1. BALANCE SHEET RECLASSIFICATION
RATIONALE AND METHODS

2. Premise
Financial accounts prepared according to the law have the advantage of being understandable in different countries
However they do not allow for an easy and coherent understanding of the firm’s financial results. Aggregation of items hinders some relevant features of firm’s financial position
BS and PL account reclassification is aimed at grouping items into homogeneous categories

3. There exist two criteria for BL and PL account reclassificationBS PL
Liquidity
Management areas
Sales and cost of goods sold
Production and value added

4. BS reclassification – Liquidity/Maturity
According to the liquidity/maturity criteria BS items are grouped as function of the time required to be transformed into cash
Liquidity: decreasing assets’ liquidity
Maturity: increasing liabilities maturity
It controls for correlation between assets and liabilities maturities

5. BS reclassification – Liquidity/Maturity
Liqudity
Cash balances, short term securities
Deferred liquidity
Trade credit
Disposables
Inventories
Tangible assets
Plants, equippements
Intangibles assets
Trademarks, know-how, licenses
Financial investments
Participations, Long term securities
Bank debt
Bank overdrafts
Debt
Suppliers, tax debt, short term debt
Long maturing liab
Mortgages, Bonds
Other long term debt
Retirement
Own funds (equity)
Equity capital
Reserves
Profit/Loss
Short lived asstes
Long lived assets
Short term debt
Long term debt E

6. BS reclassification-Liquidity/Maturity
Well Balanced
Poorly Balanced
Strongly Unbalanced
Liqud assets – L
25%
Disposables – D
27%
Fixed assets –FA
48%
Short Term Liab - STL
Long term Liab
LTL - 22%
Equity – E
53% L
25% D
27% FA
48%
STL
42%
LTL
14% E
44% L
25% D
27% FA
48%
STL
55%
LTL - 30%
E - 15%
L=STL
L+D>2xSTL
E>FA
L+D>STL+LTL
LTL<1/2FA
L<STL
L+D<2xSTL
E<FA
L+D<STL+LTL
LTL<1/2FA
L<STL
L+D<2xSTL
E<FA
L+D<STL+LTL
LTL>1/2FA

7. Reclassification according to operations
BS items are grouped according to the area they belong to (current operations vs non current operations)
Current management comprises all typical business activities according to the specific business sector of the firm. It comprises purchases (raw materials), transformation and sale. Items:
Trade credit
Trade debt
Inventories
Fixed assets: they are operational assets not belonging to current operations
Cash balances and interest bearing liabilities?

8. Reclassification according to the operations
Trade credits
Inventories
Other current assets
Operational tangibles
Operational Intangibles
Operational financial invetsments
Trade debt
Other current liab (retirement,
Tax debt)
Bank debt (mortgages..)
Bonds
Other non current liab.
Equity
Equity capital
Reserves
Profit/Losses
Operational current assets
Operational non current fixed assets
Current liabilities
Non current liabilities
Cash balances
Non operational assets
Non current

9. Reclassification according to operations
Trade credits
Inventories
Other current assets
Operational tangibles
Operational Intangibles
Operational financial invetsments
Trade debt
Other current liab (retirement,
Tax debt)
Bank debt (mortgages..)
Bonds
Other non current liab.
Equity
Equity capital
Reserves
Profit/Losses
Current operational assets
Operational non current assets
Current liabilities
Non current liabilities
Cash balances
Non current, non operational assets
Non operational fixed assets
Non operational assets
The Firm might run businesses outside the core business (ie. Renting a plant to a firm operating in another sector).
Since such assets do not contribute to firm’s operations, they are included in non-operational assets

10. Reclassification according to operations
On a financial perspective, reclassifying balance sheet items according to the area they belong to is particularly important. It is useful for the purpose of analysing the dynamics in capital invested
In particular, it allows to gain understanding of changes in:
Commercial working capital (CCCN)
Operational net invested capital (ONIC)
Net invested capital (NIC)

11. Reclassification according to operations
CURRENT ASSETS
OPERATIONAL FIXED ASSETS
CURRENT LIABILITIES
FINANCIAL LIABILITIES
EQUITY
CASH BALANCES
NON OPERATIONAL FIXED ASSETS
CCCN
WK + Operational net fixed assets = ONIC
ONIC + Non operational fixed assets = NIC

