Financial Diagnosis

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INTRODUCTION

Being a component of the evaluation activity, the diagnosis has assumed the

emphasizing within a manner at the best correctness and completeness of the strong

and weak points specific to an enterprise. The elaboration of a company’s strategy is

established for almost all the situations within a profound analysis of all components

that are in competition towards carrying out the activities. Upon basis of a diagnosis,

many elements can be identified, which might determine the increasing of a

company’s value or in contrary, its decreasing. Practically speaking, a prognosis of a

company’s progress can be accomplished, without knowing the current situation of

its, fact that suggests the dependency of applying the evaluation methods based upon

updating the future flows of cash or incomes specific to a pertinent diagnosis.

The diagnosis has as aim the description of functionality and tendencies of

evolution towards the economic body’s activity, taking into consideration the

dynamic environment, where this is carrying out the activity, and also the disturbing

factors, either internal or external. The diagnosis analysis might present different

levels of detailing, and also might refer to different durations of time (on short,

middle or long term).

The objective of this paperwork is to explain the essence and real meaning of

the concept of Financial Diagnosis, as well as its procedures and methods of

calculation, which are related by several examples. So, similarly to the activity of the

company as a social organism, the financial diagnosis involves the identification of

company’s disfunctionalities, the research and analysis of facts and responsibilities,

the identification of the causes of the disfunctionalities, as well as the elaboration of a

forecast and the recommendation of a certain therapy.

This paperwork is structured in the following way: it has 2 chapters, both

containing 2 paragraphs.

In the first chapter (The essence and objectives of the financial diagnosis) is

described the theoretical meaning of Financil diagnosis, its principles and objectives.

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So, the company is subject to a process of decision-making which ensures its

regulation in order for it to function normally. In case a disturbance appears within

the company, steps will be taken in way of adopting some regulatory decisions,

starting from the causes. This is where the diagnosis analysis appears, with the role of

identifying the causes that have offset the well being of the company. Even if the

company functions normally, the diagnosis analysis can be used with the purpose of

evaluating the performance of the company. The role of the financial diagnosis is to

evaluate the company’s financial position. Based on this diagnosis, a new strategy for

maintaining and developing in the environment specific to the local economy will be

elaborated. Practically, the finality of the financial diagnosis consists in offering

financial information to both: those inside the company and interested parties outside

the company.

In the second chapter, called „Methods of financial diagnosis and analysis of

eneterprise”, are described the main procedures and methods of financial diagnosis,

like balance method, chain substitution method and absolute difference method.

There are also given examples of calculation of finnancial diagnosis’s

indicators,taking data from the financial reports and balance sheet of the enterprise

”Larsan”.

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CHAPTER I:THE ESSENCE AND OBJECTIVES OF FINANCIAL

DIAGNOSIS

1.1 THE SIGNIFICANCE AND FUNDAMENTALS OF FINANCIAL

DIAGNOSIS

The company is subject to a process of decision-making which ensures its

regulation in order for it to function normally. In case a disturbance appears within

the company, steps will be taken in way of adopting some regulatory decisions,

starting from the causes. This is where the diagnosis analysis appears, with the role of

identifying the causes that have offset the well being of the company. Even if the

company functions normally, the diagnosis analysis can be used with the purpose of

evaluating the performance of the company.

The results of the analysis are materialized in the financial and economical

diagnosis. The term ”diagnosis” comes from the Greek ”diagnostikos” which means

”able to know”. The term is borrowed from medicine, meaning an activity envisaging

the recognition of certain diseases, based on their symptoms, in order to discover the

causes and apply therapy necessary for the healing process.

Similarly to the activity of the company as a social organism, the diagnosis

involves the identification of company’s disfunctionalities, the research and analysis

of facts and responsibilities, the identification of the causes of the disfunctionalities,

as well as the elaboration of a forecast and the recommendation of a certain therapy.

Performing a company diagnosis is done not only when the company is facing

problems, but also when the evaluation of its performance is considered or when ”the

company is in good health, but improvement is desired”.

The financial and economical diagnosis is a complex research with a view to

evaluating the activity of the company, in order to elaborate some decisions allowing

the improvement or the restoration of the company’s performance.

The diagnosis and regulatory function is explained by the fact the economical

and financial diagnosis addresses and prevents the apparition of negative variations

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from the level of established goals. Also, the economical and financial diagnosis

guides the investment, financing and dividend distributing

decisions, elaborates financial forecasts, evaluates the expected yield, helps in

continuing or initiating activities with various partners. The diagnosis is not limited to

an identification of the phenomena and their interpretation, representing an objective

of strategic management or of forecast management. Management specialist Peter

Drucker said that an efficient leader must allocate 50% of his time for diagnosis.

The financial diagnosis represents a part of the company’s global diagnosis, of

the comprehensive evaluation of the situation and performances of the company.

Consequently, the financial diagnosis can only offer a partial and specialized look at

the company’s financial situation and performance, its goal being oriented on

studying: the company’s capacity to ensure immediate and long-term solvency,

avoiding the risk of bankruptcy; the company ability of maintaining a satisfactory

level of performance, considering the resources engaged in the activity, the ability to

refinance the activity, to own enough resources to avoid financial risk.

The financial diagnosis can arise in various situations, taking on various traits:

−It becomes a strategic diagnosis when it follows the company’s strengths and

weaknesses, both in using its economical potential and in relation to the external

business environment;

−It is elaborated as a stock-market diagnosis when it considers the relationship of the

company with the stock market, if the company is quoted on the market. The

indicators supplied by the diagnosis are an important element in guiding the purchase

or sale of stock, both for the company and for the other investors in the stock market:

−It is a valuation diagnosis when it contributes to clarifying some necessary elements

for establishing the value of a company, in case of investment, mergers.

