Memoire Online - The use of accounting ratios in decision making

This chapter presents the findings of the study entitled «the use of accounting ratios in decision making» in AMAZI YA HUYE. It also presents a brief description of AMAZI YA HUYE as the case study. It also based on the analysis of both primary and secondary data collected to achieve the stated objectives. The analysis of the data collected was done in accordance with the study objectives and hypothesis. The results were reported in tables and summarizing answers to major questions asked. The researcher used focus group interview to obtain first hand information, whereby all six staff of the company who deal with accounting and finance were involved in the discussion. In short, this chapter examines the empirical evidence and establishes grounds upon which the researcher hypothesis can be proved before concluding the results of this research.

AMAZI YA HUYE is a private company that was formed in 1998, with the key aim of mineral water production and its base is in Huye District former Butare town in the Southern Province.

Their first mineral water product appeared at the market beginning with the year 2000, after the scientific laboratory experiment by the University of Shanghai in china. Experts from this University confirmed the purity of the mineral water manufactured by AMAZI YA HUYE enterprise

AMAZI YA HUYE Company do not only produce mineral water but also produces the plastic bottles into which their mineral water products are packed.

Its head office is in Kigali city at Muhima near Kabuga's building because of availability of large market. This company still sells its products locally but it imports its raw materials abroad specifically from China.

It seeks to increase the productive capacity of the mineral water and play a key role in transforming the economy and enhancing the well being of people. Through their dynamic and responsive teams, it aims at providing the products and maintains the highest levels of customer service and professional integrity.

> To support the development of the industrial sector generally through innovative and the transfer international best practice.

> To support the drive of the private sector investment for the development of the economy working with locals as well as international investment and development focused agencies.

> To meet needs and expectations of its customers by providing the products at the right quality and at the right time.

The AMAZI YA HUYE Company is not a monopoly one but operates with a perfect competition market structure.

In order to adapt itself to the business investment, this enterprise makes sure that it has a good relationship with the commercial banks and even other industries operating in Rwandan territory and other countries.

AMAZI YA HUYE enterprise is an individual Industrial company of Mr. GAKWAYA Etienne whose capital was 83,404,822 RWF at the beginning in 1998 but currently the capital is 149,000,000 RWF

IT Manager		Chief Accountant	Importation Officer	Engineer
	Human Resou rce manager

Accountant A	Acco unta nt		Secretary	Cashier
		Acco unta nt

By making description of the above organization structure, different tasks attributed to general management and different departmental services are precised in accordance to the organizational arrangement of the chart.

- Recording the daily operations of expenses and revenues of the company of AMAZI YA HUYE

- Analyzing financial transactions and gives information to the management and the third parties.

- Distribution of information system in all the departments - Repair of computers that are experiencing errors.

has been a result of a number of factors, but the main factor is a lack of rational decision making. As finalist student in Accounting Sciences in this research, we picked interest in one of techniques that is commonly used in decision making since it naturally provides much information in almost every aspect of the business. The researcher was motivated to find out the effectiveness of using accounting ratios in decision making of the enterprise. The student was also interested in knowing whether this techniques is used or not, and what could be the requirement to use them effectively.

To the opinion of the accountant and management department executives on important issues related to accounting ratios group interview (in depth interview) was conducted. All six staff of management department in AMAZI YA HUYE was interviewed including the accountants of this enterprise

The discussion took place at AMAZI YA HUYE headquarter as well as at the factory residence whereby all the participants were requested to think on all matters concerning accounting ratios in AMAZI YA HUYE. After each interview, notes are taken to unable analysis to be made. For some question clarifications are given to the interviewee so that they can give their views and opinions.

For this purpose 32 ratios were selected based upon a review of text books. These ratios were divided into 5 categories of analysis, such as ratios to use in analyzing liquidity, efficiency, sales profitability, debt, and in multiple dicsriminant analysis. The management staff of AMAZI YA HUYE disclosed that ratios are frequently used by the company in analyzing profitability and liquidity. They said that ratios used in this manner are more significant to take any decision.

