A Simple Model
Introduction to Financial
Statements
NOTES TO ACCOMPANY VIDEOS
These notes are intended to supplement the videos on ASimpleModel.com. They are not to be used
as stand‐alone study aids, and are not written as comprehensive overviews of the topic detailed. The
purpose of these notes is to provide a tangible collection of the visuals used in the videos with
comments highlighting the more important aspects covered.
2013 A Simple Model, LLC. All rights reserved.
Introduction to Financial Statements
002
The Accounting Equation
This video introduces the accounting equation, which is the most important concept in
accounting.
• This relationship between assets, liabilities and stockholders’ equity must always
hold true. There are no exceptions to this rule.
The Accounting Equation
ASSETS
=
All property ow ned by the
com pany.
LIABILITIES
+
All debts the com pany currently
has outstanding.
The resources a com pany uses
to generate revenue.
STOCKHOLDERS' EQUITY
Ow nership interests in the
com pany after all debts have
The m eans of acquiring assets.
After briefly defining the terms and walking through an illustrated example, the
equation is expanded upon to introduce double-entry bookkeeping:
DOUBLE-ENTRY BOOKKEEPING: the system most commonly employed by businesses
to record financial information. Double-entry bookkeeping requires that a change in
one account be matched in another account.
• This is done by recording debits and credits. For every entry the sum of debits must
equal the sum of credits.
• Please see video for an example and greater detail on this topic.
The Accounting Equation
Double-entry bookkeeping: m ost businesses em ploy a double-entry bookkeeping system to record financial data. Under
this system a change in one account m ust be m atched in another account. These changes are m ade by DEBITS (dr) and
CREDITS (cr) to the accounts. For every entry the sum of DEBITS m ust equal the sum of CREDITS.
ASSETS
$
=
LIABILITIES
+
-
-
dr
5,000,000
cr
dr
+
+
$
cr
5,000,000
STOCKHOLDERS' EQUITY
+
dr
cr
A Simple Model
Introduction to Financial Statements
002
The Accounting Equation
Debits and credits are difficult to grasp at first. The best way to approach this concept
is to revisit the definition as your accounting vocabulary grows.
This definition is not included in the video, but can be found under “Reference” on the
website. It can be helpful in better understanding debits and credits because it applies
the concept to something everyone understands: cash.
A Simple Model
Introduction to Financial Statements
002
The Accounting Equation
The video continues to expand upon the accounting equation to show that…
• Stockholders’ equity is equal to the sum of contributed capital and retained
earnings.
• Net income is equal to revenues less expenses.
ASSETS
=
LIABILITIES
+
+
-
-
+
dr
cr
dr
cr
STOCKHOLDERS' EQUITY
=
CONTRIBUTED CAPITAL
+
dr
NET INCOME
=
dr
+
cr
REVENUES
STOCKHOLDERS' EQUITY
+
cr
RETAINED EARNINGS
+
dr
Dividends
-
cr
Net Incom e
EXPENSES
-
+
+
-
dr
cr
dr
cr
These relationships are important in understanding how financial statements relate to
one another and will be elaborated upon in future videos.
A Simple Model
Introduction to Financial Statements
002
The Accounting Equation
The video concludes by pointing out that the balance sheet is simply a more formal
presentation of the accounting equation.
To demonstrate this the video organizes the components of the accounting equation
vertically, and then details accounts that fall under assets, liabilities and stockholders’
equity.
Balance Sheet
Balance Sheet
Company Name
Company Name
(000s)
(000s)
BALANCE SHEET
ASSETS
+
-
dr
cr
LIABILITIES
-
+
dr
cr
20X1
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Prepaid Expenses
Total Current Assets
1,773
7,750
4,800
456
14,779
Fixed Assets
PP&E, Net of Accum. Depreciation
10,913
TOTAL ASSETS
25,692
LIABILITIES
STOCKHOLDERS' EQUITY
+
dr
cr
Current Liabilities
Accounts Payable
Line of Credit
Current Maturities of Long Term Debt
Total Current Liabilities
5,665
792
500
6,957
Long Term Liabilities
Long Term Debt, Net of Current Maturities
5,000
TOTAL LIABILITIES
11,957
EQUITY
Common Stock
Additional Paid In Capital
Retained Earnings
TOTAL EQUITY
15
5,000
8,720
13,735
TOTAL LIABILITIES & EQUITY
25,692
Check
0 .0
Finally, the video points out that in every thorough financial model, for every
accounting period, the balance sheet has a check to make certain that the accounting
equation holds true.