The financial diagnosis can determine directly the patrimony value of the

company or can supply the indicators necessary for establishing its yield value,

because it allows the evaluation of the company’s durable beneficiary capacity.

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−When it intervenes in order to determine the difficulties a company is facing and

follows its stabilization, it is a crisis diagnosis. In this case, the priority of the

diagnosis is to determine if the company is capable to maintain or to regain its short-

term solvency.

The diagnosis appeared out of objective needs of various users of its results, in

the situation of making a decision regarding the management of the company,

purchase and sale of stock, granting or refusing a loan, investments, liquidation

decisions. The financial diagnosis ultimately tends to evaluate the way a company

can overcome constraints regarding performance, solvency, autonomy, financial

flexibility. Financial balance, which represents the company’s ability to honor

obligations as they reach their maturity, is of great importance in the evolution of

financial analysis. The exact measurement of the results obtained and the anticipation

of the company’s evolution trend is a preoccupation of the financial diagnosis. If the

study of performance and the analysis of the balance represent fundamental themes of

the financial diagnosis, it also considers highlighting other important financial traits,

such as: financial independence and financial flexibility.

The financial diagnosis mainly envisages the finance and accounting function of the

company, being especially oriented towards yield and risks.

The financial diagnosis involves judgment upon the financial health of the

company, the strengths and weaknesses of financial management through which past,

present and future risks arisen from the financial situation can be estimated, following

the reduction of risk and improvement of results. The financial diagnosis can be a

model usable by financial consultants, but also for the internal analysis of the

company’s financial performance. The diagnosis must indicate the company’s

strengths, weaknesses and potential. The diagnosis must describe the key

environment variables, which have an influence on the company’s activity

(demographics, economy, technology, cultural, legislation). All these factors interact.

All these key variables must be analyzed upon any financial diagnosis. The general

conclusions regarding the company’s financial diagnosis will form a SWOT matrix.

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1.2 THE OBJECTIVES AND PRINCIPLES OF FINANCIAL DIAGNOSIS

Generally, the objectives of financial diagnosis are oriented based on what is

monitored within the company.

Subsequently: if the company’s growth is envisaged, the diagnosis is oriented

towards the company’s investment resources and yield.

If it refers to the yield of the company, the financial diagnosis is oriented

toward comparing the results obtained by the resources employed.

If the company’s balance is pursued, the diagnosis is oriented towards the

financial structure of the company.

If the company risk is pursued, the diagnosis is oriented towards the company’s

weaknesses, including the identification of bankruptcy risks.

The objectives of financial diagnosis are subordinate to the interests of the users, the

role of the financial analysis being adapted to the type of diagnosis.

So, the financial diagnosis needed by the company management envisages the

answer to four essential questions regarding:

−Growth: how the company’s activity carried out throughout the examined period

and what was the growth rate compared to that of the sector;

−Yield: whether the results obtained are proportionate with resources used and

whether the growth was accompanied by a satisfactory yield;

−Balance: what is the financial structure of the company and whether it is balanced

or not, in the context of the ratio between the capital masses for a suitable financial

support;

−Risks: their nature, whether the company has weaknesses and whether or not there

is an increased bankruptcy risk.

If growth is sought after, the company is checked to see whether it has enough

resources for investments and a satisfactory level of the net working capital for the

current activity, without the risk of offsetting the balance of the financial structures.

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Also it is verified whether the company has a satisfactory yield to face the

growth, which imposes the comparison between the results obtained and the

resources employed for that purpose and the calculation of the efficiency indicators.

Knowing the results and the way they were constituted and distributed between the

company’s stakeholders allows the evaluation of the company’s performance, which

is reflected in the financial balance.

Firstly, it is of interest here whether the financial structures of the company are

balanced, in the sense of the company’s ability to deal with long and short-term

commitments, which imposes the examination of the company’s solvency and

liquidity.

Secondly, it is interesting to study the way the company is financed, which

demands the knowledge of the structure of the company’s capital by reporting equity

to debts. By comparing the results obtained to the capital employed we have

economical yield and financial yield, to which the afferent risks relate.

Thirdly, we have to see whether the company was able to maintain the

financial balance throughout the course of its evolution, which implies the study of

the financial cash flows throughout one or more financial years. Of interest here are

the new uses of the company (investments in fixed tangible or intangible assets,

financial assets, reimbursement of debts) and the new resources the company held

throughout the same period (self-financing or credit).

The financial diagnosis arose out of objective needs of various users of its

results, in the situation of making a decision regarding: patrimony and financial

management of the company, buying or selling stock, granting or turning down a

loan, buying or selling the company, partly or entirely, taking on investment projects,

liquidation decisions.

In a market economy, companies are interested in knowing the stability of their

competitors, the structure of their product portfolio, their strengths and weaknesses,

in order to identify the sources of competitor advantage and to better orient their own

development strategy.

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By exploiting the information provided by accounting under circumstances of

quality exigency imposed by international standards, the financial analysis

contributes to a better exploitation of the company resources, to the strategic choice

that optimizes the report between yield and risk, to the increase of efficiency in a

given market environment.

Traditionally speaking, the financial diagnosis envisages company performance and

solvency. Solvency refers to the company’s ability to honor its commitments, to pay

debts as they mature. This subject is of major importance in the evolution of financial

analysis.

Firstly, this subject consists its first area of interest. The instruments of

financial analysis were created by bankers and other creditors wanting to evaluate

rigorously the risks related to a current or potential debtor.

Secondly, the subject of solvency has a particular importance because the

insolvent company displays a bankruptcy risk and so it is exposed to extinction.

The diagnosis regarding solvency is confronted with a major difficulty.

Evaluating solvency implies a forecasting process regarding the conditions under

which the studied company is in the situation of handling its future maturities. The

financial diagnosis must proceed to the anticipation and elaborating of forecasts

regarding

the evolution of the company, its financial position and its financial balance. There is

the tendency of expressing doubt over the possibility of a pertinent and efficient

financial diagnosis.

