THE APPLICATION OF RATIO ANALYSIS TO BUSINESS ORGANISATIONS

ABSTRACT

Financial information provided in financial statements are useful in business decisions, however, it must be noted that financial statements are means to an end in themselves.

This study examines the effectiveness of the application of Ratio analysis to business organizations and the need to understand and interprete the contents of financial statements.

Various classes of ratios were examined under literature review. This gives an insight to how ratios can be used to predict and determine organization’s performance over a period of time. Usefulness of ratio analysis was discussed and its limitations.

Summary of major findings, conclusion and recommendations was made based on the information gathered.

The reader will find this work useful in their day-to-day business activities and its effective application to their business organizations will assist them in improving on their business performances.

CHAPTER ONE

INTRODUCTION

1.1BACKGROUND OF THE STUDY

The two primary objectives of every business are profitability and solvency.  Profitability is the ability of a business to make profit, while solvency is the ability of a business to pay debts as they come due.  (Hermanson et al, 1992).  However, the achievement of these objectives requires efficient management of resources of the business through planning, budgeting, forecasting, control, and decision – making.  Also, the strengths and weakness of the business need to be identified and necessary corrective measures applied.  Interestingly, accounting provides information that facilitates these functions.

Basically, Accounting measures and communicates economic information needed for decision –making.  Thus, the American Accounting Association (in Okezie, 2002) defined Accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the information”.

The Income Statement shows the profitability or operational result of a business while the balance sheet shows the solvency or financial position of a business.

Although profits are often used as the basis for judging the performance of a business, such profits must be related to the various items of the financial statements in order to be meaningful and useful for decision making. Furthermore, owing to the summarized nature of financial statements, a lot of truths are hidden in them. Thus, they need to the analyzed and interpreted by means of financial ratios to enable the users understand the meaning of the absolute amounts shown in them, and make informed business decisions.

In this regard, Essien (2006) observed that financial statements carry lots of financial Information that are hidden in the figures. The figures in financial statements become more useful when they are related to each other or to some other relevant financial data. Therefore, users of financial information go a further step to establish relationships (or ratios) among selected data in financial statements.