Accounting overview.  This overview is focused on how accounting is reflected in a model.  It is not meant to teach accounting concepts.  However, if you never fully “got it” in accounting, please read on, otherwise skip if you are familiar with accounting basics and the relationship between the three statements (income, cash flow, balance sheet).

What Accountants Do.  Accountants provide business owners and outsiders good information about the performance of the business.  They show (i) what the business owns and owes, (ii) how much cash the business made and spent (and on what), and (iii) how much value, when thinking about the economics of the business, the company made or lost.  These distinct views of the company are the balance sheet, cash flow statement, and income statement.  The three statements are linked, and the cash flow statement is technically a derivative of the income statement and balance sheet.  (Note:  This tutorial only uses an indirect method cash flow statement.)  Let’s look at the three statements, what they contain and a little bit about how they are linked.  Please download the free accounting example Excel spreadsheet Taxico to follow along (the Taxico example is meant to illustrate some points in this accounting discussion, not perform as a financial model).

The Income Statement.  It is important to understand that an income statement is meant to most closely reflect the economics of a business, not the cash it earns.  Many deride decisions that accountants have made in constructing an income statement, but generally net income is a good measure of the economic success or failure of an enterprise during a particular time period (but not necessarily the best way to value a company). 

Some examples of economic realities that differ from cash are revenue, cost, and depreciation (please see tab “Ex 1”).  Revenue is recognized generally when the customer accepts goods or services and promises to pay.  At that point, the company has “sold” something.  In Taxico, they have a contract with Big Oil.  Taxico drives their employees to the airport, and Big Oil Employees sign an invoice that says Big Oil will pay Taxico.  Taxico has not made money.  In fact, they spent labor and gasoline and got back a piece of paper.  The accountant would look at the situation however, and say “economically” what really happened is that Taxico sold a ride to Big Oil and made revenue.  The accountant might then look at the cost of the inventory (gasoline) used, and put that cost against the sale, independent of when the inventory was purchased.  So Taxico’s income statement would show revenue (where there was no cash coming in) and cost (where there was no cash out – they filled up the tank last month) resulting in a profit.  So, what happened physically is very different from what happened economically.  As you can see, the accountants are “right” in “booking” the revenue and cost, as that reflects what is happening from an economic standpoint. 

Another common income statement item is depreciation.  Depreciation is the accountant’s way of linking the economic cost of an asset to the goods that it produces.  Nearly all assets waste away over time, even with maintenance.  Even those that last a long time may not be as competitive as newer assets since newer assets may produce faster, consume less energy, break less often, etc.  A good way to think of depreciation is to think about the taxi owned by Taxico.  Clearly, the taxi will wear out over time.  Accountants, to reduce confusion (and cheating), have guidelines and asset categories so that everyone generally agrees on the life of each type of assets.  Let’s assume that our taxi costs $50,000 and wears out totally over 5 years (monthly depreciation is shown in example 1).  From a cash standpoint, the cost of the taxi will depend on whether you purchase it, lease it, or finance it (and then under what terms).  From an economic standpoint, how you purchased (capitalized) the taxi does not matter.  In each case, you have a dead taxi at the end of 5 years and have to start over.  Accountants, being keen on reflecting economics, would show as a cost to the taxi company the wearing out of the taxi, not the particulars of how it was purchased.  In this case, the accountants would book $10,000 per year of depreciation expense on the income statement (assuming a 5 year life of a $50,000 taxi).  This expense is real from an economic standpoint, but does not reflect cash at all.  The cash effects are shown on the cash flow statement and the asset effects on the balance sheet. 

