Definition of Financial Environment

Definition of financial environment A financial environment is a part of an economy with the major players being firms, investors, and markets. Essentially, this sector can represent a large part of a well-developed economy as individuals who retain private property have the ability to grow their capital. Firms are any business that offer goods or services to consumers. Investors are individuals or businesses that place capital into businesses for financial returns. Markets represent the financial environment that makes this all possible. Historically, firms were very small or even nonexistent in economies or financial markets. Though a few firms have always been in existence, the ability for a large number of firms was not possible until markets became more mature. Mature markets allow for more access to resources necessary to produce goods and services. As firms begin to grow, expand, and multiply, higher capital needs to persist in order for firms to succeed. Capital sources include money from outside parties, such as investors. Many times investors are individuals who have more capital than is necessary to provide a sufficient living standard. Any excess capital can actually make individuals more money if they invest the funds into a firm that offers a financial return. This symbiotic relationship in the financial environment allows both parties to increase their capital. Many different factors play a role for individuals making investments. A few of these may include risk, current market conditions, and competition, among others. Financial environment of a company refers to all the financial institutions and financial market around the company that affects the working of the company as a whole. The financial environment has a number of factors. It includes the financial institutions, government, individuals and firms around the business. Firms use their financial markets to keep their savings as property. It is extremely important for the monetary markets. Components of financial environment The financial environment is composed of three key components: (1) financial managers, (2) financial markets, and (3) investors (including creditors). Financial Managers Financial managers are responsible for deciding how to invest a company’s funds to expand its business and how to obtain funds (financing). The actions taken by financial managers to make financial decisions for their respective firms are referred to as financial management (or managerial finance). Financial managers are expected to make financial decisions that will maximize the firm’s value and therefore maximize the value of the firm’s stock price. They are usually compensated in a manner that encourages them to achieve this objective. Some more common career opportunities for financial managers are shown in Table 1.1. This table summarizes the different types of duties that financial managers perform. When a firm is initially established, one person may perform all managerial finance duties. However, as the firm grows, financial managers are hired to specialize in particular managerial finance duties. In larger firms, financial managers direct and manage departments of staff analysts who do the day-to-day analysis. In larger firms, financial managers fit within the firm’s organizational structure as shown in Figure 1.1. The key financial decisions of a firm are commonly made by or under the supervision of the chief financial officer (CFO), who typically reports directly to the chief executive officer (CEO). The lower portion of the organizational chart in Figure 1.1 shows the structure of the finance Role of Financial Managers Financial managers determine how to invest a firm’s funds to capitalize on potential opportunities. They also determine how to obtain the funds needed to finance their respective firms’ investments. Financial Markets Financial markets represent forums that facilitate the flow of funds among investors, firms, and government units and agencies. Each financial market is served by financial institutions that act as intermediaries. The equity market facilitates the sale of equity by firms to investors or between investors. Some financial institutions serve as intermediaries by executing transactions between willing buyers and sellers of stock at agreed-upon prices. The debt markets enable firms to obtain debt financing from institutional and individual investors or to transfer ownership of debt securities between investors. Some financial institutions serve as intermediaries by facilitating the exchange of funds in return for debt securities at an agreed-upon price. Thus it is quite common for one financial institution to act as the institutional investor while another financial institution serves as the intermediary by executing the transaction that transfers funds to a firm that needs financing. For example, Merrill Lynch (a financial institution) serves as an intermediary in an offering of new shares by Intel (a firm in need of financing) by selling these shares to investors, including the California Public Employees Retirement Fund (a financial instit Physical assets vs. Financial assets Money vs. Capital Primary vs. Secondary Spot vs. Futures Public vs. Private Role of Financial Markets Financial markets facilitate the flow of funds from the suppliers of funds to firms or governments who need funds. Financial institutions serve as intermediaries by channeling the savings of individuals to firms that need funds Investors Investors are individuals or financial institutions that provide funds to firms, government agencies, or individuals who need funds. In this book, our focus regarding investors is on their provision of funds to firms. Individual investors commonly provide funds to firms by purchasing their securities (stocks and debt securities). The financial institutions that provide funds are referred to as institutional investors. Some of these institutions focus on providing loans, whereas others commonly purchase securities that are issued by firms. Role of Investors Investors commonly finance the investments made by firms by purchasing debt securities or equity securities issued by those Federal reserve policy Federal budget surplus or deficit Level of business activity International factors What is a Financial market A market is a venue where goods and services are exchanged. A financial market is a place where individuals and organizations wanting to borrow funds are brought together with those having a surplus of funds Funds flow indirectly from ultimate lenders [households] through financial intermediaries [banks or insurance companies] or directly through financial markets [stock exchange/bond markets] to ultimate borrowers [business firms, government, or other households]. In order for financial system to function smoothly, must be adequate information about the markets and their operation Financial system provides a transmission mechanism between saver-lenders and borrowerspenders.  