Principles of Finance

 

Four Principles of Finance

Finance is a broad term that refers to the processes that individuals and businesses use to earn, manage, and save money. Everyday financial activities include creating budgets, investing, selling assets, buying savings bonds, and taking out loans. Understanding the principles of business and finance can help you confidently navigate these processes.

1] Cash Flow :

Perhaps the most basic of the finance principles, cash flow is the broad term for the net balance of money moving into and out of a business at a specific point in time. There are four types of cash flow that you should know:

• Operating cash flow: The net cash generated from day-to-day business activities
• Investing cash flow: The net cash generated through investment activities
• Financing cash flow: The net cash generated from financial activities, such as debt payments, shareholders’ equity, and dividend payments
• Free cash flow: The net amount of cash left over after taxes are paid; depreciation, amortization, and changes in working capital are accounted for; and capital expenditures (property, equipment, and technology investments) are subtracted. Basically it's the cash left over that doesn’t need to be allocated anywhere.

2] Diversification :

In 2022, 58% of Americans owned stock. Many people invest money in retirement accounts such as a 401(k), while others purchase stock directly from public companies, like Apple and Netflix. Businesses also purchase stock to earn money. The principle of diversification helps minimize the risk of these investments.

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: When you invest in stocks, you gain a fraction of ownership in a company and become entitled to a share in its earnings
• Bonds: When you buy a bond, you lend money to the government for a certain period and earn interest on your investment
• Cash: This category includes investments that you can quickly liquify, like money market funds and savings deposits

Together, these assets make up a portfolio. Individuals and organizations diversify their portfolios in different ratios based on their financial goals. For instance, someone saving for a down payment to buy a house will likely keep most of their savings as cash so they can access it in the near future. By contrast, a recent college graduate saving for retirement can invest in higher-risk stocks because the money has decades to grow.

3] Risk and Return :

 Risk management is a big part of making financial decisions. Managing finances requires a delicate balance between risk and return. The idea is simple: You need to invest—or risk—some money up front if you want to have the chance to make more money. Generally, more significant risks lead to the possibility of greater rewards, but these investments don’t always pay off.

Imagine this: A company can buy a $10,000 digital t-shirt printing machine that will allow it to sell new shirt designs. If the product sells well, the company could make hundreds of thousands of dollars over the machine’s lifetime. However, if the company can’t sell more than $20,000 in shirts, their risk doesn’t lead to a positive return.

Businesses and investors weigh risk and return every time they make a financial decision. Many organizations use tools like data analytics and market trend analysis to make informed choices. However, no risk ever has a guaranteed return, so it’s essential to accept the inherent uncertainty of investing.

4] Compound Interest :

Compound interest is interest you earn based on your initial investment and any accumulated interest. In other words, the compound interest is reinvested as part of your principal and starts to earn interest itself. Compound interest is one of the most powerful principles of business and finance because it can exponentially accelerate the growth of your savings and investments. Depending on the type of account, interest may compound daily, monthly, quarterly, or yearly. More frequent compounding leads to higher earnings over time.

For example, if you put $5,000 in a savings account with a 4% annual compound interest rate, your money will double to $10,000 in 18 years. In 30 years, the money would grow to $16,000. As a result, people who invest and save at a young age can accumulate significantly more wealth than people who start later in life. You can see the interest rates of your accounts both when you sign up and on financial statement. However, this can harm your finances if you owe money to a lender who charges compound interest. Many credit card companies compound interest daily, so debt can accumulate fast.⁸ For instance, if you owe $5,000 on a credit card with an 18% annual percentage rate and only repay $500 a month, you’ll end up paying an additional $450 in interest before you pay off your balance in 11 months.