When analyzing a company’s financial health, the balance sheet is one of the most important documents. It reveals a snapshot of the company’s assets, liabilities, and shareholders’ equity at a specific point in time. But, to truly understand a company’s financial situation, it’s often necessary to reformulate the balance sheet. This reformulation helps analysts better understand how the business is financed and how well it operates.
What is the Reformulation of the Balance Sheet?
This re-classification or the reformulation of the balance sheet entails separating assets and liabilities into two groups:
- Operating items – These are items of assets and liabilities that are directly involved in the core business operations of the company. As an illustration, the equipment that is involved in the manufacture of products or the payable accounts of raw materials.
- Financing items – Items of financing are assets and liabilities associated with the financing of the company, i.e., loans, bonds, or investments in financial assets.
The Reason to Reformulate the Balance Sheet
A typical GAAP (Generally Accepted Accounting Principles) balance sheet divides assets and liabilities into current and noncurrent (long-term) categories. While this helps measure liquidity (how easily a company can meet its short-term obligations) and solvency (the company’s ability to meet long-term debts), it doesn’t tell you how the company’s operations are funded or how the profits are generated.
By reformulating the balance sheet, we break down the financial health into clearer categories, focusing on how much of the business is run through operating activities versus how it is financed. This helps in analyzing:
- How much is tied up in financing decisions (such as debt or investments)
- How much of the assets are used in daily operations
Important Aspects of Reforming the Balance Sheet.
1. Operating Assets & Liabilities (Net Operating Assets)
These items represent the assets and liabilities that are directly involved in the company’s operations. This includes:
- Operating Assets: Items like inventories, accounts receivable, property, plant, and equipment (PP&E).
- Operating Liabilities: This includes accounts payable and other liabilities directly related to operations.
Together, Operating Assets and Operating Liabilities give us the Net Operating Assets (NOA), which tells us the capital tied up in operations.
2. Financing Assets & Liabilities (Net Financial Assets or Obligations)
These items include:
- Financing Assets: Cash investments, short-term investments, or financial securities not related to operations.
- Financing Liabilities: This includes debts like bonds, loans, or obligations that have been borrowed to finance the business.
These financial items are essential because they show how the company has been funded or how it invests its excess funds.
Example of Reformulated Balance Sheet
Let’s consider a company with the following components:
- Operating Assets: Machinery worth $500M, used directly in business operations.
- Financing Liabilities: Loans worth $100M used to fund business operations.
Here’s how the reformulation would look:
- Operating Assets = $500M
- Financing Liabilities = $100M
- Net Operating Assets (NOA) = $400M (Operating assets – Financing liabilities)
This shows that the company has $400M invested in the operations of the business, and the rest ($100M) is being financed through debt.
The Structure of the Reformulated Balance Sheet
A typical reformulated balance sheet is organized into two sections: Operating and Financing activities.
| Assets | Liabilities & Equity |
|---|---|
| Financial Assets | Financial Liabilities |
| Cash, short-term investments | Short-term borrowings, long-term debt |
| Operating Assets | Operating Liabilities |
| Inventories, receivables, PP&E | Accounts payable, accrued expenses |
| Net Operating Assets (NOA) | Common Equity |
Retailers like Walmart or Best Buy issue customer credit cards. These companies are involved in operating activities as the credit issued is directly related to their goods and services. In their case:
- Receivables (from credit card debt) are operating assets since they are part of the company’s main business of selling goods.
- Liabilities related to customer deposits, like in the case of banks, could also be operating liabilities, as they represent the operational funding rather than financing.
The Implications of Reformulation
By reformulating the balance sheet:
- Clearer insights into business operations – Analysts can easily see how much of the company’s resources are tied up in operations versus financing. This gives a better understanding of how efficiently the company is running its operations and managing debt.
- Better analysis of profitability – Understanding how much of the company’s assets are used to generate revenue (through operating activities) versus how much is being financed (through loans, equity) helps analyze whether the company is making efficient use of its capital.
- Improved financial ratio analysis – Reformulating the balance sheet provides a clearer picture when calculating important financial ratios like ROCE (Return on Common Equity), ROA (Return on Assets), and Operating Profit Margin.
Key Takeaways
- Operating items include everything used to run the business.
- Financing items show how a company funds its operations and investments.
- Reformulating the balance sheet helps identify the portion of assets that are actually used for business operations versus those involved in financing.
- Net Operating Assets (NOA) give a clearer view of the capital used in the company’s core operations, helping analysts assess efficiency and profitability more accurately.
Conclusion
Reformulating the balance sheet helps financial analysts and investors separate the business’s operations from its financing activities, offering a clearer and more detailed picture of a company’s financial health. This reformulation highlights the operational efficiency of a company, its reliance on debt, and overall profitability. Understanding this split can lead to better investment decisions and more accurate financial analysis.