Assignment Two

Again late but it's such a relief. Here's Assignment Two - hopefully I understand more of the tax-related calculations for Assignment Three.

ASSIGNMENT STAGE TWO

Stage 2: Restated Financial Statements

Step 1: Key Concepts and Questions from Chapter 4, Study Guide

Key Concepts

·         Well, this is going to be a bit long-winded, because I really want to understand Chapter Four. I've tried to understand it numerous times, but browsing through it just doesn't work for me. I have to sit down and nut it out. Here's some of what I understand:

·         It’s funny that in life, people’s expectations can generate what actually happens. From what I remember about firms and stock market, if people think a company is going to do well, they buy shares in it. The price of shares (due to the increase in purchases) then goes up and the firm’s position on the stock market appears healthy – and this healthy appearance leads to more share purchases, and therefore a healthier and healthier outward appearance. But if people think that the company or firm is going to do badly, they don’t buy shares in it, or they sell their existing shares, and therefore the company’s share price goes down. People see this and think that the firm is not healthy – and the longer this goes on, the reality of the firm’s increasing ‘sickness’ hits hard. So perceptions truly do change reality. It’s a scary truth but also an exciting one when thinking about it in a positive light for the future.

·         I am so glad that Dr Turner included this sentence: ‘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 ensures all earnings are included, that shareholders’ equity only includes genuine equity and that the operating and financial activities of a firm are clearly separated.’ This is the nuts and bolts of getting the truth out of the financial statements – because to me earlier, when we uploaded ours from the firm’s documents, they seemed more of a marketing presentation to prospective investors rather than an accurate representation of Dignity’s position at the time.  To fresh eyes (i.e. mine) there’s no difference between the words ‘operating’ and ‘financial’. Let me continue with this chapter and see if I understand the key difference by the end!

·         Dividends and FCF are related in a firm’s cash flow? How exactly? Well, cash flow is a measure of transfer of value. I used to work as a barista. In a coffee van situation, Free Cash Flow is driven by these two things: the cash earned from the van’s operations (cash earned by running the coffee machine and selling cappuccinos and hot drinks) and the net cash invested into the coffee van's upkeep and upgrades. The more money poured into the upgrading and maintenance of the coffee van and especially the coffee machine, the less money will be available for take-home pay (or rather equity) for the coffee van owners. The busier the coffee van gets, the sooner the owners decide to invest in a new (bigger) coffee machine, because they are hoping the increase in customers will continue to in-cline (climb the “Hill of Profit” J ). They are hoping the extra $$$$ they have poured into the newer coffee machine will be outweighed by the $$$$$ earned by being able to make more coffees in a given ten minute window. But this is not guaranteed. It’s a risk once again.

·         The example of Kings vs Marks is good. If I wanted to buy shares in one of two places where I used to work – one was a thriving café and the other was a rather stagnant one – I’d definitely pick the first one, even if it had less Free Cash Flow. This is because (we’ll call it “Kings of Dough”) they invested a lot of money in research and development into new products that customers might like and food trends. They also invested a lot of money into new equipment for new products and in perfecting each cup of coffee. They spent a lot of time testing the coffee beans and coffee extraction times to try to achieve the least bitter taste possible in the shortest amount of time. On the other hand, "Stale Cake”, the boring 'apple-cinnamon muffin with a latte' place, didn’t spend much time or much money in trying new recipes, getting a better coffee machine (they needed one) or in changing the ‘way’ they did things. As a prospective investor, I’d definitely invest in "King of Dough" because they always tried to stay on top of their game and spent money to achieve higher results in the future, even though this meant less ‘take-home pay’ in the present. Sort of like slow and steady wins the race, to an extent. I sincerely hope I’ve got this analogy right! Haven’t read enough of the chapter yet to know if so. Anyway, let’s keep going.

·         I think I can relate to operating activities. At a very successful café where I used to work, our operating activities included deciding whether to bake three apple cakes or one apple cake and two carrot cakes for the busy weekends. Our agreements included deciding which of two pre-mixed smoothie flavours we would buy from our suppliers, based on how popular we thought they would be during summer season. Another agreement included deciding which teenage school girl applicant to employ on a casual basis, depending on how friendly, approachable and hard working she was. I guess our value-adding activities including deciding to remove unnecessarily expensive electricity-sucking pie warmers, running coffee-making training sessions for employees and re-designing the layout of cakes, slices and pies in our cake cabinets. Our financial activities included personal contributions by the owner of the cafe and his obtaining loans from his bank – a debt investor!

·         NOA would be the equipment (assets) we used to bake products for our customers – e.g., our industry-sized mix-master for cookie and muffins. The operating expense was the dough mixes which we bought from suppliers. The operating income was the end-of-day profit we had after selling most of our produce and paying our suppliers for the mix.

·         NFA – well, I guess these would be the investments the head company had made into other companies. A Financial Obligation would be the loan from my boss’s bank.

·         The fact that financial statements are laid out for the benefit of debt investors, not equity investors definitely opened my eyes as to WHY the statements don’t make immediate sense from a potential shareholder perspective

·         Well, I think I definitely know more about the difference between ‘financial’ and ‘operational’ activities now. Financial has everything to do with the flow of money in the form of dividends and debt between the company, its shareholders and debt investors; while Operations has everything to do with the flow of money in the form of payments to employees, payments for operational assets, payments for land etc., between the company, its customers and its suppliers. Much like the flow of money between my former boss, the various local frozen goods and juice suppliers, me and my colleagues; and then the flow of money from my boss’s takings at the end of the quarter to Head Office and then from Head Office to the relevant shareholders and financing banks.

