Financial Statement Review

What are the three financial statements?

Income Statement, Balance Sheet, and Cash Flow Statement.

What does the Income Statement show?

Profitability over a period. It answers: did the company make money?

What does the Balance Sheet show?

Assets, liabilities, and shareholders’ equity at a specific point in time.

What does the Cash Flow Statement show?

How cash moved during a period. It answers: where did cash come from and where did it go?

What is the basic accounting equation?

Assets = Liabilities + Shareholders’ Equity.

What are assets?

What the company owns.

What are liabilities?

What the company owes.

What is shareholders’ equity?

The owners’ claim on the business.

Why must the balance sheet always balance?

Because every asset is funded either by liabilities or equity.

What is the basic Income Statement formula?

Revenue - Costs - Expenses = Net Income.

When is revenue recorded under accrual accounting?

When the company delivers the product or service, not necessarily when cash is collected.

Does a customer order count as revenue?

No. Revenue is usually recorded when the product is shipped or the service is completed.

What happens when a company sells product on credit?

Revenue increases on the Income Statement, Accounts Receivable increases on the Balance Sheet, and there is no cash impact until the customer pays.

What is net sales?

The amount the company expects to collect after discounts, returns, and allowances.

What is the formula for net sales?

Net Sales = Gross Sales - Discounts / Returns / Allowances.

What is the difference between sales and orders?

Orders are customer requests. Sales happen when the company delivers the product or service.

What is COGS?

Cost of Goods Sold: the cost of products that were actually sold.

Where does inventory sit before it is sold?

On the Balance Sheet as an asset.

What happens to inventory when it is sold?

Inventory decreases and COGS increases on the Income Statement.

What is gross profit?

Revenue - COGS.

What is gross margin?

Gross Profit / Revenue.

What does gross profit measure?

Product-level profitability before corporate overhead.

What is the difference between costs and expenses?

Costs are tied to making the product; expenses are tied to running the business.

Give examples of COGS.

Raw materials, factory labor, and manufacturing overhead.

Give examples of operating expenses.

Sales, marketing, legal, admin, and corporate salaries.

What is operating income?

Gross Profit - Operating Expenses.

What does operating income measure?

Profit from the company’s core business before interest and taxes.

What are non-operating items?

Items outside normal operations, such as interest income, interest expense, and one-time gains/losses.

What is net income?

Profit after all expenses, interest, and taxes.

What are current assets?

Assets expected to become cash or be used within 12 months.

Name the main current assets.

Cash, Accounts Receivable, Inventory, and Prepaid Expenses.

What is Accounts Receivable?

Money customers owe the company.

What is Inventory?

Goods or materials held for sale.

What are Prepaid Expenses?

Expenses already paid but not yet fully used, such as prepaid rent or insurance.

What is the current asset cycle?

Cash becomes Inventory, Inventory becomes Accounts Receivable when sold, and Accounts Receivable becomes Cash when collected.

What are the three types of inventory?

Raw materials, work-in-process, and finished goods.

What are fixed assets / PP&E? Property Plant and equipment5

Long-term assets used to run the business, such as buildings, machinery, and equipment.

How is PP&E recorded?

At historical cost, then reduced over time through depreciation.

What is depreciation?

The spreading of a fixed asset’s cost over its useful life.

Does depreciation reduce cash in the period it is recorded?

No. It lowers accounting profit but is non-cash.

What is accumulated depreciation?

Total depreciation recorded since the asset was acquired.

What are current liabilities?

Obligations due within 12 months.

Name the main current liabilities.

Accounts Payable, Accrued Expenses, Current Portion of Debt, and Income Taxes Payable.

What is Accounts Payable?

Money owed to suppliers for goods or services purchased on credit.

What happens to cash when AP increases?

Cash is preserved, so cash flow increases.

What are accrued expenses?

Expenses incurred but not yet paid.
EX: Wages employees have earned but have not yet been paid.

Short term vs Long term Debt

Debt due within one year vs more than 12 months

What are the two main parts of shareholders’ equity?

Capital stock and retained earnings.

What is capital stock?

Money invested by owners.

What are retained earnings?

Profits kept in the business instead of paid out as dividends.

What is working capital?

Current Assets - Current Liabilities.

