Analysis Of Financial Ratios As An Aid To Economic Analysis



Managers in analyzing a business situation and planning for the future have concerned the research with the use of financial ratios. lan millichamp once wrote in the student newsletter of chartered association of certificate Accountant, April, 1986 that the purpose of calculating and reviewing liquidity ratios is to determine whether a firm can meet its near future financial obligations.

It is generally agreed that ability to meet ling term financial commitment is better indicated by longer-term profitability probabilities.

  • Clearly, if a firm is possible unable to meet its short term financial obligations than it will be unable to continue in its current operational size.

He stated that liquidity ratio could be used by:

  1. Bankers and financial lenders who will wish to be assured of the ability of the firm to repay the short-term loans and overdrafts
  2. Actual and potential investors who wish to make decisions whether to invest or not in companies which are likely to fall to meet up with its financial liquidity in the near future.
  3. Management, which will be alerted to potential liquidity crisis.
  4. Actual or potential suppliers of goods on credit who will wish to know when and if they will be paid.


These decisions are important and as liquidity ratios are used in assessment. It is of great concern that liquidity ratios are correctly calculated and correct conclusion drawn.


Alan millichamp equally advocated that ratios should be treated with caution and that reliance not just be based on them alone, without considering the circumstances. Decision based on review of all possible ratios, including profitability and gearing would be better.


But ratios alone are poor indicators for the following reasons.

  1. They are based on financial statements which give very selective information and consistently applied, using generalized concept and of historical relevance only.
  2. Business is a dynamic matter, but financial statement especially the balance sheet is static review.


I . M Pandey in his contribution on ratio analysis wrote that the easiest way to evaluate performance of a firm is a compare its present ratios with the past ratios when financial ratios over a period of time are compared it gives an indication of the direction of change and reflects whether the firm financial position or performance has improved deteriorate or remained constant over time. This kind of performance is valid only when firm’s accounting policies and procedure have not changed over time.


Foulke A Roy while contributing warned that evaluating and comparing divisional performances, careful attention should be given to any differences in the treatment of cost, revenues and assets valuations by the divisions and taken as a result of the performance measurement is not distorted by inherent difference in the data.


It observed that the data from which accounting ratios are computed, is largely historic and should be approached with caution. Although they may often be used as a guide to predicting future operations of the enterprises, by providing dues that necessitate deeper probing to discover underlying causes, they are never perse to be decision itself.


William Pickles observed that the data is largely historic and should be approached with caution. Although, they may often be used as a guide predicting future operations of the enterprises, by providing dues that necessitate deeper probing to discover underlying causes, they are never perse to be decision itself.


In their book principles of financial and managerial accounting, published by south-western publishing company, professor Car I A warren and professor Philip E . Fess wrote that financial statements serve as the primary financial reporting mechanism of an entity both internally and externally.


An analysis of the financial information communicated by these statements should include the computation and interpretation of financial ratios. Management views on important issues relating financial ratios are important tools of analyzing the financial result of a firm.


They enumerated four basic types of ratios, namely:

  1. Liquidity ratios
  2. Leverage ratios
  3. Activity ratios
  4. Profitability ratios


Each type of analysis has a purpose or use that determines the different relationship emphasized in the analysis and application. The analyst, may for example being a banker considering whether or not grant a short-term loan to a firm. He is primarily interested in the firm that measure liquidity. In constant, long-term creditors place more emphasis on earning power on operating efficiency. Equity investors are similarly interested in long term profitability efficiency, management are of course concerned with all those aspect of financial analysis. It must be able to reply its debts to long and short-term creditors as well as earn profit for stockholders.


Finally, a quarterly published journal of union bank of Nigeria PLC, captioned “stallion” revealed that union bank of Nigeria PLC, before making advances or loans to any company or firms takes into cognizance the liquidity and profitability ratios of the firm concerned.


This is done by analyzing the balance sheet of the firm very carefully.


The liquidity of the firm concerned will show the bank, the ability of the firm to meet its maturing short-term obligations which its profitability reveals the management’s overall effectiveness as shown by the returns generated on sales and investments.


If these ratios did not meet the requirement of union bank of Nigeria PLC. It simply means that loans advances or overdrafts will not be granted


This is done to secure the creditor (loan, advances) approved in order to make sure that repayment is guaranted





I.M. Paendy in his write up said that financial analysis is the appraisal of the financial statement and it is projected in support of lending proposals.


It is designed to determine the relatives strengths and weakness of a business enterprise. It highlights whether the firm is financial sound and its profitability in relation to other firm in its industry and/or whether its position is improving or deteriorating over time.


The information contained in the financial statement is used by management, creditors, investors and others to form judgment about the operating performance and financial position of the firm users of the financial statement can get better insight about the financial strengths and weakness of the firm if they properly analyzed the information reported in these statement.


Management should be particularly interested in knowing the financial strength of firm to make their best use and to be able to spot out the financial weaknesses of the firm to take suitable corrective actions. The future plans of the firm should be lad down in view of the firm’s financial strengths and weaknesses. This financial analysis is the starting point for making plans, before using any sophisticated forecasting and budgeting procedures.


In view of the importance, its accuracy, completeness, reliability and proper interpretation is vital.


Both, absolute figures and key operational ratios are often used in carrying out financial analysis; comments are made on comparative figures, say, for three years and the reasons for the movement observe are duely explained. Individual ratios should not be looked at in isolation as no one ratios gives sufficient information by which to judge the financial condition and performance of a firm.



