CHAPTER ONE
INTRODUCTION
Planning is one of the most important aspects in the management o a firm. It involves an appraisal of the past performance of the firm and a projection into the future. It is also related to existing strengths and weaknesses of the firm.
The strength must be understood if they are to be used for proper advantage and the weaknesses must be recognized if corrective action is to be taken. It is necessary for instance, to find whether inventories are adequate to support the projected level of sales or whether the existing level of investment in account receivable is an indication that the firm has lax collection policy.
Ratios analysis employs basic financial data taken from the analysis of financial statement (balance sheet and income statement which is the primary financial) reporting mechanism of an entity, both internally, and externally. An analysis of the financial information communicated by the statement should include the computation and interpretation of financial ratios.
Although emphasis is focused on outside users, such as credit and owners, management is aware, that their performance will be reviewed by those external partial and for other reason. For instance, the basic fianical statement are used to access the effectiveness of management in planning and controlling operations as well as for decision making.
Management also recognizes that the evaluation of past operation, as revealed by the analysis of the basic statement, represent a good starting pointing planning future operations and serves as important means of assessing past performance and in forecasting and planning future performance.
In other words, the aim of this term paper is to evaluate financial ratios as an aid to management decision – making, to find out if any, how financial ratios helps management in decision – making, to determine if accounting si actually of any use to management, to find the importance of financial ratios, to examine the extent to which management uses financial ratios information supplied to identify the problems inherent in the use of management information.
Financial statement analysis consists of applying analyst tools and techniques to financial statement and other relevant data to obtain to useful information. This information is shown as significant relationship between data and trends in those data assessing the company’s past performance and current position. The information shows the results or consequence of prior management decision. In addition, the information is used to make prediction that may have a direct effect on decision made by many users of financial statement.
Business entities may have objects and goals. However, the two primary objectives of every business are solvency and profitability, solvency is the ability to pay debts as the become due, profit ability is the ability to generate income unless a business can produce satisfactory income and pay its debts is they become due, other objective a business may have will never be realized simply because the business will not survive.
The financial statement that reflects a company solvency is the balance sheet the financial statement reflecting the company’s profitability is the income statement. The balance sheet, sometimes called the statement of financial position lists the company assets and liabilities and stockholders equity as of a specific moment in time. It captures the financial position of a company at a particular point in time.
The income statement, sometimes called an earning statement, reports the profitability of a business organization for a statement period of time profitability is measured for period of time, by comparing the revenues generated with the expenses incurred to produce these revenues.
Present company investors and potential company to earn profits its profitability. These investors wish to predict future dividends and changes in the market price of the company common stock.
Since both dividends and price changes are likely to be influenced by earnings, investors may seek to predict earning. The company’s past earning record is the logical starting point in predicting future earning.
Sometime, outside parties are interest in predicting a company’s solvency rather than its profitability short – term solvency is affected. By the liquidity of the company. Liquidity is the state of possessing liquid assets such as cash and other assets that will soon be converted into cash.
Several types of analysis can be performed on a company financial statement.
All these analyses rely on comparison or relation hips of data because comparison enhance the utility, or practical value of accounting information for instance knowing that a company’s net income last year was #100,000 is not very useful information. Some usefulness is added when it is known that the prior year’s net income was #25,000. And even more useful information is gained if the amounts of sales and assets of the company are known. Such comparison or relationship may be expressed as:
A ratio is the relationship between two amount that result from dividng one by the other. The ratio of 1, 00 to 500 would be 1,000 / 500 = 2, sometimes expressed as 2:1. This means that the first number is twice as large as the second.
Financial ratios become relevant fro decision – making only when compared with some standard. Each analyst must decide upon to gauge the performance of the company being analyzed. Some common bases for establishing standard are considered below:
Company history
Horizontal analysis has been defined as comparing financial statement and trend analysis were presented as application of horizontal analysis. Each of the financial ratios may be computed for a number of years and then compared to form an opinion about whether the company’s performance is getting better or worse. If management inefficiency seems to be the only plausible explanation, the analyst may expect continued problem that could lead to a decision or reject a credit application or not to invest in stock of the corporation.
External standard
Ratios information about other companies is often used as a yardstick against which to examine data on industry, norms, average ratios, and credit rating from credit agencies such as dun and Bradstreet or by consulting statistics available investment service publication such as annual statement studies published by Robert Murnks association.
