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How Ratios Helps in Analysing the Financial Position of the Company

University: The University of Edinburgh

  • Unit No: 8
  • Level: Post Graduate/University
  • Pages: 13 / Words 3176
  • Paper Type: Assignment
  • Course Code: ACCT6007
  • Downloads: 136
Question :

This assessment will cover following questions:

  • How can annual accounts be produced in organisation?
  • Explain the use of income statement, balance sheet and cash flow statement in producing financial statements?
  • What are range of accounting ratios available to understand the financial performance of an organisation?
Answer :

INTRODUCTION

Financial accounting statement is considered to be as the summary of various accounting transactions which in turn is occurred over the specific period of the time (Granof and et.al., 2016). This study will highlight on understanding the various key terms and concepts which in turn is considered to be very relevant for understanding financial accounting statements. This study also effectively examines how the adjustments are applied within the financial accounting statements. Furthermore, this study also understands the role and limitations associated with the ratios in order to effectively analyse the business performance. Lastly, this study determines the use of ratio analysis which in turn helps in analysing the business performance.

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Examining appropriate accounting concepts and terms.

Accounting terms

Accounting is an appropriate procedure to record various financial activities which is useful in assessing the financial position of the business.

Accounting period is a span of time that tends to cover by various set of financial statements.

Business entity is referred to as the legal structure of the business where all operations will be carried out.

Financial statements are in turn referred to as reports which is prepared by the management of the organisation in order to analyse the financial position of the company for a given span of time (Jollands and Quinn, 2017).

Accounting concept

Accounting concepts is referred to as the basic assumption which in turn is based on certain rules and principles which in turn tends to work on basis of recording various set of financial business transactions.

  • Business entity concept: This means business and its owner tends to have separate legal identity.
  • Money measurement concept: Only those financial transaction are recorder in statements which can be valued and measured in monetary terms.
  • Going concern concept: This means business will carry out its operations for the foreseeable future (Cannon, 2019).
  • Accounting period concept: This means accounting transactions are recorded for ascertaining profit or loss for specific period of time.
  • Historical cost concept:It states all assets of the company are recorded at original purchase price.
  • Dual aspect concept: Every financial transaction has affects on two accounts on opposite side.
  • Realisation concept: The revenue generated from business transaction is recorded only at the time of its realisation.
  • Consistency concept: It states that, the accounting practices of the company must remain consistent for several years.

Interpretation of financial accounting statements from provided data.

Financial accounting statements of River Island clothing company represents that it is performing well in the market. Company is having a turnover of 877.7 million with the gross profits of 107.1 million. The profits and turnover of the company has shown a decrease from last year. The operating profit of company has declined to half from last year. The income statements of company for year 2018 shows that profit for the financial year is only 37. The cost of sales has increased of company where the revenues has declined. The balance sheet presenting the position of company shows that net assets of company have decreased from last year which were 581.6 to 341.5. The reserves and capital of company has also declined. Financial statements of company are prepared using the accounting standards and complying with the requirements of company law. Company is required to address these changes as early as possible adopting the new strategies that will help company in regaining its share and market share. Cost of sales is required to be controlled by the organisation using cost control measures. It can take part in better negotiations and reduce its costs. The turnover of company has reduced from previous year but the expenses of company has remained same. Administration expenses of company have increased. Income from interests and other receivables is reduced further declining the profit level. Company is required to take better marketing and strategic measures for increasing the sales and profits of company (Yashwanth and Yaragol, 2018). Continuous declining trend can cause the company to shut down.

Importance of making year- end adjustments to financial accounting statements

The financial statements are prepared at the end of financial year and at that time many mistakes and some transaction which were left unrecorded needs to be adjusted. This is known as year end adjustment which are done at time of preparing the financial statements (Ojala and et.al., 2019). These are named as year- end because of these are made at time of preparing financial statements. These are some additional entries which needs to be adjusted in order to adjust some unrecorded transactions or some entries which have earlier being missed by accountant and now they need to be adjusted in order to calculate accurate profit or loss. These adjustments are made because the accounting system follows the principles of revenue recognition and matching concept.

