Chapter 4 KCQ's

Step 1

Chapter 4 – Analysing Financial Statements

Key Concepts and Questions

I had not considered the idea of capital markets as trading in future expectations but that explains them so well.  Factories could only hope to make a product as flawless as an ocean makes fish.  It is much more challenging to foresee the exact outcome of an equity investment. I can see the importance of consulting with financial statements as a way of evaluating the future through looking at the past.  A way of being aware of contingencies that are involved in the return of an investment, using an educated estimate.

Another concept I established is the framework or structure of a firm using Discounted Cash Flow, DCF and the economic profit.  I was so unfamiliar with these terms, yet it makes sense to be able to view how cash invested has been used and generated. I understand that the DCF is a comparison of the cost of an investment with value of cash expected to be generated in the future.  The economic profit (opportunity cost) is still somewhat difficult to grasp. My understanding is that economic profit attempts to measure the creation of wealth that exceeds the cost of the amount of capital invested.  I’m still not sure how it does this.

I realise that separating the operational and financial activities of a firm gives a better indication of the performance of the main operation of the business.  Another key aspect, the return on net operating assets, RNOA, is the amount of capital employed and breaking it into profitability (how much value is created) and efficiency (how much effort is needed to create that value).  I believe it is somehow related to the payment of dividends. I found this link helpful in clarifying.

“Weighted average cost of capital (WACC) is the average rate of return a company expects to compensate all its different investors. The weights are the fraction of each financing source in the company's target capital structure.”  http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/weighted-average-cost-capital-wacc-2905

Free Cash Flow,   FCF = C – I.  I view this as a relationship between the cash generated from sales and the investment back into the firm’s operating assets or those assets which create the firm’s income.  This is important for the firm’s future capacity to generate cash and in turn, create more profit.  What is the difference between the cost of capital and the amount of capital?

Calculating RNOA = OI/NOA, operating income (earnings) divided by net operating assets, a direct measure of “value add.”  I see this as highlighting the amount of income generated by the operating assets.  I find ΔNOA (change in net operating assets) = C (capital outlays), somewhat confusing.  I think it means the amount of capital invested in purchasing more operating assets.  I revised chapter 3.4 and I can see now that the value of an investment is more than dividends, it’s about future earnings too.

I understand that the operating income (OI) is cash generated from the operating activities, those activities that involve the product, customers and suppliers and not financing activities which are related to the debt and equity markets.  For my comapany that would be the revenue from generating electricity rather than interest earned.  The difference between the ΔNOA (change in net operating assets) and the operating assets would show how much money the business has spent on new operating assets! I think I’m starting to get it!  Now I can see what its meant by capital outlays.  It’s not all about the cash in the bank!

The concept of economic profit is still confusing.  I comprehend how the return on net assets and the amount of operating assets is calculated, but how is the opportunity cost of capital measured?  Why does accounting leave out the cost of capital?  I do understand that once capital is invested, it can’t be invested anywhere else.  But how do we measure the opportunity cost, the cost of if we invested in something else?  I can assume that cash flow and dividends have something in common with economic profit, as they seem to be some sort of measure of money earnt.  My perception of a business now is that it can have cash in the bank, create dividends and capital can be reinvested to create future profits.  Is there more to it than that?

It seems obvious that operating activities, employees, customers, suppliers agreements are the main contributors to a firm’s value.  This is a powerful way of viewing the business as it signifies how much assets are working.  This is the reason the firm is in business!  I suppose it is like a Kinder surprise, where the finances are soon eaten away only to be left with a small toy.  Separating these from the financial activities, which relate to decisions about financial structure, equity investors and debt investors would give a better picture of how much earnings should be retained and how much to allocate to dividends.

This is the whoa bit.  I had to slow down and re-read this quite a few times. So here goes, the net operating assets show operating revenue, the net financial obligations show operating expenses and the difference is the operating income.  Net financial assets are where finances are saved and are not spent on the operation of the business.  It is usual for a business to have a net financial obligation (NFO), the debt related with the ‘equity markets, (d) (dividend payments, share issues and share buybacks) and net cash flow with debt investors (F) (net interest payments and the repayment and issue of debt).’  The connection with NFO and the NFA are the movements shown in the (C) cash flow from operations and (I) the net cash invested.  Which is FCF = C – I or represented as (OI) operating income less (ΔNOA) the change in net operating assets!  The Ryman example really helped to make sense by using numbers and how to apply these formulas.  I can see the debt incurred to pay dividends and finance obligations, a clear transfer of values between operating and financial activities.  Although the operating activities are primary, I realise that the financial activities are important too, as they are primarily used to support the business in an uncertain market.

