Financial Concepts & Financial Freedom - The Basics
Introduction
A lot has been said about finances and financial success, however if one does not have a basic understanding of the code used by the professionals you will be lost. In this article we will introduce some of the words and concepts that the non-financial expert often encounters.In order to ensure that the reader enjoy the maximum benefit from this article, the author tried to steer away from the traditional definitions in an effort to make the terms understandable to everybody.
The balance sheet
In a normal business the balance sheet can be described as a photograph of the financial position of the business at a given time. The term balance sheet implies that there are two sides and that the two sides must be in balance. The balance sheet is basically made up of four quadrants.
The top left hand side contains the long term assets. Another name for assets is possessions. Long terms assets are also called fixed assets such as land or property.
The bottom left hand side will contain the short term assets, also termed current assets. Current assets include any short term bank deposits or savings. As can be seen from the above, the left hand (asset) side reflects all the possessions, including the value of these. These assets indicate the asset structure.
On the opposite right hand side of the balance sheet termed the liabilities or claim side reflects the nature and extent of the interest in the assets. This means that the liabilities side indicates what type of claim persons and institutions have on these assets. These claims normally come about by them providing funds for the purchase of assets. This side of the balance sheet is also divided into a top part where the long term liabilities are reflected and a bottom part where the current, or short term liabilities are recorded. The liability side of the balances sheet shows the financing or capital structure at the given date.
Capital
The term capital can be briefly described as the monetary value of the assets contained in the balance sheet. Any type of operation, including a private household, requires capital for investment in fixed assets as well as capital for investment in current assets.
Income
The income or turnover of a company can be equated with cost to company pay of a private household plus any interest or other amounts due. The value of this amount will vary, depending on a number of factors. Should the salary be time based, the value will increase and decrease with the time spent at work. Any interest received will also vary depending on the interest rate and the amount invested. It must be clear form the above that the income is not equal to the money available for expenditure. In most cases very little can be done in the short term to improve income in a sustainable manner. In order to achieve financial freedom in the long run, plans to improve this important part of the equation should be implemented without fail.
Expenses/costs
The term expenses or costs can be regarded as the monetary value the household is prepared to sacrifice on goods and services for a pre-determined benefit.
In order to improve your financial position in the short term it is somewhat easier to reduce expenses. This may not be feasible in the long run and therefore should be accompanied by the plan to increase income in the medium to long term.
To enable you to make the most economic decision it would be necessary for you to understand the behaviour and impact of different types of costs.
There are basically three primary types of costs as follows:
* Fixed cost
*
* Sunk cost
Once you understand the different patterns of behaviour of these types of costs it may be easier for you to determine specific types of expenses that could be reduced with the best net effect.
Fixed cost:
Fixed cost is that portion of the cost that remains unchanged, irrespective of the volume or frequency of use.
This means that you will pay a constant amount on home rental for instance, irrespective of whether you actually stayed there for the full duration of the month or went away on leave for half of the month. This implies that the fixed cost per use will reduce with an increase in usage.
In cases where a large fixed cost component is present one should concentrate on it to maximise the utilisation in so far as it is practical to get the maximum benefit.
Variable cost
Technically there are different types of variable costs, however variable costs are essentially that part of the cost that changes according to the volume or frequency of use.
Revenue
Amount generated from sale of goods or services, or any other use of capital or assets, associated with the main operations of firm before any costs or expenses are deducted. Revenue is shown usually as the top item in an income (profit and loss) statement from which all charges, costs, and expenses are subtracted to arrive at the net income of the firm. Also called sales, in some countries it is also called turnover.
Profit
Best known measure of the success of an enterprise, it is the surplus remaining after total costs are deducted from total revenue, and the basis on which tax is computed and dividend is paid. Profit is reflected in reduction in liabilities, increase in assets, and/or increase in owners’ equity. It furnishes resources for investing in future operations, and its absence may result in the extinction of the firm. As an indicator of comparative performance, however, it is less valuable than return on investment (ROI). In economics, total costs must include a cost to cover the normal profit for the firm. It is also sometimes called earnings, gain, or income.
Sunk Cost
In economics and business decision-making, sunk costs are costs that cannot be recovered once they have been incurred. In our hamburger stand example could be the cost paid to obtain the licence. This cost cannot be recovered as licences are generally not transferable. Should you decide not to operate the hamburger stand any longer you could sell the stand and the raw materials that you still have but the cost of the licence would be lost.
Profit/loss
Profit (loss) can be described as the favourable (unfavourable) difference between the income generated and the cost incurred during the same period. The profit in a household can be viewed as the amount available for discretionary spending or saving after the normal budgeted for expenses have been paid for.
Case study
In order to establish your financial capability the so called balance sheet equation needs to be understood. This equation simply states that the assets minus the liabilities leave the owners value.
Assets - Liabilities = Owners value
This equation has far reaching consequences for the household or individual who wants to achieve sustainable financial freedom.
The Hamburger Stand Example
To explain these terms one should look at a practical example. For the purposes of this discussion we will evaluate the terms as they apply to a hamburger stand.
Understanding your cost structure is the first step in learning to control your costs. The first level of breakdown is into fixed and variable costs. Variable costs are the things that vary based on how business is going. Fixed costs are the things that remain the same.
In a Hamburger Stand the raw products will be labor, raw hamburger and flour. We combine our labor with flour to make buns, form the raw hamburger into patties, cook them and sell hamburgers as the finished product. If we buy the raw hamburger and flour for $0-60 and sell the finished hamburgers for $1-00, we would have an added value of $0-40 per hamburger to pay our fixed costs. If the fixed cost for the site rental salary and licence is calculated at $ 40-00 per day we can calculate how many hamburgers we have to sell to break even. If we sell 100 hamburgers at the $1-00 we would have revenue of $100-00 but a profit of zero. Once we have sold 100 hamburgers we would have added $40-00 value to cove the fixed cost of $40-00.
It is therefore clear that the profit is the difference between the revenue and the total cost. Taking the above example further it is clear that the profit would be $40-00 once we have sold 200 hamburgers.
Consider a Few More Examples
Should you wish to improve your net owners value and you decide that you want to achieve this by increasing the value of your hamburger cart (the assets). You decide to purchase a pergola (read asset) and get that fitted to your hamburger cart with a total value (and a price) of $1000-00. You want to finance this with a loan of $1000-00 from the bank. Your assets will increase by $1000-00 but your corresponding liabilities will also increase by $1000-00. Referring to the balance sheet equation it is clear that the transaction will have no net effect on the owners value (your hamburger cart will definitely look better and probably draw more customers, but this is not what we are talking about now).
This may not be so bad, as it may be possible for you to pay off the loan and keep the asset, thereby increasing the net owners value by $1000-00, provided that the pergola has at least maintained its purchase value. The important part is to ascertain whether the increased benefit that the new asset will bring about (draw more customers) will exceed the total cost of the assets. The total cost of the asset includes items like the initial purchase price, interest payments, admin fees raised, taxes of various types and maintenance cost to mention only a few of the most well known ones. It has been said that any true asset will have the capability to generate new funds. This may be before the purchase, during the holding or after the selling of the asset, depending on the specific type of asset.
In the above example you may wish to fund the pergola (asset) from own funds. This will only imply that you are exchanging one type of asset (cash) for another type (pergola). All the other rules will still apply as explained above.
Conclusion
Understanding the basic financial terms and concepts goes a long way to prepare one for financial freedom. Make sure you understand these and you have started on your way to financial freedom.