Chapter 4: Analysing financial statements
The feedback I received for ASS #1 and the KCQ’s on
Chapter 1 & 3 suggested dividing my thoughts and reflections into smaller
categories by separating them by subheadings. I can absolutely understand where
the marker was coming from – when writing my SPA #1 I experimented the
recommendations by splitting my thoughts and reflections into different
paragraphs and subheadings, based on the subchapters in each study guide, and it
really helped - both, me – to organise and keep my thoughts under control, as
well as the marker – to read and understand the mess if my thoughts and
reflections a little bit clearer. I also received suggestions to make my
analysis a bit briefer and try to mention and reflect on SOME of the key
concepts and not ALL of them since talking about all of them specifically would
make the SPA a little bit too summarising, which we aren’t permitted to do. Hence
I intend to select the key concepts of chapter 4 that seem to be most relevant
to me and write down my initial thoughts and reflections as I go, hopefully,
not overly summarising them.
When realising that this chapter is about analysing financial statements – basically everything that’s in our Assignment 2, I felt a little bit excited and anxious at the same time. I was excited about learning about analysing financial statements and getting started with ASS #2, and anxious because of various thoughts and questions already going around in my head: Will I understand everything? If I don’t, do I have to read the 24 pages again? What happens if I never get it – will I never finish my ASS #2? Soon I realised that the only way to find out is to start reading and explore what the chapter withholds.
When realising that this chapter is about analysing financial statements – basically everything that’s in our Assignment 2, I felt a little bit excited and anxious at the same time. I was excited about learning about analysing financial statements and getting started with ASS #2, and anxious because of various thoughts and questions already going around in my head: Will I understand everything? If I don’t, do I have to read the 24 pages again? What happens if I never get it – will I never finish my ASS #2? Soon I realised that the only way to find out is to start reading and explore what the chapter withholds.
Introduction
As usual, I yet again realised that anything to do with firms and accounting requires superb predicting skills. No one can be an equity investor if they can’t predict the future, because basically what equity investors do, is that they buy outcomes of the firm’s FUTURE business activity? How crazy is that? To assist them with their predictions, however, aren’t tealeaves nor a magic ball, but firm’s financial statements that give an insight to the past and the firm’s business and economic realities. It does make sense that it’s a lot easier to predict the future if you’re aware of the past – if a firm wasn’t doing that well in the past, you wouldn’t want to invest in it in the future, would you? Apparently viewing a firm through separated operating and financial activities can be a most powerful way of viewing a business! I sure hope that I’ll be able use my ‘power’ effectively and divide my company’s activities in the right category in order to start understanding my business better. As the author said, “it’s not like putting together a watch or constructing a cabinet from various pieces of wood, but it is a task we can do to make it easier for us to understand a firm’s past” (Turner 2015). It’s good, because I’ve never been good at assembling things.
As usual, I yet again realised that anything to do with firms and accounting requires superb predicting skills. No one can be an equity investor if they can’t predict the future, because basically what equity investors do, is that they buy outcomes of the firm’s FUTURE business activity? How crazy is that? To assist them with their predictions, however, aren’t tealeaves nor a magic ball, but firm’s financial statements that give an insight to the past and the firm’s business and economic realities. It does make sense that it’s a lot easier to predict the future if you’re aware of the past – if a firm wasn’t doing that well in the past, you wouldn’t want to invest in it in the future, would you? Apparently viewing a firm through separated operating and financial activities can be a most powerful way of viewing a business! I sure hope that I’ll be able use my ‘power’ effectively and divide my company’s activities in the right category in order to start understanding my business better. As the author said, “it’s not like putting together a watch or constructing a cabinet from various pieces of wood, but it is a task we can do to make it easier for us to understand a firm’s past” (Turner 2015). It’s good, because I’ve never been good at assembling things.
