Understanding what’s happening in the financial world is difficult because the jargon, but that doesn’t mean you have to be left out of the equation. Here are eight financial terms you should know if you’re managing money. Study them, learn them, and have them at your disposal for when you’re working with finances.
Net worth is essentially what you get when you subtract liabilities from assets (or what you owe from what you own). It can apply to a variety of financial situations. For instance, if you’re assessing a company for your stock portfolio, you’ll likely glance at its balance sheet to find out its net worth. Balance sheets highlight assets (cash, inventory, and receivables) and liabilities (debt and accounts payable). To get the net worth, you subtract the latter from the former.
There’s more to inflation than the commonly used definition: prices rising over time. Inflation is essentially about purchasing power, measuring the purchasing power of U.S. currency by tracking prices changes of the items people buy. National banks try to keep inflation under control by implementing policies and actions that regard things like the interest rates. Many hope for an annual inflation rate of no more than about 2 to 3 percent.
In its simplest terms, opportunity cost is what you lose to achieve something. For example, imagine hoping to become a doctor or a pilot. If you decide to become a pilot, you lose the experience of being a doctor and everything that goes with it. That’s the opportunity cost of becoming a pilot. Opportunity cost is also defined by the highest-value opportunity forgone.
Supply and Demand
In economics 101, the law of supply and demand influences market prices. If supply of an item is plentiful, then it’ll pressure the price of it to decrease. If the supply of an item is scarce, then it’ll pressure the price of it to increase. If you’re the only one selling a specific item in your area, it gives you pricing power since consumer don’t have anywhere else to buy it. But if other people in your area start selling the item, you’ll have to lower your prices to keep customers coming back.
Sunk cost refers to the money that has already been invested into something and can’t be recovered. For example, if you spend $50 on a non-refundable ticket to a concert but a friend invites you to his or her house at the last minute, that $50 becomes a sunk cost. Whether you decide to go to the concert or not, the ticket has already been bought and the money you spent for it doesn’t know if you attended or not. In the end, you should do whatever you like.
An annuity is a contract between a person and an insurance company; the person gives money to an insurance broker who promises to pay the money back in the future with interest. Annuities are important because you can either supplement your other retirement savings with tax-deferred annuities or add to your retirement income by receiving variable annuity guarantees for a fixed period of time for the rest of your life.
The meaning of “cash flow” depends on the context it’s used in. For example, in the accounting world, it refers to how much cash a company has over a specified time period. If the amount of cash a company has increases during that time, it’s exemplifying a positive cash flow. If it decreases, it’s a negative cash flow.
When people examine companies to see if they’re a good fit for their portfolio, they may take “free cash flow” into consideration. This reflects a company’s cash flow after its expenses have been paid.
Risk and Return
In simple terms, when it comes to finances, risk involves losing your money and return involves earning it. Although this is easy to understand, many people don’t comprehend the relationship between the two, which is represented by a trade-off. In general, the more risk you’re willing to take the greater return you can expect if your investment pans out. Risky investments can include a variety of stocks, including penny stocks that often looked at with great potential.
On the hand, if you take less risk, you’re usually not going to make a lot of return immediately. These investments tend to be made in savings accounts and government bonds.
Remembering eight terms is hardly enough to navigate your way through the financial world, but it’s a start. What other terms do you think are important? Leave a comment and let us know below.