RELATIVE IMPORTANCE OF COMPANY FINANCIAL STATEMENTS …
Transcript of RELATIVE IMPORTANCE OF COMPANY FINANCIAL STATEMENTS …
RELATIVE IMPORTANCE OF COMPANY FINANCIAL
STATEMENTS IN INVESTMENT ANALYSIS
Albert JM Bruinette
A dissertation submitted in part fulfilment of the requirements for the degree of Masters in
Commerce in the Faculty of Business Management
RAU
Study leader: Professor Aard Boessenkool
Faculty of Business Management
Johannesburg
July 1998
OPSOMMING
Die waardering van maatskappye, hetsy privaat of genoteerd, is ingewikkeld.
Dit is deels so omrede die faktore wat die waarde van 'n maatskappy bepaal
of beinvloed nie altyd bekend of duidelik is, aan die belegger.
Die belegger in maatskappye het toegang tot 'n wye verskeidenheid van
informasie bronne wat betrekking hou op 'n spesifieke maatskappy. Die
belegger moet keuses uit oefen van watter informasie branne gebruik gaan
word in die waardering van maatskappye. Die belegger moet hierdie keuses
maak as gevolg van beperkte hulpbronne beskikbaar.
Die finansiele state van 'n maatskappy is een van die informasie bronne
beskikbaar op 'n betrokke maatskappy, Die is van belang om die
belangrikheid van finansiele state as informasie bran in terme van nuttigheid
(uitwysing van waarde drywers) en toepaslikheid vas te stel.
Die studie beveel die relatiewe waarde van finansiele state aan by die
belegger. Die finansiele state van 'n maatskappy voldoen aan die vereistes
van nuttigheid en toepaslikheid wanneer finansiele state gebruik word om
maatskappye te waardeer. Die nuttigheid an toepaslikheid van finansiele
state word egter beperk onder sekere omstandighede en die belegger moet
kennis dra van hierdie omstandighede.
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ACKNOVVLEDGEMENTS
An extra special word of thanks to my mother, Andri Bruinette, for herconfidence in my abilities. Also for Marisa for her very real support during thelast two years. This study would never have seen the light of day without thesupport you have all given me. A word of thanks to my study leaderProfessor Aard Boessenkool for his advice and guidance.
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CONTENTS
OPSOMMINGACKNOWLEDGEMENTSCONTENTS
CHAPTER 1: STATEMENT OF THE PROBLEM1.1. Introduction1.2. Problem statement1.3. Study objectives1.4. Methodology1.5. Limitations of study1.6. Demarcation of the study
CHAPTER 2: LITERATURE ON SOURCES OF INVESTMENT INFORMATION
(i)(ii)(iii)
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2.1.2.2.
2.2.1.2.2.2.2.2.3.2.2.4.2.3.
2.3.1.2.3.2.2.3.3.2.3.4.
IntroductionQualitative characteristics of investment informationUnderstandabilityRelevanceReliabilityComparabilitySources of investment informationMarket indicesBrokerage firm research reportsNewspapers and magazinesAnnual company report
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CHAPTER 3: LITERATURE ON THE RELATIVE IMPORTANCE OF FINANCIAL STATEMENTS3.1. Introduction 243.2. Financial ratios 25
3.2.1. Profitability ratios 263.2.2. Debt management ratios 273.2.3. Market value ratios 283.3. Du Pont analysis 293.4. Economic Value Added 31
3.4.1. Cost of capital 323.4.1.1. Cost of debt 333.4.1.2. Cost of equity 343.4.1.3. Risk 35
3.4.1.3.1. Calculation of risk for listed companies 363.4.1.3.2. Calculation of risk for unlisted companies 37
3.5. Zulu principle 393.5.1. Growth companies 403.6. Relative importance of financial statements 41
CHAPTER 4: QUALIFICATION OF THE RELATIVE IMPORTANCE OF FINANCIAL STATEMENTS4.1. Introduction 424.2. Creative accounting 42
4.2.1. .Acquisitions 434.2.2. Disposals 444.2.3. Deferred consideration 454.2.4. Extraordinary and exceptional items 464.2.5. Off balance sheet finance 474.2.6. Contingent liabilities 484.2.7. Capitalisation of costs 494.3. Case studies 50
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CHAPTER 5: CONCLUSIONS AND RECOMMENDATIONS5.1. Conclusions
5.1.1. Qualitative characteristics5.1.2. Companyvaluation models and tools5.1.3. Creative accounting5.1.4. Relative importance of financial statements5.1.5. The role of the human factor in investment5.2. Recommendations
5.2.1 Gradingof investmentinformationsources5.2.2. Management
BIBLIOGRAPHY
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CHAPTER 1
STATEMENT OF THE PROBLEM
1.1. Introduction
The value of financial statements to stakeholders in a particular company differ from
stakeholder to stakeholder. There are numerous stakeholders involved in a particular
company. These numerous stakeholders interests are different for a particular company.
This diverse interest in a particular company by the various stakeholders result in the
different utilisation of the financial statements by the different stakeholders. The different
utilisation of the financial statements by the stakeholders lead to different values being
attached to financial statements by the numerous stakeholders. .
The following are but some of the stakeholder groups involved in a particular company;
• Management
• Employees
• Credit lenders and providers of credit
• Clients
• Governmentand regulating bodies, and
• Shareholders, analysts and investors
Information demanded from financial statements are different for the particular
stakeholders (Foster, 1986:2-9). This is because the source of the demand are different
for the particular stakeholders.
One source of demand for financial statement information by management arises from
management incentive contracts. The salaries of key management salaried employees
could be based upon pre-established corporate goals for return on invested capital. This
performance related management incentive contracts establish direct links to the
company's financial statements. Management also utilise financial statement information
in many of their financing, investment and operating decisions. A financial statement
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based ratio such as the debt-to-equity ratio or interest coverage ratio is very relevant in
the decision of how much long-term debt to raise.
The demand for financial statements by employees can arise from several motivations.
Employees can have a vested interest in the continued and profitable operations of their
firm. The financial statements are an important source of information about current and
potential future profitability and solvency. Employees can also demand financial
statements to monitor the viability of their pension plans (Foster, 1986:2-9).
In the ongoing relationship that exists between credit lenders and a company, financial
statements can play several roles. In the initial loan granting stage of the relationship,
financial statements typically are an important item. Indeed, many banks have standard
evaluation procedures that stipulate that information relating to liquidity, leverage,
profitability, and so on are to be considered when determining the amount of the loan, the
interest rate and the security to be requested. If the decision to grant a loan is made, the
terms of that loan may contractually stipulate that financial statement variables be an
important factor in determining the nature of the ongoing relationship. Many bank loans
include bond covenants that, if violated, can result in the bank restructuring the existing
loan agreement.
The relationship between a company and its clients can extend over many years. In
certain cases, these relationships take the form of legal obligations associated with
guarantees, warranties, or deferred benefits. This was the case where coal mines were
explored and mined solely for supplying coal to a particular Escom power plant (South
Africa's electricity utility). In other cases, the long-term association is based on continued
attention to customer service. Customers have a vested interest in monitoring the
financial viability of companies with which they have long-term relationships. This interest
is likely to increase when concerns develop about possible bankruptcy. The financial
statements of the company represent one source of information that customers can use to
make inferences about the viability of the company.
Demand for financial statement information by government and regulating bodies are
diverse. But one such area is that of revenue collection inter alia income tax, sales tax or
...value-added tax. To have a more effective revenue collection, government requires
insight into the financial statements of companies in order to determine the various taxes
owed to government (Foster, 1986:7). Financial statements is but one input into decision
making process for government. Other inputs such as political factors also may be
equally if not more important in some cases inter alia determining whether to approve a
government-backed loan guarantee or the policy platform of the. party in power.
Shareholders, analysts and investors demand for financial statement information is
huge. These parties require information in order to make decisions on which securities
(shares) to buy, retain or sell (Sharpe, 1981:533-544). These decisions are not limited to
which shares but also the timing of the purchases and sales of particular shares.
Shareholders, analysts and investors require information on companies, of which financial
statements are but one source of information, to value the securities of companies and
therefore make informed investment decisions .
The valuation of securities listed on a stock exchange by shareholders, analysts and
investors over the years have lead to several methods being developed. Some of these
methods have proved to be more effective than others. In general, the evaluation of
securities may be divided into two main categories, namely Technical and Fundamental
Analysis.
Technical Analysis involves the examination of past market data such as prices and the
volume of trading, which leads to an estimate of future price and, therefore an investment
decision. Whereas fundamental analysts use economic data that are usually separate
from the market, the technical analysts believes that using data from the market itself is
good because "the market is its own best predictor" (Joffe, 1995).
Technical analysis does not concern itself with the reasons for share price movements but
concern itself with the study of share price movements on the stock exchange (Sharpe,
1981:544-550). Technical analysts see no need to study the multitude of economic and
company variables to arrive at an estimate of future value because past price movements
will signal future price movements. Technicians also believe that a change in the price
trend may predict a forthcoming change in the fundamental variables such as earnings
...and risk earlier than it is perceived or anticipated by most fundamental analysts.
Technical analysts believe that all fundamental information is already factored into the
charts (graphs).
Joffe (1995:21-26) says that by analysing the different charts (graphs) inter alia showing
price behaviour, volume of transactions, new highs and lows, moving averages and
cycles, technical analysis attempts to identify areas of 'support' and 'resistance' as well as
future trends and potential price levels.
Technical analysts support the view "the market is its own best predictor" on the
assumption that the market value of any goods or services are determined solely by the
interaction of supply and demand. In fact, technical analysis is often termed demand and
supply analysis (Sharpe, 1981 :545). Supply and demand are governed by numerous
factors, both rational and irrational, inclUding factors such as opinions, moods and
guesses. The market react then to all these factors continually and automatically.
The technician usually attempts to predict short-term price movements and therefore
making recommendations concerning the timing of purchases and sales. Technical
analysis therefore concentrates on the short-term characteristics of specific securities or
of securities in general (Stevenson & Jennings, 1981 :207-219). It is sometimes said that
fundamental analysis is designed to answer the question "What?" and technical analysis
to answer the question "When?".
Technical analysts claim that a major advantage of their method is that it is not heavily
dependant on financial accounting statements - the major source of information about the
past performance of a firm or industry. The fundamental analysts evaluates financial
statements to help project future return and risk characteristics for industries or individual
securities.
