Reformulation Theory

Question 1

Why is cash considered to be either an operating or financial item

Answer 1

Normally considered to be a financial item. Can be split between operating and financial. Sometimes cash is used as working cash, or operating cash, which is needed as a buffer to pay bills as they fall due, is an operating asset. This is non interest bearing in the form of cash on hand of in a checking account. Just as the firm needs to invest in plant and equipment to carry out operations, it also has to invest in working cash. However, interest bearing cash equivalents (investment with less than three months maturirty) or cash invested in short term securities are financial assets

Question 2

Why are short term notes receibles considered to be either operating or financial

Answer 2

Notes can be written by customers for goods received in trade, with or without interest. If the notes are temporary investment of excess cash, treat them as financial assets. If they are trade notes, treat them as operating assets.

Question 3

Why is investment into long term debt considered to be either financial or operating?

Answer 3

Non financial firms, investments in bonds and other interest bearing investmet are financial assets. Banks however, make money on the spread between borrowing and lending rates, so in their case, debt investment and debt liabilities are operating items.

Question 4

Why is long investment into equity considered to bei operating or fincial?

Answer 4

Long term equity investments are investment in the operations of other companies, and so they are classified as operating assets. However if they are considered as short term equity investments in order to mop up excess cash, they are financial asset.

Question 5

Why are short term notes payable considered to be either financial or operating

Answer 5

Short term notes can be writes to generate cash, in which case they are financial obliagation. However notes can be written because of trade obligation, for the purpose of inventory for example. If these are non interest bearing, or carry an interest rate less than the market rate for this type of credit, they are classified as operating liabilities.

Question 6

Why are leases considered to be either finacial or operating?

Answer 6

Leases that are capitalized are placed on the asset side of the balance sheet as a lease asset at the present value of the expected payouts under the lease agreement. The lease asset is an operating asset. The lease obligation is reported under liabilities and classified as financial obligation in reformulated statements Interest expese on the lease obligation is reported with other interest expense in the income statemnt. Leases that are cpaitalized and placed on the balance sheet are called capital leases. Capital leases are essentially in substance purchases granting the firm a right to use the asset for most of its useful life. Accordingly if an asset satisfies criteria that indicate an insubstance purchase, he lease asset is teated similarly to any other PPE. And the obligation to service the lease is trated as if th firm had purchased the asset and borrowed to finance the purchase. The lease obligation is an effective loan to finance the ourchase of the asset Leases that deemed not to be effective purchases are called operating leases. They do not appear on the balance sheet but the rent payment are included as rent expence in the income statement.

Question 7

Outline what you would have to do in order to reformulate a set of puplished (or forecast) financial statement

Answer 7

1 step) Reformulate statement of shareholders equity by (a) restating beginning and ending balances for the period for items that are not parts of common shareholders quity, (b) Calculating net transaction with shareholders (the net dividends), (c) Calculating the comprehensive income
2 Step) Reformulating the balance sheet by splitting the firm into operating and financing asset and liabilities. The key step here is to identify operating and financial items. The reformulation has to main the balance sheet equity (CSE = NOA + NFA)
3 Step) Reformulate the Income Statement by grouping the items into operating and financing categories. However the reformulated statement is on a comprehensive basis, so it also include dirty surplus items reported within the equity statement.

Question 8

Explain why it is important for the purpose of analyzing and valuing a company to reformulate financial statement?

Answer 8

• In the form they are represented under GAAP they do not give the picture we need in order to value a company, Published balance sheets lists asset and liabilities classified into current and long term categories (useful for credit analysis, but not for equity valuation
• Reformulating financial statements brings the line items in line with business activities, so it is an essential tool for discovering the value generation
• Profitability that generates values comes from a firms business operations. Thus the analysis begins with a reformulations of the statements., to distinguish operating activities from financing activities.
• Reformulation of the financial statement brings the business activities into sharper focus
• The main aim of reformulating the balance sheet and income statement, however is to discover the drivers of ROCE and growth in preparations for forecasting and valuation.
• This discovery is made through ratio analysis, combined as always with a good knowledge of the business.
• Success of a failure of a firm typically depends upon the success or failure of the operating entity, but financial statement do not normally make a clear distinction between operating items and financial items
• An analyst who want to analyze the operating entity (the underlying business) free of distortions caused by financing activities need to be able to spate the operating and financial component of the financial statements.
• If the analyst has gone through the analysis of the balance sheet and income statement and reformulated them, he does not need a cash flow statement to get the free cash flow. If those statement are appropriately formatted, the free cash flow is given by a quick calculation

