Chapter 1: BASICS OF ANALYSIS

1.1. Definition and types of analysis

Analysis means the decomposition of a phenomenon into its component parts and then each part is
studied as individual in order to establish the causal relationships, to determine the factors that
generate the relationships, to formulate conclusions about the evolution of business.

The subject of decomposition may be a result or a change of the result against a basis of
comparison.

In the first case, the subject of analysis can be expressed as:

X = ∑ xi
and we are dealing with a structural analysis whereby a phenomenon is decomposed into its
components. For example, we can analyse the gross profit of the year, which, according to the Profit
and Loss Account, is split into the following components: operating profit, financial profit and
extraordinary profit. The share of each component gives us an insight into the sources of the profit.

In the second case, the subject of analyse is the change of an indicator against a basis of
comparison:
∆X = X1 − X 0
X1 – the current level of indicator;
X0 – the reference level of indicator (used as basis for comparison).

This is a causal analysis which explains the change on account of the influence factors.

Synthesis involves reuniting all the components of a phenomenon in a whole. While analysis
involves splitting a result, synthesis aims at examining the elements as a whole.

Analysis of financial statements is an attempt to assess the efficiency and performance of an

enterprise. Thus, the analysis and interpretation of financial statements is very essential to measure
the efficiency, profitability, financial soundness and future prospects of the business units. Financial
analysis serves the following purposes:

• Measuring the profitability

The main objective of a business is to earn a satisfactory return on the funds invested in it.
Financial analysis helps in ascertaining whether adequate profits are being earned on the capital
invested in the business or not. It also helps in knowing the capacity to pay the interest and
dividend.

• Indicating the trend

Financial statements of the previous years can be compared and the trend regarding various
expenses, purchases, sales, gross profits and net profit etc. can be ascertained. Value of assets and
liabilities can be compared and the future prospects of the business can be envisaged.

• Assessing the growth potential of the business

The trend and other analysis of the business provide sufficient information indicating the growth
potential of the business.

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 • Comparative position in relation to other firms
The purpose of financial statements analysis is to help the management to make a comparative
study of the profitability of various firms engaged in similar businesses. Such comparison also helps
the management to study the position of their firm in respect of sales, expenses, profitability and
utilising capital etc.

• Assess overall financial strength

The purpose of financial analysis is to assess the financial strength of the business. Analysis also
helps in taking decisions, whether funds required for the purchase of new machines and equipment
are provided from internal sources of the business or not. And also to assess how much funds have
been received from external sources.

Users of financial statement analysis, i.e. the parties interested in a company’s financial position
and performance are:
• company’s management uses information provided by financial statement analysis to base
decision-making in the area of financial decisions. The analysis helps the managers in
preparing budgets and assessing the performance of various divisions.
• company’s owners (shareholders) want to know the evolution of their wealth, objectified by
the proportion of company’s equity owned by each of them. Shareholders or proprietors of
the business also like to know the earning capacity of the business and its prospects of future
growth.
• investors – to make their investment decisions on the stock exchange.
• banks (lenders) provide loans for the company and are interested in the company’s
reliability as a business partner and its capability to repay these loans and corresponding
interest. They are particularly interested to know short term as well as long term solvency
position of the entity.
• business partners (clients or suppliers) are interested to know about the solvency of the
business i.e. the ability of the company to meet the debts as and when they fall due or to
deliver products in time. They change their strategic options depending on partner’s
financial situation.
• trade (labour) unions track company’s financial situation in order to negotiate the wages or
bonus agreement with the management.
• employees: they are interested to know the growth of profit. As a result of which they can
demand better remuneration and pleasant working environment.
• public institutions (especially tax authorities), both local and national, are interested in
company’s financial situation for determining the tax liability.
• competitors are interested in the company’s financial state in order to strengthen their own
market position.

