reflection ACCT

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CHAPTER 4: ANALYSING FINANCIAL STATEMENTS

But history is neither watchmaking nor cabinet construction. It is an endeavour toward better understanding.

Marc Bloch

Whoever wishes to foresee the future must consult the past …

Niccolo Machiavelli

We can be almost certain of being wrong about the future, if we are wrong about the past.

G.K. Chesterton

Capital markets, in which investors make new and trade existing equity investments in firms, are different to,

say, the Sydney Fish Market. The Sydney Fish Market trades in fish which are delivered to you immediately and

fresh. A fish might be swimming in the Pacific Ocean off Sydney’s coast one evening, and its eyes may be

looking up from a dinner plate in a terrace house in Sydney’s Balmain the next evening. In a fish market, what

you see is what you get. You get a fresh fish which is typically consumed quickly. By contrast, capital markets

trade in expectations. Expectations are people’s imaginings about things that have not yet happened. Indeed,

expectations will typically be people’s imaginings about things that will never happen; at least not exactly as

people might think they will happen. Equity investment in a firm involves predicting the future. An equity

interest in a firm is not like buying a dead fish in the Sydney Fish Market. Firms are alive and we are buying

outcomes of their future business activity.

Yet to predict the future we need to start with the past. Machiavelli is a well-known Italian from the late 15th

and early 16th century who is probably most famous for his book The Prince, which provides pragmatic advice

to leaders on managing the political process (that is, on gaining and maintaining power). He understood the

importance of consulting the past as the basis for being able to foresee the future. The English writer G. K.

Chesterton pointed out that if we fail to understand the past, indeed if we are wrong about the past, we are

unlikely to be able to predict the future very well. A firm’s financial statements may be able to help us

understand the past of a firm. To the extent they can, this may give us insights to be better able to predict a

firm’s future.

Having a framework or a structure to view a firm and how it adds value to its equity investors can help us use

financial statements to understand and make sense of our firm’s economic and business realities. You have

probably noticed a firm’s financial statements can contain a lot of information. The discounted cash flow (DCF)

and economic profit frameworks are two common frameworks used by people to analyse firms. These two

frameworks help us to know what to focus on in a firm’s financial statements as likely to be driving value in a

firm, and what we can pay less attention to. Also, as we will see in this chapter, viewing a firm as having

separate operating and financial activities can be a most powerful way of viewing a business. The most

efficient way to identify the key accounting drivers of economic profit and cash flow is to restate a firm’s

financial statements in a way that clearly separates the operating and financial activities of a firm.

After you have restated the financial statements of a few firms, it can become a mechanical process for you;

although the first time you do it you may find it somewhat frustrating and time-consuming. Remember the

words about history from Marc Bloch, a French historian who was shot by the Gestapo during the German

occupation of France in World War II for his involvement in the French Resistance and for his Jewish ancestry.

Like reviewing history, restating a firm’s financial statements is an ‘endeavour toward better understanding’. It

is not simply a task of putting together the financial statements in a different way, like putting together the

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parts of a watch or constructing a cabinet from various pieces of wood. It is a task we can do to make it easier

for us to understand a firm’s past. Indeed, the reason we will be restating our firm’s financial statements is to

help us focus on and understand each item in our firm’s financial statements. We are not so much ‘learning

about restating financial statements’; rather, we will be restating our firm’s financial statements to ‘learn

about financial statements’.

After we have done this, we will look at how we can analyse a key aspect of economic profit and cash flow,

Return on net operating assets (RNOA), by breaking it into profitability and efficiency. We will see that we can

connect the accounting ‘drivers’ of a firm’s RNOA (that is, its Return on net operating assets) with its economic

and business drivers. This analysis is anything but mechanical. It requires us to engage with a firm’s economic

and business reality and is a subtle, creative and active endeavour.

You will find there are so many acronyms in this chapter, such as RNOA, FCF and ATO. We use these acronyms

to help us refer to the various ratios and other concepts in a way that is succinct and saves us from repeating

their full names again and again. All these acronyms are a little bit like nicknames we might have for friends;

and these can be difficult to cope with at first when we are just starting to get to know our new ‘friends’. To

help you cope with all these acronyms, here is a glossary of terms. The glossary of terms gives you the

definitions we are using in this chapter. Most people find it useful to print this glossary of terms and have it

handy to help ‘translate’ the acronyms in this chapter as you read the chapter. Here also is a summary of

some of the key ratios and their acronyms that we are using in this chapter (which is based on the Penman-

Nissim framework). Also, here is an acronym finder, where you can type in the acronym and search for its

definition. When using the acronym finder, remember there are no standard definitions of ratios and financial

terms; so there can be quite a bit of variation in how people calculate ratios and use acronyms.

In this chapter, we will gain some insights into how we can use a firm’s financial statements to help us gain an

understanding of a firm’s past. Yet a firm’s past is a trip already taken by equity investors. No one ever got rich

by simply analysing the past; no one. Equity interests in firms involve us trading in expectations of an uncertain

future. Yet, as Machiavelli said 500 years ago, ‘whoever wishes to foresee the future must consult the past…’

In this chapter, we will do just that: consult our firm’s past.

4.1 How firms add value

Many of our strategies start with the premise that companies create economic value mainly by earning returns above their cost of capital.

Andrew Lacey, Lazard Asset Management (Harris et al, 2006, p. 57)

How do firms ‘add value’ to equity investors? All that equity investors receive from a firm are dividends. But

when a firm pays its equity investors a dividend this does not in itself ‘add value’ to them. It is simply a transfer

of value between a firm (which the equity investors already own) and its equity investors. We need to go

deeper into a firm than this to find out what it is doing to ‘add value’ which then allows it to pay dividends to

equity investors. As we saw in Chapter 3 above, since dividends and free cash flow (FCF) are related in a firm’s

financial statements we can focus on a firm’s cash flow rather than on the dividends it pays. In this section, we

will look at some of the strengths and weaknesses of focusing on a firm’s cash flow. We will then look more

directly at how a firm adds value by focusing on a firm’s economic profit.

Free cash flow

Instead of focusing on dividends we can focus on free cash flow (FCF). However, looking at cash flow does suffer from some of the same practical problems as looking at dividends. The key problem is that cash flow, like dividends, is not in itself a measure of creation of value. Rather, it is also a measure of transfer of value. Dividends are a transfer of value between a firm and its equity investors. Similarly, free cash flow (FCF) is a transfer of value within a firm. It is a transfer of value between a firm’s operating and financial activities. Free

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cash flow (FCF) is driven by two things: cash flow from operations (C) and net cash invested into a firm’s operating assets (I). We have seen that the amount of dividends paid to equity investors by a firm can be affected by a firm’s dividend policy, which affects how much value is transferred to equity investors in any given year. In a similar way, the amount of free cash flow (FCF) a firm generates will be affected by a firm’s decisions about how much to invest into its operating assets (I) each year.

The more a firm invests into its operating assets the less will be a firm’s free cash flow (FCF) and (other things being equal) the less will be the value of a firm under a discounted cash flow (DCF) approach. At first sight, this does not seem to make much sense. Management of the firm are presumably investing in operating assets (such as building new retirement villages, in the case of Ryman Healthcare) because they expect the additional operating assets will ‘add value’ to equity investors and not reduce value. In other words, they expect the new operating assets (such as new retirement villages) to earn greater than the cost of the capital used to acquire them, rather than to destroy value for equity investors (as implied, at least in the short-run, by the DCF approach).

Let us look at an example. In 2018, Ryman Healthcare had Operating income after tax (OI) of $396.6m. This came from its operations in developing and managing retirement villages and rest homes in New Zealand and Australia, as well as selling ‘occupation rights’ (which are a bit like leases) in retirement village units. This is the same as its operating cash flow (C) which we talked about in Chapter 3 Section 3.4 above. However, in 2018 Ryman Healthcare also invested $512.1m into its operating assets as the result of a major building program of retirement villages and rest homes. We can call this investment in operating assets of Ryman Healthcare the change in Net operating assets (∆NOA, with the ancient Greek symbol ‘delta’ ∆ representing ‘change in’). This is the same as its capital outlays (I) we talked about in Chapter 3 Section 3.4 above, where we also saw that FCF = C – I.