A Simple Model
Introduction to Financial Statements
003
Balance Sheet
This video introduces the balance sheet. After a quick reminder that the balance sheet
is just a formal presentation of the accounting equation, the video walks through some
definitions:
BALANCE SHEET: The balance sheet shows the financial position of a company at a
given moment.
• It may help to think of it as a photograph depicting everything that the company has
(Assets), what it owes (Liabilities) and the ownership interests in the company
(Stockholders’ Equity).
ASSETS: Assets consists of the physical properties of the company, money it holds or
has invested and money that is owed to the company. You can also have intangible
assets, such as goodwill.
LIABILITIES: Liabilities include debts incurred in the ordinary course of business
(accounts payable and other obligations), and more formal borrowings (notes from a
bank).
STOCKHOLDERS’ EQUITY: Stockholders’ equity represents the ownership interests in
the company.
Because these concepts can still be a little abstract the video then walks through an
illustrated example to provide greater context.
In the example you are asked to consider the items you would require to start a
company and determine how you would finance the purchase of these items.
A Simple Model
Introduction to Financial Statements
003
Balance Sheet
Rearranging these items vertically provides a familiar order that begins to resemble a
balance sheet. On the right hand side of the illustration you will note that the
accounting equation holds true as well.
The video then transitions back to a more thorough balance sheet to walk through a
few more definitions.
Balance Sheet
ASSETS
(000s)
BALANCE SHEET
ASSETS
Current Assets
Cash
Accounts Receivable
Inventory
Prepaid Expenses
Total Current Assets
Cash: Money the company holds or has invested
20X1
AR: Money that is owed to the company for goods or services sold
Inventory: Raw materials, work‐in‐process goods and finished goods that are ready for sale (or will be)
0
Prepaid Expenses: Goods or services owed to the company, which were paid for in advance
0
PP&E: Physical property of the company
Fixed Assets
PP&E, Net of Accum. Depreciation
TOTAL ASSETS
LIABILITIES
Current Liabilities
Accounts Payable
Line of Credit (or other Short Term Borrow ings)
Current Maturities of Long Term Debt
Total Current Liabilities
LIABILITIES
0
Long Term Liabilities
Long Term Debt, Net of Current Maturities
TOTAL LIABILITIES
EQUITY
Common Stock
Additional Paid In Capital
Retained Earnings
TOTAL EQUITY
TOTAL LIABILITIES & EQUITY
Check
AP: Debts incurred in ordinary course of business for goods or services purchased by the company
Debt for borrowed money
0
STOCKHOLDERS' EQUITY
Common Stock and APIC: Contributed capital
0
0
Retained Earnings: Earnings retained by the company (not paid out to shareholders)
0 .0
A Simple Model
Introduction to Financial Statements
003
Balance Sheet
The expanded accounting equation is revisited to elaborate upon the components of
stockholders’ equity.
• Contributed Capital: Investors or owners contribute capital to a business hoping for
two potential cash flows.
1. Dividends
2. Gains from selling the stock at a higher price.
• Retained Earnings: Earnings not distributed, but reinvested. The video also points
out that this account grows by net income, which is an important relationship.
