1 Chapter 1 Financial Fundamentals 1.1 FINANCE IN SOCIETY 1.2 PERSONAL FINANCIAL DECISIONS 1.3 BUSINESS FINANCIAL ACTIVITIES 1.4 GOVERNMENT FINANCES Finance in Society money finance inflation financial market security stock bond liquidity Terms Finance in Society Financial Activities in Action money any item that serves as a method of payment finance activities involved with saving, investing, and using money by individuals, businesses, and governments 1
Finance in Society Participants In Financial Systems financial system financial relationships between people, businesses and governments saving spending paying taxes earning interest receiving a salary buying investments Individual Consumers and Investors Your first role in the financial system is as a consumer. purchasing saving investing 2
Businesses Businesses sell the goods and services which they produce. pay operating expenses earn a profit borrow money Government The government provides and maintains community services. collects taxes and fees borrows money Finance in Society Factors Affecting Financial Activities Economic Conditions 1. Interest Rates are determined by supply and demand 3
2. Consumer Prices inflation a rise in the general level of prices consumer price index (cpi) measures average change in prices 3. Money Supply the amount of money in circulation in an economy affects spending and borrowing Finance in Society Governmental Regulations Governments create regulations for fairness in financial transactions. Securities and Exchange Commission (SEC) promotes clear and full investment information protects investors against fraud and deception Finance in Society Global Business Activities trade surplus when a country exports more than it imports trade deficit when a country imports more than it exports foreign exchange rate the value of a country s currency in relation to the value of the money in another country 4
Financial Markets market a place where something is bought or sold financial market a location where buyers and sellers of financial products meet to conduct business security an investment issued by a corporation, government or other organization representing ownership or debt stock a security representing ownership in a corporation bond a debt that is borrowed by a company or a government Types Of Financial Markets 5
money markets financial markets where short-term debt securities (less than one year) are bought and sold capital markets financial markets where debt and equity securities are issued for more than a year debt securities borrowing by companies or governments equity securities represent ownership stock Value Of Securities 1. Supply and Demand when a stock is in demand, the value of the stock increases when demand for a stock goes down, the value of the stock decreases 2. Future Cash Flows expected return amount of future cash flows rate of return (yield) the relationship between the amount received and the cost of an investment 3. Risk Changing economic conditions, political uncertainty, and shifting consumer buying preferences 6
4. Liquidity the ease and speed with which an investment can be converted into cash 5. Interest Rates the cost of money The risk return relationship is of primary importance. Higher-risk investments are connected with higher potential returns. Although a person has the opportunity to make more money, there will often be a loss. Personal Financial Decisions Terms personal financial planning financial plan personal financial goal opportunity cost 7
Personal Financial Decisions Finance In Your Life scarcity requires that you make financial decisions personal financial planning the process of managing your money to achieve personal economic satisfaction Benefits of personal financial planning include Better actions for using your finances Effective control of your spending Improved personal relationships A sense of freedom from financial worries financial plan a formal report with a summary of your current financial situation along with plans for future financial activities 8
Personal Financial Decisions Influences On Personal Financial Decisions Personal Life Situation Over the course of a lifetime, spending habits will change in support of and in reaction to lifestyle changes. Economic Factors Personal financial planning will be impacted by external forces including inflation, interest rates, and unemployment. The Financial Planning Process Step 1 Determine Current Situation know where you are now income savings living expenses debts assets liabilities 9
Step 2 Set Financial Goals personal financial goal a desired outcome for financial planning realistic specific and measurable time-specific action-based Step 3 Evaluate Alternatives consider a variety of solutions even if you make no new choices, not making a change also has a consequence Opportunity Cost Every course of action you choose means you will give up something else. opportunity cost what you give up by making a choice trade-offs time value of money the increase in an amount of money as a result of interest earned Risk Uncertainty is part of every decision. Gather information about risk prior to making financial decisions. 10
