Chapter 1
The Tale of Finance
Finance is more than just a measure of money. As you see in this chapter, money is incidental to finance. When discussing corporate finance, we are actually looking at the entire world in a new way — a way that measures the entire universe and the things within it in a way that makes it useful to us. We can calculate things in terms of corporate finance that simply can’t be accurately measured in any other way. Throughout this chapter we talk about the nature of money and how it applies to corporate finance.
Telling a Story with Numbers
Corporate finance is the study of relationships between groups of people that quan- tifies the otherwise immeasurable. To understand how this definition makes any sense at all, first you have to take a quick look at the role of money in the world.
According to Adam Smith, an 18th century economist, the use of money was pre- ceded by a barter system. In a barter system, people exchange goods and services of relatively equivalent value without using money. Perhaps if you worked growing hemp and making rope out of it, you could give that rope to people in exchange for food, clothes, or whatever else you needed that the people around you might be offering. What happens, though, when someone wants rope, but that person has nothing you want? What about those times when you need food, but no one needs rope? Because of these times, people started to use a rudimentary form of money. So, say that you sell your rope to someone, but they have nothing you want. Instead, they give you a credit for their services that you are free to give to anyone else. You decide to go and buy a bunch of beer, giving the brewer the note of credit, ensuring that the person who bought your rope will provide the brewer a service in exchange for giving you beer. Thus, the invention of money was born, though in a very primitive form.
Looking at money in this way, you come to realize that money is actually debt. When you hold money, it means that you’ve provided goods or services of value to someone else and that you are now owed value in return. The development of a standardized, commonly used currency among large numbers of people simply increases the number of people willing to accept your paper or coin I.O.U.s, mak- ing that currency easier to exchange among a wider number of people, across greater distances, and for a more diverse variety of potential goods and services.
According to 21st century anthropologist David Graebner, this story was probably something closer to bartering with the government as a taxation, which meant providing goods and services to the government (for example, the emperor) and then being provided units of “currency” worth production rations. So, you can say that money was invented for the first government contractors as a method for the government to acquire resources in return for units of early currency worth specific amounts of resources rather than a true barter.
Simply put, money is debt for the promise of goods and services that have an inherent usefulness, but money itself is not useful except as a measure of debt. People use money to measure the value that they place on things. How much value did a goat have in ancient Egypt? You could say that one goat was worth five chickens, but that wouldn’t be very helpful. You could say that a brick maker’s labor was worth half that of a beer maker, but you couldn’t exactly measure that mathematically, either. Using these methods, people had no real way to establish a singular, definitive measurement for the value that they placed on different things. How can you measure value, then? You measure value by determining the amount of money that people are willing to exchange for different things. This method allows you to very accurately determine how people interact, the things they value, and the relative differences in value between certain things or certain people’s efforts. Much about the nature of people, the things they value, and even how they interact together begin to become very clear when you develop an under- standing of what they’re spending money on and how much they’re spending.
Fast-forward more than eight millennia — well after the establishment of using weighted coins to measure an equivalent weight of grain, well after the standard- ized minting of currency, and well past the point where the origins of money became forgotten by the vast majority of the world’s population (welcome to the minority) — all the way into the modern era of finance. Money begins to take on a more abstract role. People use it as a way to measure resource allocations between groups and within groups. They even begin to measure how well a group of people are interacting by looking at their ability to produce more using less. Success is measured by their ability to hoard greater amounts of this interpersonal debt. The ability to hoard debt in this manner defines whether the efforts of one group of people are more or less successful than the efforts of another group. People use money to place a value on everything, and, because of this, it’s possible to compare “apples and oranges.” Which one is better, apples or oranges? The one that people place more value on based on the total amount of revenues. Higher revenues tell you that people place greater value on one of those two fruits because they are willing to pay for the higher costs plus any additional profits.
So, when I say that corporate finance is the study of the relationships between groups of people, I’m referring to measuring how groups of people are allocating resources among themselves, putting value on goods and services, and interacting with each other in the exchange of these goods and services. Corporate finance picks apart the financial exchanges of groups of people, all interconnected in pro- fessional relationships, by determining how effectively and efficiently they work together to build value and manage that value once it’s been acquired. Those organizations that are more effective at developing a cohesive team of people who work together to build value in the marketplace will be more successful than their competitors.
In corporate finance, you measure all this mathematically in order to assess the success of the corporate organization, evaluate the outcome of potential decisions, and optimize the efforts of those people who form economic relationships, even if for just a moment, as they exchange goods, services, and value in a never-ending series of financial transactions. The financial decisions made collectively form a trend of behaviors that can be analyzed using any of several types of indicators:
» Leading indicators: Leading indicators include any measures of macroeco- nomic data that indicate what the health of the economy will look like in the immediate future, including new unemployment claims, for example.
» Coincident indicators: Coincident indicators are measures of macroeco- nomic data that indicate the health of the economy now. One example is new industrial production.
