Reorganizing the Financial Statements

Question 1

Why do we reorganize the accounting statements?

Answer 1

Because they are not good for reading economic performance. Balance Sheet and Income Statement mix operating and non-operating items, while not assigning them financing.

The Goal of reorganizing the statements is that we sort each statement into operating items, non-operating items and sources of financing.

*some accounts mix operating and non-operating items and we need to scan the notes to take them apart

Question 2

What is NOPAT?

Answer 2

After tax operating profit generated by invested capital, available to all investors

Question 3

Invested Capital

Answer 3

The investors capital required to fund operations, without regard to how the capital is financed

Question 4

Formula for ROIC

Answer 4

ROIC = NOPAT / Invested Capital

Question 5

FCF Formula

Answer 5

FCF = NOPAT + Non Cash operating expenses - Investment in invested Capital

or combine non-cash expenses and invested capital to get

FCF = NOPAT + increase in Invested Capital

Question 6

What does the economic balance sheet equation look like

Answer 6

Question 7

What are the 3 steps to calculate NOPAT from the income statement?

Answer 7

1. interest is not subtracted from operating income, because interest is compensation for the company’s debt investors, not an operating expense. By reclassifying interest as a financing item, we make NOPAT independent of the company’s capital structure.
2. when calculating NOPAT, exclude income generated from assets that were excluded from invested capital. Not doing this correctly would lead to an inconsistent definition of ROIC.
3. since reported taxes are calculated after interest and nonoperating income, they are a function of nonoperating items and capital structure. Keeping NOPAT focused solely on ongoing operations requires that the effects of interest expense and nonoperating income also be removed from taxes. To calculate operating taxes, start with reported taxes, add back the tax shield from interest expense, and remove the taxes paid on nonoperating income. The resulting operating taxes should equal the hypothetical taxes that would be paid by an all-equity, pure operating company. Nonoperating taxes, the difference between operating taxes and reported taxes, are not included in NOPAT, but instead as part of income available to investors.