# FINАNСIАL AND АССОUNTING РRINСIРLЕS 1 Essay Example

• Category:
Management
• Document type:
Essay
• Level:
Masters
• Page:
2
• Words:
813

Finаnсiаl and Ассоunting Рrinсiрlеs

Finаnсiаl and Ассоunting Рrinсiрlеs

Financial analysis is significant for all the businesses because it helps in effective management. Financial reports and statements include balance sheets, income statements, and statement of changes in financial position and so on. This paper shall examine the relevant financial and accounting principles used to analyze and interpret these statements and reports.

Ratio Analysis

The most common and easy method to analyze financial reports and analysis is through the use of ratios. The accounting ratios can be used internally in an organization or they can be employed in comparing different companies in the same industry to determine the position of the corporation being analyzed. The four basic features commonly analyzed are of liquidity, leverage and turnover ratios and profitability ratios, and can be combined to formulate an idea of the position of the firm in its respective industry (Hancock et al. 2015).

Liquidity

Liquidity ratios are used to establish the ability of the company to pay for its daily bills. This ratio is meant to determine the basic functionality of the company. For example, if a company owes \$ million but they only have \$200 in the bank then the company is not going to be operation by the end of the week. The main liquidity ratios are current ratio and quick ratio. Current Ratio is calculated by dividing current assets by current liabilities. The current assets must be more than the liabilities for the company to be doing well (Frumkin et al. 2001). Some companies use quick ratio to determine liquidity because of the unreliability of inventory values especially where the inventory accumulates on the financial statements but it is valueless and difficult to dispose of, for example, outdated computers.

Leverage

The ability of a company to pay its long-term debts is called leverage. There are two ratios used to determine leverage, Debt ratio and Times Interest Earned Ratio. The debt ratio is found by taking the total assets less the total equity and dividing by the total assets. The calculation shows the percentage of the company financed by debt. Therefore, the higher the percentage, the more leveraged the company. The Times Interest Earned Ratio is used to compare the amount of interest owed to creditors every year to the amount of money earned before interest and tax. The essence is to establish the percentage of the money being used to finance the debt. For example, if a company is making \$200 but owe \$230 in interest per year, then the company is not doing well.

Turnover Ratios

The ratio calculates the estimated utilization of assets. There are three most common turnover ratios used to analyze different items on the balance sheet. The first is the Inventory Turnover that is used by technology industries method to calculate the inventory multiple. Additionally, it can be used as an indicator of management competencies. A balanced rate of inventory turnover shows increased capabilities. The second is the receivable turnover that addresses the accounts receivables (Peterson & Fabozzi, 2012). Basically, it looks at the amount owed to the business by clients who have not paid for purchased items. It is done by dividing sales by the account receivable to get a multiple. Third is the payable turnover which calculates the amount of time the company waits before paying off creditors. The period should not be too long as this would be an indication of problem or too short because the company could miss financing opportunities.

Profitability Ratios

The profits of a company are measured using profit margin, return on assets and return on equity (Frumkin et al. 2001). The profit margin is calculated by dividing the net income from all expenses to determine the amount of money by sales. The higher the profit margin, the more competitive the company can be. Return on Assets show the amounts of money a company is making given its size. The ROA is calculated by dividing the net income by the total assets. Lastly, Return on Equity is used to establish how much the firm is making per dollar invested by the shareholders. The net income is divided by total equity. Thus, a higher return on equity will keep the shareholders invested for a long-term.

In conclusion, the different accounting ratios are designed to analyze the financial status of a business. However, some can also be used to examine the work of management in the company. Different accounting principles cater for the diverse aspects of the organization. Therefore, it is necessary to apply all of them when analyzing and interpreting financial reports and resources.

References

Frumkin, P., Caton, R., & Colman, M. S. (2001). How to assess nonprofit financial performance. Cambridge.

Hancock, P., Bazley, M. E., & Robinson, P. (2015). Contemporary accounting: A strategic approach for users. Cengage Learning.

Peterson, D. P., & Fabozzi, F. J. (2012). Analysis of financial statements. Hoboken, New Jersey.