The analysis Framework and Financial Statements

Although reported financial statements are useful tools, they do not provide an
appropriate picture of the business for valuation purposes. Therefore, the first step of
any valuation is to reformulate the financial statements in a way that better aligns the
reported stocks and flows with the business activities that generate value.

Why reformulated financial statements:

The aim is to produce stylized financial statements (also referred to as reformulated
financial statements) clearly highlighting operating and financing activities. These same
statements are then used to apply valuation models.

Financing activities: It involves raising cash from the capital market, where the
investors become claimants on the value generated by the firm. These claimants can be
both debt-holders and shareholders.

Trading with debt-holders involves the payment of interests and the repayments of
principal for the cash borrowed. In this case the firm has financial obligations (also
known as financial liabilities).

Alternatively, the firm can also buy financial assets from debt issuers (governments,
banks or other firms). This represents a financing activity (of a lending nature instead of
a borrowing nature), and involves the receipt of interests (financial revenues) and the
repayments of principal to the firm: in this case the firm holds financial assets.

Operating activities: It combines assets with inputs of the production process (like
labor and materials) to produce products and services, which in turn will be sold to
customers to obtain cash. If successful, the excess cash generated by operating
activities can be reinvested in assets to be employed in operations, or to be returned to
claimants.

Investing activities: It uses the cash raised from financing activities and generated in
operations to acquire (physical and intellectual) assets to be used in operations.

Note: Given the nature of investing activities, it is common to refer to the operating and
investing activities together as operating activities. Therefore in the rest of the chapters
we will refer operating activities (inclusive of investing activities) and financing activities.

Standard Income Statement

Net revenues xxxxx

– Cost of goods sold xxxxx
Gross margin xxxxx
– Operating expenses xxxxx
Operating income xxxxx
(also referred to as earnings before interests and taxes, EBIT)

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– Net interest expenses xxxxx
Income before taxes xxxxx
– Taxes xxxxx
Income after taxes xxxxx
+/– Extraordinary items xxxxx
Net income xxxxx
– Preferred dividends xxxxx
Net income available to common shareholders xxxxx

For equity valuation, however, analysts need to reformulate the IFRS/GAAP income
statement by distinguishing operating and financing activities.
The distinction between these two types of activity is important because operating
activities are typically the source of value generation, and it is these operating activities
that we will particularly focus on when we analyze firms.

Reformulated Income Statement

1. Operating items are separated from financing items.
2. Operating income from sales is separated from other operating income.
3. Tax is allocated to components of the statement, with no allocation to items
reported on an after-tax basis

Reformulated Income statement (In short)

Operating revenue OR
Operating expense (OE)
Operating income OI
Financial expense FE
Financial revenue FR
Net financial expense (NFE)
Net income NI or CE

Reformulated Comprehensive Income Statement (Detailed)

Net sales xxxxx

– Expenses to generate sales xxxxx
Operating income from sales (before tax) xxxxx
– Tax on operating income from sales xxxxx
Operating income from sales (after tax) xxxxx
±Other operating income/expense requiring tax allocation
- Restructuring charges and asset impairments xxxx
- Merger expenses xxxx
- Gains and losses on asset sales xxxx
- Gains and losses on security transactions xxxx

− Tax on other operating income xxxxx xxxxx

xxxxx
Dirty-surplus operating items xxxxx

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 Total Operating income (after tax) xxxxx

- Net financial expenses after tax

+ Interest expense xxxxx
- Interest revenue xxxxx
Net interest expense before tax xxxxx
+ Tax benefit from net interest expenses xxxxx
Net interest expenses after tax (xxxxx)
 Gains and losses on debt retirement xxxxx
 Realized gains and losses on financial assets xxxxx
 Dirty surplus financial xxxxx
+ Preferred dividends xxxxx
 Gains and losses on redemption of preferred stock xxxxx
- Tax benefit from preferred dividends (if any) xxxxx
- Minority Interest xxxxx
Comprehensive income to common shareholders xxxxx

Note: A typical problem in the reformulation concerns tax allocation, or rather the
allocation of the one single income tax number reported in the financial statements to
the two components of income (operating and financing). This requires first the
calculation of the tax shield of debt, which is the tax benefit of deducting interest
expense on debt for tax purposes and allocating it to operating income.

