The document provides information about financial statements including profit and loss account and balance sheet. It discusses the preparation, components, and purpose of profit and loss account and balance sheet. Some key points include:
1) Profit and loss account is prepared to ascertain the net profit or loss of a business over an accounting period. It includes income and expenses that are used to determine the net profit or loss.
2) Balance sheet provides the financial position of a business on a particular date by listing assets, liabilities, and capital. It categorizes assets as current and fixed and liabilities as current and long term.
3) Various items included in the profit and loss account and balance sheet are explained such as treatment
3. INTRODUCTION
After the preparation of the trial balance, the management of a business enterprise proceeds to get
the financial statements prepared. The purpose of preparing financial statements is to enable the
management to have a periodical review of the progress made by the enterprise and deal with:-
1. The present status of investments in the business.
2. The results achieved during the period under review.
The term 'Financial Statements' means the two statements prepared the end of the accounting period
of the enterprise viz., the Balance Sheet (statement of the present financial position) and Profit and
Loss Account (income statement). The two statements together are called the final accounts in
traditional accounting language.
4. ADVANTAGES OF FINANCIAL STATEMENTS
MANAGEMENT- The management can review the up to-date progress made by an enterprise. From this
progress the management can decide the future plan of action for the enterprise.
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Creditors- From the financial statements the creditors can decide whether to expand, maintain or restrict the
credit facilities to the enterprise
Shareholders- On the basis of financial statements, the shareholders are in position to judge the future
prospects of their investment and the financial position of the company on the basis of which they can decide
whether to sell or continue their shares in the firm.
Government- Central and state governments are interested in the financial statements for the purpose of
taxation.
Employees Unions- the employees union can find out the present financial condition of the firm from the
financial statements and are thus able to decide whether the firm is in position to pay higher wages, bonus
etc.
Investors- Prospective investors, who want to invest money in the firm, would like to make an
analysis of the financial statements of that firm to know how safe the proposed investment will be.
5. LIMITATIONS OF FINANCIAL STATEMENTS
The profit shown in Profit and Loss
Account and the financial position revealed
by the Balance-Sheet cannot be exactly true
since these statements are only interim
reports. The exact financial position of the
business can be known only when business
is either liquidated or sold.
Financial statements record and reveal
only those facts which can be expressed
in terms of money. Other important
information like working condition of the
employees, administrative set up, sales
policies of the company, quality of
products introduced by the company. find
no mention in a Balance-Sheet.
The Balance-Sheet is affected by various
factors, such as, fixed assets, going
concern concept and conventions like
conservatism and consistency. As such,
the balance-sheet does not reveal exact
financial position of the concern as is
claimed by it.
Many items in financial statements are
influenced by personal judgment. Hence
the quality of statements therein depend
on the competence and integrity of those
who prepare it.
LIMITATION
6. PROFIT AND LOSS ACCOUNT
Profit and loss account reveals the net profit earned or net loss suffered by a firm in
course of its business operations during the accounting period.
It is prepared at the end of the financial year of the business.
The main purpose for which a profit and loss account prepared is to ascertain net profit
or net loss from business operations.
The net income of the current year can be compared with that of the previous years and
deviations in income of different periods may be analysed to ascertain the factors
responsible for such deviations.
Such an analysis is helpful in controlling expenses incurred in running the business
enterprise and sale of goods and thus eliminating wastage.
7. PREPARATION OF PROFIT AND LOSS ACCOUNT
On the determining the gross profit or gross loss from the trading account, the gross profit is recorded on the
credit side of the profit and loss account and gross loss is recorded on the debit side of the profit and loss
account.
After this, the other incomes' or gains, such as, rent received, interest received, commission earned, discount
received etc. are credited.
The expenses or losses, such as, salaries, rent, advertisement expenses, business expenses, printing, stationery
etc, are recorded on the debit side.
The grand total on both debit and credit sides are obtained. If the grand total on credit side is more than on the
debit side, it shows a net profit.
If the grand total on the debit side is more than on the credit side, it shows a net loss.
The net profit or a net loss as the case may be, is taken to the capital account of the proprietor.
While net profit is added to the capital account, net loss is deducted there from.
