Principles of Finance
Principles act as a guideline for the investment and financing decision. Financial managers take operating, investment and financing decisions, some of this related with short term and some long term.
Before discussing principles of finance let’s have some idea about finance, is the process of collecting funds and ensures proper utilization of funds. Many people say that finance is the management of funds and those are responsible for managing this fund are financial managers.
There are six basic principles of finance, these are:
- Principles of risk and return
- Time value of money
- Cash flow principle
- Profitability and liquidity
- Principles of diversity
- Hedging principle
The principle of Risk & Return
This principle indicates that investors have to conscious both risk and return, because higher the risk higher the rates of return and lower the risk, lower the rates of return. For business financing, we have to compare the return with risk. To ensure optimum rates of return investors need to measure risk and return by both direct measurement and relative measurement.
Time Value of Money
This principle is concerned with the value of money, that value of money is decreased when time pass. The value of dollar 1 of the present time is more than the value of dollar 1 after some time or years. So before investing or taking fund, we have to think about the inflation rate of the economy and required rate of return must be more than the inflation rate so that return can compensate the loss incurred by the inflation.
Cash Flow Principle
This principle mainly talk about the cash inflow and outflow, more cash inflow in the earlier period is preferable than later cash flow by the investors. This principle also follows the time value principle that’s why it prefers earlier more benefit rather than later years benefits.
Profitability & Liquidity Principle
This principle is very important from the investor’s perspective because the investor has to ensure both profitability and liquidity. Liquidity indicates the marketability of the investment i.e. how much easy to get cash by selling the investment. On the other hand, investors have to invest in a way that can ensure maximization of profit with moderate or lower level of risk.
Principles of diversity
This principle helps to minimize the risk by building an optimum portfolio. Never put all your eggs in the same basket because if it falls then all of your eggs will break, so put eggs by separating in a different basket so that your risk can be minimized. To ensure this principle investors have to invest in risk-free investment and some risky investment so that ultimately risk can be lower. Diversification of investment ensures minimization of risk.
Hedging principle indicates us that we have to take a loan from appropriate sources, for short-term fund requirement we have to finance from short-term sources and for long-term fun requirement we have to manage fund from long-term sources. For fixed asset financing is to be done from long-term sources.
Md. Nahian Mahmud Shaikat
Student of MBA
Institute of Business Administration (IBA)
Email: [email protected]
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