Chapter 4: Analysing financial statements

So this chapter I’m really excited about. This is how we do this!

It was a good example that I identified with being the Sydney Fish Markets being contrasted with the “capital markets”. For me, this may not be entirely correct but I understand this concept at the moment and from my experience as being actual money, investment or something that can be converted to money, or per say human capital or knowledge (which doesn’t exactly fit in this sphere but its my overall concept)

KCQ: It is definitely true that you need to understand the past to predict the future. Trends will tell us this, that in my instance that wage expenditure has increased over the last 5 years with my own business, so in predicting the future then I would also predict that wage expenditure will also increase again.

There are instances that this will not or cannot be forecast, such as in the Global Financial Crisis or other market crashes. But these are extenuating circumstances.

Using past to predict the future has also helped our family business in setting targets and managing finances, as I have previously mentioned in this Blog. Identifying operating expenses that can be reduced in light of a past history of reduced overall operating income (as in the current economic climate in Mackay) can help us manage further reductions in operating income in the future by good planning and financial management. We can cut particular operating costs, eg wages, to assist in achieving a targeted overall operating income.

KCQ: I have not heard of Discounted Cash Flow – hopefully this will be cleared up soon

4.1 How firms add value

In my previous occupation, we always used the phrase “value add” or “add value” which in this concept means to add more value to the project then what the outlay or addition is. This could be with additional partners coming on board that provide their expertise, skills, time etc with minimal cost. Sometimes this cost could be just acknowledgement in media sources rather than a financial payment for their services.

KCQ: Basically we get more out of it than what is put in.

So in my own understanding previous to Accounting can assist me in understanding this concept. I know this will change and will be consolidated as we go – but this is my current “brain drain” and understanding with it all.

Free cash flow

Ok so I understand this concept in its basic form: the FCF is what’s left over after what we have made from operational activities and reinvested in the company’s operational activities or assets. So what I have been paid less my bills, mortgage payments, other loan payments, uni fees, text books and food etc... the left over is “kind of” my FCF. A crude way of looking at it but this is the start of my conceptual understanding. If I decided to buy additional text books, of course to provide me with a greater understanding for this subject – then this is investing in my operating assets (I) because I use them in generating my income as an undergraduate accountant – then my FCF (what is left over) will be reduced. If I decided not to buy ANY text books then my (I) will be less and hence my FCF will be higher.

For my company Morgan Sindall – they re-invest in buying more assets to build bigger, faster and better. If the company decides to invest more, due to eg the Olympic Games to be prepared for increased construction ability, then they will invest more into its operating assets (I) (machinery) which will reduce the FCF in that year.

Ok – got it!

FCF = C – I

Ok – I think I picked up a mistake! I’m not sure but I have spent AGES re-reading this section... see pics below!!

The highlighted pink (C) should be (I)...... or am I wrong – just doesn’t make sense with capital outlays being (C) also which outlaying to capital means investing in the operational assets thus Investing thus net change in operating assets invested in.

Soooo.. I just turned the page and BINGO here it is correct! I just spent 30 mins going over and over this knowing in my head that I was right and there was a typo! Phew.... there was! Time wasted, BUT it proved to me that I UNDERSTAND these concepts! Do pass now???

KCQ: FCF = transfer of value NOT creation of value. This concept is a little blurry now but I guess the creation of value is in some parts operating income of what the firm can “make”. By reducing this by the investing component this identifies the value that has been transferred into the firm from the additional investment.

Economic profit

RNOA = OI/NOA

Return on the net operating assets = operating income after tax / net operating assets

Earnings per investment on assets

Economic profit = (RNOA – cost of capital) x NOA

Economic profit brings into play the opportunity cost.

Opportunity Cost – now we have a plant at home that we call “OC”. About say 20 years ago my dad was doing some prostgrad subject in accounting and opportunity cost was part of it. So he started discussing this with me. At the time, my mother decided to purchase this plant... which cost about $20 at the time. It was a golden cane palm and was about the height of me and we had it in a pot inside. There was a discussion about the cost of the plant as opposed to buying food. We discussed to overall long term benefits of both and it was decided that there was more benefit long term to purchasing the plant. OC is now planted in our garden and is massive – providing lots of shelter for animals and shade for us – also our continued amusement. He usually gets watered by rain and does not have much to be outlaid on him for his continued survival and pleasure he brings to our garden. It could be said that to purchase a number of plants to accommodate that size could well be in excess of $200. The only negative is palm fronds as it needs to be maintained. So, opportunity cost is always a interesting debate in our family! So this is a crude example but one in which has been embedded in my knowledge for a long time and is how I understand it.

So that $20 outlay has had quite a bit of impact and “return” or ECONOMIC PROFIT persay to our family – I wonder if it could be said if mum had just bought some bread and milk!

This is a picture of our beloved "OC" now

KCQ: The Economic profit is the added value above the outlay or cost.

4.2 Operating and financial activities

Back to Pearson’s ACCOUNTING 7^th ed text book as I remember qualifying these in the exam!