8. Illustration- From the information given below prepare a Profit and Loss Account of M/s
Sandeep Medical Hall, for the year ending March 31, 2009
RS
Gross Profit 68,000.00
Rent 8,000.00
Salary 25,000.00
Commission paid 4,000.00
Intereston loan 3,000.00
Advertisement 7,000.00
Discount received 4,000.00
Printing and stationery 3,000.00
Legal charges 4,000.00
Bad debits 2,000.00
Depreciation 1,000.00
Interest received 8,000.00
Loss by fire 3,000.00
9. Solution- profit and loss account of m/s Sandeep medical hall for the year ending March 31,
2009
‘Dr’ ‘Cr’
PARTICULARS AMOUNT RS PARTICULARS AMOUNT RS
To rent
To salary
To commission
To interest on loan
To advertising
To printing and
stationary
To legal charges
To bad debits
To depreciation
To loss by fire
To net profit transferred
to capital account
8,000.00
25,000.00
4,000.00
3,000.00
7,000.00
3,000.00
4,000.00
2,000.00
1,000.00
3,000.00
20,000.00
By gross profit b/d
By discount
received
By interest received
68,000.00
4,000.00
8,000.00
80,000.00 80,000.00
10. POINTS WORTH NOTING IN PROFIT AND LOSS ACCOUNT
SALARIES- "Salaries paid to employees are debited to the profit and loss account. The
item ‘salaries and wages’ is treated as salaries and is debited to profit and loss account.
However, the items "Wages and Salaries is treated as wages and is debited to the trading
account
RENT- The amount of rent paid is shown on the debit side of the profit and loss account.
However, in case of rent received, it is an item of income and as such it will appear on the
credit side of the profit and loss account
DISCOUNT- Discount is of two types 1] Trade discount 2] Cash discount
Trade discount is given on bulk purchases and bulk sales. It is deducted from the amount of
purchases and sales before they are recorded in the books. Hence no further treatment is
given to trade discount.
A cash discount is given to creditors/customers in order to encourage prompt payment of
dues. When discount is received from creditors, it is considered as income and is shown on
the credit side of profit and loss account. When discount is allowed to customers, it is
regarded as an expensé and hence it is debited to the profit and loss account
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Various types of items are included in a profit and loss account. A detailed description of some of these items is
given below for better understanding as to how a profit and loss account is prepared
11. POINTS WORTH NOTING IN PROFIT AND LOSS ACCOUNT
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COMMISSION- To increase sales, agents are appointed on commission basis. The
commission so paid is an indirect expense and is debited to the profit and loss account. The
commission paid on the purchase of goods is debited to the trading account.
PRINTING AND STATIONERY- Printing and stationery include expenses relating to
printing bills, invoices, registers, files, letter-heads, hand bills, office stationery etc. It is an
indirect expense and is debited to the profit and loss account.
ADVERTISEMENT- To boost sales of products, suitable publicity is necessary. It is an
essential expenditure for any business. Hence it is debited to profit and loss account since it
is an indirect expense.
CARRIAGE OUTWARDS OR FREIGHT OUTWARDS- These expense are incurred
by way of transportation charges in respect of goods sold. It is treated as an indirect
expense and is debited to the profit and loss account.
12. POINTS WORTH NOTING IN PROFIT AND LOSS ACCOUNT
BAD DEBTS- "An irrecoverable debt is known as bad debts. This is a loss item for
business and hence appears on the debit side of profit and loss account.
REPAIRS- Repairs to plant, machinery, building etc. are indirect expenses and are, therefore,
debited to profit and loss account.
DRAWINGS- 'Drawing represent money or goods withdrawn by the proprietor from
business for his personal use. This is debited to capital account e.g premium paid on his life
insurance policy is treated as "drawings" and is deducted from the capital account. It is not
to be taken to profit and loss account.
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13. INCOME-TAX- In case of a trader, income tax paid is treated as a personal expense and is,
therefore, deducted from capital account. However, in case of companies or partnership
firms income tax is debited to profit and los account
LOSS OR GAIN ON ASSETS SOLD- Sometimes a business enterprise may sell its fixed
assets, such as furniture, machinery, building. etc. in course of its business operations and
thus may incur a loss or make a profit on its sale. The loss on the sale of a fixed asset is
treated as a revenue loss and is debited to the profit and loss account. The profit made on
sale of a fixed asset is treated as a revenue gain and is credited to the profit and loss account.
