What are the principles of financial management?
The principles of financial management are the fundamental facts and truth that guide how you manage your finances in order to avoid financial problems. These basic principles can be applied to your personal life or business. There are three fundamental principles of financial management that you should always keep in mind when working with your money. These principles are budgeting, investing, and debt repayment. Understanding and following these principles will help you make the most informed decisions about how to spend your money and protect yourself from potential financial problems down the road.
Financial management is the process of using money efficiently, transparently, and effectively by following some principles, rules, or standards. Applying these principles of finances to a business can increase the company’s growth and when applied to your personal life can lead to self-improvement and help in wealth creation.
What is good financial management?
The characteristics of good financial management include the ability to be transparent, and accountable, and give useful reports of all financial transactions. That means when you spend, you will actually record what you spent money on, the amount you spend, and the reasons. This shows transparency. When you have a record of these transactions and you can produce it when demanded, then it can be said that you are good at managing your finances. This can be applied to managers or accountants in a company.
Other characteristics of good financial management include:
- planning, budgeting, and revisiting your expenditures.
- proper use of your money (or in the case of a firm, the proper use of funds available)
- proper recording of transactions in the balance sheet or any other financial statement in a way that any accountant can understand clearly.
What are the 10 guiding principles in financial management?
There are 10 basic principles of financial management that guide how you can make financial decisions. These 10 basic principles are organizing your finances, spending less and saving more, understanding the time value of money, spending on income-producing assets, self-improvement and education, taking note of risks associated with investments, diversifying your income sources, knowing the tax implications of every investment, preparing for uncertainties, and having the right insurance plan. Let us look at each of these 10 guiding principles in financial management.
Guiding principles in financial management
- Organize and track all your finances
- Spend less, save more
- Understand the time value of money
- Spend on income-producing assets
- Self-improvement and education
- Risk is a core principle in financial management
- Diversify your income sources
- Know the tax implications of every investment
- Prepare for unforeseen circumstances
- Take the right insurance plan
- Principle of cash flow in financial management
Organize and track all your finances
For you to manage your finances better, you must learn how to organize your spending and income in order to know what you spend more money on and what brings in more money. This is an important step in wealth creation. It is essential that you keep track of the use of credit cards, car loans, and brokerage accounts.
When you are about to use a credit card, ask yourself the value you would derive from what you are about to purchase; would it help you achieve your financial goals? can your purchase increase your income? are you investing in growth or research? When you keep records of what you do with credit cards, it helps you to know the items you need to cut down on their spending and where to channel more funding on. You can make use of budgeting software to achieve the goal.
Spend less, save more
One of the behaviors that prevent people from achieving their financial goals is lifestyle inflation. When you earn more, there is the internal desire to live a better life immediately. When you act like this, you may never achieve any financial goal. The best principle to apply in this case is to spend less. When you spend less than your income, you can save more and use your savings for investments. If an opportunity presents itself, you can use your savings to invest in such an opportunity. If you spend more than you earn, you become indebted and instead of investing, you would be faced with debt repayment.
For a company, only use funds that are necessary and invest in opportunities that would increase the revenue. A firm with good financial management practices should look for opportunities for growth and increasing revenue; this can only be achieved when the company spends less than its total revenue.
Understand the time value of money
The time value of money is the principle that says money has a higher value today than it will in the future. This is because we’ll need the money to purchase items in the future. If you have to wait for the money to make decisions, it will take you a long time to achieve your financial goals.
This can be applied in business; when a customer pays for goods immediately, the company can use the money to purchase any needed item or even invest more. When money is not received immediately, you can miss out on some opportunities while waiting to receive such money.
This can be applied to financial management to guide what type of investment a company would want to make. Investments that take longer to start bringing income should not be a priority if there are other investments that can bring in the same amount of income in a shorter time.
Imagine making an investment that ties down your funds making it impossible to take on a better investment opportunity that is available at the moment.
What the time value of money entails is that your money should not be idle, rather it should be invested in something that brings more money with time.
The time value of money does not in any way negate the importance of savings. When you save, your intention should be to accumulate enough money to invest in a good business or opportunity rather than spending the money. While the time value of money is against the notion of saving money as a means of getting rich. The time value of money shows money invested now is better than money being kept idle.
For example, if you want to buy a car that is worth $20,000, you would have to work for 10 years to earn that amount of money. However, if you wanted to borrow the same amount of money from a bank and pay it back over time, the bank would charge you interest on the money.
