USES OF ACCOUNTING RATIOS IN BUSINESS DECISIONS

CHAPTER TWO

LITERATURE REVIEW

INTRODUCTION

Our focus in this chapter is to critically examine relevant literature that would assist in explaining the research problem and furthermore recognize the efforts of scholars who had previously contributed immensely to similar research. The chapter intends to deepen the understanding of the study and close the perceived gaps.

Precisely, the chapter will be considered in three sub-headings:

• Conceptual Framework
• Theoretical Framework
• Chapter Summary

2.1 CONCEPTUAL FRAMEWORK

Financial Statement Analysis

According to Hermanson et al (1992:824), “financial statement analysis consists of applying analysis tools and techniques to financial statements and other relevant data to show important relationships and obtain useful information.” Therefore, financial statement analysis can be defined as the breaking down, interpretation, and translation of data contained in financial statements to provide information and show important relationships among the items of financial statements and drawing conclusion about the past performance, current financial position, and future potentials of a business.

Financial ratio

Martikainen, (2013),defines financial ratios as the numerical value created from two or more values taken from a company’s financial statements i.e. its balance sheet, income statement or statement of cash flow. Typically, financial ratios are presented as a quantified metric in the form of a percentage, multiple or a ratio which aims to evaluate the financial, operational performance and competitiveness of a company. The financial Ratio Analysis has been developed over many years and it has become more than a tool of evaluation. It helps tax department’s credit analysis in banks, financial market councils and CPA Accountants to determine some critical points in their jobs.

Accounting Ratios

As stated earlier, accounting ratios are an important tool of financial statements analysis. A ratio is a mathematical number calculated as a reference to relationship of two or more numbers and can be expressed as a fraction, proportion, percentage and a number of times. When the number is calculated by referring to two accounting numbers derived from the financial statements, it is termed as accounting ratio.

Parties interested in financial statement analysis

With particular reference to business organizations, parties interested in financial statement analysis are divided into two categories, namely: internal users and external users. The internal users include management and employees of an organization, while external include shareholders, investors, creditors, debenture/bond holders, financial analysis, etc.

Management and Employees: Financial statement analysis helps management and employees to know the operating results, financial position and future potentials of a business.

Shareholders/Owners: The analysis helps shareholders or owners of a business to ascertain the profitability of the operation of the business, as well as return on their investments.

Investors and Creditors: Financial statement analysis helps investors to know the profitability and return on investment in a business. In the other hand, it helps trade creditors and note holders to know the liquidity or the ability of a business to pay its debts when they fall due.

Debenture/bond holders: Those who lend money to the business would like to know the ability of the business to repay on maturity both the interests and the principal of the loans granted to it.

Financial analyst: Financial statement analysis enables financial analyst to offer professional advice to their clients on investments.

Objectives of financial statement analysis

According to Needles et al. (1996:770) financial statement analysis is used to achieve two basic objectives:

Assessment of Past Performance and Current Position: Financial statement analysis helps in assessing or judging the past performance of a business by taking a look at the trend or historical sales, expenses, net income cash flow, and return on investment. Also an analysis of current position will tell for example, what assets the business owns and what liabilities must be paid.

Assessment of Future Potential Related Risk: Information about the past and present (performance) is useful only to the extent that it bears on decisions about the future (potentials). Financial statement analysis thus help for example investors to judge the earning potential of a company. It also enables creditors to assess the potential debt paying ability of the company. Therefore financial statement analysis helps in assessing the riskiness of an investment or loan by making it easy to predict the future profitability and liquidity of a business.

Sources of information for financial statement analysis

According to Needles et al. (1996:773), the major sources of information about publicly held corporations are reports published by the company, SEC reports, business periodical, and credit and investment advisory services.

Reports Published by the Company

The annual report of a publicly held corporation is an important source of financial information.

SEC Reports

Annual, quarterly and current financial reports filed by publicly help corporations with the Securities and Exchange Commission (SEC) are sources of information for analysis of financial statements.

Business Periodicals

Financial magazines and newspapers contain reports about the performance of companies.

Credit and Investment Advisory Services

There provide data and information about the performance of companies as well as on industry norm. For example, Dun and Bradstreet Corporation in USA offers an annual analysis using fourteen rations of 125 industry groups.