Fundamental Analysis in a stock market context refers to those underlying factors which
affect the value of a share, and hence its price trend. Macro-fundamentals are the factors
affecting the market as a whole (Joffe, 1995:21-25). Included are the following:
...• Economic factors :-
The gross domestic product (GOP) is the rand value of all final goods and services
produced in the economy for a specific year. The growth in the GOP for the period
1996 and 1997 were 3,1% and 2% respectively and the forecast for 1998 is 2,7%
(Huysamer Stals, 1997:12-14). Historic growth of the South African economy were
erratic at best and through the GEAR program GOP growth has been set at 3% per
annum. The anticipation of a buoyant economy or recession may cause share prices
to rise or conversely to decline.
• Political factors :-
Markets in general dislike political instability and/or uncertainty. The national elections
in South Africa during 1994 caused uncertainty on the Johannesburg Stock Exchange
which caused share prices to move either sideways or downward.
• Monetary factors:-
The relationship between changes in the money supply and security prices has been
the subject of considerable research (Stevenson & Jennings, 1981:137-138).
Although considerable research has been conducted on the relationship between
money supply and security prices, the nature and specification of any relationship is
still not settled. Stock markets generally react positive on declining interest rates
particularly short-term rates. Conversely, markets can react negative if they suspect
rates are heading upwards.
• Industry factors :-
The shareholder, analyst and investor perform industry analysis because they believe
it helps them isolate investment opportunities that have favourable risk-return
characteristics. Consistent performance for specific time periods for different
industries would indicate that industry analysis is not necessary. For example,
assume that during 1998 the total stock market has experienced growth of 15% and
the returns for all industries were between 14% and 16%. If this was the result it
would be questioned whether it is worthwhile to find an industry that would return 16%'
when random selection would provide a return of 15%.
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Joffe (1995:21-25) says that micro-fundamentals refer to the factors specifically effecting
an individual security or group of securities. Attention towards parameters such as the
earnings of the company concerned, the dividends paid per share, the net asset value,
the debt/equity ratio - in short, all the information which companies normally provide in
their annual and interim reports (financial statements).
1.2. Problem statement
For many shareholders, analysts and investors the critical aspect of an investment
decision lies in the information available with which to make informed decisions on the
value of company securities.
The amount of information available on a company to the shareholder, analyst and
investor is however enormous (Stevenson & Jennings, 1976:53). This put the
shareholder, analyst and. investor before a selection problem as to which information
sources to utilise in the investment decision. The shareholder, analyst and investor wants
to use the relative important investment information as it would lead to an optimal effective
and correct valuation of a company being done.
The criteria that will be used in the selection of relative important investment information
sources are; qualitative characteristics that investment information sources must meet and.the input required from these investment information sources into company valuation
models or tools.
The first criteria of selection that the shareholder, analyst and investor have to go through
is to establish whether a source of investment information represent quality. This is
necessary as sources of investment information of poor quality could actually cloud the
investment decision and lead to poor valuation of companies (Stevenson & Jennings,
1976:53-66). The quality investment information source will enhance the investment
decision ain that an effective decision will be made and the benefit derived from such an
investment information source will be more than the cost involved in using the specific
investment information source (Vorster et aI., 1991 :14-18). The qualitative characteristics
...of all investment information sources, needs to be measured against the parameters of;
understandability, relevance, reliability, comparability and timeliness.
The second criteria of selection that the shareholder, analyst and investor have to go
through is to establish the input required of an investment information source into
company valuation models or tools. This will indicate that a specific investment
information source or a number of investment information sources are important in the
calculation of an "intrinsic value" for a company or business.
To the average shareholder, analyst and investor the annual report which include the
financial statements are the major source of primary information on a public company.
The financial statements contain an income statement, balance sheet, cashflow
statement, notes to the statements, the auditors report and a directors report (Winfield &
Curry, 1981:238-240).
The financial statements provide some basis for understanding the business activities and
the past financial performance of a company. The financial statements indicate to some
extent the breakdown of profitability betWeen different areas (divisions) and the fluctuation
of profits due to such factors as financial gearing (Stevenson & Jennings, 1981). The
financial statements indicate the influence of external factors such as; competition,
technological change and the economy on the company. It is evident that shareholders,
analysts and investors use the financial statements of a company extensively when
valuing companies for investment.
The problem is however, what is the relative importance of financial statements and can
financial statements be regarded as an important information source when it is but one
investment information source among many when valuing companies.
1.3. Study objectives
The primary objective of a shareholder, analyst and investor in the evaluation of a
company is to put a value on the company. This will enable these parties to make
decisions as to whether to buy, retain or sell the shares of the company but also to assist
in the timing of the purchase or sale of the shares (Foster, 1986).
The critical factor determining success in investment according to Warren Buffet is
"determining the intrinsic value of a business and paying a fair or bargain price"
(Hagstrom, 1994:v).
The fundamental approach to investment analysis assumes that each security has an
intrinsic value that can be determined on the basis of fundamentals as; earnings,
dividends, capital structure and growth potential (Foster, 1986:309). The financial
statements of a company also playa major role in determining the value of company when
applying the fundamental approach (Foster, 1986:2).
The primary study objective will focus on the relative importance of financial statements
as an information source in the evaluation process of a company in order to arrive at the
"intrinsic value" of a company. This objective will also take into consideration the other
information sources that needs to be studied.
The following objectives can be formulated for this study;
• Identification of parameters from the financial statements that could assist in
establishing the value of a company.
• Identification of other information sources that needs to be studied in the evaluation of
a company.
This study has as its objectives;
• To establish the relative importance of financial statements in the analysis of a
company for investment purposes.
• To establish what information from the financial statements needs to be studied when
analysing a company.
1.4. Methodology
A literature study will be under taken to establish what other information sources on a
company needs to be evaluated in order to place a realistic value on a company. A
literature study will also be under taken to establish the relative importance of studying
the financial statements of a company in order to place a value on a company. These
literature studies will confirm the relative importance of financial statements in the
valuation of companies for investment.
The literature studies are to be followed by an assessment of what factors will impair the
relative importance of financial statements as an investment information source.
Impairment of the relative importance of financial statements will be shown through
studying currently available financial statements of listed and recently listed companies on
the Johannesburg Stock Exchange (JSE).
1.5. Limitations of study
This study will focus primarily on the fundamental approach for the evaluation of
companies. Therefore the intrinsic value of a company needs to be established and then
it is to be compared with the market value of a company.
It is evident that numerous approaches exist for the evaluation of companies in order to
establish a value for a company. This study will only look at the fundamental valuation
approach and the relative importance of financial statements in this approach and is
therefore limited in that regard.
The study will also not cover all other information sources (besides the financial
statements) that needs to be studied or are available as all information sources represent
collectively a large number. The study is therefore limited in that only the relative
importance of financial statements as an information source in the investment decision will
be established.
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. ~ ..In order to establish the relative importance of financial statements the input from the
financial statements into the calculation of value for a company will be evaluated. A
thorough study will be conducted on a few valuation models which obtain their input
mainly from financial statement information. The study will not cover all valuation models
which obtain their input mainly from financial statement information.
This study is also limited in that it will also not focus on all fundamental factors such as
the broad indicators in the economy and a specific industry but merely on those that have
a direct influence on the establishment of value.
The field of investment is also very diverse and dynamic. The investment decision taken
by various participants also differ in regard to investment objectives and requirements of
participants. The term investment in this study relates to equity investment in listed
companies on any recognised stock exchange or investment in unlisted (private)
companies. The study is therefore limited in that only equity investment is considered and
the relative importance of financial statements in this type of investment decision.
1.6. Demarcation of the study
This study will consist of the following chapters and will continue as follows.
Chapter 2 will consist of a literature study on the sources of investment information. The
sources of investment information will be graded against parameters to establish which of
the respective sources of investment information represent quality.
Chapter 3 will consist of a literature study on the financial statements of a company. Key
indicators of value from the financial statements will be outlined which will also establish
the value of financial statements.
Chapter 4 consist of a research methodology. It will establish on what part of the investor
community this research study applies. A report on previous studies conducted on the
value of financial statements in the valuation of companies and the qualification of
financial statements will also be studied.
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Chapter 5 will make conclusions as to the relative importance of financial statements in
the evaluation of a company for investment purposes. Recommendations will also be
made in this regard.
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CHAPTER 2
LITERATURE ON SOURCES OF INVESTMENT INFORMATION
2.1. Introduction
The amount of investment information available on a company to the shareholder, analyst
and investor is enormous (Stevenson & Jennings, 1976:53). The sources of investment
information could vary from but not limtted to; financial newspapers and periodicals,
security market indices, the reports of companies, investment information services,.
brokerage houses, industry surveys, issuers of securities, economic summaries and
forecasts and software services for computers (Francis, 1976:140-182).
This enormous amount of available investment information put the shareholder, analyst
and investor before the choice as to which of the sources of investment information is to
be utilised. The cost involved in obtaining and utilising investment information may be
prohibitive in that the cost involved could be greater than the added return or reduced risk
achieved if the information were available (Everingham & Kleynhans, 1995:8).
Shareholders, analysts and investors are also usually tied to time constraints when
analysing investment information. The additional cost factors involved with investment
information versus the marginal utility thereof needs to be kept in mind (Stevenson &
Jennings, 1976:53).
The shareholder, analyst and investor also can not ignore available investment
information sources due to the enormous amount and believe that an informed investment
decision will be taken. Although the publication and standardisation of certain information
is governed by legislation, including the Companies Act, companies differ in competence
and integrity (Ogley, 1981:438-489). It may be noted that even with this drive towards
legislation and standardisation of information there are periodical lawsuits, Department of
Justice enquiries into failed companies, or when a chief executive is charged in a criminal
case, time and time again company directors state that they were not aware of the
requirements of the Companies Act and this is their excuse for their own incompetence or
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omissions. This is also evident from the recent number of fraud cases where companies
seemed to be sound due to creative accounting or giving fraudulent statements but were
not sound such as Masterbond (Blake & Salas, 1996:54-55; Hunt, 1997;22-23).
It is therefore evident that although shareholders, analysts and investors face constraints
studying all available investment information sources, the risk is inherent that if too little
information is studied uninformed investment decisions can be taken. This could have
disastrous consequences to a shareholder, analyst and investor.
