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Dynamic factor analysis of financial viability of Latvian service sector

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EKONOMIKA IR VADYBA: 2010. 15 ECONOMICS AND MANAGEMENT: 2010. 15

DYNAMIC FACTOR ANALYSIS OF FINANCIAL VIABILITY OF

LATVIAN SERVICE SECTOR COMPANIES
Nadezhda Koleda1, Natalja Lace2
1
Riga Technical University, Latvia, [email protected]
2
Riga Technical University, Latvia, [email protected]

Abstract
A business activity is a process which is orientated over a long period of time but under the influence
of various circumstances. The success of business is the result of a company’s ability to maintain the
sustainability. Taking into account authors’ competence, they consider that sustainable development of
Latvian enterprises, which deliver services in Riga region, mostly depends on the level of their financial
viability.
The aim of research is to make the factor analysis of financial viability of Latvian companies of Riga
region service industry in the dynamic to enable commercial organizations to make the process of decision
making optimal, to achieve financial sustainability and to redefine the development strategy of their activity.
The applied research methodology is factor analysis based on chain substitutions method and method of
absolute differences.
Keywords: financial viability, factor analysis, indicators of financial viability.

Introduction
The financial crisis of 2007–2010 has been called by leading economists the worst financial crisis
since the Great Depression of the 1930s (Roubini, 2009). The 2008–2009 Latvian financial crisis, part of the
global financial crisis, is a major ongoing economic and political crisis in Latvia. In 2008, after years of
booming economic success, the Latvian economy took one of the sharpest downturns in the world, picking
up pace in the last quarter which saw GDP contract by 10.5% (BBC News, 2009).
The success of the business activities of Latvian companies was significantly affected by the world
financial crisis. According to the "Lursoft" data, in 2009 there were 2,786 insolvency proceedings initiated.
In comparison with the number of insolvency proceedings started in 2008, there was an increase of 70.2%. In
2008 the rise in the number of insolvency proceedings comprised 59.2% (Yansone, 2009). At the end of last
year the research carried out by the business information service and debt collection organisation Verband
der Verein Creditreform (VVC) showed that among 8 new European Union member countries the Baltic
States would suffer the most from the effects of the world financial crisis. Last year in the Baltic region there
was registered the highest number of insolvent companies. In Lithuania 115 companies out of every 10,000
became insolvent, in Estonia – 108, in Latvia – 99.
Last year on average in the 8 new EU member countries, 52 companies out of every 10,000 were
declared insolvent (NRA.lv, 2009).
It should be noted that the insolvency of commercial organizations has an impact on the country’s
economy in general and adds to the crisis. In 2009 the debt of Latvian taxpayers against whom insolvency
proceedings were brought, comprised Ls 17,487 millions, which is a significant part of the state budget
(Latvian ratings, 2009).
Nowadays success and development of commercial organizations depend on the ability of an
enterprise to maintain and increase the level of its financial viability to be solvent and sustainable. In order to
function successfully and for a long time in the market, enterprises need to constantly control their financial
condition. Controlling the financial viability is one of a company’s crisis management tools the
implementation of which is becoming an integral part of any business management in conditions of
nowadays world financial crises.
The aim of research is to make the factor analysis of financial viability of Latvian companies of Riga
region service industry in the dynamic to find out the level of impact and interrelationship between different
elements of financial viability to enable commercial organizations to make the process of decision making
optimal, to redefine the development strategy of their activity, to achieve sustainable development, financial
viability and solvency.

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Theoretical background
The concept of financial viability characterizes a competent and focused management of all factors
which determine the results of a company’s business activities.
In microeconomics in the sphere of financial analysis authors examine the financial stability of an
enterprise characterizing it in the following way:
1. The ability of an entity to continue to achieve its operating objectives and fulfill its mission over
the long term (Business and Personal Finance Dictionary, 2009);
2. The ability of an organization to raise the funds required to meet its functional requirements in the
short, medium and long-term (Lusthaus, 2002);
3. Conditions of financial viability are multiple sources of funding, positive cash flow, financial
surplus (Adrien & Lusthaus, 1999);
4. The ability to cover costs with earned revenue (Ledgerwood, 1999);
5. Business line that at minimum pays for all the costs, that are required to carry out the related
activities (Allison & Kaye, 2005 );
6. There is also an opinion that financial viability as a component of sustainability is defined in
terms of an adequate return for the level of risk undertaken (Crowther & Aras, 2009).
The authors examined the concept of financial viability in the context of sustainable development,
assuming that sustainable development is a kind of function of various elements (like environmental, social,
economic, structural), one of which being financial viability. In the course of morphological analysis of
definitions of financial viability and sustainable development the authors have studied the following concepts
which are connected with this idea: balance; stability; development (Yefremova, 2009; Lopatnikov, 2003;
Wikianswers, 2009; Merriam-webster online dictionary, 2009).
In the course of the research carried out by the authors they have come to the conclusion that financial
viability presupposes such distribution and use of financial resources which allows to sustain the state of a
company’s equilibrium in a short-term period and provide sustainable development of a company in a long-
term period.
In order to create the mechanism for managing financial viability the authors find it necessary to
discover which factors influence financial viability the most. The results of the factor analysis presented in
this article are the logical continuation of the research carried out by the authors (Koleda & Lace 2009;
Koleda & Lace 2008).

