Andrea Dossi

(English version: Marco Morelli)

Financial Statement Analysis using ratios

Bocconi University, Milan, September 2014

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1 – Introduction
This note is a tutorial to support the study of some sets of slides produced for the course “Performance
Management”, covering the topic of financial statement analysis. The course objective is to
understand how managers design and use performance measurement systems to support their decision
making processes. That’s the reason why the perspective of an internal analyst is adopted in this note.
Despite the increasing convergence between internal and external reporting, a phenomenon
accelerated by the adoption of IAS 1, there is still variety in information available, perspectives, tools
implemented, if we adopt an internal or an external perspective for our analysis. This note adopts the
managerial perspective aimed at investigating performance and value drivers of a company.
The structure of the note is as follows. In the first section we outline the purpose of the ratio analysis
and the main issues that the analyst must face in the different stages of the analysis. In the second
section, we review how to read financial statements by reclassifying the income statement and the
balance sheet. In the third section we deal with the ratios calculated for the appreciation of three key
dimensions of analysis: long-term solvency, profitability and liquidity. In the fourth and last section,
we present the sustainable growth model and how to use it to define company objectives.

2 – Financial statement analysis: goals, actors and stages

Financial analysis applies analytical tools to financial data to assess a company’s performance and
trends in that performance. The analysis is mainly based on financial statements (income statement
and balance sheet) and the mathematical relationships among them because they provide the most
widely available data on public corporations’ economic activities. More specifically, ratio analysis is
widely adopted by financial analysts because company size sometimes confers economies of scale,
so the absolute amounts of net income and revenue are sometimes not so useful in financial analysis,
while ratios reduce the effect of size, which enhances comparisons between companies and over time.
The analysis has three main objectives:
1. Appreciate the financial performance of a company. The analysis is aimed at evaluating both
from a quantitative and qualitative point of view the results of a company in terms of profit,
long term solvency and liquidity in order to identify strengths, weaknesses and key managerial
issues.
2. Evaluate the sustainability of the growth strategy of a company. More specifically, a growth
strategy can be considered sustainable if it doesn’t threaten the autonomy of a company. This
analysis is also useful for target setting.
3. Identify performance drivers and related managerial issues. The ratio analysis allows the
decomposition of ratios in different levels of analysis and the appreciation of mathematical
and managerial links among them. It is therefore the primary technique used for investigating
the drivers of business results (in a general sense, the business value-drivers), evaluating their
impact on the overall business results and understating how to use them in allocating goals to
different organizational units (responsibility centres). By highlighting key managerial issues,
ratio analysis allows us to identify which and how much improvement we need to generate an
adequate performance and who should manage the improvement plan.

Being ratios simple numbers (mathematical relationship between two items), it is possible to achieve
the purposes described above only following some warnings.
First, it is always necessary to use a set of ratios, combined into a comprehensive framework where
ratios are logically and mathematically linked. One single ratio has a limited power of interpretation,
while a set of ratios not related to each other is difficult to be analysed.

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This note, in accordance with its purpose, does not deal explicitly with IAS / IFRS. To this extent, it mainly refers to
the financial statements written in accordance with local Italian principles (Italian GAAPs)

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Secondly, it is important to identify benchmarks for ratios. These standards are not always easily
identifiable. It is often useful to compare ratios of a company with an industry’s average performance
(relative performance evaluation) or with those of some competitors (benchmarking), if these data
are available. In addition, it is always of great help to explicitly analyse the trend over time (i.e. three
years) of major ratios, trying to understand the determinants of their variability.
Third, when you make a comparative internal analysis over years or a comparative external analysis
with competitors’ ratios, you always have to check for the homogeneity of accounting principles
adopted and the scope of activity of a company. If a company has changed accounting policies and /
or has proceeded to significant M&A initiatives, it is often necessary to collect additional information
in order to properly analyse the financial performance of the company. In some cases, if you want to
express an opinion, it is necessary to neutralize the effects of the above-mentioned phenomena, by
properly restating financial statements.