How
firms add value
I never thought that the more a firm invests into its operating assets the less will be a firm’s free cash flow as well as the value of a firm under a discounted cash flow approach. Does that decrease the firm’s value then? When looking at the example and the formulas that the author presented, it does start to make sense. It’s great that everything’s well-explained: what equals with what and even what the ∆ means! I always knew from maths that ∆ stood for delta, but without knowing its literal meaning ‘change in’ I would be so confused! My understanding regarding free cash flow is as follows:
FCF = C-I
means the same as
FCF = OI - ∆NOA
where
OI = operating income after tax
and is the same as
(C) = its operating cash flow
and
∆NOA = the ‘change in’ net operating assets
which is the same as
(I) = its capital outlays.
The only thing that got me a bit confused is that in the first part of the paragraph capital outlays is represented with (C), which is supposed to be the operating cash flow, but for the rest of the paragraph it’s put down as (I) so I’ll presume it was a typo and continue to read it as (I)? Even though when a firm invests into its operating assets and firm’s free cash flow decreases, it doesn’t mean that the company’s value decreases, because free cash flow is a measure of transfer of value rather than creation of value. At first I didn’t realise the purpose of free cash flow, but the examples of Kings Enterprises and Marks Inc made it clearer – although the expected future operating income might be the same for both companies, the less they invested in operating assets, the bigger their free cash flow is. Nevertheless apparently cash flow is not a good way to measure a firm’s performance, thus I am still curious about the purpose of it. A way we can measure the earnings of a business is return on net operating assets. My understanding regarding economic profit is as follows:
Economic profit = (RNOA – cost of capital) x NOA
where
RNOA = OI / NOA
where
RNOA = return on net operating assets,
OI = operating income being earned for each dollar
and
NOA = net operating assets invested in the business
So basically the formula could be expressed as:
Economic profit = ((OI/NOA)-cost of capital) x NOA
I’m a little bit confused about cost of capital though – what is it and where does it come from? Is it just the cost of investments made in one thing at a time?
All in all, when earning a return on net operating assets is greater than the opportunity cost of capital, firms create value for their equity investors - basically the more a firm invests in net operating assets and the returns are above its cost of capital, the more value a firm creates.
I never thought that the more a firm invests into its operating assets the less will be a firm’s free cash flow as well as the value of a firm under a discounted cash flow approach. Does that decrease the firm’s value then? When looking at the example and the formulas that the author presented, it does start to make sense. It’s great that everything’s well-explained: what equals with what and even what the ∆ means! I always knew from maths that ∆ stood for delta, but without knowing its literal meaning ‘change in’ I would be so confused! My understanding regarding free cash flow is as follows:
FCF = C-I
means the same as
FCF = OI - ∆NOA
where
OI = operating income after tax
and is the same as
(C) = its operating cash flow
and
∆NOA = the ‘change in’ net operating assets
which is the same as
(I) = its capital outlays.
The only thing that got me a bit confused is that in the first part of the paragraph capital outlays is represented with (C), which is supposed to be the operating cash flow, but for the rest of the paragraph it’s put down as (I) so I’ll presume it was a typo and continue to read it as (I)? Even though when a firm invests into its operating assets and firm’s free cash flow decreases, it doesn’t mean that the company’s value decreases, because free cash flow is a measure of transfer of value rather than creation of value. At first I didn’t realise the purpose of free cash flow, but the examples of Kings Enterprises and Marks Inc made it clearer – although the expected future operating income might be the same for both companies, the less they invested in operating assets, the bigger their free cash flow is. Nevertheless apparently cash flow is not a good way to measure a firm’s performance, thus I am still curious about the purpose of it. A way we can measure the earnings of a business is return on net operating assets. My understanding regarding economic profit is as follows:
Economic profit = (RNOA – cost of capital) x NOA
where
RNOA = OI / NOA
where
RNOA = return on net operating assets,
OI = operating income being earned for each dollar
and
NOA = net operating assets invested in the business
So basically the formula could be expressed as:
Economic profit = ((OI/NOA)-cost of capital) x NOA
I’m a little bit confused about cost of capital though – what is it and where does it come from? Is it just the cost of investments made in one thing at a time?
