Financial Accounting & Analysis

Question 1

Accounting Equation (also known as Balance sheet equation) represents the

relationship between Assets, liabilities & equities of a person/business. It is the
foundation for double-entry system of accounting. For each of the accounting
transaction, the total debits is equal to total credits. It can be represented as below:
Assets= Liabilities +Equities
Where,
Assets are resources owned by a company that help generate profit of the business and
which have future economic Value
Liabilities are financial obligations of a company
Equities are value of shares issued by a company

Based on the above accounting equation concept, following is the analysis of

transactions in the books of X Ltd :

1) Purchased Furniture for Rs. 6,75,000

In the above transaction, furniture a/c increases the asset side & assuming that the same
is bought for credit, the liability is added equally.

Accounting equation after transaction 1: Assets = Liabilities+Equities

6,75,000 = 6,75,000 + 0

2) Capital introduced by the business owner by depositing 12 Lakhs in the bank

account
In the above transaction, X Ltd received amount in bank (i.e., asset increases) & X Ltd
in turn owes this amount to X (the business owner)

Accounting equation after transaction 2 : Assets = Liabilities + Equities

18,75,000 = 6,75,000+ 12,00,000
(6,75,000+12,00,000)

i.e.; After this transaction, the asset is Rs. 18,75,000 matched by liabilities & equity
totaling to Rs. 18,75,000.
3) Goods purchased on credit from Aman Enterprises for Rs. 105000
In the above transaction purchase of goods (inventory) 0increases the asset side &
Aman enterprise is a creditor so its increase in liability

Accounting equation after transaction 3 : Assets = Liabilities + Equities

19,80,000 = 7,80,000 + 12,00,000
(6,75,000+12,00,000+1,05,000) (6,75,000+1,05,000)

i.e.; in the accounting equation the assets increase by Rs. 1,05,000 simultaneously
adding the liability by the same amount.

4) Goods sold on credit for Rs. 4,00,000. The cost of goods sold was Rs. 3,00,000

In the above transaction the goods are sold i.e., decrease in asset by the cost price of
Rs.3,00,000 & simultaneously there is increase in another asset i.e., debtors by Rs.
4,00,000. The difference of Rs 1,00,000 is profit and since it belongs to the business
owner it adds to the business capital.

Accounting equation after transaction 4 :

Assets = Liabilities + Equities
20,80,000 = 7,80,000 + 13,00,000
(6,75,000+12,00,000+1,05,000 (6,75,000+1,05,000) (12,00,000+1,00,000)
-3,00,000 +4,00,000)

i.e., the assets & the equities/capital has a net increase of RS. 1,00,000 after this
transaction.
5) Purchased goods from Sneha enterprises Rs. 6,00,000 and made the payment from
the business’s bank account

In the above transaction purchase of goods increases the asset by Rs.6,00,000 & another
asset i.e., company’s bank account gets reduced by Rs. 6,00,000

Accounting equation after transaction 5 :

Assets = Liabilities + Equities
20,80,000 = 7,80,000 + 13,00,000
(6,75,000+12,00,000+1,05,000 -3,00,000 (6,75,000+1,05,000) (12,00,000+1,00,000)
+4,00,000+6,00,000-6,00,000)

i.e., there is no change in accounting equation after this transaction.

The detailed accounting equation after all above transactions is :

Total Assets = Furniture (6,75,000)+Bank (12,00,000-6,00,000)+Inventory (1,05,000-
3,00,000+6,00,000)+ Debtor (4,00,000) = 20,80,000

Total Liabilities = Creditors (6,75,000)+ Aman enterprises Creditor (1,05,000) =

7,80,000

Equities = Capital (12,00,000+1,00,000) = 13,00,000

Total Assets= Total Liabilities+Equities

20,80,000 = 7,80,000 +13,00,000

To conclude, as seen after all the above transactions, the accounting equation always
remains balanced, that is, the left side value of the equation always matches the right-
side value.
Question 2

Revenue & operating income are essential metrics to analyze if a company is performing well.
Revenue means sum of income generated from sale of goods or services before deducting the
expenses. Operating income refers to sum of Company’s profit from ongoing operations after
deducting all operating expenses (like wages, cost of goods sold etc)
Revenue from operation is the total income generated by a Company from its primary
business activities. While, other income is income generated other than from primary business
activities. Revenue from operation helps assess the productivity & profitability of a Company’s
primary business. If the Company is generating steady flow of revenue from its operations it is
said to be running successfully.
For example : for a retailer its revenue from operation is through merchandise sales; for a
physician revenue from medical services is his revenue from operation and profit from sale of
an asset is other income.
Revenue are of two types based on their nature of earnings. Types of Revenue are:
1) Operating Revenue
2) Non-operating or other income

Operating revenue
As mentioned with regard to gifting enterprise Love Doodle, the inflows generated by
arranging gift hampers are directly related to the business & hence is its operating
revenue. That means operating revenue is the receipts from a business’s main activity.
This income is regular & indicates the growth of the business.

Non-operating revenue or other income

Income earned from other sources by Love Doodle like bank interest, dividend income,
etc are not directly related to the operation of the business this is non-operating revenue.
This income is irregular and most of the times non-recurring in nature.

