Investors must adjust a company’s financial statements for two primary reasons: (1) to better reflect the firm’s underlying economics and (2) to better facilitate comparison of companies using different accounting estimates or reporting under different accounting regimes. In the next article, I discuss financial ratio analysis. These ratios should be based on adjusted financial figures, so this article and the next can be read in conjunction.
Determining which financial statement items warrant adjustment and which do not is a subjective undertaking. There is no single accepted approach to making such adjustments. I present in this article the broad approach which we follow at Tortuga Capital, but I encourage investors to customize the approach to suit their specific purposes. I should also note that we do not always make comprehensive adjustments. Thus, we may adjust one financial statement with no corresponding adjustment to another.
- NORMALIZING OPERATING INCOME
A firm’s equity and credit investors are more concerned with the company’s ability to generate sustainable earnings than they are with the firm’s reported profits. Particularly, equity investors are interested in the capitalization of a company’s earnings power for valuation purposes. Credit investors are interested in a company’s ability to meet interest and principal payments on credit instruments. To develop estimates of sustainable earnings, investors must segregate true operating earnings from income items which are nonoperating or nonrecurring.
I suggest investors follow a two-part approach for handling nonoperating and nonrecurring items: (1) identify any items within operating earnings which are outside of a company’s recurring business operations, (2) determine which of these nonrecurring items should be provisioned for or eliminated entirely and adjust income accordingly. Through this process investors will not naively ignore these items. The goal is for the investor to develop her own income statement for the company which is better suited for valuation and credit analysis. The investor should perform this analysis for several years of financial data. For non-cyclical firms, three years of analysis may suffice but five years is recommended. For cyclical firms, investors should look at the company’s financial performance going back at least two business cycles.
2.1. Identifying Nonrecurring Items
Investors must first identify items which are least likely to persist. Not all nonrecurring items are separately disclosed on the income statement. The investor must carefully read the footnotes and the management’s discussion and analysis (MD&A) section of the annual report to identify such items. These nonrecurring items are often described by management as nonrecurring, extraordinary, one-time, or unusual, so investors should be aware of such terms. An efficient way to identify such items is to highlight them in the disclosures so they can be clearly identified later.
The following is a list of frequent sources of nonrecurring items:
- Gains or losses on investments
- Gains or losses on fixed-asset sales
- Fixed-asset impairments
- Inventory impairments
- Restructuring charges
- Litigation charges
- LIFO Liquidations
2.2. Adjusting Income for Nonrecurring Items
Determining which items should be eliminated and which items should be included in the calculation of normalized (sustainable) earnings is subjective and will require the investor to use considerable judgement.
In general, the investor should ask the following: Does the item have any explanatory value for future earnings and cash flows? If the answer is yes, the item should be provisioned for in the calculations of normalized earnings. If the answer is no, the item should be eliminated from calculations of normalized earnings. Although the analysis will be specific to the company and to the nonrecurring item, the following list serves as guidance for investors:
- Gains or losses on investments: For a typical non-financial firm, gains or losses on investments will be incidental to their core operations. These gains or losses should be considered transitory and removed from operating income.
- Gains or losses on fixed-asset sales: Asset-intensive companies may regularly dispose of fixed-assets; thus, such gains or losses should be included in operating income. The investor should provision for such items based on either the company’s average historical experience or industry averages. If a company is not asset-intensive, the gains or losses should be considered transitory and eliminated from the calculation of normalized operating earnings.
- Fixed-Asset Impairments: Asset impairments arise for a variety of reasons. For example, an asset impairment may indicate that management overpaid for the asset, in which case the impairment is informative to investors regarding management’s ability to allocate shareholders’ capital. The asset may also become impaired because the economy is in a recession. Generally, an impairment provision should be recognized in normalized earnings for an asset-intensive firm.
- Inventory Impairments: Inventory impairment charges are not unique for inventory-intensive companies (for example, retailers). However, the extent of an impairment in any given year may be abnormal. When calculating the normalized earnings for such companies, the investor can include a provision for future impairments using either the firm’s average historical charges or industry averages.
- Restructuring Charges: In today’s dynamic economy, restructuring charges may be frequent. The general rule is the more diversified a firm, the more likely it will have recurring restructuring charges. However, if a firm is in a narrow business field, restructuring charges may be considered infrequent. For most large corporations, however, the investor should include a provision for future restructuring charges.
- LIFO Liquidations: Firms which use LIFO accounting may have understated inventory carrying costs. If a firm sell older inventory “layers”, the firm will show a transitory gain by understating COGS and overstating gross margins. Such a gain is known as a LIFO liquidation. The LIFO liquidation should be disclosed in the inventory footnote. The investor should add this amount back to COGS.
