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THE EFFICIENCY OF FINANCIAL RATIOS ANALYSIS TO EVALUATE

COMPANY'S PROFITABILITY

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Journal of Global Economics and Business January 2021, Volume 2, Number 4, 119-132
ISSN: Print 2735-9344, Online 2735-9352

THE EFFICIENCY OF FINANCIAL RATIOS ANALYSIS

TO EVALUATE COMPANY’S PROFITABILITY

Chnar Abdullah RASHID,

Sulaimani Polytechnic University, Sulaimani, Iraq,
Chnar.rashid@spu.edu.iq

Abstract

The main purpose of the business unit is to make money. The profitability analysis is to
understand the current operating performance and efficiency of the commercial company. It
should be appropriately pointed out that the net income figure alone is not very helpful in
determining the efficiency and performance of the enterprise unless it is related to other
figures, such as sales, cost of goods sold, operating expenses, investment capital, etc.
Therefore, calculating the profit rate can inspire the final result and the comparison of the
company. This is the only criterion for the company to pay attention to the overall efficiency.
This paper mainly focused on reviewing and evaluating current articles that have been
conducted on analyzing companies’ performance regarding profitability. Thus, this review
discovered that profitability is the most important measure to evaluate companies’
performance. Hence, other financial indicators such as liquidity can be used for further article
reviews to boost the effectiveness of companies’ performance.

Keywords: Profitability, Financial Ratios, Liquidity, Financial Analysis.

1. Introduction

People look at the financial statements to see the company’s performance to determine
whether the company’s performance is good (financially good) or not (Rashid, 2020). They
use it to judge the value of the business. Here, we can use ratio analysis to compare one number
with another and generate a ratio, and then use them to assess whether the ratio indicates a
weakness or strength in the company's affairs. These ratios can help company shareholders and
other potential investors assess the company's value and quality (Kadim, Sunardi, and Husain,
2020).
The Efficiency of Financial Ratios Analysis to Evaluate Company’s Profitability

In recent years, the relationship between company value and financial ratio has been
highly valued in the financial field. When investors want to use stock investment companies,
they need to take some measures and analyze some factors. They cover the unique factors of
the company and affect revenue. Because they are special to the company, financial ratios can
provide investors with information about the actual value of the company. By analyzing the
expected cash flow and the company’s assets, organizational structure, technology and human
resources, we can obtain corporate value. In addition to shareholders, creditors also have the
right to use company assets because they provide financial loans to the company. This is
because when a company is about to suspend production, creditors will pay the accounts
receivable earlier than the invested capital of shareholders (Hedija, Fiala and Kuncová, 2017).

Profitability can be defined as the ultimate indicator of a company's economic success

relative to the capital invested (Budur et al., 2018; Demir et al., 2019; Rashid, 2019). This
economic success depends on the size of the net profit (Budur, 2020; Demir et al., 2021;
Mohammed et al., 2020). Profit is the remaining income after the company pays all expenses
directly related to the generation of income (such as producing products) and other expenses
related to conducting business activities (Torlak et al., 2019; Rashid, 2020). Profitability is the
main goal of all companies (Budur et al, 2019). Without profitability, companies will not be
able to survive for a long time (Amin and Ahmed, 2020; Serin, 2018; Top et al, 2020).
Therefore, it is very important to measure current and past profitability and predict future
profitability (Nuhiu, Hoti, & Bektashi, 2017).

The purpose of the current study, therefore, is to review and investigate the articles that
have been conducted on this issue. Accordingly, it discovered that the majority of the studies
that have been completed conclude that financial ratios analysis has significant effect on
profitability.

2. Financial Ratios Analysis

The value of a company when it goes public becomes crucial, which is the basis for
investment decisions. Intellectual capital, as an artificial intelligence function, can help us
reveal the big data patterns in information-based historical data, so that we can use technology
to complete work faster and better. This research aims to verify the value of model companies
based on financial ratios, intellectual capital and dividend policies. The object of this study is
the automotive sub-industry companies and components listed on the Indonesian Stock

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Rashid

Exchange (IDX) from 2010 to 2019, and 11 companies meet the sampling requirements. The
data analysis method is based on path analysis and Sobel test, including classical hypothesis
test, linearity test, total coefficients determined and estimated, and hypothesis test through
direct and indirect influence. The results of this study show that the company is based on the
discovery of financial ratios, intellectual capital and dividend policy modeling value, and
financial ratios as the result. Liquidity, solvency and profitability ratios have no significant
impact on the dividend policy, which has a significant impact on the value of the company. In
addition, the financial ratio adjusted by the dividend policy is only affected by solvency and
profitability, while the liquidity ratio and intellectual capital factors have little effect (Kadim,
Sunardi, and Husain, 2020).

