CHAPTER II
LITERATURE REVIEW
2.0 Introduction
This chapter presents the related literature and concepts
about accounting ratios and decision making. Accounting ratios as an integral
part in decision making, the researcher wanted to investigate whether the use
of accounting ratios can intervene in decision making in AMAZI YA HUYE. Using
accounting ratios and decision making concepts, the researcher will attempt to
relate their theories and what could be their applicability in AMAZI YA
HUYE.
2 1 Definition of key terms
2 1 1 Accounting
Accountancy or accounting is the art of communicating
financial information about a business entity to users such as shareholders and
managers. The communication is generally in the form of financial statements
that show in money terms the economic resources under the control of
management.
2 1 2 Ratios
According to the Webster's New Collegiate Dictionary, Mass:
G&C (1975: 958), a ratio is defined as «the indicated quotient of two
mathematical expressions» and as «the relation between two or more
things»
(Rustagi R.P., 2000: 53) notes that; a ratio is a relationship
expressed in mathematical terms between two individual and groups of figures
connected with each other in some logical manner.
2.1.3 Accounting ratios
2 1 4 Financial ratios
These are tools for interpreting financial statements to provide
a basis for valuing securities and appraising financial and management
performance.
2 1 5 Decision making
It is the study of identifying and choosing alternatives based
on the values and preferences of the decision maker. Decision making is also
the process of sufficiently reducing uncertainty and doubt about alternatives
to allow a reasonable choice to be made from among them. (Robert Version,
1998).
2 2 Essence of Ratios Analysis
The essence of the financial soundness of a company lies in
balancing its goals, commercial strategy, product-market choices and resultant
financial needs. The company should have financial capability and flexibility
to pursue its commercial strategy.
According to (Butters, K.J., 1981: 3-7), ratio analysis is a
very useful analytical technique to raise pertinent questions on a number of
managerial issues. While assessing the financial health of a company with the
help of ratio analysis answers to questions relating to the company's
profitability, as sets utilization, liquidity, financing and strategies
capabilities may be sought.
2 3 Standards of Comparison
The ratio analysis involves comparison for useful
interpretation of financial statements. A single ratio in itself does not
indicate favorable or unfavorable condition. It should be compared with some
standard.
According to (Anthony, R. N. and Reece, J. S, 1975:
260-263), standards of comparison may consist of:
· Past ratios: ratios
calculated from the past financial statements of the same firm;
· proj ected ratios: ratios developed using the
projected or pro forma financial statements of the same firm;
· competitors `ratios: ratios of some selected
firms, especially the most progressive and successful competitor, at the same
point in time and
· Industry ratios: ratios of the industry to which
the firm belongs. 2 3 1 Time series analysis
This is the way used to evaluate the performance of a firm by
comparing its current ratios with the past ratios. It gives an indication of
the direction of change and reflects whether the firm's financial performance
has improved, deteriorated or remained constant over time. (I. M Pandey, 1995:
105)
2 3 2 Pro forma analysis
Sometimes future ratios are used as a standard of comparison.
Future ratios can be developed from the pro forma financial statements. The
comparison of current ratios and the future ratios shows the firm's relative
strengths and weaknesses in the past ant the future ratios indicate weak
financial position, corrective actions should be initiated. (I. M Pandey, 1995:
105)
2 3 3 Industry analysis
To determine the financial condition and performance of a
firm, its ratios may be compared with average ratios of industry of which a
firm is a member. This sort of analysis helps to ascertain financial standing
and capability of the firm vis-à-vis other firms in the industry.
Industry ratios are important standards in view of the fact each industry has
its characteristics which influence the financial and operating relationship.
(I. M Pandey, 1995: 105)
2 3 4 Cross-sectional analysis
It consists at comparing ratios of one firm with some selected
firms in the same industry at the same point of time. This kind of a comparison
indicates the relative financial position and performance of the firm. A firm
can hardly resort to such a comparison, as it is difficult to get the published
financial statements of the similar firm. (I. M Pandey, 1995: 105)
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