What Do You Mean By Financial Ratio Accounting Essay


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Accounting has developer in the world slowly for thousand years. Accounting is the process of identifying, measuring and communication financial or economic information to help decision making to the user. Financial Statement is the formal recode of the financial data or activities of a business. Analysis of financial statement helps to identify organizational financial strength and weakness. Financial ration analysis help management to compare its business performance against competitor or against own previous performance.

1. What do you mean by financial ratio? Explain Different Types of Financial Ratio?

2. Answer to the Question Number 1:

Financial Ratio is numerical indicator of firm's performance as well as financial situation. This ratio is taken from the Financial Statement of the Organization. Financial Ratio can use by present or potential stakeholder, as well as creditors. Management use financial ratio to compare the financial performance with its competitor or performance against previous year. However, Financial Ratio can be state as decimal value (0.10) or percentage value (10%) (Higgins, 2007).

Most Common Uses of Ratio (Higgins, 2007):

To compare performance over a period of time

To compare performance against competitor

To compare performance against a target

To compare performance against industry average

In addition, Financial Ratio Analysis is a accounting process which organize accounting and financial information into structured form which identify companies strengths as well as weakness. However, use of financial ratio may be helpful but there is a chance it can direct to information overload because of as many as 44 various ratios (Higgins, 2007).

Financial Ratio Analysis can be classified as following way (Elliott, et. al., 2008):

Profitability Ratios

Liquidity Ratios

Dividend Policy Ratios

Asset turnover Ratios

Financial Leverage Ratios

1. Profitability Ratios Analysis

Profitability ratio calculates the firm's use of assets and control of its expenditure to make an satisfactory rate of return. In addition, it gives the measure of company's capability to generate profit. There many types of profitability ratio. Some of them are given below (Elliott, et. al., 2008):

1.1. Gross profit Margin

1.2. Return on Assets

1.3. Return on Equity

2. Liquidity Ratio Analysis

Liquidity Ratio Analysis gives information about thy firm's capability to meet its short-term financial Debts or Obligations. Two most common liquidity ratio is Current and quick ratio (Elliott, et. al., 2008).

2.1. Current Ratio

2.2. Quick Ratio

3. Dividend Policy Ratio

Dividend policy ratio gives the insight of the dividend policy of the organization and the probability of future growth. Two most common dividend policy ration are payout ratio and Dividend yield.

3.1. Dividend Yield

3.2 Payout Ratio

4. Asset Turnover or Efficiency Ratio

It indicates how effectively or efficiently companies use its assets (Elliott, et. al., 2008).

4.1. Inventory Turnover

4.2. Inventory Period

4.3. Receivables Turnover

4.4 Average collection period

5. Financial Leverage Ratio

It gives firm a indication of long term solvency, financial leverage ratio measure the area about how the company using its long term debt (Elliott, et. al., 2008).

5.1. Debt Ratio

5.2. Interest coverage

5.3. Debt-to-Equity Ratio

All ratios are subject to the limitation of the accounting method, different accounting method chooses may gives different value of ratio.

2. A. Describe the double entry book keeping system.

3. Answer to the Question Number 2.A:

All accounting Data were kept in book manually from about hundred years ago. So the process of recording accounting data is often called bookkeeping. Therefore, Bookkeeping is the practice of recoding accounting data or transaction in the accounting Books. In 1494, Italian merchant Lucas Pacioli wrote the first book about Double Entry Bookkeeping System. The main base of Double entry Book-keeping system is recording the data having two fundamental aspects, (giving and receiving), first one is receiving the benefit and other one is giving the benefit in the same book (Wood et. al., 2008).

However, the person or party or received the benefit is called Debtor (Dr) and one who gives the benefit is called Creditor (Cr). Under the double entry system both receiving and giving aspects are record in accounting terms. The ultimate result of the Double entry bookkeeping system is that each debit must have an equivalent credit and in the specific day total debit entry must be equal to the total credit entry in the accounting book (Wood et. al., 2008)..

For Example, Company A has got long term loan for £1000,000 from company B on December 1, as a result Company A, cash account (Assets) increased by £100,000 and debated for that amount. On the other hand, the Company's payable account (Liabilities) increased also by £100,000 and it is credited. Therefore, Bothe side of the accounting book are increased by £100,000 and the debits and credits remain equal (Wood et. al., 2008)..

The main advantage of the double entry bookkeeping is it is used to draw Trial balance to prove arithmetic accuracy of record and possible to make profit and loss account from it. In addition, it is important to make Balance sheet of the organization (Wood et. al., 2008)..

2. B. Describe the accounting process in preparation of financial statement.

4. Answer to the Question Number 2.B.:

Accounting cycle includes four basic steps, firstly recording the data; secondly, recording the data; thirdly, adjusting the accounts and finally, prepare financial statements. Generally, in the accounting period, account recodes the all transaction in the company as it occurs. Towards month end accountant post adjustment entries to correct each accounts. After make sure each account is correct, account make a Trail Balance from the Ledger book and prepare the financial statement (Wood et. al., 2008).

