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...
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…
