Performance of Emerging Financial Markets - Assignment Example

Performance of Emerging Financial Markets Introduction Financial markets the world over are today a matter of interest, maybe more a matter of concern. The current recession in the US has been one of the worst in the past forty years. Ever since the Great Depression in the 1930s, the world had not seen an economic crisis of such an enormous bearing. The recession has not only affected the U.S and Europe, it has affected the world economy to a great extent. Today, trade is not restricted to the internal boundaries of a country. Goods and currencies move from one part of the globe to another in a matter of days. As a consequence, any event occurring in one part of the world will definitely have an impact on the rest of it. The recent recession has led to the downfall of many financial companies, banks, manufacturing companies and stock markets all over the world. Companies have been wiped out or taken over, property rates have crashed and gold prices have soared in the past one-two years. The situation has however not been too grave in emerging markets like China, India, Brazil, UAE and Argentina. The subprime crisis which was the cause of the economic meltdown did not affect emerging markets to a great extent. This was possible because the lending policies in these countries were strict and banks and financial companies could not lend to people with bad track records. At a time when global economy is reeling under one of the worst recessions and uncertain market conditions, there is an urgent need to study and analyze in detail the possibility of predicting the performance of markets. This prediction assumes more importance under emerging market conditions. When many companies and banks have gone bankrupt in the developed world, surprisingly, in the case of emerging markets, this has not been witnessed. In this study, we will examine certain companies and their financial statements for the previous five years and see if we can arrive at a conclusion about the relevance of predicting the future of emerging markets. The results of the study would not only be beneficial to students, researchers and economists, but also to decision making bodies that might be planning huge investments in emerging markets. The need of the hour is a stable global economy and this can be achieved only if there is very low level of risk and uncertainty when huge investments are made by individuals, business houses and governments. Literature Review Not much literature is available about the results of previous research in the field of predicting emerging markets based on the performance of companies in Saudi Arabia. In a study undertaken by Kamal Naser & Rana Nuseibeh [2003], it was found that companies listed on the stock exchange were willing to disclose information in their annual reports to a high degree. While there was high compliance with mandatory requirements laid out by the law and degree of voluntary disclosure was high, it was found that there was a low level of voluntary disclosure. Reacting to the fall of property market in Dubai, Khalaf Al Habtoor, Chairman of Al Habtoor Group, said analysts had made too much of Dubai’s problems and that the media coverage had been overstated. He described the fall as a “grand, grand over-reaction to debt crisis”. Not in favour of any prediction or analysis of financial markets, Habtoor expressed his ire at analysts stating that they had damaged Europe and America with their analysis and prediction of the dollar and they had also damaged Japan by offering their analysis on the yen. He expressed his anger at analysts saying that they cannot make an economic call themselves and hinted at analysts being jealous human beings. Examining research reports from other parts of the world, we find that Beaver had listed a number of indicators that could predict the performance of companies in terms of success or failure almost five years before it actually happened. [1967]. He had however not been in favour of the multivariate analysis and had used only one variable to predict bankruptcy in a company. A later study by Deakin [1972] used the same 14 variables as Beaver, but applied them in multivariate discriminant models. However, the results of such analysis did not have much significance as there was only one variable considered for the study and emphasis was laid on only particular signals of expected problems. Ratio analysis of such data can be incorrect and might not be able to predict the future economic conditions