Question 9

With regard to the decomposition if the ROCE, state clearly the formula that you will use to carry of the decomposistion (you are not required to derive the formular

Answer 9

ROCE = Earnings / CSE
ROCE = RONA + [RNOA –NBC] * FLEV
ROCE = OI/ NOA + [OI/NOA – NFE/ NFO] * NFO/ CSE

Question 10

Comment briefly on any insight that might be obtained from decomposing the ROCE

Answer 10

• Now you see why the reformulation is so important, because you can easily derive the drivers of ROCE
• Return on common equity (ROCE) = operating prfitibality (RNOA) + Spread * Financial Leverage
• The decomposition focuses on separation of operating items and financial item
• The equation above clearly shows that financial leverage works only in your favour as long as you are able to finance your self with lower costs that you are able to generate operating profitability. In case your spread turns out to be negative, due to an increase in NBC and sharp fall in operating profitibilty, financial leverage can work against you.

Question 11

Explain briefly why such prfitibility decompositions are potentially important in financial analysis.

Answer 11

Profitibility analysis established where the firm is now, where the firms might be in the future
• -it discovers what drives current ROCE by decomposing it into several parts
• -With this understanding of the present, the analyst is able to forecast by asking how future ROCE will be different from current ROCE.
• -the decomposition clrearly allows analyst to identify key drivers and forecast to forecast them separately and to identify certain strength and weakness in each components also identify specific company related risks (e.g too high leverage)
• -profitibility analysis allows to identify the sources of value generation and also sources of potential components that decrease the value of the company
• -This is profibility analysis becomes a tool for management planning, stategy analysis, and decisions making, as well as valuation

Question 12

Decomposition of ROCE by reference to financial leverage

Answer 12

ROCE = Earnings / CSE
ROCE = OI/ NOA + [OI/NOA – NFE/ NFO] * NFO/ CSE
ROCE = RONA + [RNOA –NBC] * FLEV

Question 13

Decompostion of RONA by reference to operating liability

Answer 13

RNOA = OI / NOA
Return on net operating asset = ROOA + OLLEV *( ROOA – Implicit interest on operating libilities)
RNOA = (OI + IMPRINT ) / OA + [(OI +IMPRINT)/ OA – IMPRINT/ OL] * OL/NOA
In case imprint = 0
RNOA = OI / OA + [OI/ OA] *OL/NOA

Question 14

Decompostision of RNOA into margin and turnover

Answer 14

RNOA = OI / NOA
RONA = OI/ Sales * Sales/ NOA
RONA = Profit margin * Asset turnover

Question 15

Explain the dificuilties that you might expect to encounter in practice in reformulating a set of financial statements.

Answer 15

• one key issue is the differentiation between operating and financing activities, as some itmes can fall into both categories depending on the underlying business for example cash, short-term notes receivable, debt investment, long-term equity investments, deferred revenues, and leases.
• Lack of disclosure is another problem where the item such as share of income of a subsidiary may include both financing income and operating income, but the two components are often not identifiable

Question 16

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to
Deferred (unearned) Revenue:

Answer 16

First typically recognize revenue when goods are delivered or services are renders
• -sometimes a sales contract last over several years, for example for the sale of computer hardware etc, which is leading to deferred unearned revenues
• Companies collect money in advance, but the revenue is not allowd to be recognized yet, so it shown as a liability
• -This gives some flexibility and also room for manupalation for companies, as firm can be too aggressive (booking to much revenue to the current income statement) or too conservative (deferring too much to the future)
• -both have implications for the substantiality of earnings

Question 17

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to Restructering charges, asset impairments, and special charges:

