Chapter 7

International Financial Statement Analysis
Answers to Questions for Discussion

1.   Financial statement analys...
70                                                                           Chapter 7

       •   Reliability of data. T...
Chapter 7                                                                             71

12. General limitations of fina...
72                                                                           Chapter 7

         •   The base year has a...
Chapter 7                                                                            73

      (3) Differences arise from...
74                                                              Chapter 7

           Deferred liabilities               ...
Chapter 7                                                                         75

      (1) $840.0 + $100.0
76                                                                            Chapter 7

7-7   (1)                       ...
Chapter 7                                                                                     77

7.10 Sony Annual Sales ...
78                                                                            Chapter 7

7-13 (1) Current ratio in yen 10...
Chapter 7                                                                             79

      Lustra’s 1992 earnings fo...
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Chp. 7


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Chp. 7

  1. 1. Chapter 7 International Financial Statement Analysis Answers to Questions for Discussion 1. Financial statement analysis is the conversion of data in financial statements into useful information. 2. Reasons for the increasing importance of financial analysis. a. Availability of high investment returns in other countries. Investors, especially institutional investors, are often attracted by the high returns they can earn in other countries. b. Risk diversification in emerging markets. Fund managers and other investors are interested in risk diversification in emerging markets. While individual emerging markets may be volatile, as a group they are not. Knowledgeable sources agree that it is important to diversify while investing in emerging markets. c. Positioning for competitive reasons. Many companies are making direct investments abroad to have a geographic base that will position them to target certain markets. Quite a few developing countries have sizable populations with available disposable income for spending on consumer goods. d. Simultaneous appreciation of investment with currency. When currency of a country becomes relatively more valuable, the investments in that country also appreciate in value. e. Relaxation of equity ownership restrictions. Many countries have implemented economic reforms. These include relaxation or removal of the limits on equity ownership of domestic enterprises by foreigners. f. Industry and competitor analysis. The companies engaged in global trade and investments often analyze financial statements of their main competitors, and also the leading companies in industry. This allows them to note important trends, and to gain knowledge of their own relative strengths and weaknesses. This latter is termed “benchmarking.” g. Decisions involving business transactions. Financial information is needed to make many decisions in the ordinary course of conducting business. Before extending credit, for example, the suppliers need financial information to assess creditworthiness of the customer. Financial information is also helpful in price negotiations. 3. When the currency of a country becomes relatively stronger and more valuable, the value of investments made in that country increases. 4. Perceived problems related to the availability and quality of financial information in different countries are:
  2. 2. 70 Chapter 7 • Reliability of data. The data may not be accurate. • Adequacy of disclosures. The disclosures may be inadequate for decision making. • Timeliness of the availability of information. The information may not be available when needed to make decisions. • Language and terminology. Language and terminology differences may create difficulties in understanding and interpreting available information. • Different currencies. Lack of familiarity with foreign exchange rates may create difficulties in making comparisons among different alternatives. • Differences in format of financial statements. Differences in formats may require reformatting some of the financial statements, in order to achieve uniformity, before a comparison can be made. 5. International Accounting Standards Committee International Federation of Accountants European Union International Organization of Securities Commissions 6. Global capital markets are forcing the companies desiring to raise capital from cross-border sources to make disclosures that would satisfy information needs of sophisticated users—security market regulators, financial analysts, and mutual fund managers. The current trend is to make the financial statements disclosures that would be needed by investors, potential investors, creditors, and other users. 7. A complete restatement of financial statements, and developing the capability of understanding and interpreting other country’s generally accepted accounting principles are perhaps two of the most effective alternatives. 