Reorganizing the Financial Statements for Business Valuation – Part 1

Reorganizing the Financial Statements for Business Valuation – Part 1

Conventional financial statements—the income statement, balance sheet, and statement of cash flows—do not present accessible insights into operating performance and value. The balance sheet combines operating assets, non-operating assets, and sources of financing. The income statement likewise links operating profits, interest expense, and other non-operating items. To develop the financial statements for interpreting financial performance, you should reorganize every financial statement into three categories: operating items, non-operating items, and sources of financing. It usually entails hunting through the notes to separate accounts that aggregate operating and non-operating items. In this article, i present my insights on reorganizing the financial statements for business valuation – part 1.

Reorganizing the Financial Statements for Business Valuation – Part 1: Key Concepts

The initial step in valuation is to calculate the return on invested capital (ROIC) and free cash flow (FCF). It is essential to reorganize the balance sheet to measure invested capital and reorganize the income statement to evaluate NOPAT. Invested capital denotes the investor capital required to fund operations, without regard to how the capital gets financed. NOPAT represents the after-tax operating profit (generated by the firm’s invested capital) available to all investors.

ROIC = NOPAT / Invested Capital 

and 

Free Cash Flow = NOPAT + Non-Cash Operating Expenses – Investment in Invested Capital

By combining non-cash operating expenses, such as depreciation, with investment in invested capital, it is also possible to express FCF as:

FCF = NOPAT – Increase in Invested Capital

Invested Capital: Key Concepts

To develop a financial balance sheet that divides a company’s operating assets from its non-operating assets and financial structure, we begin with the conventional balance sheet. The most basic rule of accounting bounds the accounting balance sheet:

Assets = Liabilities + Equity

However, the traditional balance sheet equation mixes operating liabilities and financing sources on the equation’s right side. Assume a company has only operating assets (OA), such as accounts receivable, inventory, and property, plant, and equipment (PP&E); operating liabilities (OL), such as accounts payable and accrued salaries; interest-bearing debt (D); and equity (E). 

Using this more detailed breakdown of assets, liabilities, and equity leads to an elaborated variant of the balance sheet relationship:

OA – OL = Invested Capital = D + E

The above equation rearranges the balance sheet to indicate more specific capital employed for operations and investors’ financing to finance those operations. However, Assets consist of operating assets and non-operating assets (NOA), such as marketable securities, prepaid pension assets, nonconsolidated subsidiaries, and other long-term investments. Liabilities consist of operating liabilities and interest-bearing debt and debt equivalents (DE), such as unfunded retirement liabilities, and equity equivalents (EE), such as deferred taxes.

Taking into account, we can derive the equation as:

OA – OL + NOA = Total Funds Invested = D+DE + E+EE

Operating Working Capital 

Operating working capital denotes current operating assets minus current operating liabilities. Operating current assets encompass all current assets essential for the business’s operation, including working cash balances, trade accounts receivable, inventory, and prepaid expenses. Explicitly excluded are excess cash and marketable securities—that is, cash more significant than the business’s operating needs. Excess cash usually signifies temporary imbalances in the company’s cash position. Operating current liabilities cover those liabilities that are associated with the continuing operations of the firm. In case of an operating liability rather than financial, it should be cleared from operating assets to determine invested capital and consequently incorporated into free cash flow. 

Goodwill and Acquired Intangibles

Return on invested capital is examined both with and without the goodwill and acquired intangibles. ROIC with goodwill and acquired intangibles measures a company’s ability to create value after paying acquisition premiums. ROIC without the goodwill and acquired intangibles measure the competitiveness of the underlying business. 

To assess the impact of goodwill and acquired intangibles properly, you should perform two adjustments. First, deduct deferred-tax liabilities related to the amortization of acquired intangibles. Why? When amortization is not tax-deductible, accountants build a deferred-tax liability at the point of the acquisition drawn down over the amortization period (since reported taxes will be lower than actual taxes). Thus, to offset the liability, acquired intangibles are artificially raised by corresponding amounts, even though no cash flows. Subtracting deferred taxes related to acquired intangibles reduces this distortion. Second, add back cumulative amortization and impairment. Unlike other fixed assets, goodwill and acquired intangibles do not weather out, nor are they replaceable. Hence, you need to adjust reported goodwill and acquired intangibles upward to recover historical impairments of goodwill and amortization of intangibles.

NOPAT – Key Concepts

NOPAT is the after-tax profit produced from core operations, excluding any income from non-operating assets or financing expenses, such as interest. Whereas net income is the profit accessible to equity holders only, NOPAT is the profit free to all investors, including investors of debt, equity, and any other types of financing. It is crucial to establish NOPAT consistently with that invested capital and incorporate only those profits generated by invested capital.

Taxes get determined after interest and non-operating income. Thus, they are a function of non-operating items and capital structure. Having NOPAT concentrated only on ongoing operations requires that the effects of interest expense and non-operating income also be excluded from taxes. To measure operating taxes, begin with reported taxes, add back the tax shield from interest expense, and eliminate the taxes paid on non-operating income. The resulting operating taxes should match the postulated taxes that would be funded by an all-equity operating business. Non-operating taxes, the difference between operating taxes and reported taxes, are not included in NOPAT but rather as a component of income available to investors.

Free Cash Flow: Key Concepts

We discount projected free cash flow at a firm’s weighted average cost of capital to value its operations. FCF denotes the after-tax cash flow accessible to each investor: debt holders and equity holders. 

FCF = NOPAT + Non-Cash Operating Expenses – Investments in Invested Capital

Free cash flow excludes non-operating flows and items linked to capital structure. Thus non-operating cash flows should be examined and valued separately. Consolidating free cash flow and non-operating cash flow leads to cash flow available to investors. As is valid with total funds invested and NOPAT, cash flow available to investors, measured by employing two methodologies: one focuses on how the cash flow gets generated, and the other focuses on the recipients of free cash flow. 

Final Thoughts

In part-2 of the article that i will publish next week, i shall discuss Total Invested Capital, Non-Operating Assets, and reconciling cash flow to investors, taking into account the debt equivalents and equity equivalents.