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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Read and understand financial reports like an expert, including the “big three” financial statements
Accompanying the new 10th edition of How to Read a Financial Report, How to Read a Financial Report Workbook provides hands-on exercises and active tools that teach readers not just how to read, analyze, and interpret a variety of financial reports but in addition, provides bonus material related to better understanding the types of capital used by companies to support business growth. To explain concepts in an easy-to-understand way, this book is lighter on text and instead features a wealth of exhibits and accompanying companion exhibits to first showcase various scenarios and then compare two scenarios using different assumptions.
This workbook also includes “in the trenches” content that enables readers to equate key concepts with commonly used “street” language in finance. In this workbook, readers will learn and expand their knowledge with:
- Cash flows & capital sources, financial condition (i.e., the balance sheet), and profit performance reports (AKA the “big three” financial statements)
- Balance sheets, income statements, financial ratio analyzes, and statements of changes in shareholder equity
- Typical financial statement line items including earned sales revenue, costs of sales revenue, operating expenses, EBITDA, income taxes, accounts receivable, inventory, capital and other long-term assets, accounts payable, accrued liabilities, short-term debt, deferred revenue, long-term debt, and types of equity capital
- Most commonly used accounting and finance terminology, enabling you to speak the language of business finance
- Bonus material that covers key concepts with understanding capital sources, the capital table (i.e., cap table), and the critically important cap stack
How to Read a Financial Report Workbook is a helpful interactive learning resource that can be used every day by investors, lenders, business leaders, analysts, and managers seeking to enhance their career path and upward mobility by gaining more knowledge in understanding financial information and performances.
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Seitenzahl: 375
Veröffentlichungsjahr: 2024
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Table of Contents
Cover
Table of Contents
Title Page
Copyright
List of Exhibits
Preface
Part One: A REFRESHER COURSE IN THE BASICS
1 STARTING WITH THE LANGUAGE OF FINANCE AND CASH FLOWS
A Crash Course in the Language of Accounting and Finance
Starting with Cash Flows
Summary of Cash Flows for a Business
What Does Cash Flows Summary
Not
Tell You?
Profit Is Not Measured by Cash Flows
Cash Flows Do Not Reveal Financial Condition
A Few Additional Thoughts to Keep in Mind
2 A REFRESHER ON THE BIG THREE FINANCIAL STATEMENTS
The Financial Reporting Bedrock
The Income Statement ( aka Profit-and-Loss or P&L)
The Balance Sheet
The Statement of Cash Flows
3 TAKING A DEEPER DIVE INTO THE STATEMENT OF CASH FLOWS
Cash Flows: Why Three Different Numbers?
Changes in Assets and Liabilities That Impact Cash Flow from Operating Activities
Completing the Statement of Cash Flows with Investing and Financing Activities
Seeing the Big Picture of Cash Flows
A Few Final Words on Cash Flow
4 CONNECTING THE FINANCIAL STATEMENTS BY BUSINESS CYCLE
The Sales Cycle
The Purchasing Cycle
The Operating Expense Cycle
The Investment and Financing Cycles
Part Two: DIVING DEEPER INTO OUR CASE STUDY
5 OUR CASE STUDY—SAME BUSINESS, THREE DIFFERENT PICTURES
The Family Business (FB): Our Simple Case
The Steady Eddy Business (SEB): Our Base Case