In agriculture, more and more sustainability assessments are available, including

financial ratios. In a literature review of farm management textbooks, taking into account the
differences between European and North American practices and taking into account common
sustainability assessment methods, we determined the commonly used financial ratios. Five
ratios are related to the profitability of the indicator, and four ratios are related to the liquidity
of the indicator. The other eight financial indicators refer to financial efficiency, stability,
solvency and repayment ability indicators. Based on the accounting of more than 14,000 dairy
farms from the Swiss Farm Accounting Data Network (FADN), we conducted a Spearman
correlation analysis on standardized and unified financial ratios. Correlation analysis shows
that most of them are positive correlations. In order to evaluate the implementation of the
quantitative economic sustainability assessment, we compared the aggregate indicator
combination of all 17 ratios with two financial ratios-the European composite indicator first,
and the North American economic sustainability indicator second. The correlation between the
set of indicators and the reduced indicators shows that the two overall economic indicators can
be reasonably used to estimate the economic sustainability of Swiss dairy farms (Zorn, Esteves,
Baur and Lips, 2018).

Financial performance indicators, especially financial ratio analysis, have become

important financial decision support information used by company management and other
stakeholders to evaluate financial stability and growth potential. However, other information
may be hidden in management communications. This article analyzes the annual reports of
American companies from two perspectives, one is a financial report based on a set of financial
ratios, and the other is a language analysis based on the analysis of other information provided

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The Efficiency of Financial Ratios Analysis to Evaluate Company’s Profitability

in the company's annual report. The Spearman correlation coefficient is used to compare the
values of financial indicators and language indicators. In order to conduct a comprehensive
assessment, a novel word list is proposed, specifically designed for each financial analysis
category. The purpose is to evaluate the information capacity of the annual report and whether
successful companies accurately demonstrate their performance. The results indicate that the
proposed subject dictionary may be useful, especially for the assessment of cash flow and
leverage ratio (Myšková, & Hájek, 2017).

In the current highly competitive environment, financial performance evaluation is a

very critical process. Therefore, designing an accurate and appropriate performance evaluation
framework is beneficial to internal personnel and company shareholders. To evaluate financial
performance, we need to consider some financial indicators that reflect the company’s
competitiveness. There are many fuzzy financial indicators and standards, which can be
regarded as fuzzy multi-criteria decision-making (MCDM) problems. In this article, we
developed a new financial performance evaluation framework to rank companies in Iran’s
petrochemical industry based on the fuzzy MCDM method. In order to achieve this goal, first
of all, the main criteria must be determined through a comprehensive literature review and
expert opinions. Then, use the main financial standards and their sub-standards to build a
hierarchical financial performance evaluation model. Fuzzy analytic hierarchy process has
been used to determine the weight of the standard. Then, fuzzy AHP and fuzzy TOPSIS are
used to compare and rank companies. The results show that the rankings of companies obtained
through these methods in their own sectors are almost the same (Shaverdi et al., 2016).

The purpose of this article is to investigate the importance of financial ratios derived
from financial statements in predicting stock price trends in emerging markets. Based on the
data of 15 companies distributed in 3 fields in the Kuwait financial market from 2005 to 2014,
statistical tests were carried out on the predictive ability of 12 financial ratios. After using the
STEPWISE method to eliminate invalid variables, an equation for estimating stock prices in
various industries was established according to the multiple regression models. The results
show that certain ratios can establish a strong positive correlation with the behavior and trend
of stock prices, and the most effective ratios for stock prices in the industrial sector are ROA,
ROE and net profit margin. The most effective share price ratios in the service industry are
ROA, ROE, P/E and EPS ratios, and the investment industry is also the same. The conclusion
of this study is that it can rely on a set of financial ratios in each department to predict stock

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Rashid

prices. Decision makers of such investors can rely on the financial analysis provided by
financial ratios when making financial and operational decisions. (Arkan, 2016).

