Reorganizing the Financial Statements for Business Valuation – Part 2

Reorganizing the Financial Statements for Business Valuation – Part 2

This article is a continuation of my previous article on reorganizing the financial statements for business valuation – part 2. The link to the initial piece is here.

Computing Total Funds Invested

Invested capital denotes the capital needed to operate a company’s core market. Further to invested capital, firms can also hold non-operating assets. The aggregate of invested capital and non-operating assets is the total funds invested. Non-operating assets constitute excess cash and marketable securities, receivables from financial subsidiaries (for example, credit card receivables), non-consolidated subsidiaries, overfunded pension assets, and tax loss carry-forwards.

There are two purposes to diligently separate operating and non-operating assets. First, non-operating assets can misrepresent performance measures for both commercial and accounting reasons. For instance, various non-operating assets generate income, but firms do not report the income unless specific ownership thresholds get met. Including an asset without its analogous income misconstrues performance measurements. Next, there are more reliable techniques than discounted cash flow to value non-operating assets. You would never discount interest income at the cost of capital to value excess cash. For this asset, the book value satisfies.

Reorganizing the Financial Statements for Business Valuation – Part 2: Non-operating Assets

Excess Cash and Marketable Securities

Do not carry excess cash in invested capital. By its interpretation, excess cash is irrelevant for core operations. Instead of incorporating excess cash with core operations, examine and value excess cash independently. Given its liquidity and low risk, excess cash will draw minimal returns. If we miss separating excess cash from core operations, we will mistakenly reduce its plausible ROIC. Firms do not reveal how much cash they think essential for operations. Nor does the accounting definition of cash versus marketable securities separate working cash from excess cash. 

Non-consolidated Subsidiaries and Equity Investments

Non-consolidated subsidiaries, additionally mentioned as investments in related companies, should be estimated and valued independently from invested capital. When a business owns a minority stake in another firm, it will enter the investment as an individual line item on the balance sheet. It will not list the individual assets controlled by the subsidiary. On the income statement, only the subsidiary’s net income will get reported on the parent’s income statement, not the subsidiary’s revenues or costs. Since only net income—not revenue—is reported, including non-consolidated subsidiaries as part of operations will misrepresent margins and capital turnover. Hence, I suggest classifying non-consolidated subsidiaries from invested capital and analyzing and valuing non-consolidated subsidiaries independently from core operations.

Financial Subsidiaries

Some organizations, including Ford and Siemens, have financing subsidiaries that fund customer purchases. Because these subsidiaries carry interest on financing for purchases, they follow banks. Since bank economics are considerably different from manufacturing and service companies, you should divide line items linked to the financial subsidiary from the manufacturing business’s line items. Then assess the return on capital for each type of business independently. Otherwise, significant contortions of performance will make a significant comparison with competitors difficult.

Overfunded Pension Assets

If a firm operates a defined-benefit pension plan for its employees, it must finance each year’s plan. If a firm funds its plan quicker than its pension expenses direct or assets rise faster than foreseen, under U.S. GAAP and IFRS, the firm can recognize a part of the balance sheet’s excess assets. Pension assets are considered a non-operating asset and not part of invested capital. Their value is vital to the equity holder to be valued later, but distinctly from core operations. 

Tax Loss Carryforwards

Unless they are meager and improve consistently with revenue, omit tax loss carry-forwards—also identified as net operating losses (NOLs)—as a portion of invested capital. Depending on the deferred-tax asset’s nature, it will be valued either individually or as a component of operating cash taxes. 

Reconciling Total Funds Invested

Total funds invested can be measured as invested capital plus non-operating assets, or as the total of Debt, equity, and their equivalents. The results generated by the two methods should adjust.


Debt comprises all interest-bearing liabilities. Short-term Debt constitutes commercial paper, notes payable, and the current portion of long-term Debt, whereas Long-term Debt carries fixed/floating/convertible Debt with maturities of more than a year.

Debt Equivalents – Retirement Liabilities and Restructuring Reserves

If a firm’s defined-benefit plan is underfunded, it must identify the underfunding as a liability. The cost of underfunding is not an operating liability but a debt equivalent. It is as if the company must acquire money to finance the plan.


Equity involves investor funds (stock and additional paid-in capital) and investor funds reinvested into the business, like retained earnings and collected other comprehensive income). Other Comprehensive Income consists of currency adjustments, aggregate unrealized gains and losses from liquid assets whose value has changed but not sold, and pension plan fluctuations. Any stock repurchased and included in the treasury should be subtracted from total equity.

Equity Equivalents Such as Deferred Taxes

Equity equivalents are balance sheet accounts that appear because of non-cash changes to retained earnings. Equity equivalents are like debt equivalents; they vary in that they are not subtracted from enterprise value to ascertain equity value.

The most common equity equivalent, deferred taxes, stems from discrepancies in how businesses and the governments value taxes. For example, the government typically applies accelerated depreciation to determine a firm’s taxes, whereas the accounting statements use straight-line depreciation. This variance drives lower cash taxes than reported taxes during the initial years of an asset’s life. For growing businesses, this variance will cause reported taxes consistently to exceed its actual tax payments. To evade this bias, use cash-based (versus accrual) taxes to define NOPAT. Since reported taxes will now equal cash taxes on the income statement, the deferred-tax account—in this instance linked to accelerated depreciation—is no longer essential. Hence deferred-tax account is an equity equivalent. It depicts the adjustment to retained earnings that would get executed if the firm reported cash taxes to investors rather than accrual taxes.

