- What financial ratios are important to a small business?
A small business man must understand that financial ratios are important in measuring the business’ activities against benchmarks (i.e. similar firms or competitors). According to the Frank Cocker (2011) small companies tend to overlook the use of financial ratios principally because of the calculations involved are cumbersome. Large businesses on the other hand use financial ratios because it is one very good tool necessary for managing business performance. There are many financial ratios that are available to use but for small businesses, the more important basic ratios are:
- Accounts Receivable Days (or Days Receivables)
A small business will rely mostly on a small set of customers. The AR Days is a financial ratio that tells the business man how many days in average his revenues are tied up to receivables (sales made but without payment). The ratio indicates how many days of revenue are tied up so a higher AR Days would indicate that more of the business’ revenue remains unpaid. The length of time that revenues are tied up is a management prerogative, usually because clients are given a bit of an allowance for payment (say, 15 to 30 day terms) and managers are aware of how long they can put out and still be able to produce the products to sell while still having the cash necessary for expenses (i.e. payroll, etc.).
- Debt to Assets
This financial ratio indicates the amount of debt that the business has acquired to finance its operations or the purchase of new capital equipment necessary for continuing business operations. A lower Debt to Assets ratio indicates more debt is used by the company. The level of debt is either good or bad since the manager should know how much debt he could use and still be able to pay for interest payments because of the debt.
- Quick Ratio
The quick ratio measures the amount of current assets over the current liabilities of the company. If a company is financing its operations using debt then it could face the problem of having too much short-term debt that may hamper operations. A small Quick Ratio means there are more short-term debts that cash and equivalent assets and this may be a bit problematic since the company may not have enough cash to cover its other obligations.
- Explain the advantages and disadvantages of debt financing and why an organization would choose to issue stocks rather than bonds to generate funds.
A business will likely require additional funding sources. One way of raising capital is to borrow money. Money can come from friends, relatives, associates and it could come from more formal funding institutions such as banks. When money is borrowed from banks, it is called Debt. Debt financing allows the business man the ability to upgrade or expand his company at his own pace, given certain levels of required profitability and efficiency. However, debt financing will mean that the business owner pay for interest on the debt he acquired. While this is a negative side, it has a positive aspect as well since interest’s payments provide a “shield” again income tax payments. Another benefit of using debt is that the lender will not take any part of the profits made by the company and will be contented with the receipt of interest payments and a portion of the principal amount borrowed. The business owner is the sole recipient of the profits.
There are of course, disadvantages to using debt such as paying for interest payments, there is a risk of bankruptcy if the business cannot generate funds enough for payment of the loans such that the bank will forcibly get all the assets of the company. If a manager is the owner of the business, even his personal assets can be taken away to pay for the loan if the company does not turn any profit and gets bankrupt.
There are other ways of raising capital. Some companies issue stocks which paper documents are saying that the holder owns a portion of a company. Bonds on the other hand, are paper documents that are issued to the public saying that the company owns them money and will be paying them at a specific point in time. Companies issue either stocks or bonds but most usually issue stocks for raising capital since the buyers of stocks drive the value of the company up and they do not require payment for their investments immediately.
- Financial Returns and Risks
Risks and returns go hand in hand in business. A business will have returns based on the revenues it will generate. Constantly the business will be threatened and these are risks that the entrepreneur must be willing to shoulder. Therefore the manager of the business should always expect that the returns or results of the business will be different from what is expected. This is the technical definition of risk. Years of empirical studies show that if a risk is small for a certain investment, the returns are low. On the other hand, if risks are high the returns are high as well. This is counter intuitive and is known by any smart investor. In addition, the smart investor knows that managing risks is the first thing to do. Whether these risks are internal to the business or external meaning there is a lot of environmental factors that may affect the business and the business manager or owner must be ready for it.
- Describe the concept of beta and how it is used.
Beta is the number of the stock portfolio that describes the portfolio’s volatility. To determine its volatility it is normally associated with a financial benchmark, usually the overall financial market’s performance or some particular index related to the stock portfolio. For example, the beta of a power company will be compared with the beta of the portfolio of power companies in the world. The beta of a company could be between zero (0) meaning it moves in the opposite direction of the portfolio to more than 1 meaning it is highly volatile.
- Contrast systematic and unsystematic risk.
Business risks can be categorized as systematic or unsystematic. Systematic risk is the risk that is due to external factors that affect any organization. Because these are factors that are known to the organization but are external these factors are to a certain degree uncontrollable. These risks are macro-economic thus they influence not just the company but other companies as well. For example, systematic risks include
- Interest rate risk.
- Market risk.
- Purchasing power or Inflationary risk.
On the other hand factors that influence the business from the inside (internal) are called unsystematic risks. These risks, because they are internal can be controlled by different organizations. Unsystematic risk is not a macro-economic nature thus organizations can plan, react and address systematic skills such as:
- Business or liquidity risk.
- Financial or credit risk.
- Operational risk.
- Imagine your manufacturing corporation has just won a patent lawsuit. After attorney and other fees, your corporation will have about $1 million. Explain how you plan to invest the money in order to diversify the risk and receive a good return. Support your decisions with concepts learned in this course.
If I were the manager in this case and because I am not a very risk averse person, I will take the $1 million and purchase capital assets that would make my manufacturing better (more efficient) and more profitable. I suppose the patent lawsuit is for a new innovative design and since I have won the lawsuit and have been awarded money, I will use the money to further that contentious design, test the product and then push it to be sold in the market. That I believe would be the best example of managing risks, investments and corporate responsibility because I have demonstrated shareholder wealth maximization and guaranteed returns by doing so.
References
Akrani, G. (2012). Systematic and Unsystematic Risks. Retrieved from http://kalyan-city.blogspot.com/2012/01/types-of-risk-systematic-and.html
Coker, F. (2010). 3 Ratios Every Business Needs to Monitor. Retrieved from http://www.coreconnex.com/2010/03/30/3-ratios-every-business-needs-to-monitor/
Investopedia (2013). Risk and Returns. Retrieved from http://www.investopedia.com/university/concepts/concepts1.asp#axzz2MOlFk7hO
Peavler, R. (2013). Debt and Equity Financing: The Advantages and Disadvantages of Debt and Equity Financing. Retrieved from http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm
Little, K. (2013). Using and Misusing the Beta Ratio. Retrieved from http://stocks.about.com/od/evaluatingstocks/a/beta120904.htm