Five fundamental steps must be implemented to perform a good financial statement analysis:

1. Reading and interpreting financial statements. It is often useful to start our analysis from the
two most important quantitative documents of an annual report, the income statement and the
balance sheet, in order to identify key items and their trend. However, in order to be able to
interpret this quantitative documents, it is also necessary to read some important qualitative
documents of an annual report - such as the letter to shareholders, the report on operations,
the notes to the accounts – where we can find information about the strategy, the business
model and the structure of a company and the characteristics of the competitive environment
in which it operates. Also financial analysts’ reports provide useful information for our
analysis (only for listed companies). Obviously, an internal analyst can also use internal
documents to enrich the analysis.
2. Reclassifying the income statement and the balance sheet. Many firms report their financial
statement information in order to satisfy exigencies of external communication, drawing up
their reports in a way that ultimately helps more investors’ analyses than managers’ activities.
Many firms, less exposed to the exigency of external communication, draw up their financial
statements in forms set by the law that usually are not able to support the processes of internal
analyses either. Thus, the first step necessary for financial statement analyses is the
reclassification of income statement and balance sheet.
3. Building and reading the cash flow statement. The cash flow statement is not explicitly
analysed in this note. It has to be considered as complementary to ratio analysis. A cash flow
statement should be able to highlight the contribution of different activities (operating,
investing and financing) to the generation of cash and the free cash flow from operations/to
equity.
4. Identifying critical issues and ratios to be calculated.
5. Analysing relationships among ratios and final evaluation. In this stage you can express a
synthetic judgment on the performance of a company.

Given the approach adopted in this note, the final evaluation should adopt the perspective of a
manager who wants to have an impact on the design and use of performance measurement systems
within a company. This evaluation should be based on a classification of company’s activities
according to two criteria.
First, the analysis must adequately separate (in reclassifying financial statements, in computing ratios,
in expressing evaluation) events, items and results dealing with two macro-areas of activity managed
by a company:
a. Operating activities, mainly related to relationships with suppliers and customers and
manufacturing activities;

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 b. Financing activities, aimed at managing relationships with capital markets (shareholders and
lenders of money).
Second, we should identify short term and long term activities.

The separation of the two macro-areas of activities is relevant for any analyst, both for the specificity
of the decisions pertaining each of them and the evaluation of a company performance. The separation
in the analysis of these two macro–areas responds to various needs. In fact, it is just with the continuity
of the operating results that a company can build a sustainable business. Moreover, operating
activities generate financial needs. More specifically, the quality and quantity of financial needs are
driven by industry characteristics, the length of operating cycles, the degree of innovation
required/desired, not vice versa. That’s the reason why it is important to evaluate operating activities
before evaluating the ability of a company to manage financial resources.
In addition, these two macro-areas are characterized by different organizational attributes. More
specifically, operating activities include both operational and strategic decisions, short term and long
term perspective, and they are managed by many organizational units within a company. Financing
activities are centrally managed by the Finance function and imply only a small number of big
decisions. Thus, performance measurement systems traditionally devote more attention to operating
activities, since financing ones can be directly monitored without sophisticated systems.

Figure 1 – Drivers and perspectives of financial performance

Time Perspective
Short-Term Long-Term

Margin % management Asset management

Operating activities

• •

• Net Operating Working • Growth strategy

Capital Efficiency
Profitability
Perspective
Managerial

Liquidity Growth
Cash flow management Relationship with
Financing activities

• •
(optimization of shareholders
financing activities)
• Optimisation of
• Interest coverage financial leverage
Solvency

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3 – Reclassifying the balance sheet and the income statement: critical aspects
Before implementing ratio analysis, a reclassification of financial statements is needed. In fact, as
already mentioned, most of the firms report their financial statement information in order to satisfy
exigencies of external communication, drawing up their reports in a way that ultimately helps more
investors’ analyses than managers’ activities. Thus, the first step necessary for the financial
statements analyses is the reclassification. With this procedure, basically, analysts restate financial
statements according to formats that are more helpful in understanding the financial performance of
a company. Different reclassification criteria lead to different formats both for balance sheet and
income statement. In section 3.1 we review reclassification criteria of the balance sheet, while in
section 3.2 different formats for the income statement are described. For each format, advantages and
disadvantages are presented.

3.1 – Reclassifying the balance sheet

The two main methods used by financial analysts to reclassify the BS are:
1. Liquidity method;
2. Activity-related method.

In the first method (Figure 2), time is the discriminating factor for the aggregation of assets and
liabilities. The objective is to group assets and liabilities according to the time it takes to transform
them into cash, listing assets by decreasing liquidity and liabilities by decreasing payability. More
specifically, assets and liabilities are sometimes categorized as “short term (current)” or “long term
(noncurrent)”: noncurrent assets are assets that are expected to benefit the company over an extended
period of time (usually more than one year); current assets are those that are expected to be consumed
or converted into cash in the near future (typically one year or less); noncurrent liabilities represent
those amounts due to other parties that are not liable for repayment within the twelve-month period
following the balance sheet date; current liabilities represent amounts due for repayment to outside
parties within 12 months of the balance sheet date.

