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Reorganizing the Balance Sheet

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 The Problems with Traditional Financial Analysis
Why do we need to reorganize the company’s financial statements?

• Traditional measures of performance, such as return on equity (ROE) and return on

assets (ROA), include nonoperating items and financial structure that impair their
usefulness.
• ROE mixes operating performance with capital structure, making peer group
analysis and trend analysis less meaningful. ROE rises with leverage if ROIC is
greater than the after-tax cost of debt.

Return Debt
 ROIC  (ROIC  k d )
Equity Equity
• ROA and ROE commingle operating and nonoperating items. For instance, ROA
includes the return on assets for excess cash, which is quite low (near 3 percent).
Companies that hold large cash balances can have artificially low ROAs, even
when their operating performance is strong.
• To ground our historical analysis, we need to separate operating performance from
nonoperating assets and the financial structure used to finance the business.

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 Return on Invested Capital (ROIC)

• Return on invested capital (ROIC) is calculated by dividing the

company’s after-tax operating profits by the amount of net capital all
investors have contributed to the company.
• Return on invested capital is independent of the company’s financial
structure.
The income statement will be
After-Tax reorganized to create net operating
Operating Profit profit less adjusted taxes (NOPAT).
NOPAT represents the after-tax

ROIC = operating profit available to all financial

investors.
Invested
The balance sheet will be reorganized to
Capital
create invested capital. Invested capital
equals the total capital required to fund
operations, regardless of type (debt or
equity).

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 Free Cash Flow

• Free cash flow is the after-tax cash flow available to all investors: debt
holders, preferred stock, common equity holders, and so on.
• Unlike “cash flow from operations” reported in a company’s financial
statement, free cash flow is completely independent of financing and
nonoperating items.

FCF = NOPAT + Depreciation - Invested Capital

• ROIC and FCF rely on the identical inputs, NOPAT and invested capital.
Thus, valuations based on discounted cash flow (DCF) and on
economic profit will lead to identical results.

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 Reorganizing the Balance Sheet: Invested Capital
• The accountant’s balance sheet mixes operating and financing items. As ROIC
measures operating performance, both the numerator (NOPLAT) and the
denominator (invested capital) must separate operating items from financing
structure in a consistent manner.
• Let’s first derive invested capital. We start with the primary accounting identity:

Assets = Total Liabilities + Equity

• Next, separate operating assets (like property, plant, and equipment [PP&E])
from nonoperating assets (like equity investments), and separate operating
liabilities (like accounts payable) from financial liabilities (like interest-bearing
debt).
Operating Nonoperating Operating
Assets + Assets = Liabilities + Debt + Equity

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 Reorganizing the Balance Sheet: Invested Capital

• By separating line items and rearranging the accounting identity,

Operating Nonoperating Operating

Assets + Assets
= Liabilities
+ Debt + Equity

• We can create two new terms, invested capital and total funds invested:

Operating Operating Nonoperating

+ + = Debt + Equity
Assets Liabilities Assets

Invested capital equals

operating assets less
operating liabilities.

Total funds invested equals Total funds invested can

invested capital plus also be measured by
nonoperating assets. summing debt plus equity!

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Reorganizing the Balance Sheet: An Example
• Let’s rearrange the accountant’s balance sheet into invested capital and total
funds invested for a simple company (i.e., a company with only few line
items).
Accountant's balance sheet Invested capital
Prior Current Prior Current
Assets year year year year
Inventory 200 225 Inventory 200 225 Operating liabilities
Net PP&E 300 350 Accounts payable (125) (150) are netted against
Equity investments 15 25 Operating working capital 75 75 operating assets.
Total assets 515 600
Net PP&E 300 350
Liabilities and equity Invested capital 375 425
Accounts payable 125 150 Nonoperating assets
Interest-bearing debt 225 200 Equity investments 15 25 are not included in
Common stock 50 50 Total funds invested 390 450 invested capital.
Retained earnings 115 200
Total liabilities and equity 515 600 Reconciliation of total funds invested
Interest-bearing debt 225 200
Common stock 50 50
Retained earnings 115 200
Total funds invested 390 450

