The Importance Of Financial Ratios

Submitted By robinoc
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Pages: 6

Ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. "They are simple to calculate, easy to use, and provide a wealth of information that cannot be gotten anywhere else," James O. Gill noted in his book Financial Basics of Small Business Success. But, he added, "Ratios are aids to judgment and cannot take the place of experience. They will not replace good management, but they will make a good manager better. They help to pinpoint areas that need investigation and assist in developing an operating strategy for the future."
Financial analysis can be an important tool for small business owners and managers to measure their progress toward reaching company goals, as well as toward competing with larger companies within an industry. When performed regularly over time, financial analysis can also help small businesses recognize and adapt to trends affecting their operations.
Financial ratios can provide small business owners and managers with a valuable tool to measure their progress against predetermined internal goals, a certain competitor, or the overall industry. In general, financial ratios can be broken down into four main categories: profitability or return on investment, liquidity, leverage, and operating or efficiency with several specific ratio calculations prescribed within each. Profitability ratios provide information about management's performance in using the resources of the small business. Liquidity ratios demonstrate a company's ability to pay its current obligations. In other words, they relate to the availability of cash and other assets to cover accounts payable, short-term debt, and other liabilities. Leverage ratio is useful as it helps the user in determining the effects that a given level of operating leverage has on the earnings potential of the firm. The operating ratio shows the efficiency of a company's management by comparing operating expense to net sales.
Advantages of Debt Financing: Debt financing allows you to have control of your own destiny regarding your business. You do not have investors or partners to answer to and you can make all the decisions. You own all the profit you make. If you finance your business using debt, the interest you repay on your loan is also tax-deductible. The disadvantages of borrowing money for a small business are having large loan payments at precisely the time you need funds for start-up costs. If you don't make loan payments on time to credit cards or commercial banks, you can ruin your credit rating and make borrowing in the future difficult or impossible. The same is true if you borrow from friends and family.
Business usually issue stocks to raise capital. They may also sell stock to take the company public. Stocks have historically had the greatest risk and highest returns among the three major asset categories. The three major asset categories are cash and cash equivalents, fixed-income investments (bonds), and equities (stocks). When a business buys a bond, they are essentially lending that entity funds that they expect to be paid back with interest. Bonds are generally less volatile than stocks but offer more modest returns. A bond does not represent ownership in a corporation. Whereas buying stocks allows business to become an owner.
All investments involve some degree of risk. The bigger the potential investment return, the higher the investment risk and the longer the suggested investment timeframe. Research shows that financial risk can be thought of in terms of five factors or dimensions: Credit risk refers to the possibility that your initial investment will not be repaid and/or promised return will not be received, due to default by the entity in which you invested. Term risk arises when you invest long term in a fixed interest investment and the value