FINANCIAL STRUCTURE - Essay Example

Business/Accounting FINANCIAL STRUCTURE Financial structure and its impact on the companies has been a of interest for many economists. They have extensively investigated the relationship between financial and growth. The results of these studies show that financial development has a strong and positive impact on economic growth of a company. Before getting into the main topic it is essential to understand the definition of financial structure. Financial structure is the way in which a companys assets are financed, such as short-term borrowings, long-term debt, and owners’ equity. Financial structure differs from capital structure in that capital structure accounts for long-term debt and equity only (TheFreeDictionary, 2006). At this stage it becomes essential to address the question of weather financial structure matter for long-run economic growth? Several economists and policy-makers have tried to answer this question and have concentrated on the relative merits of intermediary- versus market-based financial systems. The debate is more than a century old and it commenced with reference to Germany and the United Kingdom in the late nineteenth and early twentieth centuries (Dolar and Meh, 2002). Financial Data and its Importance Financial data correspond to the existing results of the companys strategy and structure. Even though analyzing financial statements can be quite complex, a general idea of a companys financial position can be determined through the use of ratio analysis. Financial performance ratios can be calculated from the balance sheet and income statement. These ratios can be classified into five different subgroups: profit ratios, liquidity ratios, activity ratios, leverage ratios, and shareholder-return ratios. These ratios should be compared with the industry average or the companys prior years of performance. Profit Ratios Profit ratios are used to calculate the efficiency with which the company uses its resources. The more efficient the company, the greater is its profitability. It is useful to compare a companys profitability against that of its major competitors in its industry. In addition, the change in a companys profit ratios over time tells whether its performance is improving or declining. Liquidity Ratios It is a measure of its ability to meet short-term obligations of a company. An asset is deemed liquid if it can be readily converted into cash. Liquid assets are current assets such as cash, marketable securities, accounts receivable, and so on. Activity Ratios Activity ratios point out how efficiently a company is managing its assets. Inventory turnover and days sales outstanding (DSO) are particularly useful. Leverage Ratios It can be said that a company is highly leveraged if it utilizes more debt than equity, including stock and retained earnings. The balance between debt and equity is called the capital structure. It is essential for the companies to determine their optimal capital structure. Debt has a lower cost because creditors take less risk; they know they will get their interest and principal. However, debt can be risky to the firm because if enough profit is not made to cover the interest and principal payments, bankruptcy can occur. Shareholder-Return Ratios Shareholder-return ratios calculate the return earned by shareholders from holding stock in the company. Given the goal of maximizing stockholders wealth, providing shareholders with an adequate rate of return is a primary objective of most companies. Four commonly used ratios are total shareholder returns, price-earnings ratio, market to book value, and dividend yield (Business Resources for Students, N.D.). Since 1970, there have been widespread changes in both financial structure and behaviour as banks have been deregulated and capital markets have developed. Financial innovation has been rapid in the 1980s and 1990s. Deregulation of both banks and of financial markets has proceeded rapidly. Almost all OECD countries have abolished exchange controls; in the banking sector, the key changes have been abolition of interest-rate controls, or cartels that fixed rates, and abolition of direct controls on credit expansion. In the capital markets there has been abolition of regulations on fees and commissions. Key changes affecting both sectors include removal of regulations restricting establishment of foreign institutions and of regulations which segment financial markets and institutions (Davis, 1996). Financial Structure There are four competing views of financial structure and growth. These include the intermediary-based view, the market-based view, the financial services view, and the law and finance view. The intermediary-based view and the market-based view suggest that financial markets and intermediaries are substitute sources of financial services. On the other hand financial services view and the law and finance view suggest that financial markets and intermediaries are complements in the provision of financial services. Intermediary-based view This view emphasizes the importance of intermediaries in identifying good projects, mobilizing resources, monitoring managers, and managing risk while stressing the deficiency of market-based economies. For instance, it has been argued that financial intermediaries are useful at financing projects that are characterized by substantial asymmetric information such as adverse selection and moral hazard. This is mainly because intermediaries have developed expertise in distinguishing between \bad" and \good" borrowers. According to the intermediary-based view, intermediary-based systems, especially in countries at an early stage of economic development, are more effective at fostering growth than