Figure 2 – Balance Sheet: liquidity method

ASSETS LIABILITIES AND SHAREHOLDERS' EQUITY

SHORT TERM ASSETS SHORT THERM LIABILITIES

Prompt liquidity Overdrafts

Cash Accounts payable
Bank accounts Uncollected revenues
Marketable securities Accrued expenses
Tax fund
Deferred Liquidity Part of long term loans due within 1 year
Accounts receivable
Prepaid expenses LONG TERM LIABILITIES
Accrued revenues Long term loans
Mortgages
Other short term assets Bonds
Inventories Staff severance fund
Advances to suppliers

LONG TERM (FIXED) ASSETS EQUITY (NET WORTH)

Tangible fixed assets
Intangible fixed assets
Financial assets

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The main objective of this format is to highlight whether the company shows consistency (in terms
of timing) between assets and liabilities or not. More specifically, the autonomy and the durability of
a company could be threatened by an unbalanced structure in which investments in fixed assets are
financed by short term funds. Given the possibility to analyse this important aspect and the relatively
easy procedure to build it, the balance sheet reclassified according to the liquidity method is widely
used by companies and financial analysts.
However, this format has some limitations: more specifically, it doesn’t allow to analyse and value a
firm’s operating liabilities separately from the firm’s financial (interest bearing) liabilities.

The activity-related format (Figure 3) of the balance sheet overcomes this limitation. The
classification of assets and liabilities is by function. More specifically, we identify:
• operating and financial assets
• operating and financial liabilities.

The items included in each category are then classified according to the liquidity criterion (short term
vs long term).

Figure 3 – Balance Sheet: activity-related method

The balance sheet reclassified according to the activity-related method is thus able to highlight some
important managerial aspects, such as:
a. the presence, within assets, of relevant items not related to operating activities. In this sense,
this format better analyses how efficiently the firm uses invested capital in the business;
b. the distinction, within liabilities, of resources related to the typical input-process-output cycle
of the company vs. resources collected from capital markets.

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Financial analysts generally use a “simplified” version of this format (Figure 4). More specifically,
this format is characterized by the presence of the following items:
a. Net financial position (NFP), defined as total cash position (cash, cash equivalents and
marketable securities) net of total financial debt (bank overdrafts, current portion of long-term
debt and long-term debt);
b. Net operating working capital (NOWC), calculated by taking the current assets required in
operations and subtracting non-interest bearing liabilities. NOWC helps assess a company's
liquidity because it looks only at current assets and liabilities required to operate the business.
Current assets typically include accounts receivable and inventories, while current operating
liabilities typically include accounts payable and accruals, but exclude short term debt.

Figure 4 – Balance Sheet: activity-related method (simplified)

NET OPERATING WORKING CAPITAL NET FINANCIAL POSITION

Accounts receivable S-T NET FINANCIAL POSITION

Prepaid expenses + Overdrafts
Accrued revenues + Part of long term loans due within 1 year
Inventories - Cash
Advances to suppliers - Bank accounts
Net Invested Capital

- Accounts payable - Marketable securities

- Accrued expenses
- Tax fund

L-T NET FINANCIAL POSITION

FIXED ASSETS Long term loans
Tangible fixed assets Mortgages
Intangible fixed assets Bonds
Financial assets

OTHER
- Funds for risks and charges EQUITY
-Severance funds

This format allows to better analyze a couple of important aspects.

First, the Net Invested Capital represents the investment required by the firm’s core business and it’s
generated by two categories of activities: the current input-process-output cycle (NOWC); investment
decisions (fixed assets). The mix between these two items determines the rigidity of the firm’s assets
structure: the higher the incidence of fixed assets, the higher the rigidity. Rigidity is closely related
to the caracteristics of the business/industry: merchandising companies are mainly characterized by
a flexible structure, while manufacturing companies and technology-based services (i.e. airline
companies) generally have a rigid structure. Conversely, the NOWC doesn’t depend only on the
technology but also on other drivers, such as: average days of sales outstanding (DSO) or payables
outstanding (DPO), the value added, the length and complexity of the production cycle, the ability of
a company to plan/forecast sales. More specifically, the higher the value added and the difference
between DSO and DPO, the higher the NOWC of a company.
Second, if we observe the format in Figure 4, we can notice how, given the equity of a company, the
amounts of debts (NFP) is a function of a firm’s ability to efficiently manage the NOWC and to take
accurate investment decisions.

