Understanding Financial Statements And Ratios For Decision Making Is Crucial For Essay.

Importance of Financial Statements

The financial statements include the income statement, cash flow statement, balance sheet and statement showing changes in equity. These statements have some individual importance to the potential users. The income statement gives information about the financial performance of the company whereas the balance sheet tells about the financial position. These statements are used by different users for taking different types of decisions. For example, the creditors determine whether it should give credit to the company or not, the lenders determine the credit worthiness of the company whereas the investors decide whether to invest in the company or not (Loughran, 2011).

It is not easy to understand the information provided in the financial statement. A proper analysis has to be done. In order to carry out this analysis, some financial ratios are calculated. These financial ratios give us a better knowledge of the company in every aspect (Harrison, Horngren & Thomas, n.d.).

Let ud first understand the types of financial ratios. There are four types of financial ratios and they are as follows:

• Liquidity ratio.
• Solvency ratio.
• Profitability ratio
• Efficiency ratio

This ratio is calculated to check whether the company is able to manage its working capital requirements properly or not. A company is said to have a good liquidity position when it is able to pay the short term debts without any failure. The two types of liquidity ratio that has been calculated by me is current ratio and quick ratio (Libby, Libby & Hodge, 2012).

Current ratio
Particulars	2014	2015	2016
Current asset	69,000	77,000	87,000
Current liabilities	41,000	42,000	34,000
Current ratio	1.68	1.83	2.56

The current ratio is calculated by dividing the total current assets by the total current liabilities. A current ratio that is greater to one is considered to be very favourable for the company as it is an indication that the company is regular in meeting its short term obligations. The current ratio was good for the company but it is going on improving over the years. The current ratio of 2016 is 2.56 which means that the current assets of the company is 2.56 times the current liabilities of the company (Spiceland, Thomas & Herrmann, 2010).

Quick ratio
Particulars	2014	2015	2016
Current asset	69,000	77,000	87,000
Inventories	41,000	44,000	49,000
Current Liabilities	41,000	42,000	34,000
Quick ratio	0.68	0.79	1.12

Quick ratio creates a better understanding of the company’s liquidity position than the current ratio. This is because it excludes inventories while calculating the quick ratio as inventories cannot be converted into cash so easily. Therefore, it provides better information than current ratio. This ratio is also considered god when higher. The ratio is increasing over the years, as we can see it has increased from 0.68 to 1.12.

Types of Financial Ratios

Solvency ratio is determined to check whether the company has adequate cash flows to pay off the liabilities of the company. Debt ratio is a kind of solvency ratio that help ud to know the ratio of total liabilities to total assets (Kimmel, Weygandt & Kieso, 2012).

Debt ratio
Particulars	2014	2015	2016
Total liabilities	1,16,000	1,38,000	1,43,500
Total assets	2,66,000	2,82,000	2,87,000
Debt ratio	44%	49%	50%

A company can survive only when it has sufficient profits. This ratio gives an outlook of the financial performance of the company. The following table helps us to conclude that there is a decline in the profits of the company. There may be various reasons of the decline which can be identified only after having a detailed study about the company and its workings (Weygandt, Kimmel & Kieso, n.d.).

Operating profit margin
Particulars	2014	2015	2016
Operating profit	20,000	11,000	3,500
Sales	2,00,000	1,80,000	1,65,000
Operating profit margin ratio	10%	6%	2%

Efficiency ratio is calculated to check if the company is able to use its assets and others resources in an optimum manner. This ratio gives a clear view of the financial position of the company (Ittelson, 2009).

Few of the efficiency ratios are shown below:

Inventory turnover ratio
Particulars	2014	2015	2016
Sales	2,00,000	1,80,000	1,65,000
Inventories	41,000	44,000	49,000
Inventory turnover ratio	4.88	4.09	3.37

The inventory turnover raio is considered higher the better. We can see that it is falling over the years which is not good.

Total asset turnover ratio
Particulars	2014	2015	2016
Sales	2,00,000	1,80,000	1,65,000
Total asset	2,66,000	2,82,000	2,87,000
Total asset turnover ratio	0.75	0.64	0.57

The total asset turnover ratio has fallen which means that the company is not able to generate the correct revenue because of inefficiency in managing the assets (Harrison, Horngren & Thomas, 2015).

