Business Of Financial Ratios As A Tool Of Evaluating The Performance Of Companies For Investment Decision


Business Of Financial Ratios As A Tool Of Evaluating The Performance Of Companies For Investment Decision

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Chapter One

1.1 INTRODUCTION Financial ratios are tools used to analyze financial conditions and performance. Financial analysis means different things to different people. Trade creditors are primarily interested in the liquidity of the firm being analyzed. Their claims are short term and the ability of the firm to pay these can best be judged by an analysis of its liquidity. On the other hands, the claims of bondholders are long term. They are interested in the cash flow of the firm to service debts over a long period of time. The bondholders may evaluate this by analyzing the capital structures of the firm, the major sources and users of fund, the firms profitability. Finally, an investor in a company’s common stock is concerned principally with present and expected future earning as well as the stability of these earning about a trend. As a result the investor usually concentrates on analyzing the profitability of the firm (financial ratios) the point of view of the analyst may be either external or internal. For external, it involves suppliers of capital while that of internal, the firm needs to undertake financial analysis in order to plan and control effectively. To plan for future, the financial manager must assess the firm financial position and evaluate opportunities in relation to their effects on this position. With internal control, the financial managers is particularly concern with return on investment in the various assets of the company and in the efficiency of asset management. Financial analysis involves the use of financial statement. These statement attempt to several things. They portray the assets and liabilities of a business firm at a moment in time usually at the end of a year. They portray an income statement which involves the revenue, expenses, taxes and profit of the firm at a particular period of time usually one year. While balance sheet represent a snapshot of the firm’s statement of assets and liabilities at a moment in time. The income statement depict its profitability over time. To evaluate a firm financial condition and performance, analysis and interpretation of various ratios should be given to experiment and skilled analyst. The analysis of financial ratios involves two types of comparison 1. INTERNAL COMPARISON: Here the analyst can compare a present ratio with past ratio of the same company. It can also be computed for projected or perform a statement and compared with present and past ratio. 2. The second method of comparison involves comparing the ratio of one firm with those of similar firm or with industry (this type of comparisons is known as Finding the Industry average of firm). This comparison gives insight into the relatives of financial conditions and performance of the firm. But my emphasis in this research work is to limit it to the first comparison or internal business enterprises have leased to operate or collapsed as a result of increase in market uncertainties ( with unsteady interest raes exchange rate, political instability) and inability of some business managers to use financial ratio effectively and accurately in the assessment of the performance of their organization. In order to attain the traditional objectives of maximization of shareholders wealth, the managers should use or apply financial ratio in taking necessary business decision. Many banks have gone distressed because of inability of bank managers to check their lending by using financial ratio to ensure that they do not go below their minimum liquidity levels and that of reliable and viable business are given loans and overdraft. As a result of economic hardship and inflation prevailing in the economic, it becomes very important that an effective and reliable means of evaluating the performance of companies for investment decision should be adopted any management shareholder creditors and even general public. Financial ratios analysis is one of the major techniques and in evaluating performance of business organizations. Financial ratio exposes the position of the business in terms of performance and efficiency of operation. They show whether the management are efficient or inefficient in their utilization of resources such as capital assets, labor etc. The degree of leverage of a company is ascertained from financial ratio analysis and this will enable stockholders and other suppliers of capital known the degree of gearing in a company’s capital structures. Prospective investors can now measure their risk in the company and decide whether to invest in the company or not. Financial ratios indicate whether the value of stock of the company is increasing or falling. This provides prospective investors opportunities to decide whether to invest or not and existing stock holders whether to hold stock or dispose them Because financial ratios express areas of weakness and strength of the companies mangers used them to review operations for better performances in future. There are many financial ratios used in evaluation of a company’s performance but for purpose of this study, it will be limited to activity, leverage investment, liquidity and profitability.

1.2 PURPOSE OF THE STUDY The objectives of this research work is to assess or know the importance/usefulness of financial ratios as a tool for evaluating the performance of companies for investment decision. The research work will go or examine the indictors for investment in companies their earning performances, liquidity, positive economic soundness. It will equally examine the indicators of strength, weakness, opportunity and threat (SWOT) The management will take appropriate corrective actions to actions to improve the result when the weakness are identified. The identification of weakness and consequently improving the result will provide the investors the opportunities to know the propensity of the company to achieve progressive growth and equally make decisions of the investment.

1.3 SINGIFICANCE OF STUDY This study will be very important to the following 1. PROSPECTIVE INVESTORS IN COMPANIES: It will enable them determine risks of investment in companies ie financial position of the companies thereby making them to invest in a company that will be profitably to them. 2. MANAGEMENT OF COMPANIES: It provided tool for assessing or evaluating the companies performance and also taking decision on where to invest. 3. GOVERNEMT: It helps the tax board to know the amount that will be taxed on companies profit. 4. EXISTING INVESTORS IN COMPANIES: after analyzing the performance of the company, it will help the existing investors to know whether to continue their investment or withdraw their interest.

