Question

Your aunt recently inherited $500,000 and she has decided to invest her newfound fortune in a company that has a profit margin of 6% because it is higher than the 3% interest she can get at the bank. Provide your aunt with advice regarding this potential investment including a discussion on risk, and the limitations of ratios.

Answer 1

Investing should be done keeping in mind all the related variables to the investment. Risk is an important variable to study before investing in the instrument.

Its true that risk brings in rewards. Higher the risks taken, higher are the rewards expected from it. And if the luck is not on our side that the losses can be equally higher.

In our case the 500000$ can be either invested in a company with 6%profit margin or can be deposited in a bank with 3% interest.

Although this 6% seems higher than the 3% interest, but, the here is the catch.

- the 6% profit margin of the of the company does not ensure 6% return on investment we did in the company. Considering if the investment is in the way of equity shares then the return will be the amount of dividend received from the company. The amount of dividend distributed by the company is a part of the profits earned by the company and almost never the company distributes all its profit in form of dividends. The company sets aside some of the profits after paying the preference holders by name of retained earnings. SO the final amount of return that we get can be lower than 3 or near to 3%.

-The above return is a risky return as well. The market is dynamic and the company may soon start to incur losses and make your investment a bad decision. Although there are chances that the company may gain higher profits in the future and the returns may also increase for our investment. But the risk factor here is huge as compared to bank 3% interest which is risk free.

So if aunt is ready to take the risk then only she should consider investing in the company otherwise investing in the bank is always a safer bet.