THE ROLE OF ACCOUNTING RATIO ANALYSIS IN MEASURING FINANCIAL PERFORMANCE OF A FIRM AND AIDING INVESTMENT

CHAPTER ONE

1.1 Background to The Study

The financial statement of the firm at the end of the annual year provides a more significant tool of analyzing information to facilitate in making useful business and investment decision. This can be achieved through the use of accounting ratio analysis. Accounting ratios facilitates the determination of the efficiency and profitability of a firm which is fundamental for investment decisions based on the firm’s financial reports. Accounting ratio facilitate the comparison of two aspects of a financial statement. Some example of accounting   ratios include the dividend ratio, gross margin ratio, debt-to-equity ratio, and operating margin ratio. The relevance of this ratio for investment decisions depends on the currency of the data in the financial statement. The statement used for accounting ratio analysis is the annual financial report of a firm which consists of   three financial statements: the balance sheet, income statement and cash flow statement. The analysis conducted in each of this statement provides the vital information required regarding the financial performance of the firm for making sound investment decisions. Analysts therefor depend on the use of   the financial statements to provide the data needed to update accounting ratios. According to Igben (1999:423), “Accounting {or financial} ratio consist of the fraction, proportion or percentage which compare the relationship between one variable item in a set financial statements with another item in the financial statements. Consequently, Accounting ratios are vital for the analysis and interpretation of financial statements”.
The research therefore seeks to investigate the role of accounting ratio analysis in measuring financial performance of a firm and aiding investment

2Gross Margin and Operating Margin

3The income statement contains information about company sales, expenses and net income. It also provides an overview of earnings per share and the number of shares outstanding used to calculate it. These are some of the most popular data points for analysts to use when computing accounting ratios dealing with profitability. For example, gross profit as a percent of sales is an accounting ratio referred to as gross margin. It is calculated by dividing gross profit by sales. For example, if gross profit is $80,000 and sales are $100,000, the gross profit margin is 80%. Operating profit as a percentage of sales is referred to as operating profit margin. It is calculated by dividing operating profit by sales. For example, if operating profit is $60,000 and sales are $100,000, the operating profit margin is 60%. Both accounting ratios provide information about company profitability.

4Debt-to-Equity Ratio

5The balance sheet is a snapshot in time and provides accountants with data for calculating credit and debt ratios. The most popular debt ratio is debt-to-equity. It is calculated by dividing debt by equity. For example, if a company has debt equal to $100,000 and equity equal to $50,000, the debt-to-equity ratio is 2 to 1.

6Payout Ratio

7The cash flow statement provides data for ratios dealing with cash. For example, the payout ratio is the percentage of net income paid out to investors. Both dividends and share repurchases are considered outlays of cash and can be found on the cash flow statement. For example, if dividends are $100,000, share repurchases are $100,000, and income is $400,000, the payout ratio is calculated by dividing $200,000 by $400,000, which is 50%.

1.2 Statement of the Problem

The need to determine the financial performance of the firm is crucial for making informed decisions concerning the further deployment of resources and investment decisions. This can only be done through accounting ratio analysis. Eventually this is not often an easy task to undertake as many investors and business owners lack the understanding and skill to perform accounting ratio analysis. Accounting ratios facilitates the determination of the efficiency and profitability of a firm which is fundamental for investment decisions based on the firm’s financial reports. Accounting ratio facilitate the comparison of two aspects of a financial statement. Some example of accounting   ratios include the dividend ratio, gross margin ratio, debt-to-equity ratio, and operating margin ratio. The relevance of this ratio for investment decisions depends on the currency of the data in the financial statement. The statement used for accounting ratio analysis is the annual financial report of a firm which consists of   three financial statements: the balance sheet, income statement and cash flow statement. The analysis conducted in each of this statement provides the vital information required regarding the financial performance of the firm for making sound investment decisions. Analysts therefor depend on the use of   the financial statements to provide the data needed to update accounting ratios. According to Igben (1999:423), “Accounting {or financial} ratio consist of the fraction, proportion or percentage which compare the relationship between one variable item in a set financial statements with another item in the financial statements. Consequently, Accounting ratios are vital for the analysis and interpretation of financial statements”.
Therefore, the problem confronting the research is the role of accounting ratio analysis in measuring financial performance of a firm and aiding investment

1.3 Objectives of the Study

1.     To determine the role of accounting ratio analysis in measuring financial performance of a firm and aiding investment.

2.     To examine the relevance of accounting ratio analysis in the determination of financial performance of a firm and investment decision.