In simple terms, the standard accounting income statement is nothing more than “Revenues – Expenses = Profit or Loss”. This applies to any company in any industry in any country around the world. It just so happens that “revenues” come in many shapes and sizes, such as “sale of goods”, “rendering services”, “interest income”, “royalty income”, etc. Expenses are likewise broken down into several descriptive line items such as “salaries expense”, “rent expense”, “utilities expense”, etc. When these line items are brought together, the resulting income statement is significantly longer than the simple “Revenues – Expenses = Profit or Loss”.
Tucked away somewhere towards the end of the income statement maze is an expense item called “interest expense“. The presence of interest expense means that the company incurred interest-bearing debt. Corporate finance literature is overflowing with arguments about the pros and cons of interest-bearing debt in the balance sheet. Suffice to say that debt is a double-edged sword: it is a powerful tool if used properly, but a destructive force if used inappropriately. Too much debt is obviously bad, but sometimes, too little debt is not always good.
Accounting Income Statement
| + | Sales |
| - | Cost of goods sold |
| = | Gross profit |
| - | Operating expenses |
| = | EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortizaiton) |
| - | Depreciation expense |
| - | Amortization expense |
| = | EBIT (Earnings Before Interest & Taxes) |
| - | Interest expense |
| = | EBT (Earnings Before Tax) |
| - | Income tax |
| = | Net profit or loss |
For most companies, the income statement is supposed to measure operating performance for any given 365-day period (some companies have an operating year greater than 365 days). This 365-day period could follow the regular calendar year or it could be any other cycle such as July 01 to June 30. “Operating performance” is often condensed into one line item: the popular “bottom line” called “net income” or “net loss”. In fact, the financial markets are so addicted to this bottom line as evidenced by the popularity of “EPS” (Earnings Per Share) and “P/E Ratio” (Price to Earnings Ratio), specially among newbie investors.
Take a moment to appreciate the beauty of the detailed accounting income statement above. It uses only two mathematical operators: addition and subtraction. What does this mean? A line item that benefits the company is added, while a line item that does not benefit the company is subtracted. In simple terms, running a business is nothing more than a benefit vs. cost trade-off: performance is considered good if benefits exceed costs.
Now pause for a while and think about it: what specific types of benefits and costs should we be focusing on? Which is better: benefits that repeat day after day, month after month, and year after year? Or benefits that happen only once (i.e. a “one-off“)? Benefits that recur are called “operating revenues”, while “one-off benefits” are called “non-operating revenues”. Revenues (or benefits), however, are not free. The company has to incur some type of cost in order to generate a benefit. In Filipino, it means “bawal ang hulog ng langit”. It follows then that generating recurring revenues requires incurring expenses that likewise recur. These recurring expenses are called “operating expense”. Popular examples of “operating expenses” are “salaries expense”, “rent expense”, and “utilities expense”. From the income statement, it’s clear that if benefits exceed costs, then operating performance is good and the company reports a profit.
Turn your attention now to the line item “interest expense” in the income statement above. Strictly speaking, “interest expense” is not an operating expense. Rather, “interest expense” is what’s known as a “financing expense” that is directly related to the decision to borrow money. The act of borrowing money is considered a non-recurring “financing activity”, in contrast with recurring day-to-day operating decisions. Accounting standards allow interest expense to be deducted in the income statement along with all the other operating expense items, in order to arrive at the amount for “Earnings Before Tax”. This means that interest expense reduces the taxes obligations of the company. From a philosophical perspective, whether this is proper or not is a matter for debate in a different forum. For our analysis, what’s important to keep in mind is that accounting standards consider “cost of debt” as one of the items that a company should recover when assessing performance and calculating net income.
What exactly is a “finance activity” or a “financing decision”? A financing activity such as borrowing money from a bank is a decision to fund the business with debt (as opposed to funding with equity investments from owners). Is it possible for a company to be financed with 100% equity? Yes. In fact, all companies start out with equity investments from owners. Is it possible for a company to be financed with some mix of debt and equity? Yes. There’s an abundance of empirical research that talk about an optimal capital structure, but we won’t get into that. Is it possible for a company to be financed with 100% debt? Definitely not. Such a company would be considered bankrupt.
