Question

a. Explain the difference between Profitability Ratios and Current Ratios. If you could only see one or the other when analyzing a business which would you choose and why?

b. Explain the difference between Equity Financing and Debt Financing.

If you were a business owner and wanted to raise money to expand your business, would you choose Equity Financing or Debt Financing and why?

Answer 1

Qa:

Profitability ratios are ratios which shows the profitability of the business based on its operations. It include Profit margin, Gross profit margin, ROE, Return on Assets etc. These values can be used to analyse if the firm is profitable overall or can be compared with the performance of peers to understand the competitive advantage of the firm.

Current Ratio is current asset/current liability which shows the liquidity of the firm. This will comes under a broader range of ratios which are called Liquidity ratios and include Quick ratio, Cash ratio etc.

If only one type of ratio can be seen, from a investment perspective, Liquidity ratio or current ratio is important as it shows the ability of the firm to payback its short term obligations without which the firm can easily collapse. If a firm performs efficiently the profitability ratios can be easily improved and hence Current ratio will be important to make a decision

Qb:

Equity financing is the financing of capital that a company do by raising funds through issuing IPO, FPO, rights issue etc. In this method company will sell a part of their shares to the investors in an exchange for money. The advantage of the method is that there is no obligation for interest or dividend payment for the company compared to other mode of financing

Debt financing means raising capital through issuing debts in terms of bonds or taking loans from a bank. Through this the company becomes borrower and have to pay a certain percentage as interest annually for the raised capital.

If I am business owner, it depends on what business I am starting to decide which type of capital I should raise. For example if I am starting a restaurant business I can easily raise bank loans as the business have fairly stable cashflows once succeeded and I can give the restaurant as collateral to bank if worse case happens. Whereas if I am starting a startup model of business, it will be difficult for me to get any loan as the business will be in an experimental phase, in such cases its better to raise equity capital as there will not be any obligation even if the business fails.