Q.1 Financial ratios important to a small business and their comparison with ratios critical to a manager of a larger corporation
The following ratios are critical for small businesses:
- Acid test ratio/ Quick ratio: Current assets – stock/Inventory
Current liabilities
Measure liquidity position of a firm
- Average collection period: Average debtors – 365 days
Credit sales
Measures efficiency of a firm in collecting debts owed to it
- Inventory Turnover: Cost of sales
Average stock
Measures efficiency of a firm in sales
- Total debt/Equity: Long term debt + Current Liabilities
Shareholders’ funds
Shows the extent of leverage used by a firm
- Net profit margin: Net profit (Earnings after tax) * 100%
Sales
Measures a firm’s profitability
- Return on Total Assets: Net Profit (Earnings after tax) * 100%
Fixed assets + Current assets
Measures effective utilization of assets by a firm
The above ratios also apply to large business 9Bull, 2008), in addition to the ones listed below:
- Price/Earnings ratio = Market Price Share
Earnings per Share
Shows percentage of net profit paid to equity holders
- Current Ratio = Current Assets
Current Liabilities
Measures short-term liquidity of a corporation
- Interest coverage = Earnings before interest and tax
Interest
Determines how easily a company can repay its debt. A ratio of 1.5 is satisfactory (Bull, 2008).
Q. 2 Advantages and disadvantages of debt financing and why an organization would choose to Issue stocks rather than bonds to generate funds
Organizations have three major debt financing options. These are bond-financing, issue of stocks also known as equity financing, and lease or buy decisions (Burk & Lehmann, 2006). Depending on the prevailing economic conditions as determined by inflation and interest rates, organizations have to select the most appropriate financing technique to minimize costs. For instance, during periods of declining interest rates, fixed interest rates securities such as bonds or debentures issued a while ago when interest rates were high, become expensive to service. The ensuing paragraphs below discuss the advantages and disadvantages of debt financing and reasons why organizations prefer to issue stocks to bonds when raising funds.
Advantages of debt financing
Tax deductions – Debt financing is attractive for organizations because the interest repayment on the loan is tax-deductible. Usually, the interest and principal repayments are classified as business expenses and the appropriate accounting procedure is to deduct them from the business income that is liable to taxation. This helps to shield part of the organization’s income from taxation and therefore minimizes the tax liability each year.
Maintaining ownership - Organizations prefer to use debt financing to control ownership of the business. Their only obligation is not to default on agreed-upon loan repayments with the lender. The management can decide on how to run the business freely without outside interference, for instance the requirement of being answerable to the lender in the case of equity financing.
Higher profitability – The management is not obliged to share its profits with the lender. Its only obligation is to make loan re-payments on a timely basis.
Lower interest rates – An organization has the option of applying for small business administration loan that comes with favorable terms such as lower interest rates as compared to the usual commercial bank loans. In addition, analysis of the impact of tax deductions on the bank interest rate below will show that debt financing is cheaper.
Assuming a bank charges 10% interest on loan and the government taxes 25%, the advantage of taking such a deductible loan is determined as follows:
Multiply 10% by (1- 25% tax rate) = 7.5%. Therefore, after tax deductions, an organization will be paying 7.5% interest rate.
Disadvantages of debt financing
The organization has to make timely loan repayments even if the business fails to record profitability.
The business may have the obligation of paying high interest rates even when tax deductions have been taken into consideration. This is because interest rates vary depending on the prevailing macroeconomic conditions (Burk & Lehmann, 2006).
The more the organization relies on debt financing, the poor its credit rating. This is because the risk of defaulting increases and lenders charge higher interest rates to reflect the possibility of defaulting
In most cases, an organization is required to put up collateral on the loan if it is a start-up.
Why organizations prefer to issue stocks rather than bonds to generate funds
Issuing of stocks empowers business to obtain financing without the obligation of periodic repayments. The management is able to focus on making the entity a profitable one rather than paying back the investors. In addition, the business has the opportunity of fostering long-term relationship with shareholders throughout the joint business endeavor. Profits are ploughed back to the business to finance other investments. Most importantly, the management does not issue dividend payments when the business records losses.
