The Usefulness of Corporate Governance and Financial Ratios to

European Journal of Economics, Finance and Administrative Sciences ISSN 1450-2275 Issue 11 (2008) © EuroJournals, Inc. 2008 http://www.eurojournalsn.com The Usefulness of Corporate Governance and Financial Ratios to Credit and Financial Analysts: Evidence from Bahrain Jasim Al-Ajmi Department of Economics and Finance, College of Business Administration University of Bahrain, Bahrain Tel: +973-39444284; Fax: +973-17449776 E-mail: jasimalajmi@gmail.com Abstract Financial ratios provide useful quantitative information to investors and analysts who want to evaluate the operations of a firm and analyze its position within its industry over time. The financial indicators that analysts use as basis for decisions are not necessarily all equally useful. This study attempts to determine the perceptions of credit and financial analysts working in financial institutions in Bahrain as to the usefulness of 71 financial ratios and 6 attributes of corporate governance named in a questionnaire. There are no significant differences between credit analysts and financial analysts with respect to 40 of the indicators. Credit analysts consider the quick ratio the most useful ratio, followed by the non-recurrent ratio. Financial analysts consider price-earnings the most useful ratio, followed by the market-to-book ratio. The quality of corporate governance practices is also considered important by financial analysts, but less important by credit analysts. These results should be of interest to a variety of stakeholders, including credit analysts, financial analysts, auditors, regulators and educators. Keywords: Corporate governance, credit analysts, financial analysts, Bahrain, financial ratios 1. Introduction Accounting information is important for rationalizing the decisions of users of corporate reports in many countries including Bahrain; Anderson (1981), Arnold and Moizer (1984), Chenhall and Juchau (1977), Chang and Most (1985), Lee and Tweedie (1975a, b; 1981), Streuly (1994), Winfield (1978), Naser (2003), Al-Razeen and Karbhari (2004) and Al-Ajmi (2007), among others. Among the most important of the users groups are investors and creditors. Those users read the contents of financial statements and calculate a variety of financial indicators before they make credit and investing decisions, because they believe that financial indicators have predictive power. Among the most widely used indicators are financial ratios. Financial ratios are used for a number of reasons, to value firms [Fama and French (1992, 1993, 1995, 1996, 1998)], to differentiate creditworthy companies from others [Altman (1968), among others], to identify acquisition targets and to indicate the process of organizational turnaround [Pearce (2007)]. Altman (1968) was the first to develop a bankruptcy prediction model based on a set of financial ratios. Financial ratios have been widely used ever since. This extensive use of financial ratios by practitioners and in the accounting and finance literature is that those ratios are seen as proxies for firm fundamentals. 108 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) The usefulness of financial indicators depends largely on the integrity of financial statements. The integrity of financial disclosure is directly related to the quality of a firm’s corporate governance practices; see, for example, Kasznik and Lev (1995), Francis et al. (2004) and Wang (2006). Agency conflicts between controlling shareholders and minority investors are found to account for a significant portion of earnings management in China’s listed firms (Liu and Lu,2007). Corporate governance practices are also found to impact credit ratings (Ashbaugh-Skaife, 2006) the cost of debt and firm value (Gompers et al., 2003). Fitch (2004) asserts that shareholder and creditor interests are generally aligned when better monitoring of management occurs. Other attributes of corporate governance have a less clear impact on creditors. The purpose of this research is twofold. I report the use of financial ratios by credit analysts and financial analysts working in different financial institutions in Bahrain, to investigate (1) whether there are any significant differences between the perceptions of financial ratios by the two groups, and (2) the effect of corporate governance practices on investment and lending decisions. To the best of my knowledge, this is the first published study on this question in Bahrain and the first survey related to the usefulness of financial information and the importance of company annual reports. The study makes several contributions. It provides the first survey of professional analysts on the use of financial ratios in both credit and investment decisions in Bahrain. It thus provides a benchmark for comparative studies to identify the determinants of stock prices, firm values and company performance. It also provides evidence of users’ need for non-financial information that is not currently disclosed by companies for investment and credit decisions. Regulators, auditors and managers can use the results to determine the disclosure of accounting information that facilitates decision-making. Accounting and finance professors can use the results to identify the ratios to emphasize in teaching and curriculum development. Results on the importance of the quality of corporate governance in lending and investment decisions contribute to the literature on governance. 2. Brief Literature Review Altman’s (1968) model to predict company bankruptcy promoted a huge literature on the usefulness of financial ratios. For extensive reviews of different of aspects of financial ratios, see Chen and Shimerda (1981), Salmi and Martikainen (1994), Dimitras et al. (1996) and Kumar and Ravi (2007). Another perspective comes from studies that survey actual users of corporate reports. Some of this research finds that credit analysts and financial analysts attach particular importance to corporate reports. If this is the case, readers of corporate reports need to use analytical approaches to evaluate the financial information. One of the most common approaches is financial ratios. Ratios are classified into groups on the basis of different criteria. One way to group ratios is on the basis of the contents of the ratio; that is, cash flow ratios and other ratios. Another is on the basis of the aspects they measure; that is profitability ratios, activity ratios, leverage ratios, liquidity ratios and investors’ (market) ratios. Chen and Shimerda (1981) review 26 articles that classify 100 financial indicators, 65 of them financial ratios. They report that 41 financial ratios are considered important, given citation in one more of the 26 articles. In identifying bankrupt firms: Their final model, however, includes only seven financial indicators, namely, return on investment, debt ratio, the current ratio, cash position, net working capital turnover, inventory turnover and accounts receivable turnover. The bankruptcy model for industrial companies developed by Gombola and Ketz (1983) adds to these