Step 2: Restated Financial Statements

Restated Statement of Movements in Equity:

I think that tax on Dignity’s employee share options – as these share options are not mandatory – would be a form of financial income/loss. However, tax on employee benefit plans (as these plans might be mandatory under UK law) would probably be operating income, as the benefit plans relate directly to employee expenses.

Restated Statement of Financial Position

I wasn’t sure how exactly to classify ‘Provisions for liabilities and charges’. Luckily there is a footnote for this (footnote 19) on Dignity’s 2014 report, which states that the provisions relate to vacant leasehold properties, repairs to leased premises, and the expected costs of cancelled pre-arranged funeral plans. Assuming these provisions are operating costs for the relevant period (2014, 2013 etc.), I am entering them as Operating Liabilities.

As I classified the employee benefit plan on the Statement of Movements in Equity as an Operating Expense, I will also be entering the ‘Retirement benefit obligation’ as an Operating Liability. The ‘Retirement Benefit Asset’ will be entered as an Operating Asset. Hopefully this will avoid any miscounting on my part.

Dignity does have very large amounts of cash recorded as Current (operating) Assets. Assuming that Dignity’s sales is their total Revenue for each year, which was approximately £268.9m pounds in  2014, then their operating cash should be 1% of this: approximately £2.7m (rounding up). As per Dr. Turner’s advice in Chapter 4, I’ve taken 1% of the total cash recorded for each year (the revenue from each annual report) and allocated the remaining 99% of each total cash amount to Financial Assets. I hope this is correct – have entered my workings into right-hand-side workings column of the worksheet.

Restated Statements of Financial Performance

Regarding the correct entering of tax benefit and tax expense – I am a bit confused about the ‘Extinguishment of Old Notes’. Should I just enter the additional (comprehensive) financial costs of ‘Loss on extinguishment of Old Notes – exceptional’ and ‘Elimination of swap – exceptional’ below the Finance Costs of interest paid? That’s what I’ve done.

Another issue is that on the original Income Statement, total taxation is a positive figure – because of the loss on the extinguishment of Old Notes? But in all the years preceding, total taxation is a negative figure. I’ve left the taxation for 2014 as a positive figure to avoid errors.

 Previously, I didn’t include the Statement of Comprehensive Income in Assignment One, but I’ve now added this onto the first worksheet and used it for this Assignment Two. Overall, I am not satisfied with the quality of my workings here. I want to understand the calculations properly in time for Assignment Three and also need to involve myself in discussions on Moodle.


Step 3: Three Products/Services which Dignity PLC offers

Three products which Dignity offers are 1) pre-paid funeral plans 2) purchases of burial plots and 3) funeral services.

Assuming that a pre-paid funeral plan costs around £7000 (I am assuming this can be paid off in instalments by the client), I would guess that the variable costs, such as the sort of coffin the client wants and the type and length of service they would like involved at the funeral, the variable costs involved could be around £3000. Therefore, as contribution margin is calculated as sales revenue less variable costs, the contribution margin would be approximately £4000.

Assuming that a burial plot purchase costs around £10,000 and the variable costs might include expenses such as a choice of ornate or simple headstone and the size and placement of the burial plot, I think the variable costs could be up to £7,000. The contribution margin would then be £3,000.

For a funeral service, which sounds pretty similar to a pre-paid funeral plan but probably more expensive, I think the price might be closer to £9000. Variable costs could include the size of the service (the number of people attending), musician hire and a longer-than-usual funeral service with several speeches (which really involves variable costs in equipment and facility hire) and could easily be up to £6000. The contribution margin would be £3000.

If these assumptions are reasonably accurate, the main difference in the greater contribution margin for the pre-paid funeral plan is that Dignity have probably calculated this product quite well in advance – they are offering it as a pre-paid plan after all. They would have a very good idea of consumer behaviour when it comes to planning one’s own funeral in advance and would be able to implement cost-saving strategies where an impromptu funeral service wouldn’t allow it.

I think that Dignity would produce this range (pre-paid plans, funeral services, burial plots) to ensure that they keep their place as second-biggest market share holder in the UK. Being able to offer these products and having a significant level of ownership allows them to dominate more regional and possibly wealthier areas in the UK. If they only sold pre-paid funeral plans, it would quickly change consumer perceptions towards them - they might seem to be more of a ‘Crazy Clarks’ of the funeral world and lose some of their prestigious reputation. While they might make more of a profit on the plans alone based on the contribution margin, they would lose clientele. And clientele is what their business is based on at the end of the day.

One resource constraint that Dignity might face is the decrease in availability of ground for burial plots. After all, the UK is not a big country and the land in many areas is becoming populated and developed for more and more immigrants, and probably also by burial grounds for the older generations in the rural areas. One market constraint on funeral services would be the ageing English population. If there are soon to be less of the older and affluent Brits and an increased number of younger, value-for-money focused immigrant clients, this means less likelihood of the future profitability of prestigious funeral services and preferential burial plots. There would instead be an increased market for pre-paid funeral plans and an increased demand for value-for money. So Dignity, as a result of these two constraints, might be likely to provide a greater number of lower priced funeral-plans and less of the overly-orchestrated funeral services.