3 Financial Statements Flashcards
Tell me how the 3 financial statements are linked together.
The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement.
In terms of the balance sheet, net income flows into stockholder’s equity via retained earnings. Retained earnings is equal to the previous period’s retained earnings plus net income from this period less dividends from this period.
In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations.
Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period’s balance sheet comprise cash for this period.
If you could have 2 out of the 3 financial statements, which would you pick?
The balance sheet and income statement, if you have both of those, you can recreate a cash flow statement. (Assuming you have at least the current and past year statements)
How does $10m of depreciation flow through the financial statements?
Depreciation is a non-cash charge on the Income Statement, so an increase of $10 causes Pre-Tax Income to drop by $10 and Net Income to fall by $6, assuming a 40% tax rate.
On the Cash Flow Statement, Net Income is down by $6 but you add back the $10 of Depreciation since it’s a non-cash expense, so cash at the bottom is up by $4.
On the Balance Sheet, cash is up by $4 on the Assets side, but PP&E has declined by $10 due to the added Depreciation, so the Assets side is down by $6.
On the L&E side, Retained Earnings is down by $6 because of the reduced Net Income on the Income Statement, so both sides of the Balance Sheet are down by $6 and it remains in balance.
Walk me from revenue to free cash flow.
Assuming it’s Unlevered FCF — or what’s available to all investors in the company (which pairs with Enterprise Value):
Start with revenue and subtract COGS and Operating Expenses to get to Operating Income, or EBIT. Multiply by (1 - Tax Rate) to get to Net Operating Profit After Taxes, or NOPAT.
Then, add back the non-cash charges that appear on the Cash Flow Statement, primarily Depreciation & Amortization, and reflect the Change in Working Capital, which may be either positive or negative (follow the sign used on the company’s CFS). And then subtract Capital Expenditures (CapEx).
How do you calculate change in net working capital (NWC) and CapEx?
Change in NWC = NWC current period - NWC previous period.
CapEx = PP&E (current period) – PP&E (prior period) + Depreciation (current period)
