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.