FINANCIAL ACCOUNTING

AND ANALYSIS

QUESTION 1.

The accounting equation is considered to be the foundation of the double-

entry accounting system. On a company's balance sheet, it shows that a
company's total assets are equal to the sum of the company's liabilities and
shareholders' equity.

Based on this double-entry system, the accounting equation ensures that the
balance sheet remains “balanced,” and each entry made on the debit side should
have a corresponding entry (or coverage) on the credit side.

The accounting equation is known as the backbone of the double-entry accounting system.
The net assets are equal to the sum of the company's liabilities and shareholders' equity, as
seen on its balance sheet. Each entry made on the debit side has matching access (or
coverage) on the credit side. The financial state of every company, big or small, is obtained
by two main balance sheet components: assets and liabilities

Accounting Equation Formula and Calculation:

Assets = Liabilities + Owner’s Equity

ASSETS = LIABILITIES + CAPITAL

FURNITURE Rs
675000
Rs
CASH (675000)

ASSETS = LIABILITIES + CAPITAL

12 12 Lakhs
BANK
Lakhs

ASSETS = LIABILITIES + CAPITAL

INVENTORY Rs105000 Rs105000

ASSETS = LIABILITIES + CAPITAL

INVENTORY (Rs Rs 100000
300000)
DEBTOR Rs 400000

ASSETS = LIABILITIES + CAPITAL

INVENTORY Rs 600000

BANK (Rs
600000)
 ACCOUNTING EQUATIONS FOR DIFFERENT EQUATIONS

S Transaction Assets = Liabilities + Capital

No.

1. Purchased 675000
Furniture for
Rs675000 (675000)

2. Capital Introduced 1200000 1200000

by the business
Owner by
depositing 12
Lakhs in the bank
account
3. Goods purchased 105000 105000
on credit from
Aman Enterprises
for Rs105000

4. Goods sold on (300000) Rs 100000

credit for Rs
400000. The cost 400000
of the goods sold
was Rs 300000

5. Purchased goods Rs 600000

from Sneha
Enterprises for Rs
600000 and made
the payment from
the business's bank (Rs
account 600000)

6. TOTAL 14,05,000 14,05,000

QUESTION 2.

HOW DO OPERATING INCOME

AND REVENUE DIFFER?

Calculation of Operating Revenue

Revenue from operations is calculated by taking into account the
figure of “sales” after factoring in any sales return or discounts
allowed.

After calculating the net operating revenue from the above step
deduct the “cost of operations” to derive the operating profits of a
company. The same can be explained with the help of a simple
illustration.
 Revenue from operations refers to the revenue earned by a company from
its normal operating activities such as net sales, or services rendered. It
is the total amount of income generated by a company for the sale of its
goods or services before any expenses are deducted.

Other income refers to income that does not come from a company’s core
business. These are incomes generated by activities that do not relate to
the normal core operations of the business. Examples include income
from interest, rent, gains from the sale of fixed assets, currency

Revenue from operations is not recorded on the cash flow statement. It is

used to calculate the net income in the income statement. Other incomes
are also recorded in the income statement. They are added to the
operating income to determine the net income.
The net income figure is what is recorded on the cash flow statement under
operating activities

❖ Operating profit is one of the sources of financing for the further

activities of the enterprise and the guarantee of its prosperity. Operating
profit is used to repay loans, if any, and do not forget about taxes. In
short, operating income is subject to various adjustments. When all non-
operating expenses are deducted from operating income, the entity
remains in net income. It is from this profit that dividends are paid in
most cases.
 What is Operating Revenue?
Operating revenue refers to the revenue generated by a company from its
primary activities. The exact activity that generates the operating revenue varies
with the type of business. Consider the example of a retailer; the operating
revenue for a retailer comes by selling merchandise. In the case of a physician,
the operating revenue is generated by providing medical services.

Understanding Operating Revenue

It is important to distinguish operating revenue from total revenue because it
provides crucial information about the productivity and profitability of the
primary business operation of the company. Some companies may try to mask
the decrease in operating revenue by combining it with non-operating revenue.
Identifying the revenue sources can take the company a long way by assessing
the health of the firm and its operations.

What is Non-Operating Revenue?

Non-operating revenue is the revenue earned by activities other than the
primary activities of a company. Such activities are not frequent and can be
unusual. For example, interest income, lawsuit proceeds, and gains from
the sale of assets can be categorised as non-operating revenue. Non-operating
revenue does not count as cash inflows as they’re not consistent from one year
to the next.

If a company has to fund its operations, it must generate operating revenue.

Generating operating revenue will reduce the need for the company to seek
financing from outside.

