Corporate and financial sector dynamics

Financial Sector Indicators Note: 2 Part of a series illustrating how the (FSDI) project enhances the assessment of financial sectors by expanding the measurement dimensions beyond size to cover access, efficiency and stability. Data on these dimensions, as well as other information relevant for financial sector assessment, is intended to become available online during Spring 26. Corporate and financial sector dynamics Close dynamics exist between the corporate and financial sectors Associations across sectors govern the overall soundness and development Variety of corporate sector information can complement financial sector assessment Many characteristics of non-financial corporate sector are closely associated with those of the overall financial sector, which includes banking and capital markets. Various facets of the financial sector, such as usage and accessibility of finance, influence the corporate sector, while financial institutions in turn are affected by the soundness and profitability of the corporate sector. Thus, assessing financial sector by taking into account the corporate sector, can improve a thorough and comprehensive assessment. A variety of information on corporate sector performance, such as earnings management, liquidity, solvency, default probability, growth opportunities, dividend policy, capital structure etc., can complement information on banking, capital markets and institutional environment. Information on the corporate sector can be used for two broad purposes: To identify dynamics between the corporate sector and the financial environment. To evaluate and compare corporate sector characteristics across countries and over time. Financial and corporate sector performance, 1996-23 Non-financial corporate sector (median return on assets, %) 15 12 9 6 3-2 4 1 16-3 Financial sector (median return on assets, %) Sample: 31 countries General links reflected in profitability At a first snapshot, the close linkage between the corporate and financial sectors is clearly reflected in their overall profitability. Higher return on assets for the corporate and financial sectors (e.g. banks, insurance companies, real-estate firms) are mutually reinforcing, as shown by the strong correlation between accounting performance in both of them (chart, above). This relationship is of particular note from a policy perspective, as weakness in the corporate sector can undermine (or reinforce) the strength (or perceptions thereof) of the financial sector, and vice-versa. Such dynamics were made clear during the Asian crisis of 1997. Compre- page 1

hensive inter-sectoral analyses can highlight areas in need of attention in either sector to aid policy measures. Relationships with capital markets Some characteristics of corporate sector are also related to capital markets, and as such can influence its development. An interesting relation is between the ownership structure of the corporate sector and the volume of shares traded in capital markets. Closely-held shares belong to a small number of entities and are thus not available to the general public, leading to low trading. Countries with high ownership concentration in the corporate sector, e.g. companies whose ownership belongs to a single (or few) entity, or conglomerate(s), typically have low levels of trading (chart, left). Lack of active trading restricts the growth of capital markets, and can also hamper the growth of the financial sector. In particular, where closely held ownership exceeded 4 percent of the total market capitalization of the stock market, the value of stocks traded was limited, not exceeding 35 percent of the GDP, compared to 82 percent of GDP, on average, at low levels of ownership concentration ( to 1 percent of market capitalization). The corporate sector s interaction with capital markets can also be highlighted through the quality of accounting information. This can be illustrated by comparing the management of corporate sector earnings with share-price synchronicity in capital markets (chart, right). Earnings management illustrates the quality of account reporting by companies and synchronicity captures the extent to which individual share prices on the stock exchange move together. Higher synchronicity implies that share prices are driven by aggregate factors instead of firm-specific determinants, which should be the case if the reporting of accounts was conveying unique information to investors (traders). The positive relation between earnings management and synchronicity of share prices clearly suggests that poor accounting practices in a country s corporate sector are associated with higher synchronicity. This again can undermine investor confidence in local stock markets and may encourage inefficient use of capital. Trade volume when firms are closely-held, 1996-23 Value of stocks traded / GDP (%) 35 3 25 Accounting practices and stock markets, 21-23 Stock market synchronicity, annual ranking [1=best] 41 31 2 15 1 5 >4% closely held <35% of GDP 21 11 2 4 6 Closely held market capitalization (% of total) Sample: 41 countries 1 1 11 21 31 41 Earnings management, annual ranking [1=best] Sample: 4 countries page 2

