Accounting Fundamentals: Final Accounts and Ratio Analysis

This document provides an overview of accounting fundamentals, focusing on final accounts and ratio analysis. It includes a detailed explanation of the balance sheet and statement of financial position. The document also discusses various ratios used to assess liquidity, solvency, profitability, efficiency, and coverage. Finally, it offers a comment on the financial performance and position of Chocco Plc.

Accounting fundamentals
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Contents
Main Body.......................................................................................................................................3
Question 1....................................................................................................................................3
Question 2....................................................................................................................................5
References......................................................................................................................................11
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Main Body
Question 1
A. Final Accounts of the company
Income Statement for the year ended 31st December 2019
Particulars Amount (£)
Gross Revenue 826650
Less: Cost of sales (578650)
Gross Profit 248000
Operating Expenses:
Administrative Expenses 30000
Selling and distribution expenses (inc. outstanding commission) 31000
Other indirect expenses 5000
Add: Other operating income (inc. accrued sales debtors) 980
Net Operating Profit 182980
Less: Depreciation expenses 0
Earnings before Interest and taxes 182980
Less: Interest expenses 2000
Earning before tax 180980
Less: Corporate taxes 68000
Earning after tax/profit attributable to shareholders 112980
Dividend Paid: Ordinary dividend paid – 20000
Preference dividend paid – 30000
50000
Statement of Financial Position as at 31st December, 2019
Particulars Amount (£)
Non-current Assets
Property, plant and equipment 632730
Current Assets
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Inventory 330600
Trade receivables (inc. accrued sales debtors) 171105
Cash 12900
Total Assets 1147335
Current Liabilities
Trade Payables 171355
Other creditors (inc. outstanding commission) 3000
Non-current liabilities
Loans and other borrowings (4 % Debentures) 100000
Net Assets 872980
Equity
Ordinary Share capital 610000
Retained profits 262980
Total Equity 872980
Notes:
 Ordinary Shares - £1 equity shares – 310,000
Add: 10% £1 preference shares – 300,000 = 610,000
 Non-current Assets: Plant & Machinery – 632,730
 Retained Profit: Opening Profit – 132,000
Add: Profit adjustments – 18,000
Add: current year profit - 112,980 = 244,980
 There has been reported £3000 as outstanding commission which has not been recorded
in ledgers yet but to present a true picture, they are to be reflected in financial statements.
Therefore, company needs to pass following journal entry:
Commission A/c Dr. 3000
To Outstanding Commission A/c. 3000
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Accordingly, these accounts will now be reflected in income statement by adding
outstanding commission to commission account while outstanding commission will be reflected
in current liabilities of the Statement of Financial position.
 It has also been reported that the goods were worth £980 were sent to customers, payment
of which will be received later and therefore, it has not been recorded in ledgers but to
present a true picture, company needs to pass following journal entry so that it can reflect
in financial statement:
Accrued sales debtors A/c Dr. 980
To Sales debtors A/c 980
Accordingly, these accounts will now be reflected in income statement by adding accrued
sales debtors to sales debtors account while accrued sales debtors will be reflected in current
assets of the Statement of Financial position.
B. Why the statement of financial position balances.
Balance Sheet or statement of financial position follows the accounting principle of
double entry which says that all transactions shall be recorded in two different accounts in which
they have an equal and opposite effects (Brown and Johnston, 2019). This principle also helps in
checking whether the entries are consistent and properly recorded or not. Balance Sheet is also
based on this principle and has formula of,
Assets = Liabilities + Equity
Two sides of this formula add up to make the total value in the business on its own. Assets
side represents break down of the value used in the business while other side of liabilities and
equity breaks down the source of funding, as to how this value was acquired. Since, one side
represents value in the business and other side represents source of that funding, they must be
equal so as to ensure that all financial transactions are duly recorded.
Question 2
A. Ratio Analysis
It is a quantitative method which helps a company in knowing about its liquidity,
efficiency, profitability, etc. from the data presented in its financial statements (Samonas, 2015).
