An accountancy firm reported that its client increased its profit by $20,000 just by increasing their debt to obtain more cash and then availing cash discount from its suppliers (1). Many economists also support debt capital and high gearing as it is a cheap source of capital, due to low issuing cost, interest paid is tax deductible and therefore reduces the company's overall weighted average cost of capital (WACC) and hence increases shareholder wealth (Glen, 2005, p.959). Lehman brothers collapsed in 2008, which is the world largest bankruptcy (http://news.bbc.co.uk/1/h i/business/8563604.stm) because of high leverage ratio, which increased from 24:1 in 2003 to 31:1 by 2007 (7).
This all raises a question, what is gearing? And is gearing good or bad for the business? Gearing is very important to any business as debt provides capital help to business while growing and also gears up the return on equity if the company uses right gearing level. So, it is very important for a business to have in depth knowledge of gearing and to use right amount of gearing in its capital. So, in next few sections we see different definition of gearing, what effect does it have on shareholder wealth and weighted average cost of capital, effect of financial gearing on financial risk, different theories to suggest optimum capital structure for the firm and finally we will see what is recession and how this recession effected different businesses and how different business cope with this challenges.
2.2 Definitions of gearing:-
Firms need capital for its operation and expansion and that capital can come from debt or equity. The ratio between debt and equity is termed as gearing (Joel, 1998, p.491). Brieley, (8) says 'corporate capital gearing is a measure of the net indebtness of the corporate sector' i.e. the ratio of debt and equity capital in firms' capital structure; which is also known as capital leverage. It represents the ratio between noncurrent liabilities and total capital employed (i.e. total of share capital, reserves and noncurrent liabilities) (McLaney, 2009, p.59). Glen (2005, p.962) talked about some more methods of calculating gearing by broadening the concept of gearing which are listed below:
Capital gearing can be measured as the ratio of all borrowing (i.e. the total of long and short term borrowing) and the total of all borrowing and shareholder funds. This provides more clear gearing position of the firm which depends on overdraft facilities and other short term borrowing as this include both long and short term borrowing of the firm.
Gearing can also be measured as the ratio of long term debt and total market capitalization. This provides market value based gearing (assuming book long term debt as similar to the market value of debt). As this is based on market value so it gives a fair indication about the relative composition of the firm's total capital in terms of debt holder and shareholder (Glen, 2005, p.962).
2.3The Effect of Gearing on return to shareholder
Companies usually leverage to attempt to increase returns on equity capital, as they can increase the scope for gains or losses. That is, as the company introduces debt in its capital structure, it 'gears up' the return on equity, but at the same time a highly geared company experiences greater financial risk and therefore can have varied earnings. Like if the company's operating profits are high, a geared company will experience a greater return on equity than expected. As debt has fix cost (interest), which is tax deductible and debt introduction does not alter the ownership level, so owners receive the full benefit of good performance (expansion) of the company as shown in table 2.1 where return equity increases from 20 percent to 30 percent at expansion period as the firm introduces 50 percent gearing. On the other hand, if companies operating profit turns to be low (recession), a geared firm will face more decline in their returns as compared to a non geared firm like in table 2.1 firms return equity decline from 6 percent to 2 percent at recession time as company introduces 50 percent debt in its capital structure, as debt has fixed cost irrespective of business performance and it does not dilute the ownership (Glen, 2005, p. 966).
