Financial statements, cash flow and financial analysis

Financial decisions are about cash: cash invested, cash returned, and the timing and risk of both. Accounting statements are the main source of information about a firm's cash flows, but they are prepared for other purposes, such as measuring profit period by period and reporting to tax authorities and lenders. This lesson shows how a financial manager reads the balance sheet, income statement and statement of cash flows, how to extract free cash flow, the measure that drives valuation, and how ratios summarize liquidity, leverage, efficiency, profitability and market value. It assumes the bookkeeping and statement preparation covered in ACCT-101 and concentrates on what finance does with the numbers.

Accounting standards

US public companies report under US generally accepted accounting principles (US GAAP), set by the Financial Accounting Standards Board (FASB) and codified in the Accounting Standards Codification; the SEC accepts IFRS from foreign private issuers. Private companies often use US GAAP with simplifications from the Private Company Council, or a tax or cash basis. Differences between US GAAP and IFRS affect items such as inventory (LIFO is allowed only under US GAAP), development costs and asset revaluations, so analysts check the framework before comparing companies.

Book values and market values

The balance sheet lists assets at book value, mostly historical cost less depreciation, and the shareholders' equity figure is simply what is left after subtracting liabilities. Market values can differ enormously. A software company may have few physical assets but a market value many times its book equity because investors expect large future cash flows from its products, people and customer relationships, much of which never appears on the balance sheet. A struggling retailer may trade below book value because its stores are worth less than their recorded cost. For financial decisions, market values matter: a firm's cost of capital and its capital structure are measured at market value wherever possible, and the market-to-book ratio is a quick indicator of how much value investors see beyond the accounts.

Profit is not cash flow

Net income is measured on an accrual basis. Revenue is recognized when goods or services are delivered, not when the customer pays; expenses are matched to revenue, so the cost of a machine is spread over its life as depreciation rather than charged when the machine is bought. These conventions make income a better measure of performance from one period to the next, but they mean income and cash flow diverge. A fast-growing firm can report rising profits while its bank balance falls, because its receivables and inventory are absorbing cash and its capital spending exceeds depreciation. The statement of cash flows reconciles the two by starting with net income, adding back non-cash charges such as depreciation, and adjusting for changes in working capital, investment and financing.

Free cash flow

For valuation and capital budgeting, finance focuses on free cash flow (FCF): the cash generated by the firm's operations after the taxes it would pay if it had no debt, after the investment needed in fixed assets and working capital, and before any payments to lenders or shareholders. It is free in the sense that it is available to be distributed to all the firm's investors. Interest is excluded because the cost of debt is handled in the discount rate, as lesson 11 shows; including it in the cash flows as well would count it twice.

Here EBIT is earnings before interest and taxes, \( T \) the corporate tax rate, and \( \Delta NWC \) the increase in net working capital (current operating assets such as receivables and inventory minus current operating liabilities such as payables). The term \( EBIT(1-T) \) is sometimes called net operating profit after tax (NOPAT). Free cash flow can be negative for a growing firm that is investing heavily; that is not necessarily bad, provided the investments are worth more than they cost.

Free cash flow must go somewhere. The cash flow identity says that cash flow from the firm's assets equals cash flow to its creditors plus cash flow to its shareholders. Cash flow to creditors is interest paid (after the tax saving it generates) minus net new borrowing; cash flow to shareholders is dividends plus share buybacks minus new equity raised. If a firm generates $200 million of free cash flow, pays $40 million of after-tax interest, repays $60 million of debt and pays $100 million in dividends, the identity balances: 200 = (40 + 60) + 100. If it has more cash than it can use, it can pay it out; if it has less, it must borrow or issue shares.

# Free cash flow and where it goes (millions)
ebit, tax, dep, capex = 400, 0.25, 80, 150
nwc_start, nwc_end = 220, 250
nopat = ebit * (1 - tax)
fcf = nopat + dep - capex - (nwc_end - nwc_start)
print(f"NOPAT {nopat:.0f}  FCF {fcf:.0f}")
after_tax_interest, debt_repaid, dividends, buybacks, new_equity = 40, 60, 70, 30, 0
to_creditors = after_tax_interest + debt_repaid
to_shareholders = dividends + buybacks - new_equity
print(f"to creditors {to_creditors}, to shareholders {to_shareholders}, total {to_creditors + to_shareholders}")

NOPAT 300  FCF 200
to creditors 100, to shareholders 100, total 200

Average and marginal tax rates

Financial decisions use the marginal tax rate, the rate paid on the next dollar of income, because that is the rate that applies to the extra income from a new project. Since 2018 the US federal corporate income tax has been a flat 21 %, so a C corporation's federal marginal and average rates are the same, but state corporate income taxes add more; a common combined figure used in examples is about 25 %. Pass-through businesses such as S corporations and LLCs are taxed at the owners' personal rates instead. Rates vary by state and should be checked for the year in question.

Financial ratios

Ratios compress financial statements into numbers that can be compared over time and across firms of different sizes. No single ratio tells the whole story; the point is to ask good questions. Ratios fall into five families. Liquidity ratios, such as the current ratio (current assets divided by current liabilities) and the quick ratio (excluding inventory), measure the ability to pay short-term obligations. Leverage ratios, such as debt to equity, debt to capital and times interest earned (EBIT divided by interest), measure reliance on debt and the cushion for paying interest. Efficiency ratios, such as asset turnover, inventory turnover and days sales outstanding, measure how intensively assets are used. Profitability ratios, such as profit margin, return on assets (ROA) and return on equity (ROE), measure returns. Market value ratios, such as the price-earnings ratio, the market-to-book ratio and enterprise value to EBITDA, compare the market's valuation with accounting numbers.

The DuPont identity breaks return on equity into three drivers: how much profit the firm earns per dollar of sales, how many dollars of sales it generates per dollar of assets, and how many dollars of assets it finances per dollar of equity. It shows that a high ROE can come from good margins, efficient use of assets, or simply more borrowing, and the last of these also raises risk.

Working capital and the cash conversion cycle

Net working capital ties up cash. A firm buys inventory, holds it until it is sold, then waits for customers to pay, while it delays paying its own suppliers for as long as is reasonable. The cash conversion cycle measures the number of days between paying suppliers and collecting from customers: days of inventory plus days of receivables minus days of payables. A shorter cycle frees cash; a growing firm with a long cycle needs financing just to stand still. CON-320 applies these ideas to contractors, whose holdbacks or retainage lengthen the cycle; this course returns to working capital as part of project cash flows in lesson 8.

Limits of accounting data

Ratios and statements are a starting point. Accounting choices, such as depreciation methods, revenue recognition and lease treatment, differ between firms and standards. One-time items distort comparisons. EBITDA, popular because it approximates operating cash flow, ignores the capital spending needed to replace worn assets and the cash tied up in working capital, and it is not defined by accounting standards, so companies calculate it differently. Book values can be far from market values. And a ratio is only meaningful against a benchmark: the firm's own history, its competitors, or industry averages. Financial analysis is best seen as a way to find questions to ask management, not as a substitute for understanding the business.