Ratio Analysis

Dansby et al. (2000:845) defined ratio as “fractional relationship of one number to another”. On the other hand, Needles et al. (1996:795) defined ratio analysis as “a technique of financial analysis in which meaningful relationship is shown between the components of financial statements”. Ratio analysis is often expressed proportionately to show the relationship between figures in the financial statements. Ratios are guides or shortcuts that are useful in evaluating a company‘s financial position and operations and making comparisons with results in previous years or with other companies. The primary purpose of ratio is to point out areas needing further investigation. They should be used in connection with a general understanding of the company and its environment. (Needles et at., 1996:786). Thus, Lasher (1997:69) noted are most meaningful when used in comparison. For that reason, it is difficult to make a generalization about with a good or acceptable value is for any particular figure. One measure alone does not tell the whole story about a company and one measure should never be the sole basis for a financial decision”. Hermanson et al. (1992:840) added: “standing alone, a single financial ratio may not be informative. Greater insight can be obtained by computing and analyzing several related ratios for a company”.

Uses And Objectives Of Ratio Analysis

Basically, ratio analysis is used in determining:

1. The short-term and long-term liquidity of a firm or the ability of the firm to meet its short-term (current) and long-term financial obligations.
2. The riskness or long-term solvency of a business. That is, the level of gearing or leverage or the extent the firm is financed by debt.
3. The Performance, profitability or overall earning power of a business.
4. The assets utilization or efficiency in the use of assets of a business to generate sales revenue.
5. The potential return and risk associated with owing shares or investing in the stock a company.

Forms of ratio used by organizations

Cash flow ratios

These can be used to answer questions on a company’s performance since debt obligations are met with cash. Such an analysis will result in adequate lines of credit, unrestricted cash availability, debt maturity schedules with respect to financing requirements and the willingness to issue common equity. It will allow an analyst to examine a company’s financial health and how the company is managing its operating, investment and financing cash flows (Palepu Penman, 2010). A lack of cash flow data has caused problems for investors and analysts in assessing a company’s performance, liquidity, financial flexibility and operating capability (Gombola and Ketz 2013).

Leverage (debit) Financial Ratios

According to Helfert, 2011, this group of financial ratios show the percentage of a company’s capital structure that is made up on debt or liabilities owed to external parties, also it focuses on a company’s ability to meet its long-term debt obligations. Focusing on the long-term solvency in general, the more leveraged and higher amount of debt financing relative to equity financing, the owner faces then greater is the risk.

Liquidity (solvency) Financial Ratios

Hermanson et al (2012) explains that the liquidity or solvency ratios group focuses on a firm’s ability (current assets and current liabilities) to meet its short-term debt obligations. In other words, it lets you know the resources available for a firm to use in order to pay its current obligation and expenses. If a company cannot maintain a short-term debt-paying ability, it will not be able to maintain a long-term debt-paying ability, nor will it be able to satisfy its stockholders.

Financial Operation Ratios (Asset Efficiency) ratios

To Horrigan, (2013), the Financial Operation Ratios group which is sometimes called asset management ratios, measure the efficiency with which a firm manages and controls its assets (utilizing its capital) in generating sales and earnings. Investors can use these in order to analyze a company’s or management’s ability to efficiently use resources and how effective it converts its purchases and inventory to sales and then its sales to cash

Profitability Financial Ratios

Horrigan, J.O. (2015), explains that the profitability ratios group, also known as performance ratios, assesses the company ability to earn profits on sales, assets and equity, it measures the return earned on a company’s capital and the financial cushion relative to each dollar of sales, These are critical to determining the attractiveness of investing in company shares and investors in using these ratios widely, much like the operational performance ratios, these ratios give users a good understanding of how well the company utilized its resources(assets) in generating profit and shareholder value.

Valuation ratios (market value ratios)

James, 2008, the valuation ratios group indicates to the market value of a stock in terms of some measure of a company’s fundamentals such as EP, book value, BPS, ROE and dividends. These ratios are the ones that investors tend to look at on a daily basis and they change whenever the price of the stock changes. These ratios allow you to compare your company to others in your industry.