Table 2.1
EXAMPLE: A proposed change in financial leverage
Current
Purposed
Assets
£5,000,000
£5,000,000
Debt
£0
£2,500,000
Equity
£5,000,000
£2,500,000
Debt/Equity ratio
0
1
Share price*
£10
£10
Share outstanding
500,000
250,000
Interest rate
Na
10%
Current capital structure: No debt
Recession
Expected
Expansion
EBIT
£300,000
£650,000
£1,000,000
Interest
0
0
0
Net Income
£300,000
£650,000
£1,000,000
ROE
6%
13%
20%
EPS
£0.6
£1.3
£2.0
Proposed : D/E = 1; interest rate = 10%
Recession
Expected
Expansion
EBIT
£300,000
£650,000
£1,000,000
Interest
£250,000
£250,000
£250,000
ROE
2%
16%
30%
EPS
£0.20
£1.60
£3.00
Source:
2.4Business and Financial risk
The introduction of debt in capital structure exposes the equity shareholder to a greater business and financial risk. Business risk is defined as 'the uncertainty inherent in projection of future return on assets (ROA)' (Joel, 1999, p.493). That is, future uncertainty regarding return on asset or return on equity due to uncertain future conditions like inflation, booms, recession in the global economy, labor strike and breakdown leads to business risk (Joel, 1999, p. 494). Different businesses have different business risks, like a monopoly business of electricity and gas supply has less business risks as compared to a high tech firm which has huge risks regarding the demand for its products. Glen (2005, p. 970) added that business risk is associated to general business and economic conditions and is not affected by the financial structure whereas financial risk is risk caused due to the financial structure of the business. It is the risk to shareholders due to the introduction of debt in the firm's capital structure, which increases the chances of inconsistency in return to shareholders due to fixed charge obligation on debt (Glen, 2005, p.970). It is the risk caused by additional burden of interest (fixed charge) obligation on debt (McLaney, 2009, p.297). That is, higher gearing increases the firms fixed financial cost (interest paid on debt), therefore has the high probability of not only incurring losses to shareholders but also failing to meet the interest cost obligation, this increases the chances of a debt insolvency (Glen, 2005, p.970). So introduction of debt in firms' financial capital structure increases the business and financial risk but at the same time reduces the weighted average cost of capital. This gives rise to a capital structure puzzle i.e. how to divide firms' capital between debt and equity to achieve maximum firms' value (4). A number of financial economists have worked over several decades to solve this capital structure puzzle and had come up with many theories. But these theories not only lack in providing definite empirical evidence but also these theories given by different economists make it more complicated. For example some finance scholars say capital structure is irrelevant as suggested by Modigliani and Miller. While other economists support trade off theory which talks about balance between 'tax shields of greater debt against potentially large cost of financial distress' (4).
2.5 Theories of capital structure
Modigliani and Miller (MM) Theory
Modigliani and Miller (1958) had given a simple theory, 'that the value of a firm remains constant regardless of the debt level' (Glen, 2005, p.974). They argued that as gearing increases, equity holders demand for more return to compensate higher risks from higher gearing, hence the cost of equity rises which offsets the effect of lower debt cost and leaves the WACC constant as shown in figure 2.1(Glen, 2005, p.974). That means the shareholders wealth can only be maximized through operating activities, as introduction of debt does not have any impact on shareholders wealth (Glen, 2005, p.974). This theory has been criticized for its unrealistic assumptions. MM theory has assumed that there is a perfect capital market, where all economic agents (buyers and sellers of securities) have perfect information, no taxation, no transaction cost, there is no financial distress and liquidation cost and individuals can borrow as cheaply as corporations.
Cost of equity (ke)
WACC (Ko)
Cost
Of Cost of borrowing (Kb)
Capital
0
Level of gearing
Figure 2.1
But in reality these assumptions do not exist. Like in most developed countries, corporate debt interest payments are tax deductible, which implies that firms can reduce their tax liability by additional borrowing (McLaney, 2009, p.309). Realizing the practical world Modigliani and Miller corrected their assumption of taxation of 1958 model, and have given a new theory in 1963 which stated that 'the introduction of taxation brings an additional advantage to using debt capital: it reduces the tax bill' (2). That is, WACC reduces as gearing increases as long as the firm has taxable income that can be written off against interest paid on debt due to tax benefit. Therefore, the firm will have lowest WACC at 100 percent debt when all other assumptions hold true as shown in figure 2.2(Joel, 1999, p .515).
Cost of equity (ke)
WACC (Ko)
Cost
Of Cost of borrowing (Kb)
Capital
0
Level of gearing
Figure 2.2
This theory is again criticized by many economists on the grounds that it ignores personal taxes which offset the tax shield benefit of MM theory and argue that firms cannot have minimum WACC at 100 percent debt (4). Miller (in Joel, 1999, p.515) this time without Modigliani modified the above theory by introducing the effect of personal taxes. He stated that interest received on debt as income is taxed as personal at a rate higher than the tax rate charged on income from dividend and capital gain. Moreover, tax on capital gain is treated as a differed until the equity is sold and the gain realized (Joel, 1999, p.515). That is, higher debt although decreased the tax liability for the corporation but at the same time it increases the tax liability of an investor. This means that it is the shareholder who ultimately bears all the tax consequences of its operations, whether the company pays those taxes directly in the form of corporate income tax or indirectly in the form of higher required return on securities it sells. This makes tax advantage a less important factor for consideration (4).
