Written By-Md Kollol Hossain, CEO, CapitalinsightBD
Finance is the science and art of managing money, encompassing activities such as investing, borrowing, lending, budgeting, and saving. At its core, finance is about making informed decisions to allocate resources effectively for individuals, businesses, and governments. The fundamentals of finance include essential concepts like the time value of money, which highlights how money’s value changes over time; risk and return, which balances potential rewards with associated risks; and diversification, which spreads investments to mitigate risk. Understanding these financial fundamentals equips decision-makers with the knowledge to achieve financial goals, optimize profits, and ensure economic stability.
Principle of Finance
The principle of finance encompasses fundamental concepts that guide financial decision-making, ensuring effective management of resources and maximizing wealth. Key principles include time value of money, risk and return, diversification, and the concept of leverage. These principles help individuals and businesses understand how to assess investment opportunities, manage risks, and make informed financial decisions. By applying finance principles, organizations can allocate resources efficiently, optimize returns, and achieve long-term financial stability. Understanding these core principles is essential for anyone looking to make sound financial choices in a complex economic environment.
Business Finance
Business Finance is the field of finance focused on managing funds and making investment decisions within a business. It involves the planning, acquisition, and utilization of capital to achieve business goals, such as growth, profitability, and stability. Key areas of business finance include budgeting, forecasting, investing, and financing operations. This discipline helps businesses determine the best strategies for sourcing funds, whether through equity, debt, or retained earnings, and how to allocate resources efficiently for projects, day-to-day operations, or expansion.
Effective business finance management is essential for ensuring liquidity, managing risks, and maximizing returns. By making informed financial decisions, businesses can optimize their financial structure, support long-term growth, and improve shareholder value.
Financial Analysis
Financial Analysis is the process of evaluating a company’s financial data to assess its performance, stability, and growth potential. By analyzing financial statements, including the income statement, balance sheet, and cash flow statement, stakeholders gain insights into profitability, liquidity, solvency, and efficiency. Key methods in financial analysis include ratio analysis, trend analysis, and comparative analysis, each offering unique perspectives on financial health. This analysis is essential for investors, managers, and creditors, as it aids in decision-making, investment evaluation, and risk management. Mastering financial analysis helps businesses identify strengths, address weaknesses, and make informed strategic decisions to achieve financial success.
Capital Budgeting
Capital Budgeting is the strategic process businesses use to evaluate and select long-term investment projects, such as expanding operations, purchasing new equipment, or launching new products. This financial planning method helps organizations determine which investments will yield the best returns and align with their growth objectives. Key techniques in capital budgeting include Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period, each providing insights into a project’s profitability, risk, and payback time. Effective capital budgeting ensures optimal allocation of resources, helping companies maximize value and maintain financial health. Understanding capital budgeting is essential for making informed, profitable investment decisions.
Financial Risk Management
Financial Risk Management is the practice of identifying, analyzing, and mitigating risks that could impact an organization’s financial health. These risks, including market risk, credit risk, liquidity risk, and operational risk, can arise from various sources, such as economic changes, interest rate fluctuations, or internal operational issues. Effective financial risk management employs tools like risk assessment, Value at Risk (VaR), and hedging techniques to limit potential losses. By implementing sound risk management strategies, companies can protect their assets, stabilize cash flow, and support long-term growth. Mastering financial risk management is crucial for businesses aiming to safeguard their financial stability and adapt to changing market conditions.
The time value of money (TVM)
The time value of money (TVM) is a fundamental financial concept that states money available today is worth more than the same amount in the future due to its earning potential and associated risks. This principle is based on the idea that money can be invested to generate returns, making a dollar today more valuable than a dollar received later. For example, if you invest $1,000 today at an annual interest rate of 5%, it will grow to $1,050 in a year. Thus, the future value of money accounts for interest or returns, emphasizing why immediate funds are more advantageous for investment growth than delayed payments. Understanding TVM helps individuals and businesses make informed financial decisions, optimizing investment strategies and budgeting.
Here’s a list of key formulas used to calculate the
Time Value of Money along with brief explanations:
Future Value (FV)
- Future Value (FV) is the value of a current asset or sum of money at a specific point in the future, based on an assumed growth rate or rate of return. It reflects how much an initial investment will grow over time when it earns interest or investment returns. The future value calculation is critical in financial planning, allowing individuals and businesses to predict how much their investments or savings will be worth after a certain period, considering compound or simple interest.