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3.2 – Reclassifying the income statement

The Income Statement is reclassified in order to understand HOW the Net Income was generated.
More specifically, revenues and expenses are generally categorized according to the different
activities that have generated them: this logic is also consistent with the logic adopted in building the
balance sheet described in Figure 4. Business activities may be classified into four main groups:
a. Operating activities, are those activities that are part of the day-to-day business functioning
of an entity;
b. Subsidiary activities, are those operations carried out with no particular continuity and which
do not constitute the primary objective of the company (i.e. real estate activity);
c. Extraordinary activities: are exceptional operations that are not part of normal economic
activity since they occur only occasionally (i.e. profit from discontinued operations)
d. Financing activities involve all the means of obtaining various forms of capital to finance a
company’s operations.
This classification of activities allows the calculation of four intermediate margins, as described in
Figure 5.

Figure 5 – Reclassifying the income statement: general framework

NET PROFIT

OPERATING ACTIVITIES

Trading Profit
SUBSI DI AR Y ACTI VI TI ES

Operating Income (EBIT)

FINANCIAL ACTIVITIES
I ncom e before tax es and
ex traordinary activities
EXR AOR DI NAR Y ACTI VI TI ES

Earnings before income taxes (EBT)

INCOME TAXES

The income statement represented in Figure 5 can be considered as a general framework: the different
formats of income statement adopted by different companies, however, differ in how operating
activities are further analysed. More specifically, three aspects are important in defining how to
analyse operating activities:
a) the identification of the initial value to be highlighted in the income statement, revenues or
total value of production;
b) the choice of the intermediate margins to be calculated before the trading profit;
c) the classification of operating costs, by nature or by destination.

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The first aspect is relevant for financial analysts, because the first item of an income statement
represents the volume of a company and it’s used to evaluate operating efficiency and growth. The
choice between revenues and total value of production should be driven by the length of the
production cycle. If this cycle is short (i.e. merchandising companies), annual revenues adequately
represent the activity of a company. In companies characterized by long production cycles, however,
revenues are not enough to represent the volume of firm’s activities; in these cases, it is necessary to
also take into consideration changes in work in progress. More specifically, the total value of
production is calculated by adding to revenues changes in WIP and finished products inventories and
additions to fixed assets.
As far as the second aspect mentioned above is concerned – intermediate margins – different
approaches can be identified.
For manufacturing and merchandising companies, analysts generally classify costs as either product
costs and period costs. Product costs are those costs that are identified with goods purchased or
produced for resale. In a manufacturing organization they are (manufacturing) costs that are attached
to the product and that are included in the inventory valuation for finished goods, or for partly
completed goods (WIP), until they are sold; they are then recorded as expenses (cost of goods sold
or cost of sales) and matched against sales for calculating profit. Period costs are those costs that are
not included in the inventory evaluation (selling, general and administrative costs – SG&A), and as
a result are treated as expenses in the period in which they are incurred. The difference between
revenues and cost of goods sold is the gross profit (or gross margin) of the company (Figure 6). If
divided by revenues (gross margin index or gross margin %) this margin represent the effectiveness
of mark-up strategies and the impact of sales mix; in manufacturing companies it is also a function
of the ability of a company to efficiently manage its manufacturing processes.

Figure 6 – Reclassifying the income statement: gross profit (margin) approach

Revenues
(Rebates/Returns/Allowances)
Net Sales
(COGS)
Gross Profit
(Selling Costs)
(G&A Expenses)
(Other expenses.................)
+/- Subsidiary activities
Operating Income
(Interest Expenses)
Income Before Extraordinary Items and Taxes
+/- Extraordinary Items
EBT
(Income Taxes)
Net Income

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As far as service companies are concerned, they can be grouped into two categories: capital intensive
services (i.e. utilities) and labour intensive services (i.e. consulting companies). In both cases,
companies are able to generate value by leveraging one dominant driver: technology or human
resources. Thus, it is useful to build an income statement that is able to highlight the impact of these
two resources. The income statement described in Figure 7 is based on the distinction between
external and internal costs. The difference between revenues and external costs gives the value added;
the EBITDA is calculated by deducting personnel costs from the value added. Value Added is not a
measure of profitability, but rather a useful indicator for industrial analysis. It indicates the level of
vertical integration, that is, how much of the production activity necessary for
manufacturing/delivering the finished product/service is carried out within the company itself.
EBITDA is an important measure for financial analysts because it represents an approximation of
cash generated by operating activities and it is not affected by accounting policies related to
depreciation and amortization. Given these characteristics, the income statement described in Figure
7 is particularly useful to analyse the performance of service companies.