This is because the bank believes that it will be more profitable for them to lend this money out than to keep it in their account. You are tying down the bank’s money over a period of time; the bank would have used the money for something that would have generated more revenue. In order to get value for its money, the bank now charges you interest.
Failure to understand this concept leads to poor financial management because your money may lose its value when not channeled into the right investment vehicle.
Spend on income-producing assets
Another good principle of financial management is using your money on income-producing assets. If you must spend, then your priority should be on assets that can generate more revenue. Taking on debts for buying liabilities is poor financial management.
Self-improvement and education
If you are reading this to improve your financial knowledge and help you make good decisions in terms of finances, then this is a good principle of financial management. Always read and update your financial knowledge. Through this, you can find new investment opportunities, learn from the mistakes of others, and get to know what works from the experience of other people. You can improve yourself through courses, reading online articles, reading books, and seminars and conferences.
Risk is a core principle in financial management
In financial management, the risk is the possibility of loss. Risk can come in different forms, such as credit risk, market risk, and investment risk. Most financial managers try to minimize the amount of risk their organizations face. They do this by choosing investments that have a low risk of losing money and hedging their bets against possible swings in the market. It is important to know that every investment has some level of risk; the higher the returns, the more the risk. The concept of risk and the returns from taking on the core principles of financial management.
It can be measured in two ways: direct and indirect. Direct risk is when the investment is affected by external factors such as market volatility or rates of return. Indirect risk is when the investment is affected by internal factors such as company performance, debt levels, and competitive pressures.
Financial managers must weigh both direct and indirect risks to determine which investments are most appropriate for their business. For example, a company that operates in a volatile industry may be more sensitive to direct risks, such as market fluctuations, while a company that does not operate in a highly volatile industry may be less risk-averse and tolerant of indirect risks, such as company debt levels.
Risk in financial management should be considered in terms of probability, severity, and impact. Financial managers need to identify which risks are less severe and have less impact on the company when a loss arises from investments and causes financial impairment.
Diversify your income sources
One of the most important principles of financial management is income diversification. It is essential to invest in a variety of different assets so that you are not put at risk if one asset diminishes in value. This means that your investments should be spread out among a variety of different assets so that if one sector crashes, the overall portfolio won’t suffer as much. In addition to assuring that your portfolio isn’t overly dependent on any one type of asset, diversification also protects against volatile markets.
It is important to find creative ways of income diversification. Everyone has a special skill that can be converted into a money-making opportunity. However, one should not limit diversification to investments alone as it is also applicable to borrowing. You should keep in mind that the target is to ensure the minimum cost of borrowing and financing and gain maximum reward for your investments. This then bounces back to making decisions about risk and return. This diversification aims to make the overall monetary risk remain affordable.
Know the tax implications of every investment
One of the most common financial mistakes that people make is to rule out the issue of tax. When you think about it, taxes are actually part of every business transaction. If you sell something for $100, you have to pay taxes on that sale. The same goes for when you make a purchase: if you spend $100 on something, the seller has to report that income to the IRS. So it’s important to keep the tax in mind when making any financial decisions.
In managing your finances, it is good to know the tax implications of every investment that you make and also make provisions for tools that can help you to organize and manage tax filings.
Prepare for unforeseen circumstances
When it comes to managing your finances, it is important to be prepared for any eventuality because unforeseen circumstances are inevitable. This means having a plan for how you will react if your income falls short or if you are faced with an unexpected expense. It is also important to set aside money each month so that you have funds available when you need them. Taking these steps will help you stay on track and manage your money responsibly.
One way to do this is to have a plan for every possible financial situation. This includes preparing for lost income, unexpected medical costs, natural disasters, changes in government policies, sickness, fire outbreaks, accidents, being laid off from work, repairs, and more. You should also keep track of your expenses so that you can make informed decisions about where to allocate your resources should these things arise.
Have an insurance plan
Since we now know that unforeseen circumstances can occur in business and in our personal life; it is good to have an insurance plan to mitigate the effects of uncertainties. Therefore, an insurance plan should be one of the factors to consider when managing your finances. This will help you get reimbursed in the event that something happens and your funds are unavailable. Furthermore, having insurance will protect your assets in the event that something goes wrong.
