Financial Management: Ratios, Risk and Diversification Financial

Financial Management: Ratios, Risk and Diversification

Financial Ratios Relevant to Small Businesses and Large Corporations

In an attempt to determine the performance of his or her business, a small business owner can utilize ratios such as the current ratio and the profit margin ratio. The profit margin in the words of Needles and Powers (2010) "shows the percentage of each sales dollar that results in net income." For a small business owner, this ratio would be an appropriate measure of the profitability of his or her business. The current ratio as Stickney et al. (2009) point out helps in the measurement of a firm's ability to settle its short-term debts/obligations. A small business owner interested in determining the ability of the business to settle its everyday bills and other obligations would find this ratio useful. On the other hand, a manager of a large corporation would be interested in ratios such as return on equity (ROE) and debt-to-equity ratio. The debt to equity ratio in the opinion of Needles and Powers (2010) "shows the proportion of a company's assets that are financed by creditors and the proportion financed by stockholders." This ratio is critical for large corporations interested in determining their leverage position. ROE is regarded one of the most important ratios for not only existing stockholders but also potential investors. Both potential and existing stockholders would desire to sink their dollars in a company with a high ROE.

Debt Financing: Advantages and Disadvantages

One of the key advantages of debt financing has got to do with the prevention of ownership dilution as providers of debt in this case do not become part-owners of the business. In that regard, their say in decisions concerning the business is limited. However, debt financing puts the borrower at a greater risk of bankruptcy should such a borrower be unable to service the said debt. Further, interest payments can in some instances strain an entity's cash flows. With that in mind, some businesses may opt for equity financing i.e. stock issuance. As Shim and Siegel (2008) point out, an entity's credit rating can be improved by the issuance of common stock as opposed to a bond issue. Issuing stocks does not commit the business to periodic payments of fixed charges including but not limited to interest rates (Shim and Siegel, 2008).

The Relationship between Risk and Financial Returns

Generally, investments with a higher level of risk have a significantly higher rate of return than those with a lower risk level. As Stickney et al. (2009) point out; an individual who invests in Wal-Mart's shares would ordinarily demand a higher rate of return than an individual who invests in a certificate of deposit. Here, individuals purchasing Wal-Mart's shares would require to be compensated for embracing a riskier investment option.

The Beta Concept

Beta in the words of Shim and Siegel (2008) "measures a security's volatility relative to an average security." According to the authors, beta can hence be used by an individual in the determination of not only the risk but also the expected return.

Systematic and Unsystematic Risk

In some instances, diversification cannot help in the elimination of some kinds of risks. Such risks according to Graham and Smart (2011) are referred to as systematic risks and they include interest rate changes as well as changes in inflation. On the other hand, risks that do not affect many stocks are referred to as unsystematic risks (Graham and Smart, 2011). In the latter case, diversification can be regarded effective. Examples include raw materials availability and government regulation.