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Financial
Journal ofRatio Analysis:
Business Decisionand
Management Usefulness for Potential
Accounting, Vol. 7 (2),Shareholders'
2017 : 51-59Benefits: 51-59 51

Financial ratio analysis: Decision Usefulness for Potential

Shareholders’ Benefit
musa Usman Kabir *, Norhani aripin, redhwan ahmed ali al-Dhamari
Tunku Puteri Intan Safinaz School of Accountancy, College of Business,
Universiti Utara Malaysia, Sintok, Kedah, Malaysia

abstract

The certainty of the reliance on the use of financial ratio analysis in making investment
decisions by potential investors still remained a mystery. This has to do with the choice
of ratios to select when making investment decisions. Many shareholders in Nigeria
are uneducated or illiterate, and due to their ignorance, they cannot use ratio analysis
in evaluating firms for investment decisions. Thus, this paper explores the concept
of financial ratio analysis in terms of the decision usefulness of financial ratios. The
paper suggests that the relevant financial information needed for the purposes of
making investment decision can be sourced through the use of financial ratio analysis.
Therefore, management must ensure that disclosure of comprehensive financial ratios
form part of financial statement prepared for the overall appraisal of firms.

Keywords: Financial ratio analysis, decision usefulness, shareholders, firms.

1.0 introduction

In a competitive market where there is free entry and free exit of investments, stockholders
require the use of financial ratios to evaluate the value of firms for investment purposes.
Study established the insufficiencies of the disclosed financial ratios in satisfying the
information needs of the shareholders (Ho, Aripin, & Tower, 2012). To enable investors
make significant investment decisions, the use of financial ratio analysis is required.
The appraisal of investment opportunities is of utmost significance owing to the need
for maximizing returns on investment. Corporate firms seek capital funds which are to
be made available by the investors having been able to evaluate the firm value through
painstaking analysis of the financial reports (Mankiw, 2007).

To enable the production of goods and services for the growth of an economy, basic
knowledge of ratio analysis by investors is required for wealth maximization. The
nation’s productive capital comes from the aggregate savings within an economy. The
efficient allocation of capital resources from the potential shareholders to the corporate
entities is needed for stimulating the development of an economy. However, to enable

* Corresponding Author
E-mail Address: [email protected]
52 Journal of Business Management and Accounting, Vol. 7 (2), 2017: 51-59

this mechanism, potential investors require accounting information from business firms
to decide where to invest their capital for optimum yield.

The information needs of potential investors can be sourced through the use of financial
ratio analysis (Amran, & Aripin, 2015). If the financial information from the disclosed
financial reports cannot satisfy the information needs of the investors, then they might
make the wrong economic decisions. It will adversely affect their investments if the
usefulness of financial ratio analysis is not considered as a means of sourcing for
additional information about stock returns (Kheradyar, Ibrahim, & Nor, 2011).

Decision-making is the process of selecting one alternative among many substitutes

(Miller, 1994). The decision maker must have precise, accurate, reliable and relevant
information to define the problems, generate alternatives and ultimately make a choice
(O’reilly, Chatman, & Anderson, 1987). According to Rowe and Boulgarides (1983)
the process depends on the circumstances in which a decision is made, the decision
maker’s way of perceiving and understanding signals, what the decision maker values
or judges as important.

Martinsons and Davison (2007) claimed that two of the most significant influences on
decision-making are values and cognitive perception. Both depends on how a decision
maker will interpret and respond to a stimulus and sets of conditions. In the context
of this paper, decision-making is highlighted in terms of information obtained by the
potential investors in their decision-making processes with respect to financial ratio
analysis. More importantly, understanding the usefulness of disclosed financial ratios
in the annual reports based on the suggestion of previous studies makes the study
necessary (Aripin, Ho, & Tower, 2014).

Financial ratio is a widely-used tool of financial analysis, the use of financial ratios to
interpret financial statements provides a quick indication of a firm’s performance and
financial position to different users of the financial statement (Abdul-Baki, Uthman, &
Sanni, 2014). In the light of the above, this paper theoretically assesses the usefulness
of financial ratios analysis to the potential investors and to understand the current state
of affair as to the usefulness of ratio analysis.