factors a cash flow measure. Sun and Li (2006) have developed a model to predict companies’ financial distress, testing 35 financial ratios for 135 pairs of listed companies. Their final distress prediction model includes net profit growth rate, liabilities to tangible net assets, accounts receivable turnover, liabilities to cash flow, liabilities to equity market value, total asset turnover and gross profit margin. There are interesting observations in a comprehensive review by Kumar and Ravi (2007) of 128 articles between 1968 and 2005 that attempt to investigate bankruptcy problems for banks and other 109 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) firms, over different countries and including statistical techniques ranging from traditional to innovative. The author’s was to compare the primary techniques in bankruptcy prediction. Despite similarities in many of the studies, Kumar and Ravi (2007) show differences in the financial ratios and non-financial indicators such as firm age, degree of competitiveness, fraud and size that were finally used in the bankruptcy prediction models. While all 128 models reviewed include liquidity indicators, leverage, profitability and asset management, the ratios used to measure these attributes are not universal; that is researchers use different financial ratios as proxies for the same attribute. Models also differ in terms of the number of independent variables used to predict bankruptcy. A considerable body of research in the finance literature finds that financial ratios can differentiate value stocks from glamour stocks (see, for example, Fama and French (1992, 1993, 1995, 1996, 1998), Ho et al. (2006) and Morelli (2007), among others]. Ratios considered as measures of company fundamentals that are able to explain the cross-sectional variation between stock rates of returns are price-to-earnings, dividends to price, market-to-book and retained earnings to total assets. Matsumoto et al. (1995) examine security analysts’ views on the financial ratios of manufacturing and retailing companies in the United States. They include in their questionnaire 63 indicators classified into 8 groups: profitability ratios, leverage ratios, inventory turnover ratios, receivable turnover ratios, cash flow ratios, liquidity ratios, capital turnover ratios and cash position ratios. The analysts ranked growth rates as the most important, followed by valuation ratios and profitability ratios. EPS measures and leverage ratios are ranked slightly lower. Cash flow ratios, liquidity and cash position are ranked 6th, 10th and 13th. Surprisingly, dividend ratios are ranked 7th after the liquidity ratios. Most recently, Al-Abdulqader et al. (2007) undertook a comprehensive survey of the investment decision processes used by a variety of analysts in Saudi Arabia. Among the three groups surveyed (small investors, large investors and local shares mediators, the latter considered to be more knowledgeable about markets and more educated compared with the other two). The P/E ratio is ranked first. Profitability ratios come next, followed by estimated future dividends, while turnover ratios are ranked last of the 11 groups of ratios. The authors do not list the financial ratios included in the survey. Cash flow based financial ratios require additional examination because cash flow statements offer ways to evaluate performance. Yet many corporate finance textbooks generally pay little attention to cash flow-based financial ratios; see, for example, Brigham and Basely (2007). If cash flow information is useful but unused, the logical conclusion is that analysts are not analyzing the available data properly Carslaw and Mills (1991). Close analysis of the studies reviewed by Kumar and Ravi (2007) reveals that not all authors included cash flow measures. This observation also applies to studies published after companies started to comply with the requirements of SFAS 95 in 1988. Many new cash flow ratios are discussed in the recent professional business literature or used in financial statements in countries where the cash flow statement is mandatory. No comprehensive set of cash flow ratios has been agreed upon for evaluation of the cash flow statement, however. Different users may apply different financial ratios even for the same purpose. When different financial ratios are used comparison of results becomes rather complex Gombola and Ketz (1993). Giacomino and Mielke (1993) propose nine cash flow ratios to evaluate a company's performance and use than to evaluate US companies in the chemical, food and electronic industries, calculating three-year averages per industry. The industries were chosen had the largest number of companies among the Fortune 500. On the basis of empirical analysis ove 1986-1988, Giacomino and Mielke (1993) suggest a set of cash flow ratios for relative performance evaluation using the primary operating activities that are the primary activities of a company as a component of each ratio. The ratios are used to evaluate the sufficiency and efficiency of operating cash flows. Sufficiency means the ability of a company to provide for its cash requirements and efficiency means the extent to which cash is generated over time and compared to other companies. 110 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) Using the ratios suggested by Giacomino and Mielke (1993), Juchau and Ross (1994) studied ratio analysis of companies in the Australian food industry over 1992-1993. A comparison between cash flow ratios of the Australian and US food industries indicates they are significantly different. Jooste (1999) performs a similar evaluation of South African food companies for the period 1994-1996, after companies were required to include cash flow statements in financial reports. Comparison with the norms calculated for the same industries in the United States reveals. The industry ratios in South Africa were calculated over a three-year period 1994-1996. Giacomino and Mielke (1993) suggest that three-year averages may be used as norms with the potential to serve as benchmarks for the industries. A repeat of the analysis in Jooste (2006) compares the nine cash flow ratios in three industries, chemicals, food and electronics in South Africa and the United States. The ratios differ in the two countries. The extensive research on financial ratios reveals their importance in many important decisions, including financing and investment decisions. At the same time, there is no universal agreement about the ratios to be used in each decision, even in the same environment. For example, Ezzamel et al. (1987) find that in a study of bankrupt British firms in 1973, 1977 and 1981 that no single model can be used in each year studied, even when the methodology is the same. In the wake of the corporate scandals that hit America and Europe in the early 1990s, stakeholders started looking beyond the specific contents of financial statements. Poor corporate governance is widely cited as one reason for company problems. In response to those scandals, the US Congress enacted the Sarbanes-Oxley Act of 2002 