DBFI302 Unit-05

DBFI302: Financial Statement Analysis & Business Valuation Manipal University Jaipur (MUJ)
MASTER OF BUSINESS ADMINISTRATION

SEMESTER 3
DBFI302
FINANCIAL STATEMENT ANALYSIS &
BUSINESS VALUATION
Unit 5: The Analysis of the Balance Sheet and Income Statement 1

Unit 5
The Analysis of the Balance Sheet and
Income Statement
Table of Contents
SL Topic Fig No / SAQ / Page No
No Table / Activity
Graph
1 Introduction - -
3
1.1 Learning Objective - -
2 The Analysis of the Balance Sheet and Income - 1, I 4-10
Statement
3 Reformulation of Balance Sheet - 2, II 11-16
4 Reformulation of Income Statement and Issues - 3, III 17-20
5 Relevant Ratio Analysis - 4, IV 21-22
6 Summary - - 23-24
7 Glossary - - 25
8 Terminal Questions - - 26
9 Case Study - - 26-29
10 Answers - - 29-33
11 Suggested Books and e-References - - 33

1. INTRODUCTION
The corporation's establishment and widespread expansion have undoubtedly contributed
significantly to the need for and improvement of financial statements. The regulatory bodies
used their resources to ensure that financial statements reasonably and fairly disclose all
relevant financial information about a business.
The financial statements are designed to serve two functions. The balance sheet asserts a
company's financial position at a specific date by displaying the properties (assets) that are
being used on one side and the sources of these properties (liabilities and equity) on the
other (ownership interest). The income statement, on the other hand, depicts the
performance of a business for a specific period by describing the income on one side and the
expenses on the other.
Financial statement preparation is a significant and difficult task. It has an impact on the
decisions of thousands of people. Because a "going" business is dynamic, the proportions of
its assets, liabilities, and equity are constantly changing. It is difficult for the accountant to
assign an exact value to each account in a financial picture. A combination of recorded facts,
accounting conventions and postulates, and informed personal judgement is required to
generate the necessary financial statements. The statements cannot and should not be exact
in this regard. This fact must be remembered throughout the rest of the analysis.
1.1 Learning Objectives

After studying this chapter, you will be able to:
❖ How to analyse balance sheet and income statement

❖ Understand structure of reformulated balance sheet and income statement
❖ Suitable ratios to analyse reformulated financial statements

2. THE ANALYSIS OF THE BALANCE SHEET AND INCOME STATEMENT

Analysis of Balance Sheet
The examination of a company's assets, liabilities, and owner's capital by various
stakeholders in order to determine the correct financial position of the business at a given
point in time is known as balance sheet analysis.
The balance sheet will be divided into two distinct groups for the purposes of this analysis.
I. Analysis of Assets
II. Analysis of Liabilities
Balance Sheet Analysis

Analysis of Assets Analysis of Liabilities
Non-Current Assets Non-Current liabilities

Current assets Current Liabilities
Inventories Equity
Accounts Receivables
Cash
I. Analysis of Assets
Assets include fixed assets or non-current assets and current assets
A) Fixed Assets or Non-Current Assets

Fixed assets such as property, plant, and equipment are examples of non-current assets
(PPE). Fixed-asset analyses determine an asset's earning potential, use, and useful life. The
fixed asset turnover ratio can be used to calculate fixed asset efficiency.
i) Fixed Assets Turnover Ratio = Net sales/Average Fixed Assets. Where:

• Net sales are sales less returns and discounts
• And average fixed assets = (opening fixed assets + closing fixed assets) / 2
This ratio reflects how effectively management generates revenue from the firm's
substantial fixed assets. The greater the ratio, the more efficient are the fixed assets.

B) Current Assets
Current assets can be converted into cash within a year. Current assets include cash,
accounts receivable, and inventories. The following ratios aid in the analysis of current
assets:
i) Current Ratio = Current Assets/Current Liabilities. Where:

• Current assets = Cash & Cash equivalents + Inventories + Accounts receivable + other
assets that can be converted into cash within a year;
• Current Liabilities = Accounts payable + short term debt+ current portion of long-
term debt
ii) Quick Ratio = Quick Assets/ Current Liabilities
• Quick assets = Cash & cash equivalents + Accounts receivable + other short-term
assets
• Current liabilities = Accounts payable + short term debt + current portion of long-
term debt
It is a liquidity ratio that calculates a company's ability to pay off current liabilities using
its most liquid assets in order to assess its short-term liquidity position.
C) Inventories
The finished goods accumulated by the company for sale to its customers are referred to
as inventories. The investor will see how much money the company has locked up in
inventory.
A company calculates its inventory turnover ratio to analyse its inventory, which is
calculated as follows:
i) Inventory Turnover Ratio = Cost of goods sold / Average inventory. Where:

• Cost of goods sold = Opening stock + purchases – Closing stock
• Average inventory = (Opening inventory + Closing inventory) / 2
This ratio governs the rate at which inventory is converted into sales. A higher inventory
ratio indicates that the company's products are sold quickly, and vice versa.

D) Accounts Receivables
Accounts receivable are funds owed to a company's creditors. Accounts receivable are
analysed by a company to determine the rate at which money is collected from debtors.
The following is how the company calculates the Accounts receivable turnover ratio:
i) Accounts Receivable Turnover Ratio = Net credit sales/Average accounts receivable.

