Reformulation of financial statements

As the traditional financial statements are not organised for robust analysis of operating performance, it is necessary to reformulate them into three categories: operating, non-operating, and financial.

The reorganisation of statements reveals the key inputs for assessing a company’s core operational performance, such as NOPLAT, invested capital, net working capital, and net interest-bearing debt. These values will later be applied in profitability analysis, pro forma statements and valuation of the company.

6.4.1 Reformulation of income statement

The foremost important purpose of reformulating a company’s income statement is to determine its net operating profit less adjusted taxes (NOPLAT). It is the profit that is generated from core operations, and it excludes the incomes and expenses from non-operating assets and financing items. Therefore, it is the profit that is available to all investors in the company. (Koller et al., 2010) The original and reformulated income statements of ECCO can be seen in Appendices 4 and 7, respectively.

The following sections below discuss the main reorganisations and classifications made in reformulating the income statement.

6.4.1.1 Capitalisation of rental and lease expenses

If a company decides to lease its assets, it will have artificially low operating profits, because rental expenses include interest expense. On the other hand, the company will also have artificially high capital productivity, because the assets do not appear on its balance sheet. The net effect of these two variables is an artificial boost in ROIC, because the reduction in operating profit by rental expense is typically smaller than the reduction in invested capital. (Koller et al., 2010)

For ECCO, rental and lease expenses are categorised under other external costs in their income statement, seen in Appendix 4 and 7. Firstly, in order to capitalise these expenses, it is necessary to estimate the value of leased assets. The following equation is used in determining the value of ECCO’s leased assets:

Equation 1 – Value estimation of leased assets

𝐴𝑠𝑠𝑒𝑡 𝑣𝑎𝑙𝑢𝑒_𝑡−1=𝑅𝑒𝑛𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑠𝑒_𝑡 𝑅_𝑑+ 1

𝐴𝑠𝑠𝑒𝑡 𝑙𝑖𝑓𝑒

Equation 1 incorporates rental expense, the cost of secure debt and estimated asset life for estimation. The cost of debt is estimated by using AA-rated bonds’ credit spread and risk-free rate. (Koller et al., 2010) The high grade bond rating assumes that the properties which the expenses are capitalised for, are pledged as

Source: Koller et al. (2010)

collateral. The relevant credit spread and cost of secured debt calculation are further discussed in cost of capital part, and can be seen in Appendix 106 and 107. In order to estimate asset life variable, ECCO’s property, plant and equipment is divided by its annual depreciation. (Lim, Mann, & Mihov, 2003)

In order to estimate the capitalised asset value for year 2013, it is necessary to make few assumptions for year 2014F that are in accordance with the reasoning provided in the pro forma financial statements section. For year 2013, it is assumed that the asset life in year 2014F is the 10 year historical median value of 5,5, and rental expense is the 10 year historical median percentage value of (12,3%) of rental and lease payments to revenues. Using the latter method, not only does it provide an asset value estimation, but also the corresponding rental and lease interest payments and depreciation values. The calculations can be seen in Appendix 6.

Next, to arrive at NOPLAT generated from core operations, it is important to make adjustments to ECCO’s income statement. Firstly, the company’s rental and lease payments are removed from operating expenses.

Secondly, rental and lease depreciation originating from the capitalisation process is also deducted, and the interest payments for the capitalised assets are categorised under financial items.

6.4.1.2 Depreciation, amortisation and EBIT

As depreciation and amortisation are capitalised and lose economic value over time, they are included as operating expenses in NOPLAT calculation. As described in the previous section, an additional entry is made to adjust EBIT – lease depreciation deduction. Furthermore, EBIT is also adjusted for rental and lease payments that were originally expensed.

6.4.1.3 Operating and financial tax

As the reported taxes in the original income statement are calculated after interest expense, they are a function of capital structure. In order to keep NOPLAT purely operational, it is required that the effect of interest expense is removed from taxes. (Koller et al., 2010)

The operating taxes are calculated by adding back the tax shield caused by interest expense to the originally reported taxes. The rate used to calculate tax shield is the effective tax rate for the company. This action has an effect of reflecting the company as an all-equity and purely operating organisation. The tax calculations can be seen in Appendix 5.

