Web3ch9 - CHAPTER NINE The Analysis of the Balance Sheet...

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CHAPTER NINE The Analysis of the Balance Sheet and the Income Statement Stephen H. Penman The web page for Chapter Nine runs under the following headings: What this Chapter is Doing The Separation of Operating Activities and Financing Activities: the Key Question Reformulated Balance Sheets and Income Statement: VF Corporation Reformulated Balance Sheets: Dell Computer Reformulated Balance Sheets and Income Statements for a Firm with Net Financial Assets: Genentech, Inc. Getting the Tax Rate for Tax Allocation in the Income Statement Frustrations with Footnote Disclosure What this Chapter is Doing Chapter 9 applies the template laid out in Chapter 7 to reformulate balance sheets and income statements in a way that clearly distinguishes operations from the financing of operations. Firms add value from operations – trading with customers and suppliers – not from financing activities that involve raising cash and from claimants and returning cash to them. GAAP financial statements, unfortunately, do not make a clear distinction. They have to be cleaned up. You may not see the payoff to the reformulation exercise at this stage, so the material may seem a bit mechanical. But you will strike pay dirt as you proceed to the analysis of profitability and growth (Chapters 11 and 12) and, particularly, as you carry out valuations based on the reformulated statements in Part Three of the book. Here, however, are a couple of teasers:
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1. Analysts sometimes calculate the percentage profit margin as operating income divided by sales. However operating income can include interest income on financial assets (often lumped together with “other (operating) income”). And operating income includes other income that does not come from sales – equity income from subsidiaries, dividend income, and gains from asset sales, to name a few. The appropriate profit margin measure is: Profit margin (from sales) = Operating income from sales/Sales One must reformulate the income statement to differentiate income derived from sales from other operating income. 2. Return on Common Equity (ROCE) is affected by both operating profitability (RNOA) and leverage arising from borrowing. (Chapter 11 expands.) Operations and borrowing have very different effects on the value of a share. So, in analyzing ROCE and the amount of value it implies, one must be clear about how much of the ROCE is due to the profitability of operations and how much is due to leverage. Clean measures of the profitability of operations can only be determined by a clean distinction between operating and financing items in the financial statements. The Separation of Operating Activities and Financing Activities: the Key Question What is an operating item and what is a financing item? This is the question you will find yourself asking as you reformulate financial statements. An operating item is one that is involved in selling goods and services to customers or in trading with suppliers to develop the products for customers. Or, another way to see it is to ask: How does the firm
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This note was uploaded on 10/07/2010 for the course ECTCS ec12947322 taught by Professor Johnathayeri during the Spring '10 term at Life.

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Web3ch9 - CHAPTER NINE The Analysis of the Balance Sheet...

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