2.1 Introduction
One of the most important facts about firms is that the operating performance of the organization shapes its financial structure. The idea behind this research is testing accounting ratios as being predictors of failure. According to William Beaver (1966), failure occurs "when a firm defaults on interest payment in its debt, hence overdrawing its bank account or declaring bankruptcy."
In other words, failure can be defined as a state where a firm is unable to meet its financial obligations. Technically, an organization is said to have failed if events such as bankruptcy have occurred. Therefore, the emphasis of this research will be on ratios as predictors of important events leading to failure.
2.1.1 Financial Statements
Financial statements are records that give an indication of the business's financial situation. They are divided into four categories: balance sheet, income statements, cash-flow statements and statements of retained earnings. According to Myer (1969), "Financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets, liabilities and capital as of a certain date and the income statement showing the results of operations during a certain period."
In addition, the financial situation of the firm also determines its operating performance. Therefore, financial statements represent essential tools for evaluating the performance of firms.
Accounting reports are an important source of information for managers, investors and financial analysts. However, the data available in financial statements is voluminous and shows the relationship between the business and the outside world. In order to be useful, the information available should be organized in an understandable and coherent form. Ratios are the usual instruments for extracting this information and ratio analysis is a way of presenting the data in financial statements in a simplified, systematized and summarized form.
2.1.2 Accounting Ratios
Accounting ratios are obtained by dividing one number by another number. Ratios are used to describe the significant relationship between figures shown on a financial statement that is they show how one number is related to another. Most ratios can be calculated from information provided by the financial statements. As defined by J. Batty(1972), "The term 'accounting ratios' is used to describe significant relationships which exist between figures shown in a Balance Sheet, in a Profit & Loss A/c, in a budgetary control system or in any part of the accounting organization."
Financial ratios can be used to analyze trends and to compare the firm's financial position to those of other firms. According to an article by Edward I. Altman (1968), he writes that prior to the development of quantitative measures of company performance, companies were required to supply an amount of qualitative information assessing the credit worthiness of the business. He further adds that a study during the 1930's concluded that failing firms exhibit different ratio measurements as compared to continuing firms.
Therefore the thesis will also evaluate the underlying predictive ability of financial statements of companies through their financial ratios.
2.1.3 Types of Accounting Ratios
There are many accounting ratios which can be divided into four broad categories, namely profitability ratios, liquidity ratios, leverage ratios, operating ratios and solvency ratios. Gopinathan Thachappilly (2009) believes that "there are different categories of financial ratios that highlight different aspects of performance. Under each category, there are multiple ratios that measure different aspects, or fine tune the measurements."
Profitability Ratios
Profitability ratios are used to assess a firm's ability to generate earnings as compared to its expenses and relevant costs. It measures the operating efficiency of the business. According to Gopinathan Thachapilly (2009), "Profitability ratios measure both the profit margins that the company is able to generate as well as the returns it provides on the physical facilities and funds it employs." These ratios are used particularly by financial analysts to compare a firm's profitability with past results or with profitability of other firms.
Liquidity Ratios
Liquidity ratios measure the firm's ability to meet its current obligations or liabilities. It shows the number of times short-term liabilities are covered by cash. As defined by Gopinathan Thachapilly (2009) in one of his articles, "Liquidity ratios measure a business' ability to meet the payment obligations by comparing the cash and near-cash with the payment obligations."
Firms should be able to ensure that they do not have a lack of liquidity as well as it does not have excess liquidity. Liquidity ratios also enable businesses to examine the strength and weakness in terms of its ability to meet its short term debts.
Leverage Ratios or Solvency Ratios
Leverage ratios are used to evaluate a company's ability to meet its long term financial obligations. These ratios indicate the extent to which the firm has relied on debt in financing assets that is it shows the degree to which the firm is utilizing borrowed money to finance its activities.
Activity Ratios
Activity ratios measure the efficiency of the company in using its resources. They represent the rates at which current assets and current liabilities are used-up or paid-off through ordinary business operations. Activity ratios are indicators of how rapidly a firm converts various accounts into cash or sales. They measure the operating characteristics of the firm.
2.2 Ratio Analysis
Business owners of industrial or commercial firms usually deal with many credit transactions. They have to ascertain that they have a way of determining the degree of risk arising from the financial position of their clients. In the same way, shareholders, existing and potential investors need to find reliable measurements of profitability, risk and the long term financing of their investments or enterprises. One way of evaluating the financial position of a firm in its financial statements is ratio analysis.
Ratio analysis is therefore a tool to present accounting figures in a simple, concise and intelligible form. Gopinathan Thachappilly (2009) believes that "financial ratio analysis is done to represent the massive amount of numbers in company financial statements in a more useful way."
