Chapter 4 ideas, reflections and reactions

Before I read this chapter I must say I was keen to explore. I wondered if there would be some hidden secret to unlocking the information provided in financial statements. I have never really analysed financial statements before so this was all going to be new to me.

The analogy of the fish markets made sense. Capital markets are predictions on future cash flows based on publicly available information. Predictions take into consideration past performance, competitors, legal landscape, future needs and much more. Not all of this can be known so the future predictions may be right or they may be completely wrong. The point is with the fish market or any other physical item for that matter you can see it, touch it, even smell it if you want to however this cannot be done in the capital market. In the capital market you can only base decisions for resource allocations on predictions. As such there needs to be some sort of framework to make these predictions.

We are also at the mercy of management and their chosen accounting methods of choice and disclosure practices. I guess this is similar to the McDonalds burger ads you see on TV. They look so fresh and full yet when you receive your order the burger is not the same. What I mean by this is the financial statements can be manipulated to a certain extent to promote a positive performance just like the burgers on the ads are manipulated to show them in their best light. However what you get may not necessarily be what is promoted just like financial statements to an extent.

Looking at the free cash flow examples shows how you can be easily misled if you focus only on the cash flows with no thought of the surrounding numbers or information. In fact the same can be said for net present value (NPV) and internal rate of return (IRR) ratios. In fact the same can apply for any ratio as there is no single measure which gives you all the information you need. For example if you had two competing projects and could only choose one, logic would say choose the project with the higher NPV however all this does not show the money that needs to be invested. This is exactly what is shown in the example in this chapter. One project may have a higher NPV but it may require a lot more to be invested to earn that profit. If more money is tied up in an investment this also increases the risk of the project, something which NPV does not consider.

Reading through the economic profit section and more specifically the cost of capital really makes you think of your own life. It is definitely true that capital can only be used or invested on one thing at a particular time. Capital can be money or even time. I think of all the opportunities forgone by making the decisions I have so far in my life time. It’s funny how you don’t really consider the cost of capital in our own private lives. Especially in regards to future finances.  Oh my I wish I could go back and change some of them. I am sure many people are like that and such is the value of hindsight. Lucky we have ratios and other frameworks to assist in our finance investments. Unfortunately they are not foolproof.

The difference between the economic profit ratio and other ratios is that it takes the cost of capital into account. It essentially reduces the operating income down to an amount over and above the cost of capital the company employs. The cost of capital may be an arbitrary figure or it may be based on a weighted average and take into account such things as the debt structure of the company and the risk free rate of return or the return on government bonds.

I have never broken a financial statement down into operating and financing activities. I think it is a good thing. It allows more clarity and you can see each activity more clearly. It is important to see both the debt structure of a firm and how its operations are performing. Separating both also gives you a better measure of management performance. I was lucky as my firm already separated most of its operating and financing activities in the income statement so it was really only the balance sheet which required much attention to detail. For me restating the financial statements also allowed me to understand the underlying data more clearly as I was forced to read the attached notes when deciding whether an item was operating or financing.  

When I first saw the statement of changes in equity section I was bracing myself for the pain. I haven’t had much to do with this report and whilst it is relatively small it raises questions for me. However proceeding through the section I realised my hesitance was unfounded. In fact this looks the easiest section to restate. I wish I had time to restate other company’s financial statements to get the hang of it and develop a deeper understanding.

I used the tip and printed out my firms financial statements for the assignment to place either an O or an F next to them. It was quite helpful as it allowed me to browse through the notes to the financial statements on my computer and record the F or the O on the printout. I was able to go back and forth between the two without any confusion. At first I thought a bank overdraft would be considered a financing activity because it is essentially a short term loan provided by the bank to the company. I only vaguely knew what a bank overdraft was so I researched the term through google and after reflection I agreed that it would be an operating liability as the purpose of this item if for day to day operations. It is also linked to other operating accounts so it doesn’t really meet the requirements to classify it as a financing loan.

The ratios were familiar to me not only from previous courses but also previous work experience in an industrial supplies company. The profit margin was used mostly to ensure we had enough margins in our sales compared to other industry competitors or other customers. Where the margins were a bit light or small we investigated opportunities to increase whether through higher sales price or lower buying price. This sometimes involved renegotiating buying contracts to get better discounts which in turn required us to buy more stock in some instances. Thus we had to explore the costs and capabilities of having more stock in our warehouse and also the opportunity cost of the increased purchases.