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Cultural Understanding Is Vital to Corporate Finance

Not all financial infrastructures work the same way. Culture plays a big role in how a nation’s government, companies, and even individual transactions operate, so if you’re dealing with a company involved in international finance, you absolutely must understand a bit about the nation(s) in which the company operates to understand the context of its overall financial position.

In many nations with a prominent Muslim presence in government, sharia law forbids companies from lending money and then requesting more money in return than what was originally issued. As a result, throughout much of the Middle East, companies don’t charge or earn interest in financial transactions such as in loans or savings accounts.

In order to account for the time value of money (where increasing inflation causes an equal amount of money to be worth less over time), companies have come up with some novel solutions which resemble equity ownership and/or rent-to-own programs.

As a result, when financial analysts from a Western nation analyze the finances of a bank or other financial institution in these Muslim nations, the calculations may appear very different from what they’re used to seeing. This difference results from the lack of interest-generating loans and the way that depository accounts are treated more as equity than liabilities.

Without an understanding of the cultural and financial context in which a company operates, those analyzing the company are prone to making some very serious mistakes during their assessment.

Many attempts have been made worldwide to quantify cultural variations and develop simple, standardized methods of interpreting financial information across differing systems. For instance, many nations have adopted a method of financial accounting called the International Financial Reporting Standards (IFRS), which was developed by the International Accounting Standards Board.

The IFRS is sort of like a common language across all nations that helps them analyze the same financial reports in the same way.

Even with a common reporting method, however, culture can still influence the context in which financial transactions take place. For example, a culture in which people tend to accept higher levels of risk tends to also have higher price-to-earnings ratios because the investors are willing to accept a higher price relative to the potential for future earnings.

In contrast, a culture that tends to avoid risk may have a lower average price-to-earnings ratio. Without being aware of these differences, an analyst could end up either investing in an overvalued company or avoiding a great deal in an undervalued investment.

Companies can use the main dimensions of culture (as researched by Geert Hofstede) to help them identify financial trends that may seem unusual or even to find opportunities hidden by cultural norms unfamiliar to those outside the nation in question. These cultural dimensions include

  • Risk aversion: The degree to which people generally avoid uncertainty.

  • Power distance: The amount of social and professional equality generally recognized between an individual and their authority figures.

  • Growth versus development: The degree to which the people of a nation generally prescribe to values in growth (for example, status, wealth, and power) or development (for example, quality of life and intersocial connections).

  • Individualism: The degree to which a people generally view themselves as either individuals or as a part of a group.

  • Context (or “time horizon”): The degree to which a people generally recognize things as having inherent traits or only meaning within context of its use (including things such as reputation).

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