ASSETS
=
LIABILITIES
+
+
-
-
+
dr
cr
dr
cr
STOCKHOLDERS' EQUITY
=
CONTRIBUTED CAPITAL
+
dr
FINANCING PROVIDED BY
dr
+
cr
OWNERS
Two types of cash flows:
1. Dividends
2. Gains from selling the stock
at a higher price (Capital Gains)
STOCKHOLDERS' EQUITY
+
cr
RETAINED EARNINGS
+
dr
Dividends
&
cr
Net Incom e
COMPANY
Earnings not distributed, but
reinvested
A Simple Model
Introduction to Financial Statements
003
Balance Sheet
To demonstrate how the relationship between retained earnings and net income
translates into a financial model in excel the video walks through a couple examples.
First by showing the relationship as pictured below, and then by showing the
relationship in a fully integrated financial model.
Retained earnings grows the equity account by the amount of income generated.
INCOME STATEMENT
Revenue
Expenses
Net Incom e
20X1
BALANCE SHEET
20X1
20X2
0
0
20X2
ASSETS
Cash
Accounts Receivable
PP&E, Net of Accum. Depreciation
TOTAL ASSETS
0
0
TOTAL LIABILITIES
0
0
EQUITY
Common Stock
Additional Paid In Capital
Retained Earnings
TOTAL EQUITY
0
0
0
LIABILITIES
Accounts Payable
Line of Credit
Long Term Debt
TOTAL LIABILITIES & EQUITY
Check
0
0
0 .0
0 .0
A Simple Model
Introduction to Financial Statements
003
Balance Sheet
The video then points out (broadly) the relationship between the balance sheet and the
cash flow statement.
• An increase in an asset account consumes cash.
• An increase in a liability account provides cash.
Changes in balance sheet accounts will directly impact the Cash Flow Statement
Cash is used to acquire assets and pay down liabilities
BALANCE SHEET
20X1
20X2
ASSETS
Cash
Accounts Receivable
Inventory
500
500
600
600
1,000
1,200
500
600
500
600
PP&E, Net of Accum. Depreciation
TOTAL ASSETS
LIABILITIES
Accounts Payable
Line of Credit
Long Term Debt
TOTAL LIABILITIES
EQUITY
Common Stock
Additional Paid In Capital
Retained Earnings
TOTAL EQUITY
TOTAL LIABILITIES & EQUITY
Check
CASH IMPACT
Accounts Receivable
Inventory
Accounts Payable
0
0
500
600
5 0 0 .0
6 0 0 .0
20X2
(100)
(100)
100
A Simple Model
Introduction to Financial Statements
003
Balance Sheet
The video concludes with an illustration to begin describing how the three primary
financial statements relate to one another:
The balance sheet shows the financial position of a company at a given point in time,
and the income statement and cash flow statement show the economic activity of a
company over a given period of time. In this way consecutive balance sheets are
essentially linked by income statements and cash flow statements. The difference is that
the income statement shows economic activity on an accrual basis of accounting, and
the cash flow statement shows economic activity on a cash basis of accounting.
This is elaborated upon in the video that follows.
A Simple Model
Introduction to Financial Statements
004
Income Statement
This video introduces the income statement. The video starts by showing the income
statement in its most concise format as pictured below.
Income Statement
INCOME STATEMENT
20X1
20X2
Revenue
Growth (%)
74,452
NA
83,492
12.1%
Expenses
Margin (%)
72,434
97.3%
80,925
96.9%
Net Incom e
2,018
2,567
Measure of profitability of the firm over a specified time period.
Measure of success in selling a good or service.
After this introduction the accounting equation is revisited to help illustrate how the
balance sheet and income statement relate to one another. The most significant
relationship here is that stockholders’ equity grows with net income.
ASSETS
=
LIABILITIES
+
+
-
-
+
dr
cr
dr
cr
STOCKHOLDERS' EQUITY
=
CONTRIBUTED CAPITAL
+
dr
NET INCOME
=
dr
+
cr
REVENUES
STOCKHOLDERS' EQUITY
+
cr
RETAINED EARNINGS
+
dr
Dividends
-
cr
Net Incom e
EXPENSES
-
+
+
-
dr
cr
dr
cr
A Simple Model
Introduction to Financial Statements
004
Income Statement
The video then elaborates on the various categories of expenses found on the income
statement. The text has been included below as a reference.