Figure 7 – Reclassifying the income statement: value added and EBITDA approach

Net Sales
+ Changes in FG and WIP inventories
+ Additions to fixed assets
+ Changes in contract work in progress
Total value of production
(Purchases of RM and WIP)
+/- Changes in DM inventories
-(Other external costs)
Value added
(Personnel costs)
EBITDA
(Depreciation and amortization )
Operating Income
(Interest Expenses)
Income Before Extraordinary Items and Taxes
+/- Extraordinary Items
EBT
(Income Taxes)
Net Income

The third format (Figure 8) briefly analysed in this note is based on the distinction between variable
and fixed costs (contribution margin approach). This format is particularly useful to understand the
degree of operational riskiness of a company (degree of operating leverage, break-event point).

As far as the third aspect is concerned – classification of operating costs – operating costs can be
classified by nature (personnel costs, depreciation, etc. …) or destination (manufacturing costs, sales
costs, etc. ..). The classification by destination allows the analyst to analyse the costs incurred by
macro function, but it requires detailed information sometimes available only for internal
users/analysts.

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Figure 8 – Reclassifying the income statement: contribution margin approach

Revenues
(Rebates/Returns/Allowances)
Net Sales
(Variable Costs)
Contribution Margin
(Fixed Costs)
Operating Income
(Interest Expenses)
Income Before Extraordinary Items and Taxes
+/- Extraordinary Items
EBT
(Income Taxes)
Net Income

4 – Ratio analysis: analysing long term solvency, profitability and liquidity

There are many relationships between financial accounts. Ratios are a useful way of expressing these
relationships. Ratios express one quantity in relation to another (usually as a quotient) in order to
analyse the “accounting-based” performance of a company. Before discussing the different
perspectives analysed using ratios, it is appropriate to point out that the usefulness of this technique
is affected by:
a. the possibility to calculate ratios over a long period of time, at least three years, to be able to
appreciate the trend and to normalize accounting values by neutralizing the impact of
changing accounting policies;
b. the distinction between first–level ratios – i.e. the ratios by which it is possible to give a sign,
positive or negative, to the evaluation of a firm’s performance – and lower–level ratios
(second, third, etc. …) – needed to describe the degree of intensity of the first level evaluation
(very positive, very negative, etc.);
c. the ability to highlight mathematical and logical links among ratios.

4.1 – Analysing long term solvency

Analyzing the long term solvency of a company means giving a judgment on the ability of a company
to overcome particularly negative internal or external events. This attitude is a function of the residual
possibility a company has to collect additional funds from capital markets. In fact, adverse events
potentially have a negative impact on financial results, especially in terms of profits. In these
situations, companies need to invest in new products and / or new markets by raising additional funds
from lenders of money: it is possible to get these funds only when a firm has a balanced capital
structure in terms of autonomy. If an adverse event affects the results of a company already showing
an high exposure to third parties’ funds, the ordinary request for additional funds may be denied for
two reasons. First, the company may have difficulties in repaying debt, given the crisis in financial
results. Second, capital markets may lose confidence in the ability of the top management team to
invest these funds. In fact, an high level of debt is by definition a consequence of wrong investments.

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If, therefore, the company cannot get additional funds from lenders of money and it’s not able to self-
finance its growth, the existence of the company itself may be jeopardized. That is the reason why
the most important first level ratio used to evaluate long term solvency is the so called debt-to-equity
or gearing ratio, calculated as follows (Figure 9): NFP/Equity.

Figure 9 – Gearing ratio

First Level NOWC NFP

FA
E
Formula NFP
NIC FU NDS
Equity

Range 0 +

Meaning A measure of a company's financial leverage calculated by

dividing its interest-bearing liabilities by stockholders' equity.
It indicates what proportion of equity and debt the company
is using to finance its assets.
Standard 1 – 1.5
(1.5 especially in presence of potential assets’ revaluation)

