Draft of Assessment two!

Step 1

Chapter 4: Analysing Financial Statements

Key Concepts and Key Questions

KC

The first thing that really got me thinking was one of the quotes in the introduction by G.K. Chesterton. It’s incredibly true that if you’re wrong about the past then how can you really expect to be right. In the course I did last term, Principles of Accounting, this was so evident to me and I can safely say that I always want to check that my understand of the past is accurate so that decisions made for the future are accurate. I often found that I would be completing tutorial questions and would go through all of the 10 steps to complete that question, only to get to the end and realise that my answer was wrong. This could have been so easily avoided if I simply checked each equation was correct as I went along so that the next one would be based upon a correct answer as well. My rush to complete the question meant that each answer was built upon a faulty assumption, but after making the same mistake a handful of times; by the end of the course I was checking everything as I went along.

KQ

What are discounted cash flow (DCF) and free cash flow (FCF)???

Throughout restating the financial statements of HKEx, I learnt many things but one thing I haven’t gotten a grasp on is this cash flow framework. I’m sure its just the name of the term I cant wrap my head around but this is something I need to discuss with my peers and read further into to hopefully better understand.

KC

Operating and financial activities was the most useful concept in this chapter because it really helped me understand the terms and the connections between them. It also helped me identify just how much operating activities really do dominate and are pivotal to the company’s success or failure. For me the concept of the kinder surprise egg being similar to the operating and financial activities doesn’t quite fit. When I think about a kinder surprise, I remember the overwhelming thoughts of wanting to eat the chocolate but also to open up the toy. This was always a battle in my mind and I would quite often attempt to do both at once. This is not in my opinion similar to looking at financial statements. I feel that it is perhaps more similar to ravioli; the outside doesn’t hold a lot of interest but the inside (the operating activities) is what makes or breaks the dish.

I can see from my company that as they progressed and took on more assets and made more money, they had a lot more liabilities which went hand in hand with that which is definitely a balancing act for them.

I know that it can be said that they still made billions of dollars regardless, but the variances between their assets and liabilities was relatively small and definitely needs to be kept in check. Their financial obligations on the other hand remain fairly steady, increasing as their business does, with main differences being the acquisition of the London Metal Exchange.

My personal budget at home would be similar in way although perhaps categorized differently, but still has the set payments of rent, internet, phone bill and Netflix. The things that can vary each week or month and I actually pay very close attention to are things like food, shopping, transport, random expenses. All of these things I can have great impact on and if I don’t keep a good eye on my online banking, I could very easily get myself into a lot of debt. For me, the former are my financial activities and the latter are my operating activities.

KC

One of the steps in the study guide is restating the financials, which involves finding a way to display the statements in alternative way. A part of this is restating the cash of the company, but I must decide somehow what portion is relevant in operations and what portion can go in financial assets. Martin recommends that it should be about 0.5-1% of the sales in the cash section of operational assets. Over the four years that my assessment covers, the amount of cash is between 2-13 times the amount of revenue for the corresponding years. Because there is such a large amount of cash, I believe that it is not being actively used and there is also no reference to the company taking on any large investments over the coming year so it should be safe to allocate the other 99% to financial assets.

Overall I found this chapter very informative as it gave almost a step by step guide to how the restatement is completed. Although, I agree with what has been said that it definitely will vary for every single company and so the assignment really requires the help of peers. For me when I was reading through the chapter, I compared it with two of the exemplars and the example martin gave and it helped me to related each section back to my own company. Of course there was some differences that I needed help with from my peers and then others that just took a lot of time to ponder, but I feel like with this chapter was a great back bone to helping me understand each of the terms and steps in this difficult process.

Step 2

I spent about three days looking at the assessment sheet wondering what on earth that meant and why our first statement on the financials wasn't good enough.

I know that this helps demonstrate our understanding of the concepts and relationships between all the figures but it wasn't until I actually started working on the restating that I understood why were completing what seemed like a pointless task. Upon restating the financials, I started to see things I never noticed last time. The biggest thing I noticed was that in the way I presented the Statement of Financial Position initially it seemed like as the years progressed that the company was making more and more money. However, in restating this I have seen that they did indeed make more profit, but their assets were almost outweighed by their liabilities. So in reality, the company was better off in 2011 when they actually had the greatest amount of assets and equity.

The greatest issue I faced with restating the financials was continuing to develop my understanding of what each line on the statements meant so I could restate these into different categories accurately.

Yet again in this assessment, I found that my greatest help was my accounting dictionary and ensuring I completely understood each term before I even moved a single line.

Along with my use of the accounting dictionary, the study guide chapter 4.1 was especially useful in helping me identify terms that I could use to restate the financials, such as the section on Economic Profit.

As mentioned in my KCQ’s, when allocating cash and cash equivalents in the statement of financial position, I made the assumption that based upon their report and goals for the coming year, that it was safe for me to allocate only 1% of their cash to operating assets and the remainder to financial assets.

