Category: Accounting Content

Accounting Content!

The Account is the art of conveying financial information about a business unit for shareholders and managers etc. Accountancy has call ‘business language’. In Hindi, the words ‘लेखा विधि’ (account law) and ‘लेखाकर्म’ (accounting) are also useful in ‘Accountancy’. Accounting Content, Financial, and Accountancy!

Also learn, Accountancy is a branch of mathematical science that is useful in finding out the reasons for success and failure in business. The principles of accountancy are applicable to business units on three divisions of practical arts, namely, accounting, bookkeeping, and auditing.

As Well as the definition “Accountancy refers to the art of writing business practices in a scientific manner and classifying articles and preparing summaries and interpreting the results.”

The functioning of Accountancy is to provide quantitative information regarding economic units, which are basically financially inadequate. Which is useful in taking financial decision-making, accountancy, identifying, and measuring. Analyzing information relevant to an economic event of an organization There is a process for doing and collecting. Which is used to prompt users of this information.

  • Goodwill Meaning, Definition, Classification, Features, Types

    Goodwill Meaning, Definition, Classification, Features, Types

    Goodwill – Meaning, Definition, Classification, Features, Types, and Accounting Concept (In Hindi). In other words, goodwill shows that a business has value beyond its actual physical assets and liabilities. Discover the meaning and significance of goodwill in business. Learn how it adds value beyond physical, identifiable assets and liabilities. Goodwill is a company’s value that exceeds its assets minus its liabilities. This value can create from the excellence of management, customer loyalty, brand recognition, favorable location, or even the quality of employees. The number of goods is the purchase price the business minus the fair market value of the tangible assets, the intangible assets that can identify, and the liabilities obtained in the purchase.

    Here are explains; What is Goodwill? First Meaning, Definition, Classification, Features, Types, and finally their Accounting Concept.

    The amount in the Goodwill account will adjust to a smaller amount if there is an impairment in the value of the acquired company as of a balance sheet date or accounting treatment. Goodwill in the world of business refers to the established reputation of a company as a quantifiable asset and calculate as part of its total value when it takes over or sale. It is the vague and somewhat subjective excess value of a commercial enterprise or asset over its net worth. It is a vital component for increasing a company’s customer base and retaining existing clients.

    Meaning of Goodwill:

    Meaning; that may describe as the aggregate of those intangible attributes of a business that contributes to its superior earning capacity over a normal return on investment. It may arise from such attributes as favorable locations, the ability, and skill of its employees and management, quality of its products and services, customer satisfaction, etc.

    Definition of Goodwill:

    Definition; it is an asset that has countless definitions. Accountants, Economists, Engineers, and the Courts have to define Goodwill in several ways from their respective angles. As such, they have suggested different methods for their nature and valuation. No doubt it is an intangible real asset and not a fictitious one. “It is perhaps the most intangible of intangibles.” It is a valuable asset if the concern is profitable; on the other hand, it is valueless if the concern is a losing one. Therefore, it can state that Goodwills the value of the representative firm, judged in respect of its earning capacity.

    Some definitions of goodwill are:

    UK Accounting Standard on Accounting for Goodwill,

    “Goodwill is the difference between the value of a business as a whole and the aggregate of the fair values of its separable net assets.”

    Lord Eldon by,

    “Goodwill is nothing more than the profitability that the old customers will resort to the old place.”

    Dr. Canning by,

    “Goodwill is the present value of a firm’s anticipated excess earnings.”

    Prof. Dicksee by,

    “When a man pays for goodwill he pays for something which places him in the position of being able to earn more money than he would be able to do by his own unaided efforts.”

    Here, the word excess indicates some special hints as to its valuation which, perhaps, is equal to earnings attributable to the rate of return on tangible and intangible assets over the normal rate of return earns by the representative firms in the same industry. In short, the excess reveals the difference between the actual profits earns minus the normal rate of return on the capital employed.

    Classification of Goodwill:

    The following classification by P. D. Leake as:

    1. Dog-Goodwills: Dogs are attaching to the persons and, hence, such customers lead to personal they which is not transferable,
    2. Cat-Goodwills: Since cats prefer the person of the old home, similarly, such customers give rise to locality goodwills.
    3. Rat-Goodwills: The other variety of customers has an attachment neither to the person nor to the place, which, in other words, is known as fugitive goodwills.

    Other Classifications:

    The following classifications below are:

    1] Purchased/Acquired Goodwill:

    Purchased goodwills arise when a firm purchases another firm and when payment makes more than net assets acquired for that purpose; such excess payment know as Purchase Goodwills. The same has also been corroborating by AS 10 (Accounting for Fixed-Assets).

    2] Treatment of Purchased Goodwills as per AS 10 (Accounting for Fixed-Assets):

    In general records in the books only when some consideration in money or money’s worth has been paying for it. Whenever a business is acquired for a price (payable either in cash or in shares) that is more than the value of the net assets of the business taken over the excess is termed Goodwill. It arises from business’s reputation, connections, trade name or reputation of an enterprise, or other intangible benefits enjoyed by an enterprise. As a matter of financial prudence, goodwill written off over a period. However, many enterprises do not write off goodwill and retain it as an asset.

    3] Treatment of Purchased Goodwills as per AS 14 (Accounting for Amalgamation):

    They arising on amalgamation represent a payment made in anticipation of future income and it is appropriate to treat it as an asset to amortize to income on a systematic basis over its useful life. Due to the nature of goodwill, it is frequently difficult to estimate its useful life with reasonable certainty. Such estimation is, however, made on a prudent basis. Accordingly, it is considered appropriate to amortize goodwill over a period not exceeding 5 years unless a somewhat longer period can justify.

    4] Inherent/Latent Goodwill:

    It is practically the reputation of a firm that has been acquiring by the business over some time. It is not purchased for cash consideration. That is why; it is not recording in the books of accounts like Purchase Goodwills. This types of goodwill depends on several factors, viz, supplying goods and services at a reasonable price to the society, etc. Accountants are not concerning about it.

    5] Inherent/Internally Generated Tangible Assets — As per AS 26:

    Internally generated goodwill should not recognize as an asset. In some cases, expenditure is incurring to generate future economic benefits, but it does not result in the creation of an intangible asset that meets the recognition criteria in this statement.

    Such expenditure is often describing as contributing to internally generated them. Internally generated and factors affecting goodwill not recognizing as an asset because it is not an identifiable resource control by the enterprise that can measure reliably at cost.

    The difference between the market value of an enterprise and the carrying amount of its identifiable net assets at any point in time may be due to a range of factors that affect the value of the enterprise. However, such a difference cannot consider representing the cost of intangible assets controlled by the enterprise.

    The Features of Goodwill:

    The following features below are:

    • It is an intangible asset, it is non-visible, but it is not a fictitious asset.
    • It cannot separate from the business and therefore cannot sell like other identifiable and separable assets, without disposing of the business as a whole.
    • The value of goodwill has no relation to the amount invested or the cost incurred to build it.
    • Valuation of goodwill is subjective and is highly dependent on the judgment of the valuer.
    • It is subject to fluctuations. The value of goodwill is an intangible may fluctuate widely according to internal and external factors of the business.

    Types of Goodwill:

    It is generally of two types:

    • Purchased, and.
    • Non-Purchased or Inherent.

    1] Purchased Goodwill:

    Purchased goodwills arise when a business concern is purchased and the purchase consideration paid exceeds the fair value of the separable net assets acquired. The purchased goodwills show on the assets side of the Balance sheet. Para 36 of AS-10 “Accounting for fixed assets” states that only purchased goodwill should recognize in the books of accounts.

