ELE 3750

Financial Analysis and Valuation

 Financial Analysis and Valuation

Lecture 4
Ignacio García de Olalla
The Analytical Income Statement and Balance Sheet
 Operating versus financing activities

• A firm consists of operating, investing and financing activities.

• In calculating financial ratios which intend to measure a firm’s profitability, it is beneficial
to separate ‘operations’ and ‘investments in operations’ from financing activities
• The distinction between operating items and financial items is not always easy to make:
• The definition of operations is not clear.
• The specifications in the income statement and the balance sheet do not clearly distinguish between
operating and financing activities.
• The notes are not sufficiently informative.
 The analytical income statement
• The analytical income statement requires every accounting item to be classified
as either «operations» or «finance».

Traditional income statement Analytical income statement

Net sales (or revenue) Net sales (or revenue)
− Cost of sales − Cost of sales
Gross profit
Gross profit
+ Other income
+ Other income
− Distribution costs
− Distribution costs − Administrative expenses
− Administrative expenses −Other expenses
− Other expenses Operating income
Operating income − Operating tax
− Financial expenses, net NOPAT
Earnings before taxes
− Financial expenses, net
+ Tax savings from debt financing
− Taxes
Net earnings
Net earnings
Reformulation of the Income Statement
 The Traditional Balance Sheet

Assets Liabilities and equity

Non-current assets Equity
– Intangible assets
Minority interests
– Tangible assets
– Financial assets Non-current liabilities
– Provisions for pensions
Current assets – Financial liabilities
– Inventories
Current liabilities
– Receivables – Other provisions
– Financial assets not held as fixed assets – Financial liabilities
– Liquid funds – Accounts payable
– Tax liabilities
– Miscellaneous liabilities
 The Analytical Balance Sheet
Assets
Operating assets
+ Non-current assets
+ Inventories
+ Accounts receivables
+ Operating liquidity
– Operating liabilities
= Invested capital (net operating
assets)
Liabilities and equity
+ Equity
+ Minority interests
Interesting bearing debt (net)
+ Mortgage debt
+ Bank loan
– Excess cash
– Financial assets
– Other non operating assets
= Invested capital
 The Analytical Balance Sheet
How do we reach the analytical balance sheet?
• We first divide the items into operating and financial assets and
liabilities.
• Then we group them together.

Equity
E
Operating non- Minority M Non-interest bearing
ONCA Current assets
Provisions P
long-term liabilities

Interest bearing
Interest-
bearing debt IBD short and long-term
Financial non-
FNCA debt
current assets

Financial current
FCA assets Operating Non-interest bearing
OL
liabilities short-term liabilities
Operating current
OCA assets
The Analytical Balance Sheet (TA-format)
ONCA + FNCA + FCA + OCA = E + M + P + IBD + OL

TA = ONCA + OCA + FA = E + M + P + IBD + OL

ONCA Equity E
Operating non-
current assets Minority M

Provisions P

Financial
FA Assets Interest bearing IBD
debt

Operating current
OCA assets

Operating OL
liabilities
The Analytical Balance Sheet (CE-format)
ONCA + OCA + FA = E + M + P + IBD + OL
- OL = - OL
-P = -P
(ONCA – P) + (OCA – OL) + FA = E + M + IBD
NONCA +NOWC + FA = E + M + IBD

CE = NOA + FA = E + M + IBD
Net Operating Equity E
NOA
Assets

Minority M

Financial Financial
FA IBD
Assets Obligations
The Analytical Balance Sheet (NOA-format)
NOA + FA = E + M + IBD
- FA = - FA
NOA = E + M + NIBD NIBD>FA
NOA + NFA =E+M NIBD< FA

Equity E

Minority M

NOA Net Operating

Assets Net Financial NIBD
Obligations
The Analytical Balance Sheet (NOA-format)

NOA Net operating

assets
Equity E

NFA Net Financial

Assets Minority M
The analytical balance sheet. Example
The analytical balance sheet. Solution
 Operating or financing items?
• Special items
• Tax on ordinary activities
• Investment in associates and related income and expenses from associates
• Receivables and payables to group enterprises and associated firms
• Cash and cash equivalents
• Prepayment and financial income as part of core operation
• Exchange rate differences
• Derivative financial instruments
• Minority interests
• Retirement benefits
• Deferred tax assets/liabilities.

Rule of thumb: Financing item if interest bearing or requires a return!

 Operating or financing items?
• Special items:
• Gains and losses from sale of non-current assets
• Royalty/licence income
• Restructuring costs
• Rent income and expenses from property
• Write-down (impairment) of assets
• Others
Normally should be classified under operations.
It is important to check whether these are likely to recur in the
future.
 Operating or financing items?
• Tax on operating profit:
We can calculate the tax shield from net financial expenses by:
Tax shield= Net financial expenses x corporate tax rate

In case of doubt about the marginal tax rate, use the effective tax
rate
The effective corporate tax rate is calculated as

Corporation tax ∙ 100 100

Tax rate = = 30 ∙ = 30%
Earnings before tax 100

If we use the effective tax rate, we are assuming that operating

income and financial income are taxed at the same rate.
 Operating or financing items?
• Investment in associates:
If it is regarded as part of a firms’ core business, should be
considered as operating (invested capital).

If it is not regarded as part of core business, it should be

considered financial and it should be substracted when calculating
net-interest debt.

• Receivables and payables to group enterprises and

associated firms:
Part of financing activities unless debt is part of the usual
intercompany trading.
 Operating or financing items?
• Cash and cash equivalents:
Should be considered financial.

• Prepayment and financial income as part of core

operation:
Usually classified as operating.

• Exchange rate differences:

Treated as financial. In the income statement they already appear
as such. No need to do anything.
 Operating or financing items?
• Derivative financial instruments:
Measured at cost at recognition, and afterwards at fair value. Therefore,
value adjustments are required and appear in the income statement.We will
treat it as financial.

• Minority interests:
Treated as equity capital.

• Retirement benefits:
They are interest bearing and should be classified as financing.

• Tax payable:
If non-interest bearing, it should be treated as operating. Financing otherwise.