Finance is the study of money and how it is used. Specifically, it deals with the questions of how an individual or company acquires the money needed - called capital in the company context - and how they then spend or invest that money. Finance is often split into three areas: personal finance, corporate finance and public finance. At the same time, finance is about the overall "system" - i.e. the financial markets that allow the flow of money, via investments and other financial instruments, between and within these areas; this "flow" is facilitated by the financial services sector. A major focus within finance is thus investment management — called money management for individuals, and asset management for institutions — and finance then includes the associated securities trading, investment banking, financial engineering, and risk management.
More abstractly, finance is concerned with the investment and deployment of assets and liabilities over "space and time": i.e. it is about performing valuation and asset allocation today, based on risk and uncertainty re future outcomes, incorporating the time value of money (determining the present value of these future values, "discounting", requires a risk-appropriate discount rate). As an academic field, finance theory is studied and developed within the disciplines of management, (financial) economics, accountancy and applied mathematics. Correspondingly, given its wide application, there are several related professional qualifications, that can lead to the field. As the debate to whether finance is an art or a science is still open, there have been recent efforts to organize a list of unsolved problems in finance.
An entity whose income exceeds its expenditure can lend or invest the excess income to help that excess income produce more income in the future. Though on the other hand, an entity whose income is less than its expenditure can raise capital by borrowing or selling equity claims, decreasing its expenses, or increasing its income. The lender can find a borrower—a financial intermediary such as a bank—or buy notes or bonds (corporate bonds, government bonds, or mutual bonds) in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary earns the difference for arranging the loan.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders, of different sizes, to coordinate their activity.
Finance is used by individuals (personal finance), by governments (public finance), by businesses (corporate finance) and by a wide variety of other organizations such as schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments and methodologies, with consideration to their institutional setting.
Finance is one of the most important aspects of business management and includes analysis related to the use and acquisition of funds for the enterprise. In corporate finance, a company's capital structure is the total mix of financing methods it uses to raise funds. One method is debt financing, which includes bank loans and bond sales. Another method is equity financing – the sale of stock by a company to investors, the original shareholders (they own a portion of the business) of a share. Ownership of a share gives the shareholder certain contractual rights and powers, which typically include the right to receive declared dividends and to vote the proxy on important matters (e.g., board elections). The owners of both bonds (either government bonds or corporate bonds) and stock (whether its preferred stock or common stock), may be institutional investors – financial institutions such as investment banks and pension funds or private individuals, called private investors or retail investors.
Areas of finance
Personal finance is defined as the mindful planning of monetary spending and saving, while also considering the possibility of future risk. The following steps, as outlined by the Financial Planning Standards Board, suggest that an individual will understand a potentially secure personal finance plan after:
- Purchasing insurance to ensure protection against unforeseen personal events
- Understanding the effects of tax policies (tax subsidies or penalties) management of personal finances
- Understanding the effects of credit on individual financial standing
- Developing of a savings plan or financing for large purchases (auto, education, home)
- Planning a secure financial future in an environment of economic instability
- Pursuing a checking and/or a savings account
- Preparing for retirement/ long term expenses
- Financial position: is concerned with understanding the personal resources available by examining net worth and household cash flows. Net worth is a person's balance sheet, calculated by adding up all assets under that person's control, minus all liabilities of the household, at one point in time. Household cash flows total up all from the expected sources of income within a year, minus all expected expenses within the same year. From this analysis, the financial planner can determine to what degree and in what time the personal goals can be accomplished. Ratios are frequently used on the corporate level to measure a company's ability to cover its cost given the assets it has on hand. This can be paralleled to an individual level as well. Maintaining a ratio of 2:1 or greater is seen as healthy in this respect. This means that for every dollar of expenses there is an existing dollar value of assets such as cash to cover that cost.
- Adequate protection: the analysis of how to protect a household from unforeseen risks. These risks can be divided into the following: liability, property, death, disability, health and long term care. Some of these risks may be self-insurable, while most will require the purchase of an insurance contract. Determining how much insurance to get, at the most cost-effective terms requires knowledge of the market for personal insurance. Business owners, professionals, athletes, and entertainers require specialized insurance professionals to adequately protect themselves. Since insurance also enjoys some tax benefits, utilizing insurance investment products may be a critical piece of the overall investment planning.
- Tax planning: typically the income tax is the single largest expense in a household. Managing taxes is not a question of if you will pay taxes, but when and how much. Governments give many incentives in the form of tax deductions and credits, which can be used to reduce the lifetime tax burden. Most modern governments use a progressive tax. Typically, as one's income grows, a higher marginal rate of tax must be paid. Understanding how to take advantage of the myriad tax breaks when planning one's personal finances can make a significant impact, which can save you money in the long term.
