“The best way to predict the future is for us to create it” Abraham Lincoln
Now this looks interesting. Out comes the crystal ball to see what the future holds. This was my first thought was when I saw the heading for this chapter. Are we able to predict the future from what has happened in the past? This is the age-old argument that continues to baffle people’s minds. Looking at a company’s history has shown that a plan can be devised for what could or could not happen in the future dealings of the company.
Over the past seven weeks we have delved into the intricacies of how a firm works and how each firm has such a diverse background. Taking a step back into China Outfitters Holdings Limited has shown that although the firms Annual Reports show how the company has performed and how its equity investors have journeyed through until this day. However, to determine the value of China Outfitters Holdings the company will need to look to the future and determine how it will be able to predict its future economic growth or cash flow.
Connecting with the reading material this week has been quite an eye opener for me this week as I have come to the realisation that it doesn’t matter which company, we were given we can compare with other companies to see and understand how a firm is performing. However, we need to remember that it is not the relying on ‘Comparables’ or the market value of the assets of the firm that adds value to the equity investors, debt investors, customers, employees, suppliers and the general community or environment. We will need to use the skills that we have learned to be able to forecast the future economic profit and cash flow of the firm.
When forecasting a firm’s equity economic profit there will be three things that is required: Return on equity (ROE), the required rate of return on equity (ρE), and the book value of ordinary shareholder’s equity. Then there is the idea that we will also be forecasting a firm’s enterprise and in a similar way we will need to forecast: Return on Net Operating Assets (RNOA) The required rate of return on a firms’ operations (WACC) and the book value of Net Operating Assets.
What I see here is that as a company continues to grow through its sales there are factors that will contribute to how well the company performs in the market place. Watching the videos over the past week I have seen that Rymans Health Care has had a significant impact in the market place. For a company to succeed it needs to look at what is driving the firm. It can be seen that Return on Net Assets involves both Profit Margins (PM) and Asset Turnover (ATO). These Key accounting Drivers will utilise both Net Operating Assets and Operating Income which will give us the Free Cash Flow.
Free Cash Flow (FCF) = Operating Income (OI) – Net Operating Assets (∆NOA)
Understanding what is driving a firm’s economic profits will help us to see why these things happen. When working with these situations there will be questions that we will need to determine economic profit. Firstly, we need to take a look at the Free Cash flow of the past four years of our company and operating profit to see whether there is a positive or negative effect on the company. Have we checked to see what is causing this type of reaction? Is it large or small numbers, changed over the years or is it much the same?
If we were to check out Ryman Healthcare as described by Martin Turner you would find that over many years, the company has had a strong return on Net Operating Assets with a strong profit margin and low asset turnover of 15-30% which has been a significant contributor in growth at Ryman Healthcare.
Looking at China Outfitters Holdings I can see the following as well:
| Revenue (RMB Millions) | Retail Sales from self-operated retailers | Sales to third-party retailers | Sales through online channels | TOTAL |
| 2018 | 684.9 | 152.2 | 61.2 | 898.3 |
| % of total revenue | 76.2% | 16.9% | 6.9% | 100% |
| 2017 | 688.0 | 175.1 | 55.2 | 918.3 |
| % of total revenue | 74.9% | 19.1% | 6.0% | 100% |
| 2016 | 659.5 | 199.7 | 42.8 | 902 |
| % of total revenue | 73.1% | 22.1% | 4.8% | 100% |
| 2015 | 711.5 | 253.8 | 47.5 | 1,012.8 |
| % of total revenue | 70.2% | 25.1% | 4.7% | 100% |
What do I see here? There has been an increase in the growth of sales through the Retail Sales from Self-Operated retailers and online sales which shows that there is strong growth happening with this area. However, when you look at the Licenced Brands versus Self-owned Brands you will see that since 2015 the growth in sales is declining in Licenced Brands but Self-owned brands the growth of sales although not big has increased.
| Revenue (RMB Millions) | Licensed Brands | Self-Owned Brands | Total |
| 2018 | 797.8 | 100.5 | 898.3 |
| % of total revenue | 88.8% | 11.2% | 100% |
| 2017 | 824.0 | 94.3 | 918.3 |
| % of total revenue | 89.7% | 10.3% | 100% |
| 2016 | 816.2 | 85.8 | 902.0 |
| % of total revenue | 90.5% | 9.5% | 100% |
| 2015 | 936.2 | 76.6 | 1,012.8 |
| % of total revenue | 92.4% | 7.6% | 100% |
Ryman Healthcare’s key drivers for economic growth is a strong sales growth of (15-20%) and is supported by a steady decrease in Asset Turnover. China Outfitters Holdings Limited operates in a very competitive market and faces intense competition from its competitors within both the international and domestic arena. Doing a similar comparison, the key driver is the increase in sales of Self-owned brands within the retail industry with a slight decline in Licensed Brands.