» Lagging indicators: Lagging indicators are indicators that tend to confirm what the economy has already begun to do, such as duration of unemployment.
» Sentiment indices: These are measures of how people feel about the economy. They aren’t entirely accurate nor always helpful, but they do help give us an idea about how people feel about the economy, which does tend to be tied to other hard data. Consumer sentiment, for example, tends to be down when employment is down or when people don’t feel confident in their own employment. These factors tend to influence stocks nearly as significantly as other, more solid, indicators.
Characterizing Motivations
Corporate finance plays a very interesting role in all societies. Finance is the study of relationships between people: how they distribute themselves and their resources, place value on things, and exchange that value among each other. Because that’s the case, finance (all finance) is the science of decision-making. This is the process of studying human behavior and determining how people make decisions regarding what they do with their lives and the things they own. Corpo- rate finance, as a result, studies decision-making in terms of what is done by groups of people working together in a professional manner.
This definition guides you in two primary directions regarding what makes cor- porate finance unique:
It tells you that corporate finance is a critical aspect of human life as an intermediary that allows people to transfer value among themselves.
It tells you how groups of people interact as a single unit, a corporation, and how decisions are made on behalf of the corporation by people called managers.
Corporate finance is far more than a study about money. Money is just the unit of measure people use to calculate everything and make sense of it numerically, to compare things in absolute terms rather than relative ones. Corporate finance is a unique study that measures value. Once you accept that, it becomes apparent that everything in the world has value. Therefore, you can use corporate finance to measure everything around you that relates to a corporation, directly or indirectly (which, in the vast majority of the world, is everything).
The role of financial institutions
Probably the easiest way to understand how corporate finance acts as a critical intermediary process between groups of people is to look at the role of financial institutions in the greater economy. Financial institutions, such as banks and credit unions, have a role that involves redistributing money between those who want money and those who have excess money, all in a manner that the general population believes is based on reasonable terms.
Now, whether financial institutions as a whole are fully successful in their role is no longer a matter of debate: They are not. The cyclical role being played out time and again prior to the Great Depression, prior to the 1970s economic troubles, and prior to the 2007 collapse are symptomatic of a systematic operational failure yet to be resolved. For the most part, the role they play is necessary, however. These institutions facilitate the movement of resources across the entire world. They accept money from those who have more than they’re using and offer interest rate payments in return. Then they turn around and give that money to those seeking loans, charging interest for this service. In this role, financial institutions are intermediaries that allow people on either side of these sorts of transactions to find each other by way of the bank itself. Without this role, investments and loans would very nearly come to a total halt compared to the extremely high volume and value of the current financial system.
Corporate finance plays a similar role as an intermediary for the exchange of value of goods and services between individuals and organizations. Corporate finance, as the representation of the value developed by groups of people working together toward a single cause, studies how money is used as an intermediary of exchange between and within these groups to reallocate value as is deemed necessary.
Defining investing
It may be helpful to backtrack a bit. What the heck is an investment, anyway? An investment is anything that you buy for the purpose of deriving greater value than you spent to acquire it. Yes, yes, stocks and bonds are good examples; you buy them, they go up in value, and you sell them. But you can think of some other examples that aren’t so . . . already in this book. A house that you buy for the pur- pose of generating income is a good example of an investment: You buy it, you generate revenue as its renters pay their rent, and after the house goes up in value, you sell it. (Your own home usually isn’t considered an investment.)
Because money places an absolute value on transactions that take place, you can very easily measure not only these transactions but also all of several potential options in a given decision. In other words, you can measure the outcome of a decision before it’s made, thanks to corporate finance. That’s the second thing that makes corporate finance a very unique study: It analyzes the value of interac- tions between people, the value of the actions taken, and the value of the decisions made and then compiles that information into a single agglomerate based on pro- fessional interconnectedness in a single corporation.
This analysis allows you to measure how effectively you’re making decisions and optimize the outcome of future decisions you’ll have to make. The decisions that corporations make tend to have very far-reaching consequences, influencing the lives of employees, customers, suppliers, partners, and the greater national econ- omy, so ensuring that a corporation is making the correct decisions is of the utmost importance. Corporate finance allows you to do this, so if you have a favorite corporation, hug the financial analysts next time you see them (or maybe just send a cookie bouquet; you might freak someone out if you just randomly starting hugging people).
Setting the Stage
Unless you’re in a rare minority who live “off the grid” (secluded and self-sufficient), nearly every aspect of your life is strongly influenced, directly or otherwise, by corporate finances. The price and availability of the things you buy are decided using financial data. Chances are high that your job relies on decisions made using financial data. Your savings and investments all rely quite heavily on financial information. Your house, car, where you live, and even the laws in your area are all determined using financial information about corporations.