STATEMENT OF PROFIT AND LOSS

PARTICULARS NOTES AMOUNT

(A) Revenue from Rs 5,05,000

operations

(Other operating revenues)

1.
(B) Other Income Rs 4,200

PARTICULARS AMOUNT

Dividend Receipts Rs 4,200

QUESTION 3(A)

INTRODUCTION

What Is the Current Ratio?

The Current Ratio is that assesses a company's willingness to give short-term or
one-year commitments. It demonstrates to investors and analysts how any
business can use existing assets on its financial statement sheet to give down
current debt and other commitments

Comparing Aman Ltd and Roger Ltd

Current Ratio
Current Ratio = Current Asset / Current Liability
Standard Current Ratio = 2
Aman Ltd is Better than Roger Ltd

• A current ratio that is lower than the industry average may indicate a higher
risk of distress or default Similarly, if a company has a very high current
ratio compared to its peer group, it indicates that management may not be
using its assets efficiently.
• Weaknesses of the current ratio include the difficulty of comparing the
measure across industry groups, overgeneralization of the specific asset and
liability balances, and the lack of trending information.

• Current assets are assets that can be converted into cash within one year.
Current assets may include the following:

CASH AND CASH EQUIVALENTS

ACCOUNTS RECEIVABLE
PREPAID EXPENSES
INVENTORY
SECURITIES (MARKETABLE OR LIQUID)

ACCOUNTS PAYABLE
ACCRUED LIABILITIES
SHORT-TERM DEBT (DEBT DUE WITHIN 12
MONTHS)

How to calculate the current ratio

The current ratio formula is simple. Simply take your current asset total and
divide the total by your current liability total.

CURRENT RATIO = CURRENT ASSETS ÷

CURRENT LIABILITIES
 WHAT IS THE QUICK RATIO?

The quick ratio is an indicator of a company’s short-term position and

measures a company’s ability to meet its short-term obligations with its most liquid
assets.

The quick ratio is an indicator of a company’s short-term liquidity position and

measures a company’s ability to meet its short-term obligations with its most liquid
assets.

Since it indicates the company’s ability to instantly use its near-cash assets (assets that
can be converted quickly to cash) to pay down its current liabilities, it is also called
the acid test ratio. An "acid test" is a slang term for a quick test designed to
produce instant results.

Comparing Aman Ltd and Roger Ltd

Quick Ratio
Quick Ratio = Quick Asset / Current Liability
Standard Current Ratio = 1
Aman Ltd is Better than Roger Ltd

KEY TAKEAWAYS
 • The quick ratio measures a company's capacity to pay its current liabilities
without needing to sell its inventory or obtain additional financing.
• The quick ratio is considered a more conservative measure than the current
ratio, which includes all current assets as coverage for current liabilities.
• The higher the ratio result, the better a company's liquidity and financial health;
the lower the ratio, the more likely the company will struggle with paying
debts.

How to Calculate the Quick Ratio

QUICK RATIO = CA SH + CA SH EQUIVA LENTS +

A CCOUNTS RECEIVA BLE + SHORT -TERM
INVESTMENTS ÷ CURRENT LIA BILITIES

CURRENT RATIO QUICK RATIO

Considers assets that can be Considers only assets that can be

converted to cash within a year converted to cash in 90 days or less

Includes inventory Excludes inventory

Ideal result is 2:1 Ideal result is 1:1

 WHEN SHOULD YOU USE THE
CURRENT RATIO OR QUICK RATIO?

If you’re worried about covering debt in the next 90 days, the quick ratio is the
better ratio to use. If you’re looking for a longer view of liquidity, the current
ratio, which includes inventory, is better.

Keep in mind that if your business does not have inventory assets, the two ratios
are nearly identical, with both ratios providing the same results.

Final thoughts on the current ratio and quick ratio

When calculating ratios for your business, it’s always important to calculate more
than one ratio. Both the current ratio and the quick ratio will give you a measure
of liquidity for your business, but combining these ratios with other accounting
ratios will give you a much clearer picture of your business finances.

Accounting ratios such as the current ratio and the quick ratio can also help you
quickly identify trouble spots and if your business is headed in the wrong
direction. The results of these ratios may also be helpful when creating financial
projections for your business.

But it’s not enough to simply calculate an accounting ratio. To properly use the
results of any accounting ratio, you must understand what the results mean and
use that information to your advantage.

Taking charge of your business finances puts you one step closer to success. So,
take a deep breath, grab your balance sheet, and calculate a ratio today.
QUESTION 3(B)

INTRODUCTION

What Is the Debt-To Equity

Ratio?

The debt-to-equity (D/E) ratio is used to evaluate a company's financial

leverage and is calculated by dividing a company’s total liabilities by
its shareholder equity.