We can see that Ryman Healthcare’s free cash flow (FCF) in 2018 was negative $115.5m ($396.6m – $512.1m) as FCF = C – I; or alternatively FCF = OI – ∆NOA, if we think of OI as being operating cash flow (C) and investment in Net operating assets (∆NOA) as being capital outlays (I). However, if Ryman Healthcare had not invested so much in developing new retirement villages and rest homes in 2018 and had only invested say $200m rather than $512.1m, it could have increased its free cash flow (FCF) from negative $115.5m to positive $196.6m (that is, FCF would have been $396.6m - $200m = $196.6m). If Ryman Healthcare had in fact done this in 2018 by cutting back on its level of investment into its operating assets, would it mean the value of Ryman Healthcare would increase? Quite the reverse, if you think its investment into operating assets is likely to provide a strong return in the future, that is to ‘add value’ to equity investors.

This is a significant practical problem: free cash flow (FCF) is a measure of transfer of value rather than creation of value. Free cash flow (which we will often simply call ‘cash flow’) is a firm’s Operating income (OI) less our net investment in the operating assets of the business for a period (that is, change in Net operating assets: ∆NOA). Yet many analysts in our capital markets focus on the cash flow of firms. So why would they do this? To get an idea of the value of looking at cash flow in a business rather than simply its earnings, let us look in Table 4-1 below at the forecast operating income of two firms, King Enterprises and Marks Inc, over the next four years.

Table 4-1: Forecast Operating Income (OI)

Year 1 Year 2 Year 3 Year 4

King Enterprises

Marks Inc

1,000

1,000

1,100

1,100

1,200

1,200

1,300

1,300

Which firm would you prefer to own shares in: King Enterprises or Marks Inc? Well, based on the information

above, we might think both firms are worth the same because we expect them to earn the same operating

income in the future. But what if Marks Inc needed twice the net investment in its business (that is investment

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in NOA) than King Enterprises needed each year in the future to generate the same level of expected future

operating income? Such an issue will be clearly captured in the expected future free cash flow (FCF) of the two

businesses, as shown in Table 4-2 below.

Table 4-2: Forecast Free Cash Flow (FCF)

Year 1 Year 2 Year 3 Year 4

King Enterprises

Operating income

Net investment

1,000

300

1,100

300

1,200

300

1,300

300

Free cash flow 700 800 900 1,000

Marks Inc.

Operating income

Net investment

1,000

600

1,100

600

1,200

600

1,300

600

Free cash flow 400 500 600 700

Which firm would you to prefer to own shares in now? We see King Enterprises generates higher expected future free cash flow (FCF) than Marks Inc. Although both firms have the same expected operating income, King Enterprises expects to invest less each year to achieve the same earnings growth as Marks Inc. Expected future cash flow may give some insights into the value of firms that expected future operating income (and, as we will see later, expected economic profit) may not. However, cash flow in any given year is not a good measure of a firm’s performance. Indeed, cash flow is not a measure of ‘value-add’ for a period at all.

Free cash flow could be easily increased in any given year by simply reducing net investment as we discussed above. By contrast, economic profit is a direct measure of ‘value-add’ in a year. Economic profit is based on a firm’s accounting profit for a period compared to its cost of capital. 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. We can perhaps use financial statements to help us get closer to these realities by focusing on economic profit, which is the earnings generated over and above the opportunity cost of the capital the firm is using to generate those returns.

Economic profit One way we can measure the earnings of a business is Return on net operating assets (RNOA). RNOA is

Operating income after tax (OI) divided by the Net operating assets (NOA) invested in the business (including

both working capital such as inventory and non-current assets such as buildings). RNOA can be expressed as

OI/NOA (the ratio or relationship between Operating income and Net operating assets), or in other words the

amount of Operating income being earned (OI) for each dollar of Net operating assets (NOA) invested in the

business. We can think of RNOA as the return on capital employed or invested in the business. Economic profit

is RNOA less the opportunity cost of capital times the amount of Net operating assets (NOA). We can express

economic profit like this:

Economic profit = (RNOA – cost of capital) × NOA

where, RNOA = OI/NOA

Firms create value for their equity investors by earning a Return on net operating assets (RNOA) greater than

the opportunity cost of capital; and the more a firm can invest in Net operating assets at returns above its cost

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of capital, the more value a firm can create. One of the things accounting leaves out is the cost of the capital

the firm uses to fund its operations. Capital is never free. Its cost is the potential expected returns it could be

earning in alternative uses. For example, a few years ago I bought a property in Yeppoon, Queensland. I

invested some of my limited capital in it. I cannot now use that capital for something else, such as buying more

shares in Ryman Healthcare.

One thing about capital, you can only invest it in one thing at a time. Capital can only go on one journey at a

time. It is the same with our lives. The true cost of everything we do in life is the alternative things we could

have been doing with our time and energy and resources. Indeed, all of life is a trade. Because this opportunity

cost is usually invisible to us we often fail to consider it in life. If we were better at doing this, probably most of

us would get a pretty big shock. We do not think about all the alternative lives we could have lived; we often

fail to realise all the alternatives and options that lie before us, all the dreams, journeys and actions we could

be taking instead of what we have chosen to do.

It is the same with capital. By focusing on economic profit, we seek to include this opportunity cost of capital

in our consideration of the business realities of a firm. Just as it is not easy to assess the opportunity cost of

what we do in life so it is also difficult to assess the opportunity cost of capital; thankfully, not quite as difficult,

as capital is (at heart) an impersonal commodity, which each of our lives is not. A firm adds value by taking

capital from investors and using it to earn a return greater than the cost of that capital. Economic profit is a

measure of the extent to which a firm has been able to add value over and above its cost of capital during a

period.

Not only dividends and cash flow are related. Dividends and cash flow are also related to economic profit. The relationships are a little bit more complicated mathematics-wise, but take my word for it. It is possible to focus on cash flow or on economic profit (a measure of earnings) rather than on dividends. This draws on the same theoretical base as the discounted dividend model (which we discussed in Chapter 3 Section 3.4 above): the value of equity is the present value of expected future dividends. However, by looking at economic profit rather than dividends there are several practical advantages. We no longer need to be concerned that the value of a firm will be affected by its dividend policy nor by the amount of operating cash flow it re-invests back into its operating activities in any given year. We can focus our attention and our efforts when analysing a firm’s financial statements on those aspects that are potentially adding value. This may help us to more effectively engage with the economic and business realities of a firm.

We have seen that both cash flow and economic profit can play a part in helping us connect to how a firm is adding value to its equity investors. Before we start to use our firm’s financial statements to help us understand its cash flow and economic profit, we will have a look at a powerful way of viewing business. This way of viewing business is to clearly separate in our minds a firm’s operating and financial activities. Once we see how to do this, we will start using this way of viewing business reality to restate our firm’s Statement of changes in equity as we begin the process to see if our firm’s financial statements can help us understand what is really going on in our firm.

4.2 Operating and financial activities

Business is not financial science, it’s about trading ... buying and selling. It’s about creating a product or service so good that people will pay for it.

Anita Roddick

A powerful way of viewing business is to see a firm as having separate operating and financial activities. Also, the most efficient way to identify the key accounting drivers of economic profit and cash flow is to restate our firm’s financial statements. We do this to ensure we have clearly separated the operating and financial activities of a firm. We will first restate Ryman Healthcare’s Statement of changes in equity. In Section 4.3 below, we will look at how to restate a Balance sheet and an Income statement. There is no need to restate a firm’s Statement of cash flows, as we do not need this statement to identify the key accounting drivers of

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economic profit and cash flow. Before we start looking at how to restate our firm’s financial statements, let us have a look at a potentially powerful way of viewing business by looking at a firm as having separate operating and financial activities.