Step 4 Create an Action Plan After evaluating alternatives, develop an action plan to achieve your goals. Step 5 Review Your Progress After you have taken an action, regularly review your financial decisions. An annual review is recommended. Tweaking financial plans may be necessary in response to changes in life situations. Personal Financial Decisions Personal Financial Decisions As you implement the financial planning process, you will make decisions in five areas. Obtaining Financial Resources Planning The Use Of Financial Resources Saving And Investing Decisions Borrowing Activities Managing Financial Risk Obtaining Financial Resources Financial resources can be obtained through employment investments business ownership 11
Planning The Use Of Financial Resources Spending less than you receive is the only path for achieving personal financial security. budget a wise spending plan Saving And Investing Decisions regular savings plan setting aside income on a planned basis to cover non-routine costs, including emergencies and large purchases investments diversification investing in a variety of assets investing allows for long-term asset growth Borrowing Activities The wise use of credit is necessary to avoid financial difficulties. Be prudent when using credit. Managing Financial Risk Every financial decision has risk. Use insurance to protect your assets and future wages. 12
Business Financial Activities Terms deposit institution non-deposit institution source of funds use of funds Business Financial Activities Types of Financial Institutions financial institutions (financial intermediaries) handle money receipts, payments and lending Business Financial Activities Deposit Institutions deposit institutions (depository institutions) accept deposits from people and businesses to use in the future Commercial banks (full-service banks) offer a wide range of financial services checking accounts savings accounts loans also offer other services to individuals and businesses 13
Thrift Institutions savings and loan association (S&L) savings accounts and home mortgages mutual savings bank savings and home loans bank owned by depositors bank depositors receive bank profits Credit Union a user-owned, not-for-profit, cooperative financial institution accepts deposits makes loans offers a variety of financial services Non-deposit Institutions non-deposit institutions life insurance companies investment companies consumer finance companies mortgage companies check-cashing outlets pawnshops Life Insurance Companies People buy life insurance to provide financial security for their dependents. Many life insurance companies also sell investments. Investment Companies long-term growth opportunities worldwide, over 30,000 mutual funds are available 14
Consumer Finance Companies loans for durable goods do not accept savings Mortgage Companies provide real estate loans Check-Cashing Outlets (CCOs) Although CCOs offer a variety of financial services, their fees are normally higher than other financial institutions. Pawnshops offer loans based on the value of a tangible object usually charge higher fees than other lending institutions Business Financial Activities Sources and Uses of Funds Inflows and outflows of cash and credit provide necessary funds for current and long-term business activities. 15
source of funds inflow of cash that can be used for paying various expenses revenue investor funds borrowing use of funds outflow of money by a company current expenses involves expenses consumed within a year capital expenditures (capital projects) involves expenses consumed over multiple years Government Finances revenue income tax property tax sales tax municipal bond Terms Government Finances Government Financial Activities Government plays a significant role in every economic system. 16
Functions Of Government provide public services protect people and businesses regulate financial activities while promoting competition provide information and assistance purchase goods and services hire public employees raise revenue Levels Of Government Federal Government oversees the activities that involve two or more states or other countries regulates foreign trade regulates interstate commerce business transactions involving companies in more than one state State Government regulates business activities within own boundaries intrastate commerce transactions involving companies that do business in only one state Local Government county boards city or town councils services for an orderly society 17
Sources of Government Funds revenue government income taxes fines fees and licenses Taxes Taxes pay for government services. income taxes levied on the income of individuals corporate income taxes based on business profits property tax based on the value of land and buildings sales tax a state or local tax on goods or services that is collected by the seller Borrowing Governments often borrow money by selling bonds. The government pays interest on the bonds. 18
Federal Government Borrowing U.S. savings bonds Treasury bills Treasury notes Treasury bonds State and Local Government Borrowing municipal bonds debt security issued by a state or local government low risk tax free interest 19