Part 6 Assignment 1 ACCT13017

See below my KCQ's on Chapter 4. I found myself slightly lost doing the readings but will plan to come back to it all at the end of term to see if I understand it better.

Bon appetit...

Chapter 4 – Understanding the Past

I was able to read the line ‘expectations are people’s imaginings about things that have not yet happened’ and really let it sit with me for a moment. In the current economic uncertainty it can be harder than usual to decipher where things may end up. The trajectory of many things has been put on hold, or changed completely. It will only take time until we can see the dust settle and pick up where things have landed. During the early days of this subject I began to play the ASX Sharemarket Game – a fictitious $50,000 to play with and invest on the ASX in real time. I saw how volatile it can be and how sensitive movements are to what is currently transpiring in the world economy.

As an equity investor we are buying outcomes in exchange for funds we have given. Starting with consulting the past will help to foresee a possible future. I am looking forward to getting my hands dirty in the restating of the financial statements and to identify the accounting drivers of economic profit and cash flows. I feel as though this hands on approach will confirm all the information I have learned during my years of study.

Even though I did not study ACCT11059 in my program, I believe my many years of work in accounting and preparing financial statements should still see me through. Although I primarily work with SME’s and not listed companies at all I do feel I have a good grasp on reading the financial statements of my assigned company, SEEK Limited. Breaking down Return on Equity into leverage, profitability and efficiency using formulas will give quantitative insights into the firms past performance.

4.1 Abnormal Earnings and Restating the Financial Statements

The abnormal earnings of a firm was not something I had really heard of previously. I initially struggled with the concept but once I read that abnormal earnings are what is left after normal returns to investors it started to become a little clearer. Abnormal earnings is the (actual) return on equity less the required rate of return on equity multiplied by the average book value. Putting it into words to understand the formula put things in their place. Anyone can complete a formula but true understanding comes from the why and what it tells you. The comprehensive income being used as opposed to Profit for the year is still a little unclear but I am beginning to understand the reasons for using it. Comprehensive income is used to include all earnings, or added value to equity investors so as not to omit part of the value of equity interest.

Looking more closely at the nature of operating versus financial activities and how they interrelate and contribute differently to the firm in creating economic profit and free cash flow was interesting although not fully clear in my mind. I am hoping that putting the restating of financial statements into practice will help clear that up. I had to read a few times over that the transfer of value between operating and financing activities showing that operating income less change in net operating assets are the source of Free Cash Flow, whilst change in net financial assets less net financial investment plus dividends is the application of Free Cash Flow. A firm’s Free Cash Flow is either used to increase net financial assets by repaying debt, paying interest on a debt, or paying cash to equity investors.

When I read the quote from Franco Modigliani, it didn’t matter how many times I read it, I still didn’t feel like I understood it. I am assuming its premise is that markets are efficient, so how a firm finances its activities is irrelevant, but I don’t believe they are always efficient, so that would mean it does matter how a firm finances its activities – as a balance between debt and equities.

4.2 Restate Two Financial Statements

Now for the fun part (I hope). What can I say, but that I am a maths geek – always have been. I love the way numbers make sense and tell a story, and especially love the way in accounting that debits must equal credits. I can relate to this quote from Warren Buffett:

“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself” – Warren Buffett

And now onto the practical side of this exercise, sorting the financial statements into operating and financial sections. I would say initially you would have to know something about the background of the business and what they actually do to determine what might be operating and what would be financial. In this way the financials will be in a format that will help identify drivers and reasons why the firm has been able to generate the abnormal earnings in the past.

Understanding about the cash balance in the assets and assigning it to be partially operating and partially financing could get difficult so I appreciate the use of a range (0.5% - 1% of sales) when splitting that asset. Making assumptions is a subjective activity, but then again so much of the analysis is.

Another factor I had not considered previously was the apportionment of tax expense between operating and financial activities. In my work preparing tax returns for SME’s and individuals, tax expense is not a part of the Income Statement. In a company set of financials I would journal the end of financial year tax calculation as a credit to Tax Liability, and debit directly to equity. That’s the difference between these reports and the ones I prepare on a day to day basis. A simple way of thinking about it may be to apportion the profit/loss in the NFE/NFI section and deduct it from the OI section.

4.3 Analysis ROE: Leverage and Profitability

I must admit I started to get lost when it came to understanding leverage and profitability. I can understand that in order to make decisions about the future of a firm and viability after potential investment, we need to investigate the drivers of abnormal earnings to provide a return on equity.

I enjoyed reading the analogy of the leverage of moving the earth with a long enough lever. Being the mother of 3 boys they too tend to enjoy pulling things apart to work out how things are connected to make it work. We have the problem of putting it all back together but I feel like it’s a learning process. When it comes to firms, being able to see that the leverage is being sufficiently utilised to its benefit – using other people’s money to make more money for ourselves is a great goal.

The equation for financial leverage using debt markets rather than equity, and operating liability leverage using creditors through product and input markets, I understand combine to reduce the amount of equity needed to fund activities. However the following formula I found very confusing:

ROE = ROOA + (RNOA – ROOA) + (ROE – RNOA)

If I take out the amounts that cancel each other out (ROOA and RNOA) I am just left with ROE = ROE, but after reading further perhaps its benefit is just to show the relationship of leverage between operating and financial and how each impacts on ROE. Further, the discussion on SPREAD being the relationship between ROE and RNOA and factoring in net borrowing cost has begun to make some sense, although I am sure I will have to continue to revise this topic and hopefully once I begin my financial statement analysis its application will become clearer. It was much easier to understand that profitability adds value – it centres on the core activities of the firm, and how it is linked with efficiency

4.4 Analyse ROE: Efficiency and Leverage Revisited

The discussion around efficiency showed how well net operating assets are being used to generate sales or turnover. Different businesses will have varying efficiency ratios and my thoughts took me to my own business. Accounting is a service and as such I don’t really have any substantial operating assets – a computer system, accounting software, printers, some furniture. However I can still see that in most cases, RNOA is interrelated with PM and ATO, and can be used to work out efficiency. The question needs to be asked how we expect ROE to change in the future.

Undertaking these calculations cannot just be about doing the maths, we need to know what each ratio tells us about the firm, in order to make informed decisions about the future.