Each organization must adhere to five key principles of financial management. Because your clients and stakeholders place their faith in your firm, it is critical to record trustworthy and validated information. What are the five fundamental accounting principles? Let’s look at what the principles are to have a better understanding of them.
If the non-financial manager takes away little else from a course in finance, there are five key concepts and principles any manager must understand.
Time Value of Money
A dollar today is worth more than a dollar tomorrow. For example, would you prefer getting $100 in your bank account today or one year from now?
Unless you want to forgo a year’s worth of interest on your deposit, you would prefer your money today. Similarly, businesses value money received today more than the same amount received in the future.
Cash (not Profits) is King
Profits are important to managers and to companies, but they are affected by accounting rules and standards. Cash is not.
To think about it simply, you can pay bills with cash, but not with accounting profits.
Think in After-Tax Incremental Cash Flows
It’s only what changes that counts.
When considering an investment project, the forecasted change in incremental cash flow (after-tax cash flow ) that is directly attributable to the project is what guides a firm’s decision.
Risk Return Trade-off
Individuals or corporations should not take on additional risk unless they are compensated with additional returns.
All Risk is NOT Equal
Some risk can be diversified away by not “putting all one’s eggs in one basket.”
However, some fundamental or inherent risk is unavoidable in making investment decisions, and therefore must be taken into account.
What Is The Time Value Of Money?
Time value of money is really the concept that the money you have now is worth more than that same sum in the future because this is due because money now has potential earning capacity.
So, one principle of finance holds that money can earn interest. So, any amount of money is worth more the sooner it’s received. So again, today’s money is going to be worth more than that same sum at a future date because of its potential earning capacity regarding earning interest over time.
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To test your understanding of the content presented
1. Which of the following is not one of the key principles of financial management?Choose only one answer below.
a. All risks can be avoided through diversification
Correct. All risk is not equal. Some risk can be avoided—or diversified—by avoiding “putting all the company’s eggs in one basket,” but some inherent risks cannot be entirely avoided.
b. Cash, not accounting profits, is the most important single item to manage
c. A dollar today is worth more than a dollar in the future
d. Higher returns must be achieved for undertaking greater risk
2. Which of the following statements is consistent with the five key principles of financial management?Choose only one answer below.
a. Profit does not matter—only cash
b. Corporations will not undertake greater risk without greater reward
Correct. Profits do matter, very much, although cash is even more important. Incremental cash, not total cash, should be the barometer of a project’s success.
c. Total cash before and after a project is undertaken should be the measure of success
d. All risks can be diversified away at some level
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