with the aim of strengthening corporate governance practices. Standard & Poor’s (2002) states that corporate governance practices play a significant role both in determining a company’s creditworthiness and supporting the integrity of financial disclosure. Fitch (2004) also argues that corporate governance is important to both equity holders and lenders and that a borrower’s corporate governance must be addressed in the process of determining a credit rating. Ashbaugh-Skaife et al. (2006) confirm the link between governance and credit ratings. Griep and Samson (2002) argue that poor corporate governance practices that allow misapplication of company resources, management incentives that can compromise long-term stability for short-term gain and inadequate oversight of the integrity of financial disclosure can undermine creditworthiness. They also assert that strong corporate governance, demonstrated in part by an active, independent board that participates in determining and monitoring the control environment, can serve to make financial disclosures credible. Yet Collins and Ashbaugh (2004) report that the quality of corporate governance is not a factor in Standard & Poor’s credit ratings absent red flags on whether a board is providing adequate checks and balances to management. In a study of the effect of corporate governance practices and firm performance in Indonesia, Korea, Malaysia and Thailand, Nam and Nam (2004) report conflicting results. There is plenty of research on the relation between corporate governance and firm value (McConnell and Servaes, 1990; Kapoff et al. 1996, Yermack, 1996, Gompers et al., 2003, for example). Gompers et al. (2003) report a positive relation between the quality of corporate governance and firm value. Firm value and characteristics of leveraged buyouts are found to be related to corporate governance practices (Nikoskelainen and Wright, 2007). Company performance is also found to be linked to corporate governance (He, 2007). Chhaochharia and Grinstein (2007), however, report that firms that comply less with the provisions of the Sarbanes–Oxley Act earn a higher abnormal rate of return than firms that are more compliant. Jenson and Meckling (1976) provide the theoretical framework for studies of corporate governance. They consider firms to represent a set of contracts between stakeholders. As a result, there are “agency relationships” between parties. Two of those relationships are relevant to this research: (1) between managers and shareholders and (2) between bondholders and shareholders. The separation of ownership and control in modern corporate organizations produces information asymmetry problems 111 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) between external stakeholders and managers. Shareholders in levered firms have incentives to undertake actions that can transfer wealth from bondholders to themselves. 3. Methodology This section provides brief description of the the survey instrument, the sample, the respondents and the reliability of the questionnaire. Instrument, Sample and the Respondents My methodology is similar to that adopted elsewhere in the accounting and finance literature. Researchers who use a survey to gather information from users of financial ratios include Bouman et al. (1987), Gipson (1987), Anderson (1988), Matsumoto et al. (1995) and Al-Abdulqader (2007). Only commonly cited ratios are included in the survey instrument; an exhaustive list of choices might affect the response rate. Non-response biases can occur when a certain group of respondents systematically avoids returning questionnaires. The final version of the questionnaire is divided into four sections. The first section requires respondents to provide information about their age, type of financial institution they work with, job, length of experience and highest level of qualifications. The second section names the 71 ratios shown in Table 1. Respondents were asked to determine a ratio’s level of usefulness on a five-point Likert scale where a rating of 1 represents “very useful” and 5 is represents “least useful.” A rating of 3 is thus the midpoint between the two extremes, and ratings of 2 and 4 represent the midpoint of their adjacent scores. The third section seeks respondents’ opinion on the relative importance of five attributes of corporate governance practices in credit and lending decisions. These attributes are drawn from empirical literature in the area because there is so far no well-developed theory or model of the economic determinants of governance attributes (Hermalin and Weisbach, 2003). Sections two and three assume that both creditworthiness and firm value are functions of a firm’s financial characteristics and its corporate governance practices. The fourth section lets respondents volunteer their opinions regarding the issues. Respondents were asked to assume that they are either lending to or investing in a manufacturing or retailing company in Bahrain. The survey questionnaires were distributed to 450 respondents working in retail banks, wholesale banks and investment companies, 250 to credit analysts and 200 to financial analysts. 244 usable questionnaires were returned, resulting in a 53.11 percent response rate. Of the 244 responses 130 were from credit analysts, and 114 were from financial analysts, resulting in a 52 and 57 percent response rates from. To evaluate the possibility of a non-response bias, I compared results of the first 15 questionnaires received the last 15 received from both financial analysts. Both tests indicate that there was no significant difference between the results of the questionnaires received early with those received late, which indicated that there is no response bias. 112 Table 1: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) Financial Ratios included in the Survey 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. Dividends/CFFO Total debt/CFFO (Depreciation + Amortization)/CFFO Cash flow/long-term debt Cash flow/sales Cash flow per share/book value per share Cash flow/current liabilities Cash flow/total assets (CFFO+I interest paid)/interest paid Cash flow/total debt Cash flow/current maturities (notes payable + current bond payable) CFFO/Income from continuing operations Dividend payout ratio Dividend yield Retention rate= (EPS-DPS)/EPS Dividend growth rate Current ratio Quick ratio Quick assets/total assets Current assets/total assets Net Working Capital/Sales Net Working Capital /total assets Current liabilities/equity Current liabilities/total assets Sales/total assets Sales/net fixed assets Sales/equity Current assets turnover Cash/ Current liabilities Cash/ total assets Cash/Sales Research expenditures per share/sales per share Capital expenditure per share/book value per share Receivables/inventory Retained earnings/total assets EPS growth rate Sales growth rate Sustainable growth rate Total assets growth rate Price Earnings Ratio Market value/cash flow = Price/cash flow per share Market-to-book ratio (MB) Price/Sales per share Price/ Net Working Capital per share Operation Profit Margin Returns on Equity (ROE) 12. Returns on Sales (ROS) 48. 