MANAGING YOUR MONEY

Good spending habits reduce stress, provide control over finances and build solid credit. So why do so many people avoid actively managing their money when it's so good for them? Because budgeting, like dieting, implies depriving ourselves of what is fun in life.

So get rid of the word "budget" — it carries too many negative connotations. Coming up with a different name, and more importantly a different attitude, will get you off to the right start mentally. Let's use the term "spending plan" instead of "budget."

A spending plan is about gathering information, finding out what your financial habits are, then making wise choices for the future.

• Keep it Simple
• Prioritize
• Plan Ahead
• Prepare for Emergencies
• Track Spending
• It Doesn't Always Add Up

Keep it Simple

Successful spending plans are simple and easy to manage. Many people try to establish complex, time-consuming plans that they end up abandoning in frustration.

To ensure success, keep your spending plan simple. Start out by making a list of your monthly expenses. Find an easy way to create and maintain a list. If using a computer is second nature to you, by all means create your list on it. If you're more of the paper and pencil type, use them instead. Use the method that best suits you.

My Financial Road Map
is a document we created to help you monitor your spending and develop a spending plan. You can download the map in PDF by clicking on the icon below.

My Financial Road Map — A Spending Plan Worksheet

Using the Financial Road Map — A Spending Plan Worksheet
Financial Road Map is divided into four sections — income, monthly basic expenses, miscellaneous expenses, and debt and credit. The first three sections have four columns for you to complete — best guess, actual, revised goal and actual. Using these columns you will estimate what you think you're earning and spending and then list the actual amounts. In the debt and credit section you'll take a look at how much you owe in credit cards and other loans. With this snapshot you'll determine the payment amounts you'd like to make to reduce your debt more quickly. From there you'll set some goals to change your spending habits and keep track of that in the revised goal column. Finally you'll track how well you're meeting your goals by tracking what you really spend in the last actual column.

Prioritize

List the items on your plan in order of importance to you. Basic living needs (rent, food, utilities, etc.) should be more important than entertainment or other optional items.

Plan Ahead

Plan ahead for any big expenses due in the future. Be prepared for auto insurance, car tabs, vacations or upcoming holidays. Break annual payments into monthly amounts and put that amount into a savings account every month.

For example, your car insurance costs $350 a year. Divide $350 by 12 months and plan to save $30 each month. When your insurance is due, you'll have $350 to pay your bill without having to tap into savings or credit.

Prepare for Emergencies

Plan ahead for emergencies like car trouble and medical expenses. We obviously don't know when emergencies are going to happen, but we do know that they will. Cars break, people break, and neither break cheaply! These unpleasant events will cost you money, especially if you've done little to prepare for the unexpected.

How Much Should You Save for Emergencies?
Ideally, you should have an amount equal to six months of your basic expenses put away in an emergency fund. That's tough for most people to do. But don't let the challenge of that goal stop you from getting started.

One way to begin an emergency fund is to look back over the last year and see how much you've spent on emergencies. For example, if over the last 12 months you spent $500 on various car repairs, you know that is an average of $42 per month. By putting $42 a month into a savings account, you'll start building an emergency fund.

You still may not accumulate enough to cover all emergencies, but you'll be in a better position financially to manage the expenses without maxing out your credit cards.

Track Spending

If you're unsure of what your expenses are, especially in areas like food and entertainment, you may want to track your spending. Carry an index card or notepad with you and write down what you spend your money on.

Monitor your spending for a month. If you buy a $2 cup of coffee, write it down. At the end of the month, you'll have a clear picture of where your money goes. Another method is to get receipts for everything you buy. Transfer this information onto a calendar at the end of each day.

Compare your spending habits to your priorities. Are you spending money on the important things in your life? You may be letting money slip through your fingers without even realizing it!

Let's say you buy your lunch each day at school or work. If the average amount you spend is $6, that means you're spending $30 a week, $120 a month or $1,440 per year on lunch. Making your own lunch could save you money and allow you to cover other expenses. Consider how you could use that $6 per day to reduce or eliminate your debt!

Tracking your spending and comparing it to your priorities will help you identify what spending habits you need to change. We created the Spending Tracker to help you monitor what you spend your money on each day. To download the Spending Tracker in PDF, clicking the link below.

Download PDF

It Doesn't Always Add Up

If you're spending more money than you earn, you're heading for trouble. You have three major options:

• Cut your expenses.
• Raise your income.
• A combination of both.

You may be able to survive by juggling for a while, but financial acrobatics can only last for so long.

Cut Your Expenses
Analyze your spending and look at where you can reasonably make some cuts. You may have to make sacrifices like cutting your cable service, eating out less or forgoing the purchase of an SUV. None of these are fun choices, but they may save you from financial troubles.

Raise Your Income
Raising your income is another option. Is it time to look for a higher paying full-time job? Can you pick up extra hours at your current job? Are you able to work part-time on the weekends or during the week? Examine your options.

Building a spending plan will help you plan for the future and ease the stress of money problems. Most people struggle with finances, so you aren't alone. Stick with your spending plan and you'll be one step ahead of the crowd. Get rich slow.

Corporate finance

Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while reducing the firm's financial risks. Although it is in principle different from managerial finance which studies the financial decisions of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, the short term decisions can be grouped under the heading "Working capital management". This subject deals with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers).

The terms Corporate finance and Corporate financier are also associated with investment banking. The typical role of an investment banker is to evaluate investment projects for a bank to make investment decisions.

Capital investment decisions

Capital investment decisions^[1] are long-term corporate finance decisions relating to fixed assets and capital structure. Decisions are based on several inter-related criteria. Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate. These projects must also be financed appropriately. If no such opportunities exist, maximizing shareholder value dictates that management return excess cash to shareholders. Capital investment decisions thus comprise an investment decision, a financing decision, and a dividend decision.

