Financial Market and Institution Systems - Essay Example

Financial markets and s Before going in details regarding financial markets and financial s it is necessary to have some knowledge of financial markets and financial institutions and also the terms trade-off, profitability and liquidity. The experiences have highlighted the importance of getting the basic institutional features of a country’s financial institutions and markets because they play a key role in the economy in general. Poorly developed financial markets and institutions impose a restriction on economic development. Financial market is a system which allows people to deal money for securities or commodities such as gold and other precious metals. Any commodity market might be considered to be financial market if trader’s intention is not the immediate consumption of the commodity but as a means of delaying or accelerating consumption over time. Markets work by placing many interested sellers in one place, thus making them easier to find for potential buyers. An economy which relies primarily on connections between buyers and sellers to allot capital is known as a market economy. Financial markets are affected by forces of supply and demand, and allot capital over time through a price device such as the interest rate. Financial market could mean: organizations that facilitate the transaction in financial products, (for example, Stock exchanges facilitate the trade in stocks, bonds and warrants) and the coming together of buyers and sellers to trade financial products such as stocks and shares including: the use of stock exchanges; directly between buyers and sellers. There are different types of financial markets: capital market which provide finance through issuance of shares and bonds, commodity market which facilitate the trading of commodities, money market which arrange short term debt financing and investment, derivatives markets that provide instruments for the management of financial risk, insurance markets, which facilitate to cover of various risks and foreign exchange market which facilitate the trading of foreign exchange (Wikipedia, 2006). When looking at a financial institution it might seem to be a mediator between investors and customers. A financial institution might be considered as an agent that provides financial services for its customers. Financial institutions generally fall under financial rule from a government authority. The types of financial institutions include banks, building societies, credit unions, stock brokerages, and similar businesses. Financial institutions give service of moving funds from investors, those with surplus funds, to companies, those in need of funds. These financial institutions make it easy and realistic for small investors to invest (Wikipedia, 2006). When someone talk about tradeoff it means the amount of risk one could take while remaining comfortable with the investments is very important. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. A common misapprehension is that higher risk equals greater return. The risk/return tradeoff tells that the higher risk gives the possibility of higher returns but it can also cause higher potential losses. Risk acceptance differs from person to person. One’s decision would depend on his goals, income and personal situation, among other factors (Investopedia.com, 1999). Liquidity for a bank is the ability to generate cash quickly within a short period and at a reasonable cost. If the bank is not able to generate enough cash to meet its short-term requirement without incurring large costs then the bank comes under risk called the liquidity risk. Banks need liquidity in order to cover routine expenses, such as interest payments and overhead and unexpected liquidity shocks, such as large deposit withdrawals or heavy loan demand. One of the most severe examples of a liquidity shock is a bank run. In case all depositors decide to withdraw their money at once, almost any bank would not be able to cover their claims and would fail—even though it might otherwise be in sound financial condition. Liquidity management is mostly about being sure that enough; low-cost sources of funding are available on short notice. However, this attempt must be balanced against the impact on profitability. As a matter of fact more liquid assets earn lower rates of return .A bank can be perfectly liquid by holding only cash as an asset, but this would be an unprofitable approach because cash doesn’t earn any income (Federal Reserve Bank of Kansas City and Federal Reserve Bank of St. Louis, 2004). Banks have two goals -liquidity and profitability. Many types of costs are related to the excesses and shortages of working capital levels of investment and financing. Managing these costs can increase the profitability of a bank’s operations. Banks have to decide the individual and joint impact of the levels of short-term investment and financing on the twin objectives of working capital management. These goals involve that decisions that be inclined to maximize profitability tend not to maximize the chances of sufficient liquidity. Focusing almost entirely on liquidity will tend to reduce the potential profitability of the firm. Liquidity is the ability to pay all expenditures and short-term debt compulsions. Firms can remain liquid by either selling assets or borrowing. When liquidity is maintained through borrowing, there will be a trade-off between the interest costs paid to creditors and