reclassification

WHERE WE STAND
An annual report is a comprehensive model describing firm’s activity and exchanges. Balance sheet and income statement together
describe the company in terms of numbers. They are tools used to transform a series of decision into numbers, so to be able to
compare them. This is done because:

1. The law requires it for tax provision

2. To assess whether the company is economically viable. We need to be able to follow the trend/course/progress of the company
using a unit of value, i.e. money + build the annual report in such a way that results of year 1 can be compared with results of
year 2

Through the annual report it is possible to determine

The available resources and their mix and the changes taking place from one year to the other

The ability of the firm to honor its obligations vis à vis its stakeholders and the ability to generate an income

The financial flows

However, the net income is not "real income", but rather a number that reflects the dynamics of economic activity that took place
within a specific time interval. These dynamics have to do with:

How the mix of resources change

How cost and revenues balance [economic situation]

Whether cash in and out balance

The problem is that we have arbitrarily defined a stop in December 31st for an economic activity that will be ongoing and which will
have to be consistent with next years. This datum was built in such a way that can be compared also with other companies in same
or ≠ sectors.

SWEET POTATO CASE - SOLUTION ANALYSIS

At the end of the year, is it economically viable?

1. One year only

2. Covering costs⇒ economic equilibrium

But, they have no cash [140k under] ⇒The company is in economic equilibrium, but not monetary equilibrium net income can be
seen as wealth of company. It will go in the balance sheet in order to increase the quantity of own funds. Shareholders will be
rewarded only if there is a net income, part of which needs to be used to remunerate them because otherwise they may decide not
to invest in the company anymore.
At the end of year 2?

Net income has been redistributed as follows:

60k has been used to remunerate shareholders

At least 5% [16k]needs to stay in the company as legal reserve [= portion of net income that the law requires to stay in the
company], unless it is a non-profit [all net income has to be reinvested in company]

The remaining 243k, the company decides to keep it inside the company because it's the first year and limits the distribution of
dividends = extra-reserve

The company is strengthening from the patrimonial pov [assets grew], however the situation is worse from a cash pov [owes about
471k] and economic pov since we have a loss [no net income] ⇒
both in economic and monetary/liquidity tension

What happens when you have a loss? Shareholders are not remunerate and the company's own funds are eroded.

⇒ If we look at economic viability over time, we are interested in the trajectory. So, we are also interested in predicting whether the
company will be viable in the future

[8.6] RECLASSIFICATION
Reclassification provides more info on the economic health of a company, it relates the various components on which viability
is based to the nature of the activities that have generated economic and financial values + is a tool to orient decisions
regarding future management

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 WHY WE DO IT:

To obtain more info on how results are generated

To put info in relation

To orient future decisions

⇒ i.e. aim is to figure out where problem is and how we can solve it
INCOME STATEMENT
WHAT: How different types of operations contribute to the formation of net income and what would ideal situation be. Thus, we can
appreciate the quality of company’s decisions concerning the various operations carried out by a company.
We take all the info in income statement, we transform a 2-sided table into a list of plus and minuses starting from net revenues all
the way to net income.

Total should not change [otherwise a mistake was made]: starting from same tot. revenues, the same net income should
‼
result from the operations.

WHY: As a diagnosis to orient future decisions

WHAT ARE WE LOOKING FOR:

We obviously would like our net income to be as high as possible

We want our net income to derive as much as possible from core operations

The criterion for reclassification proposed responds to the desire to isolate the contribution of ≠ categories of operations
to the formation of income for the accounting period. Therefore, the various items on it are added or subtracted to tot
revenues, isolating:

Core operating activities: purchase and transformation of raw materials and the sale of final products, related to the company's
activity

Income from asset management: linked to the choices on how to invest savings or extra liquidity generated by core activities.
Often reclassification includes proceedings from asset to financial management activities although conceptually asset mngmt
activities are tightly related to core ops.

