Financial Concepts and Financial Ratios – Free Essay Examples

Financial Concepts and Financial Ratios

Financial ratios are vital measures used to assess the different elements of the business, which ensures its survival and profitability. The financial ratios adopted by small business owners are similar to those critical for a large corporation but have different importance for both business structures. The main financial ratios highly regarded by small businesses include profitability ratios, liquidity ratios, and activity ratios (Eun & Resnick, 2007). In this case, profitability ratios are used to depict the value of business operations to the firm through its returns. Liquidity ratios portray the capability of the firm to meet its outstanding financial responsibility when they mature. On the other hand, activity ratios indicate the effectiveness of resource utilization within the firm. Therefore, these ratios meet the desires of small businesses individuals since their interests revolve around optimization of resources and generation of sufficient revenue with significant profits. At the same time, the ratios can be used to indicate the level of performance of the business in relation to the generation of sufficient profits.

Large corporations have different needs from the financial ratios. Based on this issue, their main financial ratios include profitability ratios, leverage ratios, and market strength ratios. Profitability ratios depict the level of returns of the firm’s investment, which portrays its financial performance and position. Leverage ratios consist of multiple ratios such as debt ratio, debt to equity ratio, and time interest-earned ratio, which is used to measure the firm’s ability to meet its long-term obligations. Market strength ratios refer to ratios such as earnings per share (EPS) and payout ratio that indicate the responses of investors owning the company (Shim & Siegel, 2000). Through these ratios, the performance of a firm influences the decisions made by investors. For these reasons, managers are interested in ensuring profitability in business operations. Moreover, the managers struggle for the efficiency and liquidity of a business for its survival. All these importance of financial ratios depicts the variations in goals of small businesspersons and large corporation managers.

The choice of debt financing within an organization is attributable to some advantages and disadvantages. In this case, the main advantage of debt financing is that the sponsors of the business can maintain their control and ownership of the business. Through this benefit, they can make vital strategic decisions and reinvest the profits generated. Based on this issue, debt financing offers the business financial freedom since the obligations are limited to the maturity period of the loan when the lender has no claim in the business. Another benefit of debt financing is that it improves the creditworthiness of the business when the loan is repaid on schedule. For that reason, the business can use the credit rating to source additional finances. Lastly, debt financing is ideal for small businesses over the long term compared to the short term since they are relatively cheap in relation to equity financing (Eun & Resnick, 2007).

Regardless of the benefits of debt financing, some of its disadvantages are detrimental to the business. In most cases, debt financing is limited to established organizations since they can offer security over the loan. Therefore, the new and unproven business may find it hard to obtain this nature of finance. However, in case they access the debt financing, the amounts will not be substantial to carry out all desired activities. As a result, these businesses are forced to look for additional sources. At the same time, the interests and principal repayments may not be attractive since failure to comply will subject the businesses to penalties and a decline in credit rating. For that reason, it may prove difficult for the business to obtain future finances. As a result, organizations should determine the real situations and the length of time they wish to borrow and repay the loan.

The decision by an organization to issue stocks rather than bonds is driven by the benefits of stocks. Initially, the issuance of stocks makes the organization minimize the risks of not complying with the regular payments of bonds. In this regard, the organization will only reward its investors when the performance of the business is favorable, which reduces the financial obligations during hard economic times. In addition, the investors’ returns from stocks are uneven compared to a constant level of returns attributable to bonds. Based on this outcome, the organization will have adequate resources to direct lucrative investment opportunities. This is attributed to the freedom of complying with the needs of stock investors compared to the adherence to the needs of bond investors. Therefore, the flexibility of the stocks makes most organizations issue stocks instead of bonds (Shim & Siegel, 2000).

Financial returns are indirectly proportional to risks. This implies that when the level of returns anticipated is high, the level of financial risks one is exposed to is high. The main reason for this is that additional costs have to be paid to attract borrowers or lenders to sustain the risks. Through this practice, risk seekers will be willing to expose themselves to high financial risks to gain from high financial returns. The risk-averse individuals or organizations will attempt to minimize the level of risks attributable to their activities causing a decline in financial returns. On the other hand, risk-neutral businesses will consider a considerable level of financial risks for a reasonable level of financial returns. For that reason, the level of financial risks fluctuates in an opposite trend to financial returns.