A firm may present nonrecurring items on either a pre-tax or after-tax amount. Investors should look at item-by-item income statement trends. Thus, investors should adjust all relevant items within the income statement on a pretax basis. If the item is presented net of tax, the investor can “gross up” the item with the following formula:
(nonrecurring item) / (1- tax rate).
- ADJUSTING THE BALANCE SHEET
Investors should make certain adjustments to the balance sheet to (a) recognize obligations or assets which are not currently on the balance sheet and (b) reflect assets at estimated current market values. The resulting adjusted balance sheet is referred to as a current cost balance sheet and will better reflect the net resources available to the company’s credit and equity investors. This section outlines some adjustments which an investor should make to create a current cost balance sheet.
3.1. Adjusting for Operating Leases
Until new lease accounting rules are implemented, operating leases will not appear on the balance sheet. However, operating leases generally represent a contractual obligation and investors should recognize the liability on the balance sheet. Investors can use footnote disclosures to make the necessary calculations.
Under U.S. GAAP, firms must separately disclose the next five years of minimum lease payments (MLPs). Firms must also provide a lump sum for the MLPs beyond the five years. The investor must determine the average yearly MLPs implied in the lump sum. For ease of calculation, the investor would generally divide the lump sum by the year-5 MLP. This result will give the investor the estimated number of years of MLPs.
For example, suppose a firm’s lease footnote presents the lump sum “thereafter” portion of the lease payments as $1,070,000 and the year-5 MLP as $100,000. The investor can estimate the number of years of lease obligations by dividing the lump sum amount by the year-5 MLP: $1,070,000 / $100,000 = 10.7 years. Assuming payments in this period are equal to the year-5 payment, the company would have $100,000 payment each year for 10 years, with a final $70,000 payment made in year 11. The investor now has five years of lease payments which have been explicitly disclosed, and 11 years of lease payments which she has inferred through the above calculations. The next step is for the investor to discount all the lease payments by either (a) the firm’s long-term borrowing rate as implied on its outstanding debt, or (b) the rate implied on comparable capital leases. The investor would then adjust the balance sheet to recognize the present value of the lease payments as a leased asset and a corresponding lease liability (component of debt). The investor can further separate the lease liability into a current and a long-term component.
If the investor wishes to recreate the income statement effects of a capital lease, the investor must (a) remove the lease payment from rent expense, (b) calculate the interest component of the lease payment, and (c) determine the straight-line depreciation on the leased assets. To calculate the interest component of the lease payment, the investor would multiply the interest rate by the present value of the lease (the lease liability). If the investor is preparing a multi-period earnings forecast, the investor would calculate the interest expense for each lease payment using an amortization schedule. To calculate the depreciation expense, the investor would divide the value of the leased assets by the remaining lease years.
3.2. Adjusting for LIFO Inventory
Firms using LIFO accounting are may have inventory carrying costs below replacement value. Firms using LIFO are required to provide a disclosure showing the difference between inventory valued under FIFO and inventory valued under LIFO. This disclosure is the LIFO reserve. An investor can calculate approximate inventory replacement cost by adding the LIFO reserve to the inventory balance sheet amount.
3.3. Adjusting for Long-term Assets
The general rule is that highly specialized assets should be kept at book value, while more generalized property, such as office buildings or warehouse space can be adjusted to market values. The details of the company’s property are provided in footnote disclosures. Investors can estimate market values of property in several ways. The most reliable way is to utilize commercial real estate data-sources such as LoopNet™. Investors can use such sources to search for comparable sales data on each property listed in the footnote. For investors who do not have access to such services, the property appraiser in the jurisdiction of each property can provide useful information. Also, the company itself may have recently sold property comparable to its other properties, and the details of such transactions can be used to estimate fair values. Regardless of the approach used, the investor should always be conservative in her estimates.
Investors should generally remove goodwill when creating a current cost balance sheet. However, investors should not ignore goodwill all together. A company with significant and recurring goodwill write-offs indicates that management has an undisciplined acquisition strategy.
3.5. Capitalized Interest
Interest which is capitalized into the carrying cost of an asset should be removed from the asset and placed into interest expense. This adjustment will allow for (a) better comparison with firms which use non-debt financing for asset purchases, and (b) more conservative calculation of interest coverage ratios.
3.6. Segregation of Nonoperating Assets
The investor should identify any assets which are not a part of the firm’s core operations. Once identified, these assets should occupy a separate section within the current cost balance sheet. By segregating assets which do not support the generation of operating earnings, as described above, the investor can analyze the firm’s operations against the corresponding assets. This adjustment also allows equity and credit investors to identify those assets which the firm can sell without impeding the firm’s operations.
