How Finance Works

Based on an online lecture by Mihir Desai. Link

The world of finance has escaped by grasp from time to time. I have avoided it because it seems too complicated to understand. "Only special people understand finance and they have studied for years to get to that point," I thought. Therefore, I usually saw no need to learn finance. This was until I started building a startup and got to see that my understanding of finance was non-existent and I had no option but to learn it. I usually lament that I should have learnt finance in university or even high school. What was all that math about if it was not going to prepare me for the real world?

In this essay, I want think about finance, based on the insights I have received from the lecture by Mihir Desai, that you can find here. He is a professor at the Harvard Business School and Harvard Law School and he has written a book called How Finance Works. He dissects how it works today, why finance matters and how you can take advantage of the lessons to propel yourself in this new age of Investor Capitalism. I will use the main conclusions of his talk to discuss my thoughts and have fun with it. They are as follows:

  1. Finance is far more than money. It is about information and incentives and the biggest problem of modern capitalism (Conflict between the principal and the agent).
  2. The recipe for value creation emphasizes cash rather than profits, beating your cost of capital, doing it for as long as possible and growing
  3. Allocating capital is arguably the most important thing that managers do because we are stewards of other people's capital.

1. Finance is far more than money

When we think of finance, we think of money, cash and all those instruments that are associated with value in dollars, shillings and so on. When it comes to finance, we picture two entities, the person who has money and the person who wants money, the investor and the firm respectively. The smallest denominator of an investor is a household or an individual who has money in the bank. The smallest denominator of a firm is a small business that would like investment to grow their business or cover expenses. This is the simplest way to think about finance. The small business wants money and the household can provide money to the business, with the condition that the household gets their money back and with interest. The money invested is called the principal, the extra money added for taking the risk is called interest. From this view, we can use finance terms and call the household the principal and the small business is the agent.

There are many principals and agents in our economy and they are of varying sizes. The most important place where investment in companies takes place is the stock market. This is where principals and agents come together to trade stocks, based on the performance and future outlook of a company. However, you usually don't find households or individuals making trades in these arenas. You will always hear about investment banks, hedge funds, venture capitalist firms and private equity in this arena. They often send their employees to gather data, analyse and make decisions on what companies to invest in. Because of this, companies like Black Rock and JP Morgan are seen as white-collar criminals that suck money from the common man and plough it into making gambles in the stock market. From this activity, they make millions if not billions of dollars. They look like thieves in most people's eyes.

But what if I told you that they are solving a huge problem that most households with money cannot deal with or have time for?

The name of this problem is information asymmetry. As principal, you invest money into a business and entrust the managers with the responsibility of using this money to grow the business and give you a return on your capital. You want your principal with interest. However, you are not involved in the day-to-day activities of this business and therefore unaware of how your capital is being used. For all you know they could be spending it on penthouses in the Bahamas or paying for hookers to dance in their offices and party like it's 1999.

As a household who has things to do, you don't have the energy to follow-up or prove that such things are taking place. You need to take care of your children or get work done. However, you also want to ensure that you don't lose your money. No one likes losing money, especially if you are planning to use the money for something else like retirement. Therefore, the finance industry is the solution to the problem of following up with companies on how they are using investors' money. The principal entrusts the finance industry to keep a close eye on companies that have invested in and ensures that they allocate capital in the proper fashion. If a company is allocating capital well, the finance industry invests more money to maximise the principal's returns. If the company is allocating capital badly, they pull out their money from the business. This intricate dance is done by buying and selling of company stocks. This is why stock prices are so important, they are an indicator of what the finance industry thinks about the company's strategy on allocating capital and the future returns it could bring for an investor.

Finance is about information. Getting and analysing information about how well a company is doing and making a right decision. When you see this, it all makes sense why we have a huge machinery of financial analysts, advisors, fund managers and so on. Their daily job is learn about companies, analyse their activities and make decisions on how to allocate investor's money in safe and cash-positive companies that generate value. This is a very important job because not many people can do this kind of work. It requires a firm understanding companies finances, the projects that the company is embarking on, the net income from those projects, the defensibility and moat of that company in the market, the brand image of the business, the employee satisfaction, the legal disputes that the company is involved in and so on. All of this contributes to the longevity of the business and ultimately, the return on investment to shareholders, the finance industry and the households that have extra money to invest.

2. The recipe for value creation

I will attempt to explain 3 ideas from this section:

  1. The emphasis of cash over profits
  2. Beating your cost of capital
  3. Doing it as long as possible

Emphasis of cash over profits

From this point, I got the idea that if you have cash in the bank, you have more freedom in your business as you can fund new developments without external capital. The cash in the bank is known as free cash flow or working capital. Not sure which is which so we will ask ChatGPT.

**Q. What is the difference between free cash flow and working capital? **

*Free cash flow (FCF) is a metric used to measure a company's financial performance. It refers to the amount of cash a business has available after accounting for expenses and investments. FCF is important because it shows how much money the business can access without taking on additional debt or selling additional equity.

Working capital, on the other hand, is a measure of a company's liquidity. It measures the difference between current assets and current liabilities, which helps investors evaluate how well a company can manage its short-term obligations. Working capital is important because it indicates how well a company can finance its operations and fund day-to-day activities.*

From the lecture, free cash flow is the latest way that investors use to evaluate a business. Therefore, it means that having cash in hand to allocate to new developments, without the need for external investors, is crucial. For example, we can look at Apple, which is known to have a large store of cash, close to $130 billion. They have managed to grow this cash over time by doing the following

That means that Apple gets direct cash from customers but doesn't pay its suppliers immediately. It gets to accumulate large amounts of cash in the bank, which it can use to fund its own expansion, growth plans or research and development, before it pays suppliers. It is also not involved in the manufacturing on its phones, which makes it even less capital intensive. The core of Apple's business is their retail network of stores, the brand of their products, the access it has to customers and the wide range of patents that protect its technology. Simply put, it is a capital-light company with a lot of cash in the bank. Very powerful position to be in.

