APPLICATION OF ACCOUNTING RATIOS IN MEASURING SOLVENCY OF SMALL SCALE INDUSTRIES IN THE MANUFACTURING SECTOR OF CROSS RIVER STATE NIGERIA

Abstract

This research study is aimed at determining the Accounting ratios applied in measuring solvency of Small Scale Industries in the Manufacturing Sector of Cross River State. This research purpose was motivated by the preponderance of Small Industries failure in Cross River State due to poor business financial conditions. The design adopted is descriptive survey. The study was guided by seven research questions and seven hypotheses. The instruments used were questionnaire and an interview schedule. Population for the study comprised 667 respondents made up of

345, 163 and 159 Accounting staff working in Palm Oil, Wood; and Bread Baking

Factories, respectively. The  entire  population was  studied.  Data  collected were analyzed using mean and standard deviation for research questions and ANOVA for hypotheses. The major findings are as follows: (1) Processes relating to accounting ratios applied by Small Scale Industries are: computing the value of total current assets and current liabilities, conducting analysis of debtors to ascertain doubtful balances, ascertaining equity capital from total capital, determining gross and net profits,  computing  cost  of  goods  sold;  and  determining  the  value  of  average inventory for the year end. (2) Accounting ratios and processes not applied are: current ratio, quick ratio, interest coverage ratio, capital employed to net worth ratio, return on capital employed ratio, operating expenses ratio, net assets turnover ratio, current assets turnover ratio, comparing ratios of current year to previous year’s ratios obtained by the business organization, comparing ratios of current year to previous year’s ratios with that of similar business(es) in the same industry. These findings have far reaching implications even in education. Since accounting staff do not apply ratios, it implies that management should engage the staff on training and retraining to upgrade their capacity in handling accounting ratios. Based on the findings,  the  following  recommendations  were  made:  (a)  only  qualified  and competent accounting staff should be employed in small scale industries, accounting ratios should be applied by management of Small Scale Industries to improve the financial situation and operational efficiency of Small Scale Industries; and Agencies and  Ministries  in-charge  of  small  scale  industries  should  be  committed  to  the success of the system and at the same time be concerned on the mental development of staff through training and retraining programmes.

Background of the Study

CHAPTER I INTRODUCTION

Accounting is a service activity. It is a statement of economic dealings captured in

digits and letters according to predetermined book-keeping standard. Garbut in Okechukwu, Eneje and Okafor (2004) defined accounting as a discipline concerned with the recording, analyzing and forecasting of income and wealth of business and other entities. Ekwere (2005) opined that accounting has as its primary objective, to ascertain economic effects and communication of the economic result to the external decision makers. Accounting provides

a platform for the analysis and interpretation of financial information in a manner that would

be useful and meaningful to users of the said information. This is normally achieved using ratios and other accounting tools (Igben, 2004).

Ratios form the bases of financial performance measurement. Aborode (2004) explained that accounting ratio is a proportion or fraction or percentage expressing the relationship between

one item in a set of financial statements and another item in the same financial statements. Agara (2005) noted that ratios are indices derived from expressing the relationship between

financial data. In financial statement analysis, a ratio is used as a bench mark for evaluating the financial position and performance of a firm. To this end, Longe and Kazeem (2006)

asserted that accounting ratios are used in the interpretation of financial statement(s) and they provide means by which various items in the final accounts are compared to other items. In

accounting, ratios are used to measure performance, efficiency and effectiveness (Aborode,

2004).

Institute of Chartered Accountants of Nigeria (ICAN) (2006) asserted that, interpretation of accounts involves giving meaning to the various ratios with a view to ascertain the financial strengths and weaknesses of the firm. Interpretation is for the purpose of assessing the financial position and commercial soundness of the business organization to which those variables relate. Aborode (2004) concluded that accounting ratios are the most powerful of all tools used in the analysis and interpretation of financial statements with the view to determine solvency.

Wood and Sangster (2002a) contended that, solvency is the state of being able to pay debts

without having to sell assets. Ekwere (2005) opined that a solvent business is that which has the ability to pay its own debts when due. Accountants go a long way to ascertain a business’s short – term and long-term solvency. In the short-run (short-term solvency) accountants attempt to determine a business’s ability to pay debts when due within a relatively short period, say an accounting year (Ikpe, 2006). This is achieved through the

application of liquidity ratios. Liquidity ratios are ratios that try to asses the liquidity position

of a business to determine ability to pay current debts when due (Adams, 2002). Some ratios in this category are: current ratio, quick (acid- test) ratio, and cash ratio.

