INTRODUCTION TO FINANCIAL RATIO ANALYSIS

1.0 INTRODUCTION

Financial analysis is clearly the most important criterion for evaluating management performance, in particular, and the enterprise as a whole. The management of an enterprise and its outside suppliers of capital- creditors and investors- would want to undertake financial analysis in order to make rational economic, political or social decisions. This Unit introduces the concepts of ratio and financial analysis, emphasizing on the use of accounting ratios for effective financial analysis by business organizations.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

1. appreciate the concept of ratio 
2. understand how to conduct financial analysis, using accounting ratios 
3. test the efficiency and effectiveness of business enterprises 

 MAIN CONTENT

 Financial Ratio Analysis

 The Concept of Ratio

To evaluate the financial condition and performance of a business entity, the financial analyst needs certain yardsticks. The yardstick frequently used is a ratio, or index, relating two pieces of financial data to each other. A ratio is one number expressed in terms of another and is found by dividing one number, the base, into another. Its analysis facilities evaluation of accounting information by reducing complicated data into a smaller set. The use of ratios in accounting and finance provides the means of testing the efficiency of key features of a business as represented in the final accounts.

SELF ASSESSMENT EXERCISE 1

1. Define the term “ratio”. 
2. What is ratio use for in accounting? 

3.2 Comparative Analysis Using Ratios

The analysis of financial ratios involves two types of comparison. First, the analyst can compare a present ratio with past and expected future ratios for the same company. The acid-test ratio for the present year-end could be compared with the acid-test ratio for the preceding year-end. Using the computed financial ratios for a number of years, an analyst can study the composition of changes in financial condition and performance of a business over time. In the comparison over time, it is best to compare not only the financial ratios but also the raw figures. The second method of comparison involves comparing the ratios of the one business with those of similar businesses or with industry average at the same point in time. Such a comparison gives insight into the relative financial condition and performance of a business. It is only when

comparing the financial ratios of one business with those of similar businesses or industry average that one can make realistic judgments.

SELF ASSESSMENT EXERCISE 2

1. Discuss the two type of comparison in ratio analysis. 
2.  Why is it important to compare raw figures apart from the ratios computed from them? 

3.3 Users of Accounting Information and Their Interests 

The type of financial ratio analysis varies according to the specific interests of the party involved. A trade creditor is interested primarily in the liquidity position of a business. His claim is short-term, and the ability of a business to pay this claim is best judged by means of a thorough analysis of its liquidity position, and so financial ratios to be analyzed must be liquidity-testing in nature.

The claim of a bondholder, on the other hand, is long term. Accordingly, he would be more interested in the cash flow ability of the business to service debt over the long run. The bondholder may evaluate this ability by analyzing the capital structure of the business, the major sources and uses of funds, its profitability over times and projections of future profitability. Ratio-wise, he would concentrate on debt and profitability ratios.

An investor in a company’s common stock is concerned principally with present and expected future earnings and the stability of these earnings about a trend. As a result, the investor might concentrate his analysis on the profitability of the business. He would be concerned with its financial condition in so far as this condition affects the stability of future earnings. In his analysis, therefore, investments and profitability ratios would be concentrated on.

In order to bargain more effectively for outside funds, the management of a business should be interested in all aspects of financial analysis that outside suppliers of capital use in evaluating the business. In addition, management employs financial analysis for purposes of internal control. In particular, it is concerned with profitability on investment in the various assets of the business and in the efficiency of assets management. Management, therefore, should use all types of ratios in order to adequately analyze or test its performance.

Other interested groups in financial statement of businesses, who conduct financial ratio analysis, in one way or the other, are government and its agencies, potential buyers of business, actual and potential customers and present and aspiring employees.

SELF ASSESSMENT EXERCISE 3

1.  Discuss any three users of accounting information and their information needs. 
2. Why should management of a business be interested in all aspects of financial analysis? 

3.4 Types of Ratios and Their Formulae

Ratios can be categorized in different ways. But for the purpose of our studies, financial ratios can be divided into six types: Overall Performance, Profitability, Productivity, Liquidity, Capital Structure and Investment ratios. Some of the ratios are computed from the Balance Sheet, some from the Income Statement and others from both the Balance Sheet and the Income Statement. It is important to recognize from the outset that no one ratio gives us sufficient information by which to judge the financial condition and performance of a business. It is only when we analyze a group of ratios that we will be able to make reasonable judgments.

4.0 CONCLUSION 

The financial reports of enterprises are useless if they are not subjected to critical analysis and interpretation. The analysis is to be as comparative as possible, employing an objective tool/yardstick. The tool normally used by financial analysts to test the health, productivity and profitability of a business is ratio. This Unit presents an in-depth

introductory discussion on the concept of ratio and how to employ it in the conduct of effective financial analysis with a view to making a lot of revelation about the performance of a reporting entity.

5.0 SUMMARY

This Unit has discussed the concept of ratio, use of ratios in financial statements analysis and interpretation, users of financial ratios and their interest and different classifications of financial ratios. The formulae for these ratios and how to use the ratios in taking informed decisions were discussed to guide students as to what they should be looking out for as they study financial statements of enterprises for various decision making purposes.