What You'll Learn Today
By the end of this session, you will be able to:
The Three Financial Statements
Understanding the foundation of financial analysis
If you could only look at one financial statement to evaluate a company, which would you choose and why?
Each statement tells a different part of the story. The real power comes from understanding how they connect.
Income Statement
Performance over time
- Revenues & Expenses
- Profitability metrics
- Covers a period (quarter/year)
Balance Sheet
Financial position at a point in time
- Assets, Liabilities, Equity
- What you own vs. what you owe
- Snapshot at a specific date
Cash Flow Statement
Cash movements over time
- Operating, Investing, Financing
- Cash generation and use
- Covers a period (quarter/year)
The Fundamental Accounting Equation
This equation must ALWAYS balance. It's the foundation of double-entry bookkeeping.
Income Statement (Profit & Loss)
Measures profitability over a period of time
🔑 Key Components
- Revenue (Top Line): Total sales generated
- COGS: Direct costs of producing goods/services
- Gross Profit: Revenue - COGS
- EBIT: Operating income before interest and taxes
- Net Income (Bottom Line): Final profit after all expenses
Net Income flows to:
1. Balance Sheet → Retained Earnings
2. Cash Flow Statement → Starting point for operating activities
📈 Key Profitability Margins
Balance Sheet
Snapshot of financial position at a specific point in time
ASSETS
LIABILITIES & EQUITY
🔑 Balance Sheet Structure
Assets (What you own)
- Current: Cash, receivables, inventory (< 1 year)
- Non-Current: PP&E, intangibles (> 1 year)
Liabilities (What you owe)
- Current: Payables, short-term debt (< 1 year)
- Non-Current: Long-term debt (> 1 year)
Equity (Owners' claim)
- Common Stock: Capital invested by shareholders
- Retained Earnings: Accumulated profits kept in business
Assets = Liabilities + Equity
This must ALWAYS be true. If your balance sheet doesn't balance, there's an error!
💼 Working Capital Analysis
Cash Flow Statement
Tracks the movement of cash in and out of the business
Operating Activities
Investing Activities
Financing Activities
🔑 Three Sections of Cash Flow
📈 Operating Activities
Cash generated from core business operations. Starts with Net Income and adjusts for non-cash items and working capital changes.
🏗️ Investing Activities
Cash used for investments in assets (CapEx) or generated from asset sales. Shows how company invests for growth.
🏦 Financing Activities
Cash from debt, equity, and dividends. Shows how company funds its operations and returns value to shareholders.
"Cash is King!" A company can be profitable (Net Income) but still go bankrupt if it runs out of cash. The Cash Flow Statement reveals the true liquidity position.
Statement Inter-relationships
Understanding how the three statements connect
The Financial Statement Cycle
Statement
Sheet
Statement
Key Linkages Between Statements
(Income Statement)
(Balance Sheet)
(Income Statement)
(Cash Flow Statement)
(Cash Flow Statement)
(Balance Sheet)
(Income Statement)
(Balance Sheet)
🔗 Complete Connection Map
| Item | Income Statement | Balance Sheet | Cash Flow |
|---|---|---|---|
| Net Income | Bottom line profit | Adds to Retained Earnings | Starting point for CFO |
| Depreciation | Non-cash expense | Reduces PP&E value | Add back to Net Income |
| Receivables | Revenue (if credit sale) | Current Asset | Working capital adjustment |
| Inventory | COGS when sold | Current Asset | Working capital adjustment |
| Payables | Expense when incurred | Current Liability | Working capital adjustment |
| Debt | Interest expense | Liability | Financing activity |
| PP&E | Depreciation expense | Non-current Asset | Investing activity (CapEx) |
⚡ "The Plugs" - Making the Model Balance
In financial modeling, we use "plugs" to ensure the balance sheet balances and cash flow is accurate.
Cash Plug (Surplus)
When Assets < Liabilities + Equity, the difference goes to Cash (excess cash generated).
Revolving Credit (Shortfall)
When Assets > Liabilities + Equity, the company needs to borrow via Revolving Credit Facility.
