Analysis of Balance Sheet & Income Statement

Source: Penman
Chapter-9

9-1

Reformulating the Balance Sheet:

The Governing Accounting Relations
Net Operating Assets (NOA) = Operating Assets (OA) Operating Liabilities (OL)

NOA is also known as enterprise assets.

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

Common Shareholders Equity (CSE) = NOA NFO

In consolidated statement: CSE + Minority interest (MI) = NOA-NFO

9-2

Know the business

Banks: Deposits are operating liabilities and loans are operating
assets
Automobile companies having financing subsidiaries to finance
their sales for customer (interest income is operating income and
loans are operating assets)
Retail chains giving credit to customers through cards (loans are
operating assets)

9-3

Reformulated Balance Sheet

9-4

Issues in Reformulating Balance Sheets

Cash: Cash in hand and in checking accounts are operating assets.
Interest-bearing cash equivalents are financial assets
How to know working cash and excess cash (% of sales could be one way out)
Short term notes receivable: trade receivables or investment of cash?
Finance receivables: an operating asset (used to attract customers at owner
interest)
Debt investments: financial assets
Short-term equity investments: excess cash invested (treat as finance asset) or
part of trading portfolio (operating for the trader)
9-5

Issues in Reformulating Balance Sheets continued

Short-term notes payable: trade notes or if interest rate is less than
market rate , treat as operating liability or else financial
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

9-6

Some examples
Dell (2008) had inventory of $ 1,180 million and accounts payable
of $ 11,492 million
Oracle (2008): Deferred Revenue of $ 4,754 million
General Motors (2007): Pension liability of $43.4 billion
Whirlpool Corporation (2007): Sales warranties of $226 million

9-7

Reformulation of some balance sheets

9-8

GAAP Balance Sheet: Nike Inc.

9-9

Reformulated Balance Sheet: Nike Inc.

9-10

Strategic Balance Sheets

Reformulated balance sheets inform about the firms 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

See examples for Microsoft, Dell, and General Mills

9-11

Strategic Balance Sheet: Microsoft Corporation

9-12

Strategic Balance Sheet: Dell Inc.

9-13

Strategic Balance Sheet: General Mills Inc.

9-14

The Reformulated Income Statement (1)

1.
2.
3.

Operating items are separated from financing items.

Operating income from sales is separated from other operating income.
Tax is allocated to components of the statement, with no allocation to items reported on an after-tax
basis
Reformulated Comprehensive Income Statement

Net sales
Expenses to generate sales
Operating income from sales (before tax)
Tax on operating income from sales
+ Tax as reported
+ Tax benefit from net financial expenses
Tax allocated to other operating income
Operating income from sales (after tax)
Other operating income (expense) requiring tax allocation
Restructuring charges and asset impairments
Merger expenses
Gains and losses on asset sales
Gains and losses on security transactions
Tax on other operating income
After-tax operating items
Equity share in subsidiary income
Operating items in extraordinary income
Dirty-surplus operating items in Table 8.1
Hidden-dirty surplus operating items
Operating income (after tax)
9-15

The Reformulated Income Statement (2)

9-16

Allocation of tax: When Tax Rate = 35%

GAAP
Income Statement
Allocation

Top-down

Bottom-up
Tax Allocation

Tax

Revenue $4,000
Operating expenses
(3,400)
Interest expense (100)
Income before tax
500
Income tax expense
(150)
Net income
$ 350
Revenue
$4000
Operating expenses
(3,400)
Operating income before tax
600
Tax expense:
Tax reported
Tax benefit for interest
35
(185)
($100 x 0.35)
Operating income after tax
Net income $350
Interest expense $100
Tax benefit 35
Operating income after tax

$150
$ 415

65
$415
9-17

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.
Some other operating income items are after tax (if they appear
below the tax line on the GAAP statement)
Losses draw negative taxes

9-18

Comparative Analysis
Comparison to other firms is called cross-sectional analysis
Comparison to a firms own history is called time-series analysis
Common size analysis gives a ready comparison:
The Balance Sheet
Operating items / Totals
Financing items / Totals
The Income Statement
Each item / Total revenues

9-19

Common Size Analysis : Nike and Reebok Income

Statements> deploy across time/firms> pick up
unusual changes

9-20

Three simple ratios to be investigated

Gross margin ratio
Operating profit margin ratio (after tax basis)
Net profit margin ratio [ CI/Sales]
Change between operating profit margin ratio and net profit
margin ratio is all about how the firm is using its financing
activities

9-21

Common Size Analysis: Nike and Reebok Balance Sheets

9-22

Trend Analysis: Nike, Inc.

9-23

Insights from trend analysis of Nike

Initially sales growth was slow, later on it is high
Operating income from sales after tax has grown by 93% and net
profit to equity has gone up by 137%
COGS has grown slower than sales > higher rise in GP
Questions: in 2000, sales grew by 2.5%, but inventory grew by
23.5%. Why? Is it slow inventory or inventory build up for higher
demand?

9-24

Income Statement Ratios

Revenue composition ratios
Operating Revenue Composition Ratio:

Financial Income Composition Ratio:

Profit margin ratios

Operating Profit Margin:

Sales Profit Margin:

Other Items Profit Margin:

9-25

Income Statement Ratios (cont.)

Profit Margin Ratios (cont.)
Financial Income Contribution Ratio:
Net Financial Income
Sales

Net Income Profit Margin

Comprehensive Net Income
Sales

Expense Ratios
Expense Ratio
Expense for an Activity
Sales

1 - Sales PM = Sum of Expense Ratios

9-26

Balance Sheet Ratios

Composition Ratios
Operating Asset Composition Ratio
Specific Operating Asset
Total Operating Assets

Operating Liability Composition Ratio= Specific OL/ Total OL

Financial Asset Composition Ratio

Financial Asset
Total Financial Assets

Financial Liability Composition Ratio

Financial Obligation
Total Financial Obligations

9-27

Balance Sheet Leverage Ratios

Financial Leverage Ratios (either of these two ways, FLLEV is used generally)
Capitalization Ratio: NOA/CSE

Financial Leverage Ratio (FLEV): NFO/CSE [If the firm has net financial assets, this ratio is
negative]
Borrowing leverages ROCE
Always,

Capitalization Ratio - Leverage Ratio = 1.0

Operating Liability Leverage Ratio
Operating Liability Leverage (OLLEV) = Operating liability/NOA
It leverages return on net operating assets (RNOA) by reducing the NOA
2004: Nike: 47.8%, Rebook: 56.8% [ look for composition ratios to pin-point]

9-28

Growth Ratios

9-29

Summary Profitability Measures

Operating Profitability:
RNOA t =

OI t
1
NOA t +NOA t-1
2

Financing Profitability:

All measures are after tax.

9-30