    2] Non-Purchased Goodwill/Inherent Goodwill:

    Inherent goodwills the value of the business over the fair value of its separable net assets. It is referred to as internally generated them and it arises over some time due to the good reputation of a business. The value of goodwill may be positive or negative. Positive goodwill arises when the value of the business as a whole is more than the fair value of its net assets. It is negative when the value of the business is less than the value of its net assets.

    Goodwills for Accounting:

    Accounting for goodwill, the various ways in which they can account for are as follows:

    • Carry it as an asset and write it off over years through the profit and loss account.
    • Write it off against profits or accumulated reserves immediately.
    • Retain it as an asset with no write-off unless a permanent diminution in value becomes evident.
    • Show it as a deduction from shareholders funds which may authorize carry forward indefinitely.

    In this connection, it is important to state that they should recognize and recorded in business only when some consideration in money or money’s worth has been paying for it.

    How Goodwill entry in the Accounting Book?

    It is always paying for the future. A record of Goodwill in accounting makes only when it has a value. When a business is purchasing and an additional amount is paid more than the number of assets, then the additional amount calls goodwill. It treats as an asset and the payment made for it is a capital expenditure. It treats as an intangible asset and thus depreciation is not charging. The value of goodwill decreases and increases but the fluctuations are not recording in the books.

    The presence of goodwill in the books is not necessarily a sign of prosperity. A prospective purchaser would agree to make any payment for the goodwill only when he is convinced that the profit likely to accrue to him from the acquired business would be more than the normal return expects in a business of a similar nature. This means that any such payment refers to the future differential earnings and is a premium to the vendor for relinquishing his right thereto in favor of the vendee.

    The goodwill of a business is the intangible value to it, independent of its visible assets because the business is a well-established one having a good reputation. But at the same time, it is obvious that goodwill is inseparable from the business to which it adds value. The value of the goodwill of the business will, therefore, be the value that a reasonable and prudent buyer would give for the business as a going concern minus the value of the tangible assets.

    Why Need for Valuation of Goodwill?

    Valuation of goodwill may make due to any one of the following reasons:

    1. In the case of a Sole-Proprietorship Firm:
    • If the firm is selling to another person.
    • It takes any person as a partner, and.
    • It is converting into a company.

    2. In the case of a Partnership Firm:

    • If any new partner takes.
    • Any old partner retires from the firm.
    • There is no change in the profit-sharing ratio among the partners.
    • If any partner dies.
    • Different partnership firms are amalgamating.
    • If any firm is selling, and.
    • If any firm converts into a company.

    3. In the case of a Company:

    • If the goodwill has already been written-off in the past but the value of the same is to record further in the books of accounts.
    • If an existing company is taking with or amalgamate with another existing company.
    • The Stock Exchange Quotation of the value of shares of the company is not available to compute gift tax, wealth tax, etc., and.
    • If the shares are valued based on intrinsic values, market value, or fair value methods.

  • Valuation of Goodwill: Meaning, Need, Factors, and Methods

    Valuation of Goodwill: Meaning, Need, Factors, and Methods

    Valuation of Goodwill: What is Goodwill? Meaning of Goodwill; Goodwill is the value of the reputation of a firm built over time concerning the expected future profits over and above the normal profits. So, what is the topic we are going to study; Valuation of Goodwill – Meaning, Need, Factors, and Methods (In Hindi). A well-established firm earns a good name in the market, builds trust with the customers, and also has more business connections as compared to a newly set up business. Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business.

    Here are explained how to Valuation of Goodwill? Meaning, Need, Factors, and Methods.

    Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so.

    Valuation of Goodwill Meaning:

    There are various circumstances when it may be necessary to value goodwill. Some of the circumstances are;

    First, In the case of a partnership, when there is an admission, retirement, death or amalgamation, or a change in the profit-sharing ratio take place, the valuation of goodwill becomes necessary.

    Secondly, In the case of a company, when two or more companies amalgamate, or one company absorbs another company, or one company wants to acquire controlling interest in another company or when the Government takes over the business, valuation of goodwill becomes necessary.

    Third, In the case of a sole trader concern, goodwill is valued at the time of selling die business, to decide the purchase consideration.

    Finally, In the case of individuals, goodwill is valued for Estate Duty, Death Duty, etc. On the death of a person.

    Need for Valuation of Goodwill:

    Valuation of goodwill may make due to any one of the following reasons:

    A Sole-Proprietorship Firm:

    • If the firm sells to another person.
    • It takes any person as a partner, and.
    • It converts into a company.

    A Partnership Firm:

    • If any new partner takes.
    • Any old partner retires from the firm.
    • There is any change in the profit-sharing ratio among the partners.
    • Any partner dies.
    • Different partnership firms amalgamate.
    • Any firm sale, and.
    • Any firm converts into a company.

    A Company or Firm:

    • If the goodwill has already been written-off in the past but the value of the same is to records further in the books of accounts.
    • An existing company taking with or amalgamated with another existing company.
    • The Stock Exchange Quotation of the value of shares of the company is not available to compute gift tax, wealth tax, etc., and.
    • The shares are valued based on intrinsic values, market value, or fair value methods.

    Factors Affecting the Value of Goodwill:

    The following factors affect the value of goodwill:

    Location:

    A business which locates in the main market or at a place where there is more customer traffic tends to earn more profit and also more goodwill. If the firm centrally locates or locate in a very prominent place, it can attract more customers, increasing turnover. Therefore, the locational factor should always consider while ascertaining the value of goodwill.

    Time:

    The time dimension is another factor that influences the value of goodwill. The comparatively old firm will enjoy a more commercial reputation than the other one since the old one is better known to its customers, although both of them may have the same locational advantages.

    Nature of Business:

    A firm that deals with good quality products or has stable demand for its product can earn more profits and therefore has more value. This is another factor which also influences the value of goodwill which includes:

    • The nature of goods.
    • Risk involved.
    • Monopolistic nature of the business.
    • Benefits of Patents and Trade-marks, and.
    • Easy access to raw materials, etc.

    Capital Required:

    More buyers may interest to purchase a business that requires a comparatively small amount of capital but the rate of earning a profit is high and, consequently, raise the value of goodwill. On the contrary, for a business that required a large amount of capital but the rate of earning a profit is comparatively less, no buyer will interest to have the business and, hence, the goodwill of the said firm pull down.

    Owner’s Reputation:

    An owner, who has a good personal reputation in the market, is honest and trustworthy attracts more customers to the business, and makes more profits and also goodwill.

    Market Situation:

    The organization has a monopoly right or condition in the market or having limited competition, enables it to earn high profits which in turn leads to a higher value of goodwill.

    The trend of Profit:

    The value of goodwill may also be affected due to the fluctuation in the amount of profit (i.e., based on the rate of return). If the trend of profit is always rising, no doubt the value of goodwill will be high, and vice versa.

    The efficiency of Management:

    Efficient management may also help to increase the value of goodwill by increasing profits through properly planned production, distribution, and services. An organization with efficient management has high productivity and cost-efficiency. This gives it increased profits and also high goodwill. Therefore, to ascertain the value of goodwill, it must note that such efficiency in management must not be curtailed.

    Special Advantages:

    A firm that has special advantages like import licenses, patents, trademarks, copyrights, assured supply of electricity at low rates, subsidies for being situated in a special economic zone’s (SEZs), etc. possess a higher value of goodwill.

