Financial Ratio Analysis: the Development of a Dedicated Management Information System

Financial Ratio Analysis:
the Development of a Dedicated Management Information System
n
Voicu-Dan Dragomir
Asistent universitar doctorand
Academia de Studii Economice Bucureºti
Abstract. This paper disseminates the results of the development process for a financial analysis
information system. The system has been subject to conceptual design using the Unified Modeling Lan-
guage (UML) and has been implemented in object-oriented manner using the Visual Basic .NET 2003
programming language. The classic financial analysis literature is focused on the chain-substitution
method of computing the prior-year to current-year variation of linked financial ratios. We have applied
this technique on the DuPont System of analysis concerning the Return on Equity ratio, by designing
several structural UML diagrams depicting the breakdown and analysis of each financial ratio involved.
The resulting computer application offers a flexible approach to the analytical tools: the user is required
to introduce the raw data and the system provides both table-style and charted information on the output
of computation. User-friendliness is also a key feature of this particular financial analysis application.
Key words: financial ratio analysis; object-oriented development; unified modeling language; concep-
tual models.
n
1. Introduction
Financial statements are intended to provide informa-
the current period. In each case, comparison is possible if
tion on the resources available to management, how these
an identical basis of compilation is used. There must be
resources were financed, and what the firm accomplished
conformity and uniformity in the preparation of accounts
with them. Corporate shareholder’s annual and quarterly
to ensure a comparison of like with like.
reports include three required financial statements: the
From the computer developer’s point of view, the hun-
balance sheet, the income statement and the statement of
dreds of financial ratios that can be computed are a true
cash flows. Information from the basic financial statements
bottle-neck. The analyst’s tool-pack should not only be
can be used to determine what factors influence a firm’s
standardized, but it should also be subject to a unified
earnings, cash flows and risk characteristics.
treatment from a conceptual perspective. Object-orienta-
Accounting ratios identify irregularities, anomalies and
tion provides an elegant language for framing such prob-
surprises that require further investigation to ascertain the
lems, and powerful tools for resolving them.
current and future financial standing of a company. Finan-
In this paper we will give the reader an in-depth analy-
cial ratios describe the relationships between different items
sis of variation-based methods of financial analysis, fol-
in the financial statements. In order to achieve the desired
lowed by the detailed presentation of the unified model-
result, that is the useful information each ratio can convey,
ing process applied to financial statement analysis. Con-
we should only compare the company’s financial ratios
sidering that object-orientation and the Unified Modeling
with ratios for a preceding period and budgeted ratios for
Language (UML) are practically synonymous, the reader
Financial Ratio Analysis: the Development of a Dedicated Management Information System
77

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is presented with a brief overview of the UML and its prac-
Combining the two breakdowns, we see that a firm’s
tical implications on the subject matter. The last two major
ROE is composed of three ratios as follows:
chapters of this paper offer insights on the structural mod-
els underlying the system, followed by a graphical intro-
Income
Net

Sales
Net
Assets

Total
ROE =
×
×
duction to the software itself.
Sales
Net
Assets

Total
Common Equity
2. The employment of the chain substitution –
c) The computation of every component’s influence on
ceteris paribus method of financial ratio analysis
the primary ratio. This step is accomplished through chain
substitution of prior-year with current-year values for a
For financial ratios that adhere to a deterministic scheme
specific ratio or financial figure, considering all other terms
Economie teoreticã ºi aplicatã (that includes algebraic operations like multiplication and
fixed (ceteris paribus). If we consider the following nota-
division), the following steps can be followed in order to
tions: ∆ (delta) stands for the particular influence of a
achieve a higher level of analytical detail:
given ratio, the subscript 1 (one) for the current-year value
a) The specification of the primary form of financial
and the subscript 0 (zero) for the prior-year value, we would
ratios. Considering the computation of Return on Owner’s
compute the components’ detailed influence on ROE us-
Equity (ROE), this return would equal:
ing the algorithm:
Net Income
Return on Equity =
income)
(Net
Average Total Equity
1
ROE
∆
=
−
Equity)