All in all, when earning a return on net operating assets is greater than the opportunity cost of capital, firms create value for their equity investors - basically the more a firm invests in net operating assets and the returns are above its cost of capital, the more value a firm creates.
Operating and financial activities
The author compared a Kinder Surprise egg with separating financial activities into operating and financial; financial activities being the outside chocolate egg and operating activities the toy inside (which we are more interested in). Such a creative perspective I wouldn’t have even thought of before, but it definitely makes the concept easier to read and understand (and me craving for Kinder chocolate).
Operating activities of a firm are its interactions with the product and input markets, with its customers and suppliers whilst financial activities are a firm’s interactions with capital markets as well as equity and debt investors. I think the figure 4.1 is a great way to express the theory, it’s rather straight-forward and easy to read. Nevertheless, after a while into this course, I realised that NOTHING in accounting is as simple as it looks, so I’m sure there more to it. In order to understand all of the elements of the chart I decided to reconstruct and build it the way it would make sense to me on a more personal level:
The author compared a Kinder Surprise egg with separating financial activities into operating and financial; financial activities being the outside chocolate egg and operating activities the toy inside (which we are more interested in). Such a creative perspective I wouldn’t have even thought of before, but it definitely makes the concept easier to read and understand (and me craving for Kinder chocolate).
Operating activities of a firm are its interactions with the product and input markets, with its customers and suppliers whilst financial activities are a firm’s interactions with capital markets as well as equity and debt investors. I think the figure 4.1 is a great way to express the theory, it’s rather straight-forward and easy to read. Nevertheless, after a while into this course, I realised that NOTHING in accounting is as simple as it looks, so I’m sure there more to it. In order to understand all of the elements of the chart I decided to reconstruct and build it the way it would make sense to me on a more personal level:
I didn’t expect the chart to turn out so colourful and
initially even chaotic to look at, however, surprisingly, in my head it does
make sense. I now also understand why we are more interested in operating activities
– a firm primary adds value through its operating activities, which does make
sense – operating activities are the activities that deal with customers and
product input markets where basically the money lies. All the financial
statements interconnect. That’s great because when restating the financial
statements we can check for any errors by seeing if everything balances. I’m
sure it might become very frustrating through, if they don’t. It’s beneficial
to know that some firms may not include some of its earnings in its income
statement but put it directly into equity. Fortunately we can find them either
in the statement of changes in equity or under ‘other comprehensive income” in
the income statement. It was also surprising and a little bit scary to learn that
equity doesn’t include only genuine equity – it might include, for example,
debt. Therefore before restating anything, I have to make sure that the equity
includes only genuine equity. It seems like footnotes will be my best friends
for the rest of this assignment. At the moment, when looking at the examples of
restated statement of changes in equity, I feel confused and already frustrated
– I know it’s going to take me ages to do the same thing for my company. It’s
comforting to read though, that just like with many things in life, the ‘first’
is always the most difficult, but after practice it will get easier – just like
riding a bicycle! I hope.
Restate
two key financial statementsI find it great that the author is describing his process of restating balance sheets and income statements step by step in detail with explanations, justifications as well as pictures. I feel that it’s starting to make a little bit more sense to me, but I’m sure that the moment I open my company’s financial statement I’ll be lost again.
And obviously, nothing can be as simple – with balance sheets, cash (cash payments to suppliers, cash receipts from customers) has to come it to spice things up a little. It is impossible to be sure how much of any cash balances go under operating activities and how much goes under financial, so when there’s a low level of cash balances (0.5%-1% of total sales) it’s best to include them under operating assets. When restating a firm’s income statement, there a number of additional steps to do, such as including any items of ‘other comprehensive income’ not already included in our firm’s income statement, allocate tax (!!!) to the operating and financial components of the income statement as well as calculate both a firm’s comprehensive income after tax (OI) and its net financial expenses after tax (NFE). At first, after reading just the subheadings of each step, I was ready to give up, but then I started reading the descriptions how to actually do them, it doesn’t look that bad. I think I’ll be having the most difficulties with tax allocation but in theory, it seems quite clear – like with everything – the more you earn the more tax you pay. A firm’s tax is also affected by both – operating and financial activities so I have to make sure to keep that in mind. Also the formula
Tax benefit = Net interest expense x tax rate of the firm
where Net interest expense = interest the firm paid – the interest it received
might come in handy when stating the income statement; it seems quite self-explanatory, but hopefully I’ll be able to put the theory in a good use when doing it myself.