Due to various constraints facing shareholders, analysts and investors utilising all
available investment information they need to be selective as to which investment
information is to be utilised. One such selection criteria for investment information is the
qualitative characteristics of investment information. The qualitative characteristics of an
investment information source is important in that the quality of an investment information
source influence the effectiveness of the investment decision (Edwards et al., 1989:445;
Vorster et aI., 1992:13-16). Investment information could be measured against
information qualitative characteristics such as but not limited to; understandability,
relevance, reliability, consistency, comparability, conservative, materiality and giving the
user of the information a competitive advantage (Edwards et aI., 1989:442-450).
2.2. Qualitative characteristics of investment information
The users of investment information sources need information to asses the risk, return
and the ability of companies to pay dividends. To do such an assessment on companies,
investment information need to provide information about the financial position,
performance and changes in the financial position of companies (Everingham &
Kleynhans, 1995:5-10).
Vorster (1992:16-20) says for investment information sources to provide such quality
information, investment information sources need to have the following inherent
qualitative characteristics;
• understandability
• relevance
• reliability
• comparability
2.2.1. Understandability
In order for investment information to be of any use to the user of such information, the
average user of such information must have some knowledge on business. The user of
investment information must be able to understand the information when giving the
necessary care when studying the investment informatton (Vorster et aI., 1992:17).
Investment information of a complex nature should not be ignored by shareholders,
analysts and investors merely because it may be too difficult for the users to understand if
it is relevant to the investment decision making process.
It is therefore assumed for shareholders, analysts and shareholders to understand
investment information, they must have;
=> a reasonable knowledge of business and economic activities,
=> a willingness to study the investment information with reasonable diligence.
2.2.2. Relevance
For information to be relevant, it must be pertinent to the investment or bear upon a
decision (Edwards et aI., 1989:447-448). The information must "make a difference" to
someone who does not already have the information. Relevant information is capable of
making a difference in a decision either by affecting user predictions of outcomes of past,
present, or future events or by confirming or correcting expectations.
Actions taken now can only affect future events, and information that posses predictive
value is obviously relevant (Everingham & Kleynhans, 1995:9). This is so as it improves
the users ability to predict outcome of future events.
Information however need not be a prediction to be useful in developing, confirming or
altering expectations. Expectations are commonly based on the present or past (Edwards
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et aI., 1989:447). For instance to predict future earnings of a company one would Iike·ly
start with a review of past and present earnings of the company. Information that merely
confirms prior expectations may be less useful, but is relevant in that it reduces
uncertainty (Everingham & Kleynhans, 1995:9).
Investment information sources that confirm the relative success of users in predicting
future outcomes posses feedback value (Edwards et aI., 1989:447). Information sources
that provide feedback make a difference in decision making due to;
:::::> reducing uncertainty in a situation,
:::::> confirm or deny previous expectations,
:::::> provide a basis for further predictions (Vorster et aI., 1992:18-19).
In order for information to be relevant it must be provided in time to be considered in
reaching a decision. The utility of investment information decreases with time. If
investment information is to be of any value in decision making it must be available before
the investment decision is made. If not, the investment information is useless.
2.2.3. Reliability
In addition to being relevant, investment information must be reliable to be useful
(Edwards et aI., 1989:448). The reliability of investment information depends on its;
:::::> representational faithfulness,
:::::> verifiability,
:::::> completeness,
:::::> neutrality
:::::> and free of bias.
Representational faithfulness is where information gives a reliable representation of the
activities that it purports to represent (Vorster et aI., 1992:18). A road map would be
representational faithful when it shows roads and bridges among other things where roads
and bridges actually exist. There is correspondence between what is shown on the map
and what is physically present.
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Verifiability of investment information represent the substantial duplication of information
by independent measures using the same measurement methods (Edwards et aI.,
1989:449). The duplication of information for a financial transactions could usually be
verified by investigating the support documents such as cheques, invoices and credit
notes to reconstruct the actual transaction that took place. Some transactions can not be
physically verified for instance non-cashflow items such as depreciation but can only be
verified by establishing what procedures other accountants would have followed when
allowing for depreciation.
Completeness means that all significant information must be disclosed in a way the
promote understanding and does not mislead with taking into consideration the
constraints of relevance and cost (Vorster et aI., 1992:19). In the financial statements full
disclosure could be made as a collective in the body of the financial statements, the notes
to the financial statements, in other special communications and in the chairman's report
or other management reports.
Neutrality of investment information means that it will not be represented in such a way as
to accomplish a specific end result (Vorster et aI., 1992:18). The primary concern should
be relevance and reliability of the information that results from application of the principle.
Neutral information is needed especially when parties with opposing interest such as
credit seekers and credit grantors rely on the same information. Non neutral information
in designed to favour one set of interested parties over others.
Free of bias is where information are consistently too high or too low due to the
measurement methods employed (Edwards et aI., 1989:448). In accounting bias could
exist as an example in the valuation of stock. Due to the use of the last-in-first-out (UFO)
principle in an inflationary environment stock could be valued to low due to the high priced
items not being part of the stock value as a whole.
2.2.4. Comparability
The qualitative concept of comparability attempts to introduce a common language into
the presentation of investment information about a company for different time periods to
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the users of such information (Vorster et aI., 1992:20). Comparability is not however' a
mindless process of standardisation and uniformity.
When comparability exist in investment information, reported differences and similarities
are real and not the result of differing accounting treatment (bias) and non-neutrality
(Edwards et aI., 1989:449-450). Comparable information will reveal relative strengths and
weaknesses in a single company over a period of time and between two or more
companies at the same point in time.
The purpose of comparisons is to detect and explain similarities and differences. To
make comparisons easier the idea of consistency in measurement methods and the
manner of display (presentations) is put forward (Everingham & K1eynhans, 1995:10)..
Without such a requirement the comparability of financial statements and other sources of
investment information would be significantly affected if not destroyed altogether.
2.3. Sources of investment information
The amount of information available to the shareholder, analyst and investor is enormous
(Stevenson &Jennings, 1976:53). For many the critical aspect of an investment decision
lies in the information available and with which investment information sources to utilise to
make a wise and thoughtful trade-off between investment alternatives.
Warren Buffet, the richest man in the United States according to the Forbes magazine in
1993, has obtained his wealth from investment in listed and private companies (Hagstrom,
1994:1-2). Warren Buffet says that to earn superior profits, individuals are required to
carefully evaluate a company's economic fundamentals (Hagstrom, 1994:52). Therefore a
shareholder, analyst and investor problems lie not in obtaining investment information
about a company but in determining which investment information about the company is
useful and then interpreting it.
u.
2.3.1. Market indices
An index is an indicator (Vaughn, 1974:145-156). A market index is an indicator of
activity in some market segment (Huysamer Stals, 1998:8-10). Many Johannesburg Stock
Exchange (JSE) market indices are published, some of which are; all share index (ALSI),
industrial index (INOI), gold index and financial shares index (FINI).
These indices are indicators of different things and, are therefore useful for different
purposes. For example someone, searching for a growth industry would be more
interested in the industrial and financial index than in the gold and all share index. The
gold mining industry is currently not viewed as a growth industry and the all share index
represent the stock market as a whole (Ogley, 1981:439-440). In 1998 the Johannesburg
Stock Exchange gold index has lagged the financial shares index.
Market indices furnish a handy summary of historical price levels in a particular market
segment (Francis, 1976:143-145). This information has several uses;
• Firstly, a person that own shares of a company in a particular market segment or
industry can quickly establish how market movements have affected the value of the
particular company and the market segment.
• Secondly, indices are useful for historical analysis (Sinai, 1995:150-153; Wade,
1995:163-167). By analysing market indices and economic indicators, a shareholder,
analyst and investor can detect some relationships between different market indices
and different economic indicators.
With reference to the quality of market indices as a source of investment information;
• Understandability, the market indices is an understandable source of investment
information as it merely represents a composition of all companies performance in a
specific market segment over specific period of time.
• Relevance, market indices has feedback value as an example it gives information
about past performance of an industry in relation to the market as a whole. A market
indices could also have predictive value as an example.where correlation's between
economic indicators and specific market indices have been found it could be used to
"
forecast future trends for specific market segments on the basis of changes in
economic indicators.
• Reliability, market indices is reliable in that it faithfully represent the trend of a specific
market segment and an indices is also neutral, free from bias.
• Comparability, the market indices is comparable for a specific indices over a period of
time as the information is readily available and is also comparable between market
segments as the different market segment indices are also available.
2.3.2. Brokerage firms research reports
One service that some brokers offer to their clients is research on specific company
securities. Many stockbroking companies have research staff whose function it is to
analyse companies and their shares. The purpose of such research is to identify
undervalued securities that have the potential for price appreciation (Vaughn, 1974:144).
In some cases these findings are published by the stockbroking company such is the case
with stockbroking company, Huysamer Stals. These findings are readily available to the
clients of the stockbroking company (Huysamer Stals, 1998). The cost of these research
reports are usually included in the commission when buying and selling shares.
The stockbroking company's recommendations mostly take the form of "buy", "hold" or
"sell". The word buy means that a shareholder, investor should purchase the shares or
add to current portfolio holdings at the price indicated by the stockbroking company. Sell
indicates the opposite to a buy recommendation. Hold signifies that a shareholder or
investor should not purchase shares but should not sell the shares if already owned. A
hold recommendation therefore must not be viewed as a neutral recommendation.
The individual shareholder and investor should use such research reports in conjunction
with other sources of investment information. It must be remembered that stockbroking
firms and the traders at stockbroking firms profit from the commissions when buying and
selling shares (Mayo, 1980:142).. There is with stockbroking companies a natural bias to
encourage buying and selling of shares as opposed to holding money or placing it in a
savings account.
With reference to the quality of brokerage firms research reports as a source 'of
investment information;
• Understandability, the research reports are understandable and easy to read.
• Relevance, the research reports present relevance in the form of 'inside information'
due to interviews with the management of companies. The research reports could
present feedback (confirmatory) and predictive value but that is a function of the
research capabilities of the stockbroking company. The stockbroking companies is
rated on a yearly basis as to which companies provided and represented the best
research capabilities.
• Reliability, the reliability of the research reports are difficult to asses as one can not
establish whether the report faithfully represent the information it purports to represent
and whether the report is free from bias (neutral) is difficult. Due to the nature of the
above factors one could question the reliability of brokerage firm research reports.
