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Summary Key Concepts in Finance
Summary Key Concepts in Finance
Understanding Money
Money is a standardized unit of exchange. The physical form of money is currency. Different countries have different
currencies.
Its defined as the interest rate at which a given initial value will grow to a final value, in a given amount of time.
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Inflation
It is a rise in prices or put another way, a decrease in the value of money.
Nominal Rate (N) Inflation Rate (I) = Real Rate (R)
Nominal rate of interest (N) refers to the stated interest rate in the economy.
Inflation rate refers to the rate at which money is losing value.
Real rate of interest (R) refers to the inflation-adjusted rate of interest. That is, it is the rate you actually get
after deducting the effect of inflation.
Understanding Risk
Risk is the probability that financial loss will occur.
Risk management is a three stage process:
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2. Measuring Risk
There are different methods of measuring the types of risk. All methods consider the following factors to arrive at a
measure of risk
Probability of an adverse event: The measurement of this probability uses various statistical techniques.
Monetary impact of the adverse event: If the adverse or loss-causing event occurs, how much money
would be lost?
3. Managing Risk
Once the risk is identified and measured, the following steps can be taken to lessen its impact.
Hedging- This refers to protecting oneself against risk, using specific financial instruments.
Insurance- Another way to manage risk is to transfer it to an insuring party, by paying a fee (called the
premium).
Setting risk limits- A business can set risk limits to the amount of risk it is willing to face, and thus
manage risk.
Accounting
Businesses can be structured in 3 ways:
1. Proprietorship: Business with a single owner. Owner has complete liability for all debts of the company.
2. Partnership: Business with 2 to 20 equal owners. All partners share complete liability for all debts of the
company.
3. Limited company: Many owners with limited liability for debts of the business; this liability is only upto
their capital contributed.There are two types of limited companies: private and public. The former is held by
2-50 owners privately. The latter has unlimited number of owners, and any member of the public can be a
part-owner.
A business has numerous transactions which need to be recorded following certain accounting principles and process.
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Accounting Principles
These are called Generally Accepted Accounting Principles, or GAAP. Key GAAPs are
1.
2.
3.
4.
5.
6.
Going Concern Concept: This principle assumes that a business will go on. That is, it will continue in the
foreseeable future it has no finite life. We use this principle to project cash flows into the future.
Legal Entity: The business is an entity separate from owners; even if its a small, one person business
running out of home. Therefore the business accounts are taken separate from the owners.
Conservatism: Be cautious and conservative while accounting. Recognize income only when its definite.
Accrual Concept: Income and expense are recognized/recorded when a transaction occurs- not when cash
changes hands. Income and expense are recorded, irrespective of cash received/paid.
Matching Concept: The business must match the expenses incurred for a period, to the income earned
during that period.
Cost Concept: All assets are recorded on the books at purchase price, not market price.
Key Terms
Income: It refers to revenues/ financial benefits received by the business. If the revenues are via credit
sales, this may not result in a cash inflow at that time.
Expense: Expense is the costs incurred directly or indirectly to earn income. If the expenses are on credit,
they may not result in a cash outflow at that time.
Asset: Assets are resources with defined financial value owned by the business.
Liability: Liability is the financial obligation to pay cash or provide goods and services.
Owners Equity: It is defined as net worth, which refers to funds belonging to the owner/s, currently held
by the business.
Accounting Process
Accounting process involves 5 steps.
1.
2.
3.
4.
5.
Transaction: The process starts with transactions. Any action involving money, such as purchase, sale,
loan, deposit is called atransaction.
Journal Book: It is a Book of accounts in which transactions are entered on a serial, per day basis.
General Ledger: It is a book of accounts where transactions are entered under categories. They are
transferred from the journal into the GL. In an automated process, transactions are entered directly into the
GL.
Trial Balance: It is a process where all debits and credits from the GL are balanced. The total of the debit
side must equal the total of the credit side.
Financial Statements: Three main financial statements are cash flow statement, Profit & Loss statement
& Balance Sheet. They are prepared after the Trial Balancing is done.
Transactions are recorded using the Double Entry method; where every transaction has two entries. One is called
a Debit (Dr) entry and the other a Credit (Cr) entry. The main equation for a balance sheet is
Asset = Liability + Owners Capital/Equity.
The rules for passing Debit and Credit entries are as follows:
Assets
Increase-> Debit
= Liabilities
Increase-> Credit
Owners Equity
Increase->Credit
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An increase in an asset, leads to a debit entry in the asset account; on the other side of the equation, the result of an
increase is the reverse: a credit entry
Therefore, it is obvious that:
Assets
Decrease-> Credit
= Liabilities
Decrease-> Debit
+
Owners Equity
Decrease-> Debit
There are 3 steps while passing entries for a transaction: First, recognize which two accounts are affected by the
transaction. Next, apply the above rule for one of them (best is to apply to an asset account). Third, post the entry
into the debit or credit side of the account, and the contra entry, into the other account.
Financial Statements
Financial statements involve:
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2.
3.
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Balance Sheet:
The balance sheet is the snapshot - position - of a business as on a particular date. (Unlike the P&L and cash flow,
which are over a period of time).
It is not a record of transactions. It gives:
What the business owns: Assets
What the business owes to others: Liabilities
What the business owes to owners/ownersstake in the business: Owners equity
Assets: Assets are divided into Current Assets (CA) & Long Term Assets.
1.
Current assets: These are assets which can be converted into cash within the accounting period.For
example:
Receivables
Inventories
Prepaid expenses
Other Current Assets
2.
Long-term Assets: It includes fixed assets, long term receivables & Intangible assets.
Current Liabilities: These are items which have to be paid within the accounting period:
Short term loans
Account/Trade payables
Accrued expenses
Customer advances
Taxes payable
Current portion of long term debt
Other Current Liabilities
2.
Long Term Liabilities: It is the summation of long term debt, deferred liabilities/provisions & other
liabilities.
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