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SCH-MGMT 797AA - Financial Statement Analysis Notes for fourth day of class Ray Pfeiffer July 13, 2005
Administrative items:
Music:
Today:
Questions?
Reformulating the statement of stockholders’ equity
Reformulating the balance sheet and income statement Reformulating the cash flow statement
For Monday:
Analyzing profitability and growth
Study chapters 11 and 12, complete homework #
Recommended problems: E8.1, E8.2, E8.8, E9.3, E9.7, E10.
Why do we need to reformulate the statement of stockholders’ equity?
< For residual earnings valuation, we need appropriate measures of book value (CSE) and
of comprehensive income.
How to do the reformulation
< Template for the reformulated statement (page 242):
Beginning book value of common equity
- Net effect of transactions with common shareholders:
- capital contributions (share issues)
- share repurchases
- dividends = Net cash contribution (negative net dividends)
- Effect of operations and nonequity financing
- Net income (from income statement)
- Other comprehensive income
- Preferred dividends = Comprehensive income available to common
= Closing book value of common equity.
< Note the following:
(1) The focus is on common shareholders; the preferred shares are viewed as financial obligations; (2) Effects of transactions with shareholders are separated from effects from business activities; and (3) Operations and nonequity financing are combined, which means that preferred dividends are viewed as an expense (like interest expense) from the point of view of the common shareholders.
Reformulation procedures
- Restate beginning and ending balances for items that are not part of common shareholders' equity.
a. Preferred stock issues should be separated and treated as financial obligations. Note that ‘redeemable' preferred stock really isn't part of equity, so if it's not in equity no adjustment is required. b. Dividends payable are treated as a liability in GAAP, but they really aren't a liability, because shareholders can't have obligations to themselves. They are also a liability that does not provide debt financing. So they are reclassified from liabilities to equity. c. Unearned compensation (or deferred compensation). If a firm issues shares at less than market value, current shareholders incur a loss. Firms grant shares to employees, often at less than full market price. The discount can be thought of as compensation to the employee. The equity statement recognizes this as deferred compensation, the idea being that the compensation is for future work to be performed, and the amount is amortized to income over the service period. Penman says that if this is sort of prepaid compensation, it's an asset and it shouldn't be considered a contra-equity account, so it is reclassified. Add the amounts back to beginning and ending equity, and ignore any transactions related to it during the period.
- Calculate net transactions with shareholders (the net dividend). Dividends need to be cash dividends, not dividends declared and not yet paid (dividends payable)
From this perspective, value is generated by growing book value and ROCE. Identifying value, then lies in identifying the drivers of ROCE and B.
Thus we want financial statements that help us to clearly identify ROCE and B and their components.
Reformulating the Balance Sheet
Show page 226 as the end product:
Operating Assets Operating Liabilities NOA
Financial Obligations Financial Assets NFO (NFA) CSE
CSE = NOA - NFO (or NOA + NFA)
Specific issues (see also pages 279-283 in the text):
- Cash: Working cash (also called operating cash ) is the cash used to pay bills as they fall due. This is an operating asset. But cash equivalents should be financing.
- Short-term notes receivable: If short-term receivables are trade receivables, and the trade notes are part of the effort to get customers (offering rates below market rates), then they should be part of operations (and so, too, should the related interest revenue).
- Debt investments: If a firm holds debt securities in a trading portfolio, it probably means that they are trying to make money from investments, so that makes them an operating asset.
- Long-term equity investments: These are investments in the operations of other companies, so classify them as operating assets. See Accounting Clinic V on website for explanation of the relevant features of equity accounting and consolidations.
- Short-term equity investments: same deals as with debt investments — if they’re in a trading portfolio, then they are operating assets.
- Short-term notes payable : if these are trade-related and are at rates below market, then treat them as operating liabilities. Otherwise, they’re financing.
- Accrued expenses : these are all operating, with the exception that interest payable on financial obligations is a financing liability.
- Deferred revenues (unearned revenues) : definitely operating liabilities because they relate to transactions with customers.
- Leases: capitalized leases’ recorded assets are operating assets, but the liabilities are financing obligations.
- Deferred tax assets and liabilities: these are treated as operating, because they relate to operating income.
- Dividends payable: These are classified as shareholders’ equity, not as liabilities.
- Preferred stock is considered financial obligation.
- “Other” items: The detail can usually be discovered in the notes to statements or MD&A. Penman argues that they tend not to be material and tend also to be operating items.
- Minority interest : think of it as an equity sharing in the results of consolidated operations, not as a financial obligation (because the firm isn’t required to satisfy the obligation with cash from operations).
You try it! Reformulate your company’s balance sheets.
Reformulating the Income Statement
< Trying to get to operating income (including allocated tax) and financing
income/expense (including allocated tax).
< See p. 227 for the template:
Operating revenue Operating expense Operating income
Financial revenue Financial expense Net financial income/expense
Comprehensive income (earnings)
< Explain tax allocation — show a simple example:
Assume the following income statement:
Revenue 100 COGS (50) Interest expense (10) Income before tax 40 Income tax expense (14)
- Changes in cash equivalents (not working cash) should be viewed as financing activities (investments/liquidations of excess cash).
- Investments in/liquidations of financial assets are distinct from investments in/liquidation of NOA and should not be part of computing free cash flow.
- Interest flows should not be part of operating cash flow.
- Taxes on financing flows should be treated as financing flows.
- Non-cash transactions should be recorded as if cash were involved.
Reformulating a cash flow statement
See exhibit 10.1 for Nike’s GAAP cash flow statement and box 10.4 (p. 333) for the reformulated statement.
See “Nike reformulated statements.xls” for the reformulated statement. See also box 4 on page 331 and box 1 on page 329 for details.
Try it yourself! Reformulate your company’s cash flow statement.
Summary:
- You learned why it is necessary to reformulate the financial statements for use in valuation.
- You learned how to reformulate a statement of stockholders’ equity, an income statement, a balance sheet, and a statement of cash flows.
How does all of this fit in?
From chapter 8...
- Reformulate the statement of stockholders’ equity on a comprehensive income basis. Compute ‘comprehensive income,’ including both explicit OCI items and ‘hidden’ dirty surplus items.
- Calculate the comprehensive rate of return on common equity (ROCE), and the growth in equity from the reformulated statement of stockholders’ equity.
From chapter 9...
- Reformulate the balance sheet to distinguish operating and financial assets and obligations.
- Reformulate the income statement on a comprehensive income basis to distinguish operating and financing income. Compute basic ratios that help to evaluate the profitability/efficiency of the two business activities: operating and financing.
- Compare the reformulated balance sheets and income statements with the equivalent statements of comparison firms through common-size and trend analysis.
From chapter 10...
- Reformulate the cash flow statement.
From chapters 11 and 12...
- Carry out the analysis of ROCE.
- Carry out an analysis of growth.
While the steps in these reformulations seem mechanical, they require knowledge of the firm’s business, knowledge of accounting, and details from the footnotes and MD&A to incorporate as much detail as possible into the reformulated statements.
