FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 6 – The analysis of the Balance sheet and Income Statement (1)
What You Will Learn from this Chapter
• Why the analyst reformulates income statements and balance sheets
• How operating and financing components of the two statements are identified
• What assets and liabilities typically fall into operating and financing categories
• Why income taxes are allocated to different parts of the income statement
• What balance sheet and income statement ratios reveal
• How one learns of a firm’s strategy through the reformatted financial statements
• How firms manage “cash”
• How free cash flow can be calculated from reformulated income statements and balance sheets (without
a cash flow statement)
• How the cash conservation equation ties the cash flow statement together to equate free cash flow and
financing cash flow
• The difference between the direct and indirect calculations of cash from operations
• Problems that arise in analyzing cash flows from GAAP statements of cash flow
• What reformulated cash flow statements tell you
• How to examine the quality of reported cash flow from operations
The Big Picture
• Before statements are analyzed they must be reformulated to “sharpen the
lens on the business”

• The key to reformulation is the separation of operating and financing activities

• It’s the operating activities that add value in a business, so don’t confuse them
with the financing activities
The Picture from Chapter 8
Net operating assets are employed in operations to generate operating
revenue (by selling goods and services to customers) and incur
operating expenses (by buying inputs from suppliers). ∆ indicates changes.
Product
and Input Capital
Markets The Firm Markets
OR F Debt
Holders or
Customers C Issuers
Net Net
Operating Financial
Assets I Assets
OE d Share
Suppliers (NOA) (NFA) Holders

OR - OE = OI
OI - NOA = C - I
C - I - NFA + NFI = d

Operating Activities Financing Activities

Key: F = net cash flow to debtholders and issuers

d = net cash flow to shareholders
C = cash flow from operations
I = cash investment
NFA = net financial assets
NOA = net operating assets
OR = operating revenue
OE = operating expense
OI = operating income
NFI = net financial income
The Design from Chapter 8
The Standard Balance Sheet
Assets Liabilities and Stockholders’ Equity

Current assets: Current liabilities:

Cash Accounts payable

Cash equivalents Accrued expenses
Short-term investments Deferred (unearned) revenues
Deposits and advances Advances from customers
Accounts receivable (less allowances) Short-term notes payable
Short-term notes receivable Short-term borrowings
Other receivables Deferred taxes (current portion)
Inventories Current maturities of long-term debt
Prepaid expenses
Deferred income taxes (current portion)

Long-term assets: Long-term liabilities:

Long-term debt securities Bank loans

Equity investment at cost Bonds payable
Equity investments at market Long-term notes payable
Equity investments - equity method Lease obligations
Property plant and equipment Commitments and contingencies
(less accumulated depreciation) Deferred taxes
•Land Pension liabilities
•Buildings Post employment liabilities
•Equipment
•Leased assets
•Leasehold improvements
•Construction in progress Redeemable preferred stock

Intangible assets
•Patents
•Copyrights
•Goodwill
Equity
Deferred taxes (non-current) Preferred equity
Deferred charges Common equity
Noncontrolling interest
Reformulating the Balance Sheet:
The Governing Accounting Relations
Net Operating Assets (NOA) = Operating Assets (OA) – Operating Liabilities (OL)

Net Financial Obligations (NFO) = Financial Obligations (FO) – Financial Assets (FA)

Common Shareholders’ Equity (CSE) = NOA – NFO

____Reformulated Balance Sheet___

OA FO
(OL) (FA)
NFO
CSE
NOA NFO + CSE
________________________________
Typical Financial and Operating Items
Assets Liabilities and Stockholders’ Equity

Financial assets: Financial liabilities:

- Cash equivalents - Short-term borrowings

- Short-term investments - Current maturities of long-term debt

- Short-term notes receivable (?) - Short-term notes payable (?)

- Long-term non-marketable - Long-term borrowing (bank loans,

debt investments bonds, payable, notes payable)

- Long-term marketable - Lease obligations

debt securities
- Preferred stock

Operating assets: Operating liabilities:

all other assets all other liabilities

Noncontrolling interest

Common equity
Issues in Reformulating Balance Sheets
• Cash: working cash and excess cash
• Short term notes receivable: trade receivables or investment of cash?
• Finance receivables: an operating asset
• Debt investments: financial assets
• Short-term equity investments: excess cash or trading securities?
• Short-term notes payable: trade notes or borrowing?
• Lease assets: operating assets
• Lease liabilities: financial obligation
• Deferred tax assets and liabilities: operating
• Deferred revenues and accrued expenses: operating
• Minority interest: not a financial obligation
• For financial firms, many “financial items” are operating assets and
liabilities
GAAP Balance Sheet: Nike, Inc.
Reformulated Balance Sheet: Nike, Inc.
Nike, Inc.: Notes on the Reformulation
1. Cash and cash equivalents have been split between operating cash and
interest-bearing cash investments

