The Concept of Financial Ratio Analysis

The Concept of Financial Ratio Analysis

In the words of Udeh (2000), Ratio analysis is a very important tool of financial analysis.  It is defined as quotient of two mathematical expressions and/or as the mathematical relationship between two or more items expressed in figures.  Therefore, a ratio is used in financial analysis as a yard stick for evaluating the financial position and performance of a firm, as the absolute figures contained in the financial statements do not provide a meaningful information on the performance and financial position of a firm.

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Furthermore, Mgodille (2001) said that while the trend of one balance sheet or income statement account or group of accounts may be of great important in statement analysis, it is not possible for the analyst to estimate properly the solvency of a company as its most recent statement date, or to estimate the probability of its continued solvency, without relating particular accounts to other accounts and groups of accounts and studying the trends of these relationships.

According to Iloh (2001), financial ratio analysis is very useful to the various public of an organization.  The equity holder who is uncertain about, the ability of his organization to pay dividend and avoid bankruptcy could use the profitability and market value group of ratios to find out the firm’s ability to pay dividend promptly.  The trade creditors of a firm would want to know the ability of an organization to pay its currently maturing financial obligations with the use of liquidity group of ratios, etc.

2.2    THE GENERAL USES OF FINANCIAL RATIO ANALYSIS

According to Udeh (2000), different ratios have different uses and have diverse appeals to various interest group.  Generally, the uses of ratio analysis can be identified as follows:

  • It is a reliable yard stick for the evaluation of the efficiency of the management of a firm.
  • It provides basis and facts for the assessment of the firm’s history. That is, comparing the past, present and future expectations of the firm.
  • It is an indicator of the financial position of the firm.
  • It provides a guide to investors
  • It can be used to predict corporate bond rating.
  • Financial ratio analysis is used to predict business failures.
  • It is used to determine the credit rating of business firms
  • It provides a frame work for financial planning and control
  • It is applied in determining the profitability margin of the firm.
  • It is used to determine the price of a firm’s shares.
  • Ratio analysis is a very useful tool in raising relevant questions on a number of managerial issues and provides dues to investigate those issues in detail.
  • STANDARDS OF COMPARISON AND BASIC FINANCIAL STATEMENTS

According to Obasikene (2000), a single ratio by itself does not indicate favourable or unfavourable condition, rather it should be compared with some standards.  Standards of comparison may include:

  • Ratios calculated from the past financial statements of the same firm.
  • Ratios developed using projected or proforma.

THE INCOME STATEMENT

It is also referred to as the profit and loss Account.  The income statement measures the net result of the firm’s operations over a specified interval such as one quarter or one year.

THE STATEMENT OF CHANGES IN FINANCIAL POSITION

This is sometimes referred to as statement of source and use of funds.  It provides information about the resources provided during a specific period and the uses to which they were put.

However, the lending banks should be able to analyse these financial statements with a view to establishing the degree of performance of the firm.  The analyst does this by properly establishing relationships between the items of the financial statements.

2.4    TYPES OF FINANCIAL RATIOS

Orjih (2001), categorized Ratios as thus:

  • Liquidity Ratios
  • Leverage Ratios
  • Activity Ratios
  • Profitability Ratios

Financial Statements of the firm.

  • Ratios of some selected firms especially the most progressive and successful at that point in time.
  • Ratios of the industry to which the firm belongs.

BASIC FINANCIAL STATEMENTS

Emekekwue (1997) said that three financial statements are basically used to represent the financial status of a firm.  These statements provide the raw material for the financial analyst and they must be fully understood by any analyst including the lending officers in the bank before any meaningful analysis can be made.

THE BALANCE SHEET

This represents a statement of the financial position of the firm on a given date.  It contains information relating to the firm’s assets holding, liabilities and owner supplied capital, asset represents the resources used by the firm.  The liabilities and owner’s equity indicate how those resources were financed.

  • LIQUIDITY RATIOS: they measure the ability of the firm to meet its obligations as they become due.  The liquidity ratios by establishing a relationship between cash and other current assets to current obligations provide a quick measure of liquidity.  An excess liquidity will result in bad credit rating and loss of confidence by creditors.  Therefore, it is necessary to strike a balance between liquidity and lack of liquidity.  The two commonly used liquidity ratios are:

–    Current Ratio:   This is computed by dividing current assets by current liabilities.  This can be illustrated as thus:

Current Ratio  =  Current Assets

Current Liabilities

The higher the ratio, the greater the assumed ability of the firm to pay its bill.

  • Acid Test or Quick Ratio – It is calculated by deducting inventories from current assets and dividing the remainder by current liabilities. Inventories are the least liquid of a firms current assets.

—-This article is not complete———–This article is not complete————

This article was extracted from a Project Research Work Topic:

A STUDY OF THE USE OF FINANCIAL RATIOS FOR THE ASSESSMENT OF THE PERFORMANCE AND THE PROFITABILITY OF A FIRM

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