Table of Contents
What Is Finance?
Let me explain finance to you directly: it's the study and management of money and financial resources by individuals, corporations, and governments. Finance describes the flow of money and how people, companies, and governments make, save, invest, borrow, and spend it. When I talk about personal finance, I'm referring to budgeting, spending, borrowing, saving, and investing for the future. Corporate finance involves raising capital, issuing stock, establishing and expanding a business, purchasing equipment, leasing machinery, and hiring staff. Public finance focuses on managing public debt, spending on public services, collecting taxes, and stimulating the economy. You need to understand that finance is critical to growing wealth, making decisions, and managing risk.
Key Takeaways
Finance is all about dealing with and managing money. It can be broadly divided into three categories: personal, corporate, and public finance. People engage in finance when they manage money to use it more effectively or increase it. Finance is an academic subject with subcategories like social finance and behavioral finance. Remember, finance can help you achieve your goals, empower you to live securely, plan ahead, and build wealth.
How Finance Works
Finance is typically broken down into three broad categories: public finance, corporate finance, and personal finance. Public finance includes tax systems, government expenditures, budget procedures, stabilization policies and instruments, debt issues, and other government concerns. Corporate finance involves managing assets, liabilities, revenues, and debts for businesses. Personal finance defines all financial decisions and activities of an individual or household, including budgeting, insurance, mortgage planning, savings, and retirement planning.
Key Finance Terms
You should know these key terms in finance. An asset is something of value, such as cash, real estate, or property, and a business may have current assets or fixed assets. A balance sheet is a document that shows a company’s assets and liabilities; subtract the liabilities from the assets to find the firm’s net worth. Cash flow is the movement of money into and out of a business or household. Compound interest is calculated and added periodically, unlike simple interest, which is added to the principal only once, resulting in interest being charged on the principal and accrued interest. Equity means ownership; stocks are called equities because each share represents a portion of ownership in the underlying corporation or entity. A liability is a financial obligation, such as debt, and liabilities can be current or long-term. Liquidity refers to how easily an asset can be converted to cash; real estate isn't very liquid because it can take weeks, months, or longer to sell. Profit is the money left over after expenses, and a profit and loss statement shows how much a business has earned or lost for a particular period.
History of Finance
Finance arose as a study of theory and practice distinct from economics in the 1940s and 1950s, beginning with the works of Harry Markowitz, William F. Sharpe, Fischer Black, and Myron Scholes. Particular realms of finance, such as banking, lending, and investing, have been around in some form since the dawn of civilization. The financial transactions of the early Sumerians were formalized in the Babylonian Code of Hammurabi around 1800 BCE, regulating ownership or rental of land, employment of agricultural labor, and credit. Yes, there were loans back then, and interest was charged on them, with rates varying depending on whether you were borrowing grain or silver. Cowrie shells were used as money in China by 1200 BCE, and coinage was introduced in the first millennium BCE; King Croesus of Lydia, now Turkey, was one of the first to strike and circulate gold coins around 564 BCE, hence the expression 'rich as Croesus.' Coins were stored in temple basements in ancient Rome because priests were considered honest to safeguard assets, and temples also loaned money, acting as financial centers. Belgium claims the first exchange in Antwerp dating to 1531, and the East India Co. became the first publicly traded company in the 1600s by issuing stock and paying dividends. The London Stock Exchange was created in 1773, followed by the New York Stock Exchange less than 20 years later. The earliest recorded bond dates to 2400 BCE as a stone tablet guaranteeing repayment of grain. Governments issued debts for wars in the Middle Ages, and the Bank of England financed the British Navy in the 1600s, while the U.S. issued Treasury bonds for the Revolutionary War. The early practice of options comes from Thales in Aristotle’s work, who acquired rights to olive presses anticipating a harvest; forward and options contracts were integrated in Amsterdam by the mid-17th century. Compound interest was known to ancient civilizations, with Babylonians having a phrase for 'interest on interest.' Leonardo Fibonacci’s 1201 manuscript gives examples of compound and simple interest, Luca Pacioli’s 1494 treatise was on bookkeeping, and books by Colson in 1612 and Witt in 1613 covered compound interest tables. Interest calculations combined with survival rates created life annuities in England and the Netherlands by the late 17th century.
