Reformulating Financial Analysis for Equity Method Investments Cummins Inc. reports investments in affiliated companies, consisting mainly of investments in six manufacturing joint ventures. Cummins 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 2018 2017 2016 Net sales $7,352 $7,050 $5,654 Gross margin 1,373 1,422 1,182 Net income 647 680 499 Cummins' share of net income $336 $308 $260 Royalty and interest income 58 49 41 Total equity, royalty and interest from investees $394 $357 $301 Current assets $3,401 $3,416 Noncurrent assets 1,449 1,379 Current liabilities (2,669) (2,567) Noncurrent liabilities (218) (237) Net assets $1,963 $1,991 Cummins' share of net assets $1,144 $1,116 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 22%. The following information is derived from the 2018 form 10-K for Cummins Inc., the investor company. $ millions Revenue $23,771 Net operating profit after tax (NOPAT) 2,213 Net nonoperating expense (NNE) 26 Net income attributable to Cummins Inc. 2,141 Net operating assets (NOA) 9,210 Net nonoperating obligations (NNO) 951 Equity of Cummins Inc. shareholders 7,348 Hint: You should be able to compute the following for Cummins' investee companies: $ millions 2018 Nonoperating expense before tax $17 Net nonoperating expense (NNE) $13 a. Compute net operating profit after tax (NOPAT) for the EMI investees. Round to the nearest whole number. $ 660 million b. Compute net operating assets (NOA) and net nonoperating obligations (NNO) for the EMI investees. NOA $ 2.181 million NNO $ 218 million c. Following the process in Analyst Adjustments box 9.1, reformulate the following ratios for Cummins for 2018. For simplicity only, use year-end balance sheet numbers provided instead of averages. First, compute the adjusted balances. (Use a negative sign with adjustment answer if it reduces the unadjusted amount.) Income Statement Cummins Adjustment Adjusted Balances Revenue $ 23,771 7,352 $ 31,123 NOPAT: Subtract share of EMI earnings 2,213 (336) 2,537 Add EMI NOPAT* 0 660 0 Net nonoperating expense 26 13 39 Net income 2,141 *Note: For "Add EMI NOPAT" row, only enter an answer under the Adjustment column (EMI NOPAT). Leave Cummins and Adjusted Balances answers blank (use row above to enter Cummins' NOPAT and Adjusted NOPAT balance). 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. Hint: Adjusted Net income is $2,452 million. RNOA NOPM ROE Unadjusted Adjusted 24% 22.3% x 9.3% 8.2% ~ 29.1% 25.9% * 2.58 2.73 x (0.12) 0.07 X NOAT FLEV d. In your opinion, does the equity method of accounting for these investments obscure the economic picture? Explain. Ratios after reformulation are slightly different. The equity method of accounting understates some important ratios and obscures the level of leverage but effect here appears to be small. oRatios after reformulation are slightly different. The equity method of accounting overstates some important ratios and obscures the level of leverage but the effect here appears to be small. Ratios after reformulation are significantly different. The equity method of accounting overstates some important ratios and obscures the level of leverage and the effect here appears to be significant. Ratios after reformulation are significantly different. The equity method of accounting understates some important ratios and obscures the level of leverage and the effect here appears to be significant. NOTE: Unadjusted FLEV #-.02, .02,-.04, .04,- 12,.12 Adjusted FLEV # -.02, .02,-.04, .04, .07 Adjusted RNOA 22.3%, 22.27%, 22.2%, 22.4% Adjusted ROE # 25.9%, 29.1% Adjusted NOAT # 2.73
