Chapter 2: Basic Ideas of Finance

Assets

Resources that can be used to create future economic benefit, such as increasing income, decreasing expenses, or storing wealth, as an investment.

Income

Earnings of a given period. In the case of an individual or household, this is generally cash from wages, interest, dividends, or assets (such as rental income from real estate) that can be used for consumption or saved.

Selling Labor

Working, either for someone else or for yourself

Selling Capital

Means investing: taking excess cash and selling it or renting it to someone who needs access to cash.

The two fundamental ways of earning income in a Market economy

Selling labor and selling capital

Liquidity

Nearness to cash, or how easily and cheaply—with low transaction costs—an asset can be turned into cash.

Commodity

A fungible, standardized good used in commerce, where the market treats all instances as nearly identical regardless of who produced them.

Expenses

The costs of consumption or daily living.

Budget Deficit

A shortfall of available funds created when income is less than the expenses.

Budget Surplus

An excess of available funds created when income is greater than the expenses. 

Opportunity Cost

The cost of sacrificing the next best choice because of the choice made; the value of the next best choice, which is forgone once a choice is made.

Sunk Costs

Costs that have been incurred in past transactions and cannot be recovered.

Capital Gain

Wealth created when an asset is sold for more than the original investment.

Capital Loss

Wealth lost when an asset is sold for less than the original investment.

Equity

An ownership share in an asset, entitling the holder to a share of the future gain (or loss) in asset value and of any future income (or loss) created.

Cost of Equity

The cost of having to share the benefits—capital gains or income (dividends)—from the investment.

Risk

In finance, the probability that the value of an asset, income, or investment may decline in the future.

Debt

Borrowed capital, a liability, a loan that must be repaid.

Interest

The cost of debt expressed as an annual percentage of the principal.

Cost of Debt

The cost of borrowing capital because of having to pay interest on the principal.

Principal

The original amount of borrowed capital (a loan).

Diversification

The strategy of reducing risk by spreading income and investments among a number of different kinds, sources, and locations.