Ten Principles of Financial Management

It is not necessary to understand finance in order to understand these principles, it is however necessary to understand these principles in order to understand financial management.

Principle 1: The risk-return trade-off – we won’t take on additional risk unless we expect to be compensated with additional return.

Investors expect to be compensated with additional returns when they take on more risk. However, we are talking about ‘expected’ return, this means that on average the return is higher when grater levels of risks are taken, however given the very nature of this risk the returns can vary widely.

Principle 2: The time value of money – a dollar received today is worth more than a dollar received in the future.

A fundamental concept in finance is the time value of money, which states that money has a time value associated with it: a dollar received today is worth more than a dollar received a year from now.

As we can earn interest on money received today, it is better to receive money earlier rather than later. The concept also means that a dollar received in the future is not worth as much as a dollar today.

Principle 3: Cash – not profit – is king.

When measuring wealth or value, cash flows, not accounting profits, are generally used/recognized as a measurement tool. This is where one is more concerned with when the money hits our hand, when it can be invested to earn interest and when it can be distributed to the shareholders in the form of dividends.

Whilst successful firms may be those that generate high profits, profits are not the appropriate unit for measuring wealth. Accounting profits are ‘book’ figures, not cash flows.

Principle 4: Incremental cash flows – it’s only what changes that counts.

Incremental cash flow is an additional operating cash flow that a company earns when accepting a new project. If an organization has a positive incremental cash flow, they're more likely to increase the amount of overall cash flow if they work on new projects.

To correctly evaluate a capital budgeting project the critical question is ‘what additional cash flows will the firm receive or pay as a result of making the decision to undertake the project?’.

As these additional or incremental cash flows are only those amounts that specifically relate to the project being evaluated, the key test of whether a cash flow is incremental is the ‘with or without’ question.

If a cash-flow amount will occur if the project is accepted (‘with) and will also occur if the project is not accepted (‘without’), then the cash flow is not incremental and is not included in the evaluation of the project.

Conversely, if a cash-flow amount will only occur if the project is accepted (‘with’) and will not occur of the project is not accepted (‘without’) then the cash flow is incremental and must be included in the evaluation of the project.

Incremental cash flows can also be negative (incremental costs) or positive (incremental benefits).

Principle 5: The curse of competitive markets – why it’s hard to find exceptionally valuable projects.

In competitive markets, extremely large profits simply cannot exist for very long. Given that somewhat bleak scenario, how can managers find good projects – that is, projects that provide more than their expected rate of return given their risk level.

As competition makes these projects difficult to find, managers must invest in markets which are not perfectly competitive. Two most common ways that firms can make markets less competitive are (1) to differentiate the product in some key way or (2) to achieve a cost advantage over competitors.

Principle 6: Efficient capital markets – the markets are quick and the prices are right.

The goal of financial managers is to create wealth for the firm’s owners. Shareholder wealth is measured by the value of the shares that the shareholders hold. To understand what determines prices of securities, it is necessary to understand the concept of efficient markets.

Whether the market is efficient or not has to do with the speed with which relevant information is absorbed into security prices. An efficient market is characterized by a large number of profit-driven individuals who act independently and where the values of all assets and securities at any instant in time fully reflect all available information.

Implications of efficient markets for finance managers: first, the price is right – share prices reflect all publicly available information relative to the value of the company. The goal of maximization of shareholder wealth can be implemented, and over time good decisions with result in higher share prices.

Second, earnings manipulations through ‘cosmetic’ changes will not result in benefits to shareholders i.e., ‘bonus issues’ of shares of existing shareholders, which are merely cosmetic. Market prices reflect expected cash flows available to shareholders.

Principle 7: The agency problem – managers won’t work for owners unless it’s in their best interest.

Although the goal of the firm is the maximization of shareholder wealth, in reality the agency problem may interfere with the implementation of this goal, particularly in large companies.

The agency problem refers to the fact that a firm’s managers will not work to maximize benefits to the firm’s owners unless it is in the managers interests to do so. This is as a result of a separation of the management and the ownership of the firm.

Managerial performance can be monitored by auditing financial statements and managers’ remuneration packages. Some companies have adopted practices such as issuing of stock options (share options) to their managers and senior executives in order to lessen the agency problem.

Principle 8: Taxes bias business decisions.

Hardly any decision is made by the financial manager without considering the impact of taxes.

Governments also realize that taxes can bias business decisions and so they use taxes to encourage spending in certain ways i.e., via tax rebates.

Principle 9: All risk is not equal – some risk can be diversified away, and some cannot.

‘Don’t put all of your eggs in one basket’. Diversification allows good and bad events to cancel each other out and thus reduce risk.

Risk relative to a project changes depending on whether it is measured standing alone or together with other projects that company may take on. If shareholders are diversified, they can eliminate part of the risk associated with movements in a given company’s share price.