• Comparability, the comparability of research reports are low and comparability is.
mainly in the form of past recommendations and present and future outcomes of such
recommendations.
2.3.3. Newspapers and magazines
The are various financial newspapers in South Africa; Business Day, The Star - Business
Report and Rapport - Sake Rapport to name but a few. These daily and weekly
newspapers publishes not only equity prices but also bond prices, prices of commodities,
treasury securities and foreign currencies (Mayo, 1980:142-145). These financial
newspapers includes news bulletins that are issued by various companies and editorial
comments on the national economy and economic policy (Ogley, 1981 :438-445). The
editorial comments tend to stress those policies that affect the investment community such
as the money supply rate (Wilmot, 1995:167-173).
These newspapers publishes earnings reports of companies and make announcements of
dividends that have been declared (Stevenson & Jennings, 1976:61-64). It also indicates
to shareholders, analysts and investors when is the last day to register for an upcoming
dividend, by owning shares in the particular company.
,.
A variety of magazines also report financial news such as; Financial Mail, Finance Week
and Finansies & Tegniek. The shareholder, analyst and investor that is interested in a
particular industry could read specialised trade journals such as Martin Kramers
Engineering News which covers most developments and happenings in the engineering
industry. Such specialised trade publications will help investors, analysts and investors
keep abreast of events in a particular industry.
With reference to the quality of newspapers and magazines as a source of investment
information;
• Understandability, newspapers and magazines are written to be understood by the
public in general.
• Relevance, newspapers and magazines do have relevance where specific economic
factors that have an influence on the investment community are followed and reported
to the investment community (Wilmot, 1995:167-173). Newspapers and magazines
therefore could have feedback and predictive value where specific factors that have an
influence on the investment community such as money supply and savings rates of the
population at large are reported on (Wade, 1995:163-167).
• Reliability, newspapers and magazines are usually neutral in a democratic society and
play the role of watchdog and protector for the public at large. The reliability of
newspapers and magazines related to the presentation of information to the
investment community is good.
• Comparability, the comparability of information presented on a specific company and
between companies are low due to the nature of reporting on activities in the
investment community.
2.3.4. Annual company report
Companies listed on the Johannesburg Stock Exchange (JSE) are required by law and
stock exchange listing requirements to publish annual and semi-annual company reports.
These listed companies are also required to publish news bulletins giving any pertinent
changes in the company's financial position and any other information that may influence
the value of the company's shares. Companies not listed on the Johannesburg Stock
Exchange (JSE) are required by law to publish annual financial statements.
....
The annual company report is perhaps the most important source of investment
information (Mayo, 1980:138-140). The annual company report includes a substantial
amount of factual and financial information. Companies use the annual report to explain
their achievements of the past year. These discussions are in general terms, but the
company's careful selection of words may allow the shareholder, analyst and investor to
read "between the lines". The more substantive material is presented in the financial
statements especially in the notes to the financial statements. The notes to the financial
statements provide insight into the construction of -the financial statements and the
discovery of creative accounting is mads possible (Blake &Salas, 1996:54-55).
The typical annual report begins with a letter from the chairman of the company to the
shareholders. The letter reviews the highlights of the year and point out certain
noteworthy events such as dividend increases or take-overs that took place (Vaughn,
1974:144-145). The letter may give an indication of immediate expected future events
such as the next years sales growth and earnings. Warren Buffet's company, Berkshire
Hathaway, present yearly very lengthy annual reports. Warren Buffet believes that a
company must be candid with its shareholders and therefore believes in telling both the
good and the bad aspects of the business (Hagstrom, 1994).
The letter from the chairman is usually followed by a general description of the various
components of the business. It may even for example illustrate with words and pictures
the various products and services the company make and sell, the type of research and
development in which the company is engaged, the particular application of the
company's products and services in different market segments and the outlook for the
company's products and services in the different market segments.
The descriptive material on the components of the business is followed by a set of
financial statements. These financial statements are audited and certified on a yearly
basis by accountants (Edwards et aI., 1989). The financial statements include the
balance sheet as at the end of the company's financial year, the income statement for the
financial year and the cashflow statements. A summary might also be given for group
activities when the group consist of a number of operating companies (Ogley, 1981 :438-
441). The financial statements might also include a summary of previous years financial
statements. These summaries permits the shareholder, analyst and investor to view the
company's growth in sales, earnings and dividends as well as the value of the different
classes of fixed and working capital assets.
With reference to the quality of the annual company report as a source of investment
information;
• Understandability, the South African framework follows closely the International
Accounting Standards Committee (IASC) statement on the topic of accounting
standards (Everingham & Kleynhans, 1995:5). It is stated in statement ACOOO that
financial statements are to be understandable.
• Relevance, the financial statements of companies present a lot of feedback
(confirmatory) and predictive value to users in the investment community. This can be
seen in the number of company valuation tools that are used to value a company.
These company valuation tools derive mainly their input from company financial
statements. Some of the company valuation tools that are used include; company
financial ratios, Du Pont analysis, Economic Value Added and the Zulu principle.
• Reliability, the company financial statements represent faithfully transactions and other
events it purports to represent or could reasonably be expected to represent. The
financial statements are usually neutral (free from bias). The company financial
statements are the responsibility of the auditors and directors of the company. There
have been cases where one or both parties responsible for the financial statements
have 'influenced' the financial statements for a particular reason (Blake & Salas,
1996:54-55). The 'influencing' of financial statement by one or both parties will then
obviously lead to financial statements and annual reports to be biased (not neutral).
• Comparability, the financial statements of companies posses the quality of
comparability and which is one aspect that influence shareholders, analysts and
investors to rely a lot on financial statements when valuing a company.
CHAPTER 3
LITERATURE ON THE RELATIVE IMPORTANCE OF FINANCIAL STATEMENTS
3.1. Introduction
-- Different companies have different accounting practises despite the attempts at
- standardisation. Companies may choose among 'several procedures for reporting
expenses, assets or liabilities and these,"alternative" accounting procedures can produce
- vastly different values for expenses, income, return on assets and return on equity..
_ Therefore the shareholder, analyst and investor can have trouble in comparing the
financial statements of two firms in the same industry, much less in different industries
(Winfield & Curry, 1981 :227-261). These different accounting practises is often cited as
one reason for financial statements of companies not to be regarded as of relative
importance when valuing companies.
The standardisation of financial statements is not to important if the latest financial results
are seen as part of a series of financial results beginning five or ten years ago and
stretching for a period into the future. The shareholder, analyst and investor look at how
the latest results fit into the pattern of historical results and how it will impact on future
results. The financial statements performs a role of confirmation of information gathered
and anticipated from other sources of information.
In establishing the value of financial statements in the analysis of companies for
investment it would be prudent to look at valuation models for companies and the input of
financial statements in the various valuation models. Studyinq of these valuation models
vvould indicate the importance that financial statements play in these valuation models.
The relative input of financial statements in the various valuation models would indicate
the relative importance of financial statements in the analysis of companies for investment
and therefore the value of financial statements (Amling & Droms, 1994; Brigham, 1989;
Dobbins et aI., 1996).
A number of valuation models have been developed that attempt to deal with the special
valuation problems posed by common stock. Some of these valuation models will now be
studied as well as the input of financial statements in these valuation models.
3.2. Financial ratios
Financial ratios are but one valuation model used in the performance assessment of
companies (Gardiner & Bagshaw, 1997:30; Helfert, 1987:19). A financial ratio express
the relationship between one quantity and another. While the computation of financial
ratios is simple, the interpretation thereof tends to be far more complex. Ratios are not
absolute criteria but meaningful ratios point out changes in financial and operating
conditions within a company. These changes illustrate patterns of risk or opportunity
when valuing a company.
Financial ratios are based on historical information which is extracted from. the financial
statements of a company (Peterson, 1974:1-9). It is a so that, the valuation of companies,
is simply valuing its future earnings power (Hagstrom, 1994:27-48). A company's value
could be found by estimating the earnings of the company and multiplying those with an
appropriate capitalisation factor or multtplier. This factor is influenced by the company's
stability of earnings, assets, dividend policy and financial health. Valuation of companies
using financial ratios based on financial statements that deals in historical information
may be difficult (Francis, 1988:237-238). Since financial ratios are used by shareholders,
analysts and investors to make projections about the future of a company it is important
for shareholders, analyst and investors to understand the factors that will affect the
financial ratios in the future (Gardiner & Bagshaw, 1997:30; Helfert, 1987:5-65).
The usefulness of financial ratios in the valuation of companies is wholly dependent upon
their skilful application and interpretation.
· 3.2.1. Profitability ratios
The profitability ratios of a company is of key interest to shareholders and investors alike
(Helfert, 1987:5-65).
Shareholders, analysts and investors are interested in the current and long-term
profitability of their investment in a company. Profitability means the returns achieved
through the efforts of management, on the funds invested by the shareholders (Fisher,
1997:40-58). The most common ratio, return on equity, used for measuring the return on
the owners investment is the relationship of net profit after interest and taxes to ordinary
equity (Hagstrom, 1994:87-89; Helfert, 1987:36-40).
Benjamin Graham, the dean of financial analysis, indicated that profitability is the margin
between earnings and fixed charges (Gardiner & Bagshaw, 1997:30; Hagstrom, 1994:27
48). Graham professed that the profitability of a company would protect the shareholder
and investor from loss of capital if their was an unexpected decline in the company's
earnings. The profit margin on sales ratio is computed by dividing net income after taxes
by turnover (Helfert, 1987:23-36). The ratio essentially expresses the cosUprice
effectiveness of the company. This ratio indicates management's ability to operate a
business successfully, by recovering all costs and leaving a margin as compensation for
shareholders and investors for putting their capital at risk.
The return on total assets ratio measure the profitability of the company as a whole in
relation to the total assets employed. It is frequently referred to as the return on
investment. In theory, if a company's rate of return on an investment project exceeds its
cost of capital, the company should undertake the investment, if not the investment should
be avoided (Francis, 1988:224-227). Shareholders, analysts and investors can argue that
high historic rates of return are leading indicators of future growth, for as more funds are
employed in capital projects by the company, higher earnings would result. The ratio is
calculated by dividing earnings by total assets. Earnings could however have three
different definitions: earnings before interest and tax (EBIT), earnings before interest but
after tax (EBIAT), and earnings after interest and tax (Helfert, 1987:34-36). Using the
earnings before interest but after tax is conceptually the most correct approach as" it
includes interest which is a cost of financing and part of the capital structure of the
company.
