Answer 1: Financial ratios represent a mathematical assessment/comparison of entries (two or more) from the organization’s financial statements namely Income statement, Balance sheet, Cash flow statement and Statement of owner’s equity. These ratios facilitate managers and business owners to map the progress of the business, identify the problem areas and find out the trends in the business.
Liquidity could be regarded as an important concern for small businesses and to assess liquidity; quick ratio and current ratio are used. These ratios would indicate how well the business is in the position of meeting its short term obligations. Another important ratio would be to evaluate the amount of current liabilities (short term obligation) as a proportion of shareholder’s equity; also called current liabilities to net worth ratio.
If we analyze from the point of view of the manager of a larger corporation, then certain ratios would be important. The first would be the current ratio (as discussed above), then total debt (both short term and long term) to total asset ratio as it would assess company’s long term solvency, and the net profit margin as this ratio would assess how much company’s sales are producing in terms of revenue (after interest and tax). These ratios would help manager to find out problem areas and develop the solution.
Answer 2: The major benefit of debt financing is that the control and the ownership of the business will be retained by the founders/owners. Contrary to financing by equity, the owners can also retain and reinvest the revenues earned and make important decision/strategies; there is more financial freedom for the owners. The obligations would only be limited to the repayment time period of the debt and the creditors would not have any more claims, where as the claim of the shareholders would last till they keep the shares of the firm (Reference for Business.com, 2007). However, the major disadvantage is that small firms are required to repay the principal and interest on regular basis, sometimes on monthly basis. New established businesses may experience cash flow shortages and find it difficult to repay on regular basis. On the other hand, most creditors impose penalties on late payments; if the amount accrued continues to increase then they could take the ownership of collateral or call the due debt early. The inability of a firm to repay loan payments could adversely affect its credit rating and in the future, it might find difficulty in obtaining financing (Reference for Business.com, 2007). Firms may chose to issue stocks instead of bonds due to following reasons:
- Interest must be paid on bonds till the maturity and it can deplete the cash saved for other purposes. But paying dividends is on the discretion of the management entirely; they could be reduced, paid or omitted any time.
- At the time of repayment of bonds, companies may not have enough funds available and settling bond payment may jeopardize other operations. But money raised through stock issuance does not need to be repaid unless the firm exercises call option.
- Bondholders have the right to force the business in to bankruptcy if their repayments are not made on time but shareholders do not have this right. So the financial condition of a company may be more unstable with more debt.
Answer 3: There has been a balance between future return and risk offered by all investments. Risk could be described as the probability that some portion or all money invested will be lost and return would be the additional money made on that investment. The balance between the potential returns and the risk depends on the type of investment made, economic conditions, the issuing entity and the market (securities) cycles. Generally, it has been said that you have to take high risk to earn higher. Similarly, securities with lower risk level would get low returns (University of West Florida, n.d).
However this may not be true in some cases. Some of the leading investment researchers have argued that investors biased their chances for getting high returns by taking risks that had rewarded them with high returns, so these risks are expected to reward in the future too. But, there are risks that are not worth taking and some that are.
Answer 4: Beta (stock/portfolio) is a number that explains the asset’s volatility for the benchmark volatility (we compare the asset from the benchmark). We normally set the benchmark which includes the entire financial market and estimate it via representative index such as NASDAQ or S&P. If the beta is zero; the asset return would change independently of market return’s changes (Investopedia, 2013). Beta of a positive number signifies that asset’s return would move parallel to market return (both will wither increase or decrease); and a Beta of a negative number signifies that asset’s return would move opposite to market return. Beta measures the proportion of asset A’s risk which cannot be diversified and removed in the assets portfolio, due to the correlation of remaining assets’ returns with A’s return. For individual firms, beta can be estimated utilizing regression analysis and measuring against a stock market index such as S&P 500 (Investopedia, 2013).
Answer 5: Systematic risk which is diversifiable is that proportion of the asset’s risk which could be reduced or eliminated through diversification in the portfolio; this risk is related to random events for instance lawsuit, regulatory punishment etc. Furthermore, market does not compensate for systematic risk as it could be reduced or avoided. On the other hand, Unsystematic risk is a non-diversifiable risk is that proportion of the asset’s risk that could not be reduced or eliminated; this risk is due to certain factors that are specific to the business itself such as labor union, product characteristics, advertising, packaging, pricing or R&D. It could also be specific to industry/market/economy so that every business is being affected for instance, Inflation, political conditions, international relations (exports and imports), taxation, industry policies, investment policies etc.
The combination of both systematic and unsystematic risk is called total risk.
Answer 6: I would be investing in 4 different areas and would leave some proportion as reserve (immediate cash) to meet any obligation/investment/purchase. I would have planned to diversify my portfolio so that I could be able to diversify assets risks. Also I would allocate some proportion in the expansion of my manufacturing corporation. Another good idea would be invest in other companies that are booming or have potential growth by buying their shares. This decision could also help in related or unrelated business diversification in future. Lastly, some fraction would also be invested to buy debentures- also called short term investment.
References
Investopedia (2013). Beta Definition. Investopedia – Educating the world about finance. Retrieved from http://www.investopedia.com/terms/b/beta.asp
Reference for Business.com (2007). Debt Financing - advantage, percentage, type, disadvantages, cost. In Reference For Business - Encyclopedia of Small Business, Business Biographies, Business Plans, and Encyclopedia of American Industries. Retrieved February 26, 2013, from http://www.referenceforbusiness.com/small/Co-Di/Debt-Financing.html
