Walk me through the three financial statements
The income statement, the cash flow statement, and the balance sheet are the core financial statements. The income statement is a measure of profitability—revenue less expenses is taxed and creates net income. The cash flow statement tracks how much cash has been spent or generated from three major areas: operating activities, investing activities, and financing activities. The balance sheet is a snapshot of a company’s resources (assets), its obligations (liabilities), and equity. The assets must always equal the sum of a company’s equity and liabilities.
Walk me through an income statement (more detailed)
The income statement always starts with revenue, a company’s sales, and builds down to net income. Cost of goods sold is the costs most directly associated to the revenue and is reduced from the revenue to produce gross profit (revenue – COGS =gross profit). Operating expenses are the next series of costs and consist of sales, general, and administrative expenses, and marketing and advertising expenses, to name the two most common. Gross profit less operating expenses make EBITDA. Depreciation and amortization are the costs related to the aging of tangible and intangible assets respectively. EBITDA less D&A makes EBIT. Interest expense is reduced from EBIT to get EBT. EBT is then tax affected to get net income. You can also add: After net income there are two major sections reserved for equity distributions (noncontrolling interest expenses and dividends) and non-recurring or extraordinary events. Earnings per share is the net income divided by the shares outstanding.
What is EBITDA?
EBITDA stands for earnings before interest taxes depreciation and amortization.
EBITDA is $500MM. Which of the following has the greatest impact to EBITDA?
Assume all is equal except for the below variables.
- a. Costs increase by $10MM.
- b. Pricing increases by 10%.
- c. Volume increases by 10%.
- The answer is b. Since revenue is a product of pricing and volume, each of b and c
- would impact revenue. An increase in price of 10% would certainly increase revenue
- by 10% or $50MM. However, increasing volume, or units produced, would increase
- costs as well, assuming COGS is variable and based on units produced. Therefore, that potential increase in costs would offset the revenue benefits in some way So it’s safe to say that b would have a larger impact than c. We would immediately
- eliminate a once we realized the impact of b is greater.
Walk me through a cash flow statement (more detailed).
The cash flow statement is a measure of how much cash is generated or spent over a given period. The statement is broken up into three major sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Cash flow from operating activities is the cash generated from net income, or the net income less all non-cash items from the income statement. This consists of net income plus depreciation and amortization, deferred taxes, other non-cash items, and changes in working capital. Cash flow from investing activities is cash generated or spent from investments. This includes capital expenditures, acquisitions and divestitures, and purchases and sales of securities to name the major few. Cash flow from financing activities is cash generated or spent from debt, equity, or distributions. This consists mainly of monies raised from or used to pay debts, monies received from equity and other securities, monies spent from share buybacks, and monies spent from dividend and other equity distributions. The sum of these three cash flow components completes the cash flow statement.
What is cash flow from operations?
Cash flow from operations is defined by net income + D&A + deferred taxes + other non-cash items + changes in working capital.
What is the difference between net income and cash flow?
Net income measures profitability whose components may or may not have impacted cash. Cash flow tracks just the cash impacts generated or received from operations, investing, and financing activities.
Why would an investor care about cash flow versus net income?
This question is quite similar to the previous, but it’s important that one grasps these concepts because questions around them could be asked several different ways. An investor is more apt to base his investment using the cash flow statement as it tracks the “true” measure of how much cash has been generated or spent over a period. Net income may report profitability, but how much of that profitability had actually been converted into cash? If none, for example, the investor would be less likely to see his investment returned. “Cash is king” holds true in this context. And this is why we more commonly look at cash flow in a discounted cash flow analysis as opposed to net income.
How does maintenance CAPEX differ from growth CAPEX?
Maintenance CAPEX is the funds expended to extend the useful life of existing assets,whereas expansion CAPEX is the purchase of new assets to grow the business.
