KCQ's Chapter 4

ACCT13017 KCQ’s Chapter 4

Dividends are the only thing equity investors are owed for their investment. This is what they expect, unlike an object when what you see is what you get, dividends are intangible and difficult to predict. I suppose another way to profit from an equity investment is to sell shares at a higher rate than paid for but that would be the end of the risk and would that be the getting the most from your investment? Dividends have the possibility of being paid for the life of the firm, almost indefinitely! It makes sense that we would be likely to predict return on equity by understanding the kind of leverage a firm has in making it profitable and how efficient is its employment. Kind of like why I’m studying this degree, to gain leverage in an employability but also to use the knowledge gained to my full advantage by investing wisely in an equity investment or self-employment in a business venture! In other words, making money and making the money work for me.

Abnormal Earnings and Restating Financial Statements

The term itself, abnormal, suggests the meaning of ordinary earnings which are not normal and the best kind of not normal, is above and beyond our expectations. When I studied Accounting for Decision making in 2014, this is how I explained economic profit, “My understanding is that economic profit attempts to measure the creation of wealth that exceeds the cost of the amount of capital invested.”  My understanding now is that the creation of wealth should more accurately be the creation of value or value expectation. The measurement derived from inputting the  drivers of Abnormal Earnings into the formulae:

AE = [ROE – (ρ_E – 1)] x BV

It’s still not clear to me how we would estimate a required rate of return? I can see how using the comprehensive income divided by the average book value would calculate the ROE as an actual rate of return but what would be acceptable as a required rate of return?

Also, how can I be sure what to include as my company’s total comprehensive income? Where so I find the evidence to include or exclude relevant amounts? This is going to be the tricky part of restating the financial statements in order to make the numbers talk!

I have reviewed the videos on PP&E to revamp on revaluations. I also thought depreciation may be another item to be wary. I noticed my company had 3 significant changes in accounting policies:

1.       IFRS 9 – Financial Instruments

2.       IFRS 15 – Revenue from contracts with customers

3.       IFRIC 22 – Foreign currency translations and advance consideration

These are the areas of interest and I will be analysing with scrutiny to obtain a conceptual view. It will be necessary to examine these interactions as a part of their operating activities as it involves input markets, customers and suppliers. The financial activities might be difficult to decipher and there are endless notes to poor over and it seems to be derived from government policy as well as accounting policy. This is important to distinguish between Net operating assets and net financial assets to determine the FCF and ascertaining debt or dividends. Much like holding on to your shares in an investment is likely to continue producing exponential returns, so too is holding on revenue producing assets, rather than selling them. Therefore, most of the added value in firm must come from the operating assets. It’s odd to think that many developed countries have an efficient debt markets, but it is kind of comforting that most firms have access to available finance. This would give the firm support in an uncertain market.

Restating Two Financial Statements

Balance Sheet

Although it seems like a straight forward task, separating the operating and financial activities can be confusing. I recall in ACCT11059 struggling to decide where goodwill and deferred tax fit. After gaining a better understanding of the accounting treatment of these items, it seems obvious they would be operating activities, although I intend to challenge this with a Facebook discussion. The main thing I remember about cash is that if a business runs out of it that is the end of business. So, it makes sense that some cash will be needed for operation and some for financial. China Southern Air would need some cash for customers but also for suppliers, especially fuel for operations. They do have a significant amount of cash and cash equivalents, therefore upon Martin’s advice I will be allocating a cash amount of least 1% of sales to operating assets and the rest to financial assets.

Income Statement

Analyse ROE: Leverage and Profitability

Leverage

FLEV = NFO/Equity

Impact of Leverage:  ROE = ROOA+(RNOA-ROOA)+(ROE-RNOA)

I imagine leverage to be similar to the way I fund my textbooks. I resell the old ones that I no longer use, plus the money I earn from selling cosmetics to avoid using the cash stores in my bank. Obviously, there is a lot more involved in a company, but essentially, it’s about their intention and ability to generate future profits. It seems to me leverage provides the company with strength for current and support for future operating activities. This affects their ability to create added value to equity investors by giving them assurance for sustainable returns.

Profitability

PM = OI (Operating Income after tax) / Sales

I understand the basic profit margin of selling something for than it costs and if a company doesn’t do this their cash supply rapidly depletes causing the company’s demise. I didn’t realise that 6% (in the US) is the average, as a sort of benchmark. I have no idea of the average profit margin for the airline industry and it will be interesting to compare this to my company. I imagine most of their profitability comes from airfares and cargo charges but I’m not sure how the effects of the previous changes in accounting policies have or will impact on the operating income. This will be an interesting story to unfold.

Analyse ROE: Leverage Revisited and Efficiency

ATO = Sales / NOA ;  1/ATO = NOA/Sales

Whenever I see sales as part of an equation, I immediately associate it with profit. Sales are generally the heart of a company, the reason they are in business and how they intend to make profit. So, I can link these activities with the company’s intention. An important aspect of Mintzberg’s 5 P’s. In this way I can think that RNOA has an interaction with PM and ATO, rather than a driver. The real drivers are in the story, the intention and culture of the company. I can see from the Ryman example that its important to have a balance of leverage, profitability and efficiency but the ability of a company to exceed these averages is the real story behind success.

ROE = RNOA + (FLEV x Spread) – the relationship of ROE and RNOA

NBC = NFE/NFO – Net Borrowing Cost

An important take out from this is understanding that leverage and spread on their own are not drivers of ROE compared to RNOA, it is the interaction, how they work together is important. My understanding is, a company can theoretically continually increase borrowings but that does not increase its proficiency to generate ROE or RNOA. I like the analogy of a firms gears. The cogs and levers all working together like a well-oiled machine. I can glean from the Ryman model how these accounting decisions reflects the anticipation or response to economic drivers. What economic drivers are affecting my company? Which assets should be focused on? How is the company financing now and in the future? Are they balancing leverage, profitability and efficiency? There are so many questions that require some exploring. The difficulty will be understanding an economic environment from another country. My though process has a democratic focus and to understand China I need to shift that focus to a communist regime. That will be the challenge to portray an accurate and reliable story of the company’s economic and business realities.