From the very beginning, a corporation needs to decide how it will fund its start- up, the time when it first begins purchasing supplies to start operating. This single decision decides a significant amount about the corporation’s costs, which, in turn, decide a lot about the prices it will charge. Where it sells its goods depends greatly on whether the corporation can sell its goods at a price high enough to generate a profit after the costs of production and distribution, assuming that competitors can’t drive down prices in that area. The number of units that the corporation produces depends entirely on how productive its equipment is, and the corporation will only purchase more equipment if doing so doesn’t cost more than the corporation will be able to make in profits.
These factors affect your job, too; the corporation will hire more people who add value to the company only if it’s profitable to do so. Where your job is located will depend greatly on where in the world it’s cheapest to locate operations related to your line of work. The decision to outsource your job to some other nation depends entirely on whether that role within the company can be done more cheaply else- where, without incurring risks that are too
Visiting the Main Attractions in Finance Land
Finance Land is filled with a surprisingly large and diverse number of organiza- tions, each one specializing in a different area of financial goods or services and many of them being quite narrow in their focus. Regardless of how limited or unlimited in offerings any particular organization may be, they’re all intercon- nected, and each one plays a very important role in the greater economy. All the organizations in Finance Land influence each other and the individuals working for them in several important ways that vary depending on which type of organi- zation you’re talking about.
The following sections introduce you to some of the more common financial insti- tutions and related organizations and explain how each one plays a role in the world of corporate finance.
Corporations
In case the name of this book didn’t give it away already, corporations are the pri- mary focus, so I start your finance tour with them. Corporations are a special type of organization wherein the people who have ownership can transfer their shares of ownership to other individuals without having to legally reorganize the company. This transferring of shares is possible because the corporation is considered a sepa- rate legal entity from its owners, which isn’t the case for other forms of companies. This characteristic has a few significant implications that influence the financial operations and status of corporations compared to other forms of organizations:
» Professional managers typically run corporations rather than the owners given the wide distribution of ownership by non-owners. This leads to questions about moral hazard — the conflict of interest that occurs when managers make decisions that benefit themselves rather than the owners of the organization they’re managing, called the agency problem. Often, an individual who holds a very large proportion of a corporation’s stock will also be a manager or a director, but generally speaking, corporations have the resources to hire highly experienced professionals.
» The corporation is taxed on its earnings separately from the owners. In most organizations, the profits are considered the owners’ income and they’re only taxed as such. In corporations, however, the company itself is taxed on any earnings it makes and the owners are taxed on any income they generate by possessing stock ownership (called capital gains). This double taxation of income is one of the pitfalls associated with a corporate structure.
» Corporations have limited liability, meaning the owners can’t be sued for the actions of the company. Oddly enough, this characteristic also fre- quently protects managers, though to a lesser extent since the establishment of the Sarbanes-Oxley laws, which hold managers more accountable.
» Corporations are required to disclose all their financial information in a regulated, systematic, and standardized manner. These records are public not only to the government and the shareholders but also to the public. Shareholders can also request specialized financial information.
The primary goal of corporations is to provide goods or services in exchange for money; their underlying goal is to generate a profit, as the law requires them to operate using the Shareholder Wealth Maximization model wherein corporate man- agement is legally obligated to operate in a manner that increases profitability and corporate value and, as a result, increase the value of the shares of stock held by the shareholders as the owners of the corporation. In most cases, profits are the income of a corporation. The one exception is the nonprofit corporation, which includes such organizations as The American Red Cross, many public universities, and other organizations that operate within the parameters of a tax-exempt sta- tus. Although nonprofits can still be profitable, their profits are capped (meaning they can’t make more than a specific percentage in profit), so they use their resources to provide goods or services below cost. Many nonprofits choose not to generate any revenues, relying instead on donations. (Due to the unique consid- erations that you must give nonprofit organizations when assessing them, I don’t discuss them further in this book.)
Depository institutions
Anytime you give your money to someone with the expectation that the person will hold it for you and give it back when you request it, you’re either dealing with a depository institution or acting very foolishly. Depository institutions come in several different types, but they all function in the same basic manner:
» They accept your money and typically pay interest over time, though some accounts will provide other services to attract depositors in lieu of inter- est payments.
» While holding your money, they lend it out to other people or organizations in the form of mortgages or other loans and generate more interest than they pay you.
» When you want your money back, they have to give it back. Fortunately, they usually have enough deposits that they can give you back what you want. That’s not always true, as everyone saw during the Great Depression, but it’s almost always the case. Plus, safeguards are now in place to protect against another Great Depression in the future (at least one that occurs because banks lend out more money than they keep on hand to pay back to their lenders).
The three main types of depository institutions are commercial banks, savings institutions, and credit unions.