Where:
• Net credit sales = Sales – Sales return – discounts
• Average accounts receivable = (Opening accounts receivable + closing accounts
receivable) / 2
This ratio computes how many times the average accounts receivables are collected by the
company during a given period. The higher the ratio, the more effective the company is at
debt collection.
E) Cash or Bank
Investors are more interested in companies with a large amount of cash reported on their
balance sheet because the cash provides investors with security because it can be used in
difficult times. Growing cash year after year is a good sign, but decreasing cash can be a
warning sign. However, if a large amount of cash is held for a long period of time, investors
should investigate why the management is not using it. Management's lack of interest in
investment opportunities, or they may be short-sighted and do not know how to use the
cash, are reasons for keeping a large amount of cash. The company also performs a cash
flow analysis to determine the source of cash generation and its application.
To analyse cash, a business computes its operating cash flow margin and cash ratio, which
are calculated as follows:
i) Operating Cash Flow Margin = Cash from operating activities / Sales Revenue
ii) Cash Ratio = (Cash + Cash Equivalents) / Total Liabilities
This metric measures how effectively a company generates cash flow from sales, the
quality of its earnings, and the amount of cash a company has in comparison to its total
assets.

II. Analysis of Liabilities

Liabilities include non-current liabilities and current liabilities
A) Non-Current Liabilities
Noncurrent liabilities, also known as long-term liabilities, are balance-sheet obligations
that are due in more than a year. To assess a company's leverage, various ratios based on
noncurrent liabilities are used. This is possible using leverage or solvency ratios.
The following leverage ratios are calculated by the company:

i) Debt to equity ratio =Long term debts/ Shareholders equity
• Where long term debts = debts to be paid off after a year
• Shareholders equity = Equity share capital + preference share capital + accumulated
profits
ii) Debt Ratio = Total Debt / Total Assets
iii) Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense
Leverage ratios compare the proportion of debt versus equity funds. Understanding the
relative weights of debts and equity, as suggested in ii) and iii) above, is beneficial.
B) Current Liabilities
Current liabilities are financial obligations of a company that are due and payable within a
year.
Current liabilities can also be analysed using the current ratio and the quick ratio.
Both ratios are covered in the section on current assets above.
C) Equity
The equity, also known as shareholder's equity, represents the amount of capital contributed
by the shareholders.
Equity = Total Asset – Total Liabilities
i) Return on Equity
The shareholders expect a return on their investment in the form of company stock. Return
on equity is an important determinant that shows how the company manages its

shareholders' capital. Such returns can be analysed using the ROE ratio, which is calculated
as follows:
Return on Equity = Net Income / Shareholders’ Equity
The greater the ROE, the better for shareholders.
ii) Debt to Equity Ratio

The debt-equity ratio is another useful ratio for analysing equity. The same is explained
above for non-current liabilities.
A lower debt-to-equity ratio suggests greater financial stability. Companies with a higher
debt-equity ratio are viewed as riskier by investors and creditors.
Assets and liabilities are inextricably linked. Because his strongest claim is based on a
company's circulating or current assets, it is only natural for a short-term creditor to
carefully examine their sufficiency. Working capital, or net working capital, is the excess of
current assets over current liabilities. This working capital represents the creditors'
margin of safety and the portion of current assets supplied by longer-term investors.
Analysis of Income Statement

The income statement summarises the earnings and expenses of a company over time. We
forecast and predict the company's performance over time using various ratios. The
following are the most common ratios:
A) Sales growth
The sales growth rate evaluates your company's ability to generate revenue through sales
over a set period of time. This rate is used not only by your company to examine internal
successes and problems, but it is also used by investors to determine whether you are a
growing company or a company that is starting to stagnate. Sales growth rate is more than
just other sales analytic; it's a critical metric for assessing the health of your growing
company. The following formula is used to calculate sales growth:
Sales growth = [(Sales of the current period – Sales for the previous period) / Sales for the
previous period] x 100

B) Gross profit margin (GP margin)

The gross profit margin is a profitability metric that shows how much revenue exceeds the
cost of goods sold (COGS). The gross profit margin reflects a company's executive
management team's success in generating revenue while accounting for production costs.
To put it another way, the higher the number, the more efficient management is at generating
profit for every dollar spent. The following is how the said ratio is calculated:
Gross profit margin = (Revenue – Cost of Goods Sold) / Revenue
C) Operating profit margin

The operating margin is a profitability ratio that measures revenue after a company's
operating and non-operating expenses have been deducted. The operating income, also
known as the return on sales, shows how much of the generated sales remains after all
operating expenses have been deducted. This is computed as follows:
Operating profit margin = Operating Profit / Revenue
D) Net profit margin

Net profit margin (also known as "Profit Margin" or "Net Profit Margin Ratio") is a financial
ratio that computes a company's profit as a percentage of total revenue. It computes the
amount of net profit made by a company per dollar of revenue. The net profit margin is
computed as follows:
Net profit margin = Net Profit / Revenue
E) EBIT margin
Earnings before interest and taxes (EBIT) is a calculated figure that represents a company's
profitability from operations after non-recurring items are deducted. Excluding these items
improves comparisons with competitors and provides a solid foundation for forecasting
future profitability.
For many businesses, this figure may be the same as operating profit, and it is up to the
analyst to determine which items must be adjusted to generate a "clean EBIT" figure. The
calculation starts with operating profit and then adjusts for any one-time items.