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 Invested Capital: Operating Perspective

Operating assets include current operating assets (working cash, accounts

Operating receivable, inventory, prepaid expenses), along with PP&E and net other long-
Assets
term operating assets. Include capitalized leases and R&D as operating
− assets.
Operating liabilities include non-interest-bearing current liabilities; the most
Operating Liabilities common are related to suppliers (accounts payable), employees (accrued
salaries), customers (deferred revenue and customer advances), and the
government (income taxes payable).
=
Invested Capital

+ Nonoperating assets include excess cash, marketable securities, notes

Nonoperating receivable, prepaid pension assets, nonconsolidated subsidiaries, and other
Assets equity investments).
=
Total Funds Total funds invested from an operating perspective.
Invested

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 Why Separate Nonoperating Items?
• Evaluation by parts: A good analysis will separate accounts with
different performance characteristics. For instance, excess cash will
typically have much lower returns than operating businesses.

Total Asset Base

14% 3% 0%

Core Operations Excess Cash Equity Investments

9% 17%
Nonoperating Assets
Unit A Unit B

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 How Much Cash Is Excess Cash?

Method 1 Comments Method 3: Regression

Excess of Requires only firm-specific Regression of Log(Cash/Noncash Assets) on
2% of information, but doesn’t handle
Revenues differences in firm Independent variable Beta T-Stat
Intercept −1.921 82.89
characteristics or current
Market/book 0.137 27.11
market environment. Real size −0.046 15.09

Method 2 Cash flow/assets 0.171 4.71

Working capital/assets −0.754 29.04
Excess of Industry Data intensive (requires data
Capital expenditures/assets 0.570 8.77
Median or Average for many firms), but handles Total debt/assets −0.301 101.44
industry-specific Industry cash flow volatility 0.106 1.77
characteristics and differences R&D/sales 1.776 21.02

across time. Be careful—the Dividend dummy −0.100 8.94

Regulation dummy −0.010 0.23
average can be affected by an
asset sale at an industry rival Number of observations 87,117
(industry average will rise Adjusted R-squared 18.69%
following sale). Source: T. Opler, L. Pinkowitz, R. Stulz, and R. Williamson,
“Corporate Cash Holdings,” Journal of Applied Corporate Finance
14 (2001): 55−67.

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 Invested Capital: Financing Perspective

Debt includes all interest-bearing debt from banks and public capital markets.
Debt
Debt equivalents include off-balance-sheet debt and one-time debts owed to
+ others that are not part of ongoing operations (e.g., severance payments as
Debt part of a restructuring, an unfunded pension liability, or expected environmental
Equivalents remediation following a plant closure).

+ Equity includes original investor funds (common stock and additional paid-in
capital, net of treasury stock repurchased), investor funds reinvested into the
Equity company (retained earnings and accumulated other comprehensive income),
and investor funds to be paid out shortly (dividends payable).
+
Equity equivalents include accounts that arise because of noncash
Equity Equivalents adjustments to retained earnings; they are similar to debt equivalents but are
not deducted from enterprise value to determine equity value (e.g., most
= deferred-tax accounts and income-smoothing provisions).

Total Funds Total funds invested from a financing perspective.

Invested

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Reorganizing the Income Statement: NOPLAT

• Net operating profit less adjusted taxes (NOPLAT) is the after-tax operating
profit available to all investors.
• NOPLAT equals revenues minus operating costs, less any taxes that would
have been paid if the firm held only core assets and was financed only with
equity.
• Unlike net income, NOPLAT includes profits available to both debt holders
and equity holders.

• In order to calculate ROIC and free cash flow properly, NOPLAT should be
defined consistently with invested capital.
• For instance, if a nonoperating asset is excluded from invested capital, any
income from that asset should be excluded from NOPLAT.