Commercial banks
Commercial banks are easily the largest type of depository institution. They’re for- profit corporations that are usually owned by private investors. They often offer a wide range of services to consumers and corporations around the world. Often the size of the bank determines the exact scope of the services it offers. For example, smaller community or regional banks typically limit their services to consumer banking and small-business lending, which includes simple deposits, mortgage and consumer loans (such as car, home equity, and so on), small-business bank- ing, small-business loans, and other services with a limited range of markets. Larger national or global banks often also perform services such as money man- agement, foreign exchange services, investing, and investment banking, for large corporations and even other banks like overnight interbank loans. Large commer- cial banks have the most diverse set of services of all the depository institutions.
Savings institutions
Have you ever passed by a savings bank or savings association? Those are both forms of savings institutions, which have a primary focus on consumer mortgage lending. Sometimes savings institutions are designed as corporations; other times they’re set up as mutual cooperatives, wherein depositing cash into an account buys you a share of ownership in the institution. Corporations don’t use these institu- tions frequently, however, so I don’t cover them throughout the rest of the book.
Credit unions
Credit unions are mutual cooperatives, wherein making deposits into a particular credit union is similar to buying stock in that credit union. The earnings of that credit union are distributed to everyone who has an account in the form of dividends (in other words, depositors are partial owners). Credit unions are highly focused on consumer services, so I don’t discuss them extensively here or else- where in this book. However, their design is important to understand because this same format is very popular among the commercial banks in Muslim nations, where sharia law forbids charging or paying traditional forms of interest. As a result, the structure of a credit union in the U. S. is adopted by commercial banks in other parts of the world, so a basic awareness of this structure can be useful for international corporate banking.
Insurance companies
Insurance companies are a special type of financial institution that deals in the business of managing risk. A corporation periodically gives them money and, in return, they promise to pay for the losses the corporation incurs if some
18 PART1 What’sUniqueaboutCorporateFinance
unfortunate event occurs, causing damage to the well-being of the organization. Here are a few terms you need to know when considering insurance companies:
amount that the insured must pay before the insurer will
» Premium: The periodic payments the insured makes to ensure coverage
» Co-pay: An expense that the insured pays when sharing the cost with the insurer
» Indemnify: A promise to compensate one for losses experienced
» Claim: The act of reporting an insurable incident to request that the insurer
pay for coverage
» Benefits: The money the insured receives from the insurance company when something goes wrong
You’re probably thinking to yourself right now, “Wait. You pay the insurance company to indemnify your assets, but then it makes you pay a premium, deduct- ible, and co-pay and caps your benefits? What’s the point?” Yeah, I know. Insur- ance companies can calculate the probability of something happening and then charge you a price based on the estimated cost of insuring you. They generate profits by charging more than your statistical cost of making claims.
Think of it like this: As a nation, people in the United States overpay for every- thing that’s insured by an amount equal to the profits of the insurance companies. Originally, this setup allowed corporations and individuals to share the risk of loss; each person paid just a little bit so no person had to face the full cost of a serious disaster. Unfortunately, this is decreasingly the case, as insurance compa- nies grow in profitability and incur unnecessary overhead costs. That’s precisely why many nations require their insurance companies to operate as nonprofit organizations.
You can insure just about anything on the planet. (Consider that Lloyd’s of London will insure the hands of a concert pianist or the tongue of a famous wine taster!) The following sections outline three of the most common (and relevant) types of insurance companies as far as corporations are concerned.
Health insurance companies
Corporations deal a lot with health insurance companies because their employees often demand health insurance — not to mention healthy employees tend to be more productive. Health insurance is a very popular benefit for employees because
» Deductible: The pay anything
being insured as a part of a large group is generally less expensive than trying to find individual insurance:
» Group insurance is cheaper than individual insurance because the probability of large groups of people being rewarded more than they pay in premiums is lower than that of individuals.
» Group insurance was frequently the only option that allowed for coverage on preexisting conditions (conditions people developed before receiving insur- ance); however, under the Patient Protection and Affordable Care Act, insurance companies can no longer deny coverage to people.
Health maintenance organizations (HMOs) are a popular, and often cheaper, insur- ance option for both corporations and individuals because they require everyone insured to go through a general physician, who acts as a kind of gatekeeper by determining whether a referral to a specialist is required.
Life insurance companies
Life insurance companies work similarly to other types of insurance companies, except that the only time they pay benefits is when you die. Corporations some- times take life insurance policies on critical employees who have specialized skills or knowledge that can’t be easily replaced without significant financial losses. Many corporations also offer group life insurance which, like health insurance, is cheaper than individual insurance. Life insurance comes in two basic flavors: whole and term. Each one has a wealth of variations and additional options. The types have many differences, but the primary distinction is that term life insur- ance is paid for a set period and is only valid as long as it is being paid, while whole life insurance is considered permanent and will build value over time.
Property-casualty insurance companies
Property-casualty insurance is the most critical type of insurance for corporations to have. It covers the potential harm that can befall a company or anyone on prop- erty owned by the company should an accident occur. Did a meteor fall from the sky and smash your headquarters? That’s insurable!