Types Of Ratio Analysis

Liquidity (short-term solvency) ratios

According to Dansby et at. (2000:826) “Liquidity is the ability of a business to meet its financial obligations as they fall due”. One the other hand, Needles et al. (1996 :787) defines liquidity, as “a company’s ability to pay bills when they are due and to meet unexpected needs of cash”.

Liquidity ratios can be divided into two – short-term liquidity (solvency) ratios. However, for the purpose of this study, liquidity Ratios refers to short-term liquidity ratios while Debt Management Ratios refer to long-term liquidity ratios.

Liquidity ratios (short-terms solvency ratios) are of particular concern to short-term lenders and suppliers who provide products and services to the firm on credit. They want to be sure the company has the ability to pay its debts. (Lasher, 1997:69). Liquidity Ratios include Current Ratio and Quick or Acid Test Ratio.

Current Ration

This indicates the ability of a business to meet or pay its short-term financial obligations or current liabilities out of the current assets. Thus, it is also known as the ratio of current assets to current liabilities. It is the primary measure of a company’s liquidity.

A low current ratio may be an indication of a firm’s inability to pay its financial obligations in the near future, while a high current ratio may indicate excessive amount of current assets or inefficient asset utilization by management.

The yardstick against which current ratio are measured is the standard of 2 to 1 (2:1). This means that for every N1 current liability there must be a minimum of N2 current assets to cover it. This standard is often used by lending institutions and credit bureau and is generally considered as good. (Dansby et al., 2000).

However, prospective creditors or lenders must take care of sticking to this standard as a company may manipulate its current ratio (by inflating inventory for instance,) in order to paint a picture of better financial position. Current ratio can be calculated as follows:

CurrentRatio = CurrentAssets

CurrentLiability

Quick (Acid Test) Ratio

This measures the ability of a firm to pay all of its current liabilities if they come due immediately. (Dansby et al., 200: 828). It is a better measure of liquidity because unlike current ratio, it omits stock or inventory (which may not be easily turned into cash) from the current assets to get quick assets. It is therefore, the ratio of quick assets to current liability and indicates a firm’s ability to pay its debt quickly. It is also called acid test, which implies a particularly tough, discerning test. (Lasher, 1997:70). The standard for quick ratio is 1:1. Quick or acid Test Ratio can be calculated as follows:

QuickorAcidTestRatio = QuickAssets

CurrentLiabilities

Quick (acid test) ratio

This measures the ability of a firm to pay all of its current liabilities if they come due immediately. (Dansby et al., 2000). It is a better measure of liquidity because unlike current ratio, it omits stock or inventory (which may not be easily turned into cash) from the current assets to get quick assets. It is therefore, the ratio of quick assets to current liabilities and indicates a firm’s ability to pay its debts quickly. It is also called acid test, which implies a particularly tough, discerning test. (Lasher, 1997). The standard for quick ratio is 1:1 quick or Acid Test Ratio can be calculated as follows:

QuickorAcidTestRatio =QuickAssets

CurrentLiabilities

i.eCurrentAssets - Inventory

CurrentLiabilities

Profitability (activity) ratios

Profitability refers to the ability of a firm to earn a satisfactory income or return on investment in the business. Therefore, profitability ratios measure the profit or money making or earning success of a firm. They are of primary impotent to stockholders, investors and creditors because earnings produce cash flows with which to pay dividends and debts.

Profitability ratios are also called activity ratios because they indicate the ability of firm to earn profits in relation to the sales made, assets employed, or equity (capital) invested or employed. They are generally stated as percentages. (Lasher, 1997:76). Profitability ratios include Return on SALES, return on Assets, and Return on Equity.

Return on sales (ROS)

Return on Sales (ROS) is simply percentage of the net income or profit after tax to net sales. It is also called the profit merging (or net profit margin). It is a fundamental indication of the overall Profitability of the business. It gives insight into management’s ability to control the income statement items of revenue, cost, and expense (Lasher 1997).

ROS can be divided into Gross profit Margin, Operating Income Margin, and Net profit margin.

However, in general terms and for the purpose of this study, ROS refers to Net profit Margin.

Gross profit margin

This is otherwise known as the percentage of Gross profit to Net sales.

