Key Financial Concepts - Business Finance - ثاني ثانوي

1.2 Key Financial Concepts Key Terms Balance sheet Assets Liabilities Equity Return Risk Financial leverage Valuation Several crucial concepts are fundamental to understanding business finance: sources of finance, risk and return, financial leverage, and valuation. Each of these concepts will be addressed in the following sections of this chapter. Link to digital lesson www.den.edu.sa 1.2a Sources of Finance Finance is concerned with the management of assets, especially financial assets, and the sources of finance used to acquire the assets. These sources and the assets that a firm owns are often summarized in a financial statement called a balance sheet. (Notice that important terms are in boldface and the definitions appear in the margin to facilitate learning.) A balance sheet enumerates at a moment in time what an economic unit, such as a firm, owns, its assets; what it owes, its liabilities; and the owners' contributions to the firm, the equity. Other economic units, such as a household or a government, may also have a balance sheet that lists what is owned (assets) and what is owed (liabilities). However, since there are no owners, the equity section may be given a different name. For example, the difference between the assets and the liabilities might be referred to as the individual's "net worth," or estate. Although the construction of financial statements is explained in more detail in Chapter 3, the balance sheet in Figure 1.3, representing an international business, provides an introduction. Belauces A financial statement that enumerates (as of a point in time) what an economic unit owns and oses and is net worth Assets Items or property owned by am, household, or govemment and valued in monetary terms What an economic unit owes expressed in monetary terms Squity The sum total of a firm s assets, a firm's book value or net worth وزارة التعليدر CHAPTER An Introduction to Basic Finance 29

FIGURE 1.3 A Balance Sheel For Cupindalen Chmuras of Durumbu 31.xx Corporation X Total assets SAH 100 Liabilities Equity SATT 100 SAR 40 60 SAR HO Corporation X SAR 100 in assets it could not have acquired the avarts unless someone (or some other wrm such as a bank put up one funds in this example creditors have put up SAR 40 the abilities) The word credits derived from the Lan word credo, which means "I believe," so the cincitors believe that the borrower will pay the interest apo repay the pinopalat soITE future Thu Aquity (SAR 50) represents the funds invested by the owners srocknolders, who also have a dam on the corporation The nature of the owners claim, however, is different because the corporation does not owe them anything, themad, the owners receive the benefits and hear the risks associated with controlling the corporation Both owners of a corporation and its creditors (those who have lent funds to the corporation) are investors, as they are sources of the corporation's capital. Both make their respective investments in anticipation of earning a return, and both bear the associated risk. However, while creditors have a legal claim to be repaid on their investment, the owners do not. The firm that uses the funds and the investors who supply the funds are dependent upon each other. Bonds, for example, are a major source of long-term funds for many corporations, while investors buy the bonds that a corporation (or government) issues. The sale of the bonds is a source of finance to the corporation, while the purchase of the bonds is a use of investors' funds. Rebern What is earned on an investment the sum of income and capital gains generated by an Investment 30lyusiness Finance 1.2b Risk and Return The Return Across the globe, investments are made because the individual or management anticipates earning a return. Without the expectation of a return, an asset would not be acquired While assets may generate this return in different ways, the sources of retum are the income generated and/or price appreciation. For example: ⚫ One investor may buy stock in anticipation of dividend income and/or capital gains (price appreciation). M 2921-1085

⚫ Another investor may place funds in a savings account because he or she expects to earn interest income. ⚫ The financial manager of a firm may invest in equipment in anticipation that the equipment will generate cash flow and profits. . A real estate investor may acquire land to develop it and sell the properties at an anticipated higher price. ⚫ The financial manager of a nonprofit institution may acquire short-term securities issued by the government in anticipation of the interest earned. Why must an investor weigh op the risk against the return?

