Question

a. Why are financial statements standardized? Explain at least two methods for
standardizing financial statements.
b. Using any Income statement and Statement of Financial Position of your choice (kindly
show these statements), demonstrate how you would evaluate the profitability, asset
management, liquidity and debt management of a firm over a two year period.
c. What is the Du Pont Identity? What is the rationale for computing it?
d. Are there limitations to the use of ratio analysis? Explain

Answer 1

SOLUTION

a. financial statement is a formal record for the financial activities andan organisation position of a business or an organisation.

standardization of financial statements :-

standardization is very important for an industry or organization as it helps all relevant parties in an oraganization must adhere to ensure that all processes related to manufacturing of goods or providing serviices are performed within set guidelines, it is achieved by setting generally accepted guidelines.

A useful method for standardizing financial statements is to present all items on a common form i.e.

• income statement
• banacesheet

b. example to explain the profitability of a company

balancesheet as on.....

particulars amount($)

assets   

land and building 200000

machinary 150000

investments 18600

debtors 80000

accounts receivable 8000   

cash 30000

Total 486600

liabilities

owner's equity 268600

bank loan 140000

creditors 40000  

accounts payable 38000

Total    486600

Income statement for the year ending ......

particulars amount($)

revenue & gains

sales 25000

other incomes 5000

total revenue (A) 30000

expenses & losses

salaries 10000

interest paid 900

cost of lawsuit 500

total expenses (B) 11400

net income (A - B) 18600

from the above example we can easily identify the profitability of the company by identifing the owners equity i.e. $268600(total assets - liabilities) and the cash balance of $30000 also tells that the company have enough working capital to run its activities

c.DuPont identity is an expression that shows a company's return on its equity i.e. ROE, it can be represented as a product of three other ratios. they are : profit margin, total assets turnover and equity multiplier.

dupont identity equation:

ROE= (net assets/sales) * (sales/total assets) * (total assets/average shareholder equity)

d.  Main limitations for the use of ratio analysis is as follows :

effect of inflation

change in accounting policies

operational changes in industy

seasonal effects

usage of historical information

manipulation of financial statements