CHAPTER 9
ANALYSIS OF FOREIGN FINANCIAL STATEMENTS
Chapter Outline
I. Reasons to analyze financial statements of foreign companies include:
· making foreign portfolio investment decisions,
· making foreign merger and acquisition decisions,
· making credit decisions about foreign customers,
· evaluating foreign suppliers, and
· benchmarking against foreign competitors.
II. There are several problems an analyst might encounter in analyzing foreign financial statements, including:
· finding and obtaining financial information about a foreign company,
· understanding the language in which the financial statements are presented,
· the currency used in presenting monetary amounts,
· terminology differences that result in uncertainty as to the information provided,
· differences in format that lead to confusion and missing information,
· lack of adequate disclosures,
· financial statements are not made available on a timely basis,
· accounting differences that hinder cross-country comparisons, and
· differences in business environments that might make ratio comparisons meaningless even if accounting differences are eliminated.
III. Some of the potential problems can be removed by companies through their preparation of convenience translations in which language, currency, and perhaps even accounting principles have been restated for the convenience of foreign readers.
IV. A significant number of investors find that differences in accounting practices across countries hinder their financial analysis and affect their investment decisions. Some analysts cope with this problem by restating foreign financial statements to a familiar basis, such as U.S. GAAP.
A. Another coping mechanism is to base analysis on a measure of performance from which many accounting issues have been removed, such as EBITDA.
V. Analysts should exercise care in interpreting ratios calculated for foreign companies. What is considered to be a good or bad value for a ratio in one country may not be in another country.
A. Financial ratios can differ across countries as a result of differences in accounting principles.
B. Financial ratios also can differ across countries as a result of differences in business and economic environments. Optimally, an analyst will develop an understanding of the accounting and business environments of the countries whose companies they wish to analyze.
VI. To facilitate cross-country comparisons of financial information, foreign company financial statements can be restated in terms of a preferred format and preferred GAAP through a two-step process.
A. First, financial statements are reformatted. Adjustments are made for differences in terminology, presentation, and classification.
B. Reformatted financial statements then are restated to a preferred GAAP. This takes care of comparability problems caused by differences in accounting principles. GAAP restatement can be carried out through the use of reconciling accounting entries posted to a restatement worksheet.
Answers to Questions
1. Investors can diversify their risk by including shares of foreign companies in their investment portfolio. Correlations in the returns (increases and decreases in stock prices) earned across stock markets are relatively low. The high degree of independence across capital markets affords investors diversification opportunities.
2. Ford might want to include the following companies in a benchmarking study:
U.S. – General Motors
Japan – Honda, Toyota, Subaru
Germany – Daimler-Chrysler, BMW, Volkswagen, Audi
Korea – Hyundai, Kia
France – Renault
Note: Due to the consolidation in the automobile industry, several companies are now divisions of other companies. For example, Ford owns Mazda (Japan), Volvo (Sweden), and Jaguar (U.K.). BMW owns Land Rover (U.K.), and Renault owns Nissan (Japan). Of course the largest consolidation occurred when Daimler-Benz (Germany) acquired Chrysler (U.S.).
3. Commercial databases tend not to include notes to financial statements, which are an important source of information about a company. They also tend to force different country formats for financial statements into a common format and thereby run the risk of misclassification and loss of information. Data entry errors are also a potential problem.
4. The first (easiest) place to look for the most recent annual report is on the company’s internet website. Several internet resources can help in locating a company’s financial statements including Hoover’s, EDGAR, and CAROL.
5. Much financial statement analysis is conducted using ratios or percentage changes (comparing one year with another). Ratios and percentages are not expressed in currency amounts. In fact, in analyzing year-to-year percentage changes, analysts must be careful in translating from a foreign currency to their own currency as changes in exchange rates can distort underlying relationships.
6. If an analyst is unable to read a company’s annual report, they will be less likely to feel that they have sufficient information to make an informed investment decision. This would be analogous to making an internet purchase of an electronic product manufactured by a company with which you are unfamiliar and the only description of the product is in a language you do not read.