Current ratio compares current assets to current liabilities and is intended to indicate whether there are sufficient short-term assets to meet the short-term liabilities (Gerstenberg, 2002).

Current ratio shows to what extent creditors can be paid from short-term assets, which could be converted to cash within a year.

Further, quick ratio (acid test or liquidity ratio) expresses the ability of a business to pay its short-term financial obligations now – that is, on demand (Essien, 2004). Dewing (2003)

contended that quick ratio shows the extent to which creditors can be paid from liquid or near liquid assets.   On the other hand, cash ratio compares cash and bank balances to current

liabilities and is intended to indicate whether cash and bank balances can be used to offset

current liabilities (Agara, 2005). It shows the extent to which short-term creditors can be paid from available cash/bank balances.

Commenting on the relevance of liquidity ratios, Asaolu (2005) stressed that accounting is used, not just to calculate profitability, but also to provide information that indicates whether

or not the business will be able to pay its creditors, expenses, loans falling due, etc. at the correct time. Asaolu further noted that, failure to ensure that these payments are covered

effectively could mean that the business will have to be closed down. In considering the liquidity of a business, both its own ability to pay its debt when due and the ability of its

debtors to pay the amount they owe to the business are of great importance (Anthony, 2002). Besides these accounting ratios that focus on short term solvency of a business, there are

other ratios used by accountants to measure the gearing power (stability or leverage) or to predict the stability of a business. As the name implies, gearing or stability ratios are usually

employed to predict the stability of business overtime. In accounting, it is often said that the extent to which a business is financed by loan capital is gearing. Gearing ratios show the

proportion of debt and equity in financing a business’s assets (Martin, Petty, Keown and

Scott, 2005). Some ratios under gearing include: debt ratio, debt/equity ratio, interest

coverage ratio, capital employed to net worth ratio, income gearing ratio, among others. Lewellen (2003) opined that debt ratio compares liabilities to assets and is concerned with whether the company has sufficient assets to meet all its liabilities when due. That is, it compares debt capital to capital employed. Debt/equity ratio is different from debt ratio in that, it is a measure of the solvency of a business and indicates the extent of cover for external liabilities (Igben, 2004). Weston (2005) added that debt/equity ratio shows what proportion of the owners contribution is covered by debt funds i.e. the relationship describes the lenders proportion of each naira of the owner’s contribution. Omorokpe (2006) summarized that when debt ratio and debt/equity ratio are high, they indicate that the company is having a stability problem.

Interest coverage ratio is also a measure of a company’s stability and indicates how many times operating profit will be able to cover interest payments (Archer and D’Ambrosio,

2004). Wood and Sangster (2002a) emphasized that interest cover ratio shows whether enough profits are being earned to meet interest payments when due. Furthermore, Asaolu

(2005) upheld that capital employed to net worth ratio is another way of expressing the relationship between debts and owner’s funds. Asaolu stressed that the ratio shows how

much funds are being contributed together by lenders and owners for each naira of owner’s contribution. The ratio compares capital employed to net worth (or net assets to net worth).

Gearing (stability) ratios are longer – term in nature, being concerned more with the strategic rather than with the operational level of corporate decision-making (Hertz, 2002).

Another class of ratio outside liquidity and gearing ratios is profitability ratios which show how a business venture creates additional wealth using available resources. Some of these

ratios are: return on capital employed, gross profit margin, net profit margin, operating expenses ratio, and return on equity ratio, etc.

Return on capital employed shows the overall profitability of a business. Meltzer (2004)

reported that, it shows the efficiency of management in utilization of the resources placed at

its disposal. Similarly, return on equity ratio, as explained by Agara (2005) is one of the most important ratios in financial analysis and it indicates how well the firm has used the resources of owners. It compares profit after tax to the net worth of the business. Again, Olatunji

(2002) contended that gross profit ratio expresses gross profit as a percentage of sales. That

is, sales less cost of sales divided by sales. The gross profit margin or ratio reflects the efficiency with which management of a business produces each unit of product and the

efficiency in utilizing raw materials and other input for production (Gitman, Forrester, and

Forrester 2005).

