The Risk Outlook of a Particular Business - Essay Example

Understanding the Concept Understanding the Concept Imagine you are a small business owner. Determine the financial ratios that are important to the business. Compare your ratios with those that are important to a manager of a larger corporation. Being the owner of a small business I am required to keep in view the financial ratios associated with my business at all times. The key ratios which help me in making the decisions in my business are liquidity, profits and profit margin, sales, borrowing and assets. Liquidity is a measure of the ability of a business to keep up with its requirements which are due. Although this ratio is important for small businesses, the centers of liquidity are big business themselves. Profits and profit margin ratios help in determining if the trends followed by the profits are in favor of the company’s interest. Sales measure the rate at which the business’ sales are expanding. Sales are not considered to be increasing a lot if the expenditures increase at the same rate. Borrowing is a rate of the balance between borrowing and the debt the business is under. Assets measure the effectiveness in making the optimum usage of their fixed assets. All these ratios are very important for small business and as for corporate companies as well to keep in check the growth of a business. 2. Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds. Advantages: Debt financing enables the indebted party to keep hold of the control of the business and they can make decisions without the consent of anyone else as well as keeping the profits. The obligations of the borrower are very less and payments if made on time can greatly enhance the credit rating of a particular business. The repayments do not depend on the market and are decided in advance. Disadvantages: the risk outlook of a particular business can greatly be increased by debt financing. Collateral security is also required in order to finance debt. The repayments do not depend on the market and are fixed which prove to be a disadvantage to the borrowers when the market is down. Stocks would be more preferable than bonds in order to generate funds because the potential on their return is much greater than that of bonds in spite of being more unpredictable. Bonds can be considered as loans with the promise of their return to the investors with profit whereas shares provide the shareholders equal share in the profits. 3. Discuss how financial returns are related to risk. In terms of investment, risk means the return on a particular investment won’t be the same as the return calculated or expected. In general, the higher the risk the more chances a business have of higher returns and lower the risks, lower the returns. However it does not mean that the risk is equal to return and the return will definitely be higher with greater risk. Higher risk means a possibility of great return but it also means the losses may be of great magnitude. Different investments have different ratio of risk and return. For example risk return ratio is different for corporate bonds and government bonds. With lower risks, the chances of return decrease but on the other hand chances of losses decrease as well, and that investment is much safer. The lowest risk free rate of return means there are almost no potential losses, for example if the risk free return in an investment is 9% then the income on that money will be at least 9% annually for sure. 4. Describe the concept of beta and how it is used. Beta or beta coefficient denoted by ‘β’ measures the systematic risk of an asset as compared to the market financials as a whole. Some cases are described below: If beta is greater than one then it means that the asset is moving along the direction as the market, but with more movement. If beta is equal to one then it means that the asset is moving I the same direction as the market, and the movement of the asset is more or less the same as the market. If beta is equal to zero then it means that the direction of the movement of the asset does not pertain to the movement of the market. If beta is less than zero then it means that the market and the asset are moving in opposite directions keeping an index as the reference point. 5. Contrast systematic and unsystematic risk. With every security and port folio, there are two kinds of risks involved: Systematic and unsystematic. On summation these two risks constitute as the total risk involved. Systematic risk is the type of risk which cannot be diversified. It constitutes about a quarter to half of the total risk. These are the risks which are caused by the variation in market. Some of the factors responsible for systematic risks are change in the rates of interests, inflation and the expectations of the investor. Unsystematic risk is the type of risk which is of a diversifiable nature and is unique to a particular firm or business. Factors causing unsystematic risks are management skills, strikes, consequences of competition, availability of resources and company’s financial and operational leverage. (Moyer, R. C., & McGuigan, J. R., 1981). 6. Imagine your manufacturing corporation has just won a patent lawsuit. After attorney and other fees, your corporation will have about $1 million. Explain how you plan to invest the money in order to diversify the risk and receive a good return. Support your decisions with concepts learned in this course. If my corporation has $1 million left after attorney and other fees, from winning a patent lawsuit, I would want my money to be invested in such a way that the risk is diversified and the return is profitable. Diversification of low risk portfolios have proven to give less return on low risk assets as compared to diversification of high risk portfolios, which give more return on more risk portfolios (Wagner, W. H., & Lau, S. C., 1971). In order to diversify the risks, I will buy some shares which would serve as a long term investment and will help in the expansion of my portfolio. I will also buy real estate as its beta coefficient is less than zero and the value of my investment can increase with the decline in stocks (Kristof K., 2013). REFERENCES Kristof, K. (n.d.). How to Diversify Your Investments -- An Easy Rule of Thumb | Nolo.com. Lawyers, Legal Forms, Law Books & Software, Free Legal Information - Nolo.com. Retrieved February 16, 2013, from http://www.nolo.com/legal-encyclopedia/how-diversify-investments-easy-rule-30216.html Moyer, R. C., & McGuigan, J. R. (1981). Contemporary financial management. St. Paul: West Pub. Co.. Wagner, W. H., & Lau, S. C. (September 01, 1971). The Effect Of Diversification On Risk. Financial Analysts Journal, 27, 5, 48-53. Read More