Income Statement
INCOME STATEMENT
Revenue
Growth (%)
74,452
NA
20X2
83,492
12.1%
Gross Profit
% of Sales
COGS: All
64,440 costs directly associated with providing the good 72,524
or service sold to the customer. More specifically this would 86.6%
86.9%
include the cost of the materials used in creating the good and the associated direct labor costs.
10,012
10,968
13.4%
13.1%
Operating Expenses (SG&A)
% of Sales
Operating Expenses or SG&A: All major non‐production 6,389
6,545
expenses incurred in running the company. 8.6%
7.8%
Operating Incom e (EBIT)
Interest Expense
3,623
4,423
Interest Expense: This relates to the cost of borrowing 518
474
money. It is the price that a lender (bank) charges a Pretax Incom e
borrower (company). Interest expense creates a tax shield.
3,105
3,949
Income Tax Expense
Tax Rate
1,087
1,382
Tax Expense: The last
expense listed on the income NM
NM
statement. All profitable corporations are required to 2,018
2,567
calculate taxes owed to federal and state governments.
Cost of Goods Sold
% of Sales
EXPENSES
20X1
Net Incom e
NOT MENTIONED IN VIDEO: The text under interest expense concludes stating that
interest expense creates a tax shield. This is not elaborated upon in the video, but tax
shields (interest expense is not the only tax shield) are important and will be referenced
in future videos.
For the time being, all that is important is that interest expense is deducted from net
income before tax expense is calculated, which results in a lower tax burden (tax
shield).
A Simple Model
Introduction to Financial Statements
004
Income Statement
On this tab the video focuses on the difference between operating income (or EBIT)
and net income. The reason for making this distinction is that expenses that do not
relate to the core operation of the business come after EBIT.
For this reason the gross profit margin and EBIT margin are more commonly
referenced in analysis detailing a companies operations and profitability.
Income Statement
INCOME STATEMENT
Revenue
Growth (%)
Cost of Goods Sold
% of Sales
Gross Profit
% of Sales
EXPENSES
Operating Expenses (SG&A)
% of Sales
20X1
20X2
74,452
NA
83,492
12.1%
64,440
72,524
Operating Income vs. Net Income
86.6%
86.9%
Operating Income is calculated by subtracting expenses related to the core operation of the 10,012
10,968
13.1%
business. 13.4%
6,389
6,545
518
474
Pretax Incom e
3,105
3,949
Income Tax Expense
Tax Rate
1,087
NM
1,382
NM
Net Incom e
2,018
2,567
Operating Incom e (EBIT)
Interest Expense
Net Income is calculated by subtracting 8.6%
7.8%
additional expenses unrelated to the core 3,623
4,423
operation of the business.
A Simple Model
Introduction to Financial Statements
004
Income Statement
Continuing with measures of profitability, the video then references EBITDA. EBITDA is
an acronym that stands for Earnings Before Interest, Taxes, Depreciation and
Amortization.
It is generally not found on a company’s income statement, but it is commonly
referenced in most financial models because it is frequently used in determining the
value of a company.
Income Statement
INCOME STATEMENT
20X2
Revenue
Growth (%)
74,452
NA
Cost of Goods Sold
% of Sales
EBITDA
is frequently
used in 64,440
72,524
determining the value of a 86.6%
86.9%
company. 10,012
10,968
Gross Profit
% of Sales
Operating Expenses (SG&A)
% of Sales
Operating Incom e (EBIT)
Interest Expense
EBITDA
20X1
13.4%
83,492
12.1%
13.1%
EBITDA is an acronym that 6,389
6,545
stands for Earnings Before 8.6%
7.8%
Interest, Taxes, Depreciation 3,623
4,423
and Amortization.
