Financial Ratios as a Tool of Evaluating the Performance of Companies for Investment Decision

Financial Ratios as a Tool of Evaluating the Performance of Companies for Investment Decision

IMPORTANCE OF FINANCIAL RATIOS

          The benefits derived from the financial ratios cannot be over emphasized. Financial ratio means a ratio of monetary magnitudes obtained from a firms financial statements that reflects some aspects of the firms performance.

  1. Bernstain, sees financial ratio as a tool of financial analysis that exposes the latent problem, weakness or strength of business organization. He equally said the financial ratio when properly interpreted will show area requiring further investigation and enquiry. These ratios reveal conditions and trends that cannot be identified by an inspection of the individual components of the ratio.

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He also said that financial ratios are the most important elements in the entire decision set with which the lending officer or stock investor is concerned.  For companies to perform effectively and efficiently, they need to make use of financial ratios. These will serve as indicators about the financial position and equally give suppliers opportunities to assess the performance of company for investment decsion1985 .

Meigs comparison of ratio over time gives some ideas of a company’s performance compared with its past records and may be helpful in forecasting future performance.

In the opinion of Holines and sugden, financial ratios help in the assessment of trends and may highlight aspects of a company that merit closer scrutiny. They throw more light on financial accounting date, as a result, exposing the problem area in a firm, operation so corrections could be made.

According to fess and warren 1997, most of the items in financial accounting statement are of limited importance when considered individually.  Comparisons of items in financial statement will help users of financial statement gain or know the true positions of the business organizations it will help in evaluating or assessing both the past performances of an organization and in forecasting its future performance.  Opportunities to assess the performance of company for investment decisions.

2.2     USERS OF FINANCIAL RATIOS

          There are a lot of people who are interested in the financial statement of business organization. They are concerned about the performance of the organization to enable them make investment decision.   These users are divide or classified into two:

  1. Internal users
  2. External users

INTERNAL USERS:   These are all parties interested in the financial  statements of a business organization within the business enterprise, either as employees or owners. They are as follows:-

  1. Shareholders: These are the owners of the business, they are divided into ordinary shares and preference shareholders. The payment or dividend paid to the ordinary shareholders depend on the payment or dividend paid to the ordinary shareholders profit made by the business or the member of percentage they want to retained, but preference shareholders receive a fixed rate of dividend.

Financial ratios help both existing and prospective shareholder to measure the degree of investment risks in companies.  It equally helps them to assess the performance of management of companies, which are accountable to them to know the prospects for dividends in the future.  It also helps them to know whether to increase their share (ie buying more shares) or dispose their shares.

  1. Employees: These are also internal users of financial ratios. The managers and others employees of the business organizations and investment decision of top management.  These employees determine their job securities from financial ratios.  It helps them to know whether some staff will be dropped or employed or even increment in their salaries.

Therefore, it determine effectiveness and efficient of employees in the performance of their duties.

  1. Management: The management which usually comprises of board of directors and managers measures effectively her performance level in any given year through comparisons of financial ratio the operation of organization are properly reviewed to prevent wastage and make necessary corrections. Management equally uses financial ratios as guide for making necessary investment decision.  Financial ratio as guide show the management the business ventures that are viable for investments and consequently with yield good returns.

EXTERNAL USERS:  These are people or parties who are interested in the financial ratio but they are outside the business organization.

They include:

  1. Creditors: This includes the banks bondholders, credit suppliers of goods and services.
  2. Banks/financial institutions: financial institution such as commercial banks, merchant banks, insurance companies use financial ratios to evaluate performance of companies before they decide to lend companies or not and the terms on which to lend they enquire into the liquidity ratios, before they give loans do the companies to the compares’.  This is to enable them ensure that these business would be able to pay the fixed interest on loans plus its principals.  They also determine the risks of loans to business through the use of financial ratios. It is noticed that a highly geared business (with low equity capital) is a high loan risk while a lowly geared business (with high equity capital) is a low loan risk.  We determine this risk through leverage ratio.
  3. Credit suppliers of goods and services: People who supplied goods and services on credit to companies usually use financial ratios to determine the when to apply strict financial regulations.  It is equally from financial ratio that central banks determine the bank that will be going on distress and equally advice them to prevent it on time.

iii.      Securities and Exchange Commission:  This commission or body is responsible to regulate the activities in the Nigerian capital market, the stock exchange market.  This body evaluates the performance of companies through the use of financial ratios. They can none regulate the number of shares are equated.