MM theory had been supported by many researchers like Hamad, (1972) (in McLaney, 2009, p.309) who from his research found that 'the cost of equity increases with the increase in the level of gearing'. In another research by Masulis (1980) (in McLaney, 2009, p.309) who found that firms intentions to increase gearing have a positive effect on share price, i.e. firms share price increases with their announcement to increase debt while the share price falls with the announcement of reducing debt (McLaney, 2009, p.309). On the other hand, Bacle, Smith and Watts (1955) (in McLaney,2009, p.309) from their study found out that ' tax deductibility of interest is a factor in the level of gearing, but not a very significant one'. This finding has been supported by De Angela and Masulis (1980) (in McLaney, 2009, p.309) who from their study point out that the value of business increases upto a certain level with increase in gearing and after that it starts decreasing and this is due to the fact that ' tax advantage can become decreasingly valuable with higher gearing since the business may not have sufficient taxable operating profit against which to set the interest expense'. That is, tax deductibility of interest becomes irrelevant after a certain level of gearing. This opposes MM theory which says WACC decreases as gearing increases.
Trade off theory:
The limitation of MM theory led to the development of the trade off theory 'in which firms trade off the benefit of debt financing (favorable corporate tax treatment) against higher interest rate and bankruptcy costs' (Joel, 1999, p.516). MM theory suggests that a firm has minimum WACC at 100 percent debt due to tax shelter benefit. But trade off theory suggests that in real world firms do not use 100 percent as firstly high personal tax offsets the benefit of tax deductibility as pointed out by Miller, secondly high gearing increases the probability of bankruptcy hence increases bankruptcy related cost and after a certain level bankruptcy cost exceeds the tax benefit and WACC starts rising after that point due to increased risk of bankruptcy and its cost in terms of higher compensation to investors to compensate higher risk. The point where WACC is minimum i.e. 'O' in figure 2.3 is termed as optimum capital structure i.e. gearing level at which WACC is minimum and shareholder wealth is maximized ( Joel, 1999, p.517).
Cost of equity (ke)
WACC (Ko)
Cost
Of Cost of borrowing (Kb)
Capital
Moderate' Level of gearing
Level of gearing
Figure 2.3
Information cost theory
1) Signaling theory: - MM theory assumes that both investors and management have identical information i.e. have 'symmetric' information. But in practice managers have better information about firm's prospects than the investors i.e. have 'asymmetric' information, and this has a great impact on optimum capital structure (Joel, 199, p.518). Signaling theory suggests that the issue of equity signals negative information to investors regarding the business prospect. Issue of equity signals out that the firm does not have good future prospects and the firm's share will fall in the future, that is why the company had issued equity, while issue of debt signals out positive information to investors. That is, the firm has issue debt that means the management has good confidence regarding the firm's future prospect, that's why they have undertaken a contract to pay fixed cost and have avoided equity issue, so that future capital can be raised at higher equity price (Glen, 2005, p.984). Therefore many economists suggest that in normal business conditions a firm must use equity financing and should have lower gearing than suggested by MM and Trade off theory, so that debt capital can be used in some special events like good investment opportunity and avoiding bankruptcy related cost due to high gearing.(Joel, 1999, p.518).
2) Pecking order theory: - This theory has been suggested by Myers (1984) who ignores other capital structure theory suggesting optimum capital structure (McLaney, 2009, p.313). According to pecking order theory companies maximize their value by choosing 'cheapest available' source of fund to finance new investment. Internally generated fund (retained earnings) is given priority to external funding by the managers and debt to equity if outside funds are necessary, as the debt has lower information cost associated with it as compared to issuing cost of equity (4).
Brieley from his study finds out that in addition to capital structure theory there are a number of financial characteristics which affect the level of gearing decision. From the analysis of many businesses he found out that gearing holds a positive correlation to company size and is negatively correlated to 'growth opportunities and importance of intangible assets' (8). That is, generally big companies have high gearing while firms with high growth opportunity have low gearing. Joel (1999, p.522) talked about market condition, which have a great impact on the choice of gearing level. During boom period firms like to have high gearing in order to gear up shareholders wealth. Recession brings great challenge to highly geared companies like the present recession had led to bankruptcy.
