Understanding the Concepts Research Paper

  • Length: 5 pages
  • Sources: 5
  • Subject: Economics
  • Type: Research Paper
  • Paper: #53327281

Excerpt from Research Paper :

Finance Concepts

As a small business owner determine the financial ratios that are important to the business, and compare them with those that are important to a manager of a larger corporation.

For a small business, the most important financial ratios are those in the profitability and efficiency classes. These include profit margin, return on assets, asset turnover, and fixed asset turnover. For the most part, small businesses are able to be more efficient and have higher profitability ratios than larger companies (Upneja, Kim, & Singh, 2000, p.28). Small businesses would be especially concerned with profit margin and return on assets, while a larger corporation would focus more on earnings per share and return on equity, which are concerned with shareholder equity, something that does not concern many small businesses.

Small business owners would also be interested in the liquidity ratios that measure the cash available to pay off debt, such as the current ratio and the quick ratio. Though large corporations would also be interested in this, they have the ability to generate more cash flow and hold fewer current assets, thereby lowering their current and quick ratios (Upneja, Kim, & Singh, 2000, p.27). Both small and large companies would be interested in solvency ratios, although a small business owner would focus more on the short-term debt ratio while a large company would favor the long-term debt ratio, since small businesses are usually more leveraged in the short-term (Upneja, Kim, & Singh, 2000, p.28). They would both be equally concerned with the total debt ratio.

2. Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds.

Most businesses will incur debt at some point in their existence and they have several options available for financing. Going to a lending institution allows the business to remain independent, since the bank will have no say in the way the business is run. The company can choose to finance its debt over the short-term of for a longer period and once the money has been repaid the relationship between the lender and the company ends. Finally the amount that is borrowed is a known quantity that can be budgeted and any interest paid is tax deductible. There are disadvantages as well, however. The money must be paid back in a set amount of time and doing so can cause financial hardship if business slows. Obtaining too much debt can cause the company to have trouble repaying the loan or in raising capital in the future. A lender may often require physical assets of the company as collateral, which could be lost if payments are missed ("Debt vs. Equity Financing," 2013).

Instead of borrowing money from a lender, a corporation may choose to issue stocks or bonds to generate funds. Stocks offer a few advantages over bonds. First, unlike bonds, there is no principal to be repaid at maturity so they never have to be paid back. Also there are no interest payments to stockholders like they do to bondholders (Gallagher & Andrew, 2007, p.28).

3. Discuss how financial returns are related to risk.

For the most part, it holds that risk and financial return are directly related. Engaging in high-risk ventures should yield a higher financial return than low-risk investments. The risk-return relationship is linear in nature, meaning that the return will increase proportionally to the risk undertaken. As an example, consider bank savings accounts. These accounts are insured by the FDIC so there is no risk of losing the investment. As a result, these accounts yield low, steady returns that can be counted on to continue for the life of the investment. Conversely, someone who places an all-or-nothing wager on a horse race or other sporting event stands to instantly double his money if he chooses correctly or lose it all if he picks the wrong horse or team (Groppelli & Nikbakht, 2006, p.76). This is a very risky proposition so the potential return is much greater than that of a savings account, although there is the chance that all of the money wagered could be lost. The trick for any investor is to maximize returns while limiting the inherent risk associated with the investment.

4. Describe the concept of beta and how it is used.

Beta is a measure of the relative market risk of an investment, primarily a stock. The higher a stock's beta, the higher its market risk. A stock with a beta of zero has no market risk whatsoever, while a stock with a beta of 1.0 would have the exact same risk as the stock market as a whole (Brigham & Ehrhardt, 2011, p.950). Betas can be calculated by doing a linear regression between past returns on the stock and past returns on the market index. This is known as an historical beta. An adjusted beta is found by giving some weight to the historical beta and then taking into account that the future beta will move towards 1.0 (Brigham & Ehrhardt, 2011, p.950). This adjusted beta can be used to determine volatility and risk of a stock in the future. For example, if a stock has a beta of 2.0 and the stock market moves 2%, the individual stock can be expected to change 4%. As with all other investments, a higher beta carries both a higher risk and a potential for high returns, while a lower beta would mean less risk and lower returns.

5. Contrast systematic and unsystematic risk.

There is risk involved in any investment, even one that has been properly managed and diversified. The inherent risk that occurs across many different stocks throughout the market is called systematic risk and it may occur at any time. Such systematic risks include expansion and recession phases of the economy, changes in inflation, interest rates and exchange rates. Whenever the vast majority of stocks in the market are affected, it is an example of systematic risk (Graham & Smart, 2011, p.198).

Unsystematic risks, by contrast, are those that affect just a few stocks at a time and not the market as a whole. These risks affect an individual stock and can be eliminated by diversifying a portfolio. For example, investing in only one stock within an industry exposes an investor to the unsystematic risk in that individual company. However when an investor diversifies and holds positions with several companies within an industry the unsystematic risk is removed and only systematic risk remains (Graham & Smart, 2011, p.198).

6. A manufacturing corporation has just won a patent lawsuit. After attorney and other fees, the corporation will have about $1 million. Explain how to invest the money in order to diversify the risk and receive a good return.

The money that is received can be invested in several different ways, but it is important that it be invested to eliminate as much risk as possible. While the money could be invested in very conservative allocations, this would severely limit the return that could be gleaned from the money. This could be preferable given the fact that the money is extra income that they were not counting on having, but since the money comes from patent violations it makes sense the corporation would want to make up for any revenue that may have been lost.

Perhaps the best way to do this initially is to invest in equipment for the corporation that will help them to continue to innovate within their industry. This would be a low-risk investment with the potential for a good return on their manufacturing capacity. Investment in personnel and design could also be made to ensure that the corporation can continue to produce high-quality products. Any of these investments will increase company assets and help to improve return…

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