FINANCIAL STATEMENTS: RATIO ANALYSIS

An introduction
- The typical tools used to analyze financial statements are:
o Balance Sheet and Income Statement formats
o Ratio Analysis and Cash Flow Analysis
- Financial statement analysis is based mainly on comparison > such comparison is
carried out with reference to:
o The same entity during time
o Different entities, typically:
 Key competitors
 Industry average
- There are many relationships between financial accounts > ratios are a useful way of
expressing these relationships
o Ratios express one quantity in relation to another (usually as a quotient)
- Company size sometimes confers economies of scale, so the absolute amounts of
values makes the comparison among companies frequently useless
o Ratios reduce the effect of size in make comparisons.
- There are no authoritative bodies specifying exact formulas for computing ratios or
providing a standard comprehensive list of ratios
o Formulas and even names of ratios often differ from analyst to analyst or
from database to database
- Ratios do not have an “universally” accepted reference value to understand if a
- company is performing well, ratio analysis can be done on three levels:
o A comparative internal analysis across years
o A comparative external analysis with competitors’ ratio
o A comparative analysis with a target value
- An analyst should also evaluate financial ratios based on the following:
o Company goals and strategy
o Industry averages (peer averages)
o Economic conditions
- Areas of analysis
 - Horizontal vs vertical analysis:
1. Vertical analysis: consists of the study of the relationship (in %) of each category
of items to a specified base, which is the 100% figure > in the BS this base is
usually the value of total assets, while in the IS it is the value of total sales
revenue
o The first wat to analyze the profitability of a firm is to show each of the items
on the IS expressed as a % of sales

o The first way to analyze solvency and liquidity is to express the BS in

percentages

2. Horizontal analysis: consists of the study of % changes in comparative financial

statements of the same company
o The amount of each category of items is compared with the same category in
financial statements of previous accounting periods to get the main trend
 For example, we can wonder how much the total assets increased in %
if compared to those of a previous accounting period assumed as a
basis

Profitability ratios
- Main ratios:
- ROA breakdown

- Business model and positioning

o Volumes strategy: we refer to companies characterized by low ROS and high

AT > the adoption of a "Volume Strategy" is aimed at maximizing the volumes
sold against reduced unit margins
 Depending on the industry in which a company operates and the type
of company itself, the maximization of the turnover may mainly
concern the Fixed Asset (saturation strategy) or the Net Operating
Working Capital (turnover strategy in the strict sense)
o Value strategy: we refer to companies characterized by high ROS and low AT >
the adoption of a “Value Strategy” is aimed at maximizing profitability by
achieving high unit margins
 This maximization of sales profitability can be pursued by focusing on
two different levers:
A. Price: search for an advantage of differentiation by focusing on the
ability of the company to make its product unique and to provide
 it with features for which buyers are willing to recognize a
premium price
B. Cost: search for a cost advantage by focusing on the company’s
ability to produce similar or equivalent products to those offered
by competitors at a lower cost
- The main drivers of ROA

- The link between ROA and ROE: the financial leverage

o Only equity NI/E = EBIT/TA * f * disc

o Considering financial leverage NI/E = [EBIT/TA + (EBIT/TA – i) * D/E] * f * disc
Solvency ratios (financial strength)
- Main ratios:

Liquidity ratios
- Main ratios:

Growth ratios
- An introduction:
o Growth is an imperative for any organization, including arts, culture and
media organizations
 Ability to preserve the organization’s competitiveness
 Ability to motivate talents
o But also, independence from third parties is a fundamental imperative for any
organization
 Growth is: necessary, desirable, and unavoidable
- Growth analysis is simply applied by comparing each item, of at least two financial
statements, measuring their change (growth) between values of different years
o The aim is to understand if the proportions between the items have changed
and therefore if the structure of the IS and the BS has changes, vertical
analysis (percentage composition)
- Main ratios

- Sustainable growth
o = the ability of an organization to grow, in preserving its competitiveness and
without compromising its autonomy (without altering profitability, solvency
and liquidity)
 Dynamic equilibrium: profitability, solvency and liquidity
o Sustainable growth is the growth allowing the company not to change the
level of indebtedness nor making any capital investment
 - Unbalanced growth paths (with all other variables given as constants) can bring a
variation of D/E, unless you make extraordinary operations on equity (paid-in capital)
which could even entail the control loss
o Deficit situation: g(S) > self-financing
 D/E increases unless shareholders pay in some more share capital
o Surplus situation: g(S) < self-financing
 D/E decreases unless corporate dividends are distributed to
shareholders

Conclusion
- Limits of ratio analysis
o Comparisons with other firms may be invalid if the other firms use different
accounting conventions
o Comparisons with previous performance may be misleading if the
environment in which the organization operates changes
o There is not always a clear guide as to the optimal size of ratios
- Ratio analysis does not necessarily provide answers but rather suggests questions
that require answering
o In any case, a great deal of skill and judgment are required in the evaluation
and interpretation of ratios