Prework Module 1: What is Money?

June 13, 2022

Overview

This module provides an introduction to the concepts of value, money, and financial statements.

Module Objectives

By the end of this module, you will be able to:

Define value, and money, and how they differ from currency
Identify the major features of money
Identify the differences between commodity, representative, fiat, and crypto money
Identify the three major types of financial statements reported by public companies

Reading: Money and Value

To understand what money is, we first need to define the concept of value, which is the perceived benefit derived from a good or service. For example, one may value apples for their intrinsic capacity as food. Money is a way in which we can measure value, and serves three main functions:

Unit of account: Money can serve as a direct numerical measurement of value for a good or service, acting as a standard description of value.
Medium of exchange: A useful form of money is accepted by a large number of participants in a market.
Store of value: Money should “generally” be stable, relative to most of the goods and services it is exchanged for.

We refer to physical money as currency. Historically, money has taken many different forms, including precious metals, gems, and seashells, which we refer to as commodity money. Later, we began to create money representing discrete portions of those commodities, which we call representative money.

Most countries have moved away from representative money in favor of fiat money, which derives its value only from a government promise to back its value. While fiat money has no intrinsic value, it is beneficial as a medium of exchange within a country. For more on this topic, investigate the Breton-Woods System and Nixon Shock.

Even more recently is the development of cryptocurrencies, which derive their utility as money from highly secure networks of computers solving difficult math problems. Cryptocurrency emerged largely as a response to the Great Recession of 2008, where governments printed a glut of new money, thus causing a fall in value due to the excess supply. While this effort was needed to jumpstart the global economy, it had the side effect of sowing doubt in the ability of governments to effectively manage the value of their own currency.

Most currencies also have three other useful properties:

Fungibility: Each unit of currency is interchangeable.
Scarcity: Currency is not easy to create more of, and generating more can debase its value.
Portability: Currency is easy to transport and exchange between parties.

Student Activity: Phone a Friend

See instructions in activity file.

Reading: Financial Statements Used in Accounting

A company is a group of people that are working together to create something of value. Companies can be public or private, with public companies being ones in which ownership can be purchased on an exchange. Both are regulated by their industry, type, and scale by different departments of government. They raise financial capital through various means in order to provide goods or services. The two main fundraising vehicles are the issuance of bonds (selling debt, equivalent to taking out a loan) or selling shares (selling equity/ownership in the company). Smaller companies such as startups generally raise money through seed, angel, or venture capital (VC) investment.

Regardless of size, all companies require accounting, which is the practice by which governments, companies, and organizations measure their financial state. As a company grows, it is subject to stricter accounting standards, and public companies are required to report their accounting every year through official 10K (annual), and 10Q (quarterly) reports.

Accounting reports generally require three documents: the balance sheet, the income statement, and the cash flow statement. (However, there is far more to learn in a full accounting course!)

A balance sheet is a statement of who owns what capital, in the form of assets and liabilities. It tracks this fundamental accounting equation: Assets = Liabilities + Equity. Assets are the physical, and nonphysical, resources owned by the company that add a positive value to the balance sheet. They include things such as cash, real estate, and copyrights. Liabilities are similar to assets, but are resources that add negative value to the balance sheets. These are items such as loans, wages owed, or the purchase of another company. Finally, equity is what remains if/when all of the company’s assets are sold, and debts are paid off (i.e., Equity = Assets – Liabilities).

As an example, let’s say you purchased a home worth $200,000, and took out a loan for $160,000. Your equity in the home would be the $40,000 down payment. If the value of the house were to increase over the loan period, your loan would be contracted to a specific value, thus increasing your equity. For those interested, there is also an expanded accounting equation that takes into account other features of a company’s balance sheet.

An income statement is a statement of the total revenues and expenses for the company. It is also often referred to as the P&L (pronounced “P-N-L”) statement. Where the balance sheet tracks all of what the company owns, as well as who owns it (i.e., assets and liabilities), the income statement tracks the company’s performance in terms of money made (or lost!).

In the income statement, it all boils down to net income, which equals revenues (money made from selling things), minus expenses. Expenses for a company include typical things like the costs of purchasing from their suppliers (categorized as “cost of goods sold”), salaries, and employee compensation (categorized as “general and administrative”), or real estate lease costs. For firms that borrow (and thus have debt on the balance sheet), they also have to subtract the expense of paying interest on those loans. There is another expense known as depreciation, but this is an accounting concept that we don’t need to visit in detail (basically, it’s an expense whereby you subtract out the costs of buying large equipment or real estate over time, rather than all upfront. This has to do with tax rules).

The income statement gives investors a “bottom line” answer as to whether the company earned (or lost) money, and if so, how much. For that reason, the income statement is often used in what is known as fundamental analysis, which we will discuss in a later section. We will often calculate the earnings-per-share (EPS) by dividing the total earnings of the company by the number of shares available.

The third and final statement, the cash flow statement, is used to understand the short-term viability of a company through demonstrating how changes in the balance sheet and income statement affect cash coming into and out of a company. In general, one can derive a cash flow statement from the combination of the balance sheet and income statement. The three major parts of the statement are: the cash from operating activities, investing activities, and financing activities. For more on cash flow statements and what is contained in those activities, check out the Investopedia page.