The PE Business (PEB): Our Aggressive Case
Before You Dive In, Remember These Helpful Hints
6 ACCOUNTS RECEIVABLE: A CLOSER EXAMINATION
Refresher Connection: Accounts Receivable, Sales Revenue, and Expenses
Accounting Policies and Procedures Summary
Let’s Crunch Some Numbers
Accounting Issues
7 INVENTORY: AN ASSET RIPE FOR ERRORS
Refresher Connection: Costs of Sales Revenue, Inventory, Accounts Payable, and Other Expenses
Accounting Policies and Procedures Summary
Let’s Crunch Some Numbers
Inventory Control and Management
Accounting Issues
8 LONG-TERM ASSETS, USEFUL LIVES, AND NON-CASH EXPENSES
Intangible Assets Basics
Refresher Connection: Long-Term Capital Assets and Depreciation and Amortization Expense
Accounting Policies and Procedures Summary
Let’s Crunch Some Numbers
Accounting Issues
9 OTHER CURRENT LIABILITIES: A BREEDING GROUND FOR ABUSE
Refresher Connection: Accrued Liabilities, Other Current Liabilities, Sales Revenue, and Expenses
Accounting Policies and Procedures Summary
Let’s Crunch Some Numbers
Accounting Issues
10 BRINGING IT ALL TOGETHER WITH CASH
Accounting Adjustment Cheat Sheet
Comparing the Income Statements
Comparing the Balance Sheets and Statements of Cash Flow
History, Cash, and Artistry
Part Three: FINANCIAL ANALYSIS AND BONUS MATERIAL
11 FINANCIAL STATEMENT RATIOS AND ANALYSIS: STRENGTH
Financial Reporting Ground Rules
Financial Statement Preliminaries
Benchmark Financial Ratios: Strength
Final Comments
12 FINANCIAL STATEMENT RATIOS AND ANALYSIS: PERFORMANCE
Financial Performance versus Financial Strength
Two Cash Flow Ratios to Chew On
13 HOW TO MANUFACTURE CASH FROM THE BALANCE SHEET
When Capital Markets Turn Hostile
Crunching the Numbers: Let’s Visualize SEB’s Efforts
PEB ’s Unintended Consequences
Raising Cash Quickly, Not for the Faint of Heart
14 NET PROFITS AND CASH FLOW: REAL OR IMAGINARY
Fixed, Variable, and Semi-Variable Expenses
Generating Real Profits
Manufacturing Imaginary Profits
Cash Flow as Our Validation
15 DECIPHERING THE CAP TABLE AND CAP STACK
Equity Disguised as Debt
Preferred Equity and the Real Control
Common Equity, Options, and Warrants
My Final Raising Capital Tips, Tidbits, and Traps
About the Author
Index
End User License Agreement
List of Illustrations
Chapter 1
EXHIBIT 1.1 UNAUDITED SUMMARY OF CASH FLOWS—SIMPLE FORMAT, BASE CASE (SEB)...
Chapter 2
EXHIBIT 2.1 AUDITED FINANCIAL STATEMENTS—INCOME STATEMENT, BASE CASE (SEB)...
EXHIBIT 2.2 AUDITED FINANCIAL STATEMENTS—BALANCE SHEET, BASE CASE (SEB)...
EXHIBIT 2.3 AUDITED FINANCIAL STATEMENTS—STATEMENT OF CASH FLOWS, BASE CASE ...
Chapter 3
EXHIBIT 3.1 CASH FLOW FROM OPERATING (PROFIT-MAKING) ACTIVITIES, BASE CASE (...
EXHIBIT 3.2 CASH FLOW FROM INVESTING & FINANCING ACTIVITIES, BASE CASE (SEB)...
EXHIBIT 3.3 CASH FLOW RECONCILIATION, BASE CASE (SEB)
Chapter 4
EXHIBIT 4.1 FINANCIAL STATEMENT CONNECTIONS—THE SALES CYCLE, BASE CASE (SEB)...
EXHIBIT 4.2 FINANCIAL STATEMENT CONNECTIONS—THE PURCHASING CYCLE, BASE CASE ...
EXHIBIT 4.3 FINANCIAL STATEMENT CONNECTIONS—INVESTMENT & FINANCING CYCLE, BA...
Chapter 5
EXHIBIT 5.1 COMPILED FINANCIAL STATEMENTS—INCOME STATEMENT, SIMPLE CASE (FB)...
EXHIBIT 5.2 COMPILED FINANCIAL STATEMENTS—BALANCE SHEET, SIMPLE CASE (FB)...
EXHIBIT 5.3 COMPILED FINANCIAL STATEMENTS—STATEMENT OF CASH FLOWS, SIMPLE CA...
EXHIBIT 5.4 AUDITED FINANCIAL STATEMENTS—INCOME STATEMENT, BASE CASE (SEB)...
EXHIBIT 5.5 AUDITED FINANCIAL STATEMENTS—BALANCE SHEET, BASE CASE (SEB)...
EXHIBIT 5.6 AUDITED FINANCIAL STATEMENTS—STATEMENT OF CASH FLOWS, BASE CASE ...
EXHIBIT 5.7 AUDITED FINANCIAL STATEMENTS—INCOME STATEMENT, AGGRESSIVE CASE (...
EXHIBIT 5.8 AUDITED FINANCIAL STATEMENTS—BALANCE SHEET, AGGRESSIVE CASE (PEB...
