For someone without a financial background, finance can seem intimidating. Amid the formulas, financial statements, and spreadsheets, finance’s true importance can get lost.
“Numbers on a spreadsheet aren’t really what finance is about,” says Harvard Business School Professor Mihir Desai in the online course Leading with Finance. “It’s about understanding businesses using the logics of finance. Finance isn’t about spreadsheets; it’s about real people, real companies, and how resources get allocated in your business and the economy more broadly.”
Financial principles can enable business professionals across industries to gain a deeper understanding of their companies’ financial health, how to measure created value, and how to best communicate with shareholders.
Here are three financial principles business professionals should know, no matter their industry or role.
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DOWNLOAD NOWWhy Learn Financial Skills as a Non-Finance Professional?
As a business professional in a non-finance role, learning finance basics can help contextualize your work within your company's broader benchmarks and goals.
With knowledge of financial principles, you can advocate for projects' expected return on investment (ROI), articulate the financial impact of your team’s work, and make strategic business decisions with maximum value creation in mind.
Additionally, it can make for more productive interactions with your firm’s finance and accounting department. Finance is often called the “language of business,” and speaking it can increase collaboration and communication across teams.
Related: Financial Terminology: 20 Financial Terms to Know
3 Financial Principles All Professionals Should Know
1. Cash Flow
Cash flow—the broad term for the net balance of money moving into and out of a business at a specific point in time—is a key financial principle to understand. There are several types of cash flow:
- Operating cash flow: The net cash generated from normal business activities
- Investing cash flow: The net cash generated through investment activities
- Financing cash flow: The net cash generated from financial activities, such as debt payments, shareholders’ equity, and dividend payments
Taken together and detailed on the cash flow statement, these cash flow types paint a picture of the net cash flow that occurred over a specific period.
There’s one more type of cash flow that’s important to know: free cash flow. Free cash flow is the net amount of cash left over after taxes are paid; depreciation, amortization, and changes in working capital are accounted for; and capital expenditures (property, equipment, and technology investments) are subtracted. In short: It’s the cash left over that doesn’t need to be allocated anywhere.
In Leading with Finance, Desai calls free cash flow “finance nirvana” because it’s often leveraged to measure a company’s financial success. Once your company generates free cash flows, you’ve “made it,” so to speak. This cash is a metric investors look for when deciding where to allocate funds, and you can use it to provide returns to stakeholders. It can also be invested back into your business to create more free cash flow for subsequent periods.
Understanding cash flow types can help conceptualize which buckets your expenses fall into, provide context for budgeting, and offer insight into how your expenses and revenue factor into your company’s financial health.
Related: The Beginner’s Guide to Reading & Understanding Financial Statements
2. Time Value of Money
Finance is inherently forward-thinking and describes a company’s current position based on its trajectory. The time value of money (TVM) is a core financial principle that states a sum of money is worth more now than it will be in the future.
“If you want to understand what something is worth today, the only way to understand that is to look into the future,” Desai says in Leading with Finance. “Think about the economic returns—the free cash flows—as a way to understand what today’s values are. Something is only worth something today if it generates future benefits.”
Because of this, a specific sum of money’s value is dependent on how long you must wait before using it. The sooner you can use the cash, the more valuable it is.
The longer you must wait to use it, the more chances you miss to return your investment. To account for this when valuing a company, discount future cash flows to reflect their present-day values. Desai calls this the “gold standard of valuation.”
To calculate TVM for a sum of money, use this formula to solve for its future value (FV):
FV = PV x [ 1 + (i / n) ] (n x t)
In the TVM formula,
- FV = the future value of cash
- PV = the present value of cash
- i = interest rate
- n = number of compounding periods per year
- t = number of years
If you’re in a non-finance role, chances are you won’t need to calculate TVM or discount cash flows yourself, but understanding the time value of money can enable you to make decisions based on it.
3. Risk and Return
One central question finance tries to answer is “How do you create value?” Both the time value of money and cash flows add perspective to this question: Value is created in the relationship between money and time, and when all allocations are accounted for.
An alternative perspective on value creation comes from another financial principle: risk and return. It’s a concept you’re likely familiar with: To see returns, you often need to take calculated risks. This is closely related to the concept of return on investment, which is the net amount of cash after the initial investment has been subtracted.
“The relationship between risk and return is one of the most important relationships in finance and all of economics,” Desai says in Leading with Finance. “By and large, human beings don’t like bearing risk. As a consequence of that, if they’re forced to bear risk, they demand something in return—they demand a higher return.”
The level of risk associated with investing in an asset dictates the level of return you can expect from it. The minimum viable return on an asset in relation to its cost and risk is called cost of capital.
Imagine your business is considering purchasing a cutting-edge piece of technology that would increase production speed and quality. The only problem: It’s incredibly expensive. You predict the ROI will be worth it and use loans and equity from outside sources to purchase the technology. The sources that provided your company with the capital to make this purchase take on a fair amount of risk. What if the technology doesn’t improve quality enough to increase revenue and justify the purchase?
The cost of capital is your financing sources’ minimum requirement for the return on their investment; it’s what they demand in return for taking on a high level of risk. When pooled together, the cost of capital for all of your capital sources is called the weighted average cost of capital (WACC).
Again, if you’re not a finance professional, you likely won’t need to calculate these values. However, understanding the costs associated with higher-risk projects and the need to deliver a minimum ROI to stakeholders can be valuable as you budget, request funding for projects, and strategize around long-term investments.
Launching Into Finance
Each of these financial principles provides a piece of the puzzle for conceptualizing a company’s financial health, the direction it’s headed, and how you can create value. By understanding how these pieces operate and fit into the larger whole, you can have conversations with key stakeholders and make informed decisions regarding your business’s future.
After learning about these basic principles, what questions arise regarding how your company is valued, tracks finances, and makes decisions? Use this primer as a launch pad to explore more of what finance can offer to your career.
“Finance is an art, not a science,” Desai says in Leading with Finance. “It’s filled with judgment; it’s filled with subjectivity. As a consequence, it’s really fun.”
Do you want to understand the key financial levers that drive business performance? Explore our six-week course Leading with Finance, one of our online finance and accounting courses. To continue building your financial literacy, download our free Financial Terms Cheat Sheet.
