Ratios and Economic Profit

Economic Profit/Loss:

The Economic Profit/Loss shows how much money the firm has made over and above its expenses and its cost of capital (the opportunity cost). This figure needs to be positive, a profit. It uses the weighted average cost of capital (WACC), which is the percentage of the opportunity cost to the firm. It represents the rate of return on investment (ROI) that could have been made on another existing investment option. This is exceptionally important for a firm. For GSL, with a WACC of 10%, the results are terrible. They have not made an economic profit for any of the four years, but rather have made large economic losses. This suggests that GSL is an extremely bad investment option for shareholders.

 

How do your firm’s ratios differ to the ratios of firms of other students?

Steven Minehan’s firm of Dynamic Holdings Limited has excellent profitability ratios, poor efficiency ratios, good liquidity ratios, is more equity funded compared to debt, and has great earnings and dividends paid on shares. The firm has mixed ratios based on reformulated financial statements. Return on Equity (ROE), Return on Net Operating Assets (RNOA), Net Borrowing Cost (NBC) and Profit Margin (PM) are all pretty good. However, for all four years the efficiency ratio of Asset Turnover (ATO) is very bad and there are large economic losses.

Scott Anderson’s firm of Credit Corp Group Ltd has great profitability ratios, poor efficiency ratios, excellent liquidity ratios, is more debt funded compared to equity, has great earnings and dividends paid on shares and has excellent ratios based on reformulated financial statements (except for Asset Turnover – ATO). His firm is excellent. It is making excellent returns and has large economic profits for all years.

Kimsoth Ryan’s firm of FirstGroup PLC has modest profitability ratios, good efficiency ratios, average liquidity ratios, is heavily debt funded compared to equity, has modest earnings and dividends paid on shares and has great ratios based on reformulated financial statements (a pleasant surprise to finish). Her firm is the only one I have seen with a good efficiency ratio of Asset Turnover (ATO), being greater than 1.

My firm of Greatcell Solar Limited has poor ratios everywhere compared with the firms of these other students. Although, my firm has an improving Asset Turnover rate and still has a good Current Ratio. So, as bad as things are, it’s not over yet.

 

What do your firm’s ratios tell you about how well your firm is performing?

The ratios of my firm tell me that the firm is performing very poorly. They are making no money, but are rather losing money in a big way.

 

What new questions the ratios might raise in your mind about your firm?

No new questions were raised in my mind about GSL.

However, I could see, from the comparison with the firms of other students, that the economic profit relies on the RNOA being greater than WACC. If RNOA is not greater than WACC than there will certainly be an economic loss. The reason for this is that you will be multiplying by a negative figure. This was the main reason for the economic losses that I saw. Therefore, RNOA is indeed a key driver of economic profit.

(RNOA – WACC) x Net Operating Assets (NOA) = Economic Profit/(Loss)

 

Economic Profit Discussion:

My firm has large economic losses for all four years. I believe the key thing driving this is the large losses seen in the operating income after tax (CI) figures. The net operating assets are clearly not generating enough revenue. Therefore, there are large negative RNOA figures. As a result of this, there is a negative figure, in economic loss, for each year. The economic loss figures are roughly the same for all four years. Perhaps the most recent economic loss is lower than the other losses, but this is only because the net operating assets are a bit smaller because of the increased operating liability of ‘trade and other payables’. Perhaps the firm is also falling behind in paying its bills.

In comparison with the firms of other students (Steven Minehan, Scott Anderson and Kimsoth Ryan), I can see varying results.

Steven Minehan’s firm of Dynamic Holdings Limited has large economic losses for all four years, despite having good RNOA and PM, and big, healthy and positive NOA. However, his firm has really bad ATO, worst than my firm. This probably means that his firm is not efficient in making sales transactions, despite making excellent returns when the firm does make sales transactions. His firm simply needs to make more sales. Perhaps his firm isn’t as good as I initially thought it was.

Scott Anderson’s firm of Credit Corp Group Ltd has excellent economic profits for all four years. His firm has RNOA above 10% and positive NOA, and therefore can expect an economic profit as a certainty. The firm also has a PM above 20%, which is excellent. However, the firm also has an average ATO. Therefore, to continue the great results, the firm is going to have to make more sales transactions in the future. In other words, be more efficient with those operating assets.

Kimsoth Ryan’s firm of FirstGroup PLC has modest economic profits for the last three years. Despite not having PM above 10% for any given year, and only having RNOA above 10% for 2015 and 2017, the firm has excellent ATO rates for all four years, being well above 1.5. This means that the efficiency of the firm is the key difference. The excellent efficiency combined with the modest profitability has meant that economic profit is being made. However, the economic profits are small. It is as though the firm is really just breaking even for all four years. This is not too bad. Nevertheless, as an investor, one would want good economic profit all of the time.