To better understand the difference between the income statement and the cash flow statement, take a look at the cash flow statement in example 1 (even though this is the income statement section), beginning on row 58-83.  Taxes have been turned off in this example to help you better see connections to the income statement.  Here, in B61, you can see that the accounting loss from depreciation is added back to adjust for non-cash items in income.  B66 reflects the purchase of gasoline that does not appear on the income statement (it is not an “expense” until it is used).  Column C takes some more time to work through.  The net income contains revenue from an invoice, expense from fuel, expense from labor and depreciation.  First, in C66 you again see the non-cash depreciation added back.  Next, in C65, you see that accounts receivable have gone up.  The increase in an asset is a use of cash.  This is really recognition that A/R is paper and not cash, so it is subtracted from the net income (which contains the non-cash revenue).  In a similar manner, the net income contains expense for fuel.  Did Taxico buy fuel?  No, they bought it last month.  The taxi just burned part of the tank.  So, the expense (while economically correct) was really a reduction in inventory (reduction in an asset generates cash) and must be added back against net income.  In C68, you see that operating cash flow is now equal to the actual cash out the door, or $15 for labor.  In the next month, when the invoice is paid (and A/R goes down) $100 of cash is received.  Now you can see how the income statement is designed to reflect economics through three of its main elements:  revenue, expense, and depreciation.  You also have a glimpse of how the cash flow statement “corrects” net income to reflect cash.  Clearly, the income statement is a better reflection of what really happened from a business standpoint for Taxico in Example 1.

Now please switch to the tab “Taxico One Year”.  Here, the Taxico example reflects a year of operations with different capital structures.  Three approaches to owing the taxi are shown:  purchase, finance, and lease.  Note depreciation as an expense in the two purchase cases and lease expense in the lease case.  The difference is discussed in the balance sheet section.  Only the taxi company with a bank loan is recording interest expense.  Look at what the accountants have done for you.  Here are three companies with wildly different cash flow (take a peek at row 80), yet their net incomes are similar.  The leasing taxi company is losing the most money, yet has the lowest monthly payment.  The Taxico that paid for its taxi is not showing profit, despite having no payments.  The accountants have adjusted for all of this.  They are looking again at the economics of the situation – to the end if you will.  Each company has the same car.  It is wasting away at the same rate.  Two of the companies have chosen to pay banks interest to borrow money (this model ignores interest income, besides the bank charges more than they pay – this is how they make money).  That is the only fundamental difference between the companies from an economic profit standpoint.  The lease interest rate is higher than that on the loan, meaning Taxio #3 will pay more over time to the bank for its taxis.

The Balance Sheet.  The balance sheet is the statement that shows owned and owed.  It is often referred to as a snap shot because it shows the assets and liabilities on a particular date, whereas the income statement and cash flow statement show activity over a time period.  In this case it shows Taxico at the end of the year. 

Our Taxico example assumes that Taxico was founded at the beginning of the year with 75,000 and bought a new $50,000 taxi on the first day of the year.  Starting at the top of the balance sheet, the cash is the cash at the end of the year after the activity shown on the cash flow statement took place.  This is an example of how the statements interact.  The cash from the prior balance sheet ($75,000 assuming company formation 1 day before the beginning of this year) plus the cash flow during the year (positive or negative) equals the cash on the balance sheet at the end of the year.  The accounts receivable are the aforementioned invoices from Big Oil.  Big Oil pays about 30 days after being invoiced, so at the end of the year (or at particular point in time) Taxico is holding IOUs from Big Oil for about 30 days of services that are owed to Taxico (the rides already took place), but have not been settled (paid) by Big Oil.  The inventory is a full tank of gas in the taxi just before the end of the year. 

Typically any asset that will (or can) be liquidated inside of a year is considered a current asset.  Current liabilities are similar in that they are liabilities that are paid off currently (inside of a year).  The balance sheet separates current from long term to give the reader an indication of what the business might be expected to owe in the short term and might be able to liquidate in the near term to satisfy its obligations.

Next on the balance sheet are long-term assets.  In Taxico, this is the taxi.  The first two Taxicos own their taxis.  As of this balance sheet date, the taxis are one year old, so the book value of the taxi has been reduced by the depreciation of the taxi - the very same depreciation on the income statement.  This is another place where the statements interact.  It makes sense to have the taxis worth less on the balance sheet because they are now old, but also because the accountants took an expense for the depreciation.  Taxico #3 does not have any PP&E because they are leasing their taxi under an operating lease.  They do not own the taxi, so the “owned and owed” statement does not reflect the asset.  Because the lease is paid for current use, it does not show up as a debt either, even though the company is obligated to make the lease payments.  Look at total assets.  It may be surprising to see such a difference in assets, but remember that these are offset by liabilities, what is “owed”. 