Reviewing the key and economic drivers of Ryman Health care has shown that there is a strong demand for retirement villages within Victoria and New Zealand and that there is a growing capacity to develop, own and manage retirement villages. There could be some regulatory risks involved as a large proportion of funds comes from the Government for care fees. Industry competition also bares and element of ‘local’ monopoly for each retirement village.
China Outfitters Holdings Limited has the task of ensuring that the key drivers of the business are also met. With the fluctuations in consumer spending being caused by changes in macroeconomics conditions within the PRC, success will rely on the company’s growth in consumer market depending on worldwide economic conditions and individual income levels which will have an impact on consumer spending. As retail and apparel industry it is highly competitive with the adoption of competitive pricing strategies, expanding operations and adopting innovative retails methods or product designs this will be the key business and economic driver.
What we find next is that having the experience and ability to make sound financial judgements involves a critical thought process. A shift in focus from engaging with the firm’s financial statements to engaging directly with the firm’s economic and business realities. There are some general principles that can be followed to achieve this:
- Identifying key accounting drivers
- Focusing attention on examining economic and business realities on what drives the key accounting drivers
- Connecting the accounting drivers of the firm to economic and business realities
It is also important to take note of good and bad sales growth of a company. When looking into the sales growth of a company we need to be able to tell the difference between good and bad sales growth. What we find here is that for sales growth is the key driver of increasing the book value of Net Operating Assets (NOA) and increasing economic profit, cash flow and value of the firm.
Sales growth can occur by using some of the following:
- Discounting price
- Offering additional benefits to customers
- Increasing firm’s product range to increase customer choice
- Increasing inventories and general complexity costs of its business
Good sales growth depends on Sales and Asset Turnover. With a growth in sales and and unchanged asset turnover we can see a change in growth of NOA
∆NOA = ∆ (sales – 1/ATO)
Growth in Sales that reduces Asset turnover such as requiring higher levels of inventories for dollar of sales to support a more diverse product range will also lead to growth in Net Operating Assets.
The key accounting drivers on Return on Net Operating Assets can be shown as the following:
Economic Profit equals Return on Net Operating Assets less weighted average cost of capital multiplied by Net Operating Assets
Economic Profit = [RNOAt – (WACC-1)] x NOAt-1
OR
Return on Net Operating Assets = Profit Margin (Profitability) times Asset Turnover (Efficiency)
RNOA = PM x ATO
Actions to grow sales which in turn will reduce Asset Turnover will increase Net Operating Assets and reduce Return on Net Operating Assets. Depending on which effect is greater this type of sales growth will either increase or reduce economic profit and can either add or destroy value for equity investors. If a growth in sales reduces profit margin by the reduction of rices while having prices kept constant will also increase NOA and reduce RNOA. We need to remember that it is critical to distinguish that sales growth can add value or destroy value for equity investors.
As a student it is best to remember that economic profit framework provides us with a conceptual way to think about good and bad sales growth and how to distinguish between two. What I’m finding in regard to this particular area tonight is that when I discover the right formula and concept for my company for future growth how will I use my knowledge to understand what is being asked in the assessment.
Looking at the frameworks provided I can see how companies can either make a good or bad choice in what they want to achieve in the future. By making right choices the company will expand but if a bad decision is made can the company rectify that decision?
Feedback- Martin Turner on Assessment 2 – Step 1
You gave a good description of the key accounting drivers and also of the process of using our firm’s key accounting drivers to focus on our firm’s economic and business drivers. You also applied some of the key concepts to your own firm, China Outfitters Holdings, including an analysis of past sales growth (which in the case of your firm is past sales decline). You also discussed how to recognise good and bad sales growth.
Your Step 1 would have been strengthened if you had more carefully communicated your responses and opinions to some of the key concepts – what did you find interesting, confusing, surprising or challenging, and why – supported with evidence and reasons from your prior knowledge and previous experience. For example, what issues or concerns do you have about the task of forecasting for your firm?
My Response to Feedback
I contacted Martin to ask if I could update my blog with the changes that were suggested so I can gain a better understanding of the content. Whilst I am enjoying the second assessment pieces, I have realised that there is still so much more that I can learn. I suppose if you put the jigsaw puzzle in front of me and asked me to sort out the puzzle and interpret what it means I could see that at times a piece could be put in the wrong place or even missing.
At the moment when looking into China Outfitters Holdings growth in Sales there is a piece of the puzzle that is confusing me where if I want to predict the future growth what happens if the sales have been decreasing. Do I take a look at the interim report for June 2019 to gain an insight into how the company has been trading for the first 6 months of 2019?
