FINANCIAL STATEMENT AS DETERMINANT OF PROFITABILITY IN BUSINESS ORGANISATION
CHAPTER TWO
REVIEW OF RELATED LITERATURE
Introduction
This chapter explains why accounting and finance are such key elements of business life. Both for aspiring accountants, and those of you who may not continue to study accounting and finance beyond the introductory level, the fundamental principles of accounting and the ways in which accounting is regulated to protect owners of businesses, and the public in general, are important. A broad appreciation will be useful not only in dealing with the subsequent text, but also in the context of the day-to-day management of a business. The study will look at why accounting is needed and how it is used and by whom. Accounting and finance are wide subjects, which often mean many things to many people. They are broadly concerned with the organization and management of financial resources. Accounting and accountancy are two terms which are sometimes used to mean the same thing, although they more correctly relate separately to the subject and the profession. Accounting and accountancy are generally concerned with measuring and communicating the financial information provided from accounting systems, and the reporting of financial results to shareholders, lenders, creditors, employees and Government. The owners or shareholders of the wide range of business entities that use accounting may be assumed to have the primary objective of maximization of shareholder wealth. Directors of the business manage the resources of the business to meet shareholders’ objectives. Accounting operates through basic principles and rules.
In most third world countries, budget execution and accounting processes are either manual or supported by very old and inadequately maintained software applications. This has had deleterious effects on the functioning of their public expenditure management (PEM) systems, which are often not adequately appreciated (Diamond &Khemani, 2006). Globally however, management practices are faced with the problem of choosing among alternatives in order to make decision effectively. Considering the fact that resources are relatively scarce and limited, chief executives do not only face the problem of achieving co-operate goal or accruing loss at various stages in the process of providing products and services but also to organize, forecast, control, direct and make appropriate decisions (Clinton & van der Merwe, 2006).. These processes are facilitated by the utilization of adequate financial statement (Abiogwu, 2008; Diamond &Khemani, 2006). Management decision is one of the most important facets that pervade all organization and constitute its progress and/or failure in actualization of pre-determined goals and objectives. For this reason, for management decision to have a “fair view”, qualitative this is attributable to inadequate and inappropriate use of financial statement (Clinton, Matuszewski&Tidrick, 2011).
Financial statement has made a tremendous contribution over decision making functions. This can be attested by the numerous writers on financial statement in textbooks, magazines, journals and projects. The principal point of discussion is the minimization of the risk and insecurity by the proper use of accurate financial statement in the planning, these enough evidence that have an ever increasing demand for financial statement due to changing of environmental factors, with a corresponding increase in the scope of financial statement.
SOURCES OF FINANCIAL STATEMENT
The major sources of financial statement in an organization is the accounting unit, which is charged with responsibility of systematically recording, analyzing, interpreting summarizing financial statement as the result of a process involving the preparation of source documents, the entry of basic data into subsidiary records to ledger, which is the formal record of data” Glantter and Underdown (1981, p. 91). Accounting data therefore originates from financial transactions within the organization and source documents are the medium through which these transactions are recorded. The source documents commonly used are sales and purchases invoice, Local Purchase Order (LPC) cheque, cash receipt, cash book, test, etc. The accountant is the major supplier of financial statement required by the management in their planning and decision making processes. Users of this information can acquire them through the primary or secondary sources.
USERS OF FINANCIAL STATEMENT
Financial statement serves as bases for planning and decision making, it provides the various users the necessary data and assistance. The users are;
- Management
- Education/Curriculum planners
- Management
- Investors
- Potential investors
- Government
- Employer of labor
- Tax
- General public, etc.
USEFULNESS OF FINANCIAL STATEMENT
It is obvious that quality decision is derived from quality of information received. Financial statement has been the guiding principle in formulating policy and criteria for selected among alternatives. However, in every organization including tertiary institutions, financial statement has been a guide in the acquisition of materials and equipment into the resource center for learning purposes. Osuji (2009) stated that fund provided for media centre collected should be sufficient to enable the school instructional media programme to meet accepted standard, instructional materials and equipment needed for changing curricular and student population must maintain the collection satisfactory conditions. It is ethically believed that all these conditions to be met in acquisition of educational materials are in response to accounting standard. Take for instance, materials and equipments to be purchased must be budgeted. The chief executive and ruling council of various institutions can only know their internally generated revenue and total recurrent expenditure through the use of financial statement. According to Ezegbe (2000), the management interpret stated of account and data in particular reference to what it have done with what have provided in financial management and justifiable reasons for decision and actions. This is respect of ethic of accountability. To this end, adequate keeping of record of account encourage effective administration of school plants. By school plants here, we mean the totality of the belongings of the educational institution (Hope & Alice, 2004). Financial statement helps management to know the dilapidated facilities in the school that need to be renovated. Adherence to financial statement by the chief executive of tertiary institutions will ensure survival, curriculum development and implementations. In tertiary institutions, the following financial records are kept for smooth running of the institution and accountability purposes. Some of the records are:
• Student record
• Curricular record
• Evaluation records
Financial records: relates to income and expenditure and include receipt for purchase, vouchers, retirement, contracts, donations and budgets. All these are recorded in the appropriate financial record for smooth running of an institution.