Operating and financial activities We can view a firm as involving two distinct and different types of activities: operating and financial activities.

A firm’s financial statements include both these two aspects of a firm’s business. By carefully separating these

two types of activities in our firm’s financial statements we can more easily focus on understanding a firm’s

operating activities, which is usually where value is added (or destroyed) by a firm. We will see the power of

having a picture of a firm in our minds that sharply distinguishes between its operating and financial activities.

Like many people, you too may find it to be a powerful way of viewing business.

It is a little bit like a Kinder Surprise, a small chocolate egg manufactured by Italian confectionary company Ferrero, which contains a toy inside. As children, we pester our parents to buy us a Kinder Surprise at the supermarket checkout. When they relent and buy us one, we eagerly rip open (and quickly eat) the chocolate egg to see what toy is inside. It is a little bit like this when we focus on the operating activities of a firm. The financial activities of a firm are the outside chocolate egg surrounding the toy inside; and the toy inside is the operating activities, being the part of the firm we are particularly interested in. Learning how to restate a firm’s financial statements is a bit like learning how to rip open a Kinder Surprise and discover a firm’s operating activities within (and from my perspective, just as much fun).

As we carefully restate our firm’s financial statements we can separate our firm’s operating activities from its financial activities, ripping open the chocolate egg of the outside company with all the distractions of how it is financed to see more clearly the firm’s operating activities inside. If you are a chocoholic (like me) you could eat a small amount of chocolate (perhaps even a Kinder Surprise) while restating your firm’s financial statements, to give you an energy boost and to also perhaps remind you that you are seeking to see a firm’s operating activities more clearly when you restate your firm’s financial statements. After restating your firm’s financial statements, and while you are perhaps jogging off the calories from the chocolate you may have eaten while doing it, you could reflect on whether this is a useful way of looking at a firm or not; and also, perhaps reflect on whether we should be eating less chocolate (or maybe not).

A conceptual view of a firm

The best vision is insight.

Malcolm S. Forbes

A powerful way of viewing a firm is to clearly separate in our minds its operating and financial activities. This view of a firm is set out in Figure 4-1 below. The operating activities of a firm are its interactions with the product and input markets, with its customers and suppliers. These are shown in the left-hand side of Figure 4- 1. A firm’s operating activities include decisions about which operating assets to acquire or to sell, what agreements to enter into with employees, suppliers and customers, as well as various other activities to add value to the inputs a firm acquires from suppliers. The financial activities of a firm are its interactions with the capital markets, with equity and debt investors. These are shown in the right-hand side of Figure 4-1. These include decisions about the financial structure of a firm (how much of a firm’s operations to fund with debt or equity) and matters such as dividend policy (how much of a firm’s earnings to retain within a firm and how much to pay in dividends to equity investors).

This view of a firm in Figure 4-1 is worth having a good look at. This simple chart may well be the most valuable thing you learn from reading this entire Study Guide. So, it worth spending a little bit of time making sense of it for yourself. In Figure 4-1 you can see that the firm is divided into two pieces: Net operating assets (NOA) and Net financial assets (NFA). On the left-hand side, Net operating assets (NOA) are those assets (net of liabilities) that are used to produce products and services for customers in the product markets, and thus earn Operating revenue (OR) for the firm. They are also used to acquire inputs for a firm’s operations from

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suppliers in the input markets, and thus incur Operating expenses (OE). The difference between Operating revenue (OR) and Operating expenses (OE) is Operating income (OI).

Figure 4-1: View of a firm: operating and financial activities

This view of a firm clearly separates its operating and financial activities

Source: This figure is based on a chart for all stocks and flows for a firm in Penman (2013, p. 244).

On the right-hand side of Figure 4-1 we have Net financial assets (NFA). These are those assets (net of liabilities) of a firm that are used to store value and are not used in the operations of a firm. If a firm’s financial obligations exceed its financial assets (as is often the case for many firms), its Net financial assets (NFA) will be negative, or in other words it will have Net financial obligations (NFO) rather than Net financial assets (NFA). NFA (or alternatively NFO) involve interactions by a firm with the debt and equity capital markets. These interactions involve net cash flow with equity investors (d) (dividend payments, share issues and share buybacks) and net cash flow with debt investors (F) (net interest payments and the repayment and issue of debt).

The operating and financial activities of a firm interact with each other. In Figure 4-1 we can see the transfers within a firm between its Net operating assets (NOA) and its Net financial assets (NFA) are represented by C and I. These are made up of its Cash flow from operations (C) less its Net cash investment in NOA (I). As we have seen before, Free cash flow (FCF) equals C – I. We also have seen that we can express C as Operating income after tax (OI) and I as ∆NOA. In other words, FCF = OI – ∆NOA. In Figure 4-1 we can see a firm’s Free cash flow (FCF) comes from its Operating income (OI) – being OR minus OE – less any increase in its Net operating assets (∆NOA).

We saw in Section 4.1 above that Ryman Healthcare’s Free cash flow (FCF) in 2018 was negative $115.5m, which we calculated as Ryman Healthcare’s Operating income after tax (OI) of $396.6m less its increase in Net operating assets (∆NOA) of $512.1m. So, Ryman Healthcare was generating FCF of negative $115.5m (that is its activities were using up cash during the year). So how did Ryman Healthcare with Free cash flow (FCF) of negative $115.5m, manage to pay dividends to its equity investors of $96.0m ($94.0m + $2.0m) and pay Net financial expenses (NFE) to its debt investors of $12.2m (see Table 4-8 below)? Where did this cash come from? Well, Ryman Healthcare paid for this by increasing its Net financial obligations (NFO) by $223.7m ($1,068.7m - $845.0m: see Table 4-6 below). After allowing for interest payments on these borrowings, Ryman Healthcare’s net transactions with its debt investors (F) was $211.5m ($223.7m - $12.2m). Further, we saw that Ryman Healthcare paid dividends (d) of $96.0m to its equity investors. In other words, FCF = d – F, i.e.

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$(115.5)m = $96.0m – $211.5m. Figure 4-1 shows us where FCF comes from and where it goes to. We can see clearly that FCF (where FCF = C – I) is a transfer between a firm’s operating and financial activities.

Although we live in a world of less than ‘perfect’ capital markets, the debt markets in Australia, New Zealand, UK, Europe, Hong Kong and in some other countries in the world, are often quite close to being efficient. This means it can be difficult for a firm to add much value to its equity investors by way of its financial activities. Rather, it is through its operating activities that a firm primarily adds value. There can be considerable value in clearly separating a firm’s operating activities from its financial activities to help focus our analysis on those areas where a firm has the greatest potential to add value to equity investors. It can be like opening a ‘Kinder Surprise’ to reveal the toy of the firm’s operating activities hidden beneath the cover of a firm’s financial activities included in its financial statements. But do not totally ignore the outside chocolate egg of a firm’s financial activities. As we focus on the operating activities of a firm, we also need to have ‘eyes in the back of our head’ as we remember that financial activities can sometimes be very important; just like the chocolate in a Kinder Surprise can be tasty and part of the overall experience of getting a Kinder Surprise.

Statement of changes in equity

The Statement of changes in equity shows how a firm’s Income statement and Balance sheet inter-connect. The ‘bottom-line’ (or summary measure) of a firm’s Income statement is Net profit after tax. The ‘bottom line’ (or summary measure) of a firm’s Balance sheet is the value of equity. The value of equity (from the previous period’s Balance sheet) plus the earnings for a period (from the Income statement) should equal the value of equity (from the current Balance sheet), after allowing for any cash flows between a firm and its equity investors (such as dividends paid to equity investors). This will only be the case, however, if all earnings of a firm are included in the Income statement.