Future Value (FV) of a Single Sum
- Formula: FV=PV×(1+r)n
- Explanation: This formula calculates how much an initial investment (Present Value, PV) will grow over time at a given interest rate r compounded over n periods. It shows the potential growth of a current sum of money when invested.
https://www.capitalinsightbd.com/pv-fv-calculator/
Present Value (PV) of a Single Sum
- Formula: PV=FV/(1+r)n
- Explanation: This formula finds the current value of a future sum FV by discounting it at a rate r over n periods. It answers how much future cash is worth in today’s terms.
Future Value of an Annuity (FVA)
- Formula: FVA=PMT×((1+r)n−1)/r
- Explanation: This formula calculates the future value of a series of equal payments (annuity, PMT) made at regular intervals, compounded at an interest rate r over n periods. It’s useful for saving plans, such as retirement funds.
Present Value of an Annuity (PVA)
- Formula: PVA=PMT×(1−(1+r)−n )/r
- Explanation: This formula determines the present value of a series of future payments, such as loan repayments or rent payments, discounted to today’s value at rate r over n periods.
https://www.capitalinsightbd.com/pva-and-fva-calculation/
Future Value of an Annuity Due (FVAD)
- Formula: FVAD=PMT×((1+r)n−1)/r×(1+r)
- Explanation: Similar to the Future Value of an Annuity, this formula calculates the future value when payments are made at the beginning of each period, rather than at the end, by adjusting the regular annuity formula with an extra (1+r).
https://www.capitalinsightbd.com/pvad-and-fvad/
Present Value of an Annuity Due (PVAD)
- Formula: PVAD=PMT×(1−(1+r)−n )/r×(1+r)
- Explanation: This formula determines the present value of an annuity when payments are made at the start of each period. The extra (1+r) adjusts the calculation for upfront payments.
Perpetuity Present Value (PPV)
- Formula: PPV=PMT/r
- Explanation: For a perpetuity, which is an annuity that continues indefinitely, this formula calculates the present value based on a fixed payment PMT and a discount rate r. It is often used for assets or income streams expected to continue indefinitely, like certain investments.
Growing Perpetuity Present Value (GPPV)
- Formula: GPPV=PMT/(r−g)
- Explanation: This formula calculates the present value of a perpetuity where payments grow at a constant rate g. It’s used when payments, like dividends, are expected to grow over time rather than remain fixed.
Continuous Compounding (Future Value with Continuous Compounding)
- Formula: FV=PV×e(r×t)
- Explanation: When compounding occurs continuously, rather than at regular intervals, this formula calculates the future value. Here, e is the mathematical constant approximately equal to 2.718, r is the interest rate, and t is the time period.
Effective Annual Rate (EAR)
Effective Annual Rate (EAR), also known as the effective interest rate, is the actual annual rate earned or paid on an investment, loan, or financial product, taking into account the effect of compounding over a given period. Unlike the nominal interest rate, which doesn’t consider compounding frequency, EAR provides a true reflection of the annual interest cost or earnings, making it useful for comparing financial products with different compounding periods.
- Formula: EAR=(1+i/n)n−1
- Explanation: This formula finds the equivalent annual rate for interest that’s compounded more frequently than once a year. It adjusts the nominal interest rate iii compounded n times per year, to reflect the actual annual rate.
Each of these formulas allows financial analysts and decision-makers to evaluate cash flows, whether for investments, loans, or other financial instruments, by applying the time value of money principles.
Earning Per Share (EPS)
EPS is the ratio of total net earnings and total number of shares outstanding (EPS=Total Net Earnings/Total Number of Share Outstanding). It measures a company’s profitability and operational performance.
Net Asset Value (NAV)
NAV is the ratio of total net assets and total number of shares outstanding (NAV=Total Net Assets/Total Number of Share Outstanding). It reflects its underlying financial stability and ability to withstand adverse market conditions. Together, they (EPS and NAV) offer valuable insight into how efficiently a company uses its capital to generate shareholder value.
Dividend
A dividend is the compensation companies provide to shareholders as a reward for taking risks and foregoing other opportunities. Paid periodically, typically once a year, dividends come in two forms: cash dividends or bonus shares/stock dividends. Companies may also issue right shares at a discounted rate compared to the prevailing market price, offering shareholders additional financial privileges for their investment.
Dividend Yield
Dividend yield measures the return investors earn from holding a company’s stock. It’s calculated using a simple formula:
Dividend Yield (%) = (Cash Dividend / Current Market Price) × 100
The dividend yield increases when the cash dividend rises relative to the market price or when the market price drops. Higher dividend yield often signals a better return, making it an essential metric for assessing the value of a stock.