Analysis could be classified according to several criteria:

• Depending upon the moment the analysis is carried out:

- Post-factum analysis represents an investigation of financial situation of the company
during past periods; this kind of analysis is useful only if it indicates factors that generated
weaknesses in the past that could be limited or eliminated in the future, as well as factors
that lead to strengths in order to maintain their action during future periods;
- Real-time analysis is carried out to asses company’s financial situation at any time in order
to take immediate actions when the situation tends to deviate from the established
objectives; in order to carry out such a type of analysis it is required an up-to-date
information system that allows information to be supplied to the analysts as soon as events
happen;
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 - Prospective analysis is undertaken based upon forecasts regarding future periods. Some
opinions expressed in the specialized literature consider this type of analysis as being the
most important of all of them, as it reflects a proactive attitude of decision makers towards
future challenges that a company will encounter.

• According to the time coverage of financial information:

- Static analysis studies financial condition of a company at a certain moment in time, usually
based upon the balance sheet data, highlighting the relationship between different elements
and factors that cause a certain position of the company;
- Dynamic analysis tackle financial position based upon financial flows data covering a
certain period of time.

• According to manner of balance sheet correlations analysis:

- Horizontal analysis includes comparisons between assets and capitals, highlighting the
extent to which fixed and current assets are funded from proper sources;
- Vertical analysis studies the structure of different balance sheet elements, comparing their
value to the value of groups of elements they are part of or to the total value of
assets/liabilities.

• According to the extent to which the essential features or quantitative issues of financial
information are analysed:
- Quantitative analysis implies the examination of financial phenomena by measuring them
in terms of quantity;
- Qualitative analysis pursues the essence of financial phenomena, their basic features,
factors that are of the same nature as the element they cause.

• Depending on the provenience of the financial analyst:

- Internal analysis carried out by specialized personnel from within the company;
- External analysis that is carried out by external specialists or institutions (banks, tax
authorities, consultancy companies etc.).

The steps for carrying out an analysis are:

1) Establishment of a purpose and identification of objectives for analysis;
2) Selection of the indicator or set of indicators that define best and in the most realistic
and exact fashion the issue that is being analysed;
3) Collecting and processing information required for analysis:
- the level, dynamics and structure of the financial issue or indicator that is being
analysed;
- factorial analysis – measuring the causal relationship;
4) Company’s financial condition diagnosis, identification of strengths and weaknesses
related to the analysed financial issue or indicator;
5) Devise an improvement measures plan to limit weaknesses and generalize the strengths.

1.2. The main concepts used in economic-financial analysis

Financial statement analysis process development requires use of some specific concepts such as
phenomena, factors, causes, financial indicators.

A phenomenon is any observable occurrence. Phenomena are often, but not always, understood as
'appearances' or 'experiences'. From a financial point of view, a phenomenon is an observable form

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of financial reality, i.e. those aspects, sides and relations between financial happenings that could be
known by people in a direct way.

Financial indicator – a figure that express through numbers an aspect or a group of aspects that
describe a phenomenon, a process or a financial occurrence, defined in time, space and
organizational structure. Financial indicators could be:
- analytic or synthetic;
- expressed as absolute, relative or average measures.

Absolute measures express quantitatively, from a physical or value perspective, the volume or the
level of certain phenomena. Elements that these measures are based upon should comply with
certain rules: to be homogeneous, to refer to the same period of time etc.

Relative measures allow comparisons between absolute measures in time, space or structure. These
are calculated by dividing the compared value of an absolute measure to the comparison basis
value.

An element is one of the simplest or essential parts or principles of which anything consists, or
upon which the constitution or fundamental powers of anything are based. A financial element is a
component of a financial occurrence.

A factor represents that driving force that, in certain circumstances, causes or induces an
occurrence.

A cause is the source or reason of an event or action. Causes directly explain the genesis of a
phenomenon.

1.3. Influence factors

Analysis involves identifying the influence factors. Factors explaining the occurrence and the
evolution of phenomena can be classified according to several criteria:

1) Depending on the nature:

a) social factors;
b) technical factors;
c) economic factors;
d) political factors.

2) Depending on the way they influence the phenomenon:

a) direct factors;
b) indirect factors.

3) According to the place of action:

a) internal factors;
b) external factors.

4) According to their content:

a) simple factors - cannot be decomposed into other factors;
b) complex factors - can be decomposed into other factors.

5) Depending on the position and the feature in a causal relationship:

a) quantitative factors;
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 b) structural factors;
c) qualitative factors.