The restated statement of equity, our first glimpse at the comprehensive income.  The ‘dirty surplus’ amounts of revenue and expenses that are not shown in the income statement.  My initial reaction was ‘where are they then?” and “what are they?” I still don’t know if I could recognise a “dirty surplus” in a dark alley!  It looks like they show up in the statement of comprehensive income and are hidden in the balance sheet in the equity amount, which makes some sort of sense. I think it is the amount of other comprehensive income, which is in a separate statement, although I’m not completely sure. 

I realise that learning is a social activity and I’m very thankful for all the interactions I’ve had to complete this assignment.  The restated balance sheet or in for my company the statement of financial position purpose is to find the operating assets (NOA) and identify the financial assets (NFA) or (NFO) financial obligation, which is more common. The cash aspect is significant as some of it can be operating, money used to pay wages and suppliers for example or financial, money saved for a rainy day.  I see this as being a way to show how the operating assets are operating and also how much debt has the firm.  The difference between the NOA from concurrent years, represents the change in NOA or how many more assets have been acquired. This is the beginning of understanding how the firm intends to generate future profits.

The restated income statement makes the operating income more evident.  The tax attribute is very important to a business.  There can be serious legal consequences if this is not properly represented.  I see how this can help influence a firms decisions to reduce its tax expense and take advantage of the tax benefit, as the comprehensive operating income is clearly separated from the comprehensive net profit. 

I can understand that profit per dollar of sales is considered the main accounting driver. Profitability is how much profit a firm makes from each dollar of sales.  I can kind of see similarities in the contribution margin with the profit margin. The RNOA is how the operating income relates to the operating assets and matching it to sales, how well the invested assets are doing, and a measure of performance.  How much profit you make for each dollar invested is important too. After all, the reason for investing is to get more out than what you put in, the economic profit.  While this makes sense to me, my company’s calculations don’t seem to add up. What am I missing?  I find this part the most confusing.

Contact Energy

NOA = (4980 + 4891)/2

          = 4936

RNOA = PM (OI/sales) x ATO (sales/NOA)     RNOA = 259(OI) / 4963(NOA)

            = (259/2537) x (2537/4936)                              = 5.21%

            = 5.24% (this does not seem right)

Economic profit = (5.24% - 8.9%) x 4936

                              = confusion!

I have a lot more to learn on this and it seems very important.

Efficiency, another key accounting driver, ATO = Sales/NOA, is the amount of sales made from each dollar of net operating assets.  I like how the inverse is useful to consider the amount to allocate to operating assets, 1/ATO = NOA/Sales.  Another key concept is the interactions between the profit margin and asset turnover.  It’s like a monitoring system of the assets in relation to the creation of profit.  It indicates the value added to the investment of assets.  This is important for the growth of the business, not only to support the increase of product but to also maintain sustainability.

Contact Energy

ATO = 2537/4936

         = 0.51times

Conclusion

This has been by far the most interesting and challenging chapter so far.  I believe there is so much more to understand.  It is important to separate the operating and financial activities to gain a better knowledge of the performance and profitability of a firm.  It is also necessary to be able to analyse how these concepts are interacting with each other.  I can see some of the concepts of investing capital and investing in assets in a firm and their interactions between sales and profits.  I have a better understanding of the cash flow and the economic profit (value add) and have been introduced to ratios.  I have an insight into the operating and financial activities of a firm and how these can be broken up to interpret the profit margin and the asset turnover. 