13. Gross profit margin 49. 14. Return on common 50. 15. ROI = (EBIT+I)/total assets 51. 16. Net Income/Total Assets 52. 17. Operating Profit to total assets 53. 18. Operating profit to equity 54. 19. EPS – Fully diluted 55. 20. EPS – Primary 56. 21. Non-recurrent EPS 57. 22. Long-term debt/total capital 58. 23. Fixed charges coverage (FCC) 59. 24. Total debt/equity 60. 25. Long-term debt /equity 61. 26. Times Interest Earned 62. 27. Total Debt/Total Assets 63. 28. Long-term debt/total assets 64. 29. EBIT/current maturates (notes payable+ current bond payable) 65. 30. Selling period = inventory/(sales/365) 66. 31. Sales/inventory 67. 32. COGS/inventory 68. 33. Average Collection period = receivables/(sales/365) 69. 34. Receivable turnover ratio 70. 35. Cash flow from Operation/(LTD+ Purchases of assets + dividend paid) 71. 36. Long-term debt payments/CFFO CFFO: Cash flow from operation, EPS: Earnings per share, NWC = net working capital, EBIT= Earnings before interest and taxes, DPS= Dividends payout ratio. The demographic characteristics of the respondents are summarized in Table 2. In terms of type of financial institution for, 46.7 percent of the respondents work for retail banks and 53.3 percent for wholesale banks. 32.8 percent have experience of less than 5 years; 37.7 percent 5-9; 22.1 percent, 1015 years and 7.4 percent 15 years or more. Of the 244 respondents, approximately 53.3 percent (130) were credit analysts and 46.7 percent (114) were financial analysts. 45 percent of respondents were aged between of 20 and 29; 30 percent, 30-39; 15 percent, 40-49 and 11 percent, 50 or more. The distribution according to qualifications shows that 37.7 percent hold B.Sc. degrees; 36.5 percent graduate qualifications and 25.8 percent of the respondents professional qualifications such as ACCA, CPA and CFA. The respondents’ education levels and length of experience indicate that they are in a good position to respond to the questionnaire. 113 Table 2: European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) Sample Characteristics Frequency 114 130 244 Frequency 130 114 244 Frequency 80 92 54 18 244 Frequency 92 89 63 244 Frequency 109 72 36 27 244 Percent 46.7 53.3 100.0 Percent 53.3 46.7 100.0 Percent 32.8 37.7 22.1 7.4 100.0 Percent 37.7 36.5 25.8 100.0 Percent 44.7 29.5 14.8 11.1 100.0 Cumulative Percent 46.7 100.0 Institution Retail Bank Wholesale Bank Total Position Credit Analyst Financial Analyst Total Length of Experience Less than 5 Years 5 Years to Less than 10 Years 10 Years and Less than 15 Years Longer than 15 Years Total Highest Level of Qualification B.Sc. Graduate Degree ACC/CA/CFA/CPA Total Age 20 years - 29 Years 30 Years - 39 Years 40 Years - 49 Years 50 Years and More Total Cumulative Percent 53.3 100.0 Cumulative Percent 32.8 70.5 92.6 100.0 Cumulative Percent 37.7 74.2 100.0 Cumulative Percent 44.7 74.2 89.0 100.0 Reliability of the Instrument To verify the reliability of the questionnaire as internally consistent in measuring the qualitative variable, “usefulness of the ratios” for financing and investment decisions from the perspective of credit and financial analysts, I use the Cronbach’s alpha method. Reliability analysis indicates that: • For the responses of both groups, an alpha value equivalent to 0.941. • For the responses of credit analysts, an alpha value equivalent to 0.948. • For the responses of financial analysts, an alpha value of 0.936. Nunnally and Bernstein (1994), Peterson (1994) and Streiner and Norman (2003) argue that an alpha value similar to 0.7 is usually considered the minimum level for preliminary investigation, 0.8 for basic investigation and 0.9 for applied investigation. McKinley et al. (1997) indicate an alpha level of 0.61 implies a moderately high coefficient of reliability. Accordingly, by any benchmark, from the reliability values obtained, the questionnaire seems to have an acceptable internal consistency. These high Cronbach alphas should not be of surprise because of the nature of the financial ratios; some of them are related to each other and sometimes a group of them might be used to measure one of the aspects of interest to users of financial statements. 4. Results Table 3 depicts the mean ranking of the financial ratios according to level of usefulness as perceived by both credit analysts and investment analysts. As the respondents’ perceptions are random, to determine the level of usefulness of each ratio, I assume that an average score of at least 4.5, the ratio is considered very useful; an average score higher than 3.5 and 4.5 means the ratio is useful; if average 114 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) score is between higher 2.5 and 3.5 means the ratio is moderately useful; if the mean score is between more than 1.5 and 2.5 the ratio is assumed to be less useful; and if the mean score is higher than 1.5 means the ratio is least useful. Furthermore, following Matsumoto et al. (1995) the ratios are classified into 13 groups: growth rate ratios, valuation ratios, profitability ratios, EPS measures, leverage ratios, capital turnover ratios, cash flow ratios, cash position ratios, inventory ratios, liquidity ratios, receivable turnover ratio, dividend ratios and other ratios. This classification includes particular ratios that are seen by many as more useful to investors than to credit analysts. The section that includes cash-flow based ratios aims at investigating the importance of those ratios, even though they might be classified within some of the other 12 groups. The questionnaire does not divide the financial ratios into the 13 groups but rather mixes them. The rationale was to make it less likely that respondents would give ratios in the same group similar ratings simply because they were listed one together. Preliminary analysis of the responses shows that the mean ranks of credit analysts range between 4.52 and 3.41; one ratio is considered highly useful, one ratio moderately useful and 69 ratios useful. The mean ranks of ratios for financial analysts range between 4.61 and 3.06; five ratios are considered to be highly useful, four moderately useful, and 62 ratios useful. Combining both groups, the mean ranks of ratios range between 4.53 and 3.26. These results indicate that ratios included in the questionnaire are considered at least moderately useful by each group of users. Mean responses to each financial ratio were tested against the null hypothesis that the means are not significantly different from zero. The results of a series of ttests show that all means were significantly different from zero for the responses of each group. To ascertain whether there are any perceived differences between the credit analyst and financial analyst groups responses to the survey items, I carried out a series of t-tests on the data collected from the two groups. Before that I checked to see whether the variances of the responses of the two groups were equal; one of the assumptions of the t-test is equality or inequality of variance between the variance of the two groups. 