EVALUATION OF FINANCIAL RATIO ANALYSIS IN THE PREDICTION OF CORPORATE FAILURE AND BANKRUPTCY IN NIGERIA: A STUDY OF SELECTED COMMERCIAL BANKS

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CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS

ABSTRACT

Financial analysis is the process of identifying the financial strengths and weaknesses of a firm by properly establishing relationships between the assets and liabilities and the performance of that particular firm. Commercial banks in Nigeria need to undertake periodic financial analysis; this could not be unconnected with the recent failures that engulfed the banking industry in Nigeria and its devastating effects on both the customers and shareholders.

The study seeks to evaluate the efficiency of financial ratios analysis in predicting corporate bankruptcy and failure in the Nigerian banking industry. This is to guard against the possible loss suffered by numerous customers, owners and other stakeholders who have interest in such financial institutions. An in-depth analysis of financial statements of a firm tend to provide a deep insight into the operations of that firm. This brings to the fore the genesis and the magnitude of problems that subsequently result in poor performances. Therefore the use of financial ratios in the analysis of performance, is an indispensable aid to appraising true performance of firms. This will greatly help management to spot out financial weaknesses of firms and to take suitable corrective actions. Thus, financial analysis is the starting point for making plans before using any sophisticated forecasting and planning procedures. This is necessary as understanding the past is a prerequisite for anticipating the future. In the course of this study, stratified random sampling was employed to achieve the aims of this research work. The banks studied in this work were categorised into two strata: first generation and new generation banks. Three banks were strategically selected from the old generation banks while two banks were also selected from new generation banks. From the data obtained and the analysis made using various financial tools, the financial condition of the banks under study was not very good, according to Altman’s model and Osaze’s index respectively. Based on the analysis made using the various tools of financial analysis, it is recommended that the banks should majorly cut down their cost of operations and reduce their total debt. This will reduce their operating expenses as well as interest charges paid annually to creditors.

CHAPTER ONE

1.1        GENERAL BACKGROUND OF THE STUDY

Almost all kind of business activities, directly or indirectly, involve the acquisition and use of funds. There are several business activities of an enterprise, among these are; production finance, marketing, etc. out of these activities finance plays an important role. For example, recruitment and promotion of employees in production is clearly a responsibility of the production department; but it requires payment of wages and salaries and other benefits, and thus, involves finance. Similarly, buying a new machine or replacing an old machine for the purpose of increasing productive capacity affects the flow of funds. Sales promotion policies come within the purview of marketing, but advertising and other sales promotion activities require outlays of cash and therefore, affect financial resources. (Pandey, 2000: 5).

Financial management endeavours to make optimal investment, financing and dividend/share repurchase decisions. In an endeavour to make optimal decisions, the financial manager makes use of certain analytical tools in the analysis, planning, and control activities of the firm. Financial analysis is a necessary condition, or prerequisite, for making sound financial decisions. One of the important roles of a chief financial officer is to provide accurate information on financial performance, and the tools taken up will be instrumental in this regard (Van Horne, 2002: 8). However, financial scholars generally explain what financial management is by describing the business organisation as a ‘pool of funds’ i.e. it is a collection of funds from a variety of sources. The sources include money from investors who invest in the business stock or creditors who lend their money to the business to profit or retained earnings. The funds from these sources are being committed to a number of uses such as the purchase of assets, especially fixed, for the production of goods and services, inventories, to facilitate production and sales as well as payment for varying transactions. What is fundamental they stated was that these sources of funds and the uses or purposes for which the funds are committed do change over time and the process is known as funds flow. Financial management according to them therefore connotes the effective and efficient management of the flow of funds within and outside the organisation.

Management employs financial analysis for purposes of internal control. In particular, it is concerned with profitability on investment in the various assets of the company and in the efficiency of asset management (Ibid: 349). Financial analysis as a role of financial analyst evolved with changes in the role of financial management. Financial management as a field of study is believed to have passed though several and significant changes over the years when it first emerged as a separate field of study from management in the year 1890. At that time emphasis was primarily on the acquisition of funds. This was so because the basic problem facing business managers and firms in the early 1900 was that of obtaining the desired capital. This focus remained through to the later parts of 1920s. However, radical changes occurred and a significant departure was recorded during the periods of the world depression of the 1930s otherwise called the great depression when an unprecedented number of businesses failed. This development necessitated a redirection of attention and effort to critical issues of the moment such as bankruptcy, corporate reorganisation, corporate liquidity, the role of government and government regulations on the operation of businesses. In other words, there was shift of emphasis from corporate expansion strategies to business survival strategies. The period of 1940s through to the early parts of 1950s witnessed a redesignation of focus to basically methods of financial analysis. The intention was to help businesses maximise their total profitability, stock prices as well as predict the likelihood of failure even before it occurs.

