“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself” – Warren Buffett
Today I have had a day where some tasks that I have attempted have been a bit daunting so as I have opened up this week’s assessment, I am looking at an area that has much going on within the pages of the book. The task of looking at financial statements and evaluating the different areas and how I can put all the thoughts onto paper are showing me that there will be a way and method of completing this task. So, I need to take on Warren Buffet’s words from above and put them into action. Here’s to seeing how you can get rich by not focusing on the past.
CHAPTER 4 – Understanding the Past
As individuals we have the intuitive desire to look at what happened in the past to determine what can be foreseen in future events. Through this study, we have been looking at past accounting events to give us an understanding on what will or will not happen in the future. By using different accounting techniques, we will be able to determine the different drivers to identify a firm’s economic profit, cash flows, and the separation of both financial and operational activities.
KCQ1 – Abnormal Earnings and Restating Financial Statements
My head hurts as I now see that within the accounting system, we have two terms that mean the same thing – abnormal earnings and residual income. Both of these are an accounting measure of ‘value add’ for equity investors. No wonder people who do not do accounting get confused with so many different words with the same meaning.
Looking at this area gives us an understanding that abnormal earnings are a key factor in determining the accounting drivers. We see that we need to consider all the earnings of the firm as we consider the value of the company.
Using the following formula will give us the accounting drivers of abnormal earnings.
AE = [ROE – (pꓰ-1)] x BV
Where the ‘drivers’ of Abnormal earnings are:
- Return on equity (ROE)
- Required rate of return on equity (pꓰ-1); and
- Book value of ordinary shareholders’ equity (BV)
Whilst looking a statement of changes in equity I see that we need to do some sort of reconciling of statements. By looking at the beginning and ending balances of a company’s equity during a reporting period we will need to reconcile these to come to an understanding of the statements being put forward. How are we going to separate a firm’s operating and financial activities? Taking a conceptual view of a firm’s activities reminds me of how a person a half empty glass of water. The pessimist sees the glass as half empty, the optimist sees the glass as half full and the accountant it sees the glass in balance so when looking at financial statements, we need to take all into consideration.
KCQ2 – Restate Two Financial Statements
In this system to restate financial statements we will need to allocate assets and liabilities into either Operational or Financial from the firm’s balance sheet. However, there will be one difficulty along the way will be how cash was allocated and assumptions will need to be made at how best to allocate. This will then give us the Net Operating Assets (NOA), Net Financial Obligation (NFO) or Net Financial Assets (NFA).
What is the purpose of doing all this? At this point we need to restate the Income Statement and to do this will be to establish a game plan – being separate operating and financial revenue and expenses and then make a determination of what is Operating Income after tax (OI) and Net Financial Income after tax (NFE or NFI)
KCQ3 – Analyse ROE – Leverage and Profitability
So, what is ROE? This is Return of Equity and is one of the accounting drivers of Abnormal earnings.. This is the Lego blocks theory. You are given the pattern for making the project and for some reason something has gone wrong and you have a piece over and not sure where it should have gone. You now have to pull it apart and analyse where it went. Curiosity has got the best of me here. Where do we start? Well get out the manual and take it apart. To analyse this, we need to break Return of Equity (ROE) into three bits: leverage, profitability and efficiency.
Leverage reminds me of a saying give a man a fish and he eat for a day. Teach him to fish and you’ve sacrificed your leverage. This shows that with a little bit of effort from one can result in a multiplied effort at the other. When we separate the operating and financial activities in a firm’s financial statements, we will also be able to identify the operational and financial leverage of a firm. These two aspects of leverage combine to reduce the amount od equity needed to fund a firm’s business activities and acts as a lever on the returns of a firm providing equity investors compared to the returns earnt on its operating assets.
KCQ4 – Efficiency and Leverage Revisited
What is efficiency in Accounting? Efficiency is how well Net Operating Assets (NOA) have been used to generate Dales or turnover by a business. The measurement is called Asset Turnover (ATO) which is the relationship between Assets and turnover. This can be defined as follows:
ATO = Sales / NOA
As seen earlier we see that financial leverage (FLEV) is the relationship between Net financial obligations (NFO) and shareholders’ equity. The relationship can be expressed between ROE and RNOA as follows:
ROE = RNOA + (FLEV x Spread)
The difference between the return a firm can earn on its Net operating assets (RNOA)and the cost to the firm of borrowing (Net borrowing cost or NBC) is the Operating spread (SPREAD). The Net borrowing cost formula is as follows:
NBC = NFE / NFO
Where NFE = Net financial expenses and NFO = Net Financial Obligations.
What do I see in this chapter that from prior experience I can relate to?
In my understanding organisations that I have been involved in over the years have seen good and bad years and most of this comes down to how the different businesses had predicted what their operational and financial activities would be. Some have found that they have missed vital information that has made a significant impact on the future of the company. Others have evaluated their firm to find that what they budgeted was better in reality than on paper.
ACCT13017 - Financial Statement Analysis 