Reorganizing the Financial Statements
Traditional financial statements—the income statement, balance sheet, and statement of cash flows—are not organized for robust assessments of operating performance and value. The balance sheet mixes together operating assets, nonoperating assets, and sources of financing. The income statement similarly combines operating profits with the costs of financing, such as interest expense.
To prepare the financial statements for analysis of economic performance, you need to reorganize the items on the balance sheet, income statement, and statement of cash flows into three categories of components: operating, nonoperating, and sources of financing. This will entail searching through the notes to separate accounts that aggregate operating and nonoperating items. Although this task seems mundane, it is crucial for avoiding the common traps of double-counting, omitting cash flows, or hiding leverage that artificially boosts reported performance.
Since the process of reorganizing the financial statements is complex, this chapter proceeds in three steps. In step 1, we present a simple example demonstrating how to build invested capital, net operating profit less adjusted taxes (NOPLAT), and free cash flow (FCF). In the second step, we apply this method to the financial statements for Home Depot and Lowe’s, commenting on some of the intricacies of implementation. In the final step, we provide a brief summary of advanced analytical topics, including how ...