Learning The Basic Principles Of Finance

Post By: Admin / USA Frugal Club

When starting my journey on learning more about money I found it’s important to learn the principles of finance that will help you learn the foundation of finance. I discovered these principles will help guide my path of making financial decisions.

Cash flows rather than accounting income matter in financial decisions in situations such as analyzing mergers, acquisitions, or capital projects. The focus will always be on the timing and the amounts of cash flow. Accounting income isn’t the same as cash because cash flow (not profits) drives the value of a business. 

When doing research, I found out that I should determine marginal or incremental cash flows when making a financial decision. Incremental cash flow is the difference between the projected cash flow whether a project is selected.

The next principle I explored financial decisions that must be considered is the time value of money as cash flows received sooner will be worth more than cash flows occurring later resulting in all things being equal. Most financial decisions are long-term in nature, then the cash flows will require to be discounted.

Discounting means applying time value of money concepts as a dollar received today is worth more than a dollar received in the future such as lending money at a zero percent interest resulting in an opportunity cost of 2% could potentially be earned by depositing the money into a savings account.

The next factor I learned was risk requires a reward as investors will not take on additional risk in their investment unless they expect to be compensated with higher returns. This factor results in riskier acquisitions and projects must have higher returns on investment. Investors will expect to be compensated for “delaying consumption” and “taking on risk.”

Another important factor I considered is market prices that are generally accurate as markets are generally efficient being driven by supply and demand. Researching stock prices is generally a good indicator of the value of the firm since the market price of a stock is the equilibrium price where supply and demand intersect.

The market prices of all traded assets (bond and stocks)inefficient markets can reflect all available information at any moment in time making stock prices a useful indicator of the value of the firm. For example, good decisions will tend to increase in stock price and price changes reflect changes in the expected future cash flows.

The last principle of finance I learned about is involved conflicts of interest that can cause agency problems. Since most corporations have separate management from ownership, this can create potential agency problems.

Management positions such as the CEO and other senior staff might not deal in the best interest of the company that in most cases can result in fraud. Cases of fraud can commonly occur where members of management sometimes deal in their own best interests rather than the shareholders.