Understanding the Three Financial Statements

What are the three major financial statements?

The Income Statement, Balance Sheet, and Cash Flow Statement.

What does the Income Statement provide?

It provides the company's revenue and expenses, culminating in Net Income.

What does the Balance Sheet show?

It shows the company's Assets, Liabilities, and Shareholders' Equity, with Assets equaling Liabilities plus Shareholders' Equity.

What is the purpose of the Cash Flow Statement?

It begins with Net Income, adjusts for non-cash expenses and working capital changes, and lists cash flow from investing and financing activities.

List some major line items found on the Income Statement.

Revenue, Cost of Goods Sold, SG&A (Selling, General & Administrative Expenses), Operating Income, Pretax Income, Net Income.

What are some key line items on the Balance Sheet?

Cash, Accounts Receivable, Inventory, PP&E (Plants, Property & Equipment), Accounts Payable, Accrued Expenses, Debt, Shareholders' Equity.

What major line items are included in the Cash Flow Statement?

Net Income, Depreciation & Amortization, Stock-Based Compensation, Changes in Operating Assets & Liabilities, Cash Flow From Operations, Capital Expenditures, Cash Flow From Investing, Sale/Purchase of Securities, Dividends Issued, Cash Flow From Financing.

How do the three financial statements link together?

Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet and into the top line of the Cash Flow Statement.

If you could only use one financial statement to assess a company's health, which would it be and why?

The Cash Flow Statement, because it shows the actual cash generated by the company, independent of non-cash expenses.

If you could only look at two financial statements, which would you choose and why?

The Income Statement and Balance Sheet, as you can derive the Cash Flow Statement from these two.

What is the effect of a $10 increase in Depreciation on the Income Statement?

Operating Income would decline by $10, leading to a Net Income decrease of $6 assuming a 40% tax rate.

How does a $10 increase in Depreciation affect the Cash Flow Statement?

Net Income decreases by $6, but $10 Depreciation is added back, resulting in an overall Cash Flow from Operations increase of $4.

What happens to the Balance Sheet when Depreciation increases by $10?

PP&E decreases by $10, Cash increases by $4, resulting in a net decrease in Assets of $6, which matches the decrease in Shareholders' Equity.

What order should you follow when analyzing the impact of Depreciation on financial statements?

1. Income Statement 2. Cash Flow Statement 3. Balance Sheet.

Why does Depreciation, a non-cash expense, affect cash balance?

It is tax-deductible, reducing the amount of taxes paid, which affects cash.

Where does Depreciation typically appear on the Income Statement?

It usually shows up as an expense, often under Operating Expenses.

What is the significance of Cash and Shareholders' Equity on the Balance Sheet?

They act as 'plugs,' with Cash flowing in from the final line on the Cash Flow Statement.

What is the relationship between Assets and Liabilities plus Shareholders' Equity?

Assets must equal Liabilities plus Shareholders' Equity.

What does the Cash Flow Statement adjust for?

It adjusts for non-cash expenses and changes in working capital.

What is the primary focus when analyzing a company's financial health?

The company's cash flow.

What is the impact of an Asset increase on Cash Flow?

An increase in an Asset decreases Cash Flow.

What is the impact of a Liability increase on Cash Flow?

An increase in a Liability increases Cash Flow.

What is the effect of depreciation on Pre-Tax Income?

Depreciation always reduces Pre-Tax Income.

What happens when Accrued Compensation increases by $10?

Operating Expenses increase by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).

How does an increase in Accrued Compensation affect the Cash Flow Statement?

Net Income decreases by $6, but Accrued Compensation increases Cash Flow by $10, resulting in an overall Cash Flow from Operations increase of $4.

What is the impact of an increase in Inventory by $10 when paid with cash?

There are no changes to the Income Statement; Cash Flow from Operations decreases by $10, and the Net Change in Cash also decreases by $10.

Why does the Income Statement not reflect changes in Inventory?

Inventory expense is recorded only when the goods are sold; if inventory is unsold, it does not count as Cost of Goods Sold or Operating Expense.

What happens when Apple buys $100 worth of new iPad factories with debt at the start of Year 1?

No changes on the Income Statement; Cash Flow from Investing decreases by $100, but the debt raised adds $100 to Cash Flow, leaving cash unchanged. PP&E increases by $100 on the Balance Sheet.

What are the effects on financial statements after one year of owning the factories with a 10% depreciation and 10% interest expense?

Operating Income decreases by $10 due to depreciation; Pre-Tax Income falls by $20 (including interest expense). Net Income falls by $12. Cash Flow from Operations decreases by $2.

How does the Balance Sheet change after one year of depreciation and interest expense?

Assets decrease by $12 (Cash down by $2 and PP&E down by $10), and Shareholders' Equity decreases by $12 due to the drop in Net Income.

What happens to the factories at the start of Year 3?

The value of the equipment is written down to $0, and the loan must also be paid back.

What is the relationship between Accrued Compensation and Liabilities on the Balance Sheet?

Accrued Compensation is a liability; when it increases, Liabilities go up by the same amount.

How does Net Income affect Retained Earnings on the Balance Sheet?

A decrease in Net Income leads to a decrease in Retained Earnings.

What is the effect of a 40% tax rate on changes in Pre-Tax Income?

A decrease in Pre-Tax Income results in a proportional decrease in Net Income after tax.

What is the impact of depreciation on Cash Flow from Operations?

Depreciation is a non-cash expense, so it is added back to Net Income when calculating Cash Flow from Operations.

What occurs on the Cash Flow Statement when Inventory is purchased?

Cash Flow from Operations decreases by the amount spent on Inventory, reflecting a cash outflow.

What happens to Assets when Cash decreases due to Inventory purchase?

Assets remain balanced as Inventory increases by the same amount Cash decreases.

What is the effect of interest expense on Pre-Tax Income?

Interest expense decreases Pre-Tax Income.

How does an increase in Operating Expenses affect Net Income?

An increase in Operating Expenses reduces Net Income.

What is the significance of recognizing Accrued Compensation as an expense?

Recognizing Accrued Compensation as an expense increases Operating Expenses and reduces Pre-Tax Income.

What happens to Cash Flow from Operations when Net Income decreases?

Cash Flow from Operations may still increase if there are non-cash adjustments like depreciation.

How does the Balance Sheet remain balanced after changes in Assets and Liabilities?

Both sides balance as increases in liabilities or decreases in equity offset changes in assets.

What is the impact of a write-down of equipment value to $0 on the Balance Sheet?

Assets decrease significantly, and Shareholders' Equity decreases due to the loss recorded.

What is the relationship between Cash Flow from Investing and Cash Flow from Financing when purchasing assets with debt?

Cash Flow from Investing decreases due to the purchase, while Cash Flow from Financing increases due to the debt raised, potentially offsetting each other.

What happens to the value of equipment at the start of Year 3?

The value of the equipment is written down to $0.

How does the $80 write-down affect the Income Statement?

It shows up in the Pre-Tax Income line, causing Net Income to decline by $48 with a 40% tax rate.

What is the impact of the $80 write-down on the Cash Flow Statement?

Net Income decreases by $48, but since the write-down is a non-cash expense, it is added back, resulting in Cash Flow from Operations increasing by $32.

What changes occur in Cash Flow from Financing due to loan repayment?

There is a $100 charge for the loan payback, causing Cash Flow from Financing to fall by $100.

What is the overall Net Change in Cash after the write-down and loan repayment?

The Net Change in Cash falls by $68.

How do the changes affect the Balance Sheet?

Cash decreases by $68 and PP&E decreases by $80, leading to a total decrease in Assets of $148.

What happens to Debt and Shareholders' Equity on the Balance Sheet after the loan repayment?

Debt decreases by $100 and Shareholders' Equity decreases by $48 due to the decline in Net Income.

What is the relationship between the changes in Assets and Liabilities & Shareholders' Equity?

Both sides decrease by $148, keeping the Balance Sheet balanced.

What happens to the Income Statement when Apple orders $10 of additional iPad inventory?

There are no changes to the Income Statement.

How does the Cash Flow Statement reflect the purchase of $10 inventory?

Inventory increases by $10, leading to a decrease in Cash Flow from Operations by $10.

What is the overall effect on Cash after ordering the inventory?

Overall Cash is down by $10.

How does the Balance Sheet change after ordering the inventory?

Inventory is up by $10 and Cash is down by $10, so the Assets number stays the same.

What occurs on the Income Statement when Apple sells iPads for $20 with a cost of $10?

Revenue is up by $20, COGS is up by $10, resulting in a Gross Profit increase of $10 and Operating Income increase of $10.

How does Net Income change after selling the iPads?

Net Income increases by $6, assuming a 40% tax rate.

What is the impact on the Cash Flow Statement after selling the iPads?

Net Income increases by $6 and Inventory decreases by $10, resulting in an overall increase in Cash Flow from Operations by $16.

What is the overall change in Cash after selling the iPads?

Net Change in Cash is up by $16.

How does the Balance Sheet change after the sale of the iPads?

Cash is up by $16 and Inventory is down by $10, resulting in a total Assets increase of $6.

What happens to Shareholders' Equity after the sale of the iPads?

Shareholders' Equity is up by $6 due to the increase in Net Income.

Can shareholders' equity ever turn negative?

Yes, it can occur in leveraged buyouts with dividend recapitalizations or if a company consistently loses money.

What does negative shareholders' equity indicate?

It can indicate that the company is struggling, but it doesn't necessarily mean anything specific.

What is Working Capital?

Working Capital = Current Assets - Current Liabilities.

What does positive Working Capital signify?

It indicates that a company can pay off its short-term liabilities with its short-term assets.

What is Operating Working Capital?

Operating Working Capital = (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt), excluding financing activities.

What does negative Working Capital mean?

It can indicate various situations depending on the type of company and context; it is not inherently a bad sign.

What is a common reason for companies to have negative Working Capital?

High Deferred Revenue balances, especially in companies with subscriptions or long-term contracts.

Why do retail and restaurant companies often have negative Working Capital?

Customers pay upfront, allowing companies to use the cash to pay off Accounts Payable instead of holding large cash balances.

What can negative Working Capital indicate about a company?

It may signal business efficiency, but it can also point to financial trouble or possible bankruptcy if customers don't pay quickly.

What happens to the Income Statement when there's a $100 write-down?

The $100 write-down appears in the Pre-Tax Income line, causing Net Income to decline by $60 after a 40% tax.

How does a $100 write-down affect the Cash Flow Statement?

Net Income decreases by $60, but since the write-down is a non-cash expense, it is added back, resulting in a $40 increase in Cash Flow from Operations.

What is the overall effect on Net Change in Cash from a $100 write-down?

The Net Change in Cash rises by $40.

How does a $100 write-down affect the Balance Sheet?

Cash increases by $40, an asset decreases by $100, leading to a net decrease in Assets of $60.

What happens to Shareholders' Equity after a $100 write-down?

Shareholders' Equity decreases by $60 due to the decline in Net Income.

What is the typical scenario for a $100 bailout of a company?

An equity investment from the government.

How does a $100 bailout affect the Income Statement?

There are no changes to the Income Statement.

What happens to the Cash Flow Statement during a $100 bailout?

Cash Flow from Financing increases by $100, resulting in a $100 increase in Net Change in Cash.

How does a $100 bailout impact the Balance Sheet?

Cash increases by $100, leading to a $100 increase in Assets and a corresponding increase in Shareholders' Equity.

What is the impact of a $100 write-down of debt on the Income Statement?

Pre-Tax Income increases by $100, resulting in a $60 increase in Net Income after tax.

How does a $100 write-down of debt affect the Cash Flow Statement?

Net Income increases by $60, but Cash Flow from Operations decreases by $40 due to the debt write-down.

What is the overall effect on Cash from a $100 write-down of debt?

Net Change in Cash decreases by $40.

What happens on the Balance Sheet after a $100 write-down of debt?

Cash decreases by $40, Debt decreases by $100, and Shareholders' Equity increases by $60.

When would a company collect cash from a customer and not record it as revenue?

Examples include web-based subscription software, cell phone carriers with annual contracts, and magazine publishers with subscriptions.

What happens to cash collected that is not recorded as revenue?

It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.

How does Deferred Revenue become real revenue?

As services are performed over time, the Deferred Revenue balance decreases and is recognized as revenue on the Income Statement.

What is the difference between accounts receivable and deferred revenue?

Accounts receivable is cash not yet collected from customers, while deferred revenue is cash that has been collected.

What does accounts receivable represent?

Accounts receivable represents how much revenue the company is waiting on.

What does deferred revenue represent?

Deferred revenue represents how much cash the company has already collected but is waiting to record as revenue.

What is the typical range for accounts receivable collection days?

Generally, accounts receivable days are in the 30-60 day range.

How does cash-based accounting differ from accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is received or paid, while accrual accounting recognizes revenue when collection is reasonably certain and expenses when incurred.

Why do most large companies use accrual accounting?

Most large companies use accrual accounting due to the prevalence of credit card payments and lines of credit.

How would a credit card payment for a TV be recorded in cash-based accounting?

In cash-based accounting, revenue would not show up until the company charges the credit card, receives authorization, and deposits the funds.

How would a credit card payment for a TV be recorded in accrual accounting?

In accrual accounting, revenue would show up immediately as Accounts Receivable until the cash is deposited.

When should a purchase be capitalized rather than expensed?

A purchase should be capitalized if the asset has a useful life of over 1 year.

What happens to capitalized assets over time?

Capitalized assets are depreciated (tangible) or amortized (intangible) over a certain number of years.

Why do companies report both GAAP and non-GAAP earnings?

Companies report both because non-GAAP earnings exclude non-cash charges, which some argue makes GAAP earnings less reflective of true profitability.

What could cause a company with positive EBITDA to go bankrupt?

Possible reasons include excessive capital expenditures, high interest expenses, inability to refinance debt, or significant one-time charges.

What does EBITDA exclude that could lead to bankruptcy?

EBITDA excludes investment in long-term assets, interest, and one-time charges.