The Application Of Ratio Analysis To Business Organisations

Project and Seminar Material for Business Administration and Management BAM

The Application Of Ratio Analysis To Business Organisations


Abstract


Financial information provided in financial statements are useful in business decisions, however, it must be noted that financial statements are means to an end in themselves.

This study examines the effectiveness of the application of Ratio analysis to business organizations and the need to understand and interprete the contents of financial statements.

Various classes of ratios were examined under literature review. This gives an insight to how ratios can be used to predict and determine organization’s performance over a period of time. Usefulness of ratio analysis was discussed and its limitations.

Summary of major findings, conclusion and recommendations was made based on the information gathered.

The reader will find this work useful in their day-to-day business activities and its effective application to their business organizations will assist them in improving on their business performances.


Chapter One


Introduction

1.1 Background of the Study

The two primary objectives of every business are profitability and solvency. Profitability is the ability of a business to make profit, while solvency is the ability of a business to pay debts as they come due. (Hermanson et al, 1992). However, the achievement of these objectives requires efficient management of resources of the business through planning, budgeting, forecasting, control, and decision – making. Also, the strengths and weakness of the business need to be identified and necessary corrective measures applied. Interestingly, accounting provides information that facilitates these functions.

Basically, Accounting measures and communicates economic information needed for decision –making. Thus, the American Accounting Association (in Okezie, 2002) defined Accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the information”.

The Income Statement shows the profitability or operational result of a business while the balance sheet shows the solvency or financial position of a business.

Although profits are often used as the basis for judging the performance of a business, such profits must be related to the various items of the financial statements in order to be meaningful and useful for decision making. Furthermore, owing to the summarized nature of financial statements, a lot of truths are hidden in them. Thus, they need to the analyzed and interpreted by means of financial ratios to enable the users understand the meaning of the absolute amounts shown in them, and make informed business decisions.

In this regard, Essien (2006) observed that financial statements carry lots of financial Information that are hidden in the figures. The figures in financial statements become more useful when they are related to each other or to some other relevant financial data. Therefore, users of financial information go a further step to establish relationships (or ratios) among selected data in financial statements.

According to Igben (1999), “Accounting or financial ratio is a proportion or fraction or percentage expressing the relationship between one item in a set financial statements and another item in the financial statements. Accounting ratios are the most powerful of all tools used in analyzing and interpreting financial statements”. Therefore, ratio analysis involves taking statistics of number (or items) out of financial statements and forming ratios with them, to enhance informed judgments and decisions (Lasher, 1997).

MCShane et al (2000) defined decision-making as “a conscious process of making choices among one or more alternatives with the intention of moving toward some desired state of affairs.” Therefore, business decisions can be defined as choices relating to the allocation and/or use of business resources to achieve business goals.

Decision-making calls for information. Bittel et al. (1984:340) observed: “Managers want information because they need to make decisions. The proper use of information is an important part of decision-making.” Remarkably, one of the effective ways of providing information needed for decision-making is ratio analysis.

Business decisions of make or buy, investment or divestment, expansion or contraction, capital-organization and reconstruction, and so on cannot be properly made without the aid of financial ratios. They give clue to the financial strengths and weaknesses of a business, and highlight aspects of a business requiring further investigation.

Therefore, this research is carried out to show how ratio analysis help managers, shareholders, investors, creditors, and other stakeholders make informed judgments and decisions about the past performance, present condition, and future potential of a business.


1.2 Statement of Problems

Financial information provided in financial statements are useful in business decisions, however, it must be noted that financial statements are means to an end in themselves. Thus, the use of financial statements in decision making is not always easy owing to the following problems:

In view of the summarized nature of information contained in financial statements, they need to be analysed and interpreted by means of financial ratios to enable management and stakeholders understand them and make well informed business decisions.
Many users of financial statements are not knowledgeable about accounting ratios and how the ratios can be applied to financial statements to aid decision making.
Despite the immense benefit of ratio analysis, there are a lot of weaknesses or limitations associated with its use.

In view of the above stated problems, this research is embarked upon to identify the proper use of financial ratios and the roles ratio analysis plays in business decisions.


1.3 Objective of the Study

In the consideration of the problems identified above, the objective of this research includes:

  1. To show how ratio analysis facilitates proper understanding of information contained in financial statements
  2. To show how ratio analysis aids business decisions
  3. To examine the techniques used in analysis of financial statements.
  4. To identify the usefulness of financial ratios in measuring and predicting the performance and financial position of a business.
  5. To unravel the obstacles to the proper use of financial ratios in business decisions
  6. To suggest ways to enhance efficient use of ratio analysis in decision making.

1.4 Research Hypotheses

In order to draw a reliable inference about the population based on samples to be collected, the following hypotheses are formulated:

Hypothesis one
  • Ho: Ratio analysis cannot be used in decision making in an organization.
  • Hi: Ratio analysis can be used in decision making in an organization
Hypothesis two
  • Ho: Ratio analysis does not aid business decisions.
  • Hi: Ratio analysis aids business decisions.

1.5. Significance of the Study.

The prime position of a bank as the custodian and creator of money, as well as the financier of business ventures and economic activities has made it imperative for everybody to ensure its survival.