This decision altered my spread sheet dramatically, going from having net operating assets for the four years in their billions, to multi billion dollar negatives.

The final step that I found incredibly difficult was calculating and allocating the tax expenses and benefits. I started by determining the tax rate of 16.5% and then working out the equation that I would need to use to calculate the tax benefit and where this would fit in the restated income statement. My first obstacle was determining what my financial income versus financial expenses was and realized that my company as far as I could see, had no financial income and so multiplying the financial expenses by the tax rate and determining the tax benefit for each year did the calculation.

Step 3

In this step I identified three services that Hong Kong Exchanges provide which are the following various stocks; Cathay Pacific Air, Emperor E Hotel and China Infrastructure Investments. I attempted to find three securities that are quite different from each other with cost price and amount available.

I have calculated the selling price based upon the nominal value on the given day I was researching, which is set for the life of the stock.

Cathay Pacific Air 00293 – 13.1 HKD

Emperor E Hotel 00296 – 1.43 HKD

China Infrastructure Investments 00600 – 0.091

To calculate the variable costs, I found an annual listing fee, which is charged, based upon the nominal value of securities listed on the exchange.  I found the individual annual fee for each and then divided that by the number of securities listed.

Cathay Pacific Air 00293

Annual listing fee – 198,000

/ Securities – 3,933,844,572

= 0.00005 HKD

Emperor E Hotel 00296

Annual listing fee – 541,000

/ Securities – 1,302,545,296

= 0.00042 HKD

China Infrastructure Investments 00600 –

Annual listing fee – 198,000

/ Securities – 4,269,910,510

= 0.00005 HKD

The final step in this process was to calculate the contribution margin. Subtracting all variable costs from the selling price gave me the contribution margin, which gave me the amount left over to pay for fixed costs and then resulting in a profit or loss.

Cathay Pacific Air 00293

Selling Price – 13.1

-       Variable Costs – 0.00005

=13.09995 HKD

Emperor E Hotel 00296

Selling Price – 1.43

-       Variable Costs – 0.00042

=1.42958 HKD

China Infrastructure Investments 00600 –

Selling Price – 0.091

-       Variable Costs – 0.00005

=0.09095 HKD

When I was searching through what seemed like endless lists of securities held by HKEx, I was looking for three different ones with different prices and amounts of shares held and different services. It was very surprising to me that the variable cost for Cathay Pacific, which had the highest selling prices, and China Infrastructure that had the lowest selling prices, both shared the exact same variable costs. This was because the cheaper stocks were in much higher supply and so balanced out with the costs of Cathay with their higher cost but limited supply stocks.

HKEx has so many products but one of the most challenging things I found in my search for the three securities I would use, was finding one that had all of their costs and prices listed only in Hong Kong dollars (HKD). There were so many securities that would display various aspects in Renminbi (RMB) and others in HKD but I chose to use securities that simply deal with HKD as most of this assignment deals with that currency. The multitude of currencies is of constant concern to HKEx as one of the major goals of the company is to help internationalize the RMB currency so that trading is easier and can be open to all markets. This constraint has been addressed in the last four years of the annual reports and each year they have reported that they are edging closer and opening up their market outreach further with a prime example of this being the Hong Kong – Shanghai Connect as addressed in Assessment one.

The variable cost that is most likely the largest contributor but was too difficult for me to accurately calculate was Labour. I attempted for quite a few hours to identify how I could calculate the labour hours and fees associated with the securities I was analysing but found that due to the large amount of products offered, the foreign country’s wages agreements and all of their rewarding systems in place, my estimate could never have been accurate. I believe that although I am only a student studying accounting, that this could possibly be a constraint upon the company as it would be difficult to identify the wages cost associated with their stock sales. This is especially important, as this cost was always the largest operating expense for the last four years.

There was another reason why I decided to use the annual fees for my variable cost instead of wages and that is because it is my assumption that this cost would be inclusive in the annual fees. The annual fees referred to are the sole cost to the company listing with HKEx and so should include all costs in this such as staff costs, implementation costs of adding them into the system and maintenance as well as any other sundries involved.  I’m sure this fee probably allows for a small profit in there but was the most accurate piece of information I could use to calculate the variable costs and then onto the contribution margin.

As mention in Chapter 8.2 of the study guide, the contribution margin is one of the key equations in accounting as it can help to make decisions about how the company is progressing and which products are performing or underperforming. For example, I can see that all three of the products I chose do have a positive contribution margin and despite the Emporer E Hotel having the highest variable costs, all three products selling price are in line with their contribution margins.

	Cathay Pacific Air - 00293	Emperor E Hotel - 00296	China Infrastructure Investments - 00600
Selling Price	13.1	1.43	0.091
Variable Cost	0.00005	0.00042	0.00005
Contribution Margin	13.09995	1.42958	0.09095

*All Hong Kong Dollars