Starting into the liability section, accounts payable (bills that Taxico has yet to pay) are ignored here for simplicity.  Only Taxico #2 has any debt.  Each of the Taxicos were started with $75,000 of equity capital, so their initial shareholder’s equity is $75,000 in each case.  Next is another place where the statements tie together, retained earnings.  Retained earnings is the summation of the profits (net income) of the company over time (not paid out in dividends – which we will ignore).  Retained earnings is the retained earnings of the last balance sheet / time period, plus the net income from this time period.  Shareholder’s equity and retained earnings sum to total equity.  It is hard to fool the balance sheet.  Here, in the total equity account, you can see the net worth of each company.  Taxico #1 earned enough cash to offset for the drop in value of the taxi.  Taxicos #2 and #3 had to pay interest to a financing source, so their companies are worth less than when they started.  Taxico #3 has the most money in the bank, but is the worst off of the lot.

Think of the two balance sheet parts (assets and liabilities) as interchangeable via the income statement and cash flow statement.  A quick thought experiment will help you better understand how the balance sheet works:  A company, Easyco, that had $100 in net income, and also happened to have $100 in cash flow would affect the balance sheet by increasing retained earnings by +100 and cash by +100, resulting in the balance sheet balancing.  If $50 of the $100 of earnings were an IOU, cash would go down $50 and A/R would go up $50 – again “balance sheet neutral”.  If $25 of the net income were depreciation, cash would go up $25 and PP&E down $25.  As you can see, as the equity account is increased via earnings, the balance sheet continues to balance depending on where the items on the income statement and changes to the cash flow statement occur.

The Cash Flow Statement.  The cash flow statement is just that.  It tracks the cash in the company during the time period reflected.  It does this by looking at three main categories of cash:  operations, investing, and financing.  Operations is meant to reflect the cash that came out of running the business.  It is determined by first adjusting net income for non-cash items and then showing the effect of operating (working) capital on the business.  Investing cash flow shows what long-term assets (or companies) were purchased to further the business.  A distinction is drawn so that the user can understand the difference between the cash performance of the business (operating) and the purchases made mainly for future periods (like buying a second taxi).  The third category is financing.  This section shows the capital flows of a business – how it moves cash to fund the business itself.  Financing cash flows are not from buying or selling things that are used in the business like the other two categories.  A reader of the statements will want to know how the business raised or retired funds outside of operations to get to the total cash in the business.

First, operating cash flow.  Net income is adjusted by non-cash items (this step is not always sub-totaled) to reflect cash earnings.  Here you can see that the taxi owners get the “benefit” of depreciation.  Some say that deprecation increases cash flow – this is not correct.  From a cash (but not economic) standpoint, depreciation is a “false deduction” from income.  This deduction is merely removed by adding it back in.  Next, are adjustments from current assets and liabilities.  Recall that our friendly accountants wanted to reflect what really happened from a business standpoint in revenue.  They happily booked revenue for rides when the client signed an invoice.  Now that we are in cash land, we need to adjust for those things owed to Taxico (A/R) and that Taxico owes to others (such as an unpaid phone bill, though none is shown in this example).  Since, at our end of year snapshot, we know that Taxico was owed $2,877 by Big Oil, and we know (since it is a new company) that Taxico was owed nothing at the beginning of the year, we know that A/R increased by $2,877.  A/R is an asset.  Assets cost money, so cash was consumed by A/R.  This may seem confusing (Big Oil owes them money, and this consumed cash?), so think of it like this:  The accountants booked two kinds of revenue, cash revenue and non-cash (A/R or “IOU”) revenue.  Both types of revenue are inside of net income.  Our cash flow statement starts with net income, so the net income contains some non-cash income.  How much?  The net income contains the amount owed to Taxico.  More precisely, the difference between what is owed to Taxico at the end of this period ($2,877) and the end of last period ($0).  Inventory is a little more straight forward to think about.  If Taxico buys a tank of gas (an increase in an asset), it has to pay for it.  When inventory increases, it “uses” cash because someone bought more inventory.  Here we don’t have any current liabilities, but if we did, we would see that they are the opposite of assets – they liberate cash.  How?  Because our accountants booked expenses based on what was used or consumed, not what was paid for.  If we tell the gas station we will pay them after the first of the year, then some of our expense (or inventory purchase) was non-cash.