It is a measure of efficiency of the sales of a firm in relation to the cost of goods sold. It indicates a firm’s ability to control cost of vice versa.

Net profit margin

This id otherwise called the percentage of Net profit to Net sales. It is a measure of the proportion of net sales that remains after the deduction of all costs and expenses. It indicates the ability of a firm to control operating and non-operating expenses.

Net profit margin can be calculated as follows:

NetProfitMargin = NetIncome X 100

NetSales

Return on assets (ROA)

Return on Assets (ROA) measures the overall ability of the firm to utilize the assets in which it has invested to earn a profit. (Lasher, 1997:76) It indicates the profitability of a firm’s assets, the amount of net income it earns in relation to the assets available for use during the year. (Dansby et al., 2000:833). The higher the ROA the more profitable is the assets in producing income. ROA can be divided into two, namely; return on operating Assets and Return on Total Assts. However, in general terms and for the purpose of this study, ROA refers to return on Total Assets.

Return on operating assets

This measures the Profitability of a business in carrying out its primary functions, by indicating the proportion of the operating assets that become net operating income. Operating assets are all assets actively used in producing operating revenues. Therefore, non operating assets such as land held for future use, a factory building ranted to another company, and long-term bond investments are excluded when calculating return on operating assets. (Hermasnon et al. 1992:837) The formula is:

ReturnonOperatingAssets = NetOperatingIncome

AverageOperatingAssets

Or

NetOperatingAssets

AverageTotalAssets(Wheretherearenonon-operatingassets)

Returnontotalassets

ReturnOnTotalAssetsquantifiesthesuccessoftheeffortsofabusinessinusingitsassetsearnprofitbystatingnetincomeorprofitaftertaxasapercentageoftotalassets.

ReturnonTotalAssets = NetIncome X100

AverageTotalAssets

Returnonequity(ROE)

ReturnonEquity(ROE)measuresthefirm’sabilitytoearnareturnontheowner’sinvestedcapital.It is the most fundamental profitability ratio because stockholders are primarily interested in therelationship between net income and their investment in the company. It states net income as apercentage of equity. (Lasher, 1997:77) It is known as Return on Capitals Employed (ROCE) orReturn on Investment (ROI) because it shows proportion of capital employed, stockholders equityor owners investment (total assets less total liabilities or debts) which return to owners orstockholdersasnetincome.

ROEcanbecalculatedasfollows

ROE = NetIncome X 100

AverageStockholder’sEquity

Assetsmanagement(efficiency)ratios

Assets management ratios address the fundamental efficiency with which a company is run.(Lasher, 1997:71). They show how efficiently the business is utilizing or managing assets (currentassets and fixed assets) in generating revenue and cash flow. Thus, they are also called EfficiencyRations. Asset management Rations include: Inventory Turnover, Average Days’ Inventory OnHand,andAccountsReceivableTurnover,AverageCollectionperiodforAccountsReceivable,TotalAssetsTurnover,andFixedAssetsTurnover.

Inventory turnover

Inventory Turnover measures the number of times in which the average inventory or stock is sold in a give perio. This is of prime importance to management because for a business to generate greater sales volume for the year, it, must but, sell and replenish its goods or stock as rapidly as possible. (Dansby et al, 2000:830).

Inventory Turnover an attempt to measure whether or not the firm has excess funds tied in inventory. A higher inventory turnover is better in that it implies doing business with fewer funds tied up in inventory. A low inventory turnover figure can mean some old inventory is on the books that being used. Holding inventory costs money-it involves the cost of storage, pupilage, obsolescence, etc.

The ratio is calculated as follows:

InventoryTurnover = Costofgoodssold

AverageInventory

Average days’ inventory on hand

This is a measure of average number of days taken to sell inventory. It is an extension of inventory turnover and thus helps a firm to know the speed at which it sells inventory or stock.

The ratio computed as follows.