The investment decision

Main article: Capital budgeting

Management must allocate limited resources between competing opportunities ("projects") in a process known as capital budgeting. Making this capital allocation decision requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows.

Project valuation

Further information: stock valuation and fundamental analysis

In general, each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (see Fisher separation theorem; John Burr Williams: Theory). This requires estimating the size and timing of all of the incremental cash flows resulting from the project. These future cash flows are then discounted to determine their present value (see Time value of money). These present values are then summed, and this sum net of the initial investment outlay is the NPV.

The NPV is greatly influenced by the discount rate. Thus selecting the proper discount rate—the project "hurdle rate"—is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the financing mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI; see list of valuation topics.

Valuing flexibility

Main articles: Real options analysis and decision tree

In many cases, for example R&D projects, a project may open (or close) paths of action to the company, but this reality will not typically be captured in a strict NPV approach. Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the “flexibile and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "option value" inherent in the project.

The two most common tools are Decision Tree Analysis (DTA) and Real options analysis:

• The DTA approach attempts to capture flexibility by incorporating likely events and consequent management decisions into the valuation. In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow. (For example, management will only proceed with stage 2 of the project given that stage 1 was successful; stage 3, in turn, depends on stage 2. In a DCF model, on the other hand, there is no "branching" - each scenario must be modelled separately.) The highest value path (probability weighted) is regarded as representative of project value

• The real options approach is used when the value of a project is contingent on the value of some other asset or underlying variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low, management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a DCF valuation would capture only one of these outcomes.) Here, using financial option theory as a framework, the decision to be taken is identified as corresponding to either a call option or a put option - valuation is then via the Binomial model or, less often for this purpose, via Black Scholes; see Contingent claim valuation. The "true" value of the project is then the NPV of the "most likely" scenario plus the option value.

Quantifying uncertainty

Further information: Monte Carlo methods in finance

Given the uncertainty inherent in project forecasting and valuation, analysts will wish to assess the sensitivity of project NPV to the various inputs to the DCF model. In a typical sensitivity analysis the analyst will vary one key factor, while ceteris paribus holding constant all other inputs. The sensitivity of NPV to a change in that factor is then observed (calculated as Δ NPV / Δ factor). For example, the analyst will set annual revenue growth rates at 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case" - and produce three corresponding NPVs.

Using a related technique, analysts may also run scenario based forecasts so as to observe the value of the project under various outcomes. Under this technique, a scenario comprises a particular outcome for economy-wide, "global" factors (exchange rates, commodity prices) as well as for company-specific factors (revenue growth rates, unit costs). Here, extending the example above, key inputs in addition to growth are also adjusted, and NPV is calculated for the various scenarios. Analysts then plot these results to produce a "value-surface" (or even a "value-space"), where NPV is a function of several variables. Another application of this methodology is to determine an "unbiased NPV", where management determines a (subjective) probability for each scenario and the NPV for the project is then the probability-weighted average of the various scenarios. Note that for scenario based analysis, the various combinations of inputs must be internally consistent, whereas for the sensitivity approach these need not be so.

A further advancement is to construct stochastic or probabilistic financial models - as opposed to the traditional static and deterministic models as above. For this purpose, the most common method is to use Monte Carlo simulation to analyze the project’s NPV (introduced to finance by David B. Hertz in 1964). Here, the cash flow components that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their "random characteristics". The simulation produces several thousand trials (in contrast to the scenario approach above) and outputs a histogram of project NPV. The average NPV of the potential investment - as well as its volatility and other sensitivities - is then observed. (Typically, an add-in such as Crystal Ball is used to run simulations in spreadsheet based DCF models.)

Here, continuing the above example, instead of assigning three discrete values to revenue growth, the analyst would assign an appropriate probability distribution (commonly triangular or beta). This distribution - and that of the other sources of uncertainty - would then be "sampled" repeatedly so as to generate the several thousand realistic (but random) scenarios, and the output is a realistic, representative set of valuations. The resultant statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness" than the variance observed under the traditional scenario based approach.

The financing decision

Main article: Capital structure

Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. Management must therefore identify the "optimal mix" of financing—the capital structure that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)

The sources of financing will, generically, comprise some combination of debt and equity. Financing a project through debt results in a liability that must be serviced—and hence there are cash flow implications regardless of the project's success. Equity financing is less risky in the sense of cash flow commitments, but results in a dilution of ownership and earnings. The cost of equity is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.

Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the Pecking Order Theory, which suggests that firms avoid external financing while they have internal financing available and avoid new equity financing while they can engage in new debt financing at reasonably low interest rates. Another major theory is the Trade-Off Theory in which firms are assumed to trade-off the Tax Benefits of debt with the Bankruptcy Costs of debt when making their decisions. An emerging area in finance theory is Right-financing whereby investment banks and corporations can enhance investment return and company value over time by determining the right investment objectives, policy framework, institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and under given market conditions. One last theory about this decision is the Market timing hypothesis which states that firms look for the cheaper type of financing regardless of their current levels of internal resources, debt and equity.

The dividend decision

Main article: The Dividend Decision

 The dividend is calculated mainly on the basis of the company's unappropriated profit and its business prospects for the coming year.  If there are no NPV positive opportunities, i.e. where returns exceed the hurdle rate, then management must return excess cash to investors. These free cash flows comprise cash remaining after all business expenses have been met.

This is the general case, however there are exceptions. For example, investors in a "Growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and Real options.

Management must also decide on the form of the distribution, generally as cash dividends or via a share buyback. There are various considerations: where shareholders pay tax on dividends, companies may elect to retain earnings, or to perform a stock buyback, in both cases increasing the value of shares outstanding; some companies will pay "dividends" from stock rather than in cash. (See Corporate action.) Today it is generally accepted that dividend policy is value neutral (see Modigliani-Miller theorem).

