Balance sheet is composed of 3 main aggregates: 1) Assets, 2) Liabilities and 3) Equity.
Assets, on one side are financed by Liabilities and Equity and the other side. Assets are always balanced by Liabilities and Equity.

ASSETS = LIABILITIES + EQUITY

Impact of an asset write-down on the 3 financial statements:

When an asset is written down you record it as a loss on the Income Statement – so Pre-Tax Income goes down by GBP 1,000m due to this write-down. Assuming a 40% tax rate, Net Income is down by GBP 600m.

On the Cash Flow Statement, Net Income is down by GBP 600m, but we need to add-back that asset write-down as it is a non- cash expense (GBP 1,000m) – so Cash Flow from Operations is up by GBP 400m, and Net Change in Cash is up by GBP 400m.

On the Balance Sheet, Cash is up by GBP 400m, so Assets are down by GBP 600m. On the other side, Shareholders’ Equity is down by GBP 600m (Retained Earnings) because the Net Income was down by GBP 600m – so Liabilities & Shareholders’ Equity is down by GBP 600m and it balances.

There are 3 key financial statements:

1. Income Statement: it is a way to walk through the revenues and costs of a company. It starts with Sales/Revenues and goes down to Net Income (except for Financial Institutions). Through the Income Statement, the Analyst can have a view on the Company’s cost structure (variable vs. fixed costs) and of the Company’s efficiency (margins). The main goal of the IS or P&L is to calculate tax
2. Cash Flow Statement: it is the most important statement in Finance: “cash is king”. A cash flow statement is divided in 3 main categories: 1) cash flows from operations, 2) cash flows from investing activities and 3) cash flows from financing activities
3. Balance Sheet: it is a snapshot of the company at a particular point in time. It shows the level of stocks, debts, equity etc… of the company. It has 3 main aggregates: 1) assets, 2) liabilities and 3) equity where assets = liabilities + equity

At first glance, Income Statement (P&L) and Statement of Cash Flows seem to represent more or less the same thing but there is one major difference: CASH.

The P&L records revenues and expenses following accrual accounting. It means that revenues and expenses have to be recorded when a transaction happens. For instance, a company selling cars may sign a contract for $1m in January. The P&L will account for the sales but not the Cash Flow statement: no cash is actually getting in the company at this moment. The Cash Flow statement will account for the sales once the payment is made.

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• Revenue: what the company sells (products or services)
• COGS: cost associated with the sales (if the company sells chairs, it may be the wood and steel used in the production)
• Operating expense: personnel, marketing, R&D, rent…
• Depreciation: represent the expense (non-cash) linked to the use of tangible assets
• Amortization: represent the expense (non-cash) linked to the use of tangible assets
• Interest expense: expense linked to debt liabilities
• Interest income: income linked to cash and cash equivalent (the company invests its cash in short term cash securities)
• Taxes: taxes declared to tax authorities (rate depends on the country of operation)

If you well understood what working capital is, you can normally figure this out even if you have not thought about it before.

To have a negative working capital, the company has to get paid before having to pay / receive more money first!

If the company gets paid quickly, it means accounts receivable are fairly small. If the company has a long payment period, it means accounts payable are high.

If you take, as example, a company selling magazines through subscription, it gets the money when you order online and deliver all along the year: this type of companies would have a negative working capital.

To answer the question “is it a good or bad thing?”, well yes! It is better to get money first and then spend.

Working capital variations have a cash impact: it will appear in the Cash Flow statement.

If working capital increases, it means Inventories and/or Accounts Receivable and/or other current assets are increasing faster than Accounts Payable and/or Other current liabilities.

Because current assets represent cash tied up through operations, it means the Company has a higher need in cash. Working Capital increases have a negative impact in the cash flow statement.

Increase in Inventories means more cash tied up in current assets. It translates to an increase in working capital which has a negative impact on cash.

If suppliers are shortening the payment period, it means the company’s accounts payable are decreasing. If the accounts payable (on the Balance Sheet) are decreasing, it means it will increase working capital. If working capital increases, there will be a negative impact of variation of working capital in the cash flow statement (cash flow from operations).

If suppliers shorten payment period, it has a negative impact on cash.

Dividends are the revenue paid to stockholders.