It is possible a firm may not include some of its earnings in its Income statement and instead put it either into a separate Statement of comprehensive income. These earnings are called ‘Other comprehensive income’. We can find these earnings in the Statement of changes in equity or (as in the case of Ryman Healthcare) in the Statement of comprehensive income. Restating our firm’s Statement of changes in equity helps us to identify any Other comprehensive income. This allows us to include all the earnings of a firm in our analysis. The Statement of changes in equity for Ryman Healthcare for the year ended 31 March 2018 is included as Table 4- 3 below. You will see there are columns for 2018 and for the previous year, 2017. The restated Statement of changes in equity for Ryman Healthcare for the year ended 31 March 2018 is included as Table 4-4 below.

In the case of Ryman Healthcare, restating its Statement of changes in equity simply involves adding in a sub-

heading ‘Transaction with shareholders’ and showing Treasury stock movement and Dividends paid as

transactions with shareholders. The items making up Profit and total comprehensive income for the year (CI)

are set out in Ryman Healthcare’s Consolidated income statement and Consolidated statement of

comprehensive income.

Restating our firm’s financial statements is a technical task that with practice can be done relatively quickly and easily, although there are a few ‘traps’ we need to be careful to avoid. When you do your first restatement of a firm’s financial statements you may find it a slow and frustrating task at times. There are no short-cuts to giving it a go yourself and ‘learning by doing’. And remember, the reason we will be restating our firm’s financial statements will be to support us to carefully look at each item in our firm’s financial statements so we can better understand them as we continue to learn about financial statements.

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Table 4-3: Ryman Healthcare Statement of Changes in Equity for year ended 31 March

2018 2017

$m $m

Equity at beginning of year

Profit and total comprehensive income

Treasury stock movement

Dividends paid

Equity at end of year

1,652.1

384.4

(2.0)

(94.0)

1,940.5

1,327.5

414.2

(4.6)

(85.0)

1,652.1

Source: Ryman Healthcare 2018 Annual Report

Table 4-4: Ryman Healthcare RESTATED Statement of Changes in Equity for year ended 31 March

2018 2017

$m $m

Equity at beginning of year

Profit and total comprehensive income

Transactions with shareholders:

Treasury stock movement

Dividends paid

Total transaction with shareholders

Equity at end of year

1,652.1

384.4

(2.0)

(94.0)

(96.0)

1,940.5

1,327.5

414.2

(4.6)

(85.0)

(89.6)

1,652.1

In this section, we have seen a powerful way of viewing a firm is to clearly separate in our minds its operating and financial activities. We have also seen how to restate a firm’s Statement of changes in equity to clearly identify all a firm’s earnings. In the next section, we will see how we can restate a firm’s Balance sheet to clearly separate a firm’s operating and financial assets and liabilities. We will also see how we can restate a firm’s Income statement to clearly separate its operating and financial revenue and expenses.

4.3 Restate two key financial statements

It sounds extraordinary, but it’s a fact that balance sheets can make fascinating reading.

Mary, Lady Archer, British scientist

The other two financial statements we will restate are the Balance sheet and Income statement. I will take you through step-by-step how I did this for Ryman Healthcare. This will help you get started with restating the Balance sheet and Income statement for your own firm. Restating your firm’s financial statements for the first

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time can be a fascinating, infuriating and fun challenge. Your firm will be different to Ryman Healthcare in many ways, as all firms are unique. No two firms are the same. You will need to discuss with others about their restatements to help you figure out and make judgements about all the issues and difficulties you might find. You are free to do this (and to share your draft work with others) as everyone’s firm is different, so no-one is able to simply ‘copy’ each other’s work. We all have to think for ourselves and make our own judgements. There is no other way; there is no simple ‘cookie-cut’ solution for all firms that you can simply memorise and reproduce. It does not exist.

You will find the quality of the restatement of your firm’s financial statements will be greatly improved if you work with others in the unit rather than try to do it alone. Everyone will be facing the same issues as you, just with different firms. Since our firms are all different, you can discuss freely with each other. You can help each other out and work together co-operatively as you seek to solve the problems you will each face in restating your own firm’s financial statements. For after all, learning is a social activity. Take the opportunity to experience what it is like to learn in a cooperative, social environment. As you do this, remember restating our firm’s financial statements is not an end in itself. We are focusing on each item of our firm’s financial statements to get them ready in our spreadsheet to help us analyse and make sense of our firm. We will all face similar issues with our firms. Discussing these issues with each other and sharing in the collective wisdom of our diverse, wonderful and interesting group of people from across Australia (who are studying accounting with us this term), will help us meet the challenges we will all face as we look carefully at each item in our firm’s financial statements and decide whether it is an operating or financial item.

Balance sheet

To help separate the operating and financial assets and liabilities of a firm we restate its Balance sheet (also often called its Statement of financial position). A Balance sheet normally shows all the assets of a firm (both operating and financial) categorised as either current or non-current assets; and all the liabilities of a firm (both operating and financial) as either current or non-current liabilities. This way of categorising the assets and liabilities of a firm can be traced to the influence of the banking sector in the early development of financial statements. It facilitates an assessment of the long-term and short-term liquidity of a firm. It does little to help us view a firm from the perspective of equity investors, and to clearly distinguish between the operating and financial activities of a firm.

Our purpose in restating the Balance sheet is to clearly separate operating and financial assets and liabilities and to clearly identify Net operating assets (NOA) and Net financial assets (NFA), or more commonly Net financial obligations (NFO). Ryman Healthcare’s Balance sheet and its restated Balance sheet are shown below in Table 4-5 and Table 4-6 respectively. As can be seen from Table 4-6, I have allocated the various assets and liabilities from Ryman Healthcare’s Balance sheet between operating and financial activities. If we have a clear idea of the difference between a firm’s operating and financial activities, this is in practice a reasonably straightforward exercise. Usually we can readily identify whether each asset and liability in a firm’s financial statements is an operating or financial item, although sometimes we may need to look at the footnotes for some items to better understand what it is. It is also possible that as we look at the footnotes for some items we may decide that part of the item is operating and part is financial.

I find the best way to separate a firm’s operating and financial assets and liabilities is to print out a firm’s Balance sheet and put an ‘O’ (for operating) or an ‘F’ (for financial) next to each asset and liability in the Balance sheet. There is no need to do this for the items of equity. You will see in Figure 4-2 below how I have done this for Ryman Healthcare’s Consolidated balance sheet. I have put an ‘O’ next to each of the assets. Ryman Healthcare had no financial assets, so there are no ‘F’s next to any of its assets. You will see I did the same for each of Ryman Healthcare’s liabilities, with some liabilities being ‘O’ and some ‘F’.

Often one of the more difficult items in a balance sheet to restate is cash. A firm needs some cash to conduct its operations. It will never be possible for a firm to exactly match its cash outflows (for example, cash payments to suppliers) with its cash inflows (for example, cash receipts from customers). For example, a firm may need to pay its suppliers on a Monday and cash receipts may not come from customers until Wednesday

Page | 4-11

that week. For this reason, a firm will need some cash (either actual cash, for example in cash registers, or cash balances in the bank) or an overdraft facility with a bank to help it manage the cash outflows and inflows of its normal business operations. In such cases, a firm’s cash (or bank overdraft) would be an operating item.

However, a firm could also hold cash balances in the bank as a store of value that is not needed in the actual operations of the firm. In such cases, it would be a financial asset. It is similar at a personal level. We can keep some cash we do not need now in a savings account to earn interest and to save for some future use (a financial asset); and we can also keep some cash in a transaction account to use on a day-to-day basis to buy things with our debit card (an operating asset we need for our ‘operations’ of daily living).

Typically, it is not clear from a firm’s financial statements how much of any cash balances are needed in the operations of a firm (and are thus operating assets; or operating liabilities, if it is a bank overdraft) and how much of any cash balances are simply financial assets. Where a firm has a relatively low level of cash balances, my advice is to include these cash balances as an operating asset and assume they are needed to conduct a firm’s operations. What amounts to a ‘relatively low level of cash’ would depend on the nature of a firm’s activities, but typically up to about 0.5% or 1% of its sales might be an appropriate level of cash for many businesses to hold to help conduct their operations.

You will find some firms have large amounts of cash, sometimes amounting to many hundreds of millions of dollars. If your firm has a large level of cash balances (say, more than about 0.5% or 1% of sales), my advice would be to allocate a small amount to operating assets (say up to about 0.5% or 1% of sales) and allocate the balance to financial assets. You can see in the case of Ryman Healthcare it has no cash balances and also no bank overdraft in 2018. This is unusual; but on balance date Ryman Healthcare had no cash and no bank overdraft. The key benefit of restating a firm’s Balance sheet is to clearly identify the firm’s Net operating assets (NOA) and Net financial obligations (NFO), or alternatively Net financial assets (NFA). For example, we can see from Table 4-6 above that as at 31 March 2018 Ryman Healthcare had Net operating assets (NOA) of $3,009.2m and Net financial obligations (NFO) of $1,068.7m.

Page | 4-12

Table 4-5: Ryman Healthcare Balance Sheet as at 31 March

2018

$m

2017

$m

Assets

Cash

Trade & other receivables

Advances to employees

Property, plant & equipment

Investment properties

Intangible assets

Total Assets

Liabilities

Bank overdraft

Trade & other payables

Employee entitlements

Revenue in advance

Interest-rate swaps

Refundable accommodation deposits

Bank loans (secured)

Occupancy advances

Deferred tax liability (net)

Total Liabilities

Equity

Share capital

Asset revaluation reserve

Interest-rate swap reserve

Foreign-currency translation reserve

Treasury stock

Retained earnings

Total Equity

Total Equity and Liabilities

0.0

357.5

5.8

1,014.5

4,398.3

20.7

5,796.8

0.0

98.3

20.2

51.9

8.2

30.8

1,060.5

2,514.7

71.7

3,856.3

33.3

233.3

(5.9)

(2.2)

(22.5)

1,704.5

1,904.5

5,796.9

0.0

256.6

4.9

1,013.5

3,661.4

8.3

4,944.8

0.0

149.9

16.2

44.7

7.5

28.5

837.5

2,137.3

71.2

3,292.7

33.3

233.3

(5.4)

1.1

(20.5)

1,410.3

1,652.1

4,944.8

Source: Ryman Healthcare 2018 Annual Report

Page | 4-13

Table 4-6: Ryman Healthcare RESTATED Balance Sheet as at 31 March

2018

$m

2017

$m

Operating Assets

Cash

Trade & other receivables

Advances to employees

Property, plant & equipment

Investment properties

Intangible assets

Total Operating Assets (OA)

Operating Liabilities

Bank overdraft

Trade & other payables

Employee entitlements

Revenue in advance

Refundable accommodation deposits

Occupancy advances

Deferred tax liability (net)

Total Operating Liabilities (OL)

Net Operating Assets (NOA)

Financial Obligations

Interest-rate swaps

Bank loans (secured)

Total Financial Obligations (FO)

Financial Assets

Total Financial Assets (FA)

Net Financial Obligations (NFO)

Equity

Share capital

Asset revaluation reserve

Interest-rate swap reserve

Foreign-currency translation reserve

Treasury stock

Retained earnings

Total Equity

Total NFO + Equity

0.0

357.5

5.8

1,014.5

4,398.3

20.7

5,796.8

0.0

98.3

20.2

51.9

30.8

2,514.7

71.7

2,787.6

3,009.2

8.2

1,060.5

1,068.7

0.0

1,068.7

33.3

233.3

(5.9)

(2.2)

(22.5)

1,704.5

1,940.5

3,009.2

0.0

256.6

4.9

1,013.5

3,661.4

8.3

4,944.8

0.0

149.9

16.2

44.7

28.5

2,137.3

71.2

2,447.7

2,497.1

7.5

837.5

845.0

0.0

845.0

33.3

233.3

(5.4)

1.1

(20.5)

1,410.3

1,652.1

2,497.1

Page | 4-14

Figure 4-2: Ryman Healthcare’s Consolidated Balance Sheet as at 31 March 2018

Source: Ryman Healthcare 2018 Annual Report

Page | 4-15

Income statement Our purpose in restating the Income statement (or Statement of financial performance) is to clearly separate

operating and financial revenue and expenses, and to clearly identify Comprehensive operating income after

tax (OI) and Net financial expenses after tax (NFE) (or, alternatively, Net financial income after tax, NFI). Ryman

Healthcare’s Income statement and its restated Income statement are shown in Table 4-7 and Table 4-8

below. To restate a firm’s Income statement, we first go through each item of revenue and expenses and

allocate them between operating and financial activities. This is like what we did when restating our firm’s

Balance sheet and is often straightforward, as we usually have sufficient information in a firm’s financial

statements to do this allocation. I find the best way to do this is to print out a firm’s Income statement and to

put an ‘O’ (for operating) or an ‘F’ (for financial) next to each item of revenue and expenses in the Income

statement. You will see in Figure 4-3 below how I have done this for Ryman Healthcare’s Consolidated income

statement.

We also have a few additional steps to do when restating our firm’s Income statement. These are:

 Include any items of ‘Other comprehensive income’ not already included in our firm’s Income statement.

You can see in Table 4-8 below that in 2018 I have included ‘Gains on hedge of foreign-owned subsidiary net assets’ ($2.2m) and ‘(Loss) on translation of foreign operations’ (negative $5.5m) as items of Other operating comprehensive income in Ryman Healthcare’s restated Income statement. I have also included ‘Fair-value movement and reclassification of interest-rate swaps’ ($0.7m) and ‘Movement in deferred tax related to interest-rate swaps’ ($0.2m). These items were taken from Ryman Healthcare’s restated Statement of changes in equity in Table 4-4 above (they are also included in Ryman Healthcare’s Consolidated statement of comprehensive income in its 2018 Annual Report).

For many of these items, you may find yourself wondering what they are exactly. The names can seem quite exotic and strange. You can discuss with others, as many will have similar items in their firm’s financial statements and they will also be wondering what they are. Here is a short video on interest rate swaps. Also, ‘losses or gains of translation of foreign operations’ can occur when a firm has overseas operations (as Ryman Healthcare does in Australia). Its overseas operations will keep its accounts in the overseas currency (for Ryman Healthcare that is A$). Each year on balance date, the overseas subsidiary’s accounts are translated into the parent company’s currency (for Ryman Healthcare, that is NZ$). As exchange rates are always fluctuating, this can lead to losses or gains. Although not included in Ryman Healthcare’s Income statement (see Table 4-7 below) these items form part of Ryman Healthcare’s Comprehensive operating income (OI).

 Allocate tax to the operating and financial components of the Income statement.

This is usually the most difficult step in restating a firm’s Income statement. Tax is a real expense of a business, in exactly the same way as any other expense such as salaries, rent, interest on its borrowings, or fuel for the corporate jet. We have also seen before that profit equals revenue (both operating and financial) less expenses (both operating and financial). But there is one difference with tax expense compared to other expenses. The amount a firm pays in tax depends on its level of profits. For example, in 2018 Australian companies generally paid tax at the rate of 30% on their profits, New Zealand companies at 28%, UK companies at 19%, Chinese companies at 25%, Hong Kong companies at 16.5% and German companies at 30%. This means that the greater a firm’s profit the greater the total amount of tax it will pay; and the less its profit, the less tax it will pay.

A firm’s profit (and thus its tax expense) will depend on the level of both operating and financial revenue and expenses. The more interest a firm pays on its borrowings the less will be its profit and the less it will pay in tax. Also, the more interest a firm receives on its financial assets the more will be its profit and the more it will pay in tax. So if a firm increases its borrowings and thus pays more interest it will increase its interest expense and reduce its tax expense. Alternatively, if a firm reduces its borrowings and thus pays

Page | 4-16

less interest, it will reduce its interest expense and increase its tax expense.

