Preparation of Financial Statements with the help of Accounting Ratios

04/02/2024 0 By indiafreenotes

Preparing financial statements with the help of accounting ratios involves reverse-engineering the ratios to estimate the financial statement figures. This process is especially useful in financial modeling, forecasting, and analysis when specific details are missing, and assumptions need to be made based on available ratios.

Step 1: Gather Known Ratios and Information

Assume we have the following ratios and information for Company X:

  • Debt to Equity Ratio (D/E): 1.0
  • Current Ratio: 2.0
  • Gross Profit Margin: 40%
  • Net Profit Margin: 10%
  • Total Sales (Revenue): $200,000

Step 2: Estimate Financial Statement Figures

Balance Sheet Estimates:

  1. Using the Debt to Equity Ratio:

If the D/E ratio is 1.0, it means that the company’s total liabilities equal its total equity. Without an absolute figure, assume equity is $100,000; thus, liabilities are also $100,000.

  1. Using the Current Ratio:

With a current ratio of 2.0 and no absolute figures, you need to make assumptions. For example, if current liabilities are $50,000, then current assets must be $100,000 (2.0 * $50,000).

Income Statement Estimates:

  1. Gross Profit Margin:

Given a gross profit margin of 40% and total sales of $200,000, the gross profit can be calculated as 40% of $200,000 = $80,000.

  1. Net Profit Margin:

With a net profit margin of 10% on the same sales, net income is 10% of $200,000 = $20,000.

Step 3: Draft Preliminary Financial Statements

Balance Sheet:

  • Assets:
    • Current Assets: $100,000 (Estimated based on current ratio)
    • Non-Current Assets: The balance required to match the total of liabilities and equity, assuming it’s a simplified balance sheet where total assets equal total liabilities plus equity.
  • Liabilities and Equity:
    • Current Liabilities: $50,000 (Assumed for current ratio)
    • Non-Current Liabilities: The balance to match the D/E ratio, here assumed as part of the total $100,000 liabilities.
    • Equity: $100,000 (Assumed based on D/E ratio)

Income Statement:

  • Revenue (Sales): $200,000
  • Cost of Goods Sold (COGS): $200,000 – $80,000 (Gross Profit) = $120,000
  • Gross Profit: $80,000
  • Operating Expenses: Calculated as the difference between gross profit and net income, assuming all expenses are operating expenses, $80,000 – $20,000 = $60,000.
  • Net Income: $20,000

Step 4: Refine and Validate

  • Review assumptions against industry norms or historical data.
  • Adjust the balance sheet to ensure that total assets equal total liabilities plus equity.
  • Consider additional information such as tax rates, interest expenses, and operational costs to refine the income statement.