What Is Finance?
Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty. Investors allocate their funds among fi nancial assets in order to accomplish their objectives, and businesses and governments raise funds by issuing claims against themselves that are invested. Finance provides the framework for making decisions as to how those funds should be obtained and then invested.
It is the financial system that provides the platform by which funds are transferred from those entities that have funds to invest to those entities that need funds to invest. The theoretical foundations for finance draw from the field of economics and, for this reason, finance is often referred to as financial economics. The tools used in financial decision-making, however, draw from many areas outside of economics: financial accounting, mathematics, probability theory, statistical theory, and psychology.
In Chapters 2 and 3, we cover the mathematics of fi nance as well as the basics of fi nancial analysis that we use throughout this book. We need to understand the former topic in order to determine the value of an investment, the yield on an investment, and the cost of funds.
The key concept is the time value of money, a simple mathematical concept that allows financial decision-makers to translate future cash flows to a value in the present, translate a value today into a value at some future point in time, and calculate the yield on an investment.
The time-value-of money mathematics allows an evaluation and comparison of investments and financing arrangements. Financial analysis involves the selection, evaluation, and interpretation of financial data and other pertinent information to assist in evaluating the operating performance and financial condition of a company.
These tools include financial ratio analysis, cash flow analysis, and quantitative analysis. It is generally agreed that the field of finance has three specialty areas:
Capital markets and capital market theory
Financial management
Investment management
We cover these three areas in this book in Parts Two, Three, and Four
of this book. In this chapter, we provide an overview of these three specialty
areas and a description of the coverage of the chapters in the three parts of
the book.