EBIT Margin Formula is represented as,

EBIT Margin Formula = (Total sales – COGS – Operating expenses) / Total sales * 100% or
EBIT Margin Formula = (Net income + Interest expense + Taxes) / Total sales * 100%
F) EBITDA margin
Earnings before interest, tax, depreciation, and amortisation is calculated by subtracting the
expenses associated with long-lived assets from our EBIT number. Companies' policies for
depreciating and amortising these assets may differ, resulting in a larger (or smaller)
expense. As a result, their EBIT will fall (or increased). Adding these costs back in can help
you compare to competitors.
EBITDA is represented as:

EBITDA Margin = EBITDA / Revenue
SELF-ASSESSMENT QUESTIONS – 1
State whether the following statements are true or false:

1. The fixed asset efficiency can be calculated by calculating the current ratio.
2. Debt to equity ratio is calculated as: Short-term debt x Shareholders’ equity
3. The GP margin is a profitability metric that displays the percentage of revenue that
exceeds COGS
Activity 1
Analyse the Balance Sheet and Income Statement of Relaince Tele Communications for
the year 2020 from the website.

3. REFORMULATION OF BALANCE SHEET

Instead of classifying assets and liabilities based on their longevity, the balance sheet is now
reformulated based on their utility - operational or financial. First, assets and liabilities are
rearranged into operating or financial assets/liabilities.
As shown in Table A, reformulating the balance sheet entails categorising assets and
liabilities as operating, financing, or other nonoperating.
Exhibit A Reformulated Balance Sheet
Operating Assets (OA) Operating Liabilities (OL)

+ Financial Assets (FA) + Financial Liabilities (FL)
+ Other non-operating assets + Other non-operating liabilities
Total liabilities
+ Common Shareholders Equity (CSE)
Total Assets Total Liabilities and Equity
The reformulated balance sheet can also be presented in a net format, derived by subtracting
financial assets, operating liabilities, and other nonoperating liabilities from both sides of the
balance sheet as shown in Table B below.
Table B Reformulated Balance Sheet
Operating Assets (OA) Financial Liabilities (FL)

- Operating Liabilities (OL) - Financial Assets (FA)
Net Operating Assets (NOA) Net Financial Liabilities (NFL)
+ Net other non-operating assets
+ Common Shareholders Equity (CSE)
Net assets funded by net capital Net capital
Detailed reformulated balance sheet is expressed as under:

Company Name
Reformulated Balance sheet as at
(Amount in….)
Operating Assets
Cash xxx
Accounts receivable less allowances xxx

Inventories xxx
Prepaid expenses xxx
Other current assets xxx
Property, plant and equipment xxx
Deferred tax assets xxx
Other assets xxx xxx
Operating Liabilities
Accounts payable (xxx)
Accrued compensation (xxx)
Accrued royalties (xxx)
Accrued marketing and promotion costs (xxx)
Accrued clinical and other studies (xxx)
Deferred income (xxx)
Deferred tax liabilities (xxx)
Income tax payable (xxx) (xxx)
Net Operating Assets (NOA) xxx
Financial Assets
Cash equivalents xxx
Short-term investments xxx
Trading assets xxx
Long-term investments xxx xxx
Financial Liabilities
Short-term debt (xxx)
Long-term debt (xxx)
Warrant obligations (xxx)
Other financial obligation (xxx) (xxx)
Net Financial Assets (NFA) xxx
Common Shareholders’ Equity (NOA + NFA)

xxx
Operating assets:
Operating assets are those that are related to operating revenue and/or expenses. Cash,
accounts receivable, inventory, other working capital assets, PP&E, right-of-use operating
lease assets, goodwill, other intangible assets, operations-related notes receivable (e.g., loans
and leases of integrated financial captives), and other long-term assets related to operating
revenue and/or operating expenses are examples of operating assets.
In general, an asset is classified as operating if it contributes to operating profit (and thus

free cash flow), and excluded from operations if it generates a flow that is not included in
operating profit (measured using NOPAT, as described in reformulated income statement).

Long-term investments in marketable securities, for example, that generate NOPAT-free

interest and dividend income, should not be classified as an operating asset. Similarly, equity
method investments that generate income that is not subject to NOPAT (also known as
"investments in associates" in IFRS terminology) should not be classified as an operating
asset.
Financial assets
Non-operational financial instruments that are relatively liquid and/or represent fixed
(rather than residual) claims are referred to as financial assets. These assets include excess
liquid funds, long-term investments in marketable securities, and illiquid fixed income
instruments (e.g., unlisted bonds and nonoperating receivables). The book value of financial
assets is usually a good proxy for their fair value.
Other non-operating assets:

Non-operating assets are illiquid assets that are related to operations but are classified
separately from operations because they (or the associated income stream) are either
extremely difficult to model or are likely to evolve differently than other operating items
(e.g., because they relate to past operating activities that are not likely to recur). For example,
loss carry forward, litigation assets (e.g., expected insurance recoverable related to a
recognised loss contingency), and financial captives or other subsidiaries' assets and
liabilities (if modelled separately from operations).
Operating liabilities:
The liabilities incurred as a result of operating revenue and/or operating expenses are
referred to as operating liabilities. They typically represent credit extended to the firm by
operating creditors, with the cost of the credit reducing NOPAT. Increases in operating
liabilities boost free cash flow by lowering the amount of money required to invest in
operating assets (operating creditors effectively fund a portion of the investment in
operating assets). Accounts payable, deferred revenue, accrued compensation and other
employee-related obligations, other accrued expenses, deferred tax liabilities, and accrued
income taxes, for example, are examples of provisions.