Formally, this after-tax net interest expense can be calculated as:

After-tax net interest expense = Net interest expense – Tax benefit

OR Net interest expense × (1 – tax rate)

Q.1- Calculate net interest after tax and tax on operating income from sales for each
year in the period 2009-2014. (Fig in ’000 of $ )
2020 2019 2018 2017 2016 2015
Interest Expenses 93,900 72,100 130.500 97,088 82,876 73,958
Interest income 27,200 23,500 75,500 83,957 62,983 38,219
Effective tax rate 11% 10.5% 6.3% 11% 3.4% 9.5%
Reported tax 46,300 35,700 -11,300 48,219 15,437 32,176
expenses

Stylized balance sheet / Reformulated Balance sheet

The IFRS/GAAP balance sheet represents the assets, liabilities and shareholders’
equity of a firm. It shows the resources (assets) the firm controls and how it has
financed these assets. Assets are investments that are expected to generate future
economic benefits. Liabilities are obligations to the firm’s claimants other than owners.
Shareholders’ (stockholders’) equity is the claim by the owners. Both assets and
liabilities are classified into current and long-term categories.

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IFRS/GAAP Balance sheet (Format)

Current assets: Current liabilities:

Cash Accounts payable

Cash equivalents Accrued expenses
Short-term investments Deferred (unearned) revenues
Deposits and advances Advances from customers
Accounts receivable (less allowances) Short-term notes payable
Short-term notes receivable Short-term borrowings
Other receivables Deferred taxes (current portion)
Inventories Current maturities of long-term debt
Prepaid expenses
Deferred income taxes (current portion)

Long-term assets: Long-term liabilities:

Long-term marketable debt securities Bank loans

Long-term non-marketable debt investments Bonds payable
Equity investments at market Long-term notes payable
Equity investments - equity method Lease obligations
Property plant and equipment Commitments and contingencies
(less accumulated depreciation) Deferred taxes
•Land Pension liabilities
•Buildings Post employment liabilities
•Equipment
•Leased assets Minority Interest
•Leasehold improvements
•Construction in progress

Intangible assets
•Patents
•Copyrights
•Goodwill

Deferred taxes (non-current) Preferred equity

Deferred charges Common equity

For equity analysis, the published balance sheets are better reformulated by dividing
into operating activities and financing activities.

✓ Firms often issue debt and hold debt at the same time. The stock of net debt-
holding can thus alternatively be net financial assets or net financial
obligations.

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 ✓ Firms also invest in operating assets (such as land, factories, inventories) and
use operating liabilities (such as accounts payable) to produce goods for sales.
Positive operating stocks are known as operating assets (OA), while negative
operating stocks are called operating liabilities (OL). Their difference
represents net operating assets (NOA).

✓ Financing stocks can also be either financial assets (FA) or financial obligations
(FO). Their difference can be either negative known as net financial obligations,
NFO or positive known as net financial assets, NFA.

✓ The common shareholders’ equity (CSE) can be considered as an investment

in net operating assets and net financial assets.

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

Reformulated Balance sheet: Format

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 non-marketable - Long-term borrowing (bank loans,
debt investments bonds, payable, notes payable)
- Long-term marketable - Lease obligations
debt securities
- Preferred stock
Operating assets: Operating liabilities:
all else all else
Common equity

Issues in Reformulating Balance Sheets

Cash: working cash and excess cash: Cash and cash equivalents.
• Working cash (also called operating cash) is the cash needed to carry out normal
business and thus represents an operating asset.
• Cash equivalents (i.e. investments with less than three months’ maturity) and
cash invested in short-term securities are financial assets.

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Usually operating cash and cash equivalents are reported together, so analysts need
some hypothesis/calculation to isolate the amount of operating cash. The amount of
operating cash is very much related to the actual business of the firm. A procedure often
used is to calculate it as a percentage of sales.