    Other Factors:

    • The condition of the money market.
    • The possibility of competition.
    • Government policy, and.
    • Peace and security in the country.

    Precaution to Take in Valuing Goodwill: We know that the amount of goodwill always pays for in the future. The buyer will pay a little more than the intrinsic value of assets only when he expects that he will enjoy some extra benefits from such goodwill shortly. On the other hand, if the buyer thinks that there is no possibility of having such advantages in the future, he will not be ready to pay anything for goodwill—even if the value of goodwill is very high.

    Methods of Valuing Goodwill:

    There are two methods of valuing goodwill:

    1. Simple profit method, and.
    2. Super-profit method.

    Simple Profit Method:

    There are two methods based on simple profit:

    • Purchase of Past Profit Method, and.
    • The capitalization of the Average Profit Method.
    A. Purchase of Past Profit Method:

    Under this method, goodwill is expressed as a purchase of a certain number of years’ profit based on the adjusted average profit of a given number of years.

    This method involves two steps:

    • The profits for an agreed number of years preceding the valuation average to ar­rive at the average annual profit earned during that period. This will have to adjust in the light of future possibilities and the average future maintainable profit determined. If the profits have been fluctuating, a simple average use. If profits show a steadily increasing or decreasing trend, appropriate weights are used giving greater weightage for profits of the later year.
    • The average future maintainable profit is multiplied by a certain number of years to find out the value of goodwill. The number of years selected for this purpose base on the expectation of the number of years’ benefit to derive in the future from the past association.

    For example, if the average future maintainable profit is Rs.25, 000 and it expects that this profit would earn for at least another 3 years, then the goodwill will be:

    Goodwill,

    = Rs. 75,000 (25,000 x 3).
    = Average of profit x number of years.

    The number of years over which the profits are averaged and the number of years’ purchase applied may vary considerably in practice but generally falls between one and five years. Estimating future profit beyond a period of say, 5 years would be quite difficult and unrealistic.

    The method suffers from two defects:

    • The difficulty of finding out the right number of years’ purchase of profits as it depends on so many factors and
    • Ignoring capital to employ in the business.
    B. The capitalization of the Average Profit Method:

    The following steps are to take in ascertaining the value of goodwill under this method:

    • Ascertain the average future maintainable profit, as explained already.
    • Capitalize this average profit at the normal rate of return on investment on the type

    Of business under consideration:

    This will give the net worth of the business.

    • Find out the value of net tangible assets (i.e., net assets other than goodwill) of the business.
    • Deduct the net tangible assets from the capitalized net worth of the business and the difference is goodwill.

    Super-Profit Method:

    Strictly speaking, goodwill can attach only to a business that is earning above-normal profits of super-profits. If there is no anticipated excess earning over normal earnings, there can be no goodwill.

    Such excess profits know as super-profits and it is the difference between the average profit earned by the business and the normal profit based on the normal rate of return.

    Hence for find­ing to the super-profits, the following information will require:

    • The estimated average future profits of the firm (ascertained as already explained),
    • The normal rate of return on investment and
    • The fair value of the average capital employed in the business.

    The normal rate of return:

    The normal rate of return refers to the rate of earnings that inves­tor, in general, expect on their investments in a particular type of industry. It varies depending upon general factors like the bank rate, general economic conditions, political stability, etc., and specific factors like period of investment, risk attached to the investment, etc.

    Normal profit and Super-profit:

    If the average capital employed and the normal rates of return know, the normal profit can ascertain. For example, if the average capital employed is Rs. 1, 00,000 and the normal rate of return is 10%, the normal profit is 1, 00, 000 x 10/100 = 10, 000.

    Super-profit is the simple difference between the actual average profit earned and the normal profit. If in the above example, the average profit is Rs. 25,000, then the super-profits will be Rs. 25,000 – Rs. 10,000 = Rs. 15,000

    Goodwill based on Super-Profit:

    There are four methods of calculating goodwill based on the super-profit.

    They are:

    • Purchase of super-profits Method,
    • Sliding-scale Valuation of Super-profit Method,
    • Annuity of Super-Profit Method and
    • The Capitalization of Super-Profit Method.
    1. Purchase of Super-profit Method:

    Goodwill as per this method = Super profit * Number of years. If, for example, the super-profit is Rs. 15,000 and goodwill agree to be 3 years’ purchase of super-profits, then the goodwill will be s.45,000 (15,000 * 3)

    2. Sliding-scale Valuation of super-profits Method:

    This is the only variation of the first method. It is based on the logic that the greater the number of super-profits, the more difficult it would be to maintain. Higher profit will naturally attract competition and soon the firm’s ability to make super-profits is curtailed.

    3. Annuity super-profit Method:

    Under this method, goodwill calculates by finding the present worth of an annuity paying the super profit per year, over the estimated period discounted at the given rate of interest. Usually, the reference to the Annuity Table will give the present value of an annuity for the given number of years and at the given rate of interest.

    Goodwill = super-profit * annuity.

    For example, if the super-profits are Ts. 15,000 and the annuity of re. 1 at 10% for 3 years is 2.48,685, then the goodwill is = Rs. 15,000 * 2.48,685 = Rs. 37,302.75. This method takes into consideration the interest loss involved in paying a lump sum as goodwill in anticipation of the future of profit.

    4. The Capitalization of Super-Profit Method:

    This is similar to the capitalization of the average profit method as already explained. Under this method, the super-profits when capitalized at the normal rate of return will give the value of goodwill.

    Goodwill,

    = Rs. 1, 50, 000 (Rs. 15, 000/10 x 100).
    = Super Profit/Normal rate of return x 100.

    This method gives the maximum value for goodwill. Since the contention that super-profits will continue for long is unreasonable, this method is not safe for one to follow.

  • Top 3 Accounting Methods are very Useful with Docs

    Top 3 Accounting Methods are very Useful with Docs

    What is the Accounting Method? An accounting method is a set of rules under which revenues and expenses are reported in financial statements. The choice of accounting method can result in differing amounts of profit being reported in the short-term. Over the long-term, the choice of accounting method has a reduced impact on profitability. So, what is the topic we are going to discuss; Top 3 Accounting Methods are very Useful with Docs.

    The Concept of Accounting explain; 3 Accounting Methods.

    The primary accounting methods are the accrual basis of accounting and the cash basis of accounting. Under the accrual basis, revenue is recognized when earned, and expenses are recognized when consumed. Accrual basis accounting is required for publicly-held entities, and for any organization that wants to have its financial statements audited. This is considered the most theoretically correct accounting method, but also requires a greater knowledge of accounting, and so is less likely to be used by smaller organizations.

    The other main accounting method is the cash basis of accounting. Under the cash basis, revenue is recognized when cash is received from customers, and expenses are recognized when cash is paid to suppliers. This method is more likely to result in lumpy profitability in any given period since a large cash inflow or outflow can sharply alter profits.

    The following Methods below are;

    (A) Where Separate Set of Books is Kept:

    This method is particularly followed where there are large transactions, that is, the venture is a large one and is continued for a comparatively long period.

    (B) Where No Separate Set of Books is Kept:

    This method is applicable where the joint venture transactions are limited and the ventures reside at two different places. Under this method, each venture will record his own transactions plus the transactions relating to other co-ventures capital whereas the other venture will prepare a Joint Venture Account and the capital of the others, that is, two accounts are prepared in each party’s ledger.