The indicators of financial viability

In order to evaluate financial viability the authors use the indicators (debt to equity ratio, profitability
of assets; profitability of sales, interest coverage ratio) included into the methodology of evaluation of
financial viability offered by the International Monetary Fund (IMF, 2007). The authors have elicited that the
given methodology is a good tool of controlling the level of a company’s financial viability. The offered
indicators objectively evaluate the company’s financial condition (Koleda & Lace, 2009).
The authors of the article analysed the impact of such factors as price, cost, structure of capital and
assets, and demand on the growth rate of indicators of financial viability. The growth rates of indicators of
financial viability and impacting factors is calculated based on formula below (1):
GR i
n = (( V ni − V ni− 1 ) / V ni− 1 ) * 100 % (1)
where
GRni - growth rate of i indicator/impacting factor in n year, %;
Vni−1 - value of i indicator/impacting factor in n-1 year;
Vni - value of i indicator/impacting factor in n year.

The factor models of indicators of financial viability

The study of the influence of the factors on the indicators of financial viability was carried out using
the models of economic analysis (Gilyarovskaya & Sobolev, 2002; Savickaya, 2005; World Finance and
Credit, 2009) which are shown in table 1.

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Table 1. Factor models of indicators

Indicators Factor models Description of factors
INDi INDi = f ( Xind
1
i
2
, Xindi
n
,...Xindi
) j
X ind i

Q- sales volume, units

P – price
PRC – operating costs
Profitability of sales
(Q*P-PRC-AC-SC)/(Q*P) (2) AC – administrative
costs
SC – sales costs
L- debt
A- assets
FC – fixed assets
Debt to equity ratio ((L/A)/(FC/A)/(CA/FC)/(ECA/CA))*(ECA/E) (3) CA – current assets
E – equity
ECA – own working
capital
Percentage coverage P- profit
P/IC (4)
ratio IC- interest charges
S-sales
Profitability of assets ((S/(AC+SC+PRC))-1)*(CA/A)*(I/CA)*((AC+SC+PRC/I) (5) I – inventories

Description:
INDi
indicator i of financial viability, i=(1,2...4)
j
X ind i - factor j of indicator i, j=(1,2…n)

Timing and Regional Scope of Research

Number of observations selected on a systematic basis was chosen by authors according to the
following principles:
1. Industry sector, which has major contribution to Latvian economics, is analyzed. The level of its
impact on successful state of economic is evaluated by GDP. The contribution of services branch
to Latvian economic is crucial - 42% of total GDP (Central Statistical Bureau of Latvian Republic,
2009).
2. The most economically active region is chosen for analyses according to the quantity of
companies operating in Latvian regions. The most economically active region is Riga. It is proved
by fact that 67% of all active business units operate in Riga region (Central Statistical Bureau of
Latvian Republic, 2009).
3. The sample of statistical information is limited according to the sizes of the companies. 39681
micro enterprises, 7176 small enterprises, 1454 medium-sized enterprises and only 258 large
companies operate in Riga region (Central Statistical Bureau of Latvian Republic, 2009).
Statistical sample consists of information on small and medium sized companies.
4. The time diapason of the research is limited due to unavailability of the statistical information.
The time diapason of the research is going to be limited to the years 2003 – 2007. This analyzed
period represents such stages of the Latvian economy as admission to the European Union, the
peak of economic development, beginning of the world financial crisis.
The authors consider that it is important to evaluate the financial stability of small and medium-sized
enterprises, which are operating in Riga region on service market, because they have crucial influence on
Latvian economy.

Results of research
The authors have analyzed the dynamics of the growth rate of financial viability of the Latvian
companies, the results of which are given in the diagram (Fig.1).

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120%
100%
profitability of sales
80%

60%
growth rate

40% profitability of assets

20%
0%
debt to equity ratio
2004 2005 2006 2007
-20%
-40%

-60% percentage coverage ratio

years

Figure 1. Dynamic of growth rates of indicators of financial viability

As it is seen in diagram 1, the dynamics of change of the factors of financial viability reflects a sharp
deterioration of their values in 2007. The authors have performed the factor analysis of the change trends of
the values of the factors of financial viability.
Growth rate of profitability of sales of the analysed Latvian enterprises in the period 2004-2006
comprised on average 47%, but in 2007 decreased by 27%. This trend was affected significantly by the
growth of actual volume of sales until 2007 and then its fall. In 2007 the most important role in the decrease
of the level of profitability of sales was played by the price factor and high costs with a relatively low
volume of sales. The authors have performed the analysis of the service market in the period 2003-2007 and
came to the conclusion that the real estate property business was the most influental sphere in the service
industry. From the beginning of 2007 the amount of the real estate deals started to reduce in average by 60%
every quarter (Arco Real Estate, 2006; Arco Real Estate, 2007) – it becomes the main reason for the sharp
fall of the average level of profitability of sales in the service industry sphere. The results of the factor
analysis of the change of growth rate of companies’ profitability of sales are presented in diagram 2.