Averagedays’inventoryonhand = 365days

InventoryTurnover

AccountsReceivableTurnover = NetCreditSales

AverageAccountsReceivable

OrNet Sales

AccountsReceivable

Average collection period for accounts receivable (acp)

This is a measure of length of time taken to collect accounts receivable or number of days accounts receivable or debtors have been outstanding. It is determined by dividing the number of days in the year by the accounts receivable turnover. Thus it is an extension of accounts receivable turnover. (Dansby et al 2000:830). The ration measures average liquidity of accounts receivable and gives an indication of their quality. A comparison of the average collection period with the credit extended customers by a company or the firms, credit extension policy will provide further insight into the quality of accounts receivable.

The formula for this ration is

ACP = 365days

Accounts Receivable Turnover

Totalassetsturnover(tat)

Total assets turnover (TAT) measures how efficiently assets are used to produce sales. (Needles et al., 1996:789). It is a measure of the magnitude of net sales generated by the assets of the firm. The higher the assets turnover rate, the better the firm is using its assets to generate sales. In other words, the larger the total assets turnover, the larger will be the income on each (naira) invested in the assets of the busing. (Hermanson et al., 1992: 834). TAT can be calculated as follows.

TAT = Net Sales

Average Total Assets (excluding investments)

Investments are excluded from the formular since they are not intended\ to produce sales. (Dansby et al., 2000:834). In other words, the ratio is known as Turnover of Operating Assets, because it to generate sales revenue. (Hermanson et al., 1992:837).

Fixed assets turnover (fat)

Fixed assets Turnover (FAT) measures the capacity of fixed assets in producing sales. It shows the relationship between fixed assets and sales. The ratio is appropriate in industries where significant equipment is required to be business. (Lasher, 1997:73). A Lower FAT or a reducing sales being generated from each naira invested in fixed assets may indicate over capacity, poorer- performing equipment, or under utilization of fixed assets.

FATcancalculatedasfollows:

FAT = Nest Sales

AveragefixedAssets

Debt management Ratios measure how the firm uses other people’s money to its own advantage. The primary concern is to ensure that the firm does not borrow so much that becomes overly risky. (Lasher, 1997:73).

Therefore debt management ratios measure the briskness of a business. They are also known as long-term solvency, liquidity or stability ratios because they focus on the long-term stability and capital structure of the firm. They are of interest to management, stockholders and creditors. Management wants to know the long-term stability of the business. Creditors want to make user funds are available to pay interest and principal. Stockholders are concerned about the impact of excessive debt and interest on long-term Profitability of the business. (Lasher, 1997:76).

Thus, Debt Management Ratios tell the size of owner’s investments in the business as well as the strength of the business to pay its total liabilities (current and-term liabilities) or all of its financial obligations to outsiders at long run. Therefore, for the purpose of this purpose of this study, debt refers to total debt or total liabilities.

Debt management Ratios include Debt Ratio, Equity Ratio, debt-to Equity Ratio, Leverage Ratio, Fixed Assets to Long-term liabilities, times interest Earned, cash Coverage and fixed charge coverage.

Limitations of Ratio Analysis

According to Hermanson et al. (1992:846), “financial analysis relies heavily on informed judgment. Percentages and ratios are guides to aid comparison and useful in uncovering potential strengths and weaknesses. However, the financial analysis should seek the basic causes behind changes and established trends.” This means that, although financial ratios help us identify areas of the business that, although financial ratios help us identify areas of the business that requires further investigation, make informed business decisions and asks the right questions, they do not provide answers or solutions due to the following limitations:

