CHAPTER 3

Introduction

This chapter includes what other researchers have written about financial statement

analysis, the concepts and other terms related to the researcher topic. This entails mainly the

definitions and all the necessary details about the financial ratios, and companys performance,

their analysis and interpretation. This result in the fact that the financial analysis is based on the

information contained in the financial statements and the financial analysis is all about the analysis

interpretation of this information to get clear and more meaningful understanding of the financial

position of the firm which is one of the most indicators of a companys performance.

2.1. Conceptual Framework

2.1.1. Concept of financial statement

Financial statements are most widely used and most comprehensive way of communicating

financial information about a business enterprise to uses of the information about a business

enterprise to uses of information provided on the reports. Different uses of financial statements

have different information needs. General- purpose financial statements have been developed to

meet the needs of uses of financial statements, primarily the needs of investors and creditors

(Charles, 1993).
2.1.2. The importance of financial statement

As stated by Reeves, (2011) financial decisions are typically base on information generated

from the accounting system. Financial management stockholders, potential investors and creditors

are concerned with how well the company is doing. The three reports generated by the accounting

system and include in the company annual report are the balance sheet, income statement and

statement of cash flows. Although the form of these financial statements may vary among different

business or other economic units, their basic purpose do not change.

The balance sheet portrays the financial position of the organization at particular point in

time. It shows what you own (assets) how much you owe to vendors and lenders (liabilities) and

what is left (assets minus liabilities known as equity or not worth) A balance sheet equation can

be started as: Asset-liabilities= stockholders equity. The income statement, on the other hand,

measures the operating performance for a specified period of time. If the balance sheet is a

snapshot the income statement serves as the bridge between two consecutive balance sheets.

Simply put balance sheet indicates the wealth of your company and income statement tells you

how your company did last year. The balance sheets and income statement tell different thing

about company. The fact company made a big profit last year does not necessarily mean it is liquid

(has the ability to pay current liabilities using current assets) or solvent (non current assets are

enough to meet noncurrent liabilities) (Jae, 2008).

Information from financial statements is necessary to prepare federal and state income tax

returns. Statements themselves need not be filed. Prospective buyers of a business will ask to

inspect financial statements and the financial/operational trends they reveal before they will

negotiate a sale price and commit to the purchase. In the event that claims for losses are submitted

to insurance companies, accounting records (particularly the Balance Sheet) are necessary to
substantiate the original value of fixed assets. If business disputes develop, financial statements

may be valuable to prove the nature and extent of any loss. Should litigation occur, lack of such

statements may hamper preparation of the case. Whenever an audit is required--for example by

owners or creditors--four statements must be prepared: a Balance Sheet (or Statement of Financial

Position), Reconcilement of Equity (or Statement of Stockholders Equity for corporations),

Income Statement (or Statement of Earnings), and Statement of Cash Flows. A number of states

require corporations to furnish shareholders with annual statements. Certain corporations, whose

stock is closely held, that is, owned by a small number of shareholders, are exempt. In instances

where the sale of stock or other securities must be approved by a state corporation or securities

agency, the agency usually requires financial statements. The Securities and Exchange

Commission (SEC) requires most publicly held corporations (such as those whose stock is traded

on public exchanges) to file annual and interim quarterly financial reports (Deltacpe, 2014).

2.1.3 Types of financial statements

Financial Statements represent a formal record of the financial activities of an entity. These

are written reports that quantify the financial strength, performance and liquidity of a company.

Financial Statements reflect the financial effects of business transactions and events on the entity.

The four main types of financial statements are:

2.1.3.1. Income statement

The income statement provides a financial summary of the firms operating results during

specific period. Most common are income statement covering one year period ending at specific

date, ordinary December 31st of the calendar year. In addition monthly statement is typically

prepared for used by the management, and quarterly statements must make available to the

stockholders of publicly held corporations. The recognition measurement and reporting of business
income and its components are considered by many to be the most important tasks of accountants

(Alfred, 2013).

The uses of financial statements that must make decision regarding their relationship with

the company are always concerned with a measure of its success in using the resources committed

to its operation. Has the activity been profitable? What is the trend of profitability? Is it increasing

profitability or is there a downward trend, what is the most probable result for future years? Will

the company be profitable enough to pay interest on its debt and dividends to its stockholders and

still grow at a desire rate (Shim, 2008)?

2.1.3.2. The balance sheet

The balance sheet presents a summary of the firms financial position at a given point in

time. Which are the debts of the firm; and stockholders equity, which are the owners interests in

the firm? The income statement, however, tells part of the financial story; it does not answer

question such as: what is the company doing with its income? How is the company being financed?

How in debt is the company? And how liquid are its assets? To answer these equations, an external

uses has consider the balance sheet or statement of financial position. The balance sheet is

composed of assets and Liabilities (Alfred, 2013).