Therefore, in other words, it is the analysis of financial health of company in mathematical
terms. Below mentioned are different kinds of ratios:
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Liquidity Ratios
These ratios are used to assess a company’s ability to pay off its short-term liabilities from
the resources presented within company (Tsadira-Pocha, 2020). It includes:
 Current Ratio - It determines a company’s ability to pay off its near-term liabilities with
its current assets. Higher the ratio, better the position.
Current Ratio = Current Assets/Current Liabilities
2019 2018
Current Assets 2303 2355
Current Liabilities 2511 3046
Current Ratio 0.917 0.773
Current Ratio of Chocco Plc in both 2018 and 2019 is less than 1 which is not good a
indicator, for it indicates that company’s current assets will not able to cover current
liabilities, in case of need. Although, the good sign for company is that its ratio has
improved in 2019 from 2018.
 Acid Test Ratio – Also known as quick ratio, it analyses the abilities of company’s most
liquid assets. Therefore, it excludes inventory and prepaid instruments from current
assets.
Quick Ratio = (Current Assets – Inventory – Prepaid Instruments) / Current Liabilities
2019 2018
Quick Assets 1595 1696
Current Liabilities 2511 3046
Quick Ratio 0.635 0.557
Quick Ratio of Chocco Plc is less than 1 which is not good indicator, for it indicates that
company’s quick assets are unable to cover current liabilities, in case of contingencies.
Although, the ratio has improved in 2019 from 2018.
Solvency Ratios
They are also known as leverage ratios. They are used to analyse the prospects of long-term
sufficiency and capabilities of the business to finance itself (Brown and et.al., 2016). It includes:
 Debt-to-equity Ratio – This ratio determines the quantum of debt financed by equity.
Lower the ratio, better it is.
Debt-to-equity ratio = Total debt/total equity
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2019 2018
Total liabilities 6828 7175
Total equity 3088 2912
Debt-to-equity Ratio 2.21 2.46
As said earlier, higher debt to equity ratio is not considered positive for the company.
Debt to equity ratio of Chocco Plc shows that debt is more than twice of equity of the
company which increases the likelihood of default as the equity is unable to finance debts
in case of need.
 Debt-to-asset Ratio – This ratio analyses a company’s leverage by determining the
quantity of debts financed by assets of the company (Rachlin, 2019).
Debt-to-asset Ratio = Total debt/Total assets
2019 2018
Total liabilities 6828 7175
Total assets 9736 10087
Debt-to-asset Ratio 0.701 0.711
Debt to asset ratio more than 1 is not considered healthy. Debt to asset ratio of Chocco
plc is less than one which shows that debt is not funded significantly against assets of the
company. Moreover, its ratio has improved from 2018 in 2019.
Profitability Ratios
These ratios are used to assess the capabilities of a company to generate profit in relation to
its revenues and other operations of the business (Ehrhardt and Brigham, 2016). It includes:
 Return on Assets – This ratio is used by both internal and external stakeholders to
analyse the efficiency of a company in using its assets.
Return on Assets = Net income / Total Assets
2019 2018
Net Income 431 366
Total assets 9736 10087
Return on Asset 4.43% 3.63%
Higher return on assets, more are the assets considered efficient. Return on Asset ratio of
Chocco Plc has improved from last year which is a good sign for the company. Although,
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the ratio is not high enough and company needs to keep on making efforts to improve
their profit so that it can have better returns on assets.
Efficiency Ratios
These ratios are also called as activity ratios and are used to evaluate the capabilities of a
company in utilising its assets and liabilities to improvise its profits (Chandra, 2017). It includes:
 Asset turnover ratio – It is used to determine the efficiency with which a company is able
to maximise its sales or revenue using its assets.
Asset turnover ratio = Total sales / Average Assets
2019 2018
Total sales 6378 6441
Average Assets = (Opening asset +
closing asset)/2
(10087+9736) / 2 =
9911.5
No amount of
opening asset
provided
Asset turnover ratio .643
Higher the ratio, more efficient the company is. Asset turnover ratio of Chocco Plc for
2019 is 0.643 while, ratio of 2018 couldn’t be ascertained because opening value of
assets for 2018 was not provided. Therefore, comparative analysis for the ratio of 2 years
couldn’t be determined.
