Financial Risk the Financial Ratio Categories Are Essay

  • Length: 5 pages
  • Sources: 5
  • Subject: Economics
  • Type: Essay
  • Paper: #94994602

Excerpt from Essay :

Financial Risk

The financial ratio categories are Liquidity, Activity, Profitability, and Coverage (Kieso, Weygant, & Warfield, 2008). These ratios are comparisons of different financial accounts that show financial performance measures in different areas. Fluctuations of these ratios can be red flags. These fluctuations can show increases or decreases in performances. Increases could indicate growth, but decreases could show negative signs in performance levels that need to be analyzed and addressed. Liquidity, or solvency, ratios measure the short run ability to pay maturing obligations and include the current ratio, current cash debt coverage ratio, and the quick ratio. The current ratio measures current assets to current liabilities. The current cash debt coverage ratio measures net cash from operating activities to average current liabilities. The quick ratio measures cash, marketable securities, and net receivables to current liabilities.

The Activity, turnover or efficiency, ratios measure the effectiveness of using assets and include receivable turnover ratio, inventory turnover, and asset turnover. The receivable turnover measures net sales to average trade receivables. The inventory turnover measures cost of goods sold to average inventory. And, the asset turnover measures net sales to average total assets.

The Profitability ratios measure the degree of success, or failure, at a given time and include profit margin on sales ratio and the rate of return on assets ratio. The profit margin on sales ratio measures net income to net sales. The return on assets ratio measures net income to average total assets. If the business is incorporated, the rate of return on common stock equity, which measures net income minus preferred dividends to average common stockholder's equity, the earnings per share ratio, which measures net income minus preferred dividends to weighted shares outstanding, and the payout ratio, which measures cash dividends to net income, are also considered in a performance analysis. Corporations have the added stock performance ratios that measure the stock performance at a given time that small business does not have.

Coverage, leverage or capital structure, ratios measure the degree of protection for long-term creditors and investors and include debt to total asset ratio, times interest earned ratio, cash debt coverage, and for corporations, book value per share ratio. The debt to total assets measures debt to total assets, as it implies. The times interest earned ratio measures income before interest expense and taxes to interest expense. The cash debt coverage ratio measures net cash provided by operating activities to average total liabilities. The book value per share ratio measures common stockholder's equity to outstanding shares.

Debt financing has advantages and disadvantages (Peavler). The advantages are the owner maintains control with no one to answer to, interest repaid is tax deductible, shields part of the business income, lowers tax liability, lenders do not share in the profits, and the business can apply for a Small Business Association loan for more favorable pay back terms. The disadvantages are the business may have large payments due when cash is needed, credit can be damaged if payments are not made on time, which can cause problems for future financing, and loans to family and friends can strain relationships if they are not paid back in a timely manner. A company may choose to issue stock instead of bonds for equity financing because stocks have no interest payments or pay back involved. It is just a promise that the stock will grow in worth. And, stocks have a higher expected return than bonds because they don't have to be paid back.

Risk tolerances change with market changes (Lowrie, 2006). When market conditions are high, more risk is considered. When market conditions fall, risk-adverse, or spending is decreased, happens. Most market variability can be explained with term and default factors of bond risk premiums and the market, size, and price factors of equity risk factors. The potential premium needs to be high enough to compensate for the risk to be worthwhile. The risks with premiums fluctuate over time. Because investments have the risks of losses, they are related to the expected returns. It is common for business to have a risk tolerance, the amount they can afford to lose in case of failure. The risk tolerance will determine how much is invested and what types of investments will be considered at a given time. Some investments have low risk rates and some have high risk rates. The market conditions at a given time will affect the rate of risk. How much is invested and the returns will actually depend on how the markets are performing and the rates of risk involved with the individual investments.

Beta is a historical measurement of the volatility of, or systematic risk, of stock and how it relates to the market as a whole (Derrick, 2012). It provides a guideline of how stock should typically move in the market. The S&P 500 (NYSE:SPY) is used to represent the market. If a stock has a beta of 1, the stock is less volatile than the market. If the beta is greater than 1, the stock is more volatile. Any negative beta numbers, or drops, the stock will have losses. A low beta on a stock, without being negative, is more stable, but the gains will be less than the market. A high beta on a stock will rise rapidly and outperform the market. There is a possibility of larger returns, but it also has the possibility of larger losses. A low beta is less risky and the rewards are also less. The high beta is more risky, but can have higher returns.

Systematic risk is due to factors that affect the entire market, such as investment policy changes, foreign investment policy, change in taxation clauses, shift in socio-economic parameters, global security threats and measures, etc. (Systematic Risk and Unsystematic Risk (Financial Investments)). Unsystematic risk is due to factors that are industry specific, such as labor unions, product category, research and development, market strategy, etc. Systematic risk is beyond investor control, but the market compensates for it. Unsystematic risk can be mitigated through portfolio diversification and can be avoided. The market does not compensate for unsystematic risk. This logic forms the base for a capital asset pricing model. The greater the risk involved, the greater the return on investment.

"By investing in more than one stock, an investor can reap the benefits of diversification -- chief among them, a reduction in the riskiness of the portfolio" (Buffett, 2010). The right combination of stock reduces the risk of having only one stock. This is where one stock pays off at a given time and other stocks pay off at other times. The covariance, a measure of the degree to which two returns on two risky assets move in tandem, is the difference between individual's stock levels of risk that determines overall portfolio risk.

Combinations of high risk/high return, such as Google technology, low risk/low return, such as Coca Cola, and risk-free assets provides for an appropriate level of risk with higher returns. Caution needs to be taken with risk-free assets. Government bonds are supposed to be risk-free, but are not in reality. Gilts and Treasury bonds may be free of default risk, but higher inflation and interest rate changes will affect the value and can reduce the overall value of the bonds. Mutual funds contain numerous stocks that diversify the portfolio. The success of the portfolio rest with the skills of the investor and the time they can devote to it. Because investments constantly change, it is wise to devote plenty of time each day to evaluating the investments on a daily basis to ensure a higher rate of success with returns.

Evaluation of different investment assets needs to be done to achieve the highest return with the lowest risk for the corporation's one million. A mixture of high risk/high return stocks that pay at different times of the year, low risk/low return stocks, and some risk-free assets would create a portfolio with an appropriate risk for the greatest amount of return if the evaluation is done appropriately. There needs to be a risk tolerance set as a benchmark to evaluate the different assets. As much stocks and assets as the money can pay for is the best to ensure the highest return.

Asset allocation, investing into different asset categories, is also important for diversification (Beginner's Guide to Asset Allocation, Diversification, and Rebalancing). For example, it is important to determine how much money would be invested into stocks, bonds, and low risk investments. The asset allocation helps to determine how the portfolio gets diversified. The diversification needs to be between categories and within categories because market conditions can move one asset, or asset investment, upward while moving the other two in a downward direction. It is recommended to invest in a wide variety of companies and industry sectors.

The best allocation for the corporation at a given time would depend on the time horizon and the risk tolerance. The time horizon is the expected amount of time to invest to reach…

Cite This Essay:

"Financial Risk The Financial Ratio Categories Are" (2012, November 24) Retrieved January 18, 2017, from

"Financial Risk The Financial Ratio Categories Are" 24 November 2012. Web.18 January. 2017. <>

"Financial Risk The Financial Ratio Categories Are", 24 November 2012, Accessed.18 January. 2017,