Chapter 4
The main content of this chapter is what the title says, recognising the past. The past is basis of present and future. Without an analysis of the past, there is no more accurate judgment of the future. I prefer the references to Machiavelli in the text, use the past as an important foundation to predict the future.
KCQ: Abnormal Earnings
The first important piece of knowledge in this article is abnormal earnings. Literally, abnormal earnings refer to stock earnings after deducting normal returns from the actual purchase salary of the share. As we have said in daily life, events such as mergers and acquisitions, dividend announcements, and company lawsuits may bring abnormal returns. If the abnormal earning is “positive”, we can assume that the affair has a useful influence on the price of share; for example, the company acquired another company through normal legal business channels, and this event caused the company’s stock price to rise. Excluding the company, if the abnormal earning is “negative”, we can affair that the event has a bad influence on the share price
The calculation of Abnormal Earnings formula is “AE = [ROE – (ρE-1)] x BV“.
Of these, what interests me most is the required return on equity expressed by the abbreviation and the number. Why are other projects only represented by abbreviations, and the required return on net assets requires a rate of return minus 1. According to the example in the article, the required rate of return is 10%, and we express ρE as 1.10. To get back to 10%, we subtract 1 from the formula. I can’t understand this explanation, so I reviewed the GST knowledge I learned before and found that the two knowledge points have something in common. If a product is included GST, then if I want to know how much the original price of this product is, I need to divide the price of the product by 1 + 10%. Here, the 10% GST prescribed by the Australian government is equivalent to ρE, which is a fixed value. I don’t know if I understand it this way.
KCQ: Restating financial statements
The second point is restating financial statements. The aim of financial statements restated is to make our task of analysing abnormal income drivers more effective. Restatement of financial statements is the re-preparation of the company’s financial statements, which plays a role in checking for omissions. The previous financial statements are like a draft. After re-preparation, they will become more complete and then become a formal draft. In the process, you can find incompleteness and errors in previous financial statements. The article also mentions the course ACCT11059. Although I have not studied this course, I understand that the principles of learning are all the same. There is no shortcut to doing and learning by doing.
The most important and fundamental step to restate financial statements is to clearly detect the company’s managing and economic activities I think. In this regard, I can talk about my experience. First of all, I would like to thank Martin for his guidance on my restated financial statement, because when I first prepared this assignment, I had no clue. The financial statement of the company I researched is very complicated. There are some items that are difficult to distinguish between business and finance, such as cash and cash equivalents. This project literally means that it is a financial asset, but after I watched the video that Martin shared to me, I realised that cash and cash equivalents belong to financial assets and operating assets. Because of some reasons, I couldn’t go to class, so I lacked face-to-face interaction with the teacher. Thanks again for Martin’s help.
I uploaded a draft of the restated financial statement I made as a screenshot. As can be seen from the figure, the restatement of the financial statements subdivided the previous financial statements into several categories. This method can ensure that investors can see the true situation of the company’s operations. I put the specific steps that I made a restated financial statement in the next point, and interested readers can continue reading.
The next key point is the statement of changes in equity. Without say more, this knowledge is still related to the excel form. Recently, because of this form, I especially want to return to the school to go to class, so I can ask the teacher about how to classify the problem. Closer to home, the company’s assets can be divided into several categories, of course there are current assets and non-current assets, and the classification I am talking about here is divided into operating assets and financial assets. Operating assets are the income earned by the company from producing products and services for customers, such as operating revenue, Gain on disposal of plants, equipment and property. A characteristic of these assets is that if the company suspends operations for some reason, there will be no change in growth or reduction of these assets. Financial assets refer to the stored value that a company applies to its operations. For example, interest.
I quote a picture in the article that can clearly express the relationship between operating assets, financial assets and various factors.