Care must be taken in deciding whether ratios are to e used as standard of comparison. Many companies are so diversified that 4 is difficult to identify one particular industry in which they operate. A current ratio or inventory turnover ratio for such conglomerate would be meaningless for comparing with those statistics of another firm operating in only one industry.
The difference in accounting methods employed in generating financial information may also influence the comparability of ratios and other statistic among the different principles that firms may employ are different inventory techniques, depreciation methods;
In other words logical relationship exist between certain accounts or items in a company financial statement these accounts may appear on the same statement or they may appear on two different statement. The dollar amount of the related accounts or item at set up in fractions form and called ratios. The se ratios can be broadly classified as:
Liquidity ratios
These are used to indicate a company’s short term debt – paying ability. Thus, these ratios are designed to show interested parties the company’s capacity to meet maturing current liabilities. They are sub divided into current ratio and acid test or quick ratio.
They are applied as follows
Current assets
Current liabilities
Quick ratio or acid test = quick assets
Current liabilities
Equity or long – term solvency ratios
This shows the relationship of debt and equity financing in company the two basic sources of assets in a business are owners (stock – holders) and creditors, and the interest of both groups are referred to as total equities. But in ratio analysis, the term equity, thus, the equity ratio indicates the proportion of total assets that I provided by stockholders (owners) on a given data. Equip ratio =
Stock holders equity
Total assets (or total equities
Profitability tests
Profitability is an important measure of a company operating success. These measure management over all effectiveness as shown by the returns generated on sales and investment they include:
Profit margin on sales net profit after tax
Sales
Return on total asset net profit after tax
Total assets
Return on net worth net profit after tax
Net worth
Other measure on operating expenses to sales such as:
Market test
Certain ratios computed using information form financial statement and information about market price for the company stock. These tests help investors and potential investor’s asses the relative merit of the various stock in the market place.
Standing alone, a single financial ratio may not be very informative greater insight can be obtained by computing and analyzing several related ratios for a company.
Financial analysis relies heavily on informal judgment. Percentage and ratios are guide to aid comparison and are useful in uncovering potential strengths ad weaknesses. But the financial analyst showed seek the basic causes behind changes and established trends.
Accounting is fundamentally a measurement and communication process used to report on the activity of profit seeking business organization and not for profit organization.
As a measurement and communication process for business, accounting supplies information that permits informal judgment and decision by users of data. It also supplies management with significant financial ad economic data that are useful for decision – making.
Reliable information is necessary before a sound decision involving the allocation of scarce resources can be made. In decision – making, you always have alternative even if one of the alternative is to take no action on to delay action.
Accounting information is valuable because it can be used to predict the financial consequences for each alternative. Rather tan depend on a “crystal ball” to estimate the future, accountant can use professional judgment in quantifying the future, financial impact of various alternative thus, the uncertainty of financial result of an action is reduced. Not only does accounting information play a significant role within the organization in reducing uncertainty but also it provides the financial data required by laws, either directly or indirectly.
This information tells how a company management has discharged its stewardship responsibility for the company’s resources.
Managerial accounting is very important in the analysis of the decision – making of an enterprise. The purpose of managerial accounting is to generate information that a manager ca use to make sound internal decision.
Internal management decision can be classified into four major types:
Accounting report is very essential for the achievement of all objective of the business firms. In private organization, accounting report aid in making investment decision from a list of numerous investment option. Accounting information is also needed b managers and other users of accounting reports in predicting, comparing and evaluating a business entity earning power and also needed by management to entrance their ability to use the business resources effectively in achieving the corporate goals and objective of the business for their policy.
Finally, accounting reports are essential for the effective operation of a business. In that it provides information necessary for management and other users, for rational and sound decision – making.
The data contained in financial statement represent a quantitative summary of a company’s operation and activities.
It managers, investors, and creditors are still full in suing these financial ratios they can learn much about a company’s strength, weakness, problems, operating efficiency, solvency and profitability.
Many analytical techniques are available to assist managers and other in using financial ratios and in assessing the direction and importance of trends and changes taking place in a company. The analyst must also be concerned about the comparability of data between company’s or over periods of time, about the influence of external factors, such as completive condition in the industry and general business conditions, and about the impact of inflation on financial statement.
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