• 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

Stylized statement of cash flows

The statement of cash flows shows how the firm generates and uses cash. The
IFRS/GAAP statement of cash flows classifies cash flows into three sections:

• Cash flows from operating activities: Cash generated from selling

goods/services minus cash used to pay the cost of inputs and operations.

• Cash flows used in investing activities: Cash paid for capital expenditure and
cash spent in buying assets less cash received from selling assets.

• Cash flows from financing activities: Cash rose from or paid to the firm’s
claimants – debt-holders and shareholders.
The total cash flows from these sections provide the change in cash and cash
equivalents.

Note: This amount has to be equal to the difference in the cash balance between
the ending and beginning balance sheet.

FCF (Free Cash Flow): The cash flow associated to operating activities.
Cash flows from operations – Cash flows used in investment activities

Methods of Cash flow: There are 2 Methods:

• Direct Method
• Indirect Method

The key difference between the two formats is the way in which they represent
cash flow from operations.

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Cash flow from operating activities under direct method:
Separate sources of operating cash inflows (cash from sales, rents, interest etc.)
Less: sources of operating cash outflows (e.g. cash paid to suppliers, to employees, for
interest, cash paid for income taxes etc.).

Cash flow from operating activities under iindirect method:

Net income including changes in net working capital items (i.e. accounts
receivable, inventories and accounts payable)
Add: non-cash revenues and expenses (such as depreciation, amortization and
deferred income taxes).

Cash Flow statement as per AS – 3 (GAAP/IFRS)

Particulars Amount
A. Cash Flow from Operating Activities:
Net Profit earned during the year xxxxx
Add: Dividends declared during the year xxxxx
Provision for income tax made during the year xxxxx
Net profit before dividend & Taxation xxxxx
Add: Non Cash / Non operating Expenses:
1) Amortization of intangible assets (Witten off) xxxxx
2) Depreciation on Fixed assets xxxxx
3) Preliminary expenses written off xxxxx
4) Transfer to General Reserve xxxxx
5) Loss on sale of fixed assets and investments. xxxxx
6) Premium on redemption of shares or debentures xxxxx
7) Interest paid xxxxx
8) Interim Dividend xxxxx
9) Bonus declared on equity shares xxxxx
10) Transfer to sinking fund xxxxx
11) Discount of issue of shares/debentures written off xxxxx
xxxxx
Less: Non Cash / Non operating Incomes:
1) Profit on sale of Fixed assets and investments xxxxx
2) Dividend Received xxxxx
3) Interest Received xxxxx
xxxxx
Add: Decrease in Current Assets & Increase in Current Liab. xxxxx
Less: Increase in Current Assets & Decrease In Current Liab. xxxxx
xxxxx
Less: Payment of taxes during the year xxxxx xxxxx
B. Cash Flow from Investing Activities:
1) Purchase of Fixed Assets & Investments (xxxxx)
2) Sale of Fixed assets and Investments xxxxx xxxxx

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 C. Cash flow from Financing activities:
1) Issue of shares xxxxx
2) Redemption of shares (xxxxx)
3) Raising of loans xxxxx
4) Repayment of loans (xxxxx)
5) Payment of dividend (xxxxx) xxxxx
Total of A + B + C xxxxx
Add: Opening Cash and Cash equivalents xxxxx
Closing Cash and Cash equivalents xxxxx

The IFRS/GAAP statement of cash flows seems to distinguish between the flows from
operating activities and from financing activities. However, it somehow confuses the two
categories. The confusions are as follows:

• Change in cash and cash equivalents: The IFRS/GAAP statement of cash

flows aims at explaining the change in cash and cash equivalents. Change in
operating cash should be included in cash investment and thus concurs with the
formation of free cash flow, whereas the change in cash equivalents is an
investment of excess cash in financial assets and thus has to be included in the
debt financing section.

• Net cash interest and tax on net interest: The IFRS/GAAP reported cash flow
from operations includes cash interest payments and receipts for financing
activities. This happens because in the calculation of cash flows from operations
the starting line is net income and not operating income. However, they should
be included in the financing flows.

Analogously the reported cash flow from operations include all tax cash flows
also the ones paid on financing activities, such as interest income and expense.
Tax cash flows related to financing activities should be separated. The reported
cash flow from operations has to be corrected accordingly.

