Put it simply, finance means the flow of money. I will explain finance to you by adding more entities to it.

Level 1

You want to start a business, like selling books, but you don’t have enough money, so you decide to borrow $1000 from Amy, and promise that you will return her $1100 after 1 year. Amy does have extra money that don’t know how to use, and knows that you are good at doing business, so it can be a good chance for her to earn some money.

Then after 1 year, your business is running well and Amy earns $100, which creates a win-win situation.

This is the most basic version of finance, or the flow of money, as you can see the money is flowed from Amy to you, who can create larger values.

Finance has 2 goals:

  1. Increase the overall welfare of society. In this story, you run a business creating values for society, and Amy earn more money.
  2. Improve the efficiency of resource allocation. In this story, the resource is the money from Amy, which is allocated to a place where it can create larger value.

Level 2

Not everyone can meet Amy when he needs money to do something, to solve this problem, a middleman called bank was born, which can connect “more Amy” and “more you”:

  1. More Amy: people who want to make money from their money, instead of just putting them at home.
  2. More you: people who need money to create more values and promise to payback with more money.

So people can store their money in bank, and bank can find believable people who need money and borrow them money. In another word, bank collect some people’s money, and use these money in places where larger values can be created.

As a middleman doing these efforts, bank can also gain intermediary fee.

A triple-wins situation!

Level 3

Let’s say you have a big and new idea that is not aligned with most people’s view, and you need some money.

Banks at level 2 may refuse to borrow money to you since the risk can be too high.

So you have to find people who trust your idea and would like to invest money to you.

Because this is a new idea, it may fail, so you and your investor make an agreement that if success, the investor can earn more than borrower, if failed, you don’t need to return the money back.

You can see that I use “investor” instead of “borrower”, because there are some differences.

In level 3:

  1. People who want to get higher rewards and are acceptable about higher risks can give their money to the right place.
  2. People with higher rewards and higher risks can also get their needed money.

This is called equity investment, which means you own a part of the company, you need to accept that you may not be able to get your money back.

I will continue the next 2 levels in my next post.

Acknowledgement

Thanks for Lindsay’s video, which is the source of knowledge in this post.