Quantitative factors reflect the extensive side of the phenomenon analysed and are material bearers
of qualitative factors. They are expressed in measures different than the phenomenon.

Structural factors indicate the proportion of the elements in the overall size of the phenomenon
investigated. They are closely related to the quantitative factors.

Qualitative factors are similar in nature to the phenomenon and are expressed in the same measures.
These factors reflect the intensive side of the phenomenon analysed.

1.4. Financial statements

Since financial statements are the source for a good portion of analytical efforts, we must first
understand their nature, coverage and limitations. Financial statements reflect the cumulative effects
of all of management’s past decisions. However, they involve considerable ambiguity. Financial
statements are governed by rules which leave reported accounting results open to considerable
interpretation, especially if the analyst seeks to understand a company’s economic performance and
to establish the basis for shareholder value results. It’s common practice among professional
analysts to adjust the data reflected on financial statements for known accounting transactions
which do not affect cash flows and to make assumptions about the economic values underlying
recorded asset values.

Financial statements comprise:

- Balance Sheet or Position Statement;
- Profit and loss Account or Income Statement;
- Statement of Changes in Shareholders' Equity;
- Statement of Cash Flow;
- Notes.

These are prepared at the end of a given period of time. They are the indicators of profitability and
financial soundness of the business concern.

1.4.1. Balance Sheet

Gives a “snapshot” of the company’s financial position at a specific point in time – showing what it
owns and what it owes at the report date. The balance sheet is always divided into two halves:
Assets (presented first) and Capitals (Liabilities and Shareholders’ Equity). In the standard
accounting model,

Assets = Capitals (Liabilities + Shareholders’ Equity),

so the two halves will always be in balance. Liabilities are specific obligations that represent claims
against the assets of the business, ranking ahead of the owners in repayment priority. In contrast, the
recorded shareholders’ equity represents the net assets available to shareholders after all the
liabilities have been paid.

The major categories of assets are:

I. Long term assets (long lived assets, noncurrent assets) – are assets with a useful life greater
than one year and not intended for sale. They are used to manufacture, display, warehouse and

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transport the company’s products, along with buildings and improvements used in operations. The
category includes:

a) Intangible assets – lack physical substance and usually are very hard to evaluate. They
include constitution costs, development costs, concessions, patents, licenses, trademarks,
commercial fund, intangible assets in progress.

b) Fixed assets – are purchased for continued and long-term use in earning profit in a business.
They include property (land and constructions), plant and equipment, other equipment and
furniture, fixed assets in progress.

c) Financial assets – securities held on group companies, receivables over group companies,
securities as participation interest, receivables from participation interests, securities held as
assets.

II. Current assets – are cash and other assets expected to be converted to cash, sold, or consumed
either in a year or in the operating cycle. These assets are continually turned over in the course of a
business during normal business activity. There are four major items included into current assets:

a) Inventory – raw materials, consumables, work in process goods, finished goods,

merchandises (goods purchased for resale).

b) Receivables – commercial receivables, intercompany receivables, receivables for the

subscribed and unpaid capital.

c) Short time financial investments: securities held on short time.

d) Cash in hand and at bank.

III. Prepaid expenses –include prepaid expenses only. These are expenses paid in cash and
recorded as assets before they are used or consumed (a common example is insurance).

Capitals include five groups:

I. Debts payable in one year’s term - are short-term financial obligations that are paid off within
one year or one current operating cycle. These liabilities are reasonably expected to be liquidated
within a year and include bank loans, bonds, operating debts, invoices cashed in advance, bills
payable, other debts.

II. Debts payable over one year’s term – are liabilities that are not paid off within a year, or
within a business's operating cycle (long-term or non-current liabilities). Such liabilities often
involve large sums of money necessary to undertake opening of a business, major expansion of a
business, replace assets, or make a purchase of significant assets. These liabilities are reasonably
expected not to be liquidated within a year and include the same elements as the previous group.

III. Provisions (contingent liabilities) – there are instances in which a company reports that there
is a possible liability for an event, transaction, or incident that has already taken place; the
company, however, does not yet know whether a financial drain on its resources will result. It also
is often uncertain of the size of the financial obligation or the exact time that the obligation might
have to be paid.

