The Analysis of the Balance Sheet and the Income Statement Chapter 9 The Analysis of the Balance Sheet and the Income Statement

The Analysis of the Balance Sheet and the Income Statement Link to Previous Chapter Chapter 8 reformulated the statement of owners’ equity. This Chapter This chapter continues the What assets What items in How are taxes What ratios and liabilities the income allocated to the are calculated reformulation and analysis with the balance sheet and income statement. are classified statement are operating and from as operating ? classified as financing reformulated As financing ? operating ? As components of statements ? The reformulation follows the financing ? the income What do they design in Chapter 7. statement ? mean ? Link to Next Chapter Chapters 10 reformulates the cash flow statement. More applications and discussion are on the web page. Link to Web Page

What you will learn from this chapter Why reformulated income statements and balance sheets are desirable How knowledge of the business is incorporated in reformulated statements How operating and financing components of the two statements are identified Which 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

Analysis of Balance Sheet and Income Statement: the Steps Reformulate to distinguish between operating and financing activities Carry out common size and trend analysis Calculate balance sheet and income statement ratios

The Standard Balance Sheet

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

The Typical Reformulated Balance Sheet

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

Nike, Inc.: GAAP Balance Sheet (1)

Nike, Inc.: GAAP Balance Sheet (cont.)

Nike, Inc.: Reformulated Balance Sheets

Reebok: GAAP Balance Sheet (1) December 31 -------------------------------------- 2004 2003 ---------------- ---------------- Amounts in thousands, except per share data Assets Current assets: Cash and cash equivalents $ 565,233 $ 693,599 Accounts receivable, net of allowance for 660,599 532,320 doubtful accounts (2004, $81,280; 2003, $70.823) Inventory 458,435 352,692 Deferred income taxes 111,516 100,070 Prepaid expenses and other current assets 61,730 48,169 ----------- ------------ Total current assets 1,857,513 1,726,850 ----------- ------------ Property and equipment, net 183,799 149,765 Other non-current assets: Goodwill, net 124,125 24,690 Intangibles, net of amortization 196,138 42,296 Deferred income taxes 44,892 22,478 Other 34,161 23,663 -------------- -------------- Total Assets $ 2,440,628 $ 1,989,742

Reebok: GAAP Balance Sheet (cont.) December 31 ------------------------------------ 2004 2003 ---------------- -------------- Amounts in thousands, except per share data Liabilities and Stockholders' Equity Current liabilities: Notes payable to banks $ 63,179 $ 8,055 Current portion of long-term debt 100,627 163 Accounts payable 183,853 155,904 Accrued expenses 386,725 374,849 Income taxes payable 71,930 27,017 ----------- ----------- Total current liabilities 806,314 565,988 ----------- ----------- Long-term debt, net of current portion 360,126 353,225 Minority interest 8,514 11,657 Other long-term liabilities 45,718 25,162 Commitments and contingencies Stockholders' equity: Common stock, par value $.01; authorized 250,000 shares; 1.018 1.011 issued shares: 101,827 in 2004; 101,081 in 2003 Retained earnings 1,985,324 1,796,321 Less shares in treasury at cost: 42,619 in 2004; 41,473 in 2003 (780,510) (740,189) Unearned compensation (5,804) (1,225) Accumulated other comprehensive income (expense) 19,928 (22,208) ------------- ------------- Total Stockholders' Equity 1,219,956 1,033,710 Total Liabilities and Stockholders' Equity $ 2,440,628 $ 1,989,742 -------------- --------------

Reebok: Reformulated Balance Sheet

Microsoft Corporation: Reformulated Balance Sheet

The Standard Income Statement

The Reformulated Income Statement (1) 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)

The Reformulated Income Statement (2)

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 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% GAAP Top-down Bottom-up Income Statement Tax Allocation Tax Allocation 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 $150 Tax benefit for interest 35 (185) ($100 x 0.35) Operating income after tax $ 415 Net income $350 Interest expense $100 Tax benefit 35 65 Operating income after tax $415

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) Remember: losses draw negative tax

Starting Point for Income Statement Reformulation: Identify Comprehensive Income from Equity Statement Nike Reebok Balance May 31, 2003 $4,028 $1,035 Transactions with shareholders: Shares issued, at market $388 $83 Shares repurchased (416) (88) Common dividends (179) (207) (18) (23) Comprehensive income Net income reported $946 $192 Currency translation gain 28 38 Gains on hedging instruments 126 4 Loss on option exercise $127 $32 Tax benefit (47) (80) 1,019 12 (20) 214 Balance May 31, 2004 $4,840 $1,226

Nike, Inc; GAAP Income Statement

Nike Inc.: Reformulated Income Statement

Reebok: GAAP Income Statements

Reebok: Reformulated Income Statements

Track Nike on BYOAP

Microsoft Corporation: GAAP Income Statements

Microsoft Corporation: Reformulated Income Statements

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 Reebok Income Statements

Common Size Analysis: Nike and Reebok Balance Sheets

Common Size Analysis: Nike and Reebok Balance Sheets

Trend Analysis: Nike, Inc.

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:

Income Statement Ratios (cont.) Profit Margin Ratios (cont.) Financial Income Contribution Ratio: Net Income Profit Margin Expense Ratios Expense Ratio 1 - Sales PM = Sum of Expense Ratios

Balance Sheet Ratios Composition Ratios Operating Asset Composition Ratio Operating Liability Composition Ratio Financial Asset Composition Ratio Financial Liability Composition Ratio

Balance Sheet Leverage Ratios Financial Leverage Ratios Capitalization Ratio: Financial Leverage Ratio (FLEV) It is always the case that Capitalization Ratio - Leverage Ratio = 1.0 Operating Liability Leverage Ratio Operating Liability Leverage (OLLEV)

Growth Ratios

Summary Profitability Measures Operating Profitability: Financing Profitability: All measures are after tax.

Financial Statement Analysis Procedures 1. Reformulate the statement of stockholders’ equity on clean surplus basis (Chapter 8) 2. Calculate comprehensive rate of return on common equity, ROCE, from reformulated statement of common stockholders’ equity (Chapter 8) 3. Reformulate the balance sheet to distinguish operating and financial assets and obligations 4. Reformulate the income statement on clean surplus basis and distinguish operating and financing income 5. Compare reformulated balance sheets and income statements with reformulated statements of comparison firms and over time through a common size analysis and a trend analysis 6. Calculate balance sheet and income statement ratios 7. Carry out the analysis of ROCE: Chapter 11 8. Carry out the analysis of growth: Chapter 12

Reebok: Reformulated Income Statements