Professional financial management is one of the central prerequisites of profitability in business. This paper provides a brief overview of the most important financial management concepts. The financial ratios important to small and large business are described. The paper explains the advantages and disadvantages of debt financing and reasons why companies prefer stocks to bonds to generate funds. Besides, the relationship of financial risks and returns is discussed. The paper describes the concept of beta and how it is used. Systematic and unsystematic risks are described and contrasted as well. Moreover, diversification decisions are proposed and justified in this paper.
Keywords: finance, ratio, debt, stocks, bonds, risks, returns, beta, diversification.
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Financial Ratios: Small versus Large Business
Business is impossible without financial management. Small business owners and managers in large corporations must have a good command of the basic financial ratios. However, the financial ratios that are important to a small business owner differ from those which are important to a large corporation. As a result, small business owners and managers in larger corporations must understand what financial ratios they need the most and how they can be used to improve their organizational and financial performance.
Three most important ratios every small business must monitor include: (1) days of receivables (AR Days), (2) debt-to-assets, (3) return on investments, and (4) net profit margins. AR Days is one of the most important financial ratios showing the amount of days needed to collect revenues for the goods and services sold (Coker, 2010). Small businesses with high AR Days ratios usually experience problems when collecting their revenues and may also face cash flow issues. Low AR Days may indicate the presence of excessively strict credit policies that prevent the firm from increasing its revenues.
Debt-to-assets ratios show how small firm’s assets relate to its liabilities (Coker, 2010). Simply put, this ratio shows the amount of debt resources used by small businesses in their daily performance. Low debt-to-assets results suggest that the amount of debt exceeds the amount of assets (Coker, 2010). In this situation, small businesses should be particularly cautious with their financial and capital investment decisions. The debt-to-assets ratio shows how all firm’s assets relate to all firm’s liabilities. Net profit margins show how much profit small businesses generate for a dollar of revenue (NSW Government, n.d.). With the help of ROI, small businesses can see whether their investments work effectively and how much income they generate.
Certainly, the financial ratios used by small business owners differ from those used by managers in larger corporations. Beyond AR Days, Debt-to-Assets, ROI, and net profit margins, managers in larger corporations must constantly monitor their return on assets, inventory turnover ratios, and working capital ratios. Of particular importance is the effectiveness of long-term assets and investments. With greater resources and complex financial systems, larger corporations need a more sophisticated view on their financial performance. Meanwhile, small business owners can focus on the most important financial ratios that are easy to calculate and interpret.
Debt Financing, Stocks, and Bonds
Debt financing often becomes the only possible source of financial resources for small and large businesses. Debt financing offers considerable advantages, but it also has serious limitations. Debt financing is attractive to businesses because the current tax laws allow for “the corporate tax deductibility of interest paid on debt” (Palepu & Healy, 2008, p.102). These corporate tax benefits actually encourage firms to make debts instead of using retained revenues/earnings. Debt financing also reduces the risks of misunderstanding between shareholders and managers when they cannot decide how to use limited cash flows to improve business (Palepu & Healy, 2008). When debt resources become available to managers, they can focus on value creation and avoid criticism for the expenses or decisions, which shareholders perceive as unjustifiable.
Unfortunately, debt financing is always associated with considerable financial and legal costs. Companies need to hire expensive financial and legal consultants in order to avoid financial risks and achieve the desirable financial results (Palepu & Healy, 2008). In addition, firms using debt resources face significant difficulties trying to attract new investors and shareholders, who are wary of getting involved in the firm’s financial difficulties and disputes (Palepu & Healy, 2008). Finally, debt financing can generate conflicts between managers, who want to serve the interests of shareholders, and creditors, who want to increase the costs of borrowing for the firm’s shareholders (Palepu & Healy, 2008).
While looking for additional financial resources, firms usually choose to issue stocks rather than bonds. This is mainly because bonds are debt instruments – loans made by investors to the firm for a fixed period of time (Mobius, 2012). The firm will have to provide investors with regular interest payments and finally pay back the loan (Mobius, 2012). Bonds are a preferable option for investors due to their low price volatility, but stocks are a preferable option for businesses that seek additional financial resources with no major expenses.
Financial Returns and Risks: A Straightforward Relationship
Financial risks and returns are directly related: higher risks equal greater returns. Five factors explain the variability in returns, depending on the risks involved. These include term factor, default factor, market factor, size factor, and price factor (Lowrie, 2006). For example, the default factor relates to the quality of financial investments and instruments. Lower quality corporate bonds offer higher expected returns compared to higher quality government bonds, where expected returns usually do not exceed 0.25% annually (Lowrie, 2006). The basic understanding of the relationship between financial risks and returns can help business owners and individuals develop a portfolio that offers the highest returns for each given level of risk. These factors can help investors eliminate the asset classes that offer low or no compensation for their risks (Lowrie, 2006).
The Concept of Beta and How It Is Used
The beta coefficient measures the market risk of a stock (Brigham & Daves, 2007). To be more exact, the beta coefficient shows the amount of risk which an individual stock contributes to the entire portfolio (Brigham & Daves, 2007). The beta can be conceptualized as the basic measure of any stock’s volatility. With b=1.0, the risks of an individual stock are equal to those in the market. With b<1.0, the risks of an individual stock are lower than in the market (Brigham & Daves, 2007). With b>1.0, stock risks exceed market risks. Speaking about portfolios, the beta coefficient measures a weighted average of all risks included in this portfolio (Brigham & Daves, 2007). “Since a stock’s beta coefficient determines how the stock affects the risk of diversified portfolio, beta is the most relevant measure of any stock’s risk” (Brigham & Daves, 2007, p.55).
Systematic versus Unsystematic Risk
As mentioned earlier, beta is the central measure of any stock’s risk (Brigham & Daves, 2007). However, beta is also a measure of systematic risk. Systematic risks are usually attributed to a common market factor and cannot be diversified (Fabozzi, 2002). Systematic risks result from the general economic, market, and other conditions that are difficult to predict and cannot be eliminated. By contrast, unsystematic risks are those which can be diversified. They are also called unique risks, diversifiable risks, or company-specific risks (Fabozzi, 2002). For example, investors can anticipate the risks of litigations, strikes, or natural catastrophes and change the structure of their portfolios to minimize or avoid them.
Investing Money to Diversify Risks and Receive Good Returns
In order to diversify the risk and receive a good return, I will have to create a portfolio that (a) does not have incompatible assets as well as (b) reduces short-term risks and promotes long-term growth in returns (McMillan, Pinto, Pirie, & Venter, 2011). I will need to review the existing portfolio and the asset classes included in it. Since there is no information on the initial portfolio, it is difficult to decide which asset classes will suit the new portfolio. Moreover, diversification across asset classes may be problematic and costly (McMillan et al., 2011). This is why I will focus on index funds diversification, which entails the use of mutual funds and allows reducing the costs of portfolio diversification. Additionally, I will invest in production and patent risks insurance, which offer greater returns and are relatively immune to the inflation and currency risks (McMillan et al., 2011).
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