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 (they needed to). 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 were the shares that the business (or rather my former boss’s family trust) owned in other companies. An FO was a loan from the bank for a seriously expensive new investment. All these acronyms – I don’t like acronyms. This section of Chapter 4 is hard to absorb but I’m trying!
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