2.6 Recession:
Dictionary defines recession as 'a severe shortage of money or credit' (13), economists define it as 'two consecutive quarters of negative growth in gross domestic product (GDP)' (10). This generally results into millions of job losses, 'a decline in real income, a slowdown in industrial production and manufacturing and a slump in consumer spending' (10). Recession has its impact on both large and small firms. A large firm will face loss of sales which leads to low profit; to overcome this problem the business tries to cut down its cost by reducing number of employees, stops purchasing new technology and equipment, cuts down its research and development cost by reducing new innovations, reducing its marketing and advertising cost. These cost cutting efforts will impact other small and associated businesses, which provide goods and services used by big manufacturers (10). Shortage of fund due to recession leads to financial crises.
Financial crises: Recession results in loss of sales revenue and this reduces the company's cash flow. Recession also affects the company's cash inflow from business debtors. As an effect of recession customers may pay slowly, partly or not at all. This reduces the company's cash flow and will in turn result in late payments to its creditors which results into breech of 'credit agreement'. This will reduce the credit rating of the business. Reduced profit and cash flow may also affect company's ability to 'service its debt', like paying interest on time and may result in breach of debt covenant (it's an agreement between a company and its creditors that the company can operate within certain limits, to maintain a certain level of interest cover ratio). This ultimately may result into 'defaults on bonds and other debt' and this further can damage the firm's credit rating and prevent further borrowing (10). The company needs to restructure or refinance its debt in order to survive from bankruptcy situation. If the company fails to meet the bank covenant it can lead to bankruptcy (10). A present financial crisis is caused by sub-prime mortgage business as shown in figure 2.1, which took place due to poor bank practices in US. Banks in US issued high risk loans to people with poor credit histories. And sold these loans and other bonds and securities to investors globally as collateralized debt obligation (CDOs) which are an asset based security whose value and payments are based on portfolio of fixed-income underlying assets (11). US government raised the interest rate from 1 percent in 2004 to 5.35 percent in 2006 which made debt expensive and had a negative impact on US housing market, as homeowners found it difficult to afford their mortgage payment due to increased interest rate and homeowners with low income or poor credit history start to default on their payment. Increase in number of such defaults led the financial system into a big trouble as a number of such mortgages had been sold to banks and investors (13). This resulted into great losses to financial banks and they were in urgent need of cash to meet their debt covenant and to survive in such typical time. Many highly geared businesses applied for bankruptcy protection under chapter 11 in US and cut down their cost by reducing their workforce (13).
Figure 2.1
2.7 Steps to face recession challenges:
Government tries to solve this problem by injecting cash into the economy in the form of investment, loan or bail out and by reducing the interest rate in order to make debt cheaper (13). Companies look for survival and preserving cash which has a vital importance for the company to go through the downturn, as cash provides liquidity and helps the company to meet economy challenges. A report by Citigroup's investment bank shows that a company with high liquidity had performed better than low liquid firms in recession time (5). There are number of ways through which firms tried to preserve cash like.
It was hard and expensive to get bank credit at the time of financial crisis; even companies with sound balance sheet found it difficult to trade their debt at a reasonable price in the fragile market (5). Some experts advised to raise equity and pay down debt and to focus on 'operations and cash flows' while keeping an eye on future long term planning (9).
Some business experts suggest that cash is important and firms can raise or save it through many ways depending upon the manager's skills and opportunities available. Some companies acquire new pool of capital through 'sovereign-wealth fund' to support their finance, like by entering into joint ventures, where two firms come together to share capital and technology to achieve common goal (5).
Firms can choose to 'sell off' their underperforming business units, although firms may not get the best deal for the unit due to downturn but processing from it can help firm to survive in recession.
Another way of boosting liquidity is to reduce cash outflow from the business. Like Alcoa, an American aluminium giant, has cancelled its decision of buying back shares inorder to restrict excess cash to outflow. Companies can also reduce their dividend payment to reduce cash outflow, though several investors may not like this method as they may be 'expecting a regular stream of income' (5).
Some economists suggest refinancing of existing loan as a step to survive in recession period. It helps in achieving 'greater financial flexibility'. As in recession time companies may find it difficult to meet their debt covenant like interest cover ratio; refinancing will provide a sense of relaxation as the firm can undergo new terms and conditions for new capital and protect itself from conditions like bankruptcy (5).
Managers face the biggest challenge in generating more cash from current operation by controlling its cost and efficiency, like by controlling finance, human resource and technology. A business can also save its cash by managing its working capital, generally have huge working capital in form of debtors, inventory. Business can control its working capital by efficient use of inventory management techniques and with strict debt collection policy which can bring huge cash into the firm's capital (5).
