Finance is the set of activities dealing with the management of funds. More specifically, it is the decision of collection and use of funds. It is a branch of economics that studies the management of money and other assets. Finance is also the science and art of determining if the funds of an organization are being used properly. Through financial analysis, companies and businesses can take decisions and corrective actions towards the sources of income and the expenses and investments that need to be made in order to stay competitive. Finance is a field of study of the relationship of three things; time, risk and money. The Time Value of Money is one of three fundamental ideas that shape finance.


The Time Value of Money explains why, "A dollar today is worth more than a dollar tomorrow". This is primarily due to the market for loanable funds and inflation. If someone has a dollar today then they also have the opportunity to loan/invest that dollar at some interest rate. Therefore, a dollar today in time would be worth $1.00 plus some interest rate. That is more than a dollar by itself in the future. An example for inflation would be, let’s says you have $1 and you can buy 10 candies today. For the same 10 candies tomorrow you have to pay $1.20. So, due to inflation for the same 10 candies today you pay less than you would pay tomorrow Inflation refers to the decrease in the purchasing power. Deflation refers to the increase in the purchasing power. In layman terms, inflation causes not the value of money to decrease but the amount of consumables/items that you can now purchase to decline in quantity. Look at the example above. $1 is still $1 but after inflation the individual can probably buy only 8 candies for the same $1 amount. There are two values of money. One is the Present Value of Money and the other is the Future Value of Money. Second is the concept of "opportunity cost"; i.e. if a person deploys his money on one item or investment then he has given up the opportunity to do something else with it. Third is the concept of risk. Let us say, I have earmarked $10,000 towards investments and I decide that I will invest in Microsoft. I put all my money in Microsoft (MSFT) all $10,000 of it. As on 5th Oct., 2006 each share of Microsoft trades at $27.94. So, I would be able to purchase 357.91 shares of MSFT. My returns are completely dependent on how MSFT stock performs in the market and this means that if a Microsoft product (i.e. Vista), fails in the marketplace, MSFT stock goes tumbling down and reduces my investment in MSFT. Thus, Risk can be defined as the probability of my investment eroding its own self. In equity, the risk factor is higher than in debt financing and hence as an investor I look for equity to give me higher returns as I have taken higher risk. If I buy US Treasury notes for that value, the investment is almost risk free as the US Govt. stands to guarantee it and hence the return (typically, expressed as the rate of interest) is low. The difference between the returns from equity and from debt (US Treasury, etc) is the Risk Premium. 3

Risk Premium is the reward given to an investor to take more risk.

Cash Flows and Financial Decisions of Households

Real economic activities

(2’ )

(1’ )

(3’ )

(4’ )

Financial Assets/Liabilitie s – Bonds – Stocks – Mortgages

(5’ )

(1’) Cash raised by selling financial assets (2’) Cash invested in real assets (tangible and intangible). (3’) Cash generated by real assets. (4’) Cash consumed and reinvested. (5’) Cash invested in financial assets.

Decisions: Manage Cash Flow (1’), (2’), (4’), (5’). Real investment decision: (2’), (3’). Consumption/financing decision: (1’), (4’). Saving and financial investment decisions: (5’). Objective: Grow wealth and achieve optimal consumption.

Cash flows and Financial Decisions of Firms
(2’ ) (1’)

Firm’s operations
(3’ )

Financial manager

(4’ )

Investors – Individuals – Institutions – Etc

(5’ )

(1) Cash rose from investors by selling financial assets. (2) Cash invested in real assets (tangible and intangible). (3) Cash generated by operations. (4) Cash reinvested. (5) Cash returned to investors (debt payments, dividends, :)

Decisions: Manage Cash Flow (1), (2), (4), (5). Investment: (2) ) (3). Financing: (1), (4). Payout: (5). Risk management: (1), (5). Objective: Create value for shareholders.


Financial decisions and asset valuation: Real investment decisions  How real assets are priced. Financing and payout decisions  How financial assets are priced. Financial decisions and asset management: Risk management decisions  How to meet future investment/financing needs. Personal savings/financing/financial investment decisions  How to meet personal consumption needs.



Finance is about the bottom line of business activities. Every business is a process of acquiring and disposing assets: – Real assets - tangible and intangible. – Financial assets. Two objectives of business: – Grow wealth (create value). – Use wealth(assets) to best meet economic needs Financially, a business decision reduces to: – Valuation of assets. – Management of assets. Valuation is the central issue of finance.



