Finance Basics: Definitions, Goals, Statements & Environment

TAKEAWAYS:

• Finance is the art and science of managing money, including acquisition, allocation, and control of financial resources.
• The primary goal of a firm is to maximize shareholder wealth (not just profit), balancing risk and return.
• The financial environment includes internal (management, objectives) and external (economic, legal, political) factors that shape financial decisions.
• Four key financial statements (Income Statement, Balance Sheet, Cash Flow Statement, Statement of Changes in Equity) form the backbone of financial reporting.
• Financial institutions (banks, NBFCs, insurance companies) act as intermediaries between savers and borrowers, classified as depository (accept deposits) or non-depository (do not accept deposits).
• Financial markets (money, capital, stock, bond markets) facilitate the flow of funds between surplus and deficit units.

1. Definition of Finance

Finance is the process of managing money—how individuals, businesses, and governments acquire, allocate, and control financial resources to achieve their goals. It involves:

• Decision-making (investment, financing, dividend policies).
• Risk management (hedging, insurance).
• Asset valuation (stocks, bonds, real estate).

Why Finance Matters in Business?

Finance ensures: ✅ Survival (cash flow management). ✅ Growth (funding expansion). ✅ Profitability (cost control, revenue optimization). ✅ Risk mitigation (diversification, insurance).

2. Functions of Finance

Finance performs three primary functions in a business:

3. Financial Goal of the Firm

The ultimate goal of a business is to maximize shareholder wealth, not just profits. Why?

• Shareholder wealth = Market price of stock × Number of shares.
• Profit maximization is short-term; wealth maximization considers risk, timing, and investor expectations.

Key Features of Wealth Maximization

1. Long-term focus (not just quarterly profits).
2. Risk-adjusted returns (higher risk = higher expected return).
3. Cash flow consideration (not just accounting profits).
4. Market-based (reflects investor sentiment).

Example: NEPSE Stock Performance

• If Nepal Electricity Authority (NEA) announces a dividend of Rs. 5/share, its stock price may rise because investors value cash returns.
• However, if NEA reinvests profits to modernize infrastructure (long-term growth), shareholder wealth may increase even more over time.

4. Financial Environment

The financial environment consists of internal and external factors that influence financial decisions.

A. Internal Financial Environment

B. External Financial Environment

5. Financial Statements (The Four Pillars)

Financial statements provide quantitative information about a company’s performance and position. The four key statements are:

A. Income Statement (Profit & Loss Statement)

Shows revenue, expenses, and net profit over a period (e.g., a year).

| **Particulars**               | **Amount (Rs.)** |
|-------------------------------|------------------|
| **Revenue from Sales**        | 5,000,000        |
| **Less: Cost of Goods Sold (COGS)** | 3,000,000    |
| **Gross Profit**              | 2,000,000        |
| **Less: Operating Expenses**  | 800,000          |
| **Operating Income (EBIT)**   | 1,200,000        |
| **Less: Interest Expense**    | 200,000          |
| **Earnings Before Tax (EBT)** | 1,000,000        |
| **Less: Tax (25%)**           | 250,000          |
| **Net Profit**                | **750,000**      |

Example: A Kathmandu-based bakery (let’s call it Sweet Delights) reports:

• Sales: Rs. 5,000,000 (from bread, cakes, pastries).
• COGS: Rs. 3,000,000 (flour, sugar, labor).
• Net Profit: Rs. 750,000 (after all expenses).

B. Balance Sheet (Financial Position)

Shows assets, liabilities, and equity at a specific point in time (e.g., December 31, 2023).

| **Assets**                     | **Liabilities & Equity**       | **Amount (Rs.)** |
|--------------------------------|--------------------------------|------------------|
| **Current Assets**             | **Current Liabilities**        |                  |
| Cash                           | Accounts Payable               | 500,000          |
| Accounts Receivable           | Short-term Loan                | 300,000          |
| Inventory                     | **Total Current Liabilities**  | 800,000          |
| **Total Current Assets**      |                                | 1,500,000        |
| **Non-Current Assets**         | **Non-Current Liabilities**    |                  |
| Property, Plant & Equipment   | Long-term Loan                 | 1,000,000        |
| Goodwill                      | **Total Liabilities**          | 1,800,000        |
| **Total Assets**              | **Shareholders' Equity**       |                  |
| **5,000,000**                 | Paid-up Capital                | 2,000,000        |
|                                | Retained Earnings              | 1,200,000        |
|                                | **Total Equity**               | 3,200,000        |
|                                | **Total Liabilities + Equity** | **5,000,000**    |

Example: Sweet Delights Bakery has:

• Cash: Rs. 500,000 (for daily expenses).
• Loan: Rs. 1,000,000 (from Nepal Investment Bank for expansion).
• Owner’s Equity: Rs. 3,200,000 (initial investment + profits).

