Reorganizing the Accounting Statements: In Practice  211 Invested Capital: In Practice To compute invested capital, we reorganize the company’s balance sheet. Exhibit 11.4 presents historical balance sheets for Costco, whose fiscal year ends on the Sunday nearest August 31. The version presented is slightly more detailed than the balance sheets reported in Costco’s annual reports, because we have searched the notes in each annual report for information about ac- counts that mix operating and nonoperating items. For instance, the notes in EXHIBIT 11.4  Costco: Balance Sheet $ million Assets 2015 2016 2017 2018 2019 Cash and cash equivalents1 6,419 4,729 5,779 7,259 9,444 Receivables, net 1,224 1,252 1,432 1,669 1,535 Merchandise inventories 8,908 8,969 9,834 11,040 11,395 Deferred income taxes2 521 — — — — Other current assets 227 268 272 321 1,111 Total current assets 17,299 15,218 17,317 20,289 23,485 Property, plant, and equipment 15,401 17,043 18,161 19,681 20,890 Deferred income taxes2 109 202 254 316 398 Other assets 631 700 615 544 627 Total assets 33,440 33,163 36,347 40,830 45,400 Liabilities and shareholders’ equity Accounts payable 9,011 7,612 9,608 11,237 11,679 Accrued salaries and benefits 2,468 2,629 2,703 2,994 3,176 Accrued member awards 813 869 961 1,057 1,180 Deferred membership fees 1,269 1,362 1,498 1,624 1,711 Current portion of long-term debt 1,283 1,100 86 90 1,699 Current portion of capital leases3 10 10 7 7 26 Other current liabilities 1,686 1,993 2,632 2,917 3,766 Total current liabilities 16,540 15,575 17,495 19,926 23,237 Long-term debt 4,864 4,061 6,573 6,487 5,124 Capital leases3 286 364 373 390 395 Deferred income taxes2 462 297 312 317 543 Other liabilities 445 534 515 607 517 Total liabilities 22,597 20,831 25,268 27,727 29,816 Costco shareholders’ equity 10,617 12,079 10,778 12,799 15,243 Noncontrolling interests 226 253 301 304 341 Total shareholders’ equity 10,843 12,332 11,079 13,103 15,584 Liabilities and shareholders’ equity 33,440 33,163 36,347 40,830 45,400 Note: Costco’s fiscal year ends on the Sunday nearest August 31. For example, FY 2019 ended on September 1, 2019. 1 Includes short-term investments. 2 Deferred taxes are aggregated in other current assets, other assets, and other liabilities in original filings. 3 Capital leases are aggregated in other current liabilities and other liabilities in original filings. 212  Reorganizing the Financial Statements Costco’s 2019 annual report reveal that the company aggregates capital leases in other liabilities. Since capital leases are a form of debt and must be treated as such, the balance sheet in its original form would be unusable for valuation purposes. Invested capital combines operating working capital (current operating as- sets minus current operating liabilities), fixed assets (net property, plant, and equipment), net other long-term operating assets (net of long-term operating liabilities), and when appropriate, intangible assets (goodwill, acquired intan- gibles, and capitalized software). Exhibit 11.5 demonstrates this line-by-line aggregation for Costco. In the following subsections, we examine each ele- ment in detail. Operating Working Capital  Operating working capital represents operat- ing current assets minus operating current liabilities. Operating current assets comprise all current assets necessary for the operation of the business, includ- ing working cash balances, trade accounts receivable, inventory, and prepaid expenses. Specifically excluded are excess cash and marketable securities—that is, cash greater than the operating needs of the business.1 Excess cash gen- erally represents temporary imbalances in the company’s cash position. We discuss this later in this section.2 Operating current liabilities include those liabilities that are related to the ongoing operations of the firm. The most common operating liabilities are those related to suppliers (accounts payable), employees (accrued salaries), customers (as either prepayments or, in the case of Costco, deferred member- ship fees), and the government (income taxes payable).3 If a liability is deemed operating rather than financial, it should be netted from operating assets to determine invested capital and consequently incorporated into free cash flow. Interest-bearing liabilities are nonoperating and should not be netted from operating assets, but rather valued separately (the related interest expense is classified as a nonoperating expense). Some argue that operating liabilities, such as accounts payable, are a form of financing and should be treated no differently than debt. However, this 3 When analyzing Costco, we treat accrued member rewards as an operating-related current liability and thus part of working capital. While we believe accrued member rewards are no different from oth- er customer prepayments, the member is not paying cash specifically for the reward. One alternative is to use cash accounting for accrued member rewards, treating the liability as an equity equivalent. To convert to cash, add the increase in accrued member rewards to EBITA. Since taxes will not change, compute taxes using original EBITA. 1 Analyze excess cash separately from operating working capital for two reasons. First, excess cash is more accurately valued using a market value rather than as part of free cash flow. Second, excess cash will have a much lower risk–return profile than operating capital. Commingling assets with different risk profiles can distort your perception of performance. 2 In a company’s financial statements, accountants often distinguish between cash and marketable se- curities, but not between working cash and excess cash. We provide guidance on distinguishing work- ing cash from excess cash later in this chapter.