FINANCIAL RATIOS AS A TOOL OF EVALUATING THE PERFORMANCE OF A COMPANY FOR INVESTMENT DECISION

CHAPTER ONE

INTRODUCTION

1.1 Background of study

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.