Basic Concepts in Finance

This article concerns finance, that is, the study of how resources are valued, allocated and invested over time. Having knowledge of the basic concepts of finance is important not only for business owners, corporate executives and financial planners; ultimately, financial planning is each individual's responsibility. Three of the most fundamental concepts in finance are the time value of money, asset valuation, that is, how the value of stocks, bonds, real estate, and other investments is determined, and finally, risk management. While the time value of money is the basis for the other concepts, financial planning and investing ultimately require an understanding of risk management. This article will approach the basic concepts of finance for the individual and provide an overview of financial and investment products.

Keywords Asset; Asset Valuation; Bond; Certificate of Deposit; Compound Interest; Debt; Defined Benefit Pension Plan; Defined Contribution Plan; Financial Planning; Government Securities; Individual Retirement Account; Interest; Investment; Money Market; Money Market Deposit Account; Money Market Fund; Mutual Fund; Real Estate; Risk Management; Sarbanes-Oxley Act; Savings; Stock; Time Value; Treasury Bill

Finance > Basic Concepts in Finance

Overview

It is becoming increasingly important for individuals to assume responsibility for planning a financial future. Successful financial planning, in turn, requires one to understand the basic concepts of finance since this understanding will afford one the ability to save and invest wisely. This means that the individual needs to have knowledge of a variety of financial products and investments and comprehend how these vehicles work. Moreover, for many people, the largest investment they will make is purchasing a home. Having knowledge of the basic concepts of finance will enable them to understand mortgages and consumer debt in general. Saving, other investments and managing debt are all based upon the foundation of the first financial concept — the time value of money. Further, this concept is a building block to asset valuation and risk management. Asset valuation requires one to understand how the value of assets such as stocks, bonds and real estate are determined. Finally, understanding such concepts as compound interest and inflation can empower an individual to manage the risk of their investments over time.

Decreased Savings & Increased Debt

However, recent research indicates that many people are financially illiterate — they do not have an understanding of the basic concepts of finance. People cannot differentiate between individual stocks and stock mutual funds, nor do they comprehend that investing in individual stocks is riskier than investing in mutual funds. Further, there is a general lack of knowledge about compound interest and inflation. This lack of knowledge reflects the fact that many people do not understand how money works, and this in turn is manifested in the way people invest or fail to invest their money. For many, their primary investment vehicle is their company provided defined benefit plan or a defined contribution plan. A defined benefit plan is commonly referred to as a fully funded pension. However, pension plans are becoming less common as employers are shifting this benefit to a defined contribution plan such as a 401(k). Unfortunately, many people are not aware of the differences between these two types of plans and some are not certain which type of plan their employer provides. The result of this lack of knowledge is that the overall savings rate declined dramatically during the late twentieth and early twenty-first centuries (Carlson, 2005), and only started to rise in the wake of the 2007 recession (Samavati, Adilov, & Dilts, 2013).

More importantly, the amount of consumer debt dramatically increased as the twentieth century came to a close. This is reflected by the fact that more people carried higher amounts of unsecured consumer debt such as credit cards. This trend, as is the case with the overall savings rate, has slightly reversed since the 2007 recession (Brown, Haughwout, Donghoon, & van der Klaauw, 2013). In addition to an expansion of unsecured debt, the rise in home ownership over the last 20 years combined with the rising value of real property has resulted in a surge of mortgage debt. In order for the individual to be able to adequately finance this debt requires an understanding of the basic concepts of finance.

Applications

Successful Saving

While having an understanding of the basic concepts of finance is important to understanding the value of savings and investing, saving is really a matter of common sense money management. In this regard, there are four ways to simply start saving.

• First, large amounts of cash should not be kept on hand, but rather deposited into a savings account.
• Second, although paying outstanding bills on time is important, there is no benefit derived from paying bills early and this money can continue to earn interest.
• Further, some people intentionally have more taxes withheld in order to obtain a refund. However, that excess money could also be put to better use by earning interest.
• Finally, once the amount of money a person is saving begins to accumulate, it can then be invested in other ways to earn even more interest such as by opening an interest bearing checking account (Miller, 2003).