A preoccupation of the financial diagnosis refers to the exact measurement of

the results obtained in the past and in the present and in anticipating the trend of

evolution in the future. An evaluation of the level, instability and evolution of the

these results stems from this measurement. Once these results are established, they

have to be compared to the referential levels, expressed either by the level of

company activity (production or sales), or by the average value of the capital

employed in order to obtain these results. Only through such a comparison can the

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company efficiency be evaluated. We can thus evaluate the company’s ability to

carry out activities which are profitable enough to compensate the cost of resources

used and its capacity to value financial and fixed assets at its disposal.

Financial autonomy represents an important objective for the company leaders.

In financial terms, autonomy is evaluated firstly by studying equity, its structure and

the relationships of command over the company that it can express. On the other

hand, financial autonomy can be evaluated by analyzing the structure of financing.

The dependency of the company on its creditors (and especially on banks) represents

the essential element to be explored.

The distribution of financial resources and other liabilities between own funds

and various debts constitutes one of the characteristics best explaining a company’s

financial autonomy.

The company’s flexibility expresses its capacity to adapt to unforeseen

transformations in its environment and within its own activity and is closely followed

in all management fields. Financial flexibility is evaluated compared to the ability the

company manifests in relation to the rapid mobilization of liquidities. Financial

flexibility is evaluated compared to the company’s ability to finance itself. And it can

be related to the possibilities the company has in dividing financing needs in order to

accomplish investment projects, unfolding or forecasted, and also to perform its

current activity.

The role of the financial diagnosis is to evaluate the company’s financial

position. Based on this diagnosis, a new strategy for maintaining and developing in

the environment specific to the local economy will be elaborated. Practically, the

finality of the financial diagnosis consists in offering financial information to both

those inside the company and interested parties outside the company.

In case of internal financial diagnosis, the users can be leaders, current

shareholders or employees. The objective pursued in this case is to detect eventual

offsets of the financial balance and to adopt new decisions for managing the

company. These decisions are based on identifying the origins and causes of the

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offsets on the one hand and, on the other hand, to establish measures for fixing the

offsets. Outside the company, the users can be financial analysts, potential

shareholders, banks, financial companies and even the state.

The objective pursued is the company’s ability to generate profit, to honor

long-term and short-term obligations (the company’s liquidity and solvency), as well

as the value of the company.

In most cases, external users need a financial diagnosis either for giving the company

a loan (especially banks),or for making decisions regarding investing in a company’s

capital (potential shareholders or other companies).

Both internal and external analysis have the objective of evaluating the

company’s performance and the risks it deals with and closely follow: yield analysis,

risk analysis and company value analysis.

Elaborating the financial diagnosis has the objective of evaluating the

company’s financial performance at the end of the financial year. The main goals

considered are: evaluating the financial results, highlighting the ways to ensure

financial balance, examining the yield of the invested capital, evaluating the risks.

The results of the analysis may be used as basis for making management decisions,

elaborating a global strategic diagnosis, elaborating development policies.

The financial diagnosis supplies information regarding: current and past

performance and its perspectives, the financial position and its modification, ways to

manage resources and the administrative results of the management teams, the

company’s ability to generate cash or equivalents of cash. Thus, the financial

diagnosis becomes an indispensable instrument, capable of ensuring the identification

of development opportunities, the identification of different types of risk and the

optimal strategic choice.

The diagnosis analysis is not limited towards radiography and appreciation of

states specific to different phenomena, but also represents and organic part of the

foresight management, respectively to the strategic management. As concerns the

opinion of the well-known specialist Peter Drucker within the management field, an

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efficient leader sacrifices 50% of time towards the problems of the activities’

diagnosis. In particularly, by a diagnosis program related to a company, knowing all

the chains of its activities, meaning that juridical, technical and of production, or

those social (human resources) and economical-financial, etc., as well as the

corresponding strong and weak points. These facts will reach the aim of emphasizing

the working parameters of a company, estimating the performances and the risks

specific to a future activity. Meeting the difficulties into the economic activity,

registering certain negative results and crossing crisis times or the existence of a staff

not enough motivated will not represent fatalities, but events that happen currently to

an enterprise’s life.

The economic-financial damaging of an enterprise’s activity will not be ever

accomplished in a brutal way, but will be based upon the existence of certain

underlying causes, which have to be met and managed very fast. Nonetheless, there

will be no solution as long the managers don’t know about a potential difficulty state.

For this reason, the damaging will be maintained and also will grow worse along with

time passing, if no interventions on time are performed, by the diagnosis of activities

and through a straightening plan.

The diagnosis represents a performing instrument of the precognition analysis.

It assures to the decisional factors that realistic vision over the situation and over the

damaging process, as well as the starting point on establishing a plan of

reorganization or dissolution. The diagnosis of an enterprise, such as mentioned

above, has as objective the identification of weak points of activity, in order to

correct them and the strong points, in order to exploit them in achieving better results.

At the same time, each enterprise looking to responds adequately to a difficult

situation, has to take into consideration the fact that it progress within an environment

characterized by opportunities and risks. The diagnosis of a hard-set enterprise has to

appreciate the potential of the business and the benefits of which this disposes, where

a fatal error might be represented by trying to recover a non-viable enterprise.

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In general the main tasks of the financial diagnosis are considered the

following:

Enhance the business plan scientific establishment, norms (in the process of its

elaboration) to an upper level. It can be done first of all by performing a

detailed analysis of the enterprise’s activities. During the analysis the

development tendency of the analyzed unit is being showed up; and there are

emphasized the main action factors. A special attention must be given to the

current period analysis, which is simultaneously the period that precedes the

plan. Conclusions are applied by the plan’s calculation.

