Daft ASS2

Step 1

Chapter 4

Instead of providing a direct example of capital market, the author gave us a contrast example, Sydney Fish Market, a real image helping us to gain a clear understanding of capital markets. They are opposite concepts. Capital markets are not like fish markets in which what you see is what you get, they trade in expectations. How risky that is!! That means equity investors must have a number of particular skills in predicting the future depending on some relevant factors to reduce the risks of predictions in decision making. Because I think no one can predict exactly what will happen in the future, there must always be some unpredicted cases which decision makers should have deep considerations.

Understanding the past is the best steps forward predicting the future and the key tool supporting to have a throughout understanding of the past is a firm’s financial statements. So I think providing a high trusted quality firm’s financial statements is an important requirement of any firms.

How we can work effectively with a firm’s financial statement is my question when I know its importance in decision making. Fortunately, then the author let me know an effective way in viewing a business is to restate the financial statements including restated statement of changes in equity, restated balance sheet and restated income statement with operating and financial activities are classified. But I don’t know why we have to separate these two kinds of activities? Also, I wonder why don’t firms prepare and provide restated annual reports because of their importance and for more convenient and easier for investors in making decision? Is it mainly because while working hard with the financial statements to restate them, external entities will gain a full knowledge of firm’s activities like my practical experiments with my company BPI?

The dividends which equity investors receive are not ‘add value’ of firms to them. It is just simply a transfer of value between a firm and its equity investor. I was surprised because I had a misunderstanding before I got this document that dividends like my grandfather receives annually each year are not the profit he gains from his invest. Actually, they are the value he already owns.

Free cash flow (FCF) is also a transfer of value but within a firm, between its operating and financial activities. The more a firm invests into its operating assets, the less will be FCF and DCF approach. Yes, it did make me confuse. Is there any particular ratio? Does this simply mean that when a firm invests more, it will do not have much free cash and discounted leaf? The example of Ryman Healthcare is not about the thing I confused, it is about the expectancy of the firm is to earn grater and ‘add value’ to its equity investors when they invest more into operating assets. I think it is a normal knowledge which lots of people have. Fortunately, another more detailed example of this firm in 2014 did helped understand the relationship between FCF and investing. Because FCF = OI- I so my question is answer. And I also got that if a firm more into operating assets is, the return come in the future will be stronger and that is the way it ‘add value’ to equity investor. So my own short summary for this relationship is the more investment into operating assets, the less FCF and the more value will be.

FCF is a measure of transfer of value, whereas economic profit is a direct one. One important facet in creating value is opportunity cost of capital which requires decision makers to judge and evaluate carefully because you can only invest it in one thing at a time. That may why it is called ‘opportunity cost’.

When we want to know how a firm is adding value to its equity investors, we need to focus on cash flow and economic profit. This information help me to answer my question in the last ASS1 when I did not know that where I have to look at when I want to know whether my firm created any value or not.

Having separate operating and financial activities is necessary when restating a firm’s financial statements. Actually, I did not understand why we need to classify these two things in the introduce paragraphs of this chapter. After reading this section I understand that separating these two activities help us focus on a firm’s operating activities where value is added (or destroyed) and are firm’s interactions with the product and input markets, with its customers and suppliers. Financial activities are firm’s interactions with the capital market, with equity and debt investor to gain a full knowledge of the firm’s activities in given period time. Although the author gave me an understandable image of a small chocolate egg in which the outside chocolate egg surrounding the toy inside is the financial activities and the toy is operating activities, I am looking forward an example of a firm with their particular financial and operating activities. But thanks to this chapter especially the Finger 4-1, I have a clear understanding with these two activities helping me to restate my firm’s financial statement more effectively because when I put information from those statement to excel in the last ASS1, I have no idea about the headings.

The knowledge I gain form ‘Statement of changes in equity’ is very useful for me because it outlined the relationship between a firm’s income statement and balance sheet. Actually, I know that the value of equity (from the previous balance sheet) + the earnings (from the income statement) = the value of equity (from the current balance sheet). After I gained this knowledge, I want to check with my company but I wonder whether the value of equity in balance sheet is the total equity and the earning in income statement is the earnings per share or not?

The thing we need to do when restating a statement of changes in equity is only includes genuine equity because a firm’s equity sometimes can include some debt.

‘Restate two key financial statements’ gives me a very useful knowledge in restating my own financial statements especially balance sheet and income statement. The author suggests us an effective way to separate a firm’s operating and financial activities is to print out a firm’s balance sheet and income statement and to put an ‘O’ (for operating) and ‘F’ (for financial). This way is useful for me because as the way I did is to change the color of operating is red is not as convenient as having a hard copy of these documents. Studying carefully this section help a lot in the most difficult step in restating a firm’s income statement is to allocate tax and I also know that the greater a firm’s profit the grater the amount of tax it have pay. So by looking at the different amount of the total tax my company had to pay each year I can know the profit they created more or less than the other year.

