Small Size Business Owner Has to Continually

¶ … small size business owner has to continually assess the status of the enterprise relative to both itself (as evolution in time), as well a relative to the industry, in order to identify its current status and position. One important means in which the economic agents come to conduct this assessment is represented by the financial status of the company, revealed through the lenses of financial ratios. Some notable examples of financial rations to be considered by small size economic agents in their assessments include:

Liquidity ratios, such as the quick ratio or the current ratio, which assess the company's ability to pay its debts

Asset turnover ratios, such as the receivable turnover or the inventory turnover, which assess the company's ability to use its assets to generate revenues

Financial leverage ratios, such as the debt to equity ratio, which indicate the status of the company's capitals

Profitability ratios, such as the gross profit margin, the return on assets or the return on equity, which indicate the ability of the firm to use is resources to generate profits (Net MBA, 2010).

Aside from these ratios, larger size companies would also focus on the dividend policy ratios, such as the dividend yield or the payout ratio, which assess the company's use of equity and its repayment, as well as future (Net MBA, 2010). The ratios used by the small and larger size companies are virtually the same, with the difference that a larger size company will be interested in market power and competitiveness and will compare the ratios with those of the industry, whereas a small size entity will be focused on its evolution through time and would compare the ratios from one year to the other.

2. Debt financing

Upon the enlargement of the capitals, the economic agent has the option of borrowed capitals vs. equity financing, with each of these revealing both advantages as well as disadvantages. At the level of debt financing, this has the main disadvantage of requiring collateral and other guarantees as solicited by the bank; then, it necessitates sustained and regular payments, regardless of the profitability of the firm. Debt financing nevertheless is computed as money owed by the firm and the principal and interest rate are not subjected to taxes. Additionally, the bank does not intervene in the decision making process at the firm.

Equity financing is also a viable option as it allows repayment of the borrowed funds only when the firm is profitable, but it has the disadvantage of the stock holders' interference within the firm and the computation of the dividend payments as profits, and their subsequent taxation. Still, in the detriment of bonds, stocks are more flexible as they do not establish a strict schedule for repayment and they can also prove more profitable (Russell Investments).

3. Financial returns and risks

The relationship between risks and tradeoff is a very close one, impacting virtually every aspect of investments. In a most rudimentary formulation, there is a direct relationship between the two, in the meaning that a modification in one dimension of investments will be correlated with a similar modification in the other dimension. More specifically:

High levels of expected return are generally correlated with higher degrees of risk

Lower levels of expected return are correlated with lower levels of risk.

In other words, investors who wish to register higher returns will have to accept a higher degree of risk, whereas investors who do not wish to assume higher degrees of risk, will have to accept lower levels of financial returns. In essence, it is important for the investors to find their own balance and to make investments based on their own threshold for risk.

4. Beta

In the same line of investment discussions, it is important for investors and prospective investors to also understand the concept of beta. In a generic formulation, the beta of a stock or an investment portfolio represents the risk associated with the respective investment instrument, relative to the overall market, or relative to another instrument selected as benchmark. The beta instrument is used in the assessment of the future return of a stock in order to identify its future evolution and make informed decisions at the present time. In other words, the beta concept relies heavily on the notion of time value of money, which compares the future value of an instrument at a present time with its value at a point in the future.

According to Investopedia, the financial website under the patronage for Forbes, beta represents "a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns."

The computation of the beta is completed through regression analysis, at which level emphasis is placed on the identification of the investment's sensitivity to movements in the market. The value of the beta is compared with 1, meaning the following:

Beta = 1 means that the price (and market value) of the security will evolve in the same direction as the market

Beta < 1 means that the security is less volatile than the market, and last

Beta > 1 means that the security is more volatile than the market (Investopedia, 2012).

5. Systematic and unsystematic risk

Any investment instrument is faced with a total risk, which is compounded from the systematic risk and the unsystematic risk. The systematic risk is represented by the risk of the market, which is present in all investment activities and which cannot be controlled. In other words, the systematic risk is generated by forces which cannot be foreseen and their impacts are also unknown. In such a setting, this risk is less relevant and it is compensated for by a risk free rate.

The unsystematic risk is represented by elements which can be controlled within the market. In other words, the unsystematic risk is the one that can be controlled by people and activities within the market. This risk varies from one instrument to the other and it is the one that influences the overall risk of the various stocks, bonds and other securities.

Since the systematic risk is common and similar to all securities, it is clear that the risk which distinguishes between the various instruments is represented by the unsystematic risk. In other words, the investment decisions pegged to the threshold for risk refer to the unsystematic risk, and the acceptance of this risk is compensated through the assignment of a risk premium. While the systematic risk cannot be addressed in any way, the unsystematic risk can be decreased through the implementation of the diversification principles (Nariman HB).