well. The study dealt in detail with Z Score model and Zeta credit risk model and a comparison between the two for correctly predicting the financial health of a company. In yet another study , and graduate student studied the relevance of predicting bankruptcy by analyzing financial ratios such as return on assets (net income divided by total assets), cash flow to total liabilities (earnings before interest, depreciation, and taxes divided by both short- and long-term debt), and leverage (total liabilities to total assets) [McNichols, Beaver, Jung-Wu Rhie]. The study examined the influence of 3 forces on the predictive value in the last four decades. The first force was the advice of standard setting bodies like the Securities Exchange Board and other Commissions involved in regulating the stock markets to companies to keep the financial statements transparent and add fair values of assets and liabilities. The second force was the impact of various ratios in the financial statement of companies, the major one being ROA or Returns on Assets, cash flow of total liabilities and leverage taken by the company. The returns on assets or ROA indicate the amount received on an investment or the profitability of the company. If the cash flow of liabilities is good, a company can easily repay the interest and the loan taken from outside sources. Leverage would give an idea of the balance to be paid when compared to the value of assets of the firm. The researchers found that the three forces gave a good idea of the future of the company. Many years before a company went bankrupt, the three financial indicators mentioned above helped in predicting the same. These were referred to as “hazard rate” or the risk of going bankrupt of a company. The group concluded that an analysis of these factors would help in safely predicting the financial health or near bankruptcy of a company. The study took into consideration the financial statements of various companies over a period of 40 years, divided into two periods: Period I from 1962 to 1993 and Period 2 from 1994 to 2002.Other than the ratios in the financial statements mentioned above, the market based variables were also studied. The market capitalization of the company when compared to the size of the firm (common stock price per share times the number of common shares outstanding), the consistency of stock returns and the cumulative stock returns over an year were studied. The predictability of the bankruptcy of the firm based on the study of these market factors was also high. As the predictability of the second method (market based variables) was higher, the group combined the two methods i.e financial ratios and market based variables and got an accuracy of 96% in predicting the performance of the company in future. Research Proposal: Is it possible to predict the performance of emerging markets through the financial reports of companies? Hypothesis: It is possible to predict the performance of emerging markets through the analysis of financial reports of companies over a period of time? Conceptual Framework The conceptual framework of this proposal would include: Establishing a co-relation between the performance of financially emerging markets and the financial reports of popular companies in Saudi Arabia To see if the performance of financially emerging markets can be predicted for a definite period of time based on the financial reports of popular companies in Saudi Arabia Give a set of definitions, assumptions and financial and economic ratios for carrying out the research As discussed in the literature review, a study of various ratios in the financial statement of a company over a period of five years or more gives a fair idea of its performance in future. Thus, the emphasis of the thesis would be on analyzing the three ratios: i.e ROA (Returns on Assets), debt ratio and leverage of the selected companies. Since a majority of the companies in Saudi Arabia are state owned and debt free, it might not be practical to use this method to predict the performance of these companies in future. The study might have to consider companies in other emerging markets like India, Brazil or China. AS emphasized by Beaver , the market ratios of the firms under consideration would probably give a fair idea of the future performance of the companies or the emerging markets in totality. Research Strategy The research strategy would involve close examination and study of five companies: both domestic and having foreign collaboration having sufficient turnover to influence the economy