Step 1:
Chapter 4: Analysing financial statements
1.
My
first ‘key concept’
Why
we analyse financial statements
Why do we analyse financial statements? To predict the future. And to
predict the future, we need to start with the past. As pointed out by English
writer G. K. Chesterton, if we fail to understand the past, indeed if we are
wrong about the past, we are unlikely to be able to predict the future very
well.
A firm’s financial statements can help us understand the past of the
firm and to understand a financial statement and make sense of the firm’s
economic and business realities – you need to have a framework or structure to
be able to view the firm and see how it adds value to its equity investors. The
discounted cash flow (DCF) and economic profit frameworks are two common ways
to analyse a firm. They help you know what to focus on in a firms financial
statement and what you should also pay less attention to.
“The most efficient way to find the main counting drivers in the
economic profit and cash flow is to restate the firm’s financial statements in
a way that ensures all earnings are included, that shareholder’s equity only
includes genuine equity and that the operating financial activities of a firm
are clearly separated.” (Martin 2015, p. 1).
My
reflection: (Confusing, difficult to understand or believe, boring, exciting,
surprising?)
Okay, so financial statements are a pretty big deal. I have learnt
that they are the starting point to assist a manager to predict the near future
for a firm. I have never viewed a financial statement before but I think I am
about to. They sound complicated! This was a good introduction to get me
prepped for the information to come.
2.
My
second ‘key concept’
How
firms add value
How does a firm ‘add value’ to its equity investors? You need to look
deep into a firm to understand how the firm can ‘add value’ which then allows them
to pay dividends to equity investors. Since dividends and free cash flow (FCF)
are related in a firm’s financial statement, you can focus on a firms cash
flow. FCF is a transfer of value within a firm. It is between a firm’s
operating and financial activities. FCF is driven by two things:
1-cash flow from operations (C)
2-net cash invested into a firms operating assets (I)
Notes: FCF is a measure of transfer f value rather than a
creation of value. The amount of FCF a firm generates will be affected by a
firm’s decisions about how to invest into its operating assets (I) each year.
How to measure ‘value-add’ in a firm? Economic profit! Economic profit
is based on a firms accounting profit for a period compared to its cost of
capital.
RNOA = return on net
operating assets
NOA = net operating assets
Operating income = OI
Economic profit = (RNOA –
cost of capital) x NOA
RNOA = OI/NOA
“Firms create value for their equity investors by earning a return on
net operating assets (RNOA) greater than the opportunity cost of capital; and
the more a firm can invest in net operating assets at returns above its cost of
capital, the more value a firm can create”.
My
reflection: (Confusing, difficult to understand or believe, boring, exciting,
surprising?)
I am so glad that is over. What did I just read? I went through this
part of the chapter twice and I still feel very confused. I understand why all
the above needs to be done, but actually doing it is a killer. This has become
the hardest part of the course. I don’t have any questions and can’t really
reflect on any of this section, I am just very, very confused. Hopefully if I
read on, it will all make a little more sense.
3.
My
third ‘key concept’
Operating
and financial activities
View a firm as involving two distinct and different types of
activities: operating and financial activates. Operating activities include:
decisions about which operating assets to acquire or sell and what agreements
to enter into with employees, suppliers. The financial activities include:
decisions about the financial structure of the firm and matters such as
dividend policy.
My
reflection: (Confusing, difficult to understand or believe, boring, exciting,
surprising?)
I now regret choosing this as a key concept. It is more of an
important note to keep in the back of my mind. It’s easy to understand and
helps you to view a firm in the way that will assist you to restate a firms
financial statement. J
4.
My
fourth ‘key concept’
How to re-state a financial statement
My
reflection: (Confusing, difficult to understand or believe, boring, exciting,
surprising?)
I chose this as a “key concept”, as I understand how important it can
be for a firm. But, do I understand how it is done, and the process of achieving
a successful re-stated financial statement? I have no idea. I have re-read this
section in chapter 4 numerous times and still don’t have a clear understanding.
I am going to have to wait until I receive my marks/feedback to see how I
went!!
In summary:
Yet another full on chapter! This was the most difficult by far. My
print-out of this chapter looks a mess! I went through it so many times, and
made numerous notes... Yet I still don’t have the best understanding on the
content as I would have liked. Lots of information + lots of formulas = lost
Sophie.