Make an objective and multilateral appreciation of business plan fulfillment

based on the accounting data and reports. It studies how business plan is

accomplished from the point of view of volume, structure, production quality,

etc. In the production units is studying the production program fulfillment from

the point of view of quantity, structure, quality, ranges, rhythmically, contract

obligations accomplishment. In commercial units- a special attention is paid to

the appreciation of Sales Revenue accomplishment, ranges, and its structure,

elements co-reporting of goods circulation balance, customer harm quality.

Appreciate the efficient usage of human resources, goods, finance (each in

particular and as a whole). The production enterprises particularly study how to

use efficiently the production means, human resources, financial resources on

the whole (the owner’s or loaned).

Control how the commercial calculation requirements are made. An

enterprise’s activity in general depends a lot on the keeping of commercial

calculation principles, showing thus the production relations that absolutely

correspond to the relations, requirements created on the market.

Emphasize and measure the internal reserves (at all stages of the production

process). The reserves emphasized at each stage of production process have a

real utility in analysis. A rhythmical enhancing depends directly on the fact if

the intern emphasized reserves were used.

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The basic principles for evaluation of the company are:

1) The principle of anticipation:

- This implies that firm value is derived from expected future benefits to be derived

from possession or use of property, having regard to the state markets: international,

national, regional, at a time and continue their evolution.

2) The principle of change:

- This principle implies that supply and demand forces are in a continuous dynamic

and constantly create an economic environment, leading to fluctuations in price and

value. Under this principle, cause and effect relationship is changing in its forces

influence real property value.

3) The principle of competition:

- This principle implies that prices are sustained and the values are set by continuous

competition and interaction between buyers and other participants in the housing

market.

4) The principle of substitution:

- This principle implies that a rational buyer will not pay more for a property than the

cost of acquisition of other properties with similar characteristics.

5) The principle of contribution (marginal productivity):

-This principle implies that the value of any factor of production or composition of

the property depends on the extent to which his presence adds something to the

overall value of the property.

6) The principle of best use:

- This principle implies that to assess the market, the property would be assessed if

the best use.

7) The principle of opportunity cost

-This principle expresses the appreciation of enterprise value is determined by the

buyer. The opportunity cost is measured by removing the earnings just the best option

in an effort to maximize the effort.

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CHAPTER II: METHODS OF FINANCIAL DIAGNOSIS AND ENTERPRISE

ANALYSIS

2.1 PROCEDURES AND METHODS OF FINANCIAL DIAGNOSIS

The qualitative analysis presumes the knowledge of phenomenon nature, of its

causative sides, but the quantitative one-the establishment of the element’s size, of

the factors that explain the phenomenon. The quantification of the factor’s action is

possible only after the causative relations have been settled between these phenomena

and factors. It means that qualitative analysis precedes the quantitative analysis.

Methods of Financial Diagnosis assume to be the procedures that help us to

make the analytical processing of economic information. They can be classified

according to the level of Financial Diagnosis fulfillment. In this way each level uses

its methods of analysis, but it is also possible to use the same methods of analysis, but

it is also possible to use the same methods at different steps.

In Economic and Financial Diagnosis all methods can be distinguished in two

big groups:

I group - methods used for preliminary study of indices or the qualitative

analysis of economic results.

II group - methods used to emphasize and quantificate the factors action or the

quantitative analysis.

Both, the qualitative and quantitative models should be used in the process of

phenomena and economic result analysis.

The indices preliminary studying methods are the methods used for a

qualitative investigation of information, including comparison, grouping, calculation

of analytical indicators, calculation of relative and average values and decomposition.

Comparison takes an important place in the system of procedures used by

Financial Diagnosis. It is the most frequent materialization method of the logical

thinking in the financial activity research. Its main characteristics consist in studying

the phenomena, processes and economic and financial results by using a certain

principle and also in establishing the resemblance and differences between them.

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Thus, Financial Diagnosis has the possibility to examine and appreciate the economic

results, not as a measure by itself, but regarding a certain criterion or a basis of

comparison and to settle the levels, proportions and rhythms of their development.

There are used different types of comparison in the activity of financial

diagnosis:

Comparison with planned data or another established criteria is made to

appreciate the level of the plan fulfillment. The reserves obtained from the removed

deviation are emphasized through it. Modifications, which have derived from this

type of comparison, represent the object for the factor’s quantification.

Comparison in time between current data and those from the last year or

another past year ,taken as a basis of calculation, helps to determine the rhythms of

growth of the studying phenomena and to establish the developing tendencies of the

economic procedures. Also, we can calculate the rhythm of growth.

Comparison in space can be made between the intern administrative

departments of the enterprise and general directions with the branch average. This

type of comparison is usually used in order to establish the enterprise’s place in the

branch, to spotlight the existent reserves and to determine the following enterprise’s

perspective of development.

Comparison between effective data and economic-mathematical model is made

to establish the unused reserves.

Comparison with a special-character is made to determine the efficiency of

some technical-economical measures or solutions.

Some of indicators used in the process of financial analysis are taken from

business-plan, financial and statistical reports; other are calculated supplementary in

the analysis process. The system of indicators sensitively grows during the process of

analysis. Usually, the analytic indicators are calculated in the percentage of plan

fulfillment or in dynamic changes given to the plan.

In the process of financial diagnosis there are calculated absolute and relative

changes of current indicators given to the fundamental ones.

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Absolute change is calculated as a difference between the effective indicators

and fundamental indicators.

Relative change can be computed applying two versions of calculation. The

first version is ratio between absolute change and indicator’s fundamental size in

percents or units. And the second one can be determinate as a difference between the

effective indicator and its size in a basic period, recalculated according to the rate of

growth of the output.

Average values calculation characterizes specific properties of the studied

phenomenon. In economic practice, for example, there are calculated such values as

average value of finished products stocks, annual average labor productivity; average

number of employees and workers etc. These examples can be continued, because

there are a huge number of average values, it is necessary to know the models of their

calculation.

