Financial Instruments: Overview, Types, Classification
A financial instrument is a contract between different parties that has a financial value.
A lot of people face difficulty in understanding the concept of financial instruments because they can either be made, traded, settled, or changed over time as per the requirements of the involved parties.
In this article, we will discuss the basics of financial instruments, along with their types and classifications. Keep reading to learn more.
Two Major Types of Financial Instruments
In simple terms, a financial instrument is an asset that holds certain capital value and can be traded in the market. Different types of financial instruments need to be considered in procedures like financial instruments valuation and business valuation in Malaysia.
Generally, financial instruments can be divided into two major categories:
1. Derivative Instruments
These instruments are the ones that are derived from underlying entities like interest rates and assets.
The exact value of these financial instruments can be derived according to the performance of the underlying component. Derivative financial instruments are also associated with securities such as bonds and stocks.
2. Cash Instruments
The financial instruments that can be transferred and have a specific value in the market are called cash instruments. Some of the most popular examples of cash instruments are loans and deposits, where lenders and borrowers must agree upon the terms.
Differences Between Debt and Equity
Before diving into the further classification of the financial instruments, it is important to be familiar with the major differences between debt and equity. Both of these instruments have a direct impact on the calculation of the gearing ratio that is used to measure the financial risk of a business.
Moreover, the distinction between debt and equity also affects the business valuation procedures used to measure profit and other financial costs and liabilities.
When a company is raising finance, an instrument is considered a financial liability instead of being considered an equity instrument. Therefore, the issue of a bond results in a financial liability for the company, while the issue of ordinary shares will create an equity instrument.
It is also possible that an audit firm in Malaysia uses a single financial instrument that deals with both debt and equity elements. One of the major examples of this is a convertible bond that includes an embedded derivative with the option of converting to shares.
Dealing with such complex differences and financial instruments can be challenging, so it is better to rely on professional audit firms that can handle business valuation in Malaysia.
In this way, you won’t have to worry about handling complicated financial instruments valuation procedures yourself.
Further Classification of Financial Instruments
There are various other types of financial instruments that vary based on the company and the specific industry in which a business is operating.
Understanding and dealing with these different types of financial instruments during the financial instrument valuation process can be challenging for untrained people.
Generally, financial instruments are divided into two further categories on the basis of their asset class: equity-based and debt-based.
Equity-based financial instruments include securities, stocks, shares, stock options, and other exchange-traded derivatives.
On the other hand, debt-based financial instruments involve short-term securities such as Treasury bills that typically have a maturity period of one year or less. Other types of cash instruments, such as certificates of deposit, are also integral parts of this category.
Role of Financial Liabilities in Financial Instruments Valuation
By default, most of the financial liabilities are classified as amortized costs. With amortized cost accounting, all financial assets are listed on a balance sheet.
It means that the liability’s effective rate of interest is charged as per the finance cost to the statement of profit or loss. Fluctuations in the market rates of interest do not impact this cost.
These aspects of financial instruments show that the process of business valuation in Malaysia is composed of many different factors. Professional audit firms in Malaysia consider all of these factors during the financial instruments valuation process to obtain accurate financial value.
Companies and business managers have to look after many different aspects of a business, so it is better to rely on the experts, such as accounting and audit firms in Malaysia to deal with such complicated processes.
It gives business managers and owners more time to focus on business growth while the experts take care of financial and legal requirements.