Reading: The Accounting Framework

The income statement measures the company's financial performance over a specific accounting period (typically 1 year). The basic structure of the income statement is as follows:

 

  

As in the case of the balance sheet, we first try to identify operating, financing, and investment activities. In many cases it is safe to assume that all items that lead to earnings before interest and taxes (EBIT) are related to the firm's operating activities.[1] This is why EBIT is sometimes also referred to as operating income.

Interest expenses, however, are not part of the firm's operating activities. They are the result of a financing decision, namely the decision to finance part of the company's assets with debt. Because interest expenses are part of the financing activity, the resulting earnings before taxes (EBT), and therefore also the income taxes as well as the net income, are a mixture of operating and financing activities. To disentangle operating and financing activities, we therefore have to make a slight adjustment:

• Compute the income taxes that are related to the firm's operating activities. Those are the income taxes the firm would have to pay if it had no debt outstanding. Those are the so-called adjusted taxes.

• Compute the net income that would result if the firm had no debt debt financing. This is the so-called net operating profit less adjusted taxes (NOPLAT). Formally, we find NOPLAT by subtracting the adjusted taxes from EBIT:
   
  NOPLAT = EBIT - Adjusted taxes
   
  NOPLAT represents the net income the firm would generate if it had no debt outstanding.
   
  The difference between NOPLAT and Net income results from the firm's interest expenses and the associated tax savings. Consequently, we can also find NOPLAT by adding the interest expenses (net of tax savings) to the firm's net income:
   
  NOPLAT = Net income + Interest expenses (after taxes). 

 

  

Without debt financing, the firm's earnings before taxes would be 4'000. Given a tax rate of 20%, the firm's operating profit therefore implies a tax payment of 800:

 

 

Consequently, the firm's NOPLAT is 3'200:

 

 

This NOPLAT of 3'200 is the part of the firm's net income that is attributable to its operating activities. The difference of 400 to the actual net income of 2'800 is due to financing activities. More specifically, the interest payments of 500 the firm makes because of its decision to use debt financing has two effects on the income statement:

• Interest expenses lower the net income by 500

• Interest expenses, however, also lower the firm's tax burden. Because the firm pays interest, its taxable income drops by 500 from 4'000 to 3'500. Consequently, the tax burden is reduced by 100: 

• The after-tax (dollar) cost of debt financing is therefore 400: The interest payments of 500 to the bank minus the tax savings of 100:
  
       After-tax (dollar) cost of debt = Interest expenses - Tax savings due to interest expenses.

 

In sum, we can use the information from the income statement to split the firm's net income into two components: The NOPLAT and the after-tax (dollar) cost of debt. NOPLAT captures the net income that is attributable to the firm's operating activities, whereas the after-tax cost of debt indicates the (negative) net income that is attributable to the firms financing policy.

 

By rearranging this expression, we find an alternative way to derive NOPLAT:

 

 

These are the relevant steps to distinguish operating and financing activities in the income statement. Our primary goal here is to identify (and understand) NOPLAT.