Finance Basics & Financial Environment

TAKEAWAYS:

• Finance is the art of managing money to achieve financial goals, balancing risk and return for individuals, businesses, and governments.
• The three core functions of finance are investment, financing, and dividend decisions, each critical for a firm’s survival and growth.
• The financial goal of a firm is maximizing shareholder wealth (profitability + growth), but must align with ethical and legal constraints.
• The financial environment includes economic, legal, political, and social factors that shape financial decisions (e.g., Nepal Rastra Bank’s interest rates).
• Financial statements (income statement, balance sheet, cash flow, statement of changes in equity) are the language of business, used by investors, creditors, and regulators.
• Financial markets (primary vs. secondary) and institutions (banks, NBFCs, insurance) facilitate capital allocation, but their efficiency varies by country (e.g., NEPSE vs. global stock exchanges).

1. What is Finance?

Finance is the science of money management, covering how individuals, businesses, and governments:

• Raise capital (funding)
• Allocate resources (investments)
• Manage risk (insurance, hedging)
• Optimize returns (stocks, bonds, real estate)

Key Definitions

• Personal Finance: Managing income, expenses, savings, and investments for individuals (e.g., eSewa users budgeting for Daraz purchases).
• Corporate Finance: Decisions by businesses on capital structure, dividends, and long-term investments (e.g., Pathao’s fleet expansion).
• Public Finance: Government revenue (taxes) and expenditure (roads, schools) to achieve societal goals.

How Finance Works: The Three Core Functions

Finance revolves around three interlinked decisions:

flowchart TD
    A["Financing"] -->|"Raises capital (debt/equity)"| B["Investment"]
    B -->|"Allocates funds to projects"| C["Dividend"]
    C -->|"Returns cash to shareholders"| A

• Financing: How a firm funds operations (e.g., loans from Ncell, equity from investors).
• Investment: Where funds are deployed (e.g., Daraz’s warehouse expansion).
• Dividend: Returning profits to shareholders (e.g., NEPSE-listed companies paying dividends).

2. The Financial Goal of the Firm

The primary objective of a business is to maximize shareholder wealth, defined as: $$\text{Shareholder Wealth}=\text{Market Value of Stock}=\frac{\text{Dividends}+\text{Capital Gains}}{\text{Required Rate of Return}}$$

Key Features of the Financial Goal

Example: Jagadamba Trading Company (from past exams) must balance:

• Profit maximization (selling more goods).
• Shareholder wealth (investing in sustainable supply chains to avoid NMB’s penalties).

3. Financial Environment

The financial environment consists of external factors that influence financial decisions:

flowchart TD
    A["Economic Environment"] -->|"Interest rates, inflation"| B["Financial Decisions"]
    C["Legal Environment"] -->|"Tax laws, regulations"| B
    D["Political Environment"] -->|"Stability, policies"| B
    E["Social Environment"] -->|"Consumer trends"| B
    F["Technological Environment"] -->|"Digital payments"| B

Major Components

1. Economic Environment:

   • Interest Rates: Set by NRB (e.g., 6% base rate in 2023).
   • Inflation: Affects loan repayments (e.g., Ncell’s mobile loan EMIs rise with inflation).
   • GDP Growth: Determines consumer spending (e.g., Daraz’s sales in Kathmandu vs. rural areas).

2. Legal Environment:

   • Companies Act 2063: Mandates financial disclosures (e.g., NEPSE-listed firms must publish audited reports).
   • Tax Laws: Corporate tax (25%) and VAT (13%) impact profitability.

3. Political Environment:

   • Stability: Uncertainty discourages FDI (e.g., delays in Nepal-China transit trade).
   • Policies: Subsidies for renewable energy (e.g., solar loans from banks).

4. Social Environment:

   • Consumer Behavior: Shift to digital payments (eSewa/Khalti over cash).
   • Corporate Social Responsibility (CSR): NTC’s community projects improve brand trust.

