Study Of The Use Of Financial Ratios For The Assessment Of The Performance And The Profitability Of A Firm
Financial ratios play a crucial role in evaluating the performance and profitability of a firm by providing a quantitative analysis of its financial health. These ratios help stakeholders, including investors, creditors, and management, to make informed decisions about the company’s overall well-being and future prospects. Common financial ratios include liquidity ratios, such as the current ratio, which assess a firm’s short-term solvency; profitability ratios, like return on equity (ROE) and net profit margin, which indicate how efficiently a company generates profits; and leverage ratios, such as the debt-to-equity ratio, which measures the company’s financial leverage. By analyzing these ratios, stakeholders can gain insights into a company’s operational efficiency, financial stability, and its ability to generate returns, ultimately aiding in making informed investment or lending decisions.
The researcher intends to write on the topic “A study of the use of financial ratios for assessments of the performance and profitability of a firm”.
Presently, most lending bankers are faced with the problem of loan default as a result of in appropriate study or appraisal of the financial statements of the borrowing firm with the help of financial ratio analysis. Therefore, the proposed objective of the study is to identify the various ratios, roles and problems with the use of financial ratios in assessing the performance and profitability of a borrowing firm.
However, the researcher also intends to source her data through the secondary means of data collection, which implies the review of related textbooks, journals, magazines, etc.
Furthermore, the researcher intends to emphasis or limit her topic on the aspect of bank lending in relation to the use of financial ratio analysis to assess the performance and profitability of a borrowing firm.
Conclusively, in respect to the plan for the review of relevant literature, the researcher intends to elaborate more on the concept of financial ratios, various kinds of financial ratios, their uses and importance, as well as limitations on their uses or application.
his research work “The study of the use of financial ratios for the assessment of the performance and profitability of a firm” touched all vital aspects of ratio analysis. In addition, it identified the various kinds of ratios, their uses, those that benefits from such analysis, as well as the limitations associated with the concept of financial ratio analysis.
However, this research work showed the relevance of the financial ratio analysis mostly to the publics of an organization, that is, the equity holder, short-term creditors, long-term creditors, the management, the customers/client and the tax authority. Also, a lending banker can also be able to assess the viability of a borrowing firm with the help of ratio analysis in order to decide on whether to or not to extend credits.
To examine this research work, the researcher embarked on secondary source of data as recommended. This entails the review of related literature by renowned and prominent authors of textbooks, journals, magazines and newspapers, as well as other publications.
This research work is essential for both students and those in the agricultural sector. It constitutes a good reading for practioners in the field of agriculture.
i TABLE OF CONTENTS
ii TITLE PAGE
iii APPROVAL PAGE
iv DEDICATION IV
v ACKNOWLEDGEMENT
vii ABSTRACT
viii TABLE OF CONTENTS
CHAPTER ONE:
INTRODUCTION 1
1.1 BACKGROUND OF THE STUDY 1
1.2 STATEMENT OF THE PROBLEM 2
1.3 OBJECTIVE OF THE STUDY 3
1.4 SIGNIFICANCE OF THE STUDY 4
1.5 LIMITATION OF THE STUDY 6
1.6 DEFINITION OF TERMS 6
CHAPTER TWO
REVIEW OF RELATED LITERATURE
2.1 THE CONCEPT OF FINANCIAL RATIO ANALYSIS10
2.2 GENERAL USES OF FINANCIAL RATIO ANALYSIS11
2.3 STANDARDS OF COMPARISON AND BASIC FINANCIAL STATEMENTS 13
2.4 TYPE OF FINANCIAL RATIOS 14
2.5 LIMITATIONS OF FINANCIAL RATIO ANALYSIS 23
2.6 RATIO ANALYSIS AND THE LENDING BANKER 24
CHAPTER THREE
RESEARCH DESIGN AND METHODOLOGY
3.1 SOURCE OF DATA 30
3.2 LOCATION OF DATA 30
3.3 METHODS OF DATA COLLECTION 31
CHAPTER FOUR
FINDINGS 33
CHAPTER FIVE
RECOMMENDATIONS AND CONCLUSION
5.1 RECOMMENDATION 36
5.2 CONCLUSION 37
BIBLIOGRAPHY
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The significance of Financial Rations and its analysis can not be over emphasized. According to Iloh (2001), a good financial planning for any functional organization has to be related to the existing strength and weakness of such organization. In the effort to discover the aforementioned factors, it becomes necessary to evaluate the performance of such organization over a given period. Financial Ration analysis is therefore one of the methods used in determining the level of performance of an organization. It can be explained as the techniques of reducing aggregate financial data into meaningful quotients, which are compared to other existing financial data.