- Investment and accumulation goals: planning how to accumulate enough money – for large purchases and life events – is what most people consider to be financial planning. Major reasons to accumulate assets include purchasing a house or car, starting a business, paying for education expenses, and saving for retirement. Achieving these goals requires projecting what they will cost, and when you need to withdraw funds that will be necessary to be able to achieve these goals. A major risk to the household in achieving their accumulation goal is the rate of price increases over time, or inflation. Using net present value calculators, the financial planner will suggest a combination of asset earmarking and regular savings to be invested in a variety of investments. In order to overcome the rate of inflation, the investment portfolio has to get a higher rate of return, which typically will subject the portfolio to a number of risks. Managing these portfolio risks is most often accomplished using asset allocation, which seeks to diversify investment risk and opportunity. This asset allocation will prescribe a percentage allocation to be invested in stocks (either preferred stock or common stock), bonds (for example mutual bonds or government bonds, or corporate bonds), cash and alternative investments. The allocation should also take into consideration the personal risk profile of every investor, since risk attitudes vary from person to person.
- Retirement planning is the process of understanding how much it costs to live at retirement, and coming up with a plan to distribute assets to meet any income shortfall. Methods for retirement plans include taking advantage of government allowed structures to manage tax liability including: individual (IRA) structures, or employer sponsored retirement plans, annuities and life insurance products. Oftentimes this field of personal finance is overlooked as many individuals see this being something in their distant future. However, the sooner you start investing the greater likelihood you have for actually being prepared. Accrual compounding from the prime "work years" can create a significant impact down the road as these earlier donation years will have more time to compound on themselves giving the individual more wiggle room in their future for unexpected unforeseen events. With every additional year of missed contributions, this creates more tension on the individual to contribute a greater sum leading up to the maturity date of what they may have always thought would be their retirement age. In the same respect an individual who is able to attain a healthy amount of wealth at a young age may then be able to invest it into a mutual fund or stocks accordingly depending on how much they believe they will need to maintain their standard of living once retirement arrives. Allocating a portfolio according to your goals is crucial and also needs to be continuously adjusted as your personal needs and desires change. Oftentimes, individuals will allocate 80% of their earnings into stocks while there is still room for error (more time away from retirement) with only 20% being distributed to mutual funds as these are considered more 'steady' streams of investment. As an individual begins to get closer to their retirement, oftentimes they will gradually adjust these allocations to have a greater percentage in their mutual fund section to solidify their gains and only leave 20% to still generate higher returns. This allocation is commonly recommended by financial planners as it allows the individual to build capital in their work years and keep their gains safe in the long run, leaving less room for volatility.
- Estate planning involves planning for the disposition of one's assets after death. Typically, there is a tax due to the state or federal government at one's death. Avoiding these taxes means that more of one's assets will be distributed to one's heirs. One can leave one's assets to family, friends or charitable groups.
Corporate finance deals with the sources of funding and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
Corporate finance generally involves balancing risk and profitability, while attempting to maximize an entity's assets, net incoming cash flow and the value of its stock, and generically entails three primary areas of capital resource allocation.
- In the first, "capital budgeting", management must choose which "projects" (if any) to undertake. The discipline of capital budgeting may employ standard business valuation techniques or even extend to real options valuation; see Financial modeling.
- The second, "sources of capital" relates to how these investments are to be funded: investment capital can be provided through different sources, such as by shareholders, in the form of equity (privately or via an initial public offering), creditors, often in the form of bonds, and the firm's operations (cash flow). Short-term funding or working capital is mostly provided by banks extending a line of credit. The balance between these elements forms the company's capital structure.
- The third, "the dividend policy", requires management to determine whether any unappropriated profit (excess cash) is to be retained for future investment / operational requirements, or instead to be distributed to shareholders, and if so, in what form.
Corporate finance also includes within its scope business valuation, stock investing, or investment management. An investment is an acquisition of an asset in the hope that it will maintain or increase its value over time that will in hope give back a higher rate of return when it comes to disbursing dividends. In investment management – in choosing a portfolio – one has to use financial analysis to determine what, how much and when to invest. To do this, a company must:
- Identify relevant objectives and constraints: institution or individual goals, time horizon, risk aversion and tax considerations;
- Identify the appropriate strategy: active versus passive hedging strategy
- Measure the portfolio performance
Financial management overlaps with the financial function of the accounting profession. However, financial accounting is the reporting of historical financial information, while financial management is concerned with the allocation of capital resources to increase a firm's value to the shareholders and increase their rate of return on the investments.
Financial risk management, an element of corporate finance, is the practice of creating and protecting economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. (Other risk types include foreign exchange, shape, volatility, sector, liquidity, inflation risks, etc.) It focuses on when and how to hedge using financial instruments; in this sense it overlaps with financial engineering. Similar to general risk management, financial risk management requires identifying its sources, measuring it (see: Risk measure#Examples), and formulating plans to address these, and can be qualitative and quantitative. In the banking sector worldwide, the Basel Accords are generally adopted by internationally active banks for tracking, reporting and exposing operational, credit and market risks.
Capital, in the financial sense, is the money that gives the business the power to buy goods to be used in the production of other goods or the offering of a service. (Capital has two types of sources, equity, and debt).
The deployment of capital is decided by the budget. This may include the objective of business, targets set, and results in financial terms, e.g., the target set for sale, resulting cost, growth, required investment to achieve the planned sales, and financing source for the investment.
