Analytical Examination of Financial ratios and Information - Case Study Example

Financial ment auditing analysis By Company Analysis of PART A From the financial ments, the management commentary in the annual report and other sources, and using appropriate auditing procedures, identify FIVE areas of heightened audit risk relating to the audit of this company. Explain why you consider these areas of increased audit risk Auditing is an art in itself in the sense that, numerous procedures that guides it operations in various procedures. The process of auditing seeks to ensure that the financial statements and other documents are complete, they really occurred, correctly classified, accurate and well disclosed. This essay seeks to examine five areas of heightened audit risk relating to the audit of the Havelock Company under study. As a point of departure, the management commentary on credit and liquidity risks indicates existence of unsound control systems on revenues and the general expenditure of the company. This study will focus on the profitability, liquidity, financial leverage, working capital and valuation ratios. These instruments are essentially the reflection of the company’s financial position in terms of control system management. This follows that; analytical examination of the ratios will play a fundamental role in exhibiting the potential risks areas of Havelock Company (RODGERS, 2007). Analytical Examination of Financial ratios and Information Profitability ratios These ratios include Gross profit margin, Operating margin and net profit margin. These ratios aid in investigating profitability status of an organization through comparison of the income aspects with sales. This follows that, upon examining and comparing Havelock Company’s profitability ratios of 2011 and 2012, auditing assumptions will be made consequently, identifying the possible risk audit areas (VOGEL, 2007). Profitability ratios Formula Havelock 2012 2011 Gross Margin Operating income/sales 0.07 -4.36 Net Margin Gross profit/sales 13.16 11.95 The gross margin profit implies that the amount of sales revenue which remains after the cost of goods. The ratios above indicate the in 2011 the sales revenue left was significantly low compared to 2013. There is a shift from -0.36 to 0.07. This tells the auditors that the significant change should be widely investigated, particularly on the element of sales. The significant rate of the sales revenue remained might be investigated based on sale of goods of other brands from outside, hence creating a backlog of the company’s goods. This is a potential audit area for Havelock Company, which might be attributed to issues of disclosure (VOGEL, 2007). Liquidity ratios These ratios include liquidity ratio, quick ratio, and current ratio Liquidity ratio Formula Havelock 2012 2011 Quick ratio Current assets- Inventory/ Current liabilities 1.00 1.56 Current ratio Current assets/ current liabilities 2.88 5.43 These ratios aid in establishing the company’s capacity to meet its short-term debts. The current ratio for Havelock went down from 5.43 in 2011 to 2.88 in 2012. This implies that the company performed dismally in accumulating its current assets over the accounting period of one year. On equal measure, the quick ratio decreased from 1.56 in 2011 to 1.00 in 2012. This implies that the company struggled to repay its current liabilities. According to the auditing procedures, when both the current and quick ratios are on the decreasing trend, it indicates that company’s control systems of management of liabilities and assets are unsound. This call for a quick audit rechecks to ensure that the systems are not used for fraud purposes, because, the ratios indicate that this area has an audit risk potential (VOGEL, 2007). Financial Leverage ratios They include debt ratios, and total debt to total assets ratio. These ratios help in establishing the extent to which firms rely on debts in financing their performance and reserves. On equal measure, they help in establishing the dependability of the company through determining their potential to uphold debt repayments and equivalent periodic interests. Financial Leverage Ratios Formula Turrow 2012 2011 Debt-Equity ratio Total Debt/Total shareholders’ Equity 0.28 0.22 Total Debt to Total Assets Ratio Total Debt/ Total Assets 34.60 49.82 The debt ratio increased from 0.22 to 0.28. This implies that company was able to finance its debts through its 28% equity. However, the decrease the decreased total debt ratio from 49.82 to 34.60 indicated that the company was not able to finance its assets through debts. This negative indication considering that the shift is – 15.22. This big margin attracts the auditor’s eyes and skills, consequently the control system for debts and assets management is presumed to be a potential audit risk area (VOGEL, 2007). Working capital ratios They include accounts receivable and inventory days. Consider the following table Working capital