Assessing a Company’s Future Financial Health

Answer

1. Assessing Future Financial Health of a Company: A Case for SciTronics

    

    

   Introduction

   Uncertainties in a company’s business environment at both micro, meso, macro levels expose them to various kinds of financial risks. The impact of financial risks is felt across the entire company, ranging from owners, management, employees, shareholders, customers, suppliers, and even government entities that rely on taxes paid by the company. As such, it is crucial for businesses, with the help of financial analysts and managers, to have a comprehensive understanding of the potential impact of their finance-related decisions on the different aspects of the company. with this in mind, the purpose of this brief is to assess the potential impacts of various financial risks on the financial health and future performance of SciTronics – a company that specializes in the production and sale of medical devices.

   Systematic vs Unsystematic Risk

   Systematic and unsystematic risks differ in many respects. By definition, systematic risk is a risk that inherently exists in the stock market. It is the likelihood of a failure of the whole financial system and causes adversity to a nation’s entire financial system or economy. As Vaidya aptly puts it, systematic risk is introduced by financial system instability and catastrophic occurrences that disrupt interdependencies and other functions in the marketplace. In comparison, unsystematic risk, (also called residual risk or diversifiable risk), is a business- or industry-level risk that poses a threat to each investment. Systematic risk, therefore, differs from unsystematic risk in the sense that it is a macroeconomic risk that causes a loss to the entire market, whereas the latter (unsystematic risk) affects a specific business or industry. The two risk types also differ along the line of controllability. Unlike the unsystematic risks that can be controlled by easily controlling the internal factors associated with them, systematic risks are uncontrollable because they arise from multiple and large-scale factors that are beyond the control of a business. However, this does not mean that the effects of systematic risks cannot be abated. This leads to the last difference. Businesses can control systematic risks through asset allocation and hedging, whereas unsystematic risks can be mitigated, or avoided altogether, through portfolio diversification (Vaidya, 2021).          

   Potential impacts of different financial risks on SciTronics.

   Interest Rate Risk

   Interest rate is the potential of loss or deterioration in the value of fixed-income assets due to unexpected changes in interest rates. The assets that are largely affected by interest rate risks are bonds and owners’ equity. Between 2005 and 2008 SciTronics had an average owners’ equity of $71.5 million. A rise in interest rate will indirectly affect these investors because an increase in interest rate will consequently increase the cost of borrowing money from creditors. The company is likely to respond by postponing borrowing or borrowing less, and this may reduce spending in further investments. As a result, growth will slow down, causing a decrease in profit margins, which will consequently lower stock prices for investors.  

   Economic Risk

   Economic risk is the likelihood that changes in business conditions or macroeconomic factors will negatively affect a company’s investment. For instance, looking at SciTronics’ business model, some factors that are likely to have adverse effects on its investments and general operations include exchange rate volatility, government instability, a change in government regimes, and the introduction of unfavorable government policies.

   Credit Risk

   Credit risk is the likelihood of loss caused by a company’s failure to meet its debt obligations according to the agreed terms. At the year-end of 2008, SciTronics had $133 million and owed $48 million due to be paid within a year. The company’s current ratio was 2.77, meaning it was in a good position to cover its liabilities and other short-term obligations using its current assets. In this sense, SciTronics was less susceptible to credit risk.

   Operational Risk

   Operational risk related to the potential of loss caused by ineffective or failure of the organization’s systems, processes, policies, or procedures. Since SciTronics engages in the production and sale of medical devices, it's exposed to system failure, failed internal processes, poor management practices, employee fraud, and other operational risks that may disrupt its normal business practices, leading to decreased performance and productivity. 

   Effects of Lower Sales growth on dividend policy and retained earnings

   As in other companies, SciTronics’ dividend policy and retained earnings are affected by various factors, including net income and sales growth. Lower growth in sales with a negative gross profit margin will imply that the company is less profitable. SciTronics will, therefore, be forced to reduce its production to avoid oversupply, leading to reduced net income. As a result, it will give lower dividend payments, which may increase the amount of retained earnings. 

   Effect of Higher Sales Growth Sales on dividend policy and retained earnings.

   As established by Sumail et al. (2013), sales growth has a direct and significant effect on dividend policy and leverage. High growth in sales with a positive growth profit margin will increase a company’s net income, making it more profitable enough to pay large dividends. This means that as SciTronics’ sales growth increases, it is more likely to make higher dividend payments due to increased net income and profit margin. However, the company’s decision to pay large dividends, combined with increased investment in additional assets and production processes to meet the high demand, will significantly reduce the portion of reduced earnings.