Instruments for Saving

Certificates of Deposit

Another vehicle available for savings investment is a Certificate of Deposit or a CD. Investing in a CD is essentially a time-deposit savings device that requires an investor to keep the money in the account for a specified period of time. That period can be for as little as 3-6 months or as long as 5 years. In return for this, the interest rate paid by the bank is higher than the interest rates based on savings accounts or interest bearing checking accounts. The longer the term of the CD, the higher the interest rate that will be paid. In addition, there is usually a penalty for withdrawing the money early.

Money-Market Deposit Account

Another type of savings account available for basic investing is a Money-Market Deposit Account (MMDA). This is basically a means of saving that is a cross between a savings account and a Certificate of Deposit. An MMDA requires an investor to maintain a minimum balance ($1,000) while allowing for a maximum number of three checks to be drawn each month (but automated deposit machine withdrawals are not limited).

Money Market Mutual Fund

In addition to the MMDA, an individual can also invest in a Money Market Mutual Fund. Opening this type of fund requires a minimum initial deposit, usually $1,000, $5,000 or more depending on the financial institution. The institution uses the money invested in these funds to borrow and lend money on a short-term basis. This includes such investment vehicles as commercial paper (short-term debt obligations issued by a corporation), Treasury bills (short term debt issued by the Federal government), federal government securities such as "Ginnie Maes" (GNMAs) and "Fannie Maes (FNMAs) as well as others short term debt instruments (Miller, 2003).

Benefits of Savings Instruments

The main benefit of the foregoing savings instruments is that they allow an investor to earn interest on their money without a great deal of risk. The general rule of thumb regarding saving money is that one should have six months of living expenses set aside. This is not money to spend or to be used for making large purchases and should only be used in case of an emergency or loss of income. Having this money set aside will also enable an individual to minimize their debts. As mentioned earlier, not saving enough money is one of the biggest financial mistakes that people make. Another way to save money is to open an Individual Retirement Account (IRA) or contribute to an employer sponsored plan such as a 401(k). Investing in these instruments enables an individual to invest in stocks, bonds, mutual funds, certificates of deposit, money-market funds, and the like (Chatzky, 2004).

Interest Accrual

In addition to understanding financial concepts that are at the root of all these investments, it is also helpful to comprehend the goal of investing, and the benefits of investing in stocks, bonds, mutual funds, and even real estate. An investment is basically the use of money for the purpose of creating more money. This can be accomplished by putting money in income-producing vehicles, such as the various savings vehicles that earn interest mentioned above. Interest is essentially the cost of using money, usually over a one-year period and an interest rate is the rate charged for using that money. For example, if a bank was offering an interest rate of 2% per year on a basic savings account, and an initial deposit of $1,000 is made, after one year, that account would have $1,020 On the other hand, interest rates are charged on bonds, credit cards, and other types of consumer and business loans. If a bank charges $600 per year on a loan of $100,000, the interest rate would be 6% per year (Downes, 2006).

Real Estate

Interest rates on consumer loans are important to understand if a person is buying a home. Financing an investment in real estate usually requires obtaining a mortgage from a financial institution. A mortgage is a debt instrument a lender uses to place a lien on real property purchased by the borrower. A lien is a creditor's claim, in this case the lender, against property (Downes, 2006). By understanding the time value of money, a person will be better able to understand how much a mortgage will actually cost over 30 years. By understanding asset valuation, a person can determine the value of the house, or the asset. An asset, moreover, is anything with financial value that is owned by a business or person.

Stocks, Bonds & Mutual Funds

In addition to an asset such as real estate, an individual can also invest in stocks, bonds, and mutual funds. Investing in stock essentially means to have an ownership interest in a corporation. Shares issued by the corporation represent stock ownership, and these are claims against a company's earnings and assets. The value of stock is determined by a number of factors over time. On the other hand, an individual can also invest in bonds. Basically, a bond is an interest-bearing government or corporate instrument that requires the issuer to pay specific amounts of money at certain time intervals until the debt is paid in full by a set date (also referred to as the maturity date). Another way to invest in stocks and bonds is to invest in a mutual fund. A mutual fund is an investment vehicle that is operated by an investment company. Money is raised from shareholders, and that money is used to invest in stocks, bonds, and other investments (Downes, 2006). The benefit of investing in mutual funds is that the investment company manages the risk.