Financial liabilities
Financial liabilities include borrowings from financial institutions and capital markets, as
well as other contractual obligations with no operating interest. Interest payable, dividend
payable (once declared, dividends become a liability), short-term debt, current maturities of
long-term debt, and long-term debt are all examples of financial liabilities. Financial
liabilities should also include redeemable and nonredeemable preferred stock. While
nonredeemable preferred shares are reported as equity, the vast majority of preferred
shares are nonparticipating and cumulative in nature, paying a fixed return comparable to
debt. Companies may report temporary equity, which should be classified as debt in some
cases.
Financial liabilities should not include pension obligations, other postretirement obligations,
restructuring liabilities, or asset retirement obligations. Provisions are not a source of capital
and are thus excluded from calculations of the 'Weighted Average Cost of Capital.' Provisions
are typically created during operations and thus are not included in financial liabilities. The
cost of their implicit interest is typically accounted for in operating expenses. Non-
operational provisions, such as most pension and OPB obligations, should be classified as
"other nonoperating liabilities," rather than financial liabilities.
Other non-operating liabilities

Other non-operating liabilities include provisions that are likely to change differently than
revenue and operating assets, and the cost of which can be estimated and deducted from
NOPAT. These include provisions for truly non-recurring activities (for example, litigation
accruals related to past asbestos exposure) as well as the majority of pension and OPB
obligations. Other nonoperating liabilities include discontinued operations obligations.
Common Shareholders’ Equity

Common equity (all firms), noncontrolling interest (many firms), and preferred stock
account for the vast majority of reported equity (some firms). Noncontrolling interests are
included in equity because they represent a residual claim, similar to common equity.
Noncontrolling interests, on the other hand, are distinct from common equity in that they
represent outside interests in consolidated subsidiaries whose profitability differs from that
of the parent's own or wholly owned subsidiaries. As a result, understanding the impact of

noncontrolling interests on common equity profitability is critical when evaluating

profitability from the perspective of common shareholders.
Furthermore, because the profit claim on preference shares is generally fixed, they should
be classified as debt for the purposes of profitability analysis. The necessary changes to the
balance sheet and income statement are straightforward: preferred stock's book value
(including any arrears dividends) is reclassified as debt, and preferred dividends are added
to after-tax interest expense (no tax adjustment is required because preferred dividends,
unlike regular interest expense, are generally not tax deductible).
To make it simple, here are reformulation steps:

i. Cash:
a) Financial if firm deposits all cash in savings account regularly
b) Operating if firm requires readily accessible cash for covering obligations falling
on a daily basis, and part of the cash is kept in cheque accounts that do not earn
any interest.
c) Typically, 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ = 1% 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
ii. Receivables:
a) Accounts receivable are all operating, but notes receivable can be either.
b) Operating if written by customers for goods received in trade (e.g., extended
credit terms to attract customers).
c) Financial if short term investments
iii. Long term equity investments in shares of other companies:
a) Partly financial assets and partly operating assets
b) If information is proprietary, then treat entire amount as operating
iv. Notes payable (equivalent to notes receivable):
a) Operating if written to purchase inventory or other working assets (accounts
payable)
b) Financial if for some other purpose
v. Accrued expenses:
a) Operating, but if interest payable is part of accruals expense, then that part is
financial

vi. Deferred revenue:

a) Operating, as it is cash from customers received prior to delivering the
good/performing the service
vii. Finance lease assets:
a) Operating as it is just like PPE
b) Financial if lease obligations
viii. Deferred tax:
a) Operating, as they arise during the calculation of tax component of operating
income
ix. Preferred stock and redeemable preferred stock
a) Financial, as financial obligation to the common shareholder
x. Minority Interest (non-controlling interest):
a) Separate classification (MI) so that 𝑁𝑂𝐴 = 𝑁𝐹𝐿 + 𝐶𝑆𝐸 + 𝑀I
Choose the correct option for the following questions:
4. Financial liabilities should not include:

a) Short-term debt
b) Long-term debit
c) Provisions
d) All of the above
5. Operating assets include:
a) Accounts Receivable
b) Inventories
c) Deferred tax assets
d) All of the above
6. Financial assets include:
a) Cash equivalents
b) Prepaid expenses
c) Bank
d) Both b) and c)
Activity 2
Reformulate the Balance Sheet of Reliance Tele Communications ( which you have
analysed in the previous activity) for the year 2020.

4. REFORMULATION OF INCOME STATEMENT

A reformulated income statement is the act of reclassifying line items on a standard income
statement, typically one prepared in accordance with GAAP or IFRS, based on another
standard or criteria.
Like the reformulated balance sheet, the reformulated income statement distinguishes
between operating, financing, and other nonoperating items. Another layer of analysis is
required in addition to the balance sheet. Because recurring earnings have a greater impact
on value than transitory items and aid in forecasting future profits, it is critical to identify
and separate out transitory components before categorising items based on their nature of
activity.
Table D shows the key components of the reformulated income statement; Table D also
includes a detailed version of the reformulated income statement.
Table D - Reformulated Income Statement
Operating revenue
Less: Operating expenses (cost of revenue, recurring operating expenses, tax)
Net Operating Profit After Tax (NOPAT)
Less: Net Financial Expense (NFE)
Add: Income from other nonoperating activities
Recurring income
Add: Transitory income
Net income after preferred dividend
Less: Net income attributable to noncontrolling interest
Net income attributable to common equity
Table D – Detailed Reformulated Income Statement
+ Operating revenue OR
- Operating expense (OE)
Operating income from sales before tax xxx
(±) Restructuring or special charges xxx
+ Merger expenses xxx
(±) Gains and losses on sale of assets xxx
(±) Gains and losses on security transactions xxx xxx
Operating income before tax OIBT
- Tax as reported (xxx)
- Tax benefit from net financial expense (xxx) (xxx)
Other operating items that are reported after tax OIAT