Dynamics with the banking sector Besides capital markets, the corporate sector is closely linked to the banking sector. The cost of funds for the corporate sector and its overall vulnerability to shocks, both domestic and external, could be affected by the efficient functioning of the banking sector and vice versa. The corporate sector s financial soundness can be inhibited by inefficiencies or the lack of competition in the banking sector, as reflected in high net interest margins. Using the ratio of operating earnings over interest expenses (i.e. interest coverage ratio), it is shown that the debt payment capacity of the corporate sector is related to the presence of high interest margins in the banking sector (chart, left). For example, during the period 1996-23, the corporate sector was covering from internal cash flow, on average, only 1.7 times the amount of debt service in countries where the net interest margin of the banking sector was over 1 percent. In contrast, the coverage ratio was 3.1 times for countries in which the net interest margin was between 5 and 1 percent. Therefore, in general, inefficiencies in the banking sector can not only lead to inefficient use of credit by the corporate sector, but it can also increase its vulnerability to adverse events. Relating to institutional and economic environment Institutional and economic environment play an important role in understanding corporate sectors financing and investment patterns. Macroeconomic factors and structural weaknesses in the institutional setup affect both the financing choices of companies, as well as the vulnerability of the corporate sector. Uncertainty stemming from inflation inhibits firms long-term debt financing because of the uncertainty it poses for future interest rates (chart, right). Higher reliance on short-term debt in turn can influence adversely credit risk ratings, which in turn can push up the cost of financing in capital markets. It also increases corporate sectors exposure to fluctuations in the financing environment, which can hamper long-term strategic planning, or investment in capacity buildup. Similarly, corporations in countries with better creditor rights have more access to credit, since institutions ensure stricter enforcement of rules and investor protection. Bank "competition" and firm "solvency", 1996-23 Corporate sector's interest coverage ratio (%) 8 Economic environment and long-term financing, 23 Long-term debt as % of capital structure 27 5 18 9 2-1 4 8 12 16 Banking sector's net interest margin (%) Sample: 38 countries Net interest margin is the interest income earned on assets less interest expense paid on liabilities and capital. % 2% 4% 6% Standard deviation of inflation over 1996-23 period Sample: 4 countries page 3

Assessment of the corporate sector itself Apart from helping assess the financial sector, information on corporate sector can be utilized to evaluate its own facets, such as vulnerability, restructuring, financing structures and access to finance. Vulnerability Information and data can enable analyses, such as for identifying trends that could serve as early warnings for corporate instability, which, as indicated earlier can easily spill over to the financial sector. For example, using the interest coverage ratio, it is apparent that corporate vulnerability in Malaysia and Argentina was steadily worsening several years before the actual crises in 1997 and 21, respectively (chart, left). While the crises were instigated by a variety of external and domestic factors, insights into corporate sector performance can help inform measures aimed at mitigating vulnerabilities. Corporate sector restructuring Corporate sector data can be utilized to monitor corporate sector restructuring, among other dimensions. This is especially important given that significant changes have taken place in corporate sector debt structures following a spate of crises since the mid-199s. In addition, increasing access of the corporate sector to both domestic and external capital markets also necessitates diligent monitoring of such information, not only for the purposes of vulnerabilities, but also for assisting companies gain adequate access to capital. As an example, it is apparent in the case of Korea that after the crisis in 1997 the country s corporate sector dramatically reduced its reliance on debt and increased the portion of equity in the capital structure (chart, right). Financing structures Characteristics across countries and over time can also be identified using corporate sector data. For instance, cross-country differences can be found in accounts payable, i.e. the credit extended between firms for the purchase of goods or services. High levels of accounts payable in developing countries are often associated with lack of financial development, since firms indirectly undertake the role of financial intermediaries. Varying levels of corporate sector s accounts payable in ten emerging markets for 23 are presented in the chart (top, next page). For instance, the difference in Corporate sector solvency, 1994-23 Interest coverage ratio 8 6 Malaysia Capital structure of Korean corporate sector, 1996-23 Cumulative percentage 1% 75% 4 Argentina 5% 25% 2 Crisis Crisis 1994 1996 1998 2 22 % 1996 1997 1998 1999 2 21 22 23 Acc. Payable Debt Equity Other page 4