What this means is that a firm’s tax expense will be affected not only by its operating activities but also by its financial activities (that is, by how much money it borrows). For us to clearly separate a firm’s operating and financial activities in its financial statements we need to allocate tax to a firm’s operating and financial activities. We do this by calculating how much tax our firm would have paid on its operating activities if it had no financial assets or liabilities (rather than what it actually paid after deducting interest expense or including interest income); and to then make a corresponding (and opposite) adjustment to our net financial expenses or income.

To do this we need to split our tax expense into two bits. We have seen when we restated Ryman Healthcare’s Balance sheet as at 31 March 2018 that it had Net financial obligations (NFO) of $1,068.7m on which it pays interest. This means Ryman Healthcare paid less tax as a result of paying interest on those borrowings. This was a benefit to Ryman Healthcare of having those borrowings (as usually we all like to pay less tax). This tax benefit is sometimes called a ‘tax shield’ as having interest to reduce a firm’s profits and thus its tax protects or shields the firm from some of the painful ‘arrows’ of paying tax to the government. I calculated the tax benefit for Ryman Healthcare of its financial activities as follows:

Tax benefit = Net interest expense × tax rate of the firm

In 2018, the Net interest expense of Ryman Healthcare was $16.2m, being the difference between the interest it paid (financial expenses: $16.6m) and the interest it received (financial income: $0.4m). The tax rate of Ryman Healthcare was 28% (the NZ corporate tax rate in 2018). This means the tax benefit for Ryman Healthcare of its financial activities was:

Tax benefit = $16.2m × 28%

= $4.5m

We add this tax benefit of $4.5m to Ryman Healthcare’s tax expense of $0.6m to give an increased tax expense on its operating activities of $5.1m. This is the amount of tax Ryman Healthcare would have incurred if it had not had the benefit of deducting interest on its borrowings. In other words, it is the amount of tax incurred on its operating activities without the benefit of its financial activities. But, of course, Ryman Healthcare did not actually have a tax expense of $5.1m. It only had a tax expense of $0.6m, because it had the benefit of its financing activities that reduced its tax expense by $4.5m.

We deduct the tax benefit of its financing activities of $4.5m from Ryman Healthcare’s Net interest expense of $16.2m to reduce its Net financial expenses to $11.7m. This recognises the benefit to Ryman Healthcare of its borrowings in reducing its tax expense by $4.5m. When calculating the tax benefit for your firm you need to use the corporate tax rate of the country where your firm is based. Also, the corporate tax rate can change from year to year. In recent years there has been a trend in a number of countries to reduce company tax rates. These are the tax rates you can use when calculating the tax benefit for your firm: Global Company Tax Rates.

 Calculate both a firm’s Comprehensive operating income after tax (OI) and its Net financial expenses after tax (NFE). Both these items are calculated on an after-tax basis. We can show it this way once we have allocated tax between operating and financial activities. I have carried out these steps for Ryman Healthcare in Table 4-8 below, calculating in 2018 Comprehensive operating income after tax (OI) of $396.6 million and Net financial expense after tax (NFE) of $11.7 million (after including Other financial comprehensive income of negative $0.5m).

Page | 4-17

Table 4-7A: Ryman Healthcare Income Statement for the year ended 31 March

2018 2017

$m $m $m $m

Revenue

Care fees

Management fees

Interest received

Other income

Total revenue

Fair value movement investment properties

Total income

Operating expenses

Depreciation expense

Finance costs

Total expenses

Profit before income tax

Income tax expense

Profit for the year

270.5

70.1

0.4

1.5

(268.0)

(20.6)

(16.6)

342.5

351.5

694.0

(305.2)

388.8

(0.6)

388.2

227.4

61.0

0.5

0.3

(225.6)

(14.9)

(10.7)

289.2

325.0

614.2

(251.2)

363.0

(6.3)

356.7

Table 4-7B: Ryman Healthcare Comprehensive Income Statement for the year ended 31 March

2018 2017

$m $m $m $m

Profit for the year

Fair-value movement of interest rate swaps

Movement in def. tax related to int. rate swaps

Gains on hedge on foreign-owned sub net assets

(Loss) on translation of foreign operations

Reval’n property, plant & equipment (unrealised)

Other comprehensive income

Total comprehensive income (CI)

(0.7)

0.2

2.2

(5.5)

0.0

388.2

. (3.8)

384.4

1.8

(0.5)

1.1

(1.4)

56.5

356.7

57.5

414.2

Source: Ryman Healthcare 2018 Annual Report

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Table 4-8 Ryman Healthcare RESTATED Income Statement for the year ended 31 March

2018 2017

$m $m $m $m

Operating revenue

Care fees

Management fees

Other income

Total operating revenue

Fair value movement of investment properties

Total operating income

Operating expenses

Depreciation expense

Total operating expenses

Operating profit before income tax

Tax expense

Tax reported

Tax benefit*

Tax expense

Other operating comprehensive income

Gains on hedge on foreign-owned sub net assets

(Loss) on translation of foreign operations

Reval’n property, plant & equipment (unrealised)

Total other operating comprehensive income

Comprehensive operating income after tax (OI)

Net financial expenses (NFE)

Financial expenses (FE)

Financial income (FI)

Net financial expenses before tax

Tax benefit *

Other financial comprehensive income

Fair-value movement of interest-rate swaps

Movement in def. tax related to int. rate swaps

Net financial expense after tax (NFE)

Comprehensive net profit after tax (CI)

* Tax benefit = 16.2 x 28% (2018); 10.2 x 28% (2017)

270.5

70.1

1.5

(268.0)

(20.6)

(0.6)

(4.5)

2.2

(5.5)

0.0

(16.6)

0.4

(16.2)

4.5

(0.7)

0.2

342.1

351.5

693.6

(288.6)

405.0

(5.1)

(3.3)

396.6

(11.7)

(0.5)

(12.2)

384.4

227.4

61.0

0.3

(225.6)

(14.9)

(6.3)

(2.9)

1.1

(1.4)

56.5

(10.7)

0.5

(10.2)

2.9

1.8

(0.5)

288.7

325.0

613.7

(240.5)

373.2

(9.2)

56.2

420.2

(7.3)

1.3

(6.0)

414.2

Page | 4-19

Figure 4-3: Ryman Healthcare’s Consolidated Income Statement for the year ended 31 March 2018

Source: Ryman Healthcare 2018 Annual Report

Page | 4-20

We have seen how to restate a firm’s financial statements to clearly separate the operating and financial activities of a firm. This has allowed us to calculate Ryman Healthcare’s 2018 Net operating assets (NOA) of $3,009.2m, Net financial obligations (NFO) of $1,068.7m, Comprehensive operating income after tax (OI) of $396.6m and Net financial expense after tax (NFE) of $12.2m. Along with an estimate of our firm’s cost of capital (which we will look at in the next section), we can calculate a firm’s economic profit. We also have the financial statements in a form that will assist us to identify the drivers, or reasons, why our firm has been able to generate the economic profit it has in the past. In other words, we are ready to start analysing our firm’s financial statements by ‘breaking them into bits’.

4.4 Profitability and efficiency

Information is not knowledge

Albert Einstein

In this section, we will use information from Ryman Healthcare’s restated financial statements to look at some key aspects of its performance. We often think about profitability in terms of how much profit we make for each dollar of sales. A supermarket selling large amounts of groceries and other goods each day may make a profit of about 3 cents in every dollar of its sales. A luxury car dealer may make a profit of about $15,000 on each $100,000 Lexus it sells (or 15 cents for each dollar of sales). Which is better? To make 3 cents profit for each dollar of sales, or to make 15 cents for each dollar of sales? All other things being equal, we would rather make 15 cents for each dollar of sales.

But ‘all other things’ are rarely equal in business. What if a supermarket could make $7 in sales each year for each dollar it has invested in its business in its stores, inventory and head offices; and our car dealer could make 50 cents in sales each year for each dollar it has invested in its business in its car dealerships, inventory of cars and so on? After all, supermarkets have people going through its check outs constantly throughout the day, often queuing up to pay the supermarket money. However, a car dealership can get rather quiet sometimes during the day and only make occasional sales of cars each week. In this section, we will analyse (or break into bits) a firm’s financial performance into its profitability (how much profit it makes for each dollar of sales) and its efficiency (how much sales it makes for each dollar it has invested in its business).

