Impact of Financial Ratios and Financing Constraints on Firms
Importance of financial ratios and financing constraints on modern business. The target audiences of this paper are investors looking for financial investment options and small business firms seeking growth. Therefore, the article and information might be contained in a financial magazine such as wall street journal. The goal of this paper is to inform audiences on the important financial ratios, and how they are important in determining whether a company is worth investing in or not. Any business owner will want to find out the performance of his or her company in order to make informed management decisions.
In addition, an investor will want to have accurate financial position of any business firm for investment decision processes. In this regard, business organizations and financial analysts use a variety of analytical tools that are aimed at comparing the existing relative strengths and weaknesses of their businesses. These basic tools and techniques have enabled the investors as well as the analysts to develop fundamental analysis systems (Butzen & Fuss, 2003). Therefore, ratio analysis was developed as a tool that established the functions of quantitative analysis in the financial statement numbers. These ratios link the financial statements and determine figures that are comparable between sectors, companies, and across industries. Therefore, financial ratios have a significant financial analysis technique that is used for comparative analysis.
Financial Ratios and Business Growth
Small and growing business firms use financial ratios to determine how their businesses perform. A significant financial ratio is the activity ration that is used in measuring how companies are efficient in utilizing their assets (World Bank, 2005). Therefore a negative ratio will force a company or an organization to either increase or decrease their assets or liabilities. These ratios are widely used by investors who can easily check out the overall operation of a prospective company for investment decisions (Harrison et al, 2002). If the overall performance of a company is determined to be poor, a company may lose investor confidence and as a result, lose business.
In addition, activity ratios are deemed to be turnover ratios that are associated with a balance sheet line item and an income statement line item. Generally, income statements are used for measuring the performance of any company, but for a specified period of time. However, the balance sheet provides data for a specific point in time. The advantage of using activity ratios is that they are able to give an average figure between the two financial statements. This means that companies or organizations are able to determine the rate of turning over their liabilities or assets. This helps the companies to control their receivables or inventories per year (Harrison et al, 2002).
Moreover, there are inventory turnovers that are used in the management effectiveness of any business organization (Butzen & Fuss, 2003). This ratio is determined when the cost of goods sold is divided by the average inventory. In this regard, a company is able to know whether its inventory is sold at a higher rate, when the turnover is recorded to be high.
This ratio is then significant in giving companies signals for inventory management effectiveness. In addition, this kind of inventory ratio communicates that there are less resources which are tied up in the company’s inventory (Butzen & Fuss, 2003). However, it is also important to understand that an unusually high turnover means that the company’s inventories are too lean. Consequently, the management discovers that the company may be ineffective in keeping up with the demand that is increasing (Harrison et al, 2003). Therefore the management is forced to act swiftly in adjusting the company’s operations to fit a favorable inventory ratio. Investors are keen in checking out companies with high inventory turnovers since it means that that specific industry gets stale quickly, thus an attractive investment option.
Another significant financial ratio is the receivables turnover ratio, that enables a business organization determines how fast it collects the bills that are outstanding (Harrison et al, 2002). This specific ratio determines the effectiveness of any company credit policy towards its customers. In this regard, negative receivables will force a company to have stringent credit policies that are aimed at ensuring that bills are collected as easily and fast as possible (Butzen & Fuss, 2003). This particular ratio is achieved by dividing the all the net revenues with the average receivables. In this case a company is able to know how many times per financial period, it is able to collect all its outstanding bills and have the cash used in the operations of the business.
However, it is important for a prospective investor to understand that a high turnover does not only indicate that the company is operating in the best interests of its customers. A high turn over may also indicate that the business company policies are too stringent and thus the company is missing out on sales opportunities to its competitors (Harrison, et al, 2002). Alternatively, a low turnover or which is seen declining means that the company’s customers are struggling with the credit policy that is set out by the company and thus are having trouble paying their bills. In this regard, this turnover ratio is very significant when any company is developing its credit policy.
Creditors are able to measure how effective companies are in paying off their financial obligations, when determining whether to extend their credit facilities to them. The financial ratio that is used in this case is the liquidity ratio, that helps establish any company’s ability in meeting its financial obligations usually short term financial obligations (Harrison et al, 2003). However, it is important to understand that the level of liquidity is not standard and thus varies from different existing industries. One example is a business that runs a grocery store; this business entity, usually demands cash on a regular basis in order to run its business operations. In contrast, a technological run store will need less operational cash in the daily running business operations. In addition, every business has its own unique trend over the liquidity ratio that is recorded over a financial period.
When a company wants to expand its business operations, it is the ideal option of seeking long term financial services. In this regard, a company is able to measure or determine its payback ability by calculating its solvency ratio. This is an important financial ratio that either allows a company to get long-term financing or to stay steer on it. This ratio is able to do this because it provides an insight to the capital structure of any company as well as its existing financial leverage that is being used by a firm (Butzen & Fuss, 2002). In the recent years, investors use the insolvency ratio in determining whether firms have adequate cash flows that are important in paying fixed charges or even the interest payment. Therefore, a company that presents low cash flows is deemed to be overburdened with its debts. In this scenario, investors may opt out and the company’s bondholders are likely to push the company into default.
Ratios are an important tool of making profitable financial decisions from any angle, whether as an investor or as a business firm. All these financial ratios have their own distinct impact of firms and business organizations. They present financial constraints that may hinder firms from accessing venture capital or financial aid from companies. In addition, other constraints may include rising interest rates as well as inflation (World Bank, 2005). Therefore, it is very stringent for companies strive in building contingencies in their cash flow budgets that are important in dealing with such adverse changes that may occur in the financial environment. In addition, it will be a bad idea for any start up firm to rely fully on loans from financial institutions such as banks or funding from venture capitals for their business plans (World Bank, 2005). This is because there could be a rise of financial constraints that would be unfavorable for the company. A financial constraint such as inflation could mean that raw materials or labor costs may consequently increase to higher levels causing such start ups to close business.
Butzen P., Fuss, C. (2003) Firm’s Investment and Finance Decisions: Financial Ratios Theory and Practice. New York: Routledge
Harrison, A., McMillan M., & Love, I. (2002). Global Capital Flows and Financing Constraints. New York: Rowman & Littlefield Publishers.
World Bank. (2005). Financial Ratios in the Finance Sector: A Handbook. New York: International Monetary Fund.
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