The degree of uncertainty about whether an anticipated return will be achieved The Risk In each example, investment is made in anticipation of earning a future return. However, as this return is not guaranteed, there is an element of risk. Risk is the degree of uncertainty about whether an anticipated return will be achieved. If an individual had expected a particular investment to result in a loss rather than a gain, they would likely have chosen an alternative investment instead. While all investments involve some degree of uncertainty, possible sources of risk can be identified, and, to an extent, risk can be managed. One way is to create a 'diversified' portfolio that contains a variety of assets. When the portfolio is diversified, events that reduce the return on a particular asset may increase the return on another. By including both types of asset in the portfolio, the investor reduces the risk of choosing one investment solely over another, and spreads the risk across both. The Relationship Between Risk and Return As can be seen, risk and return are closely linked: the greater the possible return, the greater potential risk attached. All investors and financial managers want to earn a return that is favorable to the amount of risk taken. An investor may be able to achieve a small return with virtually no risk, but to earn a higher return, they will have to accept additional risk. For example, the more they invest in one particularly opportunity, the more they stand to gain or lose from the outcome. Financial leverage Use of borrowed funds in return for agreeing to pay a fixed return; use of debt financing Pl 32 Business Finance 1.2c Financial Leverage One major source of risk that permeates financial decision making around the world is the choice between equity and debt financing. Someone may acquire an asset by using their own funds or by borrowing them. The same choices are available to firms and governments. A corporation may retain earnings or sell new stock and use the funds to acquire assets. Or the firm may borrow the money. Governments use tax revenues and receipts to buy assets and provide services, but governments also may borrow funds. In each case, the borrower is using financial laverage. Financial leverage occurs when an individual or organization borrows funds in return for agreeing to pay fixed payments such as interest and repay the principal

after a period of time. If the borrower can earn a higher return than they have agreed to pay, the difference accrues to them, and magnifies the return on their investment. Notice, however, that if the borrower earns a lower return, they have to make up the difference, which magnifies their loss. The borrower cannot have it both ways. To increase the potential return, they also increase the potential loss. This trade-off between magnifying returns versus magnifying potential losses is a recurring theme in business. 100-5 Why must a borrower aim to earn a higher return than they have agreed to pay the lender 10 7 4 1 8 10040 5 X 9 63 + ( ) 2 3 Q +/- 0 50

ليم Valuation Process of determining whal an asset is currently worth 1.2d Valuation Assets are acquired in the present, but their returns accrue in the future. No individual or firm would purchase an asset unless there was an expected return to compensate for the risk. Since the return is earned in the uncertain future, there has to be a way to express the future in terms of the present. The process of determining what an asset is currently worth is called valuation. An asset's value is the present value of the future benefits. For example, the current value of a government bond is the sum of the present value of the expected interest payments and the expected repayment of the principal. The current value of equipment is the present value of the expected cash flows it will generate. This concept that value is not fixed but rather changes over time is known as the 'time value of money, and is a key consideration in business finance. It is often said that, "Money makes money." That is the essence of the time value of money: a Riyal received in the future is not equivalent to a Riyal received in the present. In other words, money that is available now has the potential to be invested into activities that generate more money. The cash outflow is in the present but the cash inflows are in the future. Time value considers these inflows and outflows to establish the return, helping the financial manager to decide whether or not to proceed with an investment. The goal of the financial manager is to maximize the company's value. As a company is made up of many assets, its value is linked to the value of these assets and the returns they will generate in the future (see Figure 1.4). If the company has shares of ownership (stock) held by the general public, then the market price of the stock can be used to work out the company's value. The market value of a share of stock times the number of shares gives the value of the company. The value of stock can go up or down, and so the price of a company's stock over time can indicate how well the management is performing. However, as many companies around the world don't have stock owned by the general public, it is more difficult to work out their current values. In these cases, the company's value is determined only when it is sold or liquidated (drawn to a close to have its assets redistributed). Hence, while owners and managers may use the value of equity on the accounting statements to indicate the company's worth, they cannot be certain of its true value. 34 Business Finance

Financial analysis is built on assumptions. For example, the phrase 'investors anticipate a return of XX% is based on an assumption because the return is not guaranteed. Sometimes, historical data or current data are assumed to apply in the future. While financial managers often use assumptions to help in planning or to predict outcomes, the results can be only as good as the accuracy of those assumptions. % WALDE OF ADSTE INE FILM ↑ FINANCIAL MANAGEMENT DECISIONS FIGURE 1.4 Factors Affecting the Value of a Firm TIME The value of a firm is directly linked to the value of its assets and the decisions of the financial management over time. Good financial management will make use of the assets currently available in the present to increase the value of the company's assets in the future. وزارة الصليدر " CHAPTER An Introduction to Basic Finance 35