Chapter 4 KCQS
The key concepts that I obtained from reading chapter four started with the fact that expectations are what capital markets trade in and that equity investments in firms includes predicting the future. The notion that we cannot predict the future without first understanding the past was interesting to me as how else could business have grown throughout the years - building on the past to make better decisions in the future.
This concept can be put towards all kinds of business scenarios to better their practices and therefore their value. By finding the driving values of a firm and identifying its key accounting drivers we can gain a better understanding of a firm and how it creates its value. Analysing and understanding financial statements can assist us with identifying these drivers.
I noted that framework structures are commonly used in relation to financial statements to assist with understanding the economic and business realities of a firm with Discounted Cash Flow (DCF) and Economic profit framework being the most commonly used.
After reading this chapter, I realised how large and essential the content is to understanding how to analyse financial statements and other key concepts in general, I decided the best way to tackle this chapter was to note down the key concepts I identified in point form and then go back and write my reflections and questions at the end as I am finding that fear is a good motivator at present with this unit. As I fear missing something vital or not translating a key fact to my experience I wanted to read everything, note everything down and then practice it by restating my financial statements at the same time, to ensure I am really gaining a deeper learning of the content. I fear that not having any accounting experience or background, I cannot write about my previous life experience reflecting on this knowledge, I can only reflect on my experience by restating my financials statements as a draft at the same time and see how I go.
The first key point I had noted down was that with the return on net operating assets (RNOA) – break it into profitability and efficiency. RNOA (which is an accounting driver) with a note regarding the DuPont approach (which I was eager to read about further from the previous chapter) and how the DuPont approach beaks down the Return on Total Equity into two ratios, being:
Return of Total Equity (ROE)
ROE = NET INCOME
Common Equity
= Net Income X Net Sales
Net sales Common Equity
- remember this reveals that ROE equals net profit margin times the equity turnover.
- Definition of Net Profit Margin is equal to how much net income is generated as a percentage of revenue. This reflects how much of each dollar in revenue collected translates into profit for a firm.
The next formula I had noted down was
Net Profit Margin (NPM) = revenue – Costs of goods sold – operating and other expenses – interest – taxes divided by revenue x 100
= Net Income
Revenue * 100
- Free Cash Flow (FCF), (from the previous chapter) is the transfer of value within a firm – between operating and financial activities and FCF is affected by firms decisions about how much they invest into operating assets each year. I noted down that where there is a reduction in net investment, there is an increase in FCF.
- the dividend policy that a firm has will affect how much is transferred to equity . This is something that I did not know previously and found really interesting to add to my knowledge base as my previous knowledge was that dividends were just paid, it is nice to have a little knowledge about how they can differ from company to company.
- Economic Profit – the return on net operating assets (RNOA) is how we can measure the earnings of a business. This RNOA is the operating income after tax (OI) divided by the net operating assets (NOA) invested in the business represented by RNOA = OI/NOA.
- Economic Profit measures the extent a firm has been able to add value over and above its costs of capital during a certain period.
- A firm adds value by taking capital from investors and using it to earn a return greater than the cost of that capital.
The present value of expected future dividends is the value of equity.
In relation to restating financial statements, the main key point that I noticed was to separate activities of the firm between operating activities and financial activities. This presents itself to me as the main concept to remember for the whole chapter!
A firm’s Operating Activities are its interactions with a product and input markets, its employees, customers and suppliers, things used in the operation of the firm.
A firm’s Financial activities are its interactions with debt investors and equity investors with examples such as bonds, stocks or a dividend policy, these are things that are not used in operational activities and that store value for the firm.
Another main point to remember is that Operating Income (OI) is the difference between the Operating Revenue (OR) and the Operating Expenses (OE).
The study guide set out the following diagram which I have attempted to recreate to remember and illustrates Net Operating Assets (NOA) and Net Financial Assets (NFA).
FCF = C- I (where I is the change in NOA and C is the operations cash flow) was also discussed in further detail this chapter.
I enjoyed reading the sections of the study guide detailing the reinstatement of the separate financial statements and viewed this as a challenge to not only understand each but to be able to do this in our next assignment. I then started to note down things I thought were important in the reinstating steps as below:
Statement of changes in equity
- the bottom line of a firm’s income statement is Net Profit after Tax
- if all of a firm’s earnings are included in the income statement then the book value of equity from previous balance sheet plus earnings for a period from the income statement should equal the book value of equity from current balance sheet.