After knowing that accounting ratios are used in AMAZI YA HUYE as a tool of analysis in decision making and after knowing that the staff management of AMAZI YA HUYE are interested in their use in decision making the researcher wanted to investigate how this technique is used.

To determine the preferred ratios the researcher asked the following question» What among the following kind of accounting ratios do you take into account while making decisions and for which purpose?»

One of the management staff said that debt ratio help to measure the extent to which a company rely on outsiders funds.

To determine whether there exists a linkage between accounting ratios and organization sustainable growth, the researcher asked the following question to the respondents «Do you agree that, the use of accounting ratios can lead to the decision making?» The following table shows categories of their responses:

Table 4 1 Respondents' view on the linkage between accounting ratios and decision making

There seems to be a majority who agree that there is a linkage between accounting ratios and decision making. The chef accountant commented that decision model like financial ratios plays a great role in assessing the financial performance of the company but he presented the problem of a lack of capacity to use them. One of the accounting department said, though financial ratio analysis is not the only measure of performance, still it is the best to measure the financial health of the company to take any decision.

added that this tool is as important as accounting ratio. The researcher asked which purpose the have while using this method; he replied that the use a flexible budget since it gives room for any change in the future.

Another participant added that in AMAZI YA HUYE they put more emphasize on the importance of preparing budget for each cots center. The researcher wanted to know different kinds of budget prepared there, one of the respondent said, here we prepare various budget like purchase budget, sales budget, production budget, selling and distribution budget.The remaining participant didn't to have any comment because she said that her task have no linkage with decisions taken in the company because she is a book keeper.

The researcher if there are any techniques used to make decisions that avoid bankruptcy as it had occurred to SORWAL SARL, among this type of analysis the researcher presented them a set of significant ratios used in the multiple discriminant analysis. The manager officer said, this could be the effective tool to take decision for avoiding bankruptcy but he added that is not yet used in their company. He concluded by saying that, what is important is to use the accounting ratios as a decision model effectively, but he insisted saying that the problem related with such use is a lack of skilled people in this area.

The secondary data also are used as source of information of a part of the analytical research, for this reason, financial statements of five consecutive years of AMAZI YA HUYE are used, that is from 2003 to 2007. The following analysis was done basing on the secondary data

The table below presents the trend of liquidity position of the company as far as current, quick and cash ratios are concerned, from 2003-2007.

	Formula	2003	2004	2005	2006	2007
RATIOS
Current ratio	Current asset/current liabilities	0.98	1.01	0.99	1.36	2.27
	Current asset-Inventory/current
Acid test ratio	liabilities	0.59	0.34	0.37	0.73	1.51
	Cash+ Marketable
Cash ratio	securities/Current liabilities	0.47	0.28	0.32	0.52	1.17

We compare the results of the current ratio basing on the standard ratio 2: 1. As far as the current ratio is concerned, it was 0.98:1 in 2003 that is not satisfactory even for three successive years of 2004, 2005 and 2006 the ratio computation is 1.01, 0.99.1.36 respectively, for this case the liquidity position went down below the standard but in 2007, the ratio was satisfactory as it was above the standard 2:1, as it was 2.27:1.

Compared to the standard of 1:1 the quick ratio of the company shows unsatisfactory situation from 2003 till 2006, as in 2003 it was 0.59:1, in 2004 it was 0.34, in 2005 it was 0.37:1 and in 2006 it was 0.73 :1. Since 2007 the ratio became satisfactory as its result was 1.51:1.

