RELEVANCE OF FINANCIAL RATIO ANALYSIS IN THE APPRAISAL OF SMALL SCALE BUSINESSES

Abstract

Relevance of financial ratio analysis in the appraisal of small scale business The study examined the establishing of the extent to which accounting ratio can be used to interpret accounting records of small scale business, finding and analysing the meaning of financial ratio analysis to the researcher knowledge and understanding of financial statement of the company, to establish the effect of ratio analysis on the users of financial statement and to highlight available ratios for measuring the true state of performance of company. The data were collected from both primary and secondary sources, while primary data was collected by the use of questionnaires; the secondary data were based on readings from textbooks, internet and journals. Data from the response to questionnaire was presented using the statistical tool Chi- square. From the analysis, the findings showed that non challant attitude in the use of financial statement affects small scale business; obsolete use of data affects small scale business and also that lack of competent management affect small scale business. It was however recommended that the retained earnings of the small scale business should be properly invested in order to have more capital for business

CHAPTER ONE

INTRODUCTION

• Background of the study

Financial ratio analysis assumes that there is a relationship between certain aspects of the activities of the firm as revealed in the income statements, Accounting figures reported in the financial statement do not provideProfit and loss accountand the balance sheet, which established a pattern of behaviour. The information contained in the financial statement of a company is connected with the financial wellbeing and performance of the reporting entity, organized to enable users of financial statement to draw a conclusion meaningful understanding of the performance of the financial position of a firm, except the figure are analyzed with other relevant information through the use of financial ratio analysis.
Having established the fact that a ratio is useful and reliable in measuring the relationship between two things, this then gives rise. It is about monitoring its own predetermined goals or stakeholders requirements (CIMA, 2008). Performance measurement is a very important aspect of business activities. The purpose of measuring performance is not only to know how a business is performing but also to enable that business perform better. It helps to improve the performance of an organization so that it may better serve its customers, employees, owners and stakeholders. A performance measurement system enables an enterprise to plan, measure, and control its performance according to a pre-defined strategy. Performance measurement can be financial or non-financial. Horngren, Datar and Foster (2006) note that many organizations are increasingly presenting financial and non-financial performance measures for their subunits in a single report called Balance Scorecard. Different Organizations stress different measures in their Balanced Scorecards, but the measures are always derived from a company’s strategy. They stressed that the balance scorecard measures an organization’s performance from four perspectives:- financial perspective, customer perspective, internal–business process perspective and learning and growth perspective. Hofmann (2001) notes that non-financial measures are often used for performance evaluation. They are especially relevant on the available financial performance measures not completely reflected on the manager’s contribution to the firm’s total value. He added that the non-financial performance measures serve as an indicator of the firm’s long term performance and may therefore be included in incentive contracts. Ofley (2003) argues that financial measure of performance is very crucial as it serves as a tool of financial management, a major objective of a business organization, and a mechanism for motivation and control within an organization. This study focuses on the financial performance measurement. An empirical analysis of the financial statement from the annual report of four brewing firms in Nigeria will be carried out.

