Wednesday, 11 April 2012

Reading 20,21 FRA Impact on several Ratios

Impacts on profitability, liquidity, activity and solvency ratios of finance lease, operating lease, inventory write downs, choice of inventory valuation etc. can be tested highly. While doing the chapter end questions of Reading 20 and 21 (Study Session 5) I encountered several questions framed on ratios. I was having a trouble in solving them but when I sketched in my mind the impact of any accounting choice to the numerator and denominator of the ratios and then tried to figure out the effects, my answers started getting correct. Another important aspect in that regard was the effect of adding the same amount to the numerator and to the denominator. Suppose a company has off balance sheet lease arrangements (operating lease) if it had classified it as finance lease the liabilities to total assets ratio would be higher or lower? This was interesting as the same amount will be added to the asset base and a liability equal to the PV of lease obligation would be created. The numerator and the denominator of the liabilities to total assets ratio will increase with the same amount. This will result in decreasing the ratio not increasing it. The answer therefore is lower. Such concepts, which are present in the chapter end questions, can be tested in the exam. I have made myself comfortable with them today and I hope when I'll be encountered with any question like this, I would be able to connect it with what I experienced today.

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