LOSS BY FIRE, THEFT ETC.- Loss due to theft etc. is considered as an abnormal loss
and is debited to the profit and loss account.
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POINTS WORTH NOTING IN PROFIT AND LOSS ACCOUNT
14. BALANCE SHEET
USES OFA BALANCE-
SHEET
It shows the financial
state of the business firm
as on a particular date.
The information regarding nature
and cost of firm liabilities
available from a balance-sheet.
It gives information
regarding the nature and
cost of the assets of the firm.
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Balance sheet is a statement of accounts prepared for the purpose of ascertaining the exact financial position of
the business on the last date of the financial year under review. It is called balance sheet because it is prepared on
a sheet of ledger folio, While the assets are recorded on the credit side, the liabilities are shown on the debit side
of the balance sheet.
It provides information as to the total amount of money
involved n running the business enterprise.
15. PREPARATION OF A BALANCE-SHEET
In a balance-sheet are given the names of all those accounts which have balances i.e. accounts of
assets, liabilities and owner's equity. While accounts of capital and liabilities shown on left-hand side
are known as 'Liabilities', assets and other debit balances are given right-hand side are called 'Assets'.
Items generally included in a Balance Sheet are as under
CURRENT ASSETS- "Current Assets are those which are either in the form of cash or can be easily
converted into cash within a year e.g. cash at bank, bills, stock, prepared expenses, debtors, short-term
security. ties etc
FIXED ASSETS- Assets held on a long-term basis in the business such as land, machinery, building,
furniture etc. are called 'fixed assets'
CURRENT LIABILITIES- Liabilities expected to be cleared within a year are called 'current
liabilities'. These are usually paid out of current assets. Salaries, wages, commission, bank overdraft,
rent, taxes, payment to creditors, bills payable etc. are all current liabilities.
LONG TERM LIABILITIES- Those liabilities which mature for payment after a period of one year
or more and do not require sale of any assets for their payment are known as 'long-term liabilities' e.g.,
loans which are repayable after a period of more than one year, mortgages on estate holdings of the
business etc.
16. PREPARATION OF A BALANCE-SHEET
INVESTMENTS- Investments represent funds invested in government securities, shares of companies
etc. These are shown at cost price in the balance-sheet. If on the date of preparation of the balance-
sheet the market price of an investment is lower than its cost price, this fact brought in the balance-
sheet by appending a suitable note.
CAPITAL- Capital is the excess of firm's assets over its liabilities It represents the amount originally
invested by the proprietor/partner and is increased by profit and decreased by losses and drawings.
DRAWINGS- 'Drawings' are sums of money or goods withdrawn the proprietor has the effect of
reducing the balance in the capital by the proprietor from the business for his personal use. Drawings
account., Therefore the drawing account is closed by transferring balance to his capital account..
17. GROUPING AND RECORDING OFASSETS AND LIABILITIES
The items included in a balance-sheet need to be properly grouped and presented in a particular order. The
term grouping means putting together items of a similar nature under a common head. The assets and
liabilities are then shown in a particular order, which can be done in one of the following two methods-
1. Order of liquidity
2. Order of permanence
Order of liquidity- It means the order in which they can be converted into cash. For example; the most
liquid asset viz. cash in hand is shown first and the least liquid asset viz. goodwill is shown at the end.
Similarly the liabilities of a business are arranged in order of urgency of their repayment. For example, the
ones which are most urgent as regards repayment e.g. short term creditors are shown first and the least
urgent e.g. long-term creditors are shown at the end
Order of permanence- This method is exactly the reverse of the first method stated above. According to
this method, the permanent assets and liabilities are shown first, followed by current assets and liabilities.
The business enterprises which are run by a sole proprietor or by a group of partners generally follow the
first method to marshal their balance sheets, whereas joint stock companies prepare their balance- sheets in
order of permanence.