Second–level indicators seek to capture three aspects that are important in better evaluating the long
term solvency of a company:
1. the ability to repay debts, which is a function of the ability to generate positive cash. In order
to evaluate this aspect, financial analysts often look at the debt-to-EBITDA ratio, calculated
as follows: NFP/EBITDA. This ratio gives the investor the approximate amount of years that
would be needed to pay off all debt. This ratio is often taken as a reference parameter for
judging the quality of corporate financial structure. More specifically, Debt/EBITDA is a
common metric used by credit rating agencies to assess the probability of defaulting, and it’s
the basis to define duration and cost (interest rate) of debt (covenant). Threshold values range
from 3.5 to 4;
2. the life-cycle stage of a firm’s investments. Ideally, each investment has a life-cycle
characterized by different phases: idea generation, growth, maturity, decline. In early phases
of a project life cycle, resource needs are usually high, so the debt-to-equity ratio could be
high as well. However, a high level of debt at the following stages is a consequence of a wrong
investment, that wasn’t able to generate planned cash flows. Given this premise, it is always
useful to conceive a company as a bundle of investments and to understand what’s, on
average, the life-cycle phase of these investments. It’s difficult to evaluate this aspect just by
using ratios. In manufacturing companies the ageing of fixed assets ratio can be calculated as
follows (Figure 10): accumulated depreciation/gross value of assets. The resulting number
can range from 0 to 1 (100%), where values close to 100% indicate investments in advanced
stage of maturity.
3. consistency between investments and funds, in terms of timing. In general terms, there should
be a balance between investments and funds, meaning that long–term investments should be
financed by long term funds. A commonly used ratio that is able to express this balance is the
fixed assets coverage ratio, calculated as follows (Figure 11): equity/fixed assets. This ratio
can also be expressed in absolute value (equity less net fixed assets): in this case it is usually

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 called structural margin. The fixed assets coverage ratio can assume values ranging from 0 to
infinity. Values greater than one indicate an adequate coverage of fixed assets by
shareholders’ funds. The fixed assets coverage ratio can also be calculated by entering long
term financial debt at the numerator.

Figure 10 – Ageing of fixed assets

Second Level

Formula Accumulated depreciation

Gross Value Fixed Assets

Range 0 +

Meaning It is a measure of fixed assets’ obsolescence. It is useful in

analyzing manufacturing, capital intensive companies. A value
around 1 should be associated with a low gearing ratio.

Standard If ratio  0 Recent investments

If ratio  1 Old investments

Figure 11 – Fixed assets coverage

Second Level

Formula Equity
Fixed Assets

Range 0 +

Meaning It expresses the Company capability to finance its investments

though Shareholders’ funds

Standard if Equity/Fixed Assets > 1 OK

if Equity/Fixed Assets = 1 Equilibrium
if Equity/Fixed Assets < 1 KO

4.2 – Analysing profitability

Profitability is the ability of a company to generate an adequate remuneration of invested capital. This
attitude is a function of: the balance between revenues and expenses; the efficient deployment of
invested capital. The two most important first level indicators are: Return on Equity (ROE) and
Return on Net Assets (RONA).
ROE (Figure 12) measures a firm's profitability by revealing how much profit a company generates
with the money shareholders have invested. Given its formula (Net Income/Equity), it is a

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fundamental ratio, since the net income is a result of all firm’s activities: operating, subsidiary,
financing, extraordinary and fiscal. Any change in the results generated by these activities have an
impact on ROE. ROE represents the residual value available to distribute dividends to shareholders
or to be retained in the company to self-finance growth. In this sense, ROE also represents the
maximum growth rate of equity, in absence of capital increases.

Figure 12 – Return on Equity (ROE)

First Level

Formula Net Income

Equity

Range - +

Meaning The amount of net income returned as a percentage of shareholders equity.

Return on equity measures a corporation's profitability by revealing how much
profit a company generates with the money shareholders have invested.

Standard Benchmarks are often identified with reference to a comparable investment a

shareholder could make instead of investing in the company. This is, however,
the perspective of a speculative investor.
Generally, the higher, the better. It’s necesessary to compare it with the
average of the industry.

If we analyze the profitability of a company, ROE can often present variability over time due to
changes in the incidence of extraordinary items and taxes. Extraordinary items are generated by
unforeseeable events, that could have a relevant impact on the net income of the year (i.e. capital
gains and capital losses). Taxes are a function of the complexity and variability of tax regulations in
different countries. In order to correctly interpret and evaluate the trend of ROE over time (same
company) or space (e.g., different units of the same multinational companies), analysts often try to
normalize profits by eliminating the impact of these two categories of activities. In order to do that,
analysts calculate the Gross ROE as follows: Income before extraordinary items and taxes/Equity.
Since this ratio is not affected by extraordinary results and taxes, it is a sort of “normalized” ROE.

RONA (Figure 13) expresses the capability of the company to remunerate its investments, regardless
how they have been financed. It is calculated as follows: Operating Income (EBIT)/Net Invested
Capital. This value does not depend on how the company is financed, since the numerator (EBIT) is
not affected by the result of financing activities.
Both for RONA and ROE, it’s difficult to find reliable benchmarks. Some potential benchmarks are:
cost of capital, the average of the industry, competitors. However, all these benchmarks do have some
limits.