    (C) Where Each Co-Venture Maintains A Record of His Own Transac¬tions (or Partial Record Method) (or Memorandum Joint Venture Method):

    Under this method, each co-venture keeps a record of Joint Venture transactions in which he is involved i.e. each venture records in his own book only the transactions of the joint venture which relate to him. Each party keeps his account in his own books. He will not record the transactions of other co-venture.

    Top 3 Accounting Methods are very Useful with Docs
    Top 3 Accounting Methods are very Useful with Docs. Image credit from #Pixabay.

  • What is a Fixed Budget in Financial Management?

    What is a Fixed Budget in Financial Management?

    A fixed budget can be usefully employed when budgeted output is close enough to the actual output. A budget can define as a management tool that puts the managers in control of the financial health of the organization. How the manager manages the budget is key to their value. Budget facilities the planning and resource allocation and help to estimate, itemized, analysis, and examined the entire product and service that the organization offers to the customer. It is also important to note that budget levels should be determined based on what is likely to happen in the future rather than based on what has happened in the past. So, what is the question we discuss; What is a Fixed Budget in Financial Management? with Meaning and Definition.

    Here are explain the Concept of Financial Management topic of Fixed Budget with Meaning and Definition.

    The Chartered Institute of Management Accountants (UK), defines a fixed budget as the budget which design to remain unchanged irrespective of the level of activity actually attained. It is based on a single level of activity. A fixed budget performance report compares data from actual op­erations with the single level of activity reflected in the budget. It is based on the assumption that the company will work at some specified level of activity and that a stated production will be achieved. It suggests that the budget not adjusts when the production level changes.

    Introduction:

    The objective of the budget is to measure the financial structure of the organization and budget is a tool that forces management to be accountable in a structured and objective way. However, in practice, fixed budgeting is rarely used. The main reason is that actual output is often significantly different from the budgeted output. In such a case the budget cannot use for cost control. The performance report may be misleading and will not contain very useful information. For example, if actual production is 12,000 units in place of the budgeted 10,000 units, the costs incurred cannot compare with the budget which relates to different levels of activity.

    Since, in fixed budgeting, units overlook, a cost to cost comparison without considering the units may give misleading results. The performance report prepared under fixed budgeting merely discloses whether actual costs were higher or lower than budgeted costs. The fact that costs and expenses are affected by fluctuations in volume limits the use of the fixed budget. If budgeted costs compare with the actual costs at the end of the year, it will be difficult to infer how successful a business firm has been in keeping expenses within the allowed limits.

    Definition of Fixed Budget:

    A fixed budget, also called a static budget, is a financial plan based on the assumption of selling specific amounts of goods during a period. In other words, fixed budgets are based on a set volume of sales or revenues. This is an easy way for management to plan out expenses; and, operations when they assume that sales volume and total revenues will be a set amount during a period.

    “The Fixed budget are those that are drafted to remain the same regardless of the activity levels it actually attained.”

    Budgeting is a simple process of consolidating budget and adhere to them as closely as possible. It is a process that turns manager attitudes forward-looking to the future and planning; managers can anticipate and react accordingly to the potential problem before it arises. The budgeting process allows the manager to focus on the opportunities instead of figuratively. Budgeting aims to give management an idea of how well the organization is projecting the income goals and how well the organization managing the working capital.

    The budgeting exercise should able to increase the profit reduce inappropriate expenses; and, it also helps to expand the markets. To achieve the budgeting aim, the management needs to build a budgeting system. A budget system varies from organization to organization and it is not a unitary concept. The fundamental concept of the budget system involves estimating the future performance of the organization, comparing the actual performance to the budget; and, analyzing the deviation of the actual result against the budget. The factors that determine the type or style of an organization depend on the type of organization; the leadership style, the method of preparation, and the desired result.

    What is a Fixed Budget in Financial Management
    What is a Fixed Budget in Financial Management? Image credit from ilearnlot.com.

  • Mode, Classification, Uses, Steps of Ratio Analysis

    Mode, Classification, Uses, Steps of Ratio Analysis

    What is the Nature of Ratio Analysis? Ratio analysis is a technique of analysis and interpretation of financial statements. So, what we discussing is – Mode, Classification, Uses, Steps of Ratio Analysis. Also, it is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end in itself. Also, it is only a means of a better understanding of the financial strengths and weaknesses of a firm.

    The Concept of Accounting explains Ratio Analysis in the points of Mode, Classification, Uses, Steps.

    In this article discussing Ratio Analysis: First Mode of Ratio Analysis, then the second Classification of Ratio Analysis, the third Uses of Ratio Analysis and finally Steps of Ratio Analysis. How to Calculation of Ratio Analysis? The calculation of mere ratios does not serve any purpose unless several appropriate ratios are analyzed and interpreted.

    Several ratios can calculate from the information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objective of the analysis. As well as, the ratios may use as a symptom like blood pressure, the pulse rate of the body temperature and their interpretation depends upon the caliber and competence of the analyst.

    Mode of Ratio Analysis:

    Ratios may express in any one or more of the following ways; Mode of ratio analysis can express as:

    • Proportion.
    • Rate or times, and.
    • Percentage.

    Each way of expression may have a distinct advantage over others. Also, the analyst will choose a particular mode or a combination suitable for a specific purpose.

    Proportion:

    In this type of expression, the amounts of two items are expressing in a common denominator. An example of this form of expression is the relationship between current assets and current liabilities as “2”: “1”.

    Rate or Times or Coefficient:

    In this type of expression, a quotient obtained by dividing one item by another is taken as a Unit of expression. An example of this form of expression is the cost of sales divided by average stock (say 8), thus 8 times is the ratio between the cost of sales and stock.

    Percentage:

    In this type of expression, a quotient obtained by dividing one item by another multiple by one hundred to show the relationship in terms of percentage. For example, the relationship between net profit and sales may express as say 25%.

    The Classification of Ratio Analysis:

    Ratios are classifying in several ways. Different approaches are used for classifying ratios. There is no uniformity in classification by different experts. They have adopted different standpoints for classifying ratios into various groups.

    The following classification of ratio analysis is discussing below:

    Ratios by Statements:

    Under this method, ratios are classifying based on statements from which the information is obtained for calculating the ratios. The only statements which provide information are i.e., balance sheet and profit and loss account.

    Users:

    Under this classification, ratios are grouping based on the parties who are interested in making use of the ratios.

    The following is the classification on this basis:

    • Management.
    • Creditors, and.
    • Stockholders.
    Relative Importance:

    This classification is adopting by the British Institute of Management, where there are three types of ratios:

    Primary Ratios:

    They are also known as explanatory ratios which include:

    • Return on capital employed.
    • Assets turnover, and.
    • Profit ratios.
    Secondary Performance Ratios:
    • Working capital turnover.
    • Stock to current assets.
    • Current assets to fixed assets.
    • Stocks to fixed assets, and.
    • Fixed assets to total assets.
    Secondary Credit Ratios:
    • Creditors turnover.
    • Debtors turnover.
    • Liquid ratio.
    • The current ratio, and.
    • Average collection period.
    Growth Ratios:
    • The growth rate in sales.
    • The growth rate in net assets.

    The above list is not exhaustive; other relevant ratios can add to each category.

    Ratios by Purpose/Function:

    The basis for classification under this head is the purpose for which the ratios are calculated. Generally, ratios are used to assess profitability, activity or operating efficiency and financial position of concern. Based on the purpose the ratios are classified as profitability ratios, turnover ratios and financial ratios or solvency ratios.

