The Basics of Finance

What Is Finance? A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed. —Warren Buffett, Letter to Shareholders of Berkshire Hathaway, February 2008

Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty. In other words, in finance we worry about money and we worry about the future. Investors allocate their funds among financial assets in order to accomplish their objectives, and businesses and governments raise funds by issuing claims against themselves and then use those funds for operations. Finance provides the framework for making decisions as to how to get funds and what we should do with them once we have them. It is the financial system that provides the platform by which funds are transferred from those entities that have funds to those entities that need funds. The foundations for finance draw from the field of economics and, for this reason, finance is often referred to as financial economics. For example, as you saw with the quote by Warren Buffett at the beginning of this chapter, competition is important in the valuation of a company.

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