2. Interest-bearing accounts payable are classified as financing items

3. Accrued liabilities exclude dividends payable (now added to shareholders’

equity)

4. Notes payable are interest bearing and classified as financing liabilities

Strategic Balance Sheets
Reformulated balance sheets inform about the firm’s strategy for running the
business:

• How the firm invests in operations

• How the firm relies on operating liabilities
• How the firm conducts its financing of the operations

Reformulated statements provide a narrative

Strategic Balance Sheet: Microsoft Corporation
Year ending June 30 2002 2001

Net Operating Assets

Operating assets:
Working cash1 $ 50 $ 50
Account receivable, net 5,129 3,671
Inventories 673 83
Deferred income taxes 2,112 1,522
Property and equipment, net 2,268 2,309
Equity investments 9,151 8,780
Convertible preferred debt2 3,036 3,925
Goodwill 1,426 1,511
Intangible assets, net 243 401
Other assets 2,952 3,372
27,040 25,624
Operating liabilities
Accounts payable 1,208 $ 1,188
Accrued compensation 1,145 742
Income taxes payable 2,022 1,468
Unearned revenue 7,743 5,614
Preferred income taxes 398 409
Other liabilities 2,950 15,466 2,120 11,541
11,574 14,083
Net financial assets
Cash equivalents 2,966 3,872
Short-term investments 35,636 27,678
Long-term debt investments 2,004 40,606 1,656 33,206

Common Stockholders’ Equity 52,180 47,289

1
Cash and cash equivalents split between working cash and financial assets.
2
Convertible debt of AT&T Corp. in connection with investment in broadband.
Strategic Balance Sheet: Dell Inc.
Strategic Balance Sheet: General Mills Inc.
The Income Statement: Typical Items
Net sales (sales minus sales allowances)
+ Other revenue (royalties, rentals, license fees)
- Cost of sales
= Gross margin
- Marketing and advertising expenses
- General expenses
- Administrative expenses
- ± Special items and nonrecurring items
o Restructuring charges
o Merger expenses
o Gains and losses on asset sales
o Asset impairments
o Litigation settlements
o Environmental remediation
- Research and development expense

+ Interest revenue
- Interest (expense)
 Realized gains and losses on financial assets
± Unrealized gains and losses on trading securities
+ Share of income of subsidiary
- Income taxes
= Income before extraordinary items and discontinued operations
 Discontinued operations
 Extraordinary items
• Abnormal gains and losses

= Net income or loss

- Noncontrolling interest
= Net income to shareholders
The Reformulated Income Statement
Net sales (sales minus sales allowances)
+ Other revenue (royalties, rentals, license fees)
- Cost of sales
= Gross margin
- Marketing and advertising expenses
- General expenses
- Administrative expenses
- ± Special items and nonrecurring items
o Restructuring charges
o Merger expenses
o Gains and losses on asset sales
o Asset impairments
o Litigation settlements
o Environmental remediation
- Research and development expense

+ Interest revenue
- Interest (expense)
 Realized gains and losses on financial assets
± Unrealized gains and losses on trading securities
+ Share of income of subsidiary
- Income taxes
= Income before extraordinary items and discontinued operations
 Discontinued operations
 Extraordinary items
• Abnormal gains and losses

= Net income or loss

- Noncontrolling interest
= Net income to shareholders
The Reformulated Income Statement (cont.)

- Net financial expenses after tax

+ Interest expense
- Interest revenue
 Realized gains and losses on financial assets
= Net taxable financial expense before tax
+ Tax benefit from net financial expenses
= Net taxable financial expense after tax
 Gains and losses on debt retirement.
 Dirty surplus financial items in Table 8.1
 Hidden dirty surplus financial items
+ Preferred dividends
 Gains and losses on redemption of preferred stock
- Tax benefit from preferred dividends (if any)
- Noncontrolling Interest

= Comprehensive Income to Common

The Allocation of Taxes
• In the income statement only one tax number is reported: It must be allocated to the operating and
financial components to put both on an after-tax basis

• First, calculate the tax benefit (tax shield) provided by deducting interest expense

Tax Benefit = Net Interest Expense t

where t is the marginal (not effective) tax rate. The statutory rate is usually the marginal rate.

