Chapter 4: Analysing Financial Statements

Free Cash Flow
This was a big lesson for me as I automatically just assumed if a company had a good cash flow that it was a goer!  I never thought whilst cash flow indicates how much cash is available for the business it is not a good gauge of profitability and says nothing about if the company is adding value and moving forward.  To me this is kind of the same mistake I made with just assuming if an entity had a lot of cash at bank than it was also a sure thing??!!

Profitability and efficiency
I would sum up economic profit as how the business is using its assets (RNOA) to create value.  Are they performing efficiently and effectively or could the resources have been utitlised better in another manner?  In my view a company can still be profitable but not working efficiently however over time contributing factors to the inefficiencies will do a full circle and will catch up in the end.

 ‘Opportunity cost of capital’ is another concept I have used numerous time for making decisions for personal reasons.  Years ago when I was trying to convince my partner the benefits of purchasing an investment property and using this is to negative gear and get a tax benefit over the dead money we were paying in tax.  He was of the opinion to play it safe and put any spare cash into the bank and earn a little interest.
I thought the ‘opportunity cost of capital’ would prove to be more beneficial over time spent in property investment and tax relief.  Then the market in Port Douglas has pretty much slowed right down to a crawl so the jury is still out on that one, lol!

Dividends and cash flow
This is still a subject of confusion for me.   I don’t even know where to start with why this confuses me – but I am pretty much at a loss as to how a company decides how much dividends to pay, retain and so forth. 

Restating Financial Statements
The essential reason for restating each of the financial statements is the same – to clearly separate financial activities from those of the operations.  My thoughts are that the operational side of business is the fundamental side of WHY a business IS in business and the reason as to whether or not operations will be successful or not – the financial side is almost the ‘side-car’ of the operations.

Operational activities are the everyday interactions of a business – suppliers and customers.  When looking at an item trying to decide whether it is financial or operational I just think “is this as a result of an interaction between the business/supplier/customer?” – if yes, then it is operational.  If not, it would have to be as a result of a financial transaction with a debt or equity investor and therefore a financial activity.

I think my biggest questions to date would be about goodwill. I honestly cannot decide financial or operational – it seems to be sitting on the fence.

Tax Benefits
Going back to my example of discussing my desire to purchase an investment property with my partner.  Essentially what I did was roughly give him a before and after picture of what our tax assessment would look like if we proceeded with the purchase.  The big incentive was the tax break would we receive as a result.  This along with the “cost of capital” and other potential uses and the fact that the property value is increasing (slowly) all ended up with us going ahead with the purchase.

Why we are restating financial statements
In my view, why were are restating financial statements is to give a no-frills view of the operations of our business, a clean picture of what is happening with the cogs and wheels.  As I stated before, the financial side is a by-product, of course essential, but is not what makes a business tick.

Step 2:  Restating Your Firm’s Financial Statements
Issues and concerns
On face value I felt that it was quite easy to decide what is operational (supplier/customers) and what is financial (equity/debt).  What I have struggled with is when I start to think further about the “root cause” of an activity.  For example Cash flow hedge - loss/gain taken to equity:  From my what I can understand that hedges are a way of accounting to provide a type of offset for a probable variation in cash flow.  As the cash flow is almost certainly to be as a result of operations I would list this as operational.  But then if I think about it even deeper – the results are transferred over to equity so should it go under financial?  I went with operational, as I believe the activity is present because of operational needs.

Repayment of shareholder's loans and share based payments - should these be excluded from equity and recorded as a liability as they relate to a debt and/or payment of a debt??  Logic says that this would be genuine equity as it is a repayment therefore putting the value back into the equity bucket.

The general consensus on Goodwill is that this is an operating activities however I am still of two minds.  I can see both sides - goodwill is generated from the acquisition of another entity as is the reside difference between purchase price less recognisable assets and liabilities.  It is an intangible asset not derived from operations namely interaction with customers or suppliers.   In saying that, it could be assumed this asset would be associated (and apportioned over cost generating units) with everyday operations such as brand names, licences etc – but who decides this? I keep thinking as it really is nothing for something it therefore feels like a financial type of transaction which would 'store the value' of the difference in price after assets/liabilities. 

Investment in associate - this looks to be the distribution of shares in an associate company being 'iinet'.  I had fully decided to that as this is an investment activity and relating to equity so I was going to list it in the financial section but then again, this company was acquired and is used in operations and revenues and expenses would be incurred as such? 