Restating the balance sheet and Income Statement
- Restating the balance sheet – clearly separate operating and financial assets and liabilities to clearly identify Net Operating Assets (NOA) and Net Financial Assets (NFA) or commonly called Net Financial Obligations (NFO)
- Low cash balance – include as operating asset
Restating Income Statement
Purpose – to clearly separate operating and financial revenue and expenses as well as operating income after tax (OI) and Net Financial expenses after tax (NFE) or alternatively Net Financial income after tax (NFI)
- Translation of foreign operations can happen when there are overseas operations of a firm. Parent company currency used and exchange rates fluctuate each year.
- Profit = revenue (both operating and financial) less expenses (both operating and financial)
- the amount a firm pays in tax depends on its level of profits
- the more interest a firm pays on its borrowings, the less profits it will have and the less tax it will pay. Therefore if a firm increases its borrowings meaning it will pay more interest – its interest expense increases and decreases its tax expense. I found this point to be extremely interesting as I had found myself wondering previously when looking into GVC Holdings PLC why it would want to have so many loans and such – this makes so much sense and I was pretty excited to put these pieces of the puzzle together!
We would also need to allocate tax to the operating and financial activities of our firm. To do this, we must calculate the tax the firm would have had to pay on its operating activities on the assumption that it has no financial assets or liabilities (regardless of whether it does or not) and we add this to our operating activities tax expense, making an opposite adjustment to net financial income or expenses for tax impacts.
Tax benefit = Net Interest expense X tax rate of the firm
- Net interest is the difference between the interest paid (financial expense) and the interest received (financial income)
- Will need to use the corporate tax rate of the country of which your firm has its base.
- Operating income (OI) and Net Financial expenses (NFE) are both calculated on an after tax basis
Profitability and efficiency – we break this down into parts – financial performance into its profitability (how much profit per dollar of sales) and efficiency (how much sales for each dollar invested into business) by looking into OI and NOA.
Economic Profit is made up of three things – cost of capital, amount of NOA invested and RNOA
RNOA = PM x ATO where PM = OI divided by sales and ATO = sales divided by NOA
8% of cost of capital to be used for my firm and when deciding to use opening or closing balance for NOA – use closing if in doubt.
So after noting these main points down in relation to chapter 4 and with reinstating the financial statements for GVC Holdings PLC in mind, I started asking myself how can I relate these points to my firm and how can I follow them in regards to an actual company, producing actual drafts of the reinstated financial statements that would be up to par. With this in mind, I have set off to watch the tutorial videos on reinstating my financial statements and attempting to draft the reinstatements.
Again I found these videos to be very helpful in breaking the steps down to achievable steps for someone with limited accounting experience. I received a sense of achievement when my formulas match the checks Maria had mentioned and such relief when a concept or idea clicked (so far).
By going through the statements line by line, asking the question does this item fall into the category of operational or financial was the best way for me to grasp the concept of categorising the items better and making sense of this chapter. In saying that, there is always an element of perhaps I have categorised an item the wrong way – I remembered that Martin has previously mentioned that accounting is a lot of judgment calls, I don’t want to make the wrong judgments or be bad at accounting so I read and re-read and attempt to reinstate my financial statements as soon as possible to ensure I have the best chance at success at this stage in the unit. As I said, fear is a good motivator!
With Maria’s comforting words of show your workings at the bottom of the spreadsheet, I may be able to explain the way I have categorised them here with the hope that a fellow student may assist with starting a discussion if I perhaps have categorised something incorrectly. A key concept I noted from the video tutorial was in relation to the allocating of cash and cash equivalents. Both the study guide and Maria mention that cash and cash equivalents can be both operational and financial – Maria made an excellent point (referencing the study guide) that we can show our workings in relation to this and allocate a percentage between 0.5 and 1% based on what percentage the company has previously been allocating to operational and the rest to financial. I really enjoyed following along with the videos and practicing what I am learning.
So far I am up to reinstating my income statement (which is meant to be the hardest spreadsheet to reinstate) so here is hoping things turn out as hoped!
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