Jan 29, 2019 in Finance

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Important Small Business Financial Ratios

In small business ventures, the ability to understand the application of financial ratios is relevant. This is associated with the fundamental assumption of the owner acquiring significant skills required in managing the performance of the business as a whole. The following are three fundamental financial ratios that a small business owner should comprehend.

  • The first ratio is the Account Receivables Days. This financial ratio allows small business owners to comprehend the average number of days of income that are still held in terms of receivables. An increase in the AR Days ratio should sum up as an alert to the owners for an impending customer inability to pay bills and thus missing funds needed in execution of the payroll duties due to lack of funds. Furthermore, an increase in the foretasted ratio might mean that debtors are not able to pay the amount owed to the business due to poor levels of profits on their part (Coker, 2010).
  • The second ratio is the Debt to Assets which determines the level of total assets corresponding to the total liabilities. Small business owners should determine this ratio given that it postulates the exact amount of business that is supported by debt financing. A decrease in the ratio should alert the owner that there are fewer assets for business operations. Hence, the business is likely to be operating under immense levels of debt (Coker, 2010).
  • The third type of ratio for small business purposes is the Quick ratio. This ratio measures the number of current assets in comparison with the total current liabilities at any given time. They are used for postulating how short-term business operations provide funds to the overall costs incurred while conducting the business activity. A significant decrease in the ratio translates to more debts being used to conduct business operations (Coker, 2010).

In comparison with small businesses, large business puts more emphasis on both investment-based and profitability-based financial ratios given that they are involved in conducting larger projects which require more funds. The investment decisions are also riskier by nature. Thus, large businesses will concentrate on such ratios as dividend per share, earnings per share ROA, and ROE ratios.

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Advantages and Disadvantages of Debt Financing

Advantages

The first advantage of debt financing is that it allows full utilization of the available resource fund. This is associated with the fact that the borrowing business will have to pay interest to creditors and thus they are obligated to make more profits by injecting all of the borrowed resources. The second advantage is that debt finance allows immense levels of security for small businesses since they can be accessed easily for short-term-based business goals. The third advantage of businesses using debt finance lies in the fact that they are entitled to tax incentives since interest paid is a deductible item in the income tax list. The fourth advantage lies in the assumption that it is accessed on a mere loan repayment model so that only the principal amount plus interest is paid to the financier. This means that financiers possess no right to direct how the funds will be used in the operations of the business: they do not secure any form of business ownership.

Disadvantages

The first disadvantage of debt financing lies in the assumption that businesses are exposed to the risks involved with lowering credit scores which might be useful in securing future funds. This is evident whenever borrowing businesses fail to repay amounts on time. Second, debt financing is only limited to the established entities within the economy. This is because lenders require security for funds borrowed. Third, businesses that are dependent on debt financing are not allowed a sufficient amount of funds for large projects, hence they might be forced to locate alternative sources of funds which are time-consuming.

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Most organizations would choose to issue stocks over bonds because funds raised from the placement of stock are flexible and sufficient. This means that businesses will use these funds for flexible projects since there is no requirement for interest payment. Unlike bonds, by raising funds through stock placement organizations are exposed to fewer risks which are a coherent feature within the money economy. Furthermore, unlike mature bonds and paid-off to the investors, stock funds are not mature thus they are long-term by nature. Organizations are only allowed to pay back dividends when profits are made (Burton, 2011).

The Relationship Between Financial Returns and Risk

The relationship between expected financial returns and the levels of risks involved is positive. This means that an increase in the expected level of risk results in an immediate increase in the level of expected financial returns. On the other hand, a decrease in the level of risk results in a decrease in the level of expected financial returns. This is because entities operate and invest their funds into projects that are executed under risky types of environments. Thus, risks play a significant role in determining the approximate levels of expected financial returns within the business investments: they have a direct effect on the economic value of holistic projects conducted by firms (Fama & French, 1992).

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Concept of Beta

Beta in finance is used to refer to a number that expounds on the apparent volatility of any given asset about the immediate benchmark volatility under consideration. It should be noted that the overall benchmark volatility is a representation of the overall financial markets. An asset that depicts beta-zero is an indication that its expected financial returns are subjected to alterations in the return markets independently. A positive beta is an indication that a given asset has its expected financial return concurrent with the return markets while a negative beta for a given asset is a clear indication that the expected returns of the asset are moving in the opposite direction (Fama & French, 1992).

Beta is used to determine the section involved with an asset statistical variance that cannot undergo the diversification process irrespective of portfolio correlation of expected returns. It can also be used to measure the performance of investment portfolios for individual entities by the application of regression analysis (Fama & French, 1992).

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Systematic risk is affected by factors associated with investment and foreign investment policies that have a positive effect on how markets operate. This form of risk cannot undergo mitigation given that investors lack the capacity to control their effects. On the other hand, unsystematic risks can be mitigated through diversification of existing business portfolios. Therefore, investors possess the ability to control them to suit their respective models of investments (Hamada, 1972).

I think that I will adopt a successive methodology of diversifying the funds, $ 1 million in different models of investments. I will use a section of money to purchase stocks in the exchange market since stocks are not affected in the course of inflation periods. Thus, the business will be able to receive dividends at the end of each financial year. This model of diversification also ensures that risk is distributed fairly. I will also consider investing in different regions across the globe to lessen the risk involved with investing within the same market. Government bonds are also an option worth considering since they mature at higher interests while their security is guaranteed.

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