• Transactions in financial assets: The IFRS/GAAP reported cash flow from

investing includes investments and disinvestments in financial assets such as
short-term marketable securities and long-term debt securities. However, these
investments should be included in the financing section because they represent a
disposition of free cash flow and not a reduction of free cash flow.

Similarly, the disinvestments of financial assets should be classified as financing

flows rather than investing flows. They satisfy a free cash flow shortfall, they do
not create it. Therefore the reported cash flow from investing has to be corrected
accordingly.

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How to calculate FCF:
➢ For the calculation of cash flow from operations, the IFRS/GAAP reported cash
flow from operations has to be corrected as regards net cash interest and tax on
net interest.
Cash flow from operations = Reported cash flow from operations + After-tax net
interest payments
➢ As for the calculation of cash investments in operations, the IFRS/GAAP reported
cash flow from investing has to be corrected as regards transactions in financial
assets, as shown below:
Cash investments in operations = Reported cash flow from investing – Net
investment in interest-bearing instruments

Adjustments in the IFRS/GAAP statement of cash flow are necessary because

some operating and financing cash flows are misclassified.

Reformulated Cash flow statements:

Cash flow from operations xxxxx
Less: Cash investments in operations xxxxx
Free cash flow from operating activities xxxxx

Cash Paid to debt-holders and issuers (xxxxx)

Add: Cash paid to shareholders (xxxxx)
Free cash flow from financing activities (xxxxx)

Free cash flow from operating activities must equal to free cash flow from
financing activities.

Reformulation of Cash Flows (detailed)

Free Cash Flow
Reported cash flow from operations
Net interest payments (after tax)
Adjusted cash flow from operation

Cash Investment reported

Investment in operating cash
Net Investment in financial assets
Adjusted cash flow from investing
Free Cash Flow

Financing Flows to claimants

Debt Financing:
Investment in cash equivalent
Net investment in financial assets
Net proceeds/repayment of borrowings
Net Interest payment (after tax)

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Other interest-bearing financing activities
Subtotal

Equity Financing
Cash Dividend Payment
Proceeds from exercise of stock options
Payment for treasury shares & shares bought back
Net Proceeds from issue of equity securities
Subtotal
Total Financing Flows

Accounting relations governing the stylized financial statements:

Accounting relations indicate how the financial statements and their components relate
to each other, and also what drives each component. These relationships are as
follows:
1. CSE = NOA + NFA Where, CSE = Common shareholder’s Equity
NOA = Net Operating assets (OA – OL)
NFA = Net Financial Assets (FA – FO)
2. CSE = NOA – NFO Where, CSE = Common shareholder’s Equity
NOA = Net Operating assets
NFO = Net Financial Obligation
Note that the above two relations restate the well-known balance-sheet equation used
for GAAP balance sheets, which indicates that shareholders’ equity is the residual claim
on the assets after subtracting liability claims. This implies that shareholders’ equity is
always equal to the difference between assets and liabilities, or rather:
Common shareholders’ equity = Assets – Liabilities
3. C – I = d + F Where, C = Cash from operations
I = Cash investments in operations
d = Net dividends to shareholders
F = Net payments to debt-holders and
issuers.
The left-hand side (C – I) represents the free cash flow (FCF). The right hand side (d +
F) represents the net cash flows paid to debt-holders or issuers and shareholders. If
operations generate more cash than is used in investments, the free cash flows (FCF) is
positive and it is used either to buy bonds (F) or pay dividends (d). If operations produce
less cash than needed for new investments, the free cash flows (FCF) is negative and it
requires that a firm either issues bonds (negative F) or issues shares (negative d) to
satisfy the cash shortfall. In doing so, the firm has to cover any net dividend it wants to
pay and any net interest cash flow (i). This can be summarized in the treasurer’s rule,
which is:
If C – I – i > d, the firm has to lend or buy back its own debt;
If C – I – i < d, the firm has to borrow or reduce its own debt.