Financial reports of Nigerian firms have been found to be deficient over time (Wallace,
1988; Adeyemi, 2006; Nzekwe, 2009; Raph, 2015) in the sense that they lacks vital
information that will enable potential investors make informed decisions. A study
conducted by the World Bank (2006) states that disclosure practices by Nigerian firms
are insufficient for investment decisions. Other scholars’ remarks are similar to that of
World Bank in the sense that they all found the Nigerian corporate reporting practices
to be deficient (Adekunle & Asaolu, 2013; Umoren, 2009; Ofoegbu & Okoye, 2006;
Okike, 2000). This paper conceptually assesses the extent to which financial ratios
analysis can be used by potential shareholders to source for vital information for
decision making.
Financial Ratio Analysis: Decision Usefulness for Potential Shareholders' Benefits: 51-59 53

2.0 Decision Usefulness: an Overview

The wisdom behind the use of financial ratios is to guide users to make good and effective
decision which is expected under normal circumstances in order to have a multiplier
effect on the economy at large (Maidoki, 2013). The objective of financial statements
is to convey information about the true financial performance or position as well as
the capability of an entity (Piotroski, 2000). There are different users of accounting
information generated through ratio analysis; each of the categories have their unique
demand in terms of their information need. For instance, potential shareholders are
interested in ascertaining the earnings that will emanate from the financial resources
they will commit to finance their organizations.

Employees, on the other hand, are strongly interested in being adequately compensated
for the services they rendered. Governments are interested in the reports to ensure that a
just and fair resources allocation is achieved and for tax purposes. Moreover, members
of the public are in need of information to understand the operational performance of
the businesses located in their domain, particularly their responsibilities to stakeholders
(Dandago & Hassan, 2013). In other words, the public are solely interested in information
from financial ratios which will guide them in appreciating the economic and social
impact of the firm’s activities.

In a market economy, the potential holders of stocks need to make significant decisions
concerning investment opportunities. However, for decisions concerning investment
to take place, investors need accounting information to take advantage of investment
opportunities that would result in value creations. Financial data generated through
financial ratio analysis conducted on annual financial statements will assist both
potential and existing investors in order to decide when to procure, dispose or hold their
shares. If the financial information disclosed in the annual reports is not sufficient, then
wrong investment decisions becomes inevitable if the process of financial ratio analysis
cannot be employed by the potential investors.

Accounting information, right from the inception, was made to protect the shareholders
and the creditors. According to Akmal, Syed and Shaikh (2012), the world accounting
standards setters, IASB and FASB, tilted and conferred excessive significance on the
concept of decision usefulness to lenders and stockholders. Thus, Statement of Financial
Accounting Concepts (SFAC) No. 1, provides the objectives of financial reporting as
to present information to potential investors and creditors and other users in making
rational investment decision.

Generally, it was alleged that the general purpose financial reports do not meet the
comprehensive needs of the potential investors which necessitate the promotion of the
single-person theory by different scholars over time. For example, scholars such as
William (2009), Godfrey, Hodgson, Holmes and Tarca (2006) and McCartney (2004)
proposed the adoption of single person theory in the preparation of annual report. This
is based on the need to provide comprehensive accounting information to investors
54 Journal of Business Management and Accounting, Vol. 7 (2), 2017: 51-59

and capital providers. The resolved to prepare general-purpose financial reports by

corporate bodies in the literature of accounting emanated in US in the 1950s vis-à-vis
decision usefulness theory (Zeff, 2012).

Financial ratios analysis can offer the comprehensive information needs of the investors
in response to the single person theory of accounting as proposed by scholars as against
the normally produced multiple purposes financial accounting annual reports. In other
words, financial ratio analysis is intended to meet the specific needs of all potential
investors who require additional comprehensive accounting data (Brearey, 2013; Barth
and Landsman, 2010).

The single-person decision usefulness theory is aimed at satisfying the accounting

information needs of potential investors. This will enable the optimal utilization of all
the means of providing relevant, reliable and timely accounting information capable of
ensuring the best investment decisions. It emphasizes that if theoretically, comprehensive
financial statements cannot be provided, then specifically comprehensive accounting
data that can aid investment decision should be provided through financial ratio
analysis. However, it should be understood that tailoring financial ratios to the needs
of each of the users could be easier than striving to satisfy the needs of all the users at
the same time.