EXHIBIT 5.9 AUDITED FINANCIAL STATEMENTS—STATEMENT OF CASH FLOWS, AGGRESSIVE...
Chapter 6
EXHIBIT 6.1 SALES REVENUE, ACCOUNTS RECEIVABLE, AND EXPENSES—BASE CASE (SEB)...
EXHIBIT 6.2 ACCOUNTS RECEIVABLE COMPARISON—THREE CASE STUDIES
EXHIBIT 6.3 ACCOUNTS RECEIVABLE DAYS SALES OUTSTANDING & TURNOVER RATIO—THRE...
Chapter 7
EXHIBIT 7.1 COSTS OF SALES REVENUE, INVENTORY, ACCOUNTS PAYABLE, AND OTHER E...
EXHIBIT 7.2 INVENTORY COMPARISON—THREE CASE STUDIES
EXHIBIT 7.3 INVENTORY DAYS SALES OUTSTANDING & TURNOVER RATIO—THREE CASE STU...
Chapter 8
EXHIBIT 8.1 DEPRECIATION & AMORTIZATION EXPENSE, LONG-TERM CAPITAL ASSETS, A...
EXHIBIT 8.2 INTANGIBLE ASSETS & RELATED EXPENSE COMPARISON—THREE CASE STUDIE...
EXHIBIT 8.3 FINANCIAL RETURN ANALYSIS—THREE CASE STUDIES
Chapter 9
EXHIBIT 9.1 ACCRUED LIABILITIES & OPERATING EXPENSES AND DEFERRED REVENUE & ...
EXHIBIT 9.2 ACCRUED LIABILITIES & OPERATING EXPENSES AND DEFERRED REVENUE & ...
EXHIBIT 9.3 OTHER CURRENT LIABILITY FINANCIAL ANALYSES—THREE CASE STUDIES...
Chapter 10
EXHIBIT 10.1 MASTER LIST OF ACCOUNTING ADJUSTMENTS—THREE CASE STUDIES...
EXHIBIT 10.2 COMPARIABLE INCOME STATEMENTS—THREE CASE STUDIES
EXHIBIT 10.3 COMPARIABLE BALANCE SHEETS—THREE CASE STUDIES
EXHIBIT 10.4 COMPARIABLE STATEMENTS OF CASH FLOW—THREE CASE STUDIES
Chapter 11
EXHIBIT 11.1 SUMMARIZED EXTERNAL FINANCIAL STATEMENTS OF BUSINESS (WITHOUT F...
Chapter 12
EXHIBIT 12.1 SUMMARIZED EXTERNAL FINANCIAL STATEMENTS OF BUSINESS (WITHOUT F...
Chapter 13
EXHIBIT 13.1 ALTERNATIVE ENDING BALANCE SHEET—BASE CASE (SEB)
EXHIBIT 13.2 ALTERNATIVE ENDING INCOME STATEMENT—BASE CASE (SEB)
EXHIBIT 13.3 ADJUSTED & REVISED AUDITED FINANCIAL STATEMENTS—INCOME STATEMEN...
EXHIBIT 13.4 ADJUSTED & REVISED AUDITED FINANCIAL STATEMENTS—BALANCE SHEET, ...
Chapter 14
EXHIBIT 14.1 E-COMMERCE PROFITABILITY ANALYSIS
EXHIBIT 14.2 LOCAL PROFESSIONAL SERVICE COMPANY PROFITABILITY ANALYSIS
Chapter 15
EXHIBIT 15.1 CAP STACK SUMMARY—AGGRESSIVE CASE (PEB) (cap is short for capit...
EXHIBIT 15.2 CAP TABLE SUMMARY—AGGRESSIVE CASE (PEB)
Guide
Cover
Table of Contents
Title Page
Copyright
List of Exhibits
Preface
Begin Reading
About the Author
Index
End User License Agreement
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HOW TO READ A FINANCIAL REPORT WORKBOOK
WRINGING VITAL SIGNS OUT OF THE NUMBERS
TAGE C. TRACY
Copyright © 2025 by Tage C. Tracy. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
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LIST OF EXHIBITS
Exhibit 1.1 Unaudited Summary of Cash Flows—Simple Format, Base Case (SEB)
Exhibit 2.1 Audited Financial Statements—Income Statement, Base Case (SEB)
Exhibit 2.2 Audited Financial Statements—Balance Sheet, Base Case (SEB)
Exhibit 2.3 Audited Financial Statements—Statement of Cash Flows, Base Case (SEB)
Exhibit 3.1 Cash Flow from Operating (Profit-Making) Activities, Base Case (SEB)
Exhibit 3.2 Cash Flow from Investing & Financing Activities, Base Case (SEB)
Exhibit 3.3 Cash Flow Reconciliation, Base Case (SEB)
Exhibit 4.1 Financial Statement Connections—The Sales Cycle, Base Case (SEB)
Exhibit 4.2 Financial Statement Connections—The Purchasing Cycle, Base Case (SEB)
Exhibit 4.3 Financial Statement Connections—Investment & Financing Cycle, Base Case (SEB)
Exhibit 5.1 Compiled Financial Statements—Income Statement, Simple Case (FB)
Exhibit 5.2 Compiled Financial Statements—Balance Sheet, Simple Case (FB)
Exhibit 5.3 Compiled Financial Statements—Statement of Cash Flows, Simple Case (FB)
Exhibit 5.4 Audited Financial Statements—Income Statement, Base Case (SEB)
Exhibit 5.5 Audited Financial Statements—Balance Sheet, Base Case (SEB)
Exhibit 5.6 Audited Financial Statements—Statement of Cash Flows, Base Case (SEB)
Exhibit 5.7 Audited Financial Statements—Income Statement, Aggressive Case (PEB)
Exhibit 5.8 Audited Financial Statements—Balance Sheet, Aggressive Case (PEB)
Exhibit 5.9 Audited Financial Statements—Statement of Cash Flows, Aggressive Case (PEB)
Exhibit 6.1 Sales Revenue, Accounts Receivable, and Expenses—Base Case (SEB)
Exhibit 6.2 Accounts Receivable Comparison—Three Case Studies
Exhibit 6.3 Accounts Receivable Days Sales Outstanding & Turnover Ratio—Three Case Studies
Exhibit 7.1 Costs of Sales Revenue, Inventory, Accounts Payable, and Other Expenses—Base Case (SEB)
Exhibit 7.2 Inventory Comparison—Three Case Studies
Exhibit 7.3 Inventory Days Sales Outstanding & Turnover Ratio—Three Case Studies
Exhibit 8.1 Depreciation & Amortization Expense, Long-Term Capital Assets, and Research & Development Expense—Aggressive Case (PEB)
Exhibit 8.2 Intangible Assets & Related Expense Comparison—Three Case Studies
Exhibit 8.3 Financial Return Analysis—Three Case Studies
Exhibit 9.1 Accrued Liabilities & Operating Expenses and Deferred Revenue & Sales Revenue—Aggressive Case (PEB)
Exhibit 9.2 Accrued Liabilities & Operating Expenses and Deferred Revenue & Sales Revenue—Three Case Studies
Exhibit 9.3 Other Current Liability Financial Analyses—Three Case Studies
Exhibit 10.1 Master List of Accounting Adjustments—Three Case Studies
Exhibit 10.2 Comparable Income Statements—Three Case Studies
Exhibit 10.3 Comparable Balance Sheets—Three Case Studies
Exhibit 10.4 Comparable Statements of Cash Flow—Three Case Studies
Exhibit 11.1 Summarized External Financial Statements of Business (without footnotes)—Base Case (SEB)
Exhibit 12.1 Summarized External Financial Statements of Business (without footnotes)—Base Case (SEB)
Exhibit 13.1 Alternative Ending Balance Sheet—Base Case (SEB)
Exhibit 13.2 Alternative Ending Income Statement—Base Case (SEB)
Exhibit 13.3 Adjusted & Revised Audited Financial Statements—Income Statement, Aggressive Case (PEB)
Exhibit 13.4 Adjusted & Revised Audited Financial Statements—Balance Sheet, Aggressive Case (PEB)
Exhibit 14.1 E-commerce Profitability Analysis
Exhibit 14.2 Local Professional Service Company Profitability Analysis
Exhibit 15.1 Cap Stack Summary—Aggressive Case (PEB) (cap is short for capital)
Exhibit 15.2 Cap Table Summary—Aggressive Case (PEB)
Part OneA REFRESHER COURSE IN THE BASICS
1STARTING WITH THE LANGUAGE OF FINANCE AND CASH FLOWS
Chapter 1 dives headfirst into two critical topics that will be on full display throughout this book. First, I provide a crash course on the language of accounting and finance. Simply put, in order to master reading (covered in my book How to Read a Financial Report), writing (covered in my book How to Write a Financial Report), and understanding financial statements and reports, it is essential that you learn the basic jargon.
