Modifying Accounting Data for Managerial Decisions 349
are needed for use in corporate decision making. In the following sections we discuss
how financial analysts combine stock prices and accounting data to make the statements
more useful.
Operating Assets and Operating Capital
Different firms have different financial structures ,different tax situations ,and different
amounts of nonoperating assets. These differences affect traditional accounting mea-
sures such as the rate of return on equity. They can cause two firms ,or two divisions
within a single firm ,that actually have similar operations to appear to be operated with
different efficiency. This is important ,because if managerial compensation systems are
to function properly ,operating managers must be judged and compensated for those
things that are under their control ,not on the basis of things outside their control.
Therefore ,to judge managerial performance ,we need to compare managers’ ability to
generateoperating income(orEBIT) with theoperating assetsunder their control.
The first step in modifying the traditional accounting framework is to divide total
assets into two categories,operating assets,which consist of the assets necessary to
operate the business ,andnonoperating assets,which would include cash and short-
term investments above the level required for normal operations ,investments in sub-
sidiaries ,land held for future use ,and the like. Moreover ,operating assets are further
divided intooperating current assets,such as inventory ,andlong-term operating
assets,such as plant and equipment. Obviously ,if a manager can generate a given
amount of profit and cash flow with a relatively small investment in operating assets,
that reduces the amount of capital investors must put up and thus increases the rate of
return on that capital.
Most capital used in a business is supplied by investors—stockholders, bondhold-
ers, and lenders such as banks. Investors must be paid for the use of their money, with
payment coming as interest in the case of debt and as dividends plus capital gains in
the case of stock. So, if a company buys more assets than it actually needs, and thus
raises too much capital, then its capital costs will be unnecessarily high.
Must all of the capital used to acquire assets be obtained from investors? The an-
swer is no, because some of the funds are provided as a normal consequence of opera-
tions. For example, some funds will come from suppliers and be reported as accounts
payable,while other funds will come as accrued wages and accrued taxes,which amount to
short-term loans from workers and tax authorities. Such funds are called operating
current liabilities.Therefore, if a firm needs $100 million of assets, but it has $10
million of accounts payable and another $10 million of accrued wages and taxes, then
its investor-supplied capitalwould be only $80 million.
Those current assets used in operations are called operating working capital,
and operating working capital less operating current liabilities is called net operat-
ing working capital.Therefore, net operating working capital is the working capital
acquired with investor-supplied funds. Here is the definition in equation form:
Net operating working capital Operating current assets Operating
current liabilities.
(9-3)
Now think about how these concepts can be used in practice. First, all companies
must carry some cash to “grease the wheels” of their operations. Companies continu-
ously receive checks from customers and write checks to suppliers, employees, and so
on. Because inflows and outflows do not coincide perfectly, a company must keep
some cash in its bank account. In other words, some cash is required to conduct
operations. The same is true for most other current assets, such as inventory and ac-
counts receivable, which are required for normal operations. However, any short-
term securities the firm holds generally result from investment decisions made by the
Financial Statements, Cash Flow, and Taxes 345