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Reorganizing the Income Statement: NOPLAT
• NOPLAT includes only operating-based income. Unlike net income,
interest expense and nonoperating income are excluded from NOPLAT.

Accountant's income statement NOPLAT

Current Current
year year
Revenues 1,000 Revenues 1,000
Operating costs (700) Operating costs (700)
Depreciation (20) Depreciation (20)
Operating profit 280 Operating profit 280

1 Taxes are calculated on

Interest (20) Operating taxes (70)
operating profits.
Nonoperating income 4 NOPLAT 210
Earnings before taxes (EBT) 264 Do not include income
After-tax nonoperating income 3 from any asset excluded
Taxes (66) Income available to investors 213 from invested capital as
Net income 198 part of NOPLAT.
Reconciliation with net income
Net income 198 Treat interest as a
1
After-tax interest expense 15 financial payout to
Income available to investors 213 investors, not an expense.

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 Devil in the Details: Operating Income

Hasbro Inc. 10-K Disclosure

Management Discussion and Analysis (MD&A)

Hasbro Inc. International segment operating profit increased

After-tax operating profits significantly by 54% to $140,784 in 2004 from 2003.
$ million 2005 2006 2007 2008 2009 International gross profits and operating profits were
Net revenues 3,087.6 3,151.5 3,837.6 4,021.5 4,067.9 positively impacted by the cessation of
Cost of sales (1,286.3) (1,303.9) (1,576.6) (1,692.7) (1,676.3) manufacturing at the Company’s Valencia, Spain
Gross profit 1,801.4 1,847.6 2,260.9 2,328.8 2,391.6
facility at the end of 2003. [Gross profit] in 2003
Royalties (247.3) (169.7) (316.8) (313.0) (330.7) included cash charges of approximately $18,400
Product development (150.6) (171.4) (167.2) (191.4) (181.2)
associated with severance related to this cost
Advertising (366.4) (369.0) (434.7) (454.6) (412.6)
Selling and administrative (624.6) (682.2) (755.1) (797.2) (793.6) reduction initiative.
Operating profit (EBITA) 412.6 455.3 587.1 572.6 673.6
The improvement in operating profit in 2004 over
2003 was also due to lower royalty expense
Include only those primarily from decreased sales of BEYBLADE,
expenses that are related which was partially offset by an increase in
advertising expense as a result of the Company’s
to ongoing core ongoing initiative to raise awareness of its core
operations. brands.

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 Determining Operating Taxes

1. Find and convert the tax reconciliation table. Search the footnotes
for the tax reconciliation table. For tables presented in dollars, build a
second reconciliation table in percentages, and vice versa. Data from
both tables are necessary to complete the remaining steps.
2. Determine taxes for “all-equity” company. Using the percent-based
tax reconciliation table, determine the marginal tax rate. Multiply the
marginal tax rate by adjusted EBITA to determine marginal taxes on
EBITA.
3. Adjust “all-equity taxes” for operating tax credits. Using the dollar-
based tax reconciliation table, adjust operating taxes by other operating
items not included in the marginal tax rate. The most common
adjustment is related to differences in foreign tax rates.

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 Operating Taxes: Step 1
• Start by converting the reported tax reconciliation table to percentages. To
convert a line item from dollars to percent, divide the line item by earnings
before taxes ($3,590 million in 2008). Earnings before taxes are reported on the
income statement.

Tax reconciliation

$ million 2004 2005 2006 2007 2008

Income taxes at statutory rate 2,769 3,249 3,258 2,317 1,257
State income taxes, net of federal 215 279 261 196 92
Foreign rate differences (17) (10) 5 − −
Other, net (25) (51) 23 (103) (71)
Reported taxes 2,911 3,444 3,547 2,410 1,278

Earnings before taxes 7,912 9,282 9,308 6,620 3,590

Step 1: Reformat tax reconciliation table

percent 2004 2005 2006 2007 2008

Income taxes at statutory rate 35.0 35.0 35.0 35.0 35.0
State income taxes, net of federal 2.7 3.0 2.8 3.0 2.6
Foreign rate differences (0.2) (0.1) 0.1 − −
Other, net (0.3) (0.5) 0.2 (1.6) (2.0)
Reported taxes 36.8 37.1 38.1 36.4 35.6

Source: Home Depot 2008 10-K, note 6.

