What is Finance?
Finance is everything that has to do with managing money, including activities such as budgeting, saving, lending, borrowing, and investing.
Finance is a broad term that describes all the activities that go into managing money. In an academic setting, finance is a branch of economics that focuses on things like resource distribution, risk, and return. In a practical context, finance includes all of the activities we do to make, manage, and save money. There are several different types of finance, including personal finance, corporate finance, public finance, social finance, and behavioral finance. Whether on a large or small scale, finance impacts each of our lives on some level.
Personal finance is an area of finance most of us are familiar with. It consists of all the activities that go into managing your individual finances, from budgeting to saving to investing. So when you sit down every month to update your monthly budget and pay your bills, this falls under the umbrella of finance.
Finance is like an umbrella — Lots of different activities fit under it. Some are activities individuals do, while others take place on the scale of a company, government, or beyond. There are three main types of finance: personal finance, corporate finance, and public finance. Two other types of finance have appeared on the scene only recently: social finance and behavioral finance.
Personal finance is the management of your money as an individual or a household. This involves all the activities you do to manage your money: creating a budget, paying monthly bills, signing up for credit cards, filing taxes, putting money into savings and retirement accounts, investing, and more. Personal finance also includes the big-picture planning that goes into managing your household finances. This means forecasting your earnings and expenses and balancing your current needs and wants with long-term financial goals.
Personal finance breaks down into five main areas:
Income: This refers to the money flowing in for an individual or household. It consists of salaries, bonuses, wages, pensions, dividends, and any other funds you receive.
Spending: This refers to the outgoing cash spent on goods and services each month. It includes expenses such as rent or mortgage payments, food, taxes, entertainment, and more.
Savings: This refers to what’s left from what you earn after your spending each month. This can be money going into a checking or savings account, funds you invest, or even cash stashed your mattress (which isn’t necessarily recommended).
Investing: This refers to money spent on investments you expect to provide a return with the hope of growing your wealth. Investing isn’t a sure thing — You run the risk of not seeing a return or of losing your money altogether. Investments include stocks, bonds, mutual funds, ETFs, real estate, and more.
Protection: This refers to the money spent to protect yourself from an unforeseen problem. These protections can include health insurance, life insurance, and homeowners insurance.
Corporate finance, also known as business finance, consists of the financial management and capital structure (the combination of debt and the shares owned by shareholders) of a company. Corporate finance includes the actions that company leaders take to increase the company’s value and distribute financial resources. For example, corporate finance would include a decision by a company either to take on debt in the form or a loan or line of credit or to increase equity by selling shares of stock. A company might choose to have an initial public offering (IPO), in which it issues public stock shares for the first time to raise funds, or to borrow money from a bank. The goal of a company is usually to increase profits, so corporate finance consists of the financial decisions they make to reach that goal.
Public finance is the management of government debt (money it owes), revenue (money it receives), and expenditures (money it spends). Government revenue consists primarily of taxes, fees, and fines, while expenditures include mostly infrastructure and government programs.
To see a particular government’s public finances, look no further than its budget. There you’ll see projected revenue, as well as a plan for spending money. A governmental body usually approves the budget, whether that’s Congress and the president, state legislatures and governors, or city councils.
Another vital component of public finance, especially for the federal government, is the national debt, which grows the government spends more money than it brings in.
Social finance is a type of money management that places importance not only on financial returns but also on social impact. Though social finance can include money going to charitable organizations, it generally comes in the form of an investment or a loan rather than a donation and holds the promise of CKl, a financial return for the investor.
Besides investments in charities, social finance can include microfinance, often in the form of small business loans to disadvantaged entrepreneurs. It can include investments in businesses that are driven by a social or environmental mission.
Social finance is a way for investors to make money while trying to improve society.
Behavioral finance is the study of the psychology behind financial decisions. Behavioral finance can help explain situations where individuals make financial decisions that aren’t rational.
Though traditional finance assumes the market and the investors in it are rational, that’s not necessarily the case of individual people. Behavioral finance studies anomalies that occur in finance because of human behavior.
While there’s definitely a relationship between finance, economics, and accounting, the three are not identical.
Economics is a social science that studies how different elements of the economy work together. On a large scale, economics studies the production, consumption, and distribution of goods and services. Macroeconomics focuses on the big-picture behavior of the economy, while microeconomics studies the behavior of individual people or companies.
Finance occurs at the microeconomic level and describes the management of money by an individual, company, or government.
Accounting exists on an even more micro level. An accountant (someone who does accounting) tracks the finances of businesses or individuals. They monitor incoming and outgoing cash flow, analyze budgets, and predict the financial impact of different decisions.
Finance, economics, and accounting are interrelated and often cross paths, but they operate at different levels and have different goals.
If you’re new to the world of finance, some of the vocabulary might sound a bit foreign. Let’s break down some of the words you’ll often see in finance:
Asset: A resource owned by a person or company that has economic value, such as a house or car.
Balance Sheet: A financial statement that summarizes a company’s financial situation, including assets and liabilities.
Cash Flow: This is the amount of money going in and coming out of a business.
Equity: In finance, equity typically refers to the amount of money that owners or shareholders of a company would receive if all assets were sold off and all debt was paid.
Expenditure: The money a person or company spends.
Interest: The fee paid on money borrowed.
Investing: Allocating resources to certain projects or assets with the expectation of seeing a return.
Liability: Debt that a person or company owes.
Net Worth: The difference between a person’s or company’s assets and liabilities.
Revenue: The money earned by a person or company.
Shareholder: Someone who owns shares of stock in a company.
Stock Market: A market that brings together buyers and sellers of stock shares.
What is Fixed Income?
A fixed income is a type of investment (aka an asset purchased to be held as an investment) that pays investors a fixed interest amount until it matures. When it matures, the principal amount that is initially invested is repaid.
What is a Waiver?
A waiver is a voluntary legal provision that releases you or another party in a contract from following the terms of the agreement without penalty.
What is Demonetization?
Demonetization is an economic intervention that strips a country’s currency unit of its legal tender status – aka it can no longer be used to buy goods and services.
What is a T-test?
A t-test is a statistic used to compare the averages of two groups (or challenge a hypothesis) to see if differences or similarities are real or just random chance.
What is the Black Market?
A black market is a segment of a country’s economy where goods and services are bought and sold illegally.