Question

Go to chapter 14. Select 3 ratios and explain their importance. In addition, with those ratios, write/list the 10 steps in the accounting cycle.

Three Ratios I chose are:

-Fixed Assets to long Term Liability Ratio

-The ratio of Labilities to Stockholders’ Equity

-Asset Turnover Ratio

Answer 1

The Ratios and their Importance

1.Fixed Assets to Long-Term Liability Ratio:This ratio is calculated by dividing the value of Fixed Assets by the total amount of Long-Term Debts.

Formula

Fixed Assets to Long-Term Liabilities Ratio=Fixed Assets/Long-Term Liabilities

Importance of this ratio

This ratio is used for measuring the solvency of a firm.It is used to evaluate how much collateral(fixed assets) a company possess and to determine whether it's sufficient to pay off the debts incase there's a defaultment in the payment of loans(debts).Fixed Assets are long-term assets which includes property,plant,equipments,furniture etc which can be used over a long-term by the firm for generating incomes.Analyzing this ratio allows the creditors to estimate how secure their loans are.

The Greater the ratio value,the greater is the ability of the firm to cover its long-term debts.Also greater ratio portrays an increased debt capacity that allows the firm to acquire more loans(longterm) in future.But in practical sense it's ideal to maintain a ratio of 0.5 because only long-term liabilities should be used for fixed assets coverage.Better keep it below 1,else it would imply short-term liabilities(current liabilities used for funding fixed assets which is not ideal for a firm.This ratio is a solvency/coverage ratio.

2.Liabilities to StockHolders Equity Ratio:This ratio is better known to us as the Debt-Equity Ratio.

Formula

Debt-Equity Ratio= Total Liabilities/Total Shareholder's Equity

Importance of this ratio

This ratio depicts the capital structure of a firm,whether its oriented towards debt financing or equity financing.It's used to evaluate how much leverage a firm is using.The Equity shareholders use this ratio to determine the financing strategy of the firm,as they are concerned about the profits available to them after distribution to the creditors,banks etc.This ratio is an important tool used by potential investors to examine the health of the firm.A high ratio indicates low liquidity and chances for bankruptcy are higher,while a low ratio indicates low risk.

As we said,it helps in understanding the profits earned by shareholders.If this ratio is high,then it implies higher interest payments goes to the creditors and banks leading to insufficient profits for dividend payouts to shareholders.If the ratio is low,the shareholders can enjoy high dividend earnings from profits.

This ratio also depicts the credit-worthiness of the company and their regularity in paying the interest dues.It's a long-term solvency ratio that indicates the soundness of the long-term financial policies of the firm;Hence this ratio is also used to compare the firms performance(position) against it competitors in the market(industry).

An ideal/Optimal Debt-Equity Ratio is considered to be 1:1 ;which means Total Liabilities=Total Equity

But this ratio will vary and is very Industry specific.

Also Note Total Liabilities includes Short-Term debts,Long-Term Debts and Other Fixed Payments.

3.Asset Turnover Ratio:This ratio measures the company's ability and its efficiency in generating sales by the use of its assets.It's done by comparing the Net Sales with Average Total Assets.

Formula  

Asset Turnover Ratio=Net Sales/Average Total Assets

Importance of this Ratio

This ratio is a general efficiency ratio that measures how efficiently a firm uses all of its assets.Higher turnover ratio implies the firm is using its assets efficiently.Lower ratio suggests the inefficiency in the asset usage and involves problems like surplus production capacity,poor inventory management and bad tax collection methods adopted by the company.The higher the ratio,the better will the company's performance.Measures the productivity of a company's assets.

10 Steps in Accounting Cycle(Process)

1.Identification,Classification and analyzing of the data of financial nature.(Business transactions/events)

2.Recording these financial transactions into the Journal in Chronological order,where double-entry bookkeeping system is used.

3.From the Journal,these transactions are posted into the Ledgers(Books of Final Entry).Here entries are posted into appropriate accounts.

4.These accounts are balanced and moved to the unadjusted Trial balances.This process is done mainly to test the equality of debts and credits.Checking the double posting or identify unaccounted transactions(missed).

5.Adjusting entries are recorded.(accrual basis of accounting)

6.Preparation of the adjusted Trial Balance (after adjustments made for the year)

7.Preparation of Financial Statements[Trading and P&L A/c as well as the Balance sheet].Also includes cash flow statements,Income statements etc.

8.Closing Entries made for Temporary accounts.

9.Final Trial Balance(Post Closing Trial Balance)are made to make sure debits equal credits.

10.Reverse entries are made at beginning of new accounting period.