What is Finance?
We all have a general idea of what Finance is, but to make sure we are on the same page, let’s let others define Finance for us. Webster’s New World dictionary defines it as (1.) money resources, income, etc (2.) the science of managing money. Used in this context it is a noun. It can also be used as a verb in which case it is to supply or get money for a project. Of these I like the definition as the management of money. Finance is the most encompassing of all business enterprises. To understand finance you must know about the entire business, indeed the entire economy.
So for a few minutes let’s step back and pretend that we never took economics and are new to this earth. The Financial system (or the economy, your choice) is composed of consumers, manufacturers, distributors. These groups need money to purchase products and services. One way of looking at Finance is that it is getting the money to purchase these goods and services. Many economists assume that households have excess money and corporations need money. (This is obviously a gross simplification. At any given point some individuals have excess money to invest where others need to borrow. The same is true for corporations and other organizations, but the simplified model makes things easier for the moment.) The purpose of the Financial System is to make sure that the money flows to those who value it the highest (that is those who can put it to the “best” use).
Now Corporations « Households (Need money) $ (have money to invest) Now, these households are not going to just give corporations money. They will demand their money back at some time in the future and a bit more for the use of their money and risks incurred etc. Future Corporations >> Households (have money) $ (Want money back)
Everything else we study in finance is just looking at this model in more detail. (Seriously, EVERYTHING!)
Let’s make it personal I remember being asked in second or third grade the key to understanding a book. My immediate response to put yourself into the book. The same is true here. If we take a few seconds now to internalize the subject it will pay large dividends (don’t you love finance humor :-)) in the future. If I ask to borrow money from you what do you say? Yes? No? It depends doesn’t it? What does it depend on? A million things! For example: how much do I want to borrow, what are the prospects of me being able to repay it, what is my reputation, what am I going to do with the money, whether you have anything better to do with the money….can you think of anything else? The same ideas are true in the financial world. People will not lend, or will require a larger repayment if they do decide to lend, if there are many things to do with their money, or if the borrower is going to do something risky with it, or if the borrower has an unsavory reputation.
If you get that, you will have fun in finance. If you do not understand the example, please reread it and imagine people asking you for money. Oh, come on, please!!! 🙂
Want more? Here is a video I made: