Financial Concepts Examples: Real-World Applications Everyone Could Use

Is financial literacy important?

These days, trying to understand basic financial terms (and basic concepts of the finance world) can feel like you need a full-fledged degree. If you've even tried investing, or even looking up the best savings account so you can take advantage of some compound interest over time, you might feel like an outsider, like you don't belong.

But that is a lie. Financial literacy is for everyone. And you belong in the world of finance as much as you want to. All of us have to consider our financial well-being. Understanding financial concepts empowers us to make wise decisions for our futures.

Finance concepts will help you understand simple interest vs. compound interest, how to invest or even read about the securities and exchange commission, how to build up your working capital, what percentage amount of your income you should be saving and more.

Financial knowledge can be applied in the business world and in your personal finances.

During the first week of my finance courses, I tell my students that they will not remember everything I have taught them throughout the course. But I also say, that they’ll learn to ask questions in order to make sound financial decisions.

As an example, I'm going to share about Corey, one of our business students. He was apprehensive when starting the finance course. He thought that the course would mostly involve solving math problems. After his first week in the course, he realized how he could use finance in real life.

Gaining financial literacy is crucial for those looking to become a successful entrepreneur, for those who want to make the most of their investments, for those who want to avoid financial scams, and for anyone looking to improve the state of their finances.

Isn't that pretty much all of us?

Concept #1: The time value of money in real life

In week two of the Principles of Finance course, students learn about how time value of money is the most important concept in finance. This is how our money grows. A dollar today is worth more than a dollar tomorrow, due to inflation. Some people choose to invest their money, so it has the potential to grow in the future.

You can use time value money calculations to…

• Plan personal and business finances
• Evaluate alternative investments
• Solve problems involving savings, annuities, loans and mortgages

Many students find they had been using time value of money for years, but did not realize it. For instance, auto loans, credit cards, mortgages, retirement accounts and investment accounts are all based on time value of money concepts.

Students can apply these concepts to manage their own money. For example, Corey was looking to determine how much he could earn in a high-yield savings account after five years if he invested an initial amount of $10,000 today that earns 5% interest compounded annually.

Solving for the future value (FV) shows that he will have $12,762.82 in the account at the end of five years. He can then play around with the numbers to find out how much he will earn in the account if he initially put in a larger amount such as $15,000.

Concept #2: The value of financial statements

Companies primarily produce three types of financial statements.

• Balance sheets
• Income statements
• Statements of cash flow

These financial statements are used by people internally and externally. Internal managers are responsible for the profitability of the company. They use the income statement to keep track of their own performance in growing the firm's profits and maximizing shareholder value. Based on this knowledge, they find ways to increase revenues and decrease expenses.

Analyzing financial statements is also a useful way to navigate investments. External investors assess these statements to evaluate the potential returns and risks associated with an equity stake in the operation.

They primarily keep an eye on the statement of cash flow. This statement tracks cash inflows and outflows for the company. It’s needed because the income statement does not provide a full picture of cash receipts and expenses.

Creditors analyze the balance sheet to assist with decisions about approving and denying loans. Their main concern is determining the company’s ability to repay its debts. The balance sheet is categorized by…

• Assets: What the firm owns, such as property, a plant or equipment
• Liabilities: What the company owes (both current and long term)
• Equity (also called net worth): This figure is calculated by subtracting the total liabilities from the total assets.

In the finance class, students realize they can use these types of statements for managing their personal finances. For example, Corey created a household budget, and each month he reviews it to find areas where he can lower expenses. This entails calling around and comparing quotes for various services to find the best prices.

Corey also has a few stocks in his investment account. He wants to make sure the companies in his portfolio are financially stable. As an investor, he needs to analyze the cash flow statements to see how effectively each company is using its cash. It’s not good for a company to have too much cash on hand, and it’s also bad for them to have too little cash on hand.

He sees one of the company’s statements detailing a very low amount of cash on hand compared to their overall revenue. After reviewing the past few statements, he also notices that their net increase in cash amount has been decreasing over time. This is cause for concern.

He considers selling his shares in the company and reinvesting in another company to help meet his financial goals.

In addition, Corey is considering applying for a personal loan to help him pay off some of his credit card debt at a lower rate. He has consistently paid his credit card bill on time for three years. Through this process, he learns about factors lenders consider when borrowing money.

As part of the application process, the bank will...

• Ask for a list of assets and liabilities. This information helps the lender determine if he has enough collateral available to pay back the loan.
• Review how much debt he currently has. A low debt-to-income ratio is helpful.
• Check his credit score. The lender needs to know that he has a good track record of paying his debts, so they check out his credit history with the credit card company and other creditors.

Concept #3: Business financing options

If you’re considering opening a business, one of the most important decisions you’ll make will be about how to finance the firm. This is referred to as the capital structure decision. You may choose to finance the company with debt or equity.

Factors to consider when funding a business include…

• Current financial obligations
• Current economic conditions
• Amount of money needed
• Future growth opportunities
• Ability to meet current and future financial obligations

The finance courses help students with understanding the advantages and disadvantages of debt and equity financing. There are many funding choices such as grants and crowdfunding that may be available.

For example, let’s say a restaurant owner has been in business for five years. He’s interested in opening a second location and needs additional funding. His business financing options include debt financing or equity financing.

Since he already has a business loan that is almost paid off, he is considering applying for another loan. He has been making his payments on time, and it has positively affected his business credit history. Having good credit will enable him to get a good rate on another business loan to finance his expansion plans.

Concept #4: Understanding cash budgeting

Understanding the cash budget of a company helps you to…

• Determine a firm’s financial stability
• Calculate revenue projections for the business
• Predict how a current decision can affect the future value of the firm

Cash is king in the business world. Business owners cannot focus only on profits. They have to ensure they are effectively managing and utilizing their cash flow, or the profits will not benefit the company in the long term.

A cash budget allows the company to predict shortages and surpluses of cash. They must ensure the company has enough cash flow to sustain them during slow seasons and changes in economic conditions.

It’s actually not good for companies to have too much cash on hand. This may seem counterintuitive. If cash is king, how can too much cash be a bad thing?

While the business will need a certain amount of cash for emergencies, large sums of cash should be invested back into the business.

The same goes for managing money in a household. You need to not just consider your income—but also how to make the most of your money in the long run. For example, it’s prudent to set aside a few months of living expenses in case of an unexpected expense. Then it’s advantageous to invest the other cash to help reach your retirement and other financial goals.

Financial literacy is good for everyone

Overall, our everyday lives revolve around financial concepts. Money is needed for everything we do. Even the quality of our healthcare depends on our finances.

It's not just business students who can apply these concepts in their real life. All of us should gain financial literacy so we can make wise choices and ultimately reach our financial goals.

If some of the concepts in this article were making your head spin, it might help to start with defining some financial terms. These terms can help you navigate the world of investments and financial statements. Discover 55 Financial Terms to Know Before Investing.

Or, if you were nodding along to lots of this, finance might be a language you are ready to dive deeper into. If that’s the case, have you ever considered making finance part of your education or career goals?

Check out 9 Signs You Have What It Takes to Major in Finance to see if it might be for you.