The money maze

There are basically four main groups of entities involved in the exchange of money on a daily basis: households, financial institutions, businesses and the Government. These entities play more than one role in the economy. For example, as a consumer, a florist falls into the household category. However, a florist is also a business.

Households

Households are individuals. They are consumers of goods and services sold by businesses. Many of them are at the same time, workers in business or governmental establishments. They receive salaries and bonuses from their employers and spend on goods and services they consume and on taxes to the Government.

Excess income earned by households is (usually) deposited with the banks as savings. Some households also purchase life insurance policies from insurance companies. This is also a form of savings which benefits the policyholders and/or their families when an unfortunate or unanticipated event occurs. Some individuals also invest directly in the capital market by purchasing shares, bonds and other investment products like unit trusts. (For more information on capital markets, see Industry-Related>Law>Capital markets)

Businesses

Businesses are commercial enterprises largely made up of manufacturers (like clothes, food etc) and service providers (cinemas, cell-phone operators, satellite TV). Businesses invest heavily in capital assets like land, buildings, factories and equipment. Businesses also employ workers (from the household category), paying them salaries, part of which flows back to the former when the latter consumes goods and services. Huge volumes of monies also change hands daily among business entities themselves in meeting their operational needs.

Profitable (sometimes even the unprofitable) businesses pay taxes to the Government and deposit funds in excess of their requirements with banks. Businesses requiring funds for expansion raise money from banks in the form of loans, or issue shares and bonds in the capital market. This then involves the evaluation of the business' financial status and operations, which is elaborated in the later part of this article.

Government

The Government spends on infrastructure developments and public services. It awards contracts and concessions to businesses to carry out these tasks. It also spends on subsidies to reduce financial burdens of businesses and households on selected types of expenditure (for example medicine, fuel and public transport). All these involve the flow of monies from the Government to households and businesses.

The Government is also a big employer. It pays salaries and pensions to its employees, all of whom fall into the household category.

To finance its public spending, the Government collects taxes from both households and businesses, and charges for certain public services it renders. Apart from this, the Government also raises funds from the issuance of government bonds and sometimes, the sale of assets. The bondholders, largely financial institutions, receive coupon (interest) payments periodically, on top of the principal amounts upon maturity.

Banks and financial institutions

Banks and financial institutions are also businesses. As financial intermediaries, they facilitate the flow of money from entities with surplus funds to those that are in need of funds. In a healthy financial system, these institutions meet the funding needs of the borrowers while offering security to the depositors.

The monies pooled by the financial institutions from deposits and insurance premiums are largely 'reinvested' as loans, or in bonds or shares in the capital market. The financial institutions also invest in government bonds.

While the bulk of the funds go to finance business enterprises, some flow back to the households to facilitate their purchases of capital goods, such as houses and cars. In addition, it also finances purchases of consumer goods, normally in the form of credit cards and personal loans.

Part of the profits made through this process is shared with the depositors as interest.

Other - Accounting and other professional services firms

In the decision making process related to investments and loans, financial institutions and investors rely on information generated by businesses. This financial information must be complete and reliable to facilitate good decisions. For this information to gain credibility, it needs to be verified by an independent and qualified party.

This role is normally undertaken by accounting firms which normally have large audit divisions that perform audits, financial investigations and due diligence reviews. This would involve evaluation of the accuracy of a business' financial statements and information.

In addition to accountants, businesses also require professionals to advise them on tax and other matters. This is where tax, management and other consultants and analysts come into the picture.

In a healthy economy with an efficient financial system, investors have readily available information to decide on where to invest their excess funds. In such a system, even consumers make well-informed decisions. The direction and measure of the overall flow of money is then the composite sum of all decisions made by each consumer, business and investor.

The flow of money through all these entities is continuous, although with varying patterns. It is a giant cycle between the major groups, with many smaller sub-cycles between numerous participants in the whole economy. The direction of the net flow of money depends on the state of the economy as a whole. For example, if the economy were to slow down, consumers would be more wary of their spending, and may purchase fewer goods and services. Instead, they would save more. Businesses would be less likely to invest in an expansion. The banking system will be flushed with cash with more deposits than the loans they are willing to extend. All these would have further repercussions on the economic and money cycle, but the cycle still goes on.

© GTI Specialist Publishers. Reproduced with permission.