Rearranging Financial Statements
Contents
Rearranging Financial Statements¶
“Financial statements are prepared according to fixed rules — for example, the U.S.’s generally accepted accounting principles (GAAP). Some set of rules is obviously necessary to ensure consistency and completeness. However, some problems faced by managers and investors may be addressed more effectively by rearranging items from the balance sheet and income statement. For example, grouping similar items together may facilitate an analysis of capital structure choice or valuation.”
Real vs. Financial¶
“One common rearrangement is designed to identify and separate real activities from financial activities. Real activities are comprised of the business chores that generate cash by producing goods and services for customers — production, sales, R&D, marketing, and so forth. Financial activities are associated with the distribution of cash to the firm’s investors — the payment of interest, principal, and dividends, or the issuance of new debt or equity. For concreteness, we can think of a stylized balance sheet with a “real” side and a “financial” side.”
Purpose¶
“We should emphasize that this rearrangement facilitates some financial analyses, which is why we consider it. We are not claiming that the accounts prepared according to GAAP are “wrong.” Clearly, an account payable, for example, really is a liability, which is why GAAP rules put it on the right side. But beyond separating assets and liabilities, we are making a further distinction between real and financial activities of the firm.”
Cash vs. Non-cash¶
“Another important distinction made by analysts is between cash and non-cash items, especially in income statements.”
“Accounting rules do not require companies to report EBITDA as such. But managers and investors often compute it because it makes a helpful distinction between cash and non-cash operating expenses.”
Simplification¶
“Detailed financial statements provide a substantial amount of valuable information. Sometimes that detail makes analysis cumbersome. Even worse, the complexity in corporate financial data can cause errors, oversight, and simple irrelevance when it finds its way into financial analyses.”
“For many financial analyses it helps to aggregate or condense items into a few broad categories. For example, a simplified balance sheet might contain only four items, two on each side. On the left: net working capital and net fixed assets, both reflecting “real” activities as described above. On the right: debt and equity, both reflecting financial activities.”
Intepretation¶
“Why is this simplified balance sheet useful? Without the clutter of financial detail, it’s easy to see, for example, how capital-intensive a company is, how much net working capital it requires compared to net fixed assets, and broadly, how it has been financed.”
“Some analysts also calculate financial ratios using just such a stylized and simplified balance sheet.”
Exceptions¶
“It will not always be possible to simplify things so neatly.”
“Sometimes companies have assets that simply aren’t part of their production of goods and services, which may make us hesitate to lump them in with either net working capital or net fixed assets. A good example is excess cash — a cash balance or holdings of marketable securities clearly in excess of what is required for canning produce. Another example is idle land — property the company owns but is not currently using in its operations. We often will keep excess cash and other non-operating assets in a separate category, even in a simplified balance sheet.”
“Some investors own claims that have features of both debt and equity, such as convertible bonds. A convertible bond is like debt in that it is a fixed claim with stipulated interest and principle payments due at certain times. It is like equity in that it may actually be converted, at the holder’s option, into a certain number of shares of stock. We may need an additional category for such securities, depending on the analysis being performed.”
“Some accounts are aggregations of a lot of small miscellaneous items. It may be difficult to determine whether they are real or financial, and difficult to know where to put them. How much it matters depends on the task at hand, but may well require further investigation.”
“Just as some securities are both debt-like and equity-like, some activities have both real and financial aspects. A good example is employee stock options. Employees receive them as compensation, so they are part of production, which makes them “real”. But they are securities (technically warrants) issued by the firm and may turn into equity, which makes them “financial.””