1. International Financial
Statement Analysis
Trends in global trade, investment, and external finance, documented in Chapter
1, imply that financial managers, vendors, investors, equity research analysts,
bankers, and other financial statement users have a growing need to read and
analyze nondomestic financial statements. Cross-border financial comparisons
are vital when assessing the financial promise and soundness of a foreign direct
or portfolio investment. There has been tremendous growth in international
capital issuance and trading in recent years due to privatizations, economic
growth, relaxation of capital controls, and continued advances in information
technology.
The need to use, and therefore understand, nondomestic financial statements
has also increased as merger and acquisition activities have become more
international. The value of cross-border mergers grew steadily during the 1990s,
and this growth shows no signs of abatement
2. • Finally, as business becomes more global, financial statements
become more important than ever as a basis for competitive analysis,
credit decisions, business negotiations, and corporate control.
Continued reduction in national trade barriers, the emergence of
Europe as a unified market, convergence of consumer tastes and
prefer- ences, and a growing sophistication of business firms in
penetrating nondomestic markets have significantly intensified
multinational business competition. All this creates a further need for
international financial statement analysis and valuation. This chapter
synthesizes information presented in Chapters 1 through 8. It
examines opportunities and challenges encountered in analyzing
foreign financial statements, and provides suggestions for the analyst.
3. BUSINESS ANALYSIS FRAMEWORK
• Palepu, Bernard, and Healy provide a useful framework for business
analysis and valu- ation using financial statement data.3 The
framework’s four stages of analysis (discussed in more detail in the
following pages) are: (1) business strategy analysis, (2) accounting
analysis, (3) financial analysis (ratio analysis and cash flow analysis),
and (4) prospective analysis (forecasting and valuation). The relative
importance of each stage depends on the purpose of the analysis.
The business analysis framework can be applied to many decision
contexts including securities analysis, credit analysis, and merger and
acquisition analysis
4. INTERNATIONAL BUSINESS STRATEGY ANALYSIS
• Business strategy analysis is an important first step in financial
statement analysis. It provides a qualitative understanding of a company
and its competitors in relation to its economic environment. This
ensures that quantitative analysis is performed using a holistic
perspective. By identifying key profit drivers and business risks, business
strategy analysis helps the analyst make realistic forecasts.4 Standard
procedures for gathering information for business strategy analysis
include examining annual reports and other company publications, and
speaking with company staff, analysts, and other financial professionals.
The use of additional information sources, such as the World Wide Web,
trade groups, competitors, customers, reporters, lobbyists, regulators,
and the trade press is becoming more common. The accuracy, reliability,
and relevance of each type of information gathered also needs to be
evaluated.
5. • Business strategy analysis is often complex and difficult in an
international set- ting. As noted previously, key profit drivers and
types of business risk vary among countries. Understanding them can
be daunting. Business and legal environments and corporate
objectives vary around the world. Many risks (such as regulatory risk,
foreign exchange risk, and credit risk, among others) need to be
evaluated and brought together coherently. In some countries,
sources of information are limited and may not be accurate.
7. • What Is Ratio Analysis?
• Ratio analysis is a quantitative method of gaining insight into a company's
liquidity, operational efficiency, and profitability by studying its financial
statements such as the balance sheet and income statement. Ratio analysis
is a cornerstone of fundamental equity analysis.
• What Does Ratio Analysis Tell You?
• Investors and analysts employ ratio analysis to evaluate the financial health
of companies by scrutinizing past and current financial statements.
Comparative data can demonstrate how a company is performing over
time and can be used to estimate likely future performance. This data can
also compare a company's financial standing with industry averages while
measuring how a company stacks up against others within the same sector.
• Investors can use ratio analysis easily, and every figure needed to calculate
the ratios is found on a company's financial statements.
8. • Ratios are comparison points for companies. They evaluate stocks
within an industry. Likewise, they measure a company today against
its historical numbers. In most cases, it is also important to
understand the variables driving ratios as management has the
flexibility to, at times, alter its strategy to make its stock and company
ratios more attractive. Generally, ratios are typically not used in
isolation but rather in combination with other ratios. Having a good
idea of the ratios in each of the four previously mentioned categories
will give you a comprehensive view of the company from different
angles and help you spot potential red flags.
9. Types of Ratio Analysis
• The various kinds of financial ratios available may be broadly grouped into
the following six silos, based on the sets of data they provide:
• 1. Liquidity Ratios
• Liquidity ratios measure a company's ability to pay off its short-term debts
as they become due, using the company's current or quick assets. Liquidity
ratios include the current ratio, quick ratio, and working capital ratio.
• 2. Solvency Ratios
• Also called financial leverage ratios, solvency ratios compare a company's
debt levels with its assets, equity, and earnings, to evaluate the likelihood
of a company staying afloat over the long haul, by paying off its long-term
debt as well as the interest on its debt. Examples of solvency ratios include:
debt-equity ratios, debt-assets ratios, and interest coverage ratios.
10. • 3. Profitability Ratios
• These ratios convey how well a company can generate profits from its
operations. Profit margin, return on assets, return on equity, return
on capital employed, and gross margin ratios are all examples of
profitability ratios.
• 4. Efficiency Ratios
• Also called activity ratios, efficiency ratios evaluate how efficiently a
company uses its assets and liabilities to generate sales and maximize
profits. Key efficiency ratios include: turnover ratio, inventory
turnover, and days' sales in inventory.
• 5. Coverage Ratios
• Coverage ratios measure a company's ability to make the interest
payments and other obligations associated with its debts. Examples
include the times interest earned ratio and the debt-service coverage
ratio.
