Reformatting financial

statements
The steps involved in Business Analysis
Step 5 – Application Step 4 – Prospective
analysis: Valuation
for example:
•Outside Investor •RIM
Compare Value with Price to BUY, •Alternatives
SELL, or HOLD
•Inside Investor •Sensitivity
Compare Value with Cost to ACCEPT
or REJECT Strategy
Step 3 – Prospective
analysis: Forecasting
•Profit and Loss
•Balance Sheet
Step 1 – Understanding the •Cash Flow
Business
e.g.: Step 2 - Analyzing Information
•The Product market – Accounting Analysis and
•The Competition Strategy Financial Analysis
•The Regulatory Constraints •Quality of Accounting
•Business strategies information?
•Re-formatting to uncover
business activities
•Ratio and cash flow analysis

22319 Financial Statement Analysis 2

Introduction
 When looking at a business we must first understand it –
industry and strategy analysis

 But, we also observe the business through the financial

statements

 The goal of Financial Analysis is to use the financial

statements to assess the performance of the firm.
 Ratio analysis
 Cash flow analysis

22319 Financial Statement Analysis 3

Learning Objectives
At the conclusion of this lecture you
should understand:
1. How to start measuring
profitability and growth
2. The activities of the firm and
problems with the measurement of
profitability and growth
3. How to reformat the financial
statements to reveal the different
activities of the firm

22319 Financial Statement Analysis 4

Measuring Overall Profitability
 The starting point is 𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅 =
return on equity 𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑠𝑠 ′ 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
(ROE):
 A firm’s value is determined by its ability to earn a return greater
than the cost of capital
 Therefore, a firm’s value is determined by the relation between
ROE and its cost of equity capital (ρe)
 Comparing ROE with ρe also gives an indication of future
profitability:
 Long run competitive equilibrium
 Deviations: industry conditions / competitive strategy /
accounting distortions
22319 Financial Statement Analysis 5
Decomposing profitability
– the traditional approach
 ROE is affected by two factors:
 How profitably it employs its assets
 Leverage
 ROE can be expressed as:
𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑠𝑠 ′ 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

𝑅𝑅𝑅𝑅𝑅𝑅 = ×
𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑠𝑠 ′ 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸

𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑅𝑅𝑅𝑅𝑅𝑅 × 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿

22319 Financial Statement Analysis 6

What is wrong with the traditional approach?

 Not the maths!

 What’s limiting is the combination of operating and

financing assets and income in the calculation of ROE

22319 Financial Statement Analysis 7

Activities of the firm and value creation
The Capital Market:
Trading Value
The Firm:
The Investors:
The Value Generator

 Critical is the
The Claimants on Value

Cash from Loans

Secondary

identification of
Debtholders Cash from Sale of Debt
Interest and Loan Repayments Debtholders
Operating Investment Financing
Activities Activities Activities

Cash from Share Issues Shareholders Cash from Sale of Shares

Secondary what creates
value within the
Shareholders
Dividends and Cash from
Share Repurchases

firm.
Statement of
Balance Income Cash Flow
Shareholders'
Sheet Statement Statement
Equity

The Financial Statements:

Information on Value

22319 Financial Statement Analysis 8

What creates value in a firm?
 Financing activities in capital markets:
1. Equity Financing Activities ?
 Share Issues ?
 Share Repurchases ?
 Dividends ?
2. Debt Financing Activities ?
 Borrowing ?
 Interest payments?

22319 Financial Statement Analysis 9

Share Issues: Creation of Value?
120 Million Shares Outstanding
 Scenario A:
 Issue 10 million shares at market price of $42/share
 What happens to market capitalization
Increases
from $5,040million to $5,460 million
 What happens to price per share
Nothing

 Scenario B:
 Issue 10 million shares at market price of $32/share
 What happens to market capitalization
Increases
from $5,040million to $5,360 million
 What happens to price per share
Drops to $41.23

 The capital raised simply increases current book value through cash
and does not generate abnormal earnings (return higher than cost of
capital) if not used wisely.
22319 Financial Statement Analysis 10
Share repurchases and Dividends:
Creation of Value?
 Share repurchases
 A way for management to communicate to the market that it
believes the firm is undervalued.
 Share repurchases are costly because of fees and price
premiums involved.