Like the gross profit margin, the net profit margin indicates the ability to manage production cost, selling cost and the administrative cost in order to make a profit (Essien, 2004). Furthermore, the operational efficiency of management of a firm can be determined with the help of operating expenses ratio (Omorokpe, 2006). This ratio compares operating expenses to sales.

In addition to the determination of liquidity, stability and profitability of a business,

accountants also determine how the daily activities of business are conducted. By so doing, they compute activity ratios. Activity (efficiency) ratios measure the firm’s efficiency in utilizing its assets to generate cash flow, i.e. how efficient the firm converts assets to cash (Merrett and Sykes, 2003). There are a good number of ratios in this category including stock turnover ratio, debtors turnover, creditors turnover, debtor days, creditor days, debtors collection period, creditors payment period, etc.

Olatunji (2002) explained that stock (inventory) turnover ratio is used to measure the number of times stocks are replaced during a given period. Weaver (2003) asserted that a high inventory turnover is indicative of good inventory management. Similarly, Igben (2004) recorded that debtors turnover ratio expresses the number of times trade debtors are turned over during the reporting period. Further, Aborode (2006) stated that debtors collection period (DCP) being another form of efficiency (activity) ratio measures the average number of days for which trade debts remain uncollected. Aborode added that for the creditor’s payment period (CPP) ratio, average trade creditors are compared to credit purchases. The creditor’s payment period ratio measures the average number of days for which trade creditors remain unpaid.

Brigham (2005) pointed that asset turnover is a measure of how effectively the assets are being used to generate sales. Wood and Sangster (2002b) upheld that where a company’s assets turnover is significantly lower than that of its competitors, it suggest there may be over investment in assets which could, in turn, make the company vulnerable to takeover by a company interested in selling off any surplus assets while otherwise retaining the business in its current form.

Capitalization of small scale industries is often small consisting mostly of equity capital (Wood and Sangster, 2002a). The injection of borrowed capital in small scale business increases the challenge of profit maximization in other to cover interest expenses and other items that would usually have claim on profit. To this end, not all accounting ratios can be applied in measuring solvency and operational efficiency of small scale industries. However, ratios that could be used for the sake of measuring the liquidity and efficiency of small scale industries include but not limited to: current ratio, acid test ratio, cash ratio, debt ratio, debt- equity ratio, interest coverage ratio, return on capital employed ratio, gross profit and net profit ratios, expenses ratios, stock turnover ratio, debtors turnover ratio, creditors turnover ratio, debtors collection period, creditors payment period, etc. The ratios discussed in the preceding paragraphs can be used to analyze the performance of small scale industries; with a view to determining their liquidity status.

The National Council of Industry (2001) defined small scale industries in line with scale of operation as follows: small scale industry is an industry with capital investment of over N1.5m but not more than N50m, excluding land but including working capital with work force that ranges from 11 – 100 employees.

Small scale industries classify their financial statements as confidential and therefore very difficult to be accessed by anybody external to the organization. These books of account are

also restricted from members of staff who are not in the account department and who have nothing official to do with the financial statements. This is because, unlike the big companies which the Companies and Allied Matters Act (CAMA) of 1990 requires that they publish

their financial statements for public consumption at the end of every accounting period, small

scale businesses do not have a legislation that compels them to do so. This makes the accessibility of their financial statements difficult.

Financial statements of small scale industries are normally prepared by their accounting staff employed in accounts section of the organization. These staff are clerks with no in-depth

knowledge of accounting concepts and conventions. They are usually employed due to management inability to pay for the services of trained accountants. This situation can best

be described as: when the desirable is not affordable, the affordable becomes desirable.

Obi (2002) noted that small business act as a motivating factor for people to get into bigger

businesses. In spite of the fact that small scale industries are the engine for economic growth as reported by Adenekan (2008), Chau (2000) acknowledged that small scale industries face liquidity crunch. This is the situation evident among Palm oil, Wood and bread factories in Cross River State from 1998 to 2008. It is reported that within this period under review, 15

Palm oil factories, 8 Wood factories and 35 Bread factories folded up due to insufficient financial resources to meet daily operational demands (Ministry of Trade and Investment,

2008). Some of these operational challenges include but not limited to high cost of raw materials, high cost of transportation, high interest expenses, high cost of equipment and

facilities, double taxation, etc.

