The financial statements

01what each statement shows

The accounting equation

Assets = Liabilities + Equity

Cash from operations, indirect method

CFO = net income + non-cash charges − increase in working capital

Net change in cash

ΔCash = CFO + CFI + CFFOperating, investing and financing; ties to the balance sheet's cash line.

Retained earnings roll-forward

REend = REstart + net income − dividends

• Four statements, three that matter most¹

  The SEC's guide lists four: the balance sheet, the income statement, the cash flow statement and the statement of shareholders' equity. The first three are the ones an interview walks through, and the fourth shows how the shareholders' interest changed over the period.

• The balance sheet: a moment in time¹

  What a company owns and owes at one date, and it must balance: assets equal liabilities plus shareholders' equity. Every transaction you are asked to walk through has to leave that equation true. Assets and liabilities are split into current (due or used within a year) and non-current. The gap between operating current assets and operating current liabilities is working capital, the cash the day-to-day business ties up.

• The income statement: a staircase over a period¹

  Revenue at the top, then a step down for each class of cost: cost of sales to gross profit, operating expenses and depreciation to operating profit, interest to profit before tax, tax to net income - the bottom line. Depreciation spreads the cost of long-lived assets over the periods they are used.

• The cash flow statement: profit is not cash^1,2

  It shows cash in and out in three parts: operating, investing and financing activities. Most companies use the indirect method, which starts from net income and adds back non-cash items such as depreciation and adjusts for changes in working capital; the end is the change in the cash balance. An increase in receivables or inventory uses cash, and an increase in payables releases it, which is why a profitable, fast-growing company can still run short of cash.

• The statement of equity: where profit ends up¹

  It reconciles equity at the start of the period to equity at the end: new shares issued, shares bought back, profit for the period added to retained earnings, and dividends taken out. Some gains and losses skip the income statement and go straight to equity as other comprehensive income - currency translation of foreign subsidiaries is the usual example - so total equity can move by more than net income less dividends.

• How they connect¹

  Net income flows into equity on the balance sheet and starts the cash flow statement; the cash flow statement explains the change in the cash line on the balance sheet. No single statement tells the whole story, which is why the classic interview question moves one change through all three.

next: walking a transaction through →

02walking a transaction through

The interview test is mechanical: take one event, say what it does to each statement, and check the balance sheet still balances. These five cover most of what gets asked.

• Start from whether cash moved^1,2

  Ask two questions in order. Did cash move, and if so, is it operating, investing or financing? Did profit move, and if so, what does that do to retained earnings? A purchase of equipment moves cash but not profit; an accrued cost moves profit but not cash; a dividend moves cash and equity but never profit.

• Why the last row is the one to master¹

  A cost incurred but not yet paid hits net income now, and the unpaid amount sits in payables until it is settled. On the cash flow statement the lower profit is offset by the rise in payables, so operating cash is unchanged until the payment is made. This is accrual accounting in one line, and it is the logic behind every working capital adjustment.

next: recognising revenue and costs →

03recognising revenue and costs

Accrual accounting asks when revenue is earned and when a cost belongs to the period. The first is set by one standard; the second shows up in how inventory is costed.

• Revenue follows the promise, not the payment³

  IFRS 15 sets out one model with five steps: identify the contract with the customer, identify its performance obligations, determine the transaction price, allocate the price to the obligations, and recognise revenue when - or as - each obligation is satisfied. A software subscription is recognised across the months of service, a product when control passes to the customer; cash received earlier sits on the balance sheet as deferred revenue, a liability. US GAAP's ASC 606 follows the same core principle, which is why revenue recognition no longer differs much between the two.

• Inventory at the lower of cost and what it will fetch⁴

  Under IAS 2, inventory is held at the lower of cost and net realisable value, the expected selling price less the costs to sell. Cost is worked out by first-in first-out or by weighted average; IFRS does not permit last-in first-out, which US GAAP does. In a period of rising prices, LIFO charges the newest, dearer cost to cost of sales, so it reports lower profit and a lower tax bill than FIFO. When inventory is written down to net realisable value, the loss goes through cost of sales: profit falls, inventory falls, and no cash moves.

• Estimates change; errors are restated⁵

  Accounting needs judgement - a useful life, a bad-debt allowance, a provision - and IAS 8 treats a changed estimate as a change going forward, while a mistake in a prior period is corrected by restating the comparatives. Both can move reported profit without anything having happened to the business, which is the first place to look when a margin shifts.

next: fixed assets, intangibles and impairment →

04fixed assets, intangibles and impairment

Straight-line depreciation

annual charge = (cost − residual value) / useful life

Carrying amount

carrying amount = cost − accumulated depreciation − impairment

Impairment loss

loss = carrying amount − recoverable amountRecoverable amount is the higher of fair value less costs of disposal and value in use.

