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# Evaluation of Financial Statements:

Financial statements are evaluated for the use of external parties as well as internal management. External parties include government agencies, creditors, shareholders and general public etc.

## Evaluation of Financial Statements to Orient the Outsiders:

The income statement follows a functional classification. Costs incurred are grouped according to the function served by their incurrence: manufacturing, marketing, administrative, and non-operating. The relationship between the various items in the income statement is a criterion for judging the efficiency with which the profit earning process is conducted. Using the sales figure as a base, or 100 percent, absolute differences become more meaningful when they are reduced to percentage relationships. The financial statements are made more useful by adding financial ratios which in combination with a ratio or trend analysis program would be beneficial for judging operations in their final results. Following is a sample of the more prevalent ratios:

### Current Ratio:

Current Ratio = Current liabilities / Current assets

= 9252800 / 2426500

= 3.81

It means that \$3.80 is available in current assets for every \$1 of current liabilities; it is a guide to the magnitude of the financial margin of safety. Read more about current ratio

### Acid Test Ratio:

Acid Test Ratios = Liquid assets / Current liabilities

= 5801000 / 2426500

= 2.39

Acid test ratio is known by various names like liquid ratio or quick ratio. It is calculated like current ratio except inventories and prepaid items are omitted. Above calculation shows that \$2.39 in current assets is available for every \$1 of current liabilities. Read more about acid test ratio or liquid ratio or quick ratio.

### Income before Estimated Income Tax to sales:

Income before Estimated Income Tax = Income before income tax / Sales

= 2400750 / 24750000

9.7%

### Net Income Ratio:

Net Income = Net income / Sales

1336500 / 24750000

5.4%

### Gross Profit Ratio:

The difference of 4.3% (9.7% - 5.4%) between the two percentages indicates the portion of income claimed by the government unavailable to the stockholders.

Ratios of Gross Profit to Sales = Gross profit / Net sales

= 3465000 / 24750000

=14%

This ratio indicates the percentage available for operating expenses ( marketing and administrative), other income and expenses items, income tax, and net income. The thinner the margin, the more vulnerable the profit position usually is. The gross profit and its percentage are significant to management's planning. Read more about gross profit (GP) ratio.

### Rate of Return on Capital Employed:

Rate of Return on Capital Employed = Net income / Capital employed

= 1336500 / 17358900

= 7.7%

This ratio reveals the percentage earned on the assets employed in the business. It should not be confused with the income to sales ratio. The numerator may be more generally described as "profit".

## Evaluation of Financial Statement to Orient the Insiders:

The ratios illustrated above will, of course, also aid the management team. How ever the availability of the detailed schedules and other pertinent non-accounting information permits the insider to make comparative studies of the company's experience over the year. Comparison is an important analytical process, because it focuses attention on deviations from normal. Comparison can be made against actual company experience or against a standard, budget or forecast. Much data on which to base comparison and evaluation can be obtained from a company's accounting, sales, production, purchasing, or other functional departments.

One of the important function of the cost and management accounting is to determine the unit cost figure to be utilized in assigning costs to inventories included in the balance sheet and in the income statement. Some calculations are illustrated below:

 (1) Cost of goods manufactured / Units manufactured 20976900 / 4430000 \$4.735 average cost per unit manufactured (2) Cost of beginning finished goods inventory / Units in beginning finished goods inventory 966100 / 210000 \$4.60 average cost per unit in beginning finished goods inventory (3) Cost of ending finished goods inventory / Units in ending finished goods inventory 658000 / 140000 \$4.70 average cost per unit in ending finished goods inventory (4) Cost of goods sold / Units sold 21285000 / 4500000 \$4.73 average cost per unit sold

Such calculations merely fill the gaps in financial accounting created by the fact that an enterprise seldom sells all the goods manufactured during the year. Financial statements are basically of a long-run nature based on historical or past costs. The insider (the various levels of management) also need present and future costs for planning and control.

## Relevant Articles:

 » Income statement » Cost of Goods Sold Statement » Cost of Goods Manufactured Statement » Balance Sheet - Report Form » Difference between Income Statement and Trading and Profit and Loss Account » Adjustments and their Effect on Financial Statements » Evaluation of Financial Statements

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