  1. The investors: They use financial ratio to have idea about the performance of companies.  Knowing the viability of the companies will help the prospective investors companies determine whether to invest or not.
  2. Securities underwriters: The underwriters make use of financial ratios to asses or evaluate the performance of companies. This enables them to make investment decision.
  3. Stock brokers: These are agents that operate in the stock exchange market. They use financial ratios to determine the companies whose shares will  be profitable. The companies that are capable of paying their dividends to their shareholders.  The stock brokers always prefer to serve as agent for viable companies. The viability can be determined by financial ratios of the companies.

2.3     RELIABILITY OF FINANCIAL RATIOS

          This is very essential in the application of financial  ratios for investment decision.  The validity and reliability on financial ratios depends on the validity of numbers entering into their computations.  It is observed that when a company’s internal into their computations.  It is observed that then a company’s internal controls are not relied upon to produce reliable figures, the ratio obtained from these accounting cannot be relied. Therefore reliability of financial ratio dispenses on the accuracy of figures used in computations.

2.4     LIMITATIONS OF FINANCIAL RATIOS

          There are certain obstacles that hinder or affect the financial ratios of business conditions that affect the financial ratios, other factored like industry position, management policies, general business conditions and weakness in the accounting affect the validity and reliability of financial ratios.

Some of these obstacles that face investor or managements in use of financial ratios are as follows:-

  1. CHANGE IN ACCOUNTING BASES: When there are change in accounting practices of companies publish. This is usually observed in stock valuation or depreciation of assets. A company that used straight line method the reducing of assets this year may decide to use reducing balance method or use last in first out  (LIFO) or use first in first out (FIFO). This will affect comparisons of financial ratio of past and present and use here it become difficult to give accurate information from them. Which means to solve this problem, the same technique or methods should be used throughout the year of comparisons.
  2. INFLATION: This could be defined as persistent or continuous increase in price of goods and services. Here prices of goods and services rise rapidly. This affect the current value component of financial ratios while historical cost components are not affected. As a result of inflation, it becomes difficult to compare figures of past years and current year. For example the number of shares in issue is not affected by inflation. It is observed that when economy is experiencing constant or rapid increase in price of goods and services. The figures or ratios obtained from financial ratios analysis become worthless and cannot indicate performance. This investors or management depending on them will take wrong investment decision. It is only when price are relatively stable that financial ratios become relevant or reliable. Otherwise, inflation if not checked will have affects or impacts on the result of financial ratio analysis.
  3. CHANGES IN THE COMPOSITION OF A GROUP: Th use of financial ratios for assessment or evaluation of both past and present performance for investment decisions would be affected where there are changes in the composition of a group. Here when a company, which was formally single becomes holding or parent company and acquires another (subsidiary) the composition of the group will change. As a result or ratio will be affected.

2.5     COMPUTATION OF FINANCIAL RATIO

          There are procedure uses in computing financial ratios of business organization. When these procedures are followed properly reliable ratios will be obtained.

These procedures are:

  1. Comparable items in the financial statements of an enterprise and identified and isolated for purpose of computing the ratios.
  2. The figures of the comparable items. This could lead to the production of ratios that tell the relationship between the comparable items.
  • Important inferences are drawn on the ratio computed. These inference will indicate weakness or strength of financial position of the organization.

2.6     EXPLANATION OF SELECTED FINANCIAL RATIOS

          There are a lot of financial ratios that are computed from financial statement of business organization but only important selected ones will be discussed in the project work.

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

This article was extracted from a Project Research Work Topic:

“THE BUSINESS OF FINANCIAL RATIOS AS A TOOL OF EVALUATING THE PERFORMANCE OF COMPANIES FOR INVESTMENT DECISION”

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Comments

  1. Nwodo Obianuju says:

    my topic is the effects of external audit on the financial management of any 2 selected local government in Nigeria

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