The analysis of financial ratios indicate the operating and financial efficiency, and growth of a firm. The financial ratios could be used to determine the ability of the firm to meet its current obligations; the extent to which the firm has used its long-term solvency by borrowing funds; the efficiency with which the firm is utilising its assets in generating sales revenue and the overall operating efficiency and performance of the firm. The job of the financial manager is, therefore, an important one and his responsibilities involves taking decisions as regards instruments the firm should take, how these instruments should be financial and how the existing resources of the firm should be managed so that the maximum benefit could be derived.

In order to perform his functions in the most effective and efficient manner, the financial manager needs some tools of analysis. One of the tools available to the financial manager is the “Financial Ratio Analysis”. Financial ratio analysis is the process of identifying the financial strengths and weaknesses of any firm by properly establishing relationship between the items of the balance sheets and profit and loss account. A financial manager wants to know through financial analysis whether the firm can reasonably afford to borrow all or part of the funds needed to finance a planned expansion, find out causes of changes in operating income relative to its competitors etc. Financial ratio analysis is therefore, used as a means of evaluating the financial position and performance of a firm as well as product the likelihood of an organisation going bankrupAlthough financial managers cannot rely on accounting information as reported in the various financial statements as most times they do not provide adequate understanding of the performance and the actual position of a firm until when they convey meaning relating to specific information. The analysis of financial analysis can also be undertaken by outsiders for example, investors who wish to determine the credit worthiness or investment potentials of the firm. According Pandey, (2000: 8-9), financial analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing relationships between the items of balance sheet and the profit and loss account. Financial analysis can be undertaken by management of the firm, or by parties outside the firm, viz, owners, creditors, investors and others. The nature of analysis will differ depending on the purpose of the analysis. Trade creditors may be interested in a firm’s ability to meet their claims over a very short period of time. Their analysis will therefore, confine to the evaluation of the firm’s liquidity position. Suppliers of long-term debt, on the other hand, are concerned with the firm’s long-term solvency and survival. They analyse the firm’s profitability over time, its ability to generate cash to be able to pay interest and repay principal and the relationship between various sources of funds (capital structure relationship). Long-term creditors do analyse the historical financial statements, but they place more emphasis on the firm’s projected, or pro forma, financial statements to make analysis about its future solvency and profitability. Investors, who have invested their money in the firm’s shares, are most concerned in those firms that show steady growth in earnings. As such, they concentrate on the analysis of the firm’s present and future profitability. They are also interested in the firm’s financial structure to the extent it influences the firm’s earnings ability and risk. Management of the firm on the other hand, would be interested in every aspect of the financial analysis. It is their overall responsibility to see that the resources of the firm are used most effectively and efficiently, and that the firm’s financial condition is sound.

It is imperative to note the importance of the proper context for ratio analysis. Like computer programming, financial ratio is governed by the GIGO law “Garbage In…Garbage Out!” A cross industry comparison of the leverage of stable utility companies and cyclical meaning companies would be worse than useless. Examining a cyclical company’s profitability ratios over less than a full community or business cycle would fail to give an accurate long-term measure of profitability. Using historical data independent of fundamental changes in a company’s situation or prospects would predict very little about future trends. For example, the historical ratios of a company that has undergone a merger or had a substantive change in its technology or market position would tell very little about the prospects for this company. Generally, a financial ratio serves as a useful tool to manager and investors in assessing the financial strengths and weaknesses of a firm. However, a single ratio in itself does not indicate favourable or unfavourable condition until it is compared with some standards. Further to the identification of the inadequacies of the univariate ratio analysis otherwise called the traditional ratio analysis, a number of empirical studies were conducted on multivariate financial analysis which can be used in the prediction of financial and corporate bankruptcy etc. Some of the standards of comparison of the traditional or univariate ratio analysis are:-

• Ratios computed from the past financial statements of the same firm;
• Ratios developed using the pro-forma financial statements of the same firm;
• Ratios of some selected firms especially the most progressive and successful in the same industry within the same period; and
• Ratios of the industry to where the firm belongs (industry average). Financial Ratios are often evaluated using:-
• Cross-sectional approach; and
• Time-series analysis.