Answer 17

• -these charge are mostly unuaual, but sometimes they occur repetitive
• -if this is the case the analyst have to adjust his forecast based on historical pattern with regard to those charges, as they can affect core income substantiatlly
• -for example a write down of PPE will lead to lower depreciations in the future, so operating income will be higher as without the write off. Hence those cost can affect core operating income.
• If a write fwon is excessive (big bath accounting) subsequent core earnings will be overstatet

Question 18

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to Research and development

Answer 18

• A drop in R&D expenditure increases current earnings, but may damage future earnings. So the analyst has to investigate wheather those reductions are teperoary.
• Sometimes analysi will look into research an development patterns, because sales margin might not come from sales growth but rather from risky cost cutting such as marketing., which will in fact affect your long term perpectices. So you migh have to include those affects into your long term forecast

Question 19

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to pension costs

Answer 19

Firms report the cost of providing defined benfit pension plans as apart of the cost of operating expenses. Pension expense, however, is a composite number, and the anyst must be aware of its makeup. It can be broken down into: Service cost, interest cost, expected return on plan assets, amortization of transition asset, amortization of prior service cost, acturial losses (gains), net pension expense.
Especially expected return on plan assets, must be handled with care, as they are not earnings from core business. The analyst must be carefull to disentangle these earnings and attribute them to the profitability of the the pension fund rather than the profitibilty of the business. For this reason they may be identified outside of core income from sales. .

Question 20

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to advertising

Answer 20

• A drop in advertising expenditures increases current earning but may damage future earnings. Again the analyst have to investigate whether changes in advertising are temporary

Question 21

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to Changes in estimate

Answer 21

• Some expenses like bad debts, warranty expenses, depreciation, and accrued expenses are estimates. When estimates for previous years turn out to be incorrect, the correction is made in the current yeat.
• Bad debts are usually estiamast as a percetange of accounts receives that is likely to go bad. If the estimate for last year was found to too high, fewer creditots went bad then expected, the correction is made to the curren years bad debt expenses.
• Thus the reported expense does not reflect the credit costs to the currents periods sales. However those changes in estimates are not disclosed that cleary, so analyst have to adjust for estimate changes.

Question 22

Outline any difficuilty that the item might present for an analyst seeking to identify core operating income with regard to Unrelaized gains and losses arising from markering of some assets and liabilities to fair value

Answer 22

• If market are efficient, changes in value should fluctuate randomly around the required rate of return, and the accounting recognition of those changes should behave in the same way.
• Component o income arising from such itmes are likely to be less predictable than for most accounting flows. But, since the expected future flows are recognized on the balance esheet, you do not need to worry about this for valuation purposes.

Question 23

Explain the concept of dirty surplus accounting (in outline only), know what the term means and be able to identify main dirty surplus items.

Answer 23

• Reporting income items as part of equity rather than in a income statement is knows as dirty surplus accounting.
• An equity statement that has no income other than net income from the income statement is a clean surplus accounting statement.
• Under dirty surplus accounting, the income in the income statement is not “clean” it is not complete.
• Dirty surplus accounting takes into accounting unrealized gain and losses on securities available fre sale, foreign currency translation gains and losses, gains on losses on derivative instruments, etc.
• Including such discontinued operations and other comprehensive income items in profitability analysis could be a more inclusive measure of performance. However, these items tend to be one-off items that may reduce the usefulness of the ratio for the purpose of predicting future aggressive earnings

Question 24

outline the SALES patterns though time that you would expect to observe in these drivers and explain the likely reasons for such patterns.

Answer 24

Sales growth rates tend to fade quickly. Firms with high sales growth currenly (in the upper groups) have lower sales growth subsequently, firms with low current sales grwoh (in the lower groups) have higher sales growth subsequently.
Compititros tend to erode cross sectional variation in changes in sales, profit margin, and asset turnover.

Question 25

outline the CORE SALES PRFOT MARGIN patterns though time that you would expect to observe in these drivers and explain the likely reasons for such patterns.

Answer 25

Changes in core sales profit margin tend to fade quickly towards common levels close to zero.

Question 26

outline the ASSET TURNOVER patterns though time that you would expect to observe in these drivers and explain the likely reasons for such patterns.