Net operating assets funds are made by producing services and product for customers. At this part, operating revenue are produced. At the same time, net operating assets will give part of the funds to suppliers to produce products and generate part of operating expenses. Net financial assets involves interactions with debt and equity capital markets, that is, debt investors (F) and equity investors (d) showed. Because net financial assets refer to assets that enterprises do not invest in operating funds, most companies deposit this part of funds in banks. But if the funds are invested in banks, what does it have to do with equity investors and debt investors?
Balance sheet, income statement and cash flow are the three most important financial statements. The balance sheet usually shows company’s assets, which is divided into current assets or non-current assets. Income statement indicates the income and expenses of the company during this period. The purpose of the income statement, except recording the income and expenses of the company, another purpose is distinguishing business and financial income and expenses, in order to determine net financial expenses and after-tax operating income.
I started to describe the KCQ of this article before I prepared the restated financial statement. At that time, I was just describing the surface meaning of the text, but when I really started to prepare the restated financial statement, I found that I was not sure about each of these. Whether it belongs to operating or financial, it really stumped me. Then my question is very simple. Is there a way to judge accurately, which one is about operating and which one is about financial?
KCQ: Restate Two Financial Statements
Although I have already mentioned some of my experience with the restate balance sheet and Income statement in the Restating financial statements project, I still want to exchange some experiences of this content, because this is the knowledge about step 4 and 5. According to what I said before, the essential to restate two financial statements is to correctly divide all the items in the two reports into financial and operating. I take the company I analyse as an example.
- Separate the items with income and the items with expenses.
| Income | Expenses |
| Revenue | Cost of sales |
| Other income | Selling and general expenses |
| Other gains-net | Research and development expenses |
| Administration expenses |
- Check every project of income, expenses and other comprehensive income, and distribute between operating activities and financial activities.
- Immediately following the distribution of taxes in the operating and financial portion of the income statement, this is the most important stage, because this will be linked to net financial expenses.
- Finally, the company’s net financial expenses (NFE) and operating income (OI) are calculated after tax. The same applies to restated balance sheets.
- In the end, I was inspired by the video that the restated balance sheet is successful when net operating assests (NOA) project equal the total NFO + Equity project.
KCQ: Analyse ROE: Leverage, Profitability
Let me study leverage. As we all know, the lever uses the long extremity to drive the short extremity.
This means that in a period of good economy, the leverage ratio will show a good direction, but in a period of economic downturn, the leverage ratio will cause trouble to the managers of the enterprise. Leverage is divided into financial leverage and operating liability leverage. The calculation formula for financial leverage is “FLEV = NFO/Equity“.
Financial leverage is a tolerance of the influence financing certain corporate operating assets through the debt markets net debt rather than shareholder equity. One example vividly describes leverage: I would ideally have 100 cows. In this way, I can expand production and sell more milk, move to larger farms, do bigger businesses, and make more money. But the reality is, I only have 50 cows. So, I loaned 50 more cows to the bank and realized my life ideal. This is the essence of leverage-liabilities. That is to borrow funds, put into operation, and use a small amount of principal (50 cows) to pry larger assets (100 cows).
A leverage is composed of two parts, the financial leverage is the long end, and the short end is the operating liability leverage. Operating liability leverage is a method of the effectiveness of creditors like suppliers or customers to finance certain total operating assets of a company through products and inputs to the market. What I understand is that when the leverage of financial assets is long enough at the same time the leverage of debt is short enough, the company’s return can be maximised. High leverage means that during the economic prosperity, financial institutions can obtain higher returns on equity, but when the market reverse, they will confront the risk of a major decline in returns. The return that leveraged companies can generate for their stock investors can be calculated by
“ROE = ROOA+ (RNOA-ROOA)+ (ROE-RNOA)“
Just like the leverage I have seen in daily life, the section that lifts a heavy object also has its maximum value, and the same is true for the leverage ratio. Although the leverage ratio can ensure that some high-quality levels’ capital be owned by bank in a good economy, because leverage does not differentiate between assets with distinct hazard and all assets need claims the same capital, so stimulate banks to effectively command asset hazard is difficult.