Of all the tools of financial analysis, ratio analysis is perhaps the most widely used. A ratio is simply the relationship between the one number and another number. Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company’s financial statements. The level of historical trends of these ratios can be used to make inferences about a company’s financial condition, its operations and attractiveness as an investment. But that surely does not mean that the resulting ratios would assist the analyst by enhancing undertaking of the firm’s financial conditions. The analyst is interested only in those ratios that are relevant to particular financial problems or decisions. It is wrong to conclude from any firm’s ratio that a firm’s liquidity position is satisfactory or not, that its capital structure is sound or unsound, or that the ratio is too high or too low. The ratio may be symptomatic of a problem, but further analysis is required to determine the cause or to draw conclusions of a qualitative nature.

The great advantage of ratio analysis is that it reduces raw data of widely varying magnitude to a common comparative basis. Thus, ratio analysis is the most meaningful way to compare financial information regarding a given firm to that of others that are larger or smaller, or to a composite of other firms such as an industry.

Credit analysts, those interpreting the financial ratios from the prospects of a lender, focus on the “downside” risk since they gain none of the upside from an improvement in operations. They pay great attention to liquidity and leverage ratios to ascertain a company’s financial risk. Equity analysts look more to the operational and profitability ratios, to determine the future profits that will accrue to the shareholder.

Although financial ratio analysis is well-developed and the actual ratios are well-known, practising financial analysts often develop their own measures for particular industries and even individual companies. Analysts will often differ drastically in their conclusions from the same ratio analysis.

1.2        STATEMENT OF THE PROBLEM

Two groups of questions will be the focus of this study. The first is how effective is the financial ratio analysis in predicting corporate bankruptcy and failure?

The second question concerns prevention of corporate bankruptcy and failure by the use of the financial ratios. Does the use of financial ratio analysis prevent corporate bankruptcy and failure? In other words are the earlier results corroborated, or have they been influenced by the limited selection of variables? In addition to the implications on the traditional financial ratios, we are interested in finding out whether the use of financial ratio analysis can help in predicting corporate bankruptcy and failure. In tackling our research problem, we shall use a hypothesis approach rather than just observing and reporting the emerging classifications. The statistical methods will be factor analysis, and transformation analysis.

In tackling our research questions special attention must be given to stability, and avoidance of definitional correlation. One of the pitfalls of inductive methods, such as factor analysis, is whether the results are a consequence of a coincidence, and thus unstable, or do they result from true underlying factors, which would mean better stability. Hence we shall test the stability of our factor analysis results with transformation analysis.

Definitional correlation between financial ratios can easily arise if they include, either directly or indirectly, the same components (e.g. net profit/total assets and net profit/sales are related by definition). We strive to avoid this pitfall by a judicious selection of the original variables.

1.3        OBJECTIVES OF THE STUDY

The purpose of this study is to evaluate the efficiency of financial ratio analysis in predicting corporate bankruptcy and failure in the Nigerian banking sector. This is in order to assess how well or otherwise financial ratio analysis can assist financial managers in predicting financial problems and to enable them adequately plan for future financial resources of their organisations.

1.4        RESEARCH QUESTION/HYPOTHESIS

Profitability, operating efficiency, output level, capital investment and dividends are considered as measures of success of a firm. Ratio analysis is a very useful tool to raise relevant question on a number of a managerial issues. This study seeks to answer the following question: “How efficient are financial ratios analysis in predicting corporate failure and bankruptcy in Nigerian banking industry?” In an attempt to answer the research question, two hypotheses have been developed. These hypotheses are null hypothesis and alternative hypothesis. The hypotheses are given as follows:-

H_o: There is no significant relationship between financial ratios analysis and prediction of corporate failure.

H₁: There is significant relationship between financial ratios analysis and prediction of corporate failure.

1.5        SIGNIFICANCE OF THE STUDY

Ratio analysis is the most powerful tool of financial analysis. Financial analysis is the process of identifying the financial strengths and weaknesses of a firm by properly establishing relationships between the items of the Balance Sheet and the Profit and Loss Account. Financial analysis can be undertaken by management of the firm, or by other stakeholders outside the firm, viz: owners, creditors, investors and others. The relationship between two accounting figures, expressed mathematically, is known as financial ratio. Financial ratios help to summarise large quantities of financial data and to make qualitative judgement about the firm’s financial performance. It is important to note that a ratio reflecting a quantitative relationship, helps to form a qualitative judgement (such is the nature of all financial ratios).