115 Table 3: Ratio European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) Mean Rank Scores of Financial Ratios by Credit and Financial Analysts Credit Analysts Mean Std. Deviation 4.45 4.40 4.18 3.41 3.84 3.79 4.03 3.82 3.91 4.03 4.35 4.13 4.13 4.05 4.11 3.92 4.28 4.48 3.81 4.45 4.51 4.25 4.46 4.05 3.78 4.11 4.28 4.12 3.74 4.18 4.18 4.32 3.95 4.14 4.08 4.11 3.53 3.83 3.92 4.05 3.69 0.599 0.592 0.840 1.173 0.979 0.860 0.889 0.752 0.884 0.889 0.619 0.875 0.811 0.905 0.819 0.630 0.747 0.625 1.035 0.500 0.502 0.916 0.684 1.008 1.080 0.662 0.647 1.042 0.803 0.762 0.691 0.728 0.905 0.775 0.924 0.856 1.156 0.873 0.969 0.874 0.939 Financial Analysts Mean Std. Deviation 4.43 4.16 4.28 3.09 4.61 3.66 3.84 4.56 3.28 3.84 4.51 4.07 4.35 3.75 3.53 4.05 4.45 4.01 4.01 3.89 4.50 4.10 4.36 3.11 3.65 4.10 4.01 4.06 4.13 4.10 4.00 4.21 4.15 3.81 3.81 3.86 3.92 3.53 3.80 3.99 3.81 0.609 0.686 0.588 1.085 0.541 1.128 0.826 0.549 1.018 0.826 0.599 0.713 0.716 0.878 1.066 0.891 0.499 0.698 0.906 0.502 0.498 0.950 0.811 1.387 0.872 0.912 0.825 0.656 0.847 0.579 0.532 0.746 0.812 0.786 0.977 0.840 0.997 1.099 0.843 0.836 0.861 Mean Difference -0.0242 -0.2422 +0.1041 -0.3201,2 0.7761,2 -0.1341 -0.189 0.7382 -0.6271,2 -0.189 0.1632 -0.0611 0.2202 -0.2922 -0.5811,2 0.1301 0.170 -0.4762 0.087 0.046 0.054 -0.150 -0.1021 -0.8941,2 -0.128 -0.0111 -0.2682 -0.0621 0.3932 -0.0801 -0.1851,2 -0.113 0.195 -0.3312 -0.2782 -0.2482 0.3901,2 -0.3041,2 -0.125 -0.063 0.115 Growth Rates EPS growth rate Sales growth rate Sustainable growth rate Total assets growth rate Valuation Ratios Price Earnings Ratio Market value/cash flow = Price/cash flow per share Price/Sales per share Market-to-Book Price/ Net Working Capital per share Profitability Ratios Operation Profit Margin Returns on Equity (ROE) Returns on Sales (ROS) Gross profit margin Return on common ROI = (EBIT+I)/total assets Net Income/Total Assets Operating Profit to total assets Operating profit to equity EPS Measures EPS – Fully diluted EPS – Primary Non-recurrent EPS Leverage Ratios Long-term debt/total capital Fixed Charges Coverage Total debt/equity Long-term debt /equity Times Interest Earned Total Debt/Total Assets Long-term debt/total assets EBIT/current maturates (notes payable+ current bond payable) Inventory Ratios Selling period = inventory/(sales/365) Sales/inventory COGS/inventory Receivable Turnover Average Collection period = receivables/(sales/365) Receivable turnover ratio Cash Flow Ratios Cash flow from Operation/(LTD+ Purchases of assets + dividend paid) Long-term debt payments/CFFO Dividends/CFFO Total debt/CFFO (Depreciation + Amortization)/CFFO CFFO/Income from continuing operations CFFO/total debt 1 2 F Levene's test is significant at .05 or less t test is significant at .05 or less 116 Table 3: Ratio European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) Mean Rank Scores of Financial Ratios by Credit and Financial Analysts (Continued) Credit Analysts Mean Std. Deviation 4.12 0.797 4.02 4.25 4.24 4.20 3.48 4.08 3.58 3.88 3.88 3.95 4.35 4.52 4.33 4.22 3.89 3.82 3.93 3.85 4.09 4.18 4.02 3.99 4.08 3.96 4.05 4.17 4.18 3.78 3.93 0.687 0.758 0.786 0.811 1.036 0.890 1.018 1.001 1.001 0.746 0.765 0.673 0.771 0.816 1.013 1.038 1.058 0.836 0.731 0.709 0.936 0.885 0.803 0.968 1.029 0.949 0.913 0.975 0.990 Financial Analysts Mean Std. Deviation 3.78 1.054 4.08 4.07 4.13 3.06 4.18 3.96 4.20 4.25 4.25 4.27 4.03 3.86 4.21 4.27 3.88 3.75 3.95 3.92 4.10 4.09 3.85 3.53 3.68 4.22 3.92 4.15 4.26 3.84 3.89 0.832 0.838 0.659 0.708 0.732 0.775 0.706 0.659 0.659 0.779 1.034 1.012 0.836 0.790 0.894 0.929 0.739 0.970 0.691 0.659 0.971 1.006 0.834 0.975 0.961 0.924 0.776 0.888 0.856 Mean Difference -0.3421,2 0.0561 -0.176 -0.107 -1.1391,2 0.6911,2 -0.1201 0.6171,2 0.3611,2 0.3611,2 0.3181,2 -0.3201,2 -0.6561,2 -0.120 0.057 -0.015 -0.077 0.0171 0.067 0.004 -0.0891 -0.172 -0.4662 -0.3932 0.2582 -0.133 -0.020 0.079 0.065 -0.036 CFFO/current maturities (notes payable + current bond payable) CFFO/long-term debt CFFO/sales CFFO per share/book value per share CFFO/current liabilities CFFO/total assets CFFO+IP/Interest paid Dividend Ratios Dividend payout ratio Dividend yield Retention rate= (EPS-DPS)/EPS Dividend growth rate Liquidity Ratios Current ratio Quick ratio Quick assets/total assets Current assets/total assets Net Working Capital/Sales Net Working Capital /total assets Current liabilities/equity Current liabilities/total assets Capital Turnover Ratios Sales/total assets Sales/net fixed assets Sales/equity Sales to Current Assets Cash Position Cash/ Current liabilities Cash/ total assets Cash/Sales Others Research expenditures per share/sales per share Capital expenditure per share/book value per share Receivables/inventory Retained earnings/total assets 1 2 F Levene's test is significant at .05 or less t test is significant at .05 or less I used Levene’s test rather than an alternative Bartlett test because the former is less sensitive than the latter to departures from normality. On the bases of Levene's test for equality of variances indicates that for 31 financial ratios the variances of the responses are significantly different from one another. Therefore, for those ratios t-tests were performed on the assumption that the variances are heterogeneous. The t-test results supported this finding, showing a significant disagreement between the two groups on only 31 of 71 total financial ratios. These results indicate that the responses of the remaining ratios (40) in the two groups could be merged into one dataset and used for subsequent analysis. It is worth noting that the t-tests results were not affected by heterogeneity of the variances of the perceptions of the credit and financial analysts to the 31 ratios; this is because the tests produced the same outcomes when they were run once on the assumption that the variances were homogeneus and then on the assumption that the variances were heterogeneous. Furthermore, the mean responses of credit and financial analysts to 17 of 31 ratios were found to differ significantly. Both credit analysts and financial analysts perceived growth rate ratios as useful or moderately useful. Both groups of analysts considered the EPS growth rate the most useful with a mean rank of 117 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) 4.45 by credit analysts and 4.43 by financial analysts. The least popular growth rate ratio for both groups was total asset growth rate. These results are similar to those reported by Matsumoto et al. (1995), although groups differ in their perceptions of sustainable growth rate and sales growth rate. Perceptions valuation ratios show that credit analysts perceived as less useful than financial analysts do. Mean ranks for the five valuation ratios by credit analysts are below 4.00 except for stock price/sales per share, which is perceived as the most useful ratio followed by stock price to net working capital per share with a mean rank of 3.94. The financial analysts consider the price-earnings ratio the most useful with a mean rank of 4.61 followed by the market-to-book value ratio with a mean rank of 4.56. In fact the financial analysts see the price-earnings