• From the operating income deduct both the total tax and the tax benefit, to capture what the operating
income would have been, after tax, had there been no financing activities

• To the net financial expense add the tax benefit, because its net effect is attributable to the financing
activities
Top-down and Bottom-up Methods for Tax Allocation: Tax Rate = 35%
Additional Tax Allocation within Operations
• Allocate taxes between operating income from sales and other operating
income (not from sales) so that both are after tax.

• Remember: some other operating income items are after tax (if they appear
below the tax line on the GAAP statement). These include other
comprehensive income.

• Remember: losses draw negative taxes

GAAP Income Statement: Nike, Inc.
Starting Point for Income Statement Reformulation:
Identify Comprehensive Income from Equity Statement
Reformulated Income Statement: Nike, Inc.
Nike, Inc.: Notes on Reformulated Income Statement

1. Advertising expense is found in the 10-K footnotes

2. Other expenses in the income statement in 2008 include gains from divestitures, classified as other
operating income here

3. Statutory tax rate for tax allocation is 36.3%, including both federal and state taxes

4. Dirty-surplus items come from the equity statement

5. Interest income is netted against interest expense in the GAAP statement

6. Preferred dividends are less than $0.5 million

Summary of Reformulated Financial Statements:
Nike, Inc., 2010
Strategic Income Statements
Reformulated income statements show how the firm’s strategy generates earnings:
• How the firm grows earnings through sales growth
• How sales are translated into operating income
• How the financing strategy affects shareholders

A useful metric: Residual Operating Income (ReOI)

ReOIt = OIt − (  − 1) NOAt-1

Value added in operations: How are operations adding value to the book value of
operations?
GAAP Income Statement: Microsoft Corporation
Year Ended June 30 2002 2001
__________________________________________________________________________________
Revenue $ 28,365 $ 25,296

Operating expenses:
Cost of revenue 5,191 3,455
Research and development 4,307 4,379
Sales and marketing 5,407 4,885
General and administrative 1,550 857
----------------------------------------------------------------------------------
Total operating expenses 16,455 13,576
----------------------------------------------------------------------------------

Operating income 11,910 11,720

Losses on equity investees and other (92) (159)
Investment income(loss) (305) (36)

----------------------------------------------------------------------------------

Income before income taxes 11,513 11,525

Provision for income taxes 3,684 3,804
----------------------------------------------------------------------------------

Income before accounting change 7,829 7,721

Cumulative effect of accounting change (net of tax) (375)

----------------------------------------------------------------------------------

Net income $ 7,829 $ 7,346

__________________________________________________________________________________
Strategic Income Statement: Microsoft Corporation
Year ended June 2002 2001

Revenue $ 28,365 $ 25,296

Operating expenses:
Cost of revenue 5,191 3,455
Research and development 4,307 4,379
Sales and marketing 5,407 4,885
General and administrative 1,550 857
16,455 13,576

Operating income from sales, before tax 11,910 11,720

Tax as reported $ 3,684 $ 3,804

Tax on other operating income 872 756
Tax on financing income (758) 3,798 (743) 3,817

Operating income from sales, after tax 8,112 7,903

Investment income in income statement:1
Dividends 357 377
Realized gains on sales of investments 2,121 3,003
Permanent impairment of investments (4,323) (4,804)
Unrealized losses on derivatives (480) (2,325) (592) (2,016)
Tax on investment income (at 37.5%)2 872 756
(1,453) (1,260)
Investment income in equity statement
(after tax):
Unrealized loss on convertible debt -- (829)
Gains (losses) on derivatives (91) 634
Unrealized losses on equity investments (281) (707)
Total investment income (1,825) (2,162)

Losses in equity subsidiaries (92) (159)

Currency translation and other 82 (39)
Cumulative effect of accounting change -- (450)
Total other income (1,835) (2,810)
1 Included in investment income is the GAAP
Total operating income 6,277 5,093
statement; details from footnotes.
Net financing income 2
Interest income3 1,762 1,808
Losses on investments draw a tax deduction.
Realized gains on short-term investments 258 172 3
2,020 1,980
Interest income is included in investment income
Tax at 37.5%4 758 743 in the GAAP statement.
1,262 1,237 4
Financing income in equity statement With net financing income, financing activities
(after tax): draw further taxes rather than a tax benefit.
Unrealized gain on financial assets 286 76

Total financing income 1,548 1,313

Comprehensive income 7,825 6,406

Strategic Income Statement: Dell Inc.
Value Added to Strategic Balance Sheets: Dell Inc.

