Practice Set For Chapters 7 And 8 Name This Practice

Practice Set Chapters 7 And 8 Name This Pract

This practice set illustrates the reorganization process covered in chapter 7. Notes are supplied before the questions to help you understand the topic. Please read these notes and then answer the questions.

Part 1 – The Reformulating the Balance Sheet

1. All assets are either operating or non-operating. Operating assets are used to generate sales while non-operating assets are typically excess monies that have not yet been invested in operating assets or excess cash that will be returned to the bondholders and stockholders at some point in the future.

2. Typical non-operating assets are excess cash or cash equivalents and investments. All other assets are typically operating.

3. Typical non-operating liabilities are current portion of long-term debt, long-term debt, and capitalized lease obligations. All other liabilities including accounts payable and accrued expenses are typically operating liabilities.

4. Invested capital equals operating assets minus operating liabilities.

5. Net non-operating assets or net liabilities equals non-operating assets minus non-operating liabilities.

Sample Balance Sheet:

  • Cash needed for operations: 200
  • Accounts payable: 300
  • Excess cash: 600
  • Accrued expenses: 250
  • Inventory: 400
  • Current portion of Long-term debt: 150
  • Investment in marketable securities: 300
  • Long-term debt: 1000
  • Plant property and Equipment: 1000
  • Stockholders Equity: 800
  • Total assets: (calculate accordingly)

What are the two non-operating assets? What do they sum to? What are the two non-operating liabilities? What do they sum to? What are the three operating assets? What do they sum to? What are the two operating liabilities? What do they sum to?

Calculate the invested capital. Calculate the net non-operating liability. Please construct a balance sheet with invested capital on the left side and the sum of net non-operating liabilities and stockholders’ equity on the other, the balance sheet must balance.

Part 2 – The Income Statement

1. As stated in part 1, all assets are either operating or non-operating -- so all revenues and expenses are also operating or non-operating.

2. Typical non-operating revenues are interest income earned on excess cash and on investments. Typical non-operating expenses are interest paid on borrowed money (bonds issued by the corporation) and interest paid on leased assets.

3. All other revenues and expenses are typically operating.

4. Net operating income less adjusted taxes (NOPLAT) equals operating revenues minus operating expenses and then minus taxes.

Sample Income Statement:

  • Sales: 2500
  • Cost of goods sold: 1400
  • Selling and administrative: 540
  • Interest received or earned: 20
  • Interest paid or expense: 80
  • Pretax income: 500
  • Taxes at 20%: 100
  • Net income: 400

Please take out the non-operating expenses and non-operating revenues and then calculate the pretax operating earnings. Using a 20 percent tax rate, calculate the net operating profit less adjusted taxes or (NOPLAT)?

Part 3 – Merging the Balance Sheet and Income Statement to measure profitability

1. Return on average invested capital (ROIC) is what the company earned operating the business. It is computed by taking the net operating profit less adjusted taxes (NOPLAT) and dividing by the average invested capital or (IC) (we do not have beginning and ending numbers in this example so assume the number given is the average). Using the invested capital from part 1 and the NOPLAT from part 2, please calculate the return on invested capital (ROIC).

Part 4 – Merging the Income statement and Portions of the Balance Sheet to get Free Cash Flow

1. Free cash flow starts with operating income.

2. To that, you add back depreciation and other noncash expenses.

3. This gives you cash from operations.

4. We must then calculate the investment in working capital and the investment in plant property and equipment.

5. To get the investment in working capital, you take all increases in the current asset accounts as a use of cash and all decreases in current asset accounts as sources of cash. For operating current liabilities, it works in reverse: all increases in current liability accounts are a source of cash, and all decreases are a use of cash.

6. Capital expenditures on plant property and equipment can be found on the investing section of the cash flow statement (or for class purposes, it will be given).

7. Free cash flow = operating income + depreciation – incremental investment in working capital – capital expenditures on plant property and equipment.

Sample Balance Sheet data:

  • Beginning Cash: 20
  • Ending Cash: 30
  • Source or (Use) of Cash: -- 10
  • Beginning Accounts Receivable: 40
  • Ending Accounts Receivable: 30
  • Source or (Use): -- 10
  • Beginning Inventory: 60
  • Ending Inventory: 80
  • Source or (Use): -- 20
  • Beginning Accounts Payable: 40
  • Ending Accounts Payable: 50
  • Source or (Use): -- 10
  • Beginning Accrued Expenses: 25
  • Ending Accrued Expenses: 20
  • Source or (Use): -- 5

Using the information above, the net incremental investment in working capital is a net use of cash or net investment of 15. Given an investment in Plant property and Equipment, the total investment in operating assets for the period is 65.