8. The objective of financial statement analysis is to extract useful information for decision making. 9. Financial ratio analysis is performed for comparability across firms, i.e., interfirm comparisons for a period or a date. Trend analysis provides intrafirm as well as interfirm comparisons for two or more periods or dates. 10. Liquidity ratios measure an enterprise’s short-run ability to pay its maturing obligations. Activity ratios measure how effectively an enterprise is using the assets employed. Profitability ratios measure the degree of success or failure of an economic entity for a given period of time. Coverage ratios measure the degree of protection for long-term creditors and investors of an organization. 11. Liquidity: Current ratio Activity: Inventory turnover Profitability:Profit margin Coverage: Debt ratio
  3. 3. Chapter 7 71 12. General limitations of financial ratio analysis are: • Valuation basis. Financial ratios are based on historical costs in most countries, but users may erroneously assume that the amounts reflect current prices. • Estimates. Due to the presence of substantial amounts involving estimates, the ratios lose their effectiveness for intercompany comparison. • Alternatives allowed by GAAP. Different companies use different alternatives allowed by accounting standards. • Omissions. Important informational items, such as product innovations, labor relations, and intellectual capital, are omitted in the ratios. This limits their usefulness. 13. Additional limitations of financial ratio analysis in the international context include: • Valuation basis. Though most countries have ratios based on historical costs, other countries’ financial statements include items using other cost bases, e.g., current cost basis. • Estimates. The varying levels of flexibility for estimating specific items allowed in different countries make the ratio comparisons more difficult. For example, the maximum period for goodwill amortization varies among countries. • Accounting frameworks—the acceptable alternatives in the application of accounting principles—vary among countries. For example, some countries do not permit the use of LIFO for inventory valuation while others do. • Omissions. The information required to be disclosed in some countries is altogether omitted in others. Disclosure requirements vary from country to country. • Different operating environments and business practices exist in different parts of the world. • The influence of tax laws on reported income is direct and profound in the countries where taxable income and income for financial reporting has to be the same. In other countries, where such requirement does not exist, there is motivation for companies to deliberately minimize reported income in order to reduce taxes. • Data accuracy. In some cases, the data may be deliberately changed to show a better-than-actual performance. Ratios based on inaccurate data would obviously be inaccurate and unreliable for comparison. 14. When performing trend analysis the amount of each succeeding year is divided by the amount of the base year. It is critical that the base year be a representative year in order to avoid distortions of the results. 15. The two limitations of trend analysis are:
  4. 4. 72 Chapter 7 • The base year has a significant impact on the long-term trend. Therefore, the base year selected must be a representative year. The base year cannot be a negative number, since the trends cannot be developed from using a negative number. • It is desirable to leave the amounts expressed in a foreign currency instead of translating them. The trend analysis based on amounts translated from a foreign currency distort the underlying financial relationships. 16. For the purpose of performing trend analysis, it is desirable to leave the amounts expressed in a foreign currency instead of translating them. Reason being that trend analysis based on amounts translated from foreign currency to the domestic currency distort the underlying financial relationships. It is true whether the year- end exchange rates are used for translation, or one of the currency translation methods. 17. In cases where currency balances have been adjusted for changes in the general purchasing power of the currency, the year-end exchange rates of the year used as the base year for inflation adjustments should be used. 18. If one of the currency translation methods is employed, distortion can result due to the nature of the translation process itself. Starting from the same data, each one of the translation methods results in translated amounts that are different in many instances. Solutions to Exercises/Problems 7.1 While there may be diversity of accounting principles, the biggest problem in financial statement analysis is the influence of different cultures on operating environments. The debt to equity ratio of Japanese companies is relatively higher because Japanese banks are major capital providers to the Japanese companies. Banks work closely with the company management to know of its financing needs. It is important to understand cultural differences to draw correct conclusions from financial statement analysis. 7-2 (1) 193 x 100 = 2.29% 8,430 (2) (44) x 100 = (0.52)% 8,430
