NICHOLAS HONLAH MENSAH( 1014308)

CHAPTER TWO

2.0 INTRODUCTION

Financial statement summarizes economic performance of firms. In order to make use of this
accounting information, the users needs to analyze and interpret its meaning. When confronted
with financial statement for decision making purposes, it is useful to have a framework of
analysis available to make an attempt to extract what is important from the mass of less
important data.

Financial analysis is a natural extension of an adjust to accounting. Accounting procedures

aggregate data and eliminate details in order to present a clear picture of the firm (Glenn V,
Henderson et al 1984).

2.1 DEFINITIONS OF RATIOS

Ratios analysis has been given several definitions in finance, banking and accounting literature.
Some of these definitions are;

A) Ratios are relationship between different balances or between account balances and
various income statements. (Henderson et al 1984).
B) Ratio is simply one number expressed in terms of another number to show the
relationship between the two numbers. (Jennings 1993)
C) Ratio is an expression of the mathematical relationship between one quantity and another.
(Engler 1990). Considering what Engler has said about ratios they are tools of analysis
that provide clues and symptoms of underlying conditions.
D) Welsh(1971) and Zlatkovich (1986) have both shown that ratios are “The indicated
quotient of two mathematical expressions” and “ the relationship between two or more
things”
2.2.1 FIANACIAL STATEMENT RATIO

Financial statement ratios continue to be the primary means by which managers and other users
of financial statement assess the progress of economic entities.

There are several of these ratios which assist stock holders in their decision making. However,
for the purpose of this study, they are categorized into;

a. Liquidity ratio
b. Leverage ratio
c. Activity ratio
d. Profitability ratio
e. Market ratio

2.2.2 LIQUIDITY RATIO

Liquidity ratio measure a firm’s ability to meet current obligations. They focus on a company’s
ability to pay bills when they fall due. In other words they show how solvent a firm is to meets
its short term obligations as they fall due ( Mulford, et al 2010). These consist of current ratio,
that is current assets/current liabilities and quick ratio that is current assets less inventory/current
liabilities.

The purpose of these ratios are to establish the companies capacity to meet its current liabilities
as they fall due and to strip out the slower moving item (inventory/stock) from current assets to
measure real short- term liquidity. In their view ACCA( 1987) states that the liquidity ratios and
working capital turnover ratios are used to test a companies liquidity, length of cash cycle and
investment in working capital.

Normally, the acceptable current ratio should not be less than 1.0 and when this happens its
signals financial problem. Most analysts consider 2.0 current ratios to be safe and desirable
target. (Yiadom 1999)
2.2.3 LEVERAGE RATIOS

Leverage ratios or debt management ratios are the extent to which a firm uses debt in financing
its operations. It has three implications according to Brigham (1995);

i) By raising funds through debt, shareholders can maintain control of a firm while
limiting their investment.
ii) Creditors look to equity or owner supply funds to provide a margin of safety, so if the
stockholders have provide only a small proportion as the total financing the risk of the
enterprise are borne by its creditors.
iii) If the firm earns more investment financed borrowed fund than its pay interest, the
return on owners capital is manifested or leveraged.

Equally, they shows the proportions of debt and equity in financing the firms assets, thus,
relative proportion of debt and equity used to finance the assets of an entity.

Principally, there are two types of leverage ratios which are debt ratio and equity ratio.
Mathematically, A) Debt ratio = Total Debt

Total Assets

B) Debt Equity = Total Debt

Total Equity

Essentially, the goal is to borrow and invest the funds in business activity that produces a greater
return than the interest that has to be paid on borrowed funds. It also attempts to measure the
long-term solvency of the company (Brigham1995), advocated that the financial leverages can
raise the expected rate of return to shareholders in many ways;

1) Since interest is deductible the use of debts lowers the tax bill and leaves more of the
firms operating income available to its investors. Notably, high price earnings ratio may
indicate that investors expect high dividend growth or the stock has low risk and
investors are content with long term prospective return and the company is expected to
 achieve average growth while paying out a high proportion at earnings (Brealy andMyres
1999).
2) Dividend per share i.e. dividend proposed/outstanding shares is the portion that is
available to shareholders.
3) Dividend yield i.e. dividend per share/stock price. It is used to compare the different
investment alternatives.
4) Dividend payout ratio i.e. dividend per share/ earnings per share, between its ordinary
shareholders and re-investing them in the firm. High growth firms typically re-invest
their earnings instead of paying them out resulting in low pay-out ratios.
5) It must be noted that a higher pay out ratio indicates a slow growth. Therefore if a
company’s earnings are particularly variable management is likely to play by setting a
low average pay-out ratio. The purpose of market ratio are the measurement of the
esteem in which in which they are held by investors.