the income earned from the investment in the assets financed from the borrowing. Therefore, both too much and too little liquidity have costs. The cost of too little liquidity is the cost of extra borrowing needed as well as the loss experienced when assets have to be sold too quickly and the damage done by a failure to meet payment demands which may end up in bankruptcy. If a firm does not keep proper amounts of working capital, it will be forced to go bankrupt on technical grounds leading to liquidation, in which case the primary claimants of a firm are its creditors while investors of the firm’s capital have a residual claim on the assets. Hence, there is a trade-off between the benefits associated with liquidity and the cost of maintaining liquidity. Management can optimize this trade-off using investment and financing policy decisions From the point of view of working capital management, firms have dual objectives, that is, maximize profitability and minimize liquidity risk. Profitability has to do with the overall objective of wealth maximization. Liquidity on the other hand has to ensure that the firm is able to satisfy all its financial commitments and has adequate funding to carry on its long-term activities of the firm (dissertations.ub.rug.nl, 2002). Thus the liquidity goal is closely associated with working capital management while the profitability goal reflects both short-term and long-term decision making. The difficulty with the dual objectives of profitability and liquidity is that, one tends to be a trade-off of the other. To assess the status of the business or to judge whether the organization is running in loss or profit one of the tool used is the Ratio Analysis. It enables the manager to spot trends in a business and to compare its performance with the other similar businesses. Ratio analysis may provide the all-important early warning indications that allow solving business problems. Important Balance Sheet Ratios measure liquidity and solvency that is a business ability to pay its bills as they come and the leverage, (the extent to which the business is dependent on creditors’ financial support). One among the important ratios is: liquidity ratios, these ratios shows how easily the assets can be turned into cash, which include the current rations, quick ratios and working capital. Current ratio = Total Current Assets/ Total Current Liabilities Quick Ratio = Cash + Government Securities + Receivables / Total Current Liabilities The Quick Ratio is a much more exacting measure than the Current Ratio Working Capital is a measure of cash flow than a ratio. Since it is calculated as: Working Capital = Total Current Assets - Total Current Liabilities The result of this calculation has to be a positive number Another important Ratio is the Return on Investment analysis (ROI). It is the percentage of return on money invested in the business by its owners. In short, this ratio tells the investor whether the business is worth comparing to the risk-free investment such as a bank saving account. The ROI is calculated as follows: Return on Investment = Net Profit before Tax / Net Worth These Ratios allows the investor to identify trends in a business and determine the strength and weaknesses of his organization (Zeromillion.com., 2004). Other important Ratios are: Leverage ratios, income statement analysis, Gross margin ratios, Net profit margin ratios, Management ratios, Inventory turnover ratios, Account receivable turnover ratios, and Return on asset ratios. Business profitability is very much determined by its financial efficiency. Firms that are able to achieve high levels of efficiency be apt to be the most profitable while inefficient firms typically suffer losses and go out of business gradually. By definition, a firm is said to be efficient when it is able to produce maximum income per unit of spending. Two financial ratios are computed to examine the financial efficiencies of businesses. One of these ratios, net profit margin, shows how successful a business is in controlling production costs. The other ratio, called the turnover ratio, mirrors how effectively a business is using its assets to generate output (Jones, 1998). Finance is an important element in sustainable economic development and stable economic growth. It is essential to develop the right sort of legal and business infrastructure to support the development of financial markets, institutions and systems in a manner compatible with the financing needs and aspirations of individuals and firms. A financial institution like bank to be successful the management should see that a proper trade-off between profitability and liquidity is maintained. Bibliography Wikipedia (2006) Financial market [Online] Wikimedia Foundation, Inc. Available from: Investopedia.com, (1999) Financial Concepts: The Risk/Return Tradeoff [Online] Owned and Operated by Investopedia Inc. Available from: Federal Reserve Bank of Kansas City and Federal Reserve Bank of St. Louis, (2004) Asset & Liability Committee [Online] Available from: Dissertations.ub.rug.nl, (2002) Literature Review: Internal Working Capital Management [Online] Available from: Zeromillion.com., (2004) Financial Ratio Analysis [Online] Available from: Jones, B.L. (1998) Capital Management: An Overview of What a Manager Needs to Know and Do When Managing Capital Resources [Online] University of Wisconsin Center for Dairy Profitability Available from: < http://cdp.wisc.edu/pdf/capmang.pdf> Read More