Governance Ratings and Earnings Quality

There is always a controversy surrounding corporate governance ratings and scores. Since the ratings are based on disclosures and other documents presented it does not necessarily translate to actions. The rating methods use multiple criteria and weights, which in turn tends to weaken correlation between good governance practices and financial performance. Nevertheless, significant/director ownership of equity has exhibited a strong correlation with financial performance, globally. However, in the list of Sri Lankan companies listed below, the top 5 do not have such individually significant holdings and the bottom 6 have individually significant holdings. However, all of them seem to have good quality of earnings, compared to many companies listed locally.

Corporates that have proper governance policies around accounting policies, disclosure, and reporting favor transparency and conservative treatment of accounting issues. They take a cautious approach to unknown factors, estimates and judgments required to prepare good financial statements. These policies lead to high- quality earnings; earnings that are , controllable, and bankable.

BUSINESS-TODAY magazine in Sri Lanka published Corporate governance scores (CGA) for large and heavily traded stocks of companies in 2011 and 2012. The Top10 of the list was selected along with their profit and revenue to compare their growth rates from the previous financial reporting period, for the summary below;

…………………….CGA….PAT…PAT..PAT….Revenue….Revenue

………………….%……Rs Bn__Grow%_Grow%_Grow%_Grow%.
Rank………………………..2012__2010_2011_2010_2011
Commercial Bank __83 _8.1 __2 _47 __-1 _10
HNB___________82 _6.1 _58 _28 __7 __10
John Keells Hold___73 _9.8 _10 _19 __17 __27
Sampath Bank_____71 _4.1 _39 _19 __11 __11
NDB___________69 _2.7 _30 _29 __13 __16
Aitken Spence_____68 _3.7 __2 _ 46 _-17 _ 22
DFCC Bank_______67 _2.9 _26 _-43 _ -2 _-23
Ceylon Tobacco____66 _6.5 _49 _ 29 _ 11 _25
United Motors_____62 _2.3 _n/a _152 _ n/a _90
SriLanka Telecom___60 _4.8 _-89 _21 __2 __1
DIMO___________60 _2.7 _n/a _27 _n/a _36

It appears that these Top companies seem to be having an ability to produce consistent results which also indicates a higher quality of earnings. The PAT of this group of companies is at the higher end of the curve for the Sri Lankan companies. These stocks have also preformed well in the market, sans significant fluctuations which i normally associated with insider dealings and manipulations.

The opposite also may be true where the poorest quality of earnings is associated with weak corporate governance, and companies with poor-quality earnings underperform the market. The firms with poor governance standards and aggressive accounting practices have lower equity returns and more volatility than companies with strong governance practices and disclosures.

A number of studies have shown that good governance may indicate less expropriation of corporate resources by management. Also employees and suppliers are more loyal believing their relationships will be more prosperous; they will be treated fairly; and the relationship will be long term. These good companies are able to attract good quality investors who don’t unnecessarily intervene in operations and are also able to lower their cost of capital.

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About surenraj

“Views expressed are my own”
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