Working capital management

Main article: Working capital

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of Working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Decision criteria

Working capital is the amount of capital which is readily available to an organization. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and cash requirements (Current Liabilities). So the decisions relating to working capital are always current decisions, i.e., short term decisions.

The short term decisions of the firm are similar to those of long term in terms of risk and return, but they differ in many other ways like time factor, discounting consideration, liquidity etc. So these decisions are not taken on the same basis as long term decisions. These decisions have different criteria like cash flow and profitability.

• The most important critreon for making shor term decisons is cash flows. And the best measure of cash flow is net operating cycle or cash conversion cycle. It represents the time difference between cash payment for raw materials and cash collection for sales. Another aspect of cash conversion cycle is gross operating cycle which is same as net operating cycle except the fact that it does not take into account the creditors deferral period. Cash conversion cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.

• In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See Economic value added (EVA).

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.

• Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
• Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity (EPQ).
• Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
• Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

Financial risk management

Main article: Financial risk management

Risk management is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management.

This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of creating, or enhancing, firm value. All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.

Derivatives are the instruments most commonly used in Financial risk management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets. These standard derivative instruments include options, futures contracts, forward contracts, and swaps.

See: Financial engineering; Financial risk; Default (finance); Credit risk; Interest rate risk; Liquidity risk; Market risk; Operational risk; Volatility risk; Settlement risk.

Relationship with other areas in finance

Investment banking

Use of the term “corporate finance” varies considerably across the world. In the United States it is used, as above, to describe activities, decisions and techniques that deal with many aspects of a company’s finances and capital. In the United Kingdom and Commonwealth countries, the terms “corporate finance” and “corporate financier” tend to be associated with investment banking - i.e. with transactions in which capital is raised for the corporation.

Personal and public finance

Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations have broad application to entities other than corporations, for example, to partnerships, sole proprietorships, not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from personal finance and public finance.

Public finance

Public finance is a field of economics concerned with paying for collective or governmental activities, and with the administration and design of those activities. The field is often divided into questions of what the government or collective organizations should do or are doing, and questions of how to pay for those activities. The broader term (public economics) and the narrower term (government finance) are also often used.

Overview

The proper role of government provides a starting point for the analysis of public finance. Private markets, if certain conditions are met, will allocate goods and services among individuals efficiently (in the sense that no waste occurs and that individual tastes are matching with the economy's productive abilities). If private markets were able to provide efficient outcomes and if the distribution of income was socially acceptable, then there would be little or no scope for government. In many cases, however, conditions for private market efficiency are violated. For example, if many people can enjoy the same good at the same time (non-rival, non-excludable consumption), then private markets may supply too little of that good. National defense is one example of non-rival consumption, or of a public good.

"Market failure" occurs when private markets do not allocate goods or services efficiently. The existence of market failure provides an efficiency-based rationale for collective or governmental provision of goods and services. Externalities, public goods, informational advantages, strong economies of scale, and network effects can cause market failures. Public provision via a government or a voluntary association, however, is subject to other inefficiencies, termed "government failure."

Under broad assumptions, government decisions about the efficient scope and level of activities can be efficiently separated from decisions about the design of taxation systems (Diamond-Mirlees separation). In this view, public sector programs should be designed to maximize social benefits minus costs (cost-benefit analysis), and then revenues needed to pay for those expenditures should be raised through a taxation system that creates the fewest efficiency losses caused by distortion of economic activity as possible. In practice, government budgeting is substantially more complicated and often results in inefficient practices.

Government can pay for spending by borrowing (borrowing), although borrowing is a method of distributing tax burdens through time rather than a replacement for taxes. A deficit is the difference between government spending and revenues. The accumulation of deficits over time is the total public debt. Deficit finance allows governments to smooth tax burdens over time, and gives governments an important fiscal policy tool. Deficits can also narrow the options of successor governments.

Public finance is closely connected to issues of income distribution and social equity. Governments can reallocate income through transfer payments or by designing tax systems that treat high-income and low-income households differently.

The "Public Choice" approach to public finance seeks to explain how self-interested voters, politicians, and bureaucrats actually operate, rather than how they should operate.

Government expenditures

Main article: Government spending

Economists classify government expenditures into three main types. Government purchases of goods and services for current use are classed as government consumption. Government purchases of goods and services intended to create future benefits--- such as infrastructure investment or research spending--- are classed as government investment. Government expenditures that are not purchases of goods and services, and instead just represent transfers of money--- such as social security payments--- are called transfer payments.^[1]

Government operations

Main article: Government operations

Government operations are those activities involved in the running of a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements) for the purpose of producing value for the citizens. Government operations have the power to make, and the authority to enforce rules and laws within a civil, corporate, religious, academic, or other organization or group.^[2] In its broadest sense, "to govern" means to rule over or supervise, whether over a state, a set group of people, or a collection of people.^[3]

Income distribution

Main article: Income distribution

• Income distribution - Some forms of government expenditure are specifically intended to transfer income from some groups to others. For example, governments sometimes transfer income to people that have suffered a loss due to natural disaster. Likewise, public pension programs transfer wealth from the young to the old. Other forms of government expenditure which represent purchases of goods and services also have the effect of changing the income distribution. For example, engaging in a war may transfer wealth to certain sectors of society. Public education transfers wealth to families with children in these schools. Public road construction transfers wealth from people that do not use the roads to those people that do (and to those that build the roads).
• Income Security
• Employment insurance
• Health Care

Financing government expenditures

Budgeted revenues of governments in 2006

Government financing can be achieved by taxes, government borrowing, or seigniorage. How a government chooses to finance its activities can have important effects on the distribution of income and wealth (income redistribution) and on the efficiency of markets (effect of taxes on market prices and efficiency). The issue of how taxes affect income distribution is closely related to tax incidence, which examines the distribution of tax burdens after market adjustments are taken into account. Public finance research also analyzes effects of the various types of taxes and types of borrowing as well as administrative concerns, such as tax enforcement.

