FINANCIAL ANALYSIS OF COOPERATIVES: ASSESSMENT’S PROBLEMS AND DIFFERENCES FROM INVESTOR-ORIENTED FIRMS

Academic course: BEC-53306 Cooperatives and Producer Organizations

Student: Michele Tosi - 891124840060

Study profile: Management, Economics and Consumer Studies - Wageningen University

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Abstract

Cooperatives are a type of company in constant evolution, which, compulsorily, shares several aspects in common with the more widespread investor-oriented firms (IOFs); however , there are also differences which must be taken into account. Precisely for this reason, to carry out a performance analysis, we must take into consideration these features and we must be able to better interpret the various results. Sometimes this could lead to misunderstandings, which reflect a different evaluation of the cooperative in relation to the IOFs. This article focuses on some of these differences, including the different composition and formation of the equity in both types of companies, the features of the reclassification of the balance sheet and income statement, implemented to carry out the subsequent ratio analysis, with the aim to find a possible solution for these problem. Furthermore, it is proposed an alternative way to evaluate the profitability that may be useful to avoid errors of assessment in the cooperatives. Finally, concerning to the problems that the fictitious results of these analysis can report, for example a lack of access to investment, it is proposed a solution performed in the past to overcome this issue.

Keywords

Cooperatives, investor-oriented firm, performance analysis, equity, ratio analysis, profitability

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1 - INTRODUCTION

According to the Statement on the Cooperative Identity (1995):

“A Cooperative is an autonomous association of persons united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly owned and democratically controlled enterprise.”

Thanks to this clear and precise definition given by ICA (International Cooperative Alliance), it is possible to place this particular kind of enterprise among all the others. In most businesses, the objective-function is to maximize the profit or the financial worth related to

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the owner’s interest in the firm. Indeed, regarding the IOFs, the objective is to reward the shareholders of the firm and reinvests the revenues in assets which will produce further earnings (Chesnick, 2000). Cooperative enterprises are owned by members and controlled by the people who use its services, and they abide by principles of democracy and solidarity. Therefore, the objective-function of this kind of business cannot be merely intended as profit maximization, rather, at the base of the cooperative there is the common desire of its members to protect their interests as consumers, workers, farmers, cultural and the ambition to create social value (Costa et al., 2012). As a result of these differences in the firms’ structure, the economic and financial analysis of cooperatives cannot be based on the traditional financial tools, as ratio analysis, reclassification of income statement and balance sheet (Lerman and Parliament, 1991). Indeed, because of the nature of these economic tools, it must be clear that these are not suitable for the interpretation of this type of company (Guzman and Arcas, 2008). The applications of these tools usually leads to a series of problems related to: first, some particular peculiarities of the financial structure of this type of company (for instance, poor equity of cooperatives compared to capitalist enterprises and the member’s participation through other forms than cash money, like contribution of goods) and, furthermore, the mutual objectives pursued, that is not a prerogative in the IOFs. Unlike capitalist enterprises, where the priority is the pursuit of the profit, cooperative’s aim is to maximize the value of the products or services given by the members (for example, in a food processing cooperative the objective is to maximize the value of the processing of raw materials made by the members). For this reason, and to avoid the drawbacks of legislation of most countries, which does not incentive the capitalization of the cooperative through the creation of the retained earnings, the financial statements of cooperative do not usually show revenues. From the difference between revenues and costs established ex post, the cooperative determines, taken into account its needs of survival and development, the maximum amount of net income payable to shareholders; for this reason, profit usually results as a ‘net zero surplus’ (Guzman and Arcas, 2008). With this methodology, the gain or loss from operating activities are divided among all the members in the form of underpayment or overpayment of the contributions given by them.. This economic mechanism usually lead to an (or a supposed) undercapitalization, which is one of the most common strategic weaknesses of agricultural cooperatives worldwide (Russo and Sabbatini, 2002). This means that all the resources like money from the capital and the retained earnings is lower than the needs of management. This problem lead to a scenario where cooperatives are not able to undertake additional investment opportunities (from the banks or from outside investors) and therefore they are not able to grow as they are expected to do (Oladede and Monkhei, 2009).It should be emphasized also that IOFs and cooperatives share some common values. The cooperative’s purpose, which is to offer to the members more advantageous conditions than those they could obtain by addressing their supply or their demand for goods or services to the market, is achieved by emphasizing the needs of customers (whose economic satisfaction is the existing reason of the company), the expected value of the resources, the need for long-term economic and financial equilibrium, and the development of skills to enable to combine all these elements and self-sustaining. This also works for the IOFs. Indeed, for any kind of business, the risk of failure is high if the interests of the owners do not align with the business objectives. In any case, the vital company is the one capable of innovation in developing valid responses to customer needs (Tandoi and Arzeni, 2001).

