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Who Cares About Regulations?

October 17, 2010 Leave a comment

American journalist Mignon McLaughlin once said that we humans are “…all born brave, trusting and greedy, and most of us remain greedy”. This has some truth to it, even if at certain levels of greed. For the most part though, the majority of individuals have control over their ‘greed’ (for a lack of a better word) by adhering to certain censorship codes, whether be it: religion, morals, ethics, social norms, etc. That doesn’t mean though, that there does not exist individuals who allow greed to consume them, and guide their decisions. With all the dangers surrounding the decisions taken by such individuals, perhaps the most of which, are those that have negative effects on other individuals. If we project such dangers onto the financial industry, then greedy decisions maybe referred to as systematic risk; “the unscrupulous actions of a few market participants could undermine public confidence in the entire financial system” (Levy and Post, p.896, 2005).

Given the potential fragility of financial markets, due to vulnerability from information asymmetry, agency problem, and transaction costs, lies the importance of regulating them. Regulations sometimes are viewed as tools, or deterrents, that “address systemic risk” (Schapiro, 2010). The main issue with financial markets is that incentives are misaligned on the “micro-level;  which [could result] in numerous potential conflicts of interest” (Kumpan, 2009). Regulations of financial markets are especially important in our current times, as when “financial institutions get bigger, markets move faster and investments grow more complex” (Schapiro, 2010), introducing potential cracks that ill-guided individuals may exploit. But one must not latch onto such negative view of regulations, as the main reason they are put there is to bring along with them added benefits to the financial industry; regulations are not closed doors. They attempt to align interests, effectively promoting for more efficient markets. They may also act as springboards in promoting more connected and expanded markets. The net effect is further industry stablility and stronger economies.

In deciding how much regulation should be put in place, one has to understand the reasons behind regulating the financial industry, and the implications that may be brought along with it. The benefits have been discussed above; which simply boil down to providing a better market platform that offers stability, efficient movement of capital and potential of growth. Many authors coined the term economic safety in describing such benefits. But “economic safety is more elusive than military safety …. too much safety undermines the very stability that safeguards promise” (Amity, 2010). Issues that should be taken into account when deciding on the level of regulation to be put in place, include:
> Available infrastructure: would a country’s given financial market infrastructure support such regulations? Whether the the answer is a yes or a no, how much will it cost to have such regulations put in place?

> Acceptability of local financial market: do such regulations actually benefit the players in a given financial market? [the point of these regulations in the first place is to benefit such users of the financial market — not burden them with no added benefits]

> Foreign investors: Given the interconnectedness of international financial markets, as a result of globalization trends, any regulation put in place by a specific country’s financial market could bare effects on other international markets. Thus, when drafting such regulations, financial market synergies along with foreign investors must be take into account; else the regulations would solve a specific issue while introducing more problematic issues.

> Market transparency and efficiency: the effect of such regulations on the market’s transparency and efficiency.

> Culture: on a more non-financial level, the regulations have to take into account social and cultural norms. These regulations, and the authorities who issue them, may find themselves in the spotlight, if for example, foreign investors are favoured over what is socially acceptable.

> … and many more issues

The degree of how much regulation should be put in place may seem like an simple task; one can argue that it borrows a page from the it ‘costs versus benefits’ theme. At the end of the day, there must exist certain goals and objectives for a given country’s financial industry; much like the goals and objective of companies. Regulations should promote and facilitate the achievement of such goals. For the most part, this is true, but what is different here is that the both internal and external environment that the financial industry interacts with is ever changing. And this change is a result of many variables, a lot of which are unknown territory for us: for example, our interpretation of the financial industry with advancements in technology, our definition of incentives, our understanding of ethics, etc.

“… it is managements’ job to organise, manage and control their businesses in a way which meets a set of high level principles … to safeguard the interest … and secure the safety and fairness of [financial] markets” (Tiner, 2005). Regulations are there to make sure that happens.

— Youssef Aboul-Naja

Income: It’s Definition, Measurement and Importance

July 11, 2010 1 comment

As per the American Institute of Certified Public Accountants (AICPA), accounting is the “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof” (Wikipedia). Thus an accountant must be able to capture a company’s financial interactions and present it in such a manner that will aid management in their decision making activities. The sensitivity of an accountant’s role comes in the form of deciding which financial data to capture, and the means of presenting them. This of course is dependant on management’s ever changing requirements, stemming directly from the owner’s objectives.