 Dividend payout policies?

 Irrelevance theory: investors are not concerned with a
company's dividend policy since they can sell a portion of
their portfolio of equities if they want cash.
 Signalling value: to convey management’s expectation of
current and future earnings.

22319 Financial Statement Analysis 11

Value is created in product markets!

Some interesting books to read:

22319 Financial Statement Analysis 12

Traditional approach issues

Problems with traditional ROE,ROA and leverage:

 Mixing operating and financing assets and liabilities

Median ROA is 7.0%

Median RNOA is 10.3%

Median Debt-to-Equity is 1.17

Median Financial leverage is 0.40

22319 Financial Statement Analysis 13

Activities of the firm
 Value is created by operating and investing activities: assets and
liabilities involved in the business, in selling goods and services.

 Value is distributed by financing activities: assets and liabilities

involved in raising cash for operations, and disbursing excess
cash from operations.

 Need to separate to get a better idea of performance:

 Investing / Operating
 Financing

 Need to do this for both the balance sheet items and profit and
loss items = reformatting the financial statements

22319 Financial Statement Analysis 14

Steps in reformatting the financial statements:
1. From Statement of Changes in Equity, identify comprehensive
income (CI), net payments to shareholders (d) and changes in
ownership interest (∆Oi).

1. Split the balance sheet into operating and financing

2. Split the P&L into operating and financing

3. Calculate FCFs and check that they equal!

22319 Financial Statement Analysis 15

1. Understanding how financial statements articulate
 All financial statements must be consistent
 At-1 = Lt-1 + OEt-1
 At = Lt + OEt
 OEt = OEt-1 + CIt - dt + ∆Oit

 Comprehensive income (CI)

 Comprehensive income (CI) = net income (NI) + other comprehensive income
(OCI)
 Examples of OCI: Foreign currency translation gains/losses, Cash flow hedges,
Pension plan gains/losses

 Net payments to shareholders (d)

 Includes all contributions by and distributions to owners
 Examples: dividends, share-based payments, share buy-back

 Change in ownership interest (∆OIt)

22319 Financial Statement Analysis 16

1. Qantas 2015

OE1 = OE0 + CI1 – d1 + ∆OI1

3,447 = 2,866 + CI1 – d1 + ∆OI1

22319 Financial Statement Analysis 17

 OE0 = 2,866

1. Qantas 2016

CI1 = 558

d1 = -19

∆OI1 = 4
22319 Financial Statement Analysis OE1 = 3,447
18
1. Qantas 2015

 OE1 = OE0 + CI1 – d1 +∆OI1

 3,447 = 2,866 + 558 – (-19) + 4

22319 Financial Statement Analysis 19

2. Separate the balance sheet into operating and
financing activities
1. Identify what are assets and liabilities are financing
(generally anything interest bearing) and calculate net
financing obligations (NFO)
2. All other items are identified as operating and
calculate net operating assets (NOA)
3. Confirm that balance sheet still balances (OE = NOA –
NFO)

22319 Financial Statement Analysis 20

2. Separate the balance sheet into operating and
financing activities
 Cash
 Short-term notes receivable
 Accrued expenses
 Deferred revenues
 Debt investments
 Long-term equity investments (Associates)
 Deferred tax assets and liabilities
 Leases
 …………………………..
 Refer to Penman textbook pp.292-296.

22319 Financial Statement Analysis 21

2. Separate the balance sheet into operating and
financing activities

Standard Balance Sheet 2012 2013

Operating assets 8,000 10,100

Marketable securities 1,600 800
Operating liabilities (400) (1,200)
Bonds payable (5,600) (5,200)
Book value (net) 3,600 4,500

Financing = ?
Operating = all others = ?
Make sure that the balance sheet still balances!
22319 Financial Statement Analysis 22
2. Separate the balance sheet into operating and
financing activities
Reformatted balance sheet 2013
Net Operating Assets

Operating assets 10,100

Operating liabilities (1,200)
Net operating assets 8,900

Net Financing Obligations

Marketable securities 800

Bonds payable (5,200)
Net financing liabilities (4,400)

