AN EVALUATION OF RATIO ANALYSIS PRACTICES IN SMALL AND MEDIUM SIZED ENTERPRISES IN BUEA

CHAPTER ONE

INTRODUCTION

1.1.      Background 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: 824). However, the achievement of these objectives requires efficient management of resources of the business through proper 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 communicates economic and financial information needed for decision–making. Thus, the American Accounting Association defined accounting as “the process of identifying, measuring and communicating economic information to permit informed judgments and decisions by the information” in Okezie (2002:1).  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 truth is hidden in them. Thus, the need to be 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 (2006:144) 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 step further to establish relationships (or ratios) among selected data in financial statements”.

According toIgben (1999:423), an “Accounting (or financial) ratio is a proportion or fraction or percentage expressing the relationship between one item in a given financial statement and another item in the same financial statement. Accounting ratios are the most powerful of all tools used in analyzing and interpreting financial statements”. Therefore, ratio analysis involves taking statistics or numbers (or items) out of financial statements and forming ratios with them, to enhance informed judgments and decisions (Lasher, 1997:66).

In recent years the advancement in information system modules and technology all over the world has made business organizations to exert resources in this area in order for them to compete favourably among their local and foreign competitors. Gone were the days when business organizations were simply required to make profit, survive and provide a fair return to investors’ or their interest.

The modern business organization finds itself in the atmosphere of global uncertainties, cut throat competition locally or internationally, and unprecedented change in the economy. Hence, a great demand is often placed on the managers of these organizations to make pragmatic and informed decisions if the organisation is to move forward or succeed. Every organization is often a function of the sum of the decisions taken in the past. However, the quality of decisions taken by managers rests upon the substance and accuracy of information provided by systems available to them.

An accounting system is one of the most effective decision making tools of management as it provides an orderly method of gathering and organizing information about the various business transactions so that it may be used as an aid to management in operating the business (Copeland and Dascher, 1978). Accounting information also may help managers understand their tasks more clearly and reduce uncertainty before making their decisions (Chong, 1996).

Thus, Accounting Information System is vital to all organizations and perhaps every organization be it profit or non-profit oriented. No organization is exempted from decision making in their operations, which means all organisations need to maintain an Accounting Information System to be functional and successful.

Accounting systems, in recent times, tend to be a system of information that does not stop at limits of data and financial information, but also includes other descriptive and quantitative information which is useful in decision-making by users with distinct plurality and diversity. Such users include current and potential investors, lenders, suppliers, creditors, customers, governments and the public in general. In addition to the administration which has the responsibility to prepare the accounting programs and displaying it, that information must be capable of achieving the goal that it has been prepared for.

Hence the role of Accounting Information System for effective decision making cannot be over emphasized. It is noteworthy to say here that Accounting Information System derives its source from accounting data. Accounting Information Systems produce results which enhances decision making. Hence, it can safely be concluded that Accounting Information System is not an end in itself but a means to an end, which is decision-making to improve corporate performance.  Accounting Information System produces detailed and comprehensible accounting information which are invaluable basis for decision making.

McShane et al. (2000:336) defined decision-making as “a conscious process of making choices among one or more alternatives with the intention of moving toward some desired state of affairs.” Therefore, business decisions can be defined as choices relating to the allocation and/or use of business resources to achieve business goals.

Decision-making calls for information. Bittel et al. (1984:340) observed that “Managers want information because they need to make decisions. The proper use of information is an important part of decision-making.” Remarkably, one of the effective ways of providing information needed for business growth and development is ratio analysis.

Business decisions like to make or buy investment or divestment, expansion or contraction, capital-organization or reconstruction amongst others cannot be properly made without the aid of financial ratios. They give clue to the financial strengths and weaknesses of a business, and highlight aspects of a business requiring further investigation. In this research I will focus on Profitability ratio, Liquidity ratio, Leverage ratio and activity ratio.

The Accounting Standards Board recommends that listed companies include an operating and financial review that provides ‘a framework for the directors to discuss and analyse the business’s performance and the factors underlying its results and financial position, in order to assist users to assess for themselves the future potential of the business’ (Blake, 1997). The following accounting information found on the Profit and Loss account, Balance Sheet and Cash Flow statement can be studied using ratios.

Ratios are typically two numbers, with one being expressed as a percentage of the other. Ratio analysis can be used to help interpret yearly trends in performance and by benchmarking to industry averages or to the performance of individual competitors. Ratio analysis can be used to interpret performance against five criteria: the rate of profitability; liquidity, i.e. cash flow; gearing, i.e. the proportion of borrowings to shareholders’ investment; how efficiently assets are utilized; and the returns to shareholders.

This research is therefore carried out to show how ratio analysis helps managers, shareholders, investors, creditors, and other stakeholders to make informed judgments and decisions about the past performance, present condition, and future potential of a business.

1.2.      Statement of the Problem and Justification of Study