Auditing Theory and Practice: Financial Statement Analysis and Ratio Calculation

This document provides a detailed assessment of financial position and performance of different companies through financial statement analysis and ratio calculation. It covers short-term and long-term solvency, efficiency of business, income calculation, loan application assessment, and net asset calculation.

Running head: AUDITING THEORY AND PRACTICE
Auditing Theory and Practice
Name of the Student:
Name of the University:
Authors Note:

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AUDITING THEORY AND PRACTICE
Contents
Introduction:....................................................................................................................................2
Part A:..............................................................................................................................................2
Part B:..............................................................................................................................................6
Part C:..............................................................................................................................................6
Conclusion:......................................................................................................................................9
References:....................................................................................................................................11

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AUDITING THEORY AND PRACTICE
Introduction:
Financial statements contain all financial information about a business and its operations.
Balance sheet contains the assets and liabilities of a business whereas profit and loss account
shows the amount of profit earned or loss incurred by a business. These if properly analyzed can
be helpful to different stakeholders of a business. In this document a detailed assessment of
financial position and performance of different companies shall be ascertained by calculating
different ratios of these companies to take important decisions.
Part A:
Requirement (a):
Calculation of ratios:
Particulars and formula 2019 2018
Current ratio
(Total current assets / Total current liabilities)
Total current assets
Cash 18 000 12 000
Accounts receivable 70 000 60 000
Inventory 130 000 150 000
Total current assets 218,0
00.00
222,0
00.00

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AUDITING THEORY AND PRACTICE
Total current liabilities 105 000 81 000
Current ratio (218000/105000)
2.08
(222000/81000)
2.74
Quick ratio
(Current assets less inventories / current liabilities)
Total current assets less inventories 88,0
00.00
72,0
00.00
Total current liabilities 105 000 81 000
Quick ratio (88000/105000)
0.84 0.89
Accounts receivable turnover (times and days)
In Times (Net credit sales / Average accounts receivable)
Net credit sales 630,0
00.00
490,0
00.00
Average accounts receivable 65,0
00.00
69,0
00.00
Accounts receivable in times

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AUDITING THEORY AND PRACTICE
9.69 7.10
Accounts receivable turnover in days (365 / Accounts
receivable turnover in days) 37.66 51.40
Inventory turnover in times
(Cost of goods sold / Average inventory)
Cost of goods sold 290,0
00.00
250,0
00.00
Average inventory
(130000+150000)/2 140,0
00.00
140,0
00.00
Inventory turnover in times
2.07 1.79
Inventory turnover in times 1
76.21
2
04.40
(365 / Inventory turnover ratio in times)
Requirements (b):
Short term solvency:

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AUDITING THEORY AND PRACTICE
Short term solvency can also be referred to as the liquidity position of an organization. In order
to assess short-term solvency of a business the current ratios and quick ratios are used. The ratios
of Big Bang Pty Limited have been calculated above shows that the short term solvency position
of the company is quite good with current ratio of 2.08: 1 in 2019. However, the quick ratio of
the company is only 0.84: 1 for the period suggests that the company lacks pure liquidity
position (Azadinamin, 2012). In fact the short term solvency position of the company has
deteriorated from the last year. In 2018 both current ratio and quick ratio were better at 2.74: 1
and 0.88: 1 respective ratios. Thus, the company must ensure that the short term solvency
position of the company improves in the future.
Efficiency of business:
In order to assess efficiency of a business management can use inventory and accounts
receivable turnover ratios. The higher the inventory turnover and accounts receivable turnover
ratios the better it is for the business. Accounts receivable turnover ratio of 9.69 in 2019 has
improved significantly from 7.10 of 2018. Thus, the business needs around 38 days to collect its
accounts receivable in 2019 as compared to around 52 days in 2018 (Belonogov, 2016).
Similarly the inventory turnover ratio in 2019 is 2.07 has improved from 1.79 of 2018. In 2019
the company has taken 177 days to turnover its inventory whereas it was around 205 days in
2018.
Thus, the efficiency of the company has improved significantly in 2019 though it must be said
that the inventory turnover ratio is still quite poor with the company only turning the inventories
only twice in a year. Thus there is significant scope to improve the efficiency of the business in
the future (Cantele and Zardini, 2018).

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AUDITING THEORY AND PRACTICE
Part B:
Sale of software: Sale of software for $25,000,000 is an income since it is part of regular
business operations of the company to generate revenue.
Revenue from update and downloads: $3,000,000 received from update and downloads again is
an income since it is part of regular business operations of the company to generate revenue from
customers (Kaliski, 2007).
Interest received on investment: $50,000 received as interest on investment from short term
money market is though not part of regular business operations of the company however, it is
still an income as the same is a revenue receipt. However, this is indirect income for the
company unlike above two items.
Discount allowed: Again discount allowed by creditors is indirect income to the company
however an income none the less. Thus, $2,000 allowed as discount is an income to the
company.
Issue of shares: $5, 00,000 received against issue of shares by the company is capital receipt and
not an income (Kim and Im, 2017).
The amount received by the company from sale of software and downloads & updates are
revenue to the company as these are business operations carried out by the company to generate
revenue.
Part C:
Requirement (a):