Answer 26

Changes in asset turnover tend to rever towards common levels very quickly, large increase in asset turnovers are temporary, as are large decreases in asset turnover.

Question 27

Outline the Core and other operating Income patterns though time that you would expect to observe in these drivers and explain the likely reasons for such patterns.

Answer 27

Some similarity with pattern overseved in RNOA. High “other Income” firms tend to remain high, likely to be and industry related effect. High core other income (for firms in the upper groups) tend to decline subsequently as a percentage of net operating assets, whereas low core other operating income tends to increase.
Some similarity with pattern overseved in RNOA. High “other Income” firms tend to remain high, likely to be and industry related effect.

Question 28

outline the UNUASAL ITEMS patterns though time that you would expect to observe in these drivers and explain the likely reasons for such patterns.

Answer 28

Unusual items tend to disappear very quickly, as expected for transitory items.
Greater degree of mean reversion than in RNOA and other income, dominated by one off items that make such items relatively difficuilt to predict

Question 29

outline the RNOA patterns though time that you would expect to observe in these drivers and explain the likely reasons for such patterns.

Answer 29

• Operating profits seems to be diminishing over time, as companies enter into the market competition. Low return companies will reduce costs or some die and lead to survivorship bias. This difference doen not diminish over time in total, which is also related to the industry effect. Meaning that there are some asset such research and development wich are not recognized. (Lecture 4, Slide 17)
• Competition tends gradually to drive down the operating profitability of firms that are in high-RNOA portfolios at time 0.
• Firms in low-RNOA portfolios at time 0 tend to increase profitability in the future – or cease to exist. (But note that patterns in low-RNOA portfolios could be distorted by survivorship bias - the ones that got worse go out of business and leave the sample.)
• But differences between high- and low-RNOA firms don’t fade completely over time. Persistent industry-related differences in the incidence of “omitted assets” (items not recognised on balance sheet) contribute to this.

Question 30

Explain the dificuilties that you might expect to encounter in practice in reformulating the income statement ?

Answer 30

• Lack of disclosure is often a problem:
a)The share of income oof subsidiary may include both financing income and operating income, but the two components are often not identifiable. As the investment in the subsidiary in the balnce sheet is identified as an operating item, so should this corresponding income statement item.
b)Detailing some expenses I often frustrating. In particular, selling, administrative, and general expenses are usually a large number with little explanation provided in footnotes.
c)Interest income is often lumped together with “other income” from perations. If this is the case, estimate interest income by apllying an interest rate to the average balances of financial assets during the period. If financial assets are all current assets, tjis rate is the short term interest rate.
• Under GAAP, interest that finances constructuin is capitalized into the cost of assets on the balance sheet. It is treated as a construction cost jult like the labor and materials that go into the asset. This is accounting practice confuses operating and financing activities; labot and material cost are investment in assets, and interest cotst are costs of financing assets. The result may be that little interest expense appears in the income statement for debt on the balance sheet. But it is difficuilt to unsramble this capitalized interest: it is deprecialted along with other constructon costs, through to the income statement and so is hard to trade. As the depreciation expense that included interest is an operating expense, the practice also distors the operating prfirability.

Question 31

What do you need to consider when reformulating the statement of shareholders equity, especially when it comes to preferred stock, noncontrolling interest and divedends payable?

Answer 31

a) ) Preffered stock is included in shareholders equity in the GAAp statement, but it is liability for the common shareholders. So reduce the balance by the amount of prefrerred sock in those balances (and ignore any preferred stock transaction during the period in the reformulation). An exception is mandatory redeemable preferred sotck which, under GAAP, is not part of equity.
b) Noncontrolling interests. Bith GAAP and IFRS report noncontrolling interest (also called minorit interest) within the equity statement. These minority interest in subsidies are cleary non common shareholder interest, so must be deducted from oping and closing balances.
c) Dividends payable. HAAP required dividends payable to common shareholders to be reports as a liability. But shareholders cannot owe dividends to themselves. And dividends payable do not provide debt financing. Common dividends payable are ports of the equity that common shareholders have in the firm. So instead of reporting them as liabilities, reclassify them to the balances of shareholders equity.