Assessment #2

Step #1 – Chapter 4 – Analysing Financial Statements

Procrastination: “the action of delaying or postponing something.”

This is the definition of me for the past two weeks! Between being stuck in hospital with gall bladder issues, work, Easter and the daily mum life, I have been throwing daggers at my laptop from across the room, having mental arguments with myself on when I should start to read chapter 4 and of course come to realise I am such a drama queen, it really wasn’t that bad. Sure, I had no understanding the first time I read it. I managed to get a friend to bring my laptop to the hospital for me for some ‘light reading and let’s just say reading about the difference between operational and financial activities whilst on morphine, really doesn’t have the exact learning outcome you expect. Haha although my children were amused. So, I finally got a spare couple of days over Easter, while the kids were comatose by chocolate I focused my energy on reading chapter 4, again…and again. Holy Moly that was a lot to swallow. I will do my best to interpret my understanding of it all and hope for the best!

How do firms add value to equity investors?

This is something that stood out to me as I recall doing the books for a client of ours that invests a lot of money in shares into various businesses. I remember seeing his dividend statements and questioning what they were. We are always so busy at work, so I seem to ask the question and then get side-tracked by a call or a client, so I now have a better understanding of dividends and equity investment. My understanding is that when a person is an equity investor they receive a dividend, which can be paid quarterly or annually, and is the percentage agreed on, of the firms’ profits. (Please correct me if I am wrong). If the firm invests its profit into something like buying property for example, then the profit would be less, resulting in a smaller dividend to be paid to its shareholders. The future benefits of investing in the property could in turn pay out a higher dividend later on.

This leads me to free cash flow, (FCF). The “measure of transfer of value.” Instead of the transfer being between the firm and its shareholders, it is within the firm itself. The way I can understand this is that it is the cash that is leftover after all money is received from all operations (money made from sales etc) minus the money that may have been invested in operating assets, (Buildings, property purchases, paying all operating expenses like bills, plant and equipment expenses etc.) I believe this is what the equity holders’ dividends are funded from. “The value between the firms’ Operating and Financial Activities.’ (FCF=C-I)

It surprised me to read that cash flow is not particularly the best way to measure a firm’s performance, as from the outside it may look like there is not much cash flow at all, but this money could potentially be invested in property for example, which would increase the equity of the business. The best way I can see to measure how a firm is really doing would be understanding Economic Profit.

What is Economic profit?

It says in chapter 4 that “we have to understand the economics and business of a firm to understand the value of the equity.” Yeah ok, what does that mean?! This is where I start to go off track a little and have no idea what I am reading. It says that Economic profit is based on the firm’s ‘Accounting profit,’ compared to its cost of ‘Capital.’ So, if I was to break it down, to me this means all of the operating expenses or basically anything the costs money in the business compared to your assets.

That seems simple enough, right? Nope. To add confusion, I read on and see in bold:

Economic Profit = (RNOA – cost of capital) x NOA

The return on net operating assets, (revenue generated from operating assets), minus the costs of capital, (potential expected returns it could be earning) x the Net operating assets. (assets from the firm related to its operation after you have taken out all of the liabilities.)

I did just google “what is Economic Profit for dummies” and watched the video below. Haha it was actually quite helpful!

https://www.khanacademy.org/economics-finance-domain/ap-microeconomics/production-cost-and-the-perfect-competition-model-temporary/types-of-profit/v/economic-profit-vs-accounting-profit

When I started to have a look at restating my SOCIE, I found Martin’s diagram on Operating and Financial activities to be quite helpful. Although I am still somewhat confused by a few line items in my financials, this did give me a better insight to what I was looking at.

I am learning as I go that the reason we separate operating and financial statements is to give us the opportunity to view our businesses differently and to give us a better understanding of our business. Restating our financial statement gives us an opportunity to take a closer look at our financials and actually understand what each line item means. (Well, most of them) As I started to enter the figures

 

into my spreadsheet I was still very lost and confused with which items were ‘operational’ and which were ‘financial’. I went back through the notes in my annual reports and ask a few questions on the Facebook page and I think I have a clearer understanding now. Paul Feasey explained it to me in a different way that I understood a little better. He said, ‘operational activities are internal’ (how we make stuff), and ‘financial activities are external’ (how we move money around). I am still not 100% if I have got it all right yet but hope to clarify in Danielle’s PASS meeting on Tuesday.

My understanding of operational activities is now to be things that are ‘people’ related. Items like superannuation, anything related to suppliers and customers, taxes and the ‘everyday’ stuff’. And my understanding of financial activities are things like assets and equity. When we are moving money around etc. The few items I was confused about in my financial statement were, ‘Net gains or Valuation on foreign exchange hedges’ and ‘Exchange differences arising on translation of foreign operations.’ This was gibberish to me, so these are a couple of things I need to ask about, but my guess was that they were operational. I came to this conclusion because in my opinion anything related to foreign exchange hedges is cash flow from operations. I understand it is imp

ortant for firms to separate the operational activities and financial activities in order for them to show a clearer picture to the firm’s investors, of where the firm gets it money.

Balance Sheet

I am yet to start restating my balance sheet, but I understand this to show all of the operational and financial assets broken into current assets and non-current assets. I can already see how much fun I am going to have, when I read that its never possible to exactly match its cash inflows. I do understand why though when it comes to bills, receipts and other cash expenses. There is no way you can rely on everything to be paid for or to have receipts for all expenses at all times. It did make me question though that if a firm stores cash in a bank as a store of value, that it would be classed as financial. This makes sense as it would just be money sitting and gathering interest and not being used but it still confuses me a little.

Income Statement

This was the trickiest financial statement to enter in my Assessment #1, so now I have a better understanding of what all of the line items mean I look forward to restating the income statement. The income statement is the boss of statements in my opinion. It shows all of the net income, expenses, losses, gain and revenue for the firm for its period stated. I see I will be restating this and working out the firm’s comprehensive operating income after tax (OI) and its net expenses after tax (NFE).

“Breaking things into bits.” I love this terminology as I am the type of person that has to break everything down and put it back together the way that I understand it for myself. My friends call me a processor, I cannot help it, If I don’t understand how something works, it will give me more drive to figure it out. This relates to my home life, my work life and my Uni life. So, I look forward breaking down the firm’s financials a little but more and understand it on a deeper level.

Profit Margins

It was interesting to read that the average profit margin in the US is 6%. I think I need some assistance in working out what my companies profit margin is. I understand it to be the comprehensive operating income after tax divided by Sales, but this is still confusing he heck out of me. Hopefully as I am continuing to watch the videos from Maria and watching the lectures I will come to a better understanding of this. Reading has never been my best way of learning, but I do find the videos to be so helpful, along with communicating with other students. I look forward to finishing my restating of my financials.

I struggled to find many things that I can relate to personally from chapter 4, I found this challenging but also got my brain working. I find it exciting to know that merely 6 weeks ago I would have died to look at these statements alone, and now I am getting to know what everything means and what to do, its comforting to know I am actually learning. ha-ha.

References

https://www.investopedia.com/ask/answers/111314/whats-difference-between-free-cash-flow-and-operating-cash-flow.asp

https://investinganswers.com/financial-dictionary/income-dividends/dividend-1304

https://www.thebalancesmb.com/free-cash-flow-393588