Total

(Average
1
b) The breakdown of the primary form into component
income)
(Net
ratios or financial elements. In the case of ROE, the appli-
0
−
Equity)

Total

(Average
cation of the DuPont System of financial analysis would
0
generate the following identity:
∆(
Margin
Profit
Net
)=
Income
Net
ROE =
=
 (
Income
Net
)
Income
Net
1
(
)
Equity
Common
0 
= 
−
 (
×
Sales
Net
)


1
( Sales
Net
)

Income
Net
Sales
Net
0

=
×
Sales
Net
Equity
Common
( Sales
Net
)0
(
Assets

Total
)0
× (
×
Assets

Total
)0 (Common Equity)0
The breakdown is an identity, because we have both
multiplied and divided by net sales. To maintain this iden-
tity, the common equity value used is the year-end figure,
∆(
Turnover

Assets

Total
) ( Income
Net
)1
=
×
rather than the average of the beginning and ending value.
( Sales
Net
)1
This identity reveals that ROE equals the net profit margin
 (
Sales
Net
)1
( Sales
Net
) 
times the equity turnover, which implies that a firm can
0
×
−
 (
×
Assets

Total
)


1
(
Assets

Total
)
improve its return on equity by either using its equity more
0 
efficiently (increasing its equity turnover) or by becoming
(
Assets

Total
)0
×
more profitable (increasing its net profit margin).
(
Equity
Common
)0
Moving forward, a firm’s equity turnover is affected by
its capital structure. Specifically, a firm can increase its
equity turnover by employing a higher proportion of debt
∆(
Multiplier

Leverage
)=
capital. We can see that effect by considering the follow-
( Income
Net
)1 ( Sales
Net
)
=
×
1
×
ing relationship:
( Sales
Net
)1 (
Assets

Total
)1
Sales
Net
 (
Assets

Total
)
Assets

Total
1
(
)0 
Turnover
Equity
=
=
×
−
Equity


 (
Equity
Common
) Common Equity
1
(
) 
0 
Sales
Net
Assets

Total
=
×
Assets

Total
Equity
The deterministic relationship between the original
financial ratios is transformed into a stochastic relation-
This equation indicates that the equity turnover ratio
ship between the variations of these ratios. The individual
equals the firm’s total assets turnover (a measure of effi-
influences sum up to the amount of variation of the pri-
ciency) times the ratio of total assets to equity (a measure
mary ratio:
of financial leverage). This financial leverage ratio is also
known as the financial leverage multiplier, whereby the
∆ROE = ∆(
Margin
Profit
Net
)+
first two ratios (profit margin and total assets turnover)
+ ∆(
Turnover

