income. An Income Statement therefore shows the operating profit (or loss) of a business. The Net Income amount is the amount by which a company's equity increases or decreases for the period. An equity account is used to record the change that results from business operations. In a proprietorship, this is typically called Retained Earnings. In corporations, it is called Owner's Equity.

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Cash Flow Statement -The Cash Flow Statement records inflows and outflows of cash during a period of time, and is divided into cash flow from operations, financing, and investing activities. To prepare a statement of cash flow you must convert net income from accrual-based accounting to cash. You therefore have to add and subtract changes in non-cash accounts that have accrued during the period. For instance, you need to add back depreciation amounts, because although depreciation expense decreases net income, it has no bearing on actual cash. Likewise, you have to deduct any decreases in accounts payable because that is a use of cash that was not accounted for on the Income Statement. The following table outlines the major sources and uses of cash: Sources of Cash Operations New loans Uses of Cash Cash Dividends Repayment of loans

New stock issues or owner Repurchase of stock investment Sale of property, plant, or Purchase of property, equipment plant, or equipment Sale of other non-current Purchase of asset current asset other non-

By analyzing the differences between the balance sheets for the beginning of the period and the end of the period, and accounting for the net income for the period, you can prepare a Cash Flow Statement: Financial Statement Interpretation Understanding the interrelatedness of the financial statements is very important when reading and interpreting them. Understanding where the numbers come from, and what they actually mean, is extremely important when evaluating your own performance, or comparing your performance to others. Armed with some knowledge of accounts, it's important to understand what the statements actually tell you. What an Income Statement says: * The Income Statement reports the main and any secondary sources of income. For example, Fees Earned would be the primary revenue in a dental

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office. If they had bonds, a secondary source of revenue would be Interest Earned from Bond Investment. * The terms used to describe the revenue will provide a clue about the nature of the organization. For example, Fees Earned implies a service company; Commissions Earned implies a brokerage; while Sales Revenue implies a retail or wholesale firm. * The items listed as expenses are expired, meaning they have no useful value left. * The result of matching the revenues and expenses yields the Net Income or Net Earnings if the statement is called the Earnings Statement. The term 'net' implies that the revenues and expenses have been matched, and therefore there is not an over or under statement of the income (loss). What an Income Statement does not say: * An Income Statement does not predict the future net income for any accounting period. Since the future is full of uncertainty, a reader of a historical Income Statement can't rely on the reported results of any single period for an indication of future results. * An Income Statement, no matter how well prepared, does not provide an exact measurement of net income for the accounting period. No matter how hard you try, it is impossible to get an exact match. Consider, for example, an advertising expense. If management spent $1,000 in December on advertising, and achieved $5,000 sales revenue for December, that does not mean that the advertising brought in exactly $5,000 revenue. There may also be revenue generated in January that can be attributed to the December advertising. When it is difficult to measure, the expense is accounted for in the period it was incurred. * An Income Statement does not report True Profit, which is the difference between total funds invested over the life of the company and funds realized from the sale of the company. To calculate this, you would have to calculate the difference between assets invested during the lifetime of the business, and the amount finally received from remaining assets after winding up the business. You would also have to deduct any personal withdrawals because these were actually paid out of the 'profits.' * Net Income does not mean cash! Always keep in mind that net income is the excess revenue over related expenses for a specific accounting period. Cash has very little to do with determining net income. True, revenue refers to an inflow of cash and expense to an outflow, but often the inflow of cash is used for further investment. Additionally, revenues and expenses are
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recorded at the time of occurrence, not when cash changes hands. What about the case of depreciation expense which does not represent an outflow of cash at all?

What a Balance Sheet says: * A Balance Sheet gives readers a detailed summary of the assets and claims against those assets, as at a particular date. * A Balance Sheet provides the reader with information about the financial position of the firm with regard to its ability to pay current debts. By comparing the current assets to the current liabilities, the reader can assess whether the company is in a position to meet to meet its short-term financial obligations. * A Balance Sheet gives the reader a view of the firm's financial position to carry on its business operations. The fixed-asset section indicates how many resources the company has working for it to assist in revenue generation. * Finally, a Balance Sheet reveals the strength of the owner's claim against the assets. Remember, however, that this claim is residual, or the remaining claim after the creditors'.

What a Balance Sheet does not say: * A Balance Sheet does not report the details of how the profits were made. That information comes from the Income Statement. * A Balance Sheet does not show the claims of the creditors and the owner(s) against a specific asset. The claims are against the assets in general. * The word 'Capital' under owner's equity must not be interpreted as cash. The investment can come in many forms cash being just one of them. The owner's original cash investment may have gone primarily to purchase fixed assets in order to assist revenue generation. Capital means investment not cash. * A Balance Sheet does not report the market value, current value, or worth of a business. Many readers believe the total assets represent a bundle of future cash reserves. This is not true because fixed assets are reported at historical cost, and their purpose is to assist revenue generation. They are not intended for sale to enhance cash flow.

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