Whenever we mention a concept in any given topic, we often forget the definition of that concept. For instance, what really is an asset? Well, we would agree that the following things are assets:
-Business entity (startups, etc.)
-Patents and R&D
-Reputation and Knowledge
Well, the list can be made very long and yet, not one hundred percent correct. Because when I mention the word asset later on, I will relate to a given, general definition that most economists agree with. You need to know what it means in order to minimise the risk of misconception.
The definition of an asset is simply "a sequence of cash flow relative to time." Where a cash flow is the movement (the flow) of cash. So, when you hear a friend saying: "company xyz has great assets," you now know that's economically incorrect. Because an asset is always relative to time, so it should be "xyz has great assets right now." But, is there only one type of assets then? Well, let's go back to the lemonade stand in order to understand it better.
Assume that you took a loan for an ice cream machine instead of the fridge, which now allows you to start making delicious ice cream. So, if you keep on doing this for a while, you start realising that this machine indirectly produces money, right? That's called a real asset. In fact, the ice cream machine is a tangible (real) asset. Concisely written, tangible assets are real assets that you can touch; for example offices and machineries. As you might be wondering, there must be intangible assets as well?! Yes. Intangible (real) assets are assets you cannot touch. For instance, trademarks, patents and technical expertises are intangible (real) assets.
At this point we know that our lemonade stand obtains a lot of real assets. You've got an ice cream machine, maybe you've got an office and you might even have a small factory where you produce you own lemonade. However, the money that the real assets are generating, should be called something as well? What's the outcome of a real asset?
The money generated from your ice cream machine is called a financial asset.
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So which one comes first in a company, the real asset or the financial asset? In order to answer that question, you really need to grasp the two definitions. Real assets (indirectly) produce money, whereas you need money to buy them. And the financial assets are the one you (for example) buy real assets with. So the answer would be financial assets.
Now, if your company needs money for the real assets, you might choose to sell financial assets (securities) in order to get cash. The following picture explains the process:
In the lemonade stand you might choose to sell financial assets to get some cash (1). Once you got the cash needed, you decide to buy the ice cream machine (2). If the ice cream machine does well, you might expect more money to be generated than in the first place (3). At this point you might choose to reinvest in your lemonade stand (4) but you might actually pay the investors back because they were the one providing the money at the beginning.
The bright reader might realise by looking at the illustration, that the financial manager faces a few problems. One could be: how much money should you invest in the stand and in what should you invest in? (In this case the ice cream machine). That's an investment decision, or CAPITAL BUDGETING DECISION. The second, rather commonly asked question is, how are we going get the cash? That is called the FINANCING DECISION.
The capital budgeting decision is vital to a company's success. Almost always when you hear about a company having economical problems, it branches down to a failure linked to capital budgeting decision. Some of you might recall the construction of Disney Land Paris Theme Park at a cost of approximately $2B in the 1980's. They opened in 1992 and recorded a loss of nearly $200M in 1994. Whether to invest in the park or not is a capital budgeting decision.
So, the example of the ice cream machine in the lemonade stand and the theme park are both physical examples of capital budgeting decisions. However, not all capital budgeting decisions need to be physical ones. You might as well advertise for your lemonade stand or advertise for the park.
But in order to construct the them park, buy the ice cream machine or advertise, you need to raise the money needed. The cash won't simply pop up from nowhere even though you wish they would. A company might offer you to buy shares and in turn share the company's profits and/or offer you a fixed payment (for instance, dividend), etc. in this case you become a shareholder and in turn, as I mentioned earlier, a part-owner of the company. Long term financing in this context is often called capital structure decision and the market for this long term financing is called capital markets. In this case, the financial manager needs to be assured of that there's no big risks in these long term decisions. Examples of that might be a rapid change in dollar value, oil price, etc. I'll later on discuss how to find these risks.
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