What is finance? For most of us, finance means money. As generic as that description is, it's apt and limited, all at once. Part of the vagueness comes from the definition of money, which is usually - and incorrectly, taken to mean cash. Another misconception stems from the belief that finance is strictly buying something on credit, like a car or a house. Some may even venture to guess the three domains of finance are cash, credit and financial instruments: everything else from stocks and bonds to money markets.
The breakdown is much simpler; it addresses different scopes of financial activity:
- Personal finance: individual and families' assets and liabilities, from the cash in their bank account to any loans they might have.
- Corporate finance: companies' capital structure, sources of funding and how they allocate financial resources.
- Public finance: economic stability, income distribution and allocation of available resources. Public finance represents the role of government in the economy.
These three 'domains' of finance have one goal in common. Individuals, corporations and governments want the highest possible yield with the least amount of risk for the resources they have at their disposal. That's where the similarities end. Individuals are self-interested, corporations are beholden to their shareholders and governments answer to their citizens. The way each 'domain' uses, conserves and manages financial resources is vastly different. Let's find out how.
Click here to find out more on finance management.
As a discipline, personal finance is a relatively new concept. Until about 100 years ago, people not counted among the wealthy had little cash at their disposal. Few bothered with a bank account and what savings they had were safeguarded close-by. Forget credit cards! Besides the fact that such things didn't exist until about 60 years ago, no financial institution would give credit to someone without any means to repay their debt or anything they could put up for collateral.
None of that means that the financial concerns of yesteryear were less than they are today. Then as now, individuals and households consider the same financial focus areas. The household budget sits at the top of the list: what's coming in versus what's going out? Next comes risk protection. Today, that includes various types of insurance - health, life, car and property.
If not self-employed - a status that calls for paying taxes on your own instead of coming out of your pay cheque, savings ranks third. Savvy savers build up an emergency fund in case income dries up. Beyond that, saving is for big-ticket items like a new telly or higher education. Finally: investment and retirement planning.
As well-intentioned and meticulous as an individual finance planner might be, their efforts may be hindered by external variables. A catastrophic illness and being aged out of their job are beyond one's control, as are investments not panning out. Insufficient investments to see one through retirement are becoming more common as people live longer, thanks to modern medicine. The flip side of that coin is, of course, rising medical costs. There may be more medical magic to keep us alive but it all comes with a price tag attached.
Managing finance at the individual level is challenging, especially because, unlike corporations and governments, we can't get big subsidies and low-interest loans to keep us afloat. Indeed, personal finance may be the riskiest of all these scopes of finance.
Starting in the 1980s, corporate finance's overarching goal has been to increase the company's value to the shareholders. To that end, finance managers have a host of tools at their disposal, all of which fall under one of two sub-headers. Capital budgeting tracks funds for projects that will add to the firm's value. Working capital covers expenses like inventory, payroll and other ordinary expenses.
Managerial finance, a branch of financial theory, is often mistakenly thought to be a part of corporate finance. It does, in fact, consider corporations when studying the finance management of firms in general but it is more of an academic exercise. It's not a part of a company's operation.
The finance manager's job is to maximise shareholder value. Thus, they are perpetually engaged in a balancing act between initiatives to increase the company's profitability and paying dividends to shareholders. Perhaps their work is better described as a tug-of-war because shareholders demand at least consistent dividends but company costs and paying for projects don't ever get any cheaper. Thus, their secondary role is finding and investing in growth opportunities that will generate higher profits.
Mergers, acquisitions and expanding operations are some examples of growth opportunities finance managers pursue. Cost-cutting measures such as inventory reduction and reducing staffing may only be undertaken if they add value and don't threaten the immediate or future health of the company's bottom line.
The concept of public finance is easy to understand if you think back on your childhood. Everyone's talking about their new game consoles. You want one too so you ask your parents. Those things are quite expensive, just on their own, and you have to buy the games separately. Oh, and the headset, too, so you can chat while you play. And it will raise the electric bill a bit.
Unfortunately, things haven't been going so well lately. Everything's more expensive, from food and petrol to school uniforms, and there are worrying times ahead. Not much left for extras, is there? Your parents examine the idea through a variety of lenses: buying it on credit, putting the purchase off - it would make a nice holiday gift; buying second-hand or refusing your request.
This scenario captures the essence of public finance. Governments have many factors to consider when allocating resources, from spending on defence to funding the NHS. They must ensure they allocate their resources efficiently, that the population benefits equally from the country's earnings (its gross domestic product or GDP), and that the economy remains stable throughout.
Managing finance at this level is no walk in the park. How and when a government might intervene in the economy depend on whether a market failure has put things on rocky ground. Redistribution of income is another reason governments might step in but, in either case, they must carefully choose which policy or financial tool - subsidies, raising/lowering taxes or some public provision, will be most effective at restoring the balance.
Those agents must also be able to rationalise why they chose as they did and analyse the intervention's effects.
Connecting the Three Domains of Finance
At a glance, connecting the dots seems to be a simple exercise. Individuals earn their pay from corporations and pay a portion of their income to the government in taxes. Corporations mean jobs through which individuals can earn money to pay their bills and shop, thus keeping the economy afloat. The government 'thanks' corporations by giving them tax breaks and other subsidies. It also makes sure that public services - transportation, healthcare and infrastructure maintenance are sufficiently funded, creating a backdrop against which everything functions.
If everything remained optimal - reasonable inflation, steady supply/demand, no tax hikes and no excessive claims to assets, the personal-corporate-public finance triangle would form the sturdiest economic structure. However, the only constant is change, as we well know. Some of the changes negatively impacting finance today are induced while others reflect the fallout of provoked changes and external events.
Corporations wield outsized economic power. Simply speculating on relocation is enough to spur the public finance sector to offer up greater incentives so firms won't pull up stakes. Their doing so would cause profound economic distress: high unemployment, abandoned structures and, of course, the loss of revenue. This must be prevented at all costs.
COVID laid bare the challenges of these three scopes of finance and their interdependence. People couldn't work so corporations' profits tanked. The government had to step in to keep both the personal and corporate corners of finance afloat. They did so at great cost, which meant cutting other areas of consideration in public finance. The pandemic's aftermath continues to prove the fragility of finance through supply chain issues and shortages, rising prices and stagnant wages.
The personal finance domain is the hardest hit by this external event and there's not much they can do about it. Corporations, beholden as they are to their shareholders, have every incentive to pursue business as usual and, perhaps, take advantage of the ongoing chaos. This further stresses both the personal and public finance domains. The government's mandate to ensure the equitable distribution of income and efficient allocation of resources is flooded with pleas to do so while simultaneously getting pounded with accusations that it's not.
All of the financial systems - lending, borrowing and investing must operate in concert to satisfy the interests of the three 'domains' of finance. Their interdependence doesn't rely on how well each does when conditions are optimal but on how well they mesh to survive the perfect storm of failures. The turmoil we see now is the result of unforeseen circumstances affecting all three scopes of finance in the most severe ways possible.
The platform that connects tutors and students