According to Stallion, vol. 52- a published journal of union bank of Nigeria PLC, for the second quarter of 1998, it was revealed that a typical appraisal of lending proposal starts with the narration of the amount of facility required by the customer followed by the purpose for the request.

Against the background, a run down of the character of the borrower is given starting briefly the history of progress made so far since commencement of business as well as branch or distributor network. Capital distribution is discussed as the man power in charge of the key functional areas of general distribution.


This is followed by a discussion of the borrower’s banking habit both with the bank and other lenders before analyzing the financial statement both historically and projected. In the process, the company’s plan for future in revolving the weakness identified in the analysis of its financial statement and utilizing its strengths to harness of opportunities in its environment can be considered appraised.


The cash flow and other projections in support of the future plans are subsequently appraised to assess customer’s request and the repayment programme proposed.

Lastly, the adequacy of the security offered is determine. This appraisal ends with a summary of the merits and demerits of the proposal to ascertain which one out weights the other to be able to arrive at a concrete decision whether to accept the proposal or to decline it.



Several ratios can be calculated from the accounting data contained in the financial statements. The ratios can be group into various classes according to the financial acting or function to be evaluated. Each type of analysis has a purpose or uses that determine the different relationships emphasised in the analysis. Union Bank of Nigeria PLC Enugu may for example, being bankers consider whether or not to grant a short term loan to a firm. It is primarily interested in the firm’s term or liquidity position, so it stresses on ratios that measure liquidity. Also it plea for more emphasis on earning power and operating efficiency. They know that unprofitable operations will erode assets values and that  a strong current ratio position is no guarantee that funds will be available to repay a 20 years bond issue. Equity investors are similarly interested in long term profitability and efficiency.

Management is, of course, concerned with those aspects of financial analysis, it must be able to repay its debts to long and short term creditors as well as earn profit for stockholders.


Ratios are classified into the following four important categories :

  • Liquidity Ratios
  • Leverage Ratios
  • Activity Ratios
  • Profitability Ratios

Liquidity ratios measure the ability of the firm to meet its current obligations as they fall due. Infact analysis of liquidity needs the preparation of cash budgets and cash flow statements, but liquidity ratios, by  establishing a relationship between cash and other current assets to current obligations, provides a quick measure of liquidity. A firm should ensure that it does not suffer from lack of liquidity and also that it is not too much highly liquid. The failure of a company to meet obligations, due to lack of sufficient liquidity will result in bad credit rating, loss of creditors confidence, or even in law suit result in the closure of the company. A very high degree of liquidity is also bad, Idle assets earn nothing. The firm’s fund will be unnecessary tied up in current assets. Therefore, it is necessary to trick a proper balance between liquidity and lack of liquidity. The ratios, which indicate the extent of liquidity or lack of it, are:

  1. Current ratio.
  2. Quick ratio.

The current ratio is calculated by dividing current assets by current liabilities.

Current Ratio= Current assets

Current liabilities

Current assets include cash and those assets which can be converted into cash within a year, such as marketable securities debtors and stock (inventories) prepaid expenses should also be included in current assets as they represent the payments that will have not to be made by the firm in the future. All obligations maturing within a year included in current liabilities include creditors, bills payable, accrued expenses, bank overdraft, income tax liability and long-term debts maturing in the current ratio is a measure of the firm’s short-term solvency. It indicates the availability of current assets in Naria for every one Naria current liability. A ratio of greater than one means that the firm has more current assets than current claims against them.

ii        Quick OR ACID-TEST RATIO

It is more refined measure of the firm’s liquidity. This ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid, if it can be converted into cash immediately or reasonably soon without a loss of value. Cash is the most liquid assets. The other assets which are considered to be relatively liquid and included in the quick assets are book debts (Debtors and bills receivable) and marketable securities (temporary investment) stock and prepaid expenses are considered to be less liquid. Inventories normally require some time for realizing into cash, the value of stock also has a tendency to fluctuate. The quick or acid test ratio. The quick ratio is found out by dividing the total of the quick assets by total current liabilities. The quick or acid test ration is something sometime called “Liquidity ratio.”

Quick or Acid-test ratio = Quick or liquid Assets



The short-term creditors, like bankers and suppliers of raw materials, are more concerned with the firm’s current debt paying ability. On the other hand, long term creditors like debenture holders, financial institutions etc strength. In fact, a firm should have a strong short- term as well as long-term financial position. Liquidity ratios as discussed in the previous section are calculated to indicate the current financial condition of the firm. To judge the long-term financial position of the firm, leverage or capital structure ratios are calculated. These ratios indicate the fund provided by owners and creditors. As a general rule, there should be an appropriate mix of debt and owners equity in financing the firm’s assets. The manner in which assets have been financed has a number of implications.

Firstly, between debt and equity, debt is more risky from the firm’s point of view. The firm has a legal obligation to pay interest to the debt holders, irrespective of the profits made or losses include by the firm. If the firm fails to pay to the firm to debt-holders in time, they can take legal actions against the firm to get payments and in extreme cases, can force the firm into liquidation.


Secondly, employment of debt is advantageous to shareholders in two ways:

  1. They can retain control of the firm within a limited stake.
  2. Their earning will be magnified, when the firm earns a rate higher than the interest rate on the invested funds.


The debt – equity ratio is the measure of the relative claims of creditors and owners against the firm’s assets. The ratio is calculated in various ways.

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