Operating activities: “Activities that create revenues and expenses for the firm. Operating activities affect the profit and loss statement. A section of the cash flow statement”

Financing activities: Activities that obtain the funds from investors and creditors needed to launch and sustain the business. A section of the cash flow statement.”

Pretty self explanatory but I remember there being issues in qualifying some of the activities!!! I am seeing how these are all starting to link in

Operating and financing activities

Operating activities – destroying a firm!! Interesting concept!

Now Martin..... a Kinder Surprise... did you have to mention chocolate. Not good when you are stressed. Yes you still have my attention. Funnily enough I usually buy one weekly – I pester myself – but I’m a big kid at heart.

We invest (and ingest) the chocolate to see what the operating toy is! Oh and we should never eat less chocolate – or is that we can never eat less chocolate.

A conceptual view of a firm

Operating = day to day running, customers, suppliers, other business, purchases, employees

Financing = markets, equity, debtors

LBM: The Firm figure really cemented the idea of the “ins and outs” of the running of the business and what the financing and operating activities are. This is a good model.

This discussion cleared up my initial questions of the financing activities and the extent, mainly what comprised of (d) and (F) and this was quite simply discussed and thus understood.

In Martin’s RYMAN example I have tried to put the figures into the table. In part they make sense but I need this to be further clarified but it is starting to connect.

NFE – was a new introduction!

KCQ: still a little confused with the NFO calculation and (F) where did the $46.5m come from? I am sure this will be cleared up as I do my own calculations

Statement of changes in equity

From the lecture I now understand that the changes in equity is the connection between income statement and the balance sheet – Maria explained this well and was able to grasp this idea

I decided to check my own company

Ø Change in equity = income statement + balance sheet CORRECT

Ø Bottom line on income statement = net profit after tax CORRECT 18.0m

Ø Bottom line on bal sheet = equity value CORRECT 267.9m

Ø Equity value prev yr on bal sheet + earnings from Income statement = Equity on Bal Sheet??

This was a little more confusing. 257.0m + 18.0m = 275m?? but actually should be 267.9 which is on the Balance sheet. I need to look into this further

These are very similar to Maria’s 4 Point checks.

KCQ: “PREFERENCE SHARES” are debts to a firm and are excluded and should be included as a liability instead!!

I decided to complete my own restatement while I was reading this chapter so my practical experience was following Martin’s explanations as well as using Ryman as the example.

I HAVE GOT PAGES ALL OVER THE PLACE!!! Does any one else's desk look this crazy????

4.3 Restate two key financial statements

I would definitely say that restating in this section was INFURIATING! And FRUSTRATIN!! Fun.. not so much, fascinating – OMG NO!

STRESSFUL – YES!

Balance Sheet

I was able to follow through this section whilst undertaking my own restatement with Morgan Sindall’s financial statements. This was a tedious process and items like “finance lease liabilities” I needed to check the notes to see where it would fit into the O/F spectrum.

Doing this as I went along while being able to check regarding Ryman’s example was a good way to go through this section. Learning by doing!

The concepts were fairly simple and straight forward and Martin explained them well.

I think formatting and the physical transcription in the Excel spreadsheet was a bit difficult, but I got there in the end. I did need to consult with the Notes on a few items which was interesting to see that they had explained them fairly well – eg provisions – for redundancies, legal issues etc, so were operating activities.

It was interesting to see that there was only “borrowings” listed in the financing activities for my company.

Regarding the “cash discussion” as Martin suggested I calculated this as under 4% of revenue. I then checked the Notes to the Financial Statements and saw that there were ‘demand deposit’ accounts and other short term investments that will come to fruition in a few years. So in taking martin’s advice I calculated 1% for operating assets (2219.9m x 1%= 22.1m) and the remainder (87.6m-22.1m = 65.5m) to financial assets. 2014 and 2013 statements included notes that proportion allocated to net cash for these years however the percentage for financial activities resulted in cash operating activities to still be over 1%, however 2012 and 2011 Financial statements did not include this in their notes, so I concluded it would be easier to go with the 1% as Martin suggested for all. HOWEVER... after I completed this the amounts did not add up and I struggled with understanding it so went back and changed it back to normal. But then jumped onto the Q&A and I discovered I had:

NFO = FO+FA and not NFO= FO-FA

Key Learning: be sure to read the formula correctly and use the Q&A section (as I usually do)

Key Learning: be sure to delete the “-“minus sign. I had to retype everything as it didn’t add up!

Income Statement

This section was gain straight forward in martin’s explanation so I was able to go through my own company along with Martin’s Ryman Company as examples. His explanation was fairly simple.

KCQ: does it get easier? He says it does but I’m not too sure.

I struggled mainly with the comprehensive section – classification of hedges etc and operating and financing activities. I assume this jut means more reading for me and more examples. What I would like is to go through some more worked samples and explanations of HOW and WHY this section was classified. Using the Q&A forum isn’t the same and I guess this is a downfall of external study.... but I’m getting there. It’s complete anyway! YAY!