For many people, one convenient way to invest in stocks, bonds and mutual funds is to participate in an employer-sponsored savings and retirement plan like a 401(k) or 403(b) plan. These plans are also called defined contribution plans. In a 401(k), the plan is managed by an investment company and requires the employee to contribute a percentage of their income. In some cases, the employer also contributes to the plan, and this is referred to as a company match. The company match usually equates to 50% of the employee's contribution. For example, an employee that contributes 6% of their income to a 401(k) will see the company make a matching contribution of 3%. In short, this means that a person will be saving and investing 9% of their annual income by participating in such a plan (Carlson, 2005).

For those that do not have access to a 401(k), another way to invest in mutual funds is to invest in an individual retirement account, also known as an IRA (Fryar, Warther, Thibodeau, & Drucker, 2012). There are different types of individual retirement accounts. A traditional IRA is one where an individual makes tax deferred payments. A Roth IRA, on the other hand, enables an investor to contribute money that has already been taxed. Of course, there are many other factors and considerations in regard to IRAs, but investing in these retirement vehicles require an individual to take responsibility for their financial planning. Regardless of the types of investment a person makes, having an understanding of the basic concepts of finance can be helpful. While the fundamental concepts of finance might be considered basic, they can also be complicated. This is so because understanding these concepts requires determining the time value of money, asset valuation and risk management.

Time Value of Money

The first and foremost principle in finance is the time value of money because financial decisions are spread out over time. This concept essentially is a means of calculating the value of a sum of money in the present or in the future. While the outcome of financial decisions cannot be known with certainty, being able to calculate the value of money at some time in the future affords one the ability to manage risk. Understanding the time value of money allows one to calculate present and future values. In the parlance of financial planning present value or "PV" means the present value of an amount that will be received in the future. On the other hand, future value or "FV" is the future worth of a present amount. For example, understanding PV will enable a bond investor to determine the value now of a $1,000 bond that will mature in ten years. On the other hand, FV will enable an individual to determine how much a $1,000 savings account will have at the end of the year if it pays 2% interest compounded annually (Clare, 2002).

Interest Calculations

With respect to interest, there are fundamentally two ways to calculate it — simple interest and compound interest.

• Simple Interest is a calculation based only on the original principal amount of the asset or debt. For instance, in the example mentioned above, a $1,000 deposit in a savings account at 2% simple interest would earn $20 per year (2% of $1,000 = $20). At the end of the first year, the amount of the principal and interest in the account would equate to $1,020.
• On the other hand, compound interest is interest earned on the principal plus any interest that was previously earned. For example, a $1,000 deposit at 5% compound interest at the end of the first year would earn $50 in the first year (5% of $1,000 = $50). If no additional deposits are made in the second year the balance in the account would be $1,102.50 or 5% of $1,050 = $52.50; $1,050 + $52.50 = $1,102.50 (Downes, 2006).

Asset Valuation

In addition to understanding the basics of time value, and being able to calculate interest, it is also necessary to understand how assets are valued. The value of an asset, in turn, is partially determined by the market where the asset is bought and sold. With respect to stocks, asset value is determined by the net value of a company's assets on a per share basis as opposed to the shares' market value (Downes, 2006). One of the key ingredients in determining this value is how profitable the company is in a given period of time. In a real estate transaction, the value of real property is determined by an appraisal of the property and there are numerous factors to consider such as the type of property, the number of units in the dwelling, the location and condition of the real property and the value of other properties in the vicinity. The importance of understanding asset valuation as it relates to the property is also an important consideration in determining the loan amount of the mortgage that a financial institution will offer to a purchaser.

