Chapter Four - Key Concepts and Questions (KCQs)

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.).