Question

1. Why is transparency; information quality/reliability and good governance important for corporations and for the financial markets ? Discuss in the context of some governments’ ability to raise credit through bond issues to combat the COVID crisis at zero or even negative interest rates?
2. What is the distinction between a stock and a flow variable? How does the stock & flow variable distinction impact the reporting and organization of financial information? Financial ratios derived from accounts are unit free. How will you use financial ratios to draw information about firms?

Answer 1

Why is transparency; information quality/reliability and good governance important for corporations and for the financial markets

Ask investors what kind of financial information they want companies to publish, and you'll probably hear two words: more and better. Quality financial reports allow for effective, informative fundamental analysis.

The word "transparent" can be used to describe high-quality financial statements. The term has quickly become a part of mainstream business vocabulary. Dictionaries offer many definitions for the word, but those synonyms relevant to financial reporting are: "easily understood," "very clear," "frank" and "candid."

Consider two companies with the same market capitalization, overall market-risk exposure and financial leverage. Assume that both also have the same earnings, earnings growth rate and similar returns on capital. The difference is that Company X is a single-business company with easy-to-understand financial statements. Company Y, by contrast, has numerous businesses and subsidiaries with complex financials.

Which one will have more value? Odds are good the market will value Company X more highly. Due to its complex and opaque financial statements, Company Y's value will likely be discounted.

The reason is simple: less information means less certainty for investors. When financial statements are not transparent, investors can never be sure about a company's real fundamentals and true risk. For instance, a firm's growth prospects are related to how it invests. It's difficult, if not impossible, to evaluate a company's investment performance if its investments are funneled through holding companies and are hidden from view. A lack of transparency may also obscure the company's debt level. If a company hides its debt, investors can't estimate their exposure to bankruptcy risk.

High-profile cases of financial shenanigans, such as those at Enron and Tyco, showed everyone that managers may employ fuzzy financials and complex business structures to hide unpleasant news. An overall lack of transparency can mean nasty surprises to come.

But let's face it, the financial statements of some firms are designed to hide rather than reveal information. Investors should steer clear of companies that lack transparency in their business operations, financial statements or strategies. Companies with impossible to understand financials and complex business structures are riskier and less valuable investments.

The reasons for inaccurate financial reporting are varied. A small but dangerous minority of companies actively intends to defraud investors. Other companies may release information that is misleading but technically conforms to legal standards.

The rise of stock-option compensation has increased the incentives for key employees of companies to misreport vital information. Companies have also increased their reliance on pro forma earnings and similar techniques, which can include hypothetical transactions. Then again, many companies just find it difficult to present financial information that complies with fuzzy and evolving accounting standards.

Beyond that, some firms are just simply more complex than others. Many operate in multiple businesses that often have little in common. For example, analyzing General Electric (GE) — an enormous conglomerate with numerous lines of business, is more challenging than examining the financials of a firm like Netflix (NFLX), a pure play online entertainment service.

When firms enter new markets or businesses, the way they structure these new businesses can result in greater complexity and less transparency. For instance, a firm that keeps each business separate will be easier to value than one that squeezes all the businesses into a single entity. Meanwhile, the increasing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements and new tax vehicles can befuddle investors.

The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand financial statements, the performance and fundamental value of that company remains either irrelevant or distorted.

Transparency Pays in the Markets

Mounting evidence suggests that the market gives a higher value to firms that are upfront with investors and analysts. Transparency pays, according to Robert Eccles, author of "The Value Reporting Revolution" (2001). Eccles shows that companies with fuller disclosure win more trust from investors. Relevant and reliable information means less risk to investors and thus a lower cost of capital, which naturally translates into higher valuations. The key finding is that companies that share the key metrics and performance indicators that investors consider important are more valuable than those companies that keep information to themselves.

Of course, there are two ways to interpret this evidence. One is that the market rewards more transparent companies with higher valuations because the risk of unpleasant surprises is believed to be lower. The other interpretation is that companies with good results usually release their earnings earlier. Companies that are doing well have nothing to hide and are eager to publicize their good performance as widely as possible. It is in their interest to be transparent and forthcoming with information so that the market can upgrade their fair value.

Further evidence suggests that the tendency among investors to mark down complexity explains the conglomerate discount. Relative to single-market or pure-play firms, conglomerates could be discounted. The positive reaction associated with spin-offs and divestment can be viewed as evidence that the market rewards transparency.

Naturally, there could be other reasons for the conglomerate discount. It could be the lack of focus of these companies and the inefficiencies that follow. Or it could be that the absence of market prices for the separate businesses makes it harder for investors to assess value.

What is the distinction between a stock and a flow variable? How does the stock & flow variable distinction impact the reporting and organization of financial information?

The distinction between a stock and a flow is very significant and we should clearly understand it since national income itself is a flow.

The basis of distinction is measurability at a point of time or period of time. Be it noted that both stocks and flows are variables. A variable is a measurable quantity which varies (changes).

A flow is a quantity which is measured with reference to a period of time. Thus, flows are defined with reference to a specific period (length of time), e.g., hours, days, weeks, months or years. It has time dimension. National income is a flow. It describes and measures flow of goods and services which become available to a country during a year.

Similarly, all other economic variables which have time dimension, i.e., whose magnitude can be measured over a period of time are called flow variables. For instance, income of a person is a flow which is earned during a week or a month or any other period. Likewise, investment (i.e., addition to the stock of capital) is a flow as it pertains to a period of time.

Other examples of flows are: expenditure, savings, depreciation, interest, exports, imports, change in inventories (not mere inventories), change in money supply, lending, borrowing, rent, profit, etc. because magnitude (size) of all these are measured over a period of time.