As far as the cash ratio is concerned, it is 0.47:1 in 2003, 0.28: 1 in 2004, 0.37:1 in 2005, 0.52:1 in 2006 and 1.17:1 in 2007. Basing on the standard of 0.5: 1, the result of this ratio shows unsatisfactory case in 2003, 2004 and 2005. But in 2006 and 2007 there is a satisfactory situation of liquidity as the ratio computation is 0.52:1 in 2006, 1.17:1 in 2007, what we can also include to the result of 2007 is that there is a portion of idle resources of 0.17.

As the table 4 3 and fig 4 1 show, the company' liquidity ratios exbhit a diclining pattern from 2003 to 2005 basing on the rule of thumb.As shown by the above figure, the cuurent ratio, quick ratio, and the cash ratio dropped from the recommendable ratio in 2003,2004 and 2005 as per the role of thumb, 2:1 to current ratio, 1:1 to quick ratio, 0.5:1 to cash ratio, that prove the less liquidity to meet the short term obligations, basing on the above analysis, in 2003, and 2005 the company has no working capital even in 2004 it was not interesting. The situation got change in 2006 and get improvement in 2007 when the results shows the figures above the recommendable ratio.

The following table indicates the trend of Debt ratios in AMAZI YA HUYE for the period of our research that is 2003 - 2007.

	Formula	2003	2004	2005	2006	2007
RATIOS
Leverage ratios	Assets/Shareholder's equity	2.12	1.83	2.22	1.75	1.35
Total debt ratio	Total debt/total asset	0.52	0.45	0.53	0.42	0.26
Debt to equity ratio	Total debt/equity	1.12	0.84	1.13	0.75	0.35
Long term debt to capital	Debt/Debt Equity	0.52	0.45	0.53	0.42	0.26
Interest coverage ratio	EBIT/Annual interest expenses	0.53	0.46	0.53	0.43	0.26

The total debt ratio indicates the extent to which the firm is using debt to finance its assets. The better when the ratio is 0.5:1 or less. In 2003 the ratio was 0.53:1, in 2004 it declined to 0.45:1, in 2005 it got increase to 0.53:1, in 2006 it deceased when it was 0.42 and in 2007 it was 0.26:1.

The result of debt to equity ratio indicates the relationship between lenders' contribution for each franc of the owners' contribution. It in this case, the lenders have contributed more in 2006 for 1 franc given by the owners the lenders give 1.12, and in 2005 for 1 franc from owners the lenders provide 1.13. For the other periods the situation was good as in 2004 for one franc from the owners, lenders provide 0.84, in 2006 for 1 franc from the owner, lenders provide 0.75, and in 2007 for 1 franc from the owners, lenders provide 0.35.

The total leverage ratio relates total as sets to shareholders `equity. This ratio is a degree to which
management has financed the company's asset investment with no ownership capital. The result
of the leverage ratio computation for AMAZI YA HUYE reveals the following situation: in 2003

the ratio was 2.21 which means, to 1 franc from owners 1.12 has been used to find the company's assets from outsiders, in 2004 the ratio was 1.83, to 1 franc from owners, outsiders provide 0.83 to fund the company's assets, in 2005 the ratio was 2.22, to 1 franc from owners, outsiders provide 1.22 to fund the company's assets, in 2006 the ratio was 0.75, to 1 franc from owners the outsiders provide 0.75, in 2007 the ratio was 0.32, to 1 franc from owners the outsiders provide 0.32.

The debt ratios generate the company's ability to meet its obligations, otherwise it measures the dependability of the company to the outsiders. Basing on the ratio computation in table 4 3 and its representation in figure 4.3, in 2003 there was an increase in dependability of the company to the outsiders funds, it declined in 2004, but in 2005 it increased which means that in this period the claims of creditors were greater than those of owners. Starting to 2006 till 2007 these ratios were trending downward, for this reason, the dependability to the outsiders declined which shows a good sign of solvency of the company.

The table below shows the sales and profitability of AMAZI YA HUYE for the period covering five successive years, that is to say 2003 - 2007.