    Uses of Ratio Analysis:

    The ratio analysis is one of the most powerful tools of financial analysis. It uses as a device to analyze and interpret the financial health of the enterprise. Just like a doctor examines his patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise.

    “A ratio knows as a symptom like blood pressure, the pulse rate or the temperature of an individual.”

    It is with the help of ratios that the financial statements can analyze more clearly and decisions made from such analysis. The use of ratios is not confined to financial managers only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes.

    The supplier of goods on credit, banks, financial institutions, investors, shareholders, and management all make use of ratio analysis as a tool in evaluating the financial position and performance of a firm for granting credit, providing loans or making investments in the firm.

    With the use of ratio analysis, one can measure the financial condition of a firm and can point out whether the condition is strong, good, questionable or poor. The conclusions can also draw as to whether the performance of the firm is improving or deteriorating.

    Thus, ratios have wide applications and are of immense use today:

    1. Managerial Uses of Ratio Analysis:

    The following managerial uses below are:

    Helps in decision-making:

    Financial statements are preparing primarily for decision-making. But the information provided in financial statements is not an end in itself and no meaningful conclusion can draw from these statements alone. Also, ratio analysis helps in making decisions from the information provided in these financial statements.

    Helps in financial forecasting and planning:

    Ratio Analysis is of much help in financial forecasting and planning. Planning is looking ahead and the ratios calculated for several years work as a guide for the future. Meaningful conclusions can draw for the future from these ratios. Thus, ratio analysis helps in forecasting and planning.

    Helps in communicating:

    The financial strength and weakness of a firm are communicating more easily and understandable by the use of ratios. Also, the information contained in the financial statements is conveyed in a meaningful manner to the one for whom it is meant. Thus, ratios help in communication and enhance the value of the financial statements.

    Helps in coordination:

    Ratios even help in coordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of enterprise results in better co­ordination in the enterprise.

    Helps in Control:

    Ratio analysis even helps in making effective control of the business. Standard ratios can base upon proforma financial statements and variances or deviations, if any, can find by comparing the actual with the standards to take corrective action at the right time. The weaknesses or otherwise, if any, come to the knowledge of the management which helps in effective control of the business.

    Other Uses:

    These are so many other uses of the ratio analysis. It is an essential part of budgetary control and standard costing. Ratios are of immense importance in the analysis and interpretation of financial statements as they bring the strength or weakness of a firm.

    2. Utility to Shareholders/Investors:

    An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment and then a return in the form of dividend or interest.

    For the first purpose, he will try to asses the value of fixed assets and the loans raised against them. The investor will feel satisfied only if the concern has a sufficient amount of assets. Long-term solvency ratios will help him in assessing the financial position of the concern.

    Profitability ratios, on the other hand, will be useful to determine profitability position. As well as, ratio analysis will be useful to the investor in making up his mind whether the present financial position of the concern warrants further investment or not.

    3. Utility to Creditors:

    The creditors or suppliers extend short-term credit to the concern. Also, they are interesting to know whether the financial position of the concern warrants their payments at a specified time or not. As well as, the concern pays the short-term creditor, out of its current assets.

    If the current assets are quite sufficient to meet current liabilities then the creditor will not hesitate in extending credit facilities. Current and acid-test ratios will give an idea about the current financial position of the concern.

    4. Utility to Employees:

    The employees are also interested in the financial position of the concern especially profitability. Their wage increases the number of fringe benefits is related to the volume of profits earned by the concern.

    The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits.

    5. Utility to Government:

    The government is interested to know the overall strength of the industry. Various financial statements published by industrial units are using to calculate ratios for determining the short-term, long-term and overall financial position of the concerns. Profitability indexes can also prepare with the help of ratios.

    The government may base its future policies based on industrial information available from various units. Also, the ratios may use as indicators of the overall financial strength of the public as well as the private sector, in the absence of reliable economic information, governmental plans and policies may not prove successful.

    6. Tax Audit Requirements:

    Section 44 AB was inserted in the Income Tax Act by the Finance Act, 1984. Under this section, every assessee engaged in any business and having the turnover or gross receipts exceeding Rs. 40 lakh requires to get the accounts audited by a chartered accountant and submit the tax audit report before the due date for filing the return of income under Section 139 (1). In the case of a professional, a similar report requires if the gross receipts exceed Rs 10 lakh.

    Clause 32 of the Income Tax Act requires that the following accounting ratios should give:

    • Gross Profit/Turnover.
    • Net Profit/Turnover.
    • Stock-in-trade/Turnover, and.
    • Material Consumed/Finished Goods Produced.

    Further, it is advisable to compare the accounting ratios for the year under consideration with the accounting ratios for the earlier two years so that the auditor can make necessary inquiries if there is any major variation in the accounting ratios.

    The Steps in Ratio Analysis:

    The following Steps in Ratio Analysis below are:

    Selection of Relevant Information:

    The first step in ratio analysis is to select relevant information from financial statements; and, also calculate appropriate ratios required for decision under consideration.

    Comparison of Calculated Ratios:

    To assess the relative meaning; also, the ratios calculated are comparing with the past ratios and industry ratios.

    Interpretation and Reporting:

    The third step in ratio analysis is to interpret the significance of various ratios, draw inferences and to write a report. Also, the report may recommend specific action in the matter of the decision situation or may present alternatives with comparative merits or it may just state the facts and interpretation.

    Mode Classification Uses Steps of Ratio Analysis
    Mode, Classification, Uses, Steps of Ratio Analysis. Image credit from #Pixabay.

  • Importance, Objectives, Advantages of Ratio Analysis

    Importance, Objectives, Advantages of Ratio Analysis

    What is the Meaning of Ratio Analysis? Ratio analysis refers to the analysis and interpretation of the figures appearing in the financial statements (i.e., Profit and Loss Account, Balance Sheet and Fund Flow statement, etc.). So, What we discussing is – Importance, Objectives, Advantages of Ratio Analysis. It is a process of comparison of one figure against another. It enables users like shareholders, investors, creditors, government, and analysts, etc. to get a better understanding of financial statements.

    The Concept of Accounting explains Ratio Analysis in the points of Importance, Objectives, Advantages.

    Definition of Ratio Analysis: Define the term ratio analysis as “The systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm, as well as its historical performance and current financial conditions, can determine.” Ratio analysis is a very powerful analytical tool useful for measuring the performance of an organization.

    Accounting ratios may just use as a symptom like blood pressure, pulse rate, body temperature, etc. The physician analyses this information to know the causes of illness. Similarly, the financial analyst should also analyze the accounting ratios to diagnose the financial health of an enterprise. In this article discussing Ratio Analysis: First Importance of Ratio Analysis, then second Objectives of Ratio Analysis, and finally Advantages of Ratio Analysis.

    Importance of Ratio Analysis:

    The following 10 best points of Importance of Ratio Analysis below are:

    Measure General Efficiency:

    Ratios enable the mass of accounting data to summarize and simplify. They act as an index of the efficiency of the enterprise. As such they serve as an instrument of management control.

    Measure Financial Solvency:

    Ratios are useful tools in the hands of management and other concerned to evaluate the firm’s performance over some time by comparing the present ratio with the past ones. They point out the firm’s liquidity position to meet its short-term obligations and long-term solvency.

    Forecasting and Planning:

    Ratio analysis is an invaluable aid to management in the discharge of its basic function such as planning, forecasting, control, etc. The ratios that are derived after analyzing and scrutinizing the past result, helps the management to prepare budgets to formulate policies and to prepare the plan of action, etc.