2.2.4 ACTIVITY RATIO

Activity ratios measure company sales per another asset account thus the most common asset
accounts used are accounts receivable, inventory, and total assets. Watson and head (2010, p.49)
states that activity ratios shows how efficiently a company has managed short-term assets and
liabilities. Activity ratio also evaluates how well the company manages its assets. Besides
determining the value of the company's assets, you and your client should also analyze how
effectively the company employs its assets.

In his view Doyle (2010) states that there are three common assessed activity ratios and these are
trade receivables turnover ratio, inventory turnover ratio and trade payable turnover ratio.
According to waston and Head (2010) trade receivables turnover gives the average period of
credit taken by customers. Inventory turnover ratio also shows how long it takes for a company
its inventories into sales and also trade payables gives the average time taken for suppliers of
goods and services to receive payment.
Mathematically, the three types of activity ratios are as follows;

A) Trade receivables turnover ratio s= debtors * 365

Credit sales
B) Inventory turnover ratio = inventory * 365
Cost of sales
C) Trade payables ratios = creditors *365
Cost of sales

The information used to calculate an activity ratio is found on a company’s balance sheet or
income statement. Doyle (2010)

2.2.5 PROFITABILTY RATIO

According to waston and Head (2010) profitability ratio indicate how successful the managers of
the company been in generating profit. To them return on capital employed is often the primary
ratio. In their view weygandt et al (2005) states that profitability measures the income or
operating success of an enterprise for a given period of time. They went to say that profitability
affects the liquidity position and the firm’s ability to grow. Profitability is used as the ultimate
test of management operating effectiveness. Weygandt et al (2005)

There are four types of profitability ratios that are used to determine the profit of a company and
these are ; Sales growth which measures the changes in growth of a rate of firm sales thus
changes in turnover/previous years turnover multiply by hundred.

Gross profit margin which also reflect the efficiency with which management produces each unit
of product. It also measure the percentage of each money of sales that results in net income.
Weygandt et al (2005). It is computed by dividing gross profit by turnover multiply by hundred.
Return on assets. This also measures the operating efficiency of the firm. Thus, net profit before
tax/total assets.

Return on equity also measures how well the company has used the resources of its owners. This
ratio shows how many dollars of net income were earned for each dollar invested by the owner.
Weygandt et al (2005). Thus net profit before tax /net worth. An increase in these ratios is
viewed as a positive trend. Doyle (2010).

2.2.6 MARKET RATIO

These are the ratios which help equity shareholders and other investors to assess the value and
quality of an investment in the ordinary shares of a company Ainsworth et al (1996). Market
ratio which is also known as the investment ratio does not only regard information in the
company’s published account but also the current price, and the fourth, fifth and sixth ratios all
involve using share price according to ACCA(1998). In their view wood and Sangster (2008)
states that the purpose of this ratio is to indicate how well a company is performing in relation to
the price of its shares and other related items including dividends and the number of shares in
issue. The usually calculated are explained below;

Dividend per share. This indicates the dividend received by each ordinary shareholder. It shows
the proportion of profit on ordinary activities for the year that is available for distribution to
shareholders and what proportion will be retained in business to finance future growth.
Ainsworth et al (1996). It is computed mathematically as;

Dividend per share (₵) = proposed dividend *100

Number of shareholders

Dividend yield. This ratio measures the real rate of return by the dividend paid to the market
price of a share. Wood and Sangster (2008). This is compared to the yield available on
alternative investments to help investors evaluate the extent to which their investment objectives
were met. The average dividend yield on common market stocks has historically been in the
range of 3% to 6%. Ainsworth et al (1996). It is computed mathematically as;
Dividend yield = dividend per share * 100

Market price per share

Earning Per share. According to Ainsworth et al (1996) earning per share measures the net
income earned on each share of common stock. They went on to say that it is most frequently
quoted measure of firm’s performance in the financial press and it is required disclosure on the
face of the income statement. It is computed by dividing the net income by the number of
shareholding.

Price earnings. This ratio relates the earning per share to the market price of the shares and is a
useful indicator of how the stock market assesses the company. It is also useful when a company
proposes an issue of new shares, thus it enable potential investors to better asses whether the
expected future earnings make the share a worthwhile investment. wood and Sangster (2008).

