Assignment 2: Step 1

Chapter 4 – Analysing Financial Statements

Using the analogy of the Sydney Fish Market to describe how the capital market works really helped to ‘set the scene’ for me in Chapter 4. I have previously heard that the capital market was based on trading assumptions/ predictions/ expectations, so although this wasn’t new to me, framing the concept with a simple analogy helped me understand that any difficulty I have in comprehending this kind of market isn’t because it’s too complex for me – it’s just different to anything I know. The notion of understanding a firms past to better predict its future makes a lot of sense to me – no doubt there are multiple aspects that are important in finance forecasting, and past performance seems like one of many important indicators. At the end of the first page, I am starting to assume that Chapter 4 is going to be pivotal to the successful completion of Assignment 1 – and I’m excited. I was initially very overwhelmed reading the outline for our next assignment, so I’m very glad to be jumping right into understanding the ‘what’ and the ‘why.’ From the perspective of someone who is genuinely interested in how companies make their money, I am excited to find out more about the economic profit drivers of Skellerup Holdings. Closing out the first section of Chapter 4, I am a little daunted by all of the acronym talk already – and we haven’t even begun! I’m definitely going to need to keep that cheat sheet handy. When I said I loved the idea of business, but was a complete and total noob at it, I really meant it. Although I’m familiar with the words ‘investor’ and ‘dividends’ (familiar … as in I know how to spell them…?) I would not be able to use them in a sentence. Starting 4.1 with Martin re-iterating the relationship between a firm, its equity investors, and the dividends has helped frame my mind correctly. In regards to how a firm ‘adds value’ vs. simply transferring value – I have no idea. I have never thought about this before!  

Two pages in and I’m learning already! Dividends = transfer of value between the firm and its equity investors and Free Cash Flow = transfer of value within a firm, between its operating and financial activities. I dreaded the day I would finally cross paths with formulas and equations in accounting … and it seems that day has arrived. It has taken reading the ‘Economic Profit = (RNOA – cost of capital) x NOA’ multiple times to get a good handle on what I’m actually looking at. I like the opportunity cost analogy – I have heard this term defined before, but not in a way such as this. It really makes me think: what is the opportunity cost of my own life? I didn’t expect to have a mid-life crisis whilst doing my accounting homework today …  So far the key point I’m understanding in 4.1 is how beneficial it can be to analyse the economic profit of a firm – in contrast to its dividends or cash flow – to help us find where our firms are adding value, rather than cycling cash flow. To understand this, we first need to separate our firms operating and financial activities!

The idea of separating a firms operating and financial activities is not something that has ever crossed my mind, although it does make sense now that the idea is presented to me. I have absolutely no idea how one would attempt this however, and I feel very uneasy that we might be about to venture into unchartered waters. As I have mentioned previously (probably an annoying amount of times) mathematics is NOT a strong point of mine. Here we go … So far into 4.2 I am glad to see a lot of text, rather than numbers. I understand things much easier when they’re explained in a casual, written style, so thank you for that Martin! An analogy involving chocolate? Now you’re speaking my language.  I am a little bit surprised that we have to get through the financial activities first before getting to the operating activities – I assumed it would be the other way around, and that the financial activities we’re the toy inside we are trying to get to.  So far, so good – I’m finding that I need to read sentences 2 – 3 times over for them to sink in, but I’m understanding things so far. The Kinder Surprise analogy is helping more than I thought it would, and once we start applying these concepts to our companies in a practical sense I think I’ll start to get the hang of it quickly! I am surprised at how simple Ryman Healthcare’s Restated Statement of changes in Equity looks – I thought we we’re going to be required to engage some sort of algebra. I had a great experience working collaborate and seeking (and providing!) feedback for Assignment 1, so I am genuinely excited to reach out to my peers again for Assignment 2. I was very surprised with how much awesome help I received last time, and no doubt, it’ll be much needed again!

The contents of page 15 has me feeling worried. I lack common sense at the best of times, so I’m not sure how I’m going to fare when listing the extra items of ‘Other comprehensive income,’ let alone understanding what the items actually are. The additional steps for restating our firm’s Income Statements are the first part of this entire reading that are confusing to me – but I think I’m just getting bogged down in the details and once I’m working through my own firm’s financial statements everything will be less overwhelming. I’m actually really excited to get stuck in! This all seems like a bit of a challenge but I’m sure I’ll have more than enough help along the way.

After working through pages 17 – 22 I’m now seeing how all of the restating pulls together to allow us to look at the economic profit of our firm, and I’m still feeling positive. In addition to this, I believe I have a pretty good understanding about how profitability and profit margins work in a general sense, however I’d be clueless at anything numbers or % related. Actually – I stand corrected. I had no idea profitability interacted with efficiency … let alone do I know what this means! Despite this, I am making good sense of RNOA = PM x ATO. I had no idea about the interaction between profitability and efficiency, but it does make a lot of sense. I’m actually really interested to learn a little bit more about this and I think I’m off to look for some Youtube videos discussing this relationship. Here’s one that I think you might enjoy …