Ratio refers to a comparison between two variables, ratios is an important component in day to day business as it enables the shareholders and other stakeholders to check the performance of business in comparison to the previous year’s which refers to trend analysis it can also be used for cross sectional analysis which involves comparing the performance of business with other business within the same industry. Other financial ratios such as liquidity ratio plays a very important part in managing working capital in that a business will be able to predict the cash required to manage day to day transactions, in overall ratios enables one to have a clear image of how the business is performing.
As a matter of fact, financial ratio are important to all businesses irrespective of their sizes though there are some ratios which apply more effectively in a small business set up compared to a large corporate .As a small business owner the most important financial ratios will include:
Accounts receivable turnover ratio =net credit sales
Average trade debtors
Where average trade debtors is equal= opening debtors + closing debtors
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This ratio indicates the number of times debtors are turn over during a given year, such that if the ratio is high it means that debtors have been managed efficiently implying better liquidity (Groppelli & Nikbakht, 2006). These means that the small business owner can manage his business well since cash flows will be sufficient to cover day to day operations on the other hand if the ratio is low it means inefficient management of debtors and poor liquidity since capital is tied up for a longer duration.
Quick ratio which is the ratio of current assets divided by the current liabilities the ratio shows how well operations are funding the cost of doing business such that if the ratio is small it means that the business is incurring more debts to finance operations.
Gross profit margin =gross profit/sales these ratio measures the performance of the business in terms of the profit it has made as a proportion of the total sales such that the higher the margin the better the performance of the business and vice versa is true.
Net profit margin=gross profit-expenses/sales these ratios also measure the performance of the business , it’s much better for measuring business performance since all expenses are deducted from the profits then divided by sales, the higher the ratio is an indication of better business performance .
Debt to asset ratio =total debts/total assets it indicates the proportion of debt which finances the business the higher the ratio it means the business is highly financed by debt which is very risky as it can easily become insolvent.
Large corporations due to their nature and size of business will mean that the stakeholders are many and in most cases the ownership of the corporations is through share purchase, the relevant applicable ratios include:
Earnings per share ratio=net earnings/number of shares, these ratio indicates the earnings a shareholder will receive from his/her investment such that a high ratio will imply better earnings by shareholders.
Payout ratio=dividends/earnings, it indicates the amount of earnings paid as dividends such that a high ratio is an indication of better business performance.
Debt equity ratio=total debts/total equity it indicates the proportion of total debts to the total equity used to finance the business such that a high ratio would mean that the company is highly financed by debt which is risky on the other hand a lower ratio indicates that the company is mostly financed by equity(Groppelli & Nikbakht, 2006).
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Return on asset=net income/average total assets, it measures the efficiency with which the assets have been used efficiently to generate revenue; a high ratio indicates more efficiency in the use of asset to generate the revenue.
Return on equity=net income/total equity ,it measures the efficiency with which owners equity is used to generate revenue for the business and a high ratio is an indication of better performance in terms of efficiency.
Return on investment=earnings before interest and tax/capital employed, these ratio measures the efficiency of investment in generation of income.
Debt financing in essence is financing a business using debt, this debt can come in various ways such as selling bonds or borrowing funds from financial institutions, virtually all businesses in the world do have some level of debt financing irrespective of the size and nature, these is because debt financing as its share of advantages and disadvantage.
Advantages of debt financing include: Ownership is maintained, in that once you borrow from a financial institution you are obligated to make payments as per the terms of contract as agreed, and it ends there and as the owner you can now run the business the way you want it without any interference as compared to equity financing where decisions are made by the board not an individual.
Tax deductions advantage, in most cases the interest and principal payments on debts are classified as business expenses meaning that its deducted from the profits before tax is applied, these means that the business will save a lot on tax since the amount of profits to be taxed will go down implying low tax paid by the business (Groppelli & Nikbakht, 2006).
Lower Interest Rate paid on the debt is tax allowable these will mean that the business will end up paying lower interest rate due to the tax relief. Debt financing is also important in improving the credit rating of small businesses, these is because if business takes loans and repays the loan as stipulated in the contract then there is a higher chance for the same business to obtain more loans in future since their credit ratings is good. Debt financing is also easy to administer compared to equity financing which as complex reporting requirements.
Disadvantages of equity financing include:
The main obligation under debt financing is to repay the loan however its very unfortunate since even if your business collapses or is making losses you have to repay your installments as required, furthermore if the business is forced to bankruptcy your lender will reclaim their repayments first before any equity investors (Groppelli & Nikbakht, 2006).