1.4 STATEMENT OF PROBLEM Although financial accounting statements shows the financial positions of a business at the end of a financial period, but they do not present accurate performance on the level of performance or efficiency of operations of a business at the end of financial period. It is usually observed that the operating profit figure of a company might be higher in the current year than the previous year but his higher profit figure cannot be used to say the company has performed better in the current year than in the previous because the cost of the asset is being considered in all the beginning of that first year which may reduce the profit for that period.. If this is judge based on this, it will have adverse or negative impact on the investment or investors. Many investors in Nigeria are uneducated or illiterate and as a result of ignorance or inexperience, they cannot use or employ financial ratios in evaluating the performance of the companies. Also existing shareholders use the cash dividends and interest paid to them in evaluating the performance of the companies for investment decision. These parameters do not give accurate information about the performance and efficiency of operation of the companies. Some managers do not employ financial ratios in performance appraisal and in the evaluation of investment decision because of technicalities involved in financial ratio analysis, fear of assessment and in experience. Therefore, they make use of other alternatives inside of using financial ratios. Because of all this problems, the research work will go or examine they importance or usefulness of financial ratios in evaluating of companies performance for investment decision. Every benefits derived from financial ratio will be examined for proper investment decisions.

1.5 STATEMENT OF HYPOTHESIS The hypothesis below would be subjected to testing Null Hypothesis Ho: The use of financial ratios has negative impacts on investment Alternative Hypothesis H1: The use of financial ratios has positive impacts on investment decision.

1.6 SCOPE AND LIMITATION OF STUDY The research work will concern or effect only profit making organization. Public corporation are not treated in the study. Time and finance were equally limiting factors of this study finally restricted access o secondary information sources was also restricted in the study.

1.7 DEFINITION OF TERMS ASSET: Economic resources owned by a business, which are expected to benefit future operation. It is divided into two a. Fixed asset eg building, Equipment etc. b. Current assets eg cash at hand , bank stock debated. LIABILITIES: These are debts or obligations of a business organization. The claims of creditors against the asset of a business eg. Creditors, bank overdraft. DIVIDEND: A distribution of cash by a company or corporation to its stockholders after allowable deduction have been made and appropriate to reserves. This benefit derived from the shareholders because of their interest in the company. BALANCE SHEET: It is a financial statement, which shows, the financial position of a business entity of a business (balance sheet and income statement). It comprises of balance sheet, profit and loss account, note to the account, value added statement sources and application of funds. PROFIT AND LOSS ACCOUNT: This is the record of business transaction of a company for a given period of time usually one year. LEVEL OF LEVERAGE: This is the ratio of debt finance (i.e fixed interest borrowing) to the equity finance in a company’s capital outlay. WORKING CAPITAL: This can be defined as the difference between the current assets and current liability i.e current asses less current liabilities. CURRENT LIABILITIES: These are debts or claim which are payable within one year eg trade creditors overdraft. CURRENT ASSETS: They are cash plus assets that are expected to be collected in cash or sold or consumed within the next year or as a part of the company’s normal operating cycle eg. Cash stock prepaid expenses. RATIO ANALYSIS: This involves the companies of one figure aginst another to produce a ratio and assessing whether the financial ratios indicate weakness or strength in the company’s affairs. HYPOTHESIS: This is proposition assumed to be true for purpose of argument. It requires testing before it can be accepted. SECURITIES: These are financial asset of a company, which are sold do investors, which could attract returns or benefit on investment. Example are stocks, bonus etc. LIQUIDITY: This is state of possing liquid asset such as cash and other assets that will soon be converted into cash. COMPARATIVE FINANCIAL STATEMENT: Present the same company’s financial statements for two or more successive period in side by side column. HORIZONTAL ANALYSIS: Analysis of a company’s financial statements for two or more successive period showing percentage and or absolute changes from previous year. The type of analysis helps detect changes in a company’s performance and highlight trend. VERTICAL ANALYSIS: This type of analysis is the study of a single financial statement in which each item is expressed as a percentage of significant total for example of sale calculation. NON-OPERATING ASSETS: Assets owned but used in producing revenue. PERIODICITY: An assumption that an entity’s life can be subdivided into time periods such as months or years. PROFITABILITY: Ability to generate income the income statement reflect a company’s profitability. SOLVENCY: Ability to pay debts as they become due. TRANSACTION: Record able happening or event that affect assets, liabilities stock holder’s equity revenue or expenses of an entity.

Chapter Two Chapter Two of “Business Of Financial Ratios As A Tool Of Evaluating The Performance Of Companies For Investment Decision Contains: Review Of Related Literature, Importance Of Financial Ratios, Users Of Financial Ratios, Reliability Of Financial Ratios, Limitations Of Financial Ratios, Computation Of Financial Ratios, Explanation Of Selected Financial Ratios, Final Consideration In Financial Statement Analysis, Chapter Three Chapter Three of “Business Of Financial Ratios As A Tool Of Evaluating The Performance Of Companies For Investment Decision Contains: Research Design And Methodology, Sources Of Data, Sample To Be Used and Methods Or System Of Investigation. Chapter Four Chapter Four of “Business Of Financial Ratios As A Tool Of Evaluating The Performance Of Companies For Investment Decision Contains: Data Presentation, Analysis And Interpretation, Data Analysis, Test Of Hypothesis and Summary Of Ratio. Chapter Five Chapter Five of Business Of Financial Ratios As A Tool Of Evaluating The Performance Of Companies For Investment Decision Contains: Summary Of Findings, Conclusion And Recommendation, Bibliography and Appendix.



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