  5. 5. Chapter 7 73 (3) Differences arise from a variety of sources. Examples include the allowable maximum period for amortization versus expensing of expenditures. Such factors contribute to the difference in profit margin. 7-3 (1) First, the order of presentation is different. The Quaker Oats consolidated balance sheet format lists assets and liabilities in descending order of liquidity, while the ICI consolidated balance sheet assets employed begins with fixed assets category and ends with current assets category. The Quaker Oat consolidated balance sheet’s two grand totals are: “total Assets,” and “Total Liabilities and Shareholders’ equity”. The two grand totals of ICI are: Total assets less current liabilities”, and the other one not labeled shows the total of noncurrent liabilities and shareholders’ equity. Second, the terminology is different. Some examples of the differences in terms used in the two balance sheets are: • Stocks vs. inventories • Debtors vs. trade accounts receivable • Called up share capital vs. preferred stock and common stock • Profit and loss account vs. reinvested earnings (2) ICI Consolidated Balance Sheet December 31, 1998 Millions Assets Current assets: Cash £ 367 Marketable securities 455 Accounts receivable, net of allowances 2,360 Inventories 1,213 Total current assets 4,935 Property, plant and equipment, net 3,816 Investments 170 Intangible assets, net of amortization 652 Total assets £ 9,033 Liabilities and shareholders’ equity Current liabilities: Short-term debt £ 1,445 Current portion of long-term debt 585 Accounts payable and other liabilities 2,356 Total current liabilities 4,386 Long-term debt 2,954 Other liabilities (£ 55 + £ 1,429) 1,484
  6. 6. 74 Chapter 7 Deferred liabilities 11 Minority interest 49 Common stock 728 Additional paid-in capital 587 Accumulated deficit (£ -1,181 + £15) (1,166) Total liabilities and shareholders’ equity £ 9,033 (3) The Quaker Oats Company Group Balance Sheet 31 December 1998 Assets employed $M Fixed assets: Intangible assets $ 245.7 Tangible assets 1,070.2 Other 79.4 1,395.3 Current assets: Stocks 261.4 Debtors 283.4 Investments 27.5 Cash (and cash equivalents) 326.6 Other 216.1 1,115.0 Total assets 2,510.3 Creditors due within one year: Short-term borrowings 41.3 Current installments of loans 95.2 Other creditors 872.6 1,009.1 Net current assets 105.9 Total assets less current liabilities $1,501.2 Financed by Creditors due after more than one year: Loans $ 795.1 Other creditors 533.4 $ 1,328.5 Shareholders’ funds-equity: Called up share capital (1) 940.0 Share premium account 78.9 Own shares (2) (1,205.9) Profit and loss account reserve 555.8 Other reserves (3) ( 196.1) $1,501.2
  7. 7. Chapter 7 75 (1) $840.0 + $100.0 (2) $(1,176.0) + $(29.9) (3) $(48.4) + $(80.1) + $(67.6) 7.4 Students’ answers will vary depending on the annual reports reviewed and analyzed. 7.5 The report should elaborate on the following points: (1) a. Financial ratios are based on historical cost. Users may think that amounts reflect current prices. b. If substantial amounts reflect estimates, such as for depreciation and amortization, ratios lose their effectiveness for intercompany comparisons. c. Different companies use different alternatives allowed by accounting standards, such as LIFO and FIFO. Use of different methods within the same accounting framework makes intercompany comparisons difficult. d. Some informational items are not included in financial statements. Examples are labor relations, competitors’ actions, product innovations, etc. (2) a. Countries may use valuation bases other than historical cost. b. Flexibility in the maximum period allowed for specific items such as depreciation impedes comparability, since the maximum periods are not the same worldwide. c. Acceptable alternatives for applying accounting principles vary among countries. For example, some countries do not allow LIFO. d. Disclosure requirements vary greatly across countries. e. Operating environments and business customs and practices differ in different parts of the world. f. In some countries, tax laws heavily influence the amount of reported income. This has a direct effect on the amount reported. 7.6 The report on general limitations of financial trend analysis should elaborate on the following: a. The base year selection decision has a significant impact on the long- term trend. b. The base year cannot be a negative number, because the trends cannot be developed from using a negative year. c. It is desirable to use the local currency for trend analysis because translating to a domestic currency can distort the underlying financial relationships.
  8. 8. 76 Chapter 7 7-7 (1) Quaker Oats ICI a. Current ratio 1,115.0 ÷ 1,009.1 = 1.10 4,395 ÷ 4,386 = 1.0 b. Debt ratio *2,337.6 ÷ 2,510.3 = 0.93 *8,835 ÷ 9,033 = 0.98 *Total liabilities: Quaker Oats $1,009.1 + $795.1 + $533.4 = $2,337.6 ICI £4,386 + £2,954 + £55 + £1,429 + £11 = £8,835 (2) Current ratio measures the ability of a firm to pay its current liabilities. The debt ratio shows the extent to which a company is leveraged. It is an indication of the extent to which the assets of a company are financed by creditors. (3) Exhibit 7-4 does not contain information on the amount of current liabilities. Therefore, it is not possible to compute current ratio based on the information provided in Exhibit 7-4. 7-8 (1) a. 6,794,619 ÷ 6,299,053 = 1.079 b. 179,004 ÷ 6,794,619 = 0.026 c. 179,004 ÷ 6,299,053 = 0.028 d. 179,004 ÷ 1,823,665 = 0.098 e. *(6,299,053 – 1,823,665) ÷ 6,299,053 = 0.710 f. *(6,299,053 – 1,823,665) ÷ 1,823,665 = 2.454 *Total liabilities = Total assets – Stockholders’ equity (2) a. Efficiency b. Profitability c. Profitability d. Profitability e. Coverage f. Coverage 7.9 Sony Annual Sales and Operating Revenue Trends 1995 1996 1997 1998 1999 Amount (¥) 3,990,583 4,592,565 5,663,134 6,755,490 6,794,619 Annual Trends 100.00% 115.09% 141.91% 169.29% 170.27%