ratio as the most useful ratio of all for investment decisions. These observations should not come as surprise if we consider the purpose of financial analysis and credit analysis; the purpose of the first is to determine the value of the company’s stock, out of the latter to determine the creditworthiness of prospective borrowers. The perception of the usefulness of the price-earnings ratio by financial analysts is line with the findings of Al-Abdulqader et al. (2007). The mean rank of the ratio price to net working capital per share is seen as the least useful by financial analysts. This is not a popular ratio in the investment industry, see Matsumoto et al. (1995). The nine profitability ratios are ranked useful by both groups, as the mean ranks of the ratios by credit analysts ranged between 4.48 for operating profit to equity and 3.92 for net income to total assets (ROA). For the financial analysts, return to equity (ROE) received a mean rank of 4.51, while return on investment (ROI, earnings before interest and taxes divided by assets) received a mean rank of 3.53. Other financial ratios generally used by analysts to evaluate company profitability are different forms of earnings per share. Both groups perceived the three EPS ratios included in the questionnaire as either very useful or useful, with the exception of fully diluted EPS. Both groups saw non-recurrent EPS as the most useful ratio of these, and that fully diluted EPS was seen by both groups as least useful. It should not be seen as a surprise, because convertible securities are not common in Bahrain. As of July 2007, only one bank of the 41 listed on the Bahrain Stock Exchange has convertible preferred stock outstanding, and that represents the only issue that has taken place in the country. The questionnaire includes eight leverage ratios. Five of them measure the extent to which a company uses debt; the other three measure the company’s ability to generate profit to cover different types of commitments arising from the use of the debt. Both groups of analysts would be expected to be highly concerned as to the burden arising from the excessive use of debt, which might lead to default or in the worst case scenario to bankruptcy. The mean ranks indicate the perceptions indicate that both groups consider the eight ratios useful, although, the ranks of are lower than those reported by Matsumoto et al. (1995). One possible explanation for the differences between my results and those reported by Matsumoto et al. (1995) is the context within which the two surveys were administered. In Bahrain, unlike the US, non-financial listed firms maintain very low debt ratios, which make leverage ratios less useful than leverage ratios in analysis of the financial statements of American firms. According to the Bahrain Stock Exchange, the debt-to-total assets ratio was 25.82 percent for the service sector in 2006, 3.42 percent for the industrial sector and 11.41 percent for the hotel and tourism sector. These figures should be read with caution, as listed companies might not berepresentative of non-listed firms. Managing inventories is considered vital for both the success of manufacturing and retailing companies. The mean rank scores of the three inventory ratios indicate that both credit and financial analysts find them useful. Inventory turnover (cost of goods sold divided by inventory) is considered by both groups as the most useful of the three. Companies make credit decisions with the idea of increasing revenues. The extension of credit risk, however, increases because purchasers may default. Two credit ratios are included in the questionnaire to solicit the opinion the participants on their usefulness in lending and investment decisions. 118 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) The mean rank scores show that both groups consider credit ratios useful. The ranks are relatively low might be because of the time period during of survey administration when Bahrain was enjoying an economic boom (February and March 2007). T-tests also show for average collection period ratio not significantly different but a significantly different for perceptions of the two groups was from zero, while that of the accounts receivable turnover. According to the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), the primary purpose of the cash flow statement is to allow assessment of a company’s liquidity, solvency, viability and financial adaptability. Both credit analysts and financial analysts rank cash flow based ratios lower than non-cash-based ratios. Nor do they rank any cash-flowbased ratios in the top ten most useful ratios. These results lend further support to those report in AlAjmi (2007) that investors in Bahrain consider both the balance sheet and the income statement as more important than the cash flow statement. One possible reason for such a perception lies in the advanced education systems. In introductory accounting and finance courses taught at the University of Bahrain, the largest institution in Bahrain that offers business degrees, and the only university until 2002 that has a business college, students are taught (implicitly) that the balance sheet and income statement are more useful than the cash flow statement. For example, the syllabus for the first corporate finance course shows that students need to review only the balance sheet and income statements and not the statement of cash flows before calculating financial ratios, which in turn do not include any cash-flow based ratios. Another reason might simply due to the preference of credit analysts and financial analysts. Based on a restricted sample, Liu et al. (2002) report that multiples based on reported earnings outperform multiples based on a variety of reported operating cash flow measures. Similar results are reported in Liu (2007) when the same exercise extended to samples of companies. Most of the cash flow based ratios received higher mean rankings than those reported by Matsumoto et al. (1995). One reason may be the time period, because the Matsumoto et al. (1995) study was conducted shortly after the introduction of the SFAS 95, while my study was completed after nearly two decades after companies started publishing cash flow statements. Ranks of ratios are also much higher than those reported by Al-Abdulqader et al. (2007). A possible reasons lies in the respondents educational qualifications and experience, as my sample is confined to professional credit and financial analysts. Other samples include investors, 45 percent of whom do not have the academic background to appreciate the usefulness of financial ratios. There three cash position ratios in the questionnaire. Their mean ranks indicate that these are not among the most popular financial ratios used. Analysts give more weight to cash-flow-based ratios in lending and investing decisions. Tests of the significance of the mean rank scores differences in perception of credit and financial analysts showed that both groups were homogeneous in their perceptions of the usefulness of the cash-to-sales ratio and heterogeneous as