So, the first step to make Financial Statement is to make a ledger and from ledger make a Trail balance and then make the financial statement from Trail balance.

Logical Order of Preparing Financial Statement (Wood et. al., 2008):

1. Income Statement of the Company for a particular period of time

2. Statement of the retain earnings

3. Balance Sheet of the Company

4. Cash flow Statement

Figure 1: Financial Statement process

1. Income Statement

Income statements generally include company's revenues, expenditure and outcome is capital gain or loss. To prepare Income Statement accountant transfer accounting data from ledger or trail balance to income statement (Wood et. al., 2008).

2. Statement of Retain Earnings

This statement present the companies retain earnings for the beginning and the ending accounting period. The information need to make Retain Earning Statement is following below (Wood et. al., 2008):

Beginning retain earnings from the last statement (ending retain earning for the last account period)

Net income or loss from the income statement

Dividends paid by the company during this account period

Balance Sheet

Balance Sheet presents the Assets, liabilities as well as share holder equity of the organization. In is prepared using the below information (Wood et. al., 2008):

Total Balance of All Assets (Cash, Account receivable)

Total Balance of all Liability (Account payable)

Capital share balance

Total retain earnings from retain earning statement.

4. Cash follow statement

This statement describe the cause for changes in the cash balance, Cash follow statement cannot be prepare from ledger rather it is make by modifying actual information to a cash-basis (Wood et. al., 2008).

3. A. Basic accounting equation as the basis for the balance sheet

5. Answer to the Question Number 3.A.:

Assets, equity and liability are the financial measure of the firms. The financial statement which presents all this information is called Balance sheet. In addition, Balance sheet includes Assets, liabilities and shareholder equity of the organization. The relationship between them can be providing algebraically or commonly known Accounting Equation. Basic Accounting Equation: Equity = Assets - Liquidity or Assets = Liabilities + Equity.

This equation means value of the organizational Assets is equal value to the liabilities plus equity of the organization (Wood et. al., 2008).

On the other hand, Balance Sheet of the company has two sections or side, one section represents the value of the Assets and other section presents the value of liabilities and equity. The balance of the two side of the balance sheet must be equal as like accounting basic equation (Assets = Liabilities + Equity) (Wood et. al., 2008).

So we can say that basic accounting equation is the basis for the Balance Sheet.

3. B. Realization of revenue and expenses for the income statement.

6. Answer to the Question Number 3.B.:

Income Statement or Profit and Loss account (P&L) is the statement which summarize the revenues, expenditure or cost sustain during a particular period of time, generally a year or a fiscal quarter. Income Statement presents capability of a company to create profit by decreasing cost or expenditure and by increasing sales. The main purpose of the Income Statement is to show the stakeholders and managements whether the company or organization makes profit or income at a particular time. The format of the Income Statement differs from company to company but most company have two main sections such as Revenues and Expenses (Elliott et. al., 2008);

1. Revenue and Gains

Revenue or Income from major activities also called operating revenue. It is the revenue from selling product or service to the customer for wholesaler, retailer and distributors and manufacturer. Service or Sells revenue shown in the Income statement in the period they are earned or delivered not on the time of receive receipt (Elliott et. al., 2008).

Revenue and Income from minor activities is also shown in Income Statement. These types of revenue include; interest from primary revenue, sale of long term assets and gains from law suits (Elliott et. al., 2008).

2. Expenses and Losses

Expenses or also called expenditure of the company. This is incurring for earnings primary revenue. Expenses are generally shown in the same period that the related sales to gain revenues (Elliott et. al., 2008).

Expenses from secondary activities called non operation expenses such as interest of non operating expense. Distribution cost, administration cost, research and development cost also include here (Elliott et. al., 2008).

3. C. Describe the income statement.

7. Answer to the Question Number 3. C:

Income Statement is the part of Financial Statement of the organization. Income Statement or Profit and Loss account (P&L) is the statement which summarize the revenues, expenditure or cost sustain during a particular period of time, generally a year or a fiscal quarter. Income Statement presents capability of a company to create profit by decreasing cost or expenditure and by increasing sales (Elliott et. al., 2008).

The main purpose of the Income Statement is to show the stakeholders and managements whether the company or organization makes profit or income at a particular time. The format of the Income Statement differs from company to company but most company have two main sections such as Revenues and Expenses (Elliott et. al., 2008);

The main Elements of Income Statement





Cost of Sales

Gross margin

Operation Profit

Profit before tax

Profit after tax

Retained Profit

8. Conclusion:

Analysis and Interpretation of the financial statement is the very important for the business organization success. It helps investor to decide where to invest. Evaluation the financial ratio analysis management of the organization can modify necessary change needed to attain the business goal of the organization.

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