Step 2

“Someone is closing deals today, regardless of the weather, economy, politics, or any other excuses. Get out there and add value to people’s lives by helping them move forward toward their financial freedom, peace of mind, and legacy.”  ― Farshad Asl

CHAPTER 2 – How a Firm Adds Value

Adding value to a firm means more than buying in the past. It is a way in which we invest in the future the strategies which a made in the present. If we can get over the first hurdle of understanding how a firm adds value, we will be able to recognise and understand its strategy. However, to do so we need to discern the key aspects of a firm’s strategy.

What I see here is that we need to see where the journey of analysing Financial Statements will lead. There needs to be a starting point to what business strategies will be used and to allow us to use real capital resources within a business strategy to show where a firm will need or intend to use to add value.

KCQ1 – A Firm’s Strategy

My understanding of this section is that to find a firm’s strategies we will need to delve into the intricacies of how a firm is performing and what strategies it has set in place. This is not just found within the financial statements but throughout the firm’s business in general. This will give us a direction of where the future of the firm will be. For the firm to ‘add value’ we will should see that its future earnings will or should be greater than the use of it cost of capital.

This can be seen in the following:

  1. Concept of strategy – what we will find here is that to view the strategy we need to see the intentions of a firm. It is like having a dream or idea and making an impact on the business world.
  2. Selling their futures – by focussing on the firm’s foundational skills it should not be the focus we need to recognize how to assess firm’s strategies that will in turn assist us in the financial statement analysis.
  3. Exceeding the cost of capital – however we need to ensure that we do not focus on the wrong issues when seeking to assess a firm’s strategy.

KCQ2 – Assessing Strategies

When we adopt a financial perspective in the analysis of Financial Statements a strategic plan would be put in place where adding value to a firm would help to engage and assess the business realities of what strategic insight has been developed.

  1. Never seen a strategy – we see that focus is the key to success and companies that focus their efforts within their completive environment will find that it may not be easy and yet with genuine added value will consistently do better than other companies.
  2. The Five P’s for Strategy – by using the 5 P’s strategy a company has the opportunity to engage different strategic management tactics to diverse opportunities. Using the plan, ploy, pattern, position and perspective techniques will help engage interest within the structure of the company which we will be investigating.

KCQ3 – Can the accounts be trusted

  1. What the accounts leave out – A logical approach on the financial statements will endeavour to give us an insight as the what the firm leaves out in its statement.
  2. What the accounts confuse – when looking at financial statement analysis we need to take a step back to consider whether there is any confusing information within the statement to give a sense of believing the accounts are correct.

When looking at these two areas both managers and accountants when checking financial statements have an ethical responsibility for making sound judgements in how the firm is performing. Being kept accountable the firm needs to take the responsibility of having the firm audited externally. Having the firm audited will ensure that accounting standards and conventions are consistent.

KCQ4 – Accrual Accounting

  1. Reveal or disguise reality – this is an important finding as it will show whether the firm is trying to hide any of the business goings. Although the firm can use discretion it must not attempt to manipulate the accounts to make a firm look better when in reality the firm could be in a big mess.
  2. Accounting choice of Ryman Healthcare – in this situation management has to remember what choices have made a significant impact on the firm’s financial statements.

Examples that showed sound judgement of how the firm’s accounting treatments were in the following:

  1. Level of bad debts provision
    • Selection of depreciation
    • Recognition of revenue
    • Basis for revaluation

CHAPTER 3 – Many Ways to Assess Value

What we will find in this chapter will be ways to analyse financial statements. Using different approaches, we will look at the different approaches and methods used to assess the conceptual framework of the firm.

KCQ1 – How Practice Developed

  1. Availability of financial statements – in this area we see where the concept of ratios came into being and became the key part of analysing financial statements. Using this judgement gave a firm the ability to analyse different concepts of their working in the financial statements. This concept is still being used today within the analysis of financial statements.
  2. Just do what works – as early as the 1890’s banks when assessing credit applications asked for a firm’s financial statements and through quantitative and qualitative processes made judgements on these accounts. The ratios were used to assess the relationship between current assets and liabilities of the firm. One thing to remember as per the saying of Warren Buffet on investment is to not put all our eggs in the one basket however Andrew Carnage added that if you do then you can watch your basket grow. However, using ratios should be one of many tools that can be used to assess financial statements and how this will reflect the business goings on.
  3. Use a Structure – Over time there have been many different frameworks or structure used to assess financial statements and the use of ratios. These structures have been as follows;
    • In 1919, the analysis of profit margins and turnovers of major manufacturing enterprise were used by the du Pont company (US). The relationship between profit and total assets found that using rations had little effect on what happened outside the company.
    • In 1923, James Bliss tried to use a framework of integrating the growing numbers of ratios. From this we will see how this approach was used in DCF and Economic profits to analyse Financial Statements.

KCQ2 – Theory and Practice not Connected.

Is the use of ratios helpful when analysing financial statements? This is one of many questions that have been asked over time. Is there a specific focus used to analyse financial statements? These are just two of many questions that can be asked within this subject.

  1. Asking the wrong questions – 1930 saw how the usefulness of different rations helped to predict the future of a company and some of these did fail in their attempt to analyse the financial statements. 1968 William Beaver using a more statistical approach was able to show how ratios could predict the failure of companies.
  2. Connect to current reality – we see here that by connecting the analysis of financial statements and using ratios we will be able to connect to the existing economic business drivers. This subject will give us an understanding of being able to do things well. Doing things well will come in two parts:
    • Being able to identify and forecast the economic drivers of a business and its future
    • Using these forecasts by connecting financial statements, ratios and quantified dollar value to the firm’s future.

KCQ3 – Comparables

By comparing different firm’s financial statements, we are able to find extensive information about industry and economic information and be able to asses the value of a firm.

  1. To see practice – using different practices we will be able make informed decisions on the practices of a company.
  2. Comparable firms – Using a multiple range of measures we will be able to evaluate ratio of market capitalisation with earnings, cash flows, sales, book value of both equity and assets
  3. No insights into value – the only theoretical basis that has been identified is the valuing of the equity of a firm’s value and what equity interest the firm is entitled to (firm’s value)

KCQ4 – Forecasting Dividends, Cash Flows or Earnings

Here we see that the are different methods and approaches that can be used to help us connect to the business realities of a firm.

  1. Discounted dividends – assessing the equity value of a firm for the present value of expected future dividends we can use the following formula:

Equity value = PV of expected future dividends

  • Discounted cash flows – This is where we build a relationship between dividends and cash flows

Dividends = Operating cash flow – Capital outlays + Net cash flow from debt owners

D = C – I + F

In this we find that Operating Cash Flow (F) Less Capital outlays (I) is known as Free Cash Flow (FCF) so FCF = C – I.

The we see how the relationship build to the following:

Dividends (d) = Operating cash flow (C)– Capital outlays (I) + Net cash flow from debt owners (F)

= Free Cash Flow (FCF) + Net Cash flow from debt owners (F)

Formula: d = FCF + F

  • Economic Profit – we find that when the opening book value of equity plus comprehensive income less expected dividends will equal the expected closing book value of equity. Thus, the formula will be as follows: BV1 = BV0 + CI2 – DIV1

We will also find that when Abnormal earnings will be the difference between Abnormal earnings (AE) and Comprehensive Income (CI) and this gives us the measure of the accounting earnings of a firm

What I’m finding interesting about this week readings?

Reading through the two chapters I am finding that the framework is being laid out for the Step 3 – 6 and that using this information we will be able to understand the financial aspects of our company that we will be assessed on.

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