Taxes

Main article: Tax

A tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state (for example, tribes, secessionist movements or revolutionary movements). Taxes could also be imposed by a subnational entity. Taxes consist of direct tax or indirect tax, and may be paid in money or as corvée labor. A tax may be defined as a "pecuniary burden laid upon individuals or property to support the government [ . . .] a payment exacted by legislative authority."^[4] A tax "is not a voluntary payment or donation, but an enforced contribution, exacted pursuant to legislative authority" and is "any contribution imposed by government [ . . .] whether under the name of toll, tribute, tallage, gabel, impost, duty, custom, excise, subsidy, aid, supply, or other name."^[5]

Debt

Main article: Government debt

Governments, like any other legal entity, can take out loans, issue bonds and make financial investments. Based on the taxing authority of the entity, they issue bonds such as tax increment bonds or revenue bonds. Government debt (also known as public debt or national debt) is money (or credit) owed by any level of government; either central government, federal government, municipal government or local government.

As the government represents the people, government debt can be seen as an indirect debt of the taxpayers. Government debt can be categorized as internal debt, owed to lenders within the country, and external debt, owed to foreign lenders. Governments usually borrow by issuing securities such as government bonds and bills. Less credit worthy countries sometimes borrow directly from commercial banks or international institutions such as the International Monetary Fund or the World Bank.

Most government budgets are calculated on a cash basis, meaning that revenues are recognized when collected and outlays are recognized when paid. Some consider all government liabilities, including future pension payments and payments for goods and services the government has contracted for but not yet paid, as government debt. This approach is called accrual accounting, meaning that obligations are recognized when they are acquired, or accrued, rather than when they are paid.

Seigniorage

Main article: Seigniorage

Seigniorage is the net revenue derived from the issuing of currency. It arises from the difference between the face value of a coin or bank note and the cost of producing, distributing and eventually retiring it from circulation. Seigniorage is an important source of revenue for some national banks.

The role of public spending and taxes

Externalities and government policy

• Internalization of externalities
• The Coase Theorem. The Coase theorem states that when trade in an externality is possible and there are no transaction costs, bargaining will lead to an efficient outcome regardless of the initial allocation of property rights.

Public goods

• Characteristics

characteristics of public goods are non - excludability and transferable. Non excludabilty means the consumption of the goods is not limited on specific group of consumers, that is the satisfaction of the people watching fireworks display is not limited to the owners of the fireworks. The transferability feature of the public goods means that the consumption of an individual will not lead to deprive the other, that is, if a consumer is doing fishing on a pond, another person may do fishing as well on the same pond.

• The demand for pure public goods
• Efficient output of a pure public good
• The free rider problem

Personal finance

Personal finance is the application of the principles of finance to the monetary decisions of an individual or family unit. It addresses the ways in which individuals or families obtain, budget, save and spend monetary resources over time, taking into account various financial risks and future life events. Components of personal finance might include checking and savings accounts, credit cards and consumer loans, investments in the stock market, retirement plans, social security benefits, insurance policies, and income tax management.

Personal financial planning

A key component of personal finance is financial planning, a dynamic process that requires regular monitoring and reevaluation. In general, it has five steps:

1. Assessment: One's personal financial situation can be assessed by compiling simplified versions of financial balance sheets and income statements. A personal balance sheet lists the values of personal assets (e.g., car, house, clothes, stocks, bank account), along with personal liabilities (e.g., credit card debt, bank loan, mortgage). A personal income statement lists personal income and expenses.
2. Setting goals: Two examples are "retire at age 65 with a personal net worth of $200,000 American" and "buy a house in 3 years paying a monthly mortgage servicing cost that is no more than 25% of my gross income". It is not uncommon to have several goals, some short term and some long term. Setting financial goals helps direct financial planning.
3. Creating a plan: The financial plan details how to accomplish your goals. It could include, for example, reducing unnecessary expenses, increasing one's employment income, or investing in the stock market.
4. Execution: Execution of one's personal financial plan often requires discipline and perseverance. Many people obtain assistance from professionals such as accountants, financial planners, investment advisers, and lawyers.
5. Monitoring and reassessment: As time passes, one's personal financial plan must be monitored for possible adjustments or reassessments.

Typical goals most adults have are paying off credit card and or student loan debt, retirement, college costs for children, medical expenses, and estate planning.

Chartered Financial Analyst

Chartered Financial Analyst (CFA) is an international professional designation offered by the CFA Institute of USA (formerly known as AIMR) to financial analysts who complete a series of three examinations. Candidates must have a bachelor's degree (or equivalent), be in the final year of their bachelor's degree program, or have at least four years of qualified, professional work experience in order to take the exams. In order to become a "CFA Charterholder" candidates must pass all three exams, agree to comply with the code of ethics, pay member dues, and have four years of work experience deemed acceptable by the CFA Institute. The CFA Institute's CFA program is not related to the Indian CFA offered by ICFAI in India. CFA charterholders are also obligated to adhere to a strict Code of Ethics and Standards([1]) governing their professional conduct.

The CFA designation

The CFA designation is a qualification for finance and investment professionals, particularly in the fields of investment management, investment banking and financial analysis of stocks, bonds and their derivative assets. The program focuses on portfolio management and financial analysis, and provides a general knowledge of other areas of finance.

From 1963 (when the CFA designation was first awarded) to 2006, approximately 78,000 people from at least 126 different countries have been awarded the right to use the CFA designation, 68,000 of them in the years since 1990. As of 2006, more than 116,000 more people are currently enrolled to take one of the examinations. [2])

History

The predecessor of the CFA Institute, the Financial Analysts Federation (FAF) was originally established in 1947 as a service organization for investment professionals in its societies and chapters. In 1990, in hopes of boosting the credential's public profile, the CFA Institute (formerly the Association for Investment Management and Research or AIMR) was created from the merger of the FAF and the Institute of Chartered Financial Analysts (ICFA). Many Financial Analysts (FA credential) were "grandfathered" into CFAs without taking any of current levels as a result of 1990 merger with between the ICFA and FAF.

