Reorganizing the Accounting Statements: Key Concepts  209
will lead to an inconsistent definition of ROIC; the numerator and denomina-
tor will include unrelated elements. If one-time items such as a major litiga-
tion settlement are reported, exclude them from NOPAT as well. One-time 
items are important to analyze, but make trends in core performance difficult 
to identify.
Finally, since reported taxes are calculated after interest and nonoper-
ating income, they are a function of nonoperating items and capital struc-
ture. Keeping NOPAT focused solely on ongoing operations requires that 
the effects of interest expense and nonoperating income also be removed 
from taxes. To calculate operating taxes, start with reported taxes, add back 
the tax shield from interest expense, and remove the taxes paid on non-
operating income. The resulting operating taxes should equal the hypo-
thetical taxes that would be paid by an all-equity, pure operating company. 
Nonoperating taxes, the difference between operating taxes and reported 
taxes, are not included in NOPAT, but instead as part of income available 
to investors.
Free Cash Flow: Key Concepts
To value a company’s operations, we discount projected free cash flow at a 
company’s weighted average cost of capital. Free cash flow is the after-tax 
cash flow available to all investors: debt holders and equity holders. Un-
like “cash flow from operations” reported in a company’s annual report, 
free cash flow is independent of financing flows and nonoperating items. 
It can be thought of as the after-tax cash flow that would be generated if 
the company held only core operating assets and financed the business 
entirely with equity. Free cash flow is defined as:
FCF
NOPAT
Noncash Operating Expenses
Investments in
Invested Ca
=
+
−
pital
As shown in Exhibit 11.3, free cash flow excludes nonoperating flows and 
items related to capital structure. Unlike the accounting cash flow statement, 
the free cash flow statement starts with NOPAT (instead of net income). As 
discussed earlier, NOPAT excludes nonoperating income and interest expense. 
Instead, interest is classified as a financing cash flow.
Changes in nonoperating assets and the gains, losses, and income asso-
ciated with these nonoperating assets are not included in free cash flow. In-
stead, nonoperating cash flows should be analyzed and valued separately. 
Combining free cash flow and nonoperating cash flow leads to cash flow 
available to investors. As is true with total funds invested and NOPAT, cash 
flow available to investors can be calculated using two methodologies: one 
focuses on how the cash flow is generated, and the other focuses on the 
recipients of free cash flow. Although the two methods seem redundant, 

210  Reorganizing the Financial Statements 
checking that both give the same result can help avoid line item omissions 
and classification pitfalls.
Reorganizing the Accounting Statements: In Practice
Reorganizing a company’s financial statements can be difficult, even for the 
savviest analyst. Which assets are operating assets? Which are nonoperating? 
Which liabilities should be treated as debt? Which count as equity?
In the following pages, we examine reorganization in practice using Costco 
Wholesale. (A complete valuation of Costco with commentary is presented in 
Appendix H.) Costco, the fourth-largest retailer in the world, is well known 
for selling everyday items in bulk. It has stores in Australia, Canada, Iceland, 
Japan, Mexico, South Korea, the United Kingdom, and the United States. 
The company entered China in 2019. We set the stage for analyzing Costco’s 
­financial performance by first reorganizing its financial statements into oper-
ating, nonoperating, and financial items.
EXHIBIT 11.3  An Example of Free Cash Flow
$ million
Accountant’s cash flow statement
Free cash flow
Current 
year
Current 
year
Net income
198
NOPAT
210
Depreciation
20
Depreciation
20
Decrease (increase) in inventory
(25)
Gross cash flow
230
Subtract 
investments 
in operating 
items from 
gross cash 
flow
Increase (decrease) in accounts payable
25
Cash flow from operations
218
Decrease (increase) in operating cash
(10)
Decrease (increase) in inventory
(25)
Capital expenditures
(70)
Increase (decrease) in accounts payable
25
Decrease (increase) in equity investments
(10)
Capital expenditures
(70)
Cash flow from investing
(80)
Free cash flow
150
Evaluate cash 
flow from 
nonoperating 
assets 
separately 
from free 
cash flow
Increase (decrease) in interest-bearing debt
(25)
Nonoperating income
4
Dividends
(103)
Nonoperating taxes
4
Cash flow from financing
(128)
Decrease (increase) in equity investments
(10)
Cash flow available to investors
148
Starting cash
5
Cash flow from operations
218
Cash flow from investing
(80)
Reconciliation of cash flow available
Treat interest 
as a financial 
payout to 
investors, not 
an expense
Cash flow from financing
(128)
to investors
Ending cash
15
Interest expense
20
Increase (decrease) in interest-bearing debt
25
Dividends
103
Cash flow available to investors
148