The interpretation of ratios analysis important factor

The interpretation of ratios is an important factor. Though calculation of ratios is also important but it is only a clerical task whereas interpretation needs skill, intelligence and foresightedness. The inherent limitation of ratios analysis should be kept in mind while interpreting them. The impact of factors such as price level changes, Change in accounting policies, window dressing etc., should also be kept in mind when attempting to interpret. A single ratio in itself does not convey much of the sense. To make ratios useful, they have to be further interpreted. For example, say, the current ratio of 3:1 does not convey any sense unless it is interpreted and conclusion is drawn from it regarding the financial condition of the firm as to whether it is very strong, good, questionable or poor. 

The interpretation of the financial ratios can made

• Generally speaking one cannot draw any meaningful conclusion when a single ratio is considered in isolation. But single ratios may be studied in relation to certain rules of thumb which is based upon well proven conventions as for example 2:1 is considered to be a good ratio for current assets to current liabilities.

• Ratio may be interpreted be calculating a group of related ratios. A single ratio supported by other related additional ratios becomes more understandable and meaningful. For example, the ratio of current assets to current liabilities may be supported by the ratio of liquid assets to liquid liabilities to draw more dependable conclusions.

• One of the easiest and most popular ways of evaluating the performance of the firm is to compare its present ratios with the past ratios called comparison overtime. When financial ratios are compared over a period of time, it gives an indication of the direction of change and reflects whether the firm's performance and financial position has improved, deteriorated or remained constant over a period of time. But while interpreting ratios from comparison over time, one has to be careful about the changes, if any, in the firm's policies and accounting procedure.

• Ratios can also be calculated for future standards based upon the projected or proforma financial statements. These future Ratios may be taken as standard for comparison and the ratios calculated on actual financial statements can be compared with the standard ratios to find out variances, if any. Such variance help in interpreting and taking corrective action for improvement in future.

• Ratios of one firm can also be compared with the ratios of some other selected firms in the same industry at the same point of time. this kind of comparison helps in evaluating relative financial position and performance of the firm. But while making use of such comparison one has to be very careful regarding the different accounting methods, policies and procedures adopted by different firms.

Method of keeping the financial records

The most common method of keeping the financial records of a company was manual. A bookkeeper kept the journals, the accounts receivable, the accounts payable and the ledgers in his best possible penmanship. In later years, an accounting machine, which was capable of performing normal bookkeeping functions, such as tabulating in vertical columns, performing arithmetic functions, and typing horizontal rows was used. The billing machine, which was designed to typewrite names, addresses, and descriptions, to multiply and extend, to compute discounts, and to add net total, posting the requisite data to the proper accounts, and so to prepare a customer’s bill automatically once the operator has entered the necessary information, was used. Early accounting machines were marvels of mechanical complexity, often combining a typewriter and various kinds of calculator elements. The refinements in speed and capacity made possible by advances in electronics and operating complexity of these machines. Many of the newer “generations” of accounting machines are operated by a computer to which they are permanently connected. Computers are rapidly changing the nature of the work for most accountants and auditors.

With the aid of special software packages, accountants summarize transactions in standard formats for financial records and organize data in special formats for financial analysis. These accounting packages greatly reduce the amount of tedious manual work associated with data management and recordkeeping. Computers enable accountants and auditors to be more mobile and to use their clients’ computer systems to extract information from databases and the Internet. As a result, a growing number of accountants and auditors with extensive computer skills specialize in correcting problems with software or in developing software to meet unique data management and analytical needs. Accountants also are beginning to perform more technical duties, such as implementing, controlling, and auditing systems and networks, and developing technology plans and budgets.

Conventional financial accounting primarily focuses

Conventional financial accounting primarily focuses on the measurement and reporting of business transactions between two or more business firms. Financial statements prepared under financial accounting are basically meant to serve the needs of shareholders and potential investors in making sound economic decisions. Exchanges between a firm and its social environment are practically ignored. The conventional financial reporting system is designed to gather process and report financial results and operating statistics with no regard to social performance information of business enterprises. This nature of financial accounting has led to, in recent years, a serious debate that business activity should conform to socially, and desirable ends, e.g., that products should not be harmful to users, the pursuit of profit should be constrained by social considerations; the environment should be protected from industrial malpractices in the form of pollution of every kind; and employees should have a right to security of employment. As business enterprises respond to pressures of new dimension–social, human and environmental–they may not necessarily change their basic business goals, but they will alter them to reflect the new constraints to be satisfied. The technology of an economic system imposes a structure on its society which not only determines its economic activities but also influences its social relationships and well–being. Therefore, a measure limited to economic consequences is inadequate as an appraisal of the cause-effect relationships of the total system; it neglects the social effects.

