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

2. 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

3. 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

4. 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

5. The Standard Balance Sheet

6. 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

7. The Typical Reformulated Balance Sheet

8. 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

9. Nike, Inc.: GAAP Balance Sheet (1)

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

11. Nike, Inc.: Reformulated Balance Sheets

12. Reebok: GAAP Balance Sheet (1)
December 31
Amounts in thousands,
except per share data
Assets
Current assets:
Cash and cash equivalents $ 565, $ 693,599
Accounts receivable, net of allowance for , ,320
doubtful accounts (2004, $81,280; 2003,
$70.823)
Inventory , ,692
Deferred income taxes , ,070
Prepaid expenses and other current assets , ,169
Total current assets ,857, ,726,850
Property and equipment, net , ,765
Other non-current assets:
Goodwill, net , ,690
Intangibles, net of amortization , ,296
Deferred income taxes , ,478
Other , ,663
Total Assets $ 2,440, $ 1,989,742

13. Reebok: GAAP Balance Sheet (cont.)
December 31
Amounts in thousands,
except per share data
Liabilities and Stockholders' Equity
Current liabilities:
Notes payable to banks $ 63, $ 8,055
Current portion of long-term debt ,
Accounts payable , ,904
Accrued expenses , ,849
Income taxes payable , ,017
Total current liabilities , ,988
Long-term debt, net of current portion , ,225
Minority interest , ,657
Other long-term liabilities , ,162
Commitments and contingencies
Stockholders' equity:
Common stock, par value $.01; authorized 250,000 shares;
issued shares: 101,827 in 2004; 101,081 in 2003
Retained earnings ,985, ,796,321
Less shares in treasury at cost: 42,619 in 2004; 41,473 in (780,510) (740,189)
Unearned compensation (5,804) (1,225)
Accumulated other comprehensive income (expense) , (22,208)
Total Stockholders' Equity ,219, ,033,710
Total Liabilities and Stockholders' Equity $ 2,440, $ 1,989,742

14. Reebok: Reformulated Balance Sheet

15. Microsoft Corporation: Reformulated Balance Sheet

16. The Standard Income Statement

17. 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)

18. The Reformulated Income Statement (2)

19. 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

20. 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
Income tax expense (150)
Net income $ 350
Revenue $4000
Operating expenses (3,400)
Operating income before tax
Tax expense:
Tax reported $150
Tax benefit for interest (185)
($100 x 0.35)
Operating income after tax $ 415
Net income $350
Interest expense $100
Tax benefit
Operating income after tax $415

21. 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

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

23. Nike, Inc; GAAP Income Statement

24. Nike Inc.: Reformulated Income Statement

25. Reebok: GAAP Income Statements

26. Reebok: Reformulated Income Statements

27. Track Nike on BYOAP

28. Microsoft Corporation: GAAP Income Statements

29. Microsoft Corporation: Reformulated Income Statements

30. 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

31. Common Size Analysis : Nike and Reebok Income Statements

32. Common Size Analysis: Nike and Reebok Balance Sheets

33. Common Size Analysis: Nike and Reebok Balance Sheets

34. Trend Analysis: Nike, Inc.

35. 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:

36. 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

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

38. 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)

39. Growth Ratios

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

41. 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

42. Reebok: Reformulated Income Statements