The CFA program began in the United States, but has become increasingly international with many people becoming charterholders across Europe, Asia and Australia. By 2003 fewer than half the candidates in the CFA program were based in the US and Canada, with most of the other candidates based in Asia or Europe. India and China have shown some of the highest growth from 2005-2006 with increases of 25% and 53% respectively in the total number of charterholders.[3]

Requirements

The basic requirements for membership in the CFA program include holding or being in the final year of a university degree (or international equivalent), or having four years of qualified, professional work experience in an investment decision-making process. The requirement necessary to begin the process of examination is to have four years of general work experience, a degree, or a combination of both, opening the door to a broad range of individuals. [4]

The CFA exam

A group of CFA candidates waiting in front of the testing location of San Francisco before the test. Dec 2, 2006

Candidates generally take one exam per year over three years and are written at a postgraduate level for financial professionals. Fees for the June 2008 exams range from $600 to $930, depending on the date at which the candidate registers to take the exam. Exams are challenging, with only 40% passing the Level I and II exams and 50% passing Level III in June 2007 (39% for Level I in December 2007) [5], [6]. In 2006, Europe achieved the highest average pass rate for the Level I, II and III of the exam with an overall success rate of 57% of candidates; versus 54% for the USA and 49% in Asia and Pacific Asia.

• The Level I study program emphasizes tools and inputs and includes an introduction to asset valuation and portfolio management techniques.
• The Level II study program emphasizes asset valuation and includes applications of the tools and inputs (including economics, financial statement analysis, and quantitative methods) in asset valuation.
• The Level III study program emphasizes portfolio management and includes strategies for applying the tools, inputs, and asset valuation models in managing equity, fixed income, and derivative investments for individuals and institutions.

All three exams are administered on paper on a single day; the Level I exam is administered twice a year (usually the first weekend of June and December). The Level II and III exams are administered once a year, usually the first weekend of June. Each exam consists of two three-hour sessions. Level I is multiple choice - all information required to answer the question is contained in the question. Level II is item set - a vignette followed by selected response questions. To answer each question, the candidate must refer to the vignette as there is insufficient information in the question stem. Level III consists of a session of short-answer questions and a session that is item set. On the multiple-choice/item set sections, there is no penalty for wrong answers.

Candidates who have taken the exam receive a score report that is intended to be fairly unspecific: there is no overall score for the test, only a Pass/Fail result. For each category of questions, each test-taker is given a broad range within which his or her performance falls: below 50%, between 50% and 70%, and above 70%. The passing grade for the exams has been defined as 70% of the top percentage of exam papers until 1989; since then, the grading method is not explicitly published.[7] and the minimum passing score is set by the Board of Governors after each exam. The Board of Governors review the results of a Standard Setting process and input from psychometricians. Standard Setting is a process by which CFA Charterholders from around the world review the exam and recommend, for each question, a minimum passing score for the "just qualified candidate". The minimum passing scores for each question are aggregated and presented to the Board of Governors as a recommended minimum passing score for the entire exam. The Board of Governors is not bound by this recommendation, but does recognize it as very important information.

The CFA curriculum

The curriculum for the CFA program is based on a Candidate Body of Knowledge established by the CFA Institute. The curriculum includes:

• Ethics and Professional Standards
• Quantitative Methods (such as the time value of money, and statistical inference)
• Economics
• Financial Statement Analysis
• Corporate Finance
• Analysis of Investments (stocks, bonds, derivatives, venture capital, real estate, etc.)
• Portfolio Management and Analysis (asset allocation, portfolio risk, performance measurement, etc.)

For exams in 2008 onwards candidates are required to purchase the curriculum readings from CFA Institute. Unsuccessful candidates are required to buy the same curriculum again when they re-register for the exam.

The ethics section is primarily concerned with compliance and reporting rules when managing an investor's money or when issuing research reports, although there are some rules which pertain to more general professional behaviour (such as prohibitions against plagiarism). There are also rules that specifically relate to the proper use of the designation for charterholders and candidates. All of these rules are delineated in the 'Code and Standards'.

The section on quantitative analysis is dominated by statistics and time series analysis. Other financial fundamentals such as the time value of money are also addressed. The statistics topics are fairly broad, but the main focuses are risk analysis, hypothesis testing and regression analysis. For the test, only two types of calculator are allowed (the Hewlett Packard 12C and the Texas Instruments BA II Plus). The test also features other quantitative topics, but these are covered in other sections. For example, calculating depreciation of assets is a part of financial statement analysis (accounting), and determining currency arbitrage is a part of international economics.

Both micro- and macroeconomics are covered. There are sections for international economics, mainly related to currency conversions and how they are affected by international interest rates and inflation.

The accounting section is heavily tested at Levels I and II, but is not a significant part of Level III. It is divided into financial statements analysis and corporate finance. Financial statement analysis considers the statement of cash flows, the balance sheet, and the income statement. Each of these documents gives a distinct view into the state and operations of a company. Corporate finance uses these views of the company to make decisions about projects, deciding how they will impact the company.

The section on security analysis is divided by the types of security. There is a general section on global markets, sections on equity (stocks), fixed income (bonds), and derivatives (futures, forwards, options and swaps). The first levels of the test require familiarity with these instruments, then the focus develops into correctly valuing them, and how to properly use them.

The final section is portfolio management. This section increases in importance with each of the three levels. Portfolio management is an analysis of the process of managing money. It depends heavily on all of the other topics. When managing money for others, ethics is obviously important. This section deals with how the investors' needs are met by the portfolio manager. Modern portfolio theory is also tested: the efficient frontier, Capital asset pricing model, etc.