Second, understanding how businesses generate and consume cash is a topic that is of critical importance and always on full display. As such, the second half of Chapter 1 dives right into the importance of cash flow, which is expanded upon further in Chapter 3, with even more insight provided in Chapters 12 and 15. True to our primary mission of translating complex accounting and financial concepts into simple and easy-to-understand tools and ideas, cash flows, the lifeblood of every business, is positioned with added reverence throughout this book to ensure that you remember the golden rule of operating a business: Never, ever run out of cash!
A Crash Course in the Language of Accounting and Finance
If you’re heading to France or Italy, it goes without saying that you should brush up on the basics of French or Italian because being able to communicate in the local dialect can improve your travel experience. The same goes for accounting and finance. If you can at least master some basic terminology, it will be less of a struggle to understand financial statements. This section of the chapter covers two buckets of terminology, basic and advanced.
Basic Terminology
Basic terminology is primarily associated with communicating the results of financial statements (from an accounting perspective), with a heavy weighting toward the income statement. Below, I’ve provided a sampling of the most commonly used basic accounting and financial terminology:
Top line: A company’s net sales revenue generated over a period of time (e.g., for a 12-month period).
COGS or COS: Pronounced like it is spelled; stands for costs of goods sold (for a service-based business or company that sells both products and services) and costs of sales (for a service-based business). COGS or COS tend to vary directly (or in a linear fashion) with the top-line sales revenue.
Gross profit and margin: Sometimes used interchangeably, gross profit equals your top line less your COGS or COS. The gross margin (a percentage calculation) is determined by dividing your gross profit by the top line.
Op Ex: A broad term that is short for operating expenses, which may include selling, general, administrative, corporate overhead, and other related expenses. Unlike COGS or COS, Op Ex tends to be fixed in nature and will not vary directly with the top-line sales revenue.
SG&A: Selling, general, and administrative expenses. Companies may distinguish between Op Ex and SG&A to assist parties with understanding the expense structure of its operations in more detail.
Bottom line: A company’s net profit or loss after all expenses have been deducted from net sales revenue. Being
in the black
indicates that a net profit is present and being
in the red
indicates that a net loss was generated.
Breakeven: The operating level where a company generates zero in profit or loss. It can also be used to identify the amount of sales revenue that needs to be generated to cover all COGS/COS and Op Ex.
Contribution margin: You may hear companies reference the term
contribution margin
. What this generally refers to is the profit generated by a specific operating unit or division of a company (but not for the company as a whole). Most larger companies have multiple operating units or divisions, so the profit (or loss) of each operating unit or division is calculated to determine how much that specific unit or division contributed to the overall performance of the entire company.
Cap Ex: Cap Ex stands for capital expenditures and is a calculation of how much a company invested in tangible or intangible assets during a given period (e.g., for equipment, machinery, new buildings, investments in intangible assets, etc.).
YTD, QTD, MTD: These are simple and stand for
year to date
,
quarter to date
, or
month to date
. For example, a flash report may present QTD sales for the period of 10/1/24 through 11/15/24 (so management can evaluate sales levels through the middle of a quarter).
FYE and QE: These two items stand for fiscal year-end and quarter-end. Most companies utilize a fiscal year-end that is consistent with a calendar year-end of 12/31/xx (which would make their quarter-ends 3/31/xx, 6/30/xx, 9/30/xx, and 12/31/xx). Please note that several companies utilize FYEs that do not follow a calendar year-end to match their business cycle with that of a specific industry. For example, companies that cater to the education industry may use a FYE of 6/30/xx to coincide with the typical operating year for schools or colleges (which tend to run from 7/1/xx through 6/30/xx).
Advanced Terminology
Advanced terminology tends to be centered in references to financial concepts that are focused on cash flows, forecasts, projections, and financing topics (i.e., raising capital such as securing loans or selling equity in a company). With that said, here’s a summary listing of advanced terminology to reference.
EBITDA: This is one of the most used (and abused) terms in finance today and stands for
earnings before interest, taxes, depreciation, and amortization
. A shorter version that is also used frequently is EBIT or
earnings before interest and taxes
. The reason for EBITDA’s popularity is that capital sources want to clearly understand just how much earning a company can generate in the form of operating cash on a periodic basis. EBITDA strips out interest, taxes, and depreciation and amortization expense (both noncash expenses) to calculate what is perceived to be a company’s ability to generate internal positive cash flow (which is widely used when evaluating the value of a company and its ability to service debt).
