Types of Finance with Explanation

Evidence proved that the origin of finance is also old like human life on this earth. Originally, the word finance is a French word. In the eighteenth century, it was adopted by the English to mean “the management of money.” Finance is the management of funds or money and involves activities such as budgeting, borrowing, forecasting, investing, lending and saving. In other words, finance is the study of managing funds and the process of acquiring the required funds.

Types of Finance

There are mainly two types of finance:

The other types of finance are

Public Finance,

Personal Finance,

Corporate Finance and

Private Finance.

Each of the types is explained below with definition and explanation.

1. Debt Finance:

Basically, the cash which you acquire to maintain or run your business is known as debt finance. Debt finance does not provide ownership control to the moneylender; the borrower must repay the principal amount along with the agreed upon interest rate. Mostly, the interest rate is determined based on the loan amount, duration, the purpose for borrowing the specific type of finance and inflation rate.

Debt finance can be classified into three types:

Short-term

Medium-term and

Long-term

Short-term Debt Finance:

Loans generally needed for a period of more than one to one hundred and eighty days is called short-term debt finance. These loans are borrowed for covering the shortage of finance and temporary or occasional requirements. Short-term finance is basically required for daily business activities such as paying wages to the staffs or getting raw materials. The amount of getting a short-term loan is dependent mostly on the other sources of income for repaying. The lines of credit from the business’s suppliers are the most common forms of short-term debt finance.

Trade credit, credit cards, bill discounting, bank overdraft, working capital loans, small business loans, short-term loans from retail banks and advances from customers are some other forms of short-term finance.

Medium-term Debt Finance:

Loans generally required for a period of more than one hundred and eighty to three hundred and sixty-five days is called medium-term debt finance. The way of utilizing the funds are mostly dependent on the type of business. The businesses generally, repay the loan from the sources of cash-flow of the businesses. Businesses choose this type of finance to purchase equipment, fixed assets and the like.

Sometimes small business owners or startups use medium-term debt finance for fulfilling the fund’s rotation. Because new businesses must pay beforehand to suppliers for every required good such as buying equipment, machinery, inventories and the like. Hire purchase finance, lease finance, medium-term credits from commercial banks and issue of bonds/debentures are some examples of medium-term debt finance.

Long-term Debt Finance:

Loans generally required for a period of more than three hundred and sixty-five days is called long-term debt finance. This type of finance is mostly needed for buying plant, land, restructuring offices or buildings, etc. for a business. Long-term finance has a better interest rate than short-term finance. This debt finance usually has a repayment duration of five, ten or twenty years.

Car loans or home loans are two popular examples of long-term finance. Issue of bonds/debentures, Issue of preference shares, issue of equity shares, long-term loans from government, financial services institutions or investment banks, venture funding or funds from investors, are other examples of long-term debt finance.

2. Equity Finance:

Equity finance is a classic way of raising capital for businesses by issues or offering shares of the company. This is one of the major differences in equity finance from debt finance. This finance is generally applied for seed funding for start-ups and new businesses. Well-known companies apply this finance to raise additional capital for the expansion of their business.

Equity finance is generally raised by issues or offering equity shares of the business. Basically, each share is an owner’s unit for that specific company. For instance, if the company has offered 10,000 equity shares to public investors. An investor buys 1000 equity shares of that company, means s/he holds 10% of ownership in the company.

The other types of finance are discussed below:

Public Finance:

Public finance deals with the study of the state’s expenditure and income. It considers only the government’s finances. The scope of public finance includes the fund’s collection and its allocation among different sectors of state activities that are considered as essential functions or duties of the government.

Public finance can be classified into three types:

Public Expenditure

Public Revenues

Public Debt

i. Public Expenditure:

Public expenditure means the expenses incurred by the government for its maintenance and for the welfare and preservation of the economy, society, and the nation.

ii. Public Revenues:

Broadly public revenues include all the receipts and income irrespective their nature and source, which the government acquires during any given period. It will also include the loans raised by the government. Narrowly, it will include only the income from revenue resources which include taxes, price, fees, penalties, fines, gifts, etc.

iii. Public Debt:

Public debt means the loans raised which is a source of public finance carrying with it the repayment obligation to the individuals and the interest.