518
474
Pretax Incom e
3,105
3,949
Income Tax Expense
Tax Rate
1,087
NM
1,382
NM
Net Incom e
2,018
2,567
Operating Income (EBIT)
Depreciation
Amortization
EBITDA
3,623
2,648
0
6,271
4,423
2,981
0
7,404
A Simple Model
Introduction to Financial Statements
004
Income Statement
The objective of the income statement is then revisited to point out two important
accounting concepts:
1.
The Matching Principle
2.
Depreciation
Objective of the Income Statement
(Defined & Simplified)
The objective of the income statement is to demonstrate how successful a company is at
selling a good or service.
Matching Principle
Matching revenue generated by the sale of a good or service with the expense of providing that good or
service in the same accounting period.
The matching principle requires that the cost incurred in generating revenues be recognized in the same
period. (REGARDLESS OF WHEN CASH IS PAID)
Depreciation
The allocation of the cost of tangible assets (property, plant or equipment) over multiple accounting periods
representing the useful life of the tangible asset.
Because the matching principle requires that expenses be recorded when revenue is
recognized, the video then details the four conditions required to recognize revenue.
Matching Principle Relies on Revenue Recognition
Revenue Principle
1
Delivery has occurred or services have been rendered.
2
There is persuasive evidence of an arrangement for customer payment. This can be cash or a promise to
pay cash at a future date (accounts receivable).
3
The price must be fixed or determinable.
4
Collection is reasonably assured. The company must review the customer's ability to pay.
A Simple Model
Introduction to Financial Statements
004
Income Statement
Another important relationship to keep in mind as you build financial models is that
the cash flow statement starts with net income.
The video demonstrates this relationship with the visual pictured below, and then by
showing this link in a fully integrated financial model.
The Cash Flow Statement Starts with Net Income
INCOME STATEMENT
Revenue
Expenses
Net Incom e
20X1
CASH FLOW STATEMENT
CASH FLOW FROM OPERATING ACTIVITIES
Net Incom e
20X1
20X2
0
Add Back Non-Cash Item s
Depreciation
Amortization
Changes in Working Capital
Accounts Receivable
Inventory
Accounts Payable
0
20X2
0
0
Net income is derived from accounting rules and accruals, and does not equate to the actual cash earnings realized in the accounting period.
Net Cash Provided by Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES
Capital Expenditures - Purchase of PP&E
Net Cash Used in Investing Activities
CASH FLOW FROM FINANCING ACTIVITIES
Revolving Credit Facility (Line of Credit)
Long Term Debt
Net Cash Provided by (Used in) Fnce Activities
Net Cash Flow
Beginning Cash Balance
Ending Cash Balance
A Simple Model
Introduction to Financial Statements
004
Income Statement
The video concludes by highlighting the difference between an accrual basis of
accounting and a cash basis of accounting.
Accrual vs. Cash Basis of Accounting
(Defined & Simplified)
ACCRUAL BASIS of Accounting
Revenue
Recognized when earned. (Revenue Principle)
Expenses
Recognized when incurred. (Matching Principle)
CASH BASIS of Accounting
Revenue
Recorded when cash is received. (Cash Receipts)
Expenses
Recorded when cash is paid. (Cash Payments)
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
This video introduces the cash flow statement, which is possibly the most straight
forward of the three primary financial statements. Whereas both the income statement
and balance sheet reflect an accrual basis of accounting, the cash flow statement
starts with net income and translates the economic activity of the firm from an accrual
basis to a cash basis.
The cash inflows and outflows are divided into three categories, which can be seen in
the screenshot below. The definitions provided for Cash Flow from Operating Activities
(CFO), Cash Flow from Investing Activities (CFI) and Cash Flow from Financing
Activities (CFF) will be referenced in the notes that follow.
Cash Flow Statement
(Defined & Simplified)
The cash flow statement starts with net income and shows how changes in balance
sheet accounts affect CASH.
This calculation is broken down into three categories of cash flows.
Cash Flow from Operating Activities (CFO)
The cash flows that relate directly to revenues and expenses reported on the income statement.
