Small Business Owner: Financial Ratios Understanding Concepts

Small Business Owner: Financial Ratios

Understanding concepts

Financial analysis is one of the most reliable means of assessing an economic agent as it relies on quantitative data, which is unbiased, objective and which can be extrapolated. Still, despite these advantages of financial analysis, fact remains that its results can generate relative findings based on the characteristics of the assessed company. For instance, while a small size company would be more interested in decreasing debt, a large size entity would pay less attention to debt.

In the context of a small size company, some of the more relevant financial ratios to be assessed refer to the profitability ratios, the liquidity ratios, the debt ratios and the activity ratios. Each of these categories contains several important ratios, as follows:

Profitability ratios: the gross profit margin, the net profit margin, the return on equity

Liquidity ratios: current ratio, quick ratio or current ratio

Debt ratios: debt ratio, debt to equity ratio, and last

Activity ratios: inventory turnover rate, accounts receivable turnover (Cooper, 2011).

All these ratios are also important in the context of the larger size business entities, but at their level, emphasis would also be placed on efficiency ratios or dividend policy ratios, such as the dividend yield or the payout ratio (Net MBA, 2010). For instance, the smaller size companies will place an increased emphasis on their own ability to pay their debt, through the assessment of the debt ratios.

The larger size companies will place a decreased emphasis on the short-term debt as they will usually posses the means and liquidity to honor them, given the large size of their turnover. These larger entities will however focus on efficiency ratios that enable them to attain their long-term objectives. Specifically, the larger size companies would place an increased emphasis on their management of the liabilities and assets as a means of attaining their pre-established objectives.

Ultimately, the smaller size companies are focused on immediate stability, whereas the larger entities are focused on long-term gains and operational efficiency, as well as the reward of their shareholders. This difference, alongside with other distinctive characteristics of the small and large size companies, determine different interests in the financial ratios across the institutions.

Large size companies often issue stocks in order to collect additional capital and they prefer these instruments as they are more facile and easy to exchange within the market. Additionally, the stocks represent participation in the company and the issuer does not have the obligation to re-buy them or to pay dividends on them unless profits are generated and dividends are decided by the board.

Bonds on the other hand, are loans, rather than ownership deeds, meaning as such that the company is obliging itself to re-buy the bonds at a specific point in time, regardless of its financial results and strength at the respective time in the future. This type of capital rising is more complex and challenging due to the incurrence of the concepts of time value of money, integrating uncertainty and making companies prefer the issuance of stock.

Aside from stocks or bonds, on other occasions, firms will choose to finance their operations through debt and the advantages in this sense include the preservation of control and the ability to deduct the debt as cost. In other words, when the economic agents solicit bank loans, these (the loans) are perceived as money owed by the company and the costs with reimbursement can be deduced from taxation; in other words, the company will not pay taxes on the loan. In the case of stock, the dividends are legally perceived as profits and they are subjected to taxation.

Furthermore, upon the issuance of stocks, the company will lose part of its control since the investors purchase shares and become new owners in the business. The decision making process at the company as such becomes more complex. In the case of debt however, the bank does not interfere in the decision making process of the firm and does not generate additional complexities at this level.

Aside from the organizational complexities in choosing the more adequate means of collecting additional capitals, these decisions also impact the players in the stock market. For investors, the choice between stocks and bonds is also difficult, as is the very investment decision. In such a setting, it is essential for the investors to fully comprehend some complex notions of investment, the more important of them being the risk associated with an investment.

For investors, the purchase of securities is associated with a different degree of risk, in the meaning that investments with higher promises of return carry a higher risk and investments with a lower possibility of gains carry a lower risk. In other words, there is a direct relationship between the returns of a security and the risks associated with the respective security; the higher the return, the higher the risk. The final decision of the investors depends on their own threshold and aversion towards risk as some investors will choose returns, whereas others will choose security.

In this context, it is important for investors to understand the risks. The beta risk is the risk assumed by the investor when they accept a null hypothesis (Investopedia, 2012). Additionally, the best risk will assess the risk associated with an investment in the context of a benchmark risk, such as one computed at the industry level. The assessment of the beta is essential for investment decisions.

The unsystematic risk is represented by the general risks pertaining to firms in the industry, such as strikes or managerial decisions. The unsystematic risk can be reduced through proper diversification of the investment portfolio. The systematic risk, on the other hand, is the risk that impacts all investments, such as wars or inflation, and this risk cannot be reduced through diversification (Nerimanhb).