What Does Finance Mean? Its History, Types, and Importance Explained (2024)

What Is Finance?

Finance is a term that addresses matters regarding the management, creation, and study of money and investments. It involves the use of credit and debt, securities, and investment to finance current projects using future income flows. Finance is closely linked to the time value of money, interest rates, and other related topics because of this temporal aspect.

Finance can be broadly divided into three categories:

• Public finance
• Corporate finance
• Personal finance

Other specific categories include behavioral finance, which seeks to identify the cognitive, emotional, social, and psychological reasons behind financial decisions.

Understanding Finance

Finance is typically broken down into three broad categories: public finance, corporate finance, and personal finance.

Public finance includes tax systems, government expenditures, budget procedures, stabilization policies and instruments, debt issues, and other government concerns. Corporate finance involves managing assets, liabilities, revenues, and debts for businesses. Personal finance defines all financial decisions and activities of an individual or household, including budgeting, insurance, mortgage planning, savings, and retirement planning.

Key Finance Terms

Asset: An asset is something of value such as cash, real estate, or property. A business may have current assets or fixed assets.

Balance sheet: A balance sheet is a document that shows a company’s assets and liabilities. Subtract the liabilities from the assets to find the firm’s net worth.

Cash flow: Cash flow is the movement of money into and out of a business or household.

Compound interest: Compound interest is calculated and added periodically, unlike simple interest which is interest added to the principal one time. This results in interest being charged not only on the principal but also on the interest that's already accrued.

Equity: Equity means ownership. Stocks are called equities because each share represents a portion of ownership in the underlying corporation or entity.

Liability: A liability is a financial obligation such as debt. Liabilities can be current or long-term.

Liquidity: Liquidity refers to how easily an asset can be converted to cash. Real estate isn't a very liquid investment because it can take weeks, months, or even longer to sell.

Profit: Profit is the money that's left over after expenses. A profit and loss statement shows how much a business has earned or lost for a particular period.

History of Finance

Finance arose as a study of theory and practice distinct from the field of economics in the 1940s and 1950s. It began with the works of Harry Markowitz, William F. Sharpe, Fischer Black, and Myron Scholes. Particular realms of finance such as banking, lending, and investing have been around in some form since the dawn of civilization.

The financial transactions of the early Sumerians were formalized in the Babylonian Code of Hammurabi around 1800 BCE. This set of rules regulated ownership or rental of land, employment of agricultural labor, and credit. Yes, there were loans back then, and yes, interest was charged on them. Rates varied depending on whether you were borrowing grain or silver.

Cowrie shells were used as a form of money inChina by 1200 BCE. Coined money was introduced in the first millennium BCE. King Croesus of Lydia, which is now Turkey, was one of the first to strike and circulate gold coins around 564 BCE. Hence the expression “rich as Croesus.”

Coins were stored in the basem*nt of temples in ancient Rome because priests and temple workers were considered to be the most honest and devout to safeguard assets. Temples also loaned money, acting as financial centers of major cities.

Early Stocks, Bonds, and Options

Belgium claims to be home to the first exchange with one in Antwerp dating back to 1531. East India Co. became the first publicly traded company in the 1600s as it issued stock and paid dividends on proceeds from its voyages. The London Stock Exchange was created in 1773 and was followed by the New York Stock Exchange less than 20 years later. The London Exchange had been around since the 1570s as the Royal Exchange.

The earliest recorded bond dates back to 2400 BCE. It was a stone tablet that recorded debt obligations that guaranteed repayment of grain. Governments began issuing debts to fund war efforts during the Middle Ages. The Bank of England was created to finance the British Navy in the 1600s. The United States began issuing Treasury bonds to support the Revolutionary War nearly a century later.

The early practice of options is outlined through an anecdote by the philosopher Thales In Aristotle’s 4th-century philosophical work, “Politics.” Thales preemptively acquired the rights to all olive presses in Chios and Miletus, believing that a great harvest of olives was on the horizon in the coming year. Both forward and options contracts were integrated into Amsterdam’s sophisticated clearing process by the mid-17th century.

Advances in Accounting

Compound interest is interest that's calculated not just on principal but on previously accrued interest. It was known to ancient civilizations. TheBabylonianshad a phrase for “interest on interest,” which basically defines the concept. But it wasn't until medieval times that mathematicians started to analyze to show how invested sums could mount up.

One of the earliest and most important sources is the arithmetical manuscript written by Leonardo Fibonacci of Pisa, known as “Liber Abaci,” in 1201. It gives examples comparing compound and simple interest.

Luca Pacioli’s “Summa de arithmetica, geometria, proportioni et proportionalita”was the first comprehensive treatise on bookkeeping and accountancy. It was published in Venice in 1494.

A book on accountancy and arithmetic written by William Colson appeared in 1612, containing the earliest tables of compound interest written in English. Richard Witt published his “Arithmeticall Questions” in London a year later in 1613 and compound interest was thoroughly accepted.

Interest calculations were combined with age-dependent survival rates to create the first life annuities in England and the Netherlands toward the end of the 17th century.