18. ILLUSTRATION- From the following Trial Balance draft the Balance-Sheet of Nidhi
Medical Hall as on 31st March 2009
PARTICULARS BALANCE
Dr (Rs) Cr (Rs)
Land and building
Plant and machinery
Furniture
Motor vehicle
Stock on 31.03.09
Debtors and creditors
Cash in hand
Bank overdraft
Drawings and capital
Investments
Net Profit
80,000.00
42,000.00
10,000.00
14,000.00
48,000.00
8,000.00
2,000.00
10,000.00
6,000.00
25,000.00
60,000.00
90,000.00
45,000.00
2,20.000.00 2,20.000.00
19. SOLUTION- Balance-sheet of M/s Nidhi Mediacal Hall as on 31st March 2009
‘Dr’ ‘Cr’
LIABILITIES AMOUNT
RS
ASSETS AMOUNT RS
Bank overdraft
Creditors
Capital 90,000.00
Add Net
Profit 45,000.00
1,35,000.00
Less
Drawing 10,000.00
60,000.00
25,000.00
1,25,000.00
Cash in hand
Investments
Debtors
Closing stock
Furniture
Motor vehicle
Plant & Machinery
Land and building
2,000.00
6,000.00
8,000.00
48,000.00
10,000.00
14,000.00
42,000.00
80,000.00
2,10,000.00 2,10.000.00
20. DIFFERENCE BETWEEN TRIAL BALANCE AND BALANCE SHEET
SR.NO TRIAL BALANCE BALANCE SHEET
1 It is prepare to check the arithmetical accuracy of
posting of transactions to the leader.
It is prepare to know the financial position of the business
enterprise on a given date.
2 A trial balance can be prepared at any time. It may
be prepared at the end of amonth or a quarter.
A balance sheet is generally prepared at the end of the
accounting period.
3 It shows ‘debit balances’ and ‘credit balaces’. It shows ‘liabilities’ and ‘assets’.
4 All type of accounts find their place in a trial
balance.
In a balance sheet accounts of assets, liabilities, capital
and those accounts which are in force on the date of the
balance sheet are presented.
5 It is not possible to have information about net
profit or net loss.
The information about net profit earned or net loss
incurred is provided in a balance sheet.
6 Generally, the opening stock appears in a trial
balance and not the closing stock.
Only the closing stock appears on the assetd side of the
balance sheet.
7 Trial balance is not recognized by the court. Balance sheet is recognize by the court.
8 It is not essential to prepare a trial balance. It is essential to prepare a balance sheet at the end of the
accounting period.
9 It can be prepared without making any adjustments
regarding prepared expenses, incomes received in
advance etc.
It cannot be prepared without making adjustments
regarding prepared expenses, outstanding expenses,
income received in advance, making provision for
possible losses etc.
21. DIFFERENCE BETWEEN PROFIT AND LOSS ACCOUNT AND BALANCE SHEET
SR.NO PROFIT AND LOSS ACCOUNT BALANCE SHEET
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In profit and loss account the nominal accounts
are shown.
In balance sheet the personal accounts and
real accounts are shown.
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The aim of profit and loss account is to provide
information regarding net profit or net loss.
The aim of balance sheet is to know the
financial position of the business.
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It is a ledger account giving information about
debits and credits.
It is only statement of assets and liabilities
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It is an account ,so the words “To’ and ‘By’
areused
It is a statement and the words “To’ and
‘By’ are notused
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The balance of the profit and loss accounts
indicates profit or loss.
The total on both sides of a balance sheet is
always the same.
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The account shows profit or loss made by the
business as on a fixed date.
It shows the financial position of the
business enterprise on a fixed date.
22. ANALYSIS OF FINANCIAL STATEMENTS
Financial analysis is a process of evaluating the relationship between component parts of financial
statements to obtain a better understanding of the financial position and performance of a firm.
The steps involved in financial analysis are as follows-
1. Select the information relevant to the purpose of analysis from the financial statements.
2. Arrange the information in a way so as to highlight significant relationships.
3. Interpret the relationships and draw relevant conclusions from them.
Financial analysis is useful to different groups in society.
However the purpose of analysis varies from one group to another.
For example the management of a firm is interested in the overall performance of the firm, the
shareholders and investors are interested in the earning per share, the debenture holders want to know the
capital structure and earning position of the company, whereas the banks and other short-term creditors
are interested in the composition of current assets and current liabilities of the firm.