Given that interest expense is due to a conscious financing choice by management to borrow money, and that accounting standards allow interest expense to be deducted as an expense in the income statement to calculate net income, is there a similar income statement treatment for the cost of equity financing? The unfortunate answer: NO. The income statement does not contain any line item that pertains to “expense related to equity financing”. If lenders are paid interest, the corresponding payment to equity owners is called “dividends“. Accounting standards require dividends to be taken from net income; i.e. dividends are not considered an expense in the income statement. In fact, all rewards given to equity owners are not considered expenses.
The implication of this is that the income statement does not adequately measure the totality of the company’s annual performance. The income statement measures benefits in excess of operating expenses and cost of debt only. The income statement does not answer the question, “do revenues exceed the rewards given to owners?”.
This shortcoming of the income statement is addressed by Economic Profit (EP), a metric that measures the ability of a company to generate benefits in excess of all sources of capital (i.e. both debt and equity). In simple terms, payments to lenders and rewards to owners are deducted from operating results to determine value creation or destruction. A positive number is called economic profit and is viewed as creating value for the business. A negative number is called economic loss and is viewed as destroying value for the business.
Economic profit is estimated as follows:
Economic Profit = Invested Capital x (ROIC – WACC)
Invested Capital (IC) is the sum of the productive operating assets (except cash) such as PP&E, intangible assets (except goodwill), biological assets, and net working capital (NWC).
Net working capital is estimated as follows:
NWC = Working current assets (WCA) – Working current liabilities (WCL)
WCA = Current assets (CA) – Cash – Investments in financial instruments
WCL = Current liabilities (CL) – Interest bearing debt (IBD)
Return on Invested Capital (ROIC) measures the profitability of the operating assets and liabilities used in the day-to-day operations. Expanding a business just for the sake of expansion and without proper consideration of the potential benefits is not always a good idea. This type of reckless empire-building could result to low ROIC and value-destruction. There are different ways to estimate ROIC as well as several variants such as Return on Assets (ROA) and Return on Equity (ROE). For our analysis, we estimate ROIC as follows:
ROIC = NOPLAT / Invested Capital
Net Operating Profit Less Adjusted Taxes (NOPLAT) is a non-standard accounting metric that measures after-tax operating performance without considering the distortion caused by interest expense (i.e. debt financing decisions). The idea behind NOPLAT is that it does not matter how a business obtains funding. If the business needs Php 1,000,000 to operate, it should not matter if it is in the form of debt, equity, or a mix of both. The Php 1,000,000 should generate the same operating income (EBIT) regardless of the funding source (i.e. debt or equity).
Example: ABC Corp. needs Php 1,000,000 to fund a project. The funding is either 100% debt or 100% equity. Assume 10% interest rate and 30% tax rate.
| WITH DEBT | NO DEBT | ||
| + | EBIT | 1,800,000 | 1,800,000 |
| - | Interest expense | (100,000) | 0 |
| = | Earnings before tax | 1,700,000 | 1,800,000 |
| - | Tax | (510,000) | (540,000) |
| = | Net income | 1,190,000 | 1,260,000 |
Regardless how the Php 1,000,000 is sourced, the EBIT should be the same. Debt financing gives rise to interest expense, which is a tax-deductible expense that leads to a lower net income. NOPLAT is essentially the “NO DEBT” column; i.e. the tax rate is multiplied to EBIT, not to earnings before tax. In our analysis, we use the statutory tax rate of 32% in estimating NOPLAT, which may or may not be the same as the effective tax rates for any given year.
The Weighted-Average Cost of Capital (WACC) is nothing more than the cost of debt and cost of equity blended together based on their corresponding proportions. In our analysis, the use of WACC is to estimate EP, not for valuation purposes. As such, we will not waste time calculating a detailed WACC for each company. For each company, we will estimate two values for EP using WACCs of 10% and 15%. This will be complemented by an EP matrix showing the EP for a range of WACC.
