Reorganizing the Accounting Statements: Key Concepts  207 For many companies, the previous equation is too simple. Assets consist of not only operating assets, but also nonoperating assets (NOA), such as mar- ketable securities, prepaid pension assets, nonconsolidated subsidiaries, and other long-term investments. Liabilities consist of not only operating liabilities and interest-bearing debt, but also debt equivalents (DE), such as unfunded retirement liabilities, and equity equivalents (EE), such as deferred taxes and income-smoothing provisions. (We explain debt and equity equivalents in de- tail later in the chapter.) We can expand our original balance sheet equation to show these: OA operating assets) NOA nonoperating assets OL operating li + = ( ( ) ( abilities D DE debt and its equivalents E EE equity and its e + + ) ( ) ( + + quivalents) Rearranging leads to total funds invested: OA OL invested capital) NOA nonoperating assets Total Fun + = − ( ( ) ds D DE debt and its equivalents E EE equity and its e = + Invested + + ( ) ( quivalents) For a company with debt and equity equivalents, invested capital no longer equals debt plus equity. It equals operating assets minus operating liabilities. From an investing perspective, total funds invested equals invested capital plus nonoperating assets. From the financing perspective, total funds invested equals debt and its equivalents plus equity and its equivalents. Exhibit 11.1 EXHIBIT 11.1  An Example of Invested Capital $ million Accountant’s balance sheet Invested capital Assets Prior year Current year Prior year Current year Cash 5 15 Cash 5 15 Inventory 200 225 Inventory 200 225 Operating liabilities are netted against operating assets Net PP&E 300 350 Accounts payable (125) (150) Equity investments 15 25 Operating working capital 80 90 Total assets 520 615 Net PP&E 300 350 Liabilities and equity Invested capital 380 440 Accounts payable 125 150 Nonoperating assets are not included in invested capital Interest-bearing debt 225 200 Equity investments 15 25 Shareholders’ equity 170 265 Total funds invested 395 465 Total liabilities and equity 520 615 Reconciliation of total funds invested Interest-bearing debt 225 200 Shareholders’ equity 170 265 Total funds invested 395 465 208  Reorganizing the Financial Statements rearranges the balance sheet into invested capital for a simple hypothetical company with only a few line items. The reconciliation at the lower right shows how the amount of total funds invested is identical regardless of the method used. Net Operating Profit after Taxes: Key Concepts NOPAT is the after-tax profit generated from core operations, excluding any income from nonoperating assets or financing expenses, such as interest. Whereas net income is the profit available to equity holders only, NOPAT is the profit available to all investors, including providers of debt, equity, and any other types of investor financing. It is critical to define NOPAT consis- tently with your definition of invested capital and to include only those profits generated by invested capital. To calculate NOPAT, we reorganize the accounting income statement in three ways (see Exhibit 11.2). First, interest is not subtracted from operating in- come, because interest is compensation for the company’s debt investors, not an operating expense. By reclassifying interest as a financing item, we make NOPAT independent of the company’s capital structure. Second, when calculating NOPAT, exclude income generated from assets that were excluded from invested capital. Mistakenly including nonoperating income in NOPAT without including the associated assets in invested capital EXHIBIT 11.2  An Example of NOPAT $ million Accountant’s income statement NOPAT Current year Current year Revenues 1,000 Revenues 1,000 Operating costs (700) Operating costs (700) Depreciation (20) Depreciation (20) Operating profit 280 EBITA 280 Taxes are calculated on operating profits Interest expense (20) Operating taxes1 (70) Income from equity investments 4 NOPAT 210 Earnings before taxes (EBT) 264 Do not include income from any asset excluded from invested capital as part of NOPAT Income from equity investments 4 Income taxes (66) Tax shield on nonoperating items2 4 Net income 198 Income available to investors 218 Reconciliation with net income Treat interest as a financial payout to investors, not an operating expense Net income 198 Interest expense 20 Income available to investors 218 1 Assumes a marginal tax of 25% on all income. 2 Interest tax shield less taxes on equity income.