Szczepaniec (2005) contended that liquidity problem in small scale industry may slow off

economic exchange; increase business expenses; hamper investment process and current business operation and may result in bankruptcy and job loses. Szczepaniec further maintained that, one third of small scale industries go through temporary liquidity problems. This may be as a result of the problems peculiar to the manufacturing industries in developing economies such as hash investment environment.

Anyaele (2003) contended that an industry is a collection of firms with different management

and operations and different lines of production while manufacturing industries are those industries involved in the transformation of raw materials into finished goods (both consumer and producer goods). Ande (2005) pointed that a manufacturing industry operates at the secondary production level adding that, they are industries that can convert raw materials to produce finished goods. The processes of manufacturing are complex and require good

record keeping practice to account for every stage of production.

Without good accounting records, information to be used in measuring the solvency of small scale businesses cannot be obtained and where this happens operators will run their small scale businesses without having to know whether or not they are exposed to the risk of insolvency or illiquidity. Ndiyo (2005) explained that measurement is the assignment of numeral to objects or events according to rules. The rules defining the assignment of an appropriate value determine the level of measurement. In accounting therefore, data collected are normally organized according to the process and outcome of a particular economic

activity such as trading or investment.

To provide accounting data that enhances the measurement of the solvency of a business, management prepares financial statements from source documents covering their business activities in line with accounting concepts and conventions. Some of the financial statements/accounts that could be kept to explain the financial activities of small scale businesses in the manufacturing industry include – manufacturing, trading, profit and loss account, balance sheet, cash flow statement, cash book and other subsidiary books.

Longe and Kazeem (2006) asserted that, manufacturing accounts are prepared to determine the cost of goods manufactured during the financial year and to determine the amount of any profit on the manufacturing process. Manufacturing account is prepared for organizations that are into manufacturing, and the basic aim of the account is to ascertain the cost of production and the profit made from the sales of the manufactured goods. On the other hand, balance sheet also provides a good measure of information applied in measuring solvency. Balance sheet is a statement drawn up at the end of each financial period setting forth the various assets, liabilities and capital of the organization in a well arranged form (Olatunji,

2002). Again the measure of cash inflow and out flow in a business is determined by a cash flow statement. Igben (2004) maintained that a statement of cash flows is one setting out, for a business enterprise, the cash receipts and their sources, on the one hand, and cash payments and for what purposes they were made, on the other hand, during the reporting period. In the same vein, Aborode (2006) opined that the value added statement shows the allocation of

that wealth among employees, government, providers of finance, and that retained for future

creation of more wealth.

The importance of these accounting records can best be appreciated on the merit of their

respective functions. Adache (2006) opined that record keeping is a good accounting practice that small scale business operators should embrace. It has the merit of providing vital information that can be employed to track the performance of a business at any point in time by way of ratio analysis. With the application of accounting ratios, a small scale business that is about to run into a liquidity problem, that need re-capitalization or that is at the verge of becoming insolvent, can be dictated and given a remedial accounting action. Proper application of accounting ratios enhances the survival, growth and sustenance of small scale industries (Anaka, 2000).

Statement of the Problem

Insolvency as a business risk causes closure of commercial and industrial ventures; whether

big or small business, new or old ones alike (Wood and Sangster, 2002b). It is shown that in

Cross River State, between 1998 and 2008, 15 Palm oil factories, 8 Wood factories and 35

Bread factories folded up due to insufficient financial resources to meet daily operational demands (Ministry of Trade and Investment, 2008). Where this is not checked, there is no guarantee that in the nearest future, more of these small scale industries would not close down.

Lack of analysis and interpretation of financial statements causes preponderance of business failure (Ohanu, 2004). This is because, where management of a business fails to analyze and interpret financial data, insolvency and operational inefficiency of the business entity may not be detected; where they exist and the business stands the risk of folding-up.