7. Unless one is familiar with German accounting, it is possible only to make an educated guess as to what the item “revenue reserves” represents. Because it is a positive amount reported in stockholders’ equity, it is likely to be an appropriation of retained earnings.
8. Disclosures in the notes to financial statements can provide additional detail related to specific line items that allows the analyst to reformat the financial statements to a format preferred by the analyst (e.g., that can be compared with other companies). Disclosures related to items such as provisions can allow analysts to assess the impact that these have on income.
9. The time lag between fiscal year end and when financial statements are made available to the public can differ substantially across countries. This time lag is influenced by the stock market regulator in many countries. For example, the SEC requires U.S. companies to file financial statements within 90 days of the fiscal year end, whereas publicly traded British companies are allowed six months to file their reports. Substantial differences in the timeliness of earnings announcements also exist across countries.
Timeliness is also a function of how often companies must prepare financial statements. Whereas the U.S., Canada, and the U.K. require publication of quarterly reports, the European Union requires only semi-annual reporting, and annual reporting only is the norm in many countries.
10. The advantage of using a measure such as EBITDA to compare profitability of companies across countries is that differences in accounting for interest (I), taxes (T), depreciation (D), and amortization (A) across countries do not affect the profitability measure. The disadvantage is that these expenses might be important in evaluating profitability and in determining the value of the firm.
11. The different features that might be “translated” in a convenience translation are:
· Language,
· Currency, and
· GAAP.
The most common type of convenience translation is a language translation only. Exhibits 9-3 through 9-7 are examples of this type of convenience translation.
12. Analysts should be careful in comparing ratios across companies in different countries because of differences in business environments that might affect those ratios. For example, in countries in which accounting income is the basis for taxation, it is logical that companies will attempt to report as little accounting income as possible. It might be misleading to therefore assume that these companies are not as profitable as companies in countries in which accounting income is not used for tax purposes.
13. Conservatism implies “overstating” expenses and liabilities, and “understating” revenues and assets. Overstating expenses and/or understating revenues results in an “understatement” of net income and retained earnings.
Profit margin -- If net income is understated because of an overstatement of expenses (or understatement of revenues), profit margins (net income/sales) will be smaller (understated).
Debt to equity ratio -- Overstatement of liabilities and understatement of retained earnings results in an inflated debt-to-equity ratio (total liabilities/total stockholders’ equity).
Return on equity -- The impact of conservatism on return on equity (net income/average stockholders’ equity) is not as clearcut because both the numerator and denominator in the ratio are understated.
Assume income would be 100 and beginning stockholders’ equity 1,000 absent any overstatement of expenses (base case). If expenses are overstated 10 each year, income is understated by 10 each year and the extent to which retained earnings are understated increases by 10 each year. As the table below illustrates, return on equity will be smaller each year as a result of the understated net income.
Effect of conservatism on Return on Equity:
Average Total Equity
Base case:
Year 1 / Year 5 / Year 10 / Year 20 / Year 40
Beginning equity / 1,000 / 1,400 / 1,900 / 2,900 / 4,900
Annual income / 100 / 100 / 100 / 100 / 100
No dividends
Ending equity / 1,100 / 1,500 / 2,000 / 3,000 / 5,000
Net Income / 100 / 100 / 100 / 100 / 100
Average Total Equity / 1,050 / 1,450 / 1,950 / 2,950 / 4,950
9.52% / 6.90% / 5.13% / 3.39% / 2.02%
Understatement of income by $10 each year:
Year 1 / Year 5 / Year 10 / Year 20 / Year 40
Beginning equity / 1,000 / 1,360 / 1,810 / 2,710 / 4,510
Annual income / 90 / 90 / 90 / 90 / 90
No dividends
Ending equity / 1,090 / 1,450 / 1,900 / 2,800 / 4,600
Net Income / 90 / 90 / 90 / 90 / 90
Average Total Equity / 1,045 / 1,405 / 1,855 / 2,755 / 4,555
8.61% / 6.41% / 4.85% / 3.27% / 1.98%
14. Companies with predominantly debt financing (rather than equity financing) will have a larger amount of liabilities (and a smaller amount of stockholders’ equity), and a larger amount of interest expense and therefore smaller income. Profit margins (net income/sales) will be smaller, and debt-to-equity ratios (total liabilities/total stockholders’ equity) will be larger. Debt financing will reduce both the numerator and the denominator in the calculation of return on equity. The net effect on return on equity (net income/average stockholders’ equity) depends upon the relation between before tax return on assets and the interest rate on borrowing. As the table below demonstrates, if the before tax return on assets is greater than the interest rate on debt, return on equity increases; if the before tax return on assets is less than the interest rate on debt, return on equity decreases. Note: Before tax return on assets is 20% (400/2,000).
