Financial Statement Analysis

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Information about Financial Statement Analysis

Published on April 10, 2008

Author: Peppar


CORPORATE FINANCIAL DATA FOR INTERNATIONAL INVESTMENT DECISIONS:  CORPORATE FINANCIAL DATA FOR INTERNATIONAL INVESTMENT DECISIONS Chapter 5:  Chapter 5 International Financial Statement Analysis FASB, IASB, and IAAER Project on Financial Reporting:  FASB, IASB, and IAAER Project on Financial Reporting Questions addressed in this project include Should the performance (income) statement be the primary focus of financial reporting? How should the performance statement complement the other financial statements? How should the cash flow statement be used? What information should be presented in the performance statement? Is one approach applicable to all countries? International Accounting Differences and Financial Statement Analysis:  International Accounting Differences and Financial Statement Analysis The key question How do differences in accounting affect earnings and cash flow assessments? These assessments are important to Investors Corporations concerned with foreign direct investment Many companies are listing on international exchanges (London, New York) Stock Market Comparisons:  Stock Market Comparisons International Accounting Differences and Financial Statement Analysis:  International Accounting Differences and Financial Statement Analysis A tendency exists to looks at earnings from a home country perspective This tendency may ignore accounting differences A need exists to better understand foreign accounting principles in the context in which they are derived International comparability is important in considering alternative investments The Impact of U.S.-U.K. Accounting Differences:  The Impact of U.S.-U.K. Accounting Differences Index of conservatism (Gray, 1980) 1 – [RA – RD / l RA l] Where RA = adjusted earnings (or returns) RD = disclosed earnings Therefore, 1 – [U.S. GAAP Earnings – U.K. GAAP Earnings / l U.S. GAAP Earnings l] If index value > 1, U.K. GAAP earnings are less “conservative” If index value < 1, U.K. GAAP earnings are more “conservative” The Impact of U.S.-U.K. Accounting Differences:  The Impact of U.S.-U.K. Accounting Differences Example 1 U.K. earnings £110 million U.S. earnings £100 million Index 1 – [100-100]/100 = 1.1 Example 2 U.K. earnings £90 million U.S. earnings £100 million Index 1 – [100-90]/100 = 0.9 The Impact of U.S.-U.K. Accounting Differences :  The Impact of U.S.-U.K. Accounting Differences It is possible to establish the relative effect of individual adjustments with partial indices of adjustment Partial index of “conservatism” 1 – [partial adjustment / l U.S. GAAP Earnings l ] The Impact of U.S.-U.K. Accounting Differences:  The Impact of U.S.-U.K. Accounting Differences Example Millions of Pounds U.K. GAAP earnings 120 Adjustments for U.S. GAAP: Deferred taxation (15) Goodwill amortization (5) Adjusted earnings per U.S. GAAP (100) Overall index of ‘conservatism’ 1.2 Partial index for deferred taxation 1 – [-15/100] = 1.15 Partial index for goodwill 1 – [-5/100] = 1.05 The Impact of U.S.-U.K. Accounting Differences:  The Impact of U.S.-U.K. Accounting Differences Differences between methods are illustrated in the Form 20-F report Form 20-F can be used to test how conservative U.S. and U.K. GAAP are in comparison with each other Form 20-F is reliable because it is provided by the company itself Research findings show U.K. GAAP to be less conservative A Global Perspective on Earnings Management:  A Global Perspective on Earnings Management How do Anglo-American earnings compare with continental Europe and Japan? Continental Europe Gray (1980) compared French and German companies to British companies Insert Exhibit 5.8, 5.9 French and German earnings are more conservative than British earnings Weetman and Gray (1991) found that Netherlands was less conservative that Sweden, U.K. Swedish methods were more conservative than U.S. GAAP A Global Perspective on Earnings Management:  A Global Perspective on Earnings Management Japan Earnings are relatively understated compared to the U.S. (33.9%, according to Aron (1991) Historically high PE ratios were deflated by adjustments for reserves, consolidation practices, depreciation, cross-holdings, and differences in capitalization (Morgan Stanley) Higher levels of gearing (leverage) and short-term payables are tolerated because of long-term relationships with bankers and suppliers Emphasis tends to be on long-term growth rather than instant profitability Factors Influencing Measurement Differences:  Factors Influencing Measurement Differences U.S. and U.K. Stock market is the dominant influence Information needs of investors encourage a more “optimistic” view of earnings and higher share prices Accounting principles are flexible Accounting profession is independent Tax rules have a limited influence Cultural values motivate a less conservative approach to measurement Factors Influencing Measurement Differences :  Factors Influencing Measurement Differences Continental Europe and Japan Taxation and sources of finance are influential Tradition of commercial codes and accounting plans Tendency to report lower earnings for tax purposes Factors Influencing Measurement Differences:  Factors Influencing Measurement Differences Continental Europe and Japan Users of financial information may be more concerned with balance sheet information Black and White (2003) findings Balance sheet info is more informative in Germany, Japan Income statement is more relative in the U.S. Professional influence is low due to legal requirements related to accounting Cultural values motivate a more conservative approach Increase in Foreign Investment:  Increase in Foreign Investment Facilitated by: Advances in telecommunications Deregulation of national capital markets Attractive returns and diversification benefits from a global portfolio Desire for corporate control through merger and acquisitions Corporate Motivations:  Corporate Motivations Achieving growth through external acquisitions Circumventing national trade barriers to gain market access Securing strategic sources of raw materials Exploiting comparative production efficiencies Slide19:  Minimizing operations and environmental risks by geographically diversifying operations and