Financial Statement Flow

Having a strong understanding of the “flow” through financial statements is essential in the valuation process. One must create forecasts and make assumptions that will impact pro-forma financials and should be able to identify how these will flow through the three primary financials. I thought it would be worthwhile to create a post covering the basic flow between each of the primary financials. As with many of my posts, this will have an emphasis on valuation uses and therefore will include certain details that are of particular concern to valuation modeling. Enjoy.

To help guide our conversations, I have created a simple graphic that outlines the most important flows between statements.  I will reference these flows and their colors through the post to help the reader gain a better understanding.

 

Due to the web of flows that is created here, I will start at the top of the income statement and work my way through these in what will hopefully be a coherent manner. Let’s get started.

The income statement starts with revenue less Cost of Goods Sold (COGS) to get gross income and then Sales, General and administrative (SG&A) along with Depreciation and Amortization (D&A) expenses are subtracted to get earnings before interest and tax (EBIT). In some financials D&A in consolidated within SG&A so be on the lookout for this. D&A (purple line) has two primary flows, first of which is to the balance sheet into the Accumulated Depreciation account. The amount of D&A expense will be added to the accumulated depreciation account to calculate Net PP&E. Remember too that only the “D” portion will flow into accumulated depreciation account, not the amortization. If a firm has no intangible assets to amortize, this is easy; however if they consolidate this you might have to dig into the footnotes to determine what amount is actually attributable to depreciation. The second flow for D&A is into the Statement of Cash Flows as an add-back to operating cash flow. Since D&A is a non-cash expense, it must be added back to net income.

Now let’s look at Interest Expense and Income (orange and brown lines). Interest Expense/Income can be found as a line item on historical financials, thus this commentary only applies to forecasting future financials. The general rule of thumb is to calculate interest expense as the average debt—(beginning balance+endining balance)/2—multiplied by the interest expense for the given debt. The same calculation is used for interest income but based on the average cash balance. You can also see the dark orange flow line from payments and issuance of Long-Term Debt (LTD), this will impact the balance and thus the interest expense.

Net Income (NI) is arguable the most important flow to understand. NI is represented by the light-red line and flows into two primary areas. First, NI is used as the starting basis for the indirect cash flow statement creation. The second flow is one that is most often forgotten, NI flows into the Retained Earnings on the balance sheet. Jumping over to the statement of cash flows, we can also see the flow between dividends under the cash flow from financing section to retained earnings (dark red line). Dividends paid will reduce the retained earnings balance while net income will increase it.

Let’s now turn out attention to some balance sheet accounts that have yet to be addressed. The Accounts Receivable (A/R), Inventory, and Accounts Payable (A/P) are all considered working capital (W/C). There may be other items such as accruals, however this is a simplified example. The change in these account balance (light blue) will flow into the statement of cash flows under the cash flow from operations section. I used the term “delta in W/C” to indicate that the change in these could either be an increase in cash flow or a decrease in cash flow. If there is an increase in net working capital (current assets less current liabilities) then this will be a use of cash and therefore a subtraction from net income; the opposite applies if it was a decrease in net working capital. We must also remember that in this instance the net working capital calculation does not include cash.

Next let’s look at the Property, Plant and Equipment (PP&E) account on the balance sheet. We can see the flow between the investing section of the statement of cash flows and the PP&E account on the balance sheet (yellow). If a firm has CapEx it will be an outflow of cash on the statement of cash flow but will be capitalized as an asset and added to PP&E on the balance sheet. Conversely, if a firm sells a piece of equipment it will be a cash inflow on the statement of cash flows while it will reduce the PP&E account on the balance sheet (both the PP&E and accumulated depreciation will be reduced as they relate to the asset being sold).

Lastly, we take a look at the bottom of the statement of cash flows to see that the ending cash balance (green line) will flow back to the balance sheet for the respective period ending. The beginning cash balance comes from the cash balance on the opening balance sheet (not shown in the image).

While this is a very simplified explanation of the flow between the statements, I do hope it puts its all in prospective and helps you better understand the process. Again, I did not list every single flow, only those most important to creating pro-forma forecasted financials. If you have questions or need clarifications, feel free to ask.