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.

10 Axioms of Finance. (2017, November 17). Retrieved from https://cpacamp.org/10-axioms-finance