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Debt financing is expensive in the long term even with tax allowance debt financing is still more expensive compared to equity financing furthermore the interest rate is subject to changes in the macroeconomic environment, hence unpredictably.
Regular cash flows will be required to meet both interest and principal repayments these will imply that the business should always maintain good liquidity positions to cover all the monthly periodic payments in addition most of the debt financing will require some form of collateral to act as security in case of default, these is a challenge since most start up business don’t have collateral ,finally it brings with it some restrictions in that if a business is highly indebted it’s hard to be given additional debt by a financial institutions (Groppelli & Nikbakht, 2006).
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An organization will choose to issue stocks than bonds to generate funds due the fact that the organization may not be liquid enough to enable it pay the periodic principal and interest payments if its financed by bonds and will opt to be financed by stocks since the shareholders’ funds will be converted to shares which does not require any periodic payments. It has also been noted that an organization financed by equity is more likely to expand compared to an organization financed by bonds due to the large pool of shareholders who are ready to see to it that the organization grows.
How financial return is related to risk
The relationship between risk and return is such that the higher the risk, then the higher the chance of earning a high return and vice versa Is true so investors who take a high risk are likely to earn high returns compared to risk averse investors. Financial returns come in different forms profits, increase in share prices, increase in revenues all these returns come at a cost called risk so when an investor is making an investment decision he has to trade off between the risk and the possible return from the investment, an investor can decide to trade off the high risk with high return expected in such a circumstance it’s not obvious that since he has incurred high risk he will earn a high return it’s not always that way the investor may end up losing everything. in particular reference to security market which is a market where securities are traded risk forms the basis of nearly all the transactions in the stock market, the components of a security market includes:
Stock exchange refers to stock markets around the world where the securities are traded and are generally classified as national and regional, as well as over the counter markets. Stocks: represent ownership of shares in a particular company which is trading in the stock exchange Brokers: refers to the persons who buys and sells securities on behalf of the investor who in these case refers to the person who owns these stocks
So in a given security market risk each an everyday phenomena since investors will be buying stocks believing that the share prices will go up then sell and make a margin these is not always the case since there are many macroeconomic factors influencing the pricing of stocks these factors ranges from performance of that particular company to the general believe by the public. stock prices is also determined by the demand and supply factors such that high demand will most likely lead to increase in stock prices, so when an investor makes a decision to buy stocks he is risking highly cause it can come down and he makes a loss vice versa is also true, however there are some set of investors who completely fear risk and end up investing in risk free assets such as treasury bills and bonds whose risk is nil tough with a very low return.
Beta is the measure of the risk of a security; it’s used in the capital asset pricing model, a model which is used in calculation of the expected return of stock based on market return and beta coefficient. If beta is 1.0 then it indicates that the security price will move with market, a beta less than one means that the security will be less risky than the market while a beta greater than 1 is an indication that security will be more volatile than the market. The basic idea behind capm model is that the investor must be compensated for the risk he takes which is measured by beta and also for the time value of money since the funds invested could have been earning a risk free rate if it was invested in treasury therefore the investor should earn more tom make worthy. As much as better is vital component in determining the return of a security it has its own limitations such as the fact that it doesn’t incorporate new information and past price changes is a very poor indicator of future prices.
Systematic risk refers to risk brought about by external factors, that is those factors beyond the control of people working in the market, this kind of risk is compensated by the risk free rate on the other hand unsystematic risk is risk brought about by factors which are controllable by people working in the market these kind of risk is compensated through risk premium
I will diversify the one million dollar in such a way that the return will be high even if the risk is low, I will invest part of the money in stocks of two blue chip companies which operate in different industries for example one in construction and the other one in food industry and since such companies are stable I will be re investing the yearly dividends so as to increase the shares of the company in the blue chip companies the fact that the companies are operating in different industries will assist in hedging risk in that the risk in construction company which is likely to be higher will be hedged by food company which is likely to have a lower risk. I will also reinvest part of the money in the existing business to drive up growth and be able to challenge big competitors I will do these through improving the quality of products and services offered in addition to differentiation of these products and services, the main aim being to attract more customers in order to make more sales and consequently better returns, finally I will also invest the remaining funds in treasury where there is no risk at all to caution against the risk in earlier investments.
Reference
Groppelli, A. A., & Nikbakht, E. (2006). Finance. Hauppauge, N.Y: Barron's.