3.2.2. Debt management ratios
Debt management ratios are indicators to what extent a company's operations are
financed with borrowed funds rather than equity capital (Francis, 1988:228-230). The
extent to which a company finance its operations with· borrowed capital has a number of
consequences:
• The more the company's operations are financed with borrowed capital (financial
leverage), the higher is the financial risk of the company (Gardiner & Bagshaw,
1997:30; Helfert, 1987:47-51). The financial risk is the measure of volatility of
earnings caused by having debt finance. This is not surprising because as a company
takes on more debt it is faced with higher interest costs. These fixed interest costs are
insensitive to economic downturns and therefore cause companies to incur lower
earnings and price instability.
• Additional risks yield additional return, if the company earns more on the borrowed
capital than what is pays in interest, the return on shareholders and investors equity is
magnified (Francis, 1988:228-230). In market upturns these companies generally
outperform the market and in downturns these companies usually decline more than
the market.
The debt management ratios deal with total debt or long term debt in relation to various
parts on the balance sheet. The ratios measure the risk exposure of creditors in relation
to the available asset values against which all claims are held and therefore the risk to
shareholders and investors of probable loss of capital invested in a company (Gardiner &
Bagshaw, 1997:30. The debt management ratios will assess the impact of financial
leverage on risk. This is important as the valuation of investments deal with two criteria;
the risk and return involved (Amling & Droms, 1994:164-172; Fischer & Jordan, 1987:3-5).
The debt ratio is the ratio of total debt divided by the total assets and measures the
percentage of total funds provided by creditors (Francis, 1988:228-230). Total debt would
.. -' .
include current liabilities and in most instances preference shares. The higher the debt
ratio the higher the financial risk but also the higher leveraged returns are foregone for
shareholders and investors.
The times interest earned ratio is determined by dividing earnings before interest and
taxes by the interest charges (Amling & Drams, 1994:276-282; Gardiner & Bagshaw,
1997:30). This ratio measures to what extent earnings can decline without causing
financial loss and meeting interest payments. Failure to meet this obligation could lead to
legal action and ultimately to insolvency.
The debt equity ratio is similar to the debt ratio except that it measures total debt divided
by total equity. This ratio indicates to what extent that debt is covered by shareholders
funds (Foster, 1986:65-67). This ratio indicates high financial risk and is consistent with
the interest cover ratio.
3.2.3. Market value ratios
The market value ratios indicate the company's share price to dividends and earnings.
These ratios are strong indicators of what shareholders and investors think of the
company's past performance and its future prospects (Francis, 1988:230-234). When the
liquidity, debt management and profitability ratios of a company are all good, shareholders
and investors tend to value a companyhighly and the market value of the company will be
high. These ratios are therefore important when valuing a company for investment
purposes.
The dividend yield ratio is the annual dividends per share divided by the current or
average price per share (Helfert, 1987:41-45; Gardiner & Bagshaw, 1997:30). The ratio
falls short as the dividend payout ratio for different companies differ and could even
fluctuate for one company due to factors such as economic climate and change of
management strategy. This ratio is also significant in that it characterise the "style" of the
company. High growth companies tend to payout relatively low percentages of earnings
in dividends because they prefer to reinvest the earnings to support profitable growth.
Stable or moderate growth companies tend to payout larger proportions of their earnings
in dividends. This ratio is however important in that the total economic return for
shareholders and investors is a combination of dividends and the market appreciation of a
company's shares.
The earnings per share ratio is calculated by taking the net income available to common
shareholders and dividing it by the number of shares outstanding. This ratio that have an
important influence on the value of the shares of a company and therefore the value of the
company as a whole (Francis, 1988:230-232; Gardiner & Bagshaw, 1997:30). It is
however important that the achievement of continuous improvement of earnings per share
are seen in relation to the equity capital employed within a company (Hagstrom, 1994:87
89). The continuous strength in this ratio i.e. the earning power underlying each share, is
also a determinant in driving value of shares.
The price earnings ratio (PIE) is sometimes called the earnings multiplier. The price
earnings ratio also shows how much shareholders and investors are willing to pay per
rand of reported profits (Foster, 1986:58-80; Gardiner & Bagshaw, 1997:30). The
stronger the earning power per underlying share as per the earnings per share ratio,
usually the higher the price earnings ratio. This confirms that the price earnings ratios are
higher for companies with high growth prospects and lower for companies that are
regarded as being risky or with low growth prospects (Foster, 1986:58-80).
3.3. Du Pont analysis
The Du Pont model is also based on ratio analysis however it is a structured company
valuation technique. It is a structured valuation technique in that the model's diagnostic
capability allows attention to be focused on problem areas within the company rather than
having shareholders and investors proceed haphazardly through a time consuming
unstructured analysis (Correia et aI., 1993:194-196; Francis, 1988:232-234). This is a
definite strength of this model. The Du Pont valuation model arrange a wide variety of
ratios in three categories.
1. Those ratios associated with income
2. Those ratios associated with capital structure
3. Those ratios associated with investment
The Du Pont model focus attention on the maximisation of shareholders or investors
wealth (Correia et al.; 1993:194-196; Stead, 1995:44-45). The maximisation of
shareholders or investors wealth is where an investment is chosen with a higher expected
return than an investmentwith a lower expected return, all other factors being equal such
as risk. Similarly if two investments both have the same expected return, the investment
chosen with the lower risk will result in shareholder and investor wealth maximisation.
This is true if the investment at least meets the cost of capital requirement set by
shareholders and investors (Correia ~t aI., 1994:299).
The Du Pont model uses the return on equity ratio as the overall indicator of success
(Stead, 1995:44-45). Warren Buffet, the well known investor from Omaha in the United
States, values both managerial excellence and economic performance with return on
equity as the primary test of performance (Hagstrom, 1994:87-89). Warren Buffet
concludes that to measure a company's performance he prefers return on equity as
yardstick. The return on equity ratio therefore is primary in the valuation of companies.
The Du Pont model is unique in that it shows the interrelationship between financial
ratios.
• The return on equity ratio is a combination of firstly, the return on assets ratio and
secondly, the financial leverage multiplier (FLM). The first ratio, return on assets, is a
measure of income produced in relation to total assets used to produce the income
and the second ratio, financial leverage ratio, is the percentage of the company's
capital structure being financed by equity (Francis, 1988:232-234, Gardiner &
Bagshaw, 1997:30). The combination of these two ratios produce the ratio, return on
equity (Stead, 1995:44-45).
• The return on assets ratio likewise is a combination of firstly, the profit margin ratio,
and secondly, the asset turnover ratio (Correia et aI., 1993:194-196). The
achievement of higher profit margins would lead to a higher return on equity ratio, all
other things being constant (Gardiner & Bagshaw, 1997:30). This confirms Benjamin
Graham's view that higher profit margins would protect the shareholder and investor
vi
.. .:
from loss of capital due to the positive effect on return on equity which is a primary
value driver in maximisation of company value.
The Du Pont model is therefore valuable in that it indicates what specific financial ratios
calculated from financial statement information is important in the company valuation
process.
3.4. Economic Value Added
Economic value added is easily the most talked about idea in business today. The
concept, economic value added (EVA), was developed by Stem Stewart & Company of
New York (Stewart III, 1991; Tully, 1993:24-32). It is far from being the newest idea in
company valuations.
"Economic value added is the idea of earning more than the cost of capital"
Earning more than the cost of a company's capital is about the oldest idea in business,
but just as Greece's glories were forgotten in the Dark Ages to be rediscovered in the
Renaissance, so has the idea behind EVA, earning more than the cost of capital, often
been lost in the procedures and methods of accounting valuation practises (Mayfield,
1997:32-33; Tully, 1993:24-32).
Management has the obligation to its shareholders and investors to maximise the value of
their equity invested (Mayfield, 1997:32-33). The market value of equity and appreciation
in equity is often used to measure the success of a company (Stewart III, 1991:1-15).
This could be misleading, since the market value of equity of a company will increase (all
other things being constant) whenever shareholders and investors entrust more capital in
the company such as taking up of more common stock in a company or through retained
earnings in the company.
The answer is actually quite straight forward in that value is created by focusing on a
measure called economic value added (EVA). Economic value added is the net profit
after tax less the cost of all the financing instruments employed to produce the profit
.. L
(Stewart III, 1991:1-15). All the financing instruments employed includes shareholders
and investors equity plus all debt funding. The challenge is in calculating the value added
which involves extracting the appropriate information from the financial statements
(Mayfield, 1997:32-33).
Economic value added (EVA) is the best indicator of business performance (Mayfield,
1997:32-33). When present economic value added (EVA) is added to the projected
economic value added for future years and discounted to its present value, it represents
the net present value of all past and future investments and cashflows (Stewart iii,
1991 :306-350). This method of valuation of company's has a great advantage in that
economic value added (EVA) links, forward looking valuation procedures with present
performance yardstick valuations.
3.4.1. Cost of capital
The cost of capital is the minimum acceptable return on investment that a company must
earn in order to create value for its shareholders and investors. It is the invisible line
between good and bad corporate performance. The cost of capital figure is primarily
calculated from information obtained from the financial statements of a company (Correia
et al., 1993:299-304; Stewart III, 1991:431-473). The cost of capital figure is important in
that it is used in the calculation of the value of a company. The cost of capital is used in
the following ways in the calculation of a value for a company;
• As the discount rate to bring projected free cash flows of a company (EVA's) to their
present value
• The cost of capital is used as a benchmark for assessing rates of return on capital
employed (rememberratio analysis and the ratio return on capital employed)
• As the capital charge rate in the calculation of economic value added in a company.
The cost of capital is not a cash cost, due to the complex nature of the cost of equity. The
cost of capital is an opportunity cost, a cost that is comparable to the total return that a
company's shareholders and investors could expect to earn by investing in a portfolio of
equities and bonds of comparable risk (Stewart III, 1991:431-473). The more risk a
-company represents for its shareholders and investors, the greater its rate of return must
be, before value is created for shareholders and investors due to the company's higher
cost of capital. The cost of capital is therefore driven by the proven trade off between risk
and return.