Simple arithmetical average is used to calculate the average level of different

indicators from an aggregate or in dynamics. It can be computed according to the

following formula:

ma=A 1+ A 2+… An

n (2.1.1)

Weighted arithmetical average is calculated in order to determine the average

level of an indicator taking in consideration number of elements from each group. It

is computed according to the formula:

mw=X 1 A 1+ X 2 A 2+… X n An

X 1+X 2+… X n (2.1.2)

Geometrical average is calculated in order to determine the annual average

growth of an investigated indicator, according to the next formula:

mg=n√ A 1∗A 2∗…∗An (2.1.3)

Chronological average is used to calculate the average value of different

indicators in dynamic, such as average of workers, average value or assets or stocks

or fixed assets. It can be calculated according to the formula:

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mc=

A 12

+A 2+A 3+…+An

2n−1

(2.1.4)

Grouping is an investigation method of analysis that is used to emphasize the

relation between grouping and the resulted indicators; to study the direction of the

analyzed phenomenon development. It is made in the analysis process. Some groups

can be found in different reports and statements of enterprises and in special

investigations. For example, assets are grouped by their terms of usage in the

enterprise’s activity; revenues are grouped according to the types of activity; the

employees can be grouped by gender, age, length of service, education etc.

Division or decomposition results represent the method that studies the

economic relations by penetrating in its structures and it consists in decomposing the

phenomena and the explored processes in its component elements. The usage of

division in financial analysis enlarges the exploration sphere till the component

elements level, establishing its contribution to the total modification of the studied

phenomena and placing in time and space the results and their causes of appearance.

Multiplication relation represents the relation when the elements of the studied

phenomenon correlate among the with the arithmetical sign of multiplication and

division.

In financial diagnosis the following methods are used to determine the factors

influence:

Balance method is the simplest method used in the factors quantification. It

can be used when between the studied phenomenon’s elements is an additive relation.

Balance method is based on the equality of two parts. Balance relations reflect the

quantitative interdependence of the phenomenon’s elements, their analysis, allowing

the evidence of causes that determined the phenomenon modification through the

comparison of the effective values of balance elements with the planned values of the

values of the previous year. The analytical model of this type of relations is: R=a+b-c

(2.1.5)

Balance method can be used in Financial Diagnosis in three cases:

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In the first case it is applied to calculate the influence of factors on the resulting

indicator.

In the second case balance method is used to verify the completeness and the

accuracy of the factors influences calculation on the modification of the result

indicator. The sum of factor action should be always equal with the absolute

difference of the effective and basic values of the financial results. The absence of

this equality shows that was made a mistake in the calculating process. To confirm

this fact it is used the factorial balance formula, presented above:

∆R=∆ Ra+∆ Rb+∆ Rc (2.1.6)

In the third case balance method is applied to establish the influence of the

unknown factors. It is used when the modification of resulting indicator and the

influence of the other factor are known. It can be calculated as a difference between

the resulting indicator modification and the influence of the known factors. Using the

factorial balance formula, the influence of the unknown factors can be computed as

follows:

∆Ra=∆ R−∆ Rb−∆ Rc; (2.1.7)

∆Rb=∆ R−∆ Ra−∆ Rc; (2.1.8)

∆Rc=∆ R−∆ Ra−∆ Rb. (2.1.9)

Chain substitution method is used when there are causative relations between

the analyzed phenomenon and the influencing factors, expressed in all forms of the

determined dependence (multiplication, division, additive and combined relations).

Substitution assumes the replacement of one factor’s value with another one in a

certain relation. The order of the factors chain can make a lot of possible variants of

substitutions with different results.

Using the chain substitution method, it is necessary to respect the following

requirements in order to obtain indicators with a real economic contains:

1)in the causative relations factors are arranged in the following economic order:

quantitative factors, structure factors and then qualitative factors;

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2) the substitution is made successively, beginning with the quantitative factor and till

the last factor-qualitative one;

3) the substitute factor rests substitute till the ending, being expressed in its effective

value;

4) the unsubstantiated factor is expressed in base or planned value.

The essence of chain substitution method consists in the successive replacing

of planned or base values of factors with their effective or current values in a certain

relation, assuming that the rest of factors are factors with a permanent action at this

moment, and they remain unchanged.

The size and the sense of each factor’s influence on the financial result are

obtained in a successive comparison between the second calculation and the first one,

the third one and the second. The sign obtained shows the result of the factor’s

action: positive or negative.

The priorities of chain substitution method are large spread, accessible as a

mathematical method; simple in usage; quality of the received answers.

While disadvantages of it are:

1) The results of the calculation depend on a certain way of the substitution

consequence. Sometimes it is impossible to determine the correctness of the

substitution. It is more difficult when we have more factors.

2) When the level of one factor’s action is being appreciated, the others rest

unchanged, but in reality the action of each factor is manifesting not separately but in

parallel with the others.

3) The active role in the change of result’s action is assigned to the qualitative factor,

that doesn’t permit to establish objective results of economic activity.

In practice when the analytical formula of the resulting indicator is presented as

a multiplication the chain substitution method is not used in its classical form. It is

applied with the help of different simplified forms and united by notion-varieties of

chain substitution method.

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The most widely used varieties of chain substitution method are absolute

difference method, relative difference method and recalculation indicator method.

Absolute difference method is the most widely used varieties of chain

substitution method. More frequently this method is applied in the presence of the

multiplication relation between factors and resulting indicator. The influence of each

factor on the economic result is determined in the same connectivity according to the

rule of chain substitution method, distinguished only by the fact that the level of each

factor’s influence is obtained after a calculus (without comparing them).

2.2 FINANCIAL DIAGNOSIS OF ENTERPRISE”LARSAN”

The diagnosis and analysis of financial situation at “Larsan” was performed

based on financial ratios system.

