SHR036-6 Accounting For Leaders - Accounting Analysis

1. Financial ratios are those ratios that are extracted from the financial statements and reports of the company. It helps to authenticate and contrast the difference between every financial year. It is divided into five groups of ratios:

Investment ratios: Investment ratio assists the investor or the investing company in whether to invest in a company or not by understanding its financial reports. For example, the price earning ratio indicates whether the investor should invest in the company or not (Weetman, 2019). In this case, the price earning ratio plays a pivotal role. 

Operating ratios: Operating ratio helps the company to identify its efficiency by looking into the turnover ratios (tangible and intangible assets) and revenue to sales ratio of each employee. An effective and efficient company can gain maximum profitability.

Profitability ratios: It is divided into two categories- gross profit margin and net profit margin. It helps the company to realize the actual profit that is obtained from the operating expenses and cost earned on the selling of products or goods.

Debt ratios: Debt ratios assists the company in protecting the company from debt (liabilities) and the assets that help them to pay their debts. Debt ratios are generally known as a debt-to-equity ratio or visa-versa (Sohrabi, 2017). The debt ratio must not be greater than 5 or else the company runs in the loss.

Liquidity ratios: Liquidity ratios or Acid Test ratios helps the company to calculate and evaluate the particular asset ratio which will, in turn, help the company to perceive and predict the duration within which those assets can be liquidated to cash. The liquidity ratio must not be greater than 1.5 or 1.5:1. In this case, the company has fulfilled its criteria because its ratio is 1.25:1.

Ratio analysis is prepared by several small and big multinational companies to figure out the difference and growth in every financial period. Coherently, by stopping to think about the meaning of the accounting numbers, the interpretation of the financial ration can be pursued. The cash flow margin helps the company to figure out and have an anticipation about the period within which cash will be generated. The information that is gathered from the financial statement of Seseka Trading as on year ended 31st July 2019 are:

The acid test ratio or liquidity ratio is calculated to figure out the liquidity of the company where cash can be rapidly switched into cash without running in loss. Assets such as inventory, building, supplies, and equipment are subtracted from current assets and then divided by current liability. Acid test ratios must be less than 1.5 so that the company can gain profit. Mathematically,

Acid Test Ratio or Liquidity ratio= Liquid Assets (Current assets-Inventory, supplies, equipment, plant) / Current Liabilities

In this case, Seseka Trading gained as 1.25 in the financial year 2019 and 1 in the financial year 2018 that means the company will gain profit because it did not target and depend on the sales of the future.  Moreover, the price earning ratio of the company increased by 20% in the financial year 2019. It was Rs10 in the financial year 2018 and then it was increased by 20% in the year 2019 i.e. (20% of Rs10 = Rs2 {Rs10 +Rs2= Rs12}) and became Rs12. Above all, when the turnover increased in 2019 the gross profit margin also increased by 7% whereas the net profit margin increased by 4%. As the total turnover and profit margins have increased, the period of liquidation of cash has decreased as the amount receivables (current asset) have decreased which means cash will be generated rapidly from all the current assets. After generating the cash all the liabilities (amount payables) will be paid so that its profitability ratio becomes equal and the company can gain maximum profitability. 

2. Financial statements and reports analyzing make it easy to understand whether the company is at risk or is gaining profitability. A proper financial statement, as well as a report, helps the investor or the investing company to make decisions about whether to put the funds on a company or not. The Board of Directors can set instructions and regulatory rules so that the financial statements are followed and maintained by the accounting standards. With the help of financial ratios, the company can evaluate and monitor their company execution or presentation of every financial year.

The implications of my analysis an illustration are as follows:

In the case of debt: An investor or the investing company must evaluate the workings of debt before investing in the company. The investor (Abdul Wadah Investments) must look after the long term debt. These liabilities are not paid off in the same financial year whereas they are paid afterwards. The Debt-to-asset ratio is calculated by dividing the total asset by total liabilities. Mathematically,

Debt-to-asset ratio = Total Assets/ Total Liabilities

In the case of profits: Financial ratios help the company to gain maximum profitability by balancing and minimizing the operating expenses. Profits are evaluated before and after the tax are calculated. In financial statements, the profit ratios are divided into two categories, gross profit margin, and net profit margin. In the case of Seseka Trading, the gross profit in 2019 is more than in 2018 which means that the cost of the raw materials and the labour cost is more in the financial year 2019 than in 2018. 

