Financial ratios and debt financing decisions in small versus large businesses

Risk, Return and Their Evaluation

Risk & Performance Indicators

Since this is a small business, therefore raising equity capital through public stock issue is less likely than debt or whatever form of paper issued to angel or venture investors. Therefore while a larger, publicly traded firm would consider the return on equity version of the short form DuPont equation, a small, more closely-held concern would focus on return on assets (ROA). If ROA is net income over sales times sales over total assets, i.e. net income over total assets, then any action that could increase the numerator, total income, or shrink the denominator(s) should increase ROA compared to past performance within the firm and the competition outside it. If competitors all use the same (best) plant, then maximizing efficiency of the same assets through process or brand innovation; input cost reductions, and also financial performance like minimizing payables days over days receivable will increase the numerator in ROA relative to total assets and increase performance compared to other investments. This would result in better quick ratio and margin before interest and taxation. Fixed asset turnover rate would be the complementary ratio for a capital-heavy business compared to say retail where the analogous ratio to maximize would be inventory turnover rate, perhaps enhanced by profit per square foot where heavy durable plant was not the value-adding asset. Maximizing either fixed asset or inventory turnover rate would reduce spoilage (fashion, in retail); storage (rent); monitoring; and like such input costs that would deliver competitive advantage where all manufacturers for example start with the same raw input be that iron; cotton; unskilled labor or what have you. The larger firm would in addition focus on maximizing assets compared to equity but also reducing shares out in order to generate higher dividends per share, assuming public ownership differentiated the large from the small company in this example. The larger firm would probably hedge risk more elaborately rather than simply reinvesting profit into growth if margin growth rate for the large firm had fallen off as it encountered boundaries of market share. Both of them would want to minimize tax expense, which brings us to question 2.

2. The benefits of debt over equity capital is that once the debt is paid off, the owners still retain their percentage of the return without sharing that with other new owners. The other reason is tax treatment and complexity: where interest payments are tax deductible, then investors effectively reinvest that payment into the firm, but if they withdraw the profit as capital gains income, the tax man takes that away for ever. The reason to pay down interest and principal is eventually to increase profit by reducing the debt load anyway, so if that ultimately is paid all the way down, the tax collector gets the capital gains income tax anyway, unless the firm takes out more debt for new investment which would indicate growth, given the same profit margin. Monthly debt payments are also generally simpler than voting dividend rates; issuing proxy statements and all the fees, monitoring and communications cost involved in even the simplest IPO or annual shareholders' meeting. On the other hand if margin is too close and the debt payment is missed, credit ratings are jeopardized and the ultimate result is bankruptcy, i.e. liquidation of assets, where since only a miniscule fraction of total assets are paid out in dividends if at all, then the fluctuations of systematic and individual risk do not cause the timing conflict where cash is necessary to pay down loans and interest. This entails explanation of risk, from broad to local.

3. It would be great if every time we put a dollar in the ATM, two came out. But what if another ATM paid out three? We don't know. It would be a cost to stop, and go find out. The other one might not: that information would be a loss. Likewise we could perhaps do something else that made more per hour so we would have to deduct that search cost as well. Plus, we would need the original dollar. If we borrowed that, someone would demand some kind of return, or they could just hold it themselves risk free under the mattress. If inflation was more than zero, that would be a loss itself. Therefore they would have to invest, and if we borrowed the original ATM dollar, the return would have to cover that borrowing cost and also inflation. But few ventures are guaranteed, or else everyone would put their money there, and so even where variable input costs due to weather events; theft, fraud, tare (ruined inputs, i.e. skill) and wear on plant; regulation change; money supply and exchange rate and thus inflation changes did not affect returns which would be a stretch, investors would offer lower and lower borrowing rates for such an implausible risk-free investment and so in order to generate higher returns, investors would actually have to seek out risk or else accept the lowest, 'risk-free' rates. Higher risk from any of the causes just mentioned, let alone competitor action taking market share, drives higher borrowing cost and thus the venture must make higher return to pay off that higher premium.

4. This risk is measured relative to other investments. If a publicly traded equity security increases more than other investments on the upside or falls more on the down side of a business cycle however short or long, then it has higher 'beta' than the rest of the market. If on the other hand the security is affected less by market volatility than the majority of other available options, its beta is lower. This is because beta measures the variance of that investment compared to the total portfolio, and thus if two investments generate different returns and the same beta, the more successful one is just that, better managed. Since beta compares all possible investments against the total portfolio, this risk cannot be hedged by diversification because there is nowhere else to invest, theoretically, so if two assets have the same return and one is more risky than the other, then the capital asset pricing model indicates the riskier investment will demand higher finance cost in order to cover that risk. For the same return, investors would rather have lower risk, i.e. lower beta and thus would be willing to lend for less.

5. Systematic risk is risk all relevant competitors face like weather events -- drought in agriculture or hurricanes, but also wars or international trade barriers, exchange rate or input price inflation, or as we have seen recently in consumer durables and housing, reduced spending due to falling disposable incomes or perceptions about the future. Unsystematic risk is faced by individual concerns, like say just for example preference change causing brand flight or not knowing how many tickets for an event will sell; not knowing how well a new advertising campaign or product line will perform; or any of those actions by particular competitors.