KEY CONCEPTS OF FINANCE

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Understanding Money

Money is a standardized unit of exchange. The physical form of money is currency. Different countries have different
currencies.
 Interest is the amount earned, on money which is lent.
 Compound interest is the ‘interest earned on interest’.
Compound Interest (C.I) = [P*(1+r/100) ^t – P]
Where: P = Principal amount, r = Rate of interest, t = Time period in years

Interest may be compounded annually, semi-annually, quarterly, monthly or even daily.

This is known as the compounding frequency. Greater the frequency of compounding, the greater the effective
return or yield. Always adjust the ‘r’ to map to the ‘t’. That is, if the compounding is quarterly, then take the quarterly
interest rate, not the annual rate.

Compounded Annual Growth Rate (CAGR)

If we come across a projection of say, sales or profit 3 years from now, we need to arrive at a rate at which the sales
was growing each year, to arrive at that future number. That growth rate, which assumes compound growth each
year, is called the CAGR.

 CAGR = (Final Value/Initial Value)1/n- 1

It’s defined as ‘the interest rate at which a given initial value will ‘grow’ to a final value, in a given amount of time.’

Time Value Concept of Money

Money earns interest with time. That means, INR 100 today is worth different amounts at different points in time.
Hence, money has a ‘time value’.

The fundamental concepts involved in understanding the time value of money are:
 Future Value of Money:
‘Future value of an amount is the amount today’s money turns into at a point of time in the future
(assuming a certain rate of return)’.
Future value is arrived at by multiplying the principal invested today by the compounding factor (1+r)^t .
 FV = PV (1+r/100)^t
Where, FV = Future Value

 Present Value of Money:

If you want to get a known sum of money in the future after a time period t, what is the principal you must
invest today, or in other words, what is its present value?
In other words, the Future Value (FV) is known; we need to find the Present Value (PV) or Today’s Value.
 PV = FV/(1+r/100)^t
The process of computing the present value is also called discounting, as the PV is at a discount (less) as
compared to the FV. The ‘r’ here is also referred to as the discount rate.

 Net Present Value of Money:

NPV is an evaluation tool, used to find out, if the rate of return of a series of cash flows, is higher or
lower than a comparison rate.

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The situation in which you use NPV is:

1. A set of cash flows, (meaning inflows and outflows/payments) at different points of time in the future,
are given.
2. You don’t know the rate of return all these cash flows will result in.

If PV (C1) is the PV of the cash outflow for an investment, and PV (C2) and PV (C3) are the cash inflows,
then NPV is the net of these flows: -PV(C1)+ PV(C2)+PV(C3).

 IRR or Yield to Maturity:

The rate which makes the present value of all future cash inflows equal to the outflow or investment today,
i.e. makes the NPV=0, is the yield of the investment.
This is the yield to maturity – i.e. the yield or return after considering all the cash flows from the
investment. This is also called the Internal Rate of Return (IRR).

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:

1. Identify the Risk

A financial institution faces the following typical types of risks:

 Credit risk - This is the risk of default by a borrower.

 Regulatory risk - This refers to the risk of loss if a Financial Institution (FI) does not comply with the
regulations needed by a country’s regulator.
 Liquidity risk - This is the risk of not having cash when it is needed. This risk is critical for a bank, as it
needs to always have sufficient money on hand, to repay withdrawals by depositors.
 Operational risk - This is the risk of loss occurring from inefficiency in a bank’s people, process and
systems. This includes risk of theft, fraud, process inefficiency and so on.
 Legal risk - Refers to when a bank is not able to reinforce a contract (such as a loan contract) it has
entered into.
 Market risk - Any entity trading in a financial market, is exposed to the risk of loss, and a bank is no
different. Depending on the specific market, the market risk can be further categorized into:
 Equity risk (risk of loss in the stock markets),
 Interest rate risk (risk of loss in bond markets), etc.

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Credit risk, operational risk and market risk are regulated by a global risk standard, called the Basel Norms. By
‘global’, we mean that, the norms are broadly similar across the world, for all banks.

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.
 Diversification- Diversification refers to spreading risk across different actions or options.
 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.

The Risk-return Principle

The higher the expected return, the higher is the attached risk and the lower the risk; the lower is the potential
reward. That means, if you expect higher returns from any investment, there will be a higher risk associated with it,
and vice versa.

Risk Management Systems

Technology plays an important role in risk management. Banks need risk management systems to manage the
different types of risk they face. For example, a market risk management will include Real time information, Real
time risk calculation, what if analytics, flexibility and customization and alerts and stops.

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: The owners (shareholders) of the company will have limited liability for debts of the
business; their liability is only up to the capital contributed by them. There are two types of limited
companies: private and public. The former is held by 200 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. 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.
2. Legal Entity: The business is an entity separate from owners; even if it’s a small, one person business
running out of home. Therefore the business accounts are taken separate from the owners.
3. Conservatism: Be cautious and conservative while accounting. Recognize income only when it’s definite.
4. 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.
5. Matching Concept: The business must match the expenses incurred for a period, to the income earned
during that period.
6. Cost Concept: All assets are recorded on the books at purchase price, not market price.

Key Terms

 Income: It refers to revenues earned or received by the business.

 Expense: Expense is the costs incurred directly or indirectly to earn income.
 Asset: Assets are resources with defined financial value owned by the business.
 Liability: Liability is the financial obligation owed by the business .
 Owners’ Equity: It is defined as net worth, which refers to funds belonging to the owner/s and the
profits/losses, currently held by the business.