Personal Finance:

Personal finance denotes the application of finance’s principles to the monetary decisions of a family or an individual. It includes the ways in which families or individuals get, budget, spend and save monetary resources over a period, considering different future life events and financial risks. Financial position is focused on understanding the available personal resources by examining the household cash flows and net worth. Net worth is an individual’s balance sheet, derived by summing up all assets under that individual’s control, minus the household’s all liabilities at a time.

Corporate Finance:

Corporate finance includes financial activities pertaining to running a corporation. It is a department or division which oversees the financial functions of a company. The primary concern of corporate finance is the maximization of shareholder value through short-term and long-term financial planning and different strategies’ implementation.

Private Finance:

Private finance denotes an alternative method of corporate finance helping a company raise fund to avoid monetary problems with a limited time frame. Basically, this method helps a company which is not listed on a securities exchange or is incapable to obtain finance on such markets. A private financial plan can also be suitable for a nonprofit organization.

Definition, Overview, Types of Finance

Finance Definition The management of money Written by CFI Team Updated November 26, 2022

What is Finance?

Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting. There are three main types of finance: (1) personal, (2) corporate, and (3) public/government. This guide will unpack the question: what is finance?

Video Explanation of Finance

Watch this short video to quickly understand the main concepts covered in this guide. It’ll explain the definition of finance, provide examples of finance, and cover some of the common topics on finance.

Examples

The easiest way to define finance is by providing examples of the activities it includes. There are many different career paths and jobs that perform a wide range of finance activities. Below is a list of the most common examples:

Investing personal money in stocks, bonds, or guaranteed investment certificates (GICs)

Borrowing money from institutional investors by issuing bonds on behalf of a public company

Lending money to people by providing them a mortgage to buy a house with

Using Excel spreadsheets to build a budget and financial model for a corporation

Saving personal money in a high-interest savings account

Developing a forecast for government spending and revenue collection

Finance Topics

There is a wide range of topics that people in the financial industry are concerned with. Below is a list of some of the most common topics you should expect to encounter in the industry.

Finance Careers

A definition of finance would not be complete without exploring the career options associated with the industry. Below are some of the most popular career paths:

Additional Finance Resources

To continue developing and preparing for a career in the field, these additional CFI materials will be helpful:

More Questions and Answers

CFI’s mission is to help anyone become a world-class financial analyst and has a wide range of resources to help you along the way. In order to become a great financial analyst, below are some additional questions and answers for you to explore further:

Financing

Financing The methods and types of funding used by a business to sustain and grow its operations Written by CFI Team Updated October 11, 2022

What is Financing?

Financing refers to the methods and types of funding a business uses to sustain and grow its operations. It consists of debt and equity capital, which are used to carry out capital investments, make acquisitions, and generally support the business. This guide will explore how managers and professionals in the industry think about the financing activities of a company.

Financing Activities

On a company’s cash flow statement, there is a section that’s referred to as cash flow from financing activities, which summarizes how the business was funded over a particular period.

Activities include:

Issuing debt to raise money

Repaying debt

Issuing equity to raise money

Repurchasing equity

Paying dividends

Debt vs Equity

Managers of businesses have two choices when it comes to funding activities: debt or equity. There are pros and cons to each, and the optimal choice is often a combination of each.

Characteristics of debt financing:

A loan that must be repaid

Bears an interest expense

Has a maturity date

Must be repaid before equity in the event of insolvency

Cheaper than equity capital

Adds risk to the business

Characteristics of equity financing:

Direct ownership in the company

Has no interest payments, but may have a dividend

Permanent capital, no maturity (except for certain types of preferred shares)

Last to be repaid

More expensive than debt

Capital Structure

The decision between debt vs equity financing is what ultimately determines a company’s capital structure. The optimal capital structure for a business is typically considered that which results in the lowest weighted average cost of capital (WACC). While that’s true in theory, in practice, managers of firms tend to have preferences depending on how risk averse they are.

A firm’s WACC is a function of the cost of debt and the cost of equity, expressed in the following formula:

Considerations

When managers of business think about their financing strategy, there are many factors that need to be taken into account.

These important considerations include:

Current cash balance

Upcoming capital expenditures

Upcoming debt maturities

Ongoing interest and dividend payments

Operating cash flow of the business

Current and expected interest rates

Risk tolerance

Capital markets conditions

Investors’ expectations

Additional Resources

Thank you for reading this CFI guide to financing, what it is, and why it matters. CFI is the official provider of the FMVA certification program, designed to help anyone become a world-class financial analyst. To learn more and advance your career, these additional CFI resources will be helpful: