Financial Statement Drivers: Balance Sheet and Income Statement Analysis

What drives Accounts Receivable?

Sales - 1:1. AR is essentially a zero-interest loan to the customer; it's the only balance-sheet item driven by sales (price x quantity).

What drives Inventory?

COGS - grows with the volume of goods produced/sold, not with sales dollars directly.

What drives Prepaid Expenses?

COGS - you've paid for something (insurance, rent) you haven't fully consumed yet.

What drives Accounts Payable?

Purchases - 1:1, a zero-interest IOU to your supplier. Not moving 1:1 with purchases (dragging payables) is a red flag.

What drives Accrued Liabilities?

COGS / labor / quantity - something you've enjoyed but haven't paid for (utility bill, payroll). The most important liability; payroll never bounces.

What drives PP&E?

CAPEX - book value grows with capital expenditures and falls with depreciation.

What drives Maintenance CAPEX?

COGS, 1:1 - grows with quantity; roughly equals depreciation over time. Smooth, predictable spending.

What drives Expansion CAPEX?

Excess capacity, NOT COGS - no need for it while there's excess capacity; near 100% utilization forces a lump-sum spend. Not smooth - an 'explosion.'

What drives Patents / R&D-based intangibles?

R&D - capitalized R&D spend creates the intangible asset.

What drives Net Working Capital?

Sales (via COGS) - NWC = Current Assets minus Current Liabilities; typically grows in proportion with sales.

What drives Goodwill?

Nothing operational - created only through acquisitions (price paid over book value of net identifiable assets). Should be stable; it is not amortized.

What drives Selling expense (part of SG&A)?

Quantity / COGS, roughly 1:1 - a variable cost; more selling spend drives more revenue.

What does 'what drives X?' mean on this exam?

A recurring question type (7+ variations) asking which line item causes another balance-sheet line to grow/shrink. See the full driver list: AR

What drives Notes Payable?

Short-term funding needs for inventory and receivables - balance swells as inventory/AR builds, shrinks as it's collected/sold. Like a revolving line of credit.

What is COGS and what drives it?

Cost of Goods Sold = labor + raw materials; a variable cost driven by quantity (not sales dollars directly).

How does COGS normally move relative to sales?

COGS typically grows about 1:1 with sales/quantity - that's the normal, stable relationship.

What does it mean if COGS grows faster than sales (relatively)?

Suspect an impairment: the firm wrote down inventory value and expensed the reduction into COGS, spiking it. Obsolescence and manufacturing variances do the same.

What does it mean if COGS grows slower than sales (relatively)?

Suspect LIFO liquidation - the firm is 'penetrating' an old, cheap LIFO inventory layer to flatter margins, or it found cheaper labor/parts.

Can depreciation be hidden inside COGS?

Yes - depreciation can sometimes be bundled into COGS, so watch for it when computing gross profit.

What is EBIT and what does it measure?

Earnings Before Interest and Taxes = Sales minus expenses associated with generating those sales. Measures the overall operating performance of the firm; called 'the line.'

What must be true of everything above EBIT on the income statement?

It must be tied to operations (revenue, COGS, SG&A). A red flag is management sneaking an operating expense below the line to inflate EBIT.

What is the Times Interest Earned (TIE) ratio and why does it matter?

TIE = EBIT / Interest Expense. It's a common bank maintenance covenant tied to EBIT.

What is the income statement build order, top to bottom?

Net Sales - COGS = Gross Profit; Gross Profit - SG&A = EBITDA; EBITDA - D&A = EBIT; EBIT +/- other income - Interest = Pre-tax income (EBT); EBT - Taxes = Net Income; Net Income - Dividends - Buybacks = addition to Retained Earnings.

What is the most volatile asset on the balance sheet?

Perishable inventory - you know its value is heading to zero, you just don't know exactly when.

What measure helps gauge/offset perishable-inventory risk?

Inventory Turnover = COGS / Inventory. A higher turnover rate can offset/negate the risk of holding a perishable item.

House leverage example - Scenario 1 (Day 1)?

House (asset) = $400,000, financed 100% with bank debt = $400,000. Equity = Assets - Liabilities = $0. You own nothing yet.

House leverage example - Scenario 2 (one year later)?

House appreciates to $425,000; loan paid down to $375,000. Equity = $425,000 - $375,000 = $50,000.

What is the core lesson of the leveraged house example?

Debt makes the good times better and the bad times worse (the 'lottery ticket' effect); equity is a buffer against tough times - with no equity cushion, an income shock (e.g., losing your job) leaves you with nothing to fall back on.

If you buy a $100,000 asset with 90% debt and 10% equity, what happens to your return?

Leverage amplifies both gains and losses on the equity slice - a given % move in the asset produces a much larger % move in the small equity slice (before financing costs).

What is Gross Sales?

The total value of invoices sent out - what you billed.

What is Net Sales?

Gross sales minus sales returns (cancelled sales) and sales allowances (price reductions granted after sale) - no chargebacks, no rebates.

Which sales figure do we care about: gross or net?

Net sales - it's the top line of the income statement and what everything else (COGS, gross profit) is measured against.

What is elastic demand?

A price change produces a big change in quantity demanded - customers easily substitute away.

What is inelastic demand?

A price change produces little/no change in quantity demanded - this is the goal for every business (raise price without losing volume).

What does 'competitive advantage' really mean?

No one can steal your customers. The dream is a monopoly in your product market.

How do you maintain a competitive advantage?

Barriers to entry/exit, a differentiated product, strong selling relationships, and brand loyalty.

What does it mean to 'blur the price-value relationship'?

Actually being better, or convincing the customer you are - works best when customer needs are complex and performance is hard to judge/compare.

What is a contestable market and why is it bad?

A market with no barriers to entry - bad for incumbents; invites price cutting, increased advertising, promotions, and litigation as retaliation tools.

What is SG&A and what is it also called?

Selling, General & Administrative expense - also called overhead (US) or functional costs (Europe). The costs you must incur to earn gross profit.

What are the three components of SG&A?

Selling (commissions to sales people, a variable cost ~1:1 with quantity), General (rent, office supplies, utilities), Administrative (salaries, insurance).

What two items are often buried in SG&A but need to be broken out?

R&D and brand marketing expenditures - both strategically important and easy to hide inside general SG&A.

Why are salespeople described as the most liquid human capital?

They can walk to a competitor at any time, taking client relationships with them.

What does the income statement (P&L) answer?

Did the firm make money? Revenues - Expenses = Earnings (Income).

Why is Net Income not the same as cash flow?

Accrual accounting recognizes revenue when earned and expenses when incurred, regardless of when cash actually moves.

What is the balance sheet equation?

Assets = Liabilities + Equity (A = L + E). Rearranged: Equity = Assets - Liabilities.

What is the single most important thing on the balance sheet?

The DATE - it's a snapshot of the firm's financial condition at one instant, like a photograph.

Does the balance sheet reveal the firm's future or overall condition?

No - it only shows a point-in-time position, not the future or true financial condition.

In what order are balance sheet items listed?

Top to bottom in order of decreasing liquidity (cash, marketable securities, AR, inventory, prepaids...).

What happens to equity if an asset's value drops without an offsetting liability reduction?

Equity is eroded directly - anything that reduces an asset without a similar reduction in liabilities erodes equity.

What is 'common sizing' of a balance sheet?

Dividing every line by Total Assets - makes it easy to compare firms of different sizes or the same firm over time.

What is the most important lesson in this class?

Cash is king! You have to have access to cash - profit is not the same as cash flow.

Where do you find out how much cash a firm will need?

The statement of cash flows.

Why is a firm with only one principal source of funds at risk?

If that single source dries up, the firm has no cash cushion - diversify your cash flows or risk failure.

What are the two dimensions of liquidity?

1) Speed - how quickly can the asset be converted to cash. 2) Transaction cost - how much value is lost/what it costs to convert the asset to cash.

Why is the current ratio a bad liquidity measure?

It ignores the timing mismatch between when specific current assets will actually monetize and when specific current liabilities are actually due.

What is the Quick Ratio and when is it used?

(Current Assets - Inventory) / Current Liabilities - used when inventory quality is questionable. Still flawed.

What is a better approach to measuring liquidity?

Bucket assets and liabilities by when they will actually convert to/require cash (3, 6, 9, 12 months) and compare like-for-like.

What is the key liquidity question for credit analysts?

Can the firm survive a sudden, catastrophic disruption to its revenue stream?

What is the formula for EBITDA?

EBITDA = Net Sales - Cash COGS - Cash SG&A (equivalently EBIT + D&A). Not a line on the financial statements.

Why is EBITDA not a good cash-flow measure?

It ignores cash consumed by increases in working capital and CAPEX - can massively overstate cash flow for capital-intensive manufacturers.

Where did EBITDA originate and what is it best used for?

1980s leveraged buyouts, to gauge ability to service debt (lenders often required EBITDA >= 4x interest expense). Works best for service companies / asset-light businesses.

What is the formula for Return on Equity (ROE)?

ROE = Net Income / Shareholders' Equity - the rate of return earned on a $1 equity investment.

What is the DuPont identity?

ROE = Profit Margin x Total Asset Turnover x Equity Multiplier = (NI/Sales) x (Sales/Total Assets) x (Total Assets/Equity).

What are the 3 ways to raise ROE (DuPont levers)?

1) Raise profitability (raise price, cut variable/fixed costs, minimize taxes). 2) Raise asset efficiency (lower DSO, higher inventory turnover, stretch prepaids, higher fixed-asset turnover, raise DPO). 3) Raise leverage.

What is the formula for ROCE and who uses it?

ROCE = EBIT / Capital, where Capital = Total Assets - Accounts Payable - Accrued Liabilities. Used more by European companies (analogue to ROE).

How does ROCE differ from ROE?

ROE uses Net Income and Equity in the denominator; ROCE uses EBIT and a capital base that strips out the 'free' financing from AP and accrued liabilities.

True or False: The balance sheet always balances.

True - A = L + E, no exceptions.

True or False: Credit is a source of funds and debit is a use of funds.

True.

True or False: Profit equals cash flow.

False - profit and cash flow are not the same thing.

True or False: EBITDA is a cash-flow measure.

False - EBITDA is not a cash-flow measure; it ignores CAPEX and working capital changes.

True or False: Land depreciates.

False - land never depreciates.

True or False: The balance sheet reveals a firm's future or overall financial condition.

False - it's only a snapshot at a single date.

True or False: Markup is always greater than gross profit margin.

True - for any positive cost/price pair.

True or False: It is possible to have Assets greater than Liabilities plus Equity.

Always FALSE - this is purely conceptual; A = L + E is an accounting identity that can't be violated.

True or False: A 100% gross profit margin is achievable.

False - it would require zero cost. A 100% markup, however, IS possible.

What are the two kinds of CAPEX?

Maintenance CAPEX (grows ~1:1 with quantity/COGS, approximates depreciation, smooth) and Expansion CAPEX (driven by capacity utilization, lumpy).

How does CAPEX flow through the financial statements?

CAPEX flows into PP&E on the balance sheet and is depreciated over the asset's useful life; on the cash flow statement it's a negative (use) under investing activities.

What is depreciation?

The allocation of a tangible asset's cost over its useful life - represents wear and tear.

Does land depreciate?

No - land never depreciates; there's no tax break for owning land.

Is depreciation a cash charge?

No - it's non-cash; it's added back to net income when building cash flow from operations on the statement of cash flows.

What is amortization and depletion?

Amortization = the equivalent of depreciation for capital leases, leasehold improvements, and intangibles (patents, copyrights, trademarks, franchises). Depletion = the equivalent for natural resources.

What is Accounts Payable and its red flag?

Driven by purchases 1:1; a zero-interest IOU to suppliers. Not growing 1:1 with purchases (dragging payables) is a red flag for liquidity problems.

What is Notes Payable used for?

Like a credit card / revolving line of credit; short-term debt to suppliers or banks up to a max limit; funds inventory and receivables. Goal: pay it down fast.

What's the difference between a seasonal and a revolving line of credit?

A seasonal line must hit zero at some point in the year; a revolving line does not have to be paid to zero.

What are Accrued Liabilities?

Driven by COGS/labor and quantity; something enjoyed but not yet paid (utility bill, payroll, pension obligations). The most important liability - payroll can never bounce.

How are financial and operating leases treated for leverage purposes?

Technically not debt, but debt-like - treated as debt when calculating leverage ratios.

What is Long-Term Debt?

Notes, bonds, mortgages, loans with maturity longer than a year; involves required interest and principal payments.

What is Pre-tax Income (EBT)?

EBIT minus interest expense (plus/minus other non-operating income/expense); the firm pays taxes on this amount.

What is the formula for Effective Tax Rate?

Effective Tax Rate = Taxes / Pre-tax Income.

Why can firms deduct interest expense before taxes?

It creates an interest tax shield (same concept as deducting mortgage interest); the present value of a tax shield can be significant.

What is the formula for Markup?

Markup = (Sales - Cost) / Cost.

What is the formula for Gross Profit Margin?

Gross Profit Margin = (Sales - Cost) / Sales.

Worked example: Cost = $100, Price = $120. What is the markup?

Markup = (120-100)/100 = 20%.

Worked example: Cost = $100, Price = $120. What is the gross margin?

Gross margin = (120-100)/120 = 16.7%.

Is markup or gross margin always larger, for the same cost/price pair?

Markup is always larger than gross profit margin (for any cost greater than 0).

Can gross profit margin ever be 100%?

No - it would require zero cost. A 100% markup, however, is achievable.

What does Gross Profit measure conceptually?

A measure of brand power - the bigger the markup a firm can command, the more it has blurred the price-value relationship in its favor.

What is Porter's Five Forces (used to explain gross margin differences)?

Threat of new entry, intensity of existing competition, threat of substitute products, bargaining power of buyers, bargaining power of vendors.

Markup-to-margin conversion: 15% markup = ?

13.0% gross profit margin.

Markup-to-margin conversion: 20% markup = ?

16.7% gross profit margin.