RATIOS	Formula	2003	2004	2005	2006	2007
Sales growth	(current year sales-last year
rate	sales)/last year sales)*100	0.00%	15.00%	-7.2%	-32.04%	-1.21%
Expenses analysis	Various expenses/Sales	0.52	0.74	0.75	0.70	0.51
Gross margin to sales	Gross profit/ Total sales	0.42	0.23	0.21	0.24	0.42
Operating profit to sales	Operating profit / Sales	0.08	0.04	0.05	0.09	0.10
EBIT to Sales	EBIT/ Net sales	0.08	0.04	0.05	0.09	0.10
Return on sales	Net income / Net sales	0.06	0.03	0.04	0.06	0.07
Return on investment	Net income / Fixed assets	1.75	1.94	1.67	1.47	1.84
Return on assets	Net income / Total assets	0.83	1.05	0.79	0.60	0.77
Return on equity	EAT /Shareholder's equity	0.09	0.58	0.06	0.07	0.07
Payout ratio	Cash dividend /Net income	0.00	0.00	0.00	0.00	0.00
Retention ratio	Retained earring/ Net income	0.01	0.01	0.01	0.01	0.01
Sustainable growth rate	REO*Retention ratio	0.0500	0.0175	0.0021	0.0040	0.0045

The sales growth rate was 0.0 in 2003 as there is no data given for the previous. Basing on 2003 in 2004 there was growth of 15%, in 2005 comparing to 2004 there was growth of 7.20%, in 2006 basing on 2005 sales there was growth of -32.04%, and in 2007 there is growth of -1.12% of sales. The results obtained shows that in 2006 the sales declined with a great percentage which

follows buy a bit decline in 2007 all of these situations involve the reinforcements of the marketing activities of the company to ensure a sustainable growth.

The gross margin to sales ratio is an indication of the management's ability to mark up its products over their cost. In 2003 the ratio was 0.42 that means to 1 unit sold the cost of product sold was 0.58, 2004 it was 0.23 that means to 1 unit sold 0.77 was the cost of product sold, in 2005 it was 0.21 that means to 1 unit sold 0.79 was cost of goods sold, in 2006 the ratio was 0.24 that means to 1 unit sold 0.76 was the cost of product sold, in 2007 the ratio was 0.42 that means to 1 unit sold the cost of product was 0.58.

The expense analysis ratio shows the rate of expenses incurred after each sale. It helps to control the expenses comparing to the rate of margin to sales. The result of this ratio was 0.52 in 2003, in 2004 it was 0.74, in 2005 it was 0.75, in 2006 it was 0.70 and in 2007 it was 0.51.

The return on sales indicates the relationship between sales and the earning of the period. It helps in controlling expenses with the rate of margin. In 2003 the ratio was 0.06, in 2004 it was 0.03, in 2004 the ratio was 0.04, in 2005 it was 0.06, and in 2007 it indicates 0.07.

The return on assets ratio shows the relationship between total assets and sales realized. The trend of this ratio in AMAZI YAHUYE indicates that in 2003 for 1 franc invested in fixed and current assets the return is 0.83 on sales, in 2004 for 1 franc invested in fixed and current assets the return is 1.05 on sales, in 2005 for 1 franc invested in fixed and current assets the return is 0.79on sales, in 2006 for 1 franc invested in fixed and current assets the return is 0.60 on sales, in 2007 for 1 franc invested in fixed and current assets the return is 0.77 on sales.

The trend of return on investment helps to analyze the income earned and capital employed. In 2003 to generate 1 franc in sales the company invested 1.75 in fixed assets , in 2004 to earn 1 franc in sales the company invested 1.94 in fixed assets, in 2005 to generate 1 franc in sales the company invested 1.67 , in 2006 to earn 1 franc in sales the company 1.47 , in 2007 to generate 1 franc in sales the company invested 1.84.