The term ‘social accounting’ is of recent origin and many other terms like, ‘social audit’ ‘socio-economic accounting’, ‘social cost benefit analysis’, ‘report on corporate social policies’, ‘social information system’, ‘social accounting’, ‘social responsibility accounting’ etc. are often interchangeably used for this. Now –a –days it is being realized that commercial evaluation of business units is not sufficient to justify commitment of funds to a business unit. Rather evaluation will be complete only if it takes into consideration social cost and benefits associated with them

Calculate the effect of error on final accounts

To calculate the effect of error on final accounts i.e. Trading and Profit and Loss and Balance sheet. It is essential to know the nature of the accounts in which errors lie, If the error affects the nominal account/accounts, it will increase or decrease the profit because all nominal accounts are transferred to Trading and Profit and Loss account. In this connection following points may be noted:

• Profit will increase or Loss will reduce if a transaction is omitted to be debited to a nominal account. On rectification of an error of such a type, profit will decrease or loss will increase. 
• Profit will reduce or Loss will increase if a nominal account is wrongly debited. When the rectification of such an error, Profit will increase or loss will decrease.
• Profit will increase or Loss will decrease if nominal account is wrongly credited. With rectification of this kind of error, Profit will decrease or Loss will increase. 
•  Profit will decrease or loss will increase if transaction is omitted to be credit to a nominal account. On the rectification the nominal account omitted to be created will be credited and Profit will increase or Loss will reduce

Thus Profit is increased or decreased on account of errors in nominal accounts. Balance Sheet will also be affected by the errors in nominal accounts because profit is ultimate transferred to Capital account which is a part of the Balance Sheet. So it can be concluded that error in nominal account will affect both profit and loss account and balance sheet. Balances of personal and real accounts from part of a Balance Sheet, so errors in such types of accounts will affect Balance Sheet only and not Profit and Loss account  

Capital and revenue as regards to expenditure

There is no proper distinction between capital and revenue as regards to expenditure, payment, profits, receipts, and losses, is one of the fundamental principles of correct accounting. it is very essential that in all cases this distinction should be rigidly observed and amounts rightly allocated between capital and revenue. Failure or neglect to discriminate between the two will falsify the whole of the results of accounting. for example, plant may be purchased and charged to the purchase account; additions may be made to the premises and debited to the repair account; some of the fixed assets may be sold and the proceeds treated as profit. In each case both the profit and loss account and Balance sheet would be inaccurate and misleading. These and similar mistake are easily made and if undetected would soon render the accounting useless as a record of financial results. As all revenue items go to the trading and profit and loss account and all capital items to the balance sheet , it is necessary that the proper distinction should be made between capital and revenue while preparing the final accounts of a business at the end of a trading period.

It is very difficult to give a clear cut rule as to distinction between the capital and revenue expenditure. how ever we try to clear such concept in the next pages and keep reading it.

Goodwill is an intangible asset

Goodwill consists of the advantage a business has in connection with its customer, employees and out side parties with whom it has to contact. That is why it was define as the probability that the old customer will resort to the old place. Goodwill has been said to be attractive force which brings in customer. Thus, to determine the nature of goodwill in a particulars case, it is necessary to consider the type of business and the type of customers which such a business is inherently likely to attract as well as surrounding circumstances of each case. Goodwill of a business is a composite thing referable in part to its locality, in part to the way in which it is conducted and personality of those who conduct and in part to the likelihood of competition. According to Braden and Allyn, “Goodwill is an intangible asset compounded from a variety of successful business ingredients – competent and energetic management, customer acceptance, a favorable location, a quality and profitable product, efficient production method, an outstanding reputation, plus the expectation that these ingredient, will continue to produce an above normal rate of return for an indefinite period of time “

Goodwill is sometimes described as a momentum or a push ‘ that keeps the business going without further effort like the momentum of a body that continues its motion against a retarding force till it comes to rest gradually. When a man pay for goodwill, he pays for something which places him in the position of being able to earn more than he would be able to do by his own unaided efforts. Goodwill is thus present value of a firm’s anticipated excess earnings. It is the extra saleable value attaching to a prosperous business beyond the intrinsic value of net assets.

Final accounts are prepared to achieve

Final accounts are prepared to achieve the objectives of accountancy. In order to know the profit or loss earned by a firm, Income statement or trading and profit and loss account is prepared. Balance sheet or position statement will portray the financial condition of the firm on a particular date. These two statement, i.e. Trading and Profit and Loss account and balance sheet are prepared to give the final results of the business that is why both these are collectively called as final accounts. Thus final accounts include the preparation of:

•  Trading and Profit and Loss Account
• Balance Sheet

Final accounts are the means of conveying to management, owners and interested outsiders a concise picture of profitability and financial position of the business. The preparation of the final accounts is not the first step in the accounting process but they are the end products of the accounting process which give concise accounting information of the accounting period after the accounting period is over. These accounts summaries all the accounting information recorded in the subsidiary books and the ledger running into hundreds or thousands of pages

Trading and Profit and Loss Accounts:

