When calculating financial ratios to measure a company’s profitability, it is beneficial to reformulate the financial statements which are conducted by separating operating activities from financing activities. Operating items are to be separated from financial items as a company’s operation is the primary driving force behind value creation and therefore, essential to isolate (Petersen et al., 2017:
107). The numbers from the analytical financial statement will be used to conduct a DuPont analysis to evaluate Lego’s profitability and conducting a cross-sectional analysis with peer companies.
4.3.1 Reformulation of the balance sheet
The balance sheet is a financial statement that summarizes a company’s assets, liabilities, and shareholders’ equity at a specific point in time. It classifies the assets on a liquidity criterion in current and non-current assets, and liabilities on a duration criterion in short-term or long-term liabilities. The reformulation of the balance sheet classifies the items in operating assets and liabilities, and financial assets and liabilities. The overall aim of reformulating the balance sheet is to isolate various financial ratios such as the Invested Capital (IC) which is calculated as a sum of Net Operating Working Capital (NOWC) and Net Operating Non-Current Assets (NONCA). NOWC is calculated as the difference between operating current assets and liabilities, whereas NONCA is the difference between operating non-current assets and liabilities.
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Appendix 3 specifies the line items for the reformulated balance, and the line items classification follows the guideline indicated by Petersen et al. (2017). Items that qualify as operating current assets are, e.g. inventories, trade receivables, prepayments, whereas operating current liabilities consist of trade payables, provisions amongst others. Items that qualify as operating non-current assets are, e.g.
property, plant and machinery, capitalized operating leases, right-of-use assets whereas the operating non-current liabilities consist of deferred tax liabilities, provisions and deferred revenue (Petersen et al., 2017: 118). Financial liabilities consist of interest-bearing liabilities such as borrowings from credit institutions and lease liabilities and financial assets consist of cash and cash equivalence, whereas Lego’s financial assets also include loans to related parties, as they are defined as a loan investment by the company (LEGO Annual Reports).
Cash and cash equivalence are often considered as excess cash, however reported cash may include cash that is needed in the day-to-day operations i.e. operating cash. Lego and its peers have not disclosed how much cash they deem necessary for operations or their excess cash in their financial statements. The companies have, however, stated combined cash and cash equivalent (CCE). In practice, different rules of thumb are used to estimate operating cash, however, it must be noted that such rules lead to imprecise and vast different results. As no additional information from the companies is supplied, cash and cash equivalence are treated as excess cash (Petersen et al., 2017: 118).
4.3.1.1 Capitalization of operating leases
As previously mentioned, new standards for addressing the accounting for leases have been issued for both IFRS and US GAAP, with the primary objective being to require lessees to recognize assets and liabilities on the balance sheet. Before January 1st, 2019, Lego and its peers employed these as operating leases with an annual lease payment which were recognized as an operating expense in the income statement. This enabled the companies not to recognize lease assets and their off-setting lease liabilities, which can produce skewed financial ratios, hiding the true performance of the companies and making comparison difficult. When leases are employed as an expense, companies can keep their debt-to-equity and financial leverage ratios low as they will appear “capital light” (Koller et al., 2010:
159). Neither of the companies restate comparison figures for previous years why it is found necessary to adjust for the historical period and counter for any imbalanced financial ratios by estimating the asset value, as the present values of the operating leases. The operating leases are valued using the following equation (ibid):
𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒𝑡−1 = (𝑅𝑒𝑛𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑡 𝑘𝑑+ 1
𝐴𝑠𝑠𝑒𝑡 𝐿𝑖𝑓𝑒 )
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Where t is time, 𝑘𝑑 equals the cost of debt on the lease and asset life is the expected life of the leased asset. The cost of debt for leases as of January 1st, 2019, is stated in the annual reports for Lego and its peers and are summarized in table 1 below. These costs of debt are used to capitalize the operating leases.
Table 4.1: Own creation – LEGOa, MATTELa & HASBROa
All companies state in their annual reports that their operating leases consist of a mix of property, plant and equipment whereas Lego, Hasbro and Mattel further state the average asset life of their leases as seen in table 4.1.
The components of the equation above applied for reviewing asset value in 2019 are used with retroactive effect for previous years to estimate capitalization of operating leases.
As all necessary components of the equation have been found to calculate the asset value for capitalizing of operating lease, the values are shown in appendix 6.
The effect of treating operating leases as capital leases is that the company no longer expenses the operating leases why the reported operating profit increases. The previous operating lease expenses have been replaced with depreciation and financial expenses accordingly, why the net profit does not change. The balance sheet increases by the leased asset and corresponding lease liability (Petersen et al., 2017).
4.3.2 Reformulation income statement
An income statement shows a company’s revenues and expenses and indicates how the revenues are transformed into a net profit during a period of time. The reformulated income statement requires every accounting item to be classified as belonging to either operations or finance to obtain a better knowledge of the different sources of value creation in a firm and will classify items in order to calculate Net Operating Profit After Taxes (NOPAT) (Petersen et al., 2017: 111).
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Firstly, operating expenses are adjusted for depreciation and amortization to calculate Earnings Before Interest, Taxes Depreciation and Amortization (EBITDA) whereas these are deducted to calculate Earnings Before Interest and Taxes (EBIT).
To obtain the value of NOPAT, tax on EBIT is to be estimated. The accrued taxes for the year, corporation taxes, are stated in the reported income statement as well as the net financial expenses for the companies. The corporation tax is positively affected by net financial expenses as these are tax-deductible why it is necessary to add back the tax advantage that the net financial expenses offer and is defined as a tax shield. The effective tax rate used to calculate the tax shield is computed as:
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 =𝐶𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑖𝑜𝑛 𝑡𝑎𝑥 ∗ 100 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥
Calculating the effective tax rate on operating profit is complicated, however the simplified calculation above is found to be a good proxy for the real effective tax rate (Petersen et al., 2017: 113). When the tax on EBIT is estimated, the NOPAT for the period can be calculated.
The reformulated income statements for Lego and its peers are found in Appendix 7.