# Comprehensive Testable Theory of Financial Ratios Analysis

Table of Content

Background of the Study

In the past decade of economic tendency, Malaysia as one of the developing countries in Asia has confronted various changes and enlargement. Achievement of Malaysia industry deeply affects the economic status of Malaysia. The movement of foreign exchange will increase when investors involve in it. Investors will always invest in good conduct industry because they will earn revenue in the short time period. However, investors need to recognize or to analyze the performance of the company properly before invest and it is not an easy job for an outsider to understand.

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By doing the financial statement analysis, it will help the analyst to understand the performance of any company. The analysis of financial statement is a study of establishing meaningful relationship between various financial facts and figure given in financial statement. The basic financial statement included balance sheet and income statement which is the indicating device of profitability and financial soundness of business concern. Simple and valuable elements have been dissected by complex figure that given in financial statement. In addition, significant relationships are established between the elements of the same dissection.

Establishing relationships and interpretation thereof to understand the working and financial position of a firm is called analysis of financial statement. Thus, analysis of financial statement is the procedure of establishing and identifying the financial weakness and strengths of the company. 1. 1 Meaning of Ratio Analysis Ratio analysis has been view as a primary technique of the analysis of financial statement from various aspects of business. (Brigham & Houston, 2004 p. 95)state” Ratio Analysis involves comparisons. A company’s ratios are compared with those of other firms in the same industry, that is, to industry average figures. Ratio refers to the relationship expressed in mathematical term among a set of numeral and two individual links with each other in logical way. It is based on the assumptions that single figure may not tell us any useful information but when expressed relative to another figure, it will definitely give us some meaningful information. Since ratio is a mathematical relationship between two or above accounting figures, it can be expressed in as a pure ratio, as a rate of times or as a percentage. The relationship between two and above accounting figures or group is called financial ratio.

Financial ratios may be calculated in different ways, using different figures (Gibson and Cassar, 2005). Financial Ratio helps to outline a large volume of financial data into a concise form so it is easy to interpret and conclude the performance and position of the firm. 1. 2 Ratio Analysis There are two steps that ratio analysis needs to be follow. First, the calculation of ratio has to be done. Second, the ratio has to compare with predetermined standards. Predetermined standards can be the average ratio of industry or the same firm past ratio.

When interpreting specific firm, the calculated ratio has to compare with the predetermined standard otherwise the analyst cannot attain any effective conclusion. There are cross section analysis, time series analysis and combined analysis three types of different way in comparison the ratio. In cross section analysis, it helps the analyst find out how the particular firm has performed associated with the firm’s competitor by using the ratio of the firm to compare with the ratio of other firms in same industry or more firm’s financial ratio at the same time.

In addition, the firm also can undercover the major operational inefficiencies by comparing the firm’s performance to compare with the top performance of the industry. Time series analysis helps the firms to measure whether the firm is near to the long-term goals or not by comparing the present performance with the past performance of the firm. A measurement about the direction progress of the firm can be made. From the time pattern of these ratios, the analyst can study economic conditions, industry conditions and firm-specific conditions for example inflation, shift in regulatory status or shift in corporate management.

Combined analysis is combined both cross section and time series analysis together to study the model and manner of ratio therefore significant and universal evaluation of the firm’s performance can be made. A trend of ratio of a firm compared with the trend of the ratio of the standard firm can give good results. For example, the ratio of operating cost to net sales for firm may be higher than the industry average however, over the years it has been declining for the firm, whereas the industry average has not shown any significant changes. 1. The Importance of Ratio Analysis Ratio analysis is a useful tool for management to making decision. By using ratio analysis, it helps management to evaluate the firm performance such as financial health, profitability and operational efficiency over a period of time by comparing the present ratios with the past ratios and comparing with other companies also so as to see where the company stands in the industry. In another way, by setting a trend with the help of ratio, management can know whether the firm financial position is improving, falling or constant over the years.

Through the direction of the trend of strategic ratio, it is helpful for management in the function of planning, forecasting and controlling. Information given in the financial statement is useless and difficult to understand by outsider. The ratio analysis interrupted and analyzed in some comparable terms from the financial statement in simplified manner so that it can be easily understood by those who do not know the language of accounting. In addition, ratio analysis can helps analyst to conclude the liquidity position of the firm.