Effect of Debt on Return on Equity:
No debt / Debt / 10% / Debt / 20% / Debt / 25%Assets / 2,000 / 2,000 / 2,000 / 2,000
Liabilities / 0 / 1,000 / 1,000 / 1,000
Stock equity / 2,000 / 1,000 / 1,000 / 1,000
2,000 / 2,000 / 2,000 / 2,000
EBIT / 400 / 400 / 400 / 400
Interest / 0 / 100 / 10% / 200 / 20% / 250 / 25%
EBT / 400 / 300 / 200 / 150
Tax / 35% / 140 / 105 / 70 / 53
Net income / 260 / 195 / 130 / 98
Net income / 260 / 195 / 130 / 98
Avg Stock Eq / 2,130 / 1,098 / 1,065 / 1,049
ROE / 12.2% / 17.8% / 12.2% / 9.3%
15. Three types of differences that might require adjustments to transform U.K. financial statements to a U.S. format are:
· Terminology differences, e.g., “stocks” are inventories;
· Presentation differences, e.g., discontinued operations are reported in a separate column in the income statement; and
· Definition/classification differences, e.g., “cash at bank” is defined differently from “cash and cash equivalents.”
16. Interest can be either capitalized as part of the cost of a depreciable asset or expensed immediately. Adjustments to capitalize interest that was previously expensed must be made to:
· Increase depreciable assets;
· Reduce interest expense; and
· Increase beginning retained earnings for the reversal of interest expense that was improperly recognized in previous years.
Solutions to Exercises and Problems
1. Imperial Chemical Industries
Ratio / Formula / U.K. GAAP / a.1. / U.S. GAAP / a.2. / b.% Diff
Current ratio / CA/CL / 3,989 / 3,989
4,386 / 0.909 / 4,245 / 0.940 / 3.32%
Total asset turnover / Sales/TA / 9,095 / 9,095
9,033 / 1.007 / 12,692 / 0.717 / -28.83%
Debt/equity ratio / TL/TSE / 8,835 / 9,086
149 / 59.295 / 3,557 / 2.554 / -95.69%
Times interest earned / EBIT/Int Exp / 409 / 244
332 / 1.232 / 332 / 0.735 / -40.34%
Profit margin / NI/Sales / 193 / (44)
9,095 / 0.021 / 9,095 / -0.005 / -122.80%
Return on equity / NI/TSE / 193 / (44)
149 / 1.295 / 3,557 / -0.012 / -100.95%
Operating profit margin / Op Inc/Sales / 406 / 241
9,095 / 0.045 / 9,095 / 0.027 / -40.64%
Operating profit as % of / Op Inc/TSE / 406 / 241
total stockholders' equity / 149 / 2.725 / 3,557 / 0.068 / -97.51%
c. The profitability ratios, especially those that use Net Income and/or Total Stockholders’ Equity, are most affected by differences in the two sets of accounting principles. There also is a larger difference in the Debt-to-Equity Ratio because of the large difference in Stockholder’s Equity under the two sets of accounting principles. The only ratio for which there is an insignificant difference is the current ratio.