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However, as it is written in this introduction, there are some critical differences between capitalist enterprises and cooperatives, such as the composition of the balance sheet and income statement, which bring to issues like undercapitalization, and regarding the interpretation of the classical financial ratios, for instance ROA and ROE.This paper aims to analyze these problems, comparing the current situation of the IOFs and the cooperatives, in order to find perhaps a solution and a more clever way of interpretation of these financial tools; furthermore, a possible alternative solution in calculating the profitability of the firm will be shown, correlated with some examples. Finally, it will be discussed a possible way to overcome the undercapitalization and to gain an improved access to outside investments.

2 - THE COMPOSITION OF EQUITY

The term “equity” refers to the owner’s investment in the business. In financial terms, it is a liability section in the balance sheet, which results from the difference between assets and liabilities. In many respects, it is the risk capital and it is commonly considered as permanent (Chesnick, 2000). With regard to the composition of the equity, it must be referred to the provisions contained in the international accounting standards IAS/IFRS and, in particular, in IAS 1 "Presentation of Financial Statements" and in IAS 32 "Financial Instruments: Presentation”. The only information contained in IAS 1 regarding the classification of the equity items is that relating to the minimum content of the balance sheet, which explain that part of the equity must be shown separately for "shares to minority interests "and" issued capital and reserves attributable to equity holders of the parent company". To confirm this, the balance sheet in Appendix to IAS 1 (for the section of shareholders' equity) is particularly synthetic distinguishing the net assets in just three categories: issued capital (share capital), reserves and accumulated profits (retained earnings) (Iannucci and Ricco, 2006). In IOFs, usually in the end of the year profits are distributed in proportion to the equity investment done when the investor became shareholder of the firm; moreover, investors usually purchase the IOFs equity in order to gain future revenues and they could also sell or buy their equity to other investors (Kenkel and Fitzwater, 2012). On the other hand, much of the cooperative’s equity is temporary: cooperatives are commonly understood as a variable capital company, while all the others are fixed capital (Tandoi and Arzeni, 2001). This concept must be properly understood in the sense that capital, like any other element of the organization, can be varied, but in cooperatives, unlike other companies, this will not affect the profits that will be distributed at year-end. Indeed, profits are usually distributed in proportion to business volume brought by the member, so there is maybe no advantage in holding a big amount of equity. Thanks to this criterion, it is possible to ensure the proper prosecution of the mutual purpose, since this principle should not meet financing needs, unlike the case of investor-oriented firms, but helps, along with the principle of mutuality, those of democracy and solidarity. Therefore, it is better to see the equity as “dynamic”, although members usually try to keep up a sort of “equity base” (Chesnick, 2000). In the following balance sheet, we must take account of the division of the cooperative equity in allocated (owned by specific members) and unallocated (used as a general reserve) portions.

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Due to this dissimilar nature of the equity’s composition, it must be clear that additional attention is necessary to analyze and explain changes in the capital accounts. For this reason and because the financial statements contain a huge quantity of information, it is better to organize it in an understandable and clean set of data, that will emphasize the cooperative’s strengths and weaknesses.

