Introduction to Finance Questions and Answers [With PDF]

Every business, family and government needs money, and needs to decide where to get it and how to use it. That is finance. This chapter covers what finance is, its types, the three financial decisions, the main principles of finance, and why modern firms aim at wealth maximization, not just profit. Here are 25 important questions with clear answers and tables, ready for exams, vivas and job interviews.

This is Chapter 1 of our Finance course. Continue with Time Value of Money afterwards.

Meaning, Functions and Types of Finance

Q1. What is finance?

Finance is the management of funds: deciding how much money to raise, from which sources, and how and where to invest it to earn the best return. A business needs funds to buy machinery, raw materials, pay wages and run its day-to-day activities, so it must collect and use funds in an organized way to keep production running without interruption.

Q2. What are the functions of finance?

1. Raising (collection of) funds
2. Capital budgeting decisions (long-term investment)
3. Management of short-term assets (working capital)
4. Distribution of funds (dividends and retained profit)

Q3. Why is finance called the main driving force of a company?

Without trade and commerce, a country’s economy cannot function, and every business activity needs money. A new business needs large sums to start production, marketing, distribution and hiring, and an established one needs funds to expand and to meet daily costs. Because everything depends on having adequate funds at the right time, finance is called the driving force of a business.

Q4. What are the types of finance?

Business, personal and non-business finance together are sometimes called private finance, as opposed to government finance.

Q5. What is personal finance?

Personal (or family) finance is how an individual or household earns, spends, saves and borrows money to meet day-to-day needs. Funds come from income, family, or a bank loan. Because money is limited, it must be used to bring the greatest satisfaction. If income is more than current spending, the surplus becomes savings that can be invested, while overspending leads to debt.

Q6. What is business finance?

Business finance is the raising and use of funds by a business to carry out its activities and earn a profit. Funds come from internal sources (retained profit) or external sources (shareholders, lenders). It covers financial planning, applying financial techniques and reviewing the financial performance of the business.

Q7. What is non-business finance?

The finance of organizations that exist for social welfare, not profit. They collect, use and control funds to serve people. Examples: schools, hospitals, libraries, orphanages, welfare societies and the Red Cross and Red Crescent. Their funds come from donations, grants, fees and government support.

Q8. What is international finance?

International finance deals with money flows and transactions between countries: exports and imports, foreign investment, exchange rates and the balance of payments. Because countries use different currencies, trade between them needs a system for exchanging currencies and settling payments.

Q9. What is government finance?

Government finance covers how the central and local governments raise revenue (taxes, fees, borrowing from home and abroad) and spend it on public services and social welfare. The government first decides its spending needs and then finds the revenue. Unlike a firm, a government is not wound up in the same way as a bankrupt company, but it can still default on its debts if it borrows too much.

Q10. What is the importance of business finance?

• It helps the owner gather the funds required at the right time and use them properly.
• A sound financial plan ensures efficient use of funds through good investment decisions.
• Good financial management gets funds from cheaper sources and earns an adequate return.
• It supports the country’s overall economic development.
• It pays for current expenses needed to earn revenue.
• It funds growth and expansion.
• It helps the business face unexpected risks.

Principles and Decisions of Finance

Q11. What are the principles of finance?

1. Liquidity and profitability
2. Risk and return
3. Portfolio diversification

Q12. What is the liquidity and profitability principle?

Liquidity is the ability to pay short-term liabilities when they fall due. A firm can hold its money as idle cash (very liquid but earning nothing) or invest it (earning a return but less available). Too much cash lowers profitability, and too little cash risks not being able to pay bills. The financial manager must balance the two, keeping enough cash for daily needs and investing the rest.

Q13. What is the risk and return principle?

Risk is the chance that the actual return will differ from, and especially be lower than, the expected return. There is a positive relationship between risk and expected return: investments that carry more risk must offer higher expected returns to attract investors, though a higher return is not guaranteed. The extra expected return for taking on extra risk is the risk premium. Example: private company shares usually offer a higher expected return than government securities, and carry more risk.

Q14. What is the portfolio diversification principle?

A portfolio is a collection of investments. Diversification means spreading money across several projects or assets instead of putting everything into one, so that the poor result of one is balanced by the good result of another. It reduces diversifiable (unsystematic) risk, the risk specific to one business or asset. It cannot remove market-wide (systematic) risk. Harry Markowitz developed modern portfolio theory in 1952.

Q15. What are the three major financial decisions, and what does a financial manager do?

The financial manager is the person who raises and uses funds, plans cash flow, manages these three decisions and tries to maximize the firm’s value.

Q16. How has finance evolved?

Profit Maximization and Wealth Maximization

Q17. What is profit maximization?

Profit maximization means making the largest possible profit, the excess of revenue over costs, from the firm’s activities. It can mean producing the most output from given inputs, or the same output from the least inputs, and it is often measured by earnings per share.

Q18. What is the logic behind profit maximization?

1. Profit is a measure of the efficiency of a firm.
2. It can be achieved only by using economic resources efficiently and cutting waste.
3. High profits attract investors. More investment raises output and can lower prices for consumers, which increases social welfare.

Q19. What are the criticisms of profit maximization?

1. The concept is vague: it is unclear whether it means short-term or long-term, before or after tax.
2. It ignores the time value of money.
3. It ignores the risk of future income.
4. It does not consider all the cash inflows and outflows of the business.
5. It can encourage narrow, short-term interests, such as cutting quality or cost on staff.

Q20. What is wealth maximization?

Wealth maximization means increasing the wealth of the shareholders by increasing the market value of their shares. It was developed because profit maximization could not overcome the weaknesses above. In practice, a project adds wealth when its net present value (NPV) is positive: that is, the present value of its future cash inflows exceeds its cost. Example: a project costs 100 and its cash inflows are worth 130 today, so NPV = +30, which adds 30 to shareholder wealth.

Q21. Why should wealth maximization be the firm’s main goal?

1. It takes the time value of money into account.
2. It is a clear, well-defined goal.
3. It accounts for the risk that expected cash flows may not be received.
4. It supports a sensible dividend policy for shareholders and the company.
5. It focuses on the market price of the shares.
6. It considers all cash flows from all projects.
7. Its aim is to raise the market value of the share, and to sustain it over the long term.

Q22. What role does finance play in social responsibility?

Businesses exist to earn a profit, but they also contribute to social and economic development. The main goal of financial management is to increase shareholders’ wealth, which itself serves society when it is pursued honestly: it creates jobs, pays taxes and supports growth. A financial manager has social responsibilities too: to act ethically, treat investors, lenders and customers fairly, report honestly, avoid harming the environment and balance short-term profit with long-term welfare.

Q23. What are the differences between wealth maximization and profit maximization?

Q24. What is the difference between business finance and government finance?

Q25. What are the money market and the financial market?

Quick Revision Points

• Finance = raising and using funds. Three decisions: investment, financing and dividend.
• Principles: liquidity vs profitability, risk vs return, portfolio diversification.
• Higher risk means higher expected return, not a guaranteed return.
• Wealth maximization considers time value and risk. Profit maximization does not.
• Money market: short-term. Financial market: short-term and long-term.

Test yourself with the chapter quiz below, then continue to Time Value of Money.