4.4 Profitability and efficiency

“Information is not knowledge” – wow that really deflated me and I guess I already knew that at this stage. Having gone over this all and restated my company, I guess I have been given the information, but knowledge – NOPE! Knowledge is a real understanding and comprehension. Do I know it all HECK NO! I only know some of it... *sigh* but it will come I hope!

Breaking things into bits

Ok so now this is where I actually finally comprehend RNOA - return on net operating assets. After completing the last section with my own company and readings this is starting to fall into place with the relationship between the ratio of OI and NOA.

Am I curious to how a firm works – yes. The complexity that has been raised over the last few weeks is ASTOUNDING and scary and maybe a little overwhelming, but its slowly making sense. The way Martin is describing it is actually helping. But…. Needing more practice will help. And I am sure I will have that.

KEY FORMULA:

Economic profit = (RNOA – cost of capital) x NOA

Where : RNOA = OI/NOA

RNOA – net operating assets

OI – operating income after tax

NOA – net operating assets

WACC – weighted average cost of capital (cost of capital)

Profitability – how much we make for each dollar

RNOA = PM x ATO

Where : PM = OI/sales and ATO= sales/NOA

Accounting drivers

KCQ – year for year is what we need to compare. Each year is going to be different in the expenditure of investment.

However it depends on when the change on NOA occurs. If its at the beginning of the year then it can be applied for the whole year but if it’s a last minute change in NOA then it doesn’t really affect that year but the next year. It hasn’t made any impact in the year.

KCQ: what is the cut off date – what happens in the NOA changes half way through the year? The average is best to be used!

WACC – I thought this would be calculated from the statements!

WOW – I gooooogled and came up with some interesting stuff – and WACC was there!

http://www.gurufocus.com/term/wacc/LSE:MGNS/Weighted%2BAverage%2BCost%2BOf%2BCapital%2B%2528WACC%2529/Morgan%2BSindall%2BGroup%2BPLC

Currently 6.32%

Some other interesting website http://www.valuecruncher.com/companies/782

Martin said to use 10% but why and what’s the significance of the difference?? Is it better to have a lower % or higher percentage…. Weighted cost of capital.

After calculating the information for Morgan Sindall I worked out that they have an Economic Profit of 16.3million and with 44.3 million shares on offer that works out to be 36.7c/share.

The calculations were easy to understand and it was just a matter of doing a bit of googling to get the extra info – its all there and some other GREAT interesting info. WOW – I said “interesting”!!

Profitability

I agree with martin in that profitability is a much easier concept – especially for us in business. Its how we make a living and literally put food on our table at night. Some nights backed beans and some nights a roast.

I calculated the PM for Morgan SIndall and it was 1.369% WHOA! Why is this so small? They appear to be a “good” company, but as a construction company maybe this is not an industry that has high profitability. Think construction and wages, machinery, project blow out, rain delays etc. This has actually been highlighted in Morgan Sindall’s financial statements with a few time lapses in 2013 and 2014. So, perhaps this is the case and what is expected. But PM is only a part of the story I guess and we need to look at the interaction with the rest of the characters in this story!

Efficiency

ATO – not the ATO that I know of – which is good being in Taxation accounting dealing with them daily can be very painful!!!.... but that’s a WHOLE other BLOG!!!

ATO = sales/NOA

1/ATO = NOA/sales

Asset Turnover- generated sales turnover for every dollar of NOA

Inverse – the amount of NOA need to generate a dollar of sales…. This actually is pretty self-explanatory for me.

Here is where it gets interesting – Morgan SIndall’s ATO is 10 times!!! So it is able to generate $10 of sales for each dollar of NOA. I consider this to be good given the fact that the average in the US is 2 times. Which means its very efficient in utilisation of the operating assets!

Conclusion

I have a greater understanding and a much greater appreciation for the financial statements and what they really mean and potentially what they COULD mean and have the ability to do. I was quite surprised by doing the restating activity along side of Ryman using my own Morgan Sindall company. It provided a bit of a comparison.

The interactions with operating and financing activities are still hard to grasp with some of the items but that’s a case of getting to know them better and using the notes. The most important Statements are the changes in equity, balance sheet and income in this respect – but all have a great interaction with each other – especially highlighted in profitability and efficiency. It ALL LINKS! What I thought was a bit disappointing with my company regarding the low PM was greatly impressed with the efficiency and the ATO. This was contrasted with Ryman. So I guess it depends on the industry, the economic climate and year to year and ultimately – how the business is run in the end. All these comparative notes can show this picture and help us making decisions in the company or whether to invest or provide feedback and advice – if we eventually get there at that level – I HOPE SO! I have actually found this interesting (even without chocolate) and with lack of sleep.

I think once this is over I will organise our own set of statements (even though we don’t need to) and start to look at our own company in this new light.

Lady Of Ledgers

Monday, 11 January 2016

Finalised Assignment 2

Friday, 8 January 2016

Ass 2 Step 3

Ass 2 Step 2 RESTATED FINANCIAL

Restated Financials!!!

Discussion Regarding Restating:

Ass 2 Step 1: Chapter 4