Reflections on Chapter 4 of the Study Guide

Well, chapter 4 was certainly a long chapter!

At this point, the main thing I recall reading about is how much Martin likes Kinder Surprises! I had been wondering why I had been able to think about nothing but chocolate for the last two days, when I realised it was all thanks to the not-so-subliminal messages in this week’s reading!

I kind of hit crisis point tonight when I realised I had no chocolate in the fridge, I couldn’t go to the shops as the kids were in bed, and I found myself googling “How to make chocolate” instead of starting on my KCQ’s.

A little bit of cocoa powder, coconut milk, butter, honey, blueberries, and 3 tablespoons of procrastination later, I’ve currently got these beauties setting in the fridge… hopefully by the time I’ve finished writing this, I’ll be able to tell you how they turned out!

(Edit: They were amazing!!)

Anyway, on a more serious note, I was not long into the reading, when I realised that chapter 4 was going to be crucial for 2 parts of the assignment.

Firstly step 1 of course, as I wouldn’t be able to complete the KCQ’s without reading chapter 4!

However, it also included really critical information about restating the financial statements, as well as calculating the ratios (steps 3 & 8).

I could really relate to the statements that capital markets and equity investors in firms, trade in expectations. Shareholders are essentially investing in what they hope is the future performance of a firm. By the time the company releases it’s annual reports, it is too late for the reader to cash in on that year’s performance. All they can do is hope that the report is a reliable indicator of how well the company will perform in the future.

I have heard friends and associates refer to the share market as “white collar gambling” on more than one occasion. And they would be correct in a sense. Certain investors, including myself at times, will purchase a firm while knowing very little information about it. They may do this based on reading someone else’s opinion of the firm, or even may go on a hunch. I recently purchased mortgage choice shares on a hunch, and sold them a month later, making a 25% profit. Needless to say, I was stoked. However, I also can not honestly say that I did a lot of company research or made a sound investment decision. Really, I just got lucky.

When someone is playing poker, they will often have to act on a hunch about whether they think another player is bluffing or not. However, once they have been playing at the table for a while, they will get to know that player. If they watch carefully, they will learn to read their body language, signals or “tells”. They will begin to identify how they act when they are bluffing, and how they act when they have the winning hand. Eventually, they will be able to make better decisions as they predict the outcome based on past behaviour. We do the same when we analyse firms. As we spend more time at the table that is the stockmarket, we learn, through the analysis of financial statements how to read the firm. Are the annual reports a whole lot of marketing bluff? Or, as we analyse the past performance of the firm, do we believe what we are reading, and feel that we are in this case, able to put our money on the table and wisely invest?

Which brings us to the question, how exactly do we go about analysing a firm’s financial statements? I already know from completing Assignment 1, that they contain a lot of information and it can be hard to know where to begin and what is relevant! Knowing that there are standard frameworks and measures used by accounting professionals is comforting to me for two reasons. One is that knowing that the methods have been tried and tested by many others before me, reassures me that the method must work, and that following this process will be beneficial to me. The other is that it provides me with a standard method of analysing all firms, so that if I am ever needing to compare one firm with another, I am able to easily do this using the same measurements and ratios.

“Restating the financial statements” actually means nothing like what I thought it did. Initially, I had thought that it would be a lot more to do with amending the financial statements based on new information that had come to light. I now see that, in this context at least, we are learning how to separate the operating and financial activities of a firm. Rather than adding, removing or changing any of the financial information, we are essentially rearranging it on the spreadsheet. We do this in a way that allows us to clearly separate the operating and financial activities in the Statement of Changes in Equity, Balance Sheet and Income Statement, and then calculating their respective totals for each.

This then provides us with the key figures of operating income and net operating assets, which are required for the calculation of the various ratios and formulae.

The concept of separating different financial activities actually makes a lot of sense to me, as I already do this for the purpose of my own budgeting. I have a spreadsheet where I total up all of my fortnightly, monthly and annual expenses, and how much I need to earn each fortnight to meet those expenses. However, I don’t actually earn the same amount every fortnight. I have fixed incomes such as rent from my investment property and family tax benefit. My income from dividends and bank interest are not necessarily fixed, however they will continue to be paid without any effort on my part. Whereas my employment income is variable depending on how much I work. By looking at these separately I am able to view the difference between my fixed income and my expenses so that I know how much I need to earn from employment (ie. my operations) in order to be profitable (ie. pay my bills or sometimes even save!) Similarly, I also show my income and expenses related to my investment property in a separate section on the spreadsheet. This helps me to keep track of just how much of my own money I am having to put into the property and how close I am to being positively geared. If I were to just lump all of my income and expenses together, it would not be possible for me to have such an accurate picture as what I do.

Similarly, I can see why doing this for financial statements of a firm would be just as helpful. Even without the calculations of any ratios, it seems like it would make the financial statements much more readable, and would give an immediately clearer picture as to where the firm’s earnings or expenses are coming from.

After we restate the financial statements; namely the Statement of Changes in Equity, Balance Sheet and Income Statement; and separate the operating and financial activities, we are able to then clearly see the respective totals of the net operating assets and the operating income. These figures are essential for the calculation of Return on Net Operating Assets, Economic Profit, Profitability and Efficiency.

