Financial ratios refer to the numerical values obtained from the balance sheet or income statement, which are used to assess the progress of the business entity in various perspectives. There is a range of aspects to be measured by using financial ratios, which includes the ability of the business to meet its financial obligations, the profits obtainable by the business during a certain financial period as well as the ease of the business assets to be converted into cash if such a need arises (Carcello, 2008). However, the financial ratios that are considered crucial differ depending on whether a business is large or small. There are some financial ratios, which a small business can barely survive without. In this regard, a small business needs to ensure it operates based on these financial ratios.
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Liquidity ratios are important financial ratios any small business should be applying in its operations. These ratios assess how a business can meet its short-term financial obligations without the need to borrow for such purposes (Marsh, 1982). With liquidity ratios in place, a business can tell whether it can afford to take advantage of any business opportunity that may arise requiring instant cash investment. For example, when a small business has higher liquidity ratios, it indicates that the cash levels the business is operating at are suitable to allow it meet any short-term cash obligation, such as a cash discount offered on the purchase of inventory in cash (Strong, 2009). Among the liquidity ratios are the quick and current ratios.
Profitability ratios are the other form of financial ratios that a small business cannot afford to operate without. These ratios assess how much money a business entity earns from its operations after catering for all the expenditures involved (Carcello, 2008). Thus, these ratios indicate how much reward the business has granted its owner for its establishment and running. Without such ratios, it would be difficult to know whether the business is running at a profit or a loss, making the decision regarding whether to continue operating the business or to close it down a big challenge. The most common of these ratios is the gross profit margin, which assesses the margin by which the sales made by a business during a certain period have exceeded the cost of purchasing the commodities sold (Puxty, Dodds & Wilson, 1988).
The other important financial ratio that a small business cannot succeed without using is the leverage ratio. The ratio assesses the long-term ability of the business to become solvent. Among the leverage ratios used in this assessment is the debt ratio, which compares the total value of the assets that a business have to its total assets (Marsh, 1982). Whenever such ratios are lower, then it is a clear indication that the value of the business assets is higher than its debts, making it good for leverage purposes. A lower debt shows that the business is solvent, in that after its closure, it can pay for all its debts and still give the owners some returns (Kristy, 1994).
Comparison of Ratios important to Small Business Manager and Manager of a Larger Corporation
A difference exits in the nature of the financial ratios for small business and those for large businesses. Despite the fact that all the ratios, regardless of whether they are for small or large businesses are calculated using the same formulas, they differ in their meaning (Strong, 2009). Therefore, while a certain level of financial ratios would mean one thing to the owner or manage of a small business, it could mean an entirely different thing to a manager of a large business. One such difference is in the leverage ratios for small and large businesses. While a higher debt-to-equity ratio would indicate that a small business is not operating at suitable safety levels in that they have a higher debt than the value of their assets, it means a very different thing to a large business. To a large business, a higher debt-to-equity ratio indicates the business is operating well, in that, it is in a good position to access credit from lenders, and thus uses other entities’ money to run its operations (Marsh, 1982).
The other difference in the characteristics of ratios between small and large business is identifiable in the profitability ratios. Whereas the gross profit margin of a small business could be higher than of a large business indicating that it might be more profitable, the case could be different. In the real sense, it is possible to find that a large business with a lower gross profit margin is more profitable than a small business, when the net profit is assessed (Kristy, 1994). Thus, different financial ratios contrast in meaning between a small business manager and a manager of a large business.
Advantages and Disadvantages of Debt Financing
Debt financing is an important aspect of business seeking to grow and realize their objectives even when they lack sufficient resources to meet such growth prospective. Debt financing allows a business to borrow money from lenders and repay such funds with interests (Puxty, Dodds & Wilson, 1988). Various advantages are associated with this form of business financing. First is the fact that debt financing allows business to operate and realize their growth prospective with borrowed funds without diluting the business control and ownership (Carcello, 2008). With debt financing, a business ensures that it safeguards its owners profit earning levels, as opposed to selling stocks, which would mean the profits earned in future would be shared amongst the new shareholders purchasing the stocks (Kristy, 1994). Another advantage is the fact that interest payable on the borrowed funds in case of debt financing can be used to reduce the company’s tax returns, reducing the tax payable by such a company.
However, various disadvantages are associated with debt financing. First is that the borrowed money has to be repaid with an interest. This serves to reduce the profits of a business entity, in that, interests payable reduces the profits earned (Strong, 2009). More to the disadvantages is the fact that a business entity might be required to pledge some of its assets, thus, limiting the businesses that can access such funding.
Why issue Stocks Rather than Bonds and the Relationship between Financial Returns and Risks
An organization would prefer to issue stocks other than bonds to prevent the dilution of a business entity’s ownership. Financial returns are related to risks in that the higher the risks associated with any given opportunity; the more beneficial such a business would be (Marsh, 1982). This is so because when the business risk is higher, only a few investors would be interested in the opportunity leaving it with only few investors; this makes such opportunities more profitable (Kristy, 1994).
Concepts of Beta, Systematic and Unsystematic Risk
The concept of Beta refers to the measurement of the change in individual stock prices, as compared to the change in the market prices. If the price change of such stock is more than the market price change, then the Beta value is more than 1 and vice versa (Derrick, 2012).
Systematic risk refers to the risk facing a business, which cannot be eliminated by the means of diversification, such as risks posed by wars and inflation (Strong, 2009). On the other hand, unsystematic risk refers to the risks that can be eliminated through diversification, such as employee strikes (Carcello, 2008). To reduce risks, while with a fee of about $1 million, I can invest in different businesses to diversify the risks involved in investing all the money in one business opportunity (Strong, 2009).
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