What is the cash impact when Accounts Receivable increases?

Cash down, because revenue was recorded but cash was not collected.

What is the cash impact when Inventory increases?

Cash down, because cash is tied up in unsold product.

What is the cash impact when Prepaid Expenses increase?

Cash down, because cash was paid before the expense was recognized.

What is the cash impact when Accounts Payable increases?

Cash up, because the company delayed payment to suppliers.

What is the cash impact when Accrued Expenses increase?

Cash up, because the expense was recorded but not yet paid.

Why is depreciation added back on the Cash Flow Statement?

Because it reduced net income but did not use cash.

What is CapEx?

Money spent to buy PP&E.

What happens when a company buys PP&E with cash?

No immediate Income Statement impact; CFI decreases; cash decreases and PP&E increases on the Balance Sheet.

How does the Income Statement link to the Cash Flow Statement?

Net income is the starting point of Cash Flow from Operations

How does the Income Statement link to the Balance Sheet?

Net income increases retained earnings.

How does the Cash Flow Statement link to the Balance Sheet?

Ending cash becomes the cash balance on the Balance Sheet.

Give the standard three-statement link script.

The Income Statement links to the Cash Flow Statement through net income. The Cash Flow Statement adjusts net income for non-cash items and working capital changes to calculate ending cash. Ending cash flows to the Balance Sheet, and net income less dividends flows into retained earnings. The Balance Sheet must balance because assets equal liabilities plus equity.

Depreciation increases by $10, tax rate is 40%. What happens to the Income Statement?

Pre-tax income decreases by $10; net income decreases by $6.

Depreciation increases by $10, tax rate is 40%. What happens to the Cash Flow Statement?

Net income decreases by $6, depreciation is added back by $10, so cash increases by $4.

Depreciation increases by $10, tax rate is 40%. What happens to the Balance Sheet?

Cash increases by $4, PP&E decreases by $10, and retained earnings decreases by $6.

Why does depreciation increase cash flow?

A: Depreciation is non-cash but tax-deductible, so it creates a tax shield.

Company buys $100 of PP&E with cash. What happens?

No immediate Income Statement impact; Cash flow from Inventory down $100; cash down $100 and PP&E up $100.

Company buys $100 of inventory with cash. What happens?

No immediate Income Statement impact; Cash flow from operations down $100; cash down $100 and inventory up $100.

Company buys $100 of inventory on credit. What happens?

No immediate Income Statement impact; no immediate cash impact; inventory up $100 and AP up $100.

Company collects Accounts Receivable. What happens?

No Income Statement impact; cash increases and AR decreases.

Company issues debt. What happens?

No immediate Income Statement impact; cash increases and debt increases.

What is the current ratio? and what does it do?

Current Assets / Current Liabilities. Measures Ability to pay near-term obligations.

What is the quick ratio? Why is the quick ratio more conservative than the current ratio?

(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities. it excludes inventory

What is inventory turnover?

COGS / Average Inventory. How quickly inventory is sold.

What is Days Inventory Outstanding?

365 / Inventory Turnover. How many days inventory sits before sale.

What is DSO? Days Sales Outstanding

Accounts Receivable / Revenue x 365. How long it takes to collect from customers.

What is DPO? Days Payable Outstanding

Accounts Payable / COGS x 365. How long the company takes to pay suppliers.

What is gross margin?

Gross Profit / Revenue.

What is operating margin?

Operating Income / Revenue.

What is net margin?

Net Income / Revenue.

How does depreciation method affect financials?

It affects net income and book value of PP&E.

How does inventory accounting affect financials?

It affects COGS, inventory, and gross margin.

How does revenue recognition affect financials?

It affects the timing of revenue and profit.

What does revenue growing faster than cash collections suggest?

Possible aggressive revenue recognition.

What does AR growing faster than revenue suggest?

Customers may not be paying.

What does inventory growing faster than sales suggest?

Demand may be weakening.

What is the time value of money?

A dollar today is worth more than a dollar tomorrow because it can be invested and future cash flows are uncertain.

What is present value?

The value today of future cash flows discounted back to the present.

What is the difference between profit and cash?

Profit is accounting income. Cash is actual money received or paid. A company can be profitable but cash-flow negative.