Finance for dummies
Finance is an indispensable aspect of modern living. A micro level view of finance is presented here. Consider the example of a person buying a car. This person first assesses whether the car is a necessity, comfort or luxury. If it is a necessity, then it needs to be financed immediately. If not, the person can set-aside some amount every month and purchase it after adequate funds have been collected.
In the first scenario, the person reviews
- Money that is available with him or her as savings; and
- Total cost of the car
If the savings are adequate, the person may choose to pay the entire cost of the car out of the savings. This is the simplest way of managing finances.
A slight variation of this way of financing is by investing the personal savings in fixed deposit fetching regular monthly returns. The person takes a car loan and uses the interest on fixed deposits for partial repayment. The future earnings make up the other part of the monthly installments. Effectively, the person borrows to invest in fixed deposit. At the end of the loan period, he or she has a car as well as fixed deposit.
An aggressive approach would be when the person uses personal savings to earn very high returns that exceed the interest he or she pays out to the car loan provider. This is what is known as financial gearing. High financial gearing results in higher returns. However risks are also much higher.
That does not mean that low financial gearing is any less risky. Investing entire funds in government securities may not necessarily cover the inflation. Therefore, partial financial gearing is always advisable.
If the cost of car far exceeds the savings, then the person will invariably go for a car loan, repaying the borrowed money and interest thereon from future earnings.
Car loan therefore makes up the deficit amount of finance for purchasing the car. This is one of the simplest examples of deficit financing.
Loans or borrowings are obviously repayable. The repayment schedule is prepared based on the amount the person can most certainly spare every month. This spare amount should, in turn, cover both the interest and principal component.
This brings us to juggling between interest rates and term. There are two cardinal rules to this.
- The term of the loan is indirectly proportionate to the regular installments.
- The installments are directly proportionate to the interest rates.
Some loans offer fixed interest rates, others adjustable rates. Fixed interest rates on finance means that there is no hope for the borrower to clear the loan before the agreed date. The adjustable interest rate loan varies the interest rates. It follows that when interest rates dip, the interest component in the regular installments will also nose dive. Generally these installments are equated for the entire term of the loan. Therefore, the principal component repaid is increased in those specific installments to cover the vacuum created by the interest component. This means that the final installments are cascading downwards, and the borrower is likely to be pleasantly surprised when his loan is cleared before the tenure. What must be borne in mind is that the surprises can be nasty ones too. If the interest rates climb, there will be more installments to be paid.
To obtain the finance, the borrower mortgages the car in our example. The borrower can also mortgage or pledge or hypothecate other assets to obtain other forms of finance. For example, if the borrower has some stocks, and requires some funds urgently, he can pledge them with the banker and obtain loans thereon. The range of assets includes residential properties, commercial properties, farms, livestock, government securities, art collections, etc.
When the car is not a necessity, then it was suggested that the person save regularly till he or she has adequate savings to buy the car. This is prudent no doubt. But then inflation plays the villain. The person soon finds that the cost of car has gone up and he or she needs to save some more. This goes on like a vicious cycle. Therefore, deficit financing is a better way to finance comforts and luxuries too.
Business enterprises require different types of finance for their day-to-day activities. There are debtors and there are creditors. Sometimes the creditors offer discount for prepayment. Under such circumstances, borrowing from banker at cheaper rate of interest for availing higher discounts makes sense. Similarly, a business may find that bulk of its assets is blocked in debtors who are liable to cough up the amounts after a month or so. And around the same time, there is an opportunity to buy some inventory at a fairly lower price. Then the business can take a loan on its receivables, based on the bills and delivery acknowledgments. This borrowing can then be repaid to the banker after receiving funds from the debtors.
Business enterprises engaged in large construction and other activities also avail finance from bankers and financial institutions on their contracts. For this, they have to submit detailed cash flow plans corresponding to project stages. The bankers release the funds in installments based on progress. As and when the party who gave the contract releases the amounts, the dues along with interests are recovered. Therefore, such contract finance is effectively a series smaller loans linked together, with limits for each type of withdrawals. The contractor cannot withdraw entire amount for labor, or material. There are ratios to which the contractor must adhere.
This information is just a preliminary view to deficit financing and types of finance. There may be terms and conditions such as prepayment of a fixed number of installments, or interest calculated on flat rates, which may become detrimental to the interest of the borrower.
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