    Facilitate Decision-Making:

    It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called a surveyor of efficiency. They help management in decision-making.

    Corrective Action:

    Ratio analysis provides the inter-firm comparison. They highlight the factors associated with successful and unsuccessful firms. If the comparison shows an unfavorable variance, corrective actions can initiate. Thus, it helps the management to take corrective action.

    Intra Firm Comparison:

    Intra firm comparisons are facilitating. It is an instrument for the diagnosis of the financial health of an enterprise. It facilitates the management to know whether the firm’s financial position is improving or deteriorating by setting a trend with the help of ratios.

    Act as a Good Communication:

    Ratios are an effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners and other interested parties. The communications by the use of simplifying and summarize ratios are more easy and understandable.

    Evaluation of Efficiency:

    Ratio analysis is an effective instrument that, when properly used, is useful to assess important characteristics of business—liquidity, solvency, profitability, etc. A study of these aspects may enable conclusions to draw relating to the capabilities of the business.

    Effective Tool:

    Ratio analysis helps in making effective control of the business- measuring performance, control of cost, etc. Effective control is the keynote of better management. The ratio ensures secrecy.

    Detection of Unfavourable Factors:

    Analysis of financial statements enables the analyst to find out the soundness or otherwise of the business. If the analysis reveals financial unsoundness, the factors responsible for such unsoundness can separate and corrective action was taken without loss of time.

    The Objectives of Ratio Analysis:

    The main objectives of ratio analysis are to show a firm’s relative strengths and weaknesses. Other objectives of ratio analysis include comparisons for a useful interpretation of financial statements, finding solutions to unfavorable financial statements and to help take corrective measures when, in comparison to other similar firms, financial conditions and performance of the firm are unfavorable.

    Ratio analysis also determines the financial condition and financial performance of a firm. Using ratio analysis allows an analyst to determine the ability of the firm to meet its obligations, the overall operating efficiency, and performance of the firm and the efficiency with which the firm is utilizing its assets in generating sales.

    Ratio analysis is a tool used to conduct a quantitative analysis of information in a company’s financial statements. Ratios are calculated by individuals from current year numbers and are these numbers are then used to judge the performance of the company by comparing them to previous years, other companies, the industry or even the economy.

    Extra Knowledge:

    Ratio analysis can help give a quick indication of how a company is doing in certain key areas and the ratios can categorize as short-term solvency ratios, debt management ratios, asset management ratios, profitability ratios, and market value ratios. Ratio analysis should only use as the first step in financial analysis.

    As it is a tool that is based on accounting information, it can limit by any distortions that arise in financial statements due to historical cost accounting and inflation. It can also be difficult to draw comparisons using ratio analysis due to differences in the analysis made by other firms.

    Using ratio analysis can identify areas that may need to be investigating further. Some of the advantages of ratio analysis include that it helps in credit analysis, it can help in financial performance analysis and that it simplifies a financial statement.

    The basic important advantages of Ratio Analysis are also great.

    Ratio analysis is an important tool for analyzing the company’s financial performance. The following are the important advantages of the accounting ratios.

    Analyzing Financial Statements:

    Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful for understanding the financial position of the company. Different users such as investors, management. bankers and creditors use the ratio to analyze the financial situation of the company for their decision making purpose.

    Judging Efficiency:

    Accounting ratios are important for judging the company’s efficiency in terms of its operations and management. They help judge how well the company has been able to utilize its assets and earn profits.

    Locating Weakness:

    Accounting ratios can also use in locating the weakness of the company’s operations even though its overall performance may be quite good. Management can then pay attention to the weakness and take remedial measures to overcome them.

    Formulating Plans:

    Although accounting ratios are using to analyze the company’s past financial performance, they can also use to establish future trends of its financial performance. As a result, they help formulate the company’s plans.

    Comparing Performance:

    A company needs to know how well it is performing over the years and as compared to the other firms of a similar nature. Besides, it is also important to know how well its different divisions are performing among themselves in different years. Ratio analysis facilitates such comparison.

    Main Advantages of Ratio Analysis:

    Ratio analysis is widely used as a powerful tool for financial statement analysis. It establishes the numerical or quantitative relationship between two figures of a financial statement to ascertain the strengths and weaknesses of a firm as well as its current financial position and historical performance. It helps various interested parties to evaluate a certain aspect of a firm’s performance.

    The following 10 best points are the principal advantages of ratio analysis:

    Forecasting and Planning:

    The trend in costs, sales, profits, and other facts can know by computing ratios of relevant accounting figures for the last few years. This trend analysis with the help of ratios may be useful for forecasting and planning future business activities.

    Budgeting:

    The budget is an estimate of future activities based on experience. Accounting ratios help to estimate budgeted figures. For example, the sales budget may prepare with the help of an analysis of past sales.

    Measurement of Operating Efficiency:

    The analysis indicates the degree of efficiency in the management and utilization of its assets. Different activity ratios indicate operational efficiency. The solvency of a firm depends upon the sales revenues generated by utilizing its assets.

    Communication:

    Ratios are effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners or other parties.

    Control of Performance and Cost:

    Ratios may also use for control of performances of the different divisions or departments of an undertaking as well as control of costs.

    Inter-firm Comparison:

    A comparison of the performance of two or more firms reveals efficient and inefficient firms, thereby enabling inefficient firms to adopt suitable measures for improving their efficiency. The best way of inter-firm comparison is to compare the relevant ratios of the organization with the average ratios of the industry.

    The indication of Liquidity Position:

    They help to assess the liquidity position i.e., the short-term debt-paying ability of a firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks, creditors and other suppliers of short-term loans.

    The indication of Long-term Solvency Position:

    They also use to assess the long-term debt-paying capacity of a firm. The long-term solvency position of a borrower is a prime concern to the long-term creditors, security analysts and the present and potential owners of a business. It measures by the leverage/capital structure and profitability ratios which indicate the earning power and operating efficiency. Ratio analysis shows the strength and weaknesses of a firm in this respect.

    The indication of Overall Profitability:

    The management is always a concern with the overall profitability of the firm. They want to know whether the firm can meet. It is short-term as well as long-term obligations to its creditors, to ensure a reasonable return to its owners. And, secures optimum utilization of the assets of the firm. This is possible if all the ratios are considered together.

    The signal of Corporate Sickness:

    A company is sick when it fails to generate a profit continuously and suffers a severe liquidity crisis. Proper ratio analysis can give the signal of corporate sickness in advance. So, timely measures can take to prevent the occurrence of such sickness.

    Aid to Decision-making:

    They help to make decisions like whether to supply goods on credit to a firm. Whether bank loans will make available etc.

    Simplification of Financial Statements:

    They make it easy to grasp the relationship between various items and helps in understanding the financial statements.

    Importance Objectives Advantages of Ratio Analysis
    Importance, Objectives, Advantages of Ratio Analysis. Image credit from #Pixabay.

  • Meaning, Definition, Nature, Steps, Limitations of Ratio Analysis

    Meaning, Definition, Nature, Steps, Limitations of Ratio Analysis

    What is Ratio Analysis? An analysis of financial statements based on ratios knows as ratio analysis. A ratio is a mathematical relationship between two or more items taken from the financial statements. Ratio analysis is the process of computing, determining, and presenting the relationship of items. So, what we discussing is – Meaning, Definition, Nature, Steps, Limitations of Ratio Analysis. It also includes comparison and interpretation of ratios and using them as a basis for future projections. Ratio analysis is helpful to management and outsiders to diagnose the financial health of a business concern. It helps in measuring the profitability, solvency, and activity of a firm.