Not applying accounting ratios in small scale industries could result in several consequences such as business failure and a slow-down or total shut-down in the productive capacity of Palm oil factories, Wood factories and Bread factories in Cross River State. This could cause scarcity of these products and increase the rate of dependence on other States that produce similar commodities at the expense of Cross River State’s economy. It could also lead to reduction of Government’s income from taxation, needed for infrastructural development. Bankruptcy and job losses may also arise from the collapse of small scale industries caused by lack of application of accounting ratios; leading to cyclical or mass unemployment in Cross River State. Where people are rendered unemployed due to business failure, there is a tendency that they would engage themselves in vices that could negatively impact on the inhabitants of the State.

Therefore, this study was designed to determine the extent to which small scale industries apply accounting ratios in interpreting financial statements in the light of measuring liquidity (short-term solvency), and predicting stability (long-term solvency); to circumvent the dangers of business failure.

Purpose of the Study

The major purpose of this study was to determine the extent of application of accounting

ratios in measuring solvency of small scale industries in the manufacturing sector of Cross

River State. Specifically, the study sought to:

(1)       Determine the extent of application of liquidity ratios in measuring short-term solvency of small scale industries in the manufacturing sector.

(2)       Determine the extent of application of gearing (stability) ratios in measuring long- term solvency of small scale industries in the manufacturing sector.

(3)       Determine the extent of application of profitability ratios in measuring performance and effectiveness of small scale industries in the manufacturing sector.

(4)       Determine the extent of application of activity (efficiency) ratios in measuring efficiency with which small scale industries in the manufacturing sector utilize assets

to generate cash flow.

(5)       Determine the extent of application of cash flow statement in reporting cash flow of

small scale industries in the manufacturing sector.

(6)       Determine the bookkeeping procedures followed and accounting records kept by

small scale industries in the manufacturing sector.

(7)       Determine the problems associated with application of accounting ratios in small

scale industries.

Significance of the Study

The failure of business at any scale (micro, small, medium and large) is associated mainly with management incompetence of their operators (Ajoma, 2005). One of such managerial

incompetence is demonstrated on the nature of cash management by small scale industries operators which in most cases lead to illiquidity (Davis, 2002). Chau (2000) contended that

the ultimate solution to the liquidity problems of small scale industries lies in long – term measures that help to gradually change the business culture of small scale industries

operators. Based on this assertion, it is hoped that the benefit that shall accrue from this study will be multifarious and to a large extent, beneficial to the following: Nigerian Association of

Small and Medium Scale Enterprise (NASME), Nigerian Association of Small Scale

Industrialists (NASSI), Small and Medium Enterprises Development Agency of Nigeria

(SMEDAN), present and potential operators, State and Federal Ministries of Commerce and

Industry, and the public at large.

The findings and recommendations of this study will be of immense benefit to the Nigerian Association of Small and Medium Scale Enterprises, Small and Medium Enterprises Development Agency of Nigeria and the Nigerian Association of Small Scale Industrialists. Being corporate organizations, the result of this work will serve as an invaluable resource pack they can depend on during the organization of seminars and capacity building workshops as measures for training and re-training.

The findings of the study if implemented will be of help to existing and potential small and medium scale enterprise operators in Cross River State. The study will create awareness, showcase principles and knowledge of improved procedures of measuring the solvency of small scale industries in order to facilitate their survival, growth, and sustenance. The result of this study will in addition assist the operators or proprietors of small scale industries to adjust their accounting systems in line with concepts and conventions presently invoke. The

operators will see the need to improve upon the procedures adopted in applying accounting ratios to determine the type of liquidity problems their businesses are facing or about to face; which the study will highlight. The proper application of relevant accounting ratios will enhance increased productivity and this will result to high efficiency and profitability.

State and Federal Ministries of Commerce and Industries (Ministry of Trade and Investment in Cross River State) will not be left out from the findings and benefits of this study. As policy markers in commerce and industrial sectors, they will find the study useful since it would make them establish or improve the capacity building programmes for small scale industry operators. Based on the findings of this study, adequate policy guidelines would be published by State and Federal Ministries of Commerce and Industries in favour of the operators; in the domain of accounting standards and practices. The enhanced productivity which will result from efficiency and effectiveness in the interpretation and analysis of financial statements of small scale industries will yield higher revenue profile. Hence, they will become a good source of government revenue through taxation.

