1.2 Reading Financial Statements
Key Takeaways
- A standard income statement walks Revenue → COGS → Gross profit → Operating expenses → EBIT → Interest → EBT → Tax → Net income.
- Net income flows to retained earnings; with no other equity items, ΔRE = NI − dividends (for example, NI $50,000 minus dividends $10,000 raises RE by $40,000).
- The indirect cash flow statement starts at net income, adds non-cash charges such as D&A, and subtracts increases in operating NWC to reach cash from operations (CFO).
- Operating net working capital in FMVA models is typically AR + Inventory − AP and excludes cash and debt; an increase in NWC is a use of cash.
- The three statements articulate: NI links the income statement to RE; the cash flow statement explains the change in cash; ending cash on the CFS must equal cash on the balance sheet.
The Income Statement Walk
The income statement (profit and loss, or P&L) reports performance over a period. For FMVA work, memorize this walk and never skip a rung:
Revenue → COGS → Gross profit → Operating expenses → EBIT → Interest → EBT → Tax → Net income
| Line | What it measures | Typical model driver |
|---|---|---|
| Revenue (sales) | Control-transferred goods and services | Price × volume, or growth on last year |
| Cost of goods sold (COGS) | Matched product or service cost | Percent of sales, or unit cost × units |
| Gross profit | Revenue minus COGS | Gross margin = GP / Revenue |
| Operating expenses (opex) | SG&A, expensed R&D, other operating | Percent of sales or independently forecast |
| EBIT (operating income) | Profit before financing and tax | Also called operating profit |
| Interest expense / income | Cost of debt, less interest income | From the debt schedule |
| Earnings before tax (EBT) | EBIT minus net interest | Book taxable income |
| Tax expense | Current plus deferred tax | Effective tax rate × EBT |
| Net income (NI) | Residual to equity holders | Flows to retained earnings |
EBIT (earnings before interest and tax) is the operating profit line most FMVA models key off. It is not cash. It is not EBITDA. EBITDA is EBIT plus depreciation and amortization — a common starting point for valuation, but still not cash from operations.
Worked example: Apex Year 1 P&L
Apex reports revenue of $1,000,000, COGS of $600,000, SG&A of $250,000 (including $40,000 of depreciation), interest expense of $30,000, and a 25% tax rate.
- Gross profit = $1,000,000 − $600,000 = $400,000 (gross margin 40%)
- EBIT = $400,000 − $250,000 = $150,000 (EBIT margin 15%)
- EBT = $150,000 − $30,000 = $120,000
- Tax = 25% × $120,000 = $30,000
- Net income = $90,000 (net margin 9%)
EBITDA = EBIT + $40,000 D&A = $190,000. That $190,000 is not the cash the company generated. Cash still depends on capex, working capital, cash interest, and cash taxes.
The Balance Sheet: Stock, Not Flow
The balance sheet is a snapshot at a date. It must satisfy Assets = Liabilities + Equity at every date, including every forecast year.
Current versus noncurrent
Current assets are expected to convert to cash within one year (or one operating cycle): cash, accounts receivable, inventory, and prepaids. Noncurrent assets include PP&E, intangibles, and long-term investments.
Current liabilities are due within one year: accounts payable, accrued expenses, deferred revenue that will be earned within a year, the current portion of long-term debt, and short-term revolver draws. Noncurrent liabilities include the long-term portion of debt, deferred tax liabilities, and some lease liabilities.
Classification matters for liquidity ratios and for how you forecast net working capital (NWC).
Operating net working capital
In FMVA three-statement models, operating NWC is usually:
NWC = Accounts receivable + Inventory − Accounts payable
Many models also fold in other operating current items (accrued expenses, deferred revenue, other current assets) and still exclude cash and debt. Cash is the plug the cash flow statement explains. Debt is forecast on a debt schedule. Mixing cash or debt into NWC double-counts financing and destroys the cash plug.
An increase in NWC is a use of cash. Growing AR or inventory consumes cash; growing AP is a source of cash.
Worked example: NWC roll-forward
| Item | Opening | Closing | Change | Cash effect |
|---|---|---|---|---|
| Accounts receivable | $80,000 | $100,000 | +$20,000 | Use |
| Inventory | $50,000 | $45,000 | -$5,000 | Source |
| Accounts payable | $30,000 | $40,000 | +$10,000 | Source |
| Operating NWC | $100,000 | $105,000 | +$5,000 | Net use of $5,000 |
Opening NWC = 80 + 50 − 30 = $100,000. Closing NWC = 100 + 45 − 40 = $105,000. ΔNWC = +$5,000, a cash outflow on the cash flow statement. Get the sign wrong and the entire model is off by $5,000, then by every subsequent year's compounded error.
The Cash Flow Statement: CFO, CFI, CFF
The statement of cash flows explains why the cash balance changed. Three sections:
- Cash from operations (CFO) — cash generated or used by the core business
- Cash from investing (CFI) — capex, asset sales, purchases of investments
- Cash from financing (CFF) — debt draws and repayments, equity issues, dividends, buybacks
CFO + CFI + CFF = Change in cash. Ending cash = opening cash + change in cash. That ending cash must equal cash on the closing balance sheet. That is the first integrity check in every CFI three-statement model.