Review of Related Literature.
Every firm is most concerned with its profitability. One of the most frequently used tools of financial ratio analysis is profitability ratio which is used to determine the company’s bottom line. Profitability measures are important to company managers and owners alike. If a small business has outside investors who have put their own money into the company, the primary owner certainly has to show profitability to those equity investors. Profitability ratios show a company’s overall efficiency and performance. Many researchers have studied the determinant of profitability in many ways. But none of them had studied on the determinant of profitability using financial management techniques. Because of this, the researchers chose this research work to show how the financial management can be used in the determination of profitability in business industry. Financial management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprises.
Profitability means ability to make profit from all the business activities of an organization, company, firm or an enterprise. It shows how efficiently the management can make profit by using all the resources available in the market. Profitability is also the ability of a given investment to earn a return from its use. However, the term profitability is not synonymous with the term efficiency. Profitability is an index of efficiency and is regarded as a measure of efficiency and management guide to greater efficiency. Though, profitability is an important yard stick for measuring efficiency, the extent of profitability cannot be taken as a final proof of efficiency. Sometimes satisfactory profits can mark inefficiency and conversely a proper degree of efficiency can be accompanied by an absence of profit. The net profit figure simply reveals a satisfactory balance between the values received and value given. The change in operational efficiency is merely one of the factors on which profitability of an enterprise largely depend. Moreover there are many other factors besides efficiency which affect profitability. Sometimes, the terms “Profit” and “Profitability” are used interchangeably but in real sense there is a difference between the two. Profit is an absolute term, whereas, profitability is a relative concept. However, they are closely related and mutually interdependent and have distinct roles in business. Profit refers to the total income earned by the enterprise during a specified period of time while profitability refers to the operating efficiency of the enterprise. It is the ability of an enterprise to get sufficient return on the capital and employees used in the business operation.
The debt-to-equity ratio is a financial ratio indicating the relative proportion of equity and debt used to finance a company’s assets which is an indicator of the financial leverage. It is equal to total debt divided by shareholders’ equity. The two components are often taken from the firm’s balance sheet. When used to calculate a company’s financial leverage, the debt usually includes only the long-term debt (LTD). This is a useful measure as it helps the investor see the way management has financed operations. A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expenses as well as volatile cash flow as principal payments on debt come due. If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings per share than it would have without this outside financing. If this were to increase earnings by a greater amount than the interest on debt, then the shareholders benefit as more earnings are being spread among the same amount of stock. However, as stated, increased interest and the need to repay the principal on borrowed fund can far outweigh the benefit. It is used to measure the net worth of the organization. Long-term-debt to Equity ratio is Long-term-debt (Loan)/Stockholder Equity. This is one of the most important metrics to measure and manage as you create strategic plans.
Nweze (2011) opine that inventory turnover is computed by dividing the cost of goods sold by the average inventory. An average inventory is determined by adding the beginning and ending inventories and dividing by two. The decline in the inventory turnover indicates the stocking of more goods. An attempt should be made to determine whether specific inventory categories are not selling well and the reason for this. Emekekwue (2002) argues that stock turnover ratio seeks to identify the length of time that stock is held as inventory before it is converted to cash. In organizations where stocks are perishable, holding of large stock is very costly to the business. However, if stock is not the perishable type, delays in disposing stock might be profitable during inflationary periods. It must be appreciated that sales will be valued at cost. This is because the stock will be valued at cost. If the sales were not valued at cost, then we shall be over stating the ratio. Moreover, one will be comparing two incomparables i.e. the sales figures and the cost of stock. Furthermore, the inventory turnover ratio measures the average number of days for which stock is held. It helps to assess the efficiency of stock utilization. Various factors affect the stock level help by the organization such as product, production-seasonal or otherwise, demand pattern, competition, funds availability etc.
Nweze (2011) is of the view that debtor’s ratio consist of debtors turnover and the collection period. The debtor’s turnover gives the number of times debts are collected during the years. The turnover is found by dividing net credit sales (if not available, then total sales) by the average debtors. Average debtors are found by adding the beginning debtors to the ending debtors and dividing by two. The higher the debtor’s turnover, the better, since this means that the company is collecting debts quickly from customers. These funds can then be invested for a return. The drop in the debtor’s turnover ratio is significant, indicating a serious problem in collecting from customers. Therefore, a careful analysis of the company’s credit policy is required. The average collection period, or the number of days sales remain with debtors is found by dividing the debtor’s turnover into 365 days. A higher collection period indicates a danger that customers’ balances may become uncollectible - perhaps the company selling to highly marginal customers - a customer whose credit worthiness is very much in doubt.