• The debt-to-equity (D/E) ratio compares a company’s total liabilities to

its shareholder equity and can be used to evaluate how much leverage a
company is using.

• Higher-leverage ratios tend to indicate a company or stock with higher

risk to shareholders.
• However, the D/E ratio is difficult to compare across industry groups
where ideal amounts of debt will vary.
• Investors will often modify the D/E ratio to focus on long-term debt only
because the risks associated with long-term liabilities are different than
short-term debt and payables.
 What is a good debt-to-equity (D/E) ratio?
What counts as a “good” debt-to-equity (D/E) ratio will depend on the nature of
the business and its industry. Generally speaking, a D/E ratio below 1.0 would
be seen as relatively safe, whereas ratios of 2.0 or higher would be
considered risky.

What does a debt-to-equity (D/E) ratio of 1.5 indicate?

A debt-to-equity ratio of 1.5 would indicate that the company in question has
$1.50 of debt for every $1 of equity. To illustrate, suppose the company had
assets of $2 million and liabilities of $1.2 million. Because equity is equal to
assets minus liabilities, the company’s equity would be $800,000. Its D/E ratio
would therefore be $1.2 million divided by $800,000, or 1.5.

What does it mean for D/E to be negative?

If a company has a negative D/E ratio, this means that the company has
negative shareholder equity. In other words, it means that the company has
more liabilities than assets. In most cases, this is considered a very risky sign,
indicating that the company may be at risk of bankruptcy. For instance, if the
company in our earlier example had liabilities of $2.5 million, its D/E ratio
would be -5.

What industries have high D/E ratios?

In the banking and financial services sector, a relatively high D/E ratio is
commonplace. Banks carry higher amounts of debt because they own
substantial fixed assets in the form of branch networks. Other industries that
commonly show a relatively higher ratio are capital-intensive industries, such
as the airline industry or large manufacturing companies, which utilize a high
level of debt financing as a common practice.

How can the D/E ratio be used to measure a company's

riskiness?
A higher D/E ratio may make it harder for a company to obtain financing in the
future. This means that the firm may have a harder time servicing its existing
debts. Very high D/Es can be indicative of a credit crisis in the future, including
defaulting on loans or bonds, or even bankruptcy.
 Comparing Aman Ltd and Roger Ltd

Debt to Equity Ratio = Total Debt / Equity

A Lower Debt to Equity Ratio Means Risk is also Lower.
Roger Ltd is using lower debt compared to equity thus Roger Ltd has
less risk than Aman Ltd.

What Is the Return on Investment?

?
Return on investment (ROI) is a performance measure used to
evaluate the efficiency or profitability of an investment or compare
the efficiency of a number of different investments. ROI tries to
directly measure the amount of return on a particular investment,
relative to the investment’s cost.

• RETURN ON INVESTMENT (ROI) IS A POPULAR

PROFITABILITY METRIC USED TO EVALUATE HOW
WELL AN INVESTMENT HAS PERFORMED.

•ROI IS EXPRESSED AS A PERCENTAGE AND IS

CALCULATED BY DIVIDING AN INVESTMENT'S NET
PROFIT (OR LOSS) BY ITS INITIAL COST OR OUTLAY.
 • ROI CAN BE USED TO MAKE APPLES-TO-APPLES
COMPARISONS AND RANK INVESTMENTS IN
DIFFERENT PROJECTS OR ASSETS.

• ROI DOES NOT TAKE INTO ACCOUNT THE HOLDING

PERIOD OR PASSAGE OF TIME, AND SO IT CAN MISS
OPPORTUNITY COSTS OF INVESTING ELSEWHERE.

What is a good ROI?

What qualifies as a “good” ROI will depend on factors such as the risk tolerance of
the investor and the time required for the investment to generate a return. All else
being equal, investors who are more risk-averse will likely accept lower ROIs in
exchange for taking less risk. Likewise, investments that take longer to pay off will
generally require a higher ROI in order to be attractive to investors.

What industries have the highest ROI?

Historically, the average ROI for the S&P 500 has been about 10% per year. Within
that, though, there can be considerable variation depending on the industry.
For instance, during 2020, technology companies such as Apple Inc., Microsoft Corp.,
and Amzon.com Inc. generated annual returns well above this 10% threshold.
Meanwhile, companies in other industries, such as energy companies and utilities,
generated much lower ROIs and in some cases faced losses year-over-year.

Over time, it is normal for the average ROI of an industry to shift due to factors such
as increased competition, technological changes, and shifts in consumer preferences.

Comparing Aman Ltd and Roger Ltd

Return on Investment = Net Income / Investment
Aman Ltd is Better than Roger Ltd since R.O.I is greater than
Roger Ltd