Question

Mark and Amanda are having the following conversation:

Mark: How can you compare the financial positions of businesses?

Amanda: You can look at the Balance Sheets of businesses.

Mark: Hum……are the measurement bases of Balance Sheet items identical for all businesses?

Amanda: not sure…..

Requirement:

Explain possible reasons (with two examples) of how items in the Balance Sheets of similar businesses may be measured differently?

Answer 1

One of the most effective ways to compare two businesses is to perform a ratio analysis on each company's financial statements. A ratio analysis looks at various numbers in the financial statements such as net profit or total expenses to arrive at a relationship between each number. To ensure accuracy, it is usually best if both statements have been audited by a certified public accountant, or CPA.

Methods:

1

Ensure that both financial statements have been audited or at the very least prepared by a neutral, third-party accounting firm, to help ensure the integrity and accuracy of the reported numbers. Also, verify that the numbers reported are from the same accounting period such as January through December.

2

Compare the statements such as the profit and loss to see if the results are reported in a similar fashion. For example, net sales are usually reported as gross sales, less customer discounts, whereas some companies report net sales as gross sales, less discounts, and cost of goods sold. If this is the case, you’ll need to adjust one statement so that it matches the reporting method of the other statement.

3

Perform a ratio analysis on some of the key components of the statements. There are many types of ratios, but some of the most important include the net profit ratio and the return on assets ratio. The net profit ratio is arrived at by taking the net, pre-tax profit shown near the bottom of the profit and loss and dividing it by the nets sales. For example, if net pre-tax profit is $100,000 and net sales are $200,000, the net profit ratio would be 50 percent ($100,000 divided by $200,000.) The same ratio should be performed both statements. The other important ratio is the return on assets ratio. This is determined by dividing the net, pre-tax profit by the total assets shown on the balance sheet. This ratio helps determine how profitable a company’s operation is based on its own assets, such as cash, machinery and real estate.

4

Compare the various ratios of each company to see which is more or less profitable or efficient in its operation. You should consult with a CPA or financial analyst to help you with the comparison. If the businesses are dependent on large machinery in their operations, look closely at ratios that focus on assets. If the business relates more on commission- sales based on service, look closer at payroll to sales-related ratios.