of the country. The GDP of Saudi Arabia is $468 Billion US dollars at current prices (2008) and the companies chosen for the study of annual reports will have at least a 5% share in the GDP of the country. Only if the turnover of the company is large enough, will it have an impact on the financial condition of the country at any point of time. The annual reports for 5 consecutive years would be analyzed for various ratios and a conclusion would be drawn. The GDP of Saudi Arabia was estimated to be $527 billion in 2008 [Bureau of Near Eastern Affairs, Jan.2009].ARAMCO is one of the biggest contributors to the GDP of Saudi Arabia. The contribution of this oil drilling and refining company has been one of the largest in the GDP of the nation. This government owned company has shown consistent growth and will be an ideal sample for study in the thesis. Another company contributing to Saudi’s GDP is SABIC or Saudi Basic Industries Corporation. Along with a study of this company, international banks could also be considered for the study to arrive at the relevance of the hypothesis. Thus, the samples considered for study would be contributing to the GDP of the country in a large way. Research Methodology Research Methodology would be a statistical method known as multiple discriminant analysis. This method consists of taking into account many variables and then comparing them for each company or the mean. Sampling : Sampling would involve non random or purposive sampling as we would not be selecting the samples at random, instead look for certain parameters to be fulfilled before selecting the sample for study. Survey: The survey would be a combination of a questionnaire and interview.[Appendix1,2] The research would basically focus on the study and financial analysis of the particular companies over a period of five years and their proposed impact on the economy of the country. These would preferably be selected from different sectors having an impact on the economy of the country. The study would have to last at least six to twelve months to see if the prediction comes true. Financial ratios of the selected companies would be analyzed over a period of five years and a hypothetical statement made, based on the performance of these companies. Financial ratios are tools for interpreting financial statements. These provide a foundation for stock valuation and evaluate financial performance of the company. To enable healthy analysis, an experienced financial analyst includes financial ratio calculations extensively in a financial modeling exercise. Financial ratios have definite advantages like standardizing information from financial statements across multiple financial years, standardizing information from financial statements from different companies to allow comparison between similar variables for firms of small and big sizes in a financial model and measure key relationships by relating inputs (costs) with outputs (benefits) and facilitates comparison of these relationships over time and across firms in a financial model. In this study we will include 4 kinds of financial ratios : Performance ratios Working capital ratios Liquidity ratios Solvency ratios These ratios help to quickly and effectively understand the financial state of the company. The performance ratio gives an idea of the returns made by the company on its capital investment, its profit margins, Working capital ratios indicate the time period required to repay debts, and the number of times inventory changed, liquidity ratio lets us know if the company can continue to pay back its debts and liabilities while the solvency ratios (Longer term) gives an idea of the debt in relation to assets and equity and how long the company can continue to run of the same debt-asset ration. By studying the balance sheets of companies, the above-mentioned ratios like performance ratio, working capital ratio, liquidity ratio and solvency ratios can be calculated and thus the future of the company and the economy of the country can be predicted. For the data collection, a questionnaire will be sent to each of the five companies and a request fro their balance sheets of the past five years will be made. Simultaneously, the economy of the country in terms of growth in GDP and other relevant factors will be made. It has to be seen if a correlation can be drawn between the performance of the companies over five years and the growth in GDP during the same period. Appendix -1 Questionnaire: Name of the company Sector % contribution to the GDP Years of operation