C. Cash Flow Statement

Shows cash inflows and outflows from operating, investing, and financing activities.

| **Activity**               | **Cash Inflow (Rs.)** | **Cash Outflow (Rs.)** | **Net Cash Flow (Rs.)** |
|----------------------------|-----------------------|------------------------|-------------------------|
| **Operating Activities**   | 4,500,000             | 3,800,000              | +700,000                |
| **Investing Activities**   | 200,000               | 1,500,000              | -1,300,000              |
| **Financing Activities**   | 1,000,000             | 300,000                | +700,000                |
| **Net Change in Cash**     |                       |                        | **+100,000**            |
| **Opening Cash Balance**    |                       |                        | 500,000                 |
| **Closing Cash Balance**    |                       |                        | **600,000**             |

Example:

• Operating Cash Flow: Rs. +700,000 (from sales).
• Investing Cash Flow: Rs. -1,300,000 (buying a new oven).
• Financing Cash Flow: Rs. +700,000 (taking a loan).

D. Statement of Changes in Equity

Shows how equity changes over time due to profits, dividends, and new investments.

| **Particulars**               | **Paid-up Capital (Rs.)** | **Retained Earnings (Rs.)** | **Total Equity (Rs.)** |
|-------------------------------|---------------------------|----------------------------|-------------------------|
| **Opening Balance (2022)**    | 2,000,000                 | 1,000,000                  | 3,000,000               |
| **Add: Net Profit (2023)**    | -                         | +750,000                   | +750,000                |
| **Less: Dividends Paid**      | -                         | -250,000                   | -250,000                |
| **Add: New Share Issue**      | +500,000                  | -                          | +500,000                |
| **Closing Balance (2023)**    | **2,500,000**             | **1,500,000**              | **4,000,000**           |

Example:

• Sweet Delights issues new shares (Rs. 500,000) to fund expansion.
• Retained Earnings increase by Rs. 500,000 (after paying dividends).

6. Financial Institutions

Financial institutions facilitate the flow of money between savers (surplus units) and borrowers (deficit units).

Classification of Financial Institutions

mindmap
  root((Financial Institutions))
    Depository
      Banks (Commercial, Cooperative, Development)
      Credit Unions
    Non-Depository
      Insurance Companies
      Pension Funds
      Investment Banks
      Finance Companies
      Mutual Funds

Depository vs. Non-Depository Institutions

Example:

• Nepal Bank Limited (depository) takes deposits and lends to businesses.
• NIC Asia Life Insurance (non-depository) invests premiums in stocks/bonds but does not accept deposits.

7. Financial Markets

Financial markets facilitate the buying and selling of financial assets (stocks, bonds, commodities).

Types of Financial Markets

mindmap
  root((Financial Markets))
    Money Market
      Short-term (T-bills, commercial paper)
    Capital Market
      Primary (IPOs, new bond issues)
      Secondary (NEPSE, stock exchanges)
    Commodity Market
      Gold, oil, agricultural products
    Foreign Exchange Market
      Currency trading (USD to NPR)

Key Financial Markets in Nepal

Example:

• Nepal Investment Bank issues corporate bonds to raise Rs. 500 million for expansion.
• NEPSE lists Nepal Electricity Authority (NEA) shares for public trading.

8. The Accounting Cycle (How Financial Statements Are Prepared)

The accounting cycle is a step-by-step process that converts transactions into financial statements.

Step-by-Step Example: Sweet Delights Bakery

Transaction: Bought Rs. 200,000 worth of flour on credit from Nepal Flour Mills.

1. Journal Entry:

   | **Date**       | **Particulars**               | **L.F.** | **Dr (Rs.)** | **Cr (Rs.)** |
   |----------------|-------------------------------|----------|--------------|--------------|
   | 2023-10-01     | Inventory                     | 101      | 200,000      |              |
   |                | Accounts Payable (Nepal Flour)| 201      |              | 200,000      |
   

2. Ledger (T-Account) Posting:

3. Trial Balance:

   | **Account**            | **Debit (Rs.)** | **Credit (Rs.)** |
   |------------------------|-----------------|------------------|
   | Cash                  | 500,000         |                  |
   | Inventory             | 200,000         |                  |
   | Accounts Payable      |                 | 200,000          |
   | **Total**             | **700,000**     | **200,000**      |
   

In the Real World

1. eSewa & Khalti: Financial Intermediaries

• Idea Used: Non-depository financial institutions (Fintech).
• How?
  • eSewa and Khalti do not accept deposits but facilitate digital payments (UPI, mobile banking).
  • They earn revenue through transaction fees (1-3%) and interest on float (money held temporarily).
  • Example: When you pay Rs. 500 for electricity via eSewa, the platform charges Rs. 5 as a fee.

