Finance describes the management, creation and study of money, banking, credit, investments, assets and liabilities that make up financial systems, as well as the study of those financial instruments. Some people prefer to divide finance into three distinct categories: public finance, corporate finance and personal finance. There is also the recently emerging area of social finance. Additionally, the study of behavioral finance aims to learn about the more human side of a science considered by most to be highly mathematical.
Public finance includes tax systems, government expenditures, budget procedures, stabilization policy and instruments, debt issues and other government concerns. Corporate finance involves managing assets, liabilities, revenues and debt for a business. Personal finance defines all financial decisions and activities of an individual or household, including budgeting, insurance, mortgage planning, savings and retirement planning.
The federal government helps prevent market failure by overseeing allocation of resources, distribution of income and stabilization of the economy. Regular funding for these programs is secured mostly through taxation. Borrowing from banks, insurance companies and other governments and earning dividends from its companies also help finance the federal government. State and local governments also receive grants and aid from the federal government. In addition, user charges from ports, airport services and other facilities; fines resulting from breaking laws; revenues from licenses and fees, such as for driving; and sales of government securities and bond issues are also sources of public finance.
Businesses obtain financing through a variety of means, ranging from equity investments to credit arrangements. A firm might take out a loan from a bank, or arrange for a line of credit. Acquiring and managing debt properly can help a company expand and ultimately become more profitable.
Startups may receive capital from angel investors or venture capitalists in exchange for a percentage of ownership. If a company thrives and decides to go public, it will issue shares on a stock exchange; such initial public offerings (IPO) bring a great influx of cash into a firm. Established companies may sell additional shares, or issue corporate bonds to raise money. Businesses may purchase dividend-paying stocks, blue-chip bonds or interest-bearing bank certificates of deposit; they may even buy other companies in an effort to boost revenue.
Personal financial planning generally involves analyzing an individual’s or a family’s current financial position, predicting short-term and long-term needs and executing a plan to fulfill those need within individual financial constraints. Personal finance is a very personal activity that depends largely on one’s earnings, living requirements and individual goals and desires.
Matters of personal finance include, but are not limited to, the purchasing of financial products for personal reasons, like credit cards, life, health and home insurance, mortgages and retirement products. Personal banking is also considered a part of personal finance, including checking and savings accounts, along with IRAs and 401(k) plans.
Among the most important aspects of personal finance are:
– Assessing your current financial status: expected cash flow, current savings, etc.
– Buying insurance to protect yourself from risk and making sure your material standing is secure
– Calculating and filing taxes
– Savings and investments
– Retirement planning
As a specialized field, personal finance is a fairly recent development, though forms of it have been taught in universities and schools as home economics or consumer economics since the early 20th century. The field was initially disregarded by male economists, as home economics appeared to be the purview of housewives. However, more recently economists have repeatedly stressed widespread education in matters of personal finance as integral to the macro performance of the overall national economy.
Social finance typically refers to investments made in social enterprises including charitable organizations and some cooperatives. Rather than an outright donation, these investments take the form of equity or debt financing, in which the investor seeks both a financial reward as well as a social gain.
Modern forms of social finance can also include some segments of microfinance, specifically loans to small business owners and entrepreneurs in less developed countries to enable their enterprises to grow. Lenders expect to earn a return on their loans, in addition to helping improve the individuals’ standard of living and to benefiting the local society and economy.
Social impact bonds (also known as Pay for Success Bonds or social benefit bonds) are a specific type of instrument that acts as a contract with the public sector or local government. Repayment and return on investment are contingent upon the achievement of certain social outcomes and achievements.
Business Finance / Loans
A business loan is a loan specifically intended for business purposes. As with all loans, it involves the creation of a debt, which will be repaid with added interest. There are a number of different types of business loans, including bank loans, mezzanine financing, asset-based financing, invoice financing, microloans, business cash advances and cash flow loans.
A bank loan may be obtained from a bank and may be either secured or unsecured. For secured loans, banks will require collateral, which may be lost if repayments are not made. The bank will probably wish to see the business’s accounts, balance sheet and business plan, as well as studying the principals’ credit histories. Many smaller businesses are now however turning towards Alternative Finance Providers, especially in the case of smaller firms.
Loans from credit unions may be referred to as bank loans as well. Business loans from credit unions received the second highest level of satisfaction from borrowers after loans from small banks.
