Principle of Finance
Principles of finance refers to some of the basic principles necessary for financial decision-making, which are applied to business, personal and public financial management. These principles serve as guidelines for effective, sound and risk-free financial decision-making. Some important Principles of Finance are described below:
Principle of time value of money
This principle applies to all types of investments. As time changes, the value of money changes. Because $100 today is not the same as $100 a year from now. Because accurate valuation of investment is determined by time value of money through a fixed interest rate. A financial manager makes an investment decision only when the discounted value of the project’s expected cash flows is greater than the initial investment. Because the cash flow without amortization may appear to be higher than the actual investment.
Principle of Risk and Return
Risk is the possibility that the actual profit from an investment will be less than the expected profit. Due to risk, expected returns may not be achieved in various areas and investment may suffer losses. Cash benefit received from investment is called profit. Investors invest with the expectation of profit.
According to the risk-return principle, the riskier the investment, the higher the expected rate of return. Because when an investor takes more risk, he expects more profit. Business financial decisions should always be made balancing risk and profit so as to achieve the organization’s goals.
The relationship between risk and profit can be explained with the help of an example.
Mr. Red Smith, a financial expert of a corporate firm. If he invests in government bonds it will be a risk-free investment. Because the dividend received from government bonds at a fixed rate every year is guaranteed. In other words, there is no uncertainty of payment of dividend and principal of the bond or the possibility of bankruptcy. That is why the profit rate obtained from government bonds is risk-free. But if Mr. Red Smith invests in the shares of any company in the stock market, the income received from the investment is not guaranteed. The price of the shares may fluctuate at any time. The market value of the shares may fall to more than the purchase price. In this case the rate of profit can be very high. The additional return investors expect for taking on additional risk. The risk premium is the difference between the rate of return on an investment in a risky asset and the rate of return on an investment in a risk-free asset. Suppose Mr. Red Smith invests in government bonds and earns a rate of return of 10%. A person invests in the shares of a corporate entity and the rate of return is 22%. In this case the risk premium is 12% (22%-10%). But if he invests in interest government bonds then the risk premium will be zero.
Principle of Profitability and Liquidity
Every financial decision of a business should be taken in such a way that both liquidity and profitability are maintained. This principle plays a role in every aspect of financial management. Liquidity is very important. Because if there is more liquidity, the cost increases and if it is less, the cost cannot be executed. Every action should be taken so that the liquidity and profitability of the business is not disturbed. It is an integrated policy that balances liquidity and profitability.
How quickly cash can be obtained by selling any product, asset or security is known as liquidity in finance. Commodity refers to the goods in which the business is involved in production, Assets are fixed assets such as buildings, machinery, furniture etc. which are not business goods. Shares, debentures, prize bonds, savings bonds, etc., which include the investment of the organization. In all these cases, it is necessary to understand why the issue of liquidity is important. Any organization creates many types of creditors while conducting its day-to-day operations. If a loan is taken from a bank or financial institution. They are creditors. A good loan has a fixed term. It is important to pay off the loan amount before the expiry of the term. If a business organization follows the correct liquidity policy, the debt can be repaid on time. On the other hand, if the company has low liquidity, say it has a lot of assets but cannot easily get cash by selling them, then the company may fail to pay its debts. In that case, financial management is considered to be a failure. This tarnishes the company’s reputation and the business suffers. Apart from the bank, the business has various creditors. Businesses need liquidity to pay their workers and employees on time. The raw materials used in the production of goods are usually purchased as per the rules of the trade and bills of exchange are issued promising to be paid after three months. It is expected that the goods manufactured with those raw materials will be sold within these three months and There will be no difficulty in paying the price of raw materials. According to the principle of liquidity, all these matters should be regulated in such a way that all types of debts can be paid on time. That is, the liquidity of the organization means the ability to pay the current liabilities from the current assets.
Investments are made in profitable sectors following the profit principle. As stated earlier that earning profit is the main objective of business. Every business has many investment options. The financial manager decides which sectors to invest in will maximize the profits of the business. The decision is not an easy one because following the profit principle can increase profits for a firm with moderate risk.
There is an inverse relationship between the profitability policy and the liquidity policy. Predominance of the liquidity policy harms profitability, while predominance of the profit policy harms liquidity. This is because there is no receipt of cash assets. An example will make the matter clear.
Let’s say Company, XYZ has total assets of $1,000,000. 10% profit from investable projects. If the money manager wants to keep 20% cash according to the liquidity policy, his investment is $800,000 and the profit is $80,000. On the other hand, if he wants to keep 30% of the total assets in cash, his investment is $700,000 and the profit will decrease by $70,000. Considering the main objective of the business to make profit, if it follows the policy of 20% liquidity and in that case the business fails to meet the dues of any creditor, it cannot be desirable at all. Again, if he were more cautious and made a profit of $70,000 instead of $80,000 and it turns out that even with 20% liquidity, the creditor could have been paid, that is also unfortunate. Since there is no way to be certain in advance, the matter is left to those who are responsible for managing the money.
The following actions can be taken to increase the liquidity of the business.
a) Formulation and implementation of cash flow plan: The cash flow plan should be formulated in such a way that the organization can maintain a satisfactory liquidity at all times. From past statistics it is possible to know what the demands of creditors are at certain times of the year. Analyzing this issue, a realistic plan can be made so that there is never unnecessary excess liquidity and never shortage of liquidity.
b) Different types of fund raising: While raising business funds, it should be noted that the funds have different tenures and will mature at different times. In this way, the business does not have to meet the demands of the creditors in a big amount at one time, but it has to settle the debts at different times, which is relatively easy for the business. The more diversity there is in the sources of funds, the better it is for the business.
Principle of Portfolio Diversification
The principle of portfolio diversification means that a trader or investor invests all his money in multiple assets rather than investing in one asset to reduce risk. The role of this policy is immense in the field of asset management. A proverb in finance sector “Don’t put all your eggs in one basket” applies here. The principle of diversification can be explained from the perspective of a trader, producer and investor. In the case of fund investment, business risk is spread and reduced as far as possible diversification of business products or services. Every business organization tries to make profit based on uncertain future. As a result, the business is exposed to various risks. These risks can arise from various reasons; Such as changes in the economic, political, social context, the presence of new products in the market, natural disasters, sudden accidents etc. It is usually not possible for managers to control or prepare for these changes. However, by following the principle of risk allocation, it is possible to achieve expected profits even in uncertain market conditions. If a trader deals in only one type of product, then earning profit in the business becomes quite risky. On the other hand, if the products of the business are varied and diversified, then the risk is distributed. That is, if the sales of one product decreases in any one situation, it is possible to compensate the reduced sales of the business with the sales of other products, thereby achieving the desired profit in all types of situations. Example:- Demand for winter clothes is only in winter, hence its sales increase. Its sales decrease during summer. If a clothing retailer sells both winter and summer clothing in his store, the profit will not suffer due to seasonal fluctuations in demand for the product.
This principle of risk reduction diversification can be used in fund raising. There is a preference for raising funds from multiple sources rather than a single source.
More Resources
Thank you for reading our resources on the Principles of Finance. Enhancing your knowledge more and progressing in your career, you may find the following guides helpful: