Valuation, 7th Edition

11Reorganizing the Financial Statements

Traditional financial statements—the income statement, balance sheet, and statement of cash flows—do not provide easy insights into operating performance and value. They simply aren’t organized that way. The balance sheet mixes together operating assets, nonoperating assets, and sources of financing. The income statement similarly combines operating profits, interest expense, and other nonoperating items.

To prepare the financial statements for analyzing economic performance, you should reorganize each financial statement into three categories: operating items, nonoperating items, and sources of financing. This often requires searching through the notes to separate accounts that aggregate operating and nonoperating items. This task may seem mundane, but it is crucial for avoiding the common traps of double-counting, omitting cash flows, and hiding leverage that distorts performance metrics, such as return on equity and cash flow from operations.

Since reorganizing the financial statements is complex, this chapter breaks down the process into three sections. The first section presents a simple example demonstrating how to build invested capital, net operating profit after taxes (NOPAT), and free cash flow. The second section applies this method to the financial statements for Costco Wholesale, with comments on some of the intricacies of implementation. Finally, we provide a brief summary of advanced analytical topics, including how to ...