The liquidity position of a firm would be pleasing if it is able to meet its current obligation when mature. Liquidity ratio reflected the firm’s capacity to meet its short term liabilities. Ratio analysis also helps the firm to evaluate long term solvency of the firm measured by the leverage ratio. Normally, it is useful for the creditors, security analyst and investors because these ratios expose whether the company is well performance or not. 1. 4 Problem Statement Management of the firm is relying on accounting information from the financial statement to make various strategic decisions. James C. Van Horne and John M. Wachowicz, 2005: 132) say to evaluate the firm’s financial condition and performance; the financial analysis needs to perform checkups on various aspects of a firm’s financial health. Financial ratio is always used during these examinations. With the proper use of accounting ratios, it assists decision makers to ensure the effectiveness of management in the enterprise. In modern competitive business environment, the survival of either large or small firms is based on the management strategic decisions made.

As such, this study is aimed to understand the information involve in financial statements so that the firm can aware of the strength or weaknesses of the firm and forecasting the future prospects of the firm and thereby enabling the financial analyst to take different decisions regarding the operations of the firm. 1. 5 Organization of the research The following describes how this study was organized in an orderly manner for the ease of the reader and show out the pictures of whole study. The study can be falls into five chapters.

Chapter one will be made up of background of the study, meaning of ratio analysis, introduction to ratio analysis, importance of ratio analysis, statement of the problem and organization of the study. Chapter two is literature review. It is to provide the fundamental acknowledgement of the ratio analysis by looking into previous studies and literature and investigate previous studies’ opinion and suggestion. Chapter three outlines the framework of the methodology used in the research to gather data. There are explanations of the ratio use in this study to investigate performance of the selected firms.

The chapter four is analysis. This is the area obtain result from the previous chapter are analyzed. Chapter five is the conclusion and recommendation of this study, which is to prove the result from the previous chapter and the argument. Chapter 2 Literature Review 2. 0 Introduction This chapter will briefly describe the development of ratio analysis. How is the origin of ratio analysis? How it is developed? In addition, this chapter will also discuss classification of financial ratio and the main approach in this area.

The profile of the companies that will be analysis in chapter 4 will be introduced and the industry that those companies belong to will also be overview. 2. 1 Historical Development of Ratio analysis There is majority of evidence prove that ratio analysis since the late1800s has been widely used in the analysis and valuation of published financial data such as security analysis firms (e. g. , Dun & Bradstreet) have published, and presumably have profited from publishing, listings of annual financial ratio values for various firms and industries.

In addition, the use of ratio analysis is emphasizes in the literature on financial statement analysis. The historical development of ratio analysis can be divided broadly into four phases. In the first phase beginning approximately in 1870 we see a spurt in the development of ratios for managerial and credit analysis. During this period, current ratio is the most important ratio that had been developed which continues to draw the attention of the analysts even today. However, the proliferation of ratios created problems for discerning the right kind of ratios for business analysis. Attempts were made to resolve the problem y developing a coherent system of ratios. In 1919, the du Pont RoI chart developed by bliss is the first such attempt and during the same period the emergence of industry-wise ratios also been found. Well-known business schools and credit agencies began publishing these ratios on a regular basis. In the second phase, beginning 1930, attempts were made to understand the statistical nature and empirical basis of financial ratios. A considerable volume of literature was produced on the subject but the empirical findings of major researchers were found to be more contradictory than corroborative.

The statistical approach to ratio analysis also led to the development of ratio models for predicting corporate bankruptcy. Most important among those works are those of Merwin (1942) and Beaver (1967), Altman (1968) and Ohlson (1980). While emphasis on empirical research enriched the discipline of ratio analysis it retarded the development of a comprehensive theory of ratios. In the third phase, beginning in the later part of the 1960s, rigorous scientific investigation being made into the information content of financial ratios with the help of Entropy Law and decomposition theory.

The problem of aggregation and consequent information loss was investigated with the help of sophisticated mathematical tools but the findings remained inconclusive. However, these studies revealed for the first time that accounting does not really have a satisfactory conceptual framework. The research on understanding the statistical nature of ratios, particularly for the purpose of predicting the health of a business, continued unabated during this period and is also being carried forward to the present. Since 1980 the discipline has entered into its fourth logical phase where the search of a theory of financial ratios has begun.

Serious attempts are being made to find a comprehensive testable theory of financial ratios. This discipline is now ripe enough to give birth to its own theory. The first attempt to present a historical review of ratio analysis was made by Horrigan (1968) followed by Barnes (1987) and Salmi and Martikainen (1994). The present review, though following in their footsteps, differs from them in the sense that here, the logical development of ratio analysis is traced to its present stage from a managerial perspective.