Types of Finance

Public Finance

The federal government helps prevent market failure by overseeing the 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 helps finance the federal government.

State and local governments receive grants and aid from the federal government. Other sources of public finance include:

• User charges from ports, airport services, and other facilities
• Fines resulting from breaking laws
• Revenues from licenses and fees, such as for driving
• Sales of government securities and bond issues

Corporate Finance

Businesses obtain financing through a variety of means 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 become more profitable.

Startups may receive capital from angel investors or venture capitalists in exchange for a percentage of ownership. A company will issue shares on a stock exchange if it thrives and goes public. Such initial public offerings (IPOs) bring a great influx of cash into a firm. Established companies may sell additional shares or issue corporate bonds to raise money.

Businesses might also purchase dividend-paying stocks, blue-chip bonds, or interest-bearing bank certificates of deposit (CDs). They may buy other companies in an effort to boost revenue.

Some examples of corporate financing include:

• Bausch & Lomb Corp.’s IPO was initially filed on Jan. 13, 2022 and officially sold shares in May 2022. The healthcare company generated $630 million in proceeds.
• Ford Motor Credit Co. LLC manages outstanding notes to raise capital or extinguish debt to support Ford Motor Co.
• HomeLight, a real estate company, used a blended financial approach to raise $115 million: $60 million by issuing additional equity and $55 million through debt financing. HomeLight used the additional capital to acquire lending startup Accept.inc.

Personal Finance

Personal financial planning generally involves analyzing an individual’s or a family’s current financial position, predicting short- and long-term needs, and executing a plan to fulfill those needswithin individual financial constraints. Personal finance depends largely on one’s earnings, living requirements, and goals and desires.

Matters of personal finance include but aren't limited to the securing of financial products like credit cards, life and home insurance, mortgages, and retirement products. Personal banking products such as checking and savings accounts, individual retirement accounts (IRAs and 401(k) plans) are also considered a part of personal finance.

The most important aspects of personal finance include:

• Assessing the current financial status such as expected cash flow and current savings
• Buying insurance to protect against risk and to ensure that one’s material standing is secure
• Calculating and filing taxes
• Earmarking savings and investments
• Planning for retirement

Personal finance is a specialized field although 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 because “home economics” appeared to be the purview of housewives. Economists have repeatedly stressed widespread education in matters of personal finance as integral to the macro performance of the overall national economy.

Social Finance

Social finance typically refers to investments made in social enterprises including charitable organizations and some cooperatives. These investments take the form of equity or debt financing in which the investor seeks both a financial reward and a social gain.

Forms of social finance 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 earn a return on their loans while simultaneously helping to improve individuals’ standards of living and to benefit 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.

Behavioral Finance

There was a time when theoretical and empirical evidence seemed to suggest that conventional financial theories were reasonably successful at predicting and explaining certain types of economic events. Academics in the financial and economic realms nonetheless detected anomalies and behaviors that occurred in the real world but couldn't be explained by any available theories.

It became increasingly clear that conventional theories could explain certain “idealized” events but the real world was a great deal messier and more disorganized. Market participants frequently behave in ways that are irrational and difficult to predict according to those models.

Academics began to turn to cognitive psychology to account for irrational and illogical behaviors that can't be explained by modern financial theory. The field of behavioral science was born out of these efforts. It seeks to explain our actions whereas modern finance looks to explain the actions of the idealized “economic man (hom*o economicus).”

Behavioral finance is a subfield of behavioral economics. It proposes psychology-based theories to explain financial anomalies such as severe rises or falls in stock prices. The purpose is to identify and understand why people make certain financial choices.It's assumed within behavioral finance that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.

Daniel Kahneman and Amos Tversky began to collaborate in the late 1960s and are considered by many to be the fathers of behavioral finance. Richard Thaler joined them later and combined economics and finance with elements of psychology to develop concepts like mental accounting, the endowment effect, and other biases that have an impact on people’s behavior.

Tenets of Behavioral Finance

Behavioral finance encompasses many concepts but four are key.

Mental accounting refers to the propensity for people to allocate money for specific purposes based on miscellaneous subjective criteria such as the source of the money and the intended use for each account. The theory of mental accounting suggests that individuals are likely to assign separate functions to each asset group or account. The result can be an illogical and even detrimental set of behaviors.Some people keep a special “money jar” set aside for a vacation or a new home while carrying substantial credit card debt at the same time.

Herd behavior states that people tend to mimic the financial behaviors of the majority whether they're rational or irrational. Herd behavior is a set of decisions and actions that an individual wouldn't necessarily make on their own in many cases but which seem to have legitimacy because “everyone’s doing it.” Herd behavior is often considered a major cause of financial panics and stock market crashes.

Anchoring refers to attaching spending to a certain reference point or level even though it may have no logical relevance to the decision at hand. One common example of anchoring is the conventional wisdom that a diamond engagement ring should cost about two months’ worth of salary. Another might be buying a stock that briefly rose from trading around $65 to hit $80 and then fell back to $65 out of a sense that it’s now a bargain. That could be true but it’s more likely that the $80 figure was an anomaly and $65 is the true value of the shares.