2.1.3.3. Statement of cash flows

In financial accounting, a cash flow statement, also known as statement of cash flows or

funds flow statement, is a financial statement that shows how changes in balance sheet accounts

and income affect cash and cash equivalents, and breaks the analysis down to operating, investing,

and financing activities. The statement of cash flows provides a summary of the cash flows over
the period of concern, typically the year just ended. The primary purpose of the statement of cash

flows is to provide information about cash receipts and cash payments of an entity during a given

period. The statement can be prepared frequently (monthly, quarterly) and is a valuable tool that

summarizes the relationship between the Balance Sheet and the Income Statement (Gitman, 2009(

Many small business owners and managers find that the cash flow statement is perhaps the

most useful of all the financial statements for planning purposes. Cash is the life blood of a small

business if the business runs out of cash chances are good that the business is out of business.

This is because most small businesses do not have the ability to borrow money as easily as larger

business can.

According to the FASB, The information provided in the statement of cash flows, if used

with the related disclosures and information in other financial statements should help investors,

creditors and others to assess an entitys ability to generate positive future net cash flows, and to

meet its current and long term obligations, including possible future dividend payments.

Essentially, the cash flow statement is concerned with the flow of cash in and cash out of

the business. The statement captures both the current operating results and the accompanying

changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in

determining the short-term viability of a company, particularly its ability to pay bills. By

understanding the amounts and causes of changes in cash balances, the entrepreneur can

realistically budget for continued business operations and growth. For example, the Statement of

Cash Flows helps answer such questions as: Will present working capital allow the business to

acquire new equipment, or will financing be necessary? (Harrington, 1993).

2.1.4. Users of financial information

There are various parties who hold vested interest in an organization and hence require the

formation provided by financial statements to ensure the security of the interests. These parties

will also need financial statement information to facilitate decision making, monitoring of

management or to interpret contracts and agreements that include provisions based on such

information (Forza, 2000).

Forza, (2000) described the following users of financial information who are: shareholders,

managers, directors, external auditors, suppliers of long term debt and financial institution,

government, competitors, recruiter and consultants, trade unions, investors, the public, creditors,

banks.

Shareholders: Shareholders are those people who invest in the company, require information for

share trading decisions and for generally evaluating the performance of the organization. As they

are the owners of the company, they also interested in how the directors are managing it on their

behalf and the amount of dividend they will receive.

Managers: The managers are interested in the overall performance of organization. Managers are

likely to be interested in information about their own part of the organization and will find

management accounting information particularly useful. This helps managers to measure the

effectiveness of its policies and decisions, determine the the advisability of adopting new policies

and procedures and documents to owners the results of managerial efforts as it is their overall

responsibility to see that the resources of firm are used efficiently and effectively(Vieira, 2010).
Directors: As elected representatives of the shareholders, they are responsible for protecting the

share holders interests by vigilantly overseeing the companys activities This demands an

understanding and appreciation of financing investing, and operating activities both business

analysis and financial statement analysis aid directors in fulfilling their oversight responsibilities.

External auditors: The product of an audit is an expression of opinion on the fairness of the

clients financial statements. At the completion of an audit, financial statement analysis can serve

as a final check on the reasonableness of financial statement as a whole. Auditors also use credit

analysis in evaluating the ability of their client to remain a going concern (Petkov, 2012).

Suppliers of long term debt and financial institution: They can ascertain on the basis of interest

coverage ratio. Whether the company will pay interest regularly or not, and on the basis of the debt

equity ratio. They can examine the capital structure of the company to ascertain whether the

company will be able to repay their loan and the principal according to its terms and to know the

relationship between the various sources of funds (Hossan, 2010).

Government: The government needs information to estimate the effects of existing and proposed

taxation and other financial and economic measures. It also needs information to estimate

economics trends, such as the likely balance of payment figure.

Competitors: They want a scoop on profitable lines business and profit margins, so they can

perhaps come in to compete. Management wants to conceal sensitive information, but generally

err on the side of concealing information helpful to investors (Petkov, 2012).

Recruiter and consultants: They want consulting gigs to asses companies and industries hire

away the best managers and generally milk the cash cow that a long corporation.
Trade unions: They are interested in the stability and profitability of organization they are

working in. The techniques of financial statement analysis are useful to trade unions in collective

bargaining negotiations (Wild 2008).

Investors: This group is concerned with the firms earnings, they concentrate on the analysis of

the firms present and future financial structure and at which extend it influences the firms

earnings ability and risk (Vieira, 2010).

The public: The public may wish to have information about the role of the organization as an

employer, its contributions to political and charitable groups, and the impact of its activities on the

balance of trade (Wild 2008).