    The Concept of Financial Statement explains the Techniques of Ratio Analysis, and they are understood by Meaning, Definition, Nature, Steps, Limitations.

    In this article we will discuss Ratio Analysis: Meaning of Ratio Analysis, second in Definition of Ratio Analysis, third simply learn Nature and Steps of Ratio Analysis and last studying Limitations of Ratio Analysis. So, Ratio analysis is the process of examining and comparing financial information by calculating meaningful financial statement figure percentages instead of comparing line items from each financial statement.

    Meaning of Ratio Analysis:

    The company’s financial information is contained in the Balance Sheet and Profit and Loss Account. The figures contained in these statements are absolute and sometimes unconnected with one another. An absolute figure does not convey much meaning. However, it is only in the light of other information that the significance of a figure is realized. For instance, Mr. X weighs 50Kg. Is he fat? We cannot answer unless we know his age and height. Similarly, a company’s profitability cannot know unless together with the amount of profit, the capital employed is also seen.

    The relationship between these two figures expressed mathematically is called a RATIO. The ratio refers to the numerical or quantitative relationship between two variables or items. A ratio is calculated by dividing one item of the relationship with the other. The ratio analysis is one of the most useful and common methods of analyzing financial statements. As compared to other tools of financial analysis, the ratio analysis provides very useful conclusions about various aspects of the working of an enterprise. The need for ratio arises because absolute figures are often misleading.

    Absolute figures are certainly valuable but their value increases manifold if they are studied with another through ratio analysis. Ratios enable the mass of data to summarize and simplify. Ratio analysis is an instrument for the diagnosis of the financial health of an enterprise. Ratios are full of meaning and communicate the relative importance of the various items appearing in the Balance Sheet and Profit and Loss Account.

    Definition of Ratio Analysis:

    Ratio Analysis is a powerful tool for financial analysis. A ratio defines as;

    Webster’s New Collegiate Dictionary,

    “The indicated quotient of two mathematical expressions and as the relationship between two or mm thing?”

    Hunt, Williams & Donaldson,

    “The ratio analysis is an aid to management in making credit decisions, but as a mechanical substitute for thinking and judgment, it is worse than useless.”

    Ratio Analysis may define as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm, as well as its historical performance and current financial condition, can determine. The term ‘ratio’ refers to the numerical or quantitative relationship between two items or variables. In financial analysis, a ratio uses as an index or yardstick for evaluating the financial position and performance of a firm.

    An accounting figure conveys meaning when it is related to some other relevant information. Therefore, ratios help to summaries the large quantities of financial data and to make a qualitative judgment about the firm’s financial performance and financial position. The accounting ratios serve any purposes, they can assist management in its basic functions like forecasting, planning, coordination, control, and communication. If they are used properly they can improve efficiency and therefore, profits.

    Nature and Steps of Ratio Analysis:

    After their meaning and definition the article following Nature of Ratio Analysis below are:

    Ratio analysis is a powerful tool for financial analysis. A ratio defines as “the indicated quotient of two mathematical expressions” and as “the relationship between two or more things”. In financial analysis, a ratio uses as an index or yardstick for evaluating the financial position and performance of a firm. Analysis of financial statements is a process of evaluating the relationship between parts of financial statements to obtain a better understanding of the firm’s position and performance.

    The financial analysis uses as a device to analyze and interpret the financial health of the enterprise. The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial performance of a firm. An accounting figure conveys meaning when it is related to some other relevant information.

    Just like a doctor examines his patient by recording his body temperature, blood pressure, etc., before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise. A ratio knows as a symptom like blood pressure, the pulse rate or the temperature of an individual. It is with the help of ratios that the financial statements can analyze more clearly and decisions are drawn from such an analysis. The point to note is that a ratio indicates a quantitative relationship, which can be, in turn, used to make a qualitative judgment. Such is the nature of all financial ratios.

    Steps in Ratio Analysis:

    The following steps below are;

    The first task of the financial analyst is to select the information relevant to the decision under consideration from the statements and calculates appropriate ratios. The second step is to compare the calculated ratios with the ratios of the same firm relating to past/with the industry ratios. This step facilitates assessing the success or failure of the firm. The third step involves interpretation, drawing of inferences and report-writing. Conclusions are drawn after comparison in the shape of the report or recommended the course of action.

    Limitations of Ratio Analysis:

    The following Limitations of Ratio Analysis below are:

    • Incorrect Accounting Data.
    • Probable Happenings in the Future.
    • Variation in Accounting Methods.
    • Price Level Changes.
    • Only One Method of Analysis.
    • No Common Standards.
    • Different Meanings Assigned.
    • Ignores Qualitative Factors, and.
    • Insignificant and Unrelated Figures.

    Now, Explain:

    Incorrect Accounting Data:

    False Results if Based on Incorrect Accounting Data. Accounting ratios can be correct only if the data (on which they are based) are correct. Sometimes, the information gives in the financial statements affects by window dressing, i.e., showing position better than what is.

    For example, if inventory values are inflating or depreciation is not charging on fixed assets, not only will one have an optimistic view of the profitability of the concern but also its financial position. So the analyst must always be on the look-out for signs of window dressing if any.

    Probable Happenings in Future:

    No Idea of Probable Happenings in the Future. Ratios are an attempt to analyze the past financial statements; so they are historical documents. Nowadays keeping in view the complexities of the business. It is important to have an idea of the probable happenings in the future.

    Variation in Accounting Methods:

    The two firms’ results are comparable with the help of accounting ratios only. If they follow the same accounting methods or bases. The comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock.

    Similarly, if the two firms are following two different standards and methods. An analysis by reference to the ratios would be misleading. Moreover, utilization of inbuilt facilities, availability of facilities and scale of operation would affect financial statements of different firms. A comparison of financial statements of such firms using ratios is bound to be misleading.

    Price Level Changes:

    Changes in price levels make the comparison for various years difficult. For example, the ratio of sales to total assets in 1996 would be much higher than in 1982 due to rising prices, fixed assets being shown at cost and not at market price.

    Only One Method of Analysis:

    Ratio analysis is only a beginning and gives just a fraction of the information needed for decision-making. So, to have a comprehensive analysis of financial statements, ratios should use along with other methods of analysis.

    No Common Standards:

    It is very difficult to lay down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. For example, a business with the current ratio of more than 2:1 might not be in a position to pay current liabilities in time because of an unfavorable distribution of current assets about liquidity. On the other hand, another business with a current ratio of even less than 2:1 might not be experiencing any difficulty in making the payment of current liabilities in time because of its favorable distribution of current assets about liquidity.

    Different Meanings Assigned:

    The different firms, to calculate the ratio, may assign different meanings. Different Meanings Assigned to the Same Term. For example, profit to calculate a ratio may take as profit before charging interest and tax or profit before tax but after interest or profit after tax and interest. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions.

    Ignores Qualitative Factors:

    Accounting ratios are tools of quantitative analysis only. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may go distort.

    For example, though credit may grant to a customer based on information regarding his financial position, yet the grant of credit ultimately depends on the debtor’s character, honesty, record, and managerial ability.

    Insignificant and Unrelated Figures:

    No use if Ratios are work out for Insignificant and Unrelated Figures. Accounting ratios may work for any two insignificant and unrelated figures as the ratio of sales and investment in government securities. Such ratios may be misleading. Ratios should calculate based on cause and effect relationships. One should be clear as to what cause is and what effect is before calculating a ratio between two figures.