Principle 10: Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance.

Ethics in finance, or rather the lack of, is a recurring theme in both fact and fiction. Ethical behavior means ‘doing the right thing’. A difficulty arises, however, in attempting to define ‘the right thing’.

The problem is that each person has his or her own set of values, which forms the basis for their personal judgements about what is right and what is wrong. However, every society adopts a set of rules or laws that prescribe what ‘doing the right thing’ involves.

Beyond the question of ethics is the question of social responsibility, which means that a company has a responsibility to society beyond the maximization of shareholder wealth. It asserts that a company answers to a broader constituency than to shareholders alone.

These ten principles are as much common sense as they are theoretical statements.

Nigel Chetty MBA

www.nigelchetty.com

Ref: Financial Management: Principles and Applications, 6th Edition

Continuous Learning and Competitive Advantage

The training and development of employees is a critical component of success for organizations — especially if you believe that a stronger team makes a competitive difference.

However, despite its importance, when times are tough training and development budgets are among the first to be cut. Often the reason behind this apparent contradiction is the lack of a clear connection between such training and results.

Continuous Learning and Competitive Advantage

Intangible assets including human capital, customer capital, social capital and intellectual capital help companies gain competitive advantage. Recognizing that formal training, informal learning and knowledge management are important for the development of intangible assets, many companies now consider training one part of a larger emphasis on continuous learning. 

Continuous training/learning is critical in assisting organizations to achieve their operational, business and performance objectives, hence adequate resources and funding should be committed to enabling a strategic and planned approach to training.

Continuous learning enables employees to understand the entire work system, acquire new skills and to apply them on the job and share what they have learned with other employees.

Key features of Continuous Learning

Training

A planned effort to facilitate the learning of job-related knowledge, skills and behavior by employees. No training/lack off planned or active efforts to facilitate training, will overtime lead to a decline in job satisfaction amongst staff and contribute to a high employee turnover. Loss of experienced employees will result in a less productive workforce due to lack of job-related knowledge. Lack of training will also potentially result in lower customer satisfaction scores as result of mediocre product knowledge.

Formal Training

Training and development programs/courses that are developed and organized by the company. Most underperforming organizations’ regard formal training as expensive and unnecessary, given the associated costs of delivery and employees requiring time away from work to attend training. 

A study by the Harvard Business Review found that most senior managers were of the view that formal training is costly and can take employees off the job for short periods of time. Employers are understandably reluctant to make big investments in workers who might not stay long, but this creates a vicious circle.

Companies won’t train workers because they might leave, and workers leave because they don’t get training. By offering employees a more balanced menu of development opportunities, employers might boost their inclination to stick around (Hamori, Cao & Koyuncu 2012).

Informal Learning

Learning that is learner initiated, involves action and doing, is motivated by an intent to develop and does not occur in a formal learning setting. Informal learning occurs without an instructor and its breadth, depth, and timing are controlled by the employee. As the outcome is often unquantifiable, it is difficult for managers to measure and evaluate outcomes from informal learning for purposes of performance, productivity and reviews.

Explicit Knowledge

Knowledge that is well documented and essentially transferred to other persons e.g. processes, checklists and operational guidelines that tend to be well documented and available both electronically and hardcopy (manuals), hence explicit knowledge is easily transferable and accessible.

Tacit Knowledge

Knowledge based on personal experience that is difficult to codify and is best acquired through informal learning. Tacit knowledge in most environments is best acquired through interaction with experienced peers and experts. However for those organizations with high employee turnover, new employees will generally have very limited access to experienced peers who would have the level of experience required to act as mentors and coaches. 

Knowledge Management

Process of enhancing company performance by using tools, processes, systems, and cultures to improve the creation, sharing and use of knowledge. Most successful organizations have a platform for employees to share their knowledge about products, solutions, projects and professional interest e.g. intranet forums where employees share product knowledge, exchange ideas and interact with senior management, allowing their employees to be more effective and productive, to keep up with trends, technological developments, access to real-time information, and the ability to contribute to business development and innovation, leading to higher job satisfaction and personal development.

Conclusion

It is important for all aspects of continuous learning, including training, knowledge management, and informal learning to contribute to and support the business strategy. Continuous learning needs to address performance issues that lead to improved business results.

To do so requires that the emphasis on continuous learning aligns with the business strategy, has visible support from senior managers and involves leaders as instructors and teachers. Creates a culture or work environment that encourages learning, provides a wide range of learning opportunities including training, informal learning, knowledge management, and employee development. Uses traditional methods and innovative technologies to design and deliver learning, and measures the effectiveness and overall business impact of learning (Noe et al. 2015).

Author: Nigel Chetty MBA - WWW.NIGELCHETTY.COM