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What is finance? Here's what you need to know

At a glance:

  • What is finance?

  • The importance of goals and strategies

  • The role of finance in business and government

  • The role of finance in personal financial planning

  • Summary of finance

We live in a world that depends upon money and financial transactions. The study of finance plays an important role in becoming an educated investor.

The principles of finance are the same for all. The more you understand of these principles, the easier it will be for you to set financial goals and select investments best suited to achieving them.

Employees monitor financial data on their computer screens as they work the brokerage ActivTrades in London on March 15, 2019. - The pound stabilised after a week that saw wild fluctuations as Prime Minister Theresa May suffered a series of embarrassing defeats in parliament as she struggles to push through her Brexit deal. Having seen it thrown out for a second time Tuesday, she will get a third crack of the whip next week after lawmakers eventually agreed to ask Brussels for a delay to the March 29 deadline for leaving the EU. (Photo by Isabel INFANTES / AFP)        (Photo credit should read ISABEL INFANTES/AFP via Getty Images)
Employees monitor financial data on their computer screens as they work the brokerage ActivTrades in London on March 15, 2019. (Photo: ISABEL INFANTES/AFP via Getty Images)

What is finance?

The term finance is used to describe all activities used to generate capital for trade or commerce.

These include raising money by investing (buying and selling) in stocks, bonds, or other investments, and using credit for the purpose of making money. Finance is an important part of the study of economics.

How finance applies to life

The principles of finance apply to governments and businesses large and small, as well as to individuals. Understanding these principles helps one make better decisions about buying, selling, and investing. Failing to understand the principles of finance often leads to bad money decisions, loss and worse, financial disaster.

One might say that finance is the process of accumulating wealth. When done well, finance produces wealth. When done poorly, finance may lead to poverty or, worse, bankruptcy.

Here are some key financial concepts and definitions:

  • Money is the medium of exchange used in trade or commerce. It replaces barter—trading one kind of good or service for another. Money by itself is worthless; its value comes from what it can purchase. It is accepted in trade and commerce by convention and faith in the issuer of money—the government. Sometimes money is referred to as "cash." Credit is a fictional representation of money based on faith that a debtor will repay the creditor with real money.

  • Capital is money or other property that can be used to generate income. Sometimes capital is referred to as "assets." A loan is money that has been borrowed (see "credit" above) from a creditor (lender) by a debtor and must be repaid. Loans are referred to as liabilities. Net worth is the difference when the amount of liabilities is subtracted from the amount of assets. It is also the amount of net capital one owns.

  • Income is money acquired from labor, services, production, or capital. Expense is money paid for consumable goods or services. Profit is the amount of income left after deducting the expenses to acquire it. Loss is the result of expenses exceeding income. Capital gains and capital losses are terms used to describe income derived from the disposition of assets.

The forces we encounter in finance

Following are the three forces at work in finance:

  • Inflation is the tendency for the prices of goods or services to increase over time. It has the effect of making money worth less in the future than it is now because it requires more money to buy the same goods and services in the future than it does today. If the value of a good or service declines, the decline is called deflation.

  • Taxes are a levy of government on income or property. Taxes tend to reduce business and personal income and capital.

  • Risk covers a multitude of natural, legal, and business events that can reduce income or capital. For example, a hurricane that destroys a warehouse containing sugar stores is a natural risk; a lawsuit that results in a high award can reduce a business' or person's income; capital is a legal risk; and investing in a highly speculative venture that fails might be considered a business risk.

    • Some risks can be mitigated through diversification or with insurance. Other risks are systematic and are so broad that there is virtually no way to avoid them: for example, investing in a portfolio of blue chip stocks the day before a major disaster leading to market decline—who could have known?

Finance is the struggle in light of adverse forces to accumulate capital to achieve one's financial goals. This is accomplished by managing income, capital, inflation, taxes, and risk. This is true for governments, businesses, and individuals.

The importance of goals and strategies

Financial success requires managing income, capital, inflation, taxes, and risks.

But how will you measure financial success, and how will you achieve it? In many sports, the winner is the team with the most points, but is accumulating the most money a good way to measure financial success?

