Finance is a term we use to refer to anything related to money.
Some common phrases associated with “finance” are financial instruments, the finance industry, financial markets, financial services, etc.
We can formally define it as the study of the system of money, investments, and a host of other financial instruments.
When we study finance, we try to understand how a company, government, or individual acquires money and how they spend or invest it.
Finance can be split into three broad categories:
- Public finance
- Corporate finance
- Personal finance
There are other categories like social and behavioral finance, but we should examine those three first.
This category is concerned with how the government of a country (its branches and agencies) and lower forms of government (state, municipal, etc) acquire and spend money.
A government oversees the welfare of the people it governs by allocating resources, distributing income and keeping the economy stable.
To fund its activities and pay its workers, a government imposes taxes on its citizens, borrows money from banks, insurance companies, or other governments. It may also earn dividends from some of its investments.
It is also acquiring money from fines, revenue from points of entry, fees on licenses, bond issues, selling securities, just to mention a few.
How a government uses its money is determined by its fiscal policy, which is usually geared towards promoting a healthy and inclusive economy (in principle).
The central bank of a country (the Federal Reserve in the US) affects public finance through its monetary policy.
Corporate finance is the type of finance associated with corporations, partnerships, and other entities. It entails managing risk; maximizing assets, income, and value of the stock; and ensuring profitability.
Businesses usually fund their operations in various ways. The avenues available to a company are dictated by its type and size.
For example, startups acquire funds from venture capitalists, angel investors, or their founders. If they grow, they can go public.
An initial public offering (IPO) also brings money into the company. Later on, a company can sell more shares to raise money.
A company can take out a loan from a bank, issue corporate bonds, or arrange for a line of credit.
A company can also invest in other companies and make money from the dividends accrued from those investments.
Personal finance entails the management of a person’s income, expenses, obligations, and investments.
The main elements of personal finance are:
- Assessing your financial status: your liquidity, assets, savings, liabilities, etc.
- Taking out various forms of insurance to mitigate risk and ensure financial security
- Paying taxes
- Saving and investing
- Retirement planning
Managing personal finance means deliberately planning your spending and saving habits taking into consideration several risks.
When you hear the term “Personal finance” you can’t help but think about paying for education, loans, and insurance; saving and investing for retirement; and financing the purchase of goods and services.
Since income tax is the largest expense in your household, it is no surprise that one of the biggest concerns you have as you manage your money is to maximize the incentives offered by the government to minimize the amount you give away as tax.
To achieve financial freedom, you minimize your expenses and maximize your income. You also plan for your retirement.
Other Types of Finance
In addition to the three widely accepted types of finance, other types are worth mentioning:
Professionals and academics study the motivations behind the financial decisions that people make in their day-to-day activities.
It became an important part of understanding how people make their financial decisions because financial theories could not explain the irrational and unpredictable processes that happened in real-world scenarios.
The experts focus on cognitive psychology to rationalize what modern financial theories cannot.
It is an area of finance concerned with the investments that people make for the social benefit they have on society. The most common form of social financing is an investment made in a social entity such as a charity.
Note that this is not an outright donation, rather an investment that results in the acquisition of equity or the settling of a debt.
Some investments may have a financial reward. An example is a loan given to someone who owns a small business. The lender earns a return on their loan while improving an individual’s living standards.