Accounting ratios represent a way of establishing a relationship between figures in the financial statements of a business. In one of his articles, Geoffrey Whittington (1980) states that "the fundamental assumption of ratio analysis is that of proportionality." In other words, it assumes that a proportionate relationship exists or ought to exist between the two variables of the ratio being computed.
When ratios had been introduced, only one single ratio had been developed, the current ratio for the evaluation of credit worthiness. Today, ratio analysis involves the use of various ratios by several users Ratio analysis measures the profitability, efficiency and financial soundness of an organization. They are useful indicators of a firm's performance and financial situation. In some cases, ratio analysis can predict future bankruptcy. In his article about the predictive nature of ratios, Rick Elam (1975) says that "financial ratios are transformations of financial statement which are data purportedly made by uses to help in decision making." He adds that potential bankruptcy represents one of the main and most serious events that a firm can be facing and therefore, it should be a subject of great interest to users of financial statements.
2.2.1 Types of Analysis
Analysis can be done through various ways, for instance vertical comparison or horizontal comparison. According to I M Pandey (2005), there are 4 types of ratio analysis:
Times series analysis
This involves evaluating the performance of a firm by comparing its present ratios with its past ratios. It shows the direction of change, if any, and indicates whether the firm's financial performance has improved, deteriorated or remained constant over time. It is also known as the trend analysis or horizontal analysis.
Cross-sectional analysis
This concerns comparing ratios of one firm with other firms in the same industry at the same point in time. It is also referred as the inter-firm analysis. This type of analysis indicates the relative financial position and performance of the firm.
Industry analysis
This is achieved by comparing ratios with average ratios of the industry of which the firm is a member. It helps to identify the financial standing and capability of the firm vis a vis other firms in the industry.
Proforma analysis
In this case, future ratios are used as the standard of comparison. Future ratios can be obtained from the projected or proforma financial statements. The comparison of current or past ratios with future ratios shows the firm's relative strengths and weaknesses in the past as well as in the future.
However, the exact choice of accounting ratios to be used in the ratio analysis process will depend on the aim of the analysis and also on the amount of data available.
2.2.2 Usefulness of ratio analysis
Ratio analysis makes it possible to compare of the performance of different firm. The ratios are helpful in deciding about their efficiency in the past and their likely performance in the future. According to Gopinathan Thachappilly (2009) in one of his articles, "the calculation of financial ratios enables management to identify trends in a business and to compare its performance with similar businesses in the same industry."
Accounting ratios help in investment decisions for instance lending decisions in the case of bankers. In one of Rick Elam's (1975) article, he says that "accounting data which are obtained in a firm's financial statements are a basis for making decisions about that firm." Similarly Gopinathan Thachappilly (2009) says that "Ratios reveal relationships that can help evaluate the performance of a company, so that investors can decide whether to invest in that company." He further adds that accounting ratios can also be used externally by helping investors to spot better investment options and internally by allowing managers to identify business weaknesses and areas requiring more attention.
Accounting ratios provide the users with a number of benchmarks against which they can measure performance. In an article about industry averages as targets for financial ratios written by Baruch Lev (1969), he says that managers can make establish goals through ratios. They can include their desired ratios in their budgeted plan for the year, and then, regulate operations in such a way as to obtain resultant ratios that will conform to the budgeted ones.
Accounting ratios can help in evaluating the performance of firms. As stipulated by Paul Barnes in one of his articles, he discusses that the positive use of financial ratios has been done mainly by accountants and analysts to anticipate future financial variables and by researchers in statistical models for mainly predictive purposes such as corporate failure. Erkki K. Laitinen's (1991) article talked about the positive use of financial ratios by researchers in statistical models which has been mainly for predictive purposes such as the failure of the firm. He also adds that the use of financial ratios in failure prediction is based on the assumption that the failure process is characterized by a worsening in the values of the ratios. In the same way, in one or Goeffrey Whittington's (1980), articles about accounting ratios, he mentions that there is an alternative use of ratios which is becoming more and more common in relation to both financial accounting and management accounting. This is the use of ratios for the estimation of a relationship and also for the purposes of prediction
Accounting ratios are used in order to identify trends over a certain time period relative to the company's performance. As Kent John Chabotar (1989) said in one of his research, the most useful type of ratio analysis examines ratios over a period of three to five years. This is done in order to minimize the influence and impact of an exceptional event in one year and to be able to spot trends.
According to Whittington (1980), in a discussion about the basic properties of accounting ratios, identifies two prime uses of ratio analysis. He expresses the first as being the traditional normative use, where a firm's ratios are compared with a pre-set standard. This method is broadly used for intra and inter-firm comparisons. The second main use is the positive use of ratios in an attempt to establish functional relationships between the variables.
2.2.3 Drawbacks of ratio analysis
Every theory has its limitations and despite the widespread use of ratios in many contexts available, evidence probably conveys the belief that ratios might be unpredictable. According to Samuels et al, (1990) they said that 'there are many theoretical problems with a ratio analysis based approach." This does not mean that the theory is entirely wrong, but there are some factors which should be taken into consideration while making use of accounting ratios for performance evaluation.