In the case of earnings: Financial ratio analysis helps the company to monitor and record the company's earning per share and its price earning ratio to pursue maximum profitability. It also helps the investor or the investing company (Abdul Wadah Investment) in making decisions about investing in a particular company (Seseka Trading). Mathematically,

Earning per share = (Net profit after tax (PAT) – Preference Dividend / Number of Equity Shares)* 100

Price earning ratio = Market price per Equity share/ Earning per share

3. The depiction and illustration of the financial statements of Seseka Trading as on year ended 31st July 2019 make the concept of the financial statement more or less clear but a little investigation is needed on various parts of the financial statement. Firstly, scrutinizing the acid test ratio or liquidity ratio and analyzing whether the company has taken into account some of the liquid assets that are needed to be liquidated in time.  Secondly, the inflation and effects such as the pressure on the inflationary gap are to be investigated. There must be a balance between the current asset and liability which means the ratio must always be on a 2:1 basis. If the ratio is more than 2:1 then the company will suffer an inflationary gap. Thirdly and finally, the company has used both quantitative and qualitative approaches and only the quantitative approach. The company must include both the approach so that the investor or the investing company can scrutinize and go through the financial and accounting reports as well as ratios and decide whether they will take a controlling stake and will investor will not invest at all. These are the important factors that are needed to be scrutinized and investigated for the completion of the assessment.

4. While defining and scrutinizing the financial statement of Seseka Trading as on year ended 31st July 2019 some limitations were taken into account. They are,

The price level ratio is the main important thing that brings the difference between each year's financial statements. This also helps the company to maintain the inflationary gap. It prevents the company from an increase in inflation. Therefore, inflation must be monitored and evaluated by the employees in the company. But, in the case of the financial report of Seseka Trading the inflationary gap and its effects have been ignored which in turn has increased the value or the amount of price earning ratio.

Plant & Equipment is an asset that can be liquidated into cash rapidly (within the same period). But, in this case, it is not understandable that whether Seseka Trading has calculated the acid test ratio without subtracting plant and equipment with the current asset or by subtracting it from current assets in the financial statement as on 31st July 2019.

While analyzing the financial statement only the quantitative prospect has been taken into account. The qualitative prospects generally known as the accounting ratios have been ignored and not evaluated in the financial statement of Seseka Trading as of 31st July 2019. Therefore, before investing in this company Abdul Wahab Investments binge goes through the accounting ratios and other quantitative prospects of Seseka Trading Company

5. After analyzing and making an illustration of the financial statement of Seseka Trading as on year ended 31st July 2019 it can be recommended that Abdul Wahab Investments must either take a controlling stake or must not at all enact to make an investment in that company.

If the investor is taking a controlling stake then they will have the overall voting power (more than 20%) and will have and the ownership (more than 30%) of that company will be handed over to the investor or the investing company. if the total voting right or power and the ownership of the company get transferred to the investor or the investing company then there is a chance of gaining profit because the financial reports and the financial ratios whether quantitative or qualitative will be scrutinized minutely by the parent company and also by the investing company. But, if the investor or the investing company is not taking a controlling stake then they must not at all invest in the company because as per their given information the company does not follow the profitability ratio to the full extent. The company does not focus on inflation and its effects which can lead to an inflationary gap. Moreover, the information is not scrutinized accurately by the company and it is not mentioned whether the company has taken plant and machinery into account or not because it is a liquid asset and it must be taken into accounting adjustments.

References

Sohrabi, M., 2017. The Relationship between Non-Financial Innovative Management Accounting Tools and Risk and Return of Iranian Stock Market Listed Companies. Dutch Journal of Finance and Management, 1(2), p.40.

Weetman, P., 2019. Financial and management accounting. Pearson UK

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