Understanding Concepts: Important financial ratios to a business - Essay Example

? Understanding Concepts Understanding Concepts Important financial ratios to a business Ratio Analysis helps the business managerto see trends in a business, and compare its condition and performance with that of like businesses in a similar industry. Therefore, the manager may evaluate the relative weaknesses and strengths of his or her business. This comparison of business ratios to those of other similar businesses will indicate the weaknesses or strengths within a business (Albrecht, 2011). The most effective way for owners of small businesses to utilize financial ratios is by conducting a ratio analysis on regular intervals. Ratios important to a manager of a large corporation include return on investment (ROI), return on assets, (ROA), and debt-to-equity. Balance Sheet Ratio Analysis calculates solvency and liquidity of a business. They include Current Ratios = Total Current Assets / Total Current Liabilities. The ratio shows whether a business has sufficient current assets to meet its current debts and leave a margin of safety in case of current assets losses such as collectable accounts or inventory shrinkage. Two to 1 is the favourable current ratio (Stickney, 2010). If the current ratio of a business is low, turning fixed assets into current assets, debts payment, and taking back profits into the business can help raise it. Quick Ratios / acid-test ratio = Cash + Government Securities + Receivables / Total Current Liabilities. 1:1 is the satisfactory acid-test ratio. Working Capital is calculated by taking Total Current Assets less Total Current Liabilities. Leverage Ratio or Debt/Worth Ratio = Total Liabilities / Net Worth. It indicates how far a business relies on debt financing. If this ratio is high, it becomes hard to obtain credit. Income Statement Ratio Analysis measures profitability. They include Gross Margin Ratio = Gross Profit / Net Sales. It calculates the sales dollars left inform of a percentage to cover the company’s overhead expenses. Net Profit Margin Ratio = Net Profit before Tax/ Net Sales. It details the sales percentage, which remain after deducting the Cost of Goods sold and any other expenses apart from income taxes (Stickney, 2010). Management Ratios include Inventory Turnover Ratio = Net Sales / Average Inventory at Cost indicates how effectively inventory is managed. Accounts Receivable Turnover Ratio (in days) = Accounts Receivable / Daily Credit Sales; it shows how effectively the receivables are collected. Return on Assets Ratio = Net Profit before Tax / Total Assets; it measures how effectively profits are being derived from the assets in the business, and Return on Investment Ratio = Net Profit before Tax / Net Worth reveals to the owner whether the effort applied into the business has been fruitful (Albrecht, 2011). Advantages and disadvantages of debt financing Debt financing involves borrowing cash from an investor or a lender with the aim of repaying the whole amount in future; mostly with an interest. The common benefit of debt financing is that it enables the owners to maintain control and ownership of their business. There are no partners or investors to report to and the owners make all the required decisions. Also, debt financing gives owners of small businesses a high degree of financial freedom. Debt obligations are only up to the repayment period of the loan. Further, debt financing is easy to acquire because it lacks the complicated reporting requirements. Also, the owners enjoy all the profits because the lender(s) do not have a share in the profits generated by the business. Finally, debt financing shields business revenues from taxes and lowers the tax liability annually because interest repaid on the loan becomes tax-deductible (Stickney, 2010). The primary shortcoming of debt financing is that a small business is required to pay interest and principal monthly. Extremely young businesses mostly experience insufficient cash flow hence it is hard for them to meet these regular payments. Severe penalties imposed by many lenders for missed or late payments are collateral possession or late fees charges (Stickney, 2010). Failing to repay a loan affects the credit rating of a small business adversely as well as its ability to get future financing. Also, for a newly established company, commercial banks will probably require the pledge of personal assets before issuing a loan. If a company goes under, these personal assets are lost. Another down side of debt financing is that it is mostly made available to established businesses only. Since lenders need to know that their funds are secure, it is often hard for newly established companies to get loans. Also, the extent of financing that small companies obtain through debt financing is mostly limited, hence requiring them to seek alternative financial sources. Finally, debt financing, increases bankruptcy risk (Rich, Mowen, & Hansen, 2012). An organization would opt to issue stocks rather than bonds to generate funds because stock does not pose the risk of bankruptcy. Further, personal cash and cash from investors can be utilized when starting up a company to cater for all the costs required for start-up rather than making large loan repayments to banks, individuals, or any other organizations. This way, it is easy to get underway with no debt burden (Albrecht, 2011). Also, if a prospectus is prepared for the potential investors and an explanation has been given to them that there is risk accompanying their money because the business is a new start-up, they will be aware that in case the business fails, there will be no refund of their money. Finally, investors may provide valuable assistance that may be required in the business. This can be valuable, particularly in the initial days of a freshly formed firm. How the financial returns are related to risk Financial risk is a loss resulting from defaults of a business partner or severe fluctuations in prices in the financial markets. Organizations and individuals engage in various business activities in order to maximize gains while at the same time minimizing risk. Risk is the anticipation of loss resulting from an adverse economic development relative to operating activities or portfolio of an investor. Return is a gain made by an investor in any business transaction, and it is often expressed as a percentage. It consists of capital gains and incomes with respect to an investment. A risk-reward trade-off describes the gains an investor is likely to make at certain levels of risk. The greater the risk, the higher the potential for more returns (Rich, Mowen, & Hansen, 2012). The concept of beta Beta can be regarded as a measure of systematic risk or relative volatility of a portfolio or a security as compared to the whole market. Its concept is "how closely does a portfolio or security track this particular index?” S&P 500 is the most popular index to calculate stocks; bond index is also common. Beta is measured by the use of regression analysis; thus, it can be thought as the tendency of returns of a security to respond to market swings. A beta of 1 show the price of the security will shift with the market. A beta of greater than 1 show that it shifts greater than the index hence price of the security being more volatile as compared to the market. A beta of less than 1 indicates that it shifts little than the index; hence, price of the security will be less volatile as compared to the market. Beta is commonly used in Capital Asset Pricing Model (CAPM), which calculates an asset’s expected return from its expected market returns and its beta (Stickney, 2010). Systematic Risk and Unsystematic Risk Systematic risk results from risk factors that have effect on the entire market. Such factors include change in parameters of socio-economic, shift in taxation clauses, foreign investment policy, changes in investment policy, threats of global measures and security among others. On the other hand, unsystematic risk results from certain factors that affect a particular company or an industry. Such factors are product category, pricing, research and development, labour unions, marketing strategy etc. Whereas it is possible to mitigate unsystematic risk to a larger extent via portfolio diversification, systematic risk cannot be controlled by investors and thus, not mitigated to a greater extent. Systematic risks are unavoidable; hence, the market compensates for exposing investors to such risks, but unsystematic risk is avoidable. Therefore, there is no compensation from the market for exposure to such risks (Rich, Mowen, & Hansen, 2012). References Albrecht, W. S. (2011). Accounting, concepts & applications: What, why, how of accounting. Mason, OH: South-Western/Cengage Learning. Rich, J. S., Jones, J. P., Mowen, M. M., & Hansen, D. R. (2012). Cornerstones of financial accounting. Mason., OH: South-Western. Stickney, C. P. (2010). Financial accounting: An introduction to concepts, methods, and uses. Mason, OH: South-Western/Cengage Learning. Read More