4. Financial Markets and Institutions

Financial Markets

Markets where financial assets (stocks, bonds) are traded:

Financial Institutions

Institutions that facilitate capital flow:

Comparison Table:

| Feature                     | Depository Institutions       | Non-Depository Institutions       |
|-----------------------------|-------------------------------|-----------------------------------|
| **Deposit Taking**          | Yes                           | No                                |
| **Risk Level**             | Higher (bank runs possible)   | Lower (diversified portfolios)    |
| **Regulation**             | NRB                          | Insurance Board, SEBON            |
| **Example**                 | NMB                           | NIS                               |

5. Financial Statements

Financial statements are the numerical reports that summarize a firm’s financial performance and position. The four key statements are:

flowchart TD
    A["Income Statement"]
    B["Balance Sheet"]
    C["Cash Flow Statement"]
    D["Statement of Changes in Equity"]
    
    A -->|"'Revenue - Expenses'"| B
    B -->|"'Assets = Liabilities + Equity'"| C
    C -->|"'Operating, Investing, Financing'"| D
    D -->|"'Retained Earnings'"| B
    
    
    caption": The **accounting cycle** linking the four financial statements. Income Statement feeds into the Balance Sheet, which updates the Statement of Changes in Equity, and all feed into the Cash Flow Statement."

1. Income Statement (Profit & Loss Statement)

Shows revenues, expenses, and net income over a period.

| Part               | Amount (NPR)       |
|--------------------|--------------------|
| **Revenue**        | 5,000,000          |
| - COGS             | -2,500,000         |
| **Gross Profit**   | 2,500,000          |
| - Operating Expenses | -800,000       |
| **Operating Income** | 1,700,000      |
| - Interest Expense | -100,000         |
| **Net Income**     | **1,600,000**      |

2. Balance Sheet

Shows assets = liabilities + equity at a point in time.

| Assets               | Amount (NPR)       | Liabilities & Equity       | Amount (NPR)       |
|----------------------|--------------------|----------------------------|--------------------|
| Current Assets       | 2,000,000          | Current Liabilities        | 1,200,000          |
| - Cash               | 500,000            | - Accounts Payable         | 800,000            |
| - Inventory          | 1,500,000          | - Short-term Loans         | 400,000            |
| Fixed Assets         | 3,500,000          | Long-term Liabilities      | 1,500,000          |
| - Property           | 3,000,000          | - Bonds Payable             | 1,500,000          |
| - Equipment          | 500,000            | **Total Liabilities**      | **2,700,000**      |
| **Total Assets**     | **5,500,000**      | **Shareholders' Equity**   | **2,800,000**      |

3. Cash Flow Statement

Tracks cash inflows and outflows from operations, investing, and financing.

| Activity          | Amount (NPR)       |
|-------------------|--------------------|
| **Operating**     | +1,800,000         |
| - Net Income      | +1,600,000         |
| - Depreciation    | +200,000           |
| **Investing**     | -500,000           |
| - Equipment Purchase | -500,000      |
| **Financing**     | +300,000           |
| - Loan Received   | +300,000           |
| **Net Cash Flow** | **1,600,000**      |

4. Statement of Changes in Equity

Shows how equity changes over time (e.g., retained earnings, dividends).

| Part               | Beginning Balance | Additions          | Deductions        | Ending Balance |
|--------------------|--------------------|--------------------|-------------------|-----------------|
| Retained Earnings  | 1,000,000          | Net Income (1,600,000) | Dividends (200,000) | 2,400,000       |

6. Real-World Applications

In the Real World

1. eSewa/Khalti (Digital Payments):

   • Idea: Time Value of Money (delayed payments incur interest).
   • How: eSewa charges a small fee (0.5–2%) for delayed bill payments, applying the concept of opportunity cost (money could earn interest elsewhere).

2. NEPSE (Stock Market):

   • Idea: Financial Markets (primary vs. secondary trading).
   • How: When Siddhartha Hospital went public, it raised funds in the primary market. Now, its shares trade in the secondary market (NEPSE), allowing investors to buy/sell.

