History of Financial Ratios
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In the beginning of nineteenth century essential improvement in ratio analysis occurred. In this period few developments are endogenous. First, large number of ratios was conceived in comparison to earlier periods. Second, proper ratio criteria were appeared. In this regard most famous was current ratio criterion. Third, different analysts understand the need of inter-firm analysis and for that purpose it felt the need for relative ratio criterion. Despite these developments ratio analysis has been used for analysis in this period and those felt the need of using ratio analysis only used current ratio.
Two very important exogenous developments in this period because of which need of ratios has surfaced were federal income tax code in 1913 and the establishment of the Federal Reserve System in 1914. These two developments also helped to improve the content of financial statements as well as increased the demand of financial statements.
In 1920s, interest in ratio analysis increased dramatically. Many publications on the topic of ratio analysis published during this period. Different credit agencies, trade unions, universities and individuals seeking analyses compiled industry data on ratio analysis.
Justin (1924) argued that the method of gathering industry data and calculates averages were called “Scientific ratio analysis”. The word “scientific” in this title was not entirely correct because no evidence had been found that the hypothesis formulation and hypothesis testing actually carried out.
Horrigan (1968) says ratios analysis has come into existence since early ages and the main reason of the development of ratio analysis was its use in the analysis of the properties of ratios in 300 B.C. in recent time it is used as a standard tool for the analysis of financial statement. In nineteenth century main reasons of using ratio analysis are power of financial institutions and shifting of management to professional managers. Ratio analysis used for two purposes that are credit and managerial. In managerial approach profitability and in credit approach capacity of firm to pay debts is the main point of focus. Generally, ratio analysis is used credit analysis.
There was rapid expansion of financial knowledge in nineteenth century and to study this rapidly expanding knowledge analyst first compared similar items then moved further and compared current assets and liabilities as well with other ratios. In that period current ratio was the most significant ratio among all other available ratios. To analyze the operating results dupont analysis is also used. The result divided into three parts and then compared with other companies to point out the problem and strong areas of business.
Bliss (1923) says basic relationship within the business is indicated by the ratios and developed complete model based on the ratios. The purpose model was not mature but inspired others to start working on this theory.
Different critics of ratio analysis also appeared. Gilman (1925) has following concerns on ratio analysis (1) ratios are bond with time and changed as time passed so cannot be interpreted (2) ratios are not natural measure for judging the performance companies manipulated them (3) ratios easily affect the mind of viewers and hide the actual position and (4) ratios swing widely that also affect the dependability.
Foulke (1931) create and promoted own set of financial ratios successfully. This set of financial ratios was printed and promptly known as important and prominent group of ratios.
Fitzpatrick (1932) with the help of thirteen different type of ratios analysis 120 failed firms and found that three out of thirteen ratios predict the failure of firms with precise accuracy while other ratios also shown some prediction power.
Rasmer and foster (1931) used eleven ratios to examine that the successful firms has higher ratios than unsuccessful firms. Although this study was immature but immaturity was ignored by considering the vital contribution this study has in the evaluation of usefulness of ratios. Security and exchange commission of America was formed in 1934. This also expands the flow and number of financial statements and with the help of this peripheral factor importance of ratio analysis further enhanced and realized.
Marwin (1942) by using several ratios analyze financial trends of huge successful and unsuccessful firms. Compared normal ratios of industry with mean ratios of large unsuccessful firms and find out that the three ratios current ratio, net working capital to total assets and net worth to debt were able to foresee failure before actual failure happened. This study shows the actual power of prediction of ratio analysis and results were still reliable.
Walter (1957) included cash flow statement items in ratio analysis. At the end of world war fund statement came into existence and with fund statement fund statement ratios was also produced.
Hickman (1958) used times interest earned ratio and net profit ratio to predict the default rate on corporate bond.
Saulnier (1958) says firms with low current ratio and debt ratio has greater chance to default then firms with high ratios.
Moore and Atkinson (1961) point out the relationship between capacity to pay and financial ratios and shows results of ratio analysis influence the borrowing ability of firms.
Beaver (1967) also examined the prediction power of ratio analysis and point out ratios ability to predict failure as early as five years before the collapsed. Statistical technique used in the study was more powerful than earlier studies and fund statement data was used to calculate ratio. This study set the foundation for future research on ratio analysis.
Sorter and Becker (1964) examined the relationship between psychological model and corporate personality of financial ratios and find out that long-established corporation maintain greater liquidity and solvency ratios.
Gombola and Ketz (1983) found that the fund and income statement are produced for different purpose and profitability ratios did not has the information that cash flow ratios provide. In other words both ratios gave important as well as different information from one and other.
