Assignment 2 Draft

Part 1 

Ideas, reflections and reactions to reading Chapter 4 of the study guide ‘Analysing Financial Statements’

 ‘Whoever wishes to foresee the future must consult the past…’

This quote by Machiavelli was the quote I liked most out of the three that were in the beginning of chapter 4.  My understanding on it, it’s that in order to predict what is going to happen in the future we need to know what has happened before and what is happening now as well.

I realized the purpose of the chapter is to restate the financial statements and while doing that also understand them. This is done through consulting past transactions that have occurred in the firm  and  through using two common frameworks: Free Cash Flow and Economic Profit.

When I began reading about Free Cash Flow I got a bit confused because it was a lot of information on this new concept I’d never really dealt with before so I had to read it once more in order to understand. I realized that free cash flow is the money that enters the firm on two directions, the investments made by the owners and the cash coming in from operations like sales. So investments are an asset and cash flow from operations would be profit. This is how I understand that FCF=C-I. I is negative because it is money spent on an investment like supplies that are expected to be future profit.  Reading through it I also realized that it is in the firm owners’ hands whether to have high or low cash flow since they are the ones controlling the investments. This got me reflecting about how to invest in a business. Before you start studying accounting or business in general it all seems either black or white. Only now I realize that if you’re going to invest on shares of a company you’re not only going to do research on their income, but also on their investments. The more I study accounting the more I realize that understanding a company is a lot more complicated than it seems.

It took me a while to wrap my head around how to calculate the economic profit through the formula. Before I read this part I believed that the economic profit was the same as the return on net operating assets but now I know that it is depended also on the costs. It was pretty easy to maintain concentration at the rest of information about economic profit.

After reading all of that I understand how Free cash flow and economic profit are different because the economic profit measures the value added to the firm (Profit for the company and the shareholders) whereas FCF is simply a transfer of value between all the stakeholders.

At first glance, financial and operating activities seemed too complicated to me. All I saw was Capital letters and numbers and I was so frightened I thought I’d never manage to make sense out of all of that information. To me both financial and operating activities seem equally important because they both affect the profit at the end of the year.

At the beginning I wondered why do we even have to restate the financial statements? It seemed like we were just organizing the same information in a different order. How would that be of use to us to understand more about the firm? I realized why after I finished restating it and that took me nearly two weeks. I realized that through restating them I understood what each (not all but most) of the activities presented there were. I gained more knowledge.

Another question that still remains unanswered to me is that why aren’t the financial statements already restated in the annual report since they are so helpful, but we have to spend so much time restating them?

What I found most difficult was separating financial and operating activities, but the chart helped distinguish between the two.

After reading the rest of the chapter I finally understood what dirty surplus actually is but I’m still wondering why does it have to exist? Why not include all earnings in the income statement in order to make it easier to restate and understand?

The explanation for restating each of the statements was very clear, but it still seemed abstract. I only understood it after I finished restating the financial statements of my firm. I believe it is almost impossible to understand them without doing and example yourself, because every firm is different and each activity is also different. I understood how to restate the balance sheet by the first time II read it and I think it’s the easiest out of the three.

I also understood that profitability and efficiency are basically the two main objectives of each company.

All in all, it was a chapter with a lot of new information and formulas so it required to read each paragraph more than once in order to understand, but now that I’m done reading it I do feel more confident. I feel like I can understand what is going on with my firm and its annual report.

Part 2.

Brief Commentary

While restating financial statements I went through some problems. First with restating statement of changes in equity what I found difficult was the Equity at the end of the year by the time I was done wasn’t the same as the Statement in the annual report. First I got confused but later I realised that I had added by mistake a transaction value. After having removed that, it all made sense.

Restating the balance sheet was the easiest for me. It was kind of difficult to distinguish between operating and financial assets, liabilities but with the help of our lecturer I understood how to separate them. And the rest seemed very easy to me.

The income statement to me was the hardest out of them all. Firstly I didn’t understand how to separate revenue and incomes and expenses because they were all put together in the annual report. It was complicated because some of them were part of revenue and the others part of expenses depending on whether they were positive or negative. On the annual report of my company CMI there were also other comprehensive income which in the beginning I thought that were operating and that caused me to make mistakes. After consulting with my lecturer I realized they weren’t operating. Also the tax benefit confused me a bit but the powerpoint slides helped me understand how to calculate it.

In general, it didn’t take me much time to understand how to restate the financial statements, but it sure was a complicated process for a first year student like myself.

Part 3: 

Products

Contribution Margin

Contribution Margin per each unit of activity is calculated through the formula:   CM= Sales – Variable Costs. So it depends on the sales and the variable costs. For example if any of the prices of the products mentioned above would drop, the contribution margin would be lower too. And the same would occur if variable cost changed depending on whether it was increased or decreased.

The Contribution Margin is different for each product that CMI produces. This happens because every product is different. First of all each product has undergone through a specific manufacturing process which had a certain cost. Depending on the labour required, the basic material and supplies, the time needed, etc a price has been decided. The price is also based on the prices of the same products that are produced by other electrical competitors. It may be slightly different because of the quality and the factors mentioned. For example the brass conduit has a very good quality because the material used to produce it is very expensive and it lasts longer than another material. This affects its price & cost and therefore it affects the contribution margin.

The firm can’t only produce one product with the highest Contribution Margin because not everyone needs that product so they are not going to buy. Customers need variety so If the firms offers a variety of products with different prices, the customer will have the opportunity to choose so the profit will be higher. For example, out of the three products of CMI electrical I’ve chosen, The Ordinary Duty Cable has the highest CM. If this company would only produce this cable, a customer who wants a multiwire cable can’t find it here so he will buy it somewhere else. The number of total sales will decrease.

This is what I've come up with so far. If you want leave your blog links or your ass#2 drafts in the comments so I can have a look at them and give you my feedback. :)