Moving to section 4.4, a thing I confuse is 'All other things being equal' so what are ' all other things'? What are being equal? They are stores, inventory, head offices, car dealership, aren't they? A car dealership usually only make occasional sales of cars each week instead of selling large amounts of goods each day like a supermarket. Do they do accounting every day like supermarkets do?

Break things in a firm's financial performance into its profitability (profit for each dollar of sales) and its efficiency (sales for each dollar it has invested).

Economic profit = (RNOA - cost of capital) * NOA

So economic profit of firms is made up of three things: RNOA, cost of capital and NOA. So I think in order to increase firm's economic profit, they need to invest into NOA and decrease the cost of capital as much as possible.

Making an 'adequate' profit margin is the ultimate aim of any firm. My company's operating profit margin for the year ended 31 December 2014 from its restated income statement is: PM = OI/Sales = £19.9m/£ 499m = 3.98%. My company’s profit margin is quite low and the ‘Sales’ in my company’s financial statement is ‘Turnover’

I agree with the author that most people including me consider profit margin as an important part in creating value to shareholders. But I want to understand why he said that he focuses more on its interaction with efficiency that motivates me moving to efficiency part. After studying this part, I understand that RNOA is not driven by PM only but by the combination of PM and ATO which is the interaction and trade-offs between them (RNOA = PM*ATO).

In conclusion, this chapter let me know where I need to look at in a firm's statement to know how a firm adds value: They are cash flow and economic profit. Also, it brings me the way to separate the operating and financial activities effectively when I restate my company’s financial statements and I have a deeper understanding the importance of classifying these two activities through a wide range of helpful provided knowledge and easily understandable examples.

Step 2

Restating my firm’s financial statements is not easy after studying carefully Chapter 4, I started with statement of changes in equity. I found it is a bit easy and it just took me a short time but there are some of the difficult account names in my firm’s financial statement I do not understand such as ‘Actuarial gain on defined benefit pension schemes’ and ‘IFRS 2 charge in relation to equity settled transactions’. I cannot find these headings in the document of Chapter 4 so I posted them in ASS#2 Forum and discussed with my fellow as well. Then I understand that ‘Actuarial gains and losses’ are accounts using for pension plans to predict about the rate of salary increases, the length of employee tenure, an appropriate discount rate for the plan obligations and the expected rate of return on plan assets in future. ‘IFRS 2’ providing guidance on the accounting for share based payments to recognize share-based payment transactions (such as granted shares, share options, or share appreciation rights) in its financial statements.

Then I moved to restate my firm’s balance sheet. It was a bit harder because I have to separate the operating and financial activities. However it was not too  difficult because almost accounts in my firm are similar with the example of Ryman Healthcare balance sheet so I can use it as an effective tool.

Finally, like many other students, I found it is so challenging to me with tax benefit. Although I got that Tax benefit = Net interest expense * Tax rate of the firm, the results of Comprehensive Net Profit After Tax (CI) are not same with the figures in financial statements. After telling my issue to others students in the course I realized that my problem is the tax rate. Because I used the same tax rate of the year 2014 to multiply with the other year, rather multiplying with their own tax rates which are different in each year (2011: 26.5%; 2012: 24.5%; 2013: 23.25%; 2014: 21.5%).

Step 3

Product 1: Light Duty Refuse Sack, Cube Dispenser

Selling price: $50.00

Variable cost: $20.00

Contribution margin: $30.00

Product 2: Recycled Plastic Planter with Corner Posts

Selling price: $40.00

Variable cost: $10.00

Contribution margin: $30.00

Product 3: Visqueen Heavy Duty Aprons

Selling price: $30.00

Variable cost: $8.00

Contribution margin: $22.00

I estimated these products’ selling price and variable cost and then calculated their contribution margin with no relevant evidence. I just guess and think that the price should be affordable and the amount of contribution margin should make up approximately two-thirds of the total price in order to contribute more profit for my company’s revenues. However, they are quite different for each of my firm’s three products. For example, the variable cost of Refuse Sack may be higher than two others. Although all of them are household products, the amount of sold product of Refuse Sack can be greater than Plastic Planter and Duty Apron’s. It simply because we normally change sack for bin almost every day but we do not buy so many planters and aprons. So the amount of product of Refuse Sack sold will be larger making its contribution margins differ from others. Actually, different products are made from different sources of material, time and labor effort affecting to the fixed cost leading to different contribution margins. The products with the highest contribution margins will have the greater amount of profit. However, because of capacity constraints and firms actually produce everything they can sale to gain profit as much as possible. Therefore firms should not only produce the product with the highest contribution margin.

My firm’s resource constraints can be polymer, my firm’s main raw material, which depends on fluctuating prices for ethylene and, to a lesser extent naphtha and oil. Energy also can be a constraints with my firm because to run the recycling system they need a huge amount of energy converting into electricity or thermal energy.

Some market constraints may impinge my firm can be the competition prices because the cost of recycling is not cheap. But almost of their main products are household goods so the prices they provide should me as affordable as possible to keep their profit. The cost of their material is expensive as well so they need to do research carefully about their available suppliers.