What Is Finance?
Finance is centred around the management of money. Budgeting, spending, saving, lending, borrowing and investing—these are all aspects of finance.
Planning your finances to suit your needs is important if you want to maximise your chances of covering the costs of living, growing wealth and achieving lifestyle goals.
At its most basic level, finance concerns acquiring funds for a particular purpose. Such funding extends beyond what is already available from household income through salaries, wages, pensions and investments, or a company’s capital from equity contributed by the company’s shareholders.
Additional funds to be acquired, or ‘financed’, are most commonly available from banks and other lenders or credit providers.
Types of Finance
Certain subsets of finance aim to meet particular needs, such as those of individuals, businesses and the public.
Personal finance is typically concerned with decision-making and money management by individuals or families. If a person’s or family’s income and savings could not cover all immediate needs, they may choose any of the following:
- Fixed-term personal loan or lease to get a new car, for example. The former can last for several years and the latter for an agreed number of years.
- Credit card to pay for goods or services, including recurring payments for such things as personal private health insurance, car insurance, vehicle registration, gym memberships and council rates.
- Decades-long home loan to buy a home.
Corporate finance—generally in the form of money borrowed under lines of credit, loans or corporate bonds—is one element of a company’s capital structure. Another is its equity, which represents money initially contributed to the company, plus any added later by shareholders who bought new shares.
Both elements are pivotal to decision-making and cash flow management carried out by a company’s directors and executives. These financing decisions are made with a view to grow a company and generate shareholder return.
Whenever a company borrows money to fund operations, it is critical that it does not become over-reliant on debt. It must remain capable of meeting its obligations to pay interest and other expenses associated with its borrowings.
Also known as government finance, public finance concerns money raised by federal, state and local governments. This can be from many revenue sources, including taxes, investments, levies (e.g. Medicare levies and ‘Budget Repair’ levies), stamp duty, fees, council rates and fines.
Public finance also relates to government spending on items such as:
- welfare payments to pensioners, the unemployed and other disadvantaged groups;
- hospitals and other health services;
- defence and border security;
- infrastructure, transport and communication; and
- public housing and public order and safety.
Read: What Is Fiscal Policy?
Governments also borrow money, accordingly carry debt and incur liabilities to pay interest on borrowings.
Governments can establish special-purpose investment bodies to make money that is to be applied in discharging large looming liabilities. For example, Australia’s ‘Future Fund’ seeks to cover annual unfunded Commonwealth superannuation liabilities. When the Australian Government sold its shareholding in Telstra, the sale proceeds went into the ‘Future Fund’ along with money from budget surpluses. The fund has grown substantially since it started in 2006 through accumulated investment returns.
Finance vs Economics
Finance tends to focus narrowly on the household, company and industry levels. It encompasses assessing risks and budgeting returns.
Economics has a broader focus. It is more concerned with the performance levels of regions, countries and markets. Economics also addresses public policy issues.
Read: What Is Economics?
Understanding Financial Economics
Financial economics is a branch of economics which analyses the use of resources in markets in which decisions always carry a degree of uncertainty. Making financial decisions when investing needs to take into account possible future events, despite usually being contingencies.
However, some events are predictable. For example, a company faces being put into the hands of receivers or other external managers if it is trading while insolvent or is unable to pay its debts as they fall due.
Other events have a small chance of occurring. For example, a trusted key employee—having signed a confidentiality agreement—later takes the employer’s customer lists or trade secrets for use in a new, competing business.
Lastly, there can be unexpected and significantly damaging events which can occur suddenly. For example, it is highly unlikely someone could have predicted the scale or been properly prepared for the COVID-19 pandemic. These rare events can heavily impact a company’s or individual’s financial decisions.
So, how does financial economics manage a collection of uncertainties that might affect financial decision-making?
Statistics, mathematics—including probability—and modelling are among some of the tools used. Modelling involves the testing and discounting of potentially relevant variables by making evaluations of time horizons. For example, accepting the fundamental principle that due to inflation and business risk $1 today is worth more than $1 a decade from now—otherwise known as discounting.
Financial economics also evaluates risks, opportunity costs and information such as the levels and types of financing in place. By distinguishing the total risk of a portfolio, investors can more comprehensively plan and mitigate investment risk.