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 Operating Taxes: Step 2

• Next, use the percentage-based tax reconciliation table to determine

the marginal tax rate. You can use the company’s statutory rate plus
state or local taxes to calculate a proxy for the marginal rate.
• In 2008, Home Depot paid 37.6 percent in federal (35.0 percent) and
state (2.6 percent) taxes.

Operating taxes 2004 2005 2006 2007 2008

Step 2 Marginal tax rate 37.7% 38.0% 37.8% 38.0% 37.6%
× Adjusted EBITA 8,214 9,731 10,231 7,787 4,845
= Marginal taxes on EBITA 3,098 3,698 3,868 2,956 1,820

• Use this marginal rate to compute taxes on adjusted EBITA. In 2008,

taxes on adjusted EBITA equaled $1,820 million (37.6 percent times
$4,845 million in EBITA).

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 Operating Taxes: Step 3
• After computing taxes on adjusted EBITA, search the dollar-based
reconciliation table for other operating taxes. For Home Depot, the only
operating taxes paid beyond marginal taxes were foreign rate
differences.
• In 2006, foreign rate differences resulted in $5 million of additional
operating taxes. Therefore, increase taxes on adjusted EBITA by $5
million to determine operating taxes in 2006.

Operating taxes 2004 2005 2006 2007 2008

Step 2 Marginal tax rate 37.7% 38.0% 37.8% 38.0% 37.6%
× Adjusted EBITA 8,214 9,731 10,231 7,787 4,845
= Marginal taxes on EBITA 3,098 3,698 3,868 2,956 1,820

Step 3 Other operating taxes (17) (10) 5 − −

Operating taxes 3,081 3,688 3,873 2,956 1,820

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 Free Cash Flow

• Free cash flow is the after-tax cash flow available to all investors: debt holders and
equity holders. Unlike “cash flow from operations” reported in a company’s annual
report, free cash flow is independent of financing and nonoperating items.
Accountant's cash flow statement Free cash flow

Current Current
year year
Net income 198 NOPLAT 210
Depreciation 20 Depreciation 20
Decrease (increase) in inventory (25) Gross cash flow 230
Increase (decrease) in accounts payable 25
Cash flow from operations 218 Decrease (increase) in inventory (25) Subtract investments in
Increase (decrease) in accounts payable 25 operating items from
Capital expenditures (70) Capital expenditures (70) gross cash flow.
Decrease (increase) in equity investments (10) Free cash flow 160
Cash flow from investing (80)
After-tax nonoperating Income 3 Evaluate cash flow from
Increase (decrease) in interest-bearing debt (25) Decrease (increase) in equity investments (10) nonoperating assets
Increase (decrease) in common stock − Cash flow available to investors 153 separately from core
Dividends (113) operations.
Cash flow from financing (138)
Reconciliation of cash flow available to investors
After-tax interest 15 Treat interest as a
Increase (decrease) in interest-bearing debt 25 financial payout to
Increase (decrease) in common stock − investors, not an expense.
Dividends 113
Cash flow available to investors 153

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 Advanced Issues

Capitalizing Research and Development (R&D)

• If a company has significant long-term R&D, do not subtract the annual R&D
expense. Instead, capitalize R&D on the balance sheet and subtract an annualized
amortization of this capitalized R&D.

Capitalizing Operating Leases

• If a company has significant operating leases, capitalized the operating leases on the
balance sheet and add back lease-based interest to operating profit. Convert the
remaining rental expense to depreciation.

Excluding Recognized Pension Gains and Losses

• Pension gains and losses booked on the income statement are usually hidden within
cost of goods sold. Remove any recognized gains or losses from NOPLAT.
Unrecognized gains do not flow through the income statement, so no change is
required for unrecognized gains.

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