I cannot see how my firm is similar to these firms at all. Simply because my firm has bad profitability and efficiency. A recipe for disaster. It makes big losses and has poor ATO rates. Therefore, the economic losses are big also.

What insights have you gained by ‘breaking into bits’ your firm’s financial statements? What insights have you not gained?

I have learnt more about the key drivers of economic profit: If RNOA is bigger than WACC and NOA is positive then there will be an economic profit as a certainty. The elements of good efficiency and good profitability make for the best RNOA. If one element is average and the other element excellent, there may be an economic profit or a break-even-ish figure.

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My new Peerwise theory

If we consider that at the beginning of this term (CQU HE Term 1, 2018) that everyone had more time to spend and work on Peerwise (with writing, answering, rating and commenting on questions), then we can conclude that progress with Peerwise and the achievement of a higher reputation score, for the reward of assessment marks, would have been realised very easily.

But now if we consider that in the middle of the term (Week 8) that everyone has no or little time to spend and work on Peerwise (this probably due to other Unit assessment tasks, and that this is worth a mere 5%; some may not bother anymore), then the achievement of a higher reputation score for assessment marks is now quite difficult.

Why?

Because for one’s reputation score to go up, people need to answer, rate and comment on your questions. If not a lot of people are consistently on Peerwise, and far less than at the beginning, then progress with one’s score will now be a lot harder.

What’s the solution?

To be on Peerwise a lot more from now on, to write, answer, rate and comment on questions. That’s right. Doing all four of these activities. Consistently. As Dr Turner has recently said, it is not good to ‘back end’ the ACCT11059 assessments and that we should be working on these progressively.

Or let me put it this way: Suppose no one got on Peerwise anymore, except for one person. That one person would also lose the remaining assessment marks, as there would be no one to answer, rate or comment on that person’s questions.

So we all need each other to get the remaining assessment marks, don’t we?

So come now, my brothers and sisters, let us progress little by little using Peerwise from now on. And, hopefully, we will all make it and receive the remaining assessment marks.

 

Good excuse for some chocolate!

Here are the links to download the files for my draft of ACCT1059 Assessment 3 Step 3:

Spreadsheet with Restated Financial Statements

Preliminary Commentary

2013-2014 Annual Report for DYE-GSL

2014-2015 Annual Report for DYE-GSL

2015-2016 Annual Report for DYE-GSL

2016-2017 Annual Report for GSL

 

Any feedback would be greatly appreciated, as I am not sure if my spreadsheet is 100% correct. I am particularly concerned about my tax benefit calculations. Thank you.

 

How did you find this learning task?

I found the task of restating the financial statements (that is, using the re-classifying of items into ‘operating’ and ‘financial’ activities) a very interesting task.

For example, it was good to see the net operating assets separate from the net financial obligations in the end. The assets that are driving value for the firm are now clearly seen. These are the ones to be actually generating the sales and profit for the firm. Or ought to be. I mean my company has been making losses for the last four years.

Also, I can now view the profit just originating from the operating activities, separate from the financial activities. Therefore, I can find out the profitability of the operating activities.

In the end, though, I think I would benefit right now from doing some analysis work, to make a bit more sense of these numbers. I am feel a bit all-over-the-place after doing this task.

I am still not sure if my spreadsheet has been done right!

It was a massive job trying to get it done. Involving research of this item, research of that term and many moments of confusion.

I found using the CQU ACCT11059 Unit Facebook page so valuable. Lots of help can be found there from fellow students (even the past ones, I found out) and Dr Turner himself. What better way to learn than through semi-real time discussions.

Did you find it frustrating, confusing or enlightening?

I found it frustrating that there was a lot of stop-start-stop moments through the progress of this task. I found myself stopping to research this item or term and then moving on quickly only to run into another item or term to research. I guess I just get frustrated with myself for not knowing enough or understanding as well as I might like to.

I found the calculation of the tax benefit confusing. Firstly, knowing whether additional items can be added to Financial Expenses (FE) and Financial Income (FI) or not. I know that these take into account Interest Paid and Interest Received, but I just wasn’t 100% sure if they could take into account other items. In the end, I just assumed that they could, thinking that ‘Other Financial Comprehensive Income’ would have ‘other comprehensive income’ only.

Also, my company’s years had differences that had a significant effect on the calculations. This made the calculation of the tax benefit not straight-forward at all. I was calculating the Interest Paid minus Interest Received by making Interest Paid negative just like it appears and is written on the Income Statement for Expenses. No, wrong way! As for the differences in the years, the ‘Tax Reported’ operating part was positive for all of the years, as my company had losses for all four years. But the ‘Tax Benefit’ operating part was negative for 2017 and 2014 and positive for 2016 and 2015. This made calculations confusing, as I initially didn’t know the exact right way of entering the numbers (and of course, they only appear via formulas), in relation to their right format, positive or negative.