The five basic corporate finance functions are described as those functions related to; 1) Raising capital to support company operations and investments (financing functions); 2) Selecting those projects based on risk and expected return that are the best use of a company's resources (capital budgeting functions); 3) Management of company cash flow and balancing the ratio of debt and equity financing to maximize company value (financial management function); 4) Developing a company governance structure to encourage ethical behavior and actions that serve the best interests of its stockholders (corporate governance function); and 5) Management of risk exposure to maintain optimum risk-return trade-off that maximizes shareholder value (risk management function). 8

The finance function consists of the people, technology, processes, and policies that dictate tasks and decisions related to financial resources of a company. Depending on the organization and the industry in which it operates, this function may be simple or complex. Some finance functions are overstaffed that is, they rely on individuals to perform both advanced and simple tasks while others are highly automated relying on people for decision making and policy setting exclusively. Regardless of the ratio of people to technology, the goal of the finance function is to serve the organization's financial/accounting needs while laying a platform for the future. This means handling clerical tasks, providing information to the organization and setting financial policies and strategies that will serve the company in the future. To succeed in these three broad areas, the small and emerging business must be prepared to develop a finance function that both suits its needs and can adapt to the growth and changes of the business. The first step is to develop an adequate finance function. To do this, it is important to understand the component parts.


The finance function consists of two basic component types: (1) concrete components and (2) soft components. Concrete components include all aspects of infrastructure including technology, software applications, and processes, as well as the people who manage them. Soft components include the standards, strategies, models, and vision that drive the finance/accounting aspect of the business. Each component stands on its own to an extent; however, ultimately all components must be woven together in a way that serves the overall organization objectives. It is not enough that all component parts exist; rather they must exist in harmony with one another, yielding synergies that serve the company's needs today and provide for the future.

Concrete Components
The term infrastructure, in this context, refers to all relevant concrete components of the finance function. These components may already exist in the organization in some fashion, although they are not thought of as infrastructure. Regardless of how they were classified, these components were assessed for their usefulness and either purchased or developed. In order for certain tasks to be undertaken on a regular basis, tools and processes must be put in place to manage them. Items of infrastructure can be classified into three major categories: (1) finance organization, (2) information systems, and (3) processes.


The term finance organization refers to the people responsible for conceptualizing, implementing, and following through with all finance and accounting related tasks and initiatives, as well as the technological tools they employ. The finance function works best when people with the right qualifications are matched with the right tasks. When the proper technological tools are put in the mix, the finance organization will excel and serve the needs of the organization. Staffing. Enlisting the right people for the job is a challenge in any business. When certain aspects of the finance organization (namely infrastructure) are lacking, it is easy for employers to lose sight of essential employee skill needs. For example, the position of Director of Budget and Forecasting may require Information Systems (IS) skills because no IS organization exists. Finding a Director of Budget and Forecasting may be difficult enough, but finding one with advanced IS skills may be impossible. Finance personnel typically rely on technological tools to do their jobs; however, they may not be so knowledgeable at maintaining the technology. If substandard tools are provided to professionals, they may have to fend for themselves when it comes to managing the secondary demands of the job (making their computer work or administering software) rather than focus on their primary objective (managing the budget and forecasting process). This human element of the finance organization can be a powerful resource for the organization if the right people are a part of the team and if they are allowed to generate and implement new ideas. Expecting people to not only perform their tasks but also to optimize the way their function fits in with the business will provide value to the organization and provide meaningful career development for employees. Personnel should be allowed to isolate all business needs and drivers, determine the impact of these on the organization, and be rewarded for the business strategy/planning that results.


