Interpreting Financial Results: Be Aware of the Impact of the Economic Crisis and Recent Accounting Changes on Financial Ratios

Article excerpt

Since 2005, many companies, including those comprising the Dow Jones Industrial Average (DJIA), have experienced deterioration in common credit ratios, including the debt-to-equity and liability-to-equity ratios. At the same time, the current financial crisis has increased focus on credit analysis and credit metrics. Complicating credit analysis is the implementation of three Financial Accounting Standards Board (FASB) accounting pronouncements: Statement of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans--an amendment of FASB Statements No. 87, 88, 106, and 132(R)"; SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements--an amendment of ARB No. 51"; and Financial Interpretation 48 (FIN 48), "Accounting for Uncertainty in Income Taxes, an Interpretation of FASB Statement No. 109." SFAS No. 158 and FIN 48 were issued in 2006 and SFAS No. 160 in 2007. Although they haven't garnered much attention, they have materially affected the balance sheets of many companies and have had a significant impact on common credit ratios and return measures, including return on equity (ROE).

In fact, SFAS No. 158 and FIN 48 continue to impact financial statements, so, as 2009 financial information is released, we recommend that financial professionals and investors interpret credit and return measures carefully. Further complicating the analysis of 2009 financial reports is SFAS No. 160, which was effective in 2009 for most companies. (See "Accounting for Noncontrolling Interests" on p. 53 for more information about SFAS No. 160.)

To learn more about the effects of all these factors, we examined the companies in the DJIA from 2005 through 2009 and analyzed the impact of SFAS No. 158 and FIN 48. Then we calculated financial ratios for each company and for the overall sample. The average ratios for the companies in our sample are shown in Table 1.

Table 1: Average Ratios for Sample Companies

                       2005  2006  2007  2008  2009

Debt/Equity *          0.73  0.78  0.76  1.11  0.84

Liabilities/Equity **  3.20  3.48  3.58  3.77  3.09

Return on Equity **     20%   23%   21%   23%   14%

* Banks were excluded from the debt/equity ratio because the ratio
isn't relevant for banks.

** This sample is composed of the firms in the Dow Jones Industrial
Average as of January 2010, excluding The Home Depot and Microsoft
because the accounting changes at these two firms weren't significant.

These ratios receive a great deal of attention from financial analysts and investors and frequently are used in designing loan covenants. The two credit metrics, debt to equity and liabilities to equity, deteriorate from 2005 to 2008 since the firms appear to be much more highly leveraged and then improve in 2009 as the relative level of debt falls. Average ROE moves between 20% and 23% from 2005 to 2008 before dropping dramatically in 2009. Return on equity is a common measure of profitability, so the ROE in Table 1 suggests that 2008 was an especially profitable year and that performance in 2009 was much weaker.

Here's a key question: Do these ratios reflect changes primarily in financial position and performance, or have accounting changes played a role?

We find that accounting changes have had a significant impact on the results.

Table 2 shows the average ratios for the companies in our sample after adjusting for implementation and ongoing compliance with SFAS No. 158 and FIN 48.

Table 2: Average Ratios After Adjustments

                                           2005  2006  2007  2008  2009

Debt to equity--as reported                0.73  0.78  0.76  1.11  0.84

Debt to adjusted equity (no adj. req. for  0.73  0.66  0.82  0.87  0.87
2005)

Liabilities to equity--as reported         3.20  3.48  3.58  3.77  3.09

Liabilities to equity--adjusted (no adj. …