11. • 6. Market Prospect Ratios
• These are the most commonly used ratios in fundamental analysis.
They include dividend yield, P/E ratio, earnings per share (EPS), and
dividend payout ratio. Investors use these metrics to predict earnings
and future performance.
• For example, if the average P/E ratio of all companies in the S&P 500
index is 20, and the majority of companies have P/Es between 15 and
25, a stock with a P/E ratio of seven would be considered
undervalued. In contrast, one with a P/E ratio of 50 would be
considered overvalued. The former may trend upwards in the future,
while the latter may trend downwards until each aligns with its
intrinsic value.
12. What Are the Uses of Ratio Analysis?
• Ratio analysis serves three main uses. First, ratio analysis can be
performed to track changes to a company over time to better
understand the trajectory of operations. Second, ratio analysis can be
performed to compare results with other similar companies to see
how the company is doing compared to competitors. Third, ratio
analysis can be performed to strive for specific internally-set or
externally-set benchmarks.
13. Why Is Ratio Analysis Important?
• Ratio analysis is important because it may portray a more accurate
representation of the state of operations for a company. Consider a
company that made $1 billion of revenue last quarter. Though this
seems ideal, the company might have had a negative gross profit
margin, a decrease in liquidity ratio metrics, and lower earnings
compared to equity than in prior periods. Static numbers on their
own may not fully explain how a company is performing.
14. FINANCIAL STATEMENT ANALYSIS AND
AUDITING
• In our earlier section on accounting analysis, we noted the importance of
assessing the quality of the information contained in a firm’s published
accounts. Thoughtful readers must judge the adequacy of accounting
measurements employed and remove distor- tions caused by the use of
accounting methods deemed inappropriate. A corollary of this quality
assessment is an assessment of the credibility of the information provided,
• irrespective of the measurement rules employed. In addition to questions
of informa- tion quality and quantity, financial analysts must be relatively
free from undue risk due to fraud or deception on the part of those making
the financial representations. We now discuss the attest or audit function
and the role it plays in international financial state- ment analysis
15. The Attest Function
• Independent auditors perform the attest function in financial reporting. As
competent outside experts they review financial information provided by a firm’s
management and then attest to its reliability, fairness, and other aspects of
quality. This process estab- lishes and maintains the integrity of financial
information.
• While auditing processes are rooted in antiquity, the growth of auditing as a
separate and distinct profession during the nineteenth century was encouraged
by the enactment in the United Kingdom, circa 1845, of a requirement that
companies keep accounts which had to be audited by persons other than
directors. The earliest accounting body was the Society of Accountants in
Edinburgh
• Investors and other readers of financial statements have a big stake in the
attestation of professional auditors. They can make decisions with better
expected outcomes if they have relatively better information available. The public
is also better served. Incomplete, unreliable, or even misleading financial
information may well have a negative effect on capital formation processes within
an economy. Moreover, scarce resources may be misdirected to socially less
desirable channels or wasted through excessive rates of bankruptcy. Sensitivity to
the importance of the attest function is probably higher in multinational settings
than it is in single-country situations
16. • Aside from decision and public interest effects, independent audits
introduce effi- ciency into the financial reporting process. If users of
financial information had to obtain firm information on their own and
verify this information item by item and user by user, an immensly
costly process would ensue. In this regard, division of responsibilities
pro- duces net benefits. Management has a comparative advantage in
preparing and offering financial information needed by outsiders.
Auditors, in turn, have a comparative advan- tage in ensuring that
management’s financial representations are relatively free of bias.
Their independent attestations enable statement readers around the
world to discrimi- nate among generally acceptable and unacceptable
accounting practices and to assess the overall quality of financial
reports at a lower cost than would otherwise be the case.
17. The Audit Report
• The auditors’ attestation is typically communicated to financial statement readers
by way of an audit report. This report either follows, or in some cases, precedes
the firm’s princi- pal financial statements appearing in its annual report. But,
what is included in such a report? Do auditors in all countries employ identical
reporting formats? Exhibit 9-8 contains a taxonomy of audit reporting
requirements in a sample of countries
• United Kingdom
• The auditor’s report discloses the responsibilities of company directors and the
scope of the audit; basis of opinion and statement of opinion. The balance sheet,
income statement, and related notes must be covered by statute; auditing
standards extend this coverage to the cash flow statement. The auditors’ opinion
must state whether the financial statements give a true and fair view and that the
statements comply with statutory requirements. Auditors must state that they
have read other information contained in the audit report, including the
corporate governance statement, and describe implications for the audit report if
the auditors become aware of any inconsistencies. The scope section also
explains the auditor’s responsibilities in relation to the separate directors’ report,
the accounting records, information and explanations required, and rules
regarding the disclosure of directors’ remuneration
18. United States
• A standard three paragraph report identifies the company and the
principal financial statements being audited (scope) and states the
responsibilities of management and the auditor. The auditor must
indicate whether or not the audit complied with generally accepted
auditing standards. The auditor must express an opinion as to
whether the financial statements are presented fairly in accordance
with GAAP and whether GAAP has been consistently observed in
relation to reports in previous years. If an opinion cannot be
expressed this must be stated.
19. Sweden
• The Swedish Companies Act requires the auditor statements about:
• 1. The preparation of the annual report is in accordance with the Act.
• 2. The adoption of the balance sheet and income statement.
• 3. The proposal included in the administration report for disposition
of the unappropriated earnings or deficit.
• 4. The discharge from the liability of members of the board of
directors and the managing director