Financial management: objective is the identification of the most appropriate ways to cover the company's financial needs

Extraordinary operations: ops outside the company's core activities, that are difficult to anticipate and are characterized by
being non-recurring

Tax management: calculation and payment of taxes and fees

Getting to the operating income [EBITDA] = revenues - COGS

They relate directly to the revenues, e.g. costs of goods sold, or relate to the period covered by the account, e.g. staff expenses

For a manufacturer, are the expenses incurred for raw materials, labor and overheads used in the production of its goods

For wholesalers and retailers, are essentially the purchase cost of merchandise used for resale

For service-related firms, are the cost of services rendered or cost of revenues

RECLASSIFICATION:
Revenues
-operating costs
-----------------------------------------

EBITDA
-Depreciation and amortization
-----------------------------------------
EBIT [operating income]

-Interests
-----------------------------------------

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 Earnings before taxes [EBT]

-Income taxes

-----------------------------------------
Net income or loss

-Dividends
-----------------------------------------

Retained earnings

LIBRO:
Starting from revenues from sales, first of all the positive and negative income components relating to core operations are
identified. The sum of these items is defined as the Cost of Goods Sold (COGS).

The difference between revenues and COGS provides a first, intermediate indicator called Operating Income from Core
Operations.

Subsequently, income and losses deriving from assets management are added, i.e. from the investment of the savings generated
by core operations. The algebraic sum between Income from Core Operations and the result of asset management leads to
Operating Income. The subtraction of financial expenses determines the Gross Income, to which the income/ losses deriving
from extraordinary management will be added or subtracted. If the algebraic sum between Gross Income and the result of
extraordinary operations (called Earnings Before Taxes) produces a positive result, it will be necessary to subtract the value of
taxes to calculate the Net Income for the accounting period.

=> The availability of a re-classified Income Statement not only allows for quantifying the wealth created by the company in a given
period of time, but also to evaluate the quality of this wealth in terms of overall viability of the company

COGS [Cost of goods sold] = sum of items from revenues

O.I. for core ops = revenues - COGS

O.I. = O.P. for core ops + result of asset management

Gross income = O.I. - financial expenses

EBT = gross income + result of extraordinary ops

Net income = EBT - taxes

QUALITY OF NET INCOME:

From pov of operating profit, C is the best. However, it has a lot of financial costs. Why? Because being profitable has boosted
growth and asked for a loan? However, if there would be a change in the environment C would suffer more than the others.
Therefore, from financial expenses pov, B is the best.
If we take into consideration core and financial operations together, A is the most balanced.

Company D is the most worrisome because we have a loss [financial expenses eat up all operating profit], which is compensated
for extraordinary items, which are not guaranteed in the following years.

⇒ most likely company A and C will do fine in the next years, while B needs to increase profits.

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 Current assets = 70% = immediate liquidity + deferred liquidity + inventory

Current liabilities = net plant equipment + intangible + financial fixed assets = 30%
Third party finances = current liabilities + long term liabilities = 75%

Owned funds = equity capital = 25%

We are satisfied w.r.t current assets and liabilities, but you would be happier if liquidity > inventory, as cash is cash, accounts
payable leaves us relatively satisfied, and inventory in principle we know they are there, so you'll use them theoretically, but there're
almost always more. So, we're happy that current assets > current liabilities, but the issue is that inventory is high in the current
assets. Also there are too many finances from third parties, we're indebted, even though it's not that bas as 25% of your funds are
yours.

LIQUIDITY

Current assets > current liabilities = very liquid = less inventory

With higher inventory and less total = less liquid = current liabilities > current assets = owes lot of money

It is about having sufficient current assets to cover short term debt.

Liquidity has to do with the idea of "do I have cash in the bank?"

A has high incidence of current assets over current liabilities, so it is very liquid.

W.r.t B, B is less liquid not only because it has less in total but also because inventory in B is high.