Profitability is also an important factor in return on equity. In layman’s terms, profitability is the company’s ability to make money. Without profitability, the company would soon go out of business. Therefore, it is regarded as the core of corporate activities to some extent. In this chapter, profitability can be calculated by
“PM = OI ÷Sales“ to calculate. The calculation of profitability is like how many bosses I can beat in a limited time when I play a game. Using operating income ÷ sales income, I can accurately observe the company’s sales revenue as a percentage of total operating income in a fixed period of time. Of course, the larger the profitability ratio, the better. The larger the ratio, the more the company relies on selling products to obtain funds. One of the typical representatives in my heart is Disney, and Disney has launched a lot of characters that children love. These characters were first launched from the theater, and later developed again through DVD. Then the company collected a TV network license fee, launched a sequel for it, and derived products, which eventually became attractions in the theme park. Every step of this means that the company’s profitability is growing. Because each newly developed franchise has become a valuable added value, making Disney’s huge content library richer, and in the next few decades, it will be able to create revenue for the company like a money printer.
KCQ: Analyse ROE: Efficiency and Leverage Revisited
Efficiency is the last component of return on equity. In layman’s terms, efficiency is the ability to generate sales or turnover. In our daily life, everything we do appears efficiently. Effective time to get up, effective time to wash, study and work are inseparable from efficiency. The most intuitive example is that step 6 is recommended to be completed in 3-3½ hours, but I completed the same quality KCQ in only two and a half hours, then my efficiency is higher. Efficiency is a top priority in running an enterprise. Efficiency is surveyed by the assets and turnover, it is called (exceeding) asset turnover (ATO). When asset turnover increases, companies will have more funds to invest in production and operations. Conversely, when asset turnover becomes low, companies are constrained by insufficient funds and repayment of loans. This relationship can be written as
“ATO = Sales÷NOA“
The special relationship between profit margin (PM) and asset turnover rate (ATO) is the formula for calculating the return on net operating assets (RNOA):
“RNOA = PM x ATO“
Through this formula, I can see that the connection between RNOA and the other two factors is directly proportional. When one or both of the profit margin or asset turnover rate rises, return on net operating assets RNOA also rises. high. By the same token, when they both fall, return on net operating assets (RNOA) also fall. The most direct message from the RNOA drop is that the business is not doing well.
Another term is called net borrowing costs and it can be showed
“NBC = NFE÷NFO“
Since I have not yet done a systematic classification, I cannot answer most of the questions in this chapter. But I believe that when I thoroughly analyse the financial statements of the company, this guide will be the best reference material that I think other students recommend.
In summary, the focus and difficulty of this article are the memory and calculation of formulas and the expression of abbreviations. At my current level, I need a lot of time to memorize formulas and use formulas in practice. So, I made the formula and all the abbreviations into a table to facilitate my learning and memory.
| “AE = [ROE – (ρE-1)] x BV” |
| “FLEV = NFO➗Equity” |
| “ROE = ROOA+ (RNOA-ROOA) + (ROE-RNOA)“ |
| “PM = OI ÷Sales“ |
| “ATO = Sales ÷NOA“ |
| “RNOA = PM x ATO“ |
| “ROE = RNOA + (FLEV x SPREAD)“ |
| “NBC = NFE÷NFO” |
| “AE is abnormal earnings”. | “FLEV is financial leverage”. | “RNOA is the return on net operating assets”. |
| “ROE is the return on equity”. | “NFO is net financial obligations“. | “PM is profit margin“ |
| “ρE is cost of equity capital”. | “ROE is the return on equity“. | “Oi is Operating Income after tax“ |
| “BV is book value of ordinary shareholders’ equity”. | “ROOA is the return on operating assets without leverage“. | “ATO is asset turnover“ |
| “FLEV is financial leverage“ | “NBC is net borrowing cost“ | “NOA is net operating assets” |
| “SPREAD is operating spread” | “NFE is net financial expenses” |
All formulas and abbreviations explained from chapter 4
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