I found the learning about the difficult terms and different unknown items enlightening. It was actually good when I came to understand certain things that were once difficult or unknown to me. Spending time looking at each item in the financial statements was definitely a worthwhile task, particularly for my learning. The restating task really forces you to consider and critically think about and assess each item. It gives you the chance to discover what each item is and how it relates to what is going in the firm.

In light of this, it now seems to me like there is a difference between looking at the economic and business realities of a firm and engaging with the economic and business realities of a firm.

And what exactly do you feel you have learnt, or not learnt, about your firm and its financial statements from restating its financial statements?

I learnt that my firm has been issuing a lot of shares as remuneration to its employees and directors. This can be seen through its share-based payment expenses in the Statements of Change in Equity.

I learnt that my firm has been issuing (paying) CSIRO in the way of shares as a means of repaying a loan.

With the cash balance allocation task, I learnt that my firm indeed has more cash than just 1% of sales. A lot more, in fact. I already knew sales were going to be low with my firm because they are yet to produce and manufacture a broad range of perovskite solar cell (PSC) technology products.

I learnt that as technology has moved on over the years, with my firm now committed to the new perovskite solar cell (PSC) technology, and older technologies, such as the original liquids based technology, being replaced, this fact has to be realised in the accounts. For this very reason, the intangible assets have dropped in value, due to the impairment assessments resulting in impairment losses on the goodwill, particularly from 2015 to 2016 with a drop of about $3.6 million. These losses are reflected in the ‘Impairment of intangible assets’ expense account.

I learnt about my firm’s ability to access finance early in expectation of their usual R&D tax rebate due. They can do this through the Commonwealth Bank using a drawdown facility.

I learnt and was quite surprised that my firm doesn’t have that much ‘financial’ borrowings (NFO) for any of their years. This is quite unusual for firms. Usually they negatively gear to invest big in good assets to bring about value creation for their equity investors in the future. I wonder if I can figure out ‘why’ before this assessment is due in earnest!

 

Second Thoughts

After re-reading the ACCT11059 Chapters 2 and 3 Study Guides, for the purpose of doing Assessment 1, I have come to doubt my way of looking at annual reports.

I accidentally wrote my ideas, reactions and reflections on sections 3.3 and 3.4, because I didn’t read the assessment instructions properly. Oops! I didn’t submit them though.

Over the final days of doing Assessment 1, I have had second thoughts and new doubts.

I said in my blog post What I look at in an Annual Report that I categorise what I look at into primary important and secondary important. I now think that perhaps I should not be doing this. My secondary important areas were:

the company’s purpose, normal business activities, direction, present key challenges, future strategy, plans and projects, and its present identified risks and capital commitments.

I feel that by making these areas ‘secondary’, I may be missing out on being able to really connect to the economic and business realities of a firm. Perhaps I need to stop separating these elements, being the financial from the general business information, and start to look at them together more closely, in order to see a better picture. Perhaps I need to stop looking at the mere numbers and thinking I see ‘the answers’ and start to have more of a concern for the actual business with its interconnected realities.

After my second reading of the study guides, I started to doubt my own selective ways of analysing financial statements. I begun to question myself if I really am looking for the right things. I came to the conclusion that while I read and look at the finances well and can accurately comment on them, I think I may be neglecting the economic and business realities and what future value they might add. I put this down to a lack of education in this area.

The last 2 paragraphs of the sub-section called ‘Just do what ‘works’’ (3.3.2) had a big impact on me. I have great faith in the judgments made by the author, Dr Martin Turner, in the text. He is extremely educated, a doctor of accounting, and someone who I esteem and trust. He has obviously done the research and is simply commenting on the findings. He concludes that we can only “gain a lot of practical wisdom and ‘good sense’ from experienced practitioners, particularly if they combine their experience with the ability to explain and communicate their insights well.” I found the named recommended writings of Benjamin Graham, David Dodd and Warren Buffett valuable, as these men actually have the ability to use financial statements to gain insights into the economic and business realities of a firm.

I had continued doubts while reading section 3.4, about seeking to determine the value of equity based on future expected cash flow relating to the dividends.

In conclusion:

I feel that I have actually learnt something very special when contrasting the thoughts of the text with my own established understanding and way of analysing. And all brought about because of my mistake in not properly reading the assessment instructions. I’m now looking forward to learning how to truly understand and connect to the economic and business realities of a firm and how to see if they will bring any future value.