Types of Finance
Let's break down the types. Public finance: The federal government prevents market failure by overseeing resource allocation, income distribution, and economic stabilization, funded mostly through taxation, borrowing from banks and others, and dividends from companies. State and local governments get grants from the federal level, plus user charges, fines, licenses, and sales of securities. Corporate finance: Businesses obtain financing through equity investments, credit, loans, or lines of credit to expand and profit. Startups get capital from angel investors or venture capitalists for ownership shares, and thriving companies issue IPOs or additional shares and bonds. Businesses might purchase dividend stocks, bonds, CDs, or other companies. Examples include Bausch & Lomb’s 2022 IPO raising $630 million, Ford Motor Credit managing notes, and HomeLight raising $115 million through equity and debt. Personal finance: This involves analyzing your current position, predicting needs, and planning within constraints based on earnings and goals. It includes credit cards, insurance, mortgages, retirement products, banking accounts, IRAs, and 401(k)s. Key aspects are assessing status, buying insurance, filing taxes, saving and investing, and retirement planning. It's taught as home economics, and economists stress its education for national economy. Social finance: This refers to investments in social enterprises for financial and social gains, including microfinance loans to entrepreneurs in less-developed countries and social impact bonds contingent on social outcomes. Behavioral finance: Traditional theories couldn't explain real-world anomalies, so this field uses psychology to account for irrational behaviors. It explains stock price anomalies and assumes market structures influence decisions. Kahneman, Tversky, and Thaler developed concepts like mental accounting, herd behavior, anchoring, and high self-rating or overconfidence, which can lead to poor investment choices.
Finance vs. Economics
Economics and finance are interrelated, but economics focuses on big-picture performance like countries or markets and public policy, while finance is more individual, company, or industry-specific. Microeconomics predicts changes like fewer car buys if prices rise or supply restrictions if a mine collapses. Finance evaluates risk and return, historically more practical than theoretical economics, though the distinction has blurred since 2000.
Is Finance an Art or a Science?
As a science, finance roots in statistics and math, with theories like Black-Scholes resembling formulas, and models like CAPM and EMH explaining markets rationally. As an art, it includes human emotions and nonscientific elements, as seen in market crashes like Black Monday in 1987 or 1929, driven by fear and panic. Markets aren't entirely efficient, influenced by weather or the January effect, showing investor sentiment plays a role.
Careers in Finance
Many career options exist in finance. An accountant manages records, tracks expenses, and runs reports. An auditor ensures accuracy, working in private practice, companies, or government. A banker provides services like accounts and loans, while investment bankers handle capital raising or mergers. A capital manager allocates resources between investments. A lender manages loan issuance, like mortgage contracts. A market analyst evaluates trends and makes forecasts for decisions. Salaries include $189,000 for personal financial advisors, $104,000 for treasury analysts (up to $180,000 with experience), $106,000 for financial analysts, $88,000 for accountants (CPAs at $231,000), $155,000 for financial managers, $155,000 for securities brokers, and $204,000 for commodities brokers. Wages in finance and insurance rose 40.5% from 2006 to 2024, with bachelor’s holders earning $78,080 median. CFOs average $154,982.
How Can I Learn Finance?
Undergraduate majors cover the basics, a master’s hones skills, and an MBA provides corporate finance knowledge. The CFA program is a rigorous self-study with three exams for a global credential. Other standards include CFP.
What Is the Purpose of Finance?
Finance involves borrowing, lending, investing, raising capital, and trading securities to fund activities repaid from future income, enabling home buys, company growth, and efficient capital allocation.
What Is the Difference Between Accounting and Finance?
Accounting tracks cash flows, expenses, and income as one aspect of finance, including bookkeeping, tax prep, and auditing.
The Bottom Line
Finance is a broad term for managing money—from getting and spending to borrowing and investing—plus the tools, instruments, systems, and institutions involved. It scales from a country’s trade deficit to dollar bills in your wallet, essential for households, corporations, and societies.
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