One could spend one's whole life accumulating wealth and never achieve one's goals, just by failing to do the things that make one happy. Financial success is measured by achieving one's financial goals. There need to be a clear objective and a strategy to achieve it.

Why you need to be clear

Financial goals need to be clearly defined and obtainable. If financial goals are not clear, you will not know if you achieved them or not.

For example, if a new company that manufactures widgets has a goal of capturing 25% of the widget market in five years and paying shareholders $5 a share, it is pretty clear what they need to do to be successful. However, if there are already 10,000 other manufacturers making widgets, that goal may not be obtainable.

If a couple earning $50,000 a year wants to save $25,000 for a down payment to buy a house in five years, the goal is clear, and they can achieve it if they save 10% of their annual income—this is probably doable. Unrealistic goals thwart a financial plan and cause frustration. Financial goals can be simple or have many facets, but if they are clear and obtainable, they will lead to a strategy for success.

Your goals can offer clues to your strategies

There may be many ways to achieve one's financial objectives, but the goals themselves will suggest ways they can be achieved. For example, if the widget company above were serious about its goal to capture 25% of the market, one strategy might be to acquire many of its successful competitors.

Another strategy might be to undersell its competitors to drive them out of the market. The couple above who wants to save $25,000 in five years might only need to save 8% instead of 10% of their income if they could get a high enough return on their savings.

Setting financial goals requires a good understanding of one's present financial position and having a clear idea of what that position needs to be at various points in the future. Financial statements of net worth and cash flow are helpful in defining one's current financial position.

The next step is to determine how the forces of inflation, taxes, and risk will affect that position over time.

Much of this is guesswork, but the guesses are based on historical data of those factors. Financial forecasts are useful in predicting one's future financial position. They are also useful in determining whether financial goals or objectives are realistic and attainable. In government and corporate finance, accountants and actuaries continually project future financial conditions to help management make day-to-day decisions leading to attainment of their financial goals.

These decisions determine how cash can be raised and how best to invest capital. In personal finance, persons can project future cash needs for education or retirement and from where the cash will come.

An understanding of how inflation, taxes, and risks may affect future cash flow also helps one develop strategies for achieving one's goals by making suitable investment decisions.

The role of finance in business and government

Business cannot operate without good financial statements.

A good balance sheet, statement of cash flow, and profit and loss statement are essential to the orderly conduct of business and for making wise business decisions. The balance sheet defines a business' financial position. The statement of cash flow describes how capital is being used. The profit and loss statement shows where income comes from, where expenses go, and whether the business is profitable or not.

Careful examination of these financial statements helps management make operational and investment decisions that affect the day-to-day operation of the business and help the business achieve its long-term financial goals. They help the business operate more efficiently so it can prosper despite inflation, taxes, and risk.

Business decisions depend on an understanding of finance

Management that understands how inflation, taxes, and risks affect its business can make wise decisions regarding the company budget, which allocates financial resources to maximize long-term profit.

Decisions about inventory, labor, employee benefits, and business expansion — as well as whether to borrow money or use capital assets — depend upon how inflation, taxes, and risks will increase or decrease profit.

For example, if inflation were likely to increase production costs significantly in the near future, management might decide to invest in inventory now to avoid future inventory costs but be able to sell its products at higher prices due to inflation, thus increasing profit.

If management perceived there was a high risk that raw materials it needed in its manufacturing process could be lost in transit, it might decide to invest in insurance to cover the potential loss. This would add a small expense and reduction of profit to avoid a potentially higher loss if the materials were lost.

Studying the financial statements also helps management make financial forecasts and set future financial goals. It then develops strategies for borrowing, capitalization, and operations to achieve those goals.

Governments also make use of financial principles

Government also uses principles of finance to determine what its expenses are and how to raise revenue to pay them.

Governments from federal, state, and on down to municipal levels operate using budgets. Governments have expenses for employees, civic projects, and social programs. Government is also affected by inflation, taxes, and risk, although for the government, taxes are a positive force.

