Financial Ratios There Are a Number of Essay

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Financial Ratios

There are a number of financial ratios that will be valuable to a small business person. A small business is often concerned with cash flow, so ratios that are the most concern fall into three categories -- liquidity, profitability and efficiency. Liquidity ratios measure the ability of the company to meet its upcoming financial obligations. These ratios are important for ensuring that there is enough cash on hand to pay the bills. The profitability ratios are important because the business will be more successful if it is able to manage its margins. Efficiency ratios are concerned with how fast items like inventory or accounts receivable are turned over. These ratios are a direct reflection of the company's working capital, and improvements in these ratios improve the working capital flow.

These ratios are going to be slightly different from those that a large corporation values. The large corporation actually does value these three ratio categories, but has others that it needs to concern itself with as well. Investment return ratios are more important -- ROA, ROE -- and so are market ratios like earnings per share. For a small business, however, there are no shareholders, and the most important concern is to ensure sufficient cash flow to meet obligations and ensure that the business continues. IF the company is growing, then cash flow remains important because of the need to plow money back into the business.

2. Debt financing has a number of advantages over equity financing. The most important is that for a business owner, debt financing allows the owner to retain control over the business. Equity financing means giving up a share of ownership, so debt financing avoids that. Also, debt financing is cheaper than equity financing. The reason is that debt is paid before anything is left for the shareholders. To compensate for being subordinated, the shareholders demand a higher payout on their investment. This means that equity costs more than debt, because of this higher payout. So for the company, debt also has the advantage of being cheaper than equity.

The downside of debt financing is that it creates an obligation. The company will need to pay interest on that debt, and will eventually pay the principle as well. This payment comes before any profits can be distributed. As a result, the company will pay the interest before it has money left over to re-invest back into the business. If the company is losing money, it would not need to pay anything to equity holders, but it will still need to make a payment to the bondholders. This obligation can constrict the ability of the company to invest what it wants into the business, especially if the company has a lot of debt. This is why banks are usually wary of lending to companies that have high debt levels -- the higher the debt the greater the risk that the business will not be able to generate sufficient cash flow to cover the debt obligation.

Another disadvantage of debt is that there are often restrictive covenants on the debt. If borrowing from a bank in particular, the bank will impose these covenants a as means of protecting its investment and the company might agree to the covenants in order to lower the interest payments. Sometimes, however, the covenants can be onerous. They usually involve things like maintain healthy liquidity ratios, and have a minimum standard for free cash flow / interest expense or similar ratio. However, trying to maintain operations within the context of these covenants can be a nuisance for the business. A company might decide that the disadvantages outweigh the advantages with respect to issuing debt, and prefer to issue equity instead. Additionally, an especially attractive firm can often raise a substantial amount of equity with an IPO. Further, if the equity comes in the form of venture capital, this might be seen as preferable because the venture capitalist will be able to bring in some outside managerial expertise in order to help the…

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