KCQ’s Preface and Chapter 1

ACCT13017 KCQ’s Preface and Chapter 1

Preface:

“Relying too heavily on other people’s opinions can damage our sense of reality.”

- Derek Rowntree

Absolutely, we need facts to create our own opinions and make decisions to suit ourselves. You only get one life, it’s important to make it your own, not someone else’s. Giving people the information returns the power dynamic to be able to control their own lives, in my opinion, the way it should be. We are all masters of our own destiny and should be entitled to accurate relevant information to make decisions to make the most of it.  What does it mean to conduct a fundamental analysis ourselves? What adds value to a genuinely interested stakeholder and why? I want to know, what adds value in a business and how does accounting help?

Chapter 1: Focus on Reality

It makes sense that investors will want to invest in a business that is doing well and would reflect so in the value of stock. Therefore, there is little need to rely on share price as an accurate measure of how well a business is doing, it is simply a reward for doing well in the past. But what of the future?

Fundamental Analysis:

From the investor’s perspective, fundamental analysis of the financial statements is a centrally forming assessment of the personal connection to a firm. A basis or a start with which judgements can be made according to what is valuable to an individual.

I’m seeing a lot of encouragement to make our own judgements and to connect our personal experiences. I can’t help but feel this is the why and how a person begins a business, invests in a venture and creates their own business agenda and what adds value not only in money terms but life fulfilment.

Efficient market hypothesis, finance theory? I’m curious about learning more and avoiding errors!

A Framework:

It seems that learning the discounted cash flow and discounted economic frameworks are the first important concepts to master and incorporate into a conceptual map. Focus needs to be on understanding the operating activities of a firm. Somehow, I must build a mental picture to create a mind map to manage an effective and efficient way to analyse financial statements, with a personal connection to draw on those skills time and time again and make excellent business decisions, personally beneficial.

 Personal and imprecise:

So, how do I currently think businesses add value, what does value adding even mean to me? I have gleaned form the study guide that a good financial statement analysis is insightful and convincing, it has to inspire confidence and be intelligent. Although using the frameworks give a precise measure of value for a firm, it is not foolproof, but it does provide a “safety margin”, if we make good judgements and assessments. Value is subjective, ‘one man’s trash is another man’s treasure’.

Economic Profit:

“Return on net operating assets (RNOA) is Operating income after tax (OI) divided by the Net operating assets invested in the business (including both working capital and non-current assets such as Property, plant and equipment).”

The opportunity cost is virtually impossible to measure. There are so many alternatives and missed opportunities available how on earth can one consider them all and waste the opportunity of time doing something else? I decided 6 years ago to embark on my accounting journey to gain qualifications firstly in a diploma and later a Bachelor of Business. I could have studied something else, Radiology for example, or simple TAFE courses, found employment or continued doing what I was doing. The list of possibilities was endless, but I analysed my options, placed my ultimate desires at centre and created a mental map of how to achieve that goal. I run my family as a business of sorts, every investment is completely personal so it’s important to make good choices. It also involves taking a risk but not without calculation and safety net.

“Also, the more a firm can invest in its Net operating assets at returns above its costs of capital, the more value a firm can create. In other words, growth creates value as long as RNOA is greater than the cost of capital on new investments of Net operating assets that a firm can make.”

Free Cash Flow:

“If you know the enemy and know yourself, you need not fear the result of a hundred battles. If you know yourself but not the enemy, for every victory gained you will also suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every battle.”

  - Sun Tzu, The Art of War

A firms operating income less our net investment in the business for a period – change in net operating assets.

FCF = OI - ∆NOA

Omg light bulb!!! Of course, different firms need different amounts to generate profit. Using less capital to create the same income means better utilization of resources!!!! This makes the amount invested in the future more valuable!!! Of course, these are projections whereas Economic profit is a direct measurement, in real time, using the firm’s accounting profit compared to the cost of capital. It’s important to note that profitability and growth are two vastly different concepts. I’m starting to recall this from previous studies.

Operating and Financial Activities:

Breaking a firm’s financial statements in bit to analyse key aspects using the DCF and Economic frameworks….what key aspects???  I guess you can ignore how a firm is financed, that is equity (invested capital) and debt (borrowed capital) because in the end the result is how much you have to work with.  Separating the operating activities from the financial activities can show where the value is created…or not. I am unfamiliar with Modigliani and Miller theorems but embrace the challenge of new financial theorem aspects. 

Many Points of View:

I read Warren Buffets letter to his grandchildren many years ago and I don’t really remember much, but he does seem to defy the logic of the efficient market hypothesis.  If it directly relates to me as a relevant stakeholder I would take more notice. I look forward to taking the perspective of an equity investor and exploring just what’s of value to me in that role.  I do recall from previous units that successful businesses must take into account all relevant stakeholders, not just shareholders points of view, and remembering that we are also part of a community that will be affected by business decisions.  The financial statements need to be useful to these stakeholders and accessible. So, how do you access this information and how can you be sure it contains useful reliable information needed?

What it Takes:

Using the past, in the present to predict the future! What a concept! Structuring all the available information to relate to our current realities is quite the skill. It helps to have a guide, a map, a framework. It does seem overwhelming to precisely forecast a firms financial and operating activities using the financial statements. It’s my understanding that the Economic Profit and DCF helps direct our efforts using their current financial information. It will be interesting to analyse how and what this information reflects the decisions our firms make.