In 1940s many nations expressed interest in ratio analysis. Current ratio has used in credit management in Australia after intense scrutiny. In England data has collected from different organization and sort in “pyramid” in order to used that data in ratio analysis so that decision made on more rational basis. In other wards British method is more management oriented than American system that is credit oriented. Indian and Canadian system is similar to American system and same kind of ratios and criteria has been used. In Japan data is available in grouping on the basis of industry and sizes of firms. China and Russia used several ratios as control measure in investment and working capital.
Empirical analysis of financial ratios:
Pinches and Mingo (1973) evaluate the structure of ratios and found that ratios can be divided into different groups. Present general classification of financial ratios on logical basis. Results concluded that the ratios can be divided into four groups that are financial leverage, short-term capital intensiveness, return on investment and long-term capital intensiveness.
Stevens (1973) also studies the topic of ratio classification and grouped the financial ratios in four categories that include activity, liquidity, leverage and profitability.
Pinches, Mingo, and Caruthers (1973) and Pinches, Eubank, Mingo, and Caruthers (1975) carry on further worked on this subject and categorized the financial ratios in seven factors that include receivable turnover, capital turnover, short-term liquidity, return on investment, inventory turnover, financial leverage and cash position.
Libby (1975) also studies the division of financial ratios and condenses that division from seven to five. Five divisions include liquidity, activity, cash position, profitability and assets balance. Johnson (1979) further studies the research of Pinches (1973) and added another factor that is decomposition measure into seven factors.
Twelve different factors or division of financial ratios are presented in five different studies. On the basis of five published studies assortment of financial ratios are very time consuming because the results of published studies was very diverse.
Chen and Shimerda (1981) deeply examined five published studies and find out that some of the twelve factors that has been presented in the studies has same and simply name is changed. Therefore, twelve factors are grouped into seven factors. Seven factors are cash position, financial leverage, inventory turnover, short-term liquidity, return on investment, receivable turnover and capital turnover.
Financial ratio analyses play a vital role in analyzing the financial situation of the company. Four companies and 35 financial ratios has been used for this study. Fauji fertilizer company ltd's financial ratios has been compared with three companies from automobile sector to find out the trend in financial performance of the companies. Five groups are formed from 35 financial ratios that include market ratios, liquidity ratios, debt ratios, profitability ratios and efficiency ratios. Results of this study proved that the financial performance of Fauji fertilizer company ltd is best among other companies that has been included in the research from 2005 to 2009.
Financial performance of a firm can be calculated with the help of financial ratios. By using ratios companies can determine financial strength or weaknesses as well as opportunities in the market or industry. Ratios can provide the actual picture of the firm's financial position. Financial ratios assist analysts to acquired insight knowledge of firm's financial situation. Data from different financial statements has used to calculate the ratios. Financial ratios can tell the investors future performance of firms by looking past trends. Ratios helped management to act more logically and made financial decision on more knowledge and less risky.
Outline of the study
Fauji fertilizer company ltd gave strong financial performance within chemical sector during 2005 to 2009. To evaluate the performance in intra industry ratios of Fauji fertilizer company ltd is compared with companies of automobile sector for the period of 2005 to 2009. The objective of the study was finding the trend in financial performance of both the industries. To examined the financial performance five groups are formed from 35 financial ratios that include:
Results from this study proved that the financial trend, performance and ratios of the companies that has been used in the study was unequaled. In other words financial results of both industries are diverse and differed and no company within automobile sector gave strong financial performance that matched the performance of Fauji Fertilizer Company limited.
Financial ratios helped to separate profitable firms from non profitable firms that were confirmed from past studies. This study also concluded that profitable firms has higher financial ratios than non profitable firms. Financial ratios has been used since early ages but still lack clear theoretical structure for selecting suitable ratios for analysis. Lot of work has been done in this field but still huge possibilities of improvement are available.
Implications and Recommendation
Financial ratio analysis is a good choice for uncomplicated and immediate analysis of financial position of the company with considerable prediction power. With the help of financial ratio analysis future performance of the company can be predicted by studying the past trend of performance. This allows the investors and shareholders to invest on the basis of actual fact and figures rather than on different assumptions. To reduce the fluctuation in the ratios and made the results more reliable no. of companies that used in the study must be increased.
Ratios analysis assists the companies to gain insight knowledge as well as external opportunities to forecast future investment trends. This analysis facilitates the companies to focus on weak points and improved them as well as takes benefits from strong points. Ratios also help the investors and shareholders to forecast return. Reducing errors and inefficiency of ratio analysis greatly help to increase the accuracy and usefulness in future studies.
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