As the art of accounting has been around for thousands of years, it intricacies have been ever evolving, catering to the needs of its users. Brinberg (1980) has classified the accounting’s evolution into four periods, naming them the: Pure Custodial Period, Traditional Custodial Period, Asset Utilization Period, and Strategic Stewardship Period. With each period, the requirements of the business owners, or financiers, progressively became more thorough. The thoroughness were a result of complexities in the financial domain, brought upon by advancements in technology. These requirements manifested themselves in the financial reporting practices of the accountants.

In understanding our current financial reporting practices, one must focus on the current accounting period, along with the one that have lead up to it; the strategic stewardship and asset utilization periods. During those times, given the evolution of the investment markets, the external capital finance was released from the exclusivity grip of “bankers, other lenders and trade creditors” (Elliotte & Elliotte, p. 40, 2009). Reporting priorities shifted from liquidity to profitability, and as such, “the balance sheet data on its own was no longer sufficient; hence, the income statement emerged” (O’Connell, 2007). Central to this shift is the concept of income.

Income may be defined in many different ways, though the different conceptional notions are “reconciled in the long term” (Elliotte & Elliotte, 2007). The two dominant income views is that of the accountant and the economist. From an accountant’s perspective, income is defined as the residual portion of revenue which is the result of subtracting total revenues generated from the total expenses incurred by a company during the revenue generation phase. An economist though, would beg to differ, by defining income in terms of residual expected cash flows available from consumption, after dividends and equity appreciation has been taken into account.

Although the accountant’s and economist’s view of the income concept differ, in that one deals with historical values and the other in future expected cashflows, its importance is of vital use. Effectively, management has been entrusted with funds from various sources [shareholders, financiers, etc.] to appreciate its value, and as such, income is an effective indicator of measuring that. Management’s stewardship on its operating effectiveness of working capital may be best monitored by charting a company’s income patterns. From a managerial point of view, income will aid in highlighting the disparities between actual and predicted performance targets. As for governments, income is a benchmark of a company’s asset appreciation for a given period, that they may apply taxes on. Investors on the other hand, may use income in assessing a company’s commitment to seeing through theirs stated dividend and retention policies. As for financiers, income history may be used in predicting future performances.

With the vast benefits of income, extending beyond the aforementioned examples, its users must be aware of some drawbacks in its measurement process. The accountant’s view of income suffers from the following:

  • Revenue/loss is recorded for only certain assets [such as land and building] as they appreciate/depreciate in value (whereas the remainder of the assets are recorded according to their cost value)
  • Capital profits go unrecorded until they are realized
  • Unrealized profits are not recorded until their date of realization, whereas unrealized losses are recorded immediately
  • The allotted depreciation depreciation expense, is an accountant’s estimate.

As for the economist’s view of income, it suffers from the future unpredictability element and differing investor expectations:

  • The predicted cash flows are not concrete (thus the expected income to be generated is at best a guesstimate)
  • As investors have differing risk thresholds and time preferences, so does the variables used in finding the present value of the future cash flows; resulting in varying income figures. Therefore, the value of the economic income is user dependant; making it difficult to produce financial statements under the economist’s view of income.

Given the various definitions and drawbacks of measuring income, it uses is still of vital role in the ever evolving “sophisticated capital market[s]” (Elliotte & Elliotte, p. 55, 2009). With “‘the need for both retrospective and prospective data” (O’Connell, 2007) from the various users of the financial statements, income may provide just that.

Youssef Aboul-Naja

Measuring Financial Performance: Is the Cash flow Method Superior to that of the Accrual Basis?

Around two thousand five hundred years ago, the Greek philosopher Heraclitus noted that “nothing endures but change” (Wikiquote, 2010). This simple axiom, if I may, is the main underlying factor that influences our behavior when it comes to interacting with the outside sphere at any point of time. Given man’s inquisitive behavior, sciences were devised to explain the outside world. However, since these sciences are nothing but a mere reflection of what we know, it is by no coincidence that they are in a continual state of work-in-progress.  From an accounting perspective, whether the art of bookkeeping is maintained according to the rules devised by “stone counters [as was the practice some 10,000 years ago]” (Atkinson, 2002), or the more complex accrual basis, accounting will continually change to better serve the needs of the stakeholders. Accountants, essentially, are communicators.