Creditors: Creditors will normally be suppliers who will be interested to see if the firm is meeting

its demands and in a position to pay its suppliers. Future contracts could depend on such issues.

Banks: Banks are interested in the financial information published by the firm as they will gain

insight into how capable the firm is of paying back any loans or mortgages they may have currently

with the lender(Hossan, 2010).

2.1.5. Tools of financial statement analysis

As stated by Harrington, (1993) they are three important sets of techniques or tools for

financial statement analysis:

Comparative of financial statement analysis: Individuals conduct comparative financial

statement analysis by reviewing consecutive balance sheet, income statements of cash flows period

to period. This usually involves a review of changes in individual account balances on year to-

year or multi year basis. The most important information often revealed comparative financial
statement analysis is trend. A comparison of statement over several periods can reveal the

direction, speed, and extent of a trend. Comparative analysis also compares trends in related items.

Comparative financial statement analysis also is referred to as horizontal analysis given the left-

right or right analysis of account balances as review comparative statements (Houston, 2009).

Common size financial statement analysis: The figures reported in financial statement

under this kind of analysis are converted into percentages to some common base specifically, in

analyzing a balance sheet; it is common to express total assets (or liabilities plus equity) as 100

percent. Then accounts within these groupings are expressed as a percentage of their respective

total. In analyzing an income statement, sales are often set at 100 percent with the remaining

income statement accounts expressed as a percentage of sales. Since the sum of individual accounts

within groups is 100 percent, this analysis is said to yield common-size financial statements. This

procedure also is called given the up-down (or down-up) evaluation of accounts in common size

statement is useful in understanding the internal makeup of financial statement (Kalem, 2012).

Temporal comparisons of a companys common-size statement are useful in revealing any

proportionate changes in accounts within groups of assets, liabilities, expenses, and others

categories. Common-size statements are especially useful for intercompany comparison because

financial statements of different companies are recast in common size format. Comparison of a

companys common size statements with those of competitors, or with industry averages, can

highlight differences in account make up and distribution (Own, 2012).

Financial ratio analysis: Financial ratio analysis has been used to assess company

performance for almost as long as modern share markets have been around. The methods are based

on tried-and-true accounting ratios which have been around for even longer. The theory of
financial analysis was first popularized by BINJAMIN GRAHAM who is considered by many to

be father of fundamental analysis. BINJAMIN GRAHAM, who from 1928 was a professor at

Colombia business school as well as a very successful investor in his own right, was mentor and

teacher to warren Buffett (Tavakkoli, 2010).

Ratios are most widely used tools of financial analysis, due to they provide clues to and

symptoms of underlying conditions. Like other analysis tools, ratios are usually future oriented,

and it helps accountant analysts to uncover conditions and trends difficult to detect by inspecting

individual components making up the ratio. Besides, a ratio expresses a mathematical relation

between two quantities. It can be expressed as a percent, rate as well as proportion. Moreover,

usefulness of a ratio analysis fully depends on a users skillful interpretation. The ratio analysis

can be used to evaluate three fundament qualities of a company: liquidity, solvency and

profitability. (Wild 2008

2.1.6 Financial Ratio Classification

Financial ratio can be grouped into four types (liquidity, efficiency, Investment, and

profitability). No one ratio gives us sufficient information by which to judge the financial condition

and performance of the firm. Only when we analyze a group of ratios are we able to make

reasonable judgments.

2.1.6.1 Liquidity ratio

Liquidity ratios measure your company ability to cover its expenses. The two most

common liquidity ratios are the current ratio and quick ratio. Both are based on balance sheet

(Foster, 2009).
Current ratio: According to Handan, (2009) the current ratio measures a companys ability to

repay short-term liabilities such as accounts payable and current debt using short-term assets such

as cash, inventory and receivables. Another way to look at it would be the value of a companys

current assets that will be converted to cash over to the next twelve months compared to the value

of liabilities that will mature over the same period. The current ratio is useful as it shows whether

a company has adequate resources to repay short-term debt or if it will experience cash flow

problems in the near term.

Current ratio=

Generally a current ratio of two times or 2:1 is considered to be satisfaction. The current ratio gives

the margin by which the value of the current assets may go down without creating any payment

problem for the firm. This represents a margin of safety for liabilities. A lower current ratio means

that company may not be able to pay its bills on time, while a higher ratio means that company has

money in cash or safe investment that could be put to better use in the business.

Quick ratio or acid-test: The quick ratio, also known as the acid test-ratio, is a conservative

variation of the current ratio, the quick ratio measures a companys immediate debt-paying ability

only cash, receivable, and current marketable securities (Quick assets) are included in the

numerator. Less liquid current assets, such as inventories and prepaid expenses, are omitted.

Inventories may take several months to sell, prepaid expenses reduce otherwise necessary

expenditures but do not lead eventually to cash receipts (Lionel, 1987).