This account is made up of two accounts i.e. Trading account and Profit and Loss account. Trading concerns i.e. those concerns which purchase goods from one market and sell these in another market at a profit, prepare this accounts This accounts is prepare to know the trading results or gross margin on trading of the business, i.e how much gross profit the business has earned from buying and selling during a particular period. The difference between the sales and cost of goods sold is gross profit. For the purpose of calculating cost of goods sold, we take into consideration opening stock, purchases, direct expenses on purchasing or manufacturing the goods and closing stock. The balance of this account represents gross profit or gross loss and is transferred to the profit and loss account. On the other hand Profit and Loss account is prepared to calculate the net profit of the business. There are certain items of incomes and expenses of the business which must be taken into consideration for calculating net profit of the business. These are indirect nature, i.e. concerning the whole business and relating to various activities which are done by the business for the purpose of making the goods available to the consumers. Indirect expenses may be selling and distribution expenses, management expenses, financial expenses etc. The nature of this account is nominal account and balance of this account is transferred to the Balance sheet’s Capital Account as the whole profit or loss will be that of the owner and it will increase or decrease his capital. 

The volume of output fluctuates

To study of the behavior of overheads in relation to changes in volume of output reveals that there are some items of cost which tend to vary directly with the volume of output where as, there are other which remain unaffected by variations in the volume of output. The former class of cost represents the variable overheads and the letter fixed overheads. Besides, there are certain items of cost which are partly fixed and partly variable and are known as semi variable or semi fixed costs.

The volume of output fluctuates from one period of time to another due to seasonal and other factors. But fixed costs being same during each period, fluctuation occur in unit cost of products produced during different periods, thus necessitating comparison of cost from one period of time to another. To obviate this uneven incidence of fixed costs on units of output fixed costs are treated as period costs and excluded from product costs. Again once certain facilities are installed, so long as there is no change in the installed capacities, certain costs will have to be incurred whether or not the facilities are being used at all or to whatever extent the facilities are used from this stand point also, there is justification of excluding fixed costs from the product costs. The essence of marginal costing technique lies in considering fixed costs on the whole as separate, quite distinct from variable costs which only are relevant to current operations. Variable costs only are matched with revenues under different conditions of production and sales to compute what is known as ‘contribution’ towards recovery of fixed costs and yielding of profits. This is very useful from the point of decision making and control.

According to the terminology of cost Accountancy of the Institute of Cost and Management Accountants, London, Marginal cost represents “ the amount of any given volume of output by which aggregate costs are changed if the volume of output is increased by one unit”.  

Journalising means recording a transaction

In  the preparation of the accounts journal play a very important role. Journal is derived from the french word 'Jour' which means a day. Journal, therefore, means daily record of business transactions. Journal is a book of original entry because transaction is first written in the journal from which it id posted to the ledger at any time.  Journalising means recording a transaction in the journal and the form which it is recorded is known as journal entry. If two or more transaction of the same nature occurs on the same day and either the debit account or credit account is common such transaction can be conveniently entered in the journal in the form of a combined journal entry instead of making a separate entry for each transaction. Such kind of entry known as compound journal entry.

In a going concern, the balances of the previous year appearing in the various accounts are brought forward at the beginning of the new accounting year by means of a journal entry known as opening entry to incorporate the previous balances in a new set of accounts.

Accounting is primarily concern

Book-keeping is recording of the financial Translations of a business in a methodical manner so that information on any point in relation to them may be quickly obtained. A book keeper may be responsible  for keeping all the information or finical records of a business or only minor segment such as maintenance of the customer's accounts in a departmental store. Much of the work of a book-keeper is clerical in nature and can be accomplished through the use of mechanical and electronic equipment.



On the other hand , Accounting is primarily concern with the design of the system of records, the preparation of reports based on the recorded data, the interpretation of the of the reports and finally communicating the results of the interpretation to persons who are interested in  such results. Accountants often direct and review the work of book-keepers, The work of accountant at the beginning may include some book-keeping but accountants must possess a much higher level of Knowledge, conceptual understanding and analytical skill than is required of the book-keepers.

Sound financial structure of the firm

The scope of Corporation finance emerged as a distinct field of study only in the early part of this century as a result of consolidation movement and formation of large scale business undertaking. In the initial stages of the evolution of corporation finance emphasis was placed on the study of sources and forms of financing the large size business enterprises. The grave economic recession of 1930’s rendered difficulties in raising finance from banks and other financial institutions. Thus emphasis was laid upon improved methods of planning and control, sound financial structure of the firm and more concern for liquidity. The post world war II era necessitated reorganization of industries and the need for selecting sound financial structure. In the early 50.s the emphasis shifted from the profitability to liquidity and from institutional finance to day to day operations of the firm.

The modern phases began in mid-fifties and the discipline of corporation finance has how become more analytical and quantitative. The techniques of models, mathematical programming and simulations are presently being used in corporation finance Corporation finance or broadly speaking business finance can be defined as the process of rising, providing and administering of all money or funds to be used in a corporate enterprise. Weeler define as “that business activity which is concerned with the acquision and conservation of capital funds in meeting the financial needs and overall objective of business enterprise.” Thus the scope of corporation finance is so wide as to cover the financial activities of a business enterprise right from its inception to its growth and expansion and in some cases to its winding up also