23. METHOD OF FINANCIALANALYSIS
Financial analysis can be made by the following methods
Comparative financial statements -These statements contain figures of two or more consecutive years,
which give a comparative view of the financial performance of a firm. A comparative profit and loss
account gives expenses and revenues of two consecutive years. Similarly, a comparative balance sheet
contains the amounts of assets and liabilities at two different points of time e.g. on 31.3.2009 and
31.3.2010 Such statements reflects the nature and trend of changes in the financial performance of the
company. Under the companies Act, 1956, the companies are required to give figures for the current year
as well as the previous year in their Profit and Loss Accounts, and Balance Sheets.
Common size financial statements- In these statements, figures are converted into percentages to some
common base. For example in the profit and loss account, the sale figure is assumed to be 100 all figures
are expressed as a percentage of sales. Similarly, in the balance sheet, the total of assets or liabilities is
taken as 100 and all other-figures are expressed as percentages of this total.
Funds Now analysis- It reveals changes in the working capital position of an enterprise. It indicates the
sources from which the working capital was obtained and the purpose for which it was used
24. METHOD OF FINANCIALANALYSIS
METHOD OF FINANCIALANALYSIS
Financial analysis can be made by the following methods
Ratio analysis –
It is the most popular method of financial analysis. Moreover, it is simple and more informative. The term
ratio refers to the numerical relationship between two items. A ratio by itself does not reveal much but its
comparison with a similar ratio of the past or of a similar firm is very useful in judging the performance
and financial position of the enterprise. A financial analyst can use various types of ratios for different
purposes. The various accounting ratios are-
a) Liquidity ratios
b) Solvency ratios
c) Activity ratios
d) Profitability ratios
e) Miscellaneous ratios
25. A] LIQUIDITY RATIOS-
These ratios, constituting ratio analysis of the short term financial position, are used to measure the ability of the
firm to meet its current obligations. The following two ratios come under the head-
(i) Current ratios (ii) Quick ratios
Current ratios (C.R.)- It is also called Working Capital Ratio and is the most widely used of all analytical
devices based on the Balance Sheet. It matches the current assets of the firm to its current liabilities.
Current ratio = Current assets/ Current liabilities
Generally a current ratio of 2 is considered satisfactory. A current ratio of two means for every one rupee of
current liabilities, two rupees of current assets are available to pay them. A satisfactory current ratio enables a firm
to meet its short-term obligations and thereby ensures smooth operation of business.
Quick ratios - It is also called Acid Test Ratio. It is used to measure the ability of the firm to convert its current
assets quickly into cash in order to meet its current liabilities.
Quick ratio = Quick assets/Current liabilities
Quick assets means current assets which can be converted into cash is immediately or on a short notice without
decrease in value. Quick assets include cash and bank balances, securities and debtors. Quick ratio is more useful
than the current ratio as it provides a more rigorous test of a firm's liquidity. Generally, a quick action of 1 is
Considered satisfactory.
26. B] SOLVENCY RATIOS-
It is also known as leverage ratio. Solvency means the liabilities as and when they mature for payment. It also
indicates the financial risk to long-term creditors. It measures the relationship between owner's funds and
creditor's funds. The greater the proportion of owner's funds, the higher is the solvency of the firm. Solvency is
measured by following two ratios- 1] Debt equity ratio (DE Ratio) 2] Debt to total capital
Debt-equity ratio (DE ratio)- It is used to measure relative claims of creditors and owners.
Debt equity ratio = Long term debt/ Shareholders equity
where Share-holder equity = Equity share capital + Surplus + Preference share capital.
Debt equity ratio is an important tool of financial analysis for evaluating the financial structure of a company. A
high debt equity ratio means the shareholder stake in the company is low. A low debt-equity ratio indicates a
higher stake for share-holders. The appropriate debt equity ratio will depend upon the nature of the company's
earnings.
Debt to total capital = Long term debt/ Permanent capital
where Permanent capital = Share-bolder equity + Long term debt.
27. C] ACTIVITY RATIOS-
It is also known as efficiency ratios. These are intended to measure the efficiency with which the firm manages
and utilizes its assets. An activity ratio is a test of the relationship between sales and various assets of a firm.