The quick ratio is computed as follows:

Quick ratio=
Cash ratio: Since cash is the most liquid asset, a financial analyst may examine the cash ratio and

its equivalent to current liabilities. Trade investment or marketable securities are equivalent to cash

and may therefore included in computation of cash ratio. (Harrington, 1993).

+
. Cash ratio=

2.1.6.2 Asset management ratios

According to Jennings, (2001) activity ratios are also called turnover ratios. Activity ratios

are employed to evaluated the efficiency with which the firm managers and utilizes its assets. They

indicate the efficiency or speed with which the capital employed is being converted or turnover

into sales. Activity ratios, thus, involve a relationship between sales and assets. A proper

relationship between sales and assets generally reflects that assets are managed well. Several

activity ratios can be calculated to judge the effectiveness of assets utilization. Higher the rate of

turnover ratio indicates the greater profitability and better use of capital.

Inventory turnover ratio: The inventory turnover ratio, is a test of efficient inventory,

management, and indicates the speed with which the stock is being sold.

Inventory turnover ratio=

This higher inventory turnover ratio, the better it is, that is, quick movement of stock and lower

ratio indicated slow movement of stock, which means locking up of working capital. The concept

of inventory turnover ratio can be extended to find out the number of days of inventory holding

(Jennings, 2001).

IHP=365/Inventory turnover ratio

Receivable turnover ratio: The receivable turnover ratio attempts to throw light on the collection

and credit policies of the firm. The receivable turnover ratio reveals the velocity of receivables. It

also indicates as to how good the debtors are. It is calculated as follows

Receivable turnover ratio=

The higher the ratio indicates that debtors are good and debt collected is working efficiently.

Evaluation of receivable turnover ratio can be made better and meaningful in term of average

collection period, which is calculated as follows:

365
Average collection period=

It indicates how quickly and efficiently the debts are collected. The shorter the period, the better it

is and longer the period, the chance of bad debts (Maheshwari, 2009).

Payable turnover ratio: It shows the velocity of debt payment by the firm. It is calculated as

follows:

Payable turnover ratio:

This can be supplemented by the average payment period

365
The average payment period:

This can be meaningfully evaluated by comparing it with the credit period allowed by the supplies.

To the extent possible, a firm should try to maintain the APP, Which is approximately equal to the

credit terms of the supplier. It improves goodwill and credit worthiness of the firm in the market

(carcello, 2008).
2.1.6.3 Solvency ratios

Leverage ratios, also referred to as gearing ratios, measure the extent to which a company

utilizes debt to finance growth. Leverage ratios can provide an indication of a companys long-

term solvency. Whilst most financial experts will acknowledge that debt is a cheaper form of

financing than equity debt carries risks and investors need to be aware of the extent of this risk.

Leverage ratios may be calculated from the balance sheet items to determine the proportion of debt

in total financial. They are also computed from the profit and loss account items by determining

the extent to which operating profits are sufficient to cover the fixed charges (Joel, 2009).

Debt to Equity ratio: The debt to equity ratio provides an indication of companys capital

structure and whether the company is more reliant a borrowing (debts) or shareholders capital

(equity) to fund assets and activities. Contrary to what many believes, debt is not necessarily a bad

thing. Debt can be positive, provided it is used for productive purposes such as purchasing assets

and improving process to increase not profit. Acceptable debt to equity ratios may also vary across

industries. Generally, companies that are capital intensive tend to have higher ratios because of the

requirement to invest more heavily in fixed assets (Schall, 1986).

Debt to total equity Ratio = Total liabilities / Total equity *100

Debt to total assets ratio measures the percentage of a companys assets that are financed by debt.

It is computed by dividing total liabilities by the total assets. (Edmonds et al. 2006)

Debt to total assets ratio = Total debts/ Total assets *100

2.1.6.4 Profitability ratios

Profitability ratios measure a company performance and provide an indication of its ability

to generate profit. As profits are used to fund business development and pay dividends to

shareholders a companys profitability and how efficient it is at generating profits is an important

consideration for shareholders (Kimmel, 2002).

Gross profit margin: Gross profit margin tells us what percentage of a companys sales revenue

would remain after deducting the cost of goods sold. This is important as it helps to determine

whether the company would still have enough funds to cover operating expenses such as employee

benefits, lease payments, advertising and so forth. A companys gross profit margin may also be

viewed as a measurement of production efficiency. A company with a gross profit margin higher

than that of its competitors or industry average is deemed to be more efficient and is therefore all

things being equal preferred (Schall, 1986)

Gross profit margin= 100

Net profit margin : Net profit margin meanwhile indicates what percentage of a companys sales

revenue would remain after all costs have been taken into account. This is best compared with

other companies in the same industry and analyzed overtime. Considering that variations from

year to year may be due to abnormal condition to explain this further, a declining net profit margin

ratio may indicate a margin squeeze possibly due to increased competition or rising costs (Keiso,

2002).