I understand that learning must connect with our prior knowledge and experiences, even if it means overturning long-held views and foundations. Sometimes we have to challenge our current views in light of better understandings. Sometimes we have to ‘unlearn’ things in order to learn new things. I also know we need other people to assist in our learning journey because different judgments will contribute to how we see things in reality. Therefore, I hope this blog post will be of good help to my readers, in contributing to their learning journey in studying accounting.

Well, I still have a lot to learn. Nevertheless, I’m loving my journey!

 

WARNING: Take care with the Balance Sheet

Hello to all of my dear Peers and Readers,

Today, I am working on my spreadsheet, Step 4. And I have just realised something very important, particularly when it comes to how I am giving people feedback.

Your Balance Sheet needs to have the words “as at” and not something like “years ended”.

Some people have got this wrong already. Balance Sheets are indeed like this. Other financial statements are not.

Click here to see Dr Turner’s video if you are still in doubt or need some extra assistance.

Also, just be careful about the $ ‘000 part, i.e. the column headings. For example, if a figure shows $1,000,000 then you would put 1,000 in a cell using the $ ‘000 heading. If you removed that heading to just a $ sign heading then you would put 1,000,000 in a cell.

Please be careful everyone, in your own work and in your feedback which you give.

And may we all get great marks and grades in this ACCT11059 Unit.

Kind regards, Evan Spurway

 

What I look at in an Annual Report

When I look at an Annual Report with the Financial Statements, I am most interested in the following things. These are the top things that I look for with a quick look, not a thorough look.

1.  Total Net Assets, and then Current Assets over Current Liabilities

What I want to really know is: Can the company pay its debts as and when they fall due?

This concept is called ‘solvency’. It is illegal to continue to do business in Australia if a company is insolvent, not being able to pay their debts as and when they fall due, see Sections 95A and 588G of the Corporations Act 2001 (Cth). So this is what Boards and Management of companies think about and look at as a top priority. And this is what I look for as a big thing as well.

I find the liquidity ratio of the ‘current ratio’ (that is, current assets over current liabilities), using a measure of 2:1, a useful ratio to give me an indication if things are OK or not.

Current Assets & Liabilities – Value realised within 12 months.

Non-Current Assets & Liabilities – Value realised beyond 12 months.

However. I must confess that the first thing I look at before the current assets and liabilities is the total net assets. I just look at this central total on the Balance Sheet first. Why? Because it’s the main total! This is actually how much the company is worth (total net assets [A = L + E] = net company worth), after all the debts (liabilities) have been paid. If you were to buy the company, this is would one of the figures you would be interested in.

2.  Net Operating Cash Flow

I find the other cash flow information on the Statement of Cash Flows secondary to this figure. I want to know if the normal business activities of a company are actually any money. In other words, is the company making or losing money as a result of its normal business activities.

This is different from the Profit/Loss result found on the Income Statement, because under accrual accounting the Income Statement takes into account some income and expenses yet to be realised. It also includes some non-cash transactions as well, e.g. depreciation expenses.

Confused? Suppose a business made a $1,000 profit. That might not be of any good news if they did not get the actual physical money to be able to pay for next month’s due bills.

So in terms of bringing in the cash, for the overall continual running of the business, I believe this figure gives a more pure result and understanding on whether the normal business activities are really benefiting the company or not.

I mean seriously: How on earth can one survive if their normal business activities just don’t make any money?

3.  Net Profit or Loss Result

This figure is important to me too. This time, I want to know if the company’s revenue (not the standalone immediate cash inflow from the operating activities) is covering the company’s expenses. The end result of the Income Statement, being a Profit or Loss, will eventually be added to the Equity total on the Balance Statement.

If there is a Profit then the Total Net Assets will increase, value has been created.

If there is a Loss then the Total Net Assets will decrease, value has been destroyed.

It is important that company’s make a Profit. If they don’t, in time they could loss their ability to pay their debts as and when they fall due. Assets are supposed to be used to make money, as a ‘Return on Investment’ for the owners of the equity.

I find usually a company that has a lot of debt is able to make higher profits. This is because the money from the debt/s is invested into assets that make more money for the company. This is called ‘gearing’.

4.  Dividends to be Paid

Another important thing I look for is what kind of dividend will be paid if I invest in the company. What will be my return on my investment? Is an investment here worth something?

In the ACCT11059 Unit, we are actually looking at these companies as outsiders, not insiders. We are looking at what a potential investor sees and should know, according to Dr Turner in Study Guide 2, Section 2.1: “We will also focus on equity investors as one of the groups of people with a genuine interest in using financial statements to better understand the economic and business realities of firms.”

Other Important Information:

I find other information, though important, secondary. Nevertheless, I will pay still pay careful attention to the company’s purpose, normal business activities, direction, present key challenges, future strategy, plans and projects, and its present identified risks and capital commitments.