Reformulating the Balance Sheet

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Most of us are familiar with the classified balance sheet where assets and liabilities are categorised based on longevity – current or non-current. This is the conventional practice, but it is not perfect. For example, in calculating the traditional Return on Assets (ROA) as a measure of operational efficiency, the denominator includes peripheral assets which reduce the calculated value. Companies with investment properties, high cash balances are penalised. To deal with imperfections of the conventional balance sheet, we will be reformulating the balance sheet based on Stephen H. Penman’s teaching.

Instead of classifying assets and liabilities according to their longevity, the balance sheet is now reformulated based on their utility – operational or financial. Assets and liabilities are first rearranged into either operating or financial assets/liabilities. Some examples are included in the table below.

Financial assets Investment securities, excess cash and investment properties
Financial liabilities Short term and long term debt, lease obligations and preferred stock
Operating assets PPE, accounts receivable, working cash
Operating liabilities Accounts payables, accrued liabilities, tax payables

The reformulated balance sheet is balanced in the following manner:

Net Operating Assets (NOA) = Operating Assets – Operating Liabilities

Net Financial Obligations (NFO) = Financial Obligations – Financial Assets

Common Shareholders’ Equity (CSE) = NOA – NFO

How do we utilise this new balance sheet? We go back the issue raised in calculating ROA based on the conventional balance sheet. We now have the flexibility of using NOA as a denominator, as opposed to total assets in typical calculations. Similarly, since we are concerned with the amount of returns accruing to the net operating assets, our numerator should correspondingly reflect operating income, rather than net income. I believe this method of calculation will provide a much fairer reflection of a company’s true operating efficiency.

There are of course many other ways in which we can play around with the reformulated balance sheet. For example, investors who are concerned about the loss of information with regards to their longevity can further sub-categorise them based on longevity, after having done the operation/financial split. The number of ways to use the reformulated balance sheet is only limited by your imagination. Many of such adjustments have been covered by Penman, but I find them to be too arcane and pedantic to be of significant use. However, for those who are interested, do check out his book – Financial Statement Analysis and Security Valuation.

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