Assets

Total
)+
equal return on total assets (ROTA), and ROTA times the
+ ∆(
Multiplier

Leverage

Financial
)
financial leverage multiplier equals ROE.
78

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This analytical approach offers significant insight into
n
Intense reusability: with object-oriented development,
a compound financial ratio’s variation mechanics. How-
we are constantly looking for objects that would be
ever, a particular breakdown of a financial ratio is not
useful in similar systems. Consequently, once an ob-
unique. Specifically, there are many other applicable break-
ject acquires a conceptual form, it is plausible that it
downs which meet the needs of one analyst or another,
will be included in several different models, with mi-
depending on the variations to be computed.
nor changes or no change at all. The financial ratio
analysis models can be reused in the context of infor-
3. The Unified Modelling Language
mation systems that serve both the managerial and the
and object-orientation: a brief discussion
investor’s approach to the firm’s profitability. There-
fore, business objects like the financial ratios are con-
Having considered the theoretical implications of chain
text-independent and highly reusable, eventually be-
substitution in the field of financial analysis, this chapter is
ing a stable and reliable source of information for ev-
dedicated to present the process of modelling the financial
ery class of users as defined by the IASB Framework.
ratios using the Unified Modeling Language (UML 2.0).
n
Dynamic approach: by applying an iterative approach,
This process ensures that the maximum flexibility of the
any subsets of the lifecycle activities are performed
system is attained by considering the latest software model-
several times to better understand the requirements and
ing paradigm – the object-oriented conceptual framework.
gradually develop a more robust system. Each cycle
A general-purpose language such as the UML may be
through these activities or a subset of these activities is
applied throughout the system-development process all
known as iteration, and a series of iterations in a step-
the way from requirement gathering to implementation of
wise manner eventually results in the final system. Par-
the system. As a broadly applicable language, UML may
ticularly, not only that existing sets of financial ratios
also be applied to different types of systems, domains, and
can be modified and extended, but brand new
processes. Therefore, we can use the UML to communicate
functionalities can be developed based on the ever
about software systems and non-software systems (often
expanding requirements of the financial users.
known as business systems) in various domains or indus-
tries such as manufacturing, banking, e-business, and so
4. Structural modeling of the financial analytical
forth. Furthermore, we can apply the UML to any process
mechanism
or approach. It is supported by various tool vendors, for it
is not a proprietary or closed modeling language (Alhir,
This chapter focuses on the class and object diagrams,
2003).
which depict the structure of the financial ratio system in
A language is generally based on a paradigm, a way of
general and at a particular point in time, respectively. As
viewing a subject, which defines the types of concepts that
an architecture-centric process focuses on the architecture
may be used in the language and the principles of why
of a system across iterations, it is important to understand
they are useful. A language’s syntax specifies the notation
what elements make up a system and how they are related
used for communication and is determined by the
to one another. That is why we usually apply class and
language’s alphabet. A language’s semantics specify the
object modeling during analysis and design activities to
meaning that is communicated and is determined by the
understand the requirements and determine how a system
language’s words and sentences. The syntax of the UML
will satisfy its requirements.
involves diagrams, and its semantics are based on the ob-
A class defines a type of object and its characteristics,
ject-oriented paradigm. Therefore, object-orientation (OO)
including structural features and behavioral features. In a
is a powerful design methodology, which has firmly moved
UML class diagram, a class is shown as a solid-outline
into the mainstream of software development (Roussev et
rectangle with three standard compartments separated by
al., 2006).
horizontal lines. The required top compartment shows the
Object-orientation, visually supported by the UML, is
class name, the optional second compartment shows a list
expected to give significant results on several key aspects
of attributes (the structural features), and the optional third
of system development:
compartment shows a list of operations (the behavioral
n
Strong integration of data and processes: during ob-
features).
ject-oriented development, data and processes are kept
together in small, easy-to-manage packages. Thus data
4.1. The Item class
is never separated from the algorithms. Considering
The Item class (Figure 1) is considered to be the funda-
the field of financial analysis we end up with both the
mental class of the system, mainly because it encompasses
computing mechanism of financial ratios and the data
the largest mass of information and behavioral characteris-
itself set up as a stand-alone module, an object as it is
tics. An item may be a financial element (i.e. stocks), a
called, that exists independently throughout the
financial highlight (i.e. gross margin) or a ratio (i.e. net
system’s execution;
profit margin).
Financial Ratio Analysis: the Development of a Dedicated Management Information System
79