Okwuosa (2005) says that creditors’ velocity means creditors’ turnover. This indicates the average number of times creditors’ turnover is paid within a year. High creditors’ turnover ratio indicates that the company is not taking advantage of credit facility and this may result in loss of profit as a result of interest on borrowed funds or bank overdraft needed to meet up. On the other hand, low creditors’ turnover ratio indicates that the company is not taking advantage of any discount associated with prompt payment and this may lead to increase in their cost of sales and consequently decrease in their profit. Therefore, a company should ensure that its creditors’ turnover ratio is neither too high nor too low. The creditors’ turnover is calculated by dividing Credit purchases by Average creditors.
Ezeamama(2010) defines total assets turnover as ratio that expresses the number of times the value of assets utilized by the firm has been generated into sales. According to Pandey (2002) total assets’ turnover ratio shows the firm’s ability in generating sales from all financial resources committed to total assets. Nweze (2011) says total assets turnover measures the level of capital investment relative to sales volume. It tells the firm how well it manages its overall assets.
Pandey (2002) notes net profit is obtained when operating expenses, interest and taxes are subtracted from the gross profit. The net profit margin ratio is measured by dividing profit after tax by sales. Net Profit margin ratio establishes a relationship between net profit and sales and indicates management’s efficiency in manufacturing, administering and selling their products. This ratio is the overall measure of the firm’s ability to turn each rupee sales into net profit. If the net margin is inadequate, the firm will fail to achieve satisfactory return on shareholder’s funds. This ratio also indicates the firm’s capacity to withstand adverse economic conditions. A firm with a high net margin ratio would be in an advantageous position to survive in the face of falling selling prices, rising costs of production or declining demand for the product. It would really be difficult for a low net margin firm to withstand these adversities. Similarly, a firm with high net profit margin can make better use of favourable conditions such as rising selling prices, falling cost of production or increasing demand for the product. Such a firm will be able to accelerate its profits at a faster rate than a firm with a low net profit margin.
Nweze (2011) adds that ratio of net income to net sales is termed the profit margin. It indicates the profitability generated from revenue and hence is an important operating performance measure.
Dave (2012) studies capital structure and profitability of the firms listed on Nigerian Stock Exchange. He observed negative association between long term debt and profitability and suggested that top management should take interest in capital structure to improve profitability. He adds that the relationship between working capital management and profitability of 131 companies listed on the Athens Stock Exchange for the period shows that account receivables, inventories and account payables had negative relationship with profitability. However, the relationship of accounts receivables and account payables with profitability was highly significant, while the relationship of inventory with profitability was not statistically significant suggesting that account receivable and account payables are the areas to be focused on to improve the profitability of the firm. Chin (1997) adds that the relationship between the profitability of a company with various capital structure variables i.e. cash and marketable securities, receivables, working capital, long term investment, debt and equity capital etc. Kieu (2001) focuses on working capital management and tools of financial management such as ratio analysis, profitability measures and break-even analysis. Niresh (2012) says that capital structure decision of a bank is similar to that of a non-financial firm. Although there are considerable inter industry differences in the capital structure of firms due to the unique nature of each industry business, the intra-firm variations are attributed to the business and financial risk of individual firms. Most studies found a negative relationship between profitability and leverage. Chary, Kasturi and Kumar (2011) argue that the relationship between working capital and profitability has been an interesting debate in financial management. Working capital decision affects both liquidity and profitability. Excess of investment in working capital may result in poor liquidity. He adds that management need to trade-off between liquidity and profitability to maximize shareholders wealth. To understand the impact of working capital on profitability, one needs to establish the relationship between these two statistical measures such that correlation and regression models can be used to understand such relationship. Because of this literature review, the researchers conclude that there are significant effects between the independent variables and dependent variable of this study. Financial management also involves planning, acquisition, allocation and control of financial resources of an organization in order to achieve the goal(s) of the organization with minimum financial discomfort, and maximum benefit which is profit maximization. Moreover, if the management manage their finance very well, it will increase the profit made by the organization while if not, the profit of the organization will be affected or decreased. In other words, inventory turnover ratio and debtors’ turnover ratio are to be maintained at higher levels for better profitability. Creditors may be kept at higher levels for shortening the length of net trade cycle. Furthermore, this inverse relationship between net trade cycle and return on assets was found different across industries depending on the type of industry. Finally, the relationship between variables such as those between working capital management and profitability i.e. if efficient working capital management increases profitability, one should expect a negative relationship between the measure of working capital management and profitability variable. There is a negative relationship between gross profitability on one hand and the measure of working capital management on the other hand. This is consistent with the view that the time lag between expenditure for purchases of raw materials and the collection of sales of finished goods can be too long, and that decreasing this time lag increases profitability.