12. Reclassification according to operations
OFA CL FL E C
NOFA CA
OFA CL FL E C
NOFA
CCCN
(+)
CCCN
(-)
CCCN positive
Lowering firm’s liquidity
Limited ability to timely monetize revenues
Limited ability to delay payments
CCCN negative
Improving firm’s liquidity
Good ability to timely monetize revenues
Good ability to delay payments

13. Reclassification according to operations
CURRENT ASSETS
(CA)
OPERATIONAL FIXED ASSTES (OFA)
CURRENT LIABILITIES
(CL)
FINANCIAL LIABILITIES
(FL)
EQUITY (E)
CASH BALANCES (C)
NON OPERATIONAL FIXED ASSTES (NOFA)
FINANCIAL LIABILITIES -
CASH BALANCES =
NFP positive
FL>C
NFP negative
FL<C
Net Financial Position
(NFP)

14. Reclassification according to operations
ASSETS (A)
(INVESTMENTS)
DEBT (D)
EQUITY (E)
According to a synthetic view, in the BS might be represented, through a single item, the total investments
In such a representation CL are deducted from CA
On the right side, there remain financial sources represented by NFP and (equity)
CCCN
A=CCCN + Fixed assets
D=NFP=FL-C

15. Example Assets Liabilities Inventory-Goods 190
Liabilities
Inventory-Goods
190
Bank debt (Maturing Installment)
7000
Trade Credits
8800
Earnings of the fiscal year
2800
Cheques
100
Extraordinary reserves
9000
Licenses, Rights
1200
Equity capital
20000
Property and Plants (non operational)
1000
Bonds (Short term) 50
Property and Plants (operational)
Tax provisions
400
Other credits
1300
Reserves
612
Bank current account
115
Trade Debt
12205
Other securities
Bonds (Long Term)
1850
Equipment
26000
Bank debt (installments due in coming years)
11000
Trade credit (due next years)
Retairment provisions
2000
Credits (subsidiaries) –Short term
3500
Bank overdrafts
Shares in controlled firms
16215
Tax debt
1900
Advances (credit)
1400
Advances (debit) 3
Shares held in other firm's equity capital (non strategic)
Total Asset
69820
Total Liabilities

16. Reclassification-Liquidity/Maturity
Assets
Liabilities
Current Assets
16005
Current Liabilities
22558
Liquidity
215
Tax provisions
400
Bank current account
115
Bonds (Short term) 50
Cheques
100
Bank overdrafts
1000
Deferred Liquidity
15600
Bank debt (Maturing Installment)
7000
Trade Credits
8800
Trade Debt
12205
Credits (subsidiaries)
3500
Advances (debit) 3
Shares held in other firm's equity capital (non strategic)
Tax debt
1900
Other securities
Long Term Liab
14850
Other credits
1300
Bonds (Long Term)
1850
Disposables
190
Bank debt (installments due in coming years)
11000
Inventory-Goods
Retairment provisions
2000
Fixed Assets
53815
Own Funds
32412
Property and Plants (non operational)
Equity capital
20000
Property and Plants (operational)
Reserves
612
Equippment
26000
Extraordinary reserves
9000
Licenses, Rights
1200
Earnings of the fiscal year
2800
Shares in controlled firms
16215
Trade credit (due next years)
Advances (credit)
1400
Total Asset
69820
Total Liabilities
Treasury Margin=Liquidity+Def. Liq-Curr. Liab=-6743
Structure Margin=Own Funds-Fixed Assets=-21403

17. Reclassification according to operations
Assets
Liabilities
Operational Working Capital
282
NFP
20685
Trade Credits
8800
Bonds (Short term) 50
Trade credit (due next years)
1000
Bank overdrafts
Credits (subsidiaries)
3500
Bank debt (Maturing Installment)
7000
Inventory-Goods
190
Bonds (Long Term)
1850
Other credits
1300
Bank debt (installments due in coming years)
11000
(-)Tax Provision
-400
(-)Bank current account
-115
(-)Trade Debt
-12205
(-)Cheques
-100
(-)Advances (debit) -3
Own Funds
32412
(-)Tax debt
-1900
Equity capital
20000
Fixed Assets (net)
49815
Reserves
612
Property and Plants (operational)
Extraordinary reserves
9000
Equipment
26000
Earnings of the fiscal year
2800
Licenses, Rights
1200
Shares in controlled firms
16215
Advances (credit)
1400
(-)Retairment provisions
-2000
NonOperational Fixed Assets
3000
Property and Plants (non operational)
Shares held in other firm's equity capital (non strategic)
Other securities
Net Invested Capital
53097
Total Financing Sources

