Key Concepts
Capital markets are
financial markets that deal in the acquiring and selling of new and existing
equity investments in firms. They trade in the expectation of future returns
for their investment; no one in their right minds would sink money into
something that will see them come out with a loss. In order to assess future
performance and expectations, you have to first analyse the firm’s history in
order to see the patterns and structures that indicate a continuation of
previous performance. A basic step in assessing a firm’s past performance is
through analysis of its financial statements as they illustrate the business’
financial position and where they are losing and creating money. The patterns
in these statements lead to the development of a pattern that can be projected
into the future to predict future returns. I agree with this concept and find
it rather interesting as we all operate in these markets or feel a direct
impact in the happenings of these.
The best way to assess these financial
statements is restatement. The
restatement of financial statements enables the identification key
accounting drivers of economic profit and cash flow by including all earnings,
genuine equity of shareholders and operating and financial activities are
separate. Through restating a firm’s
financial statements you are able to understand more about their business
realities and what makes the business tick. With this concept, I find it a
little on the irrelevant side. You can still make sense of a business through
their financial statements without restating them and it seems a little like a
pointless exercise that just takes up a lot of time and effort for little
reward.
Free cash
flow (FCF) is a measure and indicator of the amount of cash a business
creates after the accounting for capital expenditure wherein this cash can then
be put to further use by the company, be it in expansion, reduction of debt,
other investments or other purposes entirely. It is the flow of cash within an
organisation to its various securities holders. It is driven by the cash flow
from operations as well as the net cash invested into operating assets. The
free cash flow is affected by business decisions as more investing in operating
assets leads to lower FCF. I found this concept simultaneously easy and difficult
to understand; the basic idea is easy to grasp but the realities are a little
tricky for me to get, but I do agree that it is an important factor of
business.
The concept of economic profit is a direct representation of the value added to a
firm over the accounting period through the comparison of accounting profit to
cost of capital. It is the extent that a firm has been able to add value over
the cost of capital during a certain accounting period. This concept is one
which practically everyone can relate to, be it business or personal; everyone
has expenses and revenues and at the end of the day, want to be able to have a
profit with which to do something with – like investing in new assets or for
the average person, going on a holiday. Economic profit is an easy concept to
grasp and highly important so I definitely agree with it being a vital aspect
of business and accounting.
Return
on net operating assets, a vital aspect of
evaluating economic profit, is calculated by dividing net after-tax income by the gross amount of all assets used to create revenue. Pretty straightforward for me
to understand, a little on the boring side but I can see the importance of such
an equation.
Operating activities relate to a business’ core business activities which
generate the majority of the firm’s cash flow and determines whether or not it
is a profitable business. It is the business’ interaction with the product
(customers) and input (suppliers) markets. Another easy and straightforward
concept to grasp and I agree that it is an important aspect of business and
accounting.
Financial activities are any actions or transactions that are undertaken to
further the economic aims of a business and include liabilities, equity and
changes to short-term borrowings. It is
the business’ interactions with the capital (equity and debt investors) market.
This concept was fairly easy to grasp as it’s just a simple definition of what financial
activities are and what they do. They are vital to any successful business
operation.
Through the use of both operating and financial activities, you can separate the two in
order to truly get an idea of what aspects of the business contribute to its
generation of value and its success (or failure). This concept is fairly simple
and easy to understand, but in reality it’s a little trickier to master.
In the Statement
of Changes in Equity (SoCiE), when all items of revenue are stated in the
income statement, it is called clean
surplus accounting, but that doesn’t always happen and instead put some
earnings directly into the SoCiE as other comprehensive income. In restating the Statement of Changes in
Equity, data is to be organised under: opening balance, profit for the
period, other operating comprehensive income, other financial comprehensive
income, total comprehensive income, transactions with shareholders and closing
balance. This concept, I found, was a little tricky, especially when trying to
restate my own SoCiE. I found it annoying and hard annoying and made me want to
pull my hair out because it just wouldn’t work for me. I also fail to see how
it is that much different to the normal SoCiE.
In
restating the Balance Sheet, data is to be organised under operating
assets, operating liabilities (which give you net operating assets),financial
obligations, financial assets (which give you net financial obligations) and
equity. Your net operating assets (NOA) equal your net financial obligations
(NFO) plus equity.
This restatement concept
was a little easier to get the hang of and was more straightforward once I got
the hang of it.
In restating
the Income Statement you list operating revenue, operating expenses, profit
before income tax, tax expense (tax reported and tax benefit), other operating
comprehensive income, comprehensive income after tax (OI), net financial
expense (NFE) (financial expenses (FE) and financial income (FI)), net
financial expense before tax, tax benefit, other financial comprehensive
income, net financial expense after tax (NFE) and comprehensive income. This
concept was a little on the annoying side, but I could see how drastically
different the restated income statement was to the original and how it could
have a significant impact on your understanding of their business realities.
When it comes to tax, the higher the
company’s profit, the higher its tax
will be which is understandable as tax is a percentage of the profit and not a
set amount. This is fairly straightforward as everyone has the same apply to
them on their individual income tax. I only had to pay $20 tax for last year,
while my parents had to pay thousand, obviously because they earned a lot more
than my little casual employee self.