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IV. Advance revenues (deferred revenues) – represent a temporary liability, until the services
have been rendered or products have been delivered. Deferred revenues refer to revenues that have
cashed in, but represent products or services that are owed to the customer. As the product or
service is delivered over time, it is recognized as revenue on the income statement.

V. Equity: owned capital, share capital premium, re-evaluation reserves, reserves, profit/loss
carried forward, profit of the financial year.

Balance sheets are static because they reflect conditions on the date of their preparation. They’re
also cumulative because they represent the effects of all decisions and transactions that have taken
place since the inception of the business and have been accounted for up to the date of preparation.

Balance sheets (being cumulative) display assets and capitals acquired or incurred at different times.
Because the current economic value of assets can change, particularly in the case of longer-lived
items (such as buildings and machinery) or basic resources (such as land), the costs stated on the
balance sheet are not likely to reflect true economic values. Moreover, changes in the value of the
currency in which the transactions are recorded can, over time, distort the balance sheet.

Ultimately, the recorded book value of owners’ equity is affected by all of these value differentials.
There generally is quite a divergence between this residual accounting value and the current
economic value of the business as reflected in share prices or in valuations for acquisition. In fact,
the shares of successful companies are usually traded at price levels far above their recorded book
value.

1.4.2. Profit and Loss Account

Profit and Loss Account, also called Income Statement, Profit and Loss Statement and Statement of
Operations, is a financial statement that summarizes the revenues and expenses incurred during a
specific period of time - usually a fiscal year. These records provide information that shows the
ability of a company to generate profit by increasing revenue and reducing costs. The purpose of the
income statement is to show managers and investors whether the company made or lost money
during the period being reported. The important thing to remember about an income statement is
that it represents a period of time. This contrasts with the balance sheet, which represents a single
moment in time.

The income statement reflects the effect of management’s operating decisions on business
performance and the resulting accounting profit or loss for the owners of the business over a
specified period of time. The profit or loss calculated in the statement increases or decreases
owners’ equity on the balance sheet. Thus, the income statement is a necessary adjunct to the
balance sheet in explaining this major component of change in owners’ equity, and it provides a
variety of performance assessment information.

Revenues, expenses and results are being classified into three groups: operating, financial and
extraordinary.

Operating revenues comprise: net turnover or sales, sold production, sales of merchandises,
subsidies related to turnover, stocked production, capitalized production, other operating revenues.

Turnover includes sales of products manufactured, work performed and services rendered, sales of
goods purchased for resale, subsidies related to turnover.

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Stocked production includes the change in stocks of finished goods and work in progress, at the end
of the year against the beginning of the year.

Capitalized production includes the value of long lived assets (intangibles or fixed assets) the
company makes by itself and the goods manufactured and retained to be consumed by the company.

Stocked production and capitalized production are recorded at costs of production rather than at
selling price.

Operating expenses contain expenses for raw materials and consumables, expenses on energy and
water, cost of merchandises, personnel expenses, depreciation and provisions for fixed and
intangible assets, expenses for third party services, expenses for other taxes, duties and related
payments, expenses with compensations, donations and sold assets.

Operating result (profit or loss) is being calculated by subtracting the operating expenses from the
operating revenues.

Financial revenues include revenues from interests, dividends, growth of securities market value,
earnings from foreign exchange transactions.

Financial expenses include interest expenses, provisions for securities and losses from foreign
exchange transactions.

Financial result occurs by comparing the financial revenues and the financial expenses.

Extraordinary revenues and expenses regard noncurrent activities the company run.

Profit and Loss Account also contain indicators such as total revenues, total expenses, gross result,
income tax, net result.

1.4.3. Statement of Cash Flow

This document reports on the company’s cash movements during the period, separating them into
operating, investing and financing activities. The cash flows are being calculated by two methods:
direct and indirect method.

1.4.4. Statement of Changes in Shareholders' Equity

It reconciles the activity in the Shareholders’ Equity section of the balance sheet from period to
period. Generally, changes in owners’ equity result from company profits or losses, dividends and
stock issuance.

1.4.5. Notes

Provide more detailed information about the financial statements (such as salaries of managers,
average number of employees etc.).

1.5. Statement of accumulation margins

It is not a mandatory statement, but rather a management tool, useful in current and strategic
management. It’s being completed based on the Profit and Loss Account. Accumulation margins

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are actually regular indicators, some of them included in Income Statement, which emphasize the
stages of getting the net result, as a difference between revenues and expenses.

A model of Statement of accumulation margins is presented below:

Revenues Expenses Accumulation margins

Sales of merchandises (goods
purchased for resale)
Sold production
Stocked production (Cr balance)
Capitalized production
Production
Trade margin
Value added
Subsidies related to turnover
EBITDA
Other operating revenues
Operating result
Financial revenues
Extraordinary revenues
Gross result
Expenses of merchandises Trade margin
Production of financial
Stocked production (Dr balance) exercise
Expenses for third parties (cost of inputs, Value added
outside expenses or intermediate
consumption)
Taxes (Expenses for other taxes, duties Earnings before interest,
and related payments + Social security taxes and depreciation
expenses) (EBITDA)
Salaries
Depreciation and provisions
Expenses with compensations, donations Operating result
and disposed assets
Financial expenses Gross result
Extraordinary expenses
Income tax Net result

1.6. Techniques and tools of analysis

1.6.1. Division

The financial reality is extremely complex, so that it is difficult to study it as a whole. In order to
overrun this inconveniency, financial analysts use the method of division, which allows studying
the financial phenomena by understanding their structure, their basic elements.

The use of this method implies separating the contribution of each factor to make the whole,
expressing the global change of the analysed phenomenon in its constituent parts and, as well,
pinpointing in space and time the source and causes of these components.

A phenomenon could be decomposed using several criteria, such as:

1. division by time of financial phenomena genesis (semesters, quarters, months, days, weeks)
has the purpose of identifying the contribution of different time units to the whole;

2. division by place of phenomena formation (plant, department, workshop, workplace) has the
purpose of highlighting the degree to which each place contributed to the analysed aspect.
This type of division is used to indicate at each place the correlation between the effect
yielded and the resource allocated;

3. division by parts and components specific to the analysed phenomenon (for instance: assets
could be divided into noncurrent and current, short term liabilities – into financial and
operational etc.).

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 1.6.2. Comparison

No judgments related to analysed issues could be made without a standard or a basis of comparison.
Any financial performance could not be assessed without a reference value that is considered as
such, even if it was established statistically (empirically).

Based upon the criterion which it is made by, there are several types of comparisons:

1. time comparisons – a phenomenon is compared in different moments of its evolution.

2. space comparisons – between the analysed enterprise and similar enterprises. It also known
as cross-sectional analysis or inter firm comparison. This analysis helps in analysing
financial characteristics of an enterprise with financial characteristics of another similar
enterprise in that accounting period.

3. mixed comparisons (time and space);

4. comparisons with a previously established level: programs, regulations, standards, contract

clauses etc.

Comparisons allow calculating the changes (absolute and percentage) of the analysed indicator (R):
∆R = R 1 − R 0
∆R
∆R % = × 100
R0
R1 – the current level of the indicator;
R0 – the level of the indicator used as reference.

1.6.3. Chain substitution method

This technique is used to analyse the influence of factors in case of deterministic relationships that
take the mathematical form of multiplication or division.

The method is based upon successive variation of factors specific to the analysed phenomenon. The
use of this method implies applying several rules:
1. the factors are arranged according to the criterion of economic conditioning: the factors are
classified as quantitative, structural and qualitative;
2. substitutions are made successively, beginning with quantitative factors, following structural
factors and ending with qualitative factors;
3. a substituted factor is maintained at current level in all the following substitutions.

