Chapter 9 Appendix: Line-by-Line Explanation of the Condensed Statements



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Chapter 9 Appendix:

Line-by-Line Explanation of the Condensed Statements
Valuation analysis does not require financial statements as complicated as those in the Comprehensive statements. Therefore, we “condense” the Comprehensive statements into statements that are less complicated but that still accurately reflect the economic realities of the firm. Following is a line-by-line explanation of the Condensed statements. For each row in the Condensed statements, we show the Condensed formula and our rationale for the Condensed formula. Unless otherwise noted, the items on the right-hand side of the Condensed formulas come from the Comprehensive statements.

Condensed Income Statement




Row 7: Sales

Condensed formula = Total net revenues


Rationale: No special adjustments are needed here.

Row 8: Costs of goods sold (COGS)
Condensed formula = [Cost of goods sold expense + Cost of services or operations expense] + [Minority interest expense if shown as pre-tax operating expense] + [IF(Depreciation and amortization if reported combined = 0, - (Stmt of CF depreciation - Depreciation expense if reported separately), - (Stmt of CF depreciation - (Depreciation and amortization if reported combined - Amortization expense if reported separately)))] – [Stmt of CF amortization - Amortization expense if reported separately] – [LIFO reserve this year – LIFO reserve last year]
Rationale: The Condensed statement has only three categories for pre-tax operating expenses: COGS, SGA, and depreciation. We make several adjustments for COGS. (1) We combined the Comprehensive cost of goods and cost of services. (2) Minority interest expense is normally reported as a pre-tax nonoperating item, but it is sometimes reported as an operating item. If so, we include it as a part of costs of goods sold. (3) We want to report any depreciation as a separate line item, rather than have it shown as a part of COGS (this makes it easier to forecast COGS as a function of sales and depreciation as a function of net PPE). We assume that all depreciation was included with COGS. To the extent that some deprecation was actually in SGA, we are understating COGS and overstating SGA. This causes no net effect in operating profit, because the understatement of COGS is exactly offset by the overstatement of SGA. The IF statement is to ensure that we don’t “double count” depreciation, since it is sometimes reported both in the income statement and in the statement of cash flows. (4) We want to exclude any amortization from COGS. In fact, we exclude amortization from the income statement, since we don’t consider it to be a true economic cost. See the Chapter 10 Appendix for a more detailed explanation. (5) If the user has included the LIFO reserves on the Comprehensive sheet, we adjust the Condensed COGS to reflect the COGS that would have been shown under FIFO inventory accounting. See the Chapter 10 Appendix for a more detailed explanation.

Row 9: Sales, general and administrative expense (SGA)
Condensed formula = [Research and development costs if reported separately + IF(Selling, general, and administrative expenses if reported combined = 0, Sales and marketing expenses if reported separately + General and administrative expenses if reported separately, Selling, general, and administrative expenses if reported combined)] + Other operating expenses (income) – [(Interest rate on operating leases * Capitalized value of operating leases)] – [(Interest rate on pension liabilities * Retirement, pension, and health insurance related liabilities)] – [ The current years’ Investment in capitalized operating costs – the investment in capitalized operating costs from three years ago]
Rationale: We make several adjustments to SGA. (1) We want to include all research & development expenses, sales & marketing expenses, and general & administrative expenses. We use the IF statement to ensure that we do not “double count,” since sometimes these items are reported separately and sometimes combined. (2) We include all other operating expenses. (4) We allow the user to specify the amount of any operating leases that should have been capitalized to conform to economic reality (see the Chapter 10 Appendix). Therefore, we exclude an amount equal to the “interest” that would have been paid on the “debt” that is due to the capitalized value of the operating lease. (5) We treat pension related liabilities as though they are long-term debt (see the Chapter 10 Appendix). Therefore, we exclude an amount equal to the “interest” that would have been paid on the pension related “debt” rather than include it as an operating cost. (6) If the user has specified any operating costs that the company has capitalized, we want to take these capitalized operating costs out of assets (since they are costs and not assets) and include them in operating costs (keep in mind that an investment in capitalized operating costs as shown on the statement of cash flows is a negative number; hence, subtracting the negative amount from SGA actually increases SGA). But we also reduce costs by the amount of costs that were capitalized three years ago. This is an approximation that assumes that costs are capitalized over a three-year period. These capitalized costs don’t affect the actual taxes paid by the company.