Savers benefit—earn interest  Investors benefit—access to money otherwise not available  Economy benefits—efficient means of bringing savers and borrowers together  Physical VS. Financial asset markets  Spot VS. future markets  Money VS. capital markets  Primary VS. secondary markets  Public VS. private markets The Financial Markets Physical Asset Markets: It is a market for such products as wheat, autos, real estate, and machinery. Financial Asset Markets: It deals with stocks, bonds, notes, mortgages, and derivatives Spot Markets: . It is a market in which assets are bought and sold for on the spot delivery. Futures Markets: It is a market in which participants agree today to buy or sell an asset at some future date .  The Money Market:  Exchange of short-term instruments—less than one year  Highly liquid, minimal risk  Commercial paper—short-term liabilities of prime business firms and finance companies  Bank Certificates of Deposits—liabilities of issuing bank, interest bearing to corporations that hold them U.S. Treasury bills—short-term debts of US government  The Capital Market:  Exchange of long-term securities—in excess of one year  Generally used to secure long-term financing for capital investment.  Stock market—Largest part of capital market and held by private and institutional investors  Residential and commercial mortgages—Held by commercial banks and life insurance companies  Corporate bond market—Held by insurance companies, pension and retirement funds  Primary Markets:  Market for issuing a new security and distributing to saver-lenders.  Initial Public Offering Market (IPO).  Investment Banks—Information and marketing specialists for newly issued securities.  Secondary Markets:  Market where existing securities can be exchanged  New York Stock Exchange  American Stock Exchange  Over-the-counter (OTC) markets (NASDAQ). Financial Institutions Funds are transferred between those who have funds and those who need funds by three processes: -Direct transfers, - Investment banking houses, or Financial intermediaries Financial Intermediaries  Commercial banks  Savings and loan associations  Credit unions  Pension funds  Life insurance companies  Mutual funds Role of Financial Intermediaries  Act as agents in transferring funds from savers-lenders to borrowers-spenders.  Acquire funds by issuing their liabilities to public and use money to purchase financial assets  Earn profits on difference between interest paid and earned  Diversify portfolios and minimize risk  Lower transaction costs Commercial Banks  Most prominent  Range in size from huge to small  Major source of funds used to be demand deposits of public, but now rely more on “other liabilities”  Also accept savings and time deposits—interest earning Savings and Loan Associations [S&L’s]:  Traditionally acquired funds through savings deposits  Used funds to make home mortgage loans  Now perform same functions as commercial banks  issue checking accounts  make consumer and business loans Credit Unions  Organized as cooperatives for people with common interest  Members buy shares [deposits] and can borrow  Changes in the law in early 1980’s broadened their powers  checking [share] accounts  make long-term mortgage loans Pension and Retirement Funds  Concerned with long run  Receive funds from working individuals building “nest-egg”  Accurate prediction of future use of funds  Invest mainly in long-term corporate bonds and high-grade stock  Invest in wide variety of securities—minimize risk Life Insurance Companies  Insure against death  Receive funds in form of premiums  Use of funds is based on mortality statistics—predict when funds will be needed  Invest in long-term securities—high yield  Long-term corporate bonds  Long-term commercial mortgages Mutual Funds  Stock or bond market related institutions  Pool funds from many people  Invest in wide variety of securities—minimize risk The importance of cash flow A revenue or expense stream that changes a cash account over a given period. Cash inflows usually arise from one of three activities - financing, operations or investing - although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both business and personal finance Cash flow is of vital importance to the health of a business. One saying is: . What this means is that whilst it may look better to have large inflows of revenue from sales, the most important focus for a business is cash flow. Many businesses may continue to trade in the short- to medium-term even if they are making a loss. This is possible if they can, for example, delay paying creditors and/or have enough money to pay variable costs. However, no business can survive long without enough cash to meet its immediate needs. Cash inflow and outflow Cash comes into the business (cash inflows), mostly through sales of goods or services and flows out (cash outflows) to pay for costs such as raw materials, transport, labour, and power. The difference between the two is called the net cash flow. This is either positive or negative. A positive cash flow occurs when a business receives more money than it is spending. This enables it to pay its bills on time. A negative cash flow means the business is receiving less cash than it is spending. It may struggle to pay immediate bills and need to borrow money to cover the shortfall. The distinction between cash flow and profit is shown