18. PL account reclassification – Sales and cost of goods sold
Reclassification here distinguishes between revenues (and cost) belonging to current operations (core business) from non current operations
Precisely, such a criteria allows to calculate a few relevant margins
In particular, (Ebit): operational revenues- operational costs.
Before it we can calculate the industrial gross margin
All items after Ebit belong to non current operations. We can find a few balances:
Balance of financial management
Balance of accessory management

19. PL account reclassification – Sales and costs of goods sold
(+) REVENUES
(-) COST OF GOODS SOLD
(+)Inventory (begin of the year)
(+) Purchases (raw materials)
(+) Energy
(+) Employee expenses
(+) Amortisation
(+)Leasing
(+) Other industrial costs
(-) Inventory (final)
(=) GROSS INDUSTRIAL MARGIN
(-) General/administrative costs
(-) Commercial/distribution costs
(=) EBIT
(-) Financial expenses
(+) Financial revenues
(+) Other revenues (supplementary activities)
(-) Other costs (supplementary activities)
(=) INCOME BEFORE EXTR. ITEMS
(+/-) Extraordinary items
(=) INCOME BEFORE TAXES
(-) Taxes
(=) NET INCOME
INDUSTRIAL OPERATIONS
CURRENT OPERATIONS
Non industrial management area
FINANCIAL ACTIVITIES
SUPPLEMENTARY ACTIVITIES
NON CURRENT OPERATIONS
NON-RECURRING ACTIVITIES
TAX MANAGEMENT AREA

20. PL account reclassification – Production and value added
Such a criteria is aimed at measuring the value of production that the firm carried on in the fiscal year. Two relevant margins are calculated
Value of production. Corresponds to the value of all has been manufactured by the firm. Obtained subtracting to sales the cost of goods to be sold which didn’t benefit (in terms of value added) from firm’s production process
Value Added(VA). Value of production net of consumes (productive factors needed to feed production)
Abovementioned margins are gross of employee expenses and amortization. Net of these items we obtain:
Ebitda: it is the VA net of employee expenses. It is a good proxy of firm’s performance
Ebit: Ebit net of amortization. It provides the better representation of the accounting performance of the firm

21. PL account reclassification – Production and value added
(+) SALES
(+/-)Changes in inventories (goods manufactured)
(+)Value of works (economy)
(-) Purchases of goods to be exchanged
(=) PRODUCTION IN THE FISCAL YEAR
(-) Purchases (raw materials)
(-) Other purchasing costs
(+/-)Changes in inventory (raw materials)
(=) VA
(-) Employee costs
(=) EBITDA
(-) Amortization
(=) EBIT
(-) Financial expenses
(+) Financial revenues
(+) Revenues (supplementary activities)
(-) Costs (supplementary activities)
(=) INCOME BEFORE EXTR. ITEMS
(+/-) Extraordinary items
(=) INCOME BEFORE TAXES
(-) Taxes
(=) NET INCOME

22. Two ways of analyzing the balance sheet
capital-employed perspective vs a solvency-and-liquidity perspective
Ce perspective: the Bs shows all the uses of funds and analyses the origin of its sources of funds. 3 purposes:
to understand how a company finances its operating assets;
to compute the rate of return either on capital employed or on equity and
as a first step to valuing the equity of a company as a going concern
In a solvency-and-liquidity analysis, a business is regarded as a set of assets and liabilities, the difference between them representing the book value of the equity. Three purposes:
to measure the solvency of a company;
to measure the liquidity of a company; and
as a first step to valuing its equity in a bankruptcy scenario

23. Two ways of analyzing the balance sheet
The purpose of a capital-employed analysis of the balance sheet is to analyse the capital employed in the operating cycle and how this capital is financed
Fiscal year t-1
Fiscal year t
Fixed Assets A
Inventories
+ Account receivables
- Accounts payables
= Operating WK
+ Non operating WK
= WK (B)
CAPITAL EMPLOYED (A+B)
Equity (C)
Short, medium and long term borrowing
- Marketable securities
- Cash equivalent
=Net debt (D)
INVESTED CAPITAL (C+D)=CAPITAL EMPLOYED (A+B)

