UniversityofCambridge: Foundations of Finance

• Money and Capital
• Cash flows and Cash flow forecasting
• Financial reporting
• Interest and Return
• Risk and Risk management

Money and Capital

Money is a short term store of value, in the form of a promise to pay the bearer on demand. While money used to be backed by silver or gold, modern money has no inherent value. Its value derives instead from the trust and the confidence that its users have toward issuer of the promise to pay – usually a central government.

Financial capital is a longer term store of value, usually in the form of a promise to pay later. Financial capital may be backed by other assets, but not always. Whether or not the financial capital is backed by other assets, trust toward its issuer is a fundamentally important component of its value. High levels of well-founded confidence are essential in a modern economy.

Cash flows and Cash flow forecasting

Cash is an enormously important asset for most organisations and individuals, most of the time. The less cash we have, the more important it becomes. If we run out of short term cash to pay our liabilities we can go bust, even if we still have value tied up in our longer term assets.

Cash flows are the changes in our reserves of cash. Cash flow forecasting is making projections of our cash flows and cash reserves, and taking timely action to cover potential shortfalls. Related cash flow statements are a key building block of financial reporting.

Financial reporting

External financial reports are accounts – also known as financial statements – prepared by the managers of organisations to answer the legitimate questions of different stakeholders in the organisation’s activities. Stakeholders in companies include its owners (shareholders) who want to know, “What have you managers been doing with our money and our other assets?” Other stakeholders include tax authorities, who want to know, “How much tax should the company be paying?”

External financial statements are produced in standard formats, including cash flow statements, balance sheets, income statements and other information. Internal financial reports will – ideally – include all the other information the managers need to run the business from day to day, as well as strategically

Interest and Return

Investors in financial capital include depositors in banks, lenders, and shareholders. In all cases the investor wants their original invested capital to be safe. They also expect a surplus on top of the amount they orginally invested. This surplus is known as a return, often expressed as an annual percentage rate of return, to enable comparisons between different capital assets.

Interest is one form of return, generally calculated as a percentage of the amount orginally deposited, loaned or borrowed – or sometimes on an accumulating balance rolling up over time, or on a reducing balance being paid off over time. Interest is a form of income. Total returns may include capital gains as well as income. Returns can be negative, as well as positive.

Risk and Risk management

For investors in organisations, key risks they are concerned about include: losses in the capital value of their invested money, and reductions in the returns that they expected when they made their investments. Managers have fiduciary and stewardship responsibilities for the owners’ assets that they are managing on their behalf. This includes responsibilities for identifying, responding to, and reporting on the significant risks to which the organisation is exposed. Managers also have responsibilities to wider – and longer term – stakeholder interests.

Key dimensions of risk management include identifying – and prioritising – the most significant risks and focusing on general organisational robustness and resilience, as well as specific sources of risk. Competent risk management and reporting will raise the market’s well-founded confidence in our organisation and the financial capital it is issuing.