These rules are conventional, they resulted and have been accepted by economic and financial
theory and practice based upon applicative experiments.

a) Product

R = a ⋅b⋅c
• data from period considered as basis for comparison:
R0 = a 0 ⋅ b0 ⋅ c0
• data from the current period:
R1 = a 1 ⋅ b 1 ⋅ c 1

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The change of the financial indicator:
∆R = R1 − R 0 = a1 ⋅ b1 ⋅ c1 − a 0 ⋅ b0 ⋅ c0 ;
∆R % = I R − 100;
R1
IR = × 100
R0

Change of R is generated by changes of a, b and c. The influences of these three factors are
calculated according to the following order:

1.∆a

∆R 2.∆b

3.∆c

Calculation of influence for each factor:

a
∆ R = a1 ⋅ b 0 ⋅ c0 − a 0 ⋅ b 0 ⋅ c 0 ;
b
∆ R = a1 ⋅ b1 ⋅ c0 − a1 ⋅ b0 ⋅ c0 ;
c
∆ R = a 1 ⋅ b1 ⋅ c1 − a 1 ⋅ b1 ⋅ c 0 ;
a b c
∆ R + ∆ R + ∆ R = ∆R .

b) Division

a a a
R = ; ∆R = 1 − 0 = R 1 − R 0
b b1 b 0
Taking into account the principles of chain substitution and especially the fact that substitution
should begin with the quantitative factor, the calculation of each factor’s contribution to total
change of the indicators depends upon the place the factor holds within the mathematical
expression:

b1) The quantitative factor is the numerator:

a a1 a 0 a 1 − a 0
1.∆ R = − = ;
b0 b 0 b0
b a1 a 1
2.∆ R = −
b1 b 0
a b c
∆ R + ∆ R + ∆ R = ∆R .

b2) The quantitative factor is the denominator:

b a a
1.∆ R = 0 − 0 ;
b1 b 0
a1 a 0
2. ∆ aR = −
b1 b1
a b c
∆ R + ∆ R + ∆ R = ∆R .

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 1.6.4. Balance method

This method is used to measure the influence of different factors upon the change of certain
phenomena expressed by mathematical expressions of sum, of subtraction, or that combines the
two:
R=a+b–c
∆R = R1 − R 0 = (a1 + b1 − c1 ) − (a 0 + b0 − c0 )
1) influence generated by factor “a” change:
a
∆R = (a1 + b0 − c0 ) − (a0 + b0 − c0 ) = a1 − a0
2) influence generated by factor “b” change:
b
∆R = (a1 + b1 − c0 ) − (a1 + b0 − c0 ) = b1 − b0
3) influence generated by factor “c” change:
c
∆R = (a1 + b1 − c1) − (a1 + b1 − c0 ) = −(c1 − c0 ).
a b c
∆ R + ∆ R + ∆ R = ∆R .

1.6.5. Ratio method

Financial ratios provide a quick and relatively simple means of examining the financial condition of
a business. A ratio simply expresses the relation of one figure appearing in the financial statements
to some other figure appearing there (for example, net profit in relation to capital employed) or
some resource of the business (such as net profit per employee, sales per square meter).

Ratio analysis can be applied to financial statements and similar data in order to assess the
performance of a company, to determine whether it is solvent and financially healthy, to assess the
risk attached to its financial structure and to analyse the returns generated for its shareholders and
other interested parties.

Ratios can be very helpful when comparing the financial health of different businesses. Differences
may exist between businesses in the scale of operations and so a direct comparison of the profits
and other measures generated by each business may be misleading. By expressing profit in relation
to some other measure (e.g. sales) the problem of scale is eliminated. These ratios can be directly
compared whereas comparison of the absolute profit figures would be less meaningful. The need to
eliminate differences in scale through the use of ratios can also apply when comparing the
performance of the same business over time.

By calculating a relatively small number of ratios, it is often possible to build up a reasonably good
picture of the position and performance of a business. Thus, it is not surprising that ratios are widely
used by those who have an interest in business performance. Although ratios are not difficult to
calculate, they can be difficult to interpret. For example, a change in the net profit per employee of
a business may be for a number of possible reasons such as:
- a change in the number of employees without a corresponding change in the level of output;
- a change in the level of output without a corresponding change in the number of employees;
- a change in the mix of goods/services being offered which, in turn, changes the level of
profit.

