The Ten Axioms of Finance serve as the foundations of Financial Decision Making. Every decision to be made in finance could all be related to these 10 Axioms of Finance.
10 Axioms of Finance
Axiom 1. The Risk-Return Trade-off
The higher the risk, the higher the return. When Floyd Mayweather and Connor McGregor were about to fight, people who would bet on McGregor would get higher returns than betting on Mayweather. A lot of people expected Mayweather to win the match because he was more experienced and had more boxing talent than Mayweather. In order to entice people to bet on McGregor, a higher reward would be given to those who bet on the MMA star. If you would invest in a risky business like junk bonds or oil wells, you should demand a greater return. Risk evaluation should always be present in every decision you make.
Axiom 2. The Time Value of Money
The dollar you have today is worth more than a dollar you will have in the future. This is because of inflation. The value of goods and services increases constantly every year. How many candies could a dollar buy back in the 80s? How many candies can your dollar buy now? A dollar in the past could purchase more candies than today. The money you have today could be invested in order to earn more. This would compensate for inflation. The sooner you invest, the better.
Axiom 3. Cash is King
You cannot entirely spend “profit” or “net income”. These accounts are only paper figures and includes both realized and unrealized gains, cash and receivables. Cash is the primary asset of an entity that can be reinvested or used to pay bills.
Cash flow could be more vital than the income statement because it shows the actual amount that could be used in the regular business operations. Cash flow does not equal net income. This is due to the timing differences in accrual accounting between the recording of a transaction and the receipt or disbursement of cash. In finance, cash is king.
Axiom 4. Incremental Cash Flows
The increase or decrease in cash is what really counts and not the increase or decrease in profit. When deciding on whether to invest in a certain project or not, the difference between the cash flows if the project is pushed through vs the scenario if the project is not done is what matters. Will the purchase of a photocopying machine increase your cash throughout the years? What will be the effect on your cash if you construct a new building?
Axiom 5. Curse of Competitive Markets
It’s a fact that it is hard to find and maintain exceptionally profitable projects. That is because high profit projects attract competition. If you do find a highly profitable project, it is highly probable that you have a lot of competitors. You’ll have to use different techniques to stay relevant in a highly competitive market like using product differentiation (e.g. Apple), providing low cost of products and services (Toyota), and providing high service quality (Mercedes).
Axiom 6. Efficient Capital Markets
The stock markets are quick and the prices are right. Information is incorporated into security prices at the speed of light! That’s the reason why stock prices rise and fall all the time. Assuming the information is correct, then the prices will reflect all publicly available information regarding the value of the firm. The Exploding Samsung Galaxy Note 7 immediately affected Samsung’s stock prices. The death of Steve Jobs had an effect in Apple’s stock too.
Axiom 7. The Agency Problem
In general, managers are not the owners of a company. They are merely employees. The owners of a corporation are called stockholders. The primary purpose of creating a corporation is to increase shareholder’s wealth. However, managers may make decisions that are in their best interests and may be in conflict with the goals of the shareholders. This is a problem that is existent in almost all businesses.
Axiom 8. Taxes Bias Business Decisions
As the saying goes, there are only two things that are certain in this world – Death and Taxes. When there’s a business, there’s also tax. And because cash is king, businesses must always consider the after-tax cash flow on an investment (cash flow after deducting taxes). The tax consequences of a business decision will impact (reduce) cash flow Companies are given tax incentives by the government to influence their decisions.
Axiom 9. All Risk is Not Equal
There are some risk that can be diversified away and there are some risk some cannot be diversified and minimized.
Diversification can be explained by the adage – don’t put all your eggs in one basket. Diversification can create offsets between good results and bad results.
Axiom 10. Ethical Behavior Means Doing the Right Thing
In finance, ethical dilemmas are everywhere. Unethical behavior and bad image eliminates trust, which results in the loss of public confidence.
In turn, Shareholder value suffers and it takes a long time to recover. If corporations do the right thing, the value of the business would increase.