When it comes to interest, the more interest
a company pays, the less profit it
earns and vice versa. Interest is an expense, to obviously it will affect their
profit margin and to me, this is an entertaining concept and I’m not
particularly sure why.
As a result of both of these aspects, a
company’s tax expense is directly
affected by its operating and financial activities. In order to calculate the company’s tax benefit, you use the equation:
.
In my firm, Aeffe’s, case the tax rate is 31.4%. Before now, it never really occurred
to me that different countries have different tax rates. It then makes me think
that as result, would certain companies be better off based in different
countries than the ones they are in, simply because of the tax rate that
affects them?
You then
calculate your firm’s comprehensive
operating income after tax (OI) and its net financial expenses after tax (NFE) using
the items specified in the Statement of Changes in Equity. These are done on an
after tax basis. This is fairly straightforward in concept, in reality when
playing with my own restated financial statements, it was a little harder.
Plus, it was a little boring to actually do which automatically makes things
harder.
Through looking at a company’s restated financial statements, you can get
an idea of their performance in terms of accounting drivers. Return
on net operating assets (RNOA), a ratio of operating income (OI) to net
operating assets (NOA) can be identified and analysed through breaking RNOA into its component ratios of profitability
and efficiency. The relevant profitability formulas are:
Economic profit = (RNOA - cost of capital) x NOA
RNOA = PM x ATO
Profit margin (PM) = OI/tax
While the relevant efficiency formula is:
Asset turnover (ATO) = Sales/NOA
This concept is fairly new to me and a little
hard to grasp. There are a whole lot of formulas and acronyms that once again
came out of nowhere with the implied expectation that the reader should already
know them. After a certain amount of head banging against the desk, they
started to sink in and I can see how they would be relevant in assessing performance
and helping in decision making and budgeting for the future.
Things I Find Confusing/Difficult
to Understand
The subject of discounted
cash flow (DCF) confuses me. The study guide doesn’t seem to give much
mention of a definition and it is expected that we already know what it means
and its ramifications to the accounting process and business realities. I don’t
know if it’s something I’ve missed or failed to pick up on at some point,
because it just seemed out of the blue to me. As a result of this, the entire
example of Ryman Healthcare with the free cash flow makes no sense to me and
sounds like gobbledygook. As it includes a discussion of change in net
operating assets, I am totally lost on both topics.
The introduction of so many acronyms has been throwing me as well. As I’m reading through, I’ll
all of a sudden come across one that I have no idea what it means or I’ll
forget what it stands for because there are so many new ones being introduced
on top of each other with the expectation that its already standard knowledge
for the reader, which as I have never encountered any of this business and
accounting terminology before, makes it rather difficult.
All I can say is hallelujah and thank god that this diagram
was included in the Study Guide. The whole concept of operating assets and
financial assets and the five million acronyms and what not that went with it
was incredibly confusing. The whole page before the diagram was like reading
hieroglyphs, but the diagram helped immensely!
The most confusing thing however, was attempting to restate my financial statements as I read the Study Guide
chapter. I started with the Statement of Changes in Equity which I quickly
abandoned as I had absolutely no idea what I was doing whatsoever – my
statement was completely different to the one provided (and don’t get me
started on the hours I spent at my tutorial trying to sort it out with my
tutor). The Balance Sheet was quite simple once I printed out my list of
headings and designated them “F” or “O” and they balanced, huzzah! The Income
Statement was tricky as well as it is so dependent on the SoCiE for certain
aspects. The straight copy and paste elements were a piece of cake, but the
rest of it was worse than a mental Rubik’s Cube. After plenty of consultation
with both my tutor and the ever wise Martin, I managed to get my restatements
in some sort of resemblance of what they were supposed to be!
Things I Find Boring
The whole start of this chapter in the Study Guide seems to
take forever to get going. There seems to be unnecessary over discussion of each topic, with sentences reiterating the same
point over and over again in what seems to be an attempt to just make the text
appear longer and look like it’s covering more. If it was more succinct and to
the point, it would make for an easier and much more enjoyable read.
The layout of the
Study Guide is also a bit of a lacklustre experience. There isn’t a major
separation of topics, and it’s not as eye-catching or easy to follow as a
standard textbook. Perhaps the addition of more colours or clearly identifiable
sections could make for an easier read. Reading twenty four pages of plain text
with no variation makes for tough reading and focusing, especially when
astigmatism is not particularly helpful in focusing on text to begin with.
Things I Find Exciting/Surprising
I particularly found the Kinder Surprise analogy enjoyable. They’ve always been one of my
favourite treats since I was a child (and I still get the Kinder Surprise
Easter eggs at Easter time!) and their inclusion in the example helped connect
me to the key concept of restating financial statements. There was also a
flicker of amusement that any Americans wouldn’t really grasp the idea of
Kinder Surprises seeing as they are banned because of being a choking hazard
for kids (yet the same children can tote a handgun. Go figure.).