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Fig. 1 - Farmer Cooperative’s Balance sheet (Chesnick, 2002)

3 - RECLASSIFICATION OF THE BALANCE SHEET

3.1 - Definition

This operation consists in aggregating and grouping multiple values of the balance sheet to better interpret the performance of the enterprise. There are two different criteria for reclassifying the balance sheet: the financial criterion and the management pertinence criterion. Since it is more suitable for the cooperative’s analysis, the financial criterion will be used, according to which assets and liabilities are reclassified according to the duration of their cycle of realization, i.e. on the basis of their convertibility into cash (according to their ability to return to current form). For this criterion the assets represent investments made by the company, while the liabilities (including the equity in this sense) are, in general, the sources of financing of business management (Coldiretti.it, 2012).The assets are highlighted according to their degree of liquidity and the liabilities according to their degree of collectability (the duration conventional to divide the short from the long-term is 12 months). The activities are divided into two main parts: fixed assets and current assets, divided into inventory , receivables (deferred cash) and cash (immediately). Liabilities are divided into components of shareholders' equity (internal financing), consolidated liabilities (all the amounts due after one year) and liabilities (debts which are maturing within the year). Consolidated and current liabilities together represent financing from external sources (third party). So the liabilities are funding (internal and third party) of the company, while the activities represent investments (fixed and current) carried out with the use of the funds. Therefore, the two sections of the balance sheet (assets and liabilities) must always be the same as the value (total assets = total liabilities).

3.2 - Reclassification in cooperative’s balance sheet

In reclassifying the liabilities in the balance sheet of a cooperative, a distinction should be made also from the "internal" debts and "external" debts. The first, indeed, presents characteristics of greater flexibility and lower cost, and shows the degree of confidence that the member puts in the enterprise to which it belongs. For this purpose it is convenient to point out certain items , which are particularly relevant for the analysis. Indeed, it is important that the reclassified balance sheet highlights how members contribute to support the financial needs of the cooperative: from this point of view the social participation can be represented, other than the equity, by loans from members and, especially, by indirect financing, that consists of the delay in receipt of remuneration on the goods contributed, that results for the cooperative in a cumulative debt to shareholders at year-end (Coldiretti.it, 2012). The following analytical framework that it is going to be adopted for the reclassification of the balance sheet takes into account the above requirements and is distinguished both the current liabilities and the medium-long term, depending on whether they relate to third parties or members. This distinction allows then to separate the relationship of the cooperative with third-party investors (or banks) from shareholders/members and include them in the equity. In this section, the aim is to examine briefly the individual items of liabilities. By adopting this method, the passive is broken down into the following components:

i) Share capital;ii) Retained Earnings;

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iii) Net income;iv) Consolidated Liabilities;v) Loan from members;vi) Current liabilities (De Sanctis, 2012).

ASSETS LIABILITIES

Current assets Current liabilities

Cash Consolidated liabilities

Receivables Loan from members

Inventory Consolidated (long-term) liabilities

Fixed assets Members’ Equity

Net Income

Retained Earnings

Share Capital

The consolidated liabilities include all debts which do not cause payments within the short period. Commonly mortgages, bonds, debts and payables to employees for severance pay fall into this category. Current liabilities include debts due within one year. This category includes also the provision for taxes and the share of debt with longer maturities that will be paid during the twelve months following the end of the year including the severance pay and mortgages to be safely settled within one year.Typically, the loan from members is considered a consolidated liability. In this case, given its considerable importance, it is better to keep it separate. Moreover, in the cooperative, often the social lending itself is configured as an effective method of savings deposit or even as a real bank account. In fact, although the time horizon of the shareholders providers is medium to long term, loans are repayable on demand. It seems difficult in these cases, then define the time limit of the loan to members (De Sanctis, 2005). However, it is definitely an advantage for the cooperative, which can exploit a more flexible and cheaper debt compared to what would be with the banks or outside investors.

