i) Use the balance sheet identity or equation to explain the structure of and pu
ID: 428326 • Letter: I
Question
i) Use the balance sheet identity or equation to explain the structure of and purpose the balance sheet. i Explain net working capital, liquidity, market value, and book value. of of them is important in finance. Explain why each one Use the income statement identity to explain the structure and income statement. purpose of the iv) Explain GAAP and non cash items and what their use in preparing and understanding the income statement, v) Explain average tax rate, flat rate tax, and marginal tax rate? Which one of the rates is usually the most important in financial decision making and why? vi) Explain the cash flow identity or equation and why it corresponds with the balance identity. sheetExplanation / Answer
1.
Balance sheet equation is as follows:
Assets = Liability + equity
The structure of the balance sheet, shows the status of the assets and liabilities owned by the firm on a particular data. On one side of the balance sheet, it is assets and another side of the balance sheet it is liability and equity. At any particular time, above equation is fulfilled. Besides, there is a vertical structure of balance sheet is also followed. Purpose of the balance sheet is to disclose and explain position and breakup of different types of assets, liabilities and the equity capital of the firm. It tells to assess the liquidity position of the firm and a degree of balance along different sections of the assets (fixed assets and current assets) and liabilities (short term and long term). It helps the management and investors to take some corrective action on the basis of financial health exhibited by the balance sheets and subsequent ratio analysis.
2.
Net working capital refers to the excess of current assets over the current liability. It means that:
Net working capital = current assets - current liabilities
An excess investment in fixed assets, can cause the net working capital to be negative, a concern for the firm. So, it is regularly observed. A positive net working capital shows the positive and active condition of the firm. So, for finance function, it is very important.
Liquidity is the ability of the firm to repay its short term debt obligations. It is measured using the liquidity ratios. It can be current ratio and quick ratio. Here, quick ratio or acid test ratio is the stringent measure to evaluate the liquidity position of the firm as a part of the financial management.
Market value is the value that can be obtained by selling it into the open market. It is dependent upon the market conditions and varies accordingly.
Book value is the value that is mentioned in the book of accounts. It is the original purchase value, inclusive of the other related expenses, freights and installations if any.
Book values are market values tells the appreciation and or depreciation in the value of the stock or assets at a given time. Here, book value does not change, but market value keeps changing. From the perspective of investors, market value is important, and from the perspective of firm, book value is more important.
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