Ten Axioms in Financial Manangement

Ten Axioms of Financial Management

1. The risk-return trade-off

2. The time value of money
3. Cash- not profits- is king

4. Incremental cash flows

5. The curse of competitive markets

6. Efficient capital markets

7. The agency problem
8. Taxes bias business decisions
9. All risk is not equal
10. Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance

1. The risk-return trade-off. This means that the higher the risk, the higher the return. Investing an amount of money in a time deposit account would mean an almost no risk at all and an interest of around 3 % annually is expected as return. Investing in stocks or other marketable securities accompanies a higher risks like decline in market value of stocks; government policies could affect the industry; market recession and bankruptcy. The loss would only be a paper loss unless you sell the securities realizing an actual negative rate of return on investments. When the value of stocks increases, big profits are expected as long as a risk taker knows the technicalities for entry and exit in stock trading. Investments could double or could even be 10 times more the initial investment after some years.

2. The time value of money. The value of a dollar received today is worth more that the value of a dollar received in the future. This is due to inflation where the price of goods and services will increase as time goes by. If the inflation rate is higher than the interest rate being received from savings or time deposit accounts, you lose the value of your money.

3. Cash not profit is king. An accounting income or loss are only paper figures but it does not coincide with the actual cash inflows. Losing cash accompanies a higher borrowing costs that could decrease the profit. High profit does not always mean an ability to pay maturing loans, or emergency cash outflows, or cash dividends to shareholders.

4. Incremental Cash Flows. This factor is a guide when making decision on where and how to invest in business. In capital budgeting decisions, the first thing to consider is whether a proposed investment or project’s additional cash inflow in the future is justifiable.

5. The curse of competitive market. When a business is profitable, expect that many will copy the same business. This causes competition which lowers profitability in the long run. Continuous innovation, research and development and more improved customer service should be taken into consideration to mitigate the losses.

6. Efficient capital markets. This is a market where the actual and current market value of share prices are reflected which could change quickly with new and relevant information. As many investors says, “it’s impossible to beat the market.”

7. The agency problem. This is a conflict of interest between the management (agent) and the shareholders (principal). Managers won’t work for the owners unless it is in their best interest or they make decisions that are not aligned with the goal of maximizing the shareholder’s wealth.

8. Taxes bias business decisions. Decision making of managers regarding investments should always consider the after-tax effects.

9. All risk is not equal. Do not put all funds in one project since it could lead to a big loss. Even a single risk could jeopardize the whole company. Diversification of investments should be considered in order to minimize the high risks that could affect other investments.

10. Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance. Business ethics should always be incorporated with every decision making. This would not only maximize the wealth of the shareholders but will also gain the trust and loyalty of stakeholders.