Part 2 Assignment 1 ACCT13017

Hi followers

Below is my Part 2 Assignment 1.

Happy reading.

Kiah...

Chapter 2 – How a Firm Adds Value

Reading the quote from L. Susan Stebbing describing the persistent stuff, really resonated with me – to find a company that I believe in, and can get alongside and invest in – a company that has exponential value. I imagine if you could personify a company into a warrior that resists tumultuous times and battles through the ever changing ups and downs of the intimidating investor market. As in military strategies, there is planning and approaches that takes place – tactics are discussed, and changed depending on obstacles that arise. That is the kind of company I would like to seek out, to get behind, and buy into their future.

Unfortunately however, it is not as easy as that. I feel that I personally could be easily swayed and manipulated, and SOLD when it comes to the potentially exaggerated puffery that I read in company annual financial reports. Of course they want my money – it would help them grow and expand – but these managers and directors are only human after all. Driving the big company machine they’ve been entrusted to, and who knows really what their ulterior motives might be. We’ve all seen how quickly and easily greed can take place of the common good, and it’s only after the fact that investor’s eyes are opened – but often when it’s too late.

Adoption of accrual accounting in a company’s financial statements, should give a more accurate picture. Showing what has been earned for the period, and what is obligated to be paid – however there is too much room for errors in judgement, and as such I would hope I could discern if there is any reason the financials do not show a true and correct picture of the firms position at that time.

2.1 A Firm’s Strategy

To deeply understand a business strategy is to know the direction it is heading in. It’s the big picture, the master plan. It’s the knowing where the firm wants to be, and the steps it can take to get there. First we need to know its surroundings & environment. How does it compete? What are the biggest barriers it needs to overcome in order to get to its next destination? How does the firms strategies feel in congruence with our own ideas? Are there any economic factors that may interrupt or set back the goals? How much knowledge of the surrounding issues and environment do I need to be able to make an informed decision?

I am excited at the chance to learn how to translate these quantitative factors into qualitative measures of value. As previously mentioned, I can easily get carried away with the exaggerations that may exist in financial reports, so to put something subjective like that into tangible quantitative factors seems appealing. I still believe that in order to see where we are going, that we need a tiny glimpse into the past. We need to read the financial statements and decipher the story they tell, in order to see the trajectory we are heading into the future. Much like a rear-view mirror in our cars - we need to see where we have been, but the window in front of us is exponentially larger to show us where we are going. Along the way, the company needs to be prepared to adjust its strategy, especially when events that may not be easily predicted come along.

2.2 Assessing Strategies

An important factor is the need to develop strategic insight – what makes one company different to its competitors? How capable are the management and board of directors to take the company where it needs to go?

The five 5 P’s for strategy I found to be an interesting way to view strategies: Plan, Ploy, Pattern, Position, and Perspective. These can be seen as different, but overlapping, sections of a company’s past and present that can give an indication to the projection it is aiming for. Analysing these could be the difference between what is a successful company with longevity in the market, and a company that falls in a heap.

2.3 Can the Accounts Be Trusted?

I want to be sceptical when reading financial statements - the accounts really only say what management wants you to see. I understand there are accounting standards to abide by, but there are still parts where management has flexibility in the accounting treatments. I would need to make sure I understood where judgments have been made, and why. Accrual accounting for big business makes sense – declare income when earned, and deduct expenditure when incurred, however some items such as bad debts, depreciation, and revaluations of assets – all require some type of critical judgement. If a company wanted its bottom line to look better for investors, or financial institutions, it could easily alter those.

The net present value of future investments is also not shown in financial statements. They are future based, whereas financial statements look to the past events that have happened. Then there is the opportunity cost of activities – the cost of capital. How else could that capital have been invested, and what sort of returns would it have made elsewhere?

I think the key to reading accounts is to be sceptical and critical of everything. Don’t be sold by the hype. To read between the lines and see what the reports are actually trying to tell me about the strategies and directions in the future. The past is over, it can’t be changed. The future is what matters and that’s where my investment would be utilised in growth, to pay me back my investment plus dividends along the way.

Chapter 3 – Many Ways to Assess Value

I must admit when I first read about ratios I was excited. I love the way the numbers can speak and tell a story. I use ratios in my work life when preparing financial statements, mainly to compare one year to another. For example for trading businesses I like to compare their cost of sales to revenue ratio between years. I then also compare those calculations to ATO benchmark rates. Items in the financial statements are always related to other items and it is imperative to see where they fit in the big picture of the past, as well as the direction into the future. They make it easier to see where a firm is struggling, and where they are excelling. However, I can see the flaw in just relying on these calculations to make future predictions. Working out what a firm does well is one thing, but to work out their values and strategies, would mean an insight into their possible future.

3.1 How Practice Developed

The brief history of accounting included in the reading material really interested me. Ever since I started Business Principles in year 9 I have been fascinated with bookkeeping and accounting. It always balances, debits equal credits. In my work in public practice doing tax I can sometimes be given the typical shoebox of receipts (once it was actually a washing basket) & it is very satisfying to see that messy pile of numbers on paper become a meaningful set of Financial Statements. How is anyone to know exactly where their business is at unless they keep track of the everyday ins and outs? For my own business I do my books daily, and review my monthly budget regularly to see how I am tracking to achieve the goals I set for myself. How else would I know what areas I am over or under spending on?

I agree that external users of financial information have a right to view the information that affects their investment – whether that is debt or equity investors. They need to know their investment is secure and that the firm is not insolvent. I would also be interested in the firms liquidity, especially at times of global uncertainty arises. However, when looking to the future, these calculations would only play a part in establishing a foundation for the predictions. Reviewing the financial statements is only a part of the process in analysing a firm for profitability and growth, they need to be combined with the unique set of strategies and drivers the firm utilises for the future, and then we can make predictions based on the combination of both.

As far as being able to follow how many brokers and analysts value firms to arrive at a ‘good buy’, I would say that decision is quite subjective – wouldn’t an individual’s feelings and life background play a large role in what value we place in a company – for example I may be passionate about medical research, so I would quite easily get on board to invest in a company in that field that has a strategy I resonate with. On the other hand I might not be a fan of mining so despite the recent years of high profits in those companies I may not be able to see through their strategies to invest, even though I may yield a higher return.

3.4 Forecasting Dividends, Cash Flows or Earnings

The quote by Andrew Lacey, ‘Many of our strategies start with the premise that companies create economic value mainly by earning returns above their cost of capital’ seems to me the central reason behind wanting to invest in the first place. We want to give our money to help expand the business, but in return will want that money back plus our share of growth, and that growth needs to be more than we could get if invested elsewhere.

Reading about the transfer of value was enlightening, particularly when I read about how Free Cash Flow is a transfer of value between a firm’s operating and financial activity. I’d never really thought of it like that before. Ultimately the investment in capital by a firm would only be done to ‘value add’ and generate a return to equity investors higher than the cost of capital.

I found the formula for the value of equity (book value + PV of Abnormal OI) easy to follow (eventually) and realise the way it connects with being able to engage with the economic and business realities of the firm we are looking at.