Chapter 9

The Analysis of the Balance

Sheet and the Income
Statement

The Analysis of the Balance Sheet

and the Income Statement
Link to Previous Chapter
Chapter 8 reformulated the
statement of owners equity.

This Chapter
This chapter continues the
reformulation and analysis
with the balance sheet and
income statement.
The reformulation follows the
design in Chapter 7.

Link to Next Chapter

Chapters 10 reformulates the
cash flow statement.

Link to Web Page

More applications and
discussion are on the web page.

What assets
and liabilities
are classified
as operating ?
As financing ?

What items in
the income
statement are
classified as
operating ? As
financing ?

How are taxes

allocated to the
operating and
financing
components of
the income
statement ?

What ratios
are calculated
from
reformulated
statements ?
What do they
mean ?

What you will learn from this

chapter
Why reformulated income statements and
balance sheets are desirable
How knowledge of the business is incorporated
in reformulated statements
How operating and financing components of the
two statements are identified
Which assets and liabilities typically fall into
operating and financing categories
Why income taxes are allocated to different
parts of the income statement
What balance sheet and income statement
ratios reveal

Analysis of Balance Sheet and

Income Statement: the Steps
1. Reformulate to distinguish
between operating and
financing activities
2. Carry out common size and
trend analysis
3. Calculate balance sheet and
income statement ratios

The Standard Balance Sheet

Reformulating the Balance Sheet:

The Governing Accounting
Relations
Net Operating Assets (NOA)
= Operating Assets (OA) Operating
Liabilities (OL)
Net Financial Obligations (NFO)
= Financial Obligations (FO) Financial
Assets (FA)
Common Shareholders Equity (CSE)
= NOA NFO

The Typical Reformulated

Balance Sheet

Issues in Reformulating Balance

Sheets
Cash: working cash and excess cash
Short term notes receivable: trade receivables or
investment of cash?
Finance receivables: an operating asset
Debt investments: financial assets
Short-term equity investments: excess cash or trading
securities?
Short-term notes payable: trade notes or borrowing?
Lease assets: operating assets
Lease liabilities: financial obligation
Deferred tax assets and liabilities: operating
Deferred revenues and accrued expenses: operating
Minority interest: not a financial obligation
For financial firms, many financial items are
operating assets and liabilities

Nike, Inc.: GAAP Balance Sheet

(1)

Nike, Inc.: GAAP Balance Sheet

(cont.)

Nike, Inc.:
Reformulated Balance Sheets

Reebok: GAAP Balance Sheet

(1)
December 31
-------------------------------------2004
2003
------------------------------Amounts in thousands,
except per share data
Assets
Current assets:
Cash and cash equivalents
Accounts receivable, net of allowance for
doubtful accounts (2004, $81,280; 2003,
$70.823)
Inventory
Deferred income taxes
Prepaid expenses and other current assets
-----------Total current assets
Property and equipment, net
Other non-current assets:
Goodwill, net
Intangibles, net of amortization
Deferred income taxes
Other
Total Assets

1,857,513

$ 565,233
660,599

$ 693,599
532,320

458,435
111,516
61,730
-----------

352,692
100,070
48,169

1,726,850
----------183,799
124,125
196,138
44,892
34,161
-------------$ 2,440,628
--------------

-----------149,765
24,690
42,296
22,478
23,663
-------------$ 1,989,742
--------------

Reebok: GAAP Balance Sheet

(cont.)
2003
-------------Liabilities and Stockholders' Equity
Current liabilities:
Notes payable to banks

December 31
-----------------------------------2004
---------------Amounts in thousands,
except per share data
$ 63,179

$ 8,055

Current portion of long-term debt

100,627

163

Accounts payable

183,853

155,904

Accrued expenses

386,725

374,849

71,930
----------806,314
----------360,126

27,017
----------565,988
----------353,225

8,514

11,657

45,718

25,162

1.018

1.011

1,985,324

1,796,321

(780,510)

(740,189)

(5,804)
19,928

(1,225)
(22,208)