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ensures a unitary notation throughout the model database,
thus the Symbol serves to pinpoint the identity of a par-
ticular financial element.
The most crucial aspect of an object is that it has its
own identity. No two objects are the same, even if they
have the same values for their structural features. For ex-
ample, even if two financial ratio objects have the same
values for their Symbol and Name attributes, the instances
of the Item class are unique and have their own identities.
The Rank of an item signals the order in which every
Economie teoreticã ºi aplicatã
element is introduced into the model. A specific instance
Figure 1. Structural view of an Item
of a class, with its structural and behavioral characteristics,
is described by the object diagram. Consider the follow-
An attribute is what an object of a class knows, a piece
ing object diagram for the DuPont System, namely the
of data maintained by the object. The Symbol attribute
breakdown of the Return on Equity ratio:
Figure 2. Objects of class Item, describing the ROE ratio model
In a UML object diagram, an object is shown as a solid-
The Sign attribute can take the +/- values, whether the
outline rectangle with two standard compartments sepa-
financial element enters an addition or a subtraction.
rated by horizontal lines. The required top compartment
shows the object name followed by a colon followed by
4.2. The Item Collection class
the object’s class name, and the entire string is fully under-
A collection is a set of similarly typed objects that are
lined. Both names are optional, and the colon should only
grouped together. Objects of any type can be grouped into
be present if the class name is specified. The optional sec-
a single collection of a generic type Object to take advan-
ond compartment shows a list of attributes.
tage of constructs that are inherent in the UML. The Item
Collection attribute of an Item object is an enumeration of
The Predecessor attribute is a necessary backward view
other Items seen as hierarchically inferior to the main Item.
of the Rank attribute. For example, the predecessor of
An Item Collection is also an object that belongs to an Item
Item.Rank = 3 is Item.Rank = 0.
and is therefore treated as an independent entity with well-
defined attributes and methods.
On the basis of the Yes/No value provided for the
Consider the following structural diagram:
HasValue attribute, the software asks the user for the amount
of a particular financial element (e.g. the Item.Symbol =
NetSales should be provided with a value extracted from
the income statement, whereas the Item.Symbol = ROE
computes the values internally, so there is no need for the
user to provide values for this ratio).
Figure 3. Structure diagram for the Item Collection class
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The class diagram presented in Figure 3 introduces the
The Contains association is an aggregation, that is a
recursive relationships between instances of the Item class.
“part-of” relationship. An Item, even though it may belong
Associations, like Contains and Enumerates, represent
to a Collection, it is still a fairly independent entity, whereas
conceptual relationships between instances of classes. The
a Collection cannot exist in the absence of a specified Item
multiplicities of these associations, which are an indica-
to whom it is bound to belong.
tion of how many objects may participate in the given
The Add and Remove methods are self-explanatory.
relationship, state the following:
Individual Items are instantiated throughout the program’s
n
An Item contains a single Item Collection, which in
execution. They are added one by one to the correspond-
turn is a unique entity belonging to a single Item.
ing Collections, in order to take part in financial computa-
n
An Item Collection is an enumerator of multiple
tions, while retaining their previously defined attributes.
Items, possibly none. An enumerator flattens a col-
One delicate aspect of the conceptual model of an Item
lection so that the members can be accessed sequen-
Collection is its Operation attribute, which refers to the
tially. Different collection classes might have dif-
algebraic operation imposed to the Items belonging to a
ferent sequences. This suggests that the Items in a
Collection. The following object diagram provides an in-
Collection are not added at random.
sight into the mechanism of computing the financial ratios:
Figure 4. Object diagram for the Item - Item Collection associations for the DuPont System
Starting from the Return on Equity ratio, we follow the
nancial elements and ratios can be as well added or sub-
branches of the object tree up to the atomic elements that
tracted from each other; thus the Operation attribute of the
are directly extracted from the balance sheet or the income
Item Collection class will be defined accordingly.
statement. The object diagram in Figure 4 is sufficiently
explicit: ROE ratio is the result of the breakdown and mul-
4.3. The Financial Ratio class
tiplication of three ratios: net profit margin, total assets
A Financial Ratio (Figure 5) gathers under one con-
turnover and financial leverage, respectively. Aside from
ceptual model the Items and their Collections plus the
the two operations considered in the example above, fi-
mechanism of computing the period-to-period variations.
Figure 5. A holistic approach to the structural model of the system
Financial Ratio Analysis: the Development of a Dedicated Management Information System
81