in Saudi Arabia Listed on Stock exchange (yes/no) Appendix-2 Name of company Performance ratio Working capital ratio Liquidity ratios Solvency ratio Appendix-3 Sample Profit and Loss Account of BHEL Bharat Heavy Electricals « Previous Years Profit & Loss account ------------------- in Rs. Cr. ------------------- Mar '05 Mar '06 Mar '07 Mar '08 Mar '09 12 mths 12 mths 12 mths 12 mths 12 mths Income Sales Turnover 10,682.15 14,739.46 19,058.33 21,775.60 28,504.05 Excise Duty 1,043.15 1,298.01 1,695.44 2,234.52 1,889.69 Net Sales 9,639.00 13,441.45 17,362.89 19,541.08 26,614.36 Other Income 259.98 342 482.32 1,023.12 1,017.86 Stock Adjustments 539.77 386.01 181.37 827.33 1,151.54 Total Income 10,438.75 14,169.46 18,026.58 21,391.53 28,783.76 Expenditure Raw Materials 5,097.68 7,099.40 8,561.41 10,400.69 15,587.43 Power & Fuel Cost 220.54 229.01 259.08 273.07 341.82 Employee Cost 1,650.38 1,878.51 2,366.93 2,602.30 2,982.63 Other Manufacturing Expenses 783.44 1,054.67 1,733.59 1,464.58 2,086.06 Selling and Admin Expenses 1,006.38 1,216.00 887.55 1,664.57 2,414.84 Miscellaneous Expenses 116.98 126.27 190.5 216.6 165.12 Preoperative Exp Capitalised 0 0 0 0 0 Total Expenses 8,875.40 11,603.86 13,999.06 16,621.81 23,577.90 Mar '05 Mar '06 Mar '07 Mar '08 Mar '09 12 mths 12 mths 12 mths 12 mths 12 mths Operating Profit 1,303.37 2,223.60 3,545.20 3,746.60 4,188.00 PBDIT 1,563.35 2,565.60 4,027.52 4,769.72 5,205.86 Interest 81.41 58.75 43.33 35.42 30.71 PBDT 1,481.94 2,506.85 3,984.19 4,734.30 5,175.15 Depreciation 218.87 245.93 244.61 297.21 334.27 Other Written Off 0 0 0 0 0 Profit Before Tax 1,263.07 2,260.92 3,739.58 4,437.09 4,840.88 Extra-ordinary items 306.6 299.86 -13.79 -12.69 96.64 PBT (Post Extra-ord Items) 1,569.67 2,560.78 3,725.79 4,424.40 4,937.52 Tax 616.3 881.61 1,311.09 1,565.06 1,799.31 Reported Net Profit 953.4 1,679.16 2,414.70 2,859.34 3,138.21 Total Value Addition 3,777.71 4,504.46 5,437.65 6,221.12 7,990.47 Preference Dividend 0 0 0 0 0 Equity Dividend 195.81 354.9 599.66 746.52 832.18 Corporate Dividend Tax 26.64 49.78 92.83 126.87 141.43 Per share data (annualised) Shares in issue (lakhs) 2,447.60 2,447.60 2,447.60 4,895.20 4,895.20 Earning Per Share (Rs) 38.95 68.6 98.66 58.41 64.11 Equity Dividend (%) 80 145 245 152.5 170 Book Value (Rs) 246.24 298.31 359.06 220.1 264.32 Source : Asian CERC References: 1. The Theoretical or Conceptual Framework , pp 35. Chapter: 6: Literature Search http://cbdd.wsu.edu/edev/NetTOM_ToT/Resources/Other/TOM614/page35.htm 2. Naser Kamal & Nuseibeh Rana Quality of financial reporting: evidence from the listed Saudi nonfinancial companies The International Journal of Accounting Volume 38, Issue 1, Spring 2003, Pages 41-69 3. Bladd Joanne. Al Habtoor slams Dubai debts 'over reaction' Arabian Business.com.30th November, 2009. http://www.arabianbusiness.com/574832-al-habtoor-slams-dubai-debts-over-reaction 4. World Development Indicators, World Bank Report, November 20th 2009. 5. Gross Domestic Product http://www.google.com/publicdata?ds=wb-wdi&met=ny_gdp_mktp_cd&idim=country:SAU&q=what+is+the+GDP+of+Saudi+Arabia%3F 6. Altman, Edward. Predicting Financial Distress of Companies. Journal of Banking & Finance, July 2000. 7. Altman, E., "Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy," Journal of Finance, September 1968. 8. Altman, E., R. Haldeman, and P. Narayanan, "ZETA Analysis: A New Model to Identify Bankruptcy Risk of Corporations," Journal of Banking and Finance, June 1977. 9. Altman, E., J. Hartzell, and M. Peck, "Emerging Markets Corporate Bonds: A Scoring System," Salomon Brothers Inc, New York, 1995. 10. Deakin, E. B., "A Discriminant Analysis of Predictors of Business Failure," Journal of Accounting Research, March 1972. 11. Beaver, W., "Financial Ratios as Predictors of Failures," in Empirical Research in Accounting, Selected studies, 1966 in supplement to the Journal of Accounting Research, January 1967. 12. Osler, C. and G. Hong, “Rapidly Rising Corporate Debt: Are Firms Now Vulnerable to an Economic Slowdown?” Current Issues in Economics & Finance, Federal Reserve Bank of New York, June 2000. 13. Standard & Poor's, "Corporate Defaults Level Off in 1994," L. Brand, T. K. Ho, and R. Bahar, CreditWeek, May 1, 1995. 14. Moneycontrol.com, accessed on 2nd December, 2009. http://www.moneycontrol.com/financials/bharatheavyelectricals/profit-loss/BHEL. 15. LaPlante, Alice. Financial Statements Are Still Valuable Tools for Predicting Bankruptcy, November 2005. http://www.gsb.stanford.edu/news/research/acctg_mcnichols-beaver_bankruptcy.shtml Read More