Learning Outcomes
After reading this article, you will be able to explain and adjust for non-operating items and cross-holdings when evaluating group and investment structures. You will learn how to exclude non-operating gains and losses for NOPAT calculations, correctly treat intra-group investments, and manage the impact of cross-holdings and circular shareholdings on group consolidated figures. You should also be able to apply appropriate elimination methods and discuss their impact on financial performance and valuation.
ACCA Advanced Financial Management (AFM) Syllabus
For ACCA Advanced Financial Management (AFM), you are required to understand the effects of non-operating items and cross-holdings in consolidated statements and group valuations. For revision, focus on:
- Recognition and exclusion of non-operating items when appraising group financial performance
- Treatment of cross-holdings and circular shareholdings within group structures
- Elimination of intra-group investments and dividend flows in financial modelling and valuation
- Adjustments necessary for consistent profit and cash flow analysis
- Implications of complex group structures for valuation and performance measurement
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
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Which of the following should NOT be included in Net Operating Profit After Tax (NOPAT)?
- Gain on sale of surplus property
- Profit from core business operations
- Interest expense on debt
- Both a and c
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A holding company owns 30% of an associate, which also owns 10% of the holding company. What type of issue does this structure create?
- Joint venture consolidation
- Cross-holding/circular shareholding
- Non-controlling interest
- Control premium
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Briefly explain how intra-group dividends between subsidiaries should be treated in the group’s consolidated cash flows for valuation purposes.
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Why must non-operating items be excluded when estimating the value of a company using free cash flow models?
Introduction
Non-operating items and cross-holdings are adjustment areas in consolidated financial analysis and valuation that can distort reported profits and asset values if not handled correctly. For the ACCA AFM exam, you must exclude non-operating results from core operating figures and identify the effects of intra-group investments—including cross-holdings, circular shareholdings, and intra-group dividends—when considering group performance and valuations.
Key Term: non-operating items
Income and expenses not derived from the principal business activities, such as gains on asset disposals, one-off revaluations, or investment income unrelated to operations.Key Term: cross-holding
Situation where two (or more) companies hold equity interests in each other, resulting in circular shareholdings or entangled ownership within a group structure.
Non-Operating Items: Identifying and Adjusting
Non-operating items must be stripped out to analyse true operating performance or to estimate sustainable future earnings. These adjustments are required for both profit-based and cash flow-based valuation approaches.
Typical non-operating items to remove include:
- Profits/losses on disposal of assets or investments
- Fair value movements on investments not held for business operations
- Legal settlements, fines or restructuring provisions
- Unusual investment income (e.g., interest on excessive cash not needed for operations)
Such items can distort key measures, such as NOPAT and EBITDA, which are designed to reflect the recurring earning capacity of the business.
Worked Example 1.1
Company Z reported a profit before tax of $18m, including a $3m gain on sale of property, $0.5m dividend income from a non-subsidiary investment, and $1m restructuring expense. Operating tax is 25%. Calculate adjusted NOPAT for valuation.
Answer:
Exclude the gain on sale of property, the non-subsidiary dividend, and add back the restructuring expense (if one-off, otherwise allocate over relevant years).
Adjusted pre-tax operating profit = $18m – $3m – $0.5m + $1m = $15.5m
NOPAT = $15.5m × (1 – 0.25) = $11.625m
Exam Warning
Non-operating items are often spread across several lines in statements or footnotes. Carefully check notes and disclosures for exceptional or irregular items—failure to fully adjust will cause valuation errors.
Cross-Holdings and Circular Shareholdings
In complex group structures, subsidiaries may hold shares in each other or even in the parent company (directly or indirectly). Such arrangements create several adjustment issues:
- Overstated group equity or assets
- Multiple counting of dividends and profits
- Complications in calculating ownership percentages
Key Term: circular shareholding
A structure where controlling companies or subsidiaries own shares in one another, creating loops that complicate the attribution of ownership and consolidated results.
How Cross-Holdings Affect Consolidated Statements
Intra-group investments require the following adjustments:
- Eliminate any income or dividends arising from investments within the group
- Adjust share of profits and net assets owned to reflect only external economic interests
- Remove any shares in the parent owned by subsidiaries (treat as ‘treasury shares’ for group computations)
Where a subsidiary holds a stake in its parent, the parent's number of shares in issue should be reduced in consolidated EPS and net asset calculations.
Worked Example 1.2
Parent Co owns 70% of Sub A. Sub A holds 8% of Parent Co’s shares. How is this circular shareholding adjusted in group calculations?
Answer:
The shares of Parent Co held by Sub A are disregarded in consolidated equity and EPS computations. Dividend flows relating to these shares are not counted as group distributions. This prevents double-counting group value and overstatement of ownership interests.
Adjusting Cash Flows for Intra-group Investments
Intra-group dividend and interest flows do not represent genuine cash inflows or outflows for the group as a whole. For business valuation or free cash flow purposes:
- Exclude all intra-group dividend income, interest, and charges
- Only include flows between the group and external parties
This ensures free cash flow calculations used for DCF approaches accurately represent distributable cash available to all capital providers, not just internal reallocations.
Worked Example 1.3
Group X consists of Parent P and Subsidiary S. S pays a $2m dividend to P. The group also receives $1m from a 20% investment in Associate A (outside the group). What dividend income is included in consolidated free cash flows?
Answer:
The $2m internal dividend is eliminated. Only the $1m from Associate A is included as external income in group free cash flows.
Special Issues with Cross-Holdings
Cross-holdings across multiple subsidiaries may create complex circular calculations, especially when reciprocal ownership exceeds 20%. Adjustments may require iterative approaches to avoid double-counting. For exam purposes, describe the need for circular elimination and focus on clean computation of external ownership interests.
Revision Tip
If a group chart contains any subsidiary or associate owning an interest in any other member of the group, check for required cross-holding, circular, and reciprocal holding adjustments before performing any consolidation or valuation.
Summary
Non-operating items must be fully excluded from operating profit and cash flows to reflect repeatable business performance and reliable valuations. Intra-group and cross-holdings distort group results if not eliminated; only external dividends, profits, and cash flows count for the group as a whole. Exam calculations demand careful adjustment and labelling of such items, as errors in this area frequently occur.
Key Point Checklist
This article has covered the following key knowledge points:
- Identify and exclude non-operating items when calculating operating profit or cash flows for valuation
- Recognise cross-holdings and circular shareholdings within group structures
- Eliminate intra-group income and investments appropriately in consolidated statements
- Adjust group profits and cash flows to reflect only external flows in valuations
- Understand implications of cross-holdings for earnings, net assets, and ownership
Key Terms and Concepts
- non-operating items
- cross-holding
- circular shareholding