Restating Financial Statements - ASS#2

The Trials and Tribulations 

Step 2

Commentary and discussions with others

Restating the Changes in Equity Statement:

Our first daunting task after reading chapter 4 and applying the inferred knowledge.  I found it difficult to know where to start.  The first thing I noticed from my company’s, Contact Energy, statement was that it was somewhat different to the Ryman’s example.  There were no headings for other comprehensive income, just a total amount.  There were other comprehensive income listed in another statement called the statement of comprehensive income and separate from the income statement was a heading called non-statutory measure: underlying earnings in tax. I had no idea what was a ‘cash flow hedge fund.’ It sounded like some sort of investment you find in superannuation!  This confused me and I posed the following question on Facebook and the Moodle forum and mentioned my concerns in the tutorial:

Hi all, my statement of changes in equity for Contact Energy doesn't show separate headings for "Other comprehensive income after tax", this is shown in the Statement of Comprehensive Income as "change in cash flow hedge reserve." There is also a statement for "Non-statutory measure:underlying earnings after tax." My question is this, what is a hedge reserve, there are no notes & should I include the hedge reserve in the equity or income statement? I am inclined to include it in income, leaving my restated equity unchanged. Any advise?

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The only response was from Facebook and I followed a suggested link from Rebecca, which kind of made sense but I was still undecided how to approach the restated equity statement.  I didn’t get any responses from the Moodle forum, which was somewhat disappointing. I sort further clarity in the tutorial and did some revision of the chapter.  I decided to include the change in cash flow hedge reserve in my restated statement of equity, to show it as operating income. My understanding of a hedge reserve is a sort of like a term deposit to cover things like the purchase of electricity or the change in currency of overseas trading. I believe risk management would be a part of the operating activities. I figured it should be shown in the restated equity as well as income, to emphasise all the capital.  After I had already made some decisions, I realised that the wording of the question must have been just as confusing and that timing matters too.  After discussing this in a study session with Elaine, I felt more comfortable about my approach. I also discussed this with Jess Evans via Facebook which caused me to change it from financial to operating.

Restating the Statement of Financial Position:

Classifying Operational and Financial Activities

The first issue I looked at was the cash account.  I noticed that there was significantly more cash in 2013 than 2012.  So after using the advice given in the chapter, I allocated $25mill (1% $2504 revenues) to the operating activities and the balance $55mill to the financial activities and left the 2012 amount of $5.892mill as all operating activities. In 2011, I also allocated $22mill (1% $2209 revenues) to operating activities and $25 mill to the financial activities. The 2010 figure was all allocated to operating activities.  I also questioned the amount of goodwill, which was consistent over the 4 years.  I found it difficult to decide whether or not it was operating or financial.  I posed the following question on Facebook and Moodle forum and invoked a series of different responses!

So, goodwill guys, I'm unable to decide, operational or financial? It is related to the operating assets, or it is at Contact Energy, where it relates to the purchase of a power station, so I'm inclined to think financial, an intangible cash asset, but could it be operational as it relates to the main operation of making power?

Melody put forward quite a convincing argument that it was financial and I was inclined to agree. After tossing and turning over the idea, I decided that even though goodwill leans towards a financial activity, it seems more likely to be an operating activity as it relates to the value of an operating asset upon purchase.  Goodwill adds value to the company purchased that is used in the operating activities of the firm. Before finally deciding to allocate goodwill to the operating activities of the company, I referred to the footnotes in the annual report. In Contacts case, the amalgamation of Empower Ltd, which generates cash through retail electricity and LPG and the goodwill is allocated to each of these activities. I also referred to the following links for further clarification:

Research links:

 http://smallbusiness.chron.com/increase-goodwill-affect-cashflow-statement-accounting-37224.html

http://www.slideshare.net/ateeqkhan09/cash-flow-statement-n-problems

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I can’t believe I put the deferred tax amount in brackets, making it a negative number and putting out my entire calculation!  I found that using formulas in excel, was another way to double check the figures.  Although, I am constantly aware that even if the figures add up and match, they may not necessarily be the correct figures.  I am even more aware that cut, paste and copy make affect formulas too, which I discovered the hard way! Derivatives of financial instruments, even though I had no idea what they were it sounded financial and I referred to this definition.  Deferred tax I decided was related to the operating activities as tax is paid according to the income made from producing and selling.  Apart from the discrepancies of my own input, this seemed fairly straight forward to complete.