to the other two ratios. Dividends represent one of the reasons investors hold shares for the long term. Five dividend ratios are included in the questionnaire. The mean ranks of those ratios indicate that financial analysts perceived them five ratios as more useful for investment decisions compared with how those ratios were perceived by financial analysts. Four ratios were ranked above four, but the fifth one which is dividends to cash flow from operations was given a mean rank of 4.11. The mean rank score differences of the five ratios are significant at less than the 5 percent significance level. The perceptions of these ratios by financial analysts lend further support to findings report in Al-Ajmi (2007) in a survey of individual private investors. He found that individual investors prefer to invest in dividend-paying firms. One possible reasons for is that capital gains on stocks listed on the Bahrain Stock Exchange are relatively low. Liquidity ratios are financial indicators used to formulate an opinion about the company’s ability to meet its short-term commitments. Eight liquidity ratios were included in the questionnaire. The mean ranks of responses indicate that credit analysts perceive liquidity ratios, on average, as more useful than financial analysts. The quick ratio was for credit analysts the most popular with a mean 119 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) rank score of 4.52, while financial analysts found the current ratio the most popular (4.03). Both groups seem to consider liquidity ratios useful in both credit and investment decisions. The quality of a firm’s asset management is judged on the basis of a number of financial indicators. To see which financial ratios are perceived as useful in lending and investing decisions, three capital turnover ratios are included in the questionnaire: total asset turnover (sales/total assets), net fixed asset turnover (sales/net fixed assets) and current asset turnover ratio (sales/current Assets). An equity turnover also included. The results show that both groups consider all four ratios useful. Four final ratios were included in the questionnaire that do not fall into any other groups: research and development expenditures per share to sales per share; capital expenditure per share to book value per share; receivables to inventory turnover and retained earnings to total assets. All ratios were perceived to be useful by both groups’; the most popular were R&D expenditures per share to sales per share and capital expenditure per share to book value per share. These ratios could be interpreted to imply growth opportunities that companies might enjoy in the future. Table 4 lists the 15 ratios in order of the usefulness to both credit analysts and financial analysts. For credit analysts, liquidity ratios and profitability ratios are the most popular, while financial analysts’ list demonstrates that valuation, dividends and profitability ratios are generally the most popular. The differences relates to the different types of decisions that particular analysts must make. The relatively low ratings on most of the financial ratios may indicate that credit analysts and financial analysts use other information (financial and non-financial) or financial indicators in taking investment and lending decisions. To enhance our understanding of analyst lending and investment appraisal process, we include in the third section further questions regarding the impact of corporate governance on these decisions. Six attributes of corporate governance are included: audit processes and quality; board structure and processes; financial stakeholder rights and relations; financial transparency and information disclosure; ownership structure and influence and related party transactions. These attributes are drawn from the corporate governance literature (see, for example, Ashbaugh-Skaife et al., 2006) and credit rating company practices (see Fitch, 2004). No specific indicators of each attributes are included in the questionnaire because non-financial companies are not required to comply with a particular code of corporate governance, and there is no general agreement among researchers and practitioners as to how to measure corporate governance. Nam and Nam (2004) argue that determining the quality of corporate governance is subjective and can be controversial, and analysts are unlikely to agree on whether or not a certain aspect of corporate governance should be included or how much weight to give to each aspect. 120 Table 4: European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) The Most Fifteen Popular Ratios as perceived by Credit and Financial Analysts Credit Analysts Ratios Mean 4.52 4.51 4.48 4.46 4.45 4.45 4.40 4.35 4.35 4.33 4.32 4.28 4.28 4.25 4.25 Std. Deviation 0.673 0.502 0.625 0.684 0.599 0.500 0.592 0.619 0.765 0.771 0.728 0.747 0.647 0.916 0.758 Financial Analysts Ratio Price Earnings Ratio Market-to-Book Non-recurrent EPS Returns on Equity (ROE) EPS – Primary Operating Profit to total assets EPS growth rate Fixed Charges Coverage Gross profit margin Sustainable growth rate Dividend growth rate Current assets/total assets Capital expenditure per share/book value per share Dividend yield Retention rate= (EPS-DPS)/EPS Mean 4.61 4.56 4.56 4.51 4.50 4.45 4.43 4.36 4.35 4.28 4.27 4.27 4.26 4.25 4.25 Std. Deviation 0.541 0.549 0.498 0.599 0.502 0.499 0.609 0.811 0.716 0.588 0.779 0.790 0.776 0.659 0.659 Quick ratio Non-recurrent EPS Operating profit to equity Fixed Charges Coverage EPS growth rate EPS – Primary Sales growth rate Returns on Equity (ROE) Current ratio Quick assets/total assets COGS/inventory Operating Profit to total assets Total Debt/Total Assets Long-term debt/total capital Cash flow/sales The means of the relative importance and standard deviations of the components are shown in Table 5. Each groups’ ranking of the different items, while similar, varies in a number of important respects. Both groups rank audit process and quality as the most important attribute, but the financial analysts give it a higher rank than the credit analysts. Similarly, both groups rank financial stakeholder rights and relations in second place, while financial analysts attach more importance to it than credit analysts. Similar rankings, however, do not necessarily imply that an attribute has a similar effect on decisions. The groups rank the remaining four attributes in different order. The relatively low ranking of the six attributes, especially by credit analysts, do not reflect growing interest in the issue by regulators. The Central Bank of Bahrain, the regulator of financial institutions and capital markets, has taken a series of steps toward improving corporate governance practices. Among them are issuing a corporate governance code for banks, shortening the period within which listed companies are required to publish interim and annual reports and strengthening the rules governing director trading. The Ministry of Industry and Commerce has also formed a national committee of representatives of different stakeholders, charged with recommending corporate