Chapter 07 - Click to edit Master subtitle style Chapter 7...

Info iconThis preview shows pages 1–6. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Click to edit Master subtitle style Chapter 7 Reorganizing the Balance Sheet Instructors: Please do not post raw PowerPoint files on public website. Thank you! 11 22 Traditional measures of performance, such as return on equity (ROE) and return on assets (ROA), include nonoperating items and financial structure that impair their usefulness. ROE mixes operating performance with capital structure , making peer group analysis and trend analysis less meaningful. ROE rises with leverage if ROIC is greater than the after-tax cost of debt. ROA and ROE commingle operating and nonoperating items. For instance, ROA includes the return on assets for excess cash, which is quite low (near 3 percent). Companies that hold large cash balances can have artificially low ROAs, even when their operating performance is strong. To ground our historical analysis, we need to separate operating performance from nonoperating assets and the financial structure used to finance the business. The Problems with Traditional Financial Analysis Why do we need to reorganize the companys financial statements? d Return Debt ROIC (ROIC k ) Equity Equity = +- Return on Invested Capital (ROIC) After-Tax Operating Profit Invested Capital ROIC = Return on invested capital (ROIC) is calculated by dividing the companys after-tax operating profits by the amount of net capital all investors have contributed to the company. Return on invested capital is independent of the companys financial structure. The income statement will be reorganized to create net operating profit less adjusted taxes (NOPAT). NOPAT represents the after-tax operating profit available to all financial investors. The balance sheet will be reorganized to create invested capital. Invested capital equals the total capital required to fund operations , regardless of type (debt or equity). 33 44 Free Cash Flow Free cash flow is the after-tax cash flow available to all investors: debt holders, preferred stock, common equity holders, and so on. Unlike cash flow from operations reported in a companys financial statement, free cash flow is completely independent of financing and nonoperating items. FCF = NOPAT + Depreciation + Invested Capital ROIC and FCF rely on the identical inputs, NOPAT and invested capital. Thus, valuations based on discounted cash flow (DCF) and on economic profit will lead to identical results. 55 The accountants balance sheet mixes operating and financing items. As ROIC measures operating performance, both the numerator (NOPLAT) and the denominator (invested capital) must separate operating items from financing structure in a consistent manner. Lets first derive invested capital. We start with the primary accounting identity: Reorganizing the Balance Sheet: Invested Capital Assets = Total Liabilities + Equity Next, separate operating assets (like property, plant, and equipment [PP&E]) from nonoperating assets (like equity investments), and separate operating...
View Full Document

Page1 / 20

Chapter 07 - Click to edit Master subtitle style Chapter 7...

This preview shows document pages 1 - 6. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online