Financial ratios quantify many aspects of a business and are an integral part of

the financial statement analysis. Financial ratios are categorized according to the

financial aspect of the business which the ratio measures. Liquidity ratios measure the

availability of cash to pay debt. Activity ratios measure how quickly a firm converts

non-cash assets to cash assets. Debt ratios measure the firm's ability to repay long-

term debt. Profitability ratios measure the firm's use of its assets and control of its

expenses to generate an acceptable rate of return. Market ratios measure investor

response to owning a company's stock and also the cost of issuing stock.

Financial ratios allow for comparisons

between companies

between industries

between different time periods for one company

between a single company and its industry average

Ratios generally hold no meaning unless they are benchmarked against something

else, like past performance or another company. Thus, the ratios of firms in different

industries, which face different risks, capital requirements, and competition are

usually hard to compare.

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Profitability analysis

Equity investors are concerned with the firm’s ability to generate, sustain and

increase profits. The ability of a business to earn profit depends on the effectiveness

and efficiency of its operations as well as the resources available to it. Profitability

analysis, therefore, focuses primarily on the relationship between operating results as

reported in the income statement and resources available to the business as reported

in the balance sheet. Profitability can be measured in several different but interrelated

dimensions. Major analyses used in assessing profitability include the following:

Return on sales.

Contribution margin.

Return on assets.

Return on equity.

Return on sales analysis

One measure of profitability is the relationship between the enterprise’s costs

and its sales. The ability to control costs in relation to revenues enhances earnings

power. A common-size income statement shows the ratio of each cost component to

sales. In addition, 4 summary ratios measure the relationship between different

measures of profitability and sales:

1. The gross(profit) margin captures the relationship between sales

and manufacturing or merchandising costs:

Gross Margin=Gross Profit/Sales*100% (2.2.1)

2. The operating margin, calculated as:

Operating Margin=Operating Profit/Sales*100% (2.2.2)

3. The pretax margin is calculated prior to income taxes and the

formula is:

Pretax Margin=Profit before Tax/Sales*100% (2.2.3)

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4. The overall (net) profit margin is after all expenses and the formula

is:

Profit Margin=Net Profit/Sales*100% (2.2.4)

The four ratios listed above can be computed directly from an enterprise’s

financial statements. These ratios can be analyzed in comparison with the previous

year or planned data, using the following example.

We will perform the dynamic analysis of return on sales using data from

Income Statement and from Balance Sheet of the enterprise ”Larsan”.

Table 2.2.1

Dynamic analysis of return on Sales

Indicators Previous year Actual reporting year

Absolute differences(+,-)

1.Sales Revenue 18491.0 21835.2 +3344.22.Gross Profit 5580.7 5814.9 +234.23.Operating Profit 2216.7 2059.9 -156.84.Profit before taxes 2374.5 2431.9 +57.45.Net Profit 2163.3 1930.4 -232.96.Gross Margin 30.18 26.63 -3.557.Operating Margin 11.99 9.43 -2.568.Pretax Margin 12.84 11.14 -1.709.Profit Margin 11.70 8.84 -2.86

The data from the table show a decrease of all the sales ratios in dynamic. This

diminution was due to a higher increase in sales then in profits. It means that the level

of costs and expenses has increased during the current year.

At the second stage of analysis there are calculated the influence of different

factors on these ratios. According to the calculation formulas of the Return on Sales

ratios, the following general factors change them:

1. Modification in sales;

2. Modification in profit indicators.

These factors correlate between them through the division correlation. It means

that the chain substitution method can be applied to perform the return on sales

factorial analysis.

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It is necessary to compute the influence of factors on Return on Sales. The

formula of the factors influence is:

Return on Sales=Net Profit/Sales Revenues*100% (2.2.5)

In the table below we will compute the influence of factors on Return on Sales

using chain substitution method.

Table 2.2.2

Calculation of factors influence on Return on Sales

No. of calculation

No. of substituti

on

Correlated factors Return on

sales,%

Calculation of the factors

influence

Result of influence,

(+,-)Sales revenues

Net Profit

1 2 3 4 5 6 71 0 18491.0 2163.3 11.70 - -2 1 21833.2 2163.3 9.91 9.91-11.70 -1.793 2 21833.2 1930.4 8.84 8.84-9.91 -1.07

Total - - - - -2.86

The data from the table above show a diminution of Return on Sales by 2.86%

due to the negative influence of Sales Revenue and Net Profit. The growth of Sales

Revenue by 3342.20 thousand lei affected the resulted indicator, decreasing it by

1.79%.At the same time the diminution of Net profit in dynamic by 232.9 thousand

lei decreased Return on Sales ratio by 1.07%. So the enterprise possesses reserves of

growing Return on Sales by increasing its Net Profit.

Return on investment analysis

Return on investment (ROI) measures the relationship between profits and the

investment required generating of them. Diverse measures of that investment result in

different forms of ROI, such as Return on Asset, Return on Equity, Return on

Capital, etc.

The Return on Assets compares income (profit) with total assets and tells how

well management is performing on all the enterprise’s resources. It can be interpreted

in the following way:

Total Asset Turnover*Return on Sales=Sales/average value of Assets*Profit

before tax/Sales (2.2.6)

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Now will be done the factorial analysis of assets profitability in comparison with

previous year using the chain substitution model.

Table 2.2.3

Factorial analysis of the assets profitability

No.of calculation

No.of substitution

Correlated factors Return on sales,%

Calculation of the factors influence

Result of influence,(+,-)

Return on Sales

Assets Turn-over

1 2 3 4 5 6 71 0 12.84 0.8395 10.78 - -2 1 11.14 0.8395 9.35 9.35-10.78 -1.433 2 11.14 0.9545 10.63 10.63-9.35 +1.28

Total - - - - -0.15 (Chain substitution method)

The calculations show us a decrease of the return on assets level in comparison

with the previous year by 0.15%. This reduction was due to the negative influence of

the return on Sales, which decreased the return on assets by 1.43%. At the same time

a 1.115% growth of asset turnover caused arise of asset profitability by 1.28%.