The major importance of these year- end adjustments is that this help the company in knowing the true and actual financial position of company. The reason underlying this importance is that even a single transaction which is not adjusted can impact the profits of business to a great extent.

Another importance of these adjustment is that this system helps in identifying any mistake or error which have been earlier made and it can be now rectified and solved with help of these adjustments.

Also, another importance of this adjustment entries is that this help company in analysing the fact that all accounting records have been made in accordance with the accounting principles which are followed by company.

Moreover year- end adjusting entries are important for company as they help in rechecking and reconciling all the transaction which are financial in nature and oversee that all transaction have been recorded.

Another importance is that these year- end entries are based on matching principles that is it records all cost of carrying on business at the same time all revenues are being recorded (Maynard, 2017). Thus, this help the accountant in providing more accurate and correct information relating to profitability of business.

Effect of year end adjustments

The execution of year- end adjustment entries is very good and positive over the financial statements. This is majorly because of the reason that after these adjusting entries only true financial position of company will be outlined and assessed. Thus, these entries need to be made so that actual balance of cash and other assets can be outlined in good and effective manner.

Another major effect of these year- end adjusting transaction is that this will help the accountant in easily assessing all mistakes which could have been made if these entries would not be corrected. Thus, this ensures and increases trustworthiness of investors over the company and accountant (Florou, Morricone and Pope, 2019).

Another major effect will be that by making this adjustment entries the company will earn a goodwill and it will be enhanced as now the stakeholder will like that company is making adjustment and recording all transaction which have been left earlier. Due to this market value of company will increase and so as its goodwill.

Understanding meaning of various accounting ratios.

Accounting ratios are referred to as the comparison between various financial data in order analyse the financial statements of the organization.

  • Profitability ratios: This method is used to analyze how well the business is generating profits by carrying out its business operations.  
  • Liquidity ratio analysis: It is very useful in measuring the self sufficiency of the business in order to pay off the short term liabilities for the specific period (Accounting Ratios,2019).
  • Solvency ratio analysis: It helps in measuring the ability of the organization to pay off its long term debts and interest in order to assess the financial health of company.  
  • Efficiency ratio analysis: These ratios tend to indicate the return which in turn has been generated from sale of any assets. This helps in examining how effectively assets has been utilized within organization.

Uses and limitation of ratio analysis

It is the technique used in analysing and interpreting the financial statements and to take decisions but these are also affected by its limitations which are stated below.

Uses:

Ratio analysis helps in examining the financial performance of the business which helps in taking better decisions which are beneficial for the business. Not only the company but also the external users are interested in knowing the ratio analysis of the company as they are one's who invest in the company (Lessambo, 2018). It summarizes the report into various figures that helps in comparing the financial position of the organization and results of the decision taken. It simplifies the complex into simple ratios which helps in knowing the operating and financial efficiency of the business and long term positioning.

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Limitations:

Sometimes companies changes some of its figures of its financial statement to improve their financial ratios and show show better performance. This results in window dressing and wrong decision making. Ratios ignores the inflation factors and ratios are calculated using historical data and does not include changes in the price level. This leads to wrong reflection of financial situation (Mei and et.al, 2018). These financial ratios do not consider any of the qualitative aspects which is its major limitation. There no standard definition or formula of the ratios. Some companies uses different formula to calculate ratios. For example, while calculating current ratio, some companies considers all current liabilities while others exclude bank overdraft. Also, A single ratio does not create any sense, so to create a clear picture several ratios needs to be calculated.

Using appropriate ratios in order to analyse the financial business performance.