Summarizing, Ms. Dorati can record the income in the following manner in the Profit
& Loss account of Love Doodle:
 Part II – Form of Statement of Profit & Loss (extract)
Love Doodle
Statement of profit & loss for the period ending …………………..
Note
Particulars No Amount (in Rs)
I Revenue from Operations a 5,05,000
II Other income b 4,200
Total Income (a+b) 5,09,200

Notes to Accounts:
a. Revenue from operations:
Revenue from sale of gift hampers = Rs. 5,05,000
b. Other income:
Income from bank interest & dividend = Rs. 4,200
Based on the type of income received, management of Love Doodle must sufficiently disclose
the same & add them to the notes of account to give clarity to the shareholders.
Question 3(a)

Current Ratio – Current ratio also known as working capital ratio measures the liquidity of a
company. That means the ability to pay their short term obligations or those which are due
within a year with its short-term assets such as cash, trade receivables, inventories etc. The
Companies with current ratio that are in line with industrial average or slightly on the higher
side is considered generally acceptable. However, Companies with current ratio that are lower
than the industrial average indicates higher risk of default & the ones with very high current
ratio indicate that the management is not effectively using its assets. This ratio compares all
the Company’s Current assets to the Company’s Current Liabilities. Current ratio must not be
used on standalone basis as though the current ratio looks fine the quality of company’s other
assets versus the obligations may not be good. Egs the inventory could not be sold or the
customers pay very slowly etc
Formula to calculate Current Ratio is:

Current Ratio = Current Assets

Current Liabilities
Where,
Current assets include accounts receivable, cash, inventories, other current assets etc
Current Liabilities include wages payable, tax payable, accounts payable, short term debts etc
Quick ratio is also known as Acid test ratio. It indicates a company’s liquidity on short term
basis & its ability to meet the short term obligations with its liquid assets without the need to
sell its inventories.
Formula to calculate Quick ratio is:

Quick ratio = Current Assets-Inventories-Prepaid Expenses

Current Liabilities

Assets such as cash & cash equivalents, securities that are marketable at a click, accounts
receivable, that are due in near term etc are liquid assets.
In the given data, Current ratio of Aman Limited is 2:01 while that of Roger Limited is 1.60:1
which indicates that Aman Limited’s ability to meet its short term obligation is good. It means
that for every 1 rupee of debt obligation, Aman limited has 2 rupees of current assets available
to pay off the same. While Roger Limited’s current ratio indicates that for every 1 rupee of
debt obligation, Roger limited has 1.6 rupees of current assets available to pay off the same.
While, quick ratio of Aman Limited is 1.35:1 & that of Roger Limited is 1:01 which indicates
that Aman limited has 1.35 rupees of liquid assets available for every 1 rupee of short term
obligation. Similarly, Roger Limited has 1 rupee of liquid asset available for every 1 rupee of
short term obligation.
To conclude, the above analysis of current ratio & quick ratio indicates that Aman Limited’s
financial performance is better than Roger Limited on short term obligations as both its quick
ratio & current ratio is higher.
Question 3(b)
Return on investment measures efficiency or profitability of an investment as compared to
other investments. It is a metric to measure profitability of an investment. It is expressed in
percentage & doesn’t take into consideration the holding period of the investment.
Following is the formula to calculate the return on investment:
Return on investment Current Value of Investment−Cost of Investment
=
Cost of investment

Where, current value is the proceeds obtained from sale of the investment & cost of investment
is the initial cost or outlay towards the investment.
If the return on investment is positive it is worthwhile to make or continue with a particular
investment. However if higher return on investments options are available the same may be
considered. Further, return on investments that are negative must be avoided.
Debt- Equity ratio measures the company’s financial leverage. It measures the extent to which
a Company is being financed through debt versus its wholly owned funds so basically measure
of how much leverage is being used by a Company.
Following is the formula to calculate the debt-equity ratio:

Debt- equity ratio = Total liabilities

Total Shareholder’s equity

High debt equity ratio generally indicates high risk it interprets that the Company is using debt
to finance its growth. Generally a debt –equity ratio of 1 is considered as safe
In the given case, return on investment of Aman Ltd is 15% & that of Roger Ltd is 13%
indicating that the investments made in both these companies are performing well & are
positive for their investors.
Further, the debt asset ratio of Aman Ltd is 2.5:1 & that of Roger Ltd is 1:01. Interpreting the
same, Aman Ltd has a debt of 2.5 rupees for every 1 rupee of equity while Roger Ltd has 1
rupee of debt for every 1 rupee of equity indicating that Aman Ltd’s debt equity ratio is highly
risky while Roger Ltd’s debt equity ratio is safer.
To conclude, after considering the above two ratios, it can be interpreted that Aman Ltd has
high return but high risk as well as its debt-equity ratio is high. While Roger Ltd though has
lesser return on investment but is safer than Aman. The investor will have to decide on the
investment based on their risk taking appetite as high returns come with higher risk. However,
returns generated by taking high debt will be harmful for the Company in the long run.