    Meaning Definition Nature Steps Limitations of Ratio Analysis
    Meaning, Definition, Nature, Steps, Limitations of Ratio Analysis. Image credit from #Pixabay.

  • Financial Statements Analysis and Explanation of Accounting

    Financial Statements Analysis and Explanation of Accounting

    Financial Statements Analysis and Explanation; What is Analysis? An analysis is a process of breaking a complex topic or substance into smaller parts to gain a better understanding of it. Financial statements are prepared primarily for decision making. The statements are not an end in themselves but are useful in decision making. Financial analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data. The profit and Loss Account and Balance Sheet are indicators of two significant factors-Profitability and Financial Soundness. Analysis of statement means such a treatment of the information contained in the two statements as to afford a full diagnosis of the profitability and financial position of the firm concerned.

    The concept of Cost Accounting explains Analysis and their Explanation of Financial Statements.

    Financial statement analysis is largely a study of the relationship among the various financial factors in a business as disclosed by a single set of statements and a study of the trends of these factors as shown in a series of statements. This post we will discuss the analysis and interpretation of financial statements of a company.

    The main function of financial analysis is the pinpointing of the strength and weaknesses of a business undertaking by regrouping and analysis of figures contained in the financial statements, by making comparisons of various components and by examining their content. The financial statements are the best media of documenting the results of managerial efforts to the owners of the business, its employees, its customers and the public at large, and thus become excellent tools of public relations. The following topic of the analysis and explanation of the financial statements is below are;

    Analysis of Financial Statements:

    Analysis includes:

    • Breaking financial statements into simpler ones.
    • Regrouping.
    • Rearranging the figures given in financial statements, and.
    • Finding out ratios and percentages.

    Thus all processes which help in drawing certain results from the financial statements are included in the analysis. The data provided in the financial statements should methodically classify and compare with figures of the previous period or other similar firms. Thereafter, the significance of the figures is establishing. The work of an accountant in analyzing financial statements is the same as that of a pathologist, who takes a drop of blood and analyses it to point out its various components and gives a report based on his analysis.

    Similarly:

    An accountant makes an analysis of each item appearing in financial statements and then reports based on his analysis. The analysis only establishes a relationship between various amounts mentioned in the Balance Sheet and Profit and Loss Account. After analyzing the financial statements, the next step is to use the mind for forming an opinion about the enterprise. This is the interpretation stage. The technique is called “Analysis and Interpretation” of financial statements.

    The analysis consists of breaking down a complex set of facts or figures into simple elements. Interpretation, on the other hand, consists of explaining the real significance of these simplified statements. Interpretation includes both analysis and criticism. To interpret means to put the meaning of statement into simple terms for the benefit of a person. Interpretation is to explain in such a simple language the financial position and earning capacity of the company which may understand even by a layman, who does not know to account. The analysis and interpretation of financial statements require a comprehensive and intelligent understanding of their nature and limitations as well as the determination of the monetary valuation of the items.

    The analyst must grasp what represent sound and unsound relationship reflected by the financial statements. Interpretation is impossible without analysis. “Interpretation is not possible without analysis and interpretation analysis has no value”. Analysis and interpretation act as a bridge between the art of recording and reporting financial information and the act of using this information. Analysis refers to the process of fact-finding and breaking down the complex set of figures into simple components while interpretation stands for explaining the real significance of these simplified components. Interpretation is a mental process based on analysis and criticism.

    Points:

    George O May points out the following uses of financial statements:

    • Report on stewardship.
    • The basis for fiscal policy.
    • Determine the legality of dividends.
    • A guide to advise dividend action.
    • The basis for granting of credit.
    • Informative for prospective investors in an enterprise.
    • The guide to the value of investment already made.
    • An aid to Government supervision.
    • The basis for price or rate regulation, and.
    • A basis for taxation.

    A financial analyst can adopt the following tools for analysis of the financial statements:

    • Comparative Financial Statements.
    • Common Size Statements.
    • Trend Ratios or Trend Analysis.
    • Statement of Changes in Working Capital.
    • Fund Flow and Cash Flow Analysis, and.
    • Ratio Analysis.

    Procedure for Interpretation:

    • Ascertain the purpose and the extent of analysis and interpretation.
    • Study the available data contained in financial statements.
    • Get additional information, if needed.
    • Arrange the data in a useful manner.
    • Prepare comparative statements, ratios, etc.
    • Interpret the facts revealed by the analysis.
    • The interpretation drawn from the analysis is presented.
    Objectives of Analysis and Interpretation:

    The following are the main objectives of analysis and interpretation of financial statements:

    • To estimate the earning capacity of the firm.
    • To assess the financial position of the firm.
    • Decide about the prospects of the firm.
    • To know the progress of the firm.
    • To judge the solvency of the firm.
    • Measure the efficiency of operations.
    • Determine the debt capacity of the firm.
    • To assess the financial performance of the firm.
    • To have a comparative study.
    • Help in making plans.

    Analysis of financial statements should always tune to the objective. People use financial statements for satisfying their particular curiosity. Financial accounts are interpreted by different persons in different ways according to their objects. For instance, the same financial statement may be very good for one; ordinarily good for the other and worst for the third. This is because of their views and objects of interpretation differ.

    For instances:
    • A prospective shareholder would like to know whether the business is profitable and is progressing on sound lines.
    • A supplier who would like to transact business with the firms may interest in the company’s ability to honor its short-term commitments.
    • A financier would like to satisfy the safety and reliability of the return on his investment. Thus, the object of the analysis determines the extent, depth, and nature of the analysis.

    Financial Statement Analysis:

    Financial performance, as a part of financial management, is the main indicator of the success or failure of the companies. The performance analysis can consider as the heart of the financial decisions. Also, Rational evaluation of the performance of the companies is essential to prepare sound financial policies and to attract potential investors. Shareholders are interested in EPS, dividend, net worth and market value per share. Management is interested in all aspects of financial performance to adopt a good financial management system and for the internal control of the company.

    The creditors are primarily interested in the liquidity of the company. The government is interested in the regulatory point of view. Besides, other stakeholders such as economists, trade associations, competitors, etc are also interested in the financial performance of the company. Therefore, all the stakeholders are interested in the performance of the companies but their perspective may be different. Financial statement analysis helps to highlight the financial performance of the company. It is the process of identifying the financial strength and weakness of a firm by properly establishing the relationship between the items on the Balance Sheet and those on the Profit and Loss Account.

    Extra Notes:

    It is a general term referring to the process of extracting and studying information in financial statements for use in management decision making, for example, financial statement analysis typically involves the use of ratios, comparison with prior periods and budget, and other such procedures. The financial appraisal is a scientific evaluation of the profitability and strength of any business concerns.

    It seeks to spotlight the significant impacts and relationships concerning managerial performance, corporate efficiency, financial strength and weakness and creditworthiness of the company. The objective of financial statement analysis is a detailed cause and effect study of the profitability and financial position. Also, Financial Analysis is the process of determining the significant operating and financial characteristics of a firm from accounting data and financial statements.

    The goal of such analysis is to determine the efficiency and performance of the firm’s management, as reflected in the financial records and reports. Financial statements are such records and reports, which contain the data required for performance management. As well as, it is therefore important to analyze the financial statements to identify the strengths and weaknesses of the company.

    Financial Statements Analysis and Explanation of Accounting
    Financial Statements Analysis and Explanation of Accounting, Image credit from #Pixabay.