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.