It can be seen that gearing is useful if kept under control but adverse economy condition like recession have negative effect on shareholders wealth, different companies take different steps to face this challenges. In next section I will discuss about the reason for choosing of automobile industry and research methodology which I will used to analyze the performance of selected companies.
3.1 Data and sector analysis:
The world Automobile industry is a leading sector in global economy, 'accounting for 9.5 percent of world merchandise trade and 12.9 percent of world export of manufacturers' and provides employment to about 25 million peoples in the world (http://www.automotive-online.com/auto-industry.html). It is a highly diversified sector that includes 'manufacturers, suppliers, dealers, retailers, original equipment manufacturers, aftermarket parts manufacturers, automotive engineers, motor mechanics, auto electricians, spray painters or body repairers, fuel producers, environmental and transport safety groups, and trade unions'. And main products of this industry are 'passenger cars, motorcycles, buses, trucks, farm equipment, other commercial vehicles, automotive components and parts' (http://www.automotive-online.com/auto-industry.html). The USA is the leading producer and consumer of automobiles and motor vehicles in the world 'accounting for 6.6 million direct and spin-off jobs and represents nearly 10% of the S10 trillion US economies' and have a market share of 37.2 percent i.e. $432.1 billion of world market for automobiles. America is followed by Japan, China, Germany and South Korea which are said to be top five automobile manufacturer nations in the world. (http://www.automotive-online.com/auto-industry.html).
3.2 The relevance of auto industry to the study:
The automobile industry is a very important part of the global economy. It is often seen as a barometer of the world economy and is highly affected by economy shocks (22). I choose this sector as it is highly geared as suggested theoretically and can be seen practically. And it is the one of the most affected sector in the recession time. This leads to bankruptcy of many big automobile companies like general motors and Chrysler Group LLC which are the top leading automobile companies of the USA.
Finance theories suggest that automobile industry is highly geared due to many factors like: it had a high borrowing capacity due to its high investment in fixed assets, this allow company to borrow more debt by mortgaging their fixed assets which also make debt less risky to the creditor (Glen, 1999, p.984). Automobile industry has its investment more on tangible assets, which make it 'assets structure' suitable for raising fund (Joel, 2005, p.521). This is a growing industry and growing industries prefer higher debt to support the faster growing (Joel, 2005, p.521). Briekey (8) in his study about the determination of UK corporate capital gearing, found out that in uk automobile, pubs, transportation, vehicle distribution and water are highly geared industries, which have more of tangible assets on the other hand pharmaceutical and IT/ high tech industries have low gearing which have more of intangible assets in their asset structure. This supports the theory which says company with high tangible to intangible assets are normally have a high gearing (Joel, 2005, p.522).
The car industry is highly affected by the 2008 recession which leads car industry into big trouble. Companies have experienced loss in sale and profit which forces them to close their manufacturing plants and to reduce inventory and workforce in order to reduce their operating cost. Customers who rely on finance to purchase vehicles are affected by 'credit squeeze' leading to reduce their purchasing power (http://news.bbc.co.uk/1/hi/7674505.stm). Car companies faced a tough time to continue their operation due to high debt which left unprofitable company with no cash or limited cash leading to a situation of bankruptcy. In the US General Motors (GM), Ford and Chrysler, 'Detroit's Big Three', went to the US government to request for loan to survive in recession period. The US government to help the 'Detroit's Big Three' injected $25 billion cash into the industry. European policy makers are also considering the same option to help the survival of European car companies (http://news.bbc.co.uk/1/hi/7674505.stm). Inspite of , $25 billion cash help from the US government, Chrysler On April 30, 'filed for bankruptcy after some of its bondholders balked at the government's terms for writing down its debt'. And On June 1, G.M. 'filed for bankruptcy protection, saying in court papers that it had $82.3 billion in assets and $172.8 billion in debts' (http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/auto_industry/index.html).
I had choose Ford and Tata Motors the two car companies for my analysis as, Ford is the US based company and is the only survival of 'Detroit's Big Three' so it will be interesting to see financial management policies of Ford. I have chosen Tata Motors India based company, as the other choice as it is one of the leadings company in commercial vehicles (trucks and buses) and is suffering from its high debt after the acquisition of Jaguar and Land Rover India (reference). It is also listed in New York equity exchange and therefore prepares it account according to the IFRS standards. This will provide similarities in accounting policies and will make the comparison more sensible.