+ Equity shares in subsidiary income xxx

(±) Gains and losses from discontinued operations xxx
(±) Cumulative effects of an accounting change xxx
(±) Extra ordinary items xxx
(±) Dirty surplus operating items xxx xxx
Net operating income or profit after tax NOPAT
- Financial expense (xxx)
+ Financial income xxx
(±) Realised gains and losses on financial assets xxx (NFE)
Net financial income before tax NFIBT
- Tax benefit from net financial expense (xxx)
Net financial income after tax NFIAT
(±) Gains and losses on debt retirement xxx
(±) Dirty surplus financial items xxx
- Preferred dividends (xxx) xxx
- Minority interest (xxx)
Comprehensive income or Net income attributable to xxx
common equity
Reformulation steps:
1. Tax:
a) The default income statement only reports one tax line;
b) It must be divided into two parts, operating and financial, because both activities
have separate tax consequences.
c) Key question: What would the after-tax operating income be if no financing
activities occurred?
d) This is because we want to focus solely on operations, and financing activities that
add no value, such as tax breaks for taking on debt, must be eliminated.
e) Steps:
i. Calculate tax shield Tax Sheild = Net Interest Expense × Marginal Tax Rate
ii. Subtract total tax and tax shield from operating income to determine what
operating income would have been if no financing activities had taken place.
The actual tax on operating income would be higher if there were no tax
benefits and no financial activities to shield income from tax. We're looking for
a tax measure of operating profit that is unaffected by financing activities.
Total tax on Operating Income = Reported Tax Expense + Tax Benefit

iii. Add tax shield to Financial Income because it is fully attributable to financing
activities.
• If the company has a net financial expense (then tax shield is subtracted from
operating income).
• If the company has net financial income (the tax shield is added to operating
income to offset the negative effect of paying more tax due to higher income).
2. Equity share in subsidiary income
a) Operating, because we have assumed long-term equity investments as operating.
Issues in Reformulating Income Statements

1. Complicated: The process of reformulating income statement is complicated
process as it comprises of implementation various steps which are complex in
nature.
2. Time consuming: Unlike normal income statement, reformulation of income
statements is a time consuming one due to degree of complexity involved in its
application, formulation and presentaion
3. Lacks comparison: Reformulation of income statement is not a compulsion and
such it is not followed by all entities and hence one cannot compare the
reformulated income statement with another entity.
4. Allocation: Distribution or allocation of costs and income (transitory and other
components) into appropriate heads is very challenging and requires sound
knowledge for the same.
5. Tax: Split of tax component between operating and financing activities and
elimination of tax breaks is very critical. There are certain items which comprises
of both operating and finance aspect within it (e.g., Leases). In such cases identifying
tax component for each aspect is difficult
Importance of Reformulated Financial Statements

i. Readers' assistance: One of the primary reasons that businesses choose to
reformulate financial statements is to make them more accessible to readers both
inside and outside of the company. The company may be able to make it much easier
to read and highlight the most important information.

ii. Separation of liabilities: Many businesses will reformulate their balance sheets to
further divide liabilities and assets. Liabilities, in particular, benefit from being
divided into specific categories such as financial liabilities and operating liabilities.
This demonstrates which expenses are related to operations and which are more
focused on investment, future plans, and expansion.
iii. Determine surpluses and deficits: Reformulating the income statement can help
highlight recent changes that resulted in extra or lower income than previously
reported. This is frequently associated with shareholder changes.
iv. Equity changes: The business's equity can also change. When dealing with the state
of shareholders' equity, it may be easier to show beginning and ending equity
balances with a reformulation, taking into account any significant share changes and
clearly displaying earnings available to stockholders as well as net distributions.
Fill up the blanks for the following:

7. In reformulated income statement it is critical to identify and separate out
______________________components before categorising items based on their nature
of activity.
8. If company has a net financial expense, then tax shield is __________________from
operating income.
9. Total of reported tax expenses and ____________________ is equal to tax on operating
income.
Activity 3
Reformulate the Income Statemnet of Relaince Tele Communications (which you have
analysed in previous activity) for the year 2020.

5. RELEVANT RATIOS
Reformulated balance sheet and income statement are analysed with the help of relevant
ratios used for analysing the following:
1. Composition analysis of operating vs financing parts
2. Profitability analysis of operations
1. Composition analysis of operating vs financing parts
a) Size of assets
Each operating asset / Each financial asset /

Total operating assets Total financial assets
Each operating liability / Each financial liability /

Total operating liabilities Total financial liabilities
b) Proportion of revenue
Revenue from operating activity /

Total sales Revenue
Financial income from a source /
Total financial income
c) Proportion of Common Shareholder Equity
Operating assets
Capitalisation ratio - Operating liabilities
Net Operating Assets (NOA)
Financial assets
Financial leverage ratio - Financial obligations
Net Financial Assets or Obligations (NFA) or (NFO)
2. Profitability analysis of operations

a) Residual operating income model (ReOI)
𝑅𝑒𝑂𝐼 = 𝑂𝐼 − (𝑟 × 𝑁𝑂𝐴)
This is similar to residual income valuation model (RIV model), but uses operating
income instead of net income and net operating assets instead of book value of equity.