Return on asset
Particulars	2014		2015		2016
Net income	20,000		11,000		2,500
Total assets	2,66,000		2,82,000		2,87,000
Return on asset	8%		4%		1%
Return on equity
Particulars		2014		2015		2016
Net income		20,000		11,000		2,500
Total shareholders equity		1,50,000		1,44,000		1,43,500
Return on equity		13%		8%		2%

The return on equity and asset should always be higher than the previous year which will mean that the efficiency of the management of the company has increased. But in this case, we have seen that the ratios are falling which means that there is some kind of negligence in the management that is preventing them to get higher returns. 

Although financial ratios are the most commonly used tool by the various users. There are many advantages of using financial ratios but there are certain limitations also. The limitations of using the financial ratios are:

The financial ratios gives the quantitative information about the company whereas ignores the qualitative aspect completely.

Sometimes there is a confusion created because some ratios show that the company has a stable financial position whereas there might be few ratios that does not show the same

The information provided in the financial statements are entirely based on certain assumption, different methods or assumption. Therefore, it is difficult to rely on and compare such ratios with the different companies of the same industry.

Liquidity Ratio

There may be certain variation due to the presence of few seasonal factors.

The investors are usually concerned about the company’s social responsibility but the financial statement or the ratios does not give any such information to the users. 

There are huge numbers of factors that are kept in mind by the users of the financial statements (Piper, 2015). The qualitative information is not enough to draw any conclusion or take any important decisions. The users of the financial statement that includes creditors, financial institution and other stakeholders expect from the company t provide them all the information in a detailed manner. Information relating to the capital structure, profitability, presence of debt and other liabilities are considered important for the process of decision making (Atrill & McLaney, 2009). 

Ethics are values based on those morals or principles that affect an individual’s work or behaviour. The way of working in which an individual can match the societies behavior and thinking is considered to be the best value. The main objective of a firm for having a successful business is to behave in a proper manner and also keep the following principles in mind which are Impartiality, honesty, pluralism, dignity, equality and individual rights.

In the following case, the accountant of Allandale ltd, Tom Lyons is facing a huge moral problem. The company took a mortgage loan of $20 million which was given on the basis of two demands which were: the value of current ratio should be 2:1 and also after the payment of tax the returns on asset should have a minimum value of 10%. Howsoever, the balance sheet shows that the firm owns a boat valued at $500000 on the asset side which may have a net realizable value stated at $350000. There was also a customer who owed an amount of $20 million to the firm but was able to pay only the half amount because of a severe financial crisis. Thus the provisions amounting to $150000 and $200000 respectively meet all the three conditions which state that the amounts should be considered as provisions in the account. After all these calculations the current ratio will be 1.6:1 and the return on assets will be amounting to 2% whereas previously the current ratio was stated to be 2.1:1 and the value of return on assets will be amounting to 11 %. Because of such values, the creditors will ask for the immediate repayment of the mortgage loan as there will be high values of provision which shows that the company may have a financial crisis (Hart, Wilson & Fergus, 2012). Thus, a new problem was raised to recognize an expenditure which has not taken place actually and also by doing this the firm may be risking its reputation and the issues of bankruptcy and unemployment may arise leading to the firm’s failure. 

Solvency Ratio

Tom Lyons, the charted accountant of the firm, should follow certain steps to deal with the ethical problem he and the firm have been facing:

There are three conditions which are stated in the accounting standards for the recognition of a provision which are: there must have been some activities in the past which may increase the current liability; if there are chances less than 50% of facing a loss then we may make a provision; also all the reliable documents should be checked before creating a provision as it may harm the business in future. If all these conditions are applied then there shall be no problem in the creation of the provision (Berry & Jarvis, 2007).

There are certain principles like the “prudence” concept which should be kept in mind before presenting or making the financial statements. This concept states that there should be certain measures which should be adopted so that the income and assets are not overvalued and the liabilities and expenditures are not undervalued. It also means that the asset shouldn’t be valued at a higher price than what it needs to be recovered in the future and the liabilities shouldn’t be valued at a lower price than what it needs to be paid in the future.