Net profit Margin= 100

Return on assets: Return on assets, commonly referred to as ROA.Is a measurement of

management performance. ROA tells the investor how well a company uses its assets to generate

income. A higher ROA denotes a higher level of management performance. Arising ROA, for

instance may initially appear good, but turn out to be unimpressive of the companies in its industry

have been posting higher returns and greater improvements in ROA. The ROA ratio may thus be

more useful when compared to the risk free rate of return. Technically, a company should produce

on ROA higher than the risk free rate of return to be rewarded for the additional risk involved in

operating the business. If a companys ROA is equal or even less than free rate, investors should

think twice as they would be better off just purchasing a bond with guaranteed yield (Harrington,

1993).

Return on assets= 100

Return on equity (ROE): Return on equity, commonly referred as ROE. Is another measurement

of management performance.ROE tells the investor how well a company has used the capital from

its shareholders to generate profits. Similar to the ROA ratio; a higher ROE donates a higher level

of management performance (Foster, 2009).

Return on equity = Net income / Common stockholders equity*100

2.1.7 Advantages and disadvantage of ratio analysis

2.1.7.1 Advantage of ratio analysis

Simplifies financial statements: ratio analysis provides data for inter-firm comprehension

of financial statements. Ratio tells the whole story of changes in financial condition of the business.

Facilitates inter-firm comparison: ratio analysis provides data for inter-firm comparison. Ratios
highlight the factors associated with successful firms. They also reveal strong firms and weak

firms, over valued firms. Makes intra-firm comparison possible: ratio analysis also makes

possible comparison of the performance of different division of the firm. The ratio is helpful in

deciding about their efficiency or otherwise in the past and likely performance in the future helps

in planning: Ratio analysis helps in planning and forecasting. Over a period of time a firm or

industry develops certain norms that may indicate future success or failure. If relationship changes

in firms data over different period may provide clues on trends and future problems. Thus ratios

can assist management in its functions of forecasting, planning, coordinating, controlling and

communicating (Joseph, 2008).

2.1.7.2 Disadvantage of ratio analysis

While ratio analysis is obviously a very useful technique for evaluating performance, it is

subject to certain limitations that need to be considered when applying it.

Comparative study required: Ratios are useful in judging the efficiency of the business only

when they are compared with the past result of the business or with the result of similar business.

However, such a comparison only provides a glimpse of the past performance and forecasts for

the future may not be correct since several other factors like market conditions, management

policies

May affect future operations:

Limitation of financial statements: Ratios are used only on the information which has been

recorded in the financial statements. Because financial statement suffer from a number of

limitations, the ratios derived there from, are therefore also subject to those limitations.
Inadequacy of ratios: Ratios are only indicators and hence they cannot be taken as final word

regarding good or bad financial position of the business. Otherwise variable also have to be

considered. For example a high current ratio does not necessarily mean that company has a good

liquid position in case current assets mostly comprise outdated stocks (Eugene, 2009).

Window dressing: The presence of particular ratio may not be a definite indicator of good or bad

management. For example, a high stock turnover ratio is generally considered to be indication of

operational efficiency of the business. But this might have been achieved by unwarranted price

reductions or failure to maintain proper stock of goods. Similarly the current ratio may be improved

just before the balance sheet date by postponing replenishment of inventory (Carcello, 2008).

Problems of price lever changes: Financial analysis based on accounting ratios will give

misleading results if the effects of changes in price levels are not taken into account. For instance,

two companies set up in different years, having plant and machinery of different ages, cannot be

compared, on the basis of traditional accounting statements. This is because the depreciation

charges on plant and machinery in case of the old company would be as much lower figures as

compared to the company that has been set up recently (Mark, 2008).

No foxed standards: No fixed standards can be laid down for ideal ratios. For example, current

ratio is generally considered to be ideal if current assets are twice the current liabilities. However,

in case of those entities which have adequate arrangements with their bankers for providing funds

when required, it may be perfectly ideal if current assets are equal to slightly more than current

liabilities (Suzanne, 2008).

Historical cost: As financial statements are normally prepared on historical costs basis, unadjusted

for inflation, the accounting amount are removed from economic value. This will be reflected by
the understatement of fixed assets and possibly inventory, while the value of long term debt will

decline in real terms. This results in equity being understated. These factors make ratio

comparisons overtime, for a given period less reliable than would be the case in the absence of

inflation. The above limitation does not negate the usefulness of ratio analysis but is important to

note that analysts should be aware of them and make necessary adjustments. It may therefore be

concluded that ratio analysis, if done mechanically, is not only misleading but also dangerous as

the effectiveness of the exercise depends upon the interpretation of the ratios and hence the skills

of the analyst. If an analyst appliers ratio analysis perceptively, ratios will provide useful insight

into a firms operations (Eugene, 2009).