State whether the statement is true or false

10. Composition analysis is all about fixed assets and financial assets
11. Residual operating income model uses operating instead of net income and
operating liabilities instead of equity.
12. Capitalisation ratio is expressed as difference between operating assets and
operating liabilities.
Activity 4
Calculate the relevant ratios for the year 2020 of Reliance Tele Communications.

6. SUMMARY
For analysis purposes, the balance sheet can be divided into two sections: one for asset
analysis and one for liability analysis. The balance sheet's current section contains current
items, such as current assets and current liabilities. The following four important ratios were
used in this section's analysis:
• Current ratio
• Quick ratio
• Inventory turnover ratio
• Accounts Receivable turnover ratio
Generally, the current section of the balance sheet analysis focuses on the working capital
position. It is especially useful in determining a company's short-term solvency, which
creditors, bankers, and management closely monitor.
The income statement summarises a company's total revenue and expenses over time. A
variety of financial ratios can be used to gain a better understanding of a company's
operational performance and profitability. The following are the most commonly used and
accepted ratios in income statement analysis:
• Sales growth
• Gross profit margin
• Operating profit margin
• Net profit margin
• EBIT Margin
• EBITDA Margin
The process of creating financial statements for a specific period, then changing and
reorganising the items contained in them to more accurately depict various aspects of the
business, is known as reformulation.
The balance sheet is restructured by categorising assets and liabilities as operating,

financing, or other nonoperating.

Reclassifying the line items based on another standard or criteria is part of reformulating the
income statement. Items are generally classified based on their recurring and transitory
nature.
The reformulated balance sheet and income statement are analysed using composition
analysis of operating vs financing parts and profitability analysis of operations.
However, unlike formal balance sheet and income statement, reformulated balance sheet
and income statement are not simple.

7. GLOSSARY
1. NOPAT: Net operating profit after tax (NOPAT) is a financial measure that shows how
well a company performed through its core operations, net of taxes.
2. Illiquid Assets: Illiquid refers to the state of a stock, bond, or other assets that cannot
easily and readily be sold or exchanged for cash without a substantial loss in value
3. Weighted Average Cost of Capital (WACC): WACC is the average rate that a company
is expected to pay to all of its security holders in order to finance its assets. The WACC
is also known as the firm's cost of capital.
4. OPB Obligation: The portion of the Original Principal Amount that remains
outstanding from time to time is referred to as the OPB.
5. Non-controlling interest: A non-controlling interest, also known as a minority
interest, is an ownership position in a subsidiary company in which a shareholder owns
less than 50% of outstanding shares and has no decision-making authority. Non-
controlling interests are calculated using the net asset value of the entity and do not
take into account potential voting rights.
6. Redeemable preference shares: Redeemable preference shares are those in which
the issuer has the right to redeem the shares within 20 years of issuance at the
predetermined price stated in the prospectus at the time of preference share issuance.
7. Non-Redeemable preference shares: Non-Redeemable Shares are a type of preferred
stock that lacks a callable feature. These are known as shares that cannot be redeemed
during the company's lifetime.
8. Dividend: A sum of money paid by a company to its shareholders on a regular basis
(typically annually) from its profits (or reserves).
9. Tax Shield: A tax shield is a reduction in income taxes that occurs as a result of taking
an allowable deduction from taxable income. For example, because debt interest is a
tax-deductible expense, incurring debt creates a tax shelter.

8. TERMINAL QUESTIONS
A) Short Answer Questions
1. What do you understand by ROE?
2. What do you mean by reformulated income statement?
3. Briefly explain financial assets.
B) Long Answer Questions
1. Explain different ratios used to analyse income statement
2. Describe the steps to reformulate balance sheet
3. Explain the importance for reformulation of financial statements.
9. CASE STUDY
1. Investors of XYZ Corporation has requested for reformulated income statement to
analyse the profitability of the entity. You are asked to reformulate the income
statement for the period April 2021 through March 2022 based on below details:
Particulars Amount (in

USD)
Tax on financing income 288
Reported tax 3,069
Interest income 792
Interest expense 34
Purchases in process of R&D 165
Research and development 2,509
Marketing, general and administrative 3,076
expenses
Cost of sales 12,144
Unrealised gain on investments 545
Loss on debt retirement 32
Preference dividend 25
Net revenue 26,273

Answer:
XYZ Corporation
Reformulated Income Statement
April 2021 through March 2022
(Amount in USD)
Net revenue 26,273

Cost of sales 12,144
Research and development 2,509
Marketing, general and administrative 3,076
expenses
Purchases in process of R&D 165 17,894
Operating Income Before Tax 8,379
Tax as reported 3,069
Tax on financing income 288 2,781
Net Operating Income After Tax (NOPAT) 5,598
Interest income 792
Interest expense (34) 758
Net Financing Income Before Tax (NFIBT) 6,356
Tax on financing income (288)
Net Financing Income After Tax (NFIAT) 6,068
Unrealised gain on investments 545
Loss on debt retirement (32)
Preference dividend (25) 488
Comprehensive income or Net income 6,556
attributable to common equity
2. Creditors of ABC Ltd. has requested for reformulated balance sheet to analyse the credit
worthiness of the company. You are asked to reformulate the balance sheet as on 31
March 2022 based on below details:
Particulars Amount (in USD)

Cash equivalents 1,875
Short-term investments 5,272
Trading assets 316
Long-term investments 5,365
Cash 163
Accounts receivable 3,527
Inventories 1,582
Deferred tax assets 618
Other current assets 122
Property, plant and equipment (net) 11,609
Other assets 1,022
Accrued advertising 458