• Dell’s strategic balance reports $9.032 billion in net

financial assets: These add no value
• But value is added in the operating activities:

ReOIt = OIt − (  − 1)NOAt-1

For Dell (with a required return of 9%),

ReOI2011 = $2,656 − (0.09  −2,028) = $2,839

Dell’s residual income from operations is greater than

operating income: Value from negative net operating
assets!
Strategic Income Statement: General Mills Inc.
Common Size Analysis
• Comparison to other firms is called cross-sectional
analysis

• Common size analysis gives a ready comparison:

• The Income Statement

• Each item/Total revenues

• The Balance Sheet

• Operating items/Totals
• Financing items/Totals
Common Size Analysis:
Nike and General Mills Income Statements
Common Size Analysis:
Nike and General Mills Balance Sheets (Operating Section)
Trend Analysis: Nike, Inc.
Income Statement Ratios
Profit margin ratios

• Operating Profit Margin:

OI (after tax)
Sales

• Sales Profit Margin:

OI (after tax) from Sales

Sales

• Other Items Profit Margin:

OI (after tax) from Other Items

Sales

• Net Profit Margin

Comprehensive Net Income

Sales
Income Statement Ratios (cont.)
• Expense Ratios

- Expense Ratio

Expense for an Activity

Sales

1 - Sales PM = Sum of Expense Ratios

Balance Sheet Leverage Ratios
• Financial Leverage Ratios

• Capitalization Ratio:
NOA
CSE

• Financial Leverage Ratio (FLEV)

NFO
CSE
It is always the case that
Capitalization Ratio - Leverage Ratio = 1.0

• Operating Liability Leverage Ratio

• Operating Liability Leverage (OLLEV) =

Operating Liabilities
Net Operating Assets
Summary Profitability Measures
Operating Profitability:
OI t
RNOA t =
1
( NOA t +NOA t-1 )
2

Financing Profitability:
NFE t
NBCt =
1
( NFOt +NFOt-1 )
2
or
NFIt
RNFA t =
1
( NFAt +NFAt-1 )
2

All measures are after tax.

Financial Statement Analysis Procedures
1. Reformulate the statement of stockholders’ equity on clean surplus basis (Chapter
9)
2. Calculate comprehensive rate of return on common equity, ROCE, from
reformulated statement of common stockholders’ equity (Chapter 9)
3. Reformulate the balance sheet to distinguish operating and financial assets and
obligations (Chapter 10)
4. Reformulate the income statement on clean surplus basis and distinguish
operating and financing income (Chapter 10)
5. Compare reformulated balance sheets and income statements with reformulated
statements of comparison firms, and over time, with a common size analysis and
a trend analysis (Chapter 10)
6. Calculate balance sheet and income statement ratios (Chapter 10)
7. Carry out the analysis of ROCE: Chapter 12
8. Carry out the analysis of growth: Chapter 13
Accounting Quality Watch
The Big Picture
Once again, appropriate analysis distinguishes operating activities from
financing activities

-- free cash flow is the free cash flow from operating activities:
the generation of cash flow

-- cash flows to shareholders and net debtholders are financing

activities: the disposition of cash flow

GAAP and IFRS confuse the two

The Calculation of Free Cash Flow
Three methods to calculate FCF:

1. Use the sources of cash flow equation:

C - I = OI - ΔNOA
that is, free cash flow is operating income adjusted for the change in
net operating assets

2. Use the disposition of cash flows equation:

C - I = NFE - ΔNFO + d
that is, free cash flow is net financial expenses, adjusted for the
change in net financial obligations, plus dividends to common
shareholders.

3. FCF can also be obtained from the reformulated Statement of Cash

Flows.
Calculation of Free Cash Flow:
Nike, Inc.: 2010
VF

Method 1: C – I = OI - 

Operating income 2010 $ 1,814

Net operating assets 2010 $ 5,514
Net operating assets 2009 6,346 832

Free cash flow 2010 2,646

Method 2: C – I = FA - NFI + d

Net financial income 2010 $4

Net financial assets 2010 4,370
Net financial assets 2009 2,468 1902

Net dividend 2010 740

Free cash flow 2010 $2,646

The Standard GAAP Statement of Cash Flows

The statement describes the change in cash

and cash equivalents:

“Cash Flow from Operations”

- “Cash Used in Investing Activities”

+ “Cash from Financing Activities”

=  in Cash and Cash Equivalents

Nike, Inc. Statement of Cash Flows, 2010
Indirect Method for Cash Flow from Operations
Net income
+ Accruals
= Cash from operations

Nike’s statement (to follow) employs the indirect method

(as do almost all firms):

2010
Net income $ 1,906.7 million
Accruals 1,257.9
Cash provided by operations $ 3,164.2
Direct Method for Cash from Operations
Cash inflows
- Cash outflows
= Cash from operations
Problems with the Standard Statement
1. Change in operating cash should be included in the
investment section, and the change in cash equivalents in the
financing section

