Finance is a term for matters regarding the management, creation, and study of money and investments. It involves the use of credit and debt, securities, and investment to finance current projects using future income flows. Because of this temporal aspect, finance is closely linked to the time value of money, interest rates,
Finance, the process of raising funds or capital for any kind of expenditure. Consumers, business firms, and governments often do not have the funds available to make expenditures, pay their debts, or complete other transactions and must borrow or sell equity to obtain the money they need to conduct their operations. Savers and investors, on the other hand, accumulate funds which could earn interest or dividends if put to productive use. These savings may accumulate in the form of savings deposits, savings and loan shares, or pension and insurance claims; when loaned out at interest or invested in equity shares, they provide a source of investment funds.
Finance is the process of channeling these funds in the form of credit, loans, or invested capital to those economic entities that most need them or can put them to the most productive use. The institutions that channel funds from savers to users are called financial intermediaries. They include commercial banks, savings banks, savings and loan associations, and such nonbank institutions as credit unions, insurance companies, pension funds, investment companies, and finance companies.
Three broad areas in finance have developed specialized institutions, procedures, standards, and goals: business finance, personal finance, and public finance. In developed nations, an elaborate structure of financial markets and institutions exists to serve the needs of these areas jointly and separately.
Business finance is a form of applied economics that uses the quantitative data provided by accounting, the tools of statistics, and economic theory in an effort to optimize the goals of a corporation or other business entity. The basic financial decisions involved include an estimate of future asset requirements and the optimum combination of funds needed to obtain those assets. Business financing makes use of short-term credit in the form of trade credit, bank loans, and commercial paper. Long-term funds are obtained by the sale of securities (stocks and bonds) to a variety of financial institutions and individuals through the operations of national and international capital markets. See business finance.
Personal finance deals primarily with family budgets, the investment of personal savings, and the use of consumer credit. Individuals typically obtain mortgages from commercial banks and savings and loan associations to purchase their homes, while financing for the purchase of consumer durable goods (automobiles, appliances) can be obtained from banks and finance companies. Charge accounts and credit cards are other important means by which banks and businesses extend short-term credit to consumers. If individuals need to consolidate their debts or borrow cash in an emergency, small cash loans can be obtained at banks, credit unions, or finance companies.
Finance is a specialized branch of economics concerned with the origination and management of money, credit, banking and investment. Typical areas of study within finance are corporate finance, investments, financial institutions, and risk management. Corporate finance is the study of how firms raise funds from investors, how they invest those funds in return generating projects, and how they distribute those returns back to investors. Investments is the study of securities (stocks, bonds, etc) and the markets in which they trade. Financial institutions is the study of banks and other institutions which bring together the suppliers and users of funds, and risk management is the study of how individuals and firms can limit their exposures to the volatility of existing financial positions.
History of Finance
Finance, as a study of theory and practice distinct from the field of economics, arose in the 1940s and 1950s with the works of Harry Markowitz, William F. Sharpe, Fischer Black, and Myron Scholes, to name just a few.234 Particular realms of finance—such as banking, lending, and investing, of course, money itself—have been around since the dawn of civilization in some form or another.
The financial transactions of the early Sumerians were formalized in the Babylonian Code of Hammurabi (circa 1800 BC). This set of rules regulated ownership or rental of land, employment of agricultural labor, and credit.5 Yes, there were loans back then, and yes, interest was charged on them—rates varied depending on whether you were borrowing grain or silver.
By 1200 BC, cowrie shells were used as a form of money in China. Coined money was introduced in the first millennium BC. King Croesus of Lydia (now Turkey) was one of the first to strike and circulate gold coins around 564 BC—hence the expression, “rich as Croesus.”
In ancient Rome, coins were stored in the basement of temples as priests or temple workers were considered the most honest, devout, and safest to safeguard assets. Temples also loaned money, acting as financial centers of major cities.
Advances in Accounting
Compound interest—interest calculated not just on principal but on previously accrued interest—was known to ancient civilizations (the Babylonians had a phrase for “interest on interest,” which basically defines the concept). But it was not until medieval times that mathematicians started to analyze it in order to show how invested sums could mount up: One of the earliest and most important sources is the arithmetical manuscript written in 1202 by Leonardo Fibonacci of Pisa, known as Liber Abaci, which gives examples comparing compound and simple interest.
The first comprehensive treatise on book-keeping and accountancy, Luca Pacioli’s Summa de arithmetica, geometria, proportioni et proportionalita, was published in Venice in 1494.18 A book on accountancy and arithmetic written by William Colson appeared in 1612, containing the earliest tables of compound interest written in English. A year later, Richard Witt published his Arithmeticall Questions in London in 1613, and compound interest was thoroughly accepted.
Towards the end of the 17th century, in England and the Netherlands, interest calculations were combined with age-dependent survival rates to create the first life annuities.
The federal government helps prevent market failure by overseeing the allocation of resources, distribution of income, and stabilization of the economy. Regular funding for these programs is secured mostly through taxation.19 Borrowing from banks, insurance companies, and other governments and earning dividends from its companies also help finance the federal government.