On the flip-side, we have a company like Netflix. Netflix has been spending a lot of money on paying film-makers to create original films. They have been making profits as they are leading the charge in the video streaming industry. They have pricing power, which allows them to increase prices in North America from $10 per month to $12. They can even keep increasing it as people are not likely to move to other streaming services any time soon, or at least they hope. They are also expanding to other continents like Europe, Africa and Asia and supporting local studios to produce.

However, Netflix is not a good business from a free cash flow standpoint. They lose a lot of cash by investing in local studios in different countries to produce movies and series. Their subscriber base has been shrinking as many consumers seek alternative streaming services or share accounts with their family and friends. In terms of cash, they are cash-intensive as they pay local studios or create long-term payment deals with guys like Dave Chapelle for copyright and hosting of their shows. Studios can charge a premium on copyright as they can now choose to host on Amazon Prime or Hulu. The streaming service industry is becoming a commodity, not a product. The product is increasing becoming content. Netflix is a cash-intensive business that has little cash in the bank. Their position is becoming weaker day by day and I have seen it. Recently, my aunt subscribed to Amazon Prime and Showmax. We now have three streaming services when it was only one previously.

Beating your cost of capital

I am now writing myself to end of thinking capacity but I will attempt this concept as gruesomely as possible. Let's ask ChatGPT again, which you can find at AI Conversation on Cost of Capital

From these conversation with ChatGPT, we can say that cost of capital is important to both the investor and the company. If the investor puts money into a company, they want to get a rate of return on their investment like 20%. This means that a company has to use that capital to fund a project that can return more than that, let's say 40%. This means that the company can pay for the project's associated expenses, pay administration costs and ultimately give 20% of the returns to the investors. Everyone is happy in this situation. However, if the project doesn't go well and the rate of return is 10%. The company has to use it's own cash to pay expenses, pay investors their rate of return and call the project a loss in their books. To cover the loss, they need to raise external funding, get debt or get a project that can pay off itself and the previous loss-making project.

I hope I didn't butcher this concept but I am confident I got it right to a degree.

Doing it as long as possible

The saying goes that you can make money investing, not by timing the market but by time in the market. Time in the market is your best friend. A long-term investment strategy means that you have invested your capital in a company or portfolio of companies for a long period of time, by reinvesting or holding the associated company stocks. The best strategy is to use the returns on capital to buy more stocks in the company in question.

By doing it as long as possible, you are looking at it from the investor's perspective. This means that you have to look at the factors above like the free cash flow that the company has and the efforts that the company is making to beat the cost of capital that you are putting into the business. If both these things are looking good, where they have large amounts of cash to deploy and projects that are making good returns over the returns on your capital, you can continue investing more into the business for a longer period of time like 10 years, 20 years or even 30 years. The compounding effect, you reinvesting the principal amount and interest gained from the rate of return, can make you a large amount of money. You will be swimming in it in the next 20 years. You can then sell off the stocks and enjoy that sweet cash.

Time is your friend, use it as an investor.

As a company, you need to ensure that you have cash in the bank to allocate to profitable projects. This requires being on top of your game in product and process innovation, branding and market positioning, patents and moat-building to ensure your pricing power goes unchallenged and being able to collect cash immediately and choose when to spend it without pressure. This brings me to the next point.

3. Allocating capital is the most important thing that a manager does

As someone who is running a business, you are a steward of the capital of your investors. They want to see a return on their investment and they will come to you when things are going well or badly. As a manager, you believe that managing your company well is about culture, processes, policy, profits and product innovation. To the investor, these are good things but they could care less about them. To them, the capital they have invested is their main priority. They are clear of this and what to see a major return in their investment, which will see them get massive returns when they sell their ownership in your company. To understand this idea, we can look to the Bible for guidance. The parable of the 3 servants is a great one. We all know the story but for those who don't, we can ask ChatGPT to summarise because I am too lazy to type it out.

Q. Narrate the parable of the 3 servants by Jesus in the Bible?

In the Bible, Jesus tells a parable about three servants who were given different amounts of money by their master before going on a journey. The first servant was given five bags of gold, the second two bags, and the third just one bag.

When the master returned from his journey, he asked each servant what he had done with his money. The first servant said that he had invested his master’s money and earned five more bags of gold. The second said he had also invested his money and earned two more bags.

The third servant confessed that he was afraid of losing his master’s money, so he hid it in the ground and brought it back to him unchanged. The master praised the first two servants for their hard work and shamed the third servant.

From this story, which has been horribly summarised, we can see that the servants are very similar to the managers of modern companies. They are put in charge of the day-to-day activities of a company and are tasked to come up with projects that can bring a return to the owners of the company, who are the investors. The investors put in their capital and the managers use the capital to fund projects that can make a profit that can go back to investors or get ploughed back into the business.

The most important skill that a manager needs to learn is how to allocate capital to projects that have the best return on investment. Management of the companies activities is a means to this end.


I have definitely learnt a lot from this video and writing has allowed me consolidate the information I have received. Finance is clearly a subject that managers, founders and investors should be keen on understanding. As I build Shukran, a digital tipping platform that ensures the most deserving service workers are rewarded, I will take into account these learning and see myself as a steward of investor capital. The business I build is required to have a rate of return that is favourable to both investors and the company itself. The amount of money that we have in cash is very important as it can allow us to embark on new projects without seeking external capital from investors. We should also be looking to fund the projects with the best returns by looking at higher margin businesses we can create, new markets we can explore and so on.

What a great introduction to finance!