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 and economics 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. The ability to keep competitors at bay is valuable because it ensures that the company can continue to earn economic profits.
Finance is
- Analytical, using statistical, probability, and mathematics to solve problems.
- Based on economic principles.
- Uses accounting information as inputs to decision-making.
- Global in perspective.
- The study of how to raise money and invest it productively.
The tools used in financial decision-making, however, draw from many areas outside of economics: financial accounting, mathematics, probability theory, statistical theory, and psychology. We can think of the field of finance as comprised of three areas: capital markets and capital market theory, financial management, and investment management. The three areas are all intertwined, based on a common set of theories and principles.
In the balance of this website, we discuss each of these specialty areas.