The company should try and take some time to return the loan to the lender instead of paying the loan immediately which may help it to recover from the disturbing circumstances and make their present ratios presentable also helping it to avoid bankruptcy in near future (Shim, Siegel & Shim, 2013). 

According to the given case, the Giggling Bothers are facing many difficulties in the management of the continuous negative cash flows. It will be better if the company replaces its old manual accounting system with a new automatic Just-In-Time system as the major problems caused are because of the mismanagement of the stock which is caused because of excessive or less purchase of the inventories made by the firm inadequately. Just-In-Time system may be helpful to improve the management of inventories as it makes strategies which may be helpful in the increment of the efficiency and also it may decrease the waste leading to the proper functioning of the purchasing This strategy is taken into consideration so that the company can provide its customers whenever they need the product and also be safe from facing the problem of storing unused inventories and thus leading to the reduction of the inventory costs (Lalli, 2012).

Profitability Ratio

The JIT strategy assists the firm to track the demand of the environment correctly, thus leading to help the firm in deciding the amount of materials which may be needed for the production of goods. Thus the new software will help the purchasing department in the proper functioning of the firm. The accounting software should be computerized in a manner which will help to notify the firm whenever there is a low credit balance of a customer so that the firm may stop further sales and ask the debtor to clear his accounts before any further business is being done.

The adoption of the new computerized JIT system will help the firm in many ways. Some of the advantages are stated below (Loganathan, 1997):

The new system will help the company to know the demands of its customers accurately and thus order the materials accordingly with no waste left. This will help the firm to maintain a good relationship with its customers because of the high-quality goods at low costs and timely delivery.

The computerized software uses a technology which helps the firm to determine and reduce the overhead expenses, transportation costs, storage costs, etc. It also helps the firm to detect information about any malfunctioning present in the production of goods which may be helpful in the future to make a correction and reduce the production cost (Izhar & Hontoir, 2001).

It also helps to reduce the amount of fund which is invested in the stock. The saved money may be used anywhere else to improve the business. It will also be clearing the space of warehouse by removing the excessive inventories. The extra space may be used for expanding the business in any other manner.

The adoption of such system requires regular synchronizing between the several departments as if any of the departments fail to coordinate the whole organization will suffer. Thus the introduction of any such new software requires teamwork of the departments which may help the firm to improve its business indirectly (Bhattacharyya, 2011).

The new system of JIT will help the firm in better management of the firms account as it will help the department to recognize the major weaknesses of the firm by observing the unwanted expenses or to check whether there is any accrued income which is not received by the firm. These are the problems which may have been raised in the previous manual system but is now repaired by the new automatic system.

Efficiency Ratio

The new system will be less time consuming and thus the saved time may be used by the accountants for better planning and organizing of the future strategies of the firm (Epstein & Lee, 2012).

The new system may not be very cheap at cost, so the company should evaluate all other costs before implementation of the system. The Giggling Brothers are adopting the software so as to ascertain that there are less overhead expenses and normal inventory costs. The excess profit may be used to provide loans and earn interests also the free warehouse space may be rented for earning extra revenue. The company may also reduce the workforce for the accounting department as there will be less work which can be finished by two or three employees who are expert at their job thus, leading to an overall decrease in the company’s expenses.

Before setting the software and using it, the company should look at the following facts:

The system should be organized in a manner in which it shows the monthly cash flows because previously the company was suffering a loss in every six months. If such action continues then the company should take immediate steps to cure the problem.

It should also show a quarterly report which may be used to analyze the purchase made, sales made or accrued income so that the management could take steps to treat loss appropriately.

The firm should check whether there are any unusual sales taking place in the company as the maximum treachery takes place because of poor management of accounts. Thus to be on the safe side, the firm should either train its employees or replace them with the experts of the particular field.

The company should also take into account that it is investing the funds in the appropriate activities and it should also check that it is covering all the costs and incurring profits.

The company was incurring good profit before but is suffering loss recently. It is also late for the adoption of the new system as the competitors of the firm may have already adopted it a long time back in the past. They may have also faced the problems but after analyzing the new system they may have found the solutions for problems. Thus the company should try and get educated by the experience of the competitors. Thus it will be helpful for the company if they examine the whole system before implementing  

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