900% profitability of
800%
700%
sales
600% volume of sales
500%
400%
300%
200%
price
growth rate

100%
0%
-100% operating costs
-200%
20

20

20

20
04

05

06

07

-300%
-400% sales costs
-500%
-600%
-700% administrative
-800% costs
-900%
years

Figure 2. Factors influencing growth rate of profitability of sales

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The authors have also carried out an analysis of sensitivity of the indicator of sales profitability
analyzing the changes of the indicator according to the change of the costs growth rate by 1%. In the result of
the analysis it was found out that the decrease of growth rate of operating costs by 1% can increase growth
rate of sales profitability on average 26 times, decrease of growth rate of sales costs by 1% - 2 times,
decrease of growth rate of administrative costs – also 2 times, providing that the growth rate of sales volume
does not change.
The growth rate of profitability assets in the period 2004-2006 was rising on average by 47%, but in
2007 fell by 34% (Fig.3). The trend until 2007 was strongly influenced by the price factor – the price growth
positively affected the value of the given indicator, but in 2007 low stock turnover negatively was
detrimental to profitability of assets.Stagnation in the real estate market in 2007 as well as the specific
character of this type of business could affect the decrease in stock turnover.
150%
profitability of assets

100%
price
growht rate

50%
share of current assets in total
assets
0%
share of stock in current assets
20

20

20

20
04

05

06

07
-50%
stock turnover
-100% years

Figure 3. Factors influencing growth rate of profitability of assets

Growth rate of debt to equity ratio in 2004, 2005, 2006 and 2007 comprised 13%, 17%, 1% and 13%
respectively (Fig.4). The low growth rate of this indicator in 2006 was determined by the decrease of the
share of fixed assets in total assets and the increase of the shares of own operating assets in working assets.
The role of both these factors mutually compensate for positive and negative influence on the indicator
analysed.

25% debt to equity ratio

20%

15% share of debts in total assets

10%
share of fixed assets in total
5%
assets
growth rate

0%
share of working assets in
-5% fixed assets
20

20

20

20
04

05

06

07

-10% share of own operating

assets in working assets
-15%

-20% share of own operating

assets in equity
-25% years

Figure 4. Factors influencing growth rate of debt to equity ratio

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150%

percentage
100%
coverage ratio

50%
growth rate

net profit

0%
20

20

20

20
04

05

06

07
-50% interest charges

-100%
years

Figure 5. Factors influencing growth rate of percentage coverage ratio

Growth rate of percentage coverage ratio in the period 2004-2006 on average comprised 57% (Fig.5).
The profit growth influenced greatly the growth rate of the indicator analysed. In 2007 the growth rate
of the given indicator comprised 49%, which was mainly influenced by the rapid growth of percentage
coverage ratio as well as the decrease in profits. One of the reasons for such a trend is a decline in the real
estate market – the key sector of the service sphere in Latvia in 2007.

Conclusions
The issues of providing companies’ financial viability are extremely important for successful
sustainable development and stability of enrepreneurship. You can only manage those things which you can
measure. Nowadays the necessity for objective assessment of a company’s financial viability as a basis for
taking management and investment decisions has been enhanced. That is why particular emphasis is put onto
revealing the factors of providing financial viability. Factor analysis is one of the sectors of modern
multidimensional statistics and is widely used in various spheres of research. It allows a deeper
understanding of the essence of a company’s financial viability. The factor analysis of the financial viability
of the companies which operate in the service industry in Riga region showed that the main factors which
positively influence the values of the indicators of financial viability were price and actual volume of sales –
these are the factors which companies can hardly influence, these are the factors which characterize demand,
the fall of which in 2007 had a crucial impact on companies’ financial viability. The research also
demonstrated that financial viability was negatively influenced by the growth of operating costs, low stock
turnover and high interest charges when the profit was low in 2007 – a company can manage these factors.
The retrospective dynamic factor analysis of financial viability on the basis of statistical data on
finance accounting of the companies operating in the sphere of the service industry in Riga region, which
was carried out by the authors, allows: 1) comprehensively measure financial viability; 2) to reveal the
changes of a company’s financial viability in the time span concerned; 3) to reveal latent and the most
significant factors which influence sustainability of a company; 4) to reveal the reserves for increase in
financial viability and decrease in risks of the loss of solvency; 5) to determine a degree of interrelation
between the factors and values of the indicators of financial viability; 6) to work out a financial strategy and
tactics for a company’s development, to substantiate financial plans; 7) to predict the trends of a company’s
financial viability; 8) persons concerned to take managerial decisions on the basis of assessing companies’
financial viability in a prior period and projection of financial position in perspective; 9) to carry out a
comparative analysis of alternatives in the process of decision-making.
In the process of managing a company in the modern business environment one of the key aims of its
functioning is provision of a company’s sustainability in the market and improving its prosperity. Factor
analysis and sensitivity analysis of the indicators of financial viability play an important role in
implementing this task. The research carried out revealed the factors which have the strongest influence on
financial viability, which is the necessary information for creating the mechanism of managing a company’s
harmonious and sustainable development.

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