THE ROLE OF ACCOUNTING RATIO IN FINANCIAL PERFORMANCE OF THE FIRM AND INVESTMENT DECISION

1.1 Introduction

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 (Martikainen, 2013).

As a prelude to other parts of this study, this chapter will discuss the background upon which this study was initiated, the statement of problems that led to this study, the Aim and Objectives of the study. Others are Significance of the study, Scope of work, Research hypothesis and questions, Limitations of the Study and Definition of technical terms.

---

1.2 Background of Study

The financial statement of the firm at the end of the annual year provides a more significant tool of analyzing information to facilitate in making useful business and investment decision. This can be achieved through the use of accounting ratio analysis. Accounting ratios facilitates the determination of the performance and profitability of a firm which is fundamental for investment decisions based on the firm’s financial reports. Accounting ratio facilitate the comparison of two aspects of a financial statement some example of accounting ratios include the dividend ratio, gross margin ratio, debt-to-equity ratio, and operating margin ratio. The relevance of this ratio for investment decisions depends on the currency of the data in the financial statement. The statement used for accounting ratio analysis is the annual financial report of a firm which consists of three financial statements: the balance sheet, income statement and cash flow statement. The analysis conducted in each of this statement provides the vital information required regarding the financial performance of the firm for making sound investment decisions.

Beaver, W. (2017), asserts that financial ratios serve a similar purpose, but you must know what is being measured to construct a ratio and to understand the significances of the resulting number” (Stanly 1994). The statement used for accounting ratio analysis is the annual financial report of a firm which consists of three financial statements; the balance sheet, income statement and cash flow statement. The analysis conducted in each of this statement provides the vital information required regarding the financial performance of the firm for making sound investment decisions.

Brigham (2008) opined that accounting ratios are indicators of a commercial entity’s performance and financial situation. We calculate the majority of ratios from data that the firm’s financial statements provide. Accounting ratios, also known as financial ratios, are used to measure the efficiency and profitability of a company based on its financial reports. They provide a way of expressing the relationship between one accounting data point to another, and are the basis of ratio analysis.

This was attributed to the fact that an accounting ratio compares two line items in a company’s financial statements, namely made up of its income statement, balance sheet and cash flow statement. These ratios can be used to evaluate a company’s fundamentals and provide information about the performance of the company over the last quarter or fiscal year. Examples of financial ratios include gross margin, operating margin, the debt-to-equity ratio, the quick ratio and the payout ratio.

Therefore, in Nigeria where the research was carried out, the activities that was conducted is to know the Role of Accounting Ratio in Financial Performance of the Firm and Investment Decision.

---

1.3 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 and not 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 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.

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 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.

---

1.4 Aim and Objectives of Study

The aim of the study is to examine the Role of Accounting Ratio in Financial Performance of the Firm and Investment Decision. In achieving this aim, the following specific objectives were laid out as follows:

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.

---

1.5 Research Questions

The study came up with research questions so as to be able to ascertain the above stated objectives. The specific research questions for the study are stated below as follows:

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

---

1.6 Research Hypothesis

In order to pursue the objective of this study, the following generalized statements have been designed to guide and aids in obtaining the result for the experiment to be conducted. For this work, the null hypothesis will be represented with H0 while the alternative hypothesis will be represented with hypothesis H1.

Hypothesis One

• H0: Financial ratio does not aid in unraveling the mass of truth hidden in financial statements
• H1: Financial ratio aids in unraveling the mass of truth hidden in financial statements

Hypothesis Two

• H0: There are no significant obstacles that affect the proper use of ratio analysis in business decisions
• H1: There are significant obstacles that affect the proper use of ratio analysis in business decisions

---

1.7 Significance of Study

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

1. The study will help management 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.

This study will be of immense benefit to other researchers who intend to know more on this study and can also be used by non-researchers to build more on their research work. This study contributes to knowledge and could serve as a guide for other study.

---

1.8 Scope of Study

The study focuses on the Role of Accounting Ratio in Financial Performance of the Firm and Investment Decision in Nigeria.

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.

---

1.9 Limitations of the Study

During the course of this study, many things militated against its completion, some of which are:

1. Time Constraint: The time frame given to accomplish this project was very short due to school academic calendar and it was carried out under pressure which made the researcher not to implement some necessary features.
2. Establishment Policies: Establishment policies posed a serious limitation as most staffs are not ready to release information needed for this project work. There were lots of information needed from the staffs of this establishment to enhance the study which took them time to release or they did not release at all for security purposes, hence the scope was reduced.
3. Research material: availability of research material is a major setback to the scope of the study.
4. Frequent power failure: This made the researcher append more money on fuel to ensure sustainable power.
5. Financial Constraint: Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).

---

1.10 Definition of Terms

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

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 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 set of financial statements and another item in the same financial statements (Igben, 1999:423).