However, the researcher has developed interest in this particular topic in order find out the impact of financial ratio analysis, mostly to a lending banker. This is because, the issue of credit extension is not an easy task and is of technical in nature, one of the criteria for a successful lending is the review of the Financial Statements of a borrowing firm. This is actually carried out with help of ratio analysis.
Furthermore, the analysis of such financial statements will enable a lending banker to access the viability of such borrowing firm, in the area of liquidity, profitability as well as the nature of its funding.
Conclusively, having indept knowledge of the above concepts mentioned above through Financial Ration analysis, the lending banker will now be able to take appropriate decision on either to accept or reject a given loan proposal or request.
1.2 STATEMENT OF THE PROBLEM
The occurance of loan default is becoming so alarming in most NigerianBanks. This has affected most banks, specifically their capital adequacy, which invariably led to distress and failure. According to Orjih (1996), manipulation of accounting records by borrowers as well as inappropriate review and analysis of the financial statements of the borrower are among the causes of loan default and bad debt. That is, it creates room for the borrowers of fund to deviate from the terms of payment or repayment of fund borrowed from the lending banker.
For several years, most banks have experienced distress and failure as a result of bad lending through inappropriate analysis of financial statements. Therefore, the researcher intends to find out the necessary measures that could be adopted in order to remedy this urgly situation.
1.3 PURPOSE/OBJECTIVE OF THE STUDY
The study of this research work (the use of Financial Rations for the assessments of the performance and profitability of a borrower by a lending banker) intends to achieve the follow objectives:
• To identify the various classes of financial ratios as well as their importance.
• To findout how these Financial Rations are used to assess the performance and profitability of an organization.
• To find out the impact of Financial Ration analysis on a lending banker.
• To identify the effects and incidence of poor or inappropriate review and analysis of the financial statements of a borrower.
• To find out who benefits from ratio analysis.
1.4 SIGNIFICANCE OF THE STUDY
This subsection is associated with the usefulness of the study as well as who will benefit from this research work. Hence, this research work is of great significant as it deals with a study of the use of Financial Rations in assessing the performance and profitability of a firm. That is, it helps to know how viable a company or firm is. This research work will be beneficial to the following publics:
• The equity holder, it will enable them to assess the ability of firm to pay dividend and avoid bankruptcy.
• Short term creditors, it will enable them to assess the ability of firm to honour currently maturing financial obligations.
• Long term creditors, it will enable them to evaluate Annual interest rate operational efficiency and earnings power of a firm over a period.
• The management, it will create room for internal control and efficient asset management.
• The customer/client, it will enable them to know the availability of product/service.
• Tax Authority, it also creates room for tax collection.
Finally, the lending bankers will see this research work as a guide to its lending operations. The review of this work will help to increase their knowledge on ratio analysis, which will help them to evaluate the strength and weakness of a borrowing firm in order to decide accepting or rejecting any given loan proposal.
1.5 LIMITATION OF THE STUDY
According to Orjih (1999), limitations of the study are those constraints facing a researcher such as time, events, people, etc. therefore, the researcher will not forget to state the problems that confronted her in the course of carrying out this research work. The constraints include: finance, time, peoples attitudes towards the release of related materials for the study and many other factors.
