Ratio Analysis and Equity Valuation

Questions: 1: Explanation of the main financial statement of a business? 2: Comparison of the financial statement of Sole trader and Public limited company? 3: Interpretation of financial statements using ratios? Answers: Introduction The paper provides an overview of the main financial systems that are produced by the business. A comparison of the financial statement of a sole trader and a public limited company has been provided. A comparison of the financial statements using financial ratios has been conducted (Fridson and Alvarez, 2002). 1: Explanation of the main financial statement of a business The major financial statements that are produced by a business are discussed below. 1. Balance sheet The financial position is interpreted by the Balance sheet. It has the following components. Assets: The assets are entities that are owned by the business. It includes plant and machinery, land and building, inventory. Liabilities: The liabilities are the entities that a business owes to someone. It includes bank, loan, and creditors. Equity: It represents what the business owes to the owners. The difference between assets and liabilities are represented by equity. 2. Income statement The financial performance of the organization is represented by the Income statement. It comprises of the following components. Income: The earnings of the business over the period of time are represented by the income statement. It includes dividend income, sales revenue. Expenses: The costs that are incurred by the business over the period of time is represented by the expenses. It includes wages, salaries and depreciation. 3. Cash Flow statement The movement of cash and the bank balances over the period of time is represented by the cash flow statement. It comprises of the following segments which are investing activities, financing activities and operating activities. 4. Statement of the changes in Equity The movement of the owners equity over a period of time is represented by the statement (Houmes and Chira, 2015). 2: Comparison of the financial statement of Sole trader and Public limited company The business of a sole trader is fairly small and it is easy to understand the financial statements of a sole trader. The public limited company is a legal entity that is separate from owners. The owners of the organization are referred to as the share holders. The balance sheet of a sole trader has a capital account while the balance sheet of a public limited company has a capital and reserves section. The sole traders start their business with the personal capital. The sole trader with draws the money from the business for personal reasons. This is deducted from the capital account and it is shown in the drawings section of the balance sheet. The balance sheet of a public limited has various sources of capital. The shareholders funds are shown in the liability side which is not shown in the balance sheet of the sole trader. The shareholders of a public limited company are paid dividend. This is shown in the section of current liabilities while there is no such amount shown in the balance sheet of limited company. The financial statement of a sole trader does not follow any Companys Act while the financial statement of public limited company is based on the Companys Act (Nissim and Penman, n.d.). 3: Interpretation of financial statements using ratios Gross profit margin Manufacturing Wholesale Gross profit margin 25% 47% Gross Profit 10,400.00 12,430.00 Sales 40,870.00 26,540.00 The gross profit margin for the manufacturing company is 25% while it is 47% for the wholesale business. The gross profit margin indicates the ability of the company to draw profit from the total sales. The gross profit margin for manufacturing firm is lower than that of the whole sale business. Net profit margin Manufacturing Wholesale Net profit margin 14% 11% Net Profit 5,850.00 2,950.00 Sales 40,870.00 26,540.00 The net profit margin indicates the ability of the company to earn profit from the sales after deduction of the expenses. The net profit margin for the manufacturing company is 14% while the net profit margin for whole sale company is 11%. The net profit margin of the whole sale company is lower than the manufacturing company as the expenses of the whole sale company is higher than the manufacturing company. Current ratio Manufacturing Wholesale Current Ratio 1.287179487 1.71864407 Current Assets 2510 5070 Current Liabilities 1950 2950 The current ratio represents the ability of the company to repay its short term obligations. The current ratio for manufacturing firm is 1.28:1 and the current ratio for Whole sale is 1.71:1. The ideal current ratio is estimated to be 2:1. It is seen that both the companies are able to meet their short term obligations. Quick ratio Manufacturing Wholesale Quick Ratio 0.046153846 0.91525424 Current assets 2510 5070 Inventory 2420 2370 Current liabilities 1950 2950 The quick ratio represents the ability of company to repay its short term obligations without using the inventory. The repayment of the liabilities is done by liquid cash. It is seen that the quick ratio for the manufacturing and the whole sale business are quite low. However the quick ratio for the manufacturing firm is much lower than the whole sale business. Gearing ratio Manufacturing Wholesale Gearing ratio 40% 37% Long term Liabilities 2000 3170 Capital employed 5000 8670 Gearing ratio 40% 37% The gearing ratio for manufacturing sector is 40% while that of whole sale is 37% (Peterson Drake and Fabozzi, 2012). Conclusion The paper has highlighted the major financial statement. They are the income statement, balance sheet, cash flow statement and changes inequity. A comparison of the financial performance of the two companies by ratio analysis has been done. References Fridson, M. and Alvarez, F. (2002).Financial statement analysis. New York: John Wiley Sons. Houmes, R. and Chira, I. (2015). The effect of ownership structure on the price earnings ratio returns anomaly.International Review of Financial Analysis, 37, pp.140-147. Nissim, D. and Penman, S. (n.d.). Ratio Analysis and Equity Valuation.SSRN Journal. Peterson Drake, P. and Fabozzi, F. (2012).Analysis of financial statements. Hoboken, N.J.: Wiley.