Second level profitability analysis is aimed at understanding the drivers of corporate profitability,
focusing on two main aspects:
a. the relationship ROE–RONA;
b. the determinants of RONA.

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Figure 13 – Return on Net Assets (RONA)

First Level

Formula Operating Income (EBIT)

Net Invested Capital

Range - +

Meaning It expresses the capability of the company to remunerate its investments,

regardless how they have been financed

Standard The higher the return, the better the profit performance for the company. It’s
difficult to find good benchmarks.

The first relationship can be broken down into two components: the relationship ROE – Gross ROE
and the relationship Gross ROE-RONA. The difference Gross ROE – ROE is affected by the
incidence of taxes and extraordinary activities. In mathematical terms:

ROE = Gross ROE × (Net Income / Income before extraordinary items and taxes)

The ratio “Net Income / Income before extraordinary items and taxes” is expressive of the impact of
these two activities on the profit of the year. It can be further broken down into its two components:
tax burden (EBT/Net Income) and incidence of extraordinary items (Income before extraordinary
items and taxes/EBT).

As far as the relationship Gross ROE – RONA is concerned, it can be expressed in mathematical
terms as flows:

Gross ROE = RONA + RONA (RONA - i) * d

Where:
i = interest rate, calculated as the average cost of debt (interest expense/net financial position)..
d = debt-to-equity ratio (net financial position/equity)

The equation shows the two determinants of gross ROE:

• the spread between the return of company’s investments and the cost of debt;
• gearing ratio: the higher the level of d, the higher the impact of the spread on the Gross ROE.
The financial leverage increases the variability of a firm’s results and, by definition, its
riskiness. Being interest rates (i) only partially controllable by a company, this riskiness could
be particularly relevant.

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Summing-up, the second–level analysis of the relationship ROE – RONA described above allows us
to identify the following drivers of ROE:
• the impact of taxes;
• the impact of extraordinary items ;
• financial leverage, in turn determined by RONA, average cost of debt and gearing ratio;
• RONA.

The table below summarizes the determinants of ROE.

AREA RATIO METHODOLOGY

Fiscal Tax burden Net Income / EBT
Extraordinary activities Incidence of extr. items EBT / Inc. before extr. items and taxes
Financing activities Financial leverage (RONA – i) × (NFP/Equity)
Operating activities RONA EBIT / NIC

The second area of analysis, as already mentioned, is represented by the determinants of RONA.
Following the “Dupont model” (from the name of the company that first adopted it), RONA can be
broken down, from both a mathematical and managerial point of view, into two components: Return
on Sales (ROS) and NIC Turnover.
ROS is calculated as follows: Operating Income (EBIT)/Sales. It can also be calculated by taking into
consideration only operating activities, net of subsidiary activities (Trading Profit/Sales).
In general terms, the ROS expresses how much Operating Income is produced per unit of Sales. It
expresses the operating marginality and the level of operating efficiency. In fact, it depends on the
daily operating decisions taken within a company, having an impact on efficiency and, more
specifically, on the level of revenues and operating costs. The profitability drivers of ROS are:
• Selling prices;
• Sales volume;
• Sales/production mix, since different product lines, channels, customers are characterized by
differences in marginality;
• Efficiency in purchasing and using resources.
In order to better analyse the impact of this drivers, it is often useful to breakdown the ROS into some
components, according to the income statement format described in Figure 6: ROS = (Gross
Profit/Sales) – (SG&A/Sales).

The NIC turnover is calculated as follows: Sales/Net Invested Capital. The ratio expresses the amount
of sales or revenues generated per dollar of assets. The Asset Turnover ratio is an indicator of the
efficiency with which a company is deploying its assets. Thus, turnover is a function of the
relationship between the components of NIC (NOWC and NFA) and business revenues. This ratio
tends to express in a synthetic way the efficiency of the structural choices made by the company, both
in terms of working capital and production capacity installed (in a broad sense, not just manufacturing
capacity).
The NIC turnover can be broken down into two components:
1. Turnover of net fixed assets;
2. Turnover of net operating working capital.

The net fixed assets turnover (Revenues / NFA) is normally a function of the life-cycle phase of fixed
investments and their level of saturation.
The turnover of the net working capital (Revenues / NOWC) highlights the efficiency of a company
in generating revenues while minimizing the level of investments (NOWC) generated by operating
activities. The turnover of net working capital can be further broken down into many components:

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 • Turnover of accounts receivable (Revenues/Accounts Receivable);
• Turnover of inventories (Revenues/Inventories), with a detail, if necessary, by category of
inventories (WIP, finished products, direct materials);
• Turnover of accounts payable (Revenues/Accounts Payable).

