Tuesday, August 23, 2005

The ups and downs of finance

The activity of finance is the application of a set of techniques that individuals and organizations (entities) use to manage their financial affairs, particularly the differences between income and expenditure and the risks of their investments.
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An entity whose income exceeds its expenditure can lend or invest the excess income. On the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower, a financial intermediary, such as a bank or buy notes or bonds in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary pockets the difference.
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A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders of different sizes to coordinate their activity. Banks are thus compensators of money flows in space since they allow different lenders and borrows to meet, and in time, since every borrower will eventually pay back.
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A specific example of corporate finance is the sale of stock by a company to institutional investors like investment banks, who in turn generally sell it to the public. The stock gives whoever owns it part ownership in that company. If you buy one share of XYZ inc, and they have 100 shares available, you are 1/100 owner of that company. You own 1/100 of anything on the asset side of the balance sheet. Of course, in return for the stock, the company receives cash, which it uses to grow its business. This is called "Equity Financing". Equity financing mixed with the sale of bonds (or any other Debt Financing) is called the company's capital structure.