ratios Formula Havelock 2012 2011 Accounts receivables days Accounts receivables/average daily sales 45.8 63.9 Inventory days Inventories/average daily cost of sales 49.7 32.8 These ratios help in determining how a company uses its assets to realize overall gains. On equal measure, the ratios help in understanding how valuable a company manages its resources. From the above table the number of days of account receivables decreased from 63.9 to 45.8. This implies that, Havelock Company is less effective in collecting its receivables from the clients. However, this decrease raises an alarm to the auditors to analyze counter check the control system for collecting receivables (REES, 2005). Hence, days of account receivables become an audit risk potential area for the auditors and the company management. On the other hand, the Increase in inventory days may be attributed creates a possible sensitive audit risk. This is because the all inventories’ items increase in the financial stamens. On equal measure, due to higher inflation anticipations, increasing prices make the equivalent amount of inventory to value increase. Valuation ratios These ratios assess the market capitalization to book value of the company’s shareholders equity. They include earnings ratio and earnings per share. Valuation ratios formula Havelock 2012 2011 Earnings ratio Market price per share/Earnings 0.00 0.01 Earnings per share - 9.58 28.80 The decrease of earning per share from 28.80 t0 less than 10-figure is an indication of a serious problem in the share market, control system. This decrease affected the payment of dividends to shareholders who have to wait until the company recovers. In essence, the fact that the share holders are not paid dividends because of the company’s poor performance is a sure signal that some control systems relative to the share capital and the company’s system at large are at a mess (REES, 2005). The auditor should mark this area as an audit risk potential and move to examine what might be the problem. PART B In relation to ONE of the areas selected in Part A identify, and explain the reasons for, the detailed audit procedures you would carry out in attempting to reduce audit risk to an acceptably low level. As for the present trade receivables, the primary related audit contention is survival, rights & debts, completeness, assessment & allocation. Existence contention addresses the receivable as ‘real’ (REES, 2005). This implies that it does exist in financial statements. Rights and debt accentuate the receivable fit into the company, and thus should be indicated in the statement of financial position. On the other hand, completeness affirmation states that all receivable balances are complete. This implies that receivables are not under-stated. Assessment and allocation affirmation necessitate that the amount indicated for receivables is accurate. The four assertions relative to receivables are fundamental in reducing the audit risk to an passably low level. As a point of departure, completeness contention, gives a doubtful picture that receivables are misplaced from the financial statements. This implies that, we should ensure that all sales invoices record in the correct receivables accounts. Auditors should necessitate the preparation of the amounts receivable schedule of the unit financial department. This is due to the sole reason that such schedules are prepared by the organizations themselves. This calls for confirmation of their independence and credibility (REES, 2005). On the same regard, the auditors should reconsider scrutiny of the total number of the schedules, and then compare with accounts receivable ledger and financial statements. The possibility that an occurrence of inconsistency in the three accounts happens, then this calls for stringent action of establishing the reason for the difference, which might confirm our fears that the area is an audit risk potential. If that is the case then, we shall establish an audit approach of reaching the entire debtor and confirming the balances indicated in the financial statements. Moreover, enquiry and inspection of documents for probable factoring of debtors is an efficient method in assessment and distribution assertion. When ensuring that a client has cash flow difficulty, auditors should consider whether the company sells to a financial organization at a discount ( HELFERT, 2007). In the event that, this situation occurs, the customers may not recognize the change of ownership of its debt and continue to pay the client. This circumstance is easy to divulge by making proper and effective communication to the management team References HELFERT, E. A. (2007). Techniques of financial analysis. Homewood, Ill, Irwin. REES, B. (2005). Financial analysis. London, Prentice Hall. RODGERS, P. (2007). Financial analysis. Oxford, Elsevier. VOGEL, H. L. (2007). Entertainment industry economics: a guide for financial analysis. Cambridge, Cambridge University Press. Read More