The down fall of giant companies like Xerox (2000), Enron (2001), Parmalat in (2003)
at the international level as well as the Cadbury saga, Societe Generale Bank, Savannah
Bank, Intercontinental Banks, Afribank in Nigeria still lingers in the mind of potential
investors. The collapse of these corporate bodies occurred after being certified with a
clean health by auditors. Potential investors are slightly cynical on trusting the contents
of financial statements in spite of being certified by auditors (Ekwe, 2013). The loss
of confidence on the quality of financial reports in Nigeria has made auditing to be
seen as a window dressing profession. Prior to this period, the profession has always
been perceived as a credible and noble profession (Adeyemi and Uadiale, 2011; Salehi,
2007).

Moreover, accounting technologies as presented in the annual financial reports seems

too technical for the knowledgeable let alone the layman. Majority hardly comprehend
the contents of financial statement and as such investment decision becomes difficult
(Norman, 2010), knowledge of accounting data is not only significant to investors but to
other users ((Norman, 2006). Normally, accounting information reveals the investment
opportunities in a firm which could be sourced from financial reports duly certified by
external auditors (Oladipupo and Izedonmi; 2013).

The relevance placed on the information content in financial reports has been lost over
time, even in advanced nations such as USA and UK (Parera & Thrikawala, 2012;
Oyerinde, 2009; Ball & Brown 1968 and Guthrie, 2007). Due to the evident failure of
annual financial reports to satisfy the information needs of investors, there is an urgent
Financial Ratio Analysis: Decision Usefulness for Potential Shareholders' Benefits: 51-59 55

need for satisfying the investment needs of potential investors through financial ratio
analysis.

Financial ratio is a widely-used tool of financial analysis. The use of financial ratios
to interpret financial statements provides a quick indication of a firm’s performance
and financial position (Abdul-Baki, Uthman, & Sanni, 2014). In the light of the above,
this paper conceptually evaluates the usefulness of financial ratio to the shareholders.
In addition, it provides conceptual understanding of current state of affairs as to the
usefulness of financial ratio analysis in stimulating investments drive of potential
investors. More so, the study evaluates the extent to which financial ratios analysis
can be used by the investors for investment decision making purposes to accelerate the
growth of the economy.

Conceptual Framework of Decision Usefulness of Financial Ratio Analysis

!
SUFFICIENCY
OF FINANCIAL
RATIO

SATISFACTION
OF DISCLOSED
RATIO

RATIO
DISCLOSURE DECISION
REGULATION USEFULNESS
(SINGLE
PERSON
DECISION
USEFULNESS
BASIC THEORY)
ACCOUNTING
KNOWLEDGE

FIRMS
DEVELOPMENT

3.0 Underpinnings Theories

This paper is guided by two theories – the single-person decision usefulness theory.
This was developed on the basis that; if a comprehensive single purpose financial report
cannot be guaranteed, then a singular comprehensive specific accounting information
should be made available. This will stimulate the investment decisions drives of
potential investors based on the emphasis of Statement of Financial Accounting
Concepts (SFAC, No. 1).
56 Journal of Business Management and Accounting, Vol. 7 (2), 2017: 51-59

The agency theory, on the other hand, established the inherent relationship
between potential investors and the firm’s management. The utmost concern of this
theory is to mitigate potential problems that can occur in agency relationships due to
managerial shenanigan as a result of the possession of insider corporate information.
This theory presupposes that the complete disclosure of corporate value to the potential
investors through disclosed financial ratios to enable rational investment decision.

4.0 conclusion

It can be realized from the paper that financial ratios analysis is still the best way that
accounting information can fully be communicated to potential investors in order to
inspire the best investment decisions. However, the general purpose financial statement
lacks clear information on the performance of corporate firms which the investors need
to make investment decisions. For the shareholders to make the best use of the financial
statement as a guide for making investment decision there is need for single purpose
financial ratio disclosure through financial ratio analysis.

The paper conceptually shows that sufficiency of disclosed financial ratios and
satisfactions derived from them are required for decision making. In addition,
regulations mandating the disclosure of financial ratios and acquiring basic knowledge
of the understanding of disclosed ratios are important. Moreover, other theoretical
information on firms’ level of development are one of the basic requirements that will
catapult the investment drive of investors. In a nutshell, full disclosure of all relevant
corporate financial ratios are needed for useful decision making.

5.0 recommendation and Further research

Based on the foregoing, the paper recommends that in order to make financial ratios
more meaningful, there is need to consider these antecedent variables as itemised in the
conceptual framework. This will ensure adequate disclosures on performance rather
than mere window dressing for the use of both potential and existing shareholders.
Furthermore, this paper proposed the adoption of fundamental analysis as a panacea for
determining the corporate value of business entity for the purpose of taking investment
decision.

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