The cost of capital can be calculated for listed and unlisted (private) companies.
In order to establish the cost of capital for a company the following building blocks of the
cost of capital needs to be calculated;
• The cost of debt
• The cost of equity
• The risk of a company
Once the cost of debt and the cost of equity have been established the cost of capital can
be calculated for a particular company. The risk inherent to a particular company has
already been factored into its respective cost of debt and cost of equity as the lenders of
money and the providers of equity will factor the risk of a particular company into their
respective capital costs (Stewart III, 1991:444). The cost of capital is calculated by taking
the weight that each particular type of capital, debt or equity, forms part of the overall
capital structure of the company and multiplying the weight with the cost of the particular
capital (Correia et aI., 1993:299-320; Tully, 1993:24-32). The weighted costs are then
added together to establish the cost of capital for a particular company.
3.4.1.1. Cost of debt
Debt usually refers to interest bearing loans and debentures. The easiest way to
establish the cost of debt, is to verify the rate a company would have to pay in the current
market to obtain new debt, whether it is loans or debentures.
When a company raise finance in the form of debt, the before tax cost is expressed as an
interest rate. The real cost of debt to the company is however lower. This is due to the
fact that interest is a deductible expense for taxation purposes, and therefore the
Receiver of Revenue is in effect subsidising interest payments to the extent of the
corporate tax rate (Correia et aI., 1993:304-306).
The cost of debt is calculated by multiplying the cost of new debt (the interest rate that is
currently being paid) with a factor in order to calculate the after tax cost of debt, which
factor is one minus the corporate tax rate (Correia, 1993:304-306; Stewart III, 1991:432
434).
3.4.1.2. Cost of equity
The cost of funds from shareholders and investors are generally more difficult to
ascertain. This is due to the yield on equity is not a readily observable cash yield.
Shareholders and investors have a wide spectrum of investment alternatives available to
them; ranging from risk free government bonds on the low end through to various grades
of corporate bonds, preferred stocks, convertible preferred stocks and to common stock
and stock options on the high end (Stewart III, 1991:431-473). As investors accept more
risk, they must be offered the prospect of receiving a progressively greater reward. This
is also the situation with shareholders and investors in a company, where the prospect of
greater returns is offered due to the large risks involved.
Shareholders equity is the sum of all items which provide the owners with a claim against
the assets of the company. It consists of the original amounts invested by shareholders
and investors plus all accumulated profits which have not been paid out in the form of
dividends (Tully, 1993:24-32). The return to the shareholders of a company is typically
higher than what could be received on fixed interest investments (Mayfield, 1997:32-33).
This is because the shareholder and investor is bearing the largest risk in a company, by
holding an equity investment in a company (Correia et aI., 1993:541-554).
The question is therefore, how much compensation do shareholders and investors require
over and above the return provided by risk free government bonds to compensate them
for bearing the risk by investing in common stock. The answer lies in the average return
that shareholders and investors have received over the years 1960 to 1987 by investing in
the stock market in general. The historical average return for shareholders and investors
.. .
investing in the Johannesburg Stock Exchange (JSE) have been 20,03% (INET), which
aggregate return includes capital appreciation and dividend payments. The return
provided by risk free government bonds (the government R150 gilt's) over the years 1980
to 1987 has been 13% (INET). Shareholders and investors in common stock have taken
additional risk (variability in the rate of return) and have been compensated for doing
taking additional risk (variability in the rate of return). Shareholders and investors in
common stock have earned on average an additional 7% return over and above the return
provided by risk free government bonds.
The cost of equity is therefore the sum of the risk free return on government bonds plus
the additional return from investing in common stock (Correia et aI., 1993:307-309). The
additional return from investing in common stock, however needs to be multiplied by a risk
factor, either a beta for listed companies or a business risk index for unlisted companies
(Lofthouse, 1994:19-33; Stewart III, 1991:431-473). This is due to the reason that
common stock in different companies differ in risk due to a number of reasons such as
gearing, profitability, market segment and product range of the company to name but a
few.
The aim is to calculate the cost of equity for a specific company and therefore the risk
inherent to specific company needs to be assessed and factored into the cost of equity
(Lofthouse, 1994:19-33). This approach will result in that the cost of equity will differ from
company to company.
3.4.1.3. Risk
In financial terms risk implies that that the actual outcome (return) of an investment in a
company may be different from the expected outcome (return). The term risk also implies
that it is possible to attach probabilities to identified expected outcomes. Risk is
measured through variability of returns, meaning the number of possible outcomes as well
as the probability of an expected outcome happening (Lofthouse, 1994:18)~ The
statistical measure of variability commonly used is the standard deviation, which is related
to the statistical measurevariance.
w.
Concentrating specifically on investments in the shares of listed and unlisted companies,
there are two major areas of risk which will be considered by potential shareholders and
investors: business risk and financial risk (Correia et aI., 1993:83-103).
Business risk arises from the nature of the business itself. Business risk includes all
uncertainty which surrounds the industry in which the business operates. This is reflected
in the variability of sales and the structure of costs (Correia et aI., 1993:85). The
variability of sales results from such factors as increased competition, the availability of
substitute products and the effect of economic conditions on the business such as
recessions. The structure of costs within the business depends on the relationship
between fixed and variable costs.
Financial risk arises from the capital structure of the business. Financial risk results from
the utilisation of interest bearing debt to finance the company's assets in order to increase
the return to ordinary shareholders through the effect of positive leverage. Interest must
be paid on interest bearing debt regardless of the performance of the company (Correia et
aI., 1993:89). Due to the obligation of interest payments on debt a company could default
on such payments due to not being financed solely with shareholder funds.
3.4.1.3.1. Calculation of risk for listed companies
A company's return will be affected by the broad movements of the economy. One could
therefore expect that most of a company's return is to be determined by the return on the
market (Lofthouse, 1994:19-33). Should the stock market rise with one percent one
would expect that most of the shares in companies shareholders and investors have will
also appreciate with one percent. The variability of return for a particular company's
could therefore be measured to the return presented by the market as a whole. This
variability of a particular company's to the return of the market would represent the risk of
such particular company. This is better known as the beta of a particular company.
The market itself will have a beta of one and if a company has a beta equal to one, the
company's return will go up and down with the market return. If the company's beta is
greater than one than the company's return would exaggerate the market moves - returns
· ~ ..more than the market when market returns are positive, and less when market returns are
negative (Stewart III, 1991 :438-441). If beta is less than one but greater than zero, the
company's return is less than the market when market returns are positive and greater
than the market when market returns are negative. If the beta is less than zero, company
and market returns move in opposite directions.
The beta of a company in short is the position of a company's common stock on the risk
map. A beta of zero represent risk free government bonds and a beta of one the stock
market in general (Lofthouse, 1994:19-33). The beta of companies listed on the
Johannesburg Stock Exchange is calculated by the large financial institutions in South
Africa inter alia Investec, Board of Executors, Genbel and Rand Merchant Bank. The
computed beta of companies relates to the business and financial risk inherent to a
specific company (Stewart III, 1991 :445-446).
3.4.1.3.2. Calculation of risk for unlisted companies
The use of a beta is a good way to determine the risk and therefore the cost of capital for
listed (publicly) traded companies. The beta cannot be used for unlisted (private)
companies or individual business units as the share price data is not available to compute
a beta for the company.
The business risk can however be established for unlisted companies in order to establish
the company's cost of capital. This is possible due to extensive research performed by
Stern Stewart & Company who identified the characteristics in a company responsible for
the underlying business risk (Stewart 11I,1991:449).
The following four quantifiable factors were identified by Stern Stewart & Company to be
highly statistical significant in establishing the business risk between business peers,
companies in the same industry (Stewart III, 1991 :452). The four quantifiable factor
groups make use of ratio analysis in order to establish the business risk index.
1. Operating risk - The operating ratios establish the variability in returns on capital
earned for a certain business period. The greater the fluctuations in return on
capital for a specific company compared with its business peers, companies in the
same industry for instance the retail industry, the greater the business risk index
was found to be. The following five ratios were computed for operating risk;
variation in pre-tax return to capital, variation in after tax return to capital, variation
in total gross return to total gross capital, variation in operating cash flow return to
gross permanent capital and the variation in the capital growth rate.
2. Strategic risk - The strategic ratios studies the company's rate of return and its
growth rate. Research conducted by Stern Stewart and Company showed that as a
company's rate of return and .growth rate increases, signs of a high price-earnings
multiple, risk of a company rises relative to its competitors in the same industry.
The more a company is expected to create value in the future, the greater is the
risk that the value of the future investment opportunities may not be fully realised.
The five ratios of which three indicate the rate of return and two the growth of the
company. The ratios are pre-tax return to capital, after tax return to capital and
total gross return to capital (rate of return ratios), the net sales growth rate and the
internal capital growth rate (growth ratios).
3. Asset management - The six ratios study working capital management and fixed
asset management. The ratios are; accounts receivable to sales, inventory to cost
of goods, working capital variation index (working capital management ratios),
weighted average asset life, plant and equipment before depreciation to plant and
equipment after depreciation and plant plus equipment to depreciation period (fixed
asset management ratios).
4. Size and diversity - Larger companies take less risk per decision made and have a
longer track record. The two ratio are; total capital in the most recent year and net
operating profit before tax from foreign sources to the total net profit before tax.
Stem Stewart & Company computed the beta (for business risk only) for all the various
industries from available stock exchange data (New York Stock Exchange). The business
risk index is the beta calculated for a specific industry without taking into consideration the
financial risk of the particular industry. The business risk index (converted beta) only
account for business risk in the industry.
The above financial ratios are then used to calculate the business risk of a particular
company. The calculated answer from these ratios is added to the industry business risk
index which then give the business risk index for the particular company within a specific
industry. The business risk index for a particular company is then converted to account
for the financial risk of that particular company which is then the beta for the specific
company (Stewart III, 1991:449-473). The cost of capital is then computed in the same
manner as described before.
3.5. Zulu principle
The expertise of shareholders, analyst and investors can be developed by applying the
Zulu Principle (Slater, 1996:9-16). The idea of the Zulu Principle was developed by the
writer Jim Slater, coincidentally also the name of his first book, after observing his wife
reading a four page article on Zulu's in the Reader Digest. As a result of reading the
article she knew more about Zulu's than Jim Slater.: It occurred to Jim Slater that if his
wife borrowed all available books from the local library in Surrey, United Kingdom, she
would become the leading expert on Zulu's in Surrey. Should she be invited to stay on a
Zulu kraal in South Africa and read about the history of Zulu's at the University of the
Witwatersrand for another six months, she would become one of the leading experts in
the world on Zulu's.
