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THE ROLE OF
RATIO ANALYSIS IN BUSINESS DECISION
ABSTRACT
Accounting
information provided by means of financial statements- The income statement and
the Balance Sheet are often in summarized form.
Viewed on the surface, the truths about the results and the financial
position of a business hidden in them remain veiled. To be of optimal benefit and as well enable
the users make well – informed decisions, financial statements need to be
analyzed by means of ratios. Therefore,
in order to establish the role of ratio analysis in business decisions, this
research is carried out, using Ibom Power Company as the Case study. The researcher made use of both primary and
secondary sources of data collection.
However, for the former, questionnaires were administered, whereas for
the later, relevant were received. The
data Collected via the primary data sources were analyzed using simple averages
and percentages. After ratios analysis conducted on the chapter four, mode at
95 level of confidence (5% level of significance). Finally, it was established that ratios
analysis evils business decision.
CHAPTER ONE
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.
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.
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 business 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.
1.4 RESEARCH QUESTIONS i. Is ratio analysis
useful in evaluating and prediction the performance of a business as well as
intensifying areas that regret improvement? ii. Do you agree with the fact that
ratio analysis facilitates proper understanding of information contained in
financial statements?iii. Is ratio
analysis useful to management investors, shareholders and creditors in their
business divisions? iv. Does financial
ratio helps to unravel the mass of truth hidden in financial statements?
v. Are there
obstacles that affect the proper use of ratio analysis in business decisions?
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 Bros. Ent. (Nig.) Ltd, Aba 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.
1.6 SCOPE OF THE STUDYAccording 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.
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 Aba 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 Cooperation: 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.
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 in setting 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 item) 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).
1.9 BRIEF HISTORICAL BACKGROUND OF O. JACO BROS.
ENT. (NIG). LTD. ABA STATEO. Jaco Bros. Ent. (Nig) Ltd, Aba, Abia Sate was
established in 1982. It started as a sole proprietorship business owned,
runned, and managed by Nze Josephat Okolocha. The firm is a trading concern. It
specialized in sale, marketing, and distribution of various kinds of motorcycles,
spare parts, and electric generators.Meanwhile, in line with outstanding growth
witnessed by the firm in the last couple of years, the organization is now an
incorporated private limited liability company since 1999.At present, the
company has a total asset base of over N50 million and employs more than 30
workers. It has 6 branches. 4 in Aba, 1 in port Harcourt, and in Ekwulobia
(Anambra State).
The head
office located at 59, Jubilee Road, Aba,
Abia State, (which is the center focus of this study), has 4 departments: the
sales and marketing department, the purchasing and supply department, the
Administration and personnel department, and the finance and Accounts
Department.
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