Other accrued liabilities 1,094

Income tax payable 958
Put warrant obligation 201
Common Shareholders’ Equity 23,377
Deferred tax liabilities 1,387
Short-term debt 159
Long-term debt 702
Accounts payable 1,244
Deferred income 606
Accrued compensation 1,285
Answer:
ABC Limited
Reformulated Balance Sheet as at 31 March 2022
Amount (in USD)
Operating Assets
Cash 163
Accounts receivable 3,527
Inventories 1,582
Deferred tax assets 618
Other current assets 122
Property, plant and equipment (net) 11,609
Other assets 1022 18,463
Operating Liabilities
Accounts payable (1,244)
Deferred income (606)
Accrued compensation (1,285)
Accrued advertising (458)
Other accrued liabilities (1,094)
Income taxes payable (958)
Deferred tax liabilities (1,387) (7,032)
Net Operating Assets - A 11,611
Financial Assets
Cash equivalents 1,875
Short-term investments 5,272
Trading assets 316
Long-term investments 5,365 12,828
Financial Liabilities
Short-term debt (159)
Long-term debt (702)
Put warrant obligation (201) (1,062)

Net Financial Assets - B 11,766
Common Shareholders’ Equity: (A+B) 23,377
10. ANSWERS
A) Self-Assessment Questions
1. False
2. False
3. True
4. Option c)
5. Option d)
6. Option a)
7. Transitory
8. Subtracted
9. Tax benefit
10. False
11. False
12. True
B) Short Answer Questions

1) The shareholders expect return for the contribution made by them in the form of
shares in the company. Return on equity is an important determinant that shows how
the company manages the capital of its shareholders.
2) A reformulated income statement, is the act of taking a standard income statement,
typically one prepared in accordance with GAAP or IFRS, and reclassifying the line
items based on another standard or criteria.
3) Financial assets are non-operational financial instruments that are relatively liquid
and/or represent fixed (rather than residual) claims. Excess liquid funds, long-term
investments in marketable securities, and illiquid fixed income instruments (e.g.,
unlisted bonds and nonoperating receivables) are examples of these assets. Financial
assets' book value is usually a good proxy for their fair value.

C) Long Answer Questions

1. The most common ratios are as follows:
A) Sales growth
The sales growth rate assesses your company's ability to generate revenue through sales
over a specific time period. This rate is used not only by your company to examine internal
successes and problems, but it is also analysed by investors to determine whether you are
a company on the rise or a company beginning to stagnate. The sales growth is arrived with
the help of following formula,
Sales growth = [(Sales of the current period – Sales for the previous period) / Sales for the
previous period] x 100
B) Gross profit margin (GP margin)

The gross profit margin is a profitability metric that displays the percentage of revenue
that exceeds the cost of goods sold (COGS). The gross profit margin reflects a company's
executive management team's success in generating revenue while accounting for the costs
of producing their products and services. The said ratio is computed as below:
Gross profit margin = (Revenue – Cost of Goods Sold) / Revenue
C) Operating profit margin

Operating margin is a profitability ratio that measures revenue after covering a company's
operating and non-operating expenses. The operating income, also known as the return on
sales, indicates how much of the generated sales remains after all operating expenses have
been paid off. This is calculated as below:
Operating profit margin = Operating Profit / Revenue
D) Net profit margin

Net profit margin (also known as "Profit Margin" or "Net Profit Margin Ratio") is a financial
ratio that calculates the percentage of profit generated by a company based on total
revenue. It calculates the amount of net profit a company makes per dollar of revenue. The
net profit margin is calculated as:
Net profit margin = Net Profit / Revenue

E) EBIT margin
Earnings before interest or tax (EBIT) is a calculated figure that shows a company's
profitability from operations after non-recurring items are excluded. Excluding these items
improves comparisons with competitors and provides a good starting point for predicting
future profitability.
EBIT Margin Formula is represented as,

EBIT Margin Formula = (Total sales – COGS – Operating expenses) / Total sales * 100% or
EBIT Margin Formula = (Net income + Interest expense + Taxes) / Total sales * 100%
F) EBITDA margin
Earnings before interest, tax, depreciation, and amortisation is calculated by taking our
EBIT number and subtracting the expenses associated with long-lived assets. This is
represented as,
EBITDA Margin = EBITDA / Revenue
2. Steps to reformulate balance sheet are

i. Cash:
a) Financial if firm deposits all cash in savings account regularly
b) Operating if firm requires readily accessible cash for covering obligations
falling on a daily basis, and part of the cash is kept in cheque accounts that do
not earn any interest.
c) Typically, 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑎𝑠ℎ = 1% 𝑜𝑓 𝑠𝑎𝑙𝑒𝑠
ii. Receivables:
a) Accounts receivable are all operating, but notes receivable can be either.
b) Operating if written by customers for goods received in trade (e.g., extended
credit terms to attract customers).
c) Financial if short term investments
iii. Long term equity investments in shares of other companies:
a) Partly financial assets and partly operating assets
b) If information is proprietary, then treat entire amount as operating
iv. Notes payable (equivalent to notes receivable):