Additional sample income statement data: NOPLAT: 39.2; Depreciation and noncash expenses: 5.8. Using this information, calculate free cash flow.

Paper For Above instruction

Financial analysis and valuation are crucial tools for assessing a company's performance and making informed investment decisions. This paper explores the comprehensive process of reorganizing financial statements as outlined in chapters 7 and 8, focusing on balance sheet restructuring, income statement adjustments, profitability measurement, and cash flow analysis. Through detailed explanations and calculations based on provided data, the paper illustrates how to harness financial statements for strategic insights.

Reorganizing the Balance Sheet: Distinguishing Operating and Non-Operating Assets & Liabilities

The first step in financial statement analysis is to categorize assets and liabilities into operating and non-operating categories. Operating assets are those used directly in the core business activities, such as plant, property, equipment, and inventory, which generate sales. Non-operating assets include excess cash and marketable securities that are not actively used in operations but are held for liquidity or investment purposes. For instance, in the sample balance sheet, excess cash of 600 and marketable securities of 300 are identified as non-operating assets, summing to 900. Conversely, liabilities like the current portion of long-term debt and long-term debt are non-operating liabilities, totaling 1,150. Operating assets (e.g., inventory, plant, property, equipment) sum to 1,400, and operating liabilities (accounts payable, accrued expenses) total 550. These classifications enable the calculation of invested capital, which involves subtracting operating liabilities from operating assets.

Calculating Invested Capital and Net Non-Operating Liabilities

Invested capital equals operating assets (inventory, plant, property, and equipment) minus operating liabilities (accounts payable, accrued expenses). Using the sample figures, invested capital equates to 1,400 - 550 = 850. The net non-operating assets or liabilities are derived by subtracting non-operating liabilities (long-term debt, current portion) from non-operating assets (cash, securities). The total non-operating assets are 900, and the non-operating liabilities (e.g., current portion + long-term debt) sum to 1,150, yielding a net non-operating liability of 900 - 1,150 = -250, indicating a net liability position.

Income Statement Adjustments: Extracting Operating Earnings

The income statement differentiates between operating and non-operating revenues and expenses. Interest income of 20 and interest expense of 80 are non-operating. Removing these, the operating income components are sales of 2,500, cost of goods sold of 1,400, and selling & administrative expenses of 540. The pretax operating earnings are calculated by subtracting operating expenses from operating revenues: 2,500 - 1,400 - 540 = 560. Tax adjustment at 20% yields an after-tax operating profit (NOPLAT) of 560 x (1 - 0.20) = 448.

Measuring Profitability: Return on Invested Capital (ROIC)

ROIC assesses how efficiently a company generates profits from its invested capital. It is computed by dividing NOPLAT (448) by the average invested capital (assumed at 850). Therefore, ROIC = 448 / 850 ≈ 52.7%. This high ROIC indicates strong operational performance, assuming the figures are representative.

Free Cash Flow Calculation: From Operating Income to Cash Generation

Free cash flow (FCF) measures the cash generated after investing in operating assets. Starting with operating income of 560, depreciation and noncash expenses of 5.8 are added back, resulting in cash from operations of 565. To calculate the investment in working capital, increases in current assets (accounts receivable, inventory) are uses of cash, while increases in current liabilities (accounts payable, accrued expenses) are sources. Summing these, the net incremental investment in working capital is 15. Focusing on capital expenditures, given as 50, the FCF formula is:

FCF = Operating income + Depreciation – Net incremental investment in working capital – Capital expenditures

Substituting numbers: 560 + 5.8 – 15 – 50 = 500.8. This figure represents the free cash flow available for distribution to investors or reinvestment.

Conclusion

The integration of balance sheet restructuring, income statement analysis, and cash flow evaluation provides a comprehensive view of a firm's financial health. Proper classification of assets and liabilities into operating and non-operating categories allows for precise calculation of profitability metrics such as ROIC and cash flow generation. These insights are indispensable for investors, managers, and analysts aiming to assess operational efficiency, value creation, and financial stability.

References

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