Coverage Ratios
These ratios determine a company’s abilities to cover its debt expenses and other financial
obligations such as interest and dividend payments (Howard, 2019). It includes ratios such as
interest coverage ratio, debt service coverage ratio, asset coverage ratio, etc.
 Interest coverage ratio – It is used to assess a company’s ability to pay interest expenses
on its external liabilities.
Interest coverage ratio = EBIT / Interest Expense
2019 2018
Earnings before interest and tax (EBIT) 846 720
Interest expense 226 181
Interest coverage ratio 3.74 3.98
Higher the ratio, better it is. Interest coverage ratio of Chocco Plc is satisfactory and
shows that company’s profits are enough to cover its interest expense and there are no
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doubts over company’s performance. Although, this need to be noticed that ratio has
decreased in comparison to last year.
Market Prospect Ratios
These ratios are used by primarily by investors to predict earnings of the company and its
future performance, before taking investment decision (Vogel, 2020). It includes ratios like
dividend yield, P/E Ratio, earnings per share, dividend pay-out ratio, etc.
 Dividend yield – It is used to analyse how much a company is paying out on its dividends
every year in relation with its share price.
Dividend yield = Annual dividends per share / price per share
2019 2018
Annual dividend per share 0.85 0.81
Average Price per share 5.12 4.00
Dividend Yield 16.6% 20.1%
It is to be noticed that company has paid out dividend in both the years which means
Chocco Plc is regular in paying out dividends but it cannot be ignored by the investors
that dividend yield of company is not positive when two years are compared as company
has not increased its dividend pay-out rate in accordance with the increase in share prices.
B. Comment on financial performance and position of Chocco Plc.
Analysis of financial statements and ratio analysis are most effective tools to evaluate
financial health of a company (Warren and Farmer, 2020). Ratios are determined from financial
statements only to facilitate comparison by both internal and external stakeholders.
From the financial statements, it can be determined that revenue of the company has
increased from 2018 to 2019 and so are expenses accordingly but assets of the company has
reduced. Although, comparatively current liabilities have also shown a negative trend but not
non-current liabilities. From the ratio analysis seen above, it can be noticed that company does
not have satisfactory liquidity ratios, debt to equity ratio, return on asset ratio, etc. while its debt
to asset ratio or interest coverage ratio are more or less satisfactory. But, overall performance of
the company is not satisfactory and it is highly advisable to investors to take precautions with
their investment with the company and shall think carefully before investing in it, because all
these analyses may be just a result of up and down that happens while operating in a dynamic
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business environment. Financial ratios of Chocco Plc are also needed to be compared with its
industry benchmark and competitors to know more about its market value, which is useful to
determine a company's worth for investors.
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References
Books and Journal
Brown, R.G. and Johnston, K.S., 2019. Paciolo on accounting. Routledge.
Samonas, M., 2015. Financial forecasting, analysis, and modelling: a framework for long-term
forecasting. John Wiley & Sons.
Tsadira-Pocha, Z., 2020. Fair value accounting hierarchy, value relevance, quality of financial
statements and procyclical leverage: an empirical analysis in context’ (Doctoral
dissertation, School of Business Administration).
Brown, M.T. and et.al., 2016. Financial management in the sport industry. Taylor & Francis.
Rachlin, R., 2019. Return on Investment Manual: Tools and Applications for Managing
Financial Results: Tools and Applications for Managing Financial Results. Routledge.
Ehrhardt, M.C. and Brigham, E.F., 2016. Corporate finance: A focused approach. Cengage
learning.
Chandra, P., 2017. Investment analysis and portfolio management. McGraw-hill education.
Howard, D.R., 2019. Financing sport. International Journal of Sport Communication, 12,
pp.306-309.
Vogel, H.L., 2020. Entertainment industry economics: A guide for financial analysis. Cambridge
University Press.
Warren, C.S. and Farmer, A., 2020. Survey of accounting. Cengage Learning.
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