(b) Stock Variables:

A stock is a quantity which is measurable at a particular point of time, e.g., 4 p.m., 1st January, Monday, 2010, etc. Capital is a stock variable. On a particular date (say, 1st April, 2011), a country owns and commands stock of machines, buildings, accessories, raw materials, etc. It is stock of capital. Like a balance-sheet, a stock has a reference to a particular date on which it shows stock position. Clearly, a stock has no time dimension (length of time) as against a flow which has time dimension.

A flow shows change during a period of time whereas a stock indicates the quantity of a variable at a point of time. Thus, wealth is a stock since it can be measured at a point of time, but income is a flow because it can be measured over a period of time. Examples of stocks are: wealth, foreign debts, loan, inventories (not change in inventories), opening stock, money supply (amount of money), population, etc.

The distinction between flows and stocks can be easily understood by comparing the actions of Still Camera (which records position at a point of time) with that of Video Camera (which records position during a period of time).

Financial ratios derived from accounts are unit free. How will you use financial ratios to draw information about firms?

Financial ratios are created with the use of numerical values taken from financial statements to gain meaningful information about a company. The numbers found on a company’s financial statements – balance sheet, income statement, and cash flow statement – are used to perform quantitative analysis and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.

Financial ratios are grouped into the following categories:

• Liquidity ratios
• Leverage ratios
• Efficiency ratios
• Profitability ratios
• Market value ratios

Uses and Users of Financial Ratio Analysis

Analysis of financial ratios serves two main purposes:

1. Track company performance

Determining individual financial ratios per period and tracking the change in their values over time is done to spot trends that may be developing in a company. For example, an increasing debt-to-asset ratio may indicate that a company is overburdened with debt and may eventually be facing default risk.

2. Make comparative judgments regarding company performance

Comparing financial ratios with that of major competitors is done to identify whether a company is performing better or worse than the industry average. For example, comparing the return on assets between companies helps an analyst or investor to determine which company is making the most efficient use of its assets.

Users of financial ratios include parties external and internal to the company:

• External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers
• Internal users: Management team, employees, and owners

Liquidity Ratios

Liquidity ratios are financial ratios that measure a company’s ability to repay both short- and long-term obligations. Common liquidity ratios include the following:

The current ratio measures a company’s ability to pay off short-term liabilities with current assets:

Current ratio = Current assets / Current liabilities

The acid-test ratio measures a company’s ability to pay off short-term liabilities with quick assets:

Acid-test ratio = Current assets – Inventories / Current liabilities

The cash ratio measures a company’s ability to pay off short-term liabilities with cash and cash equivalents:

Cash ratio = Cash and Cash equivalents / Current Liabilities

The operating cash flow ratio is a measure of the number of times a company can pay off current liabilities with the cash generated in a given period:

Operating cash flow ratio = Operating cash flow / Current liabilities

Leverage Financial Ratios

Leverage ratios measure the amount of capital that comes from debt. In other words, leverage financial ratios are used to evaluate a company’s debt levels. Common leverage ratios include the following:

The debt ratio measures the relative amount of a company’s assets that are provided from debt:

Debt ratio = Total liabilities / Total assets

The debt to equity ratio calculates the weight of total debt and financial liabilities against shareholders’ equity:

Debt to equity ratio = Total liabilities / Shareholder’s equity

The interest coverage ratio shows how easily a company can pay its interest expenses:

Interest coverage ratio = Operating income / Interest expenses

The debt service coverage ratio reveals how easily a company can pay its debt obligations:

Debt service coverage ratio = Operating income / Total debt service

Efficiency Ratios

Efficiency ratios, also known as activity financial ratios, are used to measure how well a company is utilizing its assets and resources. Common efficiency ratios include:

The asset turnover ratio measures a company’s ability to generate sales from assets:

Asset turnover ratio = Net sales / Average total assets

The inventory turnover ratio measures how many times a company’s inventory is sold and replaced over a given period:

Inventory turnover ratio = Cost of goods sold / Average inventory

The accounts receivable turnover ratio measures how many times a company can turn receivables into cash over a given period:

Receivables turnover ratio = Net credit sales / Average accounts receivable

The days sales in inventory ratio measures the average number of days that a company holds on to inventory before selling it to customers:

Days sales in inventory ratio = 365 days / Inventory turnover ratio

Profitability Ratios

Profitability ratios measure a company’s ability to generate income relative to revenue, balance sheet assets, operating costs, and equity. Common profitability financial ratios include the following:

The gross margin ratio compares the gross profit of a company to its net sales to show how much profit a company makes after paying its cost of goods sold:

Gross margin ratio = Gross profit / Net sales

The operating margin ratio compares the operating income of a company to its net sales to determine operating efficiency:

Operating margin ratio = Operating income / Net sales

The return on assets ratio measures how efficiently a company is using its assets to generate profit:

Return on assets ratio = Net income / Total assets

The return on equity ratio measures how efficiently a company is using its equity to generate profit:

Return on equity ratio = Net income / Shareholder’s equity

Market Value Ratios

Market value ratios are used to evaluate the share price of a company’s stock. Common market value ratios include the following:

The book value per share ratio calculates the per-share value of a company based on the equity available to shareholders:

Book value per share ratio = (Shareholder’s equity – Preferred equity) / Total common shares outstanding

The dividend yield ratio measures the amount of dividends attributed to shareholders relative to the market value per share:

Dividend yield ratio = Dividend per share / Share price

The earnings per share ratio measures the amount of net income earned for each share outstanding:

Earnings per share ratio = Net earnings / Total shares outstanding

The price-earnings ratio compares a company’s share price to its earnings per share:

Price-earnings ratio = Share price / Earnings per share