Risk Assessment

The last concept that an investor needs to consider is risk or the potential for the loss of value of an asset. One such way to manage risks is to value assets by using comparative scenarios that consider a range of assumptions (Clare, 2002). Some of the specific considerations in this regard are inflation risk, interest rate risk, credit risk and risk of principal. Inflation risk is the potential that the value of an asset or income will erode as increased prices adversely affect the value of money. Interest rate risk is the possibility that a fixed rate debt instrument will decline in value as interest rates rise. Credit risk is the possibility that a debtor will not repay an obligation. Finally, risk of principal is the chance that money that was initially invested will lose its value. In short, risk management requires one to have knowledge of the asset in which they are investing as well as knowledge of various market and economic conditions affecting that market.

Viewpoints

In the final analysis, financial planning or business planning require an understanding of the basic concepts of finance. For a small business owner, understanding these concepts will enable him or her to consider how to determine the value of the good, product or service being provided to their customers while also being able to ascertain the cost to operate the business. A corporate executive needs to understand a number of financial concepts including the valuation of a company's stock and the products being provided to consumers as well as the cost of operating the business entity. While this has always been the case for chief executive officers and chief financial officers of publicly traded corporations, it is even more crucial in today's regulatory environment by virtue of the requirements of the Sarbanes-Oxley Act of 2002 (SOX). This Federal regulation requires senior management of publicly traded corporations to attest to the accuracy of the financial statements that these companies are required to file on an annual basis. Not having an understanding of the basic concepts of finance can result in serious consequences for these individuals since there have been felony convictions associated with deficiencies in financial reporting requirements. One can look to the recent history of such companies as Enron and Tyco to realize this.

In the end, small business owners, corporate executives and financial planners are not the only ones who need to understand the basic concepts of finance. In fact, every individual should have some knowledge in this regard since this will enable them to be better equipped to save and invest with confidence, and more importantly avoid acquiring excessive debt. Further, if a person plans on buying a home it can to be helpful to understand how the value of the property is determined, and how much a mortgage to finance the purchase of the dwelling will actually cost. Many people mistakenly believe that owning a home will not cost more than renting an apartment, but this is an incorrect notion at best. There are many costs to consider in addition to the actual payment of the mortgage such as the costs to insure the dwelling, the property taxes, costs of furnishing, payment of utilities and maintenance costs. Not having some basic knowledge regarding finance can result in an individual in not being able to afford the cost of a home. These situations often lead people to acquire excessive consumer debt to cover some of these costs, and paying those debts will hinder their ability to save money — and not saving enough money is the costliest mistake a person can make. By having an understanding of the basic concepts of finance, it is possible to avoid these mistakes and plan for an adequate financial future by saving and investing wisely. At the same time, it is a good idea to consult a professional about financial planning and in that regard, this paper is intended for informational purposes only and should not be considered financial advice.

Terms & Concepts

Asset: Any economic resource owned by a business, institution or individual that has commercial or exchange value.

Asset Valuation: The method for determining the net value of an asset.

Bond: Any debt security that obligates the issuer to pay the bondholder a designated amount of interest at specified intervals and to repay the full amount of the loan at maturity.

Certificate of Deposit: A debt instrument issued by a bank that usually pays interest.

Compound Interest: Interest that was earned on principal plus interest that was earned earlier.

Debt: The generic name for bonds, notes, mortgages and other forms of paper that designate amounts owed and payable on specific dates or on demand.

Defined Benefit Pension Plan: A plan that agrees to pay a predetermined amount to each person who retires after a certain number of years of service.

Defined Contribution Plan: A pension plan where the contribution amount is set at a specific level while benefits vary depending on the return of investments. In some plans such as a 401(k), 403(b) and a 457, employees make voluntary contributions into a tax deferred account which may or may not be matched by employers.

Financial Planning: The analysis of personal financial circumstances and the design of a program to meet financial needs and objectives.

Government Securities: Securities issued by U.S. government agencies — also called agency securities. Although these securities have high credit ratings, they are not the same as Government Obligations such as Treasury securities and are not backed by the full faith and credit of the U.S. Government.

Investment: The use of capital to generate more money through either income producing outlets or through risk-oriented ventures meant to result in capital gains.

