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Understanding the Concepts - Essay Example

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Organizations must evaluate and analyze the financial results of the firm. A quantitative technique that can be used to evaluate financial results is ratio analysis. There are five categories of ratios. The five categories of ratios are profitability, liquidity, leverage, efficiency, and market…
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Understanding the Concepts
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Understanding the Concepts

A current ratio is considered good if is above 1.0. Another ratio of importance for small business owners is net margin. The net margin is a financial metric that measures the absolute profitability of a company. It is calculated diving net income by total sales. A third ratio I would emphasis is return on assets (ROA). Return on assets measures the effectiveness of the owners or managers to generate net income from its assets. As a manager of a large corporation I would target other ratios that small business owners do not consider. The earnings per share (EPS) is an important ratio due to the fact that it measures the amount of income generated per common stock outstanding. A high EPS positively impacts the market value of a common stock. A second financial metric that corporations have to consider is the dividend payout ratio. The dividend payout ratio is an index showing whether a company pays out most of its earnings in dividends or reinvests the earnings internally. A third ratio I would pay close too is inventory turnover. Inventory turnover is calculated dividing cost of goods sold by average inventory balance. It measures how many times a company’s inventory has been sold during a year. Debt financing occurs when companies borrow money from other parties to finance its operations. Three types of debt financing instruments are loans, notes payables, and corporate bonds. The federal government is one of the biggest players in the debt industry. One of the greatest benefits of debt financing is the ability to raise large amounts of money to be paid in monthly payments. Each monthly payment is composed of two portions: equity and interest. Bonds are an advantageous instrument due to the fact that the principal of the bond is paid back at maturity age. A disadvantage of debt financing is the high interest rates that are paid to the lender. Companies with excellent credit scores are able to borrow money at lower prices. Sometimes companies prefer to raise capital using debt instead of equity because the sale of stocks dilutes the value of the stocks and it lowers the control of the existing owners. The financial results of a company are correlated with the risks taken by the management team of the company. Higher risks propositions tend to have higher return associated with the option. Risk adverse managers do not like risk, thus they avoid it at all costs. From the perspective of an investor purchasing stocks has more risk than investing in treasury bills. Bonds that pay a higher coupon rates have higher risks than lower paying bonds. Two companies that rate corporate and governmental bonds are Moody’s and Standard & Poor’s. The highest rated bond grades are AAA by Moody’s and Aaa by Standard & Poor’s. A financial variable that can be used to measure the risks of a company is the beta coefficient. The beta of a company measures how sensitive a common stock is in relation to fluctuations in the market. A company with a Beta of one moves in the same direction as the market. Companies with fluctuations above one are more sensitive to market fluctuations. A beta below one implies the company is not sensitive to fluctuations in the market. Beta can also be used as part of the formula of the capital pricing asset model (CAPM). The formula to calculate the capital asset pricing model is Ks = Krf +B(Km-Krf) (McCracken, 2009). CAPM compares the risk of a company against the entire ... Read More
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