There is a section comparing the differences between original currency BS and IS ratios, and ratios post-FX translation. I am referring to those “mixed ratios”, involving IS and BS items in the calculation.
Schweser emphasizes that the comparisons are made for EoP Balance sheet items and that conclusions could differ if we used BoP or avg. balances. Can anyone explain why is that? I don’t see why using BoP or avg balance BS items would change the directional movements of mixed ratios.
Imagine a hypothetical where the FX rate changes gradually from the beginning to the end of the period. I’m imagining a spectrum from one extreme to the other.
Think of: BoP as FX @ t=0, avg. as FX @ t=1, and EoP as FX @ t=2.
Say you had an IS figure (typically average FX rate) contrast with either t=0 or t=2. The IS figure would look like a significant change compared to one of your other rates, but not the other. I think this is what they’re getting at.
Thanks for the reply. But i don’t think I understand the concept.
Why would it be a significant change to one rate but not to the other? I guess it depends of the depreciation assumed from t=0 to t=2, no?
I’m quite confused…
Here’s an example I think might work… So imagine, holding COGS constant, you had accounts payable on two balance sheet dates, t=0 and t=2, that were equal in size. However, imagine the FX rates from the functional currency to presentation currency for the accounts payable were different. In the subsidiary’s country, the payables turnover ratio would look the same, but when reporting back, based on the different combination of FX rates (say either averaging BoP and EoP or just using EoP) the payables turnover would look different to the parent.
In your example, if we’re calculating the ratio for t=2, under the current rate method, as you indicated (since functional and presentation currencies were different), and we use the avg. accounts payable (as the formula for payables turnover ratio suggest), would we still use the current FX for translation, or would we use some type of an average and that is why we cannot assume ratio directions when we are not using end-of-period Balance Sheet figures?
Thanks. I’m just trying to clarify this concept which Schweser, at least to me, does not explain in a very friendly way.
In my example, t=0 is balance sheet for end of first year. t=2 would be the next balance sheet. t=1 would be the time in between, which is the income statement.
With this translating stuff, income statement items are pretty much always at the average rate (except non-monetary stuff like COGS or Depreciation) when you do the Temporal Method.
In response to your question, just remember that under the Current-Rate Method, you’d always use the spot FX rate (aka @ EoP ≈ t=2) for balance sheet items. This is the most common way to translate.
Really nice catch—in my example I should have said: the affiliates statements are in local, but the functional currency is USD (which is also presentation). This would make it Temporal. Sorry, still getting the hang of writing out this type of thinking! Most of these mixed ratio translation issues come up with Temporal Method. Hope I helped more than I confused ya.
Hehe, thanks for the replies.
I think I finally got it sorted out. Its actually simpler than I thought. It looks that the reason we analyze the ratios based on end-of-period balance sheet figures is just because it makes more sense doing it that way, since the Current Rate method implies we use the Current FX rate for translating BS figures.
So, if we were to use average or beginning-of-period BS figures, we would not have a like to like comparison, and would be translating average or BoP figures at the current (t=2) FX rate.