In order to be useful and reliable, ratios have to accurate. They should be based on information from the financial statements as well as notes to the accounts. However some data might not be disclosed in the accounts, therefore questioning the extent to which ratios are accurate. As said by R.K.S Rao (1989), "ratio analysis for any one year may not present an accurate picture of the firm."
Ratios are useful when evaluating the efficiency of the business only when they are compared with past results. However, according to Helfert (1994) "Another caveat is that performance analyses based on accounting numbers reflect past data and conditions, and may not form a sound basis for extrapolation into the future." Therefore, such a comparison only gives information about past performances and forecasts for future may not be correct since several other factors like market conditions may affect the future performance. Such factors may distort the value of the ratio.
Ratios alone are not adequate, that is we cannot rely on ratios only to take decisions about the financial status of the firm. Stephen Gilman (1925) criticized the use of ratio analysis and believed that ratios did not give a comprehensive view of the balance sheet relationships. Ratios are only indicators and they cannot be taken as final to conclude about the good or bad financial position of the business.
Accounting ratios do not differentiate between near failures and outright failures. According to an article by Craig G Johnson (1970), he writes that ratios only measure the degree to which the state of failure relates to the current status of the firm. He also mentions that even though ratios are usually compared with similar ratios for the same firm over time, or with ratios of like firms, and that ratios cannot be evaluated in isolation. He further says that ratios have meaning only if related to some standard. For example, an analyst may seek to determine the riskiness of a firm. However, the riskiness of a given value for the ratio changes with the business cycle and the liquidity of assets. Similarly, two firms with identical ratios can differ in riskiness due to different investment prospects. "Without a standard, ratio comparisons are meaningless."
2.3 Empirical Review
Over the years, empirical studies have repeatedly demonstrated the usefulness of financial ratios. For example, financially-distressed firms can be separated from the non-failed firms in the year before the affirmation of bankruptcy at an accuracy rate of 90% by investigating financial ratios.
The main models which used financial ratios to predict business failure were based on the original work of Beaver (1966) and Altman (1968).
William Beaver (1968) has made the most contributive univariate analysis of business failure. A univariate analysis involves the use of a single financial ratio in a failure prediction model.
He compared the ratios of 79 firms that failed with 79 firms that remain solvent. Beaver revealed five ratios which could discriminate between failed and non failed firms. These are cash flow to total debts, net income to total assets, total debts to total assets, working capital to total assets and current ratios.
According to one of William Beaver's (1968) articles, he emphasizes on the failure of a firm, although rare, is quite costly to providers of capital due to the reorganization costs which will definitely consume a large part of the wealth and value of the firm. He adds that it has been proved through several research and empirical evidence that financial ratios indicate increases in the probability of failure for as much as five years prior to the failure of the business.
On the other hand, Altman performed an analysis of failure by means of multiple analyses. The main objective of the multivariate analysis is to combine the information of several financial ratios into a single weighted index. Altman's his multivariate model as the Z-score model.
Edward Altman (1968) declared in one of his studies that a research during the 1930's and several others later concluded that firms which are failing exhibit significantly different ratio measurements as compared to firms which are ongoing and performing well.
William beaver and Edward Altman have several successors who did various studies with the aim of trying to improve the performance of failure analyses in numerous alternative ways. For instance, Sharma and Mahajan (1980) present a general model of failure process according to which ineffective management together with unanticipated events lead to deterioration in performance indicators such as accounting ratios.
Fizpatrick (1931, 1932) conducted a research to examine whether the trend of ratios for failed and non failed firms atleast three years prior to their failures. His sample consisted of 19 companies which failed in the time period from 1920 to 1929 and 19 successful companies. His conclusion was that 13 ratios studied predicted failure to a certain extent, three ratios in particular, namely the net profit to net worth, the net worth to debt and net worth to fixed assets.
L. Merwin (1942) analysed the trends over past 6 years of 900 continuing and discontinuing firms. The study concentrated mainly on small corporations having less than $250 000 worth of assets and which failed during the period as from 1926 to 1936. He concluded that there are three ratios which are very sensitive predictors up to as early as four to five years to discontinuance. These are net working capital to total assets, net worth to debt and the current ratio.
Persons (1995) identified 103 fraud firms which were then matched with a nonfraud firm on the basis of industry and time period. In total, ten variables, including eight ratios, were examined and used to develop models. They indicated that financial leverage, capital turnover, asset composition and firm size were significant factors influencing the possibility of falsified financial reporting.
Smith and Winakor (1930) analysed the trend over a period of 10 years. They studied the means of 21 ratios of a sample of firms, which were in financial difficulties and concluded that the ratio of net working capital to total assets was the most accurate and steady indicator of failure.
