Cleaning the Numbers – Arriving at Operating, Financing and Non-core Items

Unless privileged access to inside information on a company has been given, the information available to produce a valuation will be limited to public data, which primarily means the historic report and accounts plus other regulatory filings. Historic information is often used to forecast forward trends in profitability and cash flow that form the basis for a valuation or to compare market valuations across sectors. However, before the information in historic accounts can be used to compare or value companies, it is necessary to ensure that the information being used is relevant for the valuation being produced.

Cleaning the Numbers

Historic accounts are produced for a wide variety of interested parties, from employees of the company through to investors and industry regulators. Accounts therefore include a lot of “noise”, items that are not strictly relevant for valuation or analysis. Accounts are also required by law to include all the transactions that have taken place during the period, whether they relate to the underlying activities of the company or not. It is therefore necessary to decide which items included in the accounts relate to the underlying performance of the company (operational items), which items are being used to finance the company (financing items) and which items do not relate to the company’s underlying activities (non-core items). This exercise must be performed to get to any starting point for comparison or valuation.

What is required is an exercise to “clean up” the accounts, using knowledge of the company to identify the underlying profitability and cash flow of the business. A relative valuation, such as a comparative company (“comps”) analysis where comparisons across a sector are made, will allow us to produce an analysis of the group of companies where the accounting data is truly comparable. In an absolute valuation exercise, the clean ongoing profitability and cash flow calculated can be used as the starting point or “base camp” for a forecast that will allow the extrapolation of historic trends to produce an income and cash flow statement if there are no detailed forecasts.

As well as the annual report and accounts, data from stock market filings such as the 10K or 20F (US filings) are available. A 10K filing is filed by quoted US companies and is similar to an annual report, but covers much more detail about the business. As such, it is a very good source of information for making adjustments. A 20F filing is completed by a non-US company that has securities listed in the US (say through an ADR, an American Depository Receipt) and the 20F covers much the same information as a 10K. Broker forecasts can be used for adjustments if the broker has a particular insight into the way a company operates and Bloomberg is generally used as a source of market information.

Income Statement Adjustments

There are three main types of adjustment to the income statement:

Adjustments to Operating Income

Fortunately, under IFRS there is now complete disclosure of the continuing and discontinuing operations of the company. The decision to sell is the determinant of the split between the two, so as soon as management decides to sell part of a company its results must be reported separately. Discontinued business performance can therefore be excluded when making adjustments. 

The management of a company will often try to massage various items to improve the reported profitability of the company. Losses, which reduce profitability, will be treated as exceptional and excluded from highlighted performance lines or ratios (such as net income, EPS, etc.). Gains will be classified as part of the normal operations and therefore boost profitability. Adjustments must be made for this manipulation to get back to core, repeatable profitability. 

Goodwill is another item for which an adjustment must be made. Goodwill impairment now reflects over payment for an acquisition/asset and does not reflect the economic wasting of an intangible asset (which is now separately reported under IFRS). If goodwill impairment has been included in EBIT, it must then be removed.

Adjustments to Financing Items

There are various accounting issues that may have to be adjusted for in financing items, but the main items requiring adjustment would be pension costs and leases. Pension costs as reported will sometimes include the interest and investment return element of the pension cost, which are financing items. As pension costs are often reported in the EBIT number (i.e. pre-financing costs), if the pension cost includes an interest/investment return element, this should be removed from EBIT line and included in financing costs line. Operating lease expenses not capitalised may also be included in EBIT. These will include the interest portion of the lease payment, which again should be separated out of operating costs and included in financing costs.

Taxation

If any of the items that have been included as an adjustment have a tax effect, this must be adjusted for. One of the key problems with reported numbers is that sometimes pre-tax items have a tax element to them. For example, gains or losses on sale or restructuring costs may be included net of tax, but above the tax charge line in the income statement. Unless the amount of tax is disclosed in the notes to the accounts, it is often impossible to figure out what the tax charge would have been, so it is best not to make any adjustments. This will lead to a slightly incorrect EBIT number if the item is included above EBIT, but the amounts involved are usually immaterial. If the amount of tax is disclosed in the accounts, then both the EBIT, tax charge and the net income figure can be adjusted.

What type of item is taxation? The answer is a bit of operating and a bit of financing, as tax has to be paid on profits, but the financing charge relating to interest is deducted from profits to calculate the income statement tax charge. In practice, tax is treated as an operating item when producing a valuation, but the tax charge in the income statement is re-calculated to strip out the effect of interest. Operating returns are calculated as EBIT − Marginal tax (calculated as EBIT × Marginal tax rate), the marginal tax cash paid for each £1 or $1 of operating profit earned. In terms of the balance sheet, the current tax asset/liability is treated as an operating item but the deferred tax asset or liability, being an estimate and a provision which may or may not arise, is treated as a financing item.

Summary

Key Adjustments Summary – Income Statement

There are three main areas where adjustments may be made to an income statement, the main one being one-off items. This will include restructuring costs, that will not be part of operating revenues/costs going forward, impairment of goodwill, which reflects overpayment for goodwill and is therefore not really an operating expense (more of a financing cost) and finally profit/loss on sales of assets, which again is not an operating income/cost (as depreciation should reflect the effect of changes in value of assets).

Adjustments for accounting issues mainly relate to pension and lease accounting. Finally, adjustments must be made for results from discontinued operations which, by their very nature, are not part of the underlying operations of the business.

Cash Flow Statement Adjustments

The cash flow statement will not be a focus for adjustment as a historic cash flow statement is not included in a financial forecast. If the adjustment is part of a comps analysis, then the adjusted profit for the period from the income statement would be the starting point for the operating cash in the cash flow statement. This way, the operating cash flow incorporates all income statement adjustments. The only other adjustment that may be required is the removal of any cash flow from non-core assets, which would be included in financial income.

Balance Sheet Adjustments

In the balance sheet, the key adjustments to be made are the separation of non-core assets from underlying capital. The three main non-core items are associates, asset/liabilities held for sale (now separated out under IFRS) and investments, in effect anything that is not consolidated or that is identified as for sale. Joint ventures are difficult to judge and should probably be included in noncore assets, but this will depend on the terms of the joint venture (buyout clauses, etc.).

Generally, associates (or any investment that is not consolidated) would be treated as a

non-operating item. As such, any income or cash flow from associates is not included in underlying returns and the investment in associates is excluded from the core assets in the balance sheet. If associates are included in the core operations of the business (e.g. if there is a very strong trading relationship with the associate), then associate income would be incorporated in operating income and the investment in an enterprise value calculation. Depending on the degree of disclosure (it helps if the associate is quoted), the associate results can be incorporated to varying degrees of detail.

Key learning points:

1. Historic accounts include various items that do not relate to the underlying performance of a company. Historic accounts must therefore be “cleaned” up before they are used to compare companies or forecast forward returns.
2. The main adjustments made to the income statement ensure only continuing items are included, that one-off items are excluded and that accounting anomalies such as pension costs are adjusted for.
3. The main adjustments to the balance sheet relate to non-core assets being removed.