When going about restating Dexion’s financial statements, I found myself smiling throughout the process because Dexion has a relatively straightforward business operation whereby, with reasonable diligence, readers of its financial statements can easily comprehend its business. Dexion has no minority interests, neither does it enter into agreements like interest rate swaps or forward rate agreements. Unlike Ryman Healthcare, Dexion does not even revalue its assets, except for intangible assets which they are required to under the IFRS. Therefore, I spend more time comparing Dexion’s FS with that of other firms.
On the balance sheet, I found only one item to be classified as financial activity i.e. loans and borrowings. But after reading through the notes, I found that Dexion has many other financial activities. For example, Note 5 discloses that Dexion uses forward exchange contracts to hedge any currency risk. This is further explained in Note 28 which discloses that at balance date, Dexion had taken out foreign exchange cover for the initial payment due for the acquisition of Shanghai Xiao Bao Storage Systems Equipment Co Ltd (from Note 34) by purchasing forward RMB12million (AUD equivalent $1.9million) for delivery in March 2008. $1.9million is a material amount, but why isn’t this financial instrument being recognised in the Balance Sheet? I am guessing it is due to Dexion’s accounting policy whereby “non-derivative financial instruments is being recognised as investments in equity and debt securities, trade and other receivables, cash and cash equivalents, loans and borrowings, and trade and other payables”, as per disclosed in Note 3. This essentially means that, Balance Sheet’s items like “Trade and other receivables”, “Cash and cash equivalents”, “Loans and borrowings”, and “Trade and other payables” are not entirely operating activities as I thought before. I guess Dexion’s FS is not as straightforward as I thought it was. I have now come to a conclusion that, although from the FS there seems to be little financial activity going on in the firm, in reality there are many of them which is not visible in the FS. Almost all crucial information that I need to help me separate the financial activities from the operating activities are sitting in the notes. This is the point where I found restating FS is actually a frustrating process.
Back to the point where financial activities are hidden in items like “Cash and cash equivalents”, “Loans and borrowings” etc, I wonder how can we actually separate them from operating activities? I do not usually take Martin’s advice as is, but I now see the logic behind his advice that about 0.5% or 1% of sales might be the appropriate level of cash for a business to hold for operating activities, while the rest could be allocated for financial activities. Therefore, I apportioned Dexion’s “Cash and cash equivalents” as per below.
| Year | Total cash and cash equivalents ($‘000) | Total sales ($‘000) | % of sales | Apportioned to Operating activities ($‘000) | Apportioned to Financial Activities ($‘000) |
| 2005 | 3,851 | 130,972 | 3% | 1,309 (1% of sales) | 2,542 |
| 2006 | 2,866 | 187,147 | 1.5% | 1,871 (1% of sales) | 995 |
| 2007 | 2,518 | 250,967 | 1% | 2,518 (1% of sales) | Nil |
When reading the notes further, 2 items caught my attention. First is the “Deed of Cross Guarantee” i.e. an agreement between Dexion (the parent company) with certain subsidiaries, described in Note 35. This Deed has the effect of Dexion giving Guarantees to each creditor payment in full of any debt in the event of winding up of any subsidiaries. And second is a bank Guarantees to the value of $10,300,000 (2006: $3,194,000) have been issued as security for rental leases. Both items are classified as Contingent Liability in Note 20. These 2 agreements put Dexion in a highly risky position where it effectively agrees to bear all losses of its subsidiaries in events of liquidation. Can this constitute an operating activity? I believe yes because it is in the nature of “providing assurance to creditors”, just like Insurance. But the real issue I am interested in is, generally, can Contingent Liabilities be regarded as a financial or operating activity? Or do financial activities and operating activities only include items that are recognised in the financial statements? IFRS prohibits Contingent Liability to be recognised in the balance sheet (BS) because it does not meet the recognition criteria of “probable to occur”. Should this restrict items like Guarantees to be deemed as a financial activity? I don’t think so because providing Guarantees will render benefits to the firm by enhancing the entity’s credit worthiness and business credibility. It is similar to giving “Product Warranty”, except that it involves greater risks and it revolves around the going concern of the entity. But because Warranty is classified as an operating activity, so should Guarantees, although in this case I think Guarantees is better suited as a financial activity.
Another issue is, what are the implications of not recognising these Guarantees as financial activities? Will this affect my firm analysis; hence affect how I predict Dexion’s future? This question really comes down to what is the connection between financial activities and the value of a firm? Is it so closely connected, thus making it worthwhile to scrutinise the financial activities in assessing a firm’s value? Or should I focus more on operating activities? According to Martin, “operating activities are the ones which primarily add value to shareholders”. But I also agree with Mandy that “financial activities are the ones that provide the basic infrastructure for operating activities to take place”. Hence, I decided it is important to ascertain the magnitude of a firm’s financial activities as accurately as possible because any understatement or overstatement would distort our firm analysis.
Dexion Ltd (parent company) has 9 wholly-owned subsidiaries. By reading its annual report, I could conclude that Dexion acquired those subsidiaries for strategic purposes i.e. it wants to manipulate their technologies so that they could improve its products and services. Dexion is essentially "investing on better technology". But because they are all wholly-owned subsidiaries, items like “Investment in Dexion Australia Pty Ltd” do not appear in the consolidated account; it only appears in the parent’s account as required by IFRS. In my opinion, this does not reflect truly and fairly that Dexion has made investments on better technology. Therefore, I am of the opinion that Dexion’s financial activity, or rather financial asset, is essentially understated, and this could have an adverse effect on my firm analysis, just as I have discussed in the paragraph above.