Beta refers to the level of correlated volatility between stock performance and the values used for benchmarking. In this case, the benchmark is formulated in the financial market based on the selected index to represent the performance of overall stocks. The kind of financial asset that is assigned a beta value makes it fluctuate. For instance, since gold is one of the highly rated in the securities market it has a beta of less than zero. The other assets within the securities have a beta of between zero and one except volatile stocks such as technology stocks affected by market news. Therefore, beta is used to illustrate the sensitivity of the asset’s returns to market returns. Since beta is a non-diversifiable risk, it indicates the level of returns to securities based on market performance. In most cases, the beta concept is used in the determinations of the security market line. Through the analysis of the asset returns and beta, it is possible to establish the level of the risk-free rate of returns and the risk-associated rate of returns. Following this concept, investors can be able to evaluate the expected rate of return from their pooled investments (Eun & Resnick, 2007).

Unsystematic risks refer to the risks attributable to financial assets or businesses that can be diversified. Elimination of unsystematic risk through diversifications is because they originate from random causes. Some of the causes of unsystematic risks associated with specific businesses are labor strikes, fraudulent activities, and breaches of the law. On the greater dimension, the industry of a business could also have unsystematic risks such as pricing, market strategies, categorization of products, and labor strikes. Based on their nature, the industry or the organization could devise means of eradicating them. In the case of financial assets, the systematic risks could be eliminated through a pooling of varied types of financial assets. For that reason, unsystematic risks can be placed under business risks, financial risks, and default risks.

Systematic risks refer to risks that cannot be eliminated through diversification since they affect the whole market uniformly. Some of the market factors that affect all firms include political events, war, natural disasters, and inflation. Since the systematic risks are beyond the control of investors, little effort can be incorporated to mitigate the risks. Therefore, all systematic risks can be placed under market risks, interest rate risks, and purchasing power risks. Regardless of the fact that systematic risks are unavoidable, the financial market does recompense investors for exposure to such risks. Lastly, the combination of systematic risk and unsystematic risk is known as total risk (Shim & Siegel, 2000).

In the event that my company has won a patent lawsuit, which has led to a reward of one million dollars, the money would be directed to financial assets. In this case, it would be very critical to evaluate the returns that would be anticipated from the decision made. In addition, it is vital to establish the degree of risks exposed to the investment made. For these reasons, the first decision will involve the choice of appropriate financial assets, which would consist of a mixture of stocks and bonds. The main reason for this is to reduce the level of risks as the level of returns is enhanced. Through the pooling of investments, it would imply that systematic risks would be eliminated. During the choice of the varied financial assets, the beta concept would be used to determine the anticipated return. Such a move would be based on the knowledge that the beta measures the sensitivity of security performance in relation to market returns (Eun & Resnick, 2007). As a result, the selected stocks would have the greatest return. Furthermore, the mixture of bonds and stocks becomes a strategy to minimize the systematic risks, which affect the whole market. This is attributed to the fact that bonds have consisted of returns regardless of the market conditions.

Through the effective formulation of a pool of investments, the company would be able to derive the anticipated level of returns. At the same time, the level of risks would have been minimized although the desired level of returns would have been achieved. In addition, the manufacturing company will require a small proportion of the amount for the improvement of its production capacities. For this reason, its level of performance would improve, leading to the improvement of its share prices. As a result, the investors would benefit from the capital gains or level of dividends expected. Through this radical improvement of investments and production, the company’s rating would significantly improve its market position compared to its rivals. At the same time, in the future, the returns from the investment would significantly improve drastically.

References

Eun, C. S., & Resnick, B. G. (2007). International financial management (4th ed.). Boston: McGraw-Hill/Irwin.

Shim, J. K., & Siegel, J. G. (2000). Financial management (2nd ed.). Hauppauge, N.Y.: Barron’s.

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UniPapers. "Financial Concepts and Financial Ratios." May 9, 2022. https://unipapers.org/free-essay-examples/financial-concepts-and-financial-ratios/.

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UniPapers. 2022. "Financial Concepts and Financial Ratios." May 9, 2022. https://unipapers.org/free-essay-examples/financial-concepts-and-financial-ratios/.

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UniPapers. (2022, May 9). Financial Concepts and Financial Ratios. https://unipapers.org/free-essay-examples/financial-concepts-and-financial-ratios/

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UniPapers. (2022) 'Financial Concepts and Financial Ratios'. 9 May.