INTRODUCTION TO FINANCE

1. What is Finance?

If anyone asks what the finance is it is sure that most people answer, “finance is related to money”. This answer is partially correct but it is not complete. It is true that finance is related to money. But this does not define finance completely. There is something missing in this answer. For this reason we have to ask another question, which is: “Finance is related to money with what aspect?” By incorporating the answer to this question, we can define finance as follows:

Finance is the science of finding money (raising money) and using money. Briefly, finance is the science of money management.

As can be seen from this definition, finance or the science of money management has two aspects one of which is finding money and the second is using money. Money must be raised from some sources and this money must be used efficiently. That is what the finance is related to. Money management or finance interests individuals, government, and businesses. Accordingly, finance is divided into three sub-categories. These sub-categories are explained below.

2. Sub-categories of Finance

Sub-categories of finance are personal finance, public finance, and business finance. Personal finance is related to individuals and households, public finance is related to government, business finance is related to the businesses.

2.1. Personal Finance

Personal finance deals with several issues. One of the issues involves the decision of consumption and saving. Every individual and household has certain sources of income such as wage or salary income, business income, professional income, rent income, interest income, dividend income, etc. A portion of the income is spent for consumption. The portion of the income that is not spent for consumption is called saving. If the monetary amount of consumption in a certain period is less than the income in the same period it is said that the individual or household has saved money. Saving can be regarded as surplus money. So, the first decision an individual or a household should make is the amount of money allocated to consumption and saving. That requires consumption planning (deciding the type and amount of consumption). For example, how much money to spend for food, how much money to spend for clothing, how much money to spend for household appliances such as refrigerator, washing machine, dish washer, etc., how much money to spend for entertainment, how much money to spend for education, etc. Also, individuals should set aside some amount of money for their retirements by contributing to a pension fund. This amount of money should also be taken into account. All of these involve preparing an individual or household budget. This process is called personal financial planning.

After this, if there is surplus money a second decision must be made on how to use this money. This money should be invested in different alternatives such as time deposit bank accounts, financial instruments (stocks, government debt securities, corporate debt securities, mutual funds, etc.), precious metals, foreign currency, etc. In Turkey one of the common investment alternatives is real estate. If an individual or household buys a house to live in, it is consumption. But if an individual or household buys a house to make use of surplus money for the purpose of obtaining a return in terms of rent income or capital gain, it is investment. The purpose of investing the savings is always to obtain a return. The return may be rent, dividend, interest or capital gain. Capital gain occurs when someone sells something (house, stock, bond, etc.) at a higher price than what she/he paid to buy it. Investment decisions are very important for the individuals or households.

Sometimes the money required for consumption may be more than the income. This creates a deficit. If an individual or household has a deficit, they should find money to make it up. They may use previous savings to make up this deficit. If the previous savings are not enough or if they don’t want to use their previous savings then they have to borrow money to make up the deficit. The most common way of borrowing is to use credit card (when someone uses her/his credit card, she/he borrows money from the bank) or to take out a consumer loan from a bank. There are three main types of consumer loans, which are real estate loan, auto loan, and general-purpose consumer loan. Of course individuals and households can borrow from relatives and friends. This type of borrowing is called non-institutional (informal) borrowing. When someone borrows money from a financial institution (such as from a bank) it is called institutional (formal) borrowing. When someone borrows from relatives and friends it is called non-institutional (informal) borrowing.

2.2. Public Finance

Like individuals and households government uses money and sometimes government needs money. Government uses money for three main purposes. These are to provide public services, to make investments, to make transfer payments.

Government provides public services such as security, defense, heath care, education, justice, etc. Government must make expenditures in order to provide these services. For example, government must pay salaries to the public servants who are employed to provide these services. Also government must make payments to the suppliers from which it buys goods or services that are used in the provision of public services. There are also other expenditures related to providing public services.

Government also makes expenditures in order to acquire tangible and intangible assets. These are called investment expenditures or payments for investment.

The third type of expenditure is transfer payments. When the government makes a transfer payment it does not provide public service nor acquire tangible/intangible assets. The most common types of transfer payments are: payments to make up the deficit of the Social Security Adsministration, interest, grants, subsidies, incentives, and scholarships.