But, one must humbly observe, that words have the power of changing the world; thus the duties of an accountant are ever so important. Within this ever-changing, sensitive, backdrop does the latest accounting contention arise: is the cash-flow method superior to that of the accrual?

In a nutshell, the cash-flow methods calls for recognizing transactions as cash is physically exchanged between two parties. Proponents of this method claim that the figures provided by the accountants are more factual, since they are backed by already executed transactions. As for the accrual basis of accounting method, transactions are recognized as their execution is earned [regardless of whether or not cash has been exchanged]. The proponents on this side of the camp claim that “accrual accounting information more fully reflects the overall effects of periodic managerial decisions” (Kwon, 1989).

To that respect, according to the two dominant, non-governmental, accounting bodies, the FASB [Financial Accounting Standards Board] and IASB [International Financial Reporting Standards], companies that claim adherence to either standard must provide statements that have an accrual and cash-flow outlooks. It is to be noted that adhering to one of the standards signifies that the financial statements have been prepared in accordance to accepted bookkeeping practices; facilitating comparability. This is of utmost importance to a lot of companies, as they seek capital from various sources.

Given the high-profile, “cooking the books” (Datar, 2002), scandals of companies in recent years, it has been proposed, by the cash-flow method advocates, that if accountants drop the accrual method as they prepare the financial statements, confidence would once again be restored in the financial reporting profession. They also claim that the difficulties, and controversies, of devising a unified set of global accounting standards would be a thing of the past.

To test this claim, it is best to start by clarifying the term confidence in a financial reporting context. “The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements” (Dechow,1994). The beneficiaries of these excess cash receipts are essentially the stakeholders of the company; most probably the shareholders, but could include employees, other parties, etc. [this is a company/country/culture specific]. These stakeholders are the financiers of companies. The commitment of backing a company is highly influenced, along with other factors, by the stake-holders’ confidence that the financial statements have been prepared in manner reflective of the actual financial reality of the company.

To that accord, if the cash-flow method was the only prevalent way of transmitting financial information to the stakeholders, that would not necessarily restore confidence in financial reporting. “If people [managers] are dishonest, any system [or method] is vulnerable” (Quinn, 2003). Managers may time cash disbursement to their benefit; especially that management compensation is closely tied to performance. Also, since projects could extend beyond one-year, inaccuracies creep into the cash-flow method. For example, this method will falsely portray a loss for a company in the first year on a given project and a profit on the second; provided that revenue will come only on the second year. This scenario shows the superiority and flexibility of the accrual basis method since it more accurately reflects the reality of the financial situation.

However, many successful companies that are profitable on paper declare bankruptcy, as they mismanaged their handling of cash, the bloodline of any organization. Each method complements the other. If we liken the cash-flow method to short-term war skirmishes and the accrual method to the overall war result, a war general should be concerned with winning both; as each is dependant upon the other. The way to restore confidence in the financial reporting sector, should lay along the lines of needing “good ethics and a good system of governance“ (Quinn, 2003).

Coming back to the claim, dropping the accrual method will remove the controversies surrounding a unified set of global accounting standards, it could be argued either way. The cash-flow method is more clear cut when it comes to what constitutes a completed transaction. Thus any issues related to cultural views, status of national accounting profession, taxation (to name a few) automatically become more or less irrelevant. Though if bookkeeping is handled in such a clinical fashion, other sets of issues will arise. For example, profit seeking investors will have a problem with financial statements that deal only with liquidity. Therefore, it may seem that controversies surrounding a unified set of global accounting standards might be lessened if the cash-flow method  is solely used; this claim is not entirely true. Needless to say, given the improvements in technology, a unified set of global accounting standards is required  regardless of which method is put in use; as various economies are linked via global transactions. “No man [or in that regards a country/economy] is an island” (Donne, 1839). “The rapid spread of the financial crisis” (Anon, 2009) in 2008 is a testament of that.

Youssef Aboul-Naja

Working Capital: Benefits of the Money Market

March 14, 2010 Leave a comment

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:


Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja

Why do companies need to understand risk?