percentage of accounts payable in India versus Brazil (13 and 7 percent, respectively) could be related to the fact that Brazil has lower cost of enforcing contracts and more efficient banking sector. Access to finance Information on corporate bonds and crossborder listings of equity, primarily in the form of American depository receipts, can help shed light on specific financing decisions of companies. Corporate bonds are publicly traded longterm debt securities, while American depository receipts are dollar denominated securities issued by U.S. banks that represent a claim on the local publicly traded equity. The data can facilitate the empirical testing of the notion that companies issuing depository receipts are more dynamic, transparent, and willing to overcome the constraints of often poorly functioning domestic capital markets. For instance, the chart (middle) shows that even though companies with or without depository receipts have quite similar debt-to-asset ratios, companies with depository receipts have less short-term debt (35%) compared to firms that have not issued depository receipts (44%). In other words, insights into asset-liability structures can help clarify what determines corporate sector s access to external versus domestic financing. Accounts payable in select countries, 23 India Turkey Mexico Thailand Malaysia China Brazil Peru Argentina Colombia 3 15 4 8 12 % of total liabilities & equity Liability structure of firms with and without depository receipts (DRs), 23 Median (%) 45 Debt-to- Assets Short-term to total debt Firms with DRs Debt-to- Assets Short-term to total debt Firms without DRs Sample: 299 pairs matched by country, industry and firm size Better insights on characteristics Detailed corporate sector data have the advantage of offering more information than a simple country average. More specifically, they include the median, as well as the inter-quartile gap, that can provide crucial information on how companies are distributed (according to a particular characteristic) within a country. The importance of such information can be illustrated with an example of the current ratio (i.e. the ratio of current assets to current liabilities) for the corporate sectors of Malaysia and Philippines (chart, bottom). Focusing only on the mean Going beyond the country average Corporate sector's current ratio, 23 3 2 1 Malaysia 75th percentile 25th percentile Philippines Mean 75th percentile 25th percentile page 5

current ratio, it would appear that both countries have about the same average current ratio for their corporate sectors, about 2.7. However, the distribution shows that the mean in the Philippines is the result of extremely high values for a few firms that push up the average (i.e. the mean is well above the 25-75 percentile range for the values of current ratio). In comparison, the mean current ratio for Malaysian firms appears within the 25-75 percentile range, thus being more representative. A mere comparison of the mean between the countries would not adequately show the corporate sector s picture. Comparing only the averages would overestimate the current ratio for Philippines corporate sector, thus lead to misleading conclusions. Availability of corporate sector information through the FSDI Web site A variety of data on corporate sector will be available through the FSDI interactive Web site, currently under construction. These data can be used to complement information (traditional and new) on various dimensions of capital markets and the banking sector (size, access, efficiency and stability), and can help with the overall assessment of financial sectors. Provision of regional and country details will offer users the flexibility of customizing information to their unique requirements. Corporate sector data in FSDI Efficiency Liquidity Growth opportunities Return on assets Current ratio Market to book value of equity Return on equity Quick ratio P/E ratio EBIT margin Cash-flow to sales ratio Tobin's Q Sales growth Interest coverage ratio Capital expenditures to book value of assets Estimated average interest rate Capital intensity Earnings management Solvency Other Earnings Aggressiveness Debt to common equity ratio Dividend payout ratio Earnings Smoothing Long-term debt to common equity ratio Dividend yield Loss Avoidance Debt to total capitalization ratio Percentage of market cap. that is closely held Composite Index Long-term debt to total capitalization ratio Percentage of firms with Big-5 auditor Debt to assets ratio Kaplan-Zingales index Bankruptcy risk Debt to sales ratio Rajan-Zingales index Altman's Z-score & default probability Debt to cash flows ratio Capital structure (several variables) Ohlson's O-score & default probability Total liabilities to total assets ratio Liabilities structure (several variables) Current liabilities to total assets ratio Details of ADRs (several variables) Current assets to total assets ratio Details of bonds (several variables) Short term debt to total debt ratio Current liabilities to total liabilities ratio page 6