Current affairs (i) - Hong Kong fiscal budget 2016 - 2017

Hong Kong Financial Secretary John Tsang delivered his 2016 - 2017 fiscal budget today. Here are some of my takeaways:

Hong Kong future fund: the government is actively planning ahead to address the needs of the aging population. Hong Kong future fund (an over USD 20bn fund to cater for the future needs of Hong Kong population) was suggested in 2015 - 2016 fiscal budget and launched early 2016 to seek capital growth. More than half of the asset in the future fund will be invested in alternative assets such as hedge funds and private equity. 

My view is that this is an innovative initiative on the part of Hong Kong government, and I like the fact that Hong Kong government is taking a long term view. The impact of aging population can be felt in the next decade or so in the Hong Kong; so it is crucial that the Hong Kong government think of ways to cater for this structural change in demographics. 

My concern is the strategic allocation to alternative assets will actually achieve the goals of providing for the ageing population. Private equity, for example, is illiquid asset; timing of investments and divestment is crucial, and hence private equity assets cannot be easily liquidated to meet any payment obligations. Instead, why not consider a liability-driven approach to match payment obligations with cashflow income. 

Lack of financial talents: Mr. Tsang pointed out that there is a lack of talents in the financial industry - particularly in the insurance and asset management segment. From an employee perspective, it is a good to accumulate skills in this area (good that I am now working in asset management!).

Hong Kong government is supportive of entrepreneurship: Hong Kong government has used various means to supportive budding entrepreneurship. Three main channels of support are through providing trainings / education, providing office space (in collaboration with Hong Kong Technology Park), and providing funding (using government's money and in collaboration with venture capitals). 

My view is that these supportive measures by the government are crucial for the Hong Kong not to lose its competitive edge. Hong Kong has long been a (financial) service economy - but with the rise with cities like Shanghai and with labor wages in China increasing, Hong Kong is gradually losing its edges in the financial and the manufacturing sector. For Hong Kong to successfully adopt to this structural change, entrepreneurship needs to be encouraged. 

     

CFA topics - financial reporting and analysis (v)

This post is going to discuss financial ratios. A few categories of financial ratios allow financial analysts to understand the operating aspects of a company: profitability ratios, return ratios, leverage ratios, and working capital days.

Profitability ratios: allow analysts to understand how profitable a company is. In other words, for every $100 a company makes in revenue, how much it spends on COGS (cost of goods sold), how much it makes in operating profit, and how much it makes in net income. Popular ratios in this category include:

Gross margin = gross profit / revenue
EBIT margin (also called operating margin) = EBIT / revenue
Net margin = Net income / revenue

Return ratios: instead of measuring how much profit is made per dollar in revenue, return ratios measure how much profit is made per dollar of asset / dollar of shareholder equity. Popular ratios in this category include:

Return on asset = net income / average assets
Return on equity = net income / average equity

While profitability ratios give analysts an idea of the bargaining power of a company (ie the bargaining power over its supply chain, its customer, and its employees), return ratios give analysts an idea of the attractiveness of a company from a shareholder’s perspective.

Leverage ratios: measure how “indebted” a company is. Popular ratios in this category include:

EBITDA coverage ratio = Total debt / EBITDA (indebtedness of a company relative to cashflow)
Gearing ratio = Total debt / Total asset
Current ratio = Total current assets / total current liabilities (short term indebtedness)

Working capital days: allow analysts to understand whether a company is properly managing its working capital. For example, is inventory level too high? If so, company might have the risk of inventory write-down. Is receivable too high? Again, company might have the risk of bad debt. Popular ratios in this category include:

Inventory days = average inventory / COGS * 365 days
Receivable days = average receivable / revenue * 365 days
Payable days = average payable / COGS * 365 days

CFA topics - financial reporting and analysis (iv)

Having known what the three financial statements are and having understood how the three statements are linked, the next step is to understand the key items on financial statements.

