Time value of money is the main concept of accounting. It tells us that the value of cash is different in different times. The value of a dollar you have today is more than it will be tomorrow. “Time value of money” is referred to as the difference between the worth of cash today and tomorrow.
The money I have in my pocket today is of more value than the same amount of money I’ll get in the future. It’s not hard to understand the reason. A dollar I have today in my hand can be utilized in any productive way. I can invest it somewhere or can earn interest by simply depositing it in my savings account.
If I have to choose between $1000 today or same amount a year after, I will go for today. Because I can employ that money anywhere and make more of that. I can invest that money today and put myself into a position to receive more in the future. I will capitalize on that money instead.
For example, if I invest $1000 today and earn 2% interest annually, after a year I would receive a profit of 20 dollars, totaling an amount of $1020 in a year. So it’s clearly better to earn 20 dollars profit than waiting to get $1000 after a year.
The second reason is that the same amount of money that I will get in the future will be devalued and would have less purchasing power because of inflation or general rise in the prices. “Time value of money” is based on this concept. If you are given an alternative to receive $100 today or same amount after a year, you will probably prefer to get it today. Because you understand that you can purchase more goods today from this amount than what you will be able to purchase after a year.
For example, if the price of theater ticket in your town is $15 today, it’s possible that the price may increase to $20 in a year for the same theater. This decreases the time value of money, since it will cost you $5 more to buy the ticket for the same theater. This tells us that the value of money decreases with time.
This concept also applies when you compare the value of cash that you will get in the future and the value of cash to be received in the further future. So this principle again says, that the money I will get in a month will be worth more than the money I will receive in a year.
Thus, time value of money is a necessary principle to look upon whenever you make financial decisions. It’s a vital consideration for the business owners because it can help them make right decisions regarding the cash inflows and outflows.