Principle of Business Finance

Principle of Business Finance

Business finance management means fund collection as per requirement, investment of this fund in short and long terms, and the management of fund distribution. This management process follows some principles which are furnished below:

a) Liquidity vs. Profitability Principle

A grocer may keep all the cash money (liquid property) earned from daily sales for the purpose of buying raw materials and other related expenses, or he may keep with him some portion of this cash for buying raw materials and deposit the rest amount in a bank account from which it is possible to get some amount of interest/ profit after a certain period. In this situation, the grocer has to decide on how much-earned cash should be retained with him to meet the current needs. If the grocer keeps a large amount of cash with him to meet the daily expenses then income from the bank will decrease. Again, if a large amount of cash is deposited in a bank, the business may fall into a financial crisis which may hamper daily activities. So, business people have to do financial management in such a way that can create a balance between liquidity and investment. It means, as on one side business people need cash reserve to bear the daily expenses, thus on the other side cash should be invested for making a profit too. There is an inverse relationship between cash and liquidity. Huge cash decreases profitability, again excess investment for the purpose of high profit causes a cash crisis. Maintaining a balance between liquidity and profitability is one of the principles of finance.

b) Competence Principle

Acquiring current assets through short-term funds and fixed assets through the long-term fund –is a principle of finance. The current asset is the money that is required to run the daily expenses of a business, like- raw materials purchase, payment of labor wages, etc. On the other hand, machinery purchase, building construction for the business, etc. are fixed capital. As the amount of current capital is small, it also yields less; for this reason, this type of capital should be collected from a short-term source of finance. Commercial banks, different financial institutions, investment banks, and debenture holders these types of sources provide long-term loans. On the other hand, current capital should be managed from regular sales proceeds. A high rate of interest has to be given to the loan-providing institutions for collecting loans from long-term sources. So, if a loan is collected from long-term sources to bear the current expenses, then it appears that repayment of interest from the earned income becomes impossible.

c) Diversification and Risk Distribution Principle

In the case of fund investment, if business products or services are as much as possible diversified, the risk is distributed and reduced. Every business organization tries to earn profit centering on an uncertain future. So business has to face a lot of risks. These risks may be created for many reasons, like- changes in economic, political, or social scenarios, the arrival of new products in the market, natural calamity, sudden accident, etc. It is not possible for the managers to control these uncertain situations or take preparations for them. But through following the principle of risk distribution, profit is possible to be earned in this uncertain market. If a business person does business only for a single product, then profit earning becomes very risky. On the other hand, if the products of the business are different and diversified, then the risk is distributed. It means, in any situation if the selling of a single product is deteriorate then the decreased amount of profit can be compensated by the profit earned from the other products; and as a result, expected profit can be achieved in any situation. If a grocer sells both Halal soap and traditional soap, then customers of both kinds of soap will arrive in his shop. If the grocer keeps only general or traditional soaps, the customers of Halal soap will go to another shop to buy Halal soap and the total sales of the grocer will decrease. Sales of some products rise or fall due to the differences in weather or season also. As an example, the demand for winter wears increases only in the winter season. So, the sale of winter wears increases in that season. If a dress seller sells both summer and winter wear in his shop, then his profit earning will not be hampered by the rise and fall of demand for the products in different seasons. If in a book stall only textbooks are sold and if in another shop textbooks, story books, religious books, and different instructive books are sold, then it appears that maximum customers will prefer the second stall even to buy textbooks. Because they can purchase different types of necessary books from a single shop at a time. Besides, if the book seller sells only textbooks, then the sale may increase at the beginning of the year but at other times of the year, these sales may decrease abruptly. This principle of risk distribution through diversification can be applied in fund collection. In the case of fund collection, priority is given to fund collection from different sources.

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