Up until now when reviewing my company, I found that I have been confused revenue and cost of sales. Yes, many people would say they know what that it is but somewhere along the line I have misinterpreted what the meaning of each was. So, what do I do to rectify my query? Dilemma solved!!! Hooray!
Cost of sales is the accumulated total of all costs used to create a product or service, which has been sold. The cost of sales is the key part of the performance metrics of a company, since it measures the capacity to design, source, and manufacture goods at a reasonable cost. The term is most generally used by retailers. A manufacturer would use the term Cost of Goods Sold. The cost of sales line article appears close to the top of the Income Statement as a subtraction from Net Sales. The results of this calculation is the gross margin earned by the reporting entity. Direct Labour, Direct Materials and Overheads and cost of the commissions associated with a sale are general categories where cost of sales fall into. For example:
Beginning inventory + purchases – ending inventory = Cost of Sales
Lightbulb moment!! How could I have forgotten such a simple method of accounting?
Whereas when looking at Revenue I now see that it is the income received from normal business operations and other business activities. Revenue is found at the top line on a company’s income statement. Revenue is considered to be the income a company generates before any expenses are taken out.
This forecasting of a company’s future leaves me a bit bewildered as I’m trying to decipher the different statements to achieve the connection that its needed to achieve an answer that will satisfy the objective required. So now I see that the focus is changing from focusing on the firm’s equity to focusing on the firm’s operations. This where we are being told that by focusing on the firm’s operations will help us simplify the analysis of our financial statements.
The moment when the lights turn on has occurred. The analogy that has just come to mind is when a person has gone to the optometrist. Your vision could have been clouded prior to entering the place where you are having your eyes examined. The doctor uses the different tools to assist with your focus. If the wrong lens is chosen for your glasses, you end up with more vision whereas if he chooses the right lens you will have clear sight. Just like predicting out company’s future unless the right information is used, we will either have a company that is growing or not growing. You cannot look through rose coloured glasses to see if everything is clear.
“Vision without action is merely a dream. Action without vision just passes the time. Vison with action can change the world.” Joel a. Barker
This quote says it all. Can we predict the future of our company? Let’s put the vision into action and go for it.
Follow Up Comments – Martin Turner
Interesting comments. Some people have firms that in recent years have been experiencing declining sales, i.e. negative sales growth. Others have firms that have been experiencing flat or inconsistent sales growth in recent years. And other firms, like Ryman Healthcare, have been experiencing consistently strong sales growth. What has been causing this for your firm? And do you think these factors (economic & business drivers) will continue in the future?
My Response to Follow Up Comments
Interesting you say that as when looking at the revenue the decline was mainly attributable to the revenue received from the sale of products to third-party retailers.
Peer Feedback
Evelyn Peltohaka Iris, I am be on the wrong track but I look at all resources in determining the future. I review any media information I can find.
In real world scenario, you are trying to determine the future (which is by figures) and you may be short changing yourself as in investor, or your client, in not reviewing all available resources. Of course, you need to complete the groundwork in analysing the trends in your fin statements. Good luck with your future judgements. Ev
Peer Discussion – Sharon Field Facebook Post
Sharon Field I have updated my blog with my thoughts on chapter 5 & 6 http://sharonsaccountingdecision.blogspot.com/ The key take out for moving forward is discussion with others. One of the aspects I thought was important for my firm, China Southern Air, is that the injection of capital by the Chinese government does not add value to the equity investor. What is one thing you think is an important economic and business driver of your firm?
Iris N Kees Onvlee China Outfitters Holdings Ltd has a challenging and changing market and their drivers will be investments in brand, business digitalisation and logistics warehousing as this will be used for the purpose of laying a foundation for future growth.
The government subsidies are used as a measure to attract investments in their local areas. These subsidies are determined by reference to value-added tax, corporate income tax, city maintenance and construction tax and any other taxes paid by the group’s operating entities and are subject to the further discretion from the government.
Sharon Field That’s really interesting Iris N Kees Onvlee. I noticed that the usual tax rate of 25% for China Southern Air is subject to PRC agreements which are taxed at 15%, like Advanced and New Technology enterprises. These agreements means large contributions to government projects, one in particular is the ‘Belt and Road iniative’, which is a road and rail project. That seems to conflict with the company’s competitive edge. From discussions and research, it seems the Chinese prefer rail transport to air. I’m struggling to find a positive operational driver for the company.
Iris N Kees Onvlee China has been upgrading the transport infrastructure in 2019. This site might help you https://www.statista.com/topics/1516/transport-infrastructure-in-china/
Sharon Field Iris N Kees Onvlee omg this is fantastic 😀 Thank you so much ✌
Iris N Kees Onvlee You are welcome. Glad I could help
ACCT13017 - Financial Statement Analysis 