THE ROLE OF ACCOUNTING RATIO ANALYSIS IN MEASURING FINANCIAL PERFORMANCE OF A FIRM AND AIDING INVESTMENT DECISIONS

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Introduction

1.1 Background Information

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: 824). 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, 2002:1) defined accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the information”. Statement and the Balance Sheet. The Income Statement shows the profitability or profitability or operational result of a business, while the balance sheet shows the solvency or financial position of a business.

Although profiles 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 (2006:144) observed:

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 (1999:423), “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 analyzed and interpreting financial statements”. Therefore, ratio analysis involves taking stats of number (or items) out of financial statements and forming ratios with them, to enhance informed judgments and decisions (Lasher, 1997:66).

MCShane et al. (2000:336) defined decision-making as “a conscious process of making choices among one or more alternatives with the interior 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 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.

Yes, business dictions of make or buy, investment or divestment, expansion or contration, capital-organization and reconstruction, and so on cannot be properly made without the aid of financial ratios. They give cue 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 ratio analysis help managers, shareholders, investors, creditors, and other stakeholders make informed judgments and decisions about the past performance, present condition, and futures potential of a business.

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1.2 Statement Of Problem

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

1. In view of the summarized nature of the information contained in financial statements, they need to be analyzed and interpreted by means of financial ratios to enable management and stakeholders understand them and make well-informed business decisions.
2. 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.
3. Despite the immense benefits 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.

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1.3 Objectives Of The Study

In consideration of the problems identified above, the objective of this research include.

1. To show how ratio analysis facilitates proper understanding of information contained in financial statements.
2. To show how ratio analysis aids investment decisions.
3. To examine the techniques used in analysis 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 on ways to enhance efficient use of ratio analysis in decision-making.

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1.4 Research Questions

1. Is ratio analysis useful in evaluating and prediction the performance of a business as well as intensifying areas that regret improvement?
2. Do you agree with the fact that ratio analysis facilitates proper understanding of information contained in financial statements?
3. Is ratio analysis useful to management investors, shareholders and creditors in their business divisions?
4. Does financial ratio helps to unravel the mass of truth hidden in financial statements?
5. Are there obstacles that affect the proper use of ratio analysis in business decisions?

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1.5 Significance Of The Study

The significance of this study is that on its completion, the following benefits will be derived:

1. The study will help management of O. Jaco Brros. Ent. (Nig.) Ltd, Uyo and others to know how ratio analysis can help them understand the financial contained in financial statements and enhance their business decisions.
2. The findings of the research and the supportive reference materials will be of immense help to students in tertiary institutions and other researchers to investigate further in the area of study.
3. It is hoped that the result of the research will facilitate optimal business decisions when the recommendations are complied with.
4. The study will encourage businessmen, investors, managers, and government authorities to appreciate quantitative techniques like financial ratios when making economic and business decisions.

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1.6 Scope Of The Study

According to Akpakpan (2005:7), “scope of the study is the limits or boundary lines of the study. It is the areas covered by the research or the extent the researchers would go. Limitations of the Study are hindrances or obstacles witnessed by the researcher in the course of the study. Which could influence his conclusions.”

In view of the impossibility of covering every type of financial statement, this study is therefore restricted to the analysis of the income statement and the Balance Sheet by means of financial ratios. However, other analytical techniques such as horizontal analysis, vertical analysis and termed analysis would also be explained and illustrated.

Finally, although University Ratio Analysis is the core of the study, nevertheless, multivariate Ratio Analysis would be partly illustrated using Du pont Equations.

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1.7 Limitation Of Study

In the course of this research work, the researcher was faced with some constraints which plaved a limit he the ability and performance of the researcher encountered the following constraints among others.

1. Insufficient Financial:

The researcher needed a lot of money to travel as far as Uyo to collect the necessary data from the firm under study. Money was also required to visit secondary data sources such as the internet, libraries, professional bodies, and so on.

2. Lack of Co-Operation:

The unco-operative attitudes of many employees of the firm under study were not encouraging. Some of them were so biased and prejudiced that did not care to understand the purpose of the research. This resulted to their failure to provide sufficient information required for proper completion of the study.

3. Time Pressure:

Time allowed was not enough for through completion of the research, in consideration of the fact the we were also facing other academic studies during the semester.

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1.8 Definition Of Terms Used In The Study

Accounting:

The process of recording, summarizing, analysis and interpreting financial (money-related) activities to permit individuals and organizations to make informed judgments and decisions. (Dansby et al., 2000: 1033).

Balance Sheet:

A financial statement containing assets, liabilities, and owner’s equity or capital at a particular data or at the end of a particular period, to show the financial position of a organization. (Akpakpan, 2002:106).

Business:

An activity, enterprise or organization established to provide goods and services at a profit, in order to satisfy human wants. (Ikon,2004:2).

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.

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 action. (Ayandele, 2005:3).

Financial Ratio:

A proportion, fraction, or percentage expressing the relationship between one item ion sett of financial statements and another item in the same financial statements. (Igben, 1999:423).

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 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. (Hermanson et al. 1992:25).

Ratio:

A fractional relationship of one number (or itme) to another. (Dansby et al. 2000:1047).

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 a business. (Omuya, 1983:430).

Role:

The degree to which somebody or something is involved in a situation or an actively and the effect that they have on it. (Hornby et al.2000:1021).