Securities firms
Securities firms provide transaction services related to financial investments, which are quite distinct from the services provided by traditional depository institutions. However, many commercial banks have separate departments that offer the ser- vices of securities firms, and others merge or partner with securities firms. (For example, Bank of America is a commercial bank that bought the securities firm known as Merrill Lynch.) Still other securities firms are completely independent of any depository institution. Exactly which types of services a securities firm provides depends on the type of institution it is.
Investment banks
Investment banks deal exclusively in corporations and other businesses as clients as well as products. In other words, they offer a wide range of services, including underwriting services for companies that issue stock on the primary market, broker-dealer services for both buyers and sellers of stock on the primary and secondary markets, merger and acquisitions services, assistance with corporate reorganization and bankruptcy procedures, general consulting services for corpo- rations large enough to afford them, and other such services related to raising or transferring capital.
Broker-dealers
In case you couldn’t tell from their name, broker-dealers perform the services of both brokers and dealers:
» Brokers are organizations that conduct securities transactions on the part of their clients — buying, selling, or trading for the investment portfolio of their clients.
» Dealers are organizations that buy or sell securities of their own portfolio and then deal those securities to customers who are looking to buy them.
» Broker-dealers are organizations that do a combination of both of these services. They perform pretty much all the middle-man functions of providing securities services to corporations and individuals alike, and they’ve all but eliminated the need for organizations that specialize in either broker or dealer services.
A special type of broker, called a discount broker, performs similar functions as broker-dealers, except that they only perform the transactions, while broker- dealers often provide assistance by offering advice, analysis, and other services that can help their customers make investment decisions. Discount brokers don’t perform these additional services.
Underwriters
A special type of insurance company, called underwriters, deals only with other insurance companies. They analyze applications for insurance, determine the degree of risk and associated costs with issuing insurance, and determine
CHAPTER 2 Introducing Finance Land 21
eligibility and price. Some insurance companies have their own internal under- writing departments, while others outsource to external companies that specialize in just underwriting.
Banking underwriters are slightly different in that they assess the risk and potential of loan applicants to pay back their loans. They assist banks in determining what interest rate to charge and whether applicants are even eligible for a loan.
Securities underwriters assess the value of a particular organization or other asset for which securities are being issued. In other words, if a company wanted to become a corporation, one step in that process is to determine the value of the company, the number of shares to issue, and the amount of money the company is liable to raise and to help with the distribution and sale of the original shares of stock to raise money for the company to become a corporation.
Funds
During the early days of the Christian church and then again in the United States in the 1960s, groups often pooled all their assets together and allowed them to be managed for the good of the group. Funds are basically the free-market-investor version of this collective idea. Individuals pool their money together in a fund, that money is managed as a single investment portfolio, and the individuals who contributed to that portfolio (the fund) receive returns on their investments pro- portional to their ownership in the returns generated by the entire portfolio.
The point of pooling assets is to make professional investments and investing strategies available to people who otherwise wouldn’t have the resources on their own to pursue such investments. Funds are popular options for corporations to provide for the retirement funds of their employees, but corporations themselves also frequently trust their investment management to a fund. Generally speaking, each fund has its own investing strategy, so investors choosing between funds must pick one that has a strategy they believe will most benefit them.
Funds come in two types — hedge funds and mutual funds — and although they both have the same fundamental principles, each type has some unique traits, processes, regulations, and variations. Table 2-1 gives you a quick look at the main differences.
Financing institutions
Financing institutions are kind of like banks in that they lend money, but they’re a bit different, too. First of all, they tend to give different types of loans than banks do. Secondly, they get their funding by borrowing it themselves instead of through deposits. They earn a profit by charging you higher interest rates than they’re paying on their own loans.
Sales financing institutions
If you’ve been to a car dealership, furniture store, jewelry store, or some other retailer that deals in expensive merchandise, odds are you’ve been offered a loan that you can use to purchase an item immediately and then pay off the loan in installments. The store itself isn’t offering you the loan; a type of financing insti- tution called a sales financing institution works with the store to give you the loan. Sales financing institutions work with both individuals and companies making large purchases.
Personal credit institutions
Personal credit institutions are companies that offer small personal loans and credit cards to individuals. Because they don’t have much to do with corporate finance — unless the personal credit institution itself is a corporation or you’re using your personal line of credit to invest in a corporation (in which case, as long as your returns exceed the interest you’re paying, then good for you) — I don’t cover this topic in detail here or elsewhere in this book.
Business credit institutions
Did you know that corporations can get credit cards and credit loans just as you can? Well, they can, and those credit loans come from a type of financing institu- tion called a business credit institution. Business credit loans differ from standard business loans in that they’re a running line of credit in the same way that your credit card is a running line of credit. These loans can be freely increased or grad- ually paid off within certain limits as long as the corporation makes periodic min- imum payments on the balance.
