Financial Statements
What are the three financial statements, and how are they connected?
Income statement --> net income flows to top of cash flow statement
Cash flow statement --> ending cash flows to balance sheet
Balance sheet --> cash is in assets
Walk me through an income statement.
Revenue - COGS = Gross Profit
Gross Profit - SG&A and Operating Expenses = Operating Income (EBIT)
EBIT - Interest = Pretax Profit
Pretax Profit - Taxes = Net Income
Assets = Liabilities + Equity
Assets: Cash, accounts receivable, PPE
Liabilities: Accounts payable, taxes payable, deferred revenue
Equity: Common stock, retained earnings
Let's say I own a cupcake business. I purchase 100 pounds of flour and sugar for $1000 to make cupcakes for the next month. I also purchase a new mixer for $3000, intended to last me for the next three years.
Which purchase is capitalized and which purchase is expensed?
The flour & sugar are expensed. The mixer is capitalized.
Capitalized: Expenditures on assets benefit the firm for more than one year. Ex. PPE
Expensed: Expenditure on assets benefit the firm for less than one year. Ex. Inventory
Let’s say I could only look at 2 statements to assess a company’s prospects – which 2 would I use and why?
You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming that you have “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).
Explain the three sections of the cash flow statement.
1) Operating Activities, which reflect the cash generated or spent in the core business operations
2) Investing Activities, detailing cash used in or gained from investments like CapEx or selling assets
3) Financing Activities, showing cash flows from financing activities like loans or dividends
What is Goodwill and how is it created?
Goodwill is an intangible asset that is the excess premium paid over the fair value of an acquired business's assets.
Example: Suppose an acquirer buys a company for a $500 million purchase price with a fair market value of $450 million. The Goodwill is $50 million.
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
1. The company is spending too much on Capital Expenditures – these are not reflected at all in EBITDA, but it could still be cash-flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3. The company’s debt all matures on one date and it is unable to refinance, and it runs out of cash completely when paying back the debt.
4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company.
How would a $10 increase in depreciation flow through the financial statements? (assuming a 30% tax rate)
IS: When depreciation increases by $10, EBIT would decrease by $10. Assuming a 30% tax rate, net income will decline by $7.
CFS: At the top of the CF statement, net income has decreased by $7, but the $10 depreciation will be added back since it's a non-cash expense. The impact on the ending cash balance will be a $3 increase.
BS: PP&E will decrease by $10 from the depreciation, while cash will be up by $3 on the assets side. On the L&E side, the $7 reduction in net income flows through retained earnings. The balance sheet remains in balance as both sides went down by $7.
What are some of the most common margins used to measure profitability?
Gross Margin: Gross Profit / Revenue
Operating Margin: Operating Income / Revenue
EBITDA Margin: EBITDA / Revenue
Net Profit Margin: Net Income / Revenue
What is net working capital?
NWC = Current Assets (excluding cash) - Current Liabilities
NWC measures a company's liquidity and ability to pay off its current obligations using its current assets.
When would a company collect cash from a customer and not record it as revenue?
Companies that agree to services in the future. This makes investors happy as well since they can better predict a company’s performance.
1. Web-based subscription software.
2. Cell phone carriers that sell annual contracts.
3. Magazine publishers that sell subscriptions.
What happens when Inventory goes up by $10, assuming you pay for it with cash?
IS: Nothing
CF: Inventory is an asset, so an increase in an asset decreases your CF from Operations, and overall CF by $10
BS: Inventory is up by $10 but Cash is down by $10
What are the different drivers and levers that increase gross margins?
1. Increase Revenue (Raising prices to boost margins, increasing selling volume)
2. Decrease COGS (Negotiating better terms with suppliers, reduce waste and increase efficiency during production, outsourcing)
Why are increases in accounts receivable a cash reduction on the cash flow statement?
An increase in accounts receivable means that more customers paid on credit during the period.
Thus, a downward adjustment must be made to arrive at the ending cash balance.
The customers have yet to make the due cash payments and this amount will be sitting as receivables on the BS.
(Increase in assets on BS --> decrease in cash on CF)
(Increase in liabilities on BS --> increase in cash on CF)
Why is deferred revenue classified as a liability while accounts receivable is an asset?
Deferred Revenue: The company received payments upfront and has unfulfilled obligations to the customers that paid in advance (unused gift card)
Accounts Receivable: The company has already delivered the goods/services and all that remains is the collection of payments from the customers that paid on credit (clothing bought on a credit card)
What happens to the three financial statements if a company issues a dividend of $10?
IS: No change
CFS: Cash from financing will decrease by the dividend payout amount and lower the ending cash balance by $10.
BS: The cash balance will decline by $10 on the balance sheet, and the offsetting entry will be a decrease of $10 in retained earnings since dividends come directly out of retained earnings.
If I only had 1 financial statement and I wanted to review the overall health of a company – which statement would I use and why?
Cash Flow Statement
It focuses on how much cash the company is actually generating, independent of all the non-cash expenses you might have.
And that’s the #1 thing you care about when analyzing the overall financial health of any business – its cash flow
Is negative working capital a bad signal about a company's health?
It depends!!
Negative working capital can result from being efficient at collecting revenue (lowering A/R) and quick inventory turnover.
It could also signify impending liquidity issues. For example, they could have a high accounts payable balance due soon, with a low inventory balance and very low levels of A/R.
Do companies depreciate land?
No.
While it is classified as a long-term asset on the balance sheet, land is assumed to have an indefinite useful life under accrual accounting.