The 6 Principles of Finance

6 Core Principles of Finance You Should Know [2020] - ORDNUR

 Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting. Finance is the study of money and how it is used. Specifically, it deals with the questions of how an individual, company or government acquires the money needed – called capital in the company context – and how they then spend or invest that money. There are six key principles of finance.

  Core financial theories can largely be divided into the following categories: financial economics, mathematical finance and valuation.In the context of institutions, finance is often split into the following major categories: investment management, corporate finance, personal finance, corporate finance, and public finance.    

1. Principles of risk and return – The risk-return trade-off states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns.The risk-return trade off is the trading principle that links high risk with high reward. The appropriate risk-return trade off depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.Investors use the risk-return trade off as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return trade off can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-            than-desired potential for returns.

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2. Time value of money  (TVM) is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received .This principle is important because it allows investors to make a more informed decision about what to do with their money. The TVM can help you understand which option may be best based on interest, inflation, risk and return. The exact time value of money is determined by two factors: Opportunity Cost, and Interest Rates. The time value of money (TVM) is an important concept to investors because a dollar on hand today is worth more than a dollar promised in the future. … Provided money can earn interest, this core principle of finance holds that any amount of money is worth more the sooner it is received.

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3. Cash Flow Principle  is the net amount of cash and cash-equivalents being transferred into and out of a business. At the most fundamental level, a company’s ability to create value for shareholders is determined by its ability to generate positive cash flows, or more specifically, maximize long-term free cash flow (FCF). This is cash paid by customers for services or goods provided by the entity. Financing activities. An example is debt incurred by the entity. The three categories of cash flows are operating activities, investing activities, and financing activities. Operating activities include cash activities related to net income. Financing activities include cash activities related to non-current liabilities and owners’ equity.Why Cash Flow Statement is Important? The cash flow report is important because it informs the reader of the business cash position. For a business to be successful, it must have sufficient cash at all times. It needs cash to pay its expenses, to pay bank loans, to pay taxes and to purchase new assets.

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4. Profitability and Liquidity-Profitability refers to profits which the company has made during the year which is calculated as difference between revenue and expense done by the company.  Profitability is the ability of a business to earn a profit. A profit is what is left of the revenue a business generates  after it pays all expenses directly related to the generation of the revenue, such as producing a product, and other expenses related to the conduct of the business activities. Liquidity refers to availability of cash with the company at any point of time.The effect of liquidity on the profitability is to explain the investments or assets of the bank such a means that the bank perhaps capable of paying the rapid liability due upon it without substantial damage. The pre-arrangement of assets will lead toward gain profit.Profit equals a company’s revenues minus expenses. Earning a profit is important to a small business because profitability impacts whether a company can secure financing from a bank, attract investors to fund its operations and grow its business. Companies cannot remain in business without turning a profit.Whether you are evaluating your investments or calculating your overall financial situation, liquidity is important to understand. Simply put, liquidity refers to how quickly you can convert something to cash and still maintain its value. Assets can be bought or sold, either as short-term or long-term investments.

5. In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.  Dividing investment funds among a variety of securities with different risk, reward, and correlation statistics so as to minimize unsystematic risk.The Importance of Diversity and Inclusion in Finance. Diversity and inclusion are extremely important in business, perhaps now more than ever. Not only does diversity improve the innovation and scope of your business, it also increases employee satisfaction, making your business more attractive to potential candidates.

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6. Hedging Principle- A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. In this example, you cannot prevent a flood, but you can work ahead of time to mitigate the dangers if and when a flood occurs. There is a risk-reward trade off inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy example, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.Most investors who hedge use derivatives. These are financial contracts that derive their value from an underlying real asset, such as a stock. An option is the most commonly used derivative. It gives you the right to buy or sell a stock at a specified price within a window of time.  Hedge funds use a lot of derivatives to hedge investments. These are usually privately-owned investment funds. The government doesn’t regulate them as much as mutual funds whose owners are public corporations.Hedge funds pay their managers a percent of the returns they earn. They receive nothing if their investments lose money. That attracts many investors who are frustrated by paying mutual fund fees regardless of its performance. 

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