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 7th 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.
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