3. Profitability

The purpose of this research is to explain whether the determinants of commercial

banks' profitability affect the financial performance of Kosovo Commercial Bank. The
performance evaluation of Kosovo Commercial Bank is done by measuring financial
performance indicators, which include return on average equity (ROAE), return on average
assets (ROAA) and net interest return (NIM). The study identified the main factors affecting
the profitability of commercial banks by analyzing financial time series and panel data from
Kosovo’s banking sector. The study proposes three financial performance analysis models,
which highlight influencing factors. The model is based on regression analysis, and the results
obtained emphasize the relationship between the determinants of commercial banks'
profitability expressed through the analysis of financial performance indicators. The study
concluded that the profitability of Kosovo commercial banks is mainly driven by internal
determinants, such as capital adequacy ratio, asset quality and management efficiency, while
macroeconomic factors have little effect on the financial performance of commercial banks
(Nuhiu, Hoti and Bektashi, 2017).

This article analyzes the impact of the recent global financial crisis on the efficiency
and profitability of financial institutions. In a comparative study, the impact of the global
financial crisis on the performance of Islamic and commercial banks was studied. The
fundamental difference between Islamic banks and conventional banks is that Islamic banks
are based on the moral principles of Islamic tradition and law (Islamic teachings). By using a
sample of eight Islamic banks and eleven commercial banks, the impact of the global financial
crisis on the efficiency and profitability of the banking industry was evaluated. This research
covers the period 2006 to 2013. The results of this study are obtained from the Altman Z scoring
model, ratio analysis, data envelopment analysis (DEA) method and seemingly unrelated
regression (SUR) model. The results show that during the study period, Islamic banks (IBs)
managed to maintain efficiency, while the efficiency of most commercial banks (CBs)
declined. In addition, this study found that the financial crisis had no significant impact on the
profitability of Islamic banks (Erfani, & Vasigh, 2018).

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The Efficiency of Financial Ratios Analysis to Evaluate Company’s Profitability

The survey aims to assess the profitability of the banking industry by investigating
Zimbabwe's financial performance indicators from 2011 to 2018 to determine whether there is
a relationship between performance indicators and what policy measures should be taken to
improve the profitability of the industry. By evaluating financial performance indicators (such
as return on assets (ROA), return on equity (ROE), loan-to-deposit ratio (LDR), non-
performing loans (NPL), net interest margin) to evaluate the profitability of the banking sector
(NIM), interest Coverage ratio (ICR) and capital asset ratio (CAR). The auxiliary data used is
extracted from the Reserve Bank of Zimbabwe (RBZ) [Central Bank], which is actually a time
series. This article uses paired sample testing, regression analysis, and ordinary least squares
(OLS) regression to determine profitability and correlation tests to test the relationship between
performance indicators. The research results show that the profitability of the banking sector
is mainly driven by performance indicators, and more attention should be paid to the
relationship between non-performing loans and variables. This research suggests that the
Reserve Bank of Zimbabwe should formulate strategies to ensure the stability, growth and
safety of the interests of investors and depositors, and observe the capitalization level of
commercial banks, thereby improving profitability, which is the greatest for banking
executives; Limit the use of banks as financial intermediaries, stop charging high bank fees,
implement new policies and carry out system reforms (Gwatiringa, 2020).

The purpose of this article is to use a data envelopment analysis (DEA) model to
evaluate the economic efficiency of tourism operators in the Czech Republic from 2007 to
2014, and to prove the link between economic efficiency and profitability, and to find out
whether profitability is economic efficiency A good representative. The data is exported from
the database Albertina CZ Gold Edition. We calculated efficiency scores based on 3 inputs and
1 output, using CCR (Charnes, Cooper, and Rhodes) and BCC (Banker, Charnes, and Cooper)
models. From 2007 to 2010, almost all companies have an efficiency score higher than 0.5;
however, since 2011, we have found significant differences in the efficiency of each company,
with only about 40% of travel agencies having an efficiency score higher than 0.5. Using the
Pearson and Spearman correlation coefficients, our findings indicate that in terms of the Czech
tourism operator market, profitability does not match the efficiency of the company. Earnings
rate is not a good representative of economic efficiency, nor should it be used as the only
criterion for determining performance (Hedija, Fiala and Kuncová, 2017).

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Rashid

The purpose of this study is to understand the profitability performance of upper dairy
farms in the Midwestern United States over time and the size of the entire herd. Profitability is
divided into asset efficiency and operating profit margin. The main goal is to determine how
much information is needed to accurately benchmark server farm performance. From 2000 to
2016, the financial ratios used to measure profitability (return on assets), profit margin
(operating margin) and asset efficiency (asset turnover) were collected from Michigan State
University and University of Wisconsin dairy farm business analysis plans. The financial ratio
model was checked across time and herd size. Divide the annual distribution into quartiles and
use the average from one to five years to determine the accuracy of the quartile rank compared
to true long-term farm profitability. The financial status of the large group is more uniform
than the financial performance of the small group. The profitability of small and large herds
converges in times of poverty, but diverges in good years. Using performance for three years
or more can greatly improve the accuracy of benchmark profitability. The data used is very
rich in terms of changes over the years and herd size. The results have important implications
for farm financial management and benchmark farm financial performance. Before making
major management changes to alleviate deficiencies, a farm company should establish a
benchmark for profitability over many years (Wolf, Black, and Stephenson, 2020).

