Ass#2 Step 1 – Chapter 4

Analysing Financial Statements

When opening the link to access Chapter 4, in bold letters it states ‘This reading is of a higher level of difficulty’ uh-oh, now comes the hard stuff. I previously supposed that learning about how to analyse financial statements couldn’t be that hard, could it? I guess I’m about to find out…

I am not really familiar at this stage of the relationship between a firm and their equity investors, but I do know that the investors will only receive dividends from the firm. I am aware that firms have a dividend policy that affects how much value is shifted to equity investors in any given year, but I still have a few questions in relation to this to clear my understanding of this matter –

· Are there rules governing the distribution of dividends? E.g., is the policy a legal contract? Or just a guideline for what to expect?

· Can the firm decide to reinvest the dividends instead of giving back to the investors for something such as business expansion for example?

· If so, does the investors have a say in this decision? Or is it based purely on good faith and trust between the firm and the equity investors?

Free cash flow (FCF) and dividends are related. Dividends is the transfer of value between a firm and its equity investors, whereas free cash flow (FCF) is a transfer of value that occurs inside a firm between a firm’s operating and financial activities. FCF is driven by cash flow from operations (C) and net cash invested into a firm’s operating assets (I). Dividends and cash flow are linked to economic profit aswell. Now it makes sense to me! I started reading this chapter yesterday but could not wrap my head around it, to me it was just words jumbled together on a piece of paper. I walked away. Today I have restarted the chapter to try make sense of it all, and it is much clearer today, yesterday my brain would not cooperate.

Firm’s can make the decision on how much FCF they will invest into its operating assets every year. The investments into operating assets are expected to add value to equity investors in the future not reduce value due to them receiving less or no dividends for the year. My previous questions are slowly being answered, great! Still interested to know how much say the investors can have in this situation?

Reminder -

Ø FCF = C – I

Ø FCF = OI – ∆NOA.

Return on net operating assets (RNOA) is a way to measure a business’s earnings. RNOA is operating income after tax (OI) divided by the net operating assets (NOA).

Ø Economic profit = (RNOA – cost of capital) x NOA

Where, RNOA = OI/NOA

To restate a firm’s financial statements, it is required to separate the firm’s operating activities from its financial activities. The operating activities is what we will be interested in. Viewing figure 4-1 and figure 4-1A helped me understand the difference between operating activities and financial activities.

An appropriate level of cash for most businesses to aid their operations is up to 1% of their sales.

The amount of tax a firm will pay depends on the firm’s profits. The larger their profit, the larger the total amount of tax the firm will have to pay; the lower its profit, the less tax a firm will pay. The higher the interest a firm pays on its borrowings, the lower the profit the firm will receive and will pay less in tax. The more interest a firm receives on its financial assets the higher the firm’s profits will be and then the firm will be required to pay additional tax. Therefore, a firm’s tax expense is affected by both its operating activities and also its financial activities.

Important Calculations to Remember!

Ø FCF = C – I

Ø FCF = OI – ∆NOA.

Ø Economic profit = (RNOA – cost of capital) x NOA

Where, RNOA = OI/NOA

Ø Tax benefit = Net Interest expense x tax rate of the firm

Ø Profit Margin = OI/Sales

Where, OI = Operating income after tax

Ø Asset turnover (ATO) = Sales/NOA

Where, NOA = Net operating assets

Ø Return on net operating assets (RNOA) = PM x ATO

Where, PM = OI/Sales and ATO = Sales/NOA

Wow, there is a lot to take in this chapter. I have understood everything that I have read but, I will definitely need to revise all my notes again to make sure I am 100% familiarised with everything and to make sure all the information my brain has processed has sunk in!