Financial Principles, Flow of Cash, Value of Money
Understanding how to manage one's finances and making sound financial decisions are at the heart of the fundamental principles of finance. The time value of money, risk and return, cash flow, and the effect of information on market prices are important concepts. These guiding principles can be applied to both personal and business financial planning, budgeting, and investment decisions. An illustration of financial principles
1. Flow of Cash
A fundamental financial concept to comprehend is cash flow, which is the broad term for the net balance of money entering and leaving a business at a particular point in time. There are a few different kinds of cash flow:
• Operating cash flow: The net cash generated by everyday operations of a business
• Investing cash flow: The amount of money that is left over after investments are made
• Financing cash flow: The net cash from financial activities like paying off debt, investing in shareholders' equity, and paying dividends These types of cash flow provide a picture of the net cash flow that occurred during a particular time period when taken as a whole and detailed on the cash flow statement. There’s one more type of cash flow that’s important to know: free cash flow. The net amount of cash remaining after accounting for taxes, depreciation, amortization, and changes in working capital, as well as capital expenditures (investments in property, equipment, and technology), is known as free cash flow. To put it succinctly, this is the remaining cash that does not require any allocation. Desai calls free cash flow "finance nirvana" in Leading with Finance because it is often used to measure a company's financial success. You've "made it," so to speak, when your business generates free cash flows. You can use this cash to provide returns to stakeholders, and investors look for it when deciding where to allocate funds. It can also be reinvested in your company to generate additional free cash flow for future periods. Understanding the different types of cash flow can assist you in conceptualizing the categories into which your expenses fall, provide context for budgeting, and provide insight into how your expenses and revenue contribute to the financial health of your business.
2. Value of Money
Over Time Finance is always looking ahead and compares a company's current position to its trajectory. A fundamental financial principle, the time value of money (TVM) holds that a sum of money is worth more now than it will be in the future. “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. Consider the economic returns, or free cash flows, as a means of comprehending the values of today. A thing is only valuable now if it brings benefits in the future. As a result, the value of a certain amount of money depends on how long you wait to use it. The more valuable the cash is, the sooner you can use it. The more time you have to wait before using it, the less chances you have of getting back your money. Discount future cash flows to reflect their current values in order to take this into account when valuing a business. This is known as the "gold standard of valuation" by Desai. To calculate TVM for a sum of money, use this formula to solve for its future value (FV):
PV x [1 + (i / n)] (n x t) is FV. Based on the TVM formula,
• FV is the cash's future value.
• PV is the cash's current market value.
• i is the interest rate
• n is the annual number of compounding periods.
• t is the period of time
If you’re in a non-finance role, chances are you won’t need to calculate TVM or discount cash flows yourself, but understanding the time value of money can enable you to make decisions based on it.
3. Risk and Return
"How do you create value?" is one of the central questions that finance attempts to answer. The relationship between money and time and when all allocations are accounted for create value, according to cash flows and the time value of money. Another financial principle, risk and return, provides an alternative perspective on value creation. It’s a concept you’re likely familiar with: To see returns, you often need to take calculated risks. This has a lot in common with the idea of return on investment, which is the amount of money left over after the initial investment has been taken out. The level of risk associated with investing in an asset dictates the level of return you can expect from it. The minimum viable return on an asset in relation to its cost and risk is called cost of capital.
“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. The majority of people dislike taking risks. Because of this, whenever they are required to take on risk, they demand something in return—a higher return. Imagine your business is considering purchasing a cutting-edge piece of technology that would increase production speed and quality. The only drawback is that it is extremely expensive. You predict the ROI will be worth it and use loans and equity from outside sources to purchase the technology. The sources that gave your company the money it needed to make this purchase assume some risk. What if the technology doesn't improve quality enough to justify the purchase and generate more revenue? The minimum return that your financing sources require in exchange for taking on a high level of risk is what they call the cost of capital. The weighted average cost of capital (WACC) is the total cost of capital for all of your capital sources. Again, you probably won't need to calculate these values if you don't work in finance. But knowing how much it costs to complete projects with higher risks and how important it is to give stakeholders a minimum return on investment can help you budget, get funding for projects, and plan for long-term investments.
4. Information is reflected in market prices
New information is constantly influencing the financial markets. News, economic data, and other pertinent information have an impact on the prices of assets like stocks and bonds.
5. Incentives have an effect on individuals
Decide how much money to spend based on the incentives they face. For effective financial planning and behavior prediction, it is essential to comprehend these incentives. These fundamental principles are not the only important ideas: • Profitability and Liquidity: While liquidity refers to a company's capacity to meet short-term obligations, profitability refers to a company's capacity to generate profits.
• Diversification: Spreading investments across different assets to reduce risk.
• Hedging: Using financial instruments to reduce or offset potential losses.
Individuals and businesses can achieve their financial objectives, effectively manage risk, and make more informed financial decisions if they comprehend and apply these principles.