Government has several sources of income. The main source of income for the government is taxes and duties. Income tax, corporate tax, value added tax, excise tax, property tax, motor vehicle tax, import duty, stamp duty are the main types of taxes and duties. There are other taxes and duties as well. Government also receives fees for certain services that it provides such as judicial fee, passport fee, title deed fee, etc. Government may own shares of corporations and may receive dividend for these shares. Income from privatizations is also an important source of money for the government. Fines are another source of income for the government. There are also other sources of income for the government.

Government plans its income and expenditures for a certain period. This process is called budgeting. The budget must be approved by the Turkish Grand National Assembly to take effect. Actual income and expenditures are compared with the budgeted income and expenditures. This is called fiscal control. Budget preparation and control constitutes financial planning and control for the government. Financial planning and control is accomplished by the Ministry of Finance, General Directorate of Budget and Fiscal Control.

Sometimes expenditures exceed income. This situation creates a deficit, which is called budget deficit. When budget deficit occurs government borrows money. Government borrows money by issuing government debt securities. Here, government debt securities are discussed briefly. There are two types of government debt securities, which are treasury note and government bond. Government debt securities have nominal value. Nominal value is the amount that the government pays at maturity to the investor. Nominal value of government debt securities is 100 TL. The maturity of the treasury note is less than one year. Treasury note is issued at a discount. In other words, treasury note is issued less than the nominal value. The maturity of the government bond is at least one year. Types of government bonds are listed below:

a. Discounted government bond

b. Government bond with a coupon payment. This type of government bonds makes interest payments every three or six months.

c. Inflation adjusted government bonds. The interest (coupon) and principal payments (nominal value) of this type of bonds are adjusted to the inflation.

Banks are dealers of the government debt securities issued in Turkey. Banks buy government debt securities wholesale and sell some of them to their customers and retain the rest for themselves.

Government may issue bonds in global markets denominated in TL or foreign currency. Government may also issue bonds in a foreign country denominated in the currency of that country. For example Turkish Treasury issues bonds in Japan denominated in Japanese Yen.

Government may also borrow from International Monetary Fund (IMF) or Multilateral Development Banks such as World Bank, European Bank of Reconstruction and Development, Islamic Development Bank. These institutions lend money to governments to finance certain projects that have significant social and economic contributions. Debt management of the government is accomplished by the Undersecretariat of Treasury.

So far you have seen that finance is a subject not only related to businesses but also related to individuals, households, and government. The third sub-category of finance is business finance. Since business finance is the subject of this course, it will be explained in detail.

3. Business Finance

3.1. What is Business Finance?

Business finance deals with raising and using money in the businesses. In other words business finance deals with money management in businesses. Finance is a major function in all types of business. A sole proprietorship, a partnership, a limited partnership, a limited liability company, and a corporation must have finance function because all types of businesses need money (in other words they must raise money) and use money. Functions of the business finance are explained below.

Functions of the business finance:

a. Financial Analysis: Financial analysis deals with determining the financial position, performance, and cash flows of a business by examining its financial statements. As all of you remember, accounting is “a process that measures, records, classifies, summarizes, and reports the monetary values of the economic activities of a business”. The main output of this process is financial statements. Financial analysis is the examination and interpretation of the financial statements prepared as a result of accounting process. Financial analysis shows the financial health of a business and is used to make economic decisions related to the business.

b. Financial planning and control: Like individuals and government, businesses should plan their revenues, expenses, costs, and expenditures. This is accomplished by preparing the business budgets. Then, budgeted values must be compared with the actual values. This process is called budgetary control.

c. Raising the funds (financing): Every business must raise (finds) funds (money) for the following purposes:

- To carry out its daily operations: Businesses must make wage and salary payments, make payments to the suppliers, make daily payments such as utility bills, rent, etc. They must find money in order to make these payments.

- To make investment: Investment means acquiring assets and money is required to acquire the assets.

- To fulfill its cash liabilities.

Here, it is very important to know the difference between finance and financing because these two terms are different. We have already described what the finance is. As you can see from the explanations above, financing is raising the necessary funds (finding money) from different sources. Finance is very broad and encompasses all the functions explained here. Financing is just one function of finance.

d. Investment (using the money): Investment means acquiring assets. If a business acquires current and non-current (fixed) assets it makes an investment. Investment can be made into financial fixed assets by participating in the capital of other businesses. Investment can be made into tangible assets by buying building, vehicle, machinery and equipment, etc. Investment can be made into intangible assets by buying patent, franchise, copyright, etc. Investment can also be made into current assets. When a business buys inventory it makes an investment in inventory. When a business makes a sale on account it makes an investment in receivables. When a business makes a prepayment before receiving a service or a benefit it makes an investment in prepaid expenses.

e. Dividend Policy: Businesses must decide how to use the net income. What proportion of the net income should be retained? What proportion should be distributed as dividend?

f. Special Finance Issues: There are some special business finance issues such as going public, merger, liquidation, bankruptcy, etc. These issues are also the subjects of business finance.