It is important to appreciate that ratios are really only the starting point for further analysis. They
help to highlight the financial strengths and weaknesses of a business but they cannot, by
themselves, explain why certain strengths or weaknesses exist or why certain changes have
occurred. Only a detailed investigation will reveal underlying reasons.
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Ratios can be expressed in various forms (percentage, fraction, proportion). The way a particular
ratio is presented will depend on the needs of those who will use the information. Although it’s
possible to calculate a large number of ratios, only a few, based on key relationships may be
required by the user.

There is no generally accepted list of ratios which can be applied to the financial statements nor is
there a standard method of calculating many ratios. Variations in both the choice of ratios and their
precise definition will be found in the literature and in practice. However, it is important to be
consistent in the way in which ratios are calculated for comparison purposes.

Ratios can be grouped into certain categories:

• Profitability ratios – express the profits made in relation to other indicators from the
financial statements or to some business resource. E.g.: return on capital employed, profit
margin.
• Efficiency (activity) ratios – may be used to measure the efficiency with which certain
resources have been utilized within the business. E.g.: debtors’ ratio, creditors’ ratio, stock
turnover, fixed asset turnover.
• Liquidity/solvency ratios – a business must generate sufficient liquid resources to meet
maturing obligations. These ratios emphasize the relationship between liquid resources held
and creditors due for payment in the near future. E.g.: current ratio, quick ratio.
• Asset and capital structure ratios – reveal the structure of assets and capitals. E.g.: long term
assets ratios, financial stability ratio.
• Gearing ratios – gearing is an important issue which managers must consider when making
financing decisions. The relationship between the amount financed by the owners of the
business and the amount contributed by outsiders has an important effect on the degree of
risk associated with a business. E.g.: capital gearing, debt/equity ratio, interest cover,
operating gearing.
• Investment (investor) ratios – assess the returns and performances of shares. E.g.: dividend
per share, price/earnings ratio.

The use of ratios allows:

- highlight some aspects that could not have been made obvious through separate analysis
of the two measures used to form a ratio;
- make some time, space or mixed comparisons;
- forecasting company’s activity either in part or as a whole;
- synthetic assessment of company’s activity.

The practical use of the method should take into account certain rules that a ration shall comply
with:
- to be financially meaningful;
- ratios calculated for several successive periods should be compatible between themselves;
- compared enterprises should be from similar industries and have similar size;
- to bare informational value greater that the two separate indicators that form it taken
independently.

1.6.6. Scoring method

It’s a method of multidimensional discriminant analysis, which is based on a comparative analysis

of two groups of companies, bankrupt and non-bankrupt. This method requires the construction of a
function based on several financial ratios which are likely to differentiate the healthy firms from the

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bankrupt ones. By identifying the significant ratios able to accurately differentiate the two groups of
firms, the score function Z can be built:

Z = aR1 + bR2 + … + yRn,

where:
a, b,… y – weighting coefficients;
R1, R2, Rn – financial ratios.

The score a company gets for a certain year is given by the value of this amount and it indicates its
financial vulnerability and the likelihood to go bankrupt.

The main scoring models used in theory and practice are: the Altman model, the Conan and Holder
model, the French National Bank model.

1.6.7. Pareto chart (ABC analysis)

Pareto chart (sometimes referred to as the 80/20 rule and as ABC analysis or ABC method) is a
method of classifying items, events, or activities according to their relative importance. The precise
shape of a Pareto curve will differ for any analysis but the broad shape remains similar - following
'the 80/20 rule'. Vilfredo Pareto was a 19th century economist who observed that 80% of Italy's
wealth was owned by 20% of the population.

Pareto charts are extremely useful for analysing what problems need attention first because zone A
on the chart clearly illustrate which variables have the greatest cumulative effect on a given system.

Cumulative
results
100%

Zone
C
Zone
B
Zone
A
Cumulative no. of
variables 100 %
Figure 1.1. Pareto Chart

This method is frequently used to analyse turnover, stocks, costs, customers, suppliers etc.

Making decisions on the phenomenon studied is based on the difference between the real curve and
the theoretical one. If the real curve lies below the theoretical curve, the company has a high
percentage of its results in the areas B and C (which means a low degree of concentration). In the
opposite case, the results located in zone A prevail and the concentration of results is higher.

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