Mezzanine finance effectively secures a company’s debt on its equity, allowing the lender to claim part-ownership of the business if the loan is not paid back on time and in full. This allows the business to borrow without putting up other collateral, but risks diluting the principals’ equity share in case of default.
Once considered the finance option of last resort, asset-based lending has become a popular choice for small businesses lacking the credit rating or track record to qualify for other forms of finance. In simple terms, it involves borrowing against one of the company’s assets, with the lender focusing on the quality of the collateral rather than the credit rating and prospects of the company. A business may borrow against several different types of asset, including premises, plant, stock or receivables.
In recent years, it has become increasingly difficult for SMEs to obtain traditional finance from banks. Alternative options are invoice discounting or factoring, whereby the company borrows against its outstanding invoices, with the ability to obtain funds as soon as new invoices are created. It is often questioned which option is best for your business – factoring or discounting – and the answer depends on how the business wants to be perceived by customers. With factoring, the finance company charges interest on the loan until the invoice is paid, as well as fees, and the finance company takes ownership of the debtor ledger and uses its own credit control team to secure payment. With invoice discounting, the business maintains control of its own ledger and chases debts itself.
Smaller loans, usually for loan amounts of $100,000 USD or less, are referred to as microloans. Banks are less likely to make these loans than alternative lenders. When they do, the decision is usually based on the personal credit score of the business and/or the business credit score.
Secured and Unsecured Business Loans
Business loans may be either secured or unsecured. With a secured loan, the borrower pledges an asset (such as plant, equipment, stock or vehicles) against the debt. If the debt is not repaid, the lender may claim the secured asset.
Unsecured loans do not have collateral, though the lender will have a general claim on the borrower’s assets if repayment is not made. Should the borrower become bankrupt, unsecured creditors will usually realize a smaller proportion of their claims than secured creditors. As a consequence, secured loans will generally attract a lower rate of interest.
Is Finance an Art or a Science?
The short answer to this question is both. Finance, as a field of study and an area of business, definitely has strong roots in related-scientific areas such as statistics and mathematics. Furthermore, many modern financial theories resemble scientific or mathematical formulas. However, there is no denying the fact that the financial industry also includes non-scientific elements that liken it to an art. For example, it has been discovered that human emotions (and decisions made because of them) play a large role in many aspects of the financial world.
Modern financial theories, such as the Black-Scholes model, draw heavily on the laws of statistics and mathematics found in science; their very creation would have been impossible if science hadn’t laid the initial groundwork. Also, theoretical constructs such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH) attempt to logically explain the behavior of the stock market in an emotionless, completely rational manner, wholly ignoring elements such as market sentiment and investor sentiment.
And while these and other academic advancements have greatly improved the day-to-day operations of the financial markets, history is ripe with examples that seem to contradict the notion that finance behaves according to rational scientific laws. For example, stock market disasters such as the October 1987 crash (Black Monday), which saw the Dow Jones Industrial Average (DJIA) fall more than 22%, and the great 1929 stock market crash beginning on Black Thursday (October 24, 1929) are not suitably explained by scientific theories such as the EMH. The human element of fear also played a part (the reason a dramatic fall in the stock market is often called a panic).
In addition, the track records of investors as a whole have shown that markets are not entirely efficient and, therefore, not entirely scientific. Studies have shown that investor sentiment appears to be mildly influenced by weather, with the overall market generally becoming more bullish when the weather is predominately sunny. Other phenomena include the January effect, the pattern of stock prices falling near the end of one calendar year and rising at the beginning of the next.
The party in a financing arrangement that provides money, property, or another asset to an intermediate entity or financed entity. A financing entity receives a fee for providing financing, and is linked to the financed entity through a chain of financing transactions across all intermediaries.
Financing entities and financed entities represent the two major parties in a financing arrangement. A financing entity provides money that is used by the financed entity. Other entities may serve as intermediaries. The financing entity can borrow the money from a bank or other financial institution using assets as collateral. For example, a business may sell its inventory to a financing entity, which uses this new collateral to secure a loan from a bank. The financing entity then remits the bank funds to the business, and the business repurchases the inventory and provides the financing entity with a fee. While the legal title of the business’ inventory was transferred to the financing entity, for intents and purposes the inventory is still owned by the business.
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