The Georgia Tech Financial Analysis Lab conducts unbiased research on issues of financial reporting and analysis. Unbiased information is vital to effective investment decision-making. Accordingly, we think that independent research organizations, such as our own, have an important role to play in providing information to market participants.
Because our lab is housed within a university, all of our research reports have an educational quality, as they are designed to impart knowledge and understanding to those who read them. Our focus is on issues that we believe will be of interest to a large segment of stock market participants. Depending on the issue, we may focus our attention on individual companies, groups of companies, or on large segments of the market at large.
A recurring theme in our work is the identification of reporting practices that give investors a misleading signal, whether positive or negative, of corporate earning power. We define earning power as the ability to generate a sustainable stream of earnings that is backed by cash flow. Accordingly, our research may look into reporting practices that affect either earnings or cash flow, or both. At times our research may look at stock prices generally, though from a fundamental and not technical point of view.
The Significance of Foreign Exchange Rate Changes on Cash
While there are many causes for exchange rate fluctuations, central bank intervention and political uncertainty around the world have caused exchange rates to show extreme volatility in recent years. As more companies conduct business in multiple markets, this volatility has increasing significance. Goods and services become more expensive or less expensive, making companies in certain regions more competitive or less competitive. Throughout the years, there have been many studies on how foreign currency changes impact a company’s income statement and how to hedge against this uncertainty. However, little research has been conducted on the effects of foreign exchange rate changes on cash balances.
Holding cash in non-dollar denominated currencies presents risk to companies as they accumulate foreign-denominated cash holdings. At any point in time, a company’s cash may be worth X, or a percentage of X, just because of changes in exchange rates. Consider Exhibit 1, for example, which presents a chart of the trade weighted U.S. dollar index for the three years ended December 2012. As seen in the Exhibit, the USD has been relatively volatile over the three-years presented, with periods of both steep decline and ascent when measured against other currencies. In 2010, the index traded at 106.3 and then experienced a year-long descent to a low of 93.7 in 2011, a decline of 12%. After that steady decline, the U.S. dollar strengthened abruptly and operated in a relatively narrow range, yet still volatile. Companies holding cash in non-dollar-denominated currencies would have seen the value of that cash rise and fall as the trade weighted value of the U.S. dollar declined and then rose again.
In 2013 we continued to see large swings in currency exchange rates. Such volatility is not expected to decline, suggesting that the risk of exchange rate changes on the value of reported cash balances will continue.
Earnings Quality: Reports on Individual Companies
In these reports we examine one or more dimensions of earnings quality: the cash flow support of earnings, the sustainability of earnings, or the quality of the balance sheet.