Types of Finance
Finance is a major and vast topic to cover. Accounting and Finance are often used together, and some even deem them to be similar. But there is a significant difference between the two. The article will cover what is finance, what are the types of finance, and the different classes of financial instruments. So, let us understand what is finance.
What is Finance?
Finance is the allocation of assets, liabilities, and funds over time, process, and mediums to reap the most out of the activity. In other words, managing or multiplying funds is in the best interest while tackling the risks and uncertainties. Finance is majorly divided into three segments: Personal Finance, Corporate Finance, and Public Finance.
Personal Finance is managing the finance or funds of an individual and helping them achieve the desired goals in terms of savings and investments. The Personal Finance as a type of finance is specific to individuals and the strategies depend on the individual earning potential, requirements, goals, time frame, etc. Personal finance includes investment in education, assets like real estate, cars, life insurance policies, medical and other insurance, saving, and expense management.
The Personal Finance includes:
- Protection against unforeseen and uncertain personal events
- Transfer of wealth across generations of the family
- Managing taxes and complying with tax policies (tax subsidies or penalties)
- Preparing for retirement
- Preparing for long-term expenses or purchases involving a huge amount
- Paying for a loan or debt obligations
- Investment and wealth accumulation goals
Corporate Finance as one of the types of finance is about funding the company expenses and building the capital structure of the company. It deals with the source of funds and the channelization of those funds like the allocation of funds for resources and increasing the value of the company by improving the financial position. Corporate finance focuses on maintaining a balance between risk and opportunities and increasing asset value.
Corporate Finance Includes:
- Capital budgeting
- Employing standard business valuation techniques or real options valuation
- Identifying the source of funding in the form of equity, shareholders’ funds, creditors, debts
- Determining the utility of unappropriated profits for future investment, operational utilization, or distribution to the shareholders
- Acquisition and investment in stock or other assets
- Identifying relevant objectives, opportunities, and constraints
- Risk management and tax considerations
- Stock issuance while going public and listing on the Stock exchange
This type of finance is related to states, municipalities, and provinces in short government-required finances. It includes long-term investment decisions related to public entities. Public finance takes factors like the distribution of income, resource allocation, and economic stability into consideration. Funds are obtained majorly from taxes, borrowing from banks, or insurance companies.
Public Finance includes:
- Identifying the expenditure required by the public entity
- The sources of revenue for the public entity
- Determining the budgeting process and source of funds
- Issuing debts for public projects
- Tax management
The other two famous terms in Finance are Microfinance and Trade Finance
Microfinance is also known as microcredit. These types of finance are specifically designed for individuals who do not have easy access to financial services.
These individuals include unemployed and lower-income group individuals. Banks may even offer additional services like saving accounts, microinsurance, and training. The main motive behind providing microfinance is to provide an opportunity for these individuals to become self-reliant.
Lenders often grant loans after pooling borrowers to ensure better repayment probability. The repayment amount on such microloans is higher than that of conventional financing due to the risk involved.
- Bank checking and savings account
- Educational programs on the principles of investing
- Training on skills like accounting and bookkeeping including cash flow management, profit and loss statements, etc.
- Basic money management training
- Lessons on financial terms and concepts like interest rate, cash flow, budget, debt, etc.
The Trade Finance includes financial services and instruments as one of the types of finance that enable and facilitate trade internationally. Trade finance is ideal for importers and exporters to carry on smooth international transactions by reducing risk in global trade. Trade finance can help reduce the risk associated with global trade by reconciling the divergent needs of an exporter and importer.
Unlike conventional finance, trade finance is used to protect the two parties from the various risks involved in international trade and does not mean that the parties lack funds or liquidity. The risks involved in international trade are currency fluctuations, non-payment by the party, political instability, the creditworthiness of the parties, etc.
Trade finance involves a third party for conducting a transaction thus eliminating the risk of supply and payment. In trade finance, the exporter is provided with the payment as per the agreement and the importer can avail of a credit facility to fulfill the trade order.
Apart from protecting against the risks, non-payment, and non-receipt of goods, trade finance also improves efficiency and revenue. It enables the company to receive a cash payment based on the accounts receivables as the buyer’s bank guarantees payment. This also ensures timely payments and assured the shipment of goods. The different parties involved in trade finance are importers, exporters, banks, insurers, credit agencies, and trade finance companies.
Instruments in Finance
For availing of financial services, an individual or company needs financial instruments. A Financial Instrument is a contract between two parties and involves monetary activities. Financial instruments can be used for investment purposes or lending and borrowing purposes. Financial instruments are either classified as Cash Instruments or Derivative Instruments:
The value of Cash Instruments is determined by market forces. Cash instruments involve instruments that are easily transferable by the parties. It could be in the form of securities, loans, or deposits. The different types of cash instruments available in the market are certificates of deposits, repurchase agreements like Repos, bills of exchange, interbank loans, commercial papers, e securities, and many more.
The value of Derivative Instruments is derived from the valuation of another entity which can be an asset, an index, or any other factor that can influence the value of the derivatives. The different types of derivative instruments available in the market are futures, forwards, swaps, and options.
Financial instruments are also classified based on their asset class. A debt-based instrument is in the form of loans that the issuing party avails from the investors. Whereas, equity-based instruments reflect ownership based on the share of equity an investor holds.
Debt-based financial instruments include bonds, bond futures and options, Interest rate swaps, Treasury bills, Interest rate futures, and forward rate agreements. Another type of asset class is the Forex Instruments which include forex futures, forex options, currency swaps, and more.