A special type of business credit institution, called a captive financing company, is a company that’s owned by another organization and that handles the financing and credit only for that organization rather than for any applicants. For example, GMAC, the financing arm of General Motors, which changed its name to Ally Bank, is the captive credit financing company for the corporation General Motors.
Loan sharks and subprime lenders
All the lending I talk about in this chapter has been at the prime rate, which is the interest rate charged to customers who are considered to be of little or no risk of defaulting. In the United States, the prime rate is about 3 percent above the interest rate that banks charge each other, called the federal funds rate. (Some nations use LIBOR, which is the London Interbank Offered Rate.) For those corpo- rations and people who are considered higher risk, they will often qualify for only loans considered subprime, which are offered at interest rates higher than the prime rate.
Another form of high-interest loan is called the payday loan. The payday loan basically makes loan sharks legal (organizations that offer loans at rates above the legal level and who often have heavy-handed tactics). The payday loan gives you money for a short period, usually only one to two weeks, and charges several hun- dred percent in annual percentage rate, in addition to fees and penalties. Rather than breaking your knees, as the stereotype suggests, these lenders simply anni- hilate your credit score and financial well-being. As a result, many states have outlawed these lenders.
For a period between the 1980s and 1990s, subprime mortgage lenders were also very common. In fact, they contributed to the 2007 financial collapse, when many commercial banks were venturing into the subprime market with little or inap- propriate risk management. Bottom line: Avoid loan sharks and subprime lenders at all costs, or they’ll ruin your finances and the greater economy at large.
Exchanges
Exchanges such as the NASDAQ, NYSE, Nikkei, and others are globally renowned for being open forums for ferocious trading. In both stock and commodities exchanges, the most recognized space is called the pit, or trading floor, and it’s where large numbers of brokers and dealers shout and scream at each other, buy- ing, selling, and trading shares of this or that. Of course, computers are now replacing much of this in-your-face activity. Even on the trading floor itself, computers are becoming ever present, while the number of people who vigorously declare their intentions to anyone within a two-mile radius is quickly shrinking. The function of the exchanges themselves is more about providing a place for these trading activities to occur than anything, making them increasingly irrele- vant with modern technological advances in investing transactions.
Regulatory bodies
Numerous regulatory bodies oversee corporate finances and financial institutions, and each one warrants its own book (in fact, the role and regulations encompass- ing each regulatory body span volumes of books of information). I obviously can’t fit all that information in this book, so I just cover the basics of the main regula- tory bodies here. Armed with their names and main purposes, you can do a quick online search to find out more about the ones that interest you most.
» Securities and Exchange Commission (SEC): Sets the standards for corpo- rate public financial reporting, the rules for investment, and the regulations for securities exchanges
» Internal Revenue Service (IRS): Handles all tax reporting, tax accounting, tax collection, and pretty much all taxation issues other than determining the tax rates
» Financial Industry Regulatory Authority (FINRA): A nongovernmental organization that’s in charge of setting and enforcing regulations among its member groups, which include brokerage firms and exchange markets
» Commodity Futures Trading Commission (CFTC): The government body that regulates derivatives trading
» Federal Deposit Insurance Corporation (FDIC): One of the few private corporations owned by the United States; sells insurance to depository institutions, ensuring that the deposits of each person be insured up to $250,000 in the event that something happened to the institution
» Office of the Comptroller of Currency (OCC): Part of the U.S. Treasury; regulates all national commercial banks
» National Credit Union Administration (NCUA): A government-backed organization that regulates credit unions
» American Institute of Certified Public Accountants (AICPA): The profes- sional organization that regulates all certified public accountants
» Chartered Financial Analyst Institute (CFAI): The professional organization that regulates all chartered financial analysts
» Financial Accounting Standards Board (FASB): A nonprofit organization that creates the generally accepted accounting principles (GAAP) that are used for all public accounting in the United States.
» Government Accounting Standards Board (GASB): The non-profit organiza- tion that regulates the accounting of state and local governments
» Federal Accounting Standards Advisory Board (FASAB): An advisory committee that regulates accounting standards for the U.S. federal government
» Financial Accounting Foundation (FAF): The organization that provides oversight and regulation for other regulatory and professional bodies such as the AICPA, CFAI, and GASB
These are just U.S. regulatory bodies. Many more bodies provide oversight and regulation around the world. Plus, many nations are beginning to adopt interna- tional accounting standards (IAS), which may limit the need for individual national accounting standards; however, the standards boards will likely remain in most nations even after they adapt IAS. Looking at all the regulatory bodies that regu- late other regulatory bodies, I believe that the industry as a whole may welcome some streamlining — not less regulation, necessarily (that’s a far more compli- cated debate), but less bureaucracy.
Federal Reserve
The Federal Reserve isn’t a part of the federal government at all. It’s quasi-governmental, which means it performs functions related to managing the U.S. economy in cooperation with the government but isn’t actually under the direct control of any government body. Think of the Federal Reserve as the bank that other banks go to when they need banking services.