3. Pathao (Ride-Hailing):

   • Idea: Capital Budgeting (long-term investment decisions).
   • How: Pathao’s decision to expand to Pokhara required analyzing NPV (Net Present Value) of new bike fleets vs. expected revenue growth.

4. Ncell (Mobile Loans):

   • Idea: Financial Goal (maximizing shareholder wealth).
   • How: Ncell’s mobile loan scheme (e.g., 12% interest) balances profitability (high returns) with customer trust (affordable EMIs).

7. Worked Example: Kathmandu Retail Shop (Lalitpur)

Scenario: Rajesh’s Spices (a Kathmandu-based spice shop) wants to expand its inventory. Analyze its financial health using statements.

Given Data

• Revenue: NPR 12,000,000/year
• COGS: NPR 6,000,000
• Operating Expenses: NPR 3,000,000
• Current Assets: NPR 2,500,000 (Cash: 500k, Inventory: 2M)
• Current Liabilities: NPR 1,500,000 (Accounts Payable: 1M, Short-term Loan: 500k)
• Fixed Assets: NPR 5,000,000 (Property: 4M, Equipment: 1M)
• Long-term Liabilities: NPR 2,000,000 (Bank Loan)
• Shareholders’ Equity: NPR 3,000,000

Step 1: Income Statement

| Part               | Amount (NPR)       |
|--------------------|--------------------|
| Revenue            | 12,000,000         |
| - COGS             | -6,000,000         |
| **Gross Profit**   | 6,000,000          |
| - Operating Expenses | -3,000,000   |
| **Net Income**     | **3,000,000**      |

Step 2: Balance Sheet

| Assets               | Amount (NPR)       | Liabilities & Equity       | Amount (NPR)       |
|----------------------|--------------------|----------------------------|--------------------|
| Current Assets       | 2,500,000          | Current Liabilities        | 1,500,000          |
| Fixed Assets         | 5,000,000          | Long-term Liabilities      | 2,000,000          |
| **Total Assets**     | **7,500,000**      | **Total Liabilities**      | **3,500,000**      |
|                      |                    | **Shareholders' Equity**   | **4,000,000**      |

Step 3: Analysis

• Liquidity: Current Ratio = Current Assets / Current Liabilities = 2,500,000 / 1,500,000 = 1.67 (healthy).
• Profitability: Net Income / Revenue = 3,000,000 / 12,000,000 = 25% (good).
• Leverage: Debt/Equity = 3,500,000 / 4,000,000 = 0.875 (moderate debt).

Decision: Rajesh can expand inventory (e.g., buy 500kg of spices for NPR 1,000,000) if:

• Cash Flow allows (NPR 500k cash reserve).
• Debt is managed (current loan repayment plan).

8. Exam Tip

1. Definitions: Always define terms clearly and concisely (e.g., "Finance is the art of managing money to achieve financial goals").
2. Financial Goal: Focus on shareholder wealth maximization (not just profit) and its constraints (ethics, law).
3. Financial Statements:
   • Memorize the four types (income, balance sheet, cash flow, equity changes).
   • For numericals, show all steps (revenue → expenses → net income → balance sheet).
4. Real-World Linkage:
   • Relate concepts to Nepal’s economy (e.g., NEPSE, NRB policies, Daraz’s supply chain).
   • Use local examples (e.g., Pathao’s NPV calculations, Ncell’s loan interest).
5. Diagrams:
   • Draw flowcharts for financial cycles (financing → investment → dividends).
   • Use T-accounts for balance sheets (assets = liabilities + equity).
6. Common Pitfalls:
   • Avoid mixing profit maximization with shareholder wealth maximization.
   • Don’t ignore legal/ethical constraints in financial goals.
   • For markets, distinguish primary vs. secondary clearly.

Past Exam Question Practice:

1. Define finance and explain its three core functions with examples from Nepal.
2. Why is shareholder wealth maximization the financial goal of a firm? Discuss its limitations.
3. Prepare an income statement and balance sheet for a hypothetical Kathmandu business (like Rajesh’s Spices) using given data.