2.1.8 Business Performance

Business performance is a multidimensional concept. There are various indicators that can

be used to assess the performance of enterprises. BPM is the abbreviation

for business performance management. It is a business management approach that entails aspects

of reviewing the overall business performance and determining how the business can better reach

its goals. These activities are aided by software tools, called BPM tools. BPM is often thought of

as a business strategy that enables businesses to efficiently collect, aggregate and analyze data

from various sources in order to take the most appropriate business action (Balon, 2010).

It enables businesses to: Improve productivity, Monitor and analyze business processes,

Automate tasks, Increase efficiency, Increase effectiveness, Financial viability, Identify cost

savings opportunities, Generate new business, Measure key performance objectives, Analyze

risks, Predict business outcomes. Business performance management requires the alignment of

strategic and operational objectives to the business activities in order to manage performance. By
collecting and analyzing data, business managers are more informed about the company's position

and can make better decisions as a result (Harder, 2010).

2.2. Theoretical Study

2.2.1. Financial statement analysis

Foster, (1986) defined financial analysis as the process of identifying the financial strengths

and weaknesses of the firm by properly establishing relationship relationships between the items

of the balance sheet and profit and loss account. He father puts it that, financial analysis can be

undertaken by the management of the firm or by parties outside the firm, viz owners, creditors,

and investors. However the nature of the analysis will differ depending on the purpose of the

analyst.

Keown, (1979) defined financial analysis as one that involves the assessment of the firms

past, present and future financial condition. The objective is to identify any weaknesses in the

firms financial health that could lead to the future problems and determine the strength that firm

might capitalize upon. For example internally financial analysis might be aimed at assessing the

firms liquidity or measuring its past performance. Alternatively, from the outside, the firm might

be aiming to determine the firms credit worthiness or credit potential. However, regardless of the

origins of the analysis, the tools basically the same

Lawrence, (1992), asset that financial analysis and planning is concerned with transforming

financial data into a form that can be used to monitor the firms financial condition. These

functions encompass the entire balance sheet as well as the firms income statement and underlying

objective is to assess the firms historical as well as future cash flow.

2.3.3. Usefulness of financial ratios

Financial ratios are used to determine a companys strengths and weaknesses. A

fundamental definition of any profit-seeking business is an entity that acquires resources in order

to generate profits through the production and sale of goods and/or services. Ratios show important

relationships between a firms resources and its financial flows. In a way, ratio analysis provides

a report card. If the firms managers are doing a good job, they know it. If they are not doing a

good job, not only will they know it, but they will also have a clear understanding of what they

can do about it (Burson, 1998).

A financial ratio is a number that expresses the value of one financial variable relative to

another. It is the numeric result gained by dividing one financial number by another. Calculated

this way, financial ratio allows an analyst to assess not only the absolute value of a relationship

but also to quantify the degree of change within the relationship (Lawder, 1989).

Financial ratios are said as the most widely used indicators of company. It play a role to

value firms, to distinguish creditworthy companies compare to others, to identify acquisition

targets and to indicate the process of organizational in completing or the time needed to complete

a task (Al-Ajmi, 2008).

The financial analysis model known as a quite helpful tool for executives to measure or

predict enterprise bankruptcy or enterprise failure provides concerned decision-makers

(authorities) with the possibility or hoping to avoid failures. Also it becomes an early warning

system to the corporate management (Karacaer & Kapusuzolu, 2008).

 Financial ratios can be used as financial indicators which allow for comparisons between

companies, between industries, between different time periods for one company, between a single

company and its industry average. Apart from that, financial ratios generally hold no meaning

unless they are benchmarked against something else, like past performance or another company

and industries. The reason behind that is the ratios of firms in different industries, which face

different risks, capital requirements, and competition are usually hard to compare if we have no

other things to compare (Marshall, 2002).

A study using financial ratios in the 1930s and several later studies were concerned with

business failure (Altman, 1971). It was ascertained that failing firms exhibited significantly

different ratio measurements than businesses which were successful. Historical accounts

specifically cite the use of ratios in predicting bankruptcy. Overall, the ratios which measure

profitability, liquidity, and solvency have prevailed as the most useful indicators for business.

According to Ketz, Doogar and Jensen (1990), financial ratio analysis is frequently used:

(a) to compare a present ratio with past and expected future ratios for the same company or firm,

and (b) to compare one firm with those of similar firms or with industry averages at some point in

time.