4 - RECLASSIFICATION OF THE INCOME STATEMENT

The aim of this is operation is to provide meaningful intermediate results useful to understand the ordinary and extraordinary trends of the business, within the characteristic management.The reclassification of income statement tends to give better information arising from exposure of income based on the criterion of "the nature or origin" of its cost structure, revenues and inventories provided for in the income statement. The reclassification shall be done keeping the operational management area distinct from the extra-characteristics management, which expresses the influence on the previous one (operational management) of the results of financial management, of atypical results, extraordinary items and taxes

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Fig.2 - Reclassified balance sheet

(Coldiretti.it, 2012). This reclassification of the income statement has the great advantage of providing some intermediate results, very interesting to understand the performance of the firm. In particular the complex management is divided into three areas:

- Operational management (relative to the typical activity of the company),- Financial management (relative to interest on capital borrowed and given)- Extraordinary management (relative to one-off transactions, not part of the

normal business activities, such as the sale of assets) (Economia Oggi, 2009).

Also with regard to the reclassification of the income statement, it is appropriate to separate relationships with members from those with non-members, both relatively to the operational management that the extra-characteristics.

Cooperative’s Income Statement - Reclassification

Net sales (+)

COGS (-)

Change in inventory (+-)

Operational section’s Margin

Non-operational earnings (+)

EBIT

Financial Expenses (FE) (-)

Gross Margin (GM)

Extraordinary components & Taxes (+-)

Distributable Margin (DbM)

Margin destination:

• Distributed Margin (DtM)

• Net profit

5 - RATIO ANALYSIS

Thanks to the previous two reclassifications, it is possible to do ratio analysis, and to compare them with IOFs. Ratios are useful to provide indications which help to identify evidences about the firm’s performances. All the stakeholders interested in the business, depending on their needs, may differ in the ratios that can be useful to understand the financial position of the cooperative. Usually short-term creditors are much more concerned about the cooperative’s current effectiveness and its possession of a ready source of cash to satisfy the

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Fig.3 - Reclassified income statement

current cash requirements. On the other hand, long-term creditors and members are interested in both the short-term and the long-term results (Chesnick, 2000).In order to analyze the financial situation of a firm, five categories of ratios are available:

- Profitability ratios (Return on assets - ROA, Return on equity - ROE);- Liquidity ratios (Current ratio, Quick ratio);- Activity ratios (Total asset turnover, Receivables turnover, Average collection

period, Inventory turnover);- Leverage ratios (Debt ratio, Debt-equity ratio, Equity multiplier, Interest

coverage, Equity-assets ratio);- Development ratios (Ross et al., 2003).

Leaving aside the last four groups of ratios, the focus is going to be on the profitability ratios, because they are those that require more attention during the evaluation of the performance of the cooperatives. Profitability ratios assess the capabilities of the firm to gain a net return from all the operations. The two most important ratios which belong in this group are:

- Gross Return on Assets (ROA) = EBIT / Average total assets- ROE = Net income / Average Stockholders’ Equity (Ross et al., 2003)

Certainly, despite not being the main target of the cooperative, profit is still an important objective, because poor profitability reflects a lack of success which could bring the firm out of business. Profitability ratios could be misleading. As mentioned previously, cooperatives are not usually motivated for profit: they are more interested to serve member-owners. Therefore, the low profitability may be confusing for the analyst, especially with some pooling cooperatives. Indeed, those two ratios used with cooperatives, compared with IOFs, might return inconsistent and quite meaningless results; ROE, since it is using equity capital as the denominator, is biased versus firms that are using more debt capital than equity capital in operational management. Moreover, since, for instance, a dairy cooperative has to pay a high market price for milk in order to be competitive in attracting new members, it may generate low net savings or even cause losses. On the other hand, another dairy cooperative could return lower prices for the milk to the farmers/members and bring back great net earnings on the financial statement. These two firms could have the same performance, although they have different financial values (Ling and Liebrand, 1998). For these reasons, perhaps it is required an alternative approach to assess the profitability.