The return on equity indicates how well the company has used the owners's resources. In our
case study, the result of this ratio was 0.09 in 2003, 0.058 in 2004, 0.06 in 2005, and 0.07 in
2006 and in 2007. The percentage of this ratio reveals the relative performance and strength of

the company in attracting future investments; it means that in 2003 the capacity of AMAZI YA HUYE was too high comparing to the following years when it declined slightly till the level of 7% in 2007.

Figure 4 4 AMAZI YA HUYE expenses analysis, gross margin to sales, return on sales ratios
2003-200 7

Basing on the results from the table 4 4, from 2003 to 2006, there was a decrease of gross margin ratio, but on the other side there was an increase in expenses as shown in expenses analysis ratio. This situation leads to the reduction of net profit regarding these periods that means there is no expenses management basing on sales and cost of goods sold. This set of ratio can help to take measures for the future sales and their expenses. In 2007, we consider a slight decrease of gross profit margin, as well as a slight increase in expenses analysis ratio which provide a bit higher return on sales ratios comparing to the previous periods.

The above comments are depicted in the figure 4 4 that represents together gross profit margin ratio, expenses analysis ratio, and return on sales ratio of AMAZI YA HUYE from 2003 to 2007. In 2003-2005 the expenses curve was upward sloping comparing to the gross profit curve that was down ward sloping in 2006-2007 the expense curve changed, it was down ward sloping, comparing to the gross profit curve that was up ward sloping. These situations make an impact on the net profit of the company that could be greater in 2003-2005, but the expenses became uncontrollable comparing to the margin of cost of raw material to sales realized in that time, in the following two years, the expenses management was controlled basing on cost of raw material

to sales, the reason the sales turnover was lower than the previous years but the net profit was somehow closer to those of these periods even the sales turnover of these periods was higher (2003, 2004 and 2005).

The table below shows the trend of the efficiency ratios of AMAZI YA HUYE from 2003 - 2004.

RATIOS	Formula	2003	2004	2005	2006	2007
Inventory	Cost of Goods Sold/Average
turnover	Inventory	8.9	8.93	8	7.8	8.73
Days in	(Average Inventory/Cost of
inventory	Sales)*365	41 days	41 days	46 days	46 days	42days
Asset turnover	Net Sales/Total Assets	0.83	1.5	0.85	0.6	0.72
Receivables turnover	Credit Sales/Accounts Receivables	12.7	30.1	23.5	4.4	5.13
Average collection	(Accounts Receivable/Net
period	Sales)*365	28 days	12 days	16days	83 days	71days
Accounts ayable turnover	Purchases/Accounts Payable	1.98	1.8	1.32	0.83	1 29
Days AP	(Accounts Payable/Cost of	325	183	274	435	282
outstanding	Sales) *365	days	days	days	days	days

The trend of inventory turnover shows how rapidly the inventory into receivable through sales. In 2003 the ratio was 8.9 that is to say 41 days the raw material remain outstanding, in 2004 the ratio was 8.93 so the stock of raw material remain outstanding for 41 days, in 2006 the ratio was 8 it means that the stock of raw material remain outstanding for 42 days, in 2007 7.8 that is to say 42 days that the stock of raw material remain outstanding.

The trend of receivables (debtors) turnover measures the quality of debtors since it indicates the speed of their collection. Its interpenetration is combined together with the result of average collection period. In AMAZI YA HUYE in 2003 this ratio was 12.3 that means 20 days that the book debts remains outstanding, in 2004 the ratio was 30.1 which means 10 days that book debts remains outstanding, in 2005 the ratio was 23.5 which means 13 days that the book debts remains outstanding, in 2006 the ratio was 4.4 that means 55 days that the book debts remains outstanding, in 2007 the ratio was 5.13 that means 42 days that the book debts remains outstanding.