The analysis of financial ratios indicate the operating and financial efficiency, and growth of a firm. The financial ratios could be used to determine – the ability of the firm to meet its current obligations; the extent to which the firm has used its long-term solvency by borrowing funds; the efficiency with which the firm is utilising its assets in generating sales revenue, and the overall operating efficiency and performance of the firm.

With the current political and economic difficulties in Nigeria, business enterprises are invariably subjected to pressure and stress which in effect has constituted a threat to the corporate existence of these businesses which if not properly managed could lead to bankruptcy, or even total failure. As such, financial sectors became a battlefield for survival of the fittest with financial institutions being forced to assume greater risks. The makes the banking industry particularly prone to bankruptcy and/or failure.

Financial ratio analysis is used to computer, analyse, predict and compare the conditions and performances of business enterprises in order to evaluate their liquidity, profitability and viability. It is against this background that this topic was chosen by the writer.

1.6        SCOPE OF THE STUDY

This study seeks to evaluate the use of financial activities as a tool in predicting corporate failure and bankruptcy. It also seeks to evaluate and show how financial ratios can serve as tools for managerial control to evaluate corporate performance as well as predictors of bankruptcy or failure. Consequently, the study covers the financial activities of five banks between the period 2001 and 2004.

In an attempt to evaluate these various financial statements, industry ratios using trend analysis were compared over time. Year-to-year comparisons can highlight trends and point up the need for action. Trend analysis works best with five years of ratios. The second type of ratios analysis, cross-sectional analysis, compares a company’s financial ratios to industry ratio averages. Another popular forms of cross-sectional analysis compares the financial ratios of two or more companies in similar lines of business.

1.7        LIMITATIONS OF THE STUDY

Research on financial ratios analysis is usually based on a large number of firms. But due to time constraint, this study will base its research on five firms (banks) only. Some of the limitations of this study are:-

• Limitations of the financial ratios which could be due to alternative accounting methods – variations among companies in the application of generally accepted accounting principles may hamper comparability. Firms frequently establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels. Therefore, year-end data may not be typical of the financial condition during the year. The financial statements contain numerous estimates to the extent that these estimates render the financial ratios and percentages inaccurate. Also, traditional financial statements are based on cost and are not adjusted for price-level changes.
• Although a trend may have been developed over a period of five years, the period of the study (2000 – 2004) is too short to form an adequate opinion to give a reliable basis for realistic prediction.
• Nigeria is yet to develop industry ratio averages with which to compare its firms’ ratios. Comparison between firms’ ratios with that of the industry was therefore not possible
• Time constitutes a serious limiting factor as the study has to be concluded within a short period of time.
• Most of Nigerian firms were unwilling to release financial statement and other data.

1.8        DEFINITION OF RELATED TERMS

Accounts Payable Turnover: The number of times payables turnover during the year.

Accounts Receivable Turnover: Number of times that trade receivables turnover during the year.

Cost of Goods Sold: Percentage of sales used to pay for expenses which vary directly with sales.

Current Ratio: The ratio between all current assets and all current liabilities.

Days in Account Payable: This shows the average length of time a firm’s trade payables are outstanding before they are paid (number of days at cost in payables).

Days in Inventory: This shows the average number of days it will take to sell a firm’s inventory (number of days at cost in inventory).

Days in Receivables: This shows the average number of days it takes to collect a firm’s account receivables (number of days of sales in receivables).

Debt Coverage Ratio: Indicates how well cash flow covers debt and the capacity of the business to take on additional debt.

Debt to Equity: The between capital invested by the owners and the funds provided by lenders.

Gross Profit Margin: Indicator of how much profit is earned on firm’s product without consideration of selling and administration costs.

Inventory Turnover: Number of times that firm turns over (or sell) inventory during the year.

Net Profit Margin: Shows how much profit comes from every naira of sales.

Quick Ratio: The ratio between all assets quickly convertible into cash and all current liabilities.

Ratio: Is an expression of mathematical relationship between one quantity and another as either a percentage, rate, or proportion.

Return on Assets: Considered a measure of how effectively assets are used to generate a return.

Return on Equity: Determines the rate of return on firm’s investment in the business.

Sales Growth: Percentage increase (or decrease) in sales between two time periods.

Sales to Total Assets: Indicates how efficiently a firm business generates sales on each naira of assets.