The general public will also greatly benefit from the findings of this study. The Public will be assured of available locally made products at reduced prices, employment generation etc. due to the continuity of small scale industries in business as a result of being able to overcome

the problem of insolvency; as they apply the findings and recommendations of this study.

Similarly, improved accounting procedures would enhance the growth of small scale industries and the public will be motivated by this growth, to start their small scale industries. This will promote self-reliance of individuals, alleviate poverty, reduce unemployment, and abate crime rate and moral decadence in the society.

Finally, scholars interested in the predictive power of accounting ratios and the like, will find this study useful as a reference material and a springboard for improving or making more contributions in the accounting practices of small scale industries.

Research Questions

The following research questions were formulated to guide the study:

(1)       To what extent are liquidity ratios applied in measuring short-term solvency of small

scale industries in the manufacturing sector of Cross River State?

(2)       To what extent are gearing (stability) ratios applied in measuring long-term solvency

of small scale industries in the manufacturing sector of Cross River State? (3)       To what extent are profitability ratios applied in measuring performance and

effectiveness of small scale industries in the manufacturing sector of Cross River

State?

(4)       To what extent are activity (efficiency) ratios applied in measuring efficiency with which small scale industries in the manufacturing sector utilize assets to generate cash flow in Cross River State?

(5)       To what extent is cash flow statement applied in reporting cash flow of small scale

industries in the manufacturing sector of Cross River State?

(6)       What are the bookkeeping procedures followed and accounting records kept by small

scale industries in the manufacturing sector of Cross River?

(7)       What are the problems associated with the application of accounting ratios in Small

Scale Industries?

Null Hypotheses

The following null hypotheses based on the research questions were formulated for the study and tested at 0.05 level of significance:

Ho1        –          There is no significant difference in the mean responses of accounting staff in

Bread baking, Palm oil, and Wood processing factories on the extent of application of

liquidity ratios in measuring short-term solvency of small scale industries in the manufacturing sector of Cross River State.

Ho2        – There is no significant difference in the mean responses of accounting staff in Bread baking, Palm oil, and Wood processing factories on the extent of application of gearing ratios in measuring long-term solvency of small scale industries in the manufacturing sector of Cross River State.

Ho3        – There is no significant difference in the mean responses of accounting staff in Bread baking, Palm oil, and Wood processing factories on the extent of application of profitability ratios in measuring performance and effectiveness of small scale industries in the manufacturing sector of Cross River State.

Ho4        – There is no significant difference in the mean responses of accounting staff in Bread baking, Palm oil, and Wood processing factories on the extent of application of activity ratios in measuring efficiency with which small scale industries in the manufacturing sector utilize assets to generate cash flow in Cross River State.

Ho5        – There is no significant difference in the mean responses of accounting staff in Bread baking, Palm oil, and Wood processing factories on the extent of application of cash flow statement in reporting cash flow of small scale industries in the manufacturing sector of Cross River State.

Ho6 –   There is no significant difference in the mean responses of accounting staff in Bread baking, Palm oil, and Wood processing factories on the bookkeeping procedures followed and accounting records kept by small scale industries in the manufacturing sector of Cross River.

Ho7        – There is no significant difference in the mean responses of accounting staff in Bread baking, Palm oil, and Wood processing factories on the problems associated with application of accounting ratios by small scale industries in the manufacturing sector of Cross River State.

Delimitation of the Study

This study was delimited to the determination of the extent of application of current ratio,

acid test ratio, cash ratio, debt ratio, debt-equity ratio, interest coverage ratio, return on

capital employed ratio, gross profit and net profit ratios, expenses ratios, stock turnover ratio,

debtors turnover ratio, creditors turnover ratio, debtors collection period, creditors payment period by small scale industries in the manufacturing sector since not all ratios can be applied in measuring solvency of small scale industries due to the limited scope of their operations and sources of finance.

Moreover, the delimitation of this study to small scale industries in the manufacturing sector was due to the homogeneity of financial statements they are likely to prepare being in the same industrial sector.   In addition, Palm oil, Bread baking and Wood processing factories are used for this study because they constitute the highest population of small scale industries in the State. Igben (2004) contended that for a meaningful inter-firm comparison, firms of similar sizes, of the same industry and location would provide a better basis for decision- making. This also accounts for the delimitation of this study to Cross River State since the industries enjoy similar business incentives from Government.

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