Looking on the trend of accounts receivable turnover ratios in days from 2003 to 2004, we can see that accounts receivable are well managed at AMAZI YA HUYE as there is an downward trend from 325 days in 2004 to 183 days in 2005 the rend became upward a bit till 274 days but the situation changed in 2006 when the trend reached 435 days, this is so because the late payment on behalf of debtors leads the firm to the lack of liquidity to pay its liabilities on due time, in 2007 the trend indicated an downward trend from 435 days to 282 this situation became so as the company' s liquidity ratio reached an interesting level

Figure 4 5 AMAZI YA HUYE receivables and payables turnover ratios 2003-200 7

From the above table 4 5 and fig 4 4, keeping in mind that creditors are source of funds and debtors (receivables) are use of funds, although AMAZI YA HUYE's receivables for the period of the study have generally been higher in figures than its creditors, the company benefited by collecting receivables before paying its creditors since 2003 till 2007. It should be noted that creditors are an interest -free form of financing called, this is a spontaneous sources of financing.

The collection period in 2003-2005 was not so long and in 2006-2007 it become long a bit, comparing to the days that payables remain outstanding, the company should take advantage of the extended credit period to lengthen a bit the credit sales periods for undoubtiful customers to attract for instance the potential consumers for their products

RATIO	Formula	2003	2004	2005	2006	2007
Z	discriminant function score of a firm
X1	Net working capital/total assets (%)	-0.72%	-0.48%	-0.17%	15.50%	32.40%
X2	Retained earnings/total assets (%)	4.60%	3.20%	2.80%	3.70%	5.03%
X3	EBIT/total assets (%)	6.60%	4.45%	4.03%	5.34%	7.18%
	Market value of total equity/book value
X4	of debt (%)	88.80%	119.70%	88.63%	132.80%	282.90%
X5	Sales/total assets (times)	0.83	1.05	0.79	0.60	0.73
	0.01 2X1+0.0 14X2+0.033X3+0,006X4+
Z	0.999X5	1.64	1.96	1.49	1.81	3.12

The MDA as an academic study on the use of accounting ratios to forecast the financial failure, the management of each company can use it to take preventive measures to the bankruptcy. Firms also can use this model in making credit decisions and in monitoring receivables.

Basing on the standard, the higher of the Z score the better, and this score below 2.675 the risk to the company to go bankrupt. In our case study, in 2003, 2004, 2005, 2006 the company shows the sing of going bankrupt as the Z score as computed in the above table 4 6 was respectively, 1.64, 1.96, 1.49, 1.81 but in 2007 this situation change toward a level to which the financial sound of the company can't lead to the bankruptcy, as the Z score was above the standard, it was 3.12.

Looking at the Z measurement curve, the situation of AMAZI YA HUYE to go bankruptcy was too high in 2005, even in 2003, 2004 and 2006 also the level of AMAZI YA HUYE towards bankruptcy was remarkable. But in 2007, the situation changed as seen on the Z scored curve in 2007, so the management of AMAZI YA HUYE should take measures to maintain such situation by computing the MDA for each year the predict the financial failure.

The study hypothesis stated that: The use of accounting ratios guides management as an effective tool in decision making. From the findings derived in this study, the researcher has enough evidence to confirm the hypothesis. Based on the responses of the personnel of the company in table 4 1 of this chapter, about respondent's view on the linkage between accounting ratios and decision making, it is clear that, there is majority who agree that, ratio analysis is a

vital tool in decision making. Also the analysis made from different kind of ratios computed using financial statements of AMAZI YA HUYE proved that the management stands the better to take decision by using accounting ratios rather than not.

Another hypothesis stated that: The result of using accounting ratios relies on the effectiveness of accounting and how accountants are skilled in financial analysis techniques. From the findings derived in this study, the researcher has obtained the testimony from the accountant that the use of accounting ratios can guide management, but there was hindrance presented of using this technique which is a lack of capacity to use them. Also this hypothesis is tested.

The use of accounting ratios in decision making

CHAPTER IV

DATA ANALYSIS AND INTERPRETATION