Free cash flow: FCF is closely related to EBITDA but takes into consideration numerous other factors or adjustments such as the need for a company to invest in equipment or intangible assets on a periodic basis (to remain competitive), the required or set debt service the company is obligated to pay each year (for interest and principal payments), any guaranteed returns on preferred equity, and other similar adjustments. FCF can be a highly subjective calculation based on the estimates and definitions used by different parties.
YOY: YOY stands for a year-over-year change in financial performance (e.g., sales change for the current 12-month period compared to the prior 12-month period).
CAGR: This stands for compounded annual growth rate and represents a financial calculation that evaluates a financial performance over a number of periods (e.g., sales increased at a CAGR of 15.5 percent for the five-year period of 2019 through 2024).
Sustainable growth rate: This calculation estimates a company’s maximum achievable growth rate by using internal operating capital (i.e., positive cash flow) only. When a company exceeds its sustainable growth rate, external capital such as loans or equity from new investors may need to be secured to support ongoing operations.
Debt service: Total debt service includes both required loan interest and principal payments due over a period of time.
B2B and B2C: A company that sells primarily to other businesses is B2B (business to business), whereas a company that sells primarily to consumers is B2C (business to consumer).
Burn rate: A burn rate is generally used for newer businesses or start-ups that have not achieved profitability and are “burning” a large amount of cash. The burn rate calculates the amount of cash burn a company is incurring over a specific period, such as a month or a quarter. If a company has a burn rate of $250,000 a month (before generating any sales), then an investor could quickly calculate that this company would need $3 million of capital to support it for one year.
Runway: The runway calculates how much time a company has before it runs out of cash. In our example, if the company has $1 million of cash left and is burning $250,000 per month, it has a remaining runway of four months.
TTM and FTM: TTM stands for
trailing twelve months
and FTM stands for
forward twelve months
. These figures are often used by parties to help understand a company’s annual operating results that are not in sync with its FYE (e.g., how much sales revenue was generated for the period of the QE 9/30/19 through the QE 6/30/20, 12 months of operating history). TTM and FTM can be especially useful when evaluating companies that are growing rapidly or have experienced a recent significant change in business.
C-suite: The C-suite represents the group of company executive management team members whose titles include the word
chief
. This would include the chief executive officer (CEO), chief operating officer (COO), chief financial officer (CFO), chief technology officer (CTO), chief marketing officer (CMO), chief investment officer (CIO), and other designated chief executive management positions as determined by a company.
Throughout the remainder of this book, I will reference these concepts frequently, so you may want to bookmark this section to help refresh your memory as needed. There’s no harm in returning to these lists when you’re swimming with the financial sharks out in the open water. There’s nothing worse than looking overmatched because you can’t even understand basic accounting and financial terminology.
Starting with Cash Flows
Every book that I’ve written, either by myself or with my dad, has emphasized the importance of three critical concepts that are absolutely essential to understanding financial reports and financial statements. These are
Cash flows
The big three financial statements
How financial statements are interconnected. To avoid disappointing you, I start by emphasizing the importance of cash flow, a concept well worth repeating again and again.
Savvy business managers, lenders, and investors pay close attention to the cash flows generated by a business. Simply put, cash inflows and outflows represent the heartbeat and pulse of every business. Without a steady heartbeat and healthy pulse of positive cash flows, a business would soon have to go on life support—or alternatively, die.
Given the importance of generating cash flows, we cover this topic out of the gate before we jump into discussing the income statement, the balance sheet, and the statement of cash flows (the big three financial statements, covered in chapter 2). However, we would also like to remind you of this simple logic when understanding the big three financial statements. That is and if you remember one important concept for each financial statement, it should be these:
Understand
the income statement,
Trust
the balance sheet,
Most importantly,
rely
on the statement of cash flows.
As you work through this book, it will become readily apparent as to why it is essential to not only understand a company’s cash inflows and outflows, but also understand how to use this information to better ascertain the financial performance and reliability of a company’s overall financial performance.
