A multinational corporation is one whose operations are set up in one or more jurisdictions other than the domestic country of the company.
When a company reports its financial statements, usually on a quarterly basis, results are usually consolidated into one functional (operating) currency incorporating all subsidiaries and/or foreign operating divisions. Such consolidation usually results in translation effects, or in simpler terms exchange rate gains or losses.
When investors look at financial statements, items such as profit margins and revenues may appear to improve year on year. Many take this for granted, that the figures are sufficient to generate a positive outlook for the following quarters. This will not always be the case.
It is imperative for investors to distinguish between organically generated profits and profits resulting from translation effects. The appreciating USD over recent months, for example, would have impacted a number of US companies with foreign subsidiary operations in foreign countries.
When converting back from foreign currency to USD, a higher dollar results in lower reported revenues and earnings on a company’s consolidated income statement, predominantly due to the fewer dollars bought for one unit of the foreign currency when converting back.
Analysts must therefore distinguish and identify organic growth separately, as it could very well be sales figures and operating cash flows improved, despite unfavorable reporting results
It is also important to exclude business takeovers and acquisitions when determining organic growth as these could also mislead and bias an income statement upwards.
Inflation plays a role in determining which functioning currency to adopt for multinational corporations. Currencies tend to depreciate under inflationary pressures, as purchasing power is reduced and demand for a country’s currency becomes subdued.
Translations of weaker foreign currencies as a result would lead to weaker performance results when converted back to the stronger functioning currency, as already mentioned.
A company’s management, therefore, would clearly need to analyse the jurisdictions and currencies in which it plans to operate and accordingly choose a functioning currency that best meets its reporting responsibilities and operating objectives.
In today’s economic environment, the euro as a functioning currency, would still result in high positive translation effects, given the ongoing monetary easing policies, albeit at a slower pace, and persistent downward pressures on the currency, assuming a comparison to foreign divisions operating in USD and/or JPY as examples.
The above are imperative considerations in performance reporting, which can be affected in many other ways than through translation effects. Acceleration of revenues and expenses amongst other items are alternative voluntary manipulations by management which can significantly impact the reported financial statements.
When issuing recommendations on a company, analysts must attempt to best reconcile the above factors along with many others to best generate the stable earnings of a company to continue operating as a going-concern.
This article was issued by Mathieu Ganado, Junior Investment Manager at Calamatta Cuschieri. For more information visit www.cc.com.mt
The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.