At this point, some important subjects related to business finance must be pointed out. You have learned the difference between finance and financing. Financial management should also be defined here. Financial management encompasses all the decisions related to financing, investment, dividend policy, and special finance issues. Financial planning and control is also part of financial management. We can also say that financial management consists of managerial activities related to finance. Second important subject is about the relationship between accounting and finance. We defined accounting above. It was also stated “the main output of accounting process is financial statements.” One of the financial statements is balance sheet. Balance sheet shows the assets, liabilities, and shareholders’ equity of a business at a specific date. In fact, finance is all about managing the balance sheet. Investment decisions affect the assets. Financing decisions affect the liabilities and shareholders’ equity. Decisions related to dividend policy also affect shareholders’ equity. As you know a portion of the net income is distributed as dividend and the rest is added to the reserves and the retained earnings. Reserves and retained earnings increase the amount of shareholders’ equity. Financial analysis uses the financial statements to determine the financial health of a business. Financial planning (or budgeting) is related to preparing the financial statements before hand through budgeting process.

Financial management in the businesses is accomplished in different ways depending on the size of the business. In a sole proprietorship usually the owner manager carries out financial management activities or she/he may acquire the service of an independent accountant and financial advisor to carry out financial management activities. In a small company, financial management is carried out by one of the partners or the company may acquire the service of an independent accountant and financial advisor for this purpose. In a medium-sized company there usually is a finance section with several employees headed by the financial manager. In a large corporation financial management is performed by a finance department with many employees headed by the chief financial officer (CFO).

Depending on the size of the business there are three sub-categories of business finance. They are explained below:

a. Small business finance

b. Medium-sized business finance

c. Large corporation finance

A small business is a business that employees less than 50 people and that has assets or net sales less than 8 million TL. A medium-sized business is a business that employees less than 250 people and that has assets or net sales less than 40 million TL.

There are two types of corporations. One of them is publicly held corporation. Publicly held corporation is a corporation whose shares are offered to public and traded in an exchange. Corporations whose shares are not offered to public are called privately held corporations or closed corporation. Shares of publicly held corporation are held by many (may be millions) investors and traded in an exchange. Shares of privately held corporations are held by a small number of individuals or institutions that are closely associated with the business. Shares of privately held corporations are not traded in an exchange, so they are closed to the investment of general public. The term “corporate finance” in finance literature generally refers to the financial management in publicly held corporations. We will study the financial management in corporations in more detail later.

Glossary

Household: Hane halkı

Pension fund: Özel emeklilik fonu

Financial instrument: Finansal araç

Stock: Hisse senedi

Government debt securities: Devlet borçlanma araçları

Corporate debt securities: Anonim şirket borçlanma araçları

Mutual fund: Yatırım fonu

Capital gain: Sermaye kazancı

Return: Getiri

Consumer loan: Tüketici kredisi

Real estate loan: Konut kredisi

Auto loan: Otomobil kredisi

General-purpose consumer loan: İhtiyaç kredisi

Public service: Kamu hizmeti

Social Security Administration : Sosyal Güvenlik Kurumu

Treasury note: Hazine bonosu

Government bond: Devlet tahvili

By wholesale: Toptan olarak

Judicial fee: Yargı harcı

Passport fee: Pasaport harcı

Title deed fee: Tapu harcı

Turkish Grand National Assembly: Türkiye Büyük Millet Meclisi

Ministry of Finance: Maliye Bakanlığı

General Directorate of Budget and Fiscal Control: Bütçe ve Mali Kontrol Genel Müdürlüğü

Budget deficit: Bütçe açığı

Undersecretariat of Treasury: Hazine Müsteşarlığı

Independent accountant and financial advisor: Serbest muhasebeci mali müşavir.

Going public: Halka açılma

Merger: Birleşme

Liquidation: Tasfiye

Bankruptcy: İflas

Publicly held corporation: Halka açık anonim şirket

Privately held corporation: Halka açık olmayan anonim şirket

Exchange: Borsa

MAN305

Business Finance I

Chapter 1

Glossary