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Analysis of Foreign Financial Statements

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  1. Analysis of Foreign Financial Statements • Reasons for analyzing foreign financial statements. • Problems encountered in analyzing foreign financial statements. • Possible solutions to problems encountered in analyzing foreign financial statements.

  2. Reasons to Analyze Foreign Financial Statements Foreign portfolio investment • Investors can diversify away some risk by investing internationally. • While stock returns in many countries are positively correlated with U.S. returns, these correlations are far from perfect. • International investors, including managers of international mutual fund, rely on foreign financial statements. Learning Objective 1

  3. Reasons to Analyze Foreign Financial Statements International mergers and acquisitions • The frequency and size of international corporate mergers has increased in recent years. • Examples include Daimler/Chrysler and acquisitions by Ford Motor such as Volvo (of Sweden). • The purchaser of an international company needs to analyze the target company’s financial statements to determine the acquisition price. Learning Objective 1

  4. Reasons to Analyze Foreign Financial Statements Other reasons • Extending credit for foreign customers. • Evaluating foreign vendors. • Comparisons to international competitors. Learning Objective 1

  5. Foreign Financial Statement Analysis – Problems and Solutions Data accessibility • Relative to the U.S., financial information is difficult to obtain in many countries. • While databases of foreign financial statements do exist, these can contain errors and present information in a variety of formats. • These databases also do not contain complete disclosure notes. • Another approach is to obtain a copy of the foreign company’s annual report. Learning Objectives 2 and 3

  6. Foreign Financial Statement Analysis – Problems and Solutions Language • Many international companies do not produce financial statements in English. • The financial statement user could hire a translator or develop foreign language capability. • Since English is the language of business, companies in many foreign countries produce convenience translations of their financial statements in English. Learning Objectives 2 and 3

  7. Foreign Financial Statement Analysis – Problems and Solutions Currency • Many international companies produce their financial statements in a currency other than the U.S. dollar. • These can be converted to U.S. dollars by translating all balances at the exchange rate at the end of the current year. • In order to avoid distortions, the current exchange rate should be used for all previous years. • Analysis using ratios is not distorted by different currencies. Learning Objectives 2 and 3

  8. Foreign Financial Statement Analysis – Problems and Solutions Terminology • Differences in terminology exist between countries using the same language. • For example, sales in the U.S. is normally called turnover in the UK. • In cases of convenience translations, sometimes these include terminology unfamiliar to English speakers. • Knowledge of the business and accounting environment can help alleviate some of these problems. Learning Objectives 2 and 3

  9. Foreign Financial Statement Analysis – Problems and Solutions Format • Some format differences are not problematic because the information is given, just in a different place. • However, other format differences are a problem because the information is not provided. • It is common in Europe not to provide cost of good sold. • This prevents an analyst from determining gross margin percentage and inventory turnover. Learning Objectives 2 and 3

  10. Foreign Financial Statement Analysis – Problems and Solutions Format • German and other continental European companies often do not distinguish between current and noncurrent liabilities. • This makes it difficult or impossible to compute a current ratio. • At least one Chinese company does not present sales as a separate item. • This would hinder analysis of top-line growth. Learning Objectives 2 and 3

  11. Foreign Financial Statement Analysis – Problems and Solutions Extent of disclosure • Disclosure internationally tends to be limited compared to the U.S. where full disclosure is fundamental. • Some of the most serious disclosure limitations are information on segments, asset valuation, foreign operations, interim statements, and reserves. • Lack of disclosure contributes to the significance of format problems. • Globalization of capital markets tends to enhance disclosure as companies attempt to attract investors. Learning Objectives 2 and 3

  12. Foreign Financial Statement Analysis – Problems and Solutions Timeliness • Timeliness is one aspect of the relevance of information. • This varies significantly internationally since filing deadlines differ from country to country. • Among developed countries, the U.S. and Canada are the most timely whereas continental Europe is the least. • Requirements about the frequency of information also vary internationally from quarterly to annual reporting. • There is very little investors can do to overcome these problems. Learning Objectives 2 and 3

  13. Foreign Financial Statement Analysis – Problems and Solutions Differences in accounting principles • Differences in accounting principles often result in significantly different income and other financial statement amounts. • Some of the biggest problem areas are consolidations, fixed asset valuation and depreciation, and goodwill. • These differences cause some investors to limit the scope of their investments. • Some investors attempt to reframe foreign financial statements to a more familiar GAAP. Learning Objectives 2 and 3

  14. Restating Foreign GAAP Net Income to US GAAP Net income

  15. Foreign Financial Statement Analysis – Problems and Solutions Differences in accounting principles • Another approach is to use a stripped down measure of earnings that excludes items most affected by diversity. • Some firms alleviate some of financial statement users’ problems in their convenience translation. • In summary, as the use of IFRSs becomes more widespread, many of these problems will abate. Learning Objectives 2 and 3

  16. Foreign Financial Statement Analysis – Problems and Solutions Business environment differences • Differences in culture and economic environments have an impact on the relevance of ratios. • A study of companies in Japan, Korea, and the U.S. found significant differences due to business environment. • For example, Japanese and Korean companies borrow much more on a short-term basis than U.S. companies, leading to lower current ratios. Learning Objectives 2 and 3

  17. Foreign Financial Statement Analysis – Problems and Solutions Business environment differences • Debt ratios also tend to be higher in Japan and Korea because of the sources of financing. • Lower profit margins in Japan, relative to U.S., can be partly explained by those companies focus on market share as opposed to profits. • In summary, an investor needs to be aware of these differences and not forgo potentially profitable investments. Learning Objectives 2 and 3

  18. Restating Foreign Financial Statementsto U.S. GAAP Form 20-F • Foreign companies that file non-U.S. GAAP financial statements with the SEC are required to complete a Form 20-F. • The Form 20-F reconciles net income and stockholders’ equity to U.S. GAAP. • However, there is no requirement to reconcile assets and liabilities. • In essence, this represents a partial restatement from foreign GAAP to U.S. GAAP. Learning Objective 4

  19. Restating Foreign GAAP Net Income to US GAAP Net income • You are employed by a US-based multinational, Exxon Mobil. You have been asked to compare Exxon’s profitability (net income) for 2006 with the profitability (net income) for 2006 of the following foreign-based multinationals: • BP • Royal Dutch Shell • Total • Petrobras • All of the information necessary for these comparisons can be found on the company websites.

  20. Restating Foreign GAAP Net Income to US GAAP Net income