2.3 USES OF FINANCIAL STATEMENT RATIO

Ratio analysis of financial statement is used widely with sophisticated techniques by investors
and other stakeholders. Notably, the uses of financial ratios are;

a) Making investment and credit decision (welsch et al).

b) A tool of communicating economic situation of entity from obsolete figures in financial
statement.
c) A predicting model to project whether a firm would fail or otherwise
d) Evaluating the stewardship of management by way of their performance over a given
period of time.
e) Assessing efficiently and effectively the assets of the company have been employed or
used over a period of time.
f) Assessing the risk association with investment in a given company.
g) Inter-firm comparison (Yiadom 1999).
 h) Trend analysis.
i) Estimating marketing risk.

2.4 USERS OF FINANCIAL STATEMENT RATIOS

The main users of financial statement ratios include shareholder and potential shareholders,
creditors, tenders, government for taxation and statistical purposes particularly through their
trade unions as well as management.

The interest of the various parties or shareholders has been summarized in Table 1.

Table.1. Main users of financial statement ratios.

Parties with immediate interest Types of ratios

Potential suppliers of goods on creditors, Liquidity or credit risk. Ratio indicate how
tenders. Example bank managers, debenture well equipped the business is to pay its way.
holders and management
Shareholders (i.e. actual and potential) Profitability: how successful is the business
potential takeover bidders, lenders, trading.
management, competitive firms, tax authorizes
and employees.
Shareholders (actual and potential) potential Users of assets: how effectively are assets of
takeover bidders, tenders, management, firms utilized?
competitive firms, employment.
Shareholders (actual and potential) potential Capital structure: how does the capital
takeover bidders, tenders, management, structure of the firm affects the cost of capital
creditors in assessing risk. and return to shareholders
Shareholders (actual and takeover bidders, Investment: show how the market prices for a
management). share reflected on the company’s performance.
Source: Frank wood vol.2, sixth edition, page463.
2.5 LIMITATION OF FIANACIAL STATEMENT RATIO

In spite of the wide use of financial statement ratios, this technique has a number of limitations.
Due to these limitations, ratios must be interpreted with great care.

Some of these limitations are;

I) When the data which ratios are based on historical book value do not reflect;
a) Price level effects
b) Current market values.

This brings to therefore the effect of inflation/deflation on certain items in the financial statement
of companies. Notable examples are;

1) It increases the nominal value of work in progress and inventory profits are not a real
income except to the extent that the inventory appreciates faster than general price level.
2) As inflation progress the net book value of fixed assets become more and more out of
fixed data i.e. the book value understates current value of replacement cost. Depreciation
schedules that are based on book value may provide misleading picture change in current
value of the assets of the company.
3) It also has effect on the net profit of companies that borrow. Lenders are backed in
inflation currencies so they demand a higher interest on their loans. Pandey (1991).

Brigham (1995) also outlines limitations of ratios which are;

I) Ratios represent average conditions that exist in the past. They are based on historical
data that incorporate all the peculiarities of the past. The financial analysis is interest
in what happens in the future whiles ratios indicate what happens in the past.
Management of the company get information about the company’s plans and policies
and therefore is able to predict the future better than the outsider.
II) The method of computing each ratio is not standardized. Therefore the computation
can be influenced by data selections choice. Thus, it is difficult to decide on proper
basis of comparison.
III) Situations of two or more comparison are not the same. Similarly the factors
influencing the companies in one year may change in another year. Thus the
 comparison of the ratios of two or more companies difficulties and become
meaningless when they are operating under different situations such as product lines,
methods of finance and geographical locations. Also the uses of different accounting
methods obscure inter-firm comparison.
IV) The use of alternative accounting method may also have significant effect on the use
of financial ratios. For instance the use of first-in first-out (FIFO) versus last-in first-
out (LIFO) stock valuation purposes and /or the use of straight line versus accelerated
depreciation.
V) Change in accounting estimate and principles such as a change in FIFO to LIFO may
affect the ratio of the year of change. Also to develop that data for a long-term, its
may necessary to adjust the data, the effect usual and non-recurring items and extra-
ordinary items.
VI) All other investors have the same data available and can compute the same ratios.
Studies have shown that the market vary quickly and absorbs this information. As a
result, it is extremely difficult to consistently earn above average returns on stock
investments by relying on publicly available information. This is why probably there
is excessive reliance on ratio analysis. Welsch and Latkonch (1986).
VII) Firms can employ window dressing techniques to make their financial statements
look better than they really are.
VIII) A firm may have some ratios which look “good” and others which look “bad” making
it difficult to tell whether the company is, on balance, strong, or weak.