The study is significant for the following reasons:

  1. The study will serve as a good instrument for for predicting business failure.
  2. It will guide the business analyst in the evaluation of the capital structure and enhance adequate investment decision and recommendation.
  3. It will be a vital instrument for the managers in the industry in the effective utilization of shareholder equity and debenture stock.
  4. It is hoped that the result of the research will facilitate optimal business decisions when the recommendations are complied with.

1.6. Scope and Limitation of the Study

Application of Ratio Analysis to Business Organizations could be rather broad, depending on how the analyst analyses it; but for the purpose of this project work, this study will be restricted to Access Bank Plc. The researcher encountered some constraints, which limited the scope of the study. These constraints include but are not limited to the following

a) Availability of Research Material:

The research material available to the researcher is insufficient, thereby limiting the study

b) Time:

The time frame allocated to the study does not enhance wider coverage as the researcher has to combine other academic activities and examinations with the study.


1.7. Definition of Terms

Accounting:

The process of recording, summarizing, analyzing and interpreting financial (money-related) activities to permit individuals and organizations to make informed judgments and decisions.

Balance Sheet:

A financial statement containing assets, liabilities and owners equity capital at a particular date or at the end of a particular period to show the financial position of an organization.

Business Decision:

Choices made on matters relating to the allocation and/or use of business resources for making, buying, selling or supplying goods or services at a profit.

Business:

An activity, enterprise or organization established to provide goods and services at a profit, in order to satisfy human wants.

Decision Making:

A mental process by which an individual or group of individuals gather data and make a choice between two or more alternative courses of action.

Financial Ratio:

A proportion, fraction or percentage expressing the relationship between one item of financial statements and another item in the same financial statements.

Financial Statement:

Quantitative information on the economic activities of an organization prepared to show the result and the financial position of the entity, often presented in terms of Balance Sheet, Income Statement, Funds Flow Statement and so on.

Income Statement:

A financial statement often referred to as the trading and profit and loss account, matching revenues against expense to show the profitability or operational results of an enterprise over a period of time, such as a month or year.

Ratio Analysis:

A systematic review of accounting data by establishing relationships among various figures on the financial statements which bring together the results of the activities of a business.

Ratio:

A fractional relationship of one number to another.


1.8 Organization of the Study

This research work is organized in five chapters, for easy understanding, as follows

  • Chapter one is concerned with the introduction, which consist of the (overview, of the study), historical background, statement of problem, objectives of the study, research hypotheses, significance of the study, scope and limitation of the study, definition of terms and historical background of the study.
  • Chapter two highlights the theoretical framework on which the study is based, thus the review of related literature.
  • Chapter three deals on the research design and methodology adopted in the study.
  • Chapter four concentrate on the data collection and analysis and presentation of finding.
  • Chapter five gives summary, conclusion, and recommendations made of the study

Chapter Five


Summary, Conclusion and Recommendation

5.1 Introduction

It is important to ascertain that the objective of this study was to ascertain a critical analysis of the application of ratio analysis to business organisation.

In the preceding chapter, the relevant data collected for this study were presented, critically analyzed and appropriate interpretation given. In this chapter, certain recommendations are made, which in the opinion of the researcher will be of benefit in addressing the challenges of application of ratio analysis to business organisations.


5.2 Summary

This study aimed at having a critical analysis of the application of ratio analysis to business organisations. Six objectives were raised. These objectives include: To show how ratio analysis facilitates proper understanding of information contained in financial statements, to show how ratio analysis aids business decisions, to examine the techniques used in analysis of financial statements, to identify the usefulness of financial ratios in measuring and predicting the performance and financial position of a business, to unravel the obstacles to the proper use of financial ratios in business decisions, to suggest ways to enhance efficient use of ratio analysis in decision making


5.3 Conclusion

Based on the above findings pertaining to the objectives of the study the following conclusions are drawn.
It was seen that the development of ratio analysis has been largely ad hoc with the major emphasis in the literature being placed upon how to calculate particular ratios rather than upon why these ratios should be employed. Little work has been done to integrate the present fairly widely accepted core of ratios into a logical testable theory. In analyzing the profitability performance of a firm it is not sufficient to look at the return on asset ratio alone. The analyst needs to go to the return components to attempt to determine the reasons for the outcome.


5.4 Recommendation

With reference to the findings of the study, the researcher recommends the following:

  1. Users of financial statements need to have at least, a fair knowledge of accounting so as to enable then understand and appreciate accounting information.
  2. Prospective investors should properly analyze the financial statements of companies before deciding to invest in the companies.
  3. Users of financial statement who are not knowledgeable enough to analyze or understand the information contained in them should seek the services of qualified financial analysts, accountants, stockbrokers, bankers, etc.
  4. In view of the remarkable influence which accounting information shave on the decisions of the users, it is pertinent that only qualified and honest persons should and audit financial statements.
  5. Financial rations should be used with careful examination and proper understanding of the meaning, implication and effect of the actual figures shown in financial statements, in order to avoid making wrong judgments, conclusions and decision.
  6. Financial ratios should be judiciously used by firms, investors, lenders, shareholders, managers, and other stakeholders, in view of their numerous benefits and limitations

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