Row 10: Depreciation

Condensed formula = Depreciation as shown on the statement of cash flows – Adjustment due to “uncapitalizing” interest.


Rationale: We want to separately identify the depreciation so that we can more easily forecast it as a function of net PPE, instead of forecasting it as a function of sales (which is how we forecast COGS and SGA). We do consider depreciation to be a true economic cost even if it is not a cash flow. Our calculations of free cash flow and return on invested capital reflect this; i.e., deprecation does not affect FCF, but it does affect ROIC. In contrast, note that we do not have a category for amortization, since we do not consider it to be a true economic operating expense. Finally, we reduce depreciation by an estimate of the amount that depreciation would have been had interest not been capitalized.


Row 11: Operating profit

Condensed formula = Condensed Sales – Condensed COGS – Condensed SGA – Condensed Depreciation.


Rationale: Based on the adjustments above, the Condensed Operating profit reflects the economic operating profit of the firm.

Row 12: Interest expense
Condensed formula = Interest expense (income) + [(Interest rate on operating leases) * (Capitalized value of operating leases)] + [(Interest rate on pension liabilities) * (Retirement, pension, and health insurance related liabilities)]
Rationale: (1) This includes gross interest expense reported on the income statement. (2) Note that we do not subtract capitalized interest to get net interest expense. Instead, we “uncapitalize” any capitalized interest. (3) We add an amount equal to the interest that would have been incurred if the user had chosen to capitalize operating leases (see the Chapter 10 Appendix). (4) We add an amount equal to the interest that would have been incurred if the user had chosen to treat pension liabilities as debt (see the Chapter 10 Appendix).

Row 13: Interest income

Condensed formula = Interest income


Rationale: No special adjustments are needed here.

Row 14: Nonoperating income (Expense)
Condensed formula = Investment income (expense) if shown on pre-tax basis + [Remitted income (expense) or equity earnings (losses) in affiliates if shown on pre-tax basis + Unremitted income (expense) or equity earnings (losses) in affiliates if shown on pre-tax basis] – [Minority interest expense if shown as pre-tax nonoperating expense + Losses on equity investees and other if shown on a pre-tax basis] + Other nonoperating income (expense) if shown on pre-tax basis + [ -Minority interest expense if shown on after-tax basis / (1 - Marginal tax rate)) + ( - Equity in earnings expense if shown on after-tax basis / (1 - Marginal tax rate)) + ((Investment gains (losses) if shown on after-tax basis + All other income (losses) if shown on after-tax basis) / (1 - Marginal tax rate))
Rationale: In general, this includes all nonoperating income other than interest. (1) This includes any reported investment income. (2) This includes any investment income from affiliates. (3) This includes any minority income (i.e., minority income is found by subtracting minority expense) and gains on equity investees (i.e., this is found by subtracting losses on equity investees). (4) Any other nonoperating income. (5) If any minority expense, equity in earnings expense, investment gains, or other income that was reported on an after-tax basis, we convert it to a pre-tax basis (note that we convert the minority interest expense and equity in earnings expense to income). In other words, we moved all nonoperating income to a pre-tax basis.

Row 15: Earnings before taxes (EBT)
Condensed formula = Condensed Operating – Interest expense + Interest income + Nonoperating income
Rationale: This is the EBT that would have been reported given the adjustments above.


Row 16: Tax expense

Condensed formula = [(Merger and restructuring costs if shown on pre-tax basis) * (Marginal tax rate)]+ [Extraordinary charges or expenses if shown on a pre-tax basis) * (Marginal tax rate)] – [(Extraordinary credit or income if shown on a pre-tax basis) * (Marginal tax rate)] + [(Reserve expense (income)) * (Marginal tax rate)] – [(Gain (loss) on sale of assets or discontinued operations if shown on pre-tax basis) * (Marginal tax rate)] – [(Special nonrecurring items income (expense) if shown on pre-tax basis) * (Marginal tax rate)] + Provision for income tax expense – [((Minority interest expense if shown on after-tax basis / (1 - Marginal tax rate)) * Marginal tax rate)] – [((Equity in earnings if shown on after-tax basis / (1 - Marginal tax rate)) * Marginal tax rate)] + [(((Investment gains (losses) if shown on after-tax basis + All other income (losses) if shown on after-tax basis) / (1 - Marginal tax rate)) * Marginal tax rate)] + Adjustment to reflect impact of “uncapitalizing” capitalized interest

Rationale: In general, we want to show all “special” pre-tax items as after-tax items. Therefore, we want to show what the tax would have been if these pre-tax items had been reported as after-tax items. (1) Add back tax that was deducted due to merger and restructuring costs shown on pre-tax basis. (2) Add back tax that was deducted due to extraordinary charges shown on pre-tax basis. (3) Subtract any tax that would have been paid on extraordinary income shown on pre-tax basis. (4) Add back tax that was deducted due to reserve expenses shown on pre-tax basis. (5) Subtract any tax that would have been paid on gain on sale of assets or discontinued operations shown on pre-tax basis. (6) Subtract any tax that would have been paid on special nonrecurring income shown on pre-tax basis. (7) Any minority interest expense that was shown on an after-tax basis was previously moved to pre-tax nonoperating income, so we must subtract the tax deduction that would have been shown if this had been reported on a pre-tax basis. (8) Any equity in earnings expense that was shown on an after-tax basis was previously moved to pre-tax nonoperating income, so we must subtract the tax deduction that would have been shown if this had been reported on a pre-tax basis. (9) Any investment gain that was shown on an after-tax basis was previously moved to pre-tax nonoperating income, so we must add in the tax expense that would have been shown if this had been reported on a pre-tax basis. (10 Had interest been expensed instead of capitalized, the tax expense would have been lower.


Row 17: Net income before extraordinary items

Condensed formula = Condensed EBT – Tax expense

Rationale: This is the net income before extraordinary items that would have been reported given the adjustments above.

Row 18: After-tax extraordinary income (Expense)
Condensed formula = [-(Merger and restructuring costs if shown on pre-tax basis * (1 - Marginal tax rate))] – [(Extraordinary charges or expenses if shown on a pre-tax basis * (1 - Marginal tax rate))] + [(Extraordinary credit or income if shown on a pre-tax basis * (1 - Marginal tax rate))] – [(Reserve expense (income) * (1 - Marginal tax rate))] + [(Gain (loss) on sale of assets or discontinued operations if shown on pre-tax basis * (1 - Marginal tax rate))] + [(Special nonrecurring items income (expense) if shown on pre-tax basis * (1 - Marginal tax rate))] + [IF(Extraordinary items and discontinued operations if shown combined on after-tax basis = 0, Extraordinary items if shown separately on after-tax basis + Discontinued operations if shown separately on after-tax basis, Extraordinary items and discontinued operations if shown combined on after-tax basis)] – Special asset impairment losses, write-downs, or accounting changes
Rationale: In general, we want to show any nonrecurring as after-tax extraordinary income. (1) Convert any pre-tax merger and restructuring costs into after-tax extraordinary income. (2) Convert any pre-tax extraordinary expenses into after-tax extraordinary income. (3) Convert any pre-tax reserve expense into after-tax extraordinary income. (4) Convert any pre-tax gain on sale of assets or discontinued operations into after-tax extraordinary income. (5) Convert any pre-tax special non-recurring income into after-tax extraordinary income. (6) Report any after-tax extraordinary items or discontinued operations, being careful not to “double count.” (7) We reduce extraordinary income by any special asset impairment charges (or write-downs, or accounting changes) that the user specifies in Comprehensive Row 164, because the user must believe that these write-downs are economically significant.

Row 19: Net income (NI)
Condensed formula = Condensed net income before extraordinary items + extraordinary income
Rationale: This is the net income that reflects the adjustments above.


Row 21: Dividends—preferred

Condensed formula = - Preferred dividends


Rationale: Convert the negative amount from the statement of cash flows into a positive amount, since it will be subtracted.


Row 22: Dividends—common

Condensed formula = - Common dividends


Rationale: Convert the negative amount from the statement of cash flows into a positive amount, since it will be subtracted


Row 23: Additions to RE

Condensed formula = Net income – preferred dividends – common dividends


Rationale: No adjustment needed.


Condensed Balance Sheet: Assets




Row 27: Cash

Condensed formula = Cash and equivalents


Rationale: No adjustments needed.


Row 28: Inventory

Condensed formula = Inventories + LIFO reserve


Rationale: The only adjustment is if the user chooses to convert the inventory level to the level it would have been if the firm had used FIFO accounting (see the Chapter 10 Appendix for details).


Row 29: Accounts receivable

Condensed formula = Accounts receivable


Rationale: No adjustments needed.


Row 30: Other short-term operating assets

Condensed formula = Tax refund receivable + Progress payments + Prepaid expenses + Other operating current assets


Rationale: In general, this includes all operating assets other than cash, inventory, or receivables.


Row 31: Short-term investments

Condensed formula = Marketable securities + Notes receivable + Short-term investments or investment securities + Other nonoperating current assets


Rationale: This category contains all nonoperating current assets.


Row 32: Total current assets

Condensed formula = Condensed Cash + Inventory + Accounts receivable + Other short-term operating assets + Short-term investments


Rationale: No adjustments needed.

Row 33: Net plant, property, & equipment (PPE)
Condensed formula = Net property, plant, and equipment - cumulative impact of “uncapitalizing” interest
Rationale: (1) We start with reported net PPE and then subtract the cumulative net amount of capitalized interest.
We also include an adjustment in this account to accommodate any special asset impairment charges that are so large that they would have caused other long-term operating assets to become negative.

Row 34: Other long-term operating assets

Condensed formula = Other operating long-term assets + [Cumulative of current and past asset impairment losses and write-downs]+ [MAX(Goodwill if shown separately+ Intangibles if shown separately + Cost in excess of fair value of net assets acquired, Goodwill and intangibles if shown combined)] + Deferred charges + Deposits + [Cumulative of current and past amortization] + Capitalized value of operating leases + [Cumulative total of current and past two years of Capitalized operating costs] – Cumulative current and past special asset impairment losses, write-downs, or accounting changes


Rationale: This category contains all long-term operating assets other than net PPE. (1) It includes Other operating long-term assets. (2) This includes the cumulative of current and past asset impairment losses and write-downs, based on the assumption that the assets should not be written down. If you disagree, you may enter the amount you desire to write-down in Comprehensive Row 164. See the Chapter 10 Appendix for details. (3) We subtract the cumulative current and past accounting changes, based on the assumption that these have not changed the economic reality of the company. If the user believes that it makes economic sense to include these adjustments, then the user may enter the desired write-down in Comprehensive Row 164 (Special goodwill impairment and accounting changes). (4) This includes the reported balance sheet assets of goodwill and amortization, being careful not to “double count.” (5) It includes long-term deferred charges, since these are typically related to operations. (6) It includes Deposits, since these are usually related to operations. (7) It includes the cumulative of current and past amortization. This is based on the assumption that amortization was created through the purchase of operating assets, but that there is no good way (other than an impairment test, which we account for later) to measure the change in value of the purchased asset. Therefore, we do not amortize the asset. See the Chapter 10 Appendix for details. (8) If the user chooses to capitalize operating leases, then they are included here (see the Chapter 10 Appendix). (9) If the user chooses to “uncapitalize” operating costs that the company chose to capitalize, then long-term operating assets should be reduced by the cumulative amount of current and past capitalized costs (note that these cost are reported as a negative number in the Special section of the Comprehensive sheet, so we add a negative amount to reduce assets). We assume that the capitalized costs are being amortized over a three-year period, so we only use the current and past two years. Because the decision to capitalize costs does not affect taxes, we don’t need to make any adjustment for taxes. (10) We subtract the cumulative current and past special asset impairment charges (or write-downs, or accounting changes) that the user specifies in Comprehensive Row 164, because the user must believe that these write-downs are economically significant.
We also include an adjustment in this account to accommodate any special asset impairment charges that are so large that they would have caused other long-term operating assets to become negative.

Row 35: Long-term investments

Condensed formula = Long-term receivables + Investments in unconsolidated subsidiaries + Other investments + Long-term notes receivable + Investments & advances to subsidiaries + Other nonoperating long-term assets


Rationale: This contains all long-term assets not related to operations.


Row 36: Total assets

Condensed formula = Condensed Total current assets + Net PPE + Other long-term operating assets + Long-term investments


Rationale: This is the total assets that would have been reported based on the adjustments above.


Condensed Balance Sheet: Liabilities



Row 39: Accounts payable (AP)
Condensed formula = Accounts payable
Rationale: No adjustments needed.


Row 40: Accruals

Condensed formula = Short-term unearned revenue + Interest payable or accrued interest + Dividends payable + Taxes payable or accrued taxes + Accrued wages or salary + Other accrued expenses or accruals + Deferred income + Long-term unearned revenue


Rationale: We aggregate all accruals here, including accounts that are classified as long-term accruals because it doesn’t make a difference in valuation whether an accrual is long-term or short-term.


Row 41: Other operating current liabilities

Condensed formula = Other operating current liabilities


Rationale: No adjustment needed.


Row 42: All short-term debt

Condensed formula = Notes payable + Current portion of long-term debt + Current portion of capitalized leases + All other short-term debt


Rationale: We aggregate all short-term debt here.


Row 43: Total current liabilities

Condensed formula = Condensed accounts payable + Accruals + Other operating current liabilities + All short-term debt


Rationale: This is the total current liabilities reflecting the adjustments above.


Row 44: Long-term debt

Condensed formula = Noncurrent portion of long-term debt + Mortgages + Noncurrent portion of capitalized leases + Convertible debt + Any other long-term debt + Capitalized value of operating leases + Retirement, pension, and health insurance related liabilities


Rationale: This includes all types of long-term debt, including the Noncurrent portion of long-term debt, mortgages, the noncurrent portion of capitalized leases, convertible debt and any other long-term debt. If the user chooses to capitalize operating leases, then that amount is shown here as debt (and also in Other long-term operating assets). Rather than show retirement, pension, and health insurance related liabilities as a liability, they are shown as debt and their implied interest is shown as an interest expense.


Row 45: Deferred taxes

Condensed formula = -Current deferred tax asset - Long-term deferred tax asset + Short-term deferred taxes + Deferred tax liability in untaxed reserves + Deferred long-term income taxes


Rationale: We only need one account for deferred tax, and so we aggregate all deferred tax accounts.


Row 46: Preferred stock

Condensed formula = Preferred stock


Rationale: No adjustment needed.


Row 47: Other long-term liabilities

Condensed formula = Other nonoperating current liabilities + Provision for risks and charges + Reserve accounts + Restructuring obligations + Commitments and contingencies + Other long-term liabilities + Minority interest + Nonequity reserves + [IF(Stock options from special section = 0, Common stock warrants and stock options from balance sheet, Stock options from special section)]


Rationale: This account includes all nonoperating liabilities, including reserve accounts and minority interest. This account also includes any stock options reported on the balance sheet. Stock options are included with long-term liabilities rather than equity because they represent claims by a group other than the current common equity shareholders. In addition, if the user chooses to specify the market value of the option in the Special Section of the Comprehensive sheet, then the market values are used rather than the book values shown in the balance sheet (after being careful not to “double count”).