- ADJUSTING THE CASH FLOW STATEMENT
Recall that the cash flow statement reports cash flow in the following categories: cash flow from operations (CFO), cash flow from investing activities (CFI), and cash flow from financing activities (CFF). From an investor’s standpoint, however, not all items are appropriately classified. Thus, investors must adjust the CF statement to improve its usefulness. Like the other financial statements, investors should make these adjustments to several years of statements and look at trends in the adjusted numbers.
Adjusting the cash flow statement involves several steps: (1) reclassifying certain items from or into CFO, (2) identifying non-sustainable sources of operating cash flow, (3) separating CFO into sustainable and unsustainable components, (4) calculating and presenting free cash flow, defined as the sustainable portion of CFO minus capital expenditures.
4.1. Reclassifying Items from or into CFO
Several items included in the CFO section are better classified as either CFF or CFI. Likewise, several items included in either CFF or CFI are better classified as CFO.
- After-tax cash interest payments should be reclassified from CFO into a separate item within CFF. The interest expense should be tax adjusted by multiplying the interest paid by (1 – marginal tax rate).
- Capitalized interest should be reclassified from CFI to CFF
- Share repurchases are shown within CFF. This classification is appropriate when the share repurchases are a means of returning cash to shareholders, in which case they are considered like a dividend. However, for companies which issue employee stock options, a portion (if not all) of the share repurchases will merely offset the dilution from employee stock option exercise. This portion of share repurchases should be reclassified as a recurring component of CFO.
4.2. Identifying and Separating Unsustainable Components of CFO
Unsustainable items in CFO generally arise from the following areas:
- The corresponding cash flows of any items identified as nonrecurring in the calculation of normalized operating income (see section 2 above) contained in CFO should be considered unsustainable sources or uses of CFO.
- A sizable increase in payables should be considered a nonrecurring source of CFO.
- A sizable decrease in receivables should be considered a nonrecurring source of CFO.
- A sizable decrease in inventory should be considered a nonrecurring source of CFO.
Investors should remove the cash flow effects of these items into a separate section titled Unsustainable Sources of CFO. The remaining items within CFO should thus be titled Sustainable Sources of CFO.
4.3. Calculating Free Cash Flow
As investment manager Bruce Berkowitz has stated, “free cash flow is the well from which all returns are drawn.” Free cash flow is a somewhat opaque concept. For valuation purposes, I advocate a calculation utilizing both normalized earnings, as described above, and working capital and capital expenditure trends. However, having a “true” free cash flow measure is highly valuable. For the purposes of the adjusted cash flow statement, we calculate free cash flow (FCF) as the sustainable portion of CFO minus capital expenditures. Since we have reclassified interest expense from CFO into CFF, the FCF figure is the amount available for (1) debt service, (2) acquisitions, (3) dividends, or (4) share repurchases.
Capital expenditures include both maintenance expenditures and growth expenditures. Maintenance expenditures are those expenditures which are necessary to maintain the business in its current state, while growth expenditures are discretionary. Ideally, investors would use only maintenance expenditures when calculating FCF. However, firms may not provide disclosures on the components of capital expenditures, and investors must either (a) make assumptions based on other disclosures or industry trends, or (b) use total capital expenditures in the FCF calculation. Generally, negative FCF is a warning sign indicating that the survival of the firm is in question. However, often healthy firms may have negative FCF if they are aggressively expanding. For example, home improvement retailer Lowe’s had negative FCF for many years, despite showing healthy profits and returns on capital. The negative FCF was due to high levels of growth related expenditures from the aggressive expansion in the number of stores. This example shows that investors should attempt to understand the composition of a company’s capital expenditures before making any conclusions based on FCF.
Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer. Financial Reporting & Analysis, 6th ed. New York: McGraw-Hill, 2015.
Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn. International Financial Statement Analysis, 3rd ed. Hoboken: Wiley, 2015.
White, Gerald I., Ashwinpaul C. Sondhi, and Dov Fried. The Analysis and Use of Financial Statements, 3rd ed. Hoboken: Wiley, 2003.
 The current liability component is the present-value of the first year’s lease payment
 An amortization schedule shows a period-by-period reduction in the lease liability from the application of the “principal reduction” component of each lease payment. The interest component of each payment is determined by this decreasing balance in the lease liability and thus will change for each period.
 Benjamin Graham and David Dodd, Security Analysis (6th ed.) (New York: McGraw-Hill, reprint 2009), 339
 I describe this free cash flow calculation in detail in the equity analysis article series.