24. Book value of equity
This is a solvency-oriented concept that attempts to compute the funds invested by shareholders
It is an accounting, rather than financial, concept
BV equity: Fixed Assets+Current Assets-Borrowings of any kind
When a company is sold, the buyer will be keen to adopt an even stricter approach:
by factoring in contingent liabilities (which do not appear on the balance sheet);
by excluding worthless assets

25. ROE
ROE = ROA x Leverage x Contribution of rev/expenses outside operations
ROE = EBIT/TA x TA/E x NI/EBIT
It shows the contribution of:
Operations (ROA)
Capital structure, reflected by the leverage ratio, TA/CN, which exerts a multiplicative effect on the operational margin and on NI/EBIT
The contribution of revenues/expenses outside operations (NI/EBIT), such as interest expenses
The effect of capital structure decisions is not clearly identified being splt into two indicators

26. The contribution of operations
ROA = ROS x TURNOVER
Efficiency in the use of capital
Economic efficiency

27. ROE-An alternative approach
ROE = [ ROA + (ROA – I) x D/E ] x NI/CI
D = Debt
E = Equity
NI = Net income
CI = Current income
= Operational margin – Interest expenses (IE)
I = IE/D
= respresents an accounting estimate of the cost of debt

28. ROE-an alternative approach
NI = [EBIT - IE] (NI/CI)
NI/E = [EBIT/E - IE/E] (NI/CI)
ROE = [EBIT/TA * TA/E - IE/D * D/E] (NI/CI)
ROE = [ROA * (D+E)/E - IE/D * D/E] (NI/CI)
ROE = [ROA * (D/E + E/E) - IE/D * D/E] (NI/CI)
ROE = [ROA*E/E + ROA * D/E - IE/D*D/E] (NI/CI)
ROE = [ROA + ( ROA - I )* D/E] (NI/CI)

29. ROE-An alternative approach
ROE = [ ROA + (ROA – I) x D/E ] x NI/CI
ROE depends on:
operations (ROA)
Capital structure: cost of debt and leverage ratio
Income items outside operations: NI/CI. Excluding extraordinary revenues/expenses, the ratio becomes 1-T, where T is the tax rate
ROE = [ ROA + (ROA – I) x D/E ] x (1-T)

30. Economic income vs accounting income
An important topic in financial analysis pertains to the distinction between realized and unrealized income
Suppose you your assets, net of liab., are worth 120k € at the end of the period (100k at the beginning) and you receive 70k in wages in the period
What your income?
Many people would say 90k…
…but not the accountant, according to whom your income is just 70k (he recognize only realized gains rather than paper gains)
A non-accontant, by contrast, would say that your spending power, ignoring inflation, is the commonsense 90k (after all, if you sell your assets you could realize those 20k)

31. Economic income vs accounting incomr
€ in millions
Accountant
Economist
Operating Income
173.2 IE
20.4
Other nonoperating expenses
(1.5)
Cost of Equity
98.4
Income before taxes
154.3
55.9
Provision for taxes
47.1
- Accounting earnings
107.2
- Economic earnings
8.8

32. ROE ROE = [ ROA+ ( ROA - IE/D ) x D /E ] x NI / CI Return on equity
Contribution from
operations
Contribution of
Capital structure
Contribution of
Other businesses