Profitability
and efficiency
Throughout reading this chapter, I kept wondering, what’s actually the purpose of restating financial statements? I mean why, why can’t you just leave them how they are and everybody’s life would be so much easier. Little did I know, because after further reading I realised that we use the restated statements to look at some key aspects of a firm’s performance. Evidently analysing involves breaking things into bits, seeing up close how they work and contrasting different relationships – the relationships that many people in the business industry are interested in understanding. I suppose then I have to, too. Since we can’t physically break a firm into bits, we can break its virtual reality – the financial statements into bits. Understanding the relationship between profitability (selling something to customers for more than it costs you) and efficiency (how well net operating assets in a business are being used to generate sales or turnover) is important since it could be seen as the heart of how people make sense of and analyse financial statements: the greater the interaction between profitability and efficiency is, the more successful the business is. In human resources we explain turnover as people leaving their job – either by choice (resigning) or reluctantly (getting discharged). However, in this course turnover stands for sales. It’s a good thing I got to page 23, otherwise I’d be so very confused for the next couple of weeks in class. I also think of ATO being Australian Tax Office (haha) and not the Asset turnover – another thing I need to adjust with, if I want to make any sense of this course.
Throughout reading this chapter, I kept wondering, what’s actually the purpose of restating financial statements? I mean why, why can’t you just leave them how they are and everybody’s life would be so much easier. Little did I know, because after further reading I realised that we use the restated statements to look at some key aspects of a firm’s performance. Evidently analysing involves breaking things into bits, seeing up close how they work and contrasting different relationships – the relationships that many people in the business industry are interested in understanding. I suppose then I have to, too. Since we can’t physically break a firm into bits, we can break its virtual reality – the financial statements into bits. Understanding the relationship between profitability (selling something to customers for more than it costs you) and efficiency (how well net operating assets in a business are being used to generate sales or turnover) is important since it could be seen as the heart of how people make sense of and analyse financial statements: the greater the interaction between profitability and efficiency is, the more successful the business is. In human resources we explain turnover as people leaving their job – either by choice (resigning) or reluctantly (getting discharged). However, in this course turnover stands for sales. It’s a good thing I got to page 23, otherwise I’d be so very confused for the next couple of weeks in class. I also think of ATO being Australian Tax Office (haha) and not the Asset turnover – another thing I need to adjust with, if I want to make any sense of this course.
Conclusion
Even though it took me a while to get started with this reading, it wasn’t as horrific as I thought. There was a lot of information to take in – starting with looking at how firms add value for its equity investors through cash flow and economic profit; going on to separating a firm’s financial statements into operating and financial activities and then restating the actual statements; and finishing with the relationship between profitability and efficiency – the heart of how people make sense of and analyse financial statements. All of it was a little bit overwhelming and I’m not even sure if I understood everything correctly, but I’m sure all of the content will be extremely beneficial in regards of Assignment 2. I’m just hoping that I’ll be able to apply all the theory to practice as sufficiently as possible.
Even though it took me a while to get started with this reading, it wasn’t as horrific as I thought. There was a lot of information to take in – starting with looking at how firms add value for its equity investors through cash flow and economic profit; going on to separating a firm’s financial statements into operating and financial activities and then restating the actual statements; and finishing with the relationship between profitability and efficiency – the heart of how people make sense of and analyse financial statements. All of it was a little bit overwhelming and I’m not even sure if I understood everything correctly, but I’m sure all of the content will be extremely beneficial in regards of Assignment 2. I’m just hoping that I’ll be able to apply all the theory to practice as sufficiently as possible.
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