A budget may be long term or short term. Long term budgets have a time horizon of 5–10 years giving a vision to the company; short term is an annual budget which is drawn to control and operate in that particular year.
Budgets will include proposed fixed asset requirements and how these expenditures will be financed. Capital budgets are often adjusted annually (done every year) and should be part of a longer-term Capital Improvements Plan.
A cash budget is also required. The working capital requirements of a business are monitored at all times to ensure that there are sufficient funds available to meet short-term expenses.
The cash budget is basically a detailed plan that shows all expected sources and uses of cash when it comes to spending it appropriately. The cash budget has the following six main sections:
- Beginning cash balance – contains the last period's closing cash balance, in other words, the remaining cash of the last year.
- Cash collections – includes all expected cash receipts (all sources of cash for the period considered, mainly sales)
- Cash disbursements – lists all planned cash outflows for the period such as dividends, excluding interest payments on short-term loans, which appear in the financing section. All expenses that do not affect cash flow are excluded from this list (e.g. depreciation, amortization, etc.)
- Cash excess or deficiency – a function of the cash needs and cash available. Cash needs are determined by the total cash disbursements plus the minimum cash balance required by company policy. If the total cash available is less than cash needs, a deficiency exists.
- Financing – discloses the planned borrowings and repayments of those planned borrowings, including interest.
Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It usually encompasses a long-term strategic perspective regarding investment decisions that affect public entities. These long-term strategic periods usually encompass five or more years. Public finance is primarily concerned with:
- Identification of required expenditure of a public sector entity
- Source(s) of that entity's revenue
- The budgeting process
- Debt issuance (municipal bonds) for public works projects
Central banks, such as the Federal Reserve System banks in the United States and Bank of England in the United Kingdom, are strong players in public finance, acting as lenders of last resort as well as strong influences on monetary and credit conditions in the economy.
Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to goods and services. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance. It centres on managing risk in the context of the financial markets, and the resultant economic and financial models.
It essentially explores how rational investors would apply risk and return to the problem of an investment policy. Here, the twin assumptions of rationality and market efficiency lead to modern portfolio theory (the CAPM), and to the Black–Scholes theory for option valuation; it further studies phenomena and models where these assumptions do not hold, or are extended.
"Financial economics", at least formally, also considers investment under "certainty" (Fisher separation theorem, "theory of investment value", Modigliani–Miller theorem) and hence also contributes to corporate finance theory.
Financial econometrics is the branch of financial economics that uses econometric techniques to parameterize the relationships suggested.
Although they are closely related, the disciplines of economics and finance are distinct. The "economy" is a social institution that organizes a society's production, distribution, and consumption of goods and services, all of which must be financed.
Financial mathematics is a field of applied mathematics, concerned with financial markets. The subject has a close relationship with the discipline of financial economics, which is concerned with much of the underlying theory that is involved in financial mathematics. Generally, mathematical finance will derive, and extend, the mathematical or numerical models suggested by financial economics. In terms of practice, mathematical finance also overlaps heavily with the field of computational finance (also known as financial engineering). Arguably, these are largely synonymous, although the latter focuses on application, while the former focuses on modeling and derivation (see: Quantitative analyst). The field is largely focused on the modelling of derivatives, although other important subfields include insurance mathematics and quantitative portfolio problems. See Outline of finance: Mathematical tools; Outline of finance: Derivatives pricing.
Experimental finance aims to establish different market settings and environments to observe experimentally and provide a lens through which science can analyze agents' behavior and the resulting characteristics of trading flows, information diffusion, and aggregation, price setting mechanisms, and returns processes. Researchers in experimental finance can study to what extent existing financial economics theory makes valid predictions and therefore prove them, and attempt to discover new principles on which such theory can be extended and be applied to future financial decisions. Research may proceed by conducting trading simulations or by establishing and studying the behavior, and the way that these people act or react, of people in artificial competitive market-like settings.
Behavioral finance studies how the psychology of investors or managers affects financial decisions and markets when making a decision that can impact either negatively or positively on one of their areas. Behavioral finance has grown over the last few decades to become central and very important to finance.
Behavioral finance includes such topics as:
- Empirical studies that demonstrate significant deviations from classical theories.
- Models of how psychology affects and impacts trading and prices
- Forecasting based on these methods.
- Studies of experimental asset markets and the use of models to forecast experiments.
A strand of behavioral finance has been dubbed quantitative behavioral finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of these endeavors has been led by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001–2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm, and others have demonstrated significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.
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- Doss, Daniel; Sumrall, William; Jones, Don (2012). Strategic Finance for Criminal Justice Organizations (1st ed.). Boca Raton, Florida: CRC Press. p. 23. ISBN 978-1439892237.
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- Learn Finance Step by step with infographics tools
- OECD work on financial markets Observation of UK Finance Market
- Wharton Finance Knowledge Project – aimed to offer free access to finance knowledge for students, teachers, and self-learners.
- Professor Aswath Damodaran (New York University Stern School of Business) – provides resources covering three areas in finance: corporate finance, valuation and investment management and syndicate finance.