Are You Financially Literate?

Financial literacy translates in so many ways to so many people. It is said to be the ability to make appropriate decisions when managing personal finances. It is also defined as the set of skills and knowledge that allow you to understand the financial principles you need to make informed financial decisions, and the financial products that impact your financial well-being.

Many people are taking on financial risks without realising it.

This definition allows us to identify key personal finance topics and behaviours that support financial success. Without this knowledge, a person is unlikely to pass any test of financial competency. Our checklist would include the ability to:

• Understand the key financial products you may need throughout your life, including bank accounts, mortgages, retirement savings plans, and basic investments such as stocks, bonds, and mutual funds.

• Understand basic financial concepts such as compound interest, investment return, risk, diversification, and so on.

• Discuss money and financial issues, even if you do not really like to talk about them.

• Make good financial choices that affect your everyday financial well-being throughout your life. For example, when getting an education, starting a job, buying a house, starting a family, preparing to retire, and living out your senior year.

• Respond competently to changes that affect your everyday financial well-being, including events in the general economy such as the recent collapse of financial markets, rising unemployment, and the threat of rapid inflation.

  
  

Financial Literacy is the ability to understand how money works in the world: how someone manages to earn or make it, how that person manages it, how a person invests it (turns it into more), and how that person donates it to help others. More specifically, it refers to the set of skills and knowledge that allow an individual to make informed and effective decisions with all of their financial resources. Raising interest in personal finance is now a focus of state-run programmes in countries including Australia, Canada, Japan, the United States, and the UK.

The Singapore government, through the Monetary Authority of Singapore, funded the establishment of the Institute for Financial Literacy in July 2012. The Institute is managed jointly by Money SENSE (a national financial education programme) and Singapore Polytechnic. This Institute aims to build core financial capabilities across a broad spectrum of the Singapore population by providing free and unbiased financial education programmes to working adults and their families. From July 2012 to May 2014, the Institute reached more than 34,000 people in Singapore through workshops and talks. Some of the topics covered in these workshops and talks include:

• The UK has a dedicated body to promote financial capability: the Money Advice Service.

• The baseline survey conducted 5,300 interviews across the UK in 2005.

• Many people are failing to plan ahead.

• Many people are taking on financial risks without realising it.

• Problems of debt are severe for a small proportion of the population, and many more people may be affected during an economic downturn.

Those under 40 are, on average, less financially capable than their elders.

Financial literacy is mainly about the ability to understand and interpret financial information. Financial information is the end product of the financial accounting process, which is made up of the statement of comprehensive income, statement of financial position, and statement of cash flow. This definition encompasses all human activities that warrant accountability. In a nutshell, financial literacy has the propensity to offer financial independence and supports stewardship reporting.

The added value in any human activity requires that one must appreciate the fact that the output of the activity must be greater than the input. This is replicated in financial information and is particularly reflected in the statement of income in terms of profit.

Statement of Comprehensive Income

The statement of income details information about the income or revenue of a business activity in relation to the expenses incurred in earning that revenue. The difference between these two variables (income versus expenses) should result in either a profit or a loss.

Knowledge of the above is crucial in terms of financial literacy. Understanding the statement of income enables an individual to ensure that his or her selling price is higher than the cost of the item, plus any other incidental or operational costs incurred with regard to the sale. Any contravention of this rule will lead to a loss, which is synonymous with financial illiteracy or is contrary to the principles of wealth creation.

Statement of Financial Position

The statement of financial position is a statement that details the assets and liabilities of a business entity at any point in time. An asset is any resource owned by the business entity that is used to generate revenue or income. A liability, on the other hand, is an amount owed to a third party. This is always indicative of the indebtedness of the entity, which must invariably be serviced. Failure to do so could lead to the collapse of the business. The statement of financial position also features the owner’s contribution, or seed money, used to start the business. This is referred to as capital.

To become financially literate, it is necessary to appreciate the importance of financial reports and to understand the elements of financial statements. It is also necessary to interpret them effectively within the context of the business environment, thereby aiding decision-making.

Interpretation of Accounts

It is said that “knowledge is power.” This statement should be qualified to say that “applied knowledge is power.” This is not an understatement; rather, it is applied knowledge that truly constitutes power.

Interpretation of accounts requires the comparison of items in the financial statements (the statement of financial position and the statement of income) in order to arrive at ratios that lend themselves to better appreciation and understanding.

Some of the immediate questions that any reader of accounts would seek answers to include a business’s ability to service its short-term debt when it falls due (liquidity).

Other enquiries border on management efficiency, long-term solvency, and shareholder returns on investment.

Profitability

The profitability of any business entity can be determined from its financial statements by working out the gross profit margin, net profit margin, or the return on capital employed (ROCE). The gross profit margin can be gleaned from the statement of income, whilst ROCE is determined from both the statement of income and the statement of financial position.

Liquidity

This information relates to the cash position of the entity. Liquidity is an assessment of the ability of the entity to finance its debts whenever they fall due. It is calculated by comparing the current assets of the entity to its current liabilities. This data is available from the statement of financial position.

Management Efficiency

The efficiency of management performance can be determined from the financial statements. This is achieved by calculating ratios such as the debtors’ payment period and the stock turnover period. The information provided indicates the effectiveness of credit control and stock management.

Long Term Solvency

This determines the capital structure of the entity. It is assessed by comparing the debt portfolio to the equity base of the business. This should indicate to the reader the long-term riskiness of the business as a result of borrowing money to finance investments.

Shareholders Return On Investment

Every investor in a capitalist economy is deemed to be interested in maximising his or her wealth. This objective can be translated into earning adequate returns on the investment. The typical means for assessing this performance is through ratios such as earnings per share (EPS), price-to-earnings (P/E) ratio, and dividends earned.

Financial literacy requires a basic understanding of accounting and the elements of financial statements, such as assets. An asset is any item that earns you a return. To this effect, your private car is, in real terms, not an asset. The same applies to your house if it is occupied by your family. On the other hand, a taxi cab or a rented-out property would qualify as an asset due to their income-generating capacities. This is a very straightforward explanation of an asset, but one that reflects practical business sense.

The architects and promoters of Financial Literacy Month in Ghana should not restrict the occasion to workshops solely on financial instruments and banking facilities. This opportunity should be broadened to include financial accounting, reporting, and financial management. Doing so would increase financial literacy and, in turn, lead to better business decisions, growth, and development.

(This writer is a financial and management consultant and an advocate of good corporate governance.)