RELATIVE IMPORTANCE OF COMPANY FINANCIAL STATEMENTS …

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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

Transcript of RELATIVE IMPORTANCE OF COMPANY FINANCIAL STATEMENTS …

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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

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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)

16799

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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

1213141415161718192021

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

525252535354545454

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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

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...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

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...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:

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...• 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

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...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

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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.

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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

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• 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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I,

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.

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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

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"

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.

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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.

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,.

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.

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....

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-

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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.

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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).

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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.

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· 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

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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

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.. -' .

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

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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

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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

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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

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.. 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

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-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

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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

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.. .

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.

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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

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· ~ ..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

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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

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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.

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· ..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

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~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.

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....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.

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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).

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· 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

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. ~.;

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.

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"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

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....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).

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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

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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.

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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

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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

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· ~ ..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.

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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.

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....

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

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....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.

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56

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