What is Finance?

Seemingly an easy question: we all have an idea of what finance is about . . . money. To give a more exact definition, finance is concerned with the movement of money: when, where, and in what amounts. (We like to refer to it as cash flow because it flows through a company, or from one person to another.) Precisely then, finance is a study of managing the cash flow of an enterprise.

Just as water flows through a pipe, cash flows through our wallets and purses, our companies, and our economy. This flow is uneven however - some companies (and individuals) have more cash flowing out than coming in, and may eventually go bankrupt because of it. If we manage this flow well however, we will have more cash flowing in than goes out - allowing us to place some aside and use it later. (Individuals call this savings; business enterprises call it net income.)

Finance then is a study of how to manage this cash flow in an intelligent, responsible manner. We may do this in the context of cash flowing through a corporation (i.e., corporate finance). Other times, we may examine the cash flow associated with various securities, like stocks and bond (i.e., investments). On other occasions, maybe we will look at managing the cash flow through a bank, pension fund, or insurance company (i.e. financial institutions). But in each case there is a common thread: we want to learn how to manage the cash flow efficiently, so that we do not waste money and that we invest it wisely.

Establish A Strong Foundation

As you begin to study finance closely, you will quickly learn about several principles of finance. These principles underlie virtually everything that you will study in finance, even if you pursue a Ph.D. in the subject. They are surprisingly simple and easy to understand . . . and there are only eight of them! Yet they are the cornerstone of our free enterprise system that we enjoy. Let's take a look at just one to get a glimpse of what is involved.

The risk/return tradeoff

A very simple statement: The higher the risk of an investment, the higher the expected return must be. If this statement were not true, you (and everyone else) would never invest your money in anything. We always have a choice of investing our money in projects that possess varying degrees of risk. For example, assume that you have saved some money to pay your college tuition for next semester. (See, you already have some finance expertise!) However, you would like to earn some interest on the money between now and the beginning of the semester. You have many options, including these two: (1) you can put the money in a passbook savings account at your local bank, or (2) you can lend the money to me (a lowly college professor that you don't yet know)! If we both promise to pay you the same interest rate, which will you choose?

If you are as smart as I think, you will put the money in the bank. Why? Because the bank investment is the lower-risk of the two and the expected return is the same. However, if I doubled (or tripled) the bank's interest rate, I might persuade you to lend me the money. As your expected return goes up, it begins to outweigh the risk and you might decide to lend the money to me.

Almost every decision we make is based on the risk/return tradeoff principle - every car purchase, every decision to drive on icy streets to get groceries, every job offer that is accepted, even every decision to accept a date with someone. This is true of every business decision that we make as well - a banker deciding to lend (or not lend) to someone, a business owner deciding to buy a new machine used in manufacturing the product, or an investor deciding to invest in a particular stock. The risk/return tradeoff determines the outcome of each. First we assess the risk in the situation, estimate the expected return (or satisfaction), and then to decide if an attractive tradeoff exists. If so, we proceed; if not, we do not make the investment.

A study of finance then begins with gaining a complete understanding of this principle. How do we assess the risk of an investment? How do we measure the expected return? What determines whether the tradeoff is attractive or not? Armed with this information, we are then able to intelligently decide whether to make the investment. Coupled with the other seven principles, we are able to establish a foundation that allows us to delve into the more complex issues of finance. However, everything begins with these eight fundamental principles. After that bedrock foundation is constructed, all other financial study is simply adding bricks for the completion of our financial house.

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