Apparently there are many important items on the financial statement, and I cannot go through each and every single one in this post. Do leave a comment if you have question on any particular financial terminologies. In this post, I will introduce a selected few key items:

EBITDA (income statement): Earnings before interest, tax, depreciation and amortization. It is a proxy of the operating cashflow of a company, that can be used for capital expenditure and distribution to lenders / shareholders. 

By ignoring interest, tax, and depreciation, EBITDA allows financial analysts to compare the profitability of companies with different leverage ratios, different tax structures, or different depreciation policy. A more in-depth explanation can be found on investopedia.

EBIT (income statement): Earnings before interest and tax. Similar to EBITDA, but the difference is that EBIT includes depreciation and amortization. EBIT is commonly referred to as the "operating profit" of a company.

Working capital change (cashflow statement)

Working capital = operating current asset – operating current liabilities
Working capital change = increase in op. current asset – increase in op. current liabilities

An example. Company A sold a car to Company B for USD 500 on credit on 15th December 2015. Two accounting entries are: i) revenue increases USD 500, and ii) account receivables increases USD 500.

As at YE 2015, Company B has not settled the bill: no cash received, no account entries. So, in Company A's 2015 income statement, you are going to see a USD 500 operating profit. However, Company A’s operating cashflow should be zero (and logically so because Company A has not received any cash by year end).

How did I arrive at an operating cashflow of zero? I adjust Company A’s EBIT for working capital change. Since account receivables increases by USD 500 (while other current assets / liabilities remain unchanged), working capital change is USD 500.

Operating cashflow = EBITDA – tax – working capital changes

Assume, for simplicity, there is no tax and no depreciation expense; then operating cashflow = USD 500 – USD 0 – USD 500 = USD 0. If you want another case study on working capital changes, I’d recommend you take a look at investopedia.

CFA topics - financial reporting and analysis (iii)

Having known the roles and functionality of individual financial statements, it is also important to understand how the three financial statements are interlinked. 

There are a few “keys” that link the different financial statement with one another:

Income statement to cashflow statement: “net income” is the key that links the income statement with cashflow statement. The cashflow statement starts with net income (ie. bottom line from income statement), adjusts for non-cash items (eg. depreciation, amortization, working capital changes, etc.) to arrive at operating cashflow.

Cashflow statement to balance sheet: “ending cash” is the key that links the cashflow statement with balance sheet. As mentioned, cashflow statement starts with net income, adjusts for non-cash items, takes into account capex, investments, etc. to arrive at cash at the end of a financial period (ie. “ending cash”.) This ending cash goes into the balance sheet under current asset; in order words, we can understand the cash item as a plug that balances assets with liabilities and equities.

Income statement to balance sheet: “retained earnings’ is the key that links income statement with balance sheet. Retained earning represents the portion of net income that does not get distributed in dividend; in other words, retained earnings (from income statement) is added to equity (on balance sheet), thereby increasing the entitlement of the company’s shareholders.

Source: Tutors Globe

CFA topics - financial reporting and analysis (ii)

Having discussed income statement in the previous post, this post will discuss the key concept behind balance sheet and cashflow statement. 

Balance sheet: while an income statement shows how much a company makes in profit over a period of time, a balance sheet shows the balance between the assets vs. liabilities and equities of a company at a particular point in time (typically at the end of a relevant financial period.) The balance sheet of a company is driven by the following equation

Assets = liabilities + equities

The above equation is not that difficult to understand; in fact the above equation illustrates a simple fact about all companies – assets are financed by liabilities and equities. The liabilities and equities side tells us where a company gets it sources of funds, while the assets side tells us how these funds are being used.

Typical items on the asset side include (from more liquid assets to more illiquid asset) cash & cash equivalent, marketable securities, inventories, trade receivables, prepayments, equipment, properties & plants, goodwill, etc. Typical items on the liabilities side include trade payables, tax payables, bank borrowings, bond borrowings, etc. Last but not least, equities represents the claims of shareholders in a company’s business. Equities is increased by additional contribution from shareholders and retained earnings; on the other hand, equities is reduced by net loss.

