Importance of Financial Ratios
Financial ratios are crucial elements that help us assess how a company is performing. It is even more crucial for the performance management of a smaller firm. As a small business owner, I will have the capability to implement a wide variety of ratio management tools for finding out how the firm is and will be performing in the future. Financial ratios are quantitative analysis tools that help us assess the performance of the firm using statistical and mathematical calculations. The financial ratios cover a wide range of aspects of a business; such as, liquidity, profitability, activity ratios, debt ratios and market ratios.
All of these ratios are important for a small business owner as well as the owner of a large business, except market ratios. Market ratios mainly cater to the needs to a large established corporation. This is because the market ratios are used to assess the stock position of the business. Apart from this, the market ratio also shows the cost that the business has to incur to issue those shares.
The market ratio aids the large firm in deciding whether they have been able to maximize the shareholders wealth or not. For instance, market ratio helps calculate the earnings per share, which is the amount of profits made on every outstanding stock. Apart from this, they also help calculate the price/earnings ratio. The price/earnings ratio helps the firm assess, whether the shares of the firm are overvalued or undervalued with comparison with the current market price. Although, market ratios are very important for a large firm, it has minimal importance in the operations of a small firm (Martellini, 2003).
Advantages and Disadvantages of Debt Financing
Debt financing refers to borrowing funds from external sources for the purpose of financing the activities of a business. Debt financing is a popular way of acquiring funds for both large and small businesses. A primary advantage of debt financing is that is allows the borrower to retain control over the business, while acquiring capital. All the borrower needs to do is repay the sum in installments and the principal amount after the end of the debt period. Apart from this, the entrepreneur also has rights to all of the profits and does not need to share it with the creditors. This is because the lender does not have any rights on the profits of the firm and are only entitled to the funds that they have provided to the business. Another, advantage of debt financing is that is puts the entrepreneur under limited obligation. In addition to the obligation, the entrepreneur also has to pay less tax as interest due to the creditors is deducted before calculating taxes on them (Brealey, 2008).
One of the prime disadvantages of debt financing is that it must be accompanied with some form of collateral given to the creditor in exchange of the money. Apart from this, some of the lenders may also impose certain restrictions on the activities of the business itself. A company that acquires debt financing from outside sources, is also considered to be riskier. The responsibility of repaying the debts in a timed manner is another burden faced by the company. If the company fails to repay the debts in on time, then the creditors may also force the company to liquidate (Brealey, 2008).
Financial Returns and Beta
As a general rule risk associated with an investment and the return expected by the investor are positively correlated. The higher the risk associated with a project the higher is the return expected by the investor. Beta is used to calculate the risk associated with a given asset or even a portfolio of assets. Beta is calculated by using the CAPM model and it measures the systematic risk associated with the asset or the portfolio.
Contrast between Systematic and Unsystematic Risk
The systematic risk is also called as market risk or the non-diversifiable risk associated with the asset. Examples of systematic risk include; interest rate risk, wars and recession, components that affect the entire market and cannot be diversified by any specific business firm. Therefore, the CAPM model is used to calculate the risk of an asset with respect to its systematic risk (Ross, 2009).
Conversely, unsystematic risk refers to risk that can be controlled or diversified to some extent and are specific to any given company. For instance, it may include such events such as strikes by the employees of the firm that only affects the performance of a small number of stocks of that single firm; are considered to be unsystematic risk or diversifiable risk. This is because; events such as sudden strikes by the employees can be foreseen and also avoided by the firm’s management. Unsystematic risk also includes situations such as; nationalization of the firm’s assets, labor unrest, and also unfavorable weather conditions (Ross, 2009).
The most viable method for diversifying the portfolio of a business is by investing in a wide range of businesses. As the owner of a manufacturing business, the firm can either invest in new machinery which will increase their capacity and also future prospects of making profits. However, the degree to which the profits of the firm will increase is subject to the calculations of various capital budgeting techniques. We can use either Net Present Value method of the Internal Rate of Return method to find out whether we should invest in new machinery or not.
The manufacturing firm also has the option of investing some of the money in their own business and some of it in the stocks of other companies. The investment in stocks of other companies must be assessed according to the returns that they will give in the long-run and also the riskiness of those stocks. Assessing the time value of money is also important for the firm, because we know that 1 dollar worth today is more than the value of 1 dollar one year from now. Therefore, we should use the expected future value from all those investments and find their present value. If the present value is of an acceptable range, only then we should proceed with the investments (Martellini, 2003).
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2. Martellini.L, Priaulet. P, Priaulet. S. (2003). Fixed Income Securities:Valuation, Risk Management and Portfolio Strategies. England: John Wiley.
3. Ross. S.A, Westernfield. R.W, and Jordon, B.D. (2010). Essentials of Corporate Finance. United States: McGraw-Hill
4. Ross, S.A. (2009). Corporate Finance. United States: McGraw-Hill