Reformulating Financial Analysis for Equity Method Investments

Cummins Inc. reports investments in affiliated companies, consisting mainly of investments in nine manufacturing joint ventures. Cummins reports those investments on its balance sheet at $958 million and provides the following financial information on its investee companies in a footnote to its 10-K report.

Equity Investee Financial Summary					As of and for the years ended Dec. 31
$ millions					2015	2014	2013
Net sales					$5,946	$7,426	$7,799
Gross margin					1,265	1,539	1,719
Net income					521	630	690
Cummins' share of net income					$273	$330	$325
Royalty and interest income					42	40	36
Total equity, royalty and interest from investees					$315	$370	$361
Current assets					$2,458	$2,476
Noncurrent assets					1,539	1,667
Current liabilities					(1,796)	(1,875)
Noncurrent liabilities					(284)	(420)
Net assets					$1,917	$1,848
Cummins' share of net assets					$958	$956

Make the following assumptions about the above data.

All assets are operating assets.

All current liabilities are operating liabilities.

Non-current liabilities are loans that bear interest at 8%.

EMI (Equity Method Investments) investees tax rate is 35%.

The following information is derived from the 2015 form 10-K for Cummins Inc., the investor company.

$ millions	2015
Revenue	$19,110
Net operating profit after tax (NOPAT)	1,420
Net nonoperating expense (NNE)	21
Net income attributable to Cummins Inc.	1,399
Net operating assets (NOA)	7,578
Net nonoperating obligations (NNO)	(172)
Equity of Cummins Inc. shareholders	7,406

a. Compute net operating profit after tax (NOPAT) for the EMI investees.

Round to the nearest whole number.

$Answer million

b. Compute net operating assets (NOA) and net nonoperating obligations (NNO) for the EMI investees.

NOA $Answer million

NNO $Answer million

c. Following the process in Analyst Adjustments box 9.1, reformulate the following ratios for Cummins for 2015. For simplicity only, use year-end balance sheet numbers provided instead of averages.

First, compute the adjusted balances.

Income Statement	Adjusted Balances	Balance Sheet	Adjusted Balances
Revenue	$Answer	NOA	$Answer
NOPAT	Answer	NNO	Answer
Net nonoperating expense	Answer	Equity	Answer
Net income	Answer

Next, compute the following ratios: 1. using Cummins' figures (unadjusted) and 2. using the adjusted balances as computed above.

Round RNOA, NOPM, and ROE to one decimal place (ex: 0.2345 =23.5%)

Round NOAT and FLEV to two decimal places.

Use negative signs with answers, when appropriate.

	Unadjusted	Adjusted
RNOA	Answer%	Answer%
NOPM	Answer%	Answer%
ROE	Answer%	Answer%
NOAT	Answer	Answer
FLEV	Answer	Answer

d. In your opinion, does the equity method of accounting for these investments obscure the economic

picture? Explain.

Assets after reformulation are significantly different. The equity method of accounting understates important ratios and obscures the level of leverage.

Assets after reformulation are significantly different. The equity method of accounting overstates important ratios and obscures the level of leverage.

Equity after reformulation are significantly different. The equity method of accounting overstates important ratios and obscures the level of leverage.

Equity after reformulation are significantly different. The equity method of accounting understates important ratios and obscures the level of leverage.