market-based financial systems. Market-based view The market-based view emphasizes the role of markets in diversifying and managing risks while arguing that financial intermediaries can extract information rents from firms. Financing through financial markets such as bond and stock markets is particularly good for industries faced with continuous technological advances (Allen and Gale 1999, 2000), and where the information is sparse and diversity of opinion persists. In the view of proponents of markets, market-oriented systems are superior to intermediary-based systems in encouraging long-run economic growth. Financial services view Contrary to intermediary- and market-based views, the financial services view suggests that financial intermediaries may provide complementary services to those provided by markets. The primary emphasis behind this view is the importance of the overall level and quality of financial services rather than the channels through which those services are provided. The issue is not intermediaries versus markets, but rather the creation of an environment for better-functioning intermediaries and markets. Thus, the separation between markets and intermediaries in providing financial services is of secondary importance (Levine, 2000). Law and finance view The law and finance view is an extension of the financial services view and it has been put forward by Laporta et al. (1999). This view emphasizes that it is not the debate between intermediary- and market-based systems that really matters, but rather the legal environment and the enforcement of contracts. Hence, Laporta et al. reject the intermediary- versus market-based distinction and emphasize instead that the legal system plays the crucial role in determining the growth-stimulating nature of financial services. Financial structure and long run economic growth Many economists have empirically investigated these views of financial structure and long run economic growth. Goldsmith (1969) pioneered this work with a careful comparison of between the two countries i.e. Germany and the United Kingdom. Lately, Levine (2000) and Demirgϋç-Kunt and Levine (2001) have examined the same question. They did this by using a broad data set covering 48 countries from 1980 to 1993. The results of the study showed that the distinction between intermediary- and market-based systems is not important for explaining the finance-growth nexus. Rather, elements of a countrys legal system and the quality of its financial services are most important for fostering economic growth. In other words, they find strong support for the financial services view and the law and finance view, but they reject the market- and intermediary-based views. In contrast to the finds of Demirgϋç-Kunt and Levine, Tadesse (2001) does find that the difference between intermediary- and market-based financial systems is important for explaining economic growth. For countries with underdeveloped financial sectors, intermediary-based systems outperform market-based systems, while for countries with developed financial sectors, market-based systems outperform intermediary-based systems. In contrast, Levine and Zervos (1998) argue that higher stock market liquidity, irrespective of the development of banks (or greater bank development irrespective of the development of stock markets), leads to higher growth. Conclusion Finally it can be said that economies that have well-developed financial markets and intermediaries have an advantage. Financial structure provides an insight of profitability and survival of a company. Both market- and intermediary-based systems have their own comparative advantages: (i) financial markets are better at financing new technologies and projects where there is little agreement on how firms should be managed, while (ii) intermediaries are effective at mitigating moral hazard and adverse-selection problems that exist between lenders and borrowers. References Allen, F. and D. Gale. (1999). Diversity of Opinion and Financing of New Technologies. Journal of Financial Intermediation 8: 68-89. Allen, F. and D. Gale. (2000). Comparing Financial Systems. Cambridge, Massachusetts: MIT Press. Business Resources for Students, (N.D) The Role of Financial Analysis. [Online] Houghton Mifflin Company. Available from [Accessed 7 October 2006]. Davis, P. E. (1996) The Role of Institutional Investors in The Evolution of Financial Structure and Behaviour. [Online] Paper prepared for the Reserve Bank of Australia’s Conference on “The Future of the Financial System”, held on 8-9 July 1996 in Sydney, Australia. Available from [Accessed 7 October 2006]. Demirgϋç-Kunt, A. and R. Levine. (2001). Financial Structure and Economic Growth: A Cross-Country Comparison of Banks, Markets, and Development. Cambridge, Massachusetts: MIT Press. Dolar, V. and Meh, C. (2002). Financial Structure and Economic Growth: A Non-Technical Survey. Monetary and Financial Analysis Department, Canada, ISSN 1192-5434. Goldsmith, R.W. (1969). Financial Structure and Development. New Haven, CT: Yale University Press. Laporta, R., F. Lopez-de-Silanes, A. Shleifer, and R.W. Vishny. (1999). Investor Protection and Corporate Governance. Harvard University. Manuscript. Levine, R. (2000). Bank-Based or Market-Based Financial Systems: Which is Better? Carlson School of Management, University of Minnesota Working Paper. Levine, R. and S. Zervos. (1998). Stock Markets, Banks, and Economic Growth. The American Economic Review 88(3): 537-58. Tadesse, S. (2001). Financial Architecture and Economic Performance: International Evidence. University of South California. Manuscript. TheFreeDictionary, (2006) Financial structure. [Online] Farlex, Inc. Available from [Accessed 7 October 2006]. Read More