2.2.4. Steps to effectively financial ratios

As stated by Darrel, (2011) the basics of financial analysis usually mean calculating

different financial ratios and then coming to conclusions and clarification regarding on how the

company is financially performing in business activities. There are certain things that must be

considered before too many conclusions are drawn such as:

 Firstly, understand what comprise different financial ratios before start analyzing

companys data. Must take into consideration all financial ratios numbers derived from financial

statement comprise of balance sheet and income statement. Balance sheets represent a reflection

for a particular point in time. Income statements represent a cumulative time summary of

performance. For example, year-end financial statements should include a balance sheet that

presents how various company accounts look on that particular day at the end of the year, whereas

the income statement shows how companys performance over the period (Osteryoung &

Constand ,1992).

Second is evaluating external influencing factors. As with all companies, the financial

statements can be influenced by various factors like management or owner decisions and

discretionary spending, seasonal effects, legal structure choice, type of industry, customer mix, or

a number of other issues. These factors can influence the financial statements and will, in turn,

influence the financial ratios analysis (Seaton, 1995).

Third is look at internal trends. Always keep in mind is that one ratio alone tells one very

little. A clear picture starts developing when one looks at ratios over different time increments. By

comparing financial results against prior performance one gets a better idea of what is occurring

within the company. Trends will start to develop and can give insight into areas that may need

corrective attention or to areas that may need to be reinforced. Internal trend analysis is most likely

most beneficial because one is comparing similar business situations over various periods of time

(Divine, 1995).
 Fourth is compare results to the industry. Comparing your business performance to other

similar businesses is a common way to judge how well the business is doing. Even though this is

very common, there are limitations to doing so. First realize these comparative ratios represent an

average. Averages are simply that and most likely your business will vary somewhat. Next be sure

you are comparing your business to other businesses similar in asset size and sales volume. In

some cases there may be no suitable comparisons. Knowing what is the average for your industry

is important. The averages can serve as a general benchmark for your business. Additionally, these

averages are often times used to compare your business performance when you are seeking capital

from outside sources such as a bank. Being different may not be a deal killer, but not being able to

explain why you are different may indeed be a deal killer (Edmister, 1972).

2.2.5. Business performance management

The process of business performance management (BPM) focuses on three activities.

These activities include the selection of business goals, consolidating measurable information

relevant to those goals, and the participation of management to assist in improving future

performance. This process involves the gathering of large amounts of data. Commonly most

organizations have difficulties taking the collected data and transforming it into useful information.

Also many companies are trying to gather information from different sectors of their organization

such as finance, inventory, forecasting, and human resources eliminating the need to use

spreadsheet analysis (Cindy, 2010).

As stated by Vince, (2003) BPM systems capture and disseminate strategic information

that matters most to the firm in the form of strategic process and outcome measurement, and most
to the individuals within the firm in the form of performance measurement, incentives and

motivation. Because of this, BPM systems are a primary means of knowing (coordinating what a

firm knows and learns) and doing (how it alters what it does). Over time, they may perhaps

become the single most strategic information system resource in the firm.

Kerssens, Drongelen & Fisscher, (2003) they observed that the Performance measurement

and reporting takes place at 2 levels: (1) company as a whole, reporting to external stakeholders,

(2) within the company, between managers and their subordinates. At both levels there are 3 types

of actors: (a) evaluators (e.g. managers, external stakeholders), (b) evaluatee (e.g. middle

managers, company), (c) assessor, which is the person or institution assessing the effectiveness

and efficiency of performance measurement and reporting process and its outputs (e.g. controllers,

external accountant audits).

As stated by Neely, (1998) a performance measurement system enables informed decisions

to be made and actions to be taken because it quantifies the efficiency and effectiveness of past

actions through the acquisition, collation, sorting, analysis, interpretation, and dissemination of

appropriate data. Organizations measure their performance in order to check their position (as a

means to establish position, compare position or benchmarking, monitor progress), communicate

their position (as a means to communicate performance internally and with the regulator), confirm

priorities (as a means to manage performance, cost and control, focus investment and actions), and

compel progress (as a means of motivation and rewards).

2.3 Empirical Study

The study of Abdallah, (2008) aimed to identify whether the Jordanian industrial

companies applied the modern management accounting and to identify the most important benefits

the companies get from these methods. The results of the study showed that the most important

benefits of applying these methods is providing the administrations with the appropriate

information in appropriate time, improving the products quality and reducing the costs.

As observed by Lionel, (1987) in his paper entitled: The Farmer's Cooperative Yardstick:

Financial Ratios Useful to Agricultural Cooperatives, he found that Sound financial planning and

management are two key elements to the successful operation of cooperatives. Sound financing

relates to the need for both equity and borrowed capital for operations and growth. It also involves

the analysis of financial data to develop financial controls. Cooperative management should find

financial ratios to be an important tool in performing this management function.

