Principles of Finance (2024)

Almost everyone needs to manage money in their personal lives and many will even encounter a need for budgeting and financial analysis in their professional lives. Yet research shows that 43% of American adults lack basic financial literacy skills.¹ People who learn about financial concepts can make more informed financial decisions at work and home. Read on to learn about five principles of finance and discover how the can prepare you for the challenges you’ll face as a financial manager or C-suite leader in today’s evolving business landscape.

Five 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.

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:²

• 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.

Becoming familiar with the different types cash flow is a good place to start building your understanding of finance and allows you to get a picture of the financial status of your business or personal finances as well as make investment decisions.

Diversification

In 2022, 58% of Americans owned stock.³ 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.

Diversification decreases financial risk by spreading money across various investments and industries. If you invest all your money in stocks for a niche tech company, you could lose everything if the business fails. However, you’ll likely suffer more minor losses if you divide your money across eight stocks, three bonds, and a savings account. As a result, diversification promotes financial stability and long-term growth.

Time Value of Money

The principle of time value of money states that money earned in the present is worth more than the same amount made in the future.⁵ In other words, a $1,000 lump sum single payment from a client today is worth more than four $250 payments spread out over twelve months.

The principle of Time value of money says that money is more valuable in the present because purchasing power tends to decrease over time. The same groceries that cost $100 in January might add up to $120 in December due to inflation and other factors. In addition, you can invest the money you earn now for longer than the funds you earn in the future. Understanding the time value of money can help business leaders and private investors make important decisions about payment structures and investments.

Risk and Return

Risk management is a big part of making financial decisions. Managing finances requires a delicate balance between risk and return.⁶ The idea is simple: You need to invest—or risk—some money upfront 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 $10,000 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.

Compound Interest

Compound interest is interest you earn based on your initial investment and any accumulated interest.⁷ 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 statements.

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.

Add Value to Your Personal and Professional Lives With the Principles of Business and Finance

Some people assume that only corporate finance professionals need to understand economic foundations and how to complete financial analysis. However, anyone can use the principles of finance to create value for organizations and for dealing with personal finance endeavors.

Gain a deeper understanding of these basic principles of finance with an Online Master of Science in Finance (MSF) from William & Mary. This program includes immersive learning activities that enable you to sharpen your decision-making and strategic thinking skills. In addition, you’ll hone your leadership abilities and business decision making skills to accelerate your development into a top financial executive. Reach out to one of our Academic Outreach Advisors today to learn how an Online MSF can prepare you to deliver contemporary solutions in all facets of management and finance.