Finally, it is important to note that the concept of turnover is different from that of payment extension.
The turnover highlights how efficiently a firm uses its operating investments and, from a
mathematical point of view, it is a multiplier of ROS in determining RONA. Thus, each component
of the NOWC contributes to the RONA with its turnover, which is a function of both the payments
policies/durations related to each item and its incidence on revenues. As a consequence, the inventory
turnover depends on days of inventory on hands and the incidence of COGS on sales:

Revenues / Inventories = (Inventories / COGS) × (COGS / Revenues)

Similarly, the turnover of payables depends on days of payables outstanding (DPO) and the incidence
of purchases on revenues.

Revenues / Accounts Payable = (Accounts Payables / Purchases) * (Purchases / Revenues)

It is possible therefore to increase the turnover of the NOWC not only by increasing the DPO, but
also by increasing the incidence of purchases on revenues (e.g., outsourcing manufacturing phases).

Summing up, the cash conversion cycle depends on DSO, DPO and DOH, weighted for the incidence,
respectively, of revenues, COGS and purchases on revenues.

Cash conversion cycle = DSO × (Revenues / Revenues) + DOH × (COGS / Revenues) – DPO ×
(Purchases / Revenues)

4.3 – Analysing liquidity

Liquidity is the capability of a company to be solvent over time, which is to say: to pay off all its
liabilities within the terms established through the resources it owns. The most important ratio to
asses liquidity is the quick ratio (or acid test, Figure 14). The second level ratio is the current ratio
(Figure 15).

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Figure 14 – Quick ratio (acid test)

First Level

Formula Prompt + deferred liquidity

ST liabilities

Range 0 +

Meaning An indicator of a company’s short-term liquidity. The quick

ratio measures a company’s ability to meet its short-term
obligations with its most liquid assets. For this reason, the
ratio excludes inventories from current assets

Standard if Ratio > 1 OK

if Ratio = 1 Equilibrium
if Ratio < 1 KO

Figure 15 – Current ratio

Second Level

Formula ST assets
ST liabilities

Range 0 +

Meaning It expresses the ability of a company to meet its short term

obligations, also taking into consideration inventory as a
source of liquidity.

Standard if Ratio > 1 OK

if Ratio = 1 Equilibrium
if Ratio < 1 KO

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5 – Sustainable growth
A full discussion of the growth perspective, and how to use the techniques of financial analysis in
order to define business goals, goes beyond the scope of this note. Our aim, here, is to use this
perspective to propose a comprehensive framework for analyzing profitability, long-term solvency
and liquidity. Analysing sustainable growth means assessing the ability of a firm to grow (mainly in
terms of revenues), while preserving the equilibrium among profitability, liquidity and solidity. In a
nutshell, it is the ability to survive in the long term.
This equilibrium is a function of the ability of a firm to meet some financial constraints, highlighted
by the following equation (sustainable growth equation):

g(s) g(NIC) = r * [RONA + (RONA – i) * NFP/E ] * (1-t)

Where:
g (S) = growth of sales
g (NIC) = growth of Net Invested Capital
r = retention rate = (Net Income - Dividends)/ Net Income
t = tax rate

This equation expresses the relationship that must exist between the growth rate of revenues and
RONA in order to have a stable gearing ratio.

There are two points that need to be highlighted.

First, this equation can be used to define the financial long–term targets of a company. In fact, only
two out of seven variables of the equation can be considered as business objectives, being the
remaining five variables either exogenous variables or a consequence of discretionary decisions (see
table below).

VARIABLE CATEGORY
Sales growth rate g(s) Strategic goal
Invested capital growth rate g(NIC) Strategic goal
Retention rate (r) Discretionary choice
Operating income Profitability goal
Interest rate (i) External constraint
Debt-to-Equity ratio (D/E) Discretional choice
Tax rate (t) External constraint

Second, the equation tends to emphasize the following logical–managerial relations:

1. revenue growth requires the growth of the capital invested in operations;

2. growth of invested capital should be financed in a way that allows a firm to maintain a stable
debt-to-equity ratio;
3. the debt-to-equity ratio remains constant only if the growth rate of shareholders’ funds equals the
growth rate of net invested capital;
4. the growth of shareholders’ funds depends on the profitability of a company (self-financing)
5. self-financing is a function of the ability to consistently produce adequate levels of RONA.

Figure 16 summarizes the relationship highlighted in the sustainable growth equation

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Figure 16 – Sustainable growth

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