This could include cash receipts from the sale of goods or services, the purchase of raw materials, payments
to suppliers for goods or services and payments to employees.
Cash Flow from Investing Activities (CFI)
Cash flows that relate to the purchase or sale of long-term assets (PP&E), investments in securities
and payments related to M&A activity.
Cash Flow from Financing Activites (CFF)
This includes all cash flows with creditors (banks) and stockholders (owner's of the company).
This could include cash proceeds from raising or issuing debt, repayment of debt principal and dividends to
stockholders.
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
To demonstrate how these three categories are typically represented on the cash flow
statement, the video provides a simple cash flow statement.
The Cash Flow Statement
CASH FLOW STATEMENT
CASH FLOW FROM OPERATING ACTIVITIES
Net Incom e
20X1
20X2
Add Back Non-Cash Item s
Changes in Working Capital
Net Cash Provided by Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES
Capital Expenditures - Purchase of PP&E
Net Cash Used in Investing Activities
CASH FLOW FROM FINANCING ACTIVITIES
Revolving Credit Facility (Line of Credit)
Long Term Debt
Net Cash Provided by (Used in) Fnce Activities
Net Cash Flow
Beginning Cash Balance
Ending Cash Balance
Having introduced the components of the cash flow statement, the video again
emphasizes the relationship between net income and the cash flow statement. This is a
critical relationship in financial models. As you can see in the image below, the cash
flow statement will link directly to the income statement:
The Cash Flow Statement Starts with Net Income
Converting the economic activity of the company from accrual
accounting, which shows the outcome as net income, to reflect the
outcome on a cash basis.
INCOME STATEMENT
Revenue
Expenses
Net Incom e
20X1
CASH FLOW STATEMENT
CASH FLOW FROM OPERATING ACTIVITIES
Net Incom e
20X1
20X2
0
0
20X2
0
0
Add Back Non-Cash Item s
Changes in Working Capital
Net Cash Provided by Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES
Capital Expenditures - Purchase of PP&E
Net Cash Used in Investing Activities
CASH FLOW FROM FINANCING ACTIVITIES
Revolving Credit Facility (Line of Credit)
Long Term Debt
Net Cash Provided by (Used in) Fnce Activities
Net Cash Flow
Beginning Cash Balance
Ending Cash Balance
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
As you work through the cash flow statement from top to bottom you are effectively
converting the economic activity of the company from an accrual basis of accounting
to a cash basis.
To work towards the cash balance calculation:
1.
Calculate cash from operations:
• Start with net income.
• Add back non-cash items. In the video, depreciation and amortization are listed as non-cash
items because they are commonly referenced examples.
• Adjust for changes in working capital. Recall that as an asset increases it consumes cash,
and as a liability increases it provides cash.
2.
Calculate cash flow from investing activities:
• The video uses capital expenditures as an example. Future videos will introduce more
examples.
3.
Calculate cash flow from financing activities:
• This category will be elaborated upon in future videos describing working models.
4.
Sum all three categories to arrive at cash balance.
The Cash Flow Statement
CASH FLOW STATEMENT
CASH FLOW FROM OPERATING ACTIVITIES
Net Incom e
20X1
20X2
Add Back Non-Cash Item s
Depreciation
Amortization
Add Back Non‐Cash Items: Depreciation a nd amortization are good exa mples of non‐cash i tems.
Changes in Working Capital
Accounts Receivable
Inventory
Accounts Payable
Working Capital Accounts: Refl ect a mounts that are to be paid or recei ved in l ess than a year, and the inventory of materials a nd products.
In thi s video we will focus on three working ca pital a ccounts:
Net Cash Provided by Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES
Accounts Receivable
Capital Expenditures - Purchase of PP&E
Inventory
Net Cash Used in Investing Activities
Accounts Paya ble
CASH FLOW FROM FINANCING ACTIVITIES
Revolving Credit Facility (Line of Credit)
Long Term Debt
Net Cash Provided by (Used in) Fnce Activities
Net Cash Flow
Beginning Cash Balance
Ending Cash Balance
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
The video then shifts focus to cash flow from investing activities. The only example
provided in this video is a cash outflow: capital expenditures.
