Jan 12, 2018 in Business

Understanding the Concepts

Financial ratios are defined as  “calculations that compare important financial aspects of a business”. They measure relationships. The ratios are obtained from the financial statements of the company including the income statement, balance sheet and cash flow statement, to mention but a few. These ratios are very important for any business because they help the managers to run the business from an informed perspective. However, there exists a slight difference regarding ratios that are most important to different businesses. Vicker (2005) writes that while financial ratios are indispensable for big businesses, small companies may not always require all the ratios because of their differential requirements. 

Vicker (2005) groups all the ratios into four main categories: liquidity, profitability, leverage and activity. For large business organizations, all the ratios are very important including return on assets (ROA), return on investment (ROI), return on equity, earnings per share, quick ratio, current ratio, debt ratio, equity ratio, net profitability and gross profitability. On the other hand, as a manager of a small business, I would consider the net profit margin and the gross profit margin as the most important ratios for my business. This is because one of the most important goals of a business venture is to make profit. Therefore, with regard to profits, I would seek to know how much the business makes in the context of all expenses.

Although the above two ratios would be very important to my business, Hatten (2011) points out that “profit figures tell us only part of the story”. In this regard, he insists that ratio analyses for big corporations must transcend profitability, mentality and incorporate other categories as identified by Vicker (2005). This essay compares two profitability ratios with two liquidity ratios which are quick ratio and current ratio. Vicker (2005) views liquidity as the ability of a company to pay its debts. By comparing this measurement with the perspectives employed in a small business, it appears that ratios for big businesses are used for benchmarking and trend analysis, things I would not engage in as a small business manager; because they may not necessarily be of help to a small business.

Advantages and Disadvantages of Debt Financing

Businesses use various ways to finance their activities. One of the mostly used ways is debt financing as opposed to the equity financing. Put in simple terms, debt financing happens when a business borrows money which would be repaid on interest. It may involve sale of bills or bonds. According to Vicker (2005), debt financing should be used by businesses that have a high equity-to-debt ratio. Moreover, in deciding in which exact way a business should carry out the debt financing, it is important to consider some of the advantages and disadvantages associated with specific methods of debt financing or general pros and cons of the strategy as a fundraising tool.

Perhaps one of the greatest advantages of debt financing is the fact that the owner of the business exercises complete control over his or her business. To understand this advantage better, one should consider the other way of financing through equities. In this other way, the parties that are approached to fund the business have considerable amount of control over the business, which is not theirs. Whittington and Delaney (2007) also observe that debt is not as costly as an equity and that inflation does not affect the repayment rate. However, although the debt financing has this advantage, Chandra cautions that “it can cause financial distress” and that it impairs the flexibility of the business to operate. In choosing the specific approach to the debt financing, business owners prefer stocks to bonds because “the stock market is far more liquid than the bond market”. In other words, stocks trade in smaller quantities for many times than bonds. Although Richelson and Richelson (2011) caution that stocks are more risky, McQuown (2004) asserts that stocks protect the business owner from inflation and have also outperformed bonds.

Financial Returns versus Risk

It is always crucial to base investment decisions on a clear knowledge of the relationship between risk and return. In general terms, risk refers to the measure of uncertainty of returns or volatility. On the other hand, returns refer to expected cash flows or benefits that an investment would produce. There exists a basic rule that the expected returns are proportional to the risk involved. In other words, the greater the risk is the greater return.

The Concept of Beta and Its Use

The term “beta” is used in capital assets pricing model (CAPM). It refers to the systematic risk, portfolio or volatility in the market comparisons. It denotes a coefficient that represents the tendency of a stock to fluctuate in relation to the general market. This coefficient could be measured by S&P 500 or the Dow Jones Industrials among other indices. These indices calculate beta using regression analyses of the relationship between market fluctuations and returns on stocks.

Systematic versus Unsystematic Risk

There are quite distinct differences between systematic and unsystematic risk. Systematic risk is part of variability of an asset that cannot be diversified across a variety of assets. The term also denotes the lowest level attainable for portfolio through diversification. This is so because the systematic risk emanates from the market forces and economic conditions. In other words, with regard to the systematic risk, diversification does not necessarily reduce the risk. Contrastingly, diversification reduces unsystematic risk. One of the best ways of doing this is through the increased asset base.

Investing and Diversification of Risk

With emerging the global competitiveness, there is a need for businesses to invest in other ventures. This is usually referred to as diversification. However, although the business owners are aware of the potential benefits at their disposal, they may not always be able to make the right investment choices. According to Whittington and Delaney (2007), the main factors to consider in choosing an investment venture include returns, taxation, safety and liquidity. Moreover, in the process of selecting the specific investment venture, I would consider the context as it would be required by the industry. In choosing the industry in which my company would invest, I would consider those industries that are already performing well. Some of these could include real estate, biotechnology, stocks and industries aligned with e-commerce. The basic rule would be to invest in an industry that is different from the one in which the business is involved; this is the essence of diversification.

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