Assessment 2 – Step 1 – Chapter 4 KCQs
4.1
After reading the beginning of the chapter four the idea of attempting to analyse financial statements seems ever so daunting, so many numbers. Trying to make sense of the things I entered my spreadsheets seems a little bit too far out of my reach now. I am interested to see what learning journey this chapter takes me on. I had never really taken the time to think about what investing really was and the idea that it was trading in expectations was quite eye opening. It really is giving money to a company with the prospect that they will add value to your money and return your money to you and some extra as well. I can’t imagine applying this same logic to other things, imagine sitting down at a restaurant, prepaying for your meal, and hoping that the chefs have the skills, ingredients, and equipment necessary to make and deliver your meal without knowing if it will happen or not and if it does come we wouldn’t know if the meal is going to be large or small, instead we just expect it to happen.
How Firms Add Value
So, we have invested in a company, we have handed over the equity for the company to use, so how is it that value is added or better yet how is it measured? I’ve always thought that surely cash flow would be a good way to measure value and it would appear I am wrong. This seems to be happening quite a lot throughout this subject. From my understanding free cash flow doesn’t really mean value at all, however the transferring of value from one thing to another for example using some of the cashflow to purchase other assets that are of the same value, the free cash flow reduces but there is no further value added to the company. Looking at figure 4.1, on face value there is no difference between the companies however moving to figure 4.2 still if you are looking at figures alone the first option seems like the best however, option 2 is investing their cash flows into other things, these investments may very well produce economic profit moving forward.
Economic Profit
Economic profit can be expressed by taking the return on current operating assets and deducting the costs of capital and then multiplying it by the value of the current operating assets. Obviously, the goal of any investment is to get some return on investments, the more that a business can invest in assets that are continuously returning more than it cost to invest in them this means much more value for investors. It is my own understanding and personal experience that once you invest your money into something that there is no way to use that money for anything else. I have invested in shares in some companies as well as term deposits and once it’s in there, that’s it, no escape until the term is complete or until you sell the shares. Of course, dividends are paid as a return on investment or interest is paid on the term deposits but changing your mind after the fact can be either costly or not possible. Once you’ve invested the money its not possible to use that money on anything else. Economic profit is so much more important than free cash flow because it means that capital investors are receiving value for their money, free cash flow just means their money is sitting unused and neither losing nor making money. Economic profit on the other hand is providing the investors with the value they were searching for when they invested their money into the business.
4.2
While reading this section it kind of answered the question as to why when I did the financial statements in assessment one, I wondered why they had so many, and why were some “restated”. It seems I have the answer to that question, and it would be for a business to separate the operating activities from the financial ones. I have now gathered that by looking at some of the statements before they are restated it blurs the lines a bit to what do the operations of the business cost, separating the two categorizes the statement into column A or column B, no in between. My understanding is that operating activities include anything to do with the products/services that are being sold onto the customer as well as any other things involved with that including suppliers, equipment etc. Financial activities are any activity that involves investors, whether the investors are people buying shares and investing their own money or whether that investment comes from debt where the business has gone to a bank for a loan. Even though we view them separately they are very much interconnected, investors money is used to buy better equipment or more equipment with the goal of creating profit and value to investors.
Restating the Financial Statements
Not going to lie, here I am reading about this and it’s getting me nervous, then I get to the part when the words fascinating and infuriating are used side by side to disrobe the process, insert stress here. I’m sure it won’t be too bad, and I will get my way through it, however it seems more daunting now. I will be getting to it and starting these videos as soon as possible, once my other assignment has been completed, unsure of why I thought 3 subjects in 1 semester was a good idea. After finishing the reading, I didn’t have the best understanding of the equations at the end, but I wont lie here, I didn’t exactly spend the most quality of hours attempting to stuff the information in my head. I have run out of time to complete this step, but I do look forward to attempting the restating when the time comes. Wish me luck, I feel as though I will need it.
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