The point is that his wife applied a disproportionate effort to become a relative expert in a
very narrow subject. She has used a laser beam approach as opposed to a shotgun
approach, and therefore her intellectual and other resources have been used to maximum
advantage (Slater, 1996:13). The same concept applies to investment practises
concentrate on an approach in order to become a relative expert in a chosen area. The
Zulu Principle's area of specialisation is the valuation of growth companies and their
shares.
· ..3.5.1. Growth companies
Jim Slater (1996:23) says that the word 'growth' is used to describe companies that that
have the ability to increase earnings or earnings per share (EPS) at an above average
rate year after year. Milne (1998:3) says that a company can grow in two ways:
organically and by acquisition. In general, organic growth of after tax profits is unlikely to
exceed 30 percent for any particular company. Today it is not uncommon to see
companies listed on the Johannesburg Stock Exchange (JSE) growing faster than 30
percent. These companies managed higher growthdue to a successful acquisition policy.
These companies are good dealmakers (Milne, 1998:3).
When deciding whether a company isa growth company the following factors are to be
considered; the market segment in which the company operates, the competitive
advantage of the company, the management and earnings growth or earnings per share
growth (Slater, 1996:23-29).
Market segment in which the company operate is important. The industry in which the
company operate must be considered a growth industry such as; pharmaceuticals,
healthcare, media, support services and financial services (Devereux, 1995:473-477;
McCullagh & Scott-Ram, 1995:457-463). It follows that there are very few growth
companies in the most cyclical industries such as; building & construction, property,
engineering and building materials (Mobbs, 1995:483-487). Companies in cyclical
industries suffer from the 'feast' and 'famine' syndrome. The cyclical industries are
usually the first to suffer when interest rates rise, which are usually followed with
substantial losses in economic downturns and making surviving for these firms until the
next economic boom difficult. The future industries of growth beat those market segments
that are highly cyclical (Slater, 1996:25).
Competitive advantage of a company ensures reliable future earnings. Warren Buffet
calls the competitive advantage of a company a 'business franchise' (Hagstrom, 1994:78
79). Warren Buffet says a franchise is a company providing a product or service that is;
needed or desired, has no close substitute and is not regulated. A business franchise can
~I
.. .:
arise in several different ways as; top class brand names, patents or copyrights, legal
monopolies, dominance in an industry and an established position in a niche market
(Slater, 1996:83-96). A strong competitive advantage would manifest itself in high
operating profit margins and a high return on equity.
Management is an asset to a company when the management thinks and behaves like an
owner (shareholder) of a company. Warren Buffet says that management that behaves
like owners tend not to lose sight of a company's prime objective - to increase shareholder
value (Hagstrom, 1994:80-87). In considering business acquisition, Warren Buffet looks
hard at the quality of management.. Warren Buffet considers the following areas when
evaluating management; is management rational (behave like an owner) and is
management candid (open and honest) with shareholders. Jim Slater suggest the
following ways to evaluate management; at annual general meetings, the style of annual
reports, the constitution of the board of directors, outside activities of the chief executive,
lifestyle of the company's key executives, failure to meet profit forecasts and the calibre of
advisors used (Francis, 1988:327-331; Slater, 1996:73-81).
Earnings growth or earnings per share growth is the essence of a good growth company.
The first step in assessing a company's growth potential is to study the past record of
earnings growth of a company and then to assess the expectations for a company to
achieve future growth (Slater, 1996:26-27). Should it be evident that future earnings
growth is an almost foregone conclusion for a particular company it is important for a
shareholder, analyst and investor to asses whether the price for a share or the company
is attractive or expensive.
3.6. Relative importance of financial statements
There are numerous company valuation tools available. The valuations tools discussed
are; Ratio analysis, Du Pont analysis, Economic value added and the Zulu principle. It is
evident from these company valuation tools that each individual company valuation tool
requires substantial input from financial statements. These company valuation tools
regard the financial statements as relative important.
....CHAPTER 4
QUALIFICATION OF THE RELATIVE IMPORTANCE OF FINANCIAL
STATEMENTS
4.1. Introduction
The company financial statements are relative important as the input from financial
statements are substantial into company. valuation tools such as; Ratio analysis, Du Pont
analysis, Economic value added and the Zulu principle.
The company financial statements are also meeting the qualitative characteristics to be
considered an important information source. The qualitative characteristics that financial
statements and other information sources need to meet are; understandability, relevance,
reliability, comparability and timeliness (Vorster et aI., 1991:17-20).
The qualitative characteristics of financial statements can however be impaired. The
factors that can cause financial statements qualitative characteristics to be impaired can
mainly be attributed to creative accounting techniques. Some of the creative accounting
techniques used will now be discussed.
4.2. Creative accounting
Creative accounting is where accounting techniques are used within the parameters of
Generally Accepted Accounting Practise (GAAP) to simulate the effects of economic
growth and profit (cash) generation. The simulation of economic growth and profit
generation in the context of creative accounting is rather the result of accounting sleight of
hand.
4.2.1. Acquisitions
The basic principle in accounting for acquisitions is that the assets of the company
acquired (company B) should be brought into the acquiring company's (company A)
accounts at their 'fair value' rather than the book value at which they stood in the acquired
company's (company B) accounts prior to the acquisition.
The purpose of the 'fair value' adjustments is to obtain a good basis for the new
company's (company B) assets and liabilities to be consolidated with the acquiring
company (company A). The acquiring company's (company A) accounting practises are
not necessarily the same as that of the acquired company and the assets are to be
reflected at market value according to the acquirer's (company A) viewpoint (Smith,
1992:22-36).
Once the 'fair value' of the net assets acquired has been determined, any shortfall
between their current 'fair value' and the purchase price represents goodwill which must
be accounted for. The 'fair value' accoLinting could lead to massive goodwill write-off and
the uses and abuses of provisions. The 'fair value' accounting relates to fixed assets,
stock and debtors.
The significance of these acquisition accounting write-offs, is that it absorbs costs or
potential future costs. These write-offs is affected through the balance sheet which lead
to future profits being enhanced.
For example, under existing GAAP, company 8 is acquired by company A for R500
million. The tangible assets of company 8 is only R150 million and therefore R350 million
can be written of as goodwill against reserves without passing through the income
statement. If company 8 is later on sold by company A for R400 million a profit of R250
million (R400 million minus R150 million) will be recorded as oppose to a loss of R100
million (R500 million minus R400 million).
· 4.2.2. Disposals
Just as acquisition accounting provide major opportunities for creative accounting to
enhance economic growth prospects and future profits, so too do disposals. It is practise
that companies take profits on the disposal of assets through the income statement.
The shareholder, analyst and investor should however be aware of the size of these
items, and the extent to which these profits on sale of-assets are one-off or a continuous
situation in order to assess the true profitability of a company. The shareholder, analyst
and investor needs to assess the frequency of such profits in order to see the
sustainability of company earnings for which the shareholder, analyst and investor pay
when buying shares in a company.
Companies treat their profits differently which could lead to profits being classified as an
extraordinary item (and therefore not part of earnings per share) or part of normal trading
activities and as above the line profits (therefore part of earnings per share). For
instance, the justification of including the sales of fixed assets as part of a company's
normal trading profit or as an exceptional item would be more than opposed to the
disposal of a subsidiary company of a group of companies.
For instance, a company dispose of an asset in a financial year, whether a fixed asset or
a subsidiary company, and the profits on such disposal represent 25% of the total profits
for the year. The disposal of the asset is also not an event happening each financial year.
The valuation of the particular company would be lower when deducting these
extraordinary profits from total company profits, which is the more conservative method.
This is done as the profit from the disposal of the asset can not be seen as part of the
sustainable earnings of the particular company.
The manner in which the proceeds on disposals are shown in the accounts of a company
can also give different impressions to the reader of such accounts if care is not taken. It
is customary to show profits on announcement of a disposal rather than later when the
sale is completed. The sale could also take place on a deferred basis which could lead to
. ~.;
the deferred proceeds being treated as a long term debtor. In some cases these debtors
are eventually written off as bad debts, which mean no sale of the asset has actually
taken place (Smith, 1992:37-51).
The deconsolidation of an asset such as a subsidiary company to an investment has also
an impact. A company SUbsidiary profits and losses are shown in the groups income
statement through accounting consolidation. The re-elassification of a subsidiary to an
investment means that such profits and losses of such investment are not shown as part
of the consolidated figures of the group. This technique of de-eonsolidation is most
commonwhere the subsidiary company is making a loss.
It is therefore important to realise when sale of assets are not part of the on going trading
performance of a company it should not be considered when valuing a company or
assessing its price earnings ratio for shares listed on a stock exchange.
4.2.3. Deferred consideration
On the subject of acquisitions and disposals there is the practise of deferred
consideration. Deferred consideration is a future payment, of which the value of such
future payment is contingent upon the future performance of the business acquired
(Smith, 1992:52-59).
Typically in a deferred consideration situation, the acquiring company (company A) would
make an up front payment with further payments in either cash or shares based on a
multiple of future profits of the acquired company (company B).
This method of acquisition has several advantages;
• Downside risk is limited - if the acquisition does not meet the profit estimates as per the
initial agreement, the future deferred consideration payments can be adjusted
downwards.
"t.
• There is often an immediate enhancement of the profits of the acquiring company
(company A) as profits are consolidated at once, but the full amount of the
consideration is paid over a period of time.
• In a business where people skills and intellectual capital is important which is the case
in almost every type of business today. The key employees and owners are tied in with
such deferred consideration payments as the success of the business depends heavily
upon their creative talents.
Deferred consideration can however mean problems. This relate to the ability of the
acquirer (company A) to finance the future deferred consideration payments. Payments
can be made either by cash, debt or by way of shares. All these forms of finance could
have its own effect on the acquirer's balance sheet but influence earnings available to
shareholders similarly.
Dilution of real earnings available to shareholders and total shareholder value is a strong
possibility when the pricing of an acquisition is wrong and deferred consideration has
been used as a way of payment. Deferred consideration then can provide a smoke
screen initially that pricing of an acquisition is right but later prove that the acquisition was
too expensive (the acquirer paid too much for the company acquired).
