2.1. What is Finance?

Finance is the process which gathers and pools unused or idle funds such as savings and retirement fund contributions, and then allocates those funds (the pooled funds within the financial system is often referred to as “capital”) to productive investment.

Graphic depicting the relationship between financial assets and real assets

Productive investment results in income. Income received by the finance provider needs to be higher than the cost incurred for the funds they provide, thus rewarding the service they provide with a profit, or “return.”

Successful finance providers must be skilled at the art of assessing risk and the probability that the proposed loan or equity investment will succeed. In other words, that the loan will pay interest and repay debt, or the equity will produce a positive return. In the diagram to the right, we see the role of the financial markets in transforming financial assets into real assets. They do this through the processes described above – pooling unused funds and allocating them to investments in real assets that are expected to offer a suitable return. (Source: Mobilizing Private Finance for Development Textbook).

 
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