  9. 9. Chapter 7 77 7.10 Sony Annual Sales and Operating Revenue Change Trends Year Change from the Previous Year 1996 4,592,565 – 3,990,583 x 100 = 15.09% 3,990,583 1997 5,663,134 – 4,592,565 x 100 = 23.31% 4,592,565 1998 6,755,490 – 5,663,134 x 100 = 19.29% 5,663,134 1999 6,794,619 – 6,755,490 x 100 = 0.58% 6,755,490 7-11 Annual Net Income (Loss) Trends Year 1 Year 2 Year 3 Year 4 Year 5 (1) Net income (loss) 6,932 1,123 2,467 3,251 (5,225) Annual trends 100.0% 16.2% 35.6% 46.9% (75.4)% (2) Net income (loss) - 1,123-6,932 2,467-1,123 3,251-2,467 -5,225-3,251 change trends 6,932 1,123 2,467 3,251 - (83.8)% 119.7% 31.8% (260.7)% 7.12 Net income (loss) change trends (percentages): Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Salman - 4,224-4,856 -1,996-4,224 * * * 4,856 4,224 - (13.0)% (147.0)% * * * Hasham - * 3,104-3,109 522-3,104 3,807-522 -3,794-3,807 3,109 3,104 522 3,807 - * 0.0% (83.2)% 629.3% (199.7)% *No change trends can be computed, since these years have negative base years.
  10. 10. 78 Chapter 7 7-13 (1) Current ratio in yen 100 million x 100 = 33.3% 300 million (2) Current ratio in U.S. dollars 100 million x 99 x 100 = 33.33% 30 million x 99 (4) The answers are the same in both requirements above since the year-end change rate is a constant number for both numerator and denominator. 7-14 (1) 890 – 750 x 100 = 18.67% 750 (2) (890 ÷ 0.17) – (750 ÷ 0.17) x 100 = 18.67% (750 ÷ 0.17) (3) (890 ÷ 0.14) – (750 ÷ 0.14) x 100 = 18.67% (750 ÷ 0.14) (4) (890 ÷ 0.14) – (750 ÷ 0.17) x 100 = 44.10% (750 ÷ 0.17) (5) Using different year-end exchange rates causes distortion in the change trend analysis. This is obvious from comparing the results in the first three requirements with the result in requirement (4). 7.15 Students’ answers will vary for this problem. 7.16 Students’ answers will vary for this problem. Case: Lustra S.p.A. (B) (1) Exhibit 7-18 contains amounts of profit on ordinary activities that is attributable to ordinary shares, and earnings per share amounts for years 1990-1992. From the information, it is obvious that the average number of common shares outstanding is one million. For example, the 1990 profit on ordinary activities and attributable to ordinary shareholders is £1,050,000. The earnings per share is £ 1.05. Therefore, the average number of common share outstanding must have been one million. The same is true for 1991 and 1992 regarding the average number of common shares outstanding.
  11. 11. Chapter 7 79 Lustra’s 1992 earnings for the purpose of computing basic earnings per share in compliance with FRS3 are: Trading profit £ 850,000 Exceptional items: Unprofitable store closings £(500,000) Inventory disposal (600,000) (1,100,000) Operating loss on ordinary activities £ (250,000) Loss per ordinary share £ (0.25) (2) The adjusted earnings per share figure should be based on trading profit of £ 850,000. Adjusted earnings per share: £ 850,000 ÷ 1,000,000 = £ 0.85 By presenting the adjusted 1992 earnings per share figure, Lustra will accomplish two purposes: • It would have a better chance of selling the shares at higher price than otherwise. • It would remove the nonrecurring items in the earnings per share computations, thus decreasing volatility of this figure across periods. (3) Whether FRS3 represents a significant improvement over SSAP3 is debatable. By totally ignoring the inclusion of extraordinary items, one may argue that SSAP3 excluded information that might be of interest to some investors. On the other hand, FRS3 limits extraordinary items to very rare occurrences. This means that material items that are both unusual and infrequent may end up as being part of ordinary activities. If so, this would result in a misleading basic earnings per share figure. Also, as the critics pointed out to the Accounting Standards Board, such a treatment lends itself to volatility of reported earnings. (4) Mr. Harold Denning pointed out to Mr. Peter Scala that the FRS3 earnings per share calculation, when first proposed by the Accounting Standards Board, “was bitterly opposed by the business and financial analysts communities.” As a compromise, the Accounting Standards Board “agreed to permit companies to disclose an alternative earnings per share figure that the reporting company believed was a more useful one for investors.” It may very well encourage Mr. Scala to go ahead and list on the London Exchange with the assumption that the investors would pay more attention to the alternative earnings per share figure than the basic figure. Since Mr. Denning himself has already suggested a wording that states that “the adjustments give a better underlying picture” of the company’s performance, there is no risk of a potential problem from the independent auditor in this regard.