sources of external finance Basis for competitive analysis, credit decisions, and business negotiations Problems :  Problems Users of foreign financial data must overcome a number of obstacles Differences in language and terminology Statement format Currency differences Extent of financial disclosure Accounting measurement rules Accessibility and timeliness of the data What is Financial Statement Analysis?:  What is Financial Statement Analysis? Conversion of the data contained in financial statements into information useful in economic decision making. There is a growing need to perform financial statement analysis on an international basis.... Slide22:  And applying financial statement analysis in an international setting is particularly challenging....cross border comparisons are still very much a creative exercise in analysis.... Slide23:  The purpose of international financial statement analysis is to make financial data more comparable across firms and across time.. Slide24:  We’ve already seen that accounting practices vary widely across countries. What is the impact on net income? Slide25:  While some think that US accounting standards are among the more conservative in the world, Gray and Radebaugh suggest that may not be true. While the US is significantly more conservative than the UK, it is less conservative than Japan and many continental European countries in terms of the impact on earnings. Slide26:  If the US is taken as the yardstick with an index number of 100, its relationship with several European countries and Japan is shown on the next slide (note that this does NOT consider the effect of “secret” reserves... Comparative Impact of International Accounting Differences on Earnings:  Comparative Impact of International Accounting Differences on Earnings Slide28:  One method to deal with the difference is reconciliations Up until this year, companies that list on the US stock exchanges and are not using US GAAP were required to prepare a Form 20-F reconciliation. The Form 20-F is often confusing. Slide29:  Research shows, however, that there is significant incremental explanatory power given by the US GAAP earnings adjustment information. Stock market prices react to this information. Does Accounting Diversity Affect your Investment Decision?:  Does Accounting Diversity Affect your Investment Decision? Choi and Levich surveyed a financial professionals who dealt with international listings (1991) IT is a small sample, so it may not be representative, and it is now a decade old...but almost half claimed that international diversity did NOT affect their decision process... Slide32:  Those who claimed to not be affected indicated that they were coping by various means, including restating accounts to their own GAAP developing foreign GAAP capabilities using other sources of information using a different investment approach, e.g. macroeconomic criteria to determine a country, then diversification within the country So, what do we do?:  So, what do we do? Although the format, style of presentation, and terminology may differ dramatically from one country to the next, almost all countries with publicly traded securities require the issuance of the income statement and balance sheet. Many countries also require some form a funds flow, or cash flow, statement. The Balance Sheet:  The Balance Sheet By comparing a series of consecutive balance sheets, it is possible to assess changes in a company’s financial position. The Income Statement is more is important to separate out recurring and nonrecurring items,, and nonoperating items. Slide35:  Two questions should be asked: What significant patterns and relationships exist in the financial statements? What is observed that explains any patterns and relationships or that may cause the observed patterns or relations to change in the future? Trend Analysis and Cross-Sectional Analysis:  Trend Analysis and Cross-Sectional Analysis The first of these two questions can be addressed by trend and cross-sectional analysis. Trend analysis involves the identification of patters within financial statemnts across time. Cross sectional analysis involved identification of relationships within the same time period. Slide37:  Cross sectional relationships can also be examined for firms within the same industry or by comparison with industry averages. Trend Analysis:  Trend Analysis Companies normally report two or three years of data in the basic financial statements and ten or more years of selected data items. This disclosure is usually given only in the domestic or reporting currency. Slide39:  In order to prepare earnings forecasts, debt ratings, or make various economic and financial decisions, analysts may want to convert the raw data to some common basis. When this is done, the rates of growth of the numbers and volatility across time can be evaluated more readily. Such assessments are crucial in preparing any projections of the numbers. Common Size Financial Statements:  Common Size Financial Statements In common-size financial statements, all amounts are expressed as a percentage of some base financial statement item. For example, a common-size balance sheet might express all asset account balances as a percent of total assets. A common size income statement might express all revenue and expense accounts a a percentage of gross revenues. Slide41:  Trend analysis of common-size balance sheets permits the analyst to determine things like how the relative composition of assets is changing over time. Trend analysis of a common-size income statement reveals the changing relation of various expense accounts to the reported revenues of a company. Slide42:  Another approach is to select a base year for comparison, frequently the earliest year available, and to divide each successive reported number by that given for the base year. This way, the growth from the base year can be determined. Slide43:  It is important to know that trends may be particularly sensitive to the particular year chosen Year-to-Year Changes:  Year-to-Year Changes The pattern of changes in revenues for each firm can be compared. Looking at the rate of change for each item (percent of increase, percent of decrease) provides useful information, but may need to be examined in the context of knowledge of other economic conditions. Geometric Growth Rates:  Geometric