Indirect method, starting at net income
US GAAP and IFRS both allow the indirect method for CFO, and that is what FMVA models use:
- Start at net income
- Add back non-cash expenses (depreciation, amortization, some impairments, stock-based compensation)
- Subtract non-cash gains such as a gain on sale of PP&E
- Subtract increases in operating current assets (AR, inventory)
- Add increases in operating current liabilities (AP, accrued expenses, deferred revenue)
- Result = CFO
You start at net income because NI is the accrual bottom line. The adjustments strip out accruals and non-cash items until only operating cash remains.
CFI is usually −Capex + asset-sale proceeds. CFF is +debt draws −debt repayments −dividends +equity issuance. Interest paid is already inside NI for a typical US GAAP presentation (and therefore inside the CFO starting point); dividends are not an expense and belong in CFF.
Mini Three-Statement Example
Use Apex Year 1 P&L numbers, plus these movements: D&A already in SG&A of $40,000; capex $70,000; ΔNWC +$5,000; cash interest $30,000 and cash tax $30,000 already inside NI; dividends $20,000; opening cash $25,000; opening retained earnings $200,000; no new debt and no new equity.
Income statement (period): Revenue $1,000,000 → COGS $600,000 → gross profit $400,000 → opex $250,000 → EBIT $150,000 → interest $30,000 → EBT $120,000 → tax $30,000 → NI $90,000.
Cash flow statement:
- CFO = NI $90,000 + D&A $40,000 − ΔNWC $5,000 = $125,000
- CFI = −Capex $70,000 = −$70,000
- CFF = −Dividends $20,000 = −$20,000
- Change in cash = 125,000 − 70,000 − 20,000 = +$35,000
- Ending cash = 25,000 + 35,000 = $60,000
Balance-sheet links:
- PP&E net rises by capex $70,000 minus D&A $40,000 = +$30,000
- NWC rises $5,000 (the AR, inventory, and AP balances already set)
- Cash = $60,000
- Retained earnings = opening $200,000 + NI $90,000 − dividends $20,000 = $270,000
If the change in assets (cash + NWC + net PP&E) does not equal the change in liabilities plus equity, a line is not linked. That is articulation, not formatting. Notice that EBITDA was $190,000, CFO was $125,000, and cash after capex and dividends rose only $35,000. Those three numbers answer different questions.
How Net Income Flows to Retained Earnings
Ending retained earnings = Opening retained earnings + Net income − Dividends (plus or minus other comprehensive income items that bypass NI, which FMVA cases usually ignore).
Net income is not a cash account. It is a bridge from the income statement into equity. Dividends are not an income-statement expense; they are a distribution that reduces RE and cash (CFF).
Worked check with the mini example: opening RE $200,000 + $90,000 − $20,000 = $270,000. If you forget dividends, RE is too high and the balance sheet will not balance unless you hide the error in a plug. If you put dividends in SG&A, EBIT is too low and you have double-counted the cash — once in CFO via a lower NI, and again if you also put the dividend in CFF.
A second check: suppose NI is $50,000 and dividends are $10,000 with no other equity transactions. Retained earnings increase by $40,000, not by $50,000. That $10,000 left the equity column and left cash through CFF.
How the Three Statements Must Articulate
Three hard links:
- Income statement → balance sheet: NI flows to RE. After dividends, the RE roll-forward must match the equity section.
- Income statement + balance sheet → cash flow: Indirect CFO starts at NI and uses the changes in operating balance-sheet accounts. D&A from the income statement (or the PP&E roll-forward) is added back. Capex from the PP&E roll-forward is CFI.
- Cash flow → balance sheet: Ending cash on the CFS equals the cash line on the BS.
A useful mental picture: the income statement is the movie of performance; the balance sheet is the photograph of stocks; the cash flow statement is the reconciliation that proves the photographs of cash are consistent with the movie.
Exam trap: a case that "almost balances" is not balanced. Off by $1,000 usually means a working-capital change was applied with the wrong sign, dividends were skipped, or capex was expensed on the P&L and also placed in CFI.
Reading Statements the Way a Modeler Reads Them
When you open a 10-K or a case pack, do not start by admiring revenue growth. Read in this order:
- Revenue quality. Is growth from volume, price, or a revenue-recognition change such as more bill-and-hold or longer-term contracts?
- Margin bridge. Gross margin versus EBIT margin. If gross is stable but EBIT collapsed, opex or D&A moved.
- Interest and tax. EBT versus NI. A tax-rate jump may be a valuation-allowance or mix shift, not a cash-tax change.
- NWC days. AR days, inventory days, AP days. These become your forecast drivers.
- Cash flow quality. CFO versus NI. If NI is up and CFO is down, accruals (AR, inventory, deferred revenue) are doing the work.
- Capex versus D&A. If capex persistently exceeds D&A, the asset base is growing and free cash flow is lower than EBITDA implies.
Those six reads are the accounting you need before you type a single Excel formula in a three-statement model. The FMVA exam, because it is open-book, will not reward memorizing the walk. It will reward noticing that this year's NI of $90,000 did not produce $90,000 of cash, and then pointing to the D&A add-back, the $5,000 NWC use, the $70,000 capex, and the $20,000 dividend that explain the cash line.
Walk the income statement from revenue to net income. Which line sits immediately after subtracting operating expenses from gross profit in a standard FMVA layout?
A firm reports net income of $50,000, pays $10,000 of dividends, and has no other equity transactions. By how much does retained earnings increase?
On an indirect cash flow statement, which of the following is the correct starting point for cash from operations?