3.3 Limitations 3: Profit versus Wealth Creation (Raising the bar)

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The Language and Tools of Financial Analysis

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The University of Melbourne

The Language and Tools of Financial Analysis

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Cours 1 sur 5 dans Specialization Essentials of Corporate Finance

In this course, participants will learn the foundations of accounting principles and financial analysis, develop an understanding of the links between these, and the measurement of value creation at the firm level. This is the first course in a four-course Specialization on the Essentials of Corporate Financial Analysis and Decision-Making, created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon). View the MOOC promotional video here: http://tinyurl.com/jeoa83t

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The Links Between Accounting Principles and Financial Decision-making

Having established initial basic financial analyst's toolset in the first two weeks of this course, some caution is warranted as we turn our attention to some of the pitfalls associated with uncritical use of financial statements by analysts. Specifically, we highlight how the use of historical cost and accrual-based accounting might lead to sub-optimal corporate financial decision-making. We then discuss how the agency relationship between management and the owners of a company may also lead to poor corporate decision-making. We conclude with a cautionary tale of misleading accounting practices and the regulator's response to these cases.

3.0 Accounting Principles and Financial Decision-Making (Trust in numbers)5:31

3.1 Limitations 1: Historical Cost And Market Value (The market is always right...)7:37

3.2 Limitations 2: Accrual versus Cash Accounting (Money in the bank)5:31

3.3 Limitations 3: Profit versus Wealth Creation (Raising the bar)3:47

3.4 Accounting Scandals 1: The Fall-out From Enron (What to look out for…)5:32

3.5 Accounting Scandals 2: Earnings Management (Smoke and mirrors)9:07

Rencontrer les enseignants

Paul Kofman
Dean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean Pinder
Associate Professor
Faculty of Business and Economics

The third limitation to accounting practices we'll discuss

is the distinction between profit maximization and wealth creation.

What we try to do here is to raise the accounting bar a little.

So what is the problem?

Well, financial statements and the analysis is geared towards

a single objective, shareholder profit maximization for a particular time period.

Where profit is defined as the difference between revenue and expenses.

So, as long as revenue just exceeds expenses, we've made a profit.

Is that a significant challenge?

Is that a sufficient challenge?

Maybe not.

Maybe we should raise the bar a little higher.

Corporations have moved on.

Corporations nowadays focus on wealth maximization,

providing a longer term, forward looking business decision horizon.

It's paving the way for sustainable business operations.

So, let's take a closer look at what that entails.

It means that those corporations are focusing on other aspects

than just profits.

They look at sales,

they look at market share, they look at investments in research and development.

All of those additional items of focus will lead,

eventually, to sustainable profit maximization.

So, that suggests that profit maximization itself is just a subset of wealth creation

by the shareholders.

What it does is it requires management of the corporation to continuously look for

opportunities, for investment opportunities,

that guarantee the highest possible returns on shareholder funds invested.

Something about the efficient use of the assets available to the corporation.

While mitigating at the same time any associated risk or loss.

Forward looking, dealing with uncertainty, investing for the future.

To do this properly, we need to focus on cash flows.

To do this properly, we need to focus on cash flows.

When evaluating, when assessing a range of business propositions,

what management does is consider the net present value

of future cash flows generated by each of those business propositions.

And in the next module, we'll take a much closer look, detailed look,

at what that net present value methodology entails.

We will be using discounted cash flow methodology where we account for

the time value of money.

For the fact that we invest now for

the future where cash flows will only eventuate over time.

We'll also deal with risk involved in those decisions.

Future cash flows are not necessarily guaranteed.

How we'll deal with that will be discussed in quite some detail in the next module.

We find some direct evidence of wealth maximization by changes in

the market value of equity, the share price determined on the share market.

If a corporation decides to invest in it's cash to develop

valuable new intellectual property, then the shareholders will recognise that.

They will realise the opportunity of future positive cash flows

associated with this investment in new technology,

in new research and development, leading to better outcomes for the firm.

And they will reflect

that increase in value by bidding up the price of the shares on the share market.

That will not be easily reflected in the financial statements.

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