Row 48: Total liabilities

Condensed formula = Condensed Total current liabilities + Long-term debt + Deferred taxes + Preferred stock + Other long-term liabilities


Rationale: We include preferred stock here because it is a claim by a group other than the current common equity shareholders.

Row 49: Par plus PIC Less treasury (and other adjustments)
Condensed formula = Common stock at par + Common stock capital surplus or paid in capital + Revaluation of reserves + Other appropriated reserves + Unappropriated (free) reserves + Equity in untaxed reserves + ESOP guarantees + Treasury stock + Other equity + Unrealized gain (loss) on marketable securities + Accumulated other comprehensive income or cumulative other adjustments + Unrealized gain (loss) on foreign exchange + Cumulative foreign currency translations - [IF(Stock options from special section = 0, 0, Stock options from special section – common stock warrants and stock options from balance sheet)] + [Cumulative current and past Adjustment for reconciliation of RE account] – Adjustment for “uncapitalizing” capitalized interest
Rationale: (1) This aggregates all common stock accounts other than retained earnings. If the user chooses to specify the market value of stock options, then this account includes an adjustment to reflect the placement of stock options Other long-term liabilities (see Chapter 10 Appendix). (3) In our experience, data sources are sometimes incorrect in that even though balance sheets may balance, they do not always articulate correctly from year to year in the sense that the change in retained earnings defined by Net income minus all dividends always equals the actual change in retained earnings. To account for this, we include in our Comprehensive statement of retained earnings an account to adjust for any differences. (4) If the firm had expensed interest instead of capitalizing it, then it would have freed up extra cash due to lower tax payments. We assume that the firm would have paid this out as a special dividend, since that assumption does not distort the calculation of FCF or the calculation of value by distorting nonoperating assets or nonoperating liabilities.

Row 50: Retained earnings (RE)
Condensed formula = Retained earnings +[Cumulative of current and past asset impairment losses and write-downs] + [Cumulative of current and past amortization expenses] - [Cumulative of current and past accounting changes] + LIFO reserve - [Cumulative current and past Adjustment for reconciliation of RE account] + [Cumulative current and past two years of Capitalized operating costs] – Adjustment due to “uncapitalizing” interest – Cumulative current and past special asset impairment losses, write-downs, or accounting changes
Rationale: (1) We start with the reported retained earnings. (2) This includes the cumulative of current and past asset impairment losses and write-downs, based on the assumption that the assets should not be written down. If you disagree, you may enter the amount you desire to write-down in Comprehensive Row 168. See the Chapter 10 Appendix for details. (3) We add the cumulative of the current and past amortization expenses, since we did not subtract them from the income statement. See Chapter 10 Appendix for details. (4) We subtract the cumulative current and past accounting changes, based on the assumption that these have not changed the economic reality of the company. If the user believes that it makes economic sense to include these adjustments, then the user may enter the desired write-down in Comprehensive Row 164 (Special goodwill impairment and accounting changes). (5) If the user chooses, we add any LIFO reserve, which reflects the retained earnings that the company would have had if it had used FIFO (see the Chapter 10 Appendix). (6) We make any adjustments to retained earnings required to make the statements articulate from year-to-year; see the rationale for Row 49 shown above. (7) If the user chooses to correct any costs that the company has chosen to capitalize, we make an adjustment to retained earnings that shows what RE would have been if the costs had not been capitalized. See the comment in Row 34 for related information. (8) We adjust retained earnings by the amount that the adjustments in the income statement to “uncapitalize” capitalized interest would have reduced retained earnings. (8) We subtract the cumulative current and past special asset impairment charges (or write-downs, or accounting changes) that the user specifies in Comprehensive Row 164, because the user must believe that these write-downs are economically significant.


Row 50: Total common equity

Condensed formula = Condensed Par plus PIC less treasury and other adjustments + Retained earnings


Rationale: This is the total common equity based on the adjustments described above.


Row 51: Total liabilities and equity

Condensed formula = Condensed Total liabilities + Total common equity


Rationale: This is the total liabilities & equity based on the adjustments above.

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