Technology. Nothing is more important than providing people with the right tools for the job. This means appropriately configured computers, communication devices, and planning tools. Simply buying the best technology may not always be the answer. A mistake repeated every day by executives and business owners is falling prey to a vendor claim that if the smartest or best machine is purchased, the users objectives will be met. The nature of the tasks to be performed must be taken into account before staff is outfitted with technology. Will desktop computers suffice or will staff need laptops instead? Will finance staff need cell phones or other types of communication linkage? How about planning devices do staff need personal digital assistants or other wireless devices to share documents and Information remotely? Knowing whether staff will be performing tasks in one central location or performing tasks on the road will drive decisions for technology. The term information systems refer to the backbone technology servers, switches, operating systems, protocols, and software applications that will drive the finance function. Distinguished from technology defined earlier, information systems have a broader impact on the entire platform of the organization¡¯s technological capability. This term is used more on a macro-level as opposed to the term technology. Information systems give organizations the ability to gather data in the business environment and translate it to knowledge. They also provide the ability to communicate information and data within and outside the organization. Information systems provide a basis for evaluating customers while allowing them to provide feedback to the organization. This aspect of infrastructure also allows the organization to link with information systems of customers and companies in the same industry to achieve synergies in buying, forecasting, billing, and collecting customer payments. Processes are the protocols and procedures that envelop information systems. They leverage the impact of information systems and bridge the gap between raw systems capability and company specific needs. Processes cannot be generic but must be customized and suited for a particular organization¡¯s needs. To develop processes, the business owner/manager must have an acute knowledge of the organization and what it is trying to accomplish. To succeed in process development, 12

knowledge of employee capability, thresholds of technology, and limits of systems also must be firmly grasped.

Soft Components
Soft components of the finance function are the more advanced considerations of the function itself. Policies, standards, strategies, and analysis paradigms are examples of soft components. These components cannot be bought or replicated necessarily from an outside source; rather they are developed internally. It is management responsibility to develop the soft components of the finance function and maintain them as the company grows and adapts to its environment. The existence and relevance of soft components are good litmus tests for the strength of management. Companies that are lacking in this area put the organization at risk and leave development of the finance area to chance. Allowing the finance function to evolve on its own without a vision driven by strategies and formed with standards could create more problems than it solves. Developing finance strategies, standards, and policies may be a luxury for the small and emerging business owner when compared to the dayto-day necessities of keeping the organization running. It is important to note, however, that most soft components of the finance function are not developed overnight. In fact, rarely are they complete or relevant for very long. Soft components are always developing and changing as the business organization changes. Developing them should be embraced as an aspect of organizational culture. Although an organization may be able to enjoy success in its early years without attending to these components of the finance function, eventually issues in the business itself or business environment will demand them. For example, infrastructure may suit a small and emerging business in the short run, but increasing demands for information and new ways to serve customers may necessitate change in this area. Absent the vision for development or the strategy for addressing future data needs, the finance function always will be a step behind, which will result in perpetual short-term decision mode. This may be costly in the long run as managers purchase unscalable technology to solve an immediate need, only to find them repurchasing more technology a short time later to accommodate evolving needs.


Well-thought-out soft components will make development of all aspects of the finance function second nature. For example, developing financial analysis paradigms that are relevant to the organization business fundamentals will drive IS needs. These paradigms will in turn drive the level of qualifications of personnel. Strategies then can be developed that implement relevant software applications, technological tools, communication devices, and so on. This web of impact illustrates how all aspects of the finance function cascade off the soft components. Practically speaking, the small and emerging business owner may not be focused on the mid- and longterm time horizon. Therefore, codifying areas of vision, strategy, and policy in the finance area may not be practical. It is important to note, however, that being aware of developing soft components at the early stage of the organization will greatly benefit the business owner/manager as the business matures. The high rate of change in the business in its early years may render soft components irrelevant overnight. Laying a foundation of thought and intent to develop this aspect of the finance function will become that much easier as the business owner/manager matures with the business and becomes savvier in developing strategy.



Scope of finance deals with the application of finance knowledge in different areas of organization.

Management of Real and Financial AssetsAn organization requires two types of assets to carry out its business. A. Real Assets1. Tangible Real assets-Like machinery, building etc. 2. Intangible Real assets-Like Patent, copy right, technological collaborations. B. Financial AssetsThese assets also called financial securities stocks, bonds, debentures, and loan.


Management of Financial Resources of Organization
These are two types of funds that firms can raise1. Equity CapitalEquity capital is share capital, that supply this capital to the organization are the legal owner of the company. A company can raise the equity capital from two sources. 1. Common equity shapes-The holders of common equity shares are called ordinary share holders and residual profit is distributed to them as their share from the company which is called dividend. 2. Preference Shares-Preference share holders get their dividend at fixed rate from the company. 2. Debt CapitalThis is capital supplied by Creditors and Lenders to the company in terms of loans or by purchasing some debt securities of the company. Lenders are not the legal owner of the company and they get their returns from the company at fixed rate. Debt capital can be raised from two sources. 1. Banks and Financial Institutions in term of Loan. 2. From general investors by issuing the debentures to them.


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