The purpose of this paper is to discuss several financial concepts: Financial ratios that are important to me as a small business owner will be determined and compared to the ratios that are of importance to managers of huge corporations. In addition, this paper will describe the advantages and disadvantages of debt financing and the reasons why corporations would decide on stock issuance versus bonds to accumulate funds. This paper will also discuss how financial returns are associated with risk.
Furthermore, the concept of beta and the way in which it is used will also be discussed. Another important part of this paper is the contrast of systematic and unsystematic risk. Finally, an explanation will be provided as to how I plan to invest $1 million, as the owner of a manufacturing corporation after winning a patent lawsuit, in order to diversify risk and garner a substantial return on that investment. As a small business owner, it would be my responsibility to make prudent financial decisions that would minimize expenses and maximize profits.
The financial ratios that will be important to my business are liquidity ratios, asset management ratios, financial leverage ratios, and profitability ratios. Liquidity determines my ability to meet short-term debt obligations to creditors, and asset management determines the extent to which assets are turned over to generate revenues and profits. The success of my business will depend on the quick turnover of the inventory because generally efficient turnover results in higher profitability (Melicher & Norton, 2011).
In other words, the number of times throughout the year that the business gets rid of its inventory is directly correlated with the financial profitability of the business. Furthermore, financial leverage is an indicator of the extent to which borrowed funds are used to finance assets and it determines my ability to manage debt which is my debt to asset ratio. Profitability ratios suggest my ability to realize returns on sales, assets, and equity (Melicher & Norton, 2011).
In comparison to the ratios that are important to a manager of a larger corporation, the financial ratios of the larger corporation would have to generate a much greater turnover of inventory to maximize profits and subsequently result in higher financial ratios. The manager’s job would be to focus on the balance of profits versus expenses of the corporation. This is important to the manager because larger corporations generate much more overhead costs which have an impact on overall profits for the corporation.
In addition, larger corporations may choose to go public, issue stocks, and take on the responsibility of adding market value ratios to their plate which indicates investor willingness to value firms in the stock market relative to its value as stated in the financial statement. Debt financing involves borrowing funds to be paid back over time. The advantages and disadvantages of debt financing are important to the sustainability of businesses. The most important advantage of debt financing is, the only obligation to the borrower is repayment of the loan without compromising ownership of the business.
Lenders have no claim on future profits as they are limited to receiving the loan principal with the added interest, and the tax benefit to borrowers is that interest paid on debt is tax deductible. Debt financing is considered to be much less complex as compliance with state and federal securities regulations is not an issue (Damron, 2010). With regards to the disadvantage of debt financing, the debt has to be repaid and the amount becomes a fixed cost for the term of the loan; therefore, cash flow must be budgeted and attained.
In terms of credit worthiness, debt financing has a negative effect on the company’s debt-to-equity ratio which can cause them to be viewed by other lenders as high risk. Also, penalties for late payments due to varying business cycles will be incurred. Damron (2010) stated that in some cases, company or personal assets as collateral are required to secure the loan. If the loan is guaranteed personally, then the loan will be repaid with the owner’s personal funds if not repaid with company funds.
Another disadvantage of debt financing is that it is at times difficult to get financing for startup businesses that have no track record. If a loan is secured, the loan amount might be narrowed or restricted. This poses a problem because it forces the borrower to obtain additional financing in order to build the business, which consequently reduces its profitability. An organization might choose to issue stocks rather than bonds to generate funds because the attraction for stocks by investors is the potential for steady income through dividends.
Attracting shareholders improves a company’s profitability. In contrast, although bond interest rate payouts to investors are lower and the payments are tax deductible as a business expense, businesses must pay interest even when there are no profits (U. S. Department of State). Financial returns are related to risk in many ways. There is an invariable exposure risk when in business; however, what is important to this mix is the expectation of returns. In general, the way in which financial returns are related to risk can be explained as riskier assets are expected to provide higher returns.
The higher return is considered compensation for tolerating greater risk. Unfortunately, the losses can be extremely devastating and equally as substantial as the profits. The concept of beta and how it is used is also important to the success of businesses. Beta considers the instability of a particular stock price and measures it with prices of the remaining stock market. Beta takes a look at a targeted stock and watches to see how other stocks are performing in the general stock market. It measures the risk of stocks. Those stocks that show high betas are generally expected to have higher returns (Little, K).
When contrasting systematic and unsystematic risk, systematic risk or market risk is when something happens that results in the initiation of the demise of a particular industry or an economy. It looks at the totality of market risk and refers to risk that cannot be taken away by diversification. It deals with the risk associated with market dynamics (Melicher & Norton, 2011). Unsystematic risk (industry-specific risk or micro-economic risk) refers to part of the risk of an asset that is connected with an arbitrary reason that can be removed through diversification.
It deals with specifics such as events, firms, and actions that are regulatory. This is an industry specific risk. That is about investing in a specific single company stock versus investing in multiple specific company stocks. If one invests in a single company specific stock and there is a setback with that specific company, the losses are greater to the investor versus investing in several specific companies stocks where something goes wrong with one of the companies, the losses will not be as substantial (Melicher & Norton, 2011).
In evaluating how I plan to invest $1 million, as the owner of a manufacturing corporation after winning a patent lawsuit, in order to diversify risk and garner a substantial return on that investment, the first step I would take is study the market and look for market trends in order to find viable stock where the investment could produce a high return. The second factor that would be looked at by my company is the beta of the stock investments that my company wishes to invest in.
These two factors are very important to the return on the investment. As discussed earlier, the higher the beta of the stock, the higher the return on the investment in that particular stock. With greater risk comes the possibility of higher returns on investments. In order to better position my corporation for substantial returns, I would choose not to invest in one particular stock but rather a variety of stocks with varying risk levels in both United States markets and international markets.
Diversification is the key to managing risk when investing in the stock market. My decisions are supported by many of the concepts learned in this course which are important with regards to the financial strength of a business and individual investors. Some examples are: investment risk, beta, and diversification which illustrate risk factors in investing that correlate with expected returns.
Poor decision-making in terms of taking risks when investing in stocks has a great impact on the flow of cash (Melicher & Norton, 2011). The next concept is dealing with and evaluating stock betas. Beta, as learned, is associated with the measuring of an asset’s systematic risk and measures volatility or variability of an asset’s return (Melicher & Norton, 2011). The final concepts that were learned that will help my business make wise and prudent decisions when investing the $1 million is diversification of stock investment.
Melicher & Norton (2011) asserted that the importance of diversification relates to systematic and unsystematic risk. The complete risk of an asset has two elements: unsystematic (firm specific) and systematic or market risk. It is always wise to invest in risks that are unsystematic versus systematic. In conclusion, this paper has identified and discussed the financial ratios that will be used in my small business and the ratios that are important to the manager of a larger corporation.
It further explained the advantages and disadvantages of debt financing and why organizations would choose to issue stocks versus bonds to raise funds. It discussed how financial returns and risk are related along with the concept of beta and how it is implemented. This paper also contrasted systematic and unsystematic risk and discussed how my company would invest $1 million in order to diversify risk and increase returns. Understanding these concepts is important in safeguarding assets and increasing profitability for investors.