The Fed accepts deposits, makes loans to member banks, and facilitates loans between banks using the deposits. It also determines interest rates for certain key loans and the bank reserve requirement, which is the proportion of total deposits that commercial banks must keep available as liquid cash. Bank reserve require- ments are used to manage bank liquidity for customer withdrawals and to manage the supply of money in the nation as a whole. The Fed generates funds by charging interest and by charging member banks a membership fee.
The controversy and confusion comes into play as the Federal Reserve receives money from the U.S. Treasury and then lends it out to member banks. The setting of interest rates is also one of the responsibilities of the Federal Reserve.
The reality is that the Federal Reserve is simply acting as a middleman for the distribution of funds, although the government can distribute funds without help from the Federal Reserve by way of spending more money through hiring con- tractors or distributing stimulus spending (like the new homebuyer’s tax credit). Banks tend to only purchase money from the Federal Reserve when they need to increase the total amount of money available, because interbank loans are a cheap, fast, and easy way to handle short-term shortages of money in reserve.
What do corporations need to know about the Fed? Because it sets the rates that other banks pay to borrow money, it also indirectly controls the rates that banks will charge customers. After all, banks always charge rates higher than they, themselves, pay. The Fed also plays a large role in controlling money supply. In short, the Fed is in charge of U.S. monetary policy, so most of what I cover in this finance book is directly related to the actions of the Fed.
U.S. Treasury
The U.S. Treasury is a division of the U.S. government and is, quite possibly, the simplest arm of the U.S. government to understand, at least regarding finance. The U.S. Treasury isn’t a decision-making body, so the actions it takes must always be set in motion by the federal government — either Congress, the presi- dent, the Supreme Court, or some combination of the three. For instance, the Treasury distributes payments on behalf of the federal government, but it doesn’t make those payments on its own. Congress sets the budget for each branch of the government, and when the branches spend that money, the Treasury’s job is to distribute the allotted funds.
That being said, the Treasury is in charge of distributing government funds, col- lecting revenues by way of the IRS, issuing government debt (by selling Treasury bonds, Treasury notes, and Treasury bills, which are how government debt is generated), printing new money, and destroying old/damaged/faulty money.
What you need to know about the Treasury is that it’s where your government bonds and risk-free investments come from and it’s where your payments come from if you own government investments or do any contracting work for the fed- eral government, as many corporations do.
Getting a Job in Finance Land
As with most places in the world, your visit to Finance Land will be a short one unless you can find work. The following sections outline some roles to consider in this land of other peoples’ money.
Accounts payable and/or receivable
Accounts payable specialist and accounts receivable specialist sound like they should be similar roles. In terms of the basic paperwork and function, they are quite alike. An accounts payable specialist manages paying bills that are due, while the accounts receivable specialist collects money that is owed. The real sig- nificant difference is that paying bills is a lot easier than collecting money from people who owe, so accounts receivable quickly turns into a role of debt collection. It’s not a bad entry-level position to get started in the finance, though.
HR and payroll
This role is very much the liaison between Finance Land and the employees of a company who generally haven’t specialized in finance. Paychecks and benefits and retirement accounts and insurance stuff and time off — they are all handled here. This role has a greater customer service feel to it, so it helps to be a “people person,” as they say.
Analysts
Analysts have the best job in the financial world, as far as I’m concerned. These people get to do a whole lot of research and analysis to derive useful information from data or otherwise yet unstudied scenarios. Normally, analysts receive budget information or corporate financial information and are told to do the calculations necessary to make recommendations. Often these projects are fairly broad, and analysts have to model new forms of calculations, assess market trends, and make other similar efforts that require a degree of creativity and innovation.
Auditors
As you’re typing on the computer, if you spell a word incorrectly, spell-check will likely correct you. Auditors are kind of like the spell-checkers for corporate finance. They go back and check the work of all the other financial professionals, making sure everything is accurate, correct, and done properly. They’re also usually the ones who discover cases of fraud or embezzlement. A special type of auditing, wherein auditors do their calculations for the purpose of presenting them in court, is called forensic accounting.
Adjusters
Adjusters are people who work for insurance companies and analyze your insur- ance claim to determine how much the insurance company will pay for damages and whether your claim is fraudulent or real. Any claim large enough for a corpo- ration to file is guaranteed to attract an adjustor inspection.
Bookkeepers and accountants
“Bean counters” is the phrase used to refer to this role which, although one of the most vital in Finance Land, can be just as boring as it sounds. In this role, you keep track of the movement of all money, make records, file reports, and make sure everyone on the planet knows exactly what has happened with the money you are keeping track of.
Get a degree in accounting and then pursue your CPA to become a rock star in this field.
Modelers and scientists
These folks take the data collected by accountants and others and run all kinds of quantitative analysis on it to turn that data into useful information. If you like math, statistics, and computer coding, this is a very lucrative field to pursue.