33. CASE 1 200 IE 16 300 EBIT 30 E 100 NI 7 IE/D 8% ROA 10% T 50% ROE 7% DCE
300
EBIT 30 E
100
NI 7
T 50%
ROE 7%

34. ROE-Breakdown
ROE = [ ROA x E + ( ROA - I ) x D] x NI / CI E E

35. ROE-Breakdown ROA-i=2% D/E=2
ROE = [ ROA x E ( ROA - I ) x D ] x NI / CI 8%
10%
100
200 E 2% E =
10% + 4%
50% 7%

36. CASE 2 250 IE 23 300 EBIT 30 E 50 NI 3.5 IE/D 9.2% ROA 10% T 50% ROECE
300
EBIT 30 E 50
NI 3.5
T 50%
ROE 7%

37. ROE-Breakdown ROA-i=0.8% D/E=5
ROE = [ ROA x E ( ROA - I ) x D ] x NI / CI 8%
10% 50
250 E
0.8% E =
10% + 4%
50% 7%

38. CASE 3 100 IE 8 300 EBIT 36 E 200 NI 14 IE/D 8% ROA 12% T 50% ROE 7% DCE
300
EBIT 36 E
200
NI 14
T 50%
ROE 7%

39. ROE-Breakdown ROA-i=4% D/E=0.5
ROE = [ ROA x E ( ROA - I ) x D ] x NI/ CI 8%
12%
200
100 E 4% E =
12% + 2%
50% 7%

40. But: negative effects on risk!!
ROE: focus on leverage
ROE = [ ROA + (ROA – I) x D/E ] x NI/CI
Leverage:
if (ROA - I) > 0 
Rising the leverage ratio (D/E) allows pushing up ROE
But: negative effects on risk!!

41. ROE breakdown: an extension
ROE = ROA +
D=Financial debt
[(ROA - IE/D) X D/E +
NFD=Non-financial
debt
(ROA - 0/NFD) X NFD/E] X
(1-K) X (1-T)
ROE = [ROA +(ROA-I) D/E + ROA X NFD/E] X (1-K) X (1-T)
K = (CI – EBT) / CI
T = (EBT - NI) / EBT
Impact of other businesses
CI = EBIT - IE
Impact of taxes on the firm’s income

42. ROE Is it a good indicator of the return on equity?
A company A with an higher ROE than company B, is for sure a better company?
Is an improvement in ROE inequivaocally a sign of improved performance?
Actually, ROE has three weaknesses as a performance indicator:
The problem of time
The problem of risk
The value problem

43. The problem of risk
The risk problem reflects the traditional risk-return trade-off
The ROE says nothing on the risk levels that a company assumes
Let consider the following example. Which of the two companies is the better? A
(Risky business) B
(Low risk business)
ROA 6%
10%
TA/E 5 2
ROE
30%
20%
To overcome the distortionary effects of leverage on ROE and ROA, its better to rely on the ROCE

44. ROCE: benefits
Let consider the following companies, identical except for their capital structure
Which judgement on ROE, ROA and ROCE?
Company A
Company B
interest rate
900 E
100
1000
TA=CE
EBIT
120
(-) IE 90
EBT 30
(-) 12 48
Net earnings 18 72
ROE
18%
7.2%
ROCE
12%

45. The problem of value ROE: based on the book value of equity
What if using the market value of equity?
Let suppose
Net earnings=107.2
Book value of equity=983.8
Market value of equity=1821.8
BV=107.2/983.8=10.9%
Earning yield=107.2/1821.8=5.9%

46. EBIT/IE It is a ratio expressing financial fragility
Example: EBIT/IE=3; the firm has a 3 € margin to pay one € of IEs
Strengths:
Clear and unambiguous signals
It jointly considers both the economic and financial profiles of the firms
A low value for the ratio reveals financial fragility
Low operational margins?
Too high leverage?

47. Average accounting cost of debt
EBIT/IE
(EBIT/IE)=[(EBIT/S)*(S/D)]/(IE/D)
Return on Sales
Ratio of sales on debt
Average accounting cost of debt
EBIT/S
S/D
IE/D
EBIT/IE
CASE 1
0.6
0.2
6.0% 2
CASE 2
0.625
0.256
8.0%
CASE 3
0.8
0.15
CASE 4
0.3 5%
0.9
CASE 5
13.3%
CASE 1
CASE 2
CASE 3
CASE 4
CASE 5
EBIT 30 40 48 18
40.8 S 50 64 60 68 IE 15 20 24
45.33 D
250
400
340

48. IE/S Can be used as a signal of finacila fragility
It is the ratio of interest expenses on sales
Actually, it is a «poor» substitute of the EBIT/IE ratio
Why?

49. IE/S
EXAMPLE: 5% IE/S ratio could alternatively be acceptable or too high
Let suppose a company having EBIT/S=10%...
…or, alternatively, =2%...
EBIT/IE is significant and immediately expressive of a firm’s financial soundness
Year x
X+1
X+2
IE/S 5%
5.5% 6%
EBIT/IE 3
3.2
3.4
EBIT/S
0.15
0.176
0.204
The ratio of IEs on sales increases…but against an increase in operational margins as well