Finance, banks and capital markets

Accounting records what has happened; finance is about decisions involving money over time: how much cash a business needs, where to get it, what to invest in and how to manage risk. This lesson introduces the finance function, cash flow planning and working capital, the time value of money, short-term and long-term financing, debt versus equity, the banking system and central bank, stock and bond markets, and a first look at evaluating investments with net present value.

The finance function

In a small business, the owner handles finance with help from an accountant and a banker. In a large company, a chief financial officer (CFO) leads a team that includes a treasurer, who manages cash, banking relationships, borrowing and risk, and a controller, who runs accounting, budgeting and reporting. The core questions of finance are: what long-term investments should the firm make (capital budgeting); how should it pay for them (financing and capital structure); and how should it manage day-to-day cash, receivables, inventory and payables (working capital management)? Behind all three lies one goal: increasing the value of the business for its owners while meeting obligations to lenders, employees and other stakeholders.

Budgets and cash flow forecasts

A budget is a financial plan for a future period. The operating budget forecasts revenue and expenses; the capital budget plans spending on long-term assets; and the cash budget, or cash flow forecast, predicts cash receipts and payments month by month. The cash budget is especially important for small and growing firms, because it shows in advance when the business will need to borrow and when it will be able to repay.

Working capital and the cash conversion cycle

Working capital is current assets minus current liabilities. Managing it well frees cash. The cash conversion cycle measures how many days cash is tied up between paying suppliers and collecting from customers: days of inventory plus days sales outstanding (how long customers take to pay) minus days payables outstanding (how long the firm takes to pay suppliers). A shorter cycle means less financing is needed.

Ways to shorten the cycle include holding less inventory, invoicing promptly, offering small discounts for early payment, following up overdue accounts and negotiating longer payment terms with suppliers, though stretching payables too far damages supplier relationships.

The time value of money

A dollar today is worth more than a dollar a year from now, because today's dollar can be invested to earn interest and because the future is uncertain. This idea, the time value of money, underlies loans, savings, investments and the valuation of businesses. With compound interest, interest earns interest.

Here PV is the present value, FV the future value, r the interest rate per period and n the number of periods. Moving money forward in time is called compounding; bringing future money back to today is called discounting.

Short-term financing

Businesses use short-term financing, repaid within a year, to cover seasonal needs and working capital. Trade credit, buying from suppliers on terms such as net 30, is the most common source. A line of credit lets a business borrow up to a limit as needed and pay interest only on the amount used, usually at a variable rate tied to the bank's prime rate. Other sources include business credit cards, short-term loans, factoring (selling receivables to a finance company at a discount) and, for large companies, commercial paper.

Long-term financing: debt and equity

Long-term investments such as buildings, equipment, acquisitions and research are funded with long-term debt, equity or retained earnings. Debt includes term loans, mortgages and, for larger firms, bonds: securities in which the company borrows from investors and promises to pay interest (the coupon) and repay the principal at maturity. Equity includes shares sold to investors and profits kept in the business. Each has trade-offs.

Using debt to finance a business is called leverage. When the business earns more on its assets than it pays in interest, leverage magnifies the return to owners; when it earns less, leverage magnifies losses. That is why heavily indebted companies are hit hardest in recessions.

Banks and the central bank

Canada's banking system is dominated by six large, federally chartered banks, the Royal Bank of Canada, TD, Scotiabank, BMO, CIBC and National Bank, alongside credit unions and caisses populaires, trust companies and other lenders. Banks are regulated under the Bank Act and supervised by the Office of the Superintendent of Financial Institutions (OSFI); eligible deposits are insured by the Canada Deposit Insurance Corporation (CDIC) up to $100,000 per category. The Bank of Canada is the central bank. It sets the policy interest rate to keep inflation near 2 %, which influences the prime rate and other borrowing costs. At the time of writing (October 2026), the policy rate has been 2.25 % since October 2025; the Bank held it in September 2026 and its next decision is due on October 28, 2026.

Banks act as financial intermediaries: they take deposits from savers and lend to borrowers, earning the difference between the interest they charge and the interest they pay. When the central bank raises its policy rate, bank borrowing costs rise, loans become more expensive and spending slows; when it cuts, borrowing becomes cheaper. For businesses with variable-rate loans or lines of credit, each change feeds directly into interest costs.

Capital markets

Capital markets are where long-term securities, mainly shares and bonds, are bought and sold. In the primary market, companies sell new securities to raise money, for example in an initial public offering (IPO). In the secondary market, investors trade existing securities with each other on exchanges such as the Toronto Stock Exchange (TSX), Canada's main senior exchange, and the TSX Venture Exchange for smaller companies, both owned by TMX Group, and on alternative trading systems. Securities regulation in Canada is provincial: each province and territory has a securities commission, such as the Ontario Securities Commission, and they coordinate through the Canadian Securities Administrators (CSA). The Canadian Investment Regulatory Organization (CIRO) oversees investment dealers and trading.

Share prices reflect investors' expectations of a company's future cash flows and the risk of those flows. Market capitalization is the share price multiplied by the number of shares outstanding. The price-to-earnings (P/E) ratio compares the share price with earnings per share; a high P/E usually means investors expect strong growth. Bond prices move opposite to interest rates: when rates rise, existing bonds with lower coupons become less valuable.

Evaluating investments: net present value

When a business considers an investment, such as a new machine, store or product line, it compares the cash the investment will bring in with what it costs. Because the cash arrives over several years, it must be discounted to the present at the firm's required rate of return, which reflects its cost of capital and the project's risk. Net present value (NPV) is the present value of future cash inflows minus the initial investment. A positive NPV means the investment is expected to earn more than the required return and add value; a negative NPV means it would destroy value.