6.4.2 Reformulation of balance sheet

As ECCO’s original balance sheet, seen in Appendix 10, is set up as a mixture of operating and non-operating items, as well as sources of financing, it is necessary to reorganise them into respective groups. By reformulating the balance sheet, the capital used for operations and financing provided for funding will be more accurate. Moreover, this enables the correct calculation of the company’s invested capital, net interest-bearing debt and net working capital. The reformulated balance sheet of ECCO can be seen in Appendices 12-13.

The following sections will discuss the rationale behind the reorganisation of balance sheet into operating, non-operating and financial items.

6.4.2.1 Operational balance sheet

The operating fixed assets consist of all of the items under intangible assets, and property, plant and equipment, because they are the core of operations at ECCO. The total operating fixed assets are adjusted by the capitalised lease asset values that were calculated previously in order to be in accordance with the rental expense and depreciation adjustment in the income statement.

The main categories under operating current assets are operating cash, inventories and receivables. As ECCO’s cash and cash equivalents is divided into cash and marketable securities, cash will be further split into operating and excess cash. (Petersen & Plenborg, 2012) argue that if the cash position remains stable across time, it should be treated as excess cash. Furthermore, (Koller et al., 2010) proposes that any cash holdings over 2,0% of sales should be considered as excess cash. In fact, the company’s cash position has been rather volatile over the years, and in 2013, its cash holdings amounted up to 4,9% from total sales. In determining the operating cash amount, the former and latter arguments are applied. More specifically, cash that amounts up to 2,0% of total sales is categorised under operating cash, and the remainder is treated as excess cash. The calculation of operating and excess cash can be seen in Appendix 11.

All entries under inventories and receivables are considered as operating current assets, except receivables from affiliated companies. The latter entry is classified as interest-bearing and part of financing activities.

In order for the reorganised financial statements to be in compliance, there are no non-operational items on the reformulated balance sheet.

The company’s operational short-term liabilities consist of trade payables, other payables, income taxes and deferred income. In relation to the original balance sheet, payables to affiliated companies have been treated as a financing activity.

There are no operational long-term liabilities for ECCO, as the company’s deferred tax is classified as part of equity, and its outstanding debt is treated as interest-bearing liability.

6.4.2.2 Financial balance sheet

On this side of the balance sheet, the main categories are equity, interest-bearing assets and liabilities.

Firstly, equity consists of paid-in capital such as share capital, as well as retained earnings that are the funds investors have reinvested in the company. In addition, deferred taxes are also equity equivalents that rise because of non-cash adjustments to retained earnings. They arise from differences in how the company and the government account for taxes. (Koller et al., 2010) Another equity equivalent entry is minority interest that is treated as a financing cash flow similar to dividends. (Koller et al., 2010)

Under ECCO’s interest-bearing assets are excess cash, receivables from affiliated companies, and marketable securities. All of these assets are assumed to have gains in the means of interest.

The company’s debt obligations and payables to affiliated companies are categorised under interest-bearing liabilities. In addition, the capitalised operational lease value is also treated as a financing item in order to correspond to the lease value under operating assets.

6.4.2.3 Peer group companies

In the subsequent profitability analysis, the reformulated statements of peer group companies follow the same methodology applied to ECCO’s financial statements. With this in mind, there are few additional financial statement entries in which their classification needs to be discussed.

In the income statements, restructuring charges and asset impairments are classified as operational, because they reflect a company’s adjustments to changing market conditions. (Petersen & Plenborg, 2012) Furthermore, foreign currency translations are considered as financial items.

In principle, the method for capitalisation of rental and lease expenses is similar to what is applied for ECCO, but only with few exceptions. The estimated values in year 2014F for asset value in year 2013 are based on 7 year historical median values, and the necessary revenue estimate for year 2014F is determined also by the 7

year historical median growth rate. The relevant cost of debt is discussed in cost of capital part, and seen in Appendix 106 and 107.

In the balance sheets, pension assets and liabilities are categorised as financial items under interest-bearing assets and liabilities respectively. As a company promises future retirement benefits for its employees, it sets aside investments to fund these obligations. (Koller et al., 2010) As a result, these investments are interest-bearing. Similarly, derivative financial instruments are classified as financial items, because they are tied to hedging of financial risks. (Petersen & Plenborg, 2012)