Final answer:
Liquidity ratios, such as the current ratio and quick ratio, are used to assess a company's ability to meet its short-term financial obligations. They compare current assets to current liabilities and are critical for evaluating a firm's financial health. These financial tools are crucial for companies, especially during early stages or when they plan to expand.
Step-by-step explanation:
The ratios that help assess a firm's ability to meet its cash needs as they arise are known as liquidity ratios. These ratios measure the capacity of a company to cover its short-term liabilities with its short-term assets. The most commonly used liquidity ratios are the current ratio, which is the ratio of current assets to current liabilities, and the quick ratio (or acid-test ratio), which takes the current assets minus inventories divided by current liabilities.
For example, Fred purchases a new home for $200,000 with a 10% down payment, and the rest financed through the bank. His immediate equity in the home would be the down payment. Therefore, Fred's equity would be $20,000 (10% of $200,000).
During the early stages of corporate finance, small companies tend to raise money from private investors rather than through an Initial Public Offering (IPO) due to the high costs and regulatory requirements of going public. When companies establish themselves slightly and need capital for expansion, they may prefer an IPO over debt to avoid interest payments and to gain market exposure. Venture capitalists typically have better information about the profit potential of a small firm compared to a potential bondholder, largely due to the hands-on involvement and due diligence performed during the investment process.
From a firm's perspective, a bond is similar to a bank loan in that both are methods of raising capital and require the company to make regular interest payments. However, bonds are traded on the market and can be bought by multiple investors, whereas a bank loan is typically held by a single creditor. Additionally, bonds may have a more extended payment period and may have tax advantages over loans.