3.3 Methods of analysis:
Financial performance of a company often measure by calculating and comparing the different ratio with previous year ratio or with competitor or with sector ratio. So, in this project to judge and evaluate financial performance I will use ratio analysis as a major tool for my analysis. Financial ratio helps in providing quick and relative information to judge the financial health of the company. Ratio relates 'one figure appearing in financial statement to some other figure appearing there', like debt with equity to know gearing or profit with sales to know profit margin (Atrill and McLaney, 2009, p.182). I will use some key ratios like gearing ratio, return on capital employed, return on equity, earning per share and interest cover ratio to analyze the financial performance of Ford and Tata Motors.
Gearing ratio:As point out in literature review section gearing ratio can be calculated in many ways.......... i will use ......
Return on Capital Employed (ROCE):- this ratio compares capital employed (include share capital, any reserves and noncurrent liabilities) with operating profit (McLaney, 2009, p. 53). That is,
ROCE = operating profit (gross profit - operating expenses)
Share capital + reserves + noncurrent Liabilities
This ratio tries to find the effectiveness of assets financing by equity and debt. Higher ratio is considered good for the company which represent effectiveness in assets utilization (McLaney, 2009, p.54).
Return on Equity (ROE):- this ratio is very similar to return on capital employed. It focuses more on shareholder viewpoint. It compares Equity capital i.e. share capital and any reserve and profit for the year (McLaney, 2009, p.54). That is,
ROE = profit for the year X 100%
Share capital + reserves
This measures the effectiveness of management to utilize share holder fund (equity capital). Its, tells us that 'percent return for each pound (other monetary unit)' invested by shareholder (25).
Earnings per Share (EPS): - it expresses the companies earning on a 'per share' basis. It relates 'the profit for the year to the member of shares in issue' (Atrill and McLaney, 2009, p.212). That is,
EPS = Profit for the year
No. Of ordinary shares in issue
Higher EPS is considered good as it represent higher earnings per share.
Interest Cover Ratio (ICR):- it measures 'the amount of operating profit available to cover interest payable.' That is, it is calculate to find out firms ability to pay fixed obligation in terms of interest out of its profit (Atrill and McLaney, 2009, p.207). That is,
ICR = operating profit
Interest payable
High interest cover ratio is considered good for the company as it represent good financial position of the firm. Higher ratio indicates firm effectiveness in meeting its fixed obligation. It is one of the key ratios as many businesses are under a debt covenant to meet fixed interest cover ratio.
I will use this ratio to analyse and compare Ford and Tata Motors performance over 'five year'. Ratio will help me to understand company's performance over the five year. And from where I can analyse the effect of recession on high gearing firm by analysing return on capital employed, return on equity and interest cover ratio. At the same time I will also try to analyse what steps company had taken to meet the challenges put forward by recession, by analysing cash flow statement and consolidated balance sheet of the company. I will also try to analyse the effect of the steps taken on company performance by refereeing back to key ratios. This will help me to understand effect of high gearing in recession time and to understand similarities and differences in financial management policies to deal with this issue by two companies from same sector. Through this I will try to compare the general financial management suggested policies by different theories and economists as suggested in section 2.7 and the measure taken in practice by different firms (here Ford and Tata Motors).
3.4 Methodological Issues:
I am using ratio analysis as my major tool to analyze the performance of company, which have several limitations like:
Efficiency of ratio analysis is based on the quality of financial statement. Therefore ratio will not effective in case of creative accounting and its result depends on financial statement (Atrill and McLaney, 2009, p.220).
Ratio help in analysing one sight of information while losing other contained in the underlying financial statement. For example ' the total sale revenue, capital employed and profit figures may be useful in assessing changes in absolute size that occur over time or difference in scale between businesses'. But ratios does not provide such information, it does not measure performance in absolute form it provides relative performance i.e. provide only one aspect of the information while ignoring the other aspect. Which make it unsuitable for comparison between two companies as comparison in terms of absolute size of profit is proved to be more useful than relative profitability of businesses.(Atrill and McLaney,2009, p.221).
Ratio analysis does not consider the changes in accounting policies, which vary from business to business and from country to country, this have a great impact on accounting numbers. This makes ratio analysis as unproductive tool to compare performance of two businesses (Atrill and McLaney, 2009, p.221).
In addition to the limitation of ratio analysis my research tool lack in providing significant information regarding market and business risk, to analyze these risk highly mathematical tools are need to be used but I have ignore that point of view in this project to make this project more simple to understand by a non financial background individual.