Principle of cash flow in financial management
Cash is an asset that can be moved easily. If you learn how to manage your cash flow, it will help you make better financial decisions. The cash flow pattern can affect the financial decisions of an organization. The more the amount of cash flowing in, the bolder the company makes decisions.
If the amount of cash flowing out is more than the cash flowing in, then the company needs to reevaluate the reasons why there is more spending than income. If the reason for the spending is for investments or research which can increase the value of the company and also increase revenue in the future, then it is a good principle to apply. But when the reason for spending is for liabilities rather than assets, then that is a bad financial management principle.
Therefore, the pattern of cash flows is one influencing factor in financial decisions and should be monitored to help make better decisions.
3 fundamental principles of financial management
From the preceding sections, we can deduce that financial management is a complex process that requires careful consideration of all aspects of your finances. Of all the guiding principles of financial management, let’s take a look at the 3 principles that are fundamental.
Save more, spend less, and be careful of debts
One of the most important principles of financial management is to save money. When you put money aside each month, you are building up a financial reserve that can be used when you need it. Another principle of financial management is to make sure that you are spending your money wisely.
When you are using your money, you are investing it in something that will provide you with value in the future. Finally, always keep an eye on your debt levels. Overly heavy debt burdens can lead to difficult financial problems in the future. Make sure that you are taking advantage of available credit options and avoiding high-interest loans.
Investment and diversification
One of the most important principles of financial management is to invest your money. This means putting your money into things that will provide you with a return on investment (ROI).
When you invest your money, you are hoping to get a higher return than what you paid for the investment. This is why it is important to research the different types of investments available to you. You should also be sure to invest in things that will make sense for your goals and financial situation.
One of the best ways to achieve a high ROI on your investments is to diversify them. This means investing in different types of assets so that you are not too concentrated on any one type of investment. By spreading your investment across many different types of assets, you are more likely to achieve a high return on your money.
Diversification is an important principle of financial management because it is essential to spread your investments among different types of securities to minimize risk. For example, if you invest all of your money in stocks, you are more likely to experience a loss if the stock market crashes. By investing in bonds and other types of securities, you reduce your overall risk exposure.
Finally, always be mindful of your expenses when investing. Knowing how much money you are spending each month will help you keep track of how much money you have left over to invest. This will help you make smart financial decisions that will improve your chances of achieving a high ROI on your investments.
The power of compounding
One of the most important principles of financial management is compounding. This is the phenomenon by which an investment earns more money over time because the initial investment is multiplied by itself multiple times.
For example, if you invest $10,000 in a stock that doubles in value every year, your original $10,000 investment would be worth $20,400 after four years. If the stock continued to increase at this rate, your investments would be worth far more than $10,000 after only eight years! This is why it is important to invest money gradually over time so that your total return on your investments is the highest possible.
By following these fundamental principles of financial management, you’ll be able to manage your finances better and improve your overall financial stability.
Importance of the principles of financial management
Principles of financial management are important for two reasons. The first reason is that they provide a framework for making sound investment decisions. If a business operates within the confines of a set of principles, it can make better choices about how to allocate its resources and manage its risks.
Another benefit of applying the principles of financial management is that they form the basis for enforcing financial controls in a business. By understanding their own principles, businesses can work to protect themselves from unethical practices by their employees and other stakeholders.
What are the 6 principles of finance?
There are six principles of financial management: prudence, liquidity, investment, budgetary control, capital structure, and risk adjustment. Prudence dictates that managers should make sound decisions that will help them achieve their financial objectives. Liquidity means having enough cash to meet short-term financial obligations. Investment involves making choices about where to allocate the firm’s resources in order to maximize returns. Budgetary control ensures that the firm maintains a reasonable level of profitability and liquidity. Capital structure deals with how much debt a company has and the risks associated with it. Risk adjustment ensures that a company’s assets are not overvalued or undervalued in relation to its liabilities.
There are three fundamental principles of financial management that you should always keep in mind when working with your money. These principles are budgeting, investing, and debt repayment. Understanding and following these principles will help you make the most informed decisions about how to spend your money and protect yourself from potential financial problems down the road.Last Updated on November 8, 2023 by Nansel Nanzip Bongdap
Nansel is a serial entrepreneur and financial expert with 7+ years as a business analyst. He has a liking for marketing which he regards as an important part of business success.
He lives in Plateau State, Nigeria with his wife, Joyce, and daughter, Anael.