Internal Audit: Finance/Accounting¶
Overview¶
The financial condition of a firm is the single best measure of its competitive position and overall attractiveness to investors. Conducting an internal audit in the finance/accounting functional area involves assessing the organization’s financial strengths and weaknesses. This is essential for effectively formulating and implementing strategies. The audit typically focuses on key financial aspects such as liquidity, leverage, profitability, asset utilization, and cash flow.
Finance/Accounting Functions¶
1. Investment Decision¶
- Definition: The investment decision, also known as capital budgeting, involves the allocation and reallocation of capital and resources to projects, products, assets, and divisions within the organization.
2. Financing Decisions¶
- Definition: The financing decision determines the best capital structure for the firm. It includes examining various methods for raising capital, such as issuing stock, increasing debt, selling assets, or using a combination of these approaches.
- Key Ratios:
- Debt-to-Equity Ratio: Measures the percentage of total funds provided by creditors versus owners.
- Debt-to-Total-Assets Ratio: Indicates the percentage of total funds provided by creditors.
3. Dividend Decisions¶
- Definition: Dividend decisions concern issues such as the percentage of earnings paid to stockholders, the stability of dividends over time, and the repurchase or issuance of stock. These decisions determine the amount of funds retained in the firm compared to those paid out to stockholders.
- Key Ratios:
- Earnings-per-Share (EPS) Ratio: Measures the earnings available to the owners of common stock.
- Dividends-per-Share Ratio: Indicates the dividend earnings per share.
- Price-Earnings (P/E) Ratio: Assesses the attractiveness of the firm on equity markets.
Financial Ratio Analysis¶
Financial ratio analysis is the most widely used method for determining an organization’s strengths and weaknesses in the areas of investment, financing, and dividend decisions. These ratios are calculated from an organization’s income statement and balance sheet. Comparing financial ratios over time and against industry averages helps identify meaningful trends and evaluate the firm’s performance.
Types of Financial Ratios¶
- Liquidity Ratios: Measure a firm’s ability to meet maturing short-term obligations.
- Current Ratio: \( \text{Current assets} \div \text{Current liabilities} \)
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Quick Ratio: \( (\text{Current assets} - \text{Inventory}) \div \text{Current liabilities} \)
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Leverage Ratios: Measure the extent to which a firm has been financed by debt.
- Debt-to-Total-Assets Ratio: \( \text{Total debt} \div \text{Total assets} \)
- Debt-to-Equity Ratio: \( \text{Total debt} \div \text{Total stockholders’ equity} \)
- Long-Term Debt-to-Equity Ratio: \( \text{Long-term debt} \div \text{Total stockholders’ equity} \)
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Times-Interest-Earned Ratio: \( \text{Profits before interest and taxes} \div \text{Total interest charges} \)
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Activity Ratios: Measure how effectively a firm is using its resources.
- Inventory Turnover: \( \text{Sales} \div \text{Inventory of finished goods} \)
- Fixed Assets Turnover: \( \text{Sales} \div \text{Fixed assets} \)
- Total Assets Turnover: \( \text{Sales} \div \text{Total assets} \)
- Accounts Receivable Turnover: \( \text{Annual credit sales} \div \text{Accounts receivable} \)
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Average Collection Period: \( \text{Accounts receivable} \div (\text{Total credit sales}/365 \text{ days}) \)
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Profitability Ratios: Measure management’s overall effectiveness as shown by the returns generated on sales and investment.
- Gross Profit Margin: \( (\text{Sales} - \text{Cost of goods sold}) \div \text{Sales} \)
- Operating Profit Margin: \( \text{Earnings before interest and taxes (EBIT)} \div \text{Sales} \)
- Net Profit Margin: \( \text{Net income} \div \text{Sales} \)
- Return on Total Assets (ROA): \( \text{Net income} \div \text{Total assets} \)
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Return on Stockholders’ Equity (ROE): \( \text{Net income} \div \text{Total stockholders’ equity} \)
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Growth Ratios: Measure the firm’s ability to maintain its economic position in the growth of the economy and industry.
Financial Ratio Analysis Considerations¶
When conducting financial ratio analysis, consider the following:
- Historical Trends: How has each ratio changed over time? This helps evaluate the organization’s performance trends.
- Industry Norms: How does each ratio compare to industry norms? Comparing a firm’s ratios with industry averages provides a benchmark.
- Key Competitors: How does each ratio compare with key competitors? This helps assess the firm’s position relative to its main competitors.
Limitations of Financial Ratio Analysis¶
Financial ratio analysis is not without limitations. These include:
- Accounting Data Variations: Firms differ in their treatment of items such as depreciation, inventory valuation, R&D expenditures, pension plan costs, mergers, and taxes, which can affect ratios.
- Seasonal Factors: Seasonal factors can influence comparative ratios, making it difficult to establish whether a firm is performing normally or is well managed.
- Conformity to Industry Averages: Conformity to industry composite ratios does not guarantee that a firm is performing normally or is well managed.
Finance/Accounting Audit Checklist¶
To evaluate the finance/accounting function, consider the following questions:
- Where is the firm financially strong and weak as indicated by financial ratio analyses?
- Can the firm raise needed short-term capital?
- Can the firm raise needed long-term capital through debt and/or equity?
- Does the firm have sufficient working capital?
- Are capital budgeting procedures effective?
- Are dividend payout policies reasonable?
- Does the firm have good relations with its investors and stockholders?
- Are the firm’s financial managers experienced and well trained?
- Is the firm’s debt situation excellent?
Breakeven Analysis¶
The breakeven point (BE) is the quantity of units a firm must sell to ensure that total revenues (TR) equal total costs (TC).
Breakeven Formula¶
Example¶
- Given:
- Fixed Cost: $100 million
- Variable Cost per Unit: $2 million
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Price per Unit: $3 million
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Step 1: Breakeven Point: [ \text{BE Quantity} = \frac{100}{3-2} = 100 \text{ units} ]
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Step 2: Profit Calculation:
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To make a profit of $99 million, the firm must sell: [ \text{Total Revenue} - \text{Total Cost} = 99 ] [ N \times 3 - (100 + 2 \times N) = 99 \Rightarrow N = 199 \text{ units} ]
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Step 3: Profit for 200 Units:
- Profit when selling 200 units: [ 200 \times 3 - (100 + 2 \times 200) = 100 \text{ million} ]
This comprehensive analysis of finance/accounting functions and financial ratio analysis offers valuable insights into a firm’s financial health and helps guide strategic decision-making.
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