As a rational investor, knowing the current dividend yield is crucial for evaluating whether the market price of a stock is justified before making a purchase decision.
Difference between bonus shares and right shares
Bonus Shares and Right Shares are two distinct financial instruments issued by a company to its shareholders. Below is a professional comparison highlighting their key differences:
| Aspect | Bonus Shares | Right Shares |
| Definition | Bonus shares are additional shares issued to existing shareholders without any cost, distributed from the company’s retained earnings. | Right shares are shares offered to existing shareholders at a discounted price, giving them the right to purchase additional shares before they are offered to the public. |
| Purpose | To reward shareholders and capitalize on reserves or surplus profits. | To raise additional capital for the company. |
| Cost to Shareholders | Issued free of charge. | Offered at a discounted price to shareholders. |
| Impact on Ownership | No cash inflow to the company; only a reallocation of reserves. Shareholding percentage remains unchanged. | Increases the company’s capital. Shareholders may dilute their ownership if they choose not to subscribe. |
| Market Value Effect | Total market capitalization remains the same, but the share price decreases proportionally due to the increase in the number of shares. | Market capitalization increases, and the share price reflects the additional capital raised. |
| Eligibility | Issued only to existing shareholders as per their shareholding proportion. | Existing shareholders have the option to purchase or renounce their rights. |
| Regulatory Requirements | Requires board and shareholder approval, often governed by company laws. | Requires a prospectus and adherence to regulatory compliance for rights issuance. |
Conclusion:
While both bonus shares and right shares aim to enhance shareholder value, their purposes and impacts differ significantly. Bonus shares are a means of profit distribution, whereas right shares are a tool for capital raising. Companies select the appropriate instrument based on their financial strategy and growth objectives.
Why treasury bills considered being a risk-free investment?
Treasury Bills (T-Bills) are short-term debt instruments issued by the government to raise funds. They are widely regarded as risk-free investments due to the following reasons:
1. Backed by the Government
T-Bills are issued by the central government (such as the U.S. Department of Treasury or Bangladesh Bank), which has the authority to print money and collect taxes. This ensures that the government will always have the means to repay investors at maturity.
2. No Default Risk
Unlike corporate bonds, which depend on a company’s ability to generate profits, T-Bills are backed by the full faith and credit of the government. Governments rarely default on their debt, making these instruments virtually risk-free.
3. Highly Liquid and Marketable
T-Bills are among the most liquid financial instruments, meaning they can be easily bought and sold in the secondary market without significant price fluctuations. Investors can quickly convert them into cash with minimal risk.
4. Short-Term Maturity Reduces Risk
T-Bills have short maturities, typically 91 days, 182 days, or 364 days. This short duration minimizes exposure to inflation and interest rate risk, unlike long-term bonds that may fluctuate more in value.
5. No Interest Rate or Credit Spread Risk
- No Credit Spread Risk: Since T-Bills are government-backed, they do not carry a credit risk premium, unlike corporate bonds that require higher returns due to potential default risks.
- Minimal Interest Rate Risk: Unlike long-term bonds, T-Bills mature quickly, reducing the impact of interest rate fluctuations.
What is Financial Market?
The financial market is a broad marketplace where buyers and sellers trade financial assets such as stocks, bonds, currencies, and derivatives. It plays a crucial role in mobilizing savings, facilitating investment, and ensuring efficient capital allocation in an economy.
Key Functions of Financial Markets:
- Capital Allocation – Channels funds from surplus units (investors) to deficit units (businesses and governments).
- Liquidity Provision – Ensures assets can be easily bought or sold without significant price fluctuations.
- Price Discovery – Determines the fair market value of securities through supply and demand dynamics.
- Risk Management – Allows investors to hedge risks through derivative instruments.
- Economic Growth Facilitation – Promotes business expansion and infrastructure development by providing capital.
Types of Financial Markets:
- Money Market – Deals with short-term financial instruments (e.g., Treasury Bills, Commercial Papers).
- Capital Market – Facilitates long-term investments through stocks and bonds.
- Foreign Exchange (Forex) Market – Involves the trading of currencies for international trade and investment.
- Derivatives Market – Trades financial contracts based on underlying assets (e.g., options, futures).
Conclusion
A well-developed financial market enhances economic efficiency by ensuring capital is allocated to its most productive uses. It also fosters financial stability, supports investment, and drives long-term economic growth.
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