6 - AN ALTERNATIVE METHOD TO EVALUATE THE COOPERATIVE’S PROFITABILITY

In order to evaluate the profitability, instead of using ROE, it is possible to utilize the following model, which explain the efficacy of the cooperative action assessing several elements of the cooperative’s income statement:

DtMQuantity

= ( EBITQuantity

− FETPC

* TPCAssets

* AssetsQuantity

)* DbMGM

* DtMDbM

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Lai et al., 1991

Now each singular index will be explained and analyzed:

- DtM/Quantity is the average price of contributions given to the members. It must be compared with a no-risk conferment on the market (e.g. in a dairy cooperative this ratio reflects the amount of money that the firm is able to give to its member for the milk; the farmer has to compare this price with the free-risk price that he would receive if he sold the milk on the market).

- EBIT/Quantity reflects the income of the operational section. Specifically, it reflects the gross margin for each unit of product that the farmer brings into the cooperative.

- FE/TPC (Third-Party Capital) explains the average cost of the third-party capital, which means debts from banks and/or outside investors.

- TPC/Assets is the leverage ratio of the cooperative.- Assets/Quantity is called “capitalist intensity ratio” and explains how much the

cooperative has to invest for each unit of products brought by the members.- DbM/GM is an index which explains the impact of the extraordinary components

and taxes on the final price given to the members of the cooperative.- DtM/DbM explain what is the tendency of the firm to give back the gained margin

to the members or to use it for other purposes. If this ratio is 1, all the margin gained by the cooperative has been distributed among the members. If the result is lower than 1, it means that part of the margin has become net profit. If the result is higher that 1, the firm distributed more margin than the one it earned during the financial year: it means a loss (Lai et al., 1991).

Thanks to this formula, it is possible to verify the performance of the cooperative on the basis on each single index, which allows to find an economical reason for most of the situations that could happen. In the following example, three fictitious cooperatives will be examined.

6.1 - Alfa cooperative

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(Modello di analisi dell'efficacia dell'azione cooperativa)Fig. 4 - Alfa Cooperative

In the previous scheme, all the indices have a numeric value; it is to keep in mind that having a concrete value (the price) is probably better than a percentage, like in the ROE ratio, because everyone can immediately see the most significant result. As it is written before, during the first year (n), the price payed to the members is 49.017 €/unit of product; moreover, a positive trend regarding this price can be noted, which means that in the following years, the cooperative will be willing to pay more for the contributions of goods. Another variation that has to be described is the one of the capitalist intensity ratio: an increase in this value, like in this case, reflects a decrease in the final price payed; this could be explained as a reduction of the goods contributions, perhaps due to an exit of a member. Eventually, also the last parameter is to emphasize: 0.99 means that almost all of the available margin has been distributed among the member.

6.2 - Beta Cooperative

In this cooperative, the average price of contributions given to the members is almost constant. In spite of this feature, it has to be noted a big variation in the overall result of the three index which reflect the financial management (from 2.854 to 5.316). In order to understand the meaning of this increase, the three parameter must be analyzed singularly:

- The average cost of the third-party capital increased (from 10.72% to 14.74%), which could be explained with an increment in the financial expenses (interests).

- The leverage ratio increased (from 66.15% to 69.58%), due probably to a expansion of the third-party capital of the firm (entrance of new outside investors).

- The capitalist intensity ratio increased as well (from 40.246 to 51.836). This huge variation is probably caused by an outflow of members.

Finally, it is interesting the value related to the distribution of the margin (1.0680). As it is written before, a value higher than one reflects a loss for the cooperative, whose management decided to distribute more margin that the one the firm collected during the financial year.

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(Modello di analisi dell'efficacia dell'azione cooperativa)Fig. 5 - Beta Cooperative

6.3 - Gamma Cooperative

Examining this cooperative, two main variations jump out: first, the difference of the income of the operational section, which changes from 38.109 to 51.714: this indicates an increase in the firm’s profitability; secondly, more than the doubling of the capitalist intensity ratio, that could be only explained with an increase of the fixed investments on new assets. Apparently, the growing in the assets has led to an increment of the profitability of the cooperative. Finally, it could be assumed that this “Gamma” cooperative belongs to a different market sector compared with the previous two, because of the difference in the assets required.