2. Transactions in financial assets are included in the

investments section rather than in the financing section

3. Interest payments and receipts are included in the operating

rather than in the financing section

4. Tax cash flows are all included in the operating section, and
not allocated to operating and financing

5. The statement does not incorporate non-cash transactions

1. OPERATING CASH AND CASH IN FINANCIAL ASSETS: NIKE

Change in cash and cash equivalents $788.0 million

Increase in operating cash $ 0.8 million

Increase in financial assets 787.2
$ 788.0 million

The determination of operating cash: use a normal

percentage of sales for the industry (1/2% of sales)

See Nike’s reformulated balance sheet in Exhibit 10.3 in chapter 10

2. Transactions in Financial Assets: Lucent Technologies
Fiscal Year Ending September

1999 1998 1997

Net income 4,766 1,035 449

Cash from operating activities (276) 1,860 2,129

Cash in investing activities:

Capital expenditures (2,215) (1,791) (1,744)

Proceeds from the sale or
disposal of property, plant and equipment 97 57 108
Purchases of equity investments (307) (212) (149)
Sales of equity investments 156 71 12
Purchases of investment securities (450) (1,082) (483)
Sales or maturity of investment securities 1,132 686 356
Dispositions of businesses 72 329 181
Acquisitions of businesses - net of cash acquired (264) (1,078) (1,584)
Cash from mergers 61 - -
Other investing activities - net (69) (80) (68)

Net cash used in investing activities (1,787) (3,100) (3,371)

Net sales of financial assets 682 (396) (127)

Adjusted cash investment in operations (2,469) (2,704) (3,244)

3. Net Interest Receipts
4.Taxes on Net Interest Receipts:
Nike
In millions

Interest receipts $42.1

Interest payments (48.4)
Net interest payments
before tax 6.3
Tax benefit (at 36.3%) 2.3
Net interest receipts after tax $ 4.0

Add back to GAAP Cash from Operations

5. Non-cash Transactions
• Acquisitions with shares

• Asset exchanges

• Assets acquired with debt

• Capitalized leases

• Installment purchases

• Debt converted to equity

Reformulated Statement of Cash Flows
Cash flow from Operations

- Cash investments

= Free Cash Flow from Operating

Activities

Cash Paid to Shareholders

+ Cash Paid to Debtholders and Issuers

=Cash Paid for Financing Activities

This format follows the cash conservation equation:

C–I=d+F
The Reformulated Statement of Cash Flows:
the Adjustments
GAAP Free Cash Flow GAAP Financing Flow

+ Net cash interest outflow (after tax) + Net cash interest outflow (after tax)

+ Investments in financial assets - Noncash financing

- Sale of financial assets + Purchase of financial assets

- Noncash investments - Sales of financial assets

- Increase in operating cash + Increase in cash equivalents
= Free Cash Flow
= Financing Cash Flow
Nike, Inc. Reformulated Statement of Cash Flows
Why Free Cash Flow from Adjusted Cash Flow Statements May not Reconcile to the
Methods 1 and 2
• “Other assets” and “other liabilities” are not identified as
either operating or financing

• Cash dividends in the cash flow statement differ from

dividends in the equity statement

• Cash from share issues in the cash flow statement may

differ from share issues in the equity statement

• Details for adjustments 3,4 and 5 are not available

• GAAP’s treatment of employee stock options (Chapter 9)

• Cash flow numbers of foreign subsidiaries are translated at

average exchange rates whereas balance sheet numbers
are translated at end-of-year exchange rates
The Calculation of Cash Flow from Operations
• The practical matter of distinguishing cash flow from
operations from cash flow from investment activities is not
an easy one: the cash flow from operations in the GAAP
statement is not a clean measure.

• Some cash flows from investment activities are classified

as cash flows from operations
• R&D expenditures
• Investment in inventories
• Taxes on gains from assets sales are classified as cash
flow from operations

Note, however, that for a calculation of FCF (C – I), a

misclassification between investment and operating
activities has no effect
The Quality of the Reported Cash Flow from Operations (CFO) Number
• Non cash charges do not affect CFO, but are a loss of value (e.g.
depreciation)

• Firms can delay payments to generate cash flow

• Firms can sell receivables to generate cash flow

• Firms can reduce advertising expenditures to generate cash flow

• Firms can reduce R&D expenditures to generate cash flow

• Non-cash transactions are not in CFO

• Structured financing can make borrowing look like cash from

operations

• Capitalization policy shifts CFO to cash investment

Homework
• Attempt E10.1 to E10.9 & E11.1 to E11.9
QUESTIONS?