Subsidiary financial data may not be easily separable

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Subsidiary financial data may not be easily separable into operating and financing. How much cash is ‘strategic’ vs. ‘investment’? Are Long-term Investments related to operations or are they for investment purposes? (Same question for Short-term investments, though these are generally Financing, not Operating.) Short-term Notes Payable – Financing or operating? 52
© 2019. Michael Minnis. Please do not reproduce without permission. How do we handle Taxes? Items above the “Income tax expense” line item are gross of tax, while all items below “Income tax expense” are reported net of tax. Therefore, you do not need to consider tax effects when reclassifying items below the Income tax expense line. If the firm has Net Financial Obligations (NFO) with related financing expenses (e.g., Interest expense), then the “Income tax expense” underreports the amount of taxes related to operations. Interest tax shield = Net interest expense x Tax rate The marginal tax rate on interest income/expense is usually 35% The goal is to allocate the “Income tax expense” line item to operating and financing Usually easiest to identify the Net Financing Expense (usually interest expense – interest income) and multiply by marginal tax rate on NFE (usually 35%, though you may want to also consider state income taxes) Usually results in a negative tax expense (i.e., tax benefit) for financing and a positive tax expense for operating. 53
© 2019. Michael Minnis. Please do not reproduce without permission. A Recurrent Theme: Match Consistently Operating and Financing Classify the income or expense associated with an asset or liability just the same as the asset and liability Financing assets/liabilities Financing income/expense Operating assets/liabilities Operating income/expense Remember that the fundamental perspective is that of the common shareholder ROCE = Amounts available to common shareholders divided by common shareholder amounts invested (paid in or retained) 54
© 2019. Michael Minnis. Please do not reproduce without permission. Suggestions to Help in Reclassification Know the business and what they do. Financing for one firm may be Operating for another. Dig into the footnotes of the financial statements. These often reveal the nature of the “Other” items, if material. Spend your time on the big items. Spend less time on immaterial balances. 55
© 2019. Michael Minnis. Please do not reproduce without permission. ROA vs. RNOA The median ROA for nonfinancial firms from 1963 – 2007 was 7.1%. The median RNOA for the same set of firms was 10.5%. Why? 56
© 2019. Michael Minnis. Please do not reproduce without permission. ROA vs. RNOA Numerator differences Interest income in ROA numerator but not RNOA Trading gains in ROA numerator but not RNOA Denominator differences Financing assets are included in ROA denominator Operating liabilities are subtracted from operating assets in the denominator of RNOA 57 ROA has larger numerator ROA has larger denominator

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