February 22, 2010 2 comments

“If you have a pilot flying a plane who doesn’t understand there can be storms, what is going to happen?” (Nocera, 2009). Against this backdrop, I commence my discussion regarding the importance of understanding the nature of risk, and its profound effect on the returns of long and short term investments undertaken by businesses. The thought of escaping risk is an impossible feat. As with every action, there is an attached element of risk to it; ‘avoiding risk can itself be risky’ (Salzberg, 2010). Effectively, to survive and achieve growth, a business must learn to embrace risk by understanding its intricate elements, and the impact it brings about its operations. Thus risk, if handled properly, may very well be a source of opportunity. The Chinese captured such a concept, by denoting the symbol for risk as “a combination of two symbols—one for danger and one for opportunity (Damodaran, 2005).

What is risk? Though there is no verdict on an exact definition, Elroy Dimson proposed a rather interesting version, which states that “risk means more things can happen than will happen” (Farrell, 2007). So in that sense, risk is the anticipation of future events that will have an adversary effect on a given business; though not all events will take place. Also, not all events can be anticipated. If we can foretell the future, the element of risk would simply diminish to zero. Thus, risk is our interpretation of how the future events will unfold, given the current factors we have at hand.

From an Investment’s point of view, taking on risk will result in some form of return. How high or low the return is depends on how the predicted risk element pans out with the actual future events. Nonetheless, a return is composed of two elements: an expected part and a ‘surprise’ (Ross et. al, 2008, p.322) part. The expected part further breaks into a:
– Systematic element: a surprise element that is applicable to almost every asset
– Unsystematic element: a surprise element applicable only to a single asset

As companies go about their everyday business, they constantly engage with various activities; each having an element of risk. And as discussed earlier, each risk has a return associated to it. Thus, as companies go about their daily business, they are maintaining a portfolio of returns:
-> They must achieve a certain return to shareholders
-> They might have invested in other companies (thus they expect a certain return)
-> They might be undertaking a project (thus they need to achieve a certain return margin for the project to be profitable)
…etc
So for companies to survive, they must understand risk (the systematic and unsystematic elements), as this affects the returns generated, and would, in turn, affect the company’s return/investment portfolio on the short and long runs.

In understanding systematic risk, I bring upon an example from the company I currently work for. I work in a financing house in Saudi Arabia. Though it is a privately held company, they are constantly engaged in loan extending transactions, which bears an element of risk. The rates that are offered to the clients’ partly accounts for the systematic risk element [though it cannot be predicted precisely]. Examples include:
-> The prevailing SIBOR in the Kingdom
-> The death of King Fahd in 2005: “the market opened at a decline” (Akeel, 2005), which resonated across the whole Saudi economy, resulting in our company receiving delayed payments from its clients, and a lower overall return.
-> During the end of 2008 and throughout 2009, bearing in mind the global crisis, the oil prices fluctuated from “$98 per barrel, rose to $147 per barrel in July, then ended the year at $44 per barrel” (Anon, 2010). Such swings had an effect on government spending (especially in the early part of 2009), and effectively also affected client payments to our company.

Now, in understanding unsystematic risk, we continue upon the example of my company. Unsystematic risk examples include:
-> The change of our General Manager – the older one suddenly decided to resign. As the new GM is not tested [came from outside], this raised the risk factor to the company’s owners, thus requiring higher returns (meaning a higher cost of capital on our company) [short-term issue]
-> Changes in the leasing laws, as per directions from the Saudi Arabian Monetary Agency. This drove up the cost of doing certain parts of our business [short-term issue]
-> A conflict of interest issue, which required us to create two operational units (instead of one), and essentially drove the prices up [long-term issue]

Thus, in order to continue surviving, the company must understand how these systematic/unsystematic risks affect it – whether they are long or short term in nature. Once it understands, it will be able to minimize its risks [i.e. maximize its returns]. Also, by understanding how the various risks impacting the company and its effect on its overall returns [from current projects], they will be able to determine whether or not to “add a new project to its existing portfolio… [By] estimating the coefficient of correlation between the cash flows [returns] from the new project and the total cash flows [returns] from existing projects … it can [thus] determine the effect of the new project on the means and standard deviations of the total cash flows” (Hull, 1986) and decide on its overall benefit to the portfolio.

Understanding how risk [its systematic and unsystematic elements] impacts a company’s activities is of crucial importance to its survival in the short/long term. Failing to comprehend and incorporate such risk elements in business activity will lead to catastrophic results. Referring to the 2008/2009 global economic meltdown would suffice.

~ Youssef Aboul-Naja