Capital expenditures include the purchase of long-term assets or property, plant and
equipment (PP&E).
The Cash Flow Statement
CASH FLOW STATEMENT
CASH FLOW FROM OPERATING ACTIVITIES
Net Incom e
20X1
20X2
Add Back Non-Cash Item s
Depreciation
Amortization
Changes in Working Capital
Accounts Receivable
Inventory
Accounts Payable
Net Cash Provided by Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES
Capital Expenditures - Purchase of PP&E
Net Cash Used in Investing Activities
CASH FLOW FROM FINANCING ACTIVITIES
Revolving Credit Facility (Line of Credit)
Long Term Debt
Net Cash Provided by (Used in) Fnce Activities
Net Cash Flow
Beginning Cash Balance
Ending Cash Balance
The purpose is to provide the back drop for an illustrated example demonstrating the
conversion of the company’s economic activity from net income (accrual basis of
accounting) to cash, which can be seen on the page that follows.
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
To illustrate how this
works the video revisits
the example where the
company purchases a
crane for $5M in the first
period.
On the income statement
the crane would be
depreciated over 5
periods to reflect its
useful life.
But the $1M sums in
each period do not
reflect a cash outflow,
because depreciation is a
non-cash item.
On the cash flow
statement you are
adjusting net income to
arrive at the company’s
cash balance.
In this example that
requires adding back
depreciation (non-cash
item), and under cash
flow from investing
activities, subtracting
$5M to accurately
represent the purchase of
the crane in period 1.
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
So why is this information important? Cash is the lifeblood of a company. People may
argue that net income or earnings per share are more important, but I would have to
disagree (this is the opinion of the author – if you are a student and your professor
says otherwise I would advise agreeing with him / her for the final exam…)(after the
test remember “cash is king”).
Knowing a company’s cash balance and its ability to generate cash helps make
important decisions surrounding working capital and the purchase of equipment.
And of course, a company’s cash (or liquidity) is very important in managing a
company’s liabilities.
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
Next the video reverts back the fully integrated model to demonstrate how the cash
flow statement works in a financial model.
The first relationship highlighted is that the cash balance calculated on the cash flow
statement links to cash on the balance sheet (see arrow on left-hand side of model). In
this way the cash flow statement adjusts the asset side of your balance sheet in each
consecutive accounting period.
And as a reminder, the video then shows that net income (assuming no dividends)
adjusts the equity account (retained earnings) in each accounting period (see arrow on
right-hand side of model).
Financial Statements
INCOME STATEMENT
Revenue
Cost of Goods Sold
Gross Profit
Operating Expenses (SG&A)
Operating Incom e (EBIT)
Interest Expense
Pretax Incom e
Income Tax Expense
Net Incom e
20X1
1,000
600
400
150
250
43
208
73
135
20X2
1,100
660
440
165
275
38
238
83
154
20X3
1,210
726
484
182
303
33
270
95
176
20X4
1,331
799
532
200
333
28
305
107
198
BALANCE SHEET
Cash
Accounts Receivable
Inventory
Total Current Assets
Property Plant & Equipment (PP&E)
TOTAL ASSETS
Accounts Payable
Current Portion on Long Term Debt
Total Current Liabilities
Long Term Debt
TOTAL LIABILITIES
Common Stock
Retained Earnings
TOTAL EQUITY
TOTAL LIABILITIES & EQUITY
Check
20X1
500
82
99
681
500
1,181
49
50
99
400
499
100
582
682
1,181
0.0
20X2
576
90
108
775
515
1,290
54
50
104
350
454
100
736
836
1,290
0.0
20X3
678
99
119
897
525
1,421
60
50
110
300
410
100
911
1,011
1,421
0.0
20X4
807
109
131
1,047
528
1,575
66
50
116
250
366
100
1,110
1,210
1,575
0.0
CASH FLOW STATEMENT
CASH FLOW FROM OPERATING ACTIVITIES
Net Incom e
Add Back Non-Cash Item s
Depreciation
Amortization
Changes in Working Capital
Accounts Receivable
Inventory
Accounts Payable
Net Cash Provided by Operating Activities
CASH FLOW FROM INVESTING ACTIVITIES
Capital Expenditures - Purchase of PP&E
Net Cash Used in Investing Activities
CASH FLOW FROM FINANCING ACTIVITIES
Revolving Credit Facility
Long Term Debt (Current Portion)
Net Cash Provided by (Used in) Fnce Activities
Net Cash Flow
20X1
20X2
20X3
20X4
134.875
154
176
198
0
0
55
0
61
0
67
0
(8)
(10)
5
196
(9)
(11)
5
222
(10)
(12)
6
249
(70)
(70)
(70)
(70)
(70)
(70)
0
(50)
(50)
76
0
(50)
(50)
102
0
(50)
(50)
129
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
With that in mind, recall that the balance sheet is just a formal presentation of the
accounting equation.