Economists and consultants
Finance is only one subdiscipline of economics. Economists, as a result, do similar work to financial analysts but on a much broader scale that encompass more than money-related items. Consultants, too, are experienced experts, either directly in the field of finance or some field that complements finance. In both cases, they provide clarity, information, and guidance necessary for the proper application of financial management. The focus on these people isn’t so much about money itself, but the resources that the money represents.
Traders
The term trader refers to anyone who makes a living by buying and selling invest- ments with great frequency. Unlike investors, who purchase investments with the intention of holding onto them for an extended period of time with the expecta- tion that they’ll rise in value, traders hold onto investments just long enough for them to rise in value a little bit and then sell them at a profit. Really, any schmuck can try to be a trader; some will succeed and others will fail. The only requirement is that you have some starting capital (in other words, money).
Work on getting your Series 7 license and perfecting your networking skills to make it as a professional trader of any kind.
Treasurers
Treasurers are the people in charge of managing financial assets. In other words, they’re responsible for keeping track of cash management, foreign exchange, pension management, and capital structure. Don’t worry; I discuss all these topics in much greater detail throughout the book. Often treasurers are also in charge of risk management, although this responsibility is sometimes given a separate position, depending on the company. (See Part 4 for more on risk management.)
Bankers and more
The nature of banking depends entirely on the type of banking a person does, but there are similar functions between them. Personal and commercial bankers han- dle the logistics of executing transactions for deposits, loans, some kinds of investments, some kinds of valuations, and so on. An investment banker deals with the logistics of assessing the value of a corporation, making sure the corpo- ration gets paid for its shares, and selling those shares to private investors. Tellers work in banks and simply handle the counting and movement of money between people and/or accounts. Banking, as a whole, is really nothing more than manag- ing basic money needs for others.
“Financial advisors” are not financial experts, despite the word “finance” in the title. It is their role to sell financial products and services, and they earn more money as you make more transactions. There have been attempts to pass a fidu- ciary rule that would require financial advisors to act in the best interest of their clients, but these attempts have been reversed.
Visiting the Finance Land Information Center
Are you still feeling lost in Finance Land? Have you read this book (and all the other books written by yours truly) and are still feeling like a 2-year-old lost in the mall? Fortunately, you can go to plenty of other places for additional informa- tion. But be careful, because Finance Land is filled with people who give terrible advice. Think of this portion of the book as your guide map: It helps point you in the right direction for more exploration.
Internet sources
The Internet, with its seemingly unlimited ability to provide free, reliable infor- mation, has become a great resource tool for people involved in corporate finance. However, you have to be careful when using online sources because some of them don’t verify their accuracy, and you definitely don’t want to be misled or lied to. Here are just a few sources you can trust:
» EDGAR: This is the SEC’s database website, which provides easy access to a huge number of financial reports by public companies listed in the U.S. Check it out at http://www.sec.gov/edgar.shtml.
CHAPTER 2 Introducing Finance Land 31
» Investopedia: This online encyclopedia focuses exclusively on issues related to corporate finance and investing. Go to http://www.investopedia.com for more details.
» University websites: Many university websites publish beginner’s guides, course supplements, and other information useful for people with a range of understanding in corporate finance. These resources can be difficult to find on the websites themselves, though, so your best bet is to find them using a search engine. Just type a search for the concept you’re researching; if any of the websites have an .edu domain, then that’s probably a good reference.
» Publisher websites: Many book publishers, particularly for textbooks, provide supplementary information and resources on their websites.
Print sources
A number of different print sources are also available to help you learn more about corporate finance:
» Books: The one you’re reading right now is a great place to start! You’ll also find several other books in the For Dummies series. You can also check out some of my other books (search for Michael Taillard). If you’re looking for more, ask your librarian to help point you in the right direction. Particularly, librarians at universities can be extremely helpful because they have lots of books geared to students who are studying the same things as you.
» Magazines: CFO, Kiplinger, Global Finance, Public Finance, Money, Strategic Finance, and so many others can be great resources. The topic of corporate finance seems to sell a lot of magazines.
» Journals: Academic and professional journals are an amazing source of information and are particularly nice because the work is all peer-reviewed for accuracy and legitimacy. The problem is they also tend to include extremely advanced information — not for the beginner!
» Financial reports: All financial reports made by companies publicly listed in the United States are available for free on request or at many libraries.
Human sources
Finding the right people to talk to about corporate finance can be difficult, espe- cially when the people who talk the most are the ones who know the least and the ones who know the most are the hardest to find. Here are a few tips to help you get the best, most useful information from the finance people you talk to:
» Never trust someone giving you a stock tip!
» Understand the nature of the person’s job, and if they keep trying to give you
information outside of that job, don’t trust them.
» Make sure the person you’re talking to has credentials of some sort.
Some people frequently willing to chat who have knowledge of a wide range of finance topics include university professors, CFAs, and CPAs.