• Kevin McDonnell

Financial Laws of Nature

Updated: Oct 14, 2019

Gravity is a law of nature. If you throw a ball in air it will come down because gravity is pulling it back down to earth. Gravity, the theory of matter, and many other scientific laws are common knowledge and taught in primary schools.

There are many equally important financial laws of nature that are rarely taught in school. Understanding how these undeniable financial truths work is essential because they come into play almost every day of our lives.

Law #1 - Reward or Return is the Result of Risk - People or organizations only can receive a reward or a return by taking risk. The key is to understand the risks and ensure that the return is commensurate with the risk. You can't put money under the mattress and expect a return. Risk can come in the form of time, money or emotion. Reward can come in the form money or satisfaction - this is an essential ingredient of life and it is intertwined with our everyday lives but is rarely discussed. We make hundreds of decisions every day balancing risk and reward. Organizations that live in fear of risk will ultimately fail while organizations that understand how to take calculated risks will thrive.

Picture of street signs showing the intersection of risk and reward.
In order to create a return an organization must take risk.

Law #2 - All Organizations Have Finite Resources - Economic and financial theory is all predicated on the fact that organizations have finite resources and those resources need to be allocated wisely. It is the fundamental role of a manager to allocate the resources of both time and money. An organization can allocate resources on the strategies, projects, and tasks that align and effectively promote its organization's primary goals. Organizations normally do not fail for the lack of "good ideas" but the inability to rationalize opportunities with the organization's primary objectives. Successful organizations know how to avoid the "good idea trap™".

Law #3 - The Utilization of Assets is What Creates Value - Value is created when assets are utilized. An asset can be individual labor, an education or a physical asset, like a building or machine. Value can come in the form of increased income or reduced costs. The balancing capacity and utilization maximizes value. If the organization is looking to increase revenue, managers should look for assets that can be monetized because they are underutilized. If the goal is cost reduction, look to minimize unproductive assets or find ways to more fully utilize assets.

Law #4 - Cost of Something is Greater than the Price - When evaluating the potential cost of a project, both the direct and indirect costs must be included. For example, the cost of an employee is not only their salary but employer taxes, medical benefits, workspace, parking, management time, etc. Indirect costs can be greater than the direct costs.

Law #5 - Money Today is Worth More Than Money Tomorrow - As the saying goes, a bird in the hand is worth two in the bush. The concept that $1 today is worth than $1 in the future is at the heart of financial theory. A promise of future payment carries risk and a required return. A promise to pay $200 sometime in the future is worth less than $200 paid today. With $200 in your hand, you could invest and earn a return on the money rather than waiting for the promised $200 payment. Financial theories like Net Present Value (NPV) or Discount Cash Flow work on this basic concept.

We will continue to explore each of the above Laws of Financial Nature in future blog posts. Organizations should carefully consider each of these laws of nature as they make decisions. Organizations that ignore the Financial Laws of Nature do so at their own peril.

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