Examples on calculation and interpretation of Financial Ratios.
The relation between the absolute values of sales, costs, expenses, assets, liabilities and equity is important in understanding the financial position of a company and its likely performance in the future. Their absolute values per se do not provide much light on how financially strong or weak is the firm and of any risks inherent to its performance.
That is why the use of ratio analysis or “relationship analysis” becomes important in measuring the performance in sales and of the efficiency in using assets, own capital or other people’s money such as creditors and long term lenders.
The two retail companies below have the following Income Statements and Balance Sheets at the end of their third year of operation. Net profit for both companies have remained equal to zero in the first two years of operation, thus equity has remained with the same value than at the start of operation after these two years. Net Profit in the third year is equal for both firms, 36,000.
Opening equity is 125,000, for both companies. Drawings by shareholders were 16,000 in both companies.
In order to boost sales Company A offers 60 days credit to their buyers.
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