We will see one of the accounting ‘drivers’ of a firm’s performance can be expressed as Return on net operating assets (RNOA), a ratio of Operating income (OI) to Net operating assets (NOA). This looks at the relationship between the earnings of a business (OI) and how much it has invested in its operating activities to make those earnings (NOA). This is a relationship in a business many people can be interested in understanding. In this section, we will look at how we can analyse a firm’s RNOA by breaking it into its component ratios of profitability and efficiency.

Breaking things into bits

Analysis involves breaking things into bits. As he was growing up, my younger son was often curious about how different things worked. How does a keyboard work, or an old record player, or a watch, or a computer, or the dumb-waiter in our house, or an old clock-radio? He could not tell by looking at something from the outside. So, he would often take it apart and pull it to bits. Although he did often find it more challenging to put things back together again, breaking things into bits gave him some insights into how things work. It is the same with financial statements. Are you curious about how a firm works? We will not physically break a firm into bits, but instead we will break its virtual reality, its financial statements, into bits.

We will start with economic profit. We have seen that:

Economic profit = (RNOA – cost of capital) × NOA

where, RNOA = OI/NOA.

Page | 4-21

You will remember that RNOA is Return on net operating assets, OI is Comprehensive operating income after tax and NOA is Net operating assets. Economic profit is driven by (or made up of) three things: RNOA, cost of capital and the amount of Net operating assets (NOA) invested in the business. The cost of capital is often called weighted-average cost of capital, or WACC (pronounced ‘whack’). We will now start to analyse RNOA by lifting the ‘bonnet’ on the financial statements and taking them apart. We will first break up, or analyse, RNOA into a ratio that focuses on profitability (how much profit we make for each dollar of sales) and another ratio that focus on efficiency (how much sales we make for each dollar invested in the business), as follows:

RNOA = PM x ATO

where, PM = OI/Sales and ATO = Sales/NOA

If you remember anything from this Study Guide, remember this relationship between profitability and efficiency. In many ways, it is at the heart of how we make sense of and analyse financial statements. Understanding this relationship and maximising the interaction between profitability and efficiency is one of the keys to success in any business.

Accounting drivers

Ryman Healthcare’s economic profit can be calculated as follows:

Economic profit = (RNOA – cost of capital) × NOA

where, RNOA = OI/NOA

In 2018, Ryman Healthcare’s Operating income (OI) was $396.6m. The company had Net operating assets (NOA) on 31 March 2018 of $3,009.2m and Net operating assets (NOA) on 31 March 2017 of $2,497.1m. We can see Ryman Healthcare grew its Net operating assets (NOA) a lot during the year ended 31 March 2018; in fact, by $512.1m ($3,009.2m - $2,497.1m). That is a lot of growth in its NOA. Growth companies like Ryman Healthcare tend to be doing this sort of thing; that is, getting bigger. Children and teenagers can grow a lot in a single year, perhaps recorded by marks on a door frame at home. In the same way, companies like Ryman Healthcare are at the stage in their corporate life when they can grow a lot in a single year. At my age, I do not grow a lot each year; at least not any taller. That stopped a long time ago for me. But, of course, there are more directions for us to be growing than simply upwards; particularly if we are chocoholics.

So how do I calculate Return on net operating assets (RNOA)? Return on net operating assets (RNOA) is a ratio that expresses the relationship between two numbers or quantities in a firm’s financial statements. It is the relationship between Operating income (OI) and Net operating assets (NOA), namely RNOA = OI/NOA. Operating income (OI) is quite straightforward. It is the Comprehensive operating income after tax for the year ended 31 March 2018. We saw in Section 4.3 above how we can find this from our restated Income statement. But what about Ryman Healthcare’s Net operating assets (NOA)? Which figure should I use: the figure for NOA as at 31 March 2018 or the figure for NOA as at 31 March 2017?

Depending on which figure we use, we can get a very different number for our return on net operating assets (RNOA). For example, if we use Ryman Healthcare’s NOA as at 31 March 2018 of $3,009.2m, we can calculate its RNOA as OI/ NOA = $396.6/$3,009.2m = 13.1%. In other words, Ryman Healthcare earned a return of 13.1% in the year ended 31 March 2018 on the net operating assets (NOA) it had in the business at the end of the year. But if we use Ryman Healthcare’s NOA as at 31 March 2017 of $2,497.1m, we can calculate its RNOA as OI/NOA = $396.6m/$2,497.1m = 15.9%. That is quite a big difference. So, which one should we use?

The key to deciding this sort of thing is to remember that a ratio expresses the relationship between two or more numbers or things. In calculating Ryman Healthcare’s Return on net operating assets (RNOA), we are trying to get an idea about how much Operating income (OI) the firm earned during the year ended 31 March 2018 in relation to the amount of Net operating assets (NOA) it had in the business during the year generating that Operating income (OI). For example, $396.6 million sounds like a lot of operating income to make in a year. But let us say a firm had $40 billion of Net operating assets (NOA) invested in its business; in such a case,

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having operating income of $396.6 million would represent a return of about 1% per year on $40 billion. This is not so good, as I could simply put my $40 billion in the bank and earn more than this, without taking on the additional risk and uncertainty involved in any business.

In calculating Ryman Healthcare’s Return on net operating assets (RNOA) we want to compare its Operating income (OI) that it earned during the year ended 31 March 2018 with the Net operating assets (NOA) that were used in the business during that year to earn that Operating income (OI). If our firm’s NOA has not changed much during the year (which can be the case for many firms) then we can simply use NOA as at the end of the year as a good measure of our firm’s NOA used in the business during the year. However, this is not the case with Ryman Healthcare. Its NOA has changed a lot during the year. Now, we know from Ryman Healthcare’s Balance sheet both its NOA as at 31 March 2017 (the beginning of the year ended 31 March 2018) and its NOA as at 31 March 2018 (the end of the year). So, which one do we use? Well, it depends. If on 1 April 2017, Ryman Healthcare increased its NOA from $2,497.1m to $3,009.2m and then had this level of NOA throughout the year, then we should use $3,009.2m (the balance as at 31 March 2018) because that is the amount of NOA that was employed in the business throughout the year to earn the company’s OI that year.

Alternatively, if Ryman Healthcare kept its NOA constant until 30 March 2018 and then increased it suddenly from $2,497.1m to $3,009.2m on the last day of the year, then we should use $2,497.1m (the balance as at 31 March 2017) because that is the amount of NOA that was employed in the business throughout the year to earn the company’s OI that year. Sometimes it is possible to find out from the footnotes if there have been some sudden movements in a firm’s NOA early or late in the year (such as buying a major new business), which can help us to decide whether to use opening or closing NOA when calculating our firm’s RNOA. If in any doubt, when calculating your firm’s RNOA, you can simply use closing NOA (particularly if you have not calculated NOA for the previous year).

