Question

Financial information is provided by a company’s management and when required by law it is reviewed by auditors. Why does financial information need to be verified by external auditors who are objective? How do ratios verify financial information?

Answer 1

Purpose of verification of financial statements by external auditors -

Main objective of the audit is to express opinion on truth and fairness of financial statements. In case of large operations people preparing financial statements are not the owners of the corporations but they are prepared by management and this creats the need for external audit. In case of small corporations the owners generally does not have the knowledge of applicable financial framework.

Accountability of the management can be judged by shareholders by analysing financial statements which are prepared by management, to rely and achieve reasonable assurance that such financial statements are free from material misstatements external verification by auditor of those financial statements is required.

Verification of financial statements by ratios -

To be an informed shareholder/owner ratios are important to analyse financial statements, some examples of such ratios are given below -

1) Quick Ratio - It is calculated by dividing quick assets by current liabilities. It shows that how well current liabilities are covered by cash and by items with a ready cash value. Quick ratio of 1:1 is considered good

2) Earning per share - It is calculated by dividing total profit available for equity shareholders with total number of outstanding equity shares. Higher Earning per share is considered good.

3) Working capital ratios - It is calculated by dividing current assets by current liabilities. It shows that how easily can company turn its current assets into cash to pay its external liabilities. .

4) Debt equity ratio - It is calculated by dividing debts of company with equity of company. It shows how much company is financed by debts (borrowings) lower debts equity ratio is considered good.

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