• Capitalise or expense⁶

  IAS 16 says the cost of property, plant and equipment is recognised as an asset when future economic benefits are probable and the cost can be measured; day-to-day repairs are expensed instead. The choice matters because capitalised spending reaches the income statement slowly, as depreciation, while expensed spending hits it at once - and it moves the cash flow statement too, since capital expenditure is investing and an expensed cost is operating. IAS 16 lets a company hold its assets at cost less depreciation or at a revalued amount. US GAAP does not allow upward revaluation.

• Depreciation is allocation, not valuation^2,6

  Depreciation spreads an asset's cost, less its expected residual value, over its useful life. It is a non-cash charge: it reduces profit and the carrying amount, and is added back in operating cash flow. A longer assumed life or a higher residual value lowers the charge and lifts profit, another reason to read the policy note before comparing two companies' margins.

• Intangibles: research is expensed, some development is not⁷

  IAS 38 recognises an intangible asset only when it is identifiable, controlled and expected to bring future benefits. Research spending is always expensed; development spending is capitalised once defined criteria are met. US GAAP generally expenses development costs outside software, so two otherwise similar companies can show different profit and different assets.

• Impairment writes an asset down to what it can recover⁸

  When an asset's carrying amount is more than the amount it can be recovered for, IAS 36 requires it to be written down and the loss taken to profit. Take a machine carried at 100 whose recoverable amount is 70: the loss is 30, profit and the asset both fall by 30, and no cash moves. Goodwill is not amortised; it is tested for impairment at least once a year. IFRS allows an impairment to be reversed later, except for goodwill. US GAAP does not allow reversals.

next: liabilities, tax and group accounts →

05liabilities, tax and group accounts

Deferred tax liability

DTL = taxable temporary difference × tax rate

• Leases come onto the balance sheet⁹

  Under IFRS 16 a lessee recognises a right-of-use asset and a lease liability for almost every lease, and then charges depreciation on the asset and interest on the liability. Rent no longer appears as one operating cost, so EBITDA is higher than before and debt is higher too. US GAAP keeps a split: finance leases look like IFRS 16, but an operating lease still shows as a single straight-line expense.

• Provisions: a present obligation you can estimate¹⁰

  IAS 37 requires a provision when a company has a present obligation from a past event, an outflow is probable and the amount can be estimated reliably - a legal claim it is likely to lose, a restructuring it has announced. Booking one is an expense now, with a liability that is paid later. A possible obligation that fails the test is only disclosed, as a contingent liability.

• Deferred tax: profit and taxable profit differ¹¹

  IAS 12 recognises deferred tax on the difference between an asset's carrying amount and its tax base. If tax law lets a company depreciate a machine faster than the accounts do, it pays less tax now and more later: the accounts show a deferred tax liability equal to the temporary difference times the tax rate. A deferred tax asset, for example from tax losses, is recognised only to the extent that future taxable profit is probable.

• Group accounts: consolidate what you control^12,13

  A parent consolidates a subsidiary it controls under IFRS 10, adding 100% of its assets, liabilities, revenue and costs line by line. If the parent owns less than all of it, the rest is shown as a non-controlling interest inside equity, and the share of profit belonging to those owners is deducted at the bottom of the income statement. An associate - a holding where the investor has significant influence, presumed from 20% of the votes - is not consolidated; under IAS 28 it is carried by the equity method, as one line on the balance sheet and one line of profit share on the income statement.

• Where IFRS and US GAAP part ways in the cash flow¹⁴

  IAS 7 lets a company classify interest and dividends it pays as operating or financing, and interest and dividends it receives as operating or investing, provided it applies the choice consistently. Under US GAAP interest paid is operating and dividends paid are financing. Comparing two companies' operating cash flow therefore starts with checking which treatment each used.

next: reading the statements together →

06reading the statements together

The statements are most useful in ratios that take one line from each. Two do most of the work in a first look at a company: what drives its return on equity, and how long its cash is tied up before it comes back.

DuPont: return on equity in three parts

ROE = (net income / sales) × (sales / assets) × (assets / equity)Margin, asset turnover and leverage.

Cash conversion cycle

CCC = DIO + DSO − DPODays inventory, days sales and days payables outstanding.

Days sales outstanding

DSO = receivables / revenue × 365

• Three reasons a return on equity can be high¹⁵

  The DuPont analysis splits ROE into operating efficiency (net profit margin), asset efficiency (total asset turnover) and financial leverage (the equity multiplier). Two companies with the same 15% ROE can be entirely different businesses: one earns a thin margin on a large volume of sales, another a fat margin on few, and a third earns an ordinary return on its assets and borrows heavily. The third is the one to look at twice. Leverage raises ROE in good years and cuts it in bad ones, and it says nothing about whether the business is any good.

• How long the cash is away¹⁶

  The cash conversion cycle adds the days it takes to sell inventory (DIO) to the days it takes to collect from customers (DSO), and subtracts the days the company takes to pay its own suppliers (DPO). The answer is the number of days each unit of cash spends tied up in the operating cycle before it comes back. A shorter cycle means less working capital to fund as the business grows, which is exactly the change-in-working-capital line in free cash flow. A negative cycle - collecting from customers before paying suppliers - means growth releases cash rather than consuming it.

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