1. Differences in Accounting Policies and Procedures: Accounting policies and methods of companies differ. This makes cross-sectional analysis difficult. For instance, firms adopt different methods of depreciation, stock-valuation, treatment of goodwill, preference shares, and research and development coat, and such may result to differences in the net income of essentially identical firms.
2. Inflation: Financial statements do not reveal the impact of inflation on the reporting entity. (Hermanson et al), (1992:848). Real estate purchased years ago for example, will be carried on the Balance sheet at its original cost. Yet it may be worth many times the amount in today’s market. During periods of rapid inflation, inventory, cost of sales and depreciation can badly distort true results. (Lasher, 1997:82,83).
3. Window Dressing: In a deliberate attempt to make Balance sheets look better than they otherwise would, firms try to make some year-end improvements that don’t last, in their finances. For instance, a company with a low current ratio may try to improve it by borrowing a long-term loam a few days before the end of the year, holding the proceeds in cash over year-end, and repaying the loan a few days later.
4. Historical Information: financial ratios are computed from historical accounts, and historical information is of little use in assessing future prospects of a company. This is because trends do reverse and past may not be a useful measure of adequacy. Thus, past performance may not be enough to meet present needs and make reliable projections.
5. Uniqueness Of Companies: Every Company is unique in size, operation, management, and location. Thus, two companies that operate in the same industry may not be strictly comparable. For instance, comparing a firm which finances its fixed plant through rental, (thus not showing it as an asset), with a firm which purchases its own assets will be difficult irrespective of their operation in the same industry or sector. (Omuya, 1983:456).
6. Limited Information: Financial statements do not present information that covers all aspects of the business. Therefore, financial ratios provide only quantifiable or quantitative information and omits non-quantifiable or qualitative information such as managerial skills, staffing requirement, and changes in the operating environment, which are all necessary variables determining the success of a business.
7. No Universal Standard: Financial ratios do not have universally accepted standards, norms or yardsticks for comparison. Standards are used in accordance with industry, firm, circumstance and objective pursued. For instance, the rule-of-thumb measure of 2:1 used in current ratio may not be acceptable in certain situations or firms in consideration of some managerial policies.
8. Interpretation: Interpretation of ratios is not always clear. Interpretation of changes in a ratio needs careful examination of changes in the figures used in the computation (both the numerator and denominator). Without a very full and detailed investigation, some wrong conclusions can be drawn. Also, only experts can understand and interpret ratios properly. (Omuya, 1983:456).
9. Underestimation: Ratios often present different picture of companies from the naira figures and results. The actual naira results or effects of the business may be disregarded or underestimated as ratios are stated in small figures. For instance, millions of naira may be represented by decimal numbers or figures less than 100. This may make people to underestimate the meaning of financial ratios or effect of the operations of a business on its success.

The Components of Decision Making

Decision environment

Decision environment would include all possible information, all of it accurate, and every possible alternative.

However, both information and alternatives are constrained because the time and effort to gain information or identify alternatives are limited (Robert Version, 1998).

Decision Model

Decision model can be used to represent a productive system in mathematical terms. A decision model is expressed in terms of performance measures, constraints, and decision variables. The purpose of such a model is to find optimal or satisfactory values of decision variables which improve systems performance within the applicable constraints. These models can then help guide management decision making. (ROGER G. SCHROEDER, 1985: 7).

The effects of using a decision model

A decision model has great impact on the profits of the company. It forces the management to rationalize the depreciation, inventory and inflation policies. It warns the management against impending crises and problems in the company. It specially helps in following areas:

- The management knows exactly how much credit it could take, for how long (for which maturities) and in which interest rate. It has been proved that without proper feedback, managers tend to take too much credit and burden the cash flow of their companies.

- A decision model allows for careful financial planning and tax planning. Profits go up, non cash outlays are controlled, tax liabilities are minimized and cash flows are maintained positive throughout.

- As a result of all the above effects the value of the company grows and its shares appreciate.

The decision model is an integral part of financial management. It is completely compatible with financial ratios analysis and derives all the data that it needs from information extant in the financial statements of the company.

2.2 THEORETICAL FRAMEWORK

The Single-Person Decision Usefulness Theory.

This was developed on the basis that; if a comprehensive single purpose nancial report cannot be guaranteed, then a singular comprehensive specic accounting information should be madeavailable. This willstimulate the investmentdecisions drives of potentialinvestors based onthe emphasis ofStatement of FinancialAccounting Concepts (SFAC, No. 1).

The agencytheory

On theother hand, establishedthe inherent relationship between potentialinvestors and the firm’s management. The utmostconcern of this theory is to mitigate potential problems that can occur in agency relationships due to managerial shenanigan as a result of the possession of insider corporate information. This theory presupposes that the complete disclosure of corporate value to the potential investors through disclosed nancial ratios to enable rational investment decision

CHAPTER SUMMARY

In this review the researcher has sampled the opinions and views of several authors and scholars on accounting ratio and its uses in an organization. The works of scholars who conducted empirical studies have been reviewed also. The chapter has made clear the relevant literature.