Finance
2007 Concise Encyclopedia. Related subjects: Economics
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Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. The term finance may thus incorporate any of the following:
- The study of money and other assets
- The management and control of those assets
- Profiling and managing project risks
- As a verb, "to finance" is to provide funds for business.
Examples of some basic financial concepts
The activity of finance is the application of a set of techniques that individuals and organizations (entities) use to manage their financial affairs, particularly the differences between income and expenditure and the risks of their investments.
An entity whose income exceeds its expenditure can lend or invest the excess income. 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 in the bond market. The lender receives interest, the borrower pays a higher interest than the lender receives, and the financial intermediary pockets the difference.
A bank aggregates the activities of many borrowers and lenders. A bank accepts deposits from lenders, on which it pays the interest. The bank then lends these deposits to borrowers. Banks allow borrowers and lenders of different sizes to coordinate their activity. Banks are thus compensators of money flows in space since they allow different lenders and borrowers to meet, and in time, since every borrower, in theory, will eventually pay back.
A specific example of corporate finance is the sale of stock by a company to institutional investors like investment banks, who in turn generally sell it to the public. The stock gives whoever owns it part ownership in that company. If you buy one share of XYZ Inc, and they have 100 shares available, you are 1/100 owner of that company. You own 1/100 of the net difference between assets and liabilities on the balance sheet. Of course, in return for the stock, the company receives cash, which it uses to expand its business in a process called "equity financing". Equity financing mixed with the sale of bonds (or any other debt financing) is called the company's capital structure.
Finance is used by individuals ( personal finance), by governments ( public finance), by businesses (corporate finance), etc., as well as by a wide variety of organizations including schools and non-profit organizations. In general, the goals of each of the above activities are achieved through the use of appropriate financial instruments, with consideration to their institutional setting.
Personal finance
Questions in personal finance revolve around
- How much money will be needed by an individual (or by a family) at various points in the future?
- Where will this money come from (e.g. savings or borrowing)?
- How can people protect themselves against unforeseen events in their lives, and risk in financial markets?
- How can family assets be best transferred across generations (bequests and inheritance)?
- How do taxes (tax subsidies or penalties) affect personal financial decisions?
Personal financial decisions may involve paying for education, financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.
Business finance
In the case of a company, managerial finance or corporate finance is the task of providing the funds for the corporations' activities. It generally involves balancing risk and profitability. Long term funds would be provided by ownership equity and long-term credit, often in the form of bonds. These decisions lead to the company's capital structure. Short term funding or working capital is mostly provided by banks extending a line of credit.
On the bond market, borrowers package their debt in the form of bonds. The borrower receives the money it borrows by selling the bond, which includes a promise to repay the value of the bond with interest. The purchaser of a bond can resell the bond, so the actual recipient of interest payments can change over time. Bonds allow lenders to recoup the value of their loan by simply selling the bond.
Another business decision concerning finance is investment, or fund management. An investment is an acquisition of an asset in the hopes that it will maintain or increase its value. In investment management - in choosing a portfolio - one has to decide what, how much and when to invest. In doing so, one needs to
- Identify relevant objectives and constraints: institution or individual - goals - time horizon - risk aversion - tax considerations
- Identify the appropriate strategy: active vs passive - hedging strategy
- Measure the portfolio performance
Financial management is duplicate with the financial function of the Accounting profession. However, Financial Accounting is more concerned with the reporting of historical financial information, while the financial decision is directed toward the future of the firm.
Shared Services
There is currently a move towards converging and consolidating Finance provisions into shared services within an organization. Rather than an organization having a number of separate Finance departments performing the same tasks from different locations a more centralized version can be created.
Finance of states
Country, state, county, city or municipality finance is called public finance. It is 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
Financial economics
Financial economics is the branch of economics studying the interrelation of financial variables, s.a. prices, interest rates and shares as opposed to those concerning the real economy. Financial economics concentrates on influences of real economic variables on financial ones, in contrast to pure finance.
It studies:
- Valuation - Determination of the fair value of an asset
- How risky is the asset? (identification of the asset appropriate discount rate)
- What cash flows will it produce? (discounting of relevant cash flows)
- How does the market price compare to similar assets? (relative valuation)
- Are the cash flows dependent on some other asset or event? (derivatives, contingent claim valuation)
- Financial markets and instruments
- Commodities - topics
- Stocks - topics
- Bonds - topics
- Money market instruments- topics
- Derivatives - topics
- Financial institutions and regulation
Financial mathematics
Financial mathematics is the main branch of applied mathematics concerned with the financial markets. Financial mathematics is the study of financial data with the tools of mathematics, mainly statistics. Such data can be movements of securities - stocks and bonds etc. - and their relations. Another large subfield is insurance mathematics.
Experimental finance
The goals of experimental finance are to establish different market settings and environments to observe experimentally and analyze agents' behaviour 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 attempt to discover new principles on which such theory can be extended. Research may proceed by conducting trading simulations or by establishing and studying the behaviour of people in artificial competitive market-like settings.
Related Professional Qualifications
There are several related professional qualifications in finance, that can lead to the field:
- Qualified accountant qualifications: Chartered Certified Accountant ( ACCA), Chartered Accountant ( CA), Certified Public Accountant ( CPA)
- Non-statutory accountancy qualifications: Chartered Cost Accountant CCA Designation from AAFM
- Business qualifications: Master of Business Administration ( MBA), Doctor of Business Administration ( DBA)
- Finance qualifications: Chartered Financial Analyst (CFA), Association of Corporate Treasurers (ACT), Masters degree in Finance, Certified Market Analyst (CMA/FAD) Dual Designation, Master Financial Manager (MFM), Corporate Finance Qualification (CF)
- Quantitative Finance qualifications: Master of Quantitative Finance (MQF), Master of Computational Finance (MCF), Master of Financial Mathematics (MFM)