Some of the important turn over ratios are:-
(a) Inventory turnover ratio (ITR) (b) Capital turnover ratio
Inventory turnover ratio- It is also known as stock turn over ratio It is used to measure the firm inventory
management. The ITR can be calculated by any one of the following two formulae:-
Inventory turnover ratio = Cost of goods sold /Average inventory = Net sales/ Average inventory
A high inventory turnover ratio indicates under-investment in inventory and involves risk of the firm becoming
"outof stock. Similarly, a very low inventory turnover may indicate over-investment in inventory which results in
higher costs. Thus a firm should have a proper inventory turnover.
Capital turnover ratio- This ratio measures the relationship between the sales and the capital employed in the
business ie.
Capital turnover = Sales / Capital employed
28. D] PROFITABILITY RATIOS
These are designed to highlight the end results of business activities. So these ratios are useful to measure the
operating efficiency of the company. The various ratios covered under these are:-
1] Gross profit ratio 2] Net profit ratio 3] Return on investment
1]Gross profit ratio - Gross profit means sales minus cost of goods Sold
Gross profit ratio = Gross profit / Net sales × 100
Gross profit depends upon the selling price, sales volume and cost. A high gross profit is a sign of good
management and indicates that the cost of sales is relatively low. It may also indicates that the selling price of
goods has increased without a corresponding increase in the cost of goods sold. The other possibility is that the
cost of goods sold might have declined without a corresponding decline in the selling price of the goods. A low
gross profit ratio is due to increase in cost of goods sold or decline in selling price due to inferior quality of the
product or lack of demand etc.
2]Net profit ratio- The ratio is also known as net profit margin. It measures the relationship between net profit
and net sales
Net profit ratio = Net profit / Total sales × 100
Where Net profit means gross profit minus operating expenses, Net profit ratio is helpful in determining the
efficiency with which operations of the firm are being managed
29. 3] Return on investment (ROI)- The overall profitability of an enterprise can be measured by relating its net
profit to its investment. There are three different concepts of investments which are given below:
Return on assets = Net profit after taxes / Total assets × 100
Return on capital employed = Net profit after taxes / Capital employed × 100
Capital employed means the long-term funds supplied by the creditors and shareholders of the company.
Return on share holders equity = Net profit after taxes × 100 + preference share capital + Retained Earning
Equity share capital
Return on investment is a useful measure for judging the overall efficiency of an enterprise. It indicates as to what
degree the long-term funds of the business have been properly utilised.
30. E] MISCELLANEOUS RATIOS
The following are some of the ratios which are not covered under the main categories:
Earning per share- It is used to measure the amount of earning against each share.
Earning per share = Net profit after tax / Total number of shares x 100
Dividend per share- It is used to measure the amount of dividend paid against each share.
Dividend per share = Total amount paid to shareholder / Outstanding number of shares
Dividend pay out ratio- The ratio is utilised to evaluate the share holder return.
Dividend pay out ratio = Dividend per share/ Earning per share
Dividend yield ratio- It is utilised to evaluate the shareholder return in relation to the market value of share.
Dividend yield ratio = Dividend per share / Market value of share
Earning yield ratio- The ratio is also used to find out the return given to shareholder in lieu of the market value
of the share.
Earning yield ratio = Market value of share / Earning per share
Interest coverage ratio- It is also known as debt service ratio and is very useful to test the debt servicing
capacity of the firm.
Interest coverage ratio = Net profit before deduction of interest and taxes / Fired interest charges
31. ADVANTAGES OF RATIO ANALYSIS
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The accounting ratios of one firm can
be compared with those of others to
judge the relative financial position of
different firms. This helps the
management to detect the weaknesses
and strengths of the firm.
Ratio analysis enables the firm to
judge whether its financial position
is improving or deteriorating over
the years
It helps in easier and better
understanding of profit and
loss account and balance sheet.
It helps in future planning.
32. DISADVANTAGES OF RATIO ANALYSIS
Ratios are useful indicators only when they are compared
with similar ratios of other firms. It is difficult to compare the
firms because they may have different accounting periods or
different composition of assets.
Ration reflects only the
financial aspect of business
Ratios are only a post-mortem of
what has happened. They do not
reveal the future events
The ratios are based on the
information contained in the
financial statements. The ratios
become unreliable if the data
given in financial statement is
not accurate and up-to-date.
Due to changes of price level from
one period to another, the assets
acquired at different periods are
shown in balance-sheet at different
prices. As such, accounting ratios
based on those
DISADVANTAGES
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