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The Financial Ratio class contains the complete Item
5. Financial Ratio Analysis – The Implementation
Collection, in addition to other descriptive attributes, like
the model’s name and description, the associated chart ob-
The system had been implemented using the Visual
jects and two data tables, containing the input figures and
Basic .NET programming environment, which has been
the computed percentage changes in the financial element.
endowed with strong object-oriented features, similar to
For example, the ROE Financial Ratio computes the year-
the one’s originally owned by C++ and Java.
to-year variation in the ROE Item, plus the percentage change
The system’s functionalities are visually described by
in ROE and the line chart based on the variation.
the following interface flow diagram:
Economie teoreticã ºi aplicatã
Figure 6. Overview of system’s functionalities
Whenever the main window of the application is launched:
n
Every piece of information is summed up in the final
n
The user is asked to browse the model base, for which
report, which is to be reviewed, and then printed.
he is provided model description and the break-
5.1. The model list & details window
down structure of each financial ratio;
The introductory window of the application is designed
n
The system launches the Data Fill-In window, in
as follows:
which the user is required to provide the significant
n
The left-hand side presents the model list region in
data for the financial elements included in the model;
the form of a tree view. The root sections follow the
n
The system launches two separate windows, each
guidelines of any comprehensive financial analysis
containing financial information computed from the
(internal liquidity, profitability, risk assessment etc.),
raw data entered by the user;
while the two secondary branches exhibit the name
n
The Year-to-Year Variation window reads the table
of the model (financial ratio) and a brief abstract;
created on the analytical technique described in
n
The upper-right area of the window presents the
Chapter 2. I t also offers the possibility to display a
financial formula upon which the ratio is broke
custom chart relying on the table data;
down and variations computed;
n
The Percentage Change window shows the percent-
n
The lower-right list view is filled with the detailed
age raise or fall of the significant elements included
information of the component ratios or financial ele-
in the model. The user can individually select each
ment of the selected model. A symbol (see Chapter
financial element within the table in order to pro-
4.1) is attached to every element, exposing the Sym-
duce a custom chart in a special window;
bol attribute of the Item class.
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Figure 7. The financial model selection window
5.2. The Data Fill-In window
execution of the application. The prior-year and current-year
In Chapter 2 the reader noticed that the broke down ratios are
values identified by the element’s symbol are stored in the com-
computed from financial elements extracted from the balance
puter memory, and accessed every time calculations are being
sheet and the income statement. Even though these elements
done no matter what financial ratio is in use. Therefore the user
may be found more than one time in a financial model, the user is
can work on several models at the same time, while the system
required to produce their values only once throughout the entire
automatically transfers the data from one window to another.
Figure 8. The Financial Data Fill-In window
5.3. The Computed Variations window and chart
all variation” of the main ratio, that is, in our case, Return
The table presented in Figure 9 is a synthetical view of
on Equity (ROE). By clicking on the Create Chart button,
the algorithm presented in Chapter 2. The figures on the
the system generates the variation histogram, which can
Variation column add up to the amount spelled as “over-
be later added to the final report.
Figure 9. The computed variations in table-style and bar charted
Financial Ratio Analysis: the Development of a Dedicated Management Information System
83

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5.4. The Percentage Changes window and custom-
are a suitable visual complement to the figures presented in
ized charts
the main table. The user is able to select any financial ele-
The percentage changes table has proven to be a very
ment to be represented graphically, provided that the scale
useful analytical tool. The underlying table has been ex-
of the associated values are comparable – a chart showing
tended by customized graphs, both line and bar typed, which
values under 1 and over 1 million isn’t visually significant.
Economie teoreticã ºi aplicatã
Figure 10. The percentage changes table and the associated charts
6. Conclusion
to take into account the share price at closure date or quarterly.
The analyst can also compare ratios across a panel of compa-
Financial ratio analysis is an integral part to the assessment
nies in the same industry or against the industry sector averages.
and improvement of company performance. Financial ratios
Further improvement can be brought to the presented
help to direct attention to the areas of the business that need
system, undoubtedly. Still, we believe that the conceptual
additional analysis. Ratios are very useful when they are used
framework developed for the financial ratios, taking ad-
properly and also in conjunction with many other sources of
vantage of the flexibility and strengths of the object-ori-
information. Complementary financial ratios can be developed
ented paradigm, can be considered a reliable starting point.
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