Financial statements for finance
Financial managers and investors use the three main financial statements to judge a firm's health and value.
The three statements
The income statement shows profitability over a period; the balance sheet shows assets, liabilities, and equity at a point in time; the cash flow statement shows cash generated and used by operating, investing, and financing activities. Finance focuses especially on cash flows, because value comes from cash.
Accounting profit versus cash flow
Accounting profit includes non-cash items, such as depreciation, and records revenue before cash is collected. A growing firm can report profits but run short of cash because inventory and receivables absorb cash. Finance therefore looks at cash flows, not just earnings.
Operating cash flow and free cash flow
Operating cash flow (OCF) is cash from normal operations. Free cash flow (FCF) = operating cash flow - capital expenditures; some definitions also subtract changes in working capital. FCF is the cash available to repay lenders and reward shareholders, and it drives company valuation.
Working capital
Net working capital is current assets minus current liabilities. Increases in working capital, such as building up inventory or receivables, consume cash; decreases release it. Companies such as Amazon have operated with negative working capital, collecting cash from customers before paying suppliers.
EBIT and EBITDA
EBIT (earnings before interest and taxes) measures operating profit. EBITDA (earnings before interest, taxes, depreciation, and amortisation) is often used as a rough proxy for operating cash flow and in valuation multiples such as enterprise value / EBITDA. Critics note it ignores the real cost of replacing equipment.
Market value versus book value
Book value is the accounting value of equity on the balance sheet. Market value (market capitalisation) is the share price times shares outstanding, reflecting investors' expectations of future cash flows. Many companies, especially technology firms with valuable intangible assets, trade far above book value.
Taxes
Corporate taxes reduce cash flows. In the US, the federal corporate tax rate has been a flat 21% since 2018, plus state taxes. The marginal tax rate (on the next dollar earned) matters for decisions, while the average tax rate is total tax divided by taxable income. Interest expense is tax-deductible, creating a 'tax shield' that favours some debt.
Worked example
A firm has net income of 80,000 dollars, depreciation of 20,000, an increase in working capital of 15,000, and capital expenditures of 35,000. Operating cash flow is about 80,000 + 20,000 - 15,000 = 85,000. Free cash flow = 85,000 - 35,000 = 50,000 dollars available to investors.
Key takeaways
The income statement, balance sheet, and cash flow statement together show performance, position, and cash. Finance focuses on cash flow because accounting profit includes non-cash items. Free cash flow = operating cash flow - capital expenditures and drives value. Working capital changes consume or release cash. EBIT and EBITDA measure operating performance. Market value reflects expectations; book value reflects accounting records. Taxes reduce cash flows; interest is tax-deductible.
Flashcard
Value comes from cash
Check your understanding
Why might a profitable, fast-growing company run out of cash?