The purpose of preparing the financial statements of a company is to convey information on the overall performance and the state of affairs of such an organisation to all interested parties. Besides, users of these financial statements in such a way as to reveal the financial strengths and weaknesses of such an organisation in order to form an opinion as regard her going-concern. However, ratio analysis is one of the ways through which the financial statements could be interpreted. While ratio analysis is also a method used by financial managers and investors alike to compare a company’s financial structure, conditions and performances with standards prevailing in such industry for the purpose of high-lighting improvement or deterioration in the trend of the business performance. Lucey (1988) defined ratio analysis as the systematic products of ratios from both internal and external financial reports so as to summarize key relationships and results in order to appraise financial performance. The Financial ratios are tools used to analyze financial conditions and performance. Financial analysis means different things to different people. Trade creditors are primarily interested in the liquidity of the firm being analyzed. Their claims are short term and the ability of the firm to pay these can best be judged by an analysis of its liquidity. On the other hands, the claims of bondholders are long term. They are interested in the cash flow of the firm to service debts over a long period of time. The bondholders may evaluate this by analyzing the capital structures of the firm, the major sources and users of fund, the firms profitability. Finally, an investor in a company’s common stock is concerned principally with present and expected future earning as well as the stability of these earning about a trend. As a result the investor usually concentrates on analyzing the profitability of the firm (financial ratios)
the point of view of the analyst may be either external or internal. For external, it involves suppliers of capital while that of internal, the firm needs to undertake financial analysis in order to plan and control effectively. To plan for future, the financial manager must assess the firm financial position and evaluate opportunities in relation to their effects on this position.
With internal control, the financial managers is particularly concern with return on investment in the various assets of the company and in the efficiency of asset management. Financial analysis involves the use of financial statement. These statement attempt to several things. They portray the assets and liabilities of a business firm at a moment in time usually at the end of a year. They portray an income statement which involves the revenue, expenses, taxes and profit of the firm at a particular period of time usually one year. While balance sheet represent a snapshot of the firm’s statement of assets and liabilities at a moment in time. The income statement depict its profitability over time. To evaluate a firm financial condition and performance, analysis and interpretation of various ratios should be given to experiment and skilled analyst.
The analysis of financial ratios involves two types of comparison
1. INTERNAL COMPARISON: Here the analyst can compare a present ratio with past ratio of the same company. It can also be computed for projected or perform a statement and compared with present and past ratio.
2. The second method of comparison involves comparing the ratio of one firm with those of similar firm or with industry (this type of comparisons is known as Finding the Industry average of firm). This comparison gives insight into the relatives of financial conditions and performance of the firm. But my emphasis in this research work is to limit it to the first comparison or internal business enterprises have leased to operate or collapsed as a result of increase in market uncertainties ( with unsteady interest raes exchange rate, political instability) and inability of some business managers to use financial ratio effectively and accurately in the assessment of the performance of their organization. In order to attain the traditional objectives of maximization of shareholders wealth, the managers should use or apply financial ratio in taking necessary business decision.
Many banks have gone distressed because of inability of bank managers to check their lending by using financial ratio to ensure that they do not go below their minimum liquidity levels and that of reliable and viable business are given loans and overdraft. As a result of economic hardship and inflation prevailing in the economic, it becomes very important that an effective and reliable means of evaluating the performance of companies for investment decision should be adopted any management shareholder creditors and even general public. Financial ratios analysis is one of the major techniques and in evaluating performance of business organizations.
Financial ratio exposes the position of the business in terms of performance and efficiency of operation. They show whether the management are efficient or inefficient in their utilization of resources such as capital assets, labor etc. The degree of leverage of a company is ascertained from financial ratio analysis and this will enable stockholders and other suppliers of capital known the degree of gearing in a company’s capital structures. Prospective investors can now measure their risk in the company and decide whether to invest in the company or not. Financial ratios indicate whether the value of stock of the company is increasing or falling. This provides prospective investors opportunities to decide whether to invest or not and existing stock holders whether to hold stock or dispose them Because financial ratios express areas of weakness and strength of the companies mangers used them to review operations for better performances in future. There are many financial ratios used in evaluation of a company’s performance but for purpose of this study, it will be limited to activity, leverage investment, liquidity and profitability.

• STATEMENT OF THE PROBLEM

Although financial accounting statements shows the financial positions of a business at the end of a financial period, but they do not present accurate performance on the level of performance or efficiency of operations of a business at the end of financial period. It is usually observed that the operating profit figure of a company might be higher in the current year than the previous year but his higher profit figure cannot be used to say the company has performed better in the current year than in the previous because the cost of the asset is being considered in all the beginning of that first year which may reduce the profit for that period.. If this is judge based on this, it will have adverse or negative impact on the investment or investors. Many investors in Nigeria are uneducated or illiterate and as a result of ignorance or inexperience, they cannot use or employ financial ratios in evaluating the performance of the companies. Also existing shareholders use the cash dividends and interest paid to them in evaluating the performance of the companies for investment decision. These parameters do not give accurate information about the performance and efficiency of operation of the companies. Some managers do not employ financial ratios in performance appraisal and in the evaluation of investment decision because of technicalities involved in financial ratio analysis, fear of assessment and in experience. Therefore, they make use of other alternatives inside of using financial ratios. Because of all this problems, the research work will go or examine they importance or usefulness of financial ratios in evaluating of companies performance for investment decision. Every benefits derived from financial ratio will be examined for proper investment decisions.

• OBJECTIVE OF THE STUDY

The main objective of this study is to examine the relevance of financial ration analysis in the appraisal of small scale businesses; but to aid the completion of the study, the researcher intends to achieve the following specific objective;

1. To examine the effect of financial ration on investment decision of small scale enterprise
2. To ascertain the relationship between financial ration analysis and appraisal of small scale businesses

• To examine the impact of financial ratio analysis in chatting the future course of the business

1. To examine the effectiveness of financial ratio analysis as an effective tool of business appraisal
   • RESEARCH HYPOTHESES

The following research hypotheses were formulated by the researcher to aid the completion of the study

H₀: there is no significant relationship between financial ration analysis and appraisal of small scale businesses

H₁: there is a significant relationship between financial ration analysis and appraisal of small scale businesses

H₀: financial ration does not have any significant effect on investment decision of small scale enterprise

H₂: financial ration does have a significant effect on investment decision of small scale enterprise

• SINGIFICANCE OF STUDY

This study will be very important to the following
PROSPECTIVE INVESTORS IN COMPANIES: It will enable them determine risks of investment in companies ie financial position of the companies thereby making them to invest in a company that will be profitably to them.