State and local governments also receive grants and aid from the federal government. Other sources of public finance include user charges from ports, airport services, and other facilities; fines resulting from breaking laws; revenues from licenses and fees, such as for driving; and sales of government securities and bond issues.
Are Loans and Financing the Same Thing?
Loans and financing are not always the same thing. Loans often provide money in a shorter time frame. Financing typically refers to investing in longer-term assets.
Four Common Types of Financing
The first is equipment loans which are used for buying new equipment. These usually have a lower interest rate than other loans. The repayment period is usually shorter.
Equipment loans are good for businesses that want to purchase heavy machinery and office equipment.
Real Estate Loans
The second type of financing is real estate loans. These are typically used to purchase a building or land for a business location. This type of financing also has a low interest rate and a longer repayment period.
Real estate loans are commonly used by new and more established businesses. Banks may require additional collateral for a new business.
The third type of loan is operating loans which are often used to fund temporary cash flow shortages. This type of financing typically has the highest interest rates. It often has the most lenient repayment terms.
Operating loans are commonly used when businesses need to pay upfront costs.
The fourth and final type of public finance is term loans. These are usually used to pay off other loans such as operating loans. The repayment terms are the most lenient.
Personal financial planning generally involves analyzing an individual’s or a family’s current financial position, predicting short-term, and long-term needs, and executing a plan to fulfill those needs within individual financial constraints. Personal finance depends largely on one’s earnings, living requirements, and individual goals and desires.
Matters of personal finance include but are not limited to, the purchasing of financial products for personal reasons, like credit cards; life and home insurance; mortgages; and retirement products. Personal banking (e.g., checking and savings accounts, IRAs, and 401(k) plans) is also considered a part of personal finance.
Social finance typically refers to investments made in social enterprises including charitable organizations and some cooperatives. Rather than an outright donation, these investments take the form of equity or debt financing, in which the investor seeks both a financial reward as well as a social gain.
Modern forms of social finance also include some segments of microfinance, specifically loans to small business owners and entrepreneurs in less developed countries to enable their enterprises to grow. Lenders earn a return on their loans while simultaneously helping to improve individuals’ standard of living and to benefit the local society and economy.
Social impact bonds (also known as Pay for Success Bonds or social benefit bonds) are a specific type of instrument that acts as a contract with the public sector or local government. Repayment and return on investment are contingent upon the achievement of certain social outcomes and achievements.
Finance vs. Economics
Economics and finance are interrelated, informing and influencing each other. Investors care about economic data because they also influence the markets to a great degree. It’s important for investors to avoid “either/or” arguments regarding economics and finance; both are important and have valid applications.
In general, the focus of economics—especially macroeconomics—tends to be a bigger picture in nature, such as how a country, region, or market is performing. Economics also can focus on public policy, while the focus of finance is more individual, company- or industry-specific.
Microeconomics explains what to expect if certain conditions change on the industry, firm, or individual level. If a manufacturer raises the prices of cars, microeconomics says consumers will tend to buy fewer than before. If a major copper mine collapses in South America, the price of copper will tend to increase, because supply is restricted.
Finance also focuses on how companies and investors evaluate risk and return. Historically, economics has been more theoretical and finance more practical, but in the last 20 years, the distinction has become much less pronounced.
Is Finance an Art or a Science?
The short answer to this question is both.
Finance As a Science
Finance, as a field of study and an area of business, definitely has strong roots in related-scientific areas, such as statistics and mathematics. Furthermore, many modern financial theories resemble scientific or mathematical formulas.
However, there is no denying the fact that the financial industry also includes non-scientific elements that liken it to an art. For example, it has been discovered that human emotions (and decisions made because of them) play a large role in many aspects of the financial world.
Modern financial theories, such as the Black Scholes model, draw heavily on the laws of statistics and mathematics found in science; their very creation would have been impossible if science hadn’t laid the initial groundwork. Also, theoretical constructs, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH), attempt to logically explain the behavior of the stock market in an emotionless, completely rational manner, wholly ignoring elements such as market sentiment and investor sentiment.
Finance As an Art
Still, while these and other academic advancements have greatly improved the day-to-day operations of the financial markets, history is rife with examples that seem to contradict the notion that finance behaves according to rational scientific laws. For example, stock market disasters, such as the October 1987 crash (Black Monday), which saw the Dow Jones Industrial Average (DJIA) fall 22%, and the great 1929 stock market crash beginning on Black Thursday (Oct. 24, 1929), are not suitably explained by scientific theories such as the EMH. The human element of fear also played a part (the reason a dramatic fall in the stock market is often called a “panic”).
In addition, the track records of investors have shown that markets are not entirely efficient and, therefore, not entirely scientific. Studies have shown that investor sentiment appears to be mildly influenced by weather, with the overall market generally becoming more bullish when the weather is predominantly sunny. Other phenomena include the January effect, the pattern of stock prices falling near the end of one calendar year and rising at the beginning of the next.
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