The Code of Ethics

Members of CFA Institute (including charterholders and candidates for the CFA designation) must:

• Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.
• Place the integrity of the investment profession and the interests of clients above their own personal interests.
• Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.
• Practice and encourage others to practice in a professional and ethical manner that will reflect credit on ourselves and the profession.
• Promote the integrity of, and uphold the rules governing, capital markets.
• Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals

Financial planner

Objectives

People enlist the help of a financial planner because of the complexity of knowing how to perform the following:

• Providing direction and meaning to financial decisions;
• Allowing the person to understand how each financial decision affects the other areas of finance; and
• Allowing the person to adapt more easily to life changes in order to feel more secure.

Defining personal financial decisions

Personal financial planning is broadly defined as a process of determining an individual's financial goals, purposes in life and life's priorities, and after considering his resources, risk profile and current lifestyle, to detail a balanced and realistic plan to meet those goals. The individual's goals are used as guideposts to map a course of action on 'what needs to be done' to reach those goals.

Alongside the data gathering exercise, the purpose of each goal is determined to ensure that the goal is meaningful in the context of the individual's situation. Through a process of careful analysis, these goals are subjected to a reality check by considering the individual's current and future resources available to achieve them. In the process, the constraints and obstacles to these goals are noted. The information will be used later to determine if there are sufficient resources available to get to these goals, and what other things need to be considered in the process. If the resources are insufficient or absent to meet any of the goals, the particular goal will be adjusted to a more realistic level or will be replaced with a new goal.

Planning often requires consideration of self-constraints in postponing some enjoyment today for the sake of the future. To be effective, the plan should consider the individual's current lifestyle so that the 'pain' in postponing current pleasures is bearable over the term of the plan. In times where current sacrifices are involved, the plan should help ensure that the pursuit of the goal will continue. A plan should consider the importance of each goal and should prioritize each goal. Many financial plans fail because these practical points were not sufficiently considered.

Scope

Financial planning should cover all areas of the client’s financial needs and should result in the achievement of each of the client's goals. The scope of planning would usually include the following:

Risk Management and Insurance Planning

Managing cash flow risks through sound risk management and insurance techniques

Investment and Planning Issues

Planning, creating and managing capital accumulation to generate future capital and cash flows for reinvestment and spending

Retirement Planning

Planning to ensure financial independence at retirement

Tax Planning

Planning for the reduction of tax liabilities and the freeing-up of cash flows for other purposes

Estate Planning

Planning for the creation, accumulation, conservation and distribution of assets

Cash Flow and Liability Management

Maintaining and enhancing personal cash flows through debt and lifestyle management

The process

The personal financial planning process is generally accepted as a six-step process as follows:

Step 1: Setting goals with the client This step (that is usually performed in conjunction with Step 2) is meant to identify where the client wants to go in terms of his finances and life.

Step 2: Gathering relevant information on the client This would include the qualitative and quantitative aspects of the client's financial and relevant non-financial situation.

Step 3: Analysing the information The information gathered is analysed so that the client's situation is properly understood. This includes determining whether there are sufficient resources to reach the client's goals and what those resources are.

Step 4: Constructing a financial plan Based on the understanding of what the client wants in the future and his current financial status, a roadmap to the client goals is drawn to facilitate the achievements of those goals.

Step 5: Implementing the strategies in the plan Guided by the financial plan, the strategies outlined in the plan are implemented using the resources allocated for the purpose.

Step 6: Monitoring implementation and reviewing the plan The implementation process is closely monitored to ensure it stays in alignment to the client's goals. Periodic reviews are undertaken to check for misalignment and changes in the client's situation. If there is any deviation or significant change to the client's situation, the strategies and goals in the financial plan are revised accordingly.

What is a financial planner's job function?

A financial planner specializes in the planning aspects of finance, in particular personal finance, as contrasted with a stock broker who is only concerned with the actual investments, or with a life insurance intermediary who advises on risk products.

Financial planning is usually a six-step process, and involves considering the client's situation from all relevant angles to produce integrated solutions. The six-step financial planning process has been adopted by the International Organization for Standardization (ISO).^[1] Financial planners are also known by the title financial adviser in some countries, although these two terms are technically not synonymous, and their roles have some functional differences.

Although there are many types of 'financial planners,' the term is used largely to describe those who consider the entire financial picture of a client and then provide a comprehensive solution. To differentiate from the other types of financial planners, some planners may be called 'comprehensive' financial planners.

Other financial planners may specialize in one or more areas, such as insurance planning and retirement planning.

Financial planning is a growing industry with projected faster than average job growth through 2014.^[2]

Licensing, regulations and self-regulation

The title of 'financial planner' is largely an unregulated term in many countries. Lack of regulation has allowed financial services personnel in these countries to use the title indiscriminately. Often, financial products intermediaries, such as life insurance and unit trusts agents, use the title to project a professional image to clients even when they are not trained in the professional aspects of financial planning. This has sometimes led to abuse. Clients may be deceived to receive financial planning services that are unprofessional, from unethical providers.

To protect the industry, financial planning professionals and practitioners from across the globe (starting from the United States) have begun to form trade organisations to provide self-regulations and to maintain some orderliness in the industry. Some, such as the FPA, have begun to organize high-level training programmes and certify members who successfully completed these programmes.

The title of 'financial planner' continues, however, to be used by individuals in the financial industry in most countries, as there are little or no legal barriers to prevent the use of the title. The governments in many countries where the financial planning profession is taking roots are beginning to play an increasingly active role in tasking themselves to ensure the market is orderly. More stringent laws and guidelines are being progressively introduced to keep the profession in check.

