Principles of Finance

1. Cash Flow

Cash flow — the broad term for the net balance of money moving into and out of a business at a specific point in time—is a key financial principle to understand. There are several types of cash flow:

1. Operating cash flow

   This is the cash generated by a company’s normal or day to day business operations. It’s a key indicator of a company’s financial health.

2. Investing cash flow

   This is the cash generated by a company’s investment activities, such as buying or selling assets.

3. Financing cash flow

   This is the cash generated by a company’s financing activities, such as issuing stock or borrowing money.

4. Free cash flow

   This is the cash generated by a company’s operations after accounting for capital expenditures and other investments. Basically it's the cash left over that doesn’t need to be allocated anywhere.

Becoming familiar with the different types cash flow is a good place to start building your understanding of finance and allows you to get a picture of the financial status of your business or personal finances, as well as make informed investment decisions.

2. Time Value of Money

The concept of the time value of money is a basic principle of finance. It states that a certain amount of money today is worth more than the same amount in the future due to its earning potential. By understanding this principle, you can make informed investment decisions and assess the value of future cash flows.

In other words, a $1,000 lump sum single payment from a client today is worth more than four $250 payments spread out over twelve months. The principle of Time value of money says that money is more valuable in the present because purchasing power tends to decrease over time. The same groceries that cost $100 in January might add up to $120 in December due to inflation and other factors. In addition, you can invest the money you earn now for longer than the funds you earn in the future. Understanding the time value of money can help business leaders and private investors make important decisions about payment structures and investments.

“If you want to understand what something is worth today, the only way to understand that is to look into the future,” Desai says in Leading with Finance. “Think about the economic returns—the free cash flows—as a way to understand what today’s values are. Something is only worth something today if it generates future benefits.”

3. Risk and Return

The principle of risk and return is a fundamental concept in finance. It states that the potential return rises with an increase in risk. This means that the more risk you take on, the greater the potential return. Conversely, the less risk you take on, the lower the potential return.

“The relationship between risk and return is one of the most important relationships in finance and all of economics,” Desai says in Leading with Finance. “By and large, human beings don’t like bearing risk. As a consequence of that, if they’re forced to bear risk, they demand something in return—they demand a higher return.”

Different types of risks exist in the financial world:

• Market risk

  This is the risk that the value of an investment will decrease due to changes in the market.

• Credit risk

  This is the risk that a borrower will default on a loan or that a bond issuer will default on a bond.

• Liquidity risk

  This is the risk that an investment can’t be sold quickly enough to prevent a loss.

4. Diversification

Diversification is a risk management strategy that involves spreading your investments across different assets to reduce the risk of loss. The idea is that if one investment performs poorly, the others will help offset the loss.

By diversifying your portfolio, you can minimise losses during market downturns and achieve a more stable return on investment

Diversification is the process of dividing money between many different types of investment products.4 Experts typically recommend that individuals invest their money in three categories:

• Stocks

  Stocks are shares of ownership in a company. When you buy a stock, you’re buying a piece of the company.

• Bonds

  Bonds are loans that you give to a company or government in exchange for interest payments.

• Cash

  Cash is money that you can access quickly and easily. It’s the most liquid asset.

5. Leverage

Leverage is the use of borrowed money to increase the potential return of an investment. It can be a powerful tool for increasing profits, but it also increases the risk of loss.

“Leverage is a double-edged sword,” Desai says in Leading with Finance. “It can magnify your gains, but it can also magnify your losses.”

There are two types of leverage:

• Operating leverage

  This is the use of fixed costs to increase the potential return of an investment.

• Financial leverage

  This is the use of borrowed money to increase the potential return of an investment.

6. Capital Budgeting

Capital budgeting is the process of evaluating and selecting long-term investments that are in line with a company’s goal of maximizing shareholder wealth. It involves estimating the costs and benefits of potential investments and deciding whether they’re worth pursuing.

“Capital budgeting is the process of deciding which projects to invest in,” Desai says in Leading with Finance. “It’s a process of evaluating the future cash flows that a project will generate and comparing them to the costs of the project.”

7. Cost of Capital

The cost of capital is the rate of return that a company must earn on its investments to maintain its market value and attract investors. It’s a key concept in finance because it helps companies determine whether an investment is worth pursuing.

“The cost of capital is the rate of return that a company has to earn on its investments in order to satisfy its investors,” Desai says in Leading with Finance. “It’s a way of thinking about the opportunity cost of capital.”

Conclusion

Understanding the principles of finance is essential for making informed decisions about your personal finances and investments. By familiarizing yourself with concepts like cash flow, the time value of money, risk and return, diversification, leverage, capital budgeting, and the cost of capital, you can build a solid foundation for financial success.