Hybrid Securities and Non-controlling Interests

Apart from Debt and equity, other sources of financing cover hybrid securities and non-controlling interests. These do not have set interest payments and nor do they have the residual claim on cash flows. Hence, these accounts should be valued independently and subtracted from enterprise value to assess equity value.

Hybrid securities

The three common hybrid securities are convertible Debt, preferred stock, and employee options. Since hybrid securities comprise embedded options, it should not get interpreted as common stock. Alternatively, use the market price or, if required, option-pricing models to estimate these claims individually. Faltering to do so can undervalue the hybrid security and exceed the value of the common stock. It is particularly relevant for venture-capital-backed preferred stock and long-dated employee options. 

Non-controlling interests

A non-controlling interest happens when a third party controls a minority holding in one of the firm’s consolidated subsidiaries. If a non-controlling interest exists, treat the balance sheet amount as a source of financing. Treat the earnings attributable to any non-controlling interest as a financing cash flow similar to dividends. If data are accessible, value the subsidiary distinctly, and subtract the non-controlling interest from its enterprise value to determine equity value.

Reorganizing the Financial Statements for Business Valuation – Part 2: Calculating NOPAT

Net Operating Profit (EBITA) 

NOPAT begins with earnings before interest, taxes, and amortization of acquired intangibles, which comprises revenue minus COGS, SG&A, and depreciation. When a firm acquires a physical asset, it capitalizes on the asset on the balance sheet and depreciates it over its life. Since the asset wears out over time, any profit (and return) must realize this loss in value. A similar argument can get made to amortize acquired intangibles: they also have fixed lives and expend value over time. However, accounting for intangibles varies from accounting for tangible assets. Unlike capital expenditures, internally produced intangible assets like new customer lists and product brands are expensed and not capitalized. Therefore, when the acquired intangible expends value and is replenished through additional investment internally, the reinvestment is already expensed. The firm gets penalized twice in the corresponding period: once through amortization and another through reinvestment. Although not comprehensive, employing EBITA is consonant with existing accounting rules. Deciding which line items to add as operating expenses demands judgment. As a guiding principle, include ongoing expenses associated with the firm’s core operations. 

Adjustments to EBITA

In many firms, non-operating items get embedded within operating expenses. To assure that EBITA calculation proceeds only from operations, comprehend the notes to weed out non-operating items from operating expenses. The most apparent non-operating items are related to pensions, embedded interest expenses from operating leases, and one-time restructuring charges buried in the COGS.

Reconciliation to Net Income

We should reconcile net income to NOPAT to verify whether the re-organization is accurate. To reconcile NOPAT:

  1. Begin with net income accessible to both common shareholders and non-controlling interests, and add back the net addition in operating deferred-tax liabilities, which will give us adjusted Net Income.
  2. Add any non-operating charges like interest expense and other non-operating expenses followed by adjustments for operating lease interest and, if needed, the non-operating portion of the pension expense.
  3. Deduct tax shields on the non-operating expenses. Whether NOPAT gets calculated using revenues minus expenses or as net income plus non-operating items and other adjustments, the outcome should be the same.

Reorganizing the Financial Statements for Business Valuation – Part 2: Free Cash Flow

To formulate free cash flow, begin with NOPAT and add back non-cash expenses, including depreciation, to compute gross cash flow. From gross cash flow, deduct investments in working capital, capital expenditures, and investments in other long-term assets net of liabilities.

Gross Cash Flow

Gross cash flow depicts the cash operating profits that the company makes. It describes the cash available for investment and investor payout without selling non-operating assets, such as excess cash, or raising additional capital.

Investments in Invested Capital

To sustain and expand their operations, firms must reinvest a part of their gross cash flow back into the business. To ascertain free cash flow, deduct gross investment from gross cash flow. We segment gross investment into five primary areas:

Change in operating working capital: Developing a business needs investment in operating cash, inventory, and other elements of working capital. Operating working capital excludes non-operating assets, like excess cash, short-term Debt, and dividends payable.

Capital expenditures, net of disposals: Capital expenditures include investments in PP&E, less the book value of any PP&E sold. One method to calculate net capital expenditures is to add depreciation to the increase in net PP&E. Do not measure capital expenditures using the gross PP&E change. Since gross PP&E declines when companies retire assets, the gross PP&E change will usually undervalue the exact amount of capital expenditures.

Change in capitalized operating leases: To retain the meanings of NOPAT, invested capital, ROIC, and free cash flow constant include investments in capitalized operating leases in gross investment.

Investment in goodwill and acquired intangibles: For acquired intangible assets, where aggregate amortization gets added back, you can measure investment by calculating the change in net goodwill and acquired intangibles. For intangible assets getting amortized, add amortization to the increase in net intangibles.

Cashflow available to Investors

Although not covered in free cash flow, cash flows linked to non-operating assets are relevant and valued independently and then computed to free cash flow to give the total cash flow accessible to investors:

Enterprise Value = PV of Firm’s FCF + Value of Nonoperating Assets

Final Thoughts

Re-organization of financial statements for business valuation is crucial but a tedious process. From a valuation perspective, consistency is essential when classifying each line item else it will impact our judgments about return on invested capital and, eventually, value creation. 

A needlessly complicated model can disguise the underlying economics that would be apparent in a simple model. The financial analysis aims to provide a vital context for sound financial decision-making and robust forecasting, not to produce an overly engineered model that deftly handles unnecessary adjustments.


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