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Business Activities

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• Reformulated balance sheet– Published balance sheets list assets and liabilities,

usually classified into current and long-term categories• This division is useful for credit analysis• For equity analysis, it is more useful to reformulate the

balance sheet into operating and financial assets and operating and financial liabilities– Operating assets and liabilities : assets and liabilities used in

the business of selling to customers; involves customers and suppliers

– Financing assets and liabilities : assets and liabilities used in the financing of the business; involves trading in capital markets

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Balance Sheet

Assets Liabilities and Equity

Operating assets OA Operating liabilities OL

Financial assets FA Financial obligations FO

Common stockholders’ equity CSE

Total assets OA+FA Total claims OL+FO+ CSE

Reformulated Balance Sheet

Operating Assets Financial Obligations and Owners’ Equity

Operating assets OA Financial obligations FO

Operating liabilities (OL) Financial assets (FA)

Net financial obligations NFO

Common stockholders’ equity CSE

Net operating assets NOA Total claims NFO+ CSE

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Reformulated Balance Sheet

Assets Liabilities and Stockholders’ Equity

Financial assets: Financial liabilities:Cash equivalents Short-term borrowings

Short-term investments Current maturities of long-term debt

Short-term notes receivable Short-term notes payable

Long-term debt investments Long-term borrowing (bank loans, bonds payable, notes payable)Lease obligations

Preferred stock

Operating assets: Operating liabilities:

All else All else

Minority (noncontroling) interest

Common equity

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Net operating assets (NOA) = OA – OL– NOA also sometimes referred to as enterprise assets

If FA > FO: Net financial assets (NFA) = FA – FOCommon shareholders’ equity (CSE) = NOA + NFA

Usually FA < FO: Net financial obligations(NFO) = – NFACommon shareholders’ equity (CSE) = NOA – NFO

– NFA/NFO also sometimes referred to as net debt

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• Reformulated income statement– The income statement reports profits and losses

that NOA and NFA have produced over a given period

– The reformulated statement groups these items into operating and financing categories• Includes dirty-surplus items from the statement of

shareholders’ equity

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Reformulated Income Statement

Operating revenue OR

Operating expense (OE)

Operating income OI

Financial expense XX

Financial income (XX) (NFE)

Comprehensive income CI

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Reformulated Comprehensive Income Statement

Net sales

- Expenses to generate sales

Operating income from sales (before tax)

- Tax on operating income from sales (4)

Operating income from sales after tax

+/- Other operating income (expense) requiring tax allocation (1)

- Tax on other operating income

+/- After-tax operating items (3)

Operating income (after tax)

- Net financial expenses after tax (2)

- Minority interest

= Comprehensive income to common shareholders

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(1) Other operating income (expense) requiring tax allocation

Restructuring charges

Asset impairments

Merger expenses

Gains and losses on asset sales

Gains and losses on security transactions

• Taxes have to be calculated on these items

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(2) Net financial expenses after tax

+ Interest expense

- Interest revenue

+/- Realized gains and losses on financial assets

= Net taxable financial expense before tax

- Tax benefit from net financial expenses

= Net taxable financial expenses after tax

+/- Gains and losses on debt retirement

+/- Dirty-surplus financial items

+/- Hidden dirty-surplus financing items

Taxes have to be calculated on these items

Will come from reformulated shareholders’ equity

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(3) After-tax operating items

Equity share in subsidiary income

Operating items in extraordinary income

Dirty-surplus operating items

Hidden dirty-surplus operating items

• These items are already after-tax

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(4) Tax on operating income from sales

+ Tax as reported

+ Tax benefit from net financial expenses

Will come from (2)

- Tax allocated to other operating income

Will come from (1)

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• Reformulated statement of shareholders’ equity– The statement of owners’ equity gives the

reconciliation of beginning and ending owners’ equity

– The reformulated statement groups these items into (1) transactions with shareholders and (2) comprehensive income

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Reformulated Statement of Common Shareholders’ Equity

Beginning book value of common equity

+ Net effect of transactions with common shareholders

+ Capital contributions (share issues)

- Share repurchases

- Dividends

= Net cash contribution (negative net dividends)

+ Effect of operations and non-equity financing

+ Net income (from income statement)

+ Other comprehensive income

- Preferred dividends

= Comprehensive income available to common shareholders

Closing book value of common equity

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• Beginning/Closing book value of common equity must be adjusted for: (-) preferred stock, unless it is reported outside

of shareholders’ equity, such as redeemable preferred stock

(-) noncontrolling (or minority) interests (+) dividends payable

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• Comprehensive income = Net income + other comprehensive income– Other comprehensive income arises because of dirty

surplus accounting• Dirty surplus accounting is the practice of reporting income

items in the statement of shareholders’ equity rather than in the income statement.

• Dirty surplus items are unrealized gains and losses in assets and/or liabilities due to changes in market prices– Unrealized gains and losses on securities available for sale– Foreign currency translation gains and losses– Gains and losses on derivative instruments– Changes in assets and liabilities due to pensions and

postemployment benefits

• All dirty surplus income items are reported on an after-tax basis

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Operating income items

Changes in accounting for contingencies

Additional minimum pension liability

Tax benefits of loss carryforwards acquired

Tax benefits of dividends paid to ESOPs

Unrealized gains and losses on equity securities available for sale

Foreign currency translation gains and losses

Gains and losses on derivative instruments designated as cash flow hedges

Some adjustments of deferred tax valuation allowances

Change in funding status of pension plans

Restatement of prior years’ income due to a change in accounting principles

Financing income (or expense) items

Preferred dividends

Unrealized gains and losses on debt securities available for sale

Dirty surplus items