Walk me through a balance sheet (more detailed)
The balance sheet is a measure of a company’s assets, liabilities, and shareholder’s equity at a given point in time. The company’s assets, a resource with economic value that is expected to provide some future benefit, is broken up into current and non-current. Current assets are resources whose economic benefit is expected to come due within one year. Examples of current assets are cash, accounts receivable, and inventories. Examples of long-term assets are property, plant and equipment (PP&E), goodwill, intangible assets, and investments in securities. A liability is a debt or obligation and is also broken up into current and non-current sections. Current liabilities are debts or obligations the come due within one year. Examples of current liabilities are accounts payable, accrued expenses, and short-term debts. Examples of long-term liabilities are long-term debts and deferred tax liabilities. Shareholder’s equity consists of retained earnings and share capital less Treasury shares. The sum of the shareholder’s equity and the total liabilities must equal the total value of assets:Total Assets = Total Liabilities + Shareholder’s Equity
How do the three statements link together?
- Note there can be many ways to answer this question. Here is a suggested solution:
- Net income from the income statement flows into the top of the cash flow statement and into the shareholder’s equity section of the balance sheet. Each and every
- line item in the cash flow statement impacts a line item in the balance sheet: an asset,
- liability, or shareholder’s equity. Total cash and cash equivalents at the bottom of
- the cash flow statement impacts the cash line item at the top of the balance sheet.
- Depreciation created on its own schedule flows into the income statement, into the
- cash flow statement, and impacts PP&E on the balance sheet. Changes in each working capital line item from the working capital schedule flow into the working capital
- section of the cash flow statement, and subsequently impact each respective balance
- sheet line item. Interest expense and interest income, derived from the debt schedule,
- flows into the income statement. Finally, any debt issuances or paydowns depicted
- in the debt schedule flow into the financing activities in the cash flow statements and
- further into the respective debt balances on the balance sheet.
Walk me through the circular reference in a model.
- A circular reference can begin in the debt schedule with some issuance or paydown
- of debt. When debt is paid down, for example, the interest expense is reduced.
- This reduction in interest expense flows into the income statement and increases net
- income. The increase in net income flows into the cash flow statement and increases
- the cash flow before debt paydown balance. Cash flow before debt paydown flows
- back into the debt schedule, increasing the amount of funds that can be used to pay
- down debt. If we have more funds, we can pay down more debt, interest expense
- will reduce further, impact the income statement, increase net income, increase the
- cash balance further, and the cycle will continue.
What is working capital used for?
- Working capital is a measure of a company’s current assets less its current liabilities.
- Working capital is often looked at as a measure of a company’s near-term liquidity
- or operating efficiency as current assets (resources that will be converted into cash
- within a year) less liabilities (debt or obligations due within one year) can help determine if there will be enough cash in the short term to cover a company’s upcoming
- liabilities or obligations.
How does operating working capital differ from working capital?
- Operating working capital is a company’s current assets excluding cash and current
- liabilities excluding debts. Bankers often look at operating working capital as by
- eliminating cash and debts, you are left with line items most closely related to a
- company’s core operations (e.g., accounts receivable, inventories, accounts payable).
What is a deferred tax liability? How is such a liability created?
- A deferred tax liability is a tax balance due that has not yet been paid in cash.
- Deferred tax liabilities are created from timing differences between book accounting
- (GAAP) and tax accounting.
How is a deferred tax asset created?
- A deferred tax asset can be created if a business has a net operating loss (NOL).
- An asset can also be created by receiving government tax credits (investing in certain
- energy, for example).
If you had to choose only one of the three core statements to determine the financial
viability of a company, which statement would you choose?
- The cash flow statement provides a true measure of cash produced by the business
- as opposed to an income statement, which may or may not include non-cash items.
- To an investor, cash is the true measure of performance. This is partially why the
- discounted cash flow is a valuable valuation method
If I had to choose only two statements to assess a company’s performance, which
two would I use?
- The income statement and the balance sheet. A cash flow statement can be created
- from an income statement and two years of a balance sheet.