Australia

In Australia, the financial planning services are initially delineated by law by the granting of licence to deal in securities or advise on investments. Licences are issued under stringent criteria by the Australian Securities and Investments Commission (ASIC), which has evolved these regulations vigorously over the years.^[3] Financial planning is now a highly regulated industry in Australia especially where financial advice to the public is involved. Practitioners who offer advice that could influence a client's decision to purchase a financial product must meet minimum training requirements and be licensed by the ASIC. The meaning of 'licenced' refers to Australian Financial Services Licence (AFSL) holders and representatives or authorised representatives of licence holders. Broadly, most people embarking in financial planning will start as an authorised representative of a licence holder.

Becoming a financial planner in Australia involves two main steps:

1. Meet the training requirements of Regulation Guideline 146;
2. Select a licence holder with whom to be affiliated.

The licence holder is the authorised representative, and will be ultimately responsible for the advice given by the planner. The licence holder therefore must make sure the representatives meet all compliance and training prerequisites. As of November 2005, there were approximately 4,300 licence holders registered with ASIC and over 42,500 authorised representatives in Australia.

Malaysia

The first country to introduce legislation that requires a person to be licensed before he can hold himself out to be a 'financial planner' is Malaysia. Financial planning is considered a newer profession in the Asian region as compared to those in the west, such as the United States and Australia where the profession is more established. The Securities Commission (SC) of Malaysia introduced legislation through amendments made to the Securities Industry Act in 2003 to regulate financial planning and the use of the title or related-title of 'financial planner' or to conduct activities related to financial planning.^[4]

In 2005, amendments to the Malaysian Insurance Act require those who carry out financial advisory business (including financial planning activities related to insurance) and/or use the title of financial adviser under their firm (which, like in Singapore, must be a corporate structure) to obtain a licence from Bank Negara Malaysia (BNM).^[5] Some persons who offer financial advisory services, e.g. licenced life insurance agents, are exempted from licensing as a practising requirement.

Again, in 2007, the Capital Market Services Act (CMSA) comes into force as another of the consolidation exercises of the government to move the industry towards a one regime regulatory environment.

As it currently stands, one of the basic requirements to apply for a financial planner or financial adviser licence in Malaysia is that the key company officers, e.g. directors, must be an RFP designee (most if not all Malaysian FChFP designees also carry the RFP designation). Subsequently, in September 2006, the CFP qualification is included as one of the alternatives that can be used by the financial adviser licence applicant. With this development, the demand for financial planning courses has begun to take root in more concrete forms in Malaysia. The licence applicant must also be a member of a self-regulatory organisation (SRO) in financial planning recognised by the authorities. For this purpose, the two SROs currently recognised by both the Security Commission and Bank Negara are the Malaysia Financial Planning Council (MFPC) and the Financial Planning Association of Malaysia (FPAM). The purpose of this requirement is to ensure some form of self-supervision for persons practicing financial planning.

Other countries

In some countries, e.g., the United States, financial planners must be registered as an investment advisor first. This requires an employee within a firm to pass the series 65 or 66 Registered Investment Advisor Exam. A private advisor or company can apply to the state and SEC for an RIA Registered Investment Advisor License or Status.

Being 'licenced' to practice financial planning is not the same as merely having a professional 'qualification' in financial planning. A person may be professionally qualified in financial planning, but without a licence required by the law, he cannot practice the trade in that country or call himself a financial planner there. As of now, there are quite a bit of qualifications related to financial planning that can be found in world. The most prestigious financial planning designations are those which are not just of advanced standing and well-known, but are also recognised by the relevant authorities for licensing purpose.

In some places, individual employees within a licensed & registered Investment Advisor firm such as a: brokerage, bank or insurance company may be exempt if providing complementary financial planning services in relation to their existing products and services. Moreover, financial planners should be extremely careful in providing estate planning or taxation advice for a fee, as these fields are highly regulated by government agencies that control the practice of lawyers and Certified Public Accountants (CPAs). The term "Investment Advisor" also includes any person who uses the title "financial planner" and who, for compensation, engages in the business, whether principally or as part of another business, of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities, or who, for compensation and as part of a regular business, publishes analyses or reports concerning securities.

From the California Department of Corporations

A financial planner will be registered with the state if he or she has less than $25 million in assets under management (AUM), and with the SEC if he or she has more than $30 million in AUM. The planner is required to present a client with the ADV Part II or equivalent before the client enters into a contract with the planner. No certification, tests or training ensure that any planner is suitable for the client or any investor, and it is important to read the ADV Part II, interview them, and fully understand any contract.

History of certifications in financial planning across the globe

In a newly emerging profession such as financial planning, there is a lack of regulation, especially in the early years of development. The need for some forms of self-regulation and the demand that a financial planner be competent and trustworthy have prompted several independent financial services organizations to introduce certifications and ethical benchmarks to meet these challenges in accordance to the need in each country. Those who meet the requirement of the certification process and ethical standards will be awarded a professional financial planning designation.

One of the oldest, most well-known financial planning certification service marks is the Certified Financial Planner (CFP), which has gained global recognition because of its active standard setting activities and worldwide presence. The CFP designation was first introduced in the United States in the early 1970s to meet the need of the consumers. The CFP mark now belongs to the CFP Board of Standards (CFP Board), USA, which has member associations world-wide.

The CFP Board was founded in July 1985 as the International Board of Standards and Practices for Certified Financial Planners, Inc., (IBCFP) by the College for Financial Planning (College) and the Institute of Certified Financial Planners (ICFP). The IBCFP became Certified Financial Planner Board of Standards Inc. (CFP Board) on February 1, 1994. As a professional regulatory organization acting in the public interest by fostering professional standards in personal financial planning, the CFP Board establishes and enforces education, examination, experience and ethics requirements for CFP certificants. The CFP service mark is promoted world-wide through member associations, the FPAs.