7 - THE METHODS TO ACHIEVE A FINANCIAL STRUCTURE SUITABLE FOR THE DEVELOPMENT AND GROWTH

Cooperatives have therefore the need to find ways to ensure adequate access to sources of funding to ensure a constant development. In order to accomplish this, two methods are discussed in this section:

- Cooperative’s alliances and mergers- Structural links with company, devoted to finding resources from the financial

market or intended to acquire the assets of the production process typical of the coops.

According to Richards and Manfredo (2003), capital constraints increase the probability of the cooperative’s decision to perform the strategic choice to merge, acquire, create a joint venture or make an alliance. Moreover, it has been proven that also cooperatives follow the waves mergers typical of IOFs, probably in order to match the efficiencies gained by non-cooperative firms. Moreover, in the first place, cooperatives, in order to remain a viable kind of business, have to act wisely: their managers should recognize the significant impediment to the growth and competitiveness brought by lack of access to public stock markets. Thus, managers should take advantage of innovative financing instruments that address both the need for members to keep control and their need for outside sources of capital. Secondly a rapid rate of mergers between co-efficient has to be seen in a positive light as a means through

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(Modello di analisi dell'efficacia dell'azione cooperativa)Fig. 6 - Gamma Cooperative

which the cooperative sector can remain competitive with respect to non-cooperative competitors, rather than as a indication of weakness and despair. (Richard and Manfredo, 2003).Regarding the second method, one model of cooperative evolution in Ireland can be taken as an example. After the introduction of the milk quotas in 1984, dairy cooperatives found a major obstacle that prevented them from a natural expansion of the milk production. Therefore these firms, thanks to economies of scale, prosper cash flows and domestic organizational resources, started to consider international acquisitions (Breathnach, 1996). Furthermore, the majority of the Irish dairy cooperatives adapted the governance structure to act on the global market as international food company (Enright, 1997). The model is related to the strategies that three Irish dairy cooperatives adopt in order to improve their access to the market. The firms Kerry, Avonmore and Waterford followed the same strategic path:

- Unbundling of assets and subsequent transfer to a newly established PLC (public limited company.

- Transformation of the cooperative in holding company that owns a majority of the PLC shares (51%). In the meanwhile, the other shares of the PLC could be placed on the stock market.

- Operational activities are decentralized at the PLC which transfers the profits to the dairy cooperative/holding (Enright, 1997).

Thanks to this approach, the PLC, which owned the commercial function of the cooperative, was able to move nimbly in the market and get more easily money for development. On the

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Fig. 7 - Financing a dairy cooperative (Zwanenberg, 1994)

other hands, it has to be said also that this changing in the governance could lead to conflict of interest between outside investors and the traditional owners of the cooperative.

8 - CONCLUSIONS

The study of a cooperative enterprise has its own distinctive features but cannot prescind from a comparison with the capitalist firm. The two companies, however, can be compared only if they are managed with efficiency criteria, that, regardless of the business model, determine the capacity of them to create added value. The difference lies in the different distribution of profits: in cooperatives, in fact, the real profit is distributed in the form of premium price on the provision of products, so the profit which is in the financial statements is modest and is used to self-financing; in investor-oriented firms profit is distributed according to the amount of capital provided in the beginning of the membership. This characteristic lead to a necessary modification of the usual financial tools used for the assessment of the performances of the companies. For this reason, the composition of equity, the reclassifications of balance sheet and income statement and the ratio analysis have to be examined from a different perspective compared with the capitalist enterprise, in order to evaluate effectively the firm. Moreover, there are also possible alternative solutions for estimating the profitability of the cooperative company, which are probably more simple to analyze; additionally, these methods assess in a better way the various types of management (characteristic, extra-characteristic, financial). It is provided also a practical solution, already adopted in the past, which leads to a change in the cooperative enterprises, that are increasingly obliged to mix elements of capitalist society in order to survive in the competitive environment.

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