------------1,219,956

------------1,033,710

Income taxes payable

Total current liabilities
Long-term debt, net of current portion
Minority interest
Other long-term liabilities
Commitments and contingencies
Stockholders' equity:
Common stock, par value $.01; authorized 250,000 shares;
issued shares: 101,827 in 2004; 101,081 in 2003
Retained earnings
Less shares in treasury at cost: 42,619 in 2004; 41,473 in 2003
Unearned compensation
Accumulated other comprehensive income (expense)
Total Stockholders' Equity

Reebok: Reformulated Balance

Sheet

Microsoft Corporation:
Reformulated Balance Sheet

The Standard Income

Statement

The Reformulated Income

Statement (1)
1.
2.
3.

Operating items are separated from financing items.

Operating income from sales is separated from other operating income.
Tax is allocated to components of the statement, with no allocation to items
reported on an after-tax basis
Reformulated Comprehensive Income Statement

Net sales
Expenses to generate sales
Operating income from sales (before tax)
Tax on operating income from sales
+ Tax as reported
+ Tax benefit from net financial expenses
Tax allocated to other operating income
Operating income from sales (after tax)
Other operating income (expense) requiring tax allocation
Restructuring charges and asset impairments
Merger expenses
Gains and losses on asset sales
Gains and losses on security transactions
Tax on other operating income
After-tax operating items
Equity share in subsidiary income
Operating items in extraordinary income
Dirty-surplus operating items in Table 8.1
Hidden-dirty surplus operating items
Operating income (after tax)

The Reformulated Income

Statement (2)

The Allocation of Taxes

In the income statement only one tax number is
reported: It must be allocated to the operating and
financial components to put both on an after-tax
basis
First, calculate the tax benefit (tax shield) provided by
deducting interest expense

Tax Benefit Net Interest Expense t

where t is the marginal (not effective) tax rate.
(The statutory rate is usually the marginal rate)
From the operating income deduct both the total tax
and the tax benefit, to capture what the operating
income would have been, after tax, had there been no
financing activities
To the net financial expense add the tax benefit,
because its net effect is attributable to the financing
activities

Top-down and Bottom-up Methods

for Tax Allocation: Tax Rate = 35%
GAAP
Income Statement
Revenue
Operating expenses
Interest expense
Income before tax
Income tax expense
Net income

Top-down
Tax Allocation

Bottom-up
Tax Allocation

$4,000
(3,400)
(100)
500
(150)
$ 350
Revenue
$4000
Operating expenses
(3,400)
Operating income before tax
600
Tax expense:
Tax reported
$150
Tax benefit for interest
35
(185)
($100 x 0.35)
Operating income after tax
$ 415

Net income
Interest expense
Tax benefit
Operating income after tax

$350
$100
35

65
$415

Additional Tax Allocation within

Operations
Allocate taxes between operating
income from sales and other
operating income (not from sales)
so that both are after tax.
Remember: some other operating
income items are after tax (if they
appear below the tax line on the
GAAP statement)
Remember: losses draw negative
tax

Starting Point for Income Statement

Reformulation: Identify Comprehensive
Income from Equity Statement

Balance May 31, 2003

Nike

Reebok

$4,028

$1,035

Transactions with shareholders:

Shares issued, at market
Shares repurchased
Common dividends

$388
(416)
(179)

(207)

$83
(88)
(18)

(23)

Comprehensive income
Net income reported
$946
Currency translation gain
28
Gains on hedging instruments
126
Loss on option exercise
$127
Tax benefit
(47) (80) 1,019
Balance May 31, 2004

$4,840

$192
38
4
$32
12

(20)

214
$1,226

Nike, Inc; GAAP Income

Statement

Nike Inc.: Reformulated Income

Statement

Reebok: GAAP Income Statements

Reebok: Reformulated Income

Statements

Track Nike on BYOAP

Microsoft Corporation:
GAAP Income Statements
Year Ended June 30
2002
2001
_________________________________________________________________________________________