C has lots of long-term liabilities, and C and D have same level of third-party liabilities but D is mostly short term, and C is
mostly long term, so you want to compare with the level of fixed assets. C is better as 800 net assets are covered by 1100 long
term liabilities, while the 900 net assets of D but 300 of medium-long term liabilities are covered by just 300. would say B is
very illiquid, so risky, as it owes a lot of money, so lot of more current liabilities than current assets. It risks liquidity tension. D
has lots of fixed assets and too much current liabilities, no balance between the assets and liabilities sides. C may be better as
it has less inventories so it is nicely liquid and has lots of medium to long term liabilities, still you should reduce the debt a bit
because the capital is low. C would be very okay when interests rate is low. Instead, when there's a lot of incertitude and capital
A is better.

Long term liabilities are better generally because you have more time to repay, but if the structure has a lot of current assets, then
you have lot of cash, and you can pay back what you have to.
When reclassified > net asset is the net of depreciation funds, i.e. net assets = assets - depreciation funds

BALANCE SHEET

WHAT: reorganization of assets as a function of how much time (and costs) are needed to turn them into cash (liquidity), and that of
liabilities as a function of how soon they will have to be repaid to the providers of funds (collectability).

WHY: goal of comparing the structure and composition of assets and that of liabilities.
WHAT ARE WE LOOKING FOR:

A progressive growth in net total assets

flexibility: the higher current assets over fixed assets, the more flexible the company (a street vendor vs Gucci flagship store).
However, please note that fixed assets help you in rainy days

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 Incidence of third parties liabilities on total liabilities: we do not want too much debt, as it could mine autonomy and income

Balance between the structure of asset and liabilities

We are looking for economic and monetary equilibrium. Can look at cash balance, but also debt receivables ⇒
want to relate
current assets and current liabilities and get a better understanding of company's monetary situation. Want to see them aligned

From liabilities side, you want to control the relative importance of equity vs. the amount of funds you owe to sb else
⇒ Reorganize info in order to be able to see whether asset and liabilities balance, current a and l balance and whether current
funds and financing are equal. The more it is true, the more it will enable your company to last over time.
Structure remains in 2 sections
Values of assets and liabilities are recorded net of the corresponding depreciation provisions

Plant and equipment net of the respective depreciation provisions

Credit balances net of the write-down provision

Assets are ordered according to the criterion of decreasing liquidity.

Current assets include resources already available in the form of cash, securities, receivables and the revenue services,
inventories

Fixed assets are resources that can be transformed into cash in long time periods, and not without uncertainty. There are
various types: tangible or technical or financial

Liabilities are ordered based on maturity, i.e. the deadline by which the company must meet the commitment they represent

Short-term debts: usually due within the accounting period

Medium to long-term debts

Resources provided by providers of capital are "permanently" available to the company

⇒ reclassification according to the criterion of liquidity/collectability allows for comparing the asset and liabilities structure of the
B.S. + for expressing 3 fundamental types of judgements

1. Composition and structure of assets in terms of flexibility: the greater the incidence of net fixed assets on tot assets, the
greater the structural rigidity of the company. There are more fixed costs and thus the profitability is more vulnerable in the
event of a drop in demand, i.e. a more rigid firm has more variability of its results and is therefore more risky

2. Composition and structure of liabilities in terms of incidence of loan capital on tot liabilities and their mix : the greater
the incidence of short-term debt, the more the company will have to face "pressing" payment obligations and will have more
difficulty reaching monetary equilibrium, i.e. while the company is still investing and generating income from it, it has to pay
back short term debt simultaneously. Also, indebtedness in the short-term is subject to oscillations in interest rates and the
impact on future income equilibrium is harder to foresee

3. Consistency between the asset and liability structures : the greater the ratio between current assets and liabilities, the
more likely it is that the company will succeed in meeting its payment obligations in the immediate future. To the extent that
current assets are made up of immediate liquidity and inventories, rather than receivables

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