The correct construction and interpretation of financial statements
The purpose of this article is to identify a model of cash flow statement that can be conveniently used for a correct financial analysis, based on the calculation of NOPAT (Net Operating Profit After Taxes).
For an audit of the company’s performance from a financial point of view, it is essential to provide for the construction of the financial statement which is an account that highlights the causes of change, positive or negative, of cash occurred in a given year, as set forth by IAS 1.
IAS 1 refers to the specifics included in IAS 7 for provisions relating to the presentation of the financial statement. The cash flow statement should present cash flows occurring in the pertaining fiscal year and classify them based on the business activity by which are generated:
– Cash-flow from operating activities: originates mainly from the major revenue-generating activities of the enterprise, or those facts and other management operations involved in the determination of net profit (loss) of the period;
– Cash-flow from investments: includes the purchase and sale of non-current assets and other investments not included in cash and cash equivalents;
– Cash-flow from financing: changes of the size and composition of the capital issued and loans obtained by the company.
Cash-flows from operating activities may be presented in two alternative ways:
– the direct method, through which you indicate the main categories of gross proceeds and payments;
– the indirect method, whereby net profit or loss for the year is adjusted for the effects of non-monetary transactions, for any deferral or provision of prior or future proceeds or operating payments, and items of income or costs associated with the cash flows from investing or financing activities.
Between the two modes of presentation, IAS 7 standard recommends to use the direct method for “it provides information that may be useful in estimating future cash flows that are not available under the indirect method”. In practice, however, the indirect method is usually the most used one.
The indirect model used by IAS is as follows:
|Cash flows from operating activities|
|Profit before tax|
|Adjustments for non-cash items|
|+ Depreciation and amortization|
|- Profit on sale of plant|
|Adjustments for changes in working capital|
|+ Decrease in trade receivables|
|+ Decrease in inventories|
|+ Increase in trade payables|
|+ Interest expense|
|Cash generated from operating activities|
|- Interest paid|
|- Taxes paid|
|Net Cash from operating activities|
|Cash flows from investing activities|
|- Acquisition of property, plant and equipment|
|- Acquisition of investment property|
|- Acquisition of goodwill|
|- Acquisition of non-current biological assets|
|- Acquisition of other investments|
|Net Cash used in investing activities|
|Cash flows from financing activities|
|+ Proceeds from issue of capital|
|+ Proceeds from borrowings|
|- Repayment of borrowings|
|- Dividends paid|
|Net Cash from (used in) financing activities|
|Net increase (decrease) in cash and cash equivalents|
|Cash and cash equivalents at beginning of period|
|Cash and cash equivalents at end of period|
The question we ask is the following: is the model described above suitable to meet the need of a proper financial analysis?
The answer is definitely negative because it lacks a vital element represented by operating cash flow (see article) also known as free cash flow for shareholders and lenders (Unlevered Free Cash Flow or Free Cash Flow to the Firm) that being the cash-flow generated by the ordinary activity of the company, which is not influenced by the company's financial management and non-ordinary activities.
It represents a fundamental element either to pass judgment on the company's financial dynamics and to assess the value of the whole business.
To build a financial statement that clearly highlights the value of the operating cash flow you must operate bearing in mind three considerations:
- you have to rectify cash-flows by removing values that originate from the non-operating activity and extraordinary items, so to obtain an amount representing the cash generated or absorbed by the ordinary activities;
- remove those values that represent payments for sources of debt capital (such as financial expenses) or risk capital (as dividends) and proceedings from non-core financial assets (as financial income)
Once you have made such adjustments we can divide the company management in:
A study needs to be done with regard to the concept of NOPAT, calculated by the method of Taxes on operating profit (or notional taxes).
In case of indebtedness and fiscal recognition of its charges, the tax system has a dual effect on cash-flows: a reductive effect as it reduces the income generated from operating activities and an incremental effect due to the tax benefit coming from the deductibility of interests on debt.
If we take as a reference the cash-flow generated by the ordinary activity of the company, we must eliminate that quota of taxes that can be saved due to the fact that interest expenses are tax-deductible. Now, if it is true that the cash-flow should not be affected by financial management it is also true that we must add to the amount of taxes of the year that part which the company spared due to the deductibility of finance charges.
EBIT = $ 10,000
Interest Expense = $ 1,000
Profit (Loss) before Tax = $ 9,000
Income Tax Expense = 27.5% * $ 9,000 = $ 2,475
EBIT-Taxes = $ 10,000 – $ 2,475 = $ 7,525
If I correct this value accounting for the tax effect due to financial management we will have:
EBIT = $ 10,000
Interest Expense = $ 1,000
Profit (Loss) before Tax = $ 9,000 Tax operating profit without deductibility = 27.5% * $ 10,000 = $ 2,750, or $ 275 of additional taxes
EBIT – Tax operating profit = NOPAT = $ 7,250
As you can see from this simple example, by calculating NOPAT we obtained a cash-flow value that is less than $ 275 compared to that generated by taking into account the deductibility of interest expenses. For this reason, in order to correctly calculate the operating cash flow, the reporting model to be adopted is as follows:
A model of correct financial reporting for financial analysis
|- Tax operating profit|
|Gross Operating Cash-flow|
|- Increase in Trade Receivables|
|- Increase in Inventories|
|+ Increase in Trade Payables|
|- Other Increase in assets|
|+ Other Increase in Liabilities|
|Changes in Working Capital|
|Cash-flow from Current Activities|
|+ Debt Tax Shelter|
To reconcile the values of cash-flows originating from fiscal management, you have to calculate the so called debt tax shield.
The most common mistake that you make in not calculating taxes on operating profit
The issue of correctly calculating NOPAT is not purely academic but takes on a crucial importance in case you want to estimate the value of the company using the Discounted Cash Flow method or if you want calculate the Net Present Value (NPV) of an investment project.
As it is well-known, the formula for WACC is as follows:
WACC = kd * (1 - t) * D/(E + D) + ke * E/(E + D)
WACC is the weighted average cost of all resources through which the company finances itself, which is the weighted average of the "costs" of the different funding sources placed on the company's debt by way of venture capital.
As you can see in the formula, kd is reduced to take into account the share of deductible taxes. In this way the kd value will be lower, and consequently the WACC will be lower. But if I keep into account the deductibility in the WACC formula I should remove this effect in the calculation of operating cash-flow, and then use the actual amount taxes. If I didn't make that operation I would commit the error of considering the deductibility of interest expenses twice: once with the cash-flows to be discounted and yet another time with the discount rate (WACC). So, if I use the classic formula of WACC I should remove from the operating cash-flow the share coming from the deductibility of borrowing costs through the tax effect.
The correct options are the following:
1. keep account of notional taxes by eliminating the deductibility of financial costs in the calculation of cash-flows and at the same time apply a factor (1-t) to the cost of debt in the WACC formula that allows you to take into account the deductibility of such expenses.
2. calculate the cash-flows taking account of taxes from the income statement, net of the deductibility of borrowing costs, but consider a cost of debt equal to the full kd without the factor (1-t). The first option is definitely the most correct and is the one used in financial literature. Remember that the higher the WACC, the higher the discount rate and the smaller the present value of future discounted cash-flows
In case you want to determine a company's value through the Discounted Cash Flow method or every time you use WACC to discount future cashflow, the IAS 7 cash-flow statement model is not suitable and needs some adjustments to reconcile the WACC formula with the correct values of operating cash-flow.