Ratio analysis of River Island and Matalan Ltd is enumerated below:

Profitability ratios

 

 

River Island

Matalan Ltd

Particulars

 

2017

2018

2017

2018

 

         

Gross profit

 

143.5

107.1

0

0

Operating profit

 

87.7

42.2

-1525.7

-400

Net profit

 

74.6

37

-1528.4

-402.8

Sales

 

901.9

877.7

0

0

GP ratio

GP / sales * 100

15.9%

12.2%

#DIV/0!

#DIV/0!

OP ratio

OP / sales * 100

9.7%

4.8%

#DIV/0!

#DIV/0!

NP ratio

NP / sales * 100

8.3%

4.2%

#DIV/0!

#DIV/0!

Liquidity ratio analysis

 

 

River Island

Matalan Ltd

Particulars

 

2017

2018

2017

2018

Current assets

 

632

399.5

145084

144497

stock

 

95.8

81

0

0

prepaid expenses

 

0

0

0

0

Quick assets

 

536.2

318.5

145084

144497

Current  liabilities

 

139.7

142.8

61580.3

61396.7

Current ratio

CA / CL

4.52

2.80

2.36

2.35

Quick ratio

CA - (stock + prepaid expenses / CL)

3.84

2.23

2.36

2.35

Solvency ratio analysis

 

 

River Island

Matalan Ltd

Particulars

 

2017

2018

2017

2018

           

Long-term debt

 

12.2

12

0

0

Shareholders fund

 

581.6

341.5

96788.1

96385.3

Debt-equity ratio

Debt / shareholders’ equity

0.02

0.04

0.00

0.00

Efficiency ratio analysis

   

River Island

Matalan Ltd

Particulars

 

2017

2018

2017

2018

COGS

 

758.4

770.6

0

0

Stock

 

95.8

81

0

0

Sales

 

901.9

877.7

0

0

Fixed assets

 

103.2

106.1

13284.7

13284.7

Total assets

 

735.2

505.6

158368

157782

Inventory turnover ratio

 

7.92

9.51

#DIV/0!

#DIV/0!

Fixed assets turnover ratio

 

8.74

8.27

0.00

0.00

Total assets turnover ratio

 

1.23

1.74

0.00

0.00

Analysing the results of ratios and identify appropriate strategy to improve the business performance.

Profitability ratios

It has been interpreted that, the GP of the River Island has reduced from 15.9% in 2017 to 12.2% in 2018. It means company is not making reasonable amount of profit from sales by its controlling overhead cost (Accounting Ratios, 2019).

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Liquidity ratio analysis

It has been interpreted that, the current ratio of River Island has reduced from 4.52 in 2017 to 2.80 in 2018. It means company has low ability to generate cash. There is no significant difference in the current ratio in Matalan Ltd.

Solvency ratio analysis

It has been interpreted that, the debt equity ratio of River Island has increased from 0.02 to 0.04. It means company is not taking higher advantage of increased profits.

Efficiency ratio analysis

It has been interpreted that, inventory turnover ratio of the River  Island has increased from 7.92 in 2017 to 9.51 in 2018. This means company has been increasing its sales to generate higher profit.

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CONCLUSION

This study concludes that, ratios helps in analysing the financial position of the company. Accounting is useful for summarizing the accounting information to ascertain better decision making.  

REFERENCES

  • Cannon, M.L., 2019. An Exploration of Key Accounting Concepts Through Case Studies.
  • Florou, A., Morricone, S. and Pope, P.F., 2019. Proactive Financial Reporting Enforcement: Audit Fees and Financial Reporting Quality Effects. The Accounting Review.
  • Granof, M.H and et.al., 2016. Government and not-for-profit accounting: Concepts and practices. John Wiley & Sons.
  • Jollands, S. and Quinn, M., 2017. Politicising the sustaining of water supply in Ireland–the role of accounting concepts. Accounting, Auditing & Accountability Journal.
  • Lessambo, F. I., 2018. Financial Ratios Analysis. In Financial Statements (pp. 207-247). Palgrave Macmillan, Cham.
  • Maynard, J., 2017. Financial accounting, reporting, and analysis. Oxford University Press.
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