Growth Rates Geometric, or compound, growth rates are frequently used as a means of comparing average growing in financial numbers, such a revenues or earnings, over a given period. By examining growth over a period of time, random volatility in year-to-year numbers is eliminated, and a clearer picture of relative growth may emerge. Slide46:  Some problems can occur: Trends cannot be developed using negative numbers as a base if one or more later observations are positive. Annual changes may be very volatile. Long term trends maybe be very sensitive to the base year chosen. Ratio Analysis:  Ratio Analysis While common-size financial statements facilitate comparisons of financial statement categories, it fails to capture informative aggregations of categories. Ratio analysis summarizes multiple financial statement categories into one or a few relative indices of performance and financial position. Ratio Analysis:  Ratio Analysis Ratio analysis compares two financial statement items,usually from the same year. The purpose is to gain an understanding of the firm’s profitability, leverage, liquidity, and efficiency. Slide49:  This information can be useful in evaluating future profitability prospects, the operating and financial risk of the firm, and when these ratios are calculated for more than a single year, the relative stability or volatility of the relationships over time. Moreover, such ratios provide a basis for comparing two or more firms whose sizes and even currencies may be different. Ratio Analysis:  Ratio Analysis To the extent that percentages are used, translation of financial information into a common currency is not an issue. Slide51:  When the analysis is based on numbers rather than percentages, however, care must be used in translation. Slide52:  Another problem is that company statistics may have been prepared in accordance with an unfamiliar set of accounting measurements may cause differences in accounting-based financial ratios; these differences may hide real differences in the underlying attributes being investigated. Slide53:  Further, examination of ratios and trends that don't consider the local environment may be misleading. Slide54:  It is risky to try to compare ratios for companies that are located in different countries. It may be more useful to compare ratios for a given company over time, or to compare trends in ratios for one company to trends in ratios for the industry in a given country. Slide55:  And there are some relationships that just don’t show up in ratio analysis a company’s emphasis on product innovation a company’s expertise at developing marketing campaigns Pro Forma Statements... :  Pro Forma Statements... Pro forma analysis can enhance the analysis of historical financial statements by incorporating forecasts of future events into the traditional accounting framework. At one extreme, a set of pro forma financial statements can be prepared by projecting one determinant of a company’s financial results and holding all other historical results constant. Slide57:  At the other extreme, forecasts of changes in all the determinants can be estimated. Slide58:  Projection of the future cash flows may be particularly useful. Slide59:  Another option is to evaluate market “comparables”. Availability of Information:  Availability of Information Access to financial data is widespread in the US Similar information is often available in other countries However, 1/3 of the information services provide users with only selected statistics Some provide only in the local language Availability of Information:  Availability of Information Some only provide hard copy rather than electronic information Slide62:  And in some countries, the reliability of the data is an issue This is particularly true for developing economies, which may not have developed reliable systems to accumulate data, or that may actually deliberately skew data (Zimbabwe) Delays in Information:  Delays in Information UK: Annual reports of publicly held companies must be filed within 7 months of year-end UK: Listed companies file with Stock Exchange within 6 months South Korea: Listed companies must file within 45-60 days after year-end Slide64:  France: File 15 or more days before annual meeting, but the annual meeting may be up to 6 months after the year-end Additional time lags with publication of information for foreign audiences Country Risk Analysis:  Country Risk Analysis Country risk represents the potentially adverse impact of a country’s environment on the cash flows of the MNC. Increased Awareness of Country Risk... :  Increased Awareness of Country Risk... In 1976, a division of Consolidated Foods, Inc., searched for an appropriate country for a new manufacturing plant. The company decided on a location described at that time as a “happy, sleepy country.” The location was El Salvador. Slide67:  Within two years of this decision, political turmoil arose. In the process a group of rebels held the division’s president and about 120 employees hostage until the company agreed to provide wage increases. By 1979 the division was closed. Slide68:  Think about a business located in Iran, Iraq, or Afghanistan... Slide69:  These are issues that cannot be evaluated by just looking at the financial statement items but affect the risk of any given investment decision. Slide70:  Country risk can be partitioned ito Political Risk Financial Risk Political Risk Factors:  Political Risk Factors Attitudes of Consumers in the Host Country Attitude of Host Government regulation, such as pollution control standards taxation fund transfer restrictions Slide72:  Currency Inconvertiblity or Currency Volatility War Bureaucracy Slide73:  Some analysts use turnover in government members or philosophy as a proxy for a country’s political risk Financial Risk Factors:  Financial Risk Factors Current and potential state of the country’s economy: recession? Expansion? Interest rates Exchange Rates Inflation Comparison of Alternatives:  Comparison of Alternatives One model: First decide to diversify, then select geographic region, and examine investment alternatives within that region. Second model: Attempt to reconcile GAAP differences Third model: Specialize in one or two countries, learning in depth about GAAP, transparency, and local conditions

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