governance codes for non-financial companies including state-owned enterprises. Before testing whether there are any differences between credit analysts and financial analysts group responses to the five components of corporate governance, I use Levene’s test to examine whether there is a significant difference between the variances of the responses to each item. The results of Levene’s tests for equality of variances show that for the five components the variances of the responses are significantly different from each other. Accordingly, t-tests are conducted on the assumption that the variances are not similar in all attributes except board structure and process and financial transparency and information disclosure. The t-test results show that the mean responses of credit analysts and financial analysts are significantly different. The mean ranks of the responses indicate that financial analysts seem to see corporate governance practices as more important in investment decisions than credit analysts in every case except financial transparency and related party transactions. Perceptions of credit analysts of corporate governance seem to be in line with the practices of international credit rating agencies such as Fitch and Standard & Poor’s. Although the rating agencies acknowledge the importance of corporate governance practices, these practices are considered only if a board fails to exercise overall control over a company’s affairs. Another reason that might explain the results may relate to the context within which the respondents expressed their perceptions, as the questionnaire asks them to assume they are either 121 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) lending to or investing in a manufacturing or retailing company. Sixty-one of the respondents note that, despite their perception of the importance of the six factors, they find it difficult to obtain the information necessary for evaluating the quality of a firm’s corporate governance and also for completely evaluating a firm’s financial position. A review of the 2006 annual reports of non-financial companies listed on the BSE reveals no report sections on corporate governance practices, and no report refers to board committees. Respondent comments regarding the limited information provided in companies’ annual reports might be seen as evidence supporting enactment of International Financial Reporting Standard (IFRS) 8, which is expected to come into effect in 2009 as recommended by the IFSB. Implementation of such a standard is expected to improve the quantity and quality of disclosed information. Table 5: Mean Rank Scores of Corporate Governance Attributes by Credit and Financial Analysts Both Samples Corporate Governance Attributes Audit processes and quality Board structure and processes Financial stakeholder rights and relations Financial transparency and information disclosure Ownership structure and influence Related party transactions 1 Credit Analysts Mean 3.3615 3.2692 3.2692 3.4923 3.0462 3.3077 Std. Deviation 1.11372 1.21864 1.19293 1.14963 1.50895 1.25040 Mean 3.6967 3.1077 3.5984 3.5410 3.2131 3.3648 Std. Deviation 1.04931 1.28344 1.16999 1.11958 1.38617 1.18380 Financial Analysts Std. Mean Deviatio n 4.0789 3.6930 3.9737 3.5965 3.4035 3.4298 .82166 1.14542 1.02586 1.08668 1.20998 1.10485 Mean Diff. 0.717411,2 -0.585292 0.704451,2 -0.10418 0.357351,2 -.122131 F Levene's test is significant at .05 or less. 2 t test is significant at .05 or less. The relative low regard for of credit analysts of the six factors have very important implications for regulators regarding firms’ compliance with the provisions of a corporate governance code. The most important implication is that banks might not play a significant role in enforcing a code’s requirements if they do not factor the quality of corporate governance of their clients into their lending decisions. 5. Concluding Remarks and Future Research Financial ratios provide useful quantitative financial information to both investors and analysts who use them to evaluate the operation of a firm and analyze its position within an industry or sector over time. The usefulness of these ratios largely depends on the integrity of financial statements, which in turn is a function of firms’ corporate governance practices. Governance practices play a role in reducing information asymmetry as well as influence both a firm’s creditworthiness and value. Perceptions of 244 credit analysts and financial analysts in Bahrain are measured by the ranking of 71 financial indicators and 5 components of corporate governance. The research follows surveys of US analysts and Saudi Arabian investors and the corporate governance literature. The financial ratios are useful in making lending and investment decisions. These results lend support to the importance of corporate reports as a primary source of information. We can also see that creditors and investors attach importance to the cash flow statement as well as balance sheet and income statement, although some users may not fully appreciate its importance. Regulatory authorities and universities in Bahrain might need to increase awareness as to the importance of the cash flow statement. While there are some differences between credit analysts and financial analysts as to the perceived usefulness of particular ratios, the professional users generally find all the financial ratios in 122 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) the questionnaire useful credit and investment decisions. These conclusions are based on both tests for equality of variances of the groups’ perception of each ratio and t-tests of the mean ranks of each ratio. Corporate governance practices are perceived by financial analysts as very important, while financial analysts perceive them as important. The results of the test indicate that the perceptions of the two groups on the importance of corporate governance attributes are significantly different. Credit and investment decision processes are sophisticated and cannot rely on one single financial indicator or one indicator of corporate governance. Constant research is needed if we are to enhance such a process. Research might explore particular ratios in actual decisions by modeling rates of return in relation to some ratios. Another area of research might identify the specific non-financial information that credit and financial analysts use in lending and investing decisions. A final extension of the research is to investigate the relation between proxies for corporate governance and firm value and those indicators and credit ratings of companies that are rated by international rating agencies. What is the effect of each attribute of corporate governance on investment and lending decisions? What is the effect of regulation? 123 European Journal of Economics, Finance And Administrative Sciences - Issue 11 (2008) Al-Abdulqader, K. A., Hannah, G., and Power, D. M., 2007, The appraisal of ordinary shares by Saudi investors”, Research in International Business and Finance 21, 69-86. 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