Summary of Cash Flows for a Business
A business’s cash inflows and outflows appear and are reported in a summary of cash flows, most often referred to as the statement of cash flows (one of the big three financial statements covered in Chapters 2 and 3). For our example company introduced in Exhibit 1.1, we use a technology business (a fictitious business I’ve named QW Example Tech, Inc.) that has been operating for many years. This established business has historically generated a profit on an annual basis but, more recently, hit a bit of a bump in the road as the company pivoted its business interests toward selling more software products and fewer hardware products. Equally important, the company maintains a solid financial condition to ensure the business has ample liquidity and cash to support ongoing operations. The company has a good credit history, and financial lending groups extend loans to it on competitive terms. Its present stockholders would be willing to invest additional capital in the business, if needed.
None of this comes easily, as most business owners will attest. It takes a strong management team and sound business model to generate consistent profits, manage and secure capital (both debt and equity), and for lack of a better term, stay out of financial hot water. Many businesses fail these imperatives, especially when the going gets tough, whether it be from difficult macroeconomic conditions, increased competition, or rapidly changing customer demands.
For the remainder of this book, I will use our fictitious example company, QW Example Tech, Inc., as the basis for presenting, reading, and analyzing financial information, statements, and reports. Multiple years of financial information will also be presented to assist with providing more insight into how to better understand and read financial statements. To add some intrigue and twists to this book, our fictitious example company will be presented in three separate case studies (summarized in depth in Chapter 5), including a base case, a simple case, and an aggressive case. The cases depict the same company and the same financial transactional activity for the year, but under different management at the C-suite level and at the level of the management team responsible for the accounting and financial function.
If you would like to leap ahead and dig into our fictitious example company and gain a complete understanding of each case study, then please jump to Chapter 5. If you would prefer a quick refresher course on the importance of cash flows, the big three financial statements, and financial statement connections, then Chapters 1 through 4 have been designed especially for you.
Before I provide a more detailed explanation of the cash inflows and outflows summarized in Exhibit 1.1, please keep these three points in mind:
First, the format presented in
Exhibit 1.1
is not within the guidelines dictated by GAAP (i.e., Generally Accepted Accounting Principles) but rather has been simplified for ease of review and understanding. This is why the header to
Exhibit 1.1
references financial information and not a financial statement. In
Chapter 2
, we present a formal statement of cash flows in
Exhibit 2.3
that is within the guidelines established by GAAP. Of course, one consistency between the exhibits will be that the change in cash between the two years will be exactly the same (which should be expected).
Second, note that the caption describes this as
unaudited
. This reference is always extremely important to keep in mind because, when a qualified third party (e.g., a CPA firm) is retained to audit financial information, the report issued will clearly state that the financial information has been audited. If no mention is made to the financial information being audited or it clearly states that the financial information is unaudited, this usually indicates the financial information has been prepared internally by the company. This is not to say the financial information is incorrect and/or inaccurate but rather indicates that it has not been examined, evaluated, or audited by an independent third party, so the risk of errors or omissions may be increased.
Third, in
Exhibit 1.1
we reference profit in lieu of income for ease of presentation and understanding. It is important to keep in mind that for most businesses, profit or net profit is synonymous with the term income or net income, which I use interchangeably throughout the book.
EXHIBIT 1.1 UNAUDITED SUMMARY OF CASH FLOWS—SIMPLE FORMAT, BASE CASE (SEB)
Dollar Amounts in Thousands
Summary of Cash Flows
For the Fiscal Year Ending
12/31/2023
Cash Flows from Profit-Making Activities
From sales of products & services to customers, which includes some sales made last year
$ 58,261
For acquiring products & services that were sold, or are still being held for future sale
$(19,650)
For operating & other expenses, some of which were incurred last year
$(33,888)
For interest on short-term and long-term debt, some of which applies to different years
$ (407)
For income tax, some of which was paid on last year’s taxable income
$ (438)
Net cash flow from profit-making activities during year
$ 3,879
Cash Flows from Other Sources and Uses
From increasing amount borrowed on interest-bearing notes payable, net of repayments
$ 3,000
From repayments of loans and other amounts borrowed during the year
$ (2,240)
From issuing additional capital stock (ownership shares) in the business
$ 2,500
For building improvements, new machines, new equipment, and intangible assets
$ (5,500)
For distributions or dividends to stockholders from profit
$ (250)
Net cash decrease from other sources and uses
$ (2,490)
Net Cash Increase (Decrease) during Year
$ 1,389
Exhibit 1.1 summarizes the company’s cash inflows and outflows for the year just ended 12/31/23 and shows two separate groups of cash flows.