They are announced and then paid. They appear:

• Income Statement: dividends are not expenses and do not appear in the Income Statement. They will appear below Net Income and EPS (e.g. Apple Inc.’s Income Statement)

• Cash Flow statement: dividends appear in the Financing section (e.g. Apple Inc.’s Cash Flow statement)

• Balance sheet: dividends appear in the statement of shareholder’s equity (e.g. Apple Inc.’s Balance Sheet)

Cash flow from operations

Cash flow from operations reflects the cash which is generated by the company’s “normal” business. It is gives a view on how much auto-financed the company can be. It is a fairly pure metrics as it strips away some accounting effects (D&A for example).

Cash flow from investing activities

Cash flow from investing activities relates to any investment the company makes or sell. It takes into account the loss and profit made on investments. It also takes into account new machines, land, buildings, software etc… purchased by the Company over the period.

Cash flow from financing activities

Cash flow from financing activities relates to financing. It takes into account debt repaid, interest paid, debt raised, dividend paid to shareholders, debt buy-back, shares buy-back etc…

It is very important to keep in mind that the 3 main financial statements (income statement, cash flow statement and balance sheet) are interrelated.

The Income Statement will show all the expenses the company incurs: they can be cash or non-cash (paid right away or not). The cash flow statement will reconcile all the cash and non-cash items. The balance sheet will reflect the change in cash obtained with the cash flow statement while variation in assets and liabilities will be shown in the cash flow statement whether they are cash generative or not.

The different assets and liabilities have an impact on the P&L as they generate some income and expense for the Company.

To answer this question, you have to go down the Balance Sheet and try to understand how the different aggregates impact or are impacted by the cash flow statement.

The different assets and liabilities have an impact on the P&L as they generate some income and expense for the Company.

This question is fairly common and is asked to test your understanding of the interrelation of the 3 financial statements: Income Statement (P&L), Cash Flow Statement and Balance Sheet.

For this type of questions, it is very important to go through the 3 financial statements and analyze the potential impact. For this specific example:

• Income Statement: depreciation is an operating expense. $10 of additional depreciation will contribute to lower EBIT (as there are a $10 increase in “opex”). If EBIT is lower, you will pay less tax.
• Cash Flow Statement: in the cash flow statement, the main point is “is the new expense cash or non-cash?”. Depreciation is a non-cash item, the company does not have to actually pay $10 more. Taxes are lower so net impact of cash is a positive impact of $2 (assuming a 20% tax rate)
• Balance sheet: Cash increases by $2, PP&E decrease by $10 (due to the additional depreciation) and Equity decrease by $8 (impact of Net Income on retained earnings/ Equity)

EBITDA stands for Earnings Before Interests, Taxes, Depreciation and Amortization.

It is a good proxy for cash generated through operations. It excludes non-cash items such as depreciation and amortization.

It is not an Accounting aggregate, so calculation of EBITDA can differ from one company to another and from one period to another for the same company. When comparing EBITDAs, it is important to pay attention to consistency.

Working capital is a measure of a company’s operational efficiency and short-term financial health. It is calculated as Current Assets – Current Liabilities:

If a company rents machines or cars or trucks from a third party, it is considered as a lease.

A financial or capital lease is a type of lease. It is a commercial arrangement where:

• the lessee (company) will select an asset (machine, software, hardware etc…)
• the lessor (third party) will purchase that asset
• during the lease period, the lessee will have use of the asset
• the lessee will pay a series of rentals for the use of the asset
• the third party will recover a large part or all of the costs of the particular asset + interests from the lessee
• at the end of the contract, the lessee (company) has the option to buy the asset for a residual amount

The third party is the legal owner of the asset during the life of the contract but the lessee has the economic ownership (providing the benefits and risks related to the asset).

Because Financial lease implies a transfer of economic ownership, the asset will be on the Balance Sheet of the Company. The company will then pay interest and installments which will be in the Income Statement and the Cash Flow Statement (similar impacts on the 3 statement to a loan).

An operating lease is a type of lease. It allows the lessee, in return for a rent, to use an asset (machine, software, hardware etc…). It does not give any ownership right to the lessee.

For the lessee, an operating lease is an “off-balance sheet” item, it is not “capitalized”. The lease expenses are treated as operating expenses (“rent”).
For the lessor, the asset will be on the balance sheet and will be depreciated.

As assets used through an operating lease are not on the Balance Sheet, they contribute to improve ratio such as Return on Assets (as they are not accounted as assets).

FCF (Free Cash Flows) is a measure of financial performance (cash generation), which is equal to cash flow from operations – capital expenditure: it show how much cash a company is able to generate after paying capex to maintain and grow the business.

Free cash flow to the firm is calculated as follow: