The first concept I can identify is the understanding that history will provide a better understanding of the future. I imagine reviewing history is the main way in which a firm’s shares can be valued or priced because we cannot predict what will happen in the future. Investors can look at the past performance of a firm to decide whether it is a good investment or not. I think this makes sense because I continue to go back to the same hairdresser and mechanic because they have provided a good service in the past. In doing this, I am banking on the fact that because they did a good job last time, they will do a good job in the future. However, I believe that history should only be used for consideration, not to base an entire decision on because if we only used the past to make decisions about the future then I feel as though we would never progress forward with innovation and technology. I think it is also important to be able to think beyond what has happened in the past.
I understand that adding value and transferring value are two concepts that can easily be confused. Within a firm, free cash flow and paying shareholders dividends are examples of transferring value because these actions are not creating any extra value for the firm. Whereas, adding value can be achieved by investing in capital assets which generate more income than what was spent to establish them. Why do we bother to look at cash flow statements then? Wouldn’t it just be like looking at my bank accounts and seeing me transferring money to and from my own accounts? What is the point?
Martins states “To understand the value of the equity of a firm we need to engage with the economic and business realities of a firm that are driving the creation of value by the firm for its equity investors” and I need to break it down to relay in my own words. Therefore, the value of equity means the share price. The economic and business realities is a concept I am still struggling with. Does this refer to things which are happening within a business, positive and negative. Like the actions of a business? Driving the creation of value means increasing the share price for the shareholders. So, if I put this all together in my own words – To price a share, we need to identify how the actions of a firm will affect the price of the firms share for the shareholders. My statement is not as easy to follow as Martins which is frustrating. This concept is difficult to articulate in my own words. At my workplace, management recently terminated a property manager (action) and now the department is understaffed. This has meant that there is no one in the department arranging maintenance which has upset the landlords of many of our managed properties. We have lost several managements over the last month. I think that terminating an employee and then being understaffed is a business reality which has led to lost managements. Loosing managements means our business is not generating as much income. Therefore, if investors could purchase shares in our business, I believe the share price would have dropped as a direct result from termination the property manager. This example does not explore creating wealth. It explores losing it, but I still think it is applicable.
I am comfortable with the concept of opportunity cost which I believe is an implicit cost. The opportunity cost of any investment or activity is the highest valued alternative option that has to be sacrificed. It is an implicit cost because it does not cost physical money (like an electricity bill), but rather it costs the company the possible income from investing the capital in some other option. For example, I started studying at 5am this morning instead of sleeping in until 8am. My opportunity cost is the 3 hours of sleep I sacrificed. Would I have been more productive because I am less tired during the day if I slept in for an extra 3 hours? The benefits and drawbacks need to be compared in order to make a decision which minimises opportunity cost. I like the concept of opportunity cost because I often use pros and cons list when making a decision. In the cons list I always write down what I “miss out on” by choosing a different option/decision. So without realising it, I think I have been considering my opportunity costs.
Economic profit and accounting profit vary in definition. Accounting profit comprises of all explicit costs, whereas, economic profit comprises of all explicit and implicit cost (including opportunity cost). I learned about this concept in ECON11026. However, in ECON11026, we learned that Accounting only considers explicit cost (hence the term accounting profit) but now I am learning about opportunity costs in this course I am wondering if that was false information. Does accounting also consider economic costs? How much of economics is considering in accounting? I really hope that economics is not that important in accounting because I find ECON11026 really difficult compared to this course.
It is easier to find the key accounting drivers of economic profit and cashflow by restating a company’s financial statements. When the company’s financial statements are separated into two categories, financial activity and the operating activity, we can focus on and interpret the operating activities easier. I remember Martin discussing that a company may try to hide information within their financial statements and when I first read about re stating financial statements, I thought to myself what is the point? However, reading this chapter, I now understand we are re stating the financial statements to “strip away” the excess information to get down to the “juicy” information. We are discovering the truth of the company’s business realities.
How does a company decide how much and when to pay investors dividends? This is a question that keeps popping into my head over the last few weeks of this course. Is there some sort of equation or guide? I hope this question will be answered throughout this course.
Cash in a balance sheet is a harder item to categorise as either a financial or operating asset. If the cash is held in the till or as an overdraw facility at the bank, it is considered an operating asset. Whereas, if the cash is held in a bank account, the cash is considered a financial asset. I hope I have this concept explained correctly. After reading Martin’s example I can relate because I have an spending account with a visa card attached to it which I use for day to day expenses such as groceries, this would be my operating cash. I also have a saving account which I let accumulate and earn interest, this would be my financial cash.
Profitable is the amount of money made by a company for each dollar of sales. Efficiency is the amount of sales the company can make for each dollar the company has invested in its business. These two items must be considered together because there is no point being profitable if the company is not efficient and vice versa. This concept raises the question whether it is better to produce or service with a high profit margin but low sales or to mass produce or service but at a low profit margin. I understand the difference between these two concepts as well as the relationship between them. For example, in my workplace we could charge a higher commission fee of 3.3% on all sales but when there are other agents in the area charging only 2.8%, we would only be likely to list one or two properties per month. If we sold two homes per month (at $400,000.00 for argument sake) we would receive $26,400.00 in commission. In this situation our profitability is high but our efficiency is low. Whereas, if we only charged 1% commission, we would be likely to list 10 houses per month. If we sold 10 houses in the month, we would receive $40,000.00 in commission. In this situation we would be highly efficient but not as profitable. It would be important to find the right balance between profitability and efficiency.
After reading this chapter, I am feeling slightly overwhelmed by the concept of restating the financial statements. So far, I have not had to review any of the Study Guide chapters after I read them the first time, however I think I will certainly be revisiting this chapter while re stating my company’s financial statements. Although anxious, I am also excited to re state the financial statement to find out if there really are hidden truths to find in the statements.
Make it Account 