Restating the Income Statement:

Figuring out financial income and expenses was not easy.  Other significant items, net interest expense, asset impairments, provision release, all were not familiar and I did a lot of research to discover there meanings and classifications. I found Facebook and Moodle forum discussions by others most informative.  I felt that I didn’t need to ask as many questions just by reading them.  I soon found that associated earnings was an item I had in common with someone on the Moodle form and answering that question, helped me get an insight to its meaning. This was my response:

I had equity accounted earnings of associates in Contact Energy. The footnotes refer to various dealings with other associated companies. I initially classified this as operating revenue, mainly because it relates to the shared expenses & revenues of purchased similar businesses, ie, other power companies, however one of the companies trades in energy futures. I tossed and turned on the idea that I could apportion that interest held between FI & FE and also to operating expenses.  It was doing my head in! So I decided to go with operating revenue as it mainly adds value due to similar operating activities. Even as I write this I'm thinking maybe it is financial as it is an investment that generates profits, not power. Whatever you decide, write how you justify it in the running commentry.

I also brought up the issue in the tutorial and decided that these were indeed an operating activity as my company uses these associated firms as a backup, so to speak, to supply extra energy should demand require.  After discussions with Jess Evans, I made adjustments to the classification of the cash flow hedge fund, which are also shown in the restated equity.  Overall I learnt a great deal during the restating process.  I had to really look into the footnotes for all items and research answers further to get a better understanding.  Reading the forums and Facebook posts helped enormously, but face to face is by far my favourite.  Elaine showed me a few tricks in linking the numbers from the previous worksheet.  I decided it would be too time consuming to fix all the numbers but I managed to incorporate a few key figures and had a little fun in the working space provided. I also became a little more familiar with some of the terms used.

Identifying 5 products

1.  Contact Energy’s home check up

2.  The installation of “smart meters”

3.  Maintenance

4.  Installation of gas bottles

5.  Installation of “gas meters”

Direct costs:  The cost of salaries, electrical devices, equipment and safety gear.

Indirect costs:  The costs involved with the receipt and allocation of each call out, such as receptionist wages, telephone, online or other communication with the customer and the provision of company vehicles.

Fixed costs:  Electrical monitoring device and other equipment used for testing electrical items.

Variable costs:  The cost of labour per hour, the safety certificate issued, the smart meter and instruction booklet, gas meter, electrical wiring and gas bottles.

Contribution Margin:  The charge of the service provided less variable costs involved for that service.

Example:

The service charge of installing a “smart meter” -    $130

Less

Variable costs:  Labour costs-                  30

                            Smart meter -                 12

                            Instruction booklet -        3

                            Electrical wire-                  2                    $37

Contribution Margin-                                                         $93

Discussion:

I was definitely thrown trying to identify a particular product or service, so I had to ask for advice. I raised the issue at the tutorial and after I listened to Martin’s advice, I was prompted to think outside the box. Still unsure of all the particulars, I also interacted with Facebook and Moodle. There has been much support from others and for this I am truly grateful.  In the end I made up a few figures, I estimated that it would take about ½ hr ($30 @ $60/hr) for a technician to install a ‘smart meter’, a device that measures and transmits electricity consumption remotely back to Contact, which cost about $12, using $2 of electrical wire and giving the customer a $3 instruction booklet and charging the customer $130.  This means that there is $93 to cover direct costs and contribute to profit.  This margin may be different to the installation of gas bottles or meters.  They may require more labour time, different equipment, the gas bottles may cost more and there might be safety issues.  Gas may cost more to produce than electricity.  Gas may require different qualified staff or on-going training of staff for workplace, health and safety reasons.  This might mean the margin may need to higher, to cover costs. 

Identify a resource constraint and a market restraint

There are weather constraints on the hydro and geothermal production of electricity. The carbon emission program is one of the environmental constraints, which is carefully monitored and regulated.  Solar power is becoming popular, influencing supply and demand.  The competition between rival power companies is also an important consideration.

How does this impact the decision of producing and selling the product?

Periods of high and low rainfall, including drought impacts the effectiveness of producing power.  This has led to the purchase of extra power and the management of storage of excess power produced.  Electricity prices have increased to cover production costs due to lack of production and also that production being subjected to the carbon tax. A $2 billion investment plan initialised 5 years prior to 2013, has helped maintain the strength of Contacts market position.  The competition between rival companies has prompted Contact to introduce the “What’s my number” campaign in an attempt to regain customer loyalty. In addition, Contact has offered new customers a fixed price for a fixed term. The annual report emphasises that Contact is committed to the focus of the retainment and attraction of new and existing customers.  I am wondering if the cost of promotion and their community initiatives are factored into costs too.