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Accounting relations on the drivers of each component of reformulated financial
statements
The reformulated statement of cash flows and the reformulated income statement are
statements of flows over a period, while the reformulated balance sheet is a statement
of the stocks at the end of a period. The flows and the changes in stocks are linked by
some accounting relations, which describe what drives, or determines, each
component.

The drivers of free cash flow can either relate to its sources or to its uses
To see how the free cash flow is generated, or rather what are the sources of the free
cash flow; we can refer to the following equation:

FCF = OI – ΔNOA Where, OI = Operating Income

ΔNOA = Change in net operating assets
That is, operations generate operating income, and the free cash flow is the part of
operating income remaining after reinvesting some of it in net operating assets.

If the investment in NOA is higher than the operating income, the free cash flow is
negative. This implies that an infusion of cash is required.
Alternatively, by focusing on the disposition of free cash flow, the uses of free cash flow
can be formalized in two different ways according to the presence of net financial
obligations or net financial assets.

➢ If the firm has net financial obligations, free cash flow can be written as follows:

FCF = NFE + ΔNFO + d Where, NFE = Net financial Expenses

ΔNFO = Change in net Financial Obligations
d = Net dividends

This implies that the free cash flow is used to pay for the net financial expenses, to
reduce net borrowing and to pay net dividends.

➢ If the firm has net financial assets, the free cash flow can be written as follows:
FCF = ΔNFA – NFI + d Where, Δ NFA =Change in Net financial Assets
NFI = Net Financial Income
d = Net dividends
Free cash flow and net financial income increase net financial assets and are also used
to pay net dividends.

The drivers of dividends

d = FCF – NFE + ΔNFO
Where; d = Net dividends
FCF = Free cash flow
NFE = Net financial expenses
ΔNFO = Change in net financial obligations

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This means that dividends are generated from free cash flow after paying net interest
expenses, but also by increasing borrowing. This accounting relation explains why
dividends are not a good indicator of value generation in the short term the firm can
borrow in order to pay out dividends.

Conversely, if the firm has financial assets, by reordering equation the drivers of
dividends become:
d = FCF – ΔNFA + NFI
Where, d = Net dividends
FCF = Free cash flow
ΔNFA = Change in net financial assets
NFI = Net financial income

This relation implies that dividends are paid out of free cash flow and net financial
income and by selling financial assets. Financial assets are sold to pay dividends if free
cash flow is insufficient to pay dividends.

The drivers of net operating assets and net financial obligations

The changes in the balance sheet components can also be explained on the basis of
the free cash flow accounting relation.
NOAt = NOAt-1 + OIt – FCFt
Where, NOAt = Net operating assets (end)
NOAt-1 = Net operating assets (beginning)
OIt = Operating income
FCFt = Free cash flow

C-I = OI - NOA
NOA= NOAt - NOAt-1
Thus, NOAt = NOAt-1+OI-(C-I)
• Operating income in the income statement adds to net operating assets in the
balance sheet.
• Free cash flow reduces NOA.

Net Financial Obligations:

NFO t = NFO t −1 + NFE t − (C t − I t ) + d t
• Net financial expense increases indebtedness
• Free cash reduces indebtedness, after paying out net dividends from the free cash
flow
• If the firm has net financial assets rather than NFO, then?
• Find the equation for NFA
• NFAt = NFAt-1 + NFIt + (Ct – It) – dt
• Or, NFAt = NFAt-1 - NFEt + (Ct – It) – dt

Value for shareholders

 CSE = NOA+NFA
 OR, CSE = NOA - NFO

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  CSE = NOA - NFO
 CSE = OI - (C-I) - [NFE- (C-I)+d]
 CSE = OI – NFE - d
= CI – d
Hence, CSEt = CSEt-1 +CIt – dt
Free cash flow drops out in this calculation: Free cash flow (C - I) does not add
value to shareholders. Free cash flow is a dividend from the operating activities to the
financing activities

The value added from operations (represented by operating income) increases the net
operating assets, whereas the free cash flow reduces net operating assets as cash is
taken from operations and invested in net Financial Assets.