4.2.4. Extraordinary and exceptional items
There is always a lot of debate what constitutes and should be classified as an
extraordinary item and what as an exceptional item. The answer for all this debate and
sometimes heated discussions lies in Earnings per Share (EPS). The earnings per share
is usually taken as the single biggest determinant of a share's value in conjunction with
the Price-Earnings Ratio (PER).
Since the calculation of earnings per share is normally calculated by taking earnings
before extraordinary items there is a keen interest in deciding whether an item is an
exceptional item taken 'above the line' and therefore included in the earnings per share
(EPS) calculation or as an extraordinary item taken 'below the line'. The expression 'the
....line' refers to the line in the income statement at which the earnings per share is
calculated (Smith, 1992:63).
Extraordinary items are material items which derive from events or transactions that fall
outside the ordinary activities of the company and which are therefore expected not to re
occur frequently or regularly.
Exceptional items are material items which derive from. events or transactions that fall
within the ordinary activities of the company, and which need to be disclosed separately
by virtue of their size or incidence if the financial statements are to give a true and fair
view (Smith, 1992:64).
Extraordinary items are supposed to be very rare occurrences and therefore most items
should rather be classified by management and their auditors as exceptional items and
therefore affect the earnings of a company.
4.2.5. Off balance sheet finance
Off balance sheet finance is the funding or refinancing of a company's operations in such
a way that, under legal requirements and existing accounting conventions (GAAP), some
or all of the finance may not be shown on a company's balance sheet.
Mostly liabilities as well as assets are removed from the balance sheet of the company
concerned. The primary aim of off balance sheet finance is to reduce a company's
ostensible gearing (Smith, 1992:76-91).
Off balance sheet finance activities are evident in the following financial transactions;
subsidiary companies that is not a subsidiary, sale and leaseback of assets, sale and
repurchase of assets to quasi subsidiaries of the group company, sale and repurchase of
assets with an option to repurchase the asset sold, joint ventures and partnerships
(specific type of joint venture and partnership format).
A company (company A) sells an asset with gearing to a subsidiary company (company B)
with a leaseback arrangement which is not consolidated with company A financial
statements. In doing so company A reduce its assets but also its liabilities. This is often
seen where particular assets gearing is not in line with stated company policy and bank
loan covenants.
4.2.6. Contingent liabilities
Close to the creative accounting technique of off balance sheet finance is that of
contingent liabilities. This is due to that, off balance sheet finance and contingent
liabilities are literally not shown on the balance sheet. Contingent liability as creative
accounting technique primary function is therefore also to reduce a company's liabilities.
A contingency is defined by GAAP as a condition which exists at the balance sheet date
where the outcome will be confirmed only on the occurrence or non-occurrence of one or
more uncertain future events (Smith, 1992:92-100).
The following are common contingent liabilities;
• Guarantees of subsidiary overdrafts; where a bank lends to a subsidiary company
within a group of companies the bank will normally require the holding company to
guarantee such loans. If not, the holding company could rely upon its limited liability
when a subsidiary experience financial distress and leave the bank to carry the loss
(Smith, 1992:93).
• Performance bonds; their are many types and are specific to the special circumstances.
For example, a software development company must provide a performance bond to a
client on of their new products. A bond would be issued by a reputable bank to the
client and the bank would in tum require certain guarantees and collateral from the
software development company.
• Discounted bills; where a company raises finance by selling (discounting) bills of
exchange (IOU's) or debtors it has received finance with recourse, the bank or finance
house will have recourse on the bills or debtors if they are not met at maturity. Once
the bills or debtors are on-sold it does not appear on the balance sheet, but a
contingent liability should be shown.
The absence of a need for double entry book keeping for contingent liabilities should ring
a warning bell. Even major public companies may have their contingent liabilities
recorded in a simple card index system, and the auditors are reliant upon the Directors
assurances that all contingent liabilities have been recorded and revealed (Shoredits
Holdings Limited, 1996).
.The rule with accounting practise is to give attention to detail, failing to pay due regard to
contingent liabilities can prove fatal or just very expensive. The slogan 'read the fine print'
which applies to contracts apply to financial statements as well. The 'fine print' of
financial statements are the notes to the financial statements.
4.2.7. Capitalisation of costs
Capitalisation of costs is the 'How to make an expense become an asset' creative
accounting technique. Many different types of expenditures may be capitalised but some
of the common capitalised expenditures are; interest on property under development and
research and development on products especially in the electronics industry (Smith,
1992:101).
Capitalisation of costs is a process by which an item which would normally be seen as an
expense in the income statement is instead classified as an asset in the balance sheet.
As with all the other creative accounting techniques described, capitalisation of costs is a
legitimate technique to use in the financial statements of a company according to
Generally Accepted Accounting Practise.
The argument for the capitalisation of costs are that the particular costs is a legitimate
cost of the project or service offered and therefore it is appropriate to capitalise the cost
as part as the cost of the product or service.
It is worth noting that if companies are not allowed to capitalise costs, there asset base
would be lower as well as the net profit. The cost would not be added to the cost of the
asset and therefore the resultant lower asset base and the cost will be deducted from the
income statement and therefore reducing the net profit.
The interest cover ratio is therefore an important measure of the financial health of a
company. Itmeasures the company's ability to cover the interest payments to its bankers,
and the margin of cover should profits decline. Interest cover of two times is usually
regarded as the margin required by which profits should cover interest paid.
.A banker of a company is not interested in whether his monthly, quarterly or bi-annual
interest charged is capitalised as part of an asset or is expensed in the income statement.
A banker sole interest is in cash. Is there enough cash coming into the business so that
the bank's interest charge is being paid? If not, there is a problem that could affect the
future of the company as a going concern (Smith, 1992:108).
4.3. Case studies
The following study will show that creative accounting techniques are used even among
large listed companies on the Johannesburg Stock Exchange. Creative accounting is
therefore not merely a phenomenon that can be seen among small private companies.
Columns one to seven is the creative accounting techniques as described above;
1. Acquisitions
2. Disposals
3. Deferred consideration
4. Extraordinary and exceptional items
5. Off balance sheet finance
6. Contingent liabilities
7. Capitalisation of costs
vi
COMPANY LISTED ON JSE 1 2 3 4 5 6 7
Anglovaal Industries Limited • • • •Barlow Limited • • •Iscor Limited • •Kolosus Holdings Limited • • • •Primedia Limited • •PSG Group Limited • • • •Sappi Limited . • • •Sentrachem Limited • • • •Shoprite Holdings Limited • • •Shoredits Holdings Limited • • • • •Tigon Limited • • •Voltex Holdings Limited • • •Table 4.3. Case studies
· ~ ..CHAPTERS
CONCLUSIONS AND RECOMMENDATIONS
5.1. Conclusions
5.1.1. Qualitative characteristics
Investment information sources needs to.be subjected to qualitative characteristics before
it can be used as an information source when valuing companies for investment. The.
qualitative characteristics that all proposed investment information sources must be
measured against are; understandability, relevance, reliability, comparability and
timeliness.
Financial statements as an information source meet all the qualitative characteristics
against which all investment information sources should be measured.
5.1.2. Company valuation models and tools
The company valuation models and tools that this study looked at are; Company financial
ratios, Du Pont analysis, Economic Value Added and the Zulu principle. These company
valuation models are currently being used by leading portfolio and asset managers in the
South African asset management industry.
The asset management industry consist of mainly; retail banks, merchant banks, long
term insurance companies, short term insurance companies, pension fund managers of
large corporations and specialised niche asset management operations.
The input required from company financial statements into these company valuation
models and tools are large. The indication from most of these company valuation models
and tools are that more than fifty percent of the input required into these company
valuation models and tools is derived from the companyfinancial statements.
5.1.3. Creative accounting
Creative accounting is where accounting techniques are used within the parameters of
Generally Accepted Accounting Practise (GAAP) to simulate the effects of economic
growth and profit (cash) generation. The simulation of economic growth and profit
generation in the context of creative accounting is rather the result of accounting sleight of
hand.
Creative accounting techniques influence the reliability and comparability qualitative
characteristics of company financial statements. The creative accounting techniques
create a distorted picture of the real and sustainable earnings of a company. This lead to
an incorrect assessment being made of a company and therefore a - too high intrinsic
value - given to a company.
The shareholder, analyst and investor can however counter the creative accounting
techniques. The understanding of these techniques and the influence of these techniques
on parameters in the financial statements needs to be understood by the shareholder,
analyst and investor. Comprehension and understanding of these techniques help the
shareholder, analyst and investor to make the necessary changes to financial statement
information so that the true picture - the correct intrinsic value - about a company is
reflected when valuing the company.
5.1.4. Relative importance of financial statements
Shareholders, analysts and investors use the financial statements extensively when a
company is research for investment purposes. A lot of information can be gathered from
the financial statements of a company. The financial statements of a company is almost a
concise description of the business as a whole. It is up to the shareholder, analyst and
investor to study the financial statements in detail, only then will the volume of information
contained in the financial statements of a company be unlocked to the reader of the
financial statements.
....
It is evident that the financial statements of a company is relative important when valuing
a company for investment purposes. The financial statements is probably the most
important primary source of investment information when valuing a company for
investment.
5.1.5. The role of the human factor in investment
It should be noted that even if one study all available investment information sources, one
should exercise patience and diligence when doing investments.
Warren Buffet says that the shareholder, analyst and investor needs to control his
emotions, which include fear and greed, when making investment decisions. Warren
Buffet goes so far as to say that one needs to develop a certain.ernotional maturity when
investments are made.
5.2. Recommendations
5.2.1. Grading of investment information sources
As there are an enormous number of available investment information sources, it is
recommended that investment information sources are graded on a scale of importance
when valuing companies for investment. This would make the profession of investment
and investment analysis more professional as more scientific and rational processes are
brought to the industry.
5.2.2. Management
Some literature has studied the subject of evaluating management of a company. There
is however still a lot of study that could be done in the valuation of management.
Management is probably also one of the largest determinants of success of a company.
The study of management could provide a basis to detect performing companies prior to
....long track records of success already being established. This would help the
shareholder, analyst and investor to detect early, the winners from a group of companies.
This would obviously assist the shareholder, analyst and investor to earn above average
return on investment.
56
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