Unit_4_Financial_Statements___Ratio_Analysis

UNIT 4: FINANCIAL STATEMENTS & RATIO ANALYSIS

4.1 FINAL ACCOUNTS

Preparation of Final Accounts: The last phase of the accounting process to determine the profitability and financial position of a business entity. The preparation of final accounts is essential for stakeholders to understand the overall financial health and operational effectiveness of the business.

Final accounts consist of the following for non-manufacturing businesses:

• Trading Account: Reflects the direct revenues and costs associated with the trading activities.

• Profit and Loss Account: Summarizes all incomes and expenditures to ascertain the net profit or loss.

• Balance Sheet: Provides a snapshot of the business's financial position at a specific point in time by listing its assets and liabilities.

4.1.1 Introduction

Purpose: Final accounts serve to accumulate accounting data, allowing stakeholders to determine profit or loss, assess the company's performance over a certain period, and present a clear financial status of the business.

Final Accounts provide summarized statements aggregating various accounting transactions and presenting detailed financial information including:

• Gross profit: Indicates the profitability from sales after accounting for the cost of goods sold.

• Net profit: The actual profit remaining after all expenses, taxes, and other costs are deducted.

• Current financial position: A crucial snapshot showing a business's assets versus its liabilities, guiding investment and financing decisions.

4.2 TRADING ACCOUNT

Purpose: A key document to calculate gross profit or loss from trading activities, thereby giving insights into business operations' efficiency.

Components of Trading Account:

• Dr. Side (Debit): Includes items that increase the cost:

  • Opening Stock: The value of unsold goods at the beginning of the accounting period.

  • Purchases: All goods acquired for resale during the period.

  • Direct Expenses: Such as wages and carriage directly related to production or sales.

• Cr. Side (Credit): Includes income:

  • Sales: Total revenue generated from the sale of goods.

  • Closing Stock: Value of unsold goods at the end of the accounting period.

  • Gross Profit: Present when the credit side exceeds the debit side (Gross Loss occurs otherwise).

4.2.1 Need and Importance of Trading Account

• Displays gross profit or loss, facilitating financial comparison and planning for future transactions.

• Summarizes direct expenses, thus aiding business owners in effective cost control and budgeting.

• Enables comparison of closing stock with previous years to monitor inventory levels and turnover.

• Assists in identifying potential losses through a review of profitability ratios, enhancing profitability management efforts.

4.2.2 Preparation of Trading Account

• The preparation involves detailing all purchases, sales, and associated direct expenses to yield clear insights into trading efficiency and effectiveness.

4.3 PROFIT AND LOSS ACCOUNT

Purpose: To ascertain the net profit or loss, reflecting all business expenses and gains not included in the trading account. This account is crucial for understanding the comprehensive financial performance of the business.

Components:

• Direct Expenses: Directly related to production.

• Indirect Expenses: Including operating, interest, administrative, and other expenses not directly tied to production activities.

• Net Profit Calculation: It’s calculated as net income remaining after deducting all types of expenses from total income.

4.4 BALANCE SHEET

Purpose: Provides a snapshot of the financial position at a specific point in time, encapsulating assets and liabilities to reflect the company's net worth.

Importance:

• Assesses company solvency, critical for creditors and investors.

• Aids in future financial planning and managing liabilities efficiently,

• Components:

  • Assets: Divided into Current (cash, inventory) and Fixed Assets (property, machinery).

  • Liabilities: Current (due within a year) and Long-term (due after a year).

4.5 LIQUIDITY RATIOS

• Current Ratio: Indicative of a company's ability to cover short-term liabilities. Formula: Current Assets / Current Liabilities. Example: If current assets = 450,000 and current liabilities = 150,000, the Current Ratio = 3.0.

• Quick Ratio: A more stringent measure of liquidity. Formula: (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities. Example: If current assets = 550,000 and current liabilities = 100,000, Quick Ratio = 4.5.

4.6 PROFITABILITY RATIOS

• Gross Profit Margin: Calculation of efficiency in sales after accounting for the cost of goods sold. Formula: Gross Profit / Total Revenue. Higher percentages indicate an effective sales strategy.

• Net Profit Margin: Reflects overall profitability. Formula: Net Income / Total Revenue.

• Return on Assets (ROA) and Return on Equity (ROE): Metrics indicating how effectively a company is utilizing its assets or equity to generate profit growth.

4.7 EFFICIENCY RATIOS

• Inventory Turnover Ratio: Evaluates how effectively inventory is managed. Formula: COGS / Average Inventory.

• Receivables Turnover Ratio: Measures the efficiency in collecting debts. Formula: Net Credit Sales / Average Accounts Receivable.

4.8 LEVERAGE RATIOS

• Debt-to-Equity Ratio: Measures financial risk due to debt usage. Formula: Total Liabilities / Shareholder Equity.

• Debt-to-Asset Ratio: Shows proportion of assets financed by debt. Formula: Total Liabilities / Total Assets.

4.9 MANAGEMENT ACCOUNTING

Involves rearranging and analyzing financial data for informed decision-making. Analytical tools comprise of ratio analysis, trend analysis, comparative statements, and others, enabling companies to evaluate their operational efficiency and financial strategies.

4.10 PREPARATION OF FINANCIAL STATEMENTS

Illustrates the methods for representing financial data, namely vertical and horizontal formats, catering to different analytical needs. Importance of analysis and interpretation of financial data for assessing firm performance, guiding investment decisions, and ensuring financial robustness.

4.11 TREND ANALYSIS

Provides predictive insights into financial trends over several periods, crucial for stakeholders in identifying areas of strength and potential concern, enabling timely adjustments to strategy and operations.