In the case of Ryman Healthcare, its growth in NOA occurred gradually during the year as it continued to grow its existing business through building new retirement villages and through its existing retirement villages increasing in value progressively during the year. For this reason, for Ryman Healthcare, the best assumption to make about NOA is that it grew gradually during the year. So, when calculating Ryman Healthcare’s return on net operating assets (RNOA) for the year ended 31 March 2018, I will use average NOA for the year, in other words:

NOA = (opening NOA + closing NOA)/2

= ($2,497.1m + $3,009.2m)/2

= $5,506.3m/2

= $2,753.15m

Using average NOA of $2,753.15m, I can then calculate Ryman Healthcare’s RNOA as follows:

RNOA = OI/NOA

= $396.6m/$2,753.15m

= 14.4%

Now that we have calculated Ryman Healthcare’s RNOA, we can calculate its economic profit as follows:

Economic profit = (RNOA – cost of capital) × NOA

We can use a cost of capital for Ryman Healthcare of 8.0% per year. This is an appropriate average level of cost of capital for listed companies internationally at present. You can also use 8.0% as the cost of capital for your firm. I have calculated Ryman Healthcare’s RNOA of 14.4%, used 8.0% as cost of capital and also calculated its

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average net operating assets (NOA) for the year ended 31 March 2018 of $2,753.15m (which I have decided is the most relevant way of calculating NOA for Ryman Healthcare that year). I can now calculate Ryman Healthcare’s economic profit for the year ended 31 March 2018 as follows:

Economic profit = (RNOA – cost of capital) × NOA

= (14.4% – 8.0%) × $2,753.15m

= 6.4% × $2,753.15m

= $176.2m

Ryman Healthcare has 500 million shares on issue, so economic profit of $176.2m represents about 35 cents per share. Shares in Ryman Healthcare listed on the New Zealand Stock Exchange in mid-1999 at 27 cents per share (after adjusting for a 5:1 share split in January 2007, which means shareholders ended up with five shares for every one they had previously; the actual share price on listing was $1.35). Within about 19 years, equity investors who acquired shares in Ryman Healthcare when it floated in mid-1999 achieved an economic profit in 2018 (that is, earnings greater than those required to compensate them for the capital they had invested) of more than their original investment (i.e. 35 cents compared to 27 cents). Not bad; and a sure way of getting rich if you can keep it up over time.

Profitability

I find in business most people have a strong understanding of the concept of profitability. Most people have a clear grasp of the idea of profit margins: how much profit I make from each dollar of sales. There are several ways of measuring it and looking at it, but the idea itself of selling something to customers for more than it costs you (to buy inputs from suppliers and to transform those inputs in some way) seems clear enough to most people. Also, it is easy to grasp the idea that if you do not make an ‘adequate’ profit margin you will quickly go out of business. Indeed, the concept of a firm’s profitability largely ‘cuts to the chase’ in terms of a firm’s ability to add value to equity investors. It is in some way core to the activities of a firm.

We define profit margin (PM) as:

PM = OI/Sales

where, OI = comprehensive operating income after tax

The profit margin focuses our attention on the profitability of each dollar of sales. Clearly, the more profit a

firm can achieve from each dollar of sales, the greater the ‘value add’ to equity investors. The ‘average’ profit

margin in the US is about 6%, but can vary widely between industries and between companies within

industries, and over time depending on where we are in the economic cycle (Nissim and Penman, 2001, p.

129). For example, many firms can be expected to have profit margins (PMs) more than about 10% or less than

about 3%. We can calculate Ryman Healthcare’s operating profit margin for the year ended 31 March 2018

from its restated income statement (see Table 4-8 in Section 4.3 above), as follows:

PM = OI/Sales

= $396.6m/$694.0m

= 57.1%.

As we can see, Ryman Healthcare’s profit margin of 57.1% is very high. For every dollar of sales it made 57.1 cents profit. There are not many businesses that can achieve profit margins like this.1 A key part of Ryman Healthcare’s ability to generate a RNOA of 14.4% lies in its ability to generate profit margins of 57.1% that year. However, it is only part of the story and all parts of the story interact with each other. As I said previously, in business I find most people have a strong connection with and understanding of the importance of profit margins in generating returns to shareholders. However, I often find much less understanding of the fact that profit margins are not of importance in themselves. Rather, it is the interaction of profit margins with

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efficiency (the amount of Sales generated by each dollar of Net operating assets invested in the business) that is critical.

Efficiency

Efficiency is how well Net operating assets (NOA) in a business are being used to generate Sales or turnover (turnover is another word for Sales). It is measured as the relationship between Assets and turnover, called (unimaginatively) Asset turnover (ATO).

We define ATO as:

ATO = Sales/NOA

where, NOA = Net operating assets

Asset turnover (ATO) is the amount of sales generated by each dollar of Net operating assets (NOA) in the business. It is the ability of NOA in the business to generate sales.

Alternatively, ATO can be looked at as its inverse:

1/ATO = NOA/Sales

The inverse of ATO (that is, 1/ATO) is the amount of NOA needed to be put in place in the business to generate each dollar of sales.

An average ATO in the US is about 2.0 times; but can vary widely between firms with many firms having an ATO between about 1.0 and 3.0 times (Palepu and Healy, 2013, pp. 5–25). Typically, a firm’s ATO tends to be more stable over time than its Profit margins (PM), although ATO can fall significantly for firms during economic downturns. A firm with an ATO of 2.0 times can generate $2 of sales each year for each dollar of Net operating assets (NOA) put in place in the business, or alternatively, 50 cents of NOA are used by the firm to generate each dollar of annual Sales. It is surprising how easy it is in business to overlook the importance of a firm’s ATO. Return on net operating assets (RNOA) is driven by the interaction between Profit margins (PM) and Asset turnover (ATO):

RNOA = PM × ATO

This is the du Pont analysis of operating profitability, named after the major US manufacturing company that used this analysis in the early 20th century (see Chapter 3 Section 3.3 above). We can calculate Ryman Healthcare’s ATO for the year ended 31 March 2018 from its restated Balance sheet and Income statement (see Table 4-6 and Table 4-8 above), as follows:

ATO = Sales/NOA

= $694.0m/[($2,497.1m + $3,009.2m)/2]

= $694.0m/$2,753.15m

= 0.25 times

Ryman Healthcare’s ATO is low at 0.25 times. It can generate 25 cents of sales each year for each dollar of NOA the firm has in place in the business. This low ATO reduces the impact of Ryman Healthcare’s strong profit margins (57.1%) on its Return on net operating assets (RNOA) (14.4%). Profitability and efficiency interact to generate RNOA. In business, many have a good grasp of PM, but can often fail to fully appreciate that RNOA (that is, operating profitability as a percentage of NOA) is not driven by PM alone but by the interaction of PM and ATO. It is the interaction and trade-offs between PM and ATO that need to be the focus of attention in running a business; and maximising this interaction is a primary means for management to ‘add value’ to equity investors.

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Conclusion

In this chapter, we got to know a firm’s financial statements a bit better, more than we would at a simple first introduction. We have seen two ways of looking at how a firm adds value for its equity investors: cash flow and economic profit. These are two common ways of looking at a firm’s value creation activities. We also saw a powerful way we can look at a business, by clearly separating in our minds the operating and financial activities of a firm. We then restated Ryman Healthcare’s Statement of changes in equity, Balance sheet and Income statement.

We can calculate a range of ratios based on a firm’s financial statements and based on its restated financial statements. One set of ratios will mix up a firm’s operating and financial activities; the other will have these two aspects of a firm clearly separated. Using an economic profit view of ‘value-add’ in a firm, we saw how we could break up a key aspect of a firm’s economic profit, its Return on net operating assets (RNOA), into Profit margin (PM) and Asset turnover (ATO) using a firm’s restated financial statements. So far, we have been looking at how people outside a firm can use financial statements to help them connect to a firm’s economic and business realities. In the next chapter, we turn our attention to management and how people inside a firm can use accounting information to help them find out what is really going on in their firms.

Footnotes

1. Ryman Healthcare does not include ‘sales’ of occupancy rights in retirement village units as part of its sales. This has the effect of increasing its PM (and correspondingly reducing its ATO). It has no effect on its RNOA.

References

Harris, T et al. 2006, ‘From stock selection to portfolio alpha generation: The role of fundamental analysis’, Journal of applied corporate finance, vol. 18, no. 1, Winter.

Nissim, D & Penman, SH 2001, ‘Ratio analysis and equity valuation: From research to practice’, Review of accounting studies, March, no. 6, pp. 109–154.

Palepu, KG & Healy, PM 2013, Business analysis and valuation: Using financial statements: text & cases, 5th edn, Thomson/South-Western, Mason, OH.

Penman, S 2013, Financial statement analysis and security valuation, 5th edn, Mc-Graw-Hill/Irwin, New York.