Q. 2- In 2020, a company generated £4,236 million from operations and invested £172
in operations. Compute FCF.

Q. 3- A firm generated £143 million in free cash flow and paid a net dividend of £49
million to shareholders. How much was paid to debt holders and debt issuers?

Q. 4- A firm paid a dividend to shareholders of £162 million and repurchased stock for
£53 million. There were no share issues. The firm received net cash of £86 million from
debt financing transactions. What are its free cash flows?

Q. 5- Microsoft paid £1,729million in cash dividends and repurchased shares worth

£730 million. It issued shares worth £189 million. Compute net dividend (d).

Q. 6- Considering all information of Q. no. 5 apply Treasurer’s Rule if co. received £338
million in interest net of tax.

Q. 7- A firm generated free cash flow of £2,348 million and paid net interest of £23
million after tax. It paid a dividend of £14 million and issued shares for £54 million.
There were no share repurchases. What did the treasurer do with the remaining cash
flow and for how much?

Q. 8- A firm generated a negative free cash flow of £1,857 million, but the board of
directors, understanding that the firm was quite profitable, maintained the dividend of
£1.25 per share on the 840 million shares outstanding. The firm also paid £32 million in
net interest (after tax). What are the responses open to the treasurer?

Q. 9- During 2020, General Electric generated £34.8 billion in cash flow from Operations
but made £61.2 billion further investment in operations. It paid out £8.1 billion to
shareholders. Interest paid on debt was £6.1 billion. Apply Treasurer's Rule.

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Q. 10- A firm generated free cash flow of £2,348 million and paid net interest of £23
million after tax. It paid a dividend of £14 million and issued shares for £54 million. What
did the treasurer do with the remaining cash flow?

Q. 11- A firm holding £432 million in interest-bearing financial assets and with financing
debt of £1,891 million, reported shareholders’ equity of £597 million. What were its net
financial assets? What were its net operating assets?

Q. 12- A firm reported £108 million in comprehensive income and net financial
expenses, after tax, of £47 million. What was its after tax operating income?

Q. 13- Below are a balance sheet and an income statement that have been
reformulated. Ignore income taxes.
Balance Sheet as on 31st December, 2020 & 2019
(Fig in ‘000 million)
Assets 2020 2019 Liabilities 2020 2019
Operating Assets 205.3 189.9 Operating Liabilities 40.6 34.2
Financial Assets 45.7 42.0 Financial obligations 120.4 120.4
Shareholder ’equity 90.0 77.3
251.0 231.9 251.0 231.9

Income statement as on 31st December, 2020

Operating revenues 134.5
Operating expenses (112.8)
Operating income 21.7
Interest revenues 2.5
Interest expenses (9.6)
Comprehensive income 14.6

(a) How much was paid out in net dividends during 2020?
(b) What is free cash flow for 2020?

Q. 14- During 2020, General Electric generated £34,848 in cash flow from Operations
but made £61,227 further investment in operations. It paid out £8,142 to shareholders.
Interest paid on debt was £6,082. Net issue of debt was £40,603.

Prepare a reformulated Cash flow statement with the information.

Q. 15- Below are financial statements that have been reformulated. Some items are
missing; they are indicated by capital letters.
Income statement six months to June 30, 2020
Revenue A
Operating expenses:
Cost of sales 2,453
Research and development expenses 507
Selling, Administrative & general Exp. 2,423

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Other Operating exp., including taxes 2,929 B
Other operating income after tax 850
Net Financial expenses after tax
Interest expenses 153
Interest Income C 59
Comprehensive Income 791

Balance sheet as on 30th June, 2020

June,20 June,19 June,20 June,19
Operating assets 28,631 30,024 Operating Liab. G 8,747
Financial assets D 4,238 Financial Liab. 7,424 6,971
Common Equity 18,470 H
33,088 E 33,088 F

Cash Flow statement six months ending June 30, 2020

Cash flow from operations 584
Cash investment I
Free cash flow J

Net dividends (dividends and share repurchase – share issue) K

Payment to net debt holders L
Total financing flows M
(a) Supply the missing numbers using the accounting relations.
(b) What were the total new operating accruals in the first half of 2020?
(c) How much new net debt was issued during this period?

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