Presented first are the cash flows of its profit-making activities—cash inflows from sales and cash outflows for expenses. Second up, we present the other cash inflows and outflows of the business—raising capital from loans or the sale of stock, repaying borrowings, investing capital in assets, and distributing some of its profit to shareowners.
We assume you’re fairly familiar with the cash inflows and outflows listed in Exhibit 1.1. Therefore, we are brief in describing the cash flows at this early point in the book:
The business received $58,261,000 during the year from selling products and services to its customers. It should be no surprise that this is its largest source of cash inflow. Cash inflow from sales revenue is needed for paying expenses. During the year, the company paid $19,650,000 for the products and services it sells to customers while incurring sizable cash outflows for operating expenses ($33,888,000), interest on its debt (borrowed money of $407,000), and income taxes ($438,000). The net result of its cash flows of profit-making activities is a $3,879,000 cash increase for the year—an extremely important number that managers, lenders, and investors watch closely.
Moving on to the second group of cash flows during the year, the business increased the amount borrowed on notes payable by $3,000,000, repaid $2,240,000 of borrowings during the year, and its stockholders invested an additional $2,500,000 in the business. Together these three external sources of capital provided a net of $3,260,000, which is in addition to the internal $3,879,000 cash from its profit-making activities during the year. On the other side of the ledger, the business spent $5,500,000 for building improvements, new machines and equipment, and intangible assets. Finally, the business distributed $250,000 in the form of a dividend to its stockholders.
The net result of all cash inflows and outflows is a $1,389,000 cash
increase
during the year. It should be noted that when you see an increase in cash, you shouldn’t jump to any conclusions. In and of itself, a net increase in cash is neither good nor bad. You need more information than appears in the summary of cash flows to come to any conclusions about the financial performance and situation of the business.
What Does Cash Flows Summary Not Tell You?
In Exhibit 1.1 we see that cash, the all-important lubricant of business activity, increased $1,389,000 during the period (in this case, a year). In other words, the total cash inflows exceeded the total of cash outflows by this amount for the period. The cash increase and the reasons for it are vital information. The summary of cash flows tells us part of the story, but cash flows alone do not tell the whole story. A business’s managers, investors, lenders, and other stakeholders need to know two additional pieces of information that are not reported in an organization’s summary of cash flows. They are:
The profit earned (or loss suffered) by the business for the period, which is reported in the income statement.
The financial condition of the business at the end of the period, which is reported in the balance sheet.
Now, hold on. Exhibit 1.1 just informed us that the net cash increase from sales revenue less expenses was $3,879,000 for the year. This may lead you to ask, “Doesn’t this cash increase equal the amount of profit earned for the year?” No, it doesn’t. The net cash flow from profit-making operations during the period does not equal the amount of profit earned for the period. In fact, it’s not unusual for these two numbers to be very different.
Profit is an accounting-determined number that requires much more than simply keeping track of cash flows. The differences between using a checkbook to measure profit and using accounting methods to measure profit are important to understand. Cash flows during a period are hardly ever the correct amounts for measuring a company’s sales revenue and expenses for that period. To summarize: Profit cannot be determined from cash flows.
Furthermore, a summary of cash flows reveals virtually nothing about the financial condition of the business. Financial condition refers to the assets of the business matched against its liabilities at the end of the period. For example: How much cash does the company have in its checking account(s) at the end of the year? From the summary of cash flows (Exhibit 1.1) we can see that the business increased its cash balance by $1,389,000 during the year, but we cannot determine the company’s ending cash balance. More importantly, the cash flows summary does not report the amounts of assets and liabilities of the business at the end of the period.
Profit Is Not Measured by Cash Flows
The company in this example sells both products and services on credit. The business offers its customers a short time period (e.g., 30 days) to pay for their purchases. Most of the company’s sales are to other businesses, which demand credit. (In contrast, most retailers selling to individuals accept credit cards, debit cards, and other forms of immediate electronic payments instead of extending credit to their customers.) In this example, the company collected $58,261,000 from its customers during the year. However, some of this cash inflow was for sales made in the previous year. And some sales made on credit in the year just ended had not been collected by the end of the year.
At year-end, the company had receivables from sales made to its customers during the latter part of the year. These receivables should be collected early next year (hopefully). To clarify, some cash was collected from last year’s sales but some cash was not yet collected before the year ended, so the total amount of cash collected during the year differs from the amount of sales revenue for the year.
Cash disbursements during the year are not