Q. 3 how financial returns are related to risk
The relationship between financial returns and risks is that the returns are higher for investors if they undertake to put their money in high risk factor securities. Similarly, investors who undertake minimal risks are expected to earn smaller returns. In financial and money markets, risk may be defined as the chance an individual is taking that returns on a given investment are likely to vary. However, it is prudent to note that higher risk taking does not guarantee higher returns. According to leading financial analysts, individuals bias their chances of obtaining favorable returns by choosing to take risk that has rewarded reliably in the past, expecting the same securities to reward in the future. Markowitz approach to portfolio selection is that an investor should evaluate portfolios based on their expected returns E(r) and risk as measured by standard deviation (Reilly & Brown, 1997). He postulates that we should select the portfolio that has the smallest risk for a given level of return. No portfolio on the efficient frontier can dominate any other portfolio as seen below:
Sourced from: Satyanarayan & Varangis (1994)
Portfolios on the efficient frontier have different returns and risk measures with E(r) that increases with higher level of risk.
Q.4 the concept of beta and how it is used
The risk of a diversified portfolio is called market risk. The capital market line helps investors to select diversified portfolios. The risk of an individual security relative to that of the market portfolio is known as beta.
Beta is the covariance between an individual security return and the return of the market portfolio. The market portfolio is the most diversified and efficient portfolio and is assigned a beta = 1. The earliest measure of beta relied on the security market line that specifies how the required rate of return and risk for any given asset are related. It assumes a linear relationship as shown below:
Sourced from: Sourced from Reilly & Brown (1997)
Q. 5 Contrast systematic and unsystematic risk
Systematic risk refers to the variability in a security’s total returns directly associated with the overall movements in the market economy. This risk is as a result of factors such as increase in interest rates, inflation, and changes in government legislation. This type of risk cannot be diversified by holding a portfolio in the same market.
Unsystematic risk, also known as company specific risk, is unique and brought about by two variables. These are business risk, for instance operating costs, and financial risk, that is level of debt/leverage held by a business. Unsystematic risk can be completely diversified away by holding the correct portfolio (Reuvid, 2005).
Q. 6 how to invest $ 1 million in order to diversify the risk and receive a good return
The first step will be to device a way of maximizing utility from the windfall amount. Before investing the amount in any sector of the economy, I will apply the concept of Net Present Value (NPV) to determine expected returns on the initial amount invested at the end of the investment time horizon. PV = FV/(1 + r)t
The next move will be to invest the cash in a diversified portfolio to minimize the inherent risk. I will distribute the amount evenly in the following:
Stocks ($200,000) - this will assist the portfolio to grow
Bonds ($200,000) – this will provide a source of income
Real estate ($200,000) – hedges the portfolio against low correlation of stocks and inflation
Cash/Liquid assets ($200,000) – will give me security and stability
International investment ($200,000) – helps maintain the manufacturing firm’s buying power in the increasingly globalized world.
The steps that I will follow in the portfolio management and evaluation are as follows:
- Formulation of an investment policy by providing information in the following order:
Objectives: Includes return requirements and risk tolerance level (Reilly & Brown, 1997).
Constraints and preference: Liquidity, laws & regulations, taxes, time horizon and preferences
- Analysis of the economy by industry and sector
- Development and implementation of strategies involving asset allocation, selection of securities and portfolio optimization
- Monitoring of portfolio factors
- Measurement and evaluation of the portfolio performance using risk adjusted techniques.
References
Bull, R. (2008). Financial ratios: how to use financial ratios to maximise value and success for your business. Oxford: CIMA.
Burk, J. E., & Lehmann, R. P. (2006).Financing your small business. Naperville, Ill.: Sphinx Pub.
Reilly, F. K., & Brown, K. C. (1997).Solutions manual, Investment analysis and portfolio management (5th ed.). Fort Worth, Tex.: Dryden Press.
Reuvid, J. (2005). Managing business risk a practical guide to protecting your business
(2nd ed.). London: Kogan Page.
Satyanarayan, S., & Varangis, P. N. (1994). An efficient frontier for international portfolios with commodity assets. Washington, D.C.: World Bank, International Economics Department, International Trade Division.