2. MANAGEMENT OF COMPANIES: It provided tool for assessing or evaluating the companies performance and also taking decision on where to invest.
3. GOVERNEMT: It helps the tax board to know the amount that will be taxed on companies profit.
4. EXISTING INVESTORS IN COMPANIES: after analyzing the performance of the company, it will help the existing investors to know whether to continue their investment or withdraw their interest

• SCOPE AND LIMITATION OF STUDY

The research work focuses on the relevance of financial ratio analysis in the appraisal of small scale businesses, but in the cause of the study, there are some factors that limited the scope of the study;

1. a) AVAILABILITY OF RESEARCH MATERIAL: The research material available to the researcher is insufficient, thereby limiting the study
2. b) TIME: The time frame allocated to the study does not enhance wider coverage as the researcher has to combine other academic activities and examinations with the study.
3. c) Finance: Limited Access to the required finance makes it difficult to get all the necessary and required information concerning the activities.

1.7 OPERATIONAL DEFINITION OF TERMS

ASSET: Economic resources owned by a business, which are expected to benefit future operation. It is divided into two

1. Fixed asset eg building, Equipment etc.
2. Current assets eg cash at hand, bank stock debated.
   LIABILITIES: These are debts or obligations of a business organization. The claims of creditors against the asset of a business eg. Creditors, bank overdraft.
   DIVIDEND: A distribution of cash by a company or corporation to its stockholders after allowable deduction have been made and appropriate to reserves. This benefit derived from the shareholders because of their interest in the company.

BALANCE SHEET: It is a financial statement, which shows, the financial position of a business entity of a business (balance sheet and income statement). It comprises of balance sheet, profit and loss account, note to the account, value added statement sources and application of funds.
PROFIT AND LOSS ACCOUNT: This is the record of business transaction of a company for a given period of time usually one year.
LEVEL OF LEVERAGE: This is the ratio of debt finance (i.e fixed interest borrowing) to the equity finance in a company’s capital outlay.
WORKING CAPITAL: This can be defined as the difference between the current assets and current liability i.e current asses less current liabilities.
CURRENT LIABILITIES: These are debts or claim which are payable within one year eg trade creditors overdraft.
CURRENT ASSETS: They are cash plus assets that are expected to be collected in cash or sold or consumed within the next year or as a part of the company’s normal operating cycle eg. Cash stock prepaid expenses.
RATIO ANALYSIS: This involves the companies of one figure aginst another to produce a ratio and assessing whether the financial ratios indicate weakness or strength in the company’s affairs.
HYPOTHESIS: This is proposition assumed to be true for purpose of argument. It requires testing before it can be accepted.
SECURITIES: These are financial asset of a company, which are sold do investors, which could attract returns or benefit on investment. Example are stocks, bonus etc.

LIQUIDITY: This is state of posing liquid asset such as cash and other assets that will soon be converted into cash.

COMPARATIVE FINANCIAL STATEMENT: Present the same company’s financial statements for two or more successive period in side by side column.
HORIZONTAL ANALYSIS: Analysis of a company’s financial statements for two or more successive period showing percentage and or absolute changes from previous year. The type of analysis helps detect changes in a company’s performance and highlight trend.

VERTICAL ANALYSIS: This type of analysis is the study of a single financial statement in which each item is expressed as a percentage of significant total for example of sale calculation.

NON-OPERATING ASSETS: Assets owned but used in producing revenue.
PERIODICITY: An assumption that an entity’s life can be subdivided into time periods such as months or years.

PROFITABILITY: Ability to generate income the income statement reflect a company’s profitability.

SOLVENCY: Ability to pay debts as they become due.

TRANSACTION: Record able happening or event that affect assets, liabilities stock holder’s equity revenue or expenses of an entity.

ORGANIZATION OF THE STUDY

This research work is organized in five chapters, for easy understanding, as follows. Chapter one is concern with the introduction, which consist of the (background of the study), statement of the problem, objectives of the study, research questions, research hypotheses, significance of the study, scope of the study etc. Chapter two being the review of the related literature presents the theoretical framework, conceptual framework and other areas concerning the subject matter.     Chapter three is a research methodology covers deals on the research design and methods adopted in the study. Chapter four concentrate on the data collection and analysis and presentation of finding.  Chapter five gives summary, conclusion, and recommendations made of the study.

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