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In: Accounting

Given recent accounting scandals, how important is financial ratio analysis in assessing firm performance and developing...

Given recent accounting scandals, how important is financial ratio analysis in assessing firm performance and developing a firm’s financial strategy? Explain your rationale thoroughly be sure to include examples.

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Expert Solution

Financial Ratio analysis is a very useful tools.It is one of the important technique used in fiancial statement anlysis.Its importance can be explained as under

  1. Firm's ability to meet is financial commitments/obligations can be evaluated with Liquidity Ratios i.e Current Ratio & quick ratio asssesss firms short term solvency of firm
  2. It helps to know firms ability to repay short term commitments,ability to meet its liabilites,availability of cash to meet its short term obligations,& regular cash expenses.
  3. Ratio analysis indicates firms long term solvency,nature of fiancing, extent of own funds used in business organisaation
  4. It indicatees relationship between Equity & Debt.
  5. It indicates how much should be the ratios like Ideal ratio for Debt Equity is 2:1,Equity to Total funds ratio should be 33%,Current ratio: 2:1,Ideal liquid ratio is 1.33:1,
  6. Basic indicators of firm's profitability of firm are profitability ratio i.e Gross profit ratio,Operating profit ratio, Net profit ratio
  7. ROCE,ROZ , EPS assesses financial performance of the firm.
  8. Ratios assesses operating efficiency of management & utilisation of aseets & resources of entity.
  9. Firms ability to generate revenue can be evaluated by Activity/ performance /turnover ratios like Stock turnover ratio,debtors turnover ratio,Fixed asset turnover ratio etc
  10. Financial strength /solvency is indicated by Debt equity ratio,Gearin ratios,Leverage ratios
  11. Ratio analysis helps to assess whether firm is exposed to any serious fiancial strain.
  12. Firm's ratio analysis helps to compare & evaluate firm's ratio with industry average.
  13. It analyses firms strengths & weaknesses & helps to take timely & corrective actions
  14. It helps to depict future financial position of the company.
  15. It helps in Planning & forecasting business activities for future period.
  16. It shows the performance of the firm at particular point of time
  17. It assist in evaluating firms ability to generate cash from current or continuing operations like cash flow yield,cash flow to sales, cash flow to assets
  18. Ratio analysis assist in knowing the firm's basic profitability,operating performance of business.
  19. It helps in knowing the extent of current earnings available for meeting interest & installmetn commitmentts.
  20. Ratio analysis helps in determining how fast /regularly raw material are used in production,WIP movement,how fast inventory is used,speed of collection of credit sales/ debtors,speed of payment to creditors,
  21. Price earnings ration shows the relationship between market price ,EPS & shareholders perception of entiry.

Example on Ratio analysis,

  1. Working capital of the company is $135,000 & current ratio is 2.5.Liquid ratio is 1.5 & Propriety ratio is 0.75.
  2. Bank Overdraft is $30,000.There are no Long term loans & fictitious assets.
  3. Gearing ratio is 2.Retained Earnings=$90,000.
  4. Calculate Current assets,Current liabilities,Net block of asset,Propriety fund, Quick liabiliites,Quick assets,stock

Solution:

1.Current ratio=current assets/current liabiliites=2.5

current assets=2.5 *current liabiliites

2.Net working capital=current assets-current liabiliites=$135,000

2.5 * current liabiliites-current liabiliites=$135,000

1.5 current liabiliites=$135,000

so current liabiliites=$135,000/1.5

Therefore,current liabiliites= $ 90,000

Hence,Current Assets=2.5*$90000=$225,000

3. Quick ratio= Quick assets/Quick liabilites=1.5 times

Current assets-Stock/Current liabiliites-Bank OD=1.5 times

$225,000-Stock/$90,000-$30,000=1.5 times

Hence,Stock=$135,000

4. There are no Loans or fictitious assets.

Capital employed=Propriety fund=Fixed assets+ Net working capital

Propriety ratio=Propriety funds/Total assets=0.75

Hence,Fixed assets + Net working capital/Fixed assets+curretn assets=0.75

Fixed assets + $135,000/Fixed assets+$225,000=0.75

(Fixed assets + $135,000)=0.75*Fixed assets+$225,000)

Fixed assets=$135,000

Total Propriety Fund=Fixed assets+ Net working capital

=$135,000 +$135,000=$270,000

Share capital( Balancing figure )=$180,000

Equity + Prefernce share capital=2:1

So, Equity=$180,000*2/3=$120,000

Preference Capital=$180,000*1/3=$60,000

Retained Earnings=$90,000 (given)

Please feel free to reach or comment back if you need further clarity or something is missing.


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