Cashflow statement: while an income statement shows how much profit is made over a period of time, cashflow statement shows how much cash is generated over a period of time. It is important to note that profit generation and cash generation are two different concepts: profit generated can be in form of cash, receivables, etc; cashflow statement tells us how much of the net income is actually converted into cash.

Three main categories of cashflow include operating cashflow, investing cashflow, and financing cashflow.

Operating cashflow includes the cash inflow / outflow involved in the core operation of a company’s business. Company’s operating profit and working capital changes, for example, are part of operating cashflow. Investing cashflow concerns the capital expenditure and financial investments of a company. Financing cashflow includes loan drawdown, loan repayment, equity contribution, dividend payments, etc.

CFA topics - financial reporting and analysis (i)

The idea of financial reporting is to report a business activity (eg. sale of a good) on financial statements, in a format (eg. GAAP, IFRS, etc.) that is commonly understood among the readers of financial reports.

The idea of financial analysis, on the other hand, is to extract different numbers from a financial report and perform analysis in order to understand the operations of a company.

In order to do financial reporting and analysis, it is important to first understand the three different financial statements that we come across daily as financial analysts:

Income statement (also called Profit and Loss Account): income statement records all the sales made and costs incurred during a particular financial period.

The bigger picture is revenue minus costs equals profits (or net income). Typically the topline is revenue (ie. sales), which minus costs of goods sold (“COGS”) to give us the gross profit of a company. Other operating expenses (excluding COGS) is then subtracted from gross profit to arrive at profit before tax. Finally profit before tax minus tax expense will give us net income.

To recap the different elements within an income statement:

Restaurant ABC	FY 2016
Revenue	1,000
Less: Costs of Goods Sold (“COGS”)	(500)
Gross Profit	500
Less: Sales and General Admin expense (“SG&A)	(120)
Less: Interest expense	(100)
Profit before tax	280
Less: Tax expense	(40)
Net income	240

Let’s assume the above is the income statement of Restaurant ABC. COGS represents the costs of buying the raw materials – in this case, costs of buying raw food. SG&A represents salaries, rentals, utility expenses, admin expenses, marketing expenses, etc. Interest expense represents the financing costs – for example, if Restaurant ABC has taken out a loan from a bank, then it has to pay this interest expense. After COGS, SG&A, interest expense, and tax are being deducted from the topline revenue, we get the net income – ie. how much Restaurant ABC makes in profit after paying for all the operating costs.

I will discuss balance sheet and cashflow statement in the next post.

CFA topics - level I curriculum breakdown

With so many different topics covered by the CFA curriculum and yet only limited time, it is important to study “strategically” (eg. knowing what exam topics are more important and becoming familiar with those topic first).

Table below shows the different components of CFA level I curriculum (in descending order of exam weight).

Exams topics	Exam weight
Financial reporting and analysis	20%
Ethical and professional standards	15%
Quantitative methods	12%
Economics	10%
Equity investment	10%
Fixed income	10%
Corporate finance	7%
Portfolio management	7%
Derivatives	5%
Alternative investments	4%
Total	100%

Source: CFA institute

As you can see financial reporting and analysis (20%) is the most important topic for level I, followed by ethical and professional standards (15%). Other important topics include economics (10%), equity investments (10%), fixed income investments (10%), etc. If you master the concepts in these topics, you already secured >60% of the exam score; in that case, passing the CFA exam should be a low-hanging fruit for you. I am not saying other exam topics, such as portfolio management, derivatives, etc., can be ignore; but these topics tend to be slightly more complicated for level I candidate, and they carry less weight in the exam. Now, you know how to better plan your study time.

Given my background (investment banking and asset management), I am a bit more familiar with / interested in financial reporting & analysis and equity investment. So I am going to write a “topic guide” on both of these topics to help candidates get a head start.