Speaking of investments in subsidiaries, I came across a number of people who classify them as operating activities. Initially, I cannot help thinking that it is operating activities because Dexion’s investment is carried out with the objective of producing better products. Therefore, these investments add value to Dexion's shareholders. However, come to think about it, I would be double counting it if I classify these investments as operating activities. This is because, having acquired those subsidiaries and having used the subsidiaries' technology to enhance its production, this results in increased sales. These increased sales already constitute operating activities. And if we again deem the "investments on the technology to increase the sales" to be operating activity, that would be double counting. "Investing in technology" should not be confused with "producing goods using the technology which you have invested in". Both add value to Dexion's shareholders, but only the latter one is Dexion's primary activity i.e. what Dexion is set up to do. And the former is the infrastructure for improvised production to take place. Therefore, I would classify these investments as financial activities.
However, Ly Yi has a valid reason for classifying Investments as operating activities. Unlike Dexion, her firm makes those investments with the objective of receiving dividends. Therefore, it is done on a constant basis and it probably renders a large portion of her firm’s income like how Advertising and Marketing does. Therefore, if Advertising and Marketing can be classified as operating activities, so could Investments, I think.
My firm had no minority interest (MI), but I am interested with a question posed by Daniel on whether profit attributed to MI which amounted to $385,000, should be excluded from the comprehensive income. He decided that it should, because “when analysing we are interested in understanding value and value creation in the economic entity controlled and run by the parent company” (CMB, pg 150). This confuses me because doesn’t the parent entity have control of the entire subsidiary, including minority interests? Shouldn’t then the minority interest equity be included in the value of the economic entity because it has control over the value created by that equity? In response to this, David had consulted the book by Stephen H Penman "Financial Statement Analysis Security Valuation" (one of Martin's recommended text). Unlike Martin, Penman set out clearly the ROE before MI and ROE after MI and as for CI, he excludes MI. Hence, I am justified that MI are to be deducted so as to arrive at the profit belonging to the equity investors in the parent company.
In restating her balance sheet, Rose found an item in the current assets and non-current assets called "Capitalised finance costs". She thought it is an operating activity because the finance cost is included in the purchase of operating assets. I then wonder, what is the use of restating financial statements then, if we are to classify items according to what it was incurred with? The question is rather, what is it incurred for? Capitalised finance costs is usually incurred because there is borrowing of money involved when purchasing or constructing assets like property or equipment. If the firm did not borrow but paid cash instead, this finance costs would not be incurred. Hence, it should be separated from operating activities so that the economic nature of the operating activity could be ascertained more accurately.
Ly Yi and I had a difficulty with deferred tax. She classified it as an operating activity because it is the amount her firm will pay in the future based on what they did in the current year to earn its accounting profit (which is the operating activities). As mentioned in Appendix 2 of TKWAV, deferred tax arises due to timing differences. I think deferred tax should always be apportioned according to what is causing it. Companies pay tax for many reasons i.e. tax on profit from selling goods/services (which is an operating activity), tax on gain from selling non-current assets (can be both operating or financial activity), tax on gain from share repurchases (which is a financial activity), and many more. Rose suggests that tax on capital gains would be realised at the date of sale, so it wouldn't have an affect on the deferred tax, leaving deferred tax relating to operating activities only. But due to insufficient information, there is no way we could be sure of this. A simplistic approach would be to classify the whole lot as operating activities, but this would understate/overstate the Net Operating Asset figure. I can only hope that this understatement/overstatement would be immaterial.
I found myself lost when trying to understand how Martin restates Ryman’s Income Statement. Jay asked Martin how he calculated operating income before tax. Martin explained i.e. by deducting depreciation and interest income from Earnings Before Interest, Tax and Depreciation (EBITD). I tried to use this formula, but failed because Dexion does not provide its EBITD figure. I asked Farzana whom then told me that Dexion’s Operating Income Before Tax figure is already staring at me from the Income Statement. This is very amusing because I spent hours figuring out how to calculate EBITD, when what I really needed was sitting right in front of my eyes. The moral of the story is, all firms are different, and hence all FS are different from each other. Ryman does not provide Operating Income Before Tax figure, which was why Martin had to work backward to find it. Whereas Farzana’s firm provides Total Operating Income Including Interests figure. Therefore she has to take 1 step further to deduct the Expenses from continuing operations (including depreciation) and Interest Received, to arrive at Operating Income Before Tax.
Another issue while restating Dexion’s income statement relates to ‘Dirty Surplus’. Dexion does not seem to have ‘Dirty Surplus’ items in its Statement of Movement in Equity other than ‘Currency translation differences reserves’ which is worth -$263,000 in 2007. I realise Ryman Healthcare has Fair value movement of investment property worth $65.5m in 2008 as its dirty surplus. I wonder, wouldn’t dirty surplus impede the way we assess value? In Chapter 3 of TKWAV, we see how Martin argued that the ‘Comparables’ method of assessing value is subject to logical fallacy. This is because the method uses share price to value the business, which is essentially a circular process. Similarly, to include ‘dirty surplus’ such as Fair value movement of investment property and Currency translation differences reserves as part of comprehensive income, this would constitute intervention of market value, which then results in circular process as well. Since Dexion’s dirty surplus is only $263,000, it may not have too much effect on its comprehensive income. But Ryman’s dirty surplus worth $61.9 million is too large a figure to constitute market intervention. It could dangerously distort the value of the firm which we are trying to assess.
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