Accounting Process

Accounting process involves 5 steps.

1. Transaction: The process starts with transactions. Any action involving money, such as purchase, sale,
loan, deposit is called atransaction.
2. Journal Book: It is a Book of accounts in which transactions of a business get recorded on a daily basis, in
serial order.
3. 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.
4. Trial Balance: It is a process where all debits and credits from the GL are balanced. The total of the debit
side must be equal to the total of the credit side.
5. 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 = Liabilities + Owners’ Equity

Increase-> Debit Increase-> Credit 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 = Liabilities + Owners’ Equity

Decrease-> Credit Decrease-> Debit Decrease-> Debit

 Income
Increase-> Credit Decrease-> Debit

 Expense
Increase-> debit Decrease-> Credit

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.

Concept of Depreciation and Amortization

As per the ‘matching principle’, expenses must of a particular period must be matched with the revenues of the
same period. Hence for all large, one time expenses such as building of a plant, purchase of machinery, furniture,
computers, or promotion of a new product, the expense is spread over time. That is, a portion of the expense is
recorded each year. This expense is called Depreciation or Amortization.

The term ‘Depreciation’ is used when physical assets are purchased, whereas the term ‘amortization’ is used when
intangible assets are purchased, or for reasons such as the one mentioned above – one time promotion/advertising
expenses for the launch of a new product. Amortization is also used for land.

The concept of Suspense Accounts

Suspense accounts are temporary accounts. They are created to hold amounts which are doubtful in nature – that
is, one is not sure of their source or where they should go. Suspense accounts are temporary in nature, and when
books are closed – that is, when the accounting period (such as a quarter or a year) is over, and final trial balance
etc. is being prepared – suspense accounts should be cleared. How are they cleared? By posting ‘adjustment
entries’, which clear the suspense account and post the balance to the correct accounts.

Financial Statements
Financial statements involve:

 Income statement or Profit & Loss account

 Cash flow statement
 Balance Sheet or Statement of Financial Position

Income Statement or Profit & Loss (P&L) account

This statement gives the income earned and expenses, and therefore the profit, for a particular period.

Components of P&L are:

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1. Revenues: All income earned, by the business of the company. Hence if the business is selling chocolates or
cars, this is the income from chocolates/cars sold during the period.

2. Direct expenses: Theseare expenses which vary directly with units produced. Direct expenses include raw
material and labour, and appear only in the P&L of a manufacturing company.

3. Operating expenses: Itrefers to the day to day running expenses of the business. E.g. Stationery items,
electricity, salaries, telephone bills, travel, promotional activities, etc.

4. Operating profit: Calculated by [Revenues – (direct+operating expenses)], it is an important indicator of the

health of the business: it shows whether the core business is profitable!

5. Depreciation/amortization: It is that portion of large costs/lump-sum expense, which you are considering in
this accounting period.

6. Other Expenses: These are non-operating expenses. For example, if you have hired a lawyer to provide a legal
opinion, the lawyer’s fee would come under this. Of course, if you have a lawyer as an employee, then it’s part
of operational expenses.

7. Other income: It is non-operating income, such as interest income on deposits.

8. Extra ordinary income and expense are large, unusual sums which occur rarely. For example, when a
business unit is sold off or bought.

9. PBIT/EBIT: Operating Profit – (Depreciation & Amortization) + Other Income – Other expenses + Extra-
ordinary income – Extra-ordinary expense = Profit or Earnings Before Interest & Tax, called PBIT or EBIT.

10. Interest Expense: It is the borrowing cost for a business, and is important to check how much in debt the
business is having , how much debt it is servicing. Hence, it is segregated and watched separately.

11. PAT/Net income: After deducting interest expenses on any borrowings, the profit left is called Profit Before
Tax or PBT; tax is then applied as a percentage of PBT, resulting in Profit After Tax or PAT.

12. Retained Earnings: PAT is what the share-holders or owners have a claim on. If any of the profits are
distributed back to the owners, that’s called dividend. The remainder gets re-invested back into the business and
appears under the heading ‘Retained Earnings’, under the Owners’ Equity part of the balance sheet.

Cash Flow Statement

As we have seen, items on a P&L are recorded on accrual basis, not cash basis. Hence it is clear that we do need a
statement that gives us the actual cash with a business. The cash flow statement fulfills the requirement of tracking
the cash of a business.

Cash flows for a business can be further sub-divided on the basis of broad activities of a business:

1. Cash Flow from Financing:

The cash flow arrived at by financing activities such as borrowing money, getting capital from owners, and
repaying both.

2. Cash Flow from Investing:

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The cash flow arrived at by investment activities such as purchasing or selling stocks and bonds or machinery.

3. Cash Flow from Operations:

The cash flow arrived at by operating activities: sales and expenses. This cash flow is of prime importance for a
lender as it ensures ongoing repayment capacity

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/owners’stake 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.

Liabilities: It includes both current liabilities and long-term liabilities.

1. 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.

Net Worth or Owners’ Equity:

It includes share capital, retained earnings & reserves. It can be calculated as difference of assets and liabilities.

Contingent Assets & Contingent Liabilities:

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They are not assets or liabilities as on balance sheet date. But they may become assets/liabilities based on, or
contingent upon some external occurrence.

Concept of ‘Sources and Uses of Funds’:

In a business, there are certain components of the balance sheet which bring in funds into the business: such as
loans, owners’ capital, customer advances.

Hence, all liabilities and owners’ equity are described as a source of funds for a business; and all assets (except cash)
as a use of funds.

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