Tax is one way governments raise revenue; borrowing is another. When you hear about a government budget deficit or deficit spending, it means that the government will need to borrow money to pay those expenses. It will get the money back from future taxes to pay the loans. If inflation or risk costs the government more money, taxes may be raised in order to pay for it.

Government plans its budget several years in advance so it has an idea of how much revenue it needs to raise, how much will come from taxes, and how much will come from borrowing by selling bonds.

Both business and government rely on the principles of finance to achieve their financial goals. They project future cash needs and determine how the forces of inflation, taxes, and risk will affect them. They then make strategic investment decisions to maximize profits and minimize expenses to achieve their goals.

The role of finance in personal financial planning

The principles of finance can be used by persons who want to achieve specific financial goals.

When applied to individuals and families, the principles of finance are called personal financial planning. The process starts by defining clear financial objectives.

A personal net worth statement and statement of cash flow are important to identifying current capital resources (net worth) and income resources (cash flow) available for achieving those goals.

A financial plan is like a map you would use when planning a trip. You need to know where you are starting from (current net worth) and where you want to end up (goals), and to assess the resources you have to make the trip (cash flow).

Of course, if you have the resources, you may decide to make some side trips off the main route (intermediate goals). You must also consider potential setbacks to your plans (inflation, taxes, and risks) that might cause you to alter your plan.

These are identified in various cash needs analyses such as educational funding needs, insurance needs, retirement needs, and estate planning. Cash needs analysis is a personal financial forecast.

Why you should use financial data

Financial statements and forecasts help persons develop financial strategies for achieving their financial objectives.

First, they help determine whether one's goals are achievable.

Next, they help determine an individual's risk tolerance and risk aversion. Risk aversion is an emotional reaction to risk. No one really wants risk. If given a choice of taking risk and achieving one's goals or taking no risk and achieving one's goals, most sane persons would choose the latter.

However, it is never that simple. There is always risk, so the conundrum becomes how much risk and what kind of risk one is willing to take—risk tolerance. Since the only three things that can prevent persons from achieving their realistic goals are inflation, taxes, and risk, a personal financial plan needs to address those forces and develop strategies for overcoming them.

Much of what goes into cash needs analysis is guesswork about the effects of inflation, taxes, and risk over various future time periods.

But these are educated guesses based on historic data and current economic policy and conditions. It is even possible to develop hypothetical models to determine the probability of success or failure for different strategies.

No strategy can be guaranteed, but with regular updates and fine tuning, a strategy is more likely to be successful than leaving things to random chance is.

A good personal financial plan is flexible and periodically (usually annually) tests assumptions about inflation, taxes, and risks as well as updating one's financial statements to see whether the plan is on course. If adjustments are made periodically and whenever there are major financial changes in one's life (marriage, divorce, childbirth, death, job change, etc.), a financial plan is more likely to succeed.

Why you need a budget

The mainstay of a personal financial plan is a good cash management plan (budget).

A budget helps persons allocate capital and income to provide for present financial needs and accumulate capital for future needs. A budget minimizes income shrinkage due to taxes and helps control expenses.

A budget also helps persons determine how best to use credit. A budget forces persons to focus on their financial goals. Akin to a budget is an investment plan that directs how capital assets are to be invested to maximize short-, intermediate-, and long-term returns with minimum investment risk and tax loss.

A risk management plan helps persons handle potential risks such as loss of income due to illness, accident, or death; loss of income and capital resulting from legal action (tort) such as liability in an accident; or loss of capital (property loss) due to natural disaster or mischief.

Finally, an estate plan helps persons determine how best to position capital assets to avoid unnecessary taxes and to provide for those who survive the person.

Summary of finance

The principles of finance have been around since the invention of money. These principles help governments, businesses, and individuals plan to achieve their financial goals. Without these principals, financial success is a matter of luck.

Financial success relies on income and capital to provide for economic needs and expenses. Financial goals define future needs. Financial strategies map out the way to achieve the goals.

There are three kinds of hindrance to financial success: inflation, taxes, and risk. By managing these deterrents to income and capital, one has a better chance at achieving one's goals.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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