As previous research and literature have shown, there is a correlation between financial
crisis and bank performance. Today's business world is more global than ever before, and the
financial crisis is affecting the national economy like dominoes. More importantly, the
financial crisis has several negative effects, such as unemployment, high inflation, reduced
investment, low privatization, and mergers and acquisitions. Similarly, the role of the banking
industry in the modern economy must not be ignored. This is because banks are the locomotives
of the market and they play important roles, such as facilitating investment, lending, supporting
entrepreneurship and providing liquidity. Therefore, revealing the two-way link between the
financial crisis and banking performance has many advantages and helps to take corrective
measures for the future. However, the link between the financial crisis and the banking industry
is still not very clear, and the debate on this issue is still ongoing without a satisfactory
explanation. In addition, research on emerging markets (which studies the correlation between
financial crises and banking performance) is more limited. This research focuses on the impact
of the 2008 financial crisis on the performance and profitability of the banking industry in
Turkey, an emerging economy. For this reason, the 2002-2015 financial periods was included
in the analysis to test the impact before and after the crisis. Financial ratio as a variable and

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The Efficiency of Financial Ratios Analysis to Evaluate Company’s Profitability

indicator of the performance of the banking sector is used as a research method to introduce
accounting methods into research. In addition, both state-owned banks and private banks have
been included in the study to avoid prejudice and subjectivity and ensure independence
(Hanişoğlu and Kizil, 2016).

During the period 1999-2013, using a sample of 1992 banks from 39 OECD countries,
we studied whether raising the capital ratio effectively reduced risks and improved the
efficiency and profitability of banking institutions. We prove that although risk-based and non-
risk-based capital ratios improve bank efficiency and profitability, risk-based capital ratios fail
to reduce bank risks. Our results cast doubt on the effectiveness of the weighting method used
to calculate the risk-based capital ratio and the effectiveness of regulatory oversight. The
adoption of the new Basel III capital standards may exacerbate the ineffectiveness of risk-based
capital ratios against bank risks. Although Basel III requires banks to have higher liquidity
ratios and higher capital ratios, our research results show that imposing capital ratios may have
a negative impact on the efficiency and profitability of highly liquid banks. Our results cover
different sub-samples, alternative risk, efficiency and profitability indicators, and a series of
estimation techniques (Bitar, Pukthuanthong and & Walker, 2018).

This study provides a citation-based systematic literature review on banking

performance, especially in terms of profitability, productivity, and efficiency. Specifically, the
research aims to determine the main sources of knowledge based on the most influential
journals, authors and papers. This article presents a content analysis of the 100 most cited
papers. Using a comprehensive list of keywords, a total of 1996 peer-reviewed papers were
found to be relevant in the Scopus database. The results show that in terms of number of
publications and citations, "Journal of Banking and Finance" seems to be the leading journal.
Based on total citations, Allen Berger is the most prolific writer. The most cited paper is
"Problem Lending and Cost Efficiency of Commercial Banks" by Allan Berger and Robert
DeYoung. The content analysis of the top 100 papers identified five basic themes: efficiency,
methodology, ownership, financial crisis and the determinants of economies of scale. In terms
of estimation methods, 74% of the papers used cutting-edge analysis, including 34%
parameterized and 40% non-parametric methods and the remaining 26% of papers used
financial ratio analysis. In addition, random boundary and data envelopment analysis are
widely used in parametric and non-parametric methods, respectively. An intermediate method
is widely used in the input and output specifications (Ahmad, et al., 2020).

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Rashid

Liquidity and profitability are two very important and vital aspects of a company's
business life. Without liquidity, no company can survive. An unprofitable company may be
considered morbid, but an illiquid company may soon collapse and eventually die. Financial
ratios are useful indicators to measure company performance and financial status. This study
aims to analyze the liquidity and profitability of selected Indian telecommunications companies
(Bharti Airtel and Vodafone India). 1. It is clear that the operating performance of a company
depends on some key factors, such as turnover, profit, asset utilization, etc., as well as variables
found in the company's income statement and balance sheet. Thereafter, considering the growth
and prosperity of the telecommunications market, the research aims to analyze the financial
performance of selected telecommunications companies in terms of liquidity and profitability.
Research conducted through empirical methods may use ratios and indicators to measure the
performance of companies operating under one of the most active sectors in the Indian
economy and determine their financial health (Khan, & SAFIUDDIN, 2016).