However, it can be mentioned that the return on assets level is a small one in the both

years. That fact does not allow the enterprise to renew its assets in a short period of

time.

Return on Equity

Return on equity measures how well management is doing for the investor,

because it tells how much earnings they are getting for each invested lei. The return

on total stockholder’s equity (ROE) excludes debt in the denominator and uses either

profit before tax or net profit. It can be calculated according to the following

formulas:

ROE=(Profit before tax/Average value of Stockholder’s Equity)*100%; (2.2.7)

ROE=(Net profit/Average value of Stockholder’s Equity)*100% (2.2.8)

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Now will be done the factorial analysis of equity profitability in comparison

with previous year. The data are taken from the Balance Sheet of the enterprise

”Larsan”.

Table 2.2.4

Initial data for ROE analysis

Indicators Previous year Actual reporting year

Absolute differences(+,-)

1.Profit before tax 2374.5 2431.9 +57.42.Sales revenue 18491.0 21835.2 +3344.23.Average value of assets

22026.3 22877.3 +851.0

4.Average value of equity

19152.7 20368.1 +1215.4

5.Return on sales 12.84 11.14 -1.706.Assets Turnover 0.8395 0.9545 +0.1157.ROA 10.78 10.63 -0.158.Financial Leverage

1.15 1.1232 -0.0268

9.ROE 12.40 11.94 -0.46

Calculation of influence of factors on the Return on Equity is shown in the

table below.

Table 2.2.5

Factorial analysis of the equity profitability

Name of factors The calculation of factors influence

Result ofinfluence(+,-), %

1.Modification on Return on sales

(-1.70)*0.8395*1.15 -1.65

2. Modification on Assets Turnover

11.14*(+0.115)*1.15 +1.48

3. Modification on Financial leverage ratio

11.14*0.9545*(-0.0268) -0.29

Total -0.46

From the previous year to current year ROE decreased from 12.40% to

11.94%.The decrease of ROE resulted primary from a significant decrease in return

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on sales ratio from 12.84% to 11.14%. Also a negative influence under the ROE has

the modification in capital structure, namely increase in the weight of equity in the

total value of assets. Due to this influence, the ROE decreased by 0.29%. At the same

time the growth of asset turnover by 0.115 caused a rise of equity profitability by

1.48%.

However, it can be mentioned that the equity profitability level is a very small

one in both years. That fact will determine the enterprise to pay more attention to the

return on sales and to its capital structure.

Debt Ratio

Debt ratio formula plays an important part to calculate the ratio of mortgage to

further clear the company's long term debt. If the leverage of the company is higher,

the ratio is higher. This ratio is a long term debt to total capitalization. 

Assortments of ratios are computed, depending on the purpose of the customer

analyzing the financial statements. Debt ratio analysis is done on the structure of you

total income and the debts. Debt to equity ratio is used to measure the solvency and t

research capital ratio. It signifies us how much the company is capable to repay, lend

and borrow funds or money. This kind of ratio is viewed and analyzed by the

investors and creditors. Lenders are sensitive about debt equity ratio because, the

high ratio of debt can put their loans at jeopardy of being paid back.  

Debt equity ratio is calculated with the total liabilities divided by the

shareholders equity. This is the formula of calculating the ratio. This indicates the

proportion of equity and debts that a company uses to finance assets. Sometimes it

happens that the investors use only long term debts apart from the total liabilities for

an inflexible test. Debt asset ratio is formulated as the total liabilities divided by the

total assets which signify that the company's assets are financed all the way through a

debt.

Assets Turnover Analysis

An enterprise’s operating activities require investments in both short term and

long term assets. If a business does not use its assets effectively, investors in the

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business would rather take their money and place it somewhere else. Activity ratios

describe the relationship between the enterprise’s level of operations and the assets

needed to sustain operating activities. So, these ratios are therefore used to assess

how active their assets are in the business.

Total assets turnover is an overall activity that measures sales to total assets. It

is calculated according to the following formula:

Total Asset Turnover = Sales /Average Total Assets (2.2.9)

Now we will determine assets turnover and the turnover ratios of asset

component elements.

Table 2.2.6

The analysis of assets turnover

Indicators Previous year Current year Absolute difference (+;-),lei

1.Sales,lei 18481002 21835176 +3344174.02.Average value of total assets

22026288.0 22877280.0 +850992.0

3.Average value of inventories

2057241.5 1549784.5 -507457

4.Average value of fixed assets

16295255.0 15079985.5 -1215269.5

5.Average value of receivables

1549857.5 3166149.5 +1616292.0

6.Average value of cash 1717681.5 2186631 +468949.57.Total assets turnover 0.8395 0.9545 +0.1158.Number of days 435 382 -539.Fixed assets turnover 1.1347 1.4480 +1.313310.Number of days 322 252 -7011.Inventory turnover 8.99 14.09 +5.1012.Number of days 41 25 -1613.Receivables turnover 11.93 6.90 -5.0314.Number of days 31 53 +2215.Cash turnover 10.76 9.99 -0.7716.Number of days 34 37 +3

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The calculations made above show an increase of total asset turnover and fixed

assets turnover ratios respectively by 0.115 and 0.3133. So, the enterprise uses more

efficient its assets and especially fixed assets in current period.

The inventory turnover ratio has improved significantly from 8.99 (41 days) in

previous year to 14.09 (25 days) in current year. But the receivables turnover ratio

decreased by 5.03 (22 days) in current year in comparison with previous year. The

similar decrease shows the cash turnover ratio over this period.

Liquidity Ratios Analysis

Liquidity ratios are probably the most commonly used of all the business

ratios. They are ratios that come off the Balance Sheet and hence measure the

liquidity of the enterprise as on particular day the day that Balance Sheet was

prepared.