Book value (net) 4,500

22319 Financial Statement Analysis 23

3. Separate income statement into operating and financing

1. Identify what is financing (interest paid or received + any

others?) and calculate net interest expense.
2. Adjust net interest expense for tax shelter to calculate an
net financing expense after tax (i.e., NFE = Net interest x (1
– tax rate (i.e., 30%))
3. Identify other revenues and expenses as operating and
calculate operating profit before tax
4. Adjust reported tax expense for tax shelter on net interest
to calculate net operating profit after tax (NOPAT)
5. NI=NOPAT – NFEat
6. If there is other comprehensive income,
CI=NOPAT – NFEat + OCI

22319 Financial Statement Analysis 24

3. Separate income statement into operating and financing

2013
Sales 8,900
Operating expenses (6,668)

Interest revenue 108

Interest expense (548)
Tax expense (rate = 30%) (424)

Net Income 1,368

Other comprehensive income 10
Comprehensive income 1,378

22319 Financial Statement Analysis 25

3. Separate income statement into operating and financing
2013
Sales 8,900
Operating expenses (6,668)
2,232
Tax expense (424+132) (556)
NOPAT 1,676

Interest expense (548)

Interest Revenue 108
(440)
Tax Shelter (30%) 132
Net Financing Expense (308)
Net Income 1368
Other comprehensive income 10
Comprehensive income 1,378

22319 Financial Statement Analysis 26

4. Calculate free cash flow

 Derive free cash flow generated by operations

FCF = NOPAT - ∆NOA + OCI
 Derive free cash flow spent on financing
FCF = NFEat - ∆NFO + d – ∆OI
 Double check:
NOPAT - ∆NOA + OCI = NFEat - ∆NFO + d – ∆OI
NOPAT – NFEat + OCI - d + ∆OI = ∆NOA - ∆NFO
CI – d + ∆OI = ∆ OE

22319 Financial Statement Analysis 27

4. Calculate free cash flow
 Assume no changes in OI in the example:
OEt = OEt-1 + CI – d (d: net payments to shareholders)
4,500 = 3,600 + 1,378 – d
d = 478

 FCF = NOPAT - ∆NOA + OCI

FCF = 1676 – (8,900- 7,600)+10
FCF = 386

 FCF = NFEat - ∆NFO + d – ∆OI

FCF = 308 – (4,400- 4,000)+478-0
FCF = 386

 In assignment need to show the FCF check.

22319 Financial Statement Analysis 28

Common mistakes!
“Why my two FCF formulas don’t give the same results?”

 Reason 1: not all financial statements items are included in the reformatted statements, or
double count items
 Make sure you go item by item when doing reformatting
 Make sure footnote subtotals add up to the total amount in original financial statements when
using footnote information

 Reason 2: tax allocation is incorrect when reformatting income statement.

 Tax saving (shelter) is a revenue while tax expense is an expense.
 Make sure tax allocated to operating and financing activities add up to the original tax amount.

 Reason 3: net payments to shareholders (d) is calculated incorrectly.

 d should include all contributions by and distributions to owners, not just dividends!

 Reason 4: confuse item signs with the formula signs in reformatting.

 Don’t get confused with the positive/negative signs.
 Always think whether the item is an expense or a revenue? An assets or a liability?

 Even if you wrongly classify Operating and financing activities, you should still have the same
two FCF results.

22319 Financial Statement Analysis 29

Other issues

 Lack of disclosure
 Financial footnotes include details on the components and nature
of account items.
 Sometimes the disclosure may not be transparent. Depends on the
disclosure quality!
 Unusual items
 Earnings that can repeat in the future, and grow, are sustainable
earnings, persistent earnings, core earnings, or underlying earnings.
 Earnings based on temporary factors are called transitory earnings
or unusual items.
 Core earnings are the base for growth and should be the focus of
fundamental analysis.
 Reformatting should be consistent

22319 Financial Statement Analysis 30

Summary
This week Next week
 Formatting financial  Using reformatted
statements to emphasize financial statements to
value evaluate firm
 Splitting operating performance
activities (value adding)
from financing (value
allocating)
 Consistency – Financial
statement the ‘balance’

22319 Financial Statement Analysis 31