Now, investing cash flow.  This is pretty straight forward (especially after operating cash flow).  This is the cash spent on long-term assets.  Why is it here?  Because, it is not anywhere else.  Just as working capital is linked into the balance sheet, investing cashflow is linked to the balance sheet.  If you buy an asset, it needs to show up on the balance sheet.  If it does not, the balance sheet will not balance.  Think back to Easyco, where there were no working capital movements and no purchases.  If Easyco bought a machine at the end of the year for $50, their operating cash flow would not change (nothing will not show up on the income statement at all, as there are zero days of depreciation) cash would drop by $50 (obviously) and their PP&E would go up by $50.  Their investors and others reading the cash flow statement could clearly see that Easyco invested for the future.

Finally, financing cash flow.  Again, this is straight forward and again, this communicates with the balance sheet.  Here, debt is shown broad so that you may see the borrowing in Taxico #2 and the partial payback in one year of payments.  Note the debt payment is split such that the interest portion is on the income statement and the principal portion is down here on the cash flow statement.  Crazy!, you may think.  If you put your green eyeshade on and think accounting, it makes perfect sense.  When you make your car payment you are doing two things.  One is paying back what you borrowed (financing).  This is not a cost or expense; it is just giving back what you got.  The other is paying the bank for the use of its money (interest).  This is a cost.  It is real money out the door to someone else that you did not first borrow.  Taxico #1 got its money from shareholders / its bank account.  From a cash standpoint that money is free (even though shareholders expect a return).  The bankdemands a return.  So, when finding “What did they pay for their taxis?” during the year, Taxico #3 is all in expense (the check to the leasing company), Taxico #2 is part in expense (interest) and part in capital (cash flow statement), and Taxico #1 is zero, because they bought it.  You know Taxico #1 owns theirs because, (i) there it is sitting in assets, (ii) there is no expense (interest or lease) on the income statement, (iii) there is no debt on the balance sheet, (iv) there are no repayments of debt on the cash flow statement.

The punch line.  In advanced techniques and valuation, unlevered cash flow will be discussed.  For now, stand in wonder at the difference in cash flow for three identical businesses that had the exact same (save for interest expense) economic performance.  This example illustrates why, even though “cash is king”, you need to know what you are looking at before passing judgment on total cash flow.  It also shows how accountants are pretty good at what they do, because the income statement is such a good comparison between the companies. 

If you think through each company’s situation, you will be able to predict their performance relative to each other.  To help that process, a projection of each company (not really something that could be called a model) is on the tab called “Taxico Projection”.  Cash Taxico (#1) is the best of the sorry lot.  At the end of five years, it has its $75,000 back, but part of the money is stuck in A/R and inventory ($72,048 in cash + $2,877 A/R + $75 inventory = $75,000, or look at current assets).  Those accountants were right!  Her taxi is dead (no asset value), and she has just enough (if Big Oil pays up) to buy a new one.  The whole time she was making zero net income, but $10,000 in EBITDA (herein lies a lesson for pure EBITDA or EBITDA multiple analysis).  Her economic value was zero.  She did nothing but waste time (and provide employment and buy gas).  Now on to Taxico #2.  Note how interest expense decreases over time as the loan is paid off.  Also note that there is zero debt in the 4th year on the balance sheet.  This is because it is at the end of the fourth year, and the 48 month note is paid off.  The payoff can be seen in the cash flow financing section.  Taxico #2 is in a bit of a spot.  He has actually destroyed value because of the bank loan, and ends the time period with $69,416 of value.  The last year felt good, though.  Now, poor Taxico #3.  Leasing looked good (low monthly payments), but alas, the higher interest rate (and the 5th year payment) caught up to him.  You should note however, that Taxico #3 is now in his 3rd Taxi, since he is leasing for 24 months.  This is one place where the “value” went.  Also ignored here is residual value for the owned taxis, which if running, are still worth something despite what your balance sheet and the accountants say.

This quick analysis is meant to familiarize you with three statement accounting by walking through a quick example, not to be a value analysis or a commentary on lease vs. own vs. purchase.  Many factors, such as tax, cost of capital, availability of capital, strategy (my customers want shiny taxis), and technical obsolescence (think Prius vs. Town Car) weigh into asset capitalization decisions.