Liquidity ratios provide information about an enterprise’s ability to meet its

short-term financial obligations. Companies will generally pay their interest

payments and other short-term debts with current assets. Therefore, it is essential that

an enterprise have an adequate surplus of current assets in order to meet their current

liabilities. If an enterprise has only illiquid assets, it may not be able to make

payments on their debts.

In economic process the following ratios are applied:

Current ratio measures an enterprise’s ability to pay their current obligations.

The greater extent to which current assets exceed current liabilities, the easier an

enterprise can meet its short-term obligations. The Current Ratio is obtained by

dividing the Total Current Assets of an enterprise by its Total Current Liabilities:

Current Ratio=Total Current Assets/ Total Current Liabilities (2.2.10)

Now, taking the initial data from Balance Sheet, we’ll determine Current Ratio.

Table 2.2.7

Current ratio calculation

Indicators Previous year

Current year Absolute difference

Safety level

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A 1 2 3 4Current ratio 2.35 5.57 +3.22 2.0-2.5

The enterprise has 5.57 lei of Current Assets to meet 1.00 lei of its Current

Liability in current year more by 3.22 than in previous one.

A ratio lower than that of the industry average suggests that the company may

have liquidity problems. However, a significantly higher ratio may suggest that the

company is not efficiently using its funds. A satisfactory Current Ratio for a company

will be within close range of the industry average.

Quick Ratio. Sometimes an enterprise could be carrying heavy inventory as

part of its current assets, which might be obsolete or slow moving. Thus eliminating

inventory from current assets and the doing the liquidity test is measured by this ratio.

Like the Current Ratio, to have an Acid Test Ratio within close range to the industry

average is desirable. Its safety level is from 0.8 to 0.7.

This ratio is obtained by the following formula:

Quick ratio= Total Quick Assets / Total Current Liabilities (2.2.11)

where Quick Assets= Total Current Assets-Inventory (2.2.12)

Now we’ll determine Quick Ratio, taking the initial data from Balance Sheet.

Table 2.2.8

Quick Ratio Calculation

Indicators Previous year

Current year Absolute difference

Safety level

A 1 2 3 4Quick ratio 1.66 4.69 +3.03 0.7-0.8

The enterprise has 4.69 lei of Quick Assets to meet 1.00 lei of its Current

Liability in current year, more by 3.03 than in previous one.

Cash Ratio is the most conservative liquidity ratio. It excludes all current assets

except the most liquid: cash and cash equivalents. The cash ratio is an indication of

the enterprise’s ability to pay off its current liabilities if for some reason immediate

payment were demanded. Its safety level is from 0.2 to 0.25.

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The formula of Cash Ratio is:

Cash Ratio= Cash / Total Current Liabilities (2.2.13)

Now, taking the initial data from Balance Sheet, we’ll determine Cash Ratio.

Table 2.2.9

Cash Ratio Calculation

Indicators Previous year

Current year Absolute difference

Safety level

A 1 2 3 4Cash ratio 0.97 1.24 +0.27 0.2-0.25

The enterprise has 1.24 lei of Cash to meet 1.00 lei of its Current Liability in

current year, more by 0.27 than in previous one. The level of this ratio much more

overcomes its safety level.

Additionally, all the ratios have increased over the two year period, meaning

that the enterprise has a stronger liquidity position than it had before. Normally that is

a good thing. So, the ratios of the enterprise attained the optimal level in previous

year (the enterprise was able to obtain long-term short-term credits, being solvent).

On the other hand, the liquidity ratios overrun their safety level in current year,

meaning that the assets of the enterprise have an irrational structure. For this

enterprise, there has been major turnaround between the two years as the ratios have

increased. Looking at the accounting information from the appendix, we can see that

the business has increased its sales by 18.08% over the two years, its stocks have

raised by 54.19%; debtors have decreased by 58.52%.

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CONCLUSION

This paperwork reveals the big importance of Financial Diagnosis for the life

of the enterprise. So, a constant need to evaluate the performances and the potential

of the activity irrespective of the level or area of its manifestation, to compare them

with something considered as ”reference” at a certain moment, to define the priorities

and the ways of the management activity is manifested in the actual economic

context. That is why the Financial Diagnosis appears as a necessity and utility at the

same time.

The diagnosis appears with a view to have knowledge of the economic

phenomena and procedures. It implies the research of one phenomenon by dividing it

into its component parts and studying each of them separately.

It is very important to establish the limit in diagnosis, further on the object is

not of a great importance in the division, because the object’s characteristics can be

lost. The limit of the analysis is appreciated by its goal and tasks.

Step by step, the diagnosis became a requirement in the civilized society. The

conscious activity of the human being comes to be impossible without diagnosis.

The process of thinking passes through 3 interdependent steps: real, natural

contemplation, abstract thinking, formulating new purposes and conclusions.

The diagnosis proceeds through the same stages. The real contemplation is the

beginning of the knowledge- of the analysis. This is the cognition of the reality by

gathering facts. At the second step the necessary information is collected and

processed. This information allows us to discover the meaning and some issues of the

studied phenomenon development and this fact permits us to make conclusions, to

define practice purposes for a permanent development.

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In such circumstances the logic of the analytical research represents the act of

passing from the abstract to concrete, the transformation of the theoretical situations

into practical ones for a further economic development.

The decomposition is made in steps, from the complex to the simple, with the

view to identify the final causes that explain a certain state, a certain level of

performance, or a certain evolution.

In this way the Financial Diagnosis starts from the results of the completed

process to the elements and factors. Elements represent the component parts of the

analyzed phenomenon. Factors are the dynamic forces that motivate a phenomenon

or a result. And final causes represent the events that in a certain conditions explain

the appearance of a phenomenon, its state and evolution.

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