2. NEPSE & NMB Bank: Capital Markets in Action

• Idea Used: Stock market (capital market).
• How?
  • NMB Bank’s stock is traded on NEPSE at Rs. 360/share.
  • If you buy 100 shares, your investment = Rs. 36,000.
  • If NMB declares a 10% dividend, you earn Rs. 3,600 (without selling the stock).
  • Real Example: In 2023, Nepal Bank’s stock rose by 15% after announcing expansion into digital banking.

3. Daraz & Pathao: Working Capital Management

• Idea Used: Cash flow management (operating activities).
• How?
  • Daraz must maintain sufficient inventory (current asset) but avoid excess stock (ties up cash).
  • Pathao drivers receive advance payments (cash inflow) but must pay fuel, maintenance, and salaries (cash outflow).
  • Example: During Diwali season, Daraz increases inventory by 30% but also negotiates better payment terms with suppliers to manage cash flow.

Exam Tip

What Examiners Look For

✅ Definitions: Always define key terms (e.g., "Finance is the art and science of managing money..."). ✅ Differentiation: Compare depository vs. non-depository institutions in a table (as above). ✅ Real-world examples: Use Nepali companies (Nepal Bank, NEPSE, eSewa) to illustrate concepts. ✅ Financial statements: Know the format of Income Statement, Balance Sheet, and Cash Flow Statement. ✅ Goal of the firm: Wealth maximization ≠ profit maximization—explain why. ✅ Diagrams: Draw T-accounts, journal entries, or the accounting cycle flowchart in exams.

Common Mistakes to Avoid

❌ Vague answers: Instead of "Finance is important," say "Finance ensures efficient allocation of resources to maximize shareholder wealth." ❌ Ignoring real-world links: Always connect theory to Nepali businesses (e.g., NEPSE, Khalti). ❌ Incorrect formats: Debit (Dr) vs. Credit (Cr)—always label clearly in journal entries. ❌ Overlooking adjustments: In Cash Flow Statement, distinguish operating, investing, and financing activities.

Practice Questions (Based on Past Exams)

1. "Define finance and explain its three main functions."

   • Answer: Finance is the management of money involving investment, financing, and dividend decisions.

2. "Distinguish between depository and non-depository financial institutions with examples."

   • Answer: Use the table above with Nepal Bank (depository) vs. NIC Asia (non-depository).

3. "What is the financial goal of a firm? How does it differ from profit maximization?"

   • Answer: Wealth maximization (stock price × shares) vs. short-term profit maximization.

4. "Prepare an Income Statement for a bakery with given sales and expenses."

   • Answer: Use the Income Statement table with realistic Nepali bakery numbers.

Final Worked Example: Nepal Investment Bank’s Loan Decision

Scenario: Nepal Investment Bank (NIB) is considering lending Rs. 10 million to Sweet Delights Bakery for expansion. The bank’s cost of capital (required return) is 12%.

Question: Should NIB approve the loan if Sweet Delights promises:

• Annual profit increase of Rs. 2 million (after tax)?
• Loan repayment in 5 years with 8% interest?

Solution:

Step 1: Calculate Net Present Value (NPV)

NPV = Present Value of Cash Flows – Initial Investment

Decision:

• NPV = -Rs. 2,210,400 (Negative → Reject the loan).
• Why? The expected return (8%) < Bank’s cost of capital (12%).

Step 2: Alternative Scenario (Higher Profit)

If Sweet Delights guarantees Rs. 3 million profit/year:

• NPV becomes +Rs. 1,500,000 → Approve the loan.

Real-World Link:

• Nepal Bank uses similar NPV analysis before lending to SMEs (Small and Medium Enterprises).
• Nepal Investment Bank’s SME loan approval depends on cash flow projections and risk assessment.

Summary Table: Key Concepts at a Glance

Final Checklist Before Exam

✔ Can you define finance and list its three functions? ✔ Do you know the difference between profit maximization and wealth maximization? ✔ Can you prepare an Income Statement and Balance Sheet from scratch? ✔ Do you understand depository vs. non-depository institutions with Nepali examples? ✔ Can you explain the accounting cycle using a flowchart? ✔ Are you familiar with real-world applications (eSewa, NEPSE, Nepal Bank)?

Good luck! 🚀