Question

Explain why a company’s past balance sheets and income statements need to be reformulated in order to be useful for forecasting future residual operating income.

Answer tips: Discussion of need to reformulate balance sheet and income statement to differentiate between operating and financial performance is the key task here. In addition, the need to distinguish between recurring and non-recurring items in the income statement to facilitate forecasting of future performance should be discussed.

Answer 1

Reformulation refers to making the financial statements for a particular period, then changing them, reorganizing the items they contain in order to more accurately depict various aspects of the business. Reformulating financial statements means rewriting them to allow clearer examination of different aspects of the company's business. Financial statements include key documents like the income statement, the statement of shareholders' equity and the balance sheet that provide information on business finances. Companies use these to make many operational decisions, while investors use them to examine businesses and industries from the outside.

Instead of classifying assets and liabilities according to their longevity, the balance sheet is reformulated based on their utility – operational or financial. This could be relevant to a potential buyer who could settle the loan or get better financing. Splitting up the information this way makes it easier to show whether the day-to-day activity of the business is fundamentally profitable. Assets and liabilities are first rearranged into either operating or financial assets/liabilities.

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

               

A business can also reformulate there financial transaction as Recurring and Non-Recurring, like those transactions that are part of its regular activity and those that might not reoccur.

For example, the amount the business spent on rent is a reasonable guide to future expenses: if it's too high, the company's outlook appears bleak. On the other hand, a big loss caused by an unfavorable currency exchange rate change between taking an order from a foreign client and receiving payment is more likely a one-off; dealing with that client might be more profitable if exchange rates are more stable in future.