Essay about Understanding the Concepts

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Understanding the Concepts

The main financial ratios that are useful to a small business include profitability and efficiency ratios. The financial ratios which fall under profitability ratio are: gross profit margin, operating profit margin, and the return on capital employed. Gross profit margin indicates a business’ ability to manage the margins it makes on the goods it buys and sells. Operating profit margin indicates a business’s ability to control operating costs or overheads. Return on capital employed indicates the returns (profitability) that a business has made available before making any distribution of the returns. Efficiency ratios give insight into how efficient the business is employing the resources invested and include sales/capital employed ratio, stock turnover, profit/fixed assets ratio and credit given/creditor-days ratio (Bodie, Alex & Alan, 2004). Although the above ratios can be useful to large businesses, there are specific categories of ratios that are of more importance to bigger businesses. These ratios include gearing ratio, interest cover, earning per share, price earnings ratio and dividend yield. These ratios focus on the long term financial health of big businesses (Houston & Brigham, 2009). In particular, the gearing ratio measures the proportion of assets that are financed by borrowing. A higher level of borrowing indicates higher risks for the business. Interest cover measures the ability of a business to manage its debts in due time. Earnings per share ratio indicates the overall profit generated for each share that has been in existence over a particular period of time, while price-earnings ratio is a measure of how highly the market rates or values the business. Lastly, dividend yield, also called payout ratio provides a guide on the ability of a business to maintain its dividend payments (McNeil & Embrechts, 2005).

The main advantage of debt financing is that it allows a business to pay for new fixed assets such as buildings, equipment and other assets that can be used to expand the firm before it starts to earn necessary profits. This can be a good way to pursue growth strategies especially when there is access to low interest rates. Another advantage of equity financing is that it allows the business to pay off debts in installments over a long period of time. In addition, the business benefits by not relinquishing the ownership of the business to the financiers. A major disadvantage of equity financing is the loan has to be repaid plus interest; otherwise assets may be repossessed by the financier. Secondly, overreliance on debt financing can severely limit future cash flow and hence stifle growth (Horcher, 2005). Most companies may resort to issuing stocks rather than bonds as a source of financing. A major advantage of issuing stocks is that this system of financing allows funds to be kept indefinitely. Secondly, no payments are required on the funds (dividends may be paid out but only on earnings). Lastly, no collateral security is required on funds raised through stocks. The greatest disadvantage of issuing bonds is interest payments. A company must pay competitive interest on bonds so as to attract investors. Moreover, since the bond must be repaid, a business may not have sufficient funds when the bond comes due. A business’ inability to refinance maturing debt can jeopardize its operations (Houston & Brigham, 2009).

In any investment, risk refers to the uncertainty of the returns expected from the investment. Equity financing present risks to shareholders that projected profits might not be met. Similarly, debt financing presents risks to debtors that the company might default on the debt if it makes losses (Houston & Brigham, 2009). Generally, the relationship between financial returns and risks is positive or direct meaning that if there are higher levels of risks associate with a particular
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