How Finance Works by Mihir A. Desai
How Finance Works ? Credit, capital and its circulation are a summary of the events that occur in the financial markets.
But these few words together have created a game full of noise, excitement and risk.
For this reason, looking at this story with different glasses can make the rule of the game clearer for us and make us professional in its implementation. In this section, refer to the book “How Finance Works” We leave “Mihir Desai” and bring you several reading points from its words. Stay with us.
What Is Financial Analysis And Why Is It Important?
The first chapter of the book “How Finance Works” deals with the definition of financial analysis and its need. The author starts like this: “How do you find out the value of a company? Do you just check the financial statements for this? Are you applying your own unwanted assumptions or biases to your final decision-making? Do you think you would still make the same decision about companies if you looked at their data without knowing their brand names?”
Financial analysis allows you to get to the hidden story behind the numbers in a much deeper, more professional and practical way. This new story and perspective will help you monitor the process of value creation by successful companies and leave the fate of your capital in the hands of those who know how to add it to a cycle of profitability and creativity.
How Finance Works And Why Is It Important?
The first chapter of the book “How Finance Works” deals with the definition of financial analysis and its need. The author starts like this: “How do you find out the value of a company?
Do you just check the financial statements for this? Are you applying your own unwanted assumptions or biases to your final decision-making? Do you think you would still make the same decision about companies if you looked at their data without knowing their brand names?”
Financial analysis allows you to get to the hidden story behind the numbers in a much deeper, more professional and practical way.
This new story and perspective will help you monitor the process of value creation by successful companies and leave the fate of your capital in the hands of those who know how to add it to a cycle of profitability and creativity….
assets
A company’s assets are the things it invests in to get the value it wants. This makes those assets part of the company itself.
For example, Starbucks invests in buying the best coffee beans, shops, coffee machines and everything needed to deliver a coffee to a customer. In turn, this investment makes Starbucks the owner of all those coffee beans, machines, stores, etc. This is the main thing you need to know about assets.
It goes without saying that the most important assets are those that are liquidated more easily than others.
Cash and tradable securities
Some large companies hold significant amounts of cash, and you can see it on their balance sheets. This story has several reasons.
For example, companies use this cash for opportunities to supply raw materials in the future, a backup for days when the company’s situation is not so good, and so on.
Since government securities have the highest level of liquidity and companies want to benefit from their stagnant money, they convert a significant amount of it into securities.
Accounts Receivable
The money that the company is going to receive from its customers in the future is called accounts receivable.
Some companies base a large part of their business on accounts receivable to attract more customers. On the contrary, some others prefer to limit such accounts very much.
In fact, companies that deal directly with customers have the lowest accounts receivable and companies that are in the middle chain – for example, produce a specific piece of a product – have the highest amount of accounts receivable.
inventory
Materials or products that the company can sell are classified as inventories. Maybe these products are still raw materials, maybe they are in the production process, and maybe they are ready to be marketed as a complete product. Of course, not all companies have inventory. Because some of them offer services instead of products.
Property and equipment
The long-term assets of companies are included in this category.
For example, the factory, the office building, the devices in the production line, the goods distribution machines and everything that the company uses to produce or distribute its products are among the property and equipment.
Other assets
One of the most challenging sections in the financial data of companies is the section called “Other Assets”. The existence of this section is due to the inability of the accounting system to estimate the real value of assets. In simple words, accounting cannot calculate the exact value of some of the company’s assets, such as brand reputation, etc. For this reason, it does not consider them at all!
- Equity
This category of financial resources is provided by the shareholders of the company. - Accounts and payable documents
These accounts are those that the company must pay to others in a short period of time. Usually, the parties to the company’s account in accounts payable are suppliers of raw materials, etc.
Long-term debt
Companies, like individuals, are under the burden of debt and must pay the principal amount along with interest.
Some companies have financed a third or even half of their assets through the loans they have taken or the debts they have incurred.
Preferred stock
Preferred stock consists of the combination of debt and equity elements. The owners of this type of shares receive their profits before ordinary shareholders.
If the company’s situation is good, they grow along with it, and if the company has a crisis, they get their rights before other shareholders.
The reason for this obvious discrimination is the decision made by the owners of preferred shares.
At a time when the company was not doing well and investing in it was associated with a lot of risk, they provided their capital to the company and caused its growth and prosperity.
For this reason, their account is different from other shareholders who have decided to invest only considering the company’s profitability.
Why don’t finance and accounting flow in the same stream?
A little while ago we said that accounting includes a section called “other assets” in the balance sheet of companies. And that’s just because he can’t estimate its real value. Finance has a problem with such dealings in accounting. Apart from this, accounting can provide a lot of loopholes in the hands of company managers to legally manipulate profit and cash flow to create a perfect image for shareholders.
The challenges of net profit in the actual measurement of corporate performance
Shareholders enjoy checking the net profit of companies. because it shows them the yield of their shares; But this issue alone cannot be a criterion for checking the performance of companies because:
It looks at all types of expenses at a glance
Traces of accounting recommendations can also be seen in this story; For example, accountants suggest managers to keep the yield at the same level by making different decisions. This story does not match the reality of what happens in an industry or business.
Pure profit is combined with taste seasoning. Because managers find the ability to manipulate numbers according to their own wishes.
