Types of Financial Instruments and Their Uses
Financial instruments are contracts or any document that acts as financial assets. For example, bonds, cash deposits, bank balances, swaps, caps, bills of exchange, and forward rate agreements are considered financial instruments.
It is important for businesses to be familiar with different types of financial instruments and their uses for financial instrument valuation. Keep reading to learn all about financial instruments and the critical role they play in business valuation in Malaysia.
Two Major Types of Financial Instruments
There are many different types of financial instruments, but most of them can be classified into two categories.
1. Derivative Instruments
It means deriving the value of instruments from the attributes and values of the assets they represent. In simpler words, derivative instruments are securities that are associated with other securities.
Assets like interest rates and shares are typically considered derivative instruments. Some of the most prominent derivative instruments are futures and options contracts. Moreover, these instruments can either be exchange-traded or over-the-counter (OTC) derivatives
2. Cash Instruments
The instruments whose market value is readily available are called cash instruments. There is a direct impact of market forces and conditions on these instruments. It is easy to transfer cash instruments.
Some of the most popular cash instruments are cheques, shares, and bonds. Loans and deposits are also considered cash instruments if both the lender and borrower have an agreement about the transferability of the instrument.
Other Classifications of Financial Instruments
Some experts and businesses classify financial instruments on the basis of the asset class as well. These are equity-based and debt-based financial instruments.
Equity-based financial instruments include a wide range of instruments such as securities, shares, stocks, equity futures, and other exchange-traded instruments.
On the other hand, debt-based financial instruments mainly include short-term securities such as commercial paper and treasury bills that have a maturity period of one year or even shorter. Some of the exchange-traded derivatives, such as short-term interest rates, also fall into this category.
Why Are There So Many Financial Instruments?
People who are not familiar with business valuation methods often get confused by the different types of financial instruments. However, each and every type of financial instrument is important in one way or another.
Each financial instrument serves a unique purpose to fulfill the specific needs of an investor. Moreover, financial instrument valuation plays a significant role in business valuation in Malaysia.
Whenever an experienced investor is thinking of investing in a company, he or she is likely to consider a lot of factors, including these different types of financial instruments, to make a smart decision.
Benefits of Financial Instruments
There are many benefits to financial instruments and financial instrument valuation. Professional audit firms in Malaysia use different types of financial instruments for reliable business valuation procedures.
Following are some of the most important benefits of financial instruments:
- Liquid assets like cash are critical for the company to make quick payments and deal with other financial requirements of operating a business.
- Stakeholders often feel secure in a company that has significant capital in its liquid assets.
- Financial instruments are vital for the funding of tangible assets. It is made possible by fund transfers from tangible assets that are in surplus to assets that are in deficit.
- Financial instruments minimize the risk associated with risk-bearing capacities, especially when investment in intangible assets is involved.
- Companies that focus on investing in real assets are able to yield higher revenue through a diversified portfolio of hedged inflation. Moreover, they can also hedge against the uncertainties caused by political or economic factors.
- Some of the financial instruments, such as equity, are useful in acting as a permanent source of funds for a business. Equity shares are also important to facilitate a business in open borrowing and getting retained earnings.
Financial instruments and financial instrument valuation are critical parts of an organization. It is common for people to just assume that financial instruments are nothing but documents that represent the financial assets of a business.
However, the truth is they hold great significance to the stakeholders and in other important procedures like business valuation in Malaysia. Knowing every single detail of different types of financial instruments is indeed challenging.
Therefore, if an organization is facing issues with financial instrument valuation, it should engage the service of an audit firm in Malaysia to ensure the best results.