The Fellow Chartered Financial Practitioner (FChFP) designation was developed by the National Association of Malaysian Life Insurance and Financial Advisors] (NAMLIFA) in 1996. The designation was adopted by the Asia Pacific Financial Services Association (APFinSA) in 2001 as the unified designation for its member associations in 11 countries.

The Registered Financial Planners Institute (RFPI) formed in 1983 in the United States to promote professionalism among those who are or will be active in the field of financial planning for individuals and businesses. The RFPI is an international organization with chapters and members throughout the world. The RFPI offers study programs both in classroom conducted seminars and correspondence courses. RFPI is a collective membership of financial planners and is designed to serve the interest of both its members and the general public in matters relating to financial planning. RFPI recognizes qualified individuals by designation of RFP, SRFP who are in the field of financial planning which would include: insurance, attorneys, real estate, bankers, CPAs, stock brokers, securities or other professionals licensed in similar fields that have the ability to properly financial plan individuals or businesses in their related fields.

The Personal Financial Specialist (PFS) credential was established for CPAs in the United States who specialize in personal financial planning. The credential is awarded exclusively to members of the American Institute of Certified Public Accountants (AICPA) who have demonstrated considerable experience and expertise in that area. As of today, the AICPA has granted approximately 3,300 CPA/PFS credentials.

In Australia, the financial planning specialisation, CPA (FPS), is available to those members of CPA Australia who can demonstrate their eligibility through experience and education within the financial services industry.

The objectives of the FPS designation are to:

• achieve public recognition for those who hold the specialisation;
• enhance the quality of financial planning services that members provide; and
• increase practice development and career opportunities for CPAs.

The FPS designation is available to CPAs, and is based on a points system, where a minimum of 100 points must be accrued. Although all CPA Australia members who provide financial product advice must be licensed by ASIC, a member does not have to be licensed to first obtain the CPA (FPS) designation.

The Chartered Financial Consultant (ChFC) is another financial planning qualification, conferred by American College, USA). Since 1982, the ChFC has remained among the most extensive education available for professionals seeking a designation in financial planning. To date, more than 41,000 individuals have attained this distinction. This designation has also spread to Asia, where designees are found in countries like Singapore, Malaysia, Indonesia, China and Hong Kong.

In Europe, the €uropean Financial Planner (€FP) designation conferred by the €uropean Financial Planning Association (€FPA) is gaining ground as a financial planning certification mark. The €FPA is the largest professional and educational organisation for financial planners and financial advisors in Europe and is the only Financial Planning Association created solely in the interest of European financial planning consumers and practitioners.

The rest of the certification qualifications related to financial planning include: Fellow, Financial Services Institute (conferred by LOMA, USA; the Chartered Wealth Manager (CWM, conferred by the AAFM) designation; the Certified Financial Marketing Consultant (CFMC) conferred by the Institute of Marketing Malaysia.

Accredited business school, training centers and other providers

Globally, cross-recognition agreements are being developed to facilitate the learning of financial planning. The 2 major accrediting agencies, the Association to Advance Collegiate Schools of Business (AACSB) and the Association of Collegiate Business Schools and Programs (ACBSP), which accredit over 560 of the best business school programs, provide the Certification of MFP Master Financial Planner Professional from the American Academy of Financial Management, which is available to AACSB and ACBSP business school graduates with finance or financial services related concentrations.

Financial Analysis

Financial analysis refers to an assessment of the viability, stability and profitability of a business, sub-business or project.

It is performed by professionals who prepare reports using ratios that make use of information taken from financial statements and other reports. These reports are usually presented to top management as one of their bases in making business decisions. Based on these reports, management may:

• Continue or discontinue its main operation or part of its business;
  
• Make or purchase certain materials in the manufacture of its product;
  
• Acquire or rent/lease certain machineries and equipments in the production of its goods;
  
• Issue stocks or negotiate for a bank loan to increase its working capital.
  
• other decisions that allow management to make an informed selection on various alternatives in the conduct of its business.

Contents [hide] 1 Goals 2 Methods 3 See also 3.1 Ratios 4 Notes 5 External links

[edit] Goals

Financial analysts often assess the firm's:

1. Profitability- its ability to earn income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on the income statement, which reports on the company's results of operations;

2. Solvency- its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity- its ability to maintain positive cash flow, while satisfying immediate obligations;

Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a given point in time.

4. Stability- the firm's ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

[edit] Methods

Financial analysts often compare financial ratios (of solvency, profitability, growth...):

• Past Performance: Across historical time periods for the same firm (the last 5 years for example),
  
• Future Performance: Using historical figures and certain mathematical and statistical techniques, including present and future values, This extrapolation method is the main source of errors in financial analysis as past statistics can be poor predictors of future prospects.
  
• Comparative Performance: Comparison between similar firms.

These ratios are calculated by dividing a (group of) account balance(s), taken from the balance sheet and / or the income statement, by another, for example :

Net profit / equity = return on equity

Gross profit / balance sheet total = return on assets

Stock price / earnings per share = P/E-ratio

Comparing financial ratios are merely one way of conducting financial analysis. Financial ratios face several theoretical challenges:

• They say little about the firm's prospects in an absolute sense. Their insights about relative performance require a reference point from other time periods or similar firms.
• One ratio holds little meaning. As indicators, ratios can be logically interpreted in at least two ways. One can partially overcome this problem by combining several related ratios to paint a more comprehensive picture of the firm's performance.
• Seasonal factors may prevent year-end values from being representative. A ratio's values may be distorted as account balances change from the beginning to the end of an accounting period. Use average values for such accounts whenever possible.
• Financial ratios are no more objective than the accounting methods employed. Changes in accounting policies or choices can yield drastically different ratio values.
• They fail to account for exogenous factors like investor behavior that are not based upon economic fundamentals of the firm or the general economy (fundamental analysis)