1.6 DEFINITON OF TERMS
RATIO – A ratio is the indicated quotient of two mathematical expressions.
FINANCIAL RATIO ANALYSIS: This is one of the methods used in determining the level of performance of an organisation.
PROFITABILITY: This implies the extent or level of profits, which a firm realized over a period of time.
BANK LENDING: This is the extension of credits or funds to deficit hands who need fund for business expansion and other purposes.
LIQUIDITY: Liquidity entails the ability of a firm to meet its obligations as they become due.
BANK DISTRESS: A bank is declared distress when it is unable to meet the bank examination rating system known as CAMEL, or when it is not able to meet balance sheet test of having enough assets at market value to cover its liabilities.
Use Of Financial Ratios For The Assessment Of The Performance And The Profitability Of A Firm:
The study of financial ratios for assessing the performance and profitability of a firm is a fundamental aspect of financial analysis and is critical for investors, creditors, and management to make informed decisions. Financial ratios provide a quantitative way to evaluate various aspects of a company’s financial health and performance. Below, I’ll provide an overview of this study, including its objectives, key ratios, and the insights it can offer.
Objectives of Studying Financial Ratios:
- Performance Evaluation: Financial ratios help assess how well a company is performing in terms of generating profits, managing assets, and using resources efficiently.
- Profitability Analysis: Ratios can provide insights into a company’s ability to generate profits in relation to its sales, assets, and equity.
- Risk Assessment: Ratios can be used to gauge the financial risk associated with the company, which is crucial for investors and creditors.
- Comparative Analysis: Ratios enable comparisons of a company’s performance with industry peers, competitors, or historical performance.
- Forecasting: They can be used as predictive tools to estimate future performance and make informed investment decisions.
Key Financial Ratios:
- Liquidity Ratios:
- Current Ratio: Current Assets / Current Liabilities
- Quick Ratio (Acid-Test Ratio): (Current Assets – Inventory) / Current Liabilities
- Profitability Ratios:
- Gross Profit Margin: (Gross Profit / Total Revenue) * 100
- Net Profit Margin: (Net Income / Total Revenue) * 100
- Return on Assets (ROA): (Net Income / Total Assets) * 100
- Return on Equity (ROE): (Net Income / Shareholders’ Equity) * 100
- Efficiency Ratios:
- Asset Turnover Ratio: Total Revenue / Average Total Assets
- Inventory Turnover Ratio: Cost of Goods Sold / Average Inventory
- Solvency Ratios:
- Debt to Equity Ratio: Total Debt / Shareholders’ Equity
- Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expense
- Market Ratios:
- Price-to-Earnings (P/E) Ratio: Market Price per Share / Earnings per Share
- Price-to-Book (P/B) Ratio: Market Price per Share / Book Value per Share
Insights Offered by Financial Ratios:
- Liquidity: Liquidity ratios help assess a company’s short-term financial health. A low current ratio might indicate potential liquidity issues.
- Profitability: Profitability ratios show how well a company generates profits. Higher margins and returns are generally favorable.
- Efficiency: Efficiency ratios reveal how effectively a company utilizes its assets. Higher asset turnover ratios indicate efficient asset utilization.
- Solvency: Solvency ratios assess a company’s ability to meet its long-term obligations. A high debt-to-equity ratio might signify a higher financial risk.
- Market Perception: Market ratios reflect investor sentiment. A high P/E ratio may suggest that investors have high expectations for future earnings.
In conclusion, the study of financial ratios is a crucial aspect of financial analysis, providing valuable insights into a firm’s performance and profitability. However, it’s important to note that no single ratio should be considered in isolation; a comprehensive analysis requires examining multiple ratios and considering the specific industry and economic context. Financial ratios should also be used alongside qualitative factors to gain a complete understanding of a company’s financial health and prospects.