As stated by Karacaer and Kapusuzolu, (2008) in their paper entitled: An Analysis of the

Effect of Financial Ratios on Financial Situation of Turkish Enterprises, they found that the most

highest ratios contribution in the analysis regarding them variables whose effect the financial

condition of the sample enterprise are ROE, debt ratio, net working capital, acid test ratio, net

profit ratio, cash ratio, and current ratio respectively. Among of them, the liquidity ratios are the

main element in these ratios. It is observed that all the variables have differing but significant

effects on the corporate financial situation.

Thachappilly (2009), in this articles he discuss about the Financial Ratio Analysis for

Performance evaluation. It analysis is typically done to make sense of the massive amount of
numbers presented in company financial statements. It helps evaluate the performance of a

company, so that investors can decide whether to invest in that company. Here we are looking at

the different ratio categories in separate articles on different aspects of performance such as

profitability ratios, liquidity ratios, debt ratios, performance ratios, investment evaluation ratios.

Clausen (2009), He state that the Profitability Ratio Analysis of Income Statement and

Balance Sheet Ratio analysis of the income statement and balance sheet are used to measure

company profit performance. He said the learn ratio analyses of the income statement and balance

sheet. The income statement and balance sheet are two important reports that show the profit and

net worth of the company. It analyses shows how the well the company is doing in terms of profits

compared to sales. He also shows how well the assets are performing in terms of generating

revenue. He defines the income statement shows the net profit of the company by subtracting

expenses from gross profit (sales cost of goods sold). Furthermore, the balance sheet lists the

value of the assets, as well as liabilities. In simple terms, the main function of the balance sheet is

to show the companys net worth by subtracting liabilities from assets. He said that the balance

sheet does not report profits, theres an important relationship between assets and profit. The

business owner normally has a lot of investment in the companys assets.

White (2008), He refer that the accounts receivable is an important analytical tool for

measuring the efficiency of receivables operations is the accounts receivable turnover ratio. Many

companies sell goods or services on account. This means that a customer purchases goods or

services from a company but does not pay for them at the time of purchase. Payment is usually
due within a short period of time, ranging from a few days to a year. These transactions appear on

the balance sheet as accounts receivable.

Jenkins (2009), Understanding the use of various financial ratios and techniques can help

in gaining a more complete picture of a company's financial outlook. He thinks the most important

thing is fixed cost and variable cost. Fixed costs are those costs that are always present, regardless

of how much or how little is sold. Some examples of fixed costs include rent, insurance and

salaries. Variable costs are the costs that increase or decrease in ratios proportion to sales.

As mentioned by Salmi, Timo, Dahlstedt, Martti & Laakkonen (1988), financial ratios are

commonly used for comparison of financial position intra-industry. Also, in financial statement

analysis a firm's performance and financial status are frequently evaluated in relation to other firms

in the same branch of industry or in relation to industry averages.

Jagetia has given an article in the journal Management Accountant March, 1996 on the

subject, Ratio Analysis in Evaluation of Financial Health of a Company:. The main objective of

this article was that the ratio analysis is often under-rated but extremely helpful in providing

valuable insight into a companys financial picture. He observed that the ratios normally pinpoint

business strengths and weakness in two ways-Ratios provide an easy way to compare todays

performance with the past. Ratios depict the areas in which a particular business is competitively

advantageous or disadvantageous through comparing ratios to those of other business of the same

size within the same industry. He concluded that the ratio analysis should not be viewed as an end
but should be viewed as a starting point. Ratios by themselves do not answer the questions. One

must look at other sources of data in order to make a judgment about the future of the company.

Forza & Salvador, (2000), in the International Journal of Operations & Production

Management, Vol. 20, No. 3, pp. 359-385 entitled: Assessing Some Distinctive Dimensions of

Performance Feedback Information in High Performing Plants, they concluded that a performance

measurement system is an information system that supports managers in the performance

management process mainly fulfilling two primary functions: the first one consists in enabling and

structuring communication between all the organizational units (individuals, teams, processes,

functions, etc.) involved in the process of target setting. The second one is that of collecting,

processing and delivering information on the performance of people, activities, processes,

products, business units,

Ittner, Larcker & Randall , (2003),in their paper entitled: Strategic performance of a firm,

they observed that a strategic performance measurement system: (1) provides information that

allows the firm to identify the strategies offering the highest potential for achieving the firms

objectives, and (2) aligns management processes, such as target setting, decision-making, and

performance evaluation, with the achievement of the chosen strategic objectives.

Maisel, (2001).In his book entitled: Performance Measurement Practices Survey Results,

he concluded that a BPM system enables an enterprise to plan, measure, and control its

performance and helps ensure that sales and marketing initiatives, operating practices, information
technology resources, business decision, and peoples activities are aligned with business

strategies to achieve desired business results and create shareholder value.