a) Operating if written to purchase inventory or other working assets (accounts

payable)
b) Financial if for some other purpose
v. Accrued expenses:
a) Operating, but if interest payable is part of accruals expense, then that part is
financial
vi. Deferred revenue:
a) Operating, as it is cash from customers received prior to delivering the
good/performing the service
vii. Finance lease assets:
a) Operating as it is just like PPE
b) Financial if lease obligations
viii. Deferred tax:
a) Operating, as they arise during the calculation of tax component of operating
income
ix. Preferred stock and redeemable preferred stock
a) Financial, as financial obligation to the common shareholder
x. Minority Interest (non-controlling interest):
a) Separate classification (MI) so that 𝑁𝑂𝐴 = 𝑁𝐹𝐿 + 𝐶𝑆𝐸 + 𝑀I
3. Importance of reformulated financial statements may be described as follows
i. Readers' assistance: One of the primary reasons that businesses choose to
reformulate financial statements is to make them more accessible to readers both
inside and outside of the company. The company may be able to make it much
easier to read and highlight the most important information.
ii. Separation of liabilities: Many businesses will reformulate their balance sheets to
further divide liabilities and assets. Liabilities, in particular, benefit from being
divided into specific categories such as financial liabilities and operating
liabilities. This demonstrates which expenses are related to operations and which
are more focused on investment, future plans, and expansion.

iii. Determine surpluses and deficits: Reformulating the income statement can help
highlight recent changes that resulted in extra or lower income than previously
reported. This is frequently associated with shareholder changes.
iv. Equity changes: The business's equity can also change. When dealing with the
state of shareholders' equity, it may be easier to show beginning and ending
equity balances with a reformulation, taking into account any significant share
changes and clearly displaying earnings available to stockholders as well as net
distributions.
11. BOOKS AND E-REFERENCES

Books
➢ Ratio Analysis of financial statements by FURR, Donald Eugene
e-References
➢ How Do You Read a Balance Sheet? (2022, September 6). Investopedia.
➢ Nissim, D. (2022, April 19). Reformulated Financial Statements by Doron Nissim:SSRN.
Reformulated Financial Statements by Doron Nissim: SSRN.
➢ McSherry, J. (2001, March 1). 5 a framework for reformulating financial statements. 5 a
Framework for Reformulating Financial Statements.

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DBFI302: Financial Statement Analysis & Business Valuation Manipal University Jaipur (MUJ)

MASTER OF BUSINESS ADMINISTRATION

Unit 5: The Analysis of the Balance Sheet and Income Statement 1

Unit 5: The Analysis of the Balance Sheet and Income Statement 2

1.1 Learning Objectives

❖ How to analyse balance sheet and income statement

Unit 5: The Analysis of the Balance Sheet and Income Statement 3

2. THE ANALYSIS OF THE BALANCE SHEET AND INCOME STATEMENT

Balance Sheet Analysis

Non-Current Assets Non-Current liabilities

A) Fixed Assets or Non-Current Assets

i) Fixed Assets Turnover Ratio = Net sales/Average Fixed Assets. Where:

Unit 5: The Analysis of the Balance Sheet and Income Statement 4

i) Current Ratio = Current Assets/Current Liabilities. Where:

i) Inventory Turnover Ratio = Cost of goods sold / Average inventory. Where:

Unit 5: The Analysis of the Balance Sheet and Income Statement 5

i) Accounts Receivable Turnover Ratio = Net credit sales/Average accounts receivable.

Unit 5: The Analysis of the Balance Sheet and Income Statement 6

II. Analysis of Liabilities

The following leverage ratios are calculated by the company:

Unit 5: The Analysis of the Balance Sheet and Income Statement 7

ii) Debt to Equity Ratio

Analysis of Income Statement

Unit 5: The Analysis of the Balance Sheet and Income Statement 8

B) Gross profit margin (GP margin)

C) Operating profit margin

Operating profit margin = Operating Profit / Revenue

D) Net profit margin

Unit 5: The Analysis of the Balance Sheet and Income Statement 9

EBIT Margin Formula is represented as,

EBITDA is represented as:

State whether the following statements are true or false:

Unit 5: The Analysis of the Balance Sheet and Income Statement 10

3. REFORMULATION OF BALANCE SHEET

Exhibit A Reformulated Balance Sheet

Operating Assets (OA) Operating Liabilities (OL)

Table B Reformulated Balance Sheet

Operating Assets (OA) Financial Liabilities (FL)

Detailed reformulated balance sheet is expressed as under:

Unit 5: The Analysis of the Balance Sheet and Income Statement 11

Net Operating Assets (NOA) xxx

Net Financial Assets (NFA) xxx

Common Shareholders’ Equity (NOA + NFA)

In general, an asset is classified as operating if it contributes to operating profit (and thus

Unit 5: The Analysis of the Balance Sheet and Income Statement 12

Long-term investments in marketable securities, for example, that generate NOPAT-free

Other non-operating assets:

Unit 5: The Analysis of the Balance Sheet and Income Statement 13

Other non-operating liabilities

Common Shareholders’ Equity

Unit 5: The Analysis of the Balance Sheet and Income Statement 14

noncontrolling interests on common equity profitability is critical when evaluating

To make it simple, here are reformulation steps:

Unit 5: The Analysis of the Balance Sheet and Income Statement 15

vi. Deferred revenue:

Choose the correct option for the following questions:

4. Financial liabilities should not include:

Unit 5: The Analysis of the Balance Sheet and Income Statement 16

4. REFORMULATION OF INCOME STATEMENT

Table D - Reformulated Income Statement

Table D – Detailed Reformulated Income Statement

Unit 5: The Analysis of the Balance Sheet and Income Statement 17

+ Equity shares in subsidiary income xxx

Total tax on Operating Income = Reported Tax Expense + Tax Benefit