in the example. In accounting, negative figures are shown in brackets. Liquidity Businesses aim to provide greater financial returns than the level of interest earned by simply placing the cash in a bank. They can also hold too much cash. Cash does not earn anything so holding too much cash could mean potential losses of earnings. The cash situation is referred to as the liquidity position of the business. The closer an asset is to cash, the more 'liquid' it is. A deposit account at a bank or stock that can easily be sold are liquid. Assets such as buildings are the least liquid. Liquid assets are those that are most easily turned into cash. Cash flow is always important, but especially when it is not easy to obtain credit. When the economy is in recession, financial service providers are reluctant to lend money. Borrowing also becomes more expensive as interest rates are raised to partially offset the risk of borrowers not paying back loans. Controlling cash    Controlling cash is essential and management accountants deal with a range of cash issues: ensuring that sufficient cash is available for investment by not tying up cash in stock unnecessarily putting procedures in place for chasing up outstanding debts controlling different levels of cash outflows in relation to the size of the business. For example, a car repair garage buys parts and tyres whilst a hairdresser buys shampoos, equipment and pays for power. In each case, if the business has cash problems it may be slow to pay its bills to suppliers. This creates further cash problems which spread throughout the economy. If small suppliers are not paid they may go out of business. This in turn may affect businesses further up the ladder. Chartered Institute of Management Accountants | C | Cash flow is the net change in your company's cash position from one period to the next. If you take in more cash than you send out, you have a positive cash flow. You have a negative cash flow if you have more cash outflow than inflow. Cash flow is a key indicator of financial health. Cash is King . Keeping Up With Debt When you borrow money to buy buildings, equipment and inventory, you essentially use future cash flow to make your purchases. Inherently, you need positive future cash flow to pay for your debt commitments. Companies commonly have long-term loans and short-term credit accounts with vendors. Each loan requires monthly payments. The obligation to make these payments on an ongoing basis restricts your free cash flow, which is money available to invest in growing your business. Growth Along with debt management, strong cash flow provides the comfort and capabilities a business needs to invest in growth. Building new locations, investing in research and development, renovating infrastructure, improving technology, providing more training and purchasing more assets and inventory are among the ways your business can grow and improve with strong positive cash flow. Getting to a position of excess cash flow helps your company operate in a strategic, proactive way, rather than a reactive, defensive way. . Importance Of Cash Flow Accounting AGGIE Cash flow is the movement of money into or out of a business, project or financial product from operating, investing and financing activities. It is usually measured during a specified finite period of time or accounting period. The measurement of cash flow can be used for calculating other parameters that give information on a company's value, liquidity or solvency, and situation. Without positive cash flow a company cannot meet its financial obligations. Management is interested in the company's cash inflows and cash outflows because these determine the availability of cash necessary to pay its financial obligations. In addition management uses cash flow for the following 1. To determine problems with a company's liquidity The importance of strong cash flow is aptly stated in the common expression "cash is king." The premise of this is that having cash puts an organization in a more stable position with better buying power. While an organization can borrow money at times, cash affords you greater protection against loan defaults or foreclosures. Cash flow is distinct from cash position. Having cash on hand is critical but cash flow indicates an ongoing ability to generate and use cash 2. To determine a project's rate of return or value The analysis of cash flows ensures that the business is not investing in wrong projects and that the projects are profitable 3. To determine the timeliness of cash flows into and out of projects which are used as inputs in financial models such as internal rate of return and net value.This ensures the principal payments of loans and salaries of employees are paid on time. This safeguards the trust of employees and upholds the credit rating 4. Income Assurance The business or organization tends to have an assured income irrespective of the outside economic condition. Many business corporations have a very well balances and uniform inward and outward cash flow 5. Flexibility Cash flows also give business greater flexibility in responding to emerging dilemma or making critical decisions. Confidence in cash flows makes it easier to make critical purchases in the near term rather than waiting.it allows to disperse cash in form of dividends to shareholders .This strengthens the bond between the company and its owners .strong cash flows makes business more appealing to a lender if the organization desires to borrow. They also have the ability to offer favorable credit terms to attract new buyers if they are less desperate for cash. 6. It keeps the organization out of debts Timely cash flows plays a very instrumental role in keeping organization out of debt as a timely inflow of cash prevents them from getting loans. 7. It saves the organization unnecessary expenditure Use of inward and outward cash flow prevents all unnecessary expenditure such as late payment charges and accrued interest rates 8. It enables timely investments As the inflows and outflow of cash is on time, organization is left with adequate free and liquid finances which can be invested in time bound instruments and securities 9.