If the cash flow statement adjusts the left hand side of the equation, or assets, by the
companies cash flow in that period, and the income statement adjusts the right-hand
side of the equation, or stockholders’ equity, by net income… THEN the cash flow
statement, which starts with net income, is making adjustments so that the accounting
equation holds true.
And that is how the accounting equation is balanced in financial models, and
therefore how the balance sheet is balanced in financial models.
The cash flow statement grows the left-hand side of this equation by the company's cash balance.
The income statement grows the right-hand side of this equation by net income.
ASSETS
=
LIABILITIES
+
+
-
-
+
dr
cr
dr
cr
STOCKHOLDERS' EQUITY
=
CONTRIBUTED CAPITAL
+
dr
cr
STOCKHOLDERS' EQUITY
+
dr
+
cr
RETAINED EARNINGS
+
dr
Dividends
cr
Net Incom e
This is how the accounting equation is balanced in financial models.
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
To elaborate on this concept, consider what would happen if all of the accounts on the
balance sheet maintained the same value in each period. Without any fluctuation in
balance sheet accounts the effect on cash would be zero.
Changes in balance sheet accounts will directly impact the Cash Flow Statement
Cash is used to acquire assets and pay down liabilities
BALANCE SHEET
20X1
20X2
ASSETS
Cash
Accounts Receivable
Inventory
500
500
500
500
1,000
1,000
500
500
500
500
PP&E, Net of Accum. Depreciation
TOTAL ASSETS
LIABILITIES
Accounts Payable
Line of Credit
Long Term Debt
TOTAL LIABILITIES
EQUITY
Common Stock
Additional Paid In Capital
Retained Earnings
TOTAL EQUITY
TOTAL LIABILITIES & EQUITY
Check
CASH IMPACT
Accounts Receivable
Inventory
Accounts Payable
0
0
500
500
5 0 0 .0
5 0 0 .0
20X2
0
0
0
To take it one step further, what that means is that in any example where all items on
the balance sheet are held constant, net income and net cash flow would have the
same value.
A Simple Model
Introduction to Financial Statements
005
Cash Flow Statement
The videos concluding remarks highlight three concepts, all of which can be seen in
the image below.
Cash Flow Statement & Modeling
(Concepts / Relationships to Keep in Mind)
Three Cash Flow Categories
Cash Flow from Operating Activities
Cash Flow from Investing Activities
Cash Flow from Financing Activities
Cash Flow Statement Starts with Net Income
The cash flow statement starts with net income and adjusts for non-cash items, working capital,
investment and financing activity to arrive at the company's cash balance.
Financial Models are Balanced by the Cash Flow Statement
Retained earnings, an account on the balance sheet, grows stockholders' equity by net income. The
cash flow statement starts with net income and adjusts this sum to account for every other change to
balance sheet accounts to arrive at the company's cash balance.
This maintains the relationship: Assets = Liabilities + Stockholder's Equity
A Simple Model