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 TO 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:
(i) To show how ratio analysis facilitates proper understanding of information contained in financial statements
(ii) To show how ratio analysis aids business decisions
(iii) To examine the techniques used in analysis of financial statements.
(iv) To identify the usefulness of financial ratios in measuring and predicting the performance and financial position of a business.
(v) To unravel the obstacles to the proper use of financial ratios in business decisions
(vi) To suggest ways to enhance efficient use of ratio analysis in decision making.
1.4 RESEARCH QUESTIONS
i.) Is ratio analysis useful in evaluating and predicting the performance of a business as well as intensifying areas that require improvement?
ii) Does Ratio Analysis facilitate proper understanding of information contained in financial statement?
iii) Is ratio Analysis useful to management, investors, shareholders and creditors in their business divisions?
iv) Are there obstacles that affect the proper use of ratio analysis in business decision?
1.5 RESEARCH HYPOTHESIS
In order to draw a reliable inference about the population based on samples to be collected, the following hypotheses are formulated:
Hypothesis
HO: Ratio analysis cannot be used in decision making in an organization.
H1: Ratio analysis can be used in decision making in an organization
1.6. 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:
(a)The study will serve as a good instrument for for predicting business failure.
(b)It will guide the business analyst in the evaluation of the capital structure and enhance adequate investment decision and recommendation.
(c)It will be a vital instrument for the managers in the industry in the effective utilization of shareholder equity and debenture stock.
(d)It is hoped that the result of the research will facilitate optimal business decisions when the recommendations are complied with.
1.7. 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.
1.8. 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.