The purpose of this article is to compare the production efficiency and service quality
of major foreign banks operating in India and newly established private banks, and to study the
link between efficiency, service quality and financial performance. The data envelopment
analysis (DEA) method is used as a benchmark for production efficiency, and the SERVQUAL
framework is used for service quality analysis. The relationship between production efficiency,
service quality and financial performance of selected foreign and private banks is studied. It is
pointed out that although efficiency and service quality are extremely important, they do not
necessarily lead to excellent bank profitability. This research promotes the emerging need for
a comprehensive framework for measuring efficiency, service quality, and financial
performance and their interconnections in Indian banks with different ownership structures
(George, 2016).

The purpose of this article is to study the factors that affect the earnings of listed
companies in Malaysia. Some people believe that profitability is the main pillar of any
company's long-term survival. Although profitability is the main goal of all enterprises, little
attention is paid to the factors that affect the profitability of developing countries. This study
investigates the factors affecting the profitability of listed companies in Malaysia. This research
is based on five independent variables, which empirically test the relationship between them
and profitability. These variables are: company size (measured by total sales), working capital
(WC), company efficiency (asset turnover), liquidity (current ratio) and leverage (debt equity

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The Efficiency of Financial Ratios Analysis to Evaluate Company’s Profitability

ratio and leverage ratio). The company's annual report extracts data on 120 companies listed
on Bursa Malaysia from 2012 to 2014. Use combined ordinary least squares regression and
fixed effects to analyze the data. The survey results show that there is a strong positive
correlation between company size (total sales), WC, company efficiency (asset turnover) and
profitability. The results also show that there is a negative correlation between the debt-equity
ratio and the leverage ratio and profitability. There is no significant relationship between
liquidity (current ratio) and profitability. Due to time constraints, the data only includes 120
companies listed on Bursa Malaysia, covering the period from 2012 to 2014. These results
benefit internal users (such as managers, shareholders, and employees). They can realize the
determinants of improving the company's profitability after the devaluation of the Malaysian
currency, so they can focus more on the factors that improve the company's profitability. On
the other hand, other external users (such as investors, creditors, newly established companies,
tax authorities) can also benefit from these results. Obviously, these users worry about the
company's profitability and the determinants of its profitability after currency depreciation.
This study differs from previous studies in many ways: First, it focuses on non-financial listed
companies in Malaysia. Previous research has focused on companies in the financial sector,
such as banks and financial institutions or industry organizations. Second, this research
analyzes the data in the company's annual report for the three years from 2012 to 2014. During
this period, Malaysia's economy fluctuated due to currency devaluation. Third, the study uses
return on equity and earnings per share as earnings indicators. Fourth, the research results
provide empirical evidence that large companies with effectively managed assets can increase
operating income and ultimately increase profitability. Last but not least, this research applies
resource-based theory and trade-off theory (Alarussi, & Alhaderi, 2018).

This research aims to empirically prove the research framework of the company's value
based on the profit ratio related to the dividend policy. The value of the company is measured
using the book value (PBV) method. This study included a sample of 11 companies in the
compatriot sector of automobiles and parts listed on the Indonesian Stock Exchange. It includes
data for the period 2014-2018. This study uses Sobel's test to analyze the direct and indirect
effects of IBM SPSS 23.0. The study found that the profit rate has no significant impact on the
dividend policy, and the dividend policy has no significant impact on the company's value.
However, the dividend policy did not mediate the impact of interest rates on the company's
value. This research can be further expanded by considering all IDX listed companies, which

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Rashid

can provide us with more insights into financial ratio measurement in the Indonesian context
(Husain, & Sunardi, 2020).

4. Conclusion

This work reviewed and compared academic studies about different countries about the
efficiency of financial ratios analysis to evaluate the company’s profitability. Most of them
recommend that financial ratios analysis can play a significant role in evaluating the company’s
profitability. However, financial ratios analysis regarding to liquidity can be used to evaluate
the company’s performance (Rashid, 2018). Hence, corporate social responsibility, risk, and
corporate governance can be conducted to evaluate performance.

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