Revenue

$ 28,365

$ 25,296

Operating expenses:
Cost of revenue
5,191
3,455
Research and development
4,307
4,379
Sales and marketing
5,407
4,885
General and administrative
1,550
857
-------------------------------------------------------- ------ - Total operating expenses
16,455
13,576
-------------------------------------------------------- ------ - -

Operating income
Losses on equity investees and other
Investment income(loss)
--------------------------------------------------------

11,910
(92)
(305)

11,720
(159)
(36)

- ------ -

- -

Income before income taxes

11,513
11,525
Provision for income taxes
3,684
3,804
-------------------------------------------------------- ------ - Income before accounting change
Cumulative effect of accounting change (net of tax)
--------------------------------------------------------

Net income

7,829
- ------ -

7,721
(375)
- -

$ 7,829
$ 7,346
__________________________________________________________________________________

Microsoft Corporation:
Reformulated Income Statements

Common Size Analysis

Comparison to other firms is called crosssectional analysis
Common size analysis gives a ready
comparison:
The Income Statement
Each item/Total revenues
The Balance Sheet
Operating items/Totals
Financing items/Totals

Common Size Analysis : Nike

and Reebok Income Statements

Common Size Analysis: Nike

and Reebok Balance Sheets

Common Size Analysis: Nike

and Reebok Balance Sheets

Trend Analysis: Nike, Inc.

Income Statement Ratios

Revenue composition ratios
Operating Revenue Composition Ratio:

Financial Income Composition Ratio:

Profit margin ratios

Operating Profit Margin:

Sales Profit Margin:

Other Items Profit Margin:

Income Statement Ratios

(cont.)
Profit Margin Ratios (cont.)
Financial Income Contribution Ratio:
Net Financial Income
Sales

Net Income Profit Margin

Comprehensive Net Income
Sales

Expense Ratios
Expense Ratio
Expense for an Activity
Sales

1 - Sales PM = Sum of Expense Ratios

Balance Sheet Ratios

Composition Ratios
Operating Asset Composition Ratio
Operating Asset
Total Operating Assets

Operating Liability Composition Ratio

Operating Liability
Total Operating Liabilities

Financial Asset Composition Ratio

Financial Asset
Total Financial Assets
Financial Liability Composition Ratio
Financial Obligation
Total Financial Obligations

Balance Sheet Leverage Ratios

Financial Leverage Ratios
Capitalization Ratio:
NOA
CSE

Financial Leverage Ratio (FLEV)

NFO
CSE

It is always the case that

Capitalization Ratio - Leverage Ratio = 1.0
Operating Liability Leverage Ratio
Operating Liability Leverage (OLLEV)
Operating Liabilities
Net Operating Assets

Growth Ratios

Growth Rate in Sales

Change in Sales
Prior Period' s Sales

Growth Rate in Operating Income =

Change in Operating Income (after Tax)

Prior Period' s OI

Growth in NOA

Change in Net Operating Assets

Beginning NOA

Growth in CSE

Change in CSE
Beginning CSE

Summary Profitability
Measures
Operating Profitability:
RNOA t

OI t
1
NOA t NOA t 1
2

Financing Profitability:
NBC t

or

NFE t
1
NFO t NFO t 1
2

RNFA t

NFI t
1
NFA t NFA t 1
2

All measures are after tax.

Financial Statement Analysis

Procedures
1. Reformulate the statement of stockholders equity on clean
surplus basis (Chapter 8)
2. Calculate comprehensive rate of return on common equity,
ROCE, from reformulated statement of common
stockholders equity (Chapter 8)
3. Reformulate the balance sheet to distinguish operating and
financial assets and obligations
4. Reformulate the income statement on clean surplus basis
and distinguish operating and financing income
5. Compare reformulated balance sheets and income
statements with reformulated statements of comparison
firms and over time through a common size analysis and a
trend analysis
6. Calculate balance sheet and income statement ratios
7. Carry out the analysis of ROCE: Chapter 11
8. Carry out the analysis of growth: Chapter 12

Reebok: Reformulated Income

Statements