High self-rating refers to a person’s tendency to rank themself better than others or higher than an average person.An investor might think that they're an investment guru when their investments perform optimally, blocking out the investments that are performing poorly. High self-rating goes hand in hand with overconfidence which reflects the tendency to overestimate or exaggerate one’s ability to successfully perform a given task. Overconfidence can be harmful to an investor’s ability to pick stocks. A 1998 study by researcher Terrance Odean found that overconfident investors typically conducted more trades compared with their less-confident counterparts and these trades produced yields significantly lower than the market.

Finance vs. Economics

Economics and finance are interrelated, informing and influencing each other. Investors care about economic data because they also influence the markets to a great degree. Investors should avoid “either/or” arguments regarding economics and finance. Both are importantand havevalidapplications.

The focus of economics and especially macroeconomics tends to be a bigger picture in nature such ashow a country, region, ormarket is performing. Economics can also focus onpublic policy. The focus of finance is more individual-, company-, orindustry-specific.

Microeconomics explains what to expect if certain conditions change on the industry, firm, or individual level. Microeconomics says that consumers will tend to buy fewer cars than before if a manufacturer raises the prices of cars. The price of copper increases if a major copper mine collapses in South America because supply is restricted.

Finance also focuses onhow companies and investors evaluateriskand return. Economics has historically been more theoretical and finance more practical but the distinction has become much less pronounced since 2000.

Is Finance an Art or a Science?

Finance As a Science

As a field of study and an area of business, finance has strong roots in related scientific areas such as statistics and mathematics. Many modern financial theories resemble scientific or mathematical formulas.

There's no denying, however, that the financial industry also includes nonscientific elements that liken it to an art. It's 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. Theoretical constructs such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH) attempt to explain the behavior of the stock market in an emotionless, completely rational manner, ignoring elements such as market and investor sentiment.

Finance As an Art

Academic advancements have greatly improved the day-to-day operations of the financial markets but history is rife with examples that seem to contradict the notion that finance behaves according to rational scientific laws.

Stock market disasters such as the October 1987 crash (Black Monday) that saw the Dow Jones Industrial Average (DJIA) fall 22% and the great 1929 stock market crash beginning on Black Thursday (Oct. 24, 1929) aren't suitably explained by scientific theories. The human element of fear also played a part. A dramatic fall in the stock market is often called a “panic."

The track records of investors have shown that markets aren't entirely efficient and they're therefore not entirely scientific, either. Studies have shown that investor sentiment appears to be mildly influenced by weather with the overall market generally becoming more bullish when it's predominantly sunny. Other phenomena include the January effect when stock prices fall near the end of one calendar year and rise at the beginning of the next.

Careers in Finance

Many career options are available for those interested in finance.

Accountant: An accountant manages a company’s financial records, tracks expenses, and runs reports.

Auditor: An auditor is tasked with ensuring accuracy in financial records. They may work in private practice auditing client companies, be employed by a company to ensure internal propriety, or they may work for the government.

Banker: A commercial banker works with businesses to provide banking services such as accounts and loans. An investment banker focuses on companies looking to raise capital or conduct a sale or merger.

Capital manager: A capital management professional helps a company allocate its capital resources between investment options.

Lender: An individual who works in lending, such as a loan officer, manages the issuance of loans. A mortgage lender would work contracts to secure a real estate loan.

Market analyst: Market analysts evaluate trends and make forecasts that account for changing market conditions. They prepare recommendations that can guide a company’s financial decisions.

How Much Do Finance Jobs Pay?

• A personal financial advisor’smedianannual compensation is $94,170, according to U.S.Bureau of Labor Statistics (BLS) statistics.
• The median pay for budget analysts, the professionals who examine how a company or organization spends money, is a solid $79,940 annually. A job as a treasury analyst pays $64,508 a year on average, according to Payscale. Corporate treasurers who have more experience make an average salary of $118,704.
• Financial analysts earn a median of $81,410 although salaries usually run in the six figures at major Wall Street firms.
• Accountants and auditors’ median pay clocks in at $77,250. The average salary for CPAs ranges from $50,000 to $126,000 per year, according to Payscale.
• Financial managers create financial reports, direct investment activities, and develop plans for the long-term financial goals of their organization. They have a median pay of $131,710 per year, reflecting that theirs is a fairly senior position.
• Securities, commodities, and financial services sales agents are brokers and financial advisors who connect buyers and sellers in financial markets. They earn a median of $62,910 per year. Their compensation is often commission-based, however, so a salaried figure may not fully reflect their earnings.

Chief financial officers (CFOs) have the highest salaried jobs in finance, according to an Indeed survey. They earned an average of $144,563 before bonuses as of 2024.

The Bottom Line

Finance is a broad term that describes a variety of activities but they all boil down to the practice of managing money: getting, spending, and everything in between from borrowing to investing. Finance also refers to the tools and instruments people use in relation to money and the systems and institutions through which activities occur.

Finance can involve something as large as a country’s trade deficit or as small as the dollar bills in a person’s wallet. Very little could function without it, not an individual household, a corporation, or a society.