When reading the explanations for calculating these measures, one area that really got me stuck was the difference between the cost of capital and capital outlays. Due to my work experience as a tax consultant, I am familiar with the concept of capital expenses being the purchase of assets which are expected to generate income in the future. Depending on the cost of the asset and the size of the business, these may or may not be able to written off as an immediate tax deduction. Otherwise, they need to be depreciated over a number of years based on the asset’s expected effective life. I had then just picked up on the word ‘capital’ and assumed that the cost of capital and capital outlays both also meant the same thing, and originally written quite a lot in this document based on that wrong understanding. This shows that there is at least one instance where having prior knowledge is not always beneficial, as I have read the study guide in that context, rather than what the author was actually trying to convey. I have now come to the understanding that capital outlays are quite similar to what I thought they were. I still don’t feel that the study guide provides a clear enough explanation of the meaning of cost of capital, however I have found an explanation here which made some sense to me:

https://en.wikipedia.org/wiki/Cost_of_capital

If I have understood correctly, cost of capital then means the additional cost to the firm of borrowing or acquiring the money which they then use to invest in capital expenses. For example, I have a mortgage on my investment property. Purchasing this property was a capital expense as it is an asset that is intended to generate an income. The interest that I pay on my mortgage is the cost of capital. For me to be generating value from my investment property, I should be receiving more in rent each month than what I am paying out in interest.

At first I was a little surprised that we are to use a flat rate of 8% for all firms! When we are going to so much effort to restate the financial statements in order to obtain more accurate information about a firm’s performance, using an average estimate like this seemed quite contradictory. However, after seeing the formula that is used to actually calculate cost of capital when one wants to be precise, I am more than happy to go with the 8%!

I read that you can only ever invest capital in one thing at a time, and that the cost of capital is the potential expected returns it could be earning in alternative uses. I have been learning about this concept of Opportunity Cost in my economics unit.

In my own life, I am all too familiar with the concept of trade-offs. I have chosen to send my children to a private school, however to be able to afford this, we need to live in a unit rather than a nice big house with a yard. If I choose to shop at Coles so that I can collect Stikeez, I miss out on the opportunity to shop at Woolworths and collect Disney tiles. There are always trade-offs in life, and unfortunately we can not have everything!

We do not think about all the alternative lives we could have lived; we often fail to realise all the alternatives and options that lie before us, all the dreams, journeys and actions we could be taking instead of what we have chosen to do.”

Reading this actually gave me a huge jolt to the point that it made me stop doing any uni work for 3 days! I still honestly don’t know if I’m making the right decision, and am second guessing myself all the time. If I weren’t studying, I could be in the workforce earning good money right now. Or, I could be a stay at home Mum spending more valuable time with my children. The concept of opportunity costs is a huge reality for me right now, and I am well aware of what I am missing out on in order to undertake this degree.

Firms need to have the same consideration when making decisions, and the measure of economic profit is able to assist them to do this. Has a firm been able to create value greater than the cost of it’s capital? And if so, by how much?

Through reading through the instructions on how to restate the various financial statements, I initially thought that this would be a fairly straightforward process. However, after taking a quick look at my firm’s balance sheet, I quickly realised how wrong I was!

Restating the cash seemed easy enough, however when I checked the footnotes for items such as “trade and other receivables” and “trade and other payables”, I realised that these are actually broken down into many smaller sections, these being a mixture of both operating and financial assets. I’m also still trying to figure out the meaning of tax assets and deferred tax assets, and the difference between current and non-current assets and liabilities. This is definitely going to take a lot longer than I first anticipated (and a lot of wine and chocolate!)

I am fortunate in the fact that my firm already separated it’s operating and financial income and costs in it’s income statements, and the comprehensive income statement is made up operating activities only. I am comforted by the fact that restating the income statements and the statement of movements in equity will at least be a much less arduous task.

I can now clearly see that the return on net operating assets basically looks at the profit that a business generates from it’s operations as shown in the restated income statements and compares this to the net operating assets shown in the restated balance sheet.

This measure of RNOA can then be used to further calculate the economic profit, profitability and efficiency. A quick peruse of the “ratios” tab of the company spreadsheet shows me that there are many other ratios we will be learning to calculate throughout this course as well!

I find the concept of profitability relatively easy to grasp. I have previously dabbled in buying and selling baby clothing online. Essentially, as long as I am selling the products for more than I paid for them, then I am making a profit. However, I can see that the profitability measure calculates this to a more exact percentage which would be helpful when perhaps choosing between two different products to purchase for the purpose of reselling.

I initially found the concept of efficiency a little harder to get my head around, it almost seemed like it would be the same as RNOA. However, I then realised that where the formula for calculating efficiency uses the total sales figure (ie turnover), the RNOA formula uses the operating income which is most likely the same figure, but with the expenses minused off.

I am unsure as to why efficiency would be a useful measure though, as having a high turnover is not that great if there are also a lot of expenses as well. I feel like profitability would be a lot more indicative of whether or not a business is doing well.

As I conclude this reflection, my head is almost bursting with all of the new concepts that I have been learning, and at the same time I am more than well aware that I am only just beginning to scratch the surface. Whilst learning by reading is definitely beneficial, I am someone who much more learns by doing, so I am looking forward to putting my learning into practice as I start to restate the financial statements and see these concepts come to life.

And at least I now have lots of yummy chocolate to eat while I am doing it!

3 thoughts on “Reflections on Chapter 4 of the Study Guide

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