And …
For this reason, it is suggested to monitor the amount of cash flow instead of checking the net profit. Because cash flows are not easily manipulated and are much closer to the reality of a company’s performance than net profit.
What is the cash conversion cycle?
When we talk about finance, we should not tie it only to the flow of debt or equity.
Because finance flows in the heart of the company’s daily money circulation.
For example, consider the cash conversion cycle. Normally, it is customary for investors to consider turnovers only from a financial point of view. This is despite the fact that part of a company’s financial turnover is tied to time periods.
This means that there are several time periods between purchasing raw materials, creating value, and receiving revenue from its sale. In this case, sometimes companies have to pay their debts before receiving their claims.
This means they have to look for a way to compensate for this lack of liquidity to pay their debts.
It is interesting here that none of these events of the company,
which are sometimes tied to the fate of the company or even in the larger view of the economy, are not included in the financial statements of the companies and suddenly fall like a hidden bomb on the life of the company and the economy; Just like the recession that took everyone by surprise in 2008.
What is meant by the value of companies?
Every company struggles to create value, both for itself and for its shareholders.
There were many companies whose stock analysts failed to have a professional look at their information and trends, and because of that, they were valued more or less than their real value.
Now the main question is how companies create value? Companies’ efforts to create value can be summed up in two names:
book value
They are the funds that are given to the company by the shareholders. This value is calculated by accounting operations and on paper. If you remember a little while ago we said that accounting systems ignore many invisible values of companies. With this account, it is not possible to reach a correct conclusion about the value or worthlessness of its shares by only considering the book value of a company.
Market value
The value of the company in financial markets is called market value.
Finally, the market value of a company is obtained by dividing the market value by its book value. Many factors such as: “return on investment”, “cost of capital”, “return on equity”, “the amount of profit that is reinvested in the business” and “project duration” also affect the change in the value of the company.
Finance Is Not Easy, Please Be Careful A Guide to How Finance Works
If we put aside all our financial knowledge and look at the story of financial markets very simply, we will face two categories.
The first category is people who have some capital and want to make a profit by investing it.
The second category is companies or organizations that need capital for growth and development.
In this situation, all we have to do is give our capital to the companies and get the profit we want.
This is the main story that happens in finance, but it is not the whole story. When we take our lens closer, I see brokerage firms, analysts, bankers, brokers, traders, investment funds, and so on, standing right between us and the companies that need our capital.
A Brief Look At The Factors Complicating To How Finance Works
Usually, after every economic crisis, at least once the finger of accusation is pointed towards financial intermediaries and all the pots and pans are broken on them; But do these intermediaries really have no benefit for investors and companies? Let’s take a look at these financial intermediaries and subvert them through our own glasses:
Stock analysts
Perhaps the most useful person who benefits both investors and companies is this stock analyst – of course, the honest and conscientious type.
The work of stock analysts is to analyze companies, discover opportunities and threats, collect information and finally make recommendations to investors.
We must accept the fact that a significant part of capitalists do not have the time, ability and mood to struggle with company data and financial statements.
For such people, stock analysts are like saviors who do complicated and boring work for them in exchange for some money.
Institutional investors
In finance, different people have different job names, most of which can be summarized in a few simple concepts; For example, money manager, financial manager and asset manager all three convey the concept of “institutional investors”. This type of investor represents a number of capitalists who have given their money to institutional investors. He, on behalf of those people, invests the money in the situations he thinks is appropriate. Usually, this type of investors get the information they need from stock analysts. Institutional investors fall into different categories:
Mutual funds
Pension funds
Deposit funds
National wealth funds
Hedge funds
Traders
These people find buyers and sellers for the financial markets.
For this reason, they are also called “market makers”.
Usually, traders are in contact with a stock analyst and work with him. A trader is paid for his activity from the commissions he receives for executing trades.
Of course, fortunately, now the legal amount of these commissions has decreased compared to the past.
Sellers
Dealers are the ones who sell the ideas presented by the stock analysts to the big investors and the wider society at large. In return, they receive their commission.
Investment bankers
Ordinary banks do things like depositing, receiving loans, etc.; But investment banks are specifically focused on investments. Their clients are small and large companies that are either present in the stock market or want to enter this market.
Investment banks do things like: “initial supply of shares”, “financing”, “merging or divesting different companies with each other” and… In fact, they act like traders for companies. In addition to providing these services, they also take their own profits and fees.
media
The media platform – such as online and offline newspapers, social networks, TV channels, etc. – is a great opportunity for extensive information exchange between stock analysts and investors.
Of course, we should not expect all the content presented in this platform to be true or false. Having an unbiased view is the key to making the most of the information presented in the media.
4 Things You Should Know About How Finance Works
Knowing the following headlines can help you complete your view of finance and the adventures of the financial markets:
Finance Is Not Money; It Is Information!
At first glance, you may think that the main foundation inHow Finance Works is money and capital; But the thing that circulates money and capital and takes it from one side to another is information and factors that lie behind financial movements.
The biggest challenge of financial managers is not financing but its allocation!
Finally, every company finds a way to finance itself. The important thing is, can he bring this collected capital to profit?
Valuation and time are tied together!
It doesn’t matter if a company can create value and give good returns to its shareholders in a short period of time. The important point and real value is that companies can continue the value creation process during a long period of time.