In specie distributions was another area of confusion.  I have decided as it is shares and will be held for use as a “payment in the same form” being shares then it fits into the financial slot.  But again, what if it use as payment in a deal with suppliers – I have to make an assumption that this then would change over to operation as it is now in a transaction within the customer/supplier realm?

Amcom’s original Statement of Change in Equity was extremely clean and had already separated other comprehensive income/expenditure (see below), I just needed to find out what it was and allocate F or O.  This therefore filtered through to the Income Statement so again, nice and clean.

Due to the nature of this assignment and personal judgement required, I very much hope that these assignments are compressively marked with in-depth feedback as to the allocation of financial or operational activity, otherwise I feel probably wont get much out of this section as I have been quite unsure of some of the allocations I have made.

Unfortunately my conversations online or trolling through blogs from this year and last, didn’t provide any firm answers towards my uncertainties and I assume this was simply because most students, like me, were unsure.  I absolutely hate (and feel it is a little unfair also) that I will probably look marks because I have not contributed to many conversations this assignment piece, nor received any feedback for questions I have posted.  Unless I am sure of what I am saying or feel I have accurate input which I can back up, I will not add meaningless or erroneous contributions that may contribute to others other students loosing marks.  I am more than happy to wear and learn from my errors but I still have trouble that I could steer others in the wrong direction. 

I also need to mention that one-liners such as “Goodwill is operational” is completely unhelpful unless there is some logic or reasoning provided – I would just disregard this answer as a guess otherwise??!! 

Step 3:  We have got to make some decisions
Due to the variation and combinations available for products and services, I am going to make up a hypothetical products and service with completely estimated costs, within each of the following categories.

5 Products and services

Users can securely access data on mobile devices and tablets such as iPads, iPhone and Android devices
1TB remote server access/month
Sell Price:
$1200
Variable cost:
-
Contribution margin:
$1,200 [CM ratio = 100%]


This provides data storage requirements and reduces the need for costly investments.
Server rental 20TB/month.
Sell Price:
$7,500
Variable cost:
-
Contribution margin:
$7,500 [CM ratio = 100%]


This service consolidates, controls and maintains the licensing and maintenance including renewals and requests for service.
Adobe Professional licence yearly.
Sell Price:
$1,500
Variable cost:
$600 – cost of licence from product owner
Contribution margin:
$900 [CM ratio = 60%]


Data and Internet services Network solutions provide highly reliable, flexible, and easily scalable. 
2TB data year contract.
Sell Price:
$2,100
Variable cost:
$ -
Contribution margin:
$2,100 [CM ratio = 100%]

Supply and install of 50 Cisco integrated phones
Sell Price:
$30,000 - 50 x $600/phone
Variable cost:
$10,000 - 50 x $200/phone
Contribution margin:
$20,000 [CM ratio = 67%]
                                    =       $10,000 variable cost of goods sold
                                    =       $  4,600 variable cost of goods sold

As Amcom is a service-based company it has relatively little to no fixed costs.  This is completely normal as the vast majority of costs incurred in the IT industry are predominately fixed.  For example the amount of data/access ports etc needs to be predetermined and contracted out from suppliers, then reviewed periodically to ensure customer demands are met.
Although the amount of data/access ports required to be purchased for on-sale will vary, this costs would still be considered fixed as it would only change after a period ie – contracts reviewed and locked into place over say a 5 year period.  Fixed costs will still vary but not in a direct with changes in activity levels as would variable costs associated with purchasing beef patties at a MacDonalds franchise.

The obvious risk with this situation is one of insufficient utilisation of this ‘inventory’, which then requires the company to absorb the residual costs of unsold goods, inturn increasing cost of goods sold.  I guess this is the nature of the beast, possibility of too much or too little.

One of the variable costs I have identified (hypothetical) was the purchase of 50 Cisco integrated phones.  This would be considered a variable cost for the business as it is a cost that will vary as a consequence of activities levels.  For example:

50 x phones purchased  =       $30,000 revenue
23 x phones purchased   =       $13,800 revenue

Constraints

Possible constraints Amcom may face could include restrictions on network reception eg positioning of signal towers and fibre optic cabling infrastructure.  The risk of capital outlay required to extend boundaries of an existing network may out weight the possible revenue.

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