1. Reorganizing the Balance Sheet
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Chapter 7
Reorganizing the Balance Sheet

2. 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.
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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3. 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 reorganized to create net operating profit less adjusted taxes (NOPAT). NOPAT represents the after-tax operating profit available to all financial investors.
After-Tax
Operating Profit
Invested
Capital
ROIC =
The balance sheet will be reorganized to create invested capital. Invested capital equals the total capital required to fund operations, regardless of type (debt or equity).

4. FCF = NOPAT + Depreciation + Invested Capital
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.

5. 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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6. 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
Assets Liabilities Assets
= Debt + Equity +
Invested capital equals operating assets less operating liabilities.
Total funds invested equals invested capital plus nonoperating assets.
Total funds invested can also be measured by summing debt plus equity!
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7. 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).
Prior
Current
Assets
year
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
operating assets.
Total assets
515
600
Liabilities and equity
Invested capital
375
425
Accounts payable Interest-bearing debt
125
150
Nonoperating assets
are not included in
Common stock 50
Total funds invested
390
450
invested capital.
Retained earnings
115
Total liabilities and equity
Reconciliation of total funds invested
Interest-bearing debt
Accountant's balance sheet
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8. Invested Capital: Operating Perspective
Operating assets include current operating assets (working cash, accounts receivable, inventory, prepaid expenses), along with PP&E and net other long-term operating assets. Include capitalized leases and R&D as operating assets.
Operating Assets −
Operating liabilities include non-interest-bearing current liabilities; the most common are related to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue and customer advances), and the government (income taxes payable).
Operating Liabilities =
Invested Capital +
Nonoperating assets include excess cash, marketable securities, notes receivable, prepaid pension assets, nonconsolidated subsidiaries, and other equity investments).
Nonoperating Assets =
Total Funds Invested
Total funds invested from an operating perspective.
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9. 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

10. How Much Cash Is Excess Cash?
Method 1
Excess of
2% of
Revenues
Comments
Requires only firm-specific information, but doesn’t handle differences in firm characteristics or current market environment.
Method 2
Excess of Industry Median or Average
Data intensive (requires data for many firms), but handles industry-specific characteristics and differences across time. Be careful—the average can be affected by an asset sale at an industry rival (industry average will rise following sale).
Method 3: Regression
Regression of Log(Cash/Noncash Assets) on
Independent variable
Beta
T-Stat
Intercept
−1.921
82.89
Market/book
0.137
27.11
Real size
−0.046
15.09
Cash flow/assets
0.171
4.71
Working capital/assets
−0.754
29.04
Capital expenditures/assets
0.570
8.77
Total debt/assets
−0.301
101.44
Industry cash flow volatility
0.106
1.77
R&D/sales
1.776
21.02
Dividend dummy
−0.100
8.94
Regulation dummy
−0.010
0.23
Number of observations
87,117
Adjusted R-squared
18.69%
Source: T. Opler, L. Pinkowitz, R. Stulz, and R. Williamson, “Corporate Cash Holdings,” Journal of Applied Corporate Finance 14 (2001): 55−67.

11. Invested Capital: Financing Perspective
Debt
Equity Equivalents
Debt Equivalents +
Equity =
Total Funds Invested
Debt includes all interest-bearing debt from banks and public capital markets.
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 part of a restructuring, an unfunded pension liability, or expected environmental 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 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 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 invested from a financing perspective.
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12. 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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13. Reorganizing the Income Statement: NOPLAT
NOPLAT includes only operating-based income. Unlike net income, interest expense and nonoperating income are excluded from NOPLAT.
Current
year
Revenues
1,000
Operating costs
(700)
Depreciation
(20)
Operating profit
280
Interest
Operating taxes 1
(70)
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
Treat interest as a
After-tax interest expense 15
financial payout to
investors, not an expense.
Accountant's income statement
Taxes are calculated on
operating profits.
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14. Devil in the Details: Operating Income
Hasbro Inc. 10-K Disclosure
Management Discussion and Analysis (MD&A)
International segment operating profit increased significantly by 54% to $140,784 in 2004 from International gross profits and operating profits were positively impacted by the cessation of manufacturing at the Company’s Valencia, Spain facility at the end of [Gross profit] in 2003 included cash charges of approximately $18,400 associated with severance related to this cost reduction initiative.
The improvement in operating profit in 2004 over 2003 was also due to lower royalty expense primarily from decreased sales of BEYBLADE, which was partially offset by an increase in advertising expense as a result of the Company’s ongoing initiative to raise awareness of its core brands.
Hasbro Inc.
After-tax operating profits
$ million
2005
2006
2007
2008
2009
Net revenues
3,087.6
3,151.5
3,837.6
4,021.5
4,067.9
Cost of sales
(1,286.3)
(1,303.9)
(1,576.6)
(1,692.7)
(1,676.3)
Gross profit
1,801.4
1,847.6
2,260.9
2,328.8
2,391.6
Royalties
(247.3)
(169.7)
(316.8)
(313.0)
(330.7)
Product development
(150.6)
(171.4)
(167.2)
(191.4)
(181.2)
Advertising
(366.4)
(369.0)
(434.7)
(454.6)
(412.6)
Selling and administrative
(624.6)
(682.2)
(755.1)
(797.2)
(793.6)
Operating profit (EBITA)
412.6
455.3
587.1
572.6
673.6
Include only those expenses that are related to ongoing core operations.

15. Determining Operating Taxes
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.
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.
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.

16. 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.
$ 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
percent
35.0
2.7
3.0
2.8
2.6
(0.2)
(0.1)
0.1
(0.3)
(0.5)
0.2
(1.6)
(2.0)
36.8
37.1
38.1
36.4
35.6
Source: Home Depot K, note 6.
Tax reconciliation
Step 1: Reformat tax reconciliation table

17. 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.
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).

18. 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%
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 −
3,081
3,688
3,873

19. 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.
Current
year
Net income
198
NOPLAT
210
Depreciation 20
Decrease (increase) in inventory
(25)
Gross cash flow
230
Increase (decrease) in accounts payable 25
Cash flow from operations
218
Subtract investments in
operating items from gross cash flow.
Capital expenditures
(70)
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
nonoperating assets
Increase (decrease) in common stock −
Cash flow available to investors
153
separately from core operations.
Dividends
(113)
Cash flow from financing
(138)
Reconciliation of cash flow available to investors
After-tax interest 15
Treat interest as a
financial payout to
investors, not an expense.
113
Accountant's cash flow statement

20. 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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