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AUDITING THEORY AND PRACTICE
In order to decide which loan application should be approved it is imperative to assess the short
term and long term solvency of both the applicant companies. The table below contains the ratios
to assess the short term and long term solvency positions of both these companies (MANISHA
B, 2012).
Short term solvency
Companies ABC Company XYZ Company
Current ratio (Current assets / Current liabilities)
Total current assets 7,200.00 26,000.00
Total current liabilities 52,800.00 12,000.00
Current ratio 0.14 2.17
Long term solvency
Net equity
Equity 8,400.00 34,200.00
From the above table it is clear that both short term and long term solvency position of XYZ
Company Limited are significantly better than ABC Company Limited. The current ratio of 2.17:
1 of XYZ as against a dismal 0.14: 1 of ABC Company is significantly better suggesting the
ability of the former to repay loan on time. Thus, the loan application of $6,000 of XYZ

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AUDITING THEORY AND PRACTICE
Company should be accepted and the application of ABC Company should be rejected (Patil and
Mohanthy, 2017).
Requirement (b):
In order to calculate the prices to be paid to acquire different companies the best estimate is to
ascertain the net assets of the companies. In this case also the net assets of both ABC and XYZ
shall be calculated to ascertain which company has higher net asset and accordingly, the
interested buyer would pay higher price to buy that company (Sapovadia and Rehman, 2007).
The net asset of both these companies have been calculated in the table below:
Net assets of the companies
Companies ABC Company ($) XYZ Company ($)
Total current assets 7,200.00 26,000.00
Total non-current assets 54,000.00 20,200.00
61,200.00 46,200.00
Less; External liabilities 52,800.00 12,000.00
Net assets 8,400.00 34,200.00
Net asset of XYZ Limited at $34,200 is significantly higher than the net asset of ABC Company
hence, the interested buyer would be will to pay higher price to buy XYZ Company and not ABC
Company.

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AUDITING THEORY AND PRACTICE
Requirement (c):
However, in case the existing owners agreed to be accountable for all the existing liabilities then
the decision would certain change as in that case only the assets of both the companies shall be
considered and obviously the company which has higher value of assets shall be the most
desirable option for a buyer to buy. The total assets of ABC Company and XYZ Company are
shown below in the table (Velez-Pareja, 2009).
Total assets of the companies
Companies ABC Company XYZ Company
Total current assets 7,200.00 26,000.00
Total non-current assets 54,000.00 20,200.00
Total assets 61,200.00 46,200.00
As can be seen the total assets of ABC Limited is $61,200 is much more than the total assets of
XYZ Company with $46,200. Hence, in case the existing owners of the businesses decided to be
accountable for all the existing liabilities of the respective businesses then the interested buyer
will be willing to pay significantly higher price to acquire the business of ABC Company instead
of XYZ Company.
Conclusion:
Financial statements contain all necessary financial information about a business. These
statements if properly analyzed help the stakeholders of the businesses as well as others to

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AUDITING THEORY AND PRACTICE
ascertain the financial position and performance of a business. On the basis of the assessment
important decisions can be taken. In this document the ratio analysis showed us the importance
of short-term solvency as well as long term solvency to determine the eligibility of loan
applications of different companies.

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AUDITING THEORY AND PRACTICE
References:
Azadinamin, A. (2012). The Predictability of Enron's Bankruptcy: Analyzing Financial
Statements 5 Years Prior to the Bankruptcy Using Altman's Z-Score. SSRN Electronic Journal,
3(6), p.13.
Belonogov, A. (2016). ECONOMIC ANALYSIS OF EXPLORATION FOR AND
EVELUATION OF MINERAL RESOURCES BASED ON FINANCIAL
STATEMENTS. Krasnoyarsk Science, 1(6), p.80.
Cantele, S. and Zardini, A. (2018). Is sustainability a competitive advantage for small
businesses? An empirical analysis of possible mediators in the sustainability–financial
performance relationship. Journal of Cleaner Production, 182(189), pp.166-176.
Kaliski, B. (2007). Encyclopedia of business and finance. 3rd ed. Detroit: Macmillan Reference
USA, p.37.
Kim, J. and Im, C. (2017). Reported Profits And Effective Tax Rate Following Accounting
Standards Changes Analysis Of Consolidated Financial Statements And Separate Financial
Statements. Journal of Applied Business Research (JABR), 33(6), p.1171.
MANISHA B, R. (2012). Financial Performance Analysis. Global Journal For Research
Analysis, 3(5), pp.9-10.
Patil, D. and Mohanthy, J. (2017). Analysis of Financial Statements in the Sugar Industry. SSRN
Electronic Journal, 3(4), pp.17-18.
Sapovadia, D. and Rehman, R. (2007). Reading & Analyzing Financial Statements (Financial
Accounting for Non-Finance Managers). SSRN Electronic Journal, 2(5), pp.10-12.

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AUDITING THEORY AND PRACTICE
Velez-Pareja, I. (2009). Guidelines for Forecasting Financial Statements from Historical
Financial Statements for Valuation Purposes (Updated). SSRN Electronic Journal, 2(3), pp.13-
15.