Interest: Cost of using money, conveyed as a rate per specific period of time, usually one year, which is known as an annual rate of interest.

Individual Retirement Account: Also known as an Individual Retirement Arrangement or IRA that is a personal tax-deferred retirement account that an employed person can set up with maximum annual deposits.

Money Market: The market for the issuance purchase and sale of short-term debt instruments.

Money Market Deposit Account: Market sensitive bank account that has a minimum balance requirement ($1,000), limits checks to 3 per month, and the funds for these accounts are considered liquid.

Money Market Fund: Open-ended mutual fund that invests in commercial paper, government securities, certificates of deposit and other highly liquid and safe securities and pays money market rates of interest.

Mutual Fund: Funds owned and operated by investment companies that raises money from shareholders and invests in stocks, bonds, options, or money market securities. The funds offer investors the advantage of diversification and professional money management.

Real Estate: A piece of land and all physical property related to it, including houses, fencing, landscaping, and all rights to the air above and the earth below the property.

Risk Management: The ability to value assets over time in order to minimize the risk of loss of principal.

Savings: An account that pays interest on a day-of-deposit to day-of-withdrawal basis.

Stock: Ownership of a corporation reflected by shares which represent claims against a company's earnings or assets.

Sarbanes-Oxley Act: Federal law requiring senior executives of publicly traded corporations to attest to the accuracy of annual financial statements and that requires internal policies and control procedures to ensure compliance with the act.

Treasury Bill: Negotiable debt instrument of the U.S. Federal Government secured by its full faith and credit and issued at various schedules and maturities.

Bibliography

Brown, M., Haughwout, A., Donghoon, L., & van der Klaauw, W. (2013). The financial crisis at the kitchen table: Trends in household debt and credit. Current Issues in Economics & Finance, 19, 1-10. Retrieved on November 12, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=88300342&site=ehost-live

Carlson, L. (2005, Oct). Lack of basic financial knowledge impairs retirement. Employee Benefit News, 19 18-24. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18501264&site=ehost-live

Chatzky, J. Bigda, C. & Jervey, G. (2004, Dec). The six biggest money mistakes and how to avoid them. Money, 33 92-101. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=15060434&site=ehost-live

Clare, M. (2002). Solving the knowledge — value equation (part one). KM Review, 5 14-18. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6798862&site=ehost-live

Downes, J. & Goodman, J.E. (2006). Dictionary of financial and investment terms. Barons Educational Services, Inc. Hauppauge, NY. (Print Content)

Fryar Jr., J., Warther, J., Thibodeau, T., & Drucker, M. (2012). Retirement and estate planning with an emphasis on individual retirement accounts. Journal of Business & Economics Research, 10, 397-405. Retrieved on November 12, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=80160731&site=ehost-live

Gallo, J.J. (2005). Estate planning conundrums worth repeating. Journal of Financial Planning, 18 30-31. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=17857441&site=ehost-live

Miller, T. (2003). Chapter 2: How to boost your savings. Kiplinger's Practical Guide to Your Money, 19-28. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9442231&site=ehost-live

Miller, T. (2003). Chapter 3: First, maximize your savings. Kiplinger's Practical Guide to Your Money, 31-46. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=9395859&site=ehost-live

Samavati, H., Adilov, N., & Dilts, D. A. (2013). Empirical analysis of the saving rate in the United States. Journal of Management Policy & Practice, 14, 46-53. Retrieved on November 12, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89922139&site=ehost-live

Suggested Reading

Brown, G. & Cliff, M. (2005). Investor sentiment and asset valuation. Journal of Business, 78 405-440. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=17002456&site=ehost-live

Braunstein, S. & Welch, C. (2002, Nov). Financial literacy: An overview of practice, research and policy. Federal Reserve Bulletin, 88 445-458. Retrieved on January 18, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=8584843&site=ehost-live

Flaig, J.J. (2005). Improving project selection using expected net present value analysis. Quality Engineering, 17, 535-538. Retrieved on January 18, 2007, from EBSCO Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=18518221&site=ehost-live