Common-Size Analysis
Standardizing financial statements for comparison
What is Common-Size Analysis?
Common-size analysis expresses all line items as a percentage of a base figure, making it easier to:
- Compare companies of different sizes
- Analyze trends over time
- Identify structural changes in the business
- Benchmark against industry peers
📊 Income Statement (Vertical Analysis)
All items as % of Revenue
| Line Item | Amount | % |
|---|---|---|
| Revenue | $1,000,000 | 100.0% |
| COGS | $600,000 | 60.0% |
| Gross Profit | $400,000 | 40.0% |
| SG&A | $150,000 | 15.0% |
| R&D | $50,000 | 5.0% |
| Depreciation | $40,000 | 4.0% |
| EBIT | $160,000 | 16.0% |
| Interest | $20,000 | 2.0% |
| Net Income | $105,000 | 10.5% |
🏦 Balance Sheet (Vertical Analysis)
All items as % of Total Assets
| Line Item | Amount | % |
|---|---|---|
| Cash | $150,000 | 16.7% |
| Receivables | $120,000 | 13.3% |
| Inventory | $180,000 | 20.0% |
| Total Current Assets | $450,000 | 50.0% |
| PP&E (Net) | $400,000 | 44.4% |
| Intangibles | $50,000 | 5.6% |
| TOTAL ASSETS | $900,000 | 100.0% |
| Total Liabilities | $360,000 | 40.0% |
| Total Equity | $540,000 | 60.0% |
📈 Horizontal Analysis (Trend Analysis)
Compare line items across multiple periods to identify trends
| Line Item | 2023 | 2024 | 2025 | % Change (2-Year) |
|---|---|---|---|---|
| Revenue | $800,000 | $900,000 | $1,000,000 | +25.0% |
| Gross Profit | $300,000 | $360,000 | $400,000 | +33.3% |
| Net Income | $70,000 | $88,000 | $105,000 | +50.0% |
| Total Assets | $750,000 | $820,000 | $900,000 | +20.0% |
Net Income grew 50% while Revenue grew only 25%, indicating improving operational efficiency and margin expansion. This is a positive trend!
💻 Implementing in Excel
Vertical Common-Size Formula
Where B2 is the Revenue cell. Use absolute reference ($) to lock the base.
Horizontal Analysis Formula
Where B2 is the earlier period and D2 is the later period.
Hands-On Practice
Apply what you've learned with these exercises
📥 Download Practice Files
Download the data files and practice guide to work through the exercises.
Practice Guide
📖 Download Practice Guide (MD)The practice guide contains step-by-step instructions for all exercises with expected results.
View all practice files →🎯 Practice Exercises
Exercise 1: Build a Three-Statement Model
Using the provided data, build interconnected Income Statement, Balance Sheet, and Cash Flow Statement.
Verify: Your Balance Sheet balances and Cash Flow ending cash matches Balance Sheet cash.
Exercise 2: Common-Size Analysis
Create vertical common-size Income Statements for 3 years of data. Identify which expense categories are growing faster than revenue.
Exercise 3: Working Capital Analysis
Calculate the Cash Conversion Cycle using: Days Sales Outstanding + Days Inventory Outstanding - Days Payable Outstanding.
📚 Key Terms - Click to Flip
Test Your Understanding
Let's see what you've learned!
Key Takeaways
📝 What We Covered Today
- Income Statement: Measures profitability over a period; Net Income flows to Retained Earnings and Cash Flow
- Balance Sheet: Snapshot of financial position; Assets = Liabilities + Equity (always!)
- Cash Flow Statement: Tracks cash movement through Operating, Investing, and Financing activities
- Inter-relationships: Net Income links all three statements; ending cash must match balance sheet cash
- Common-Size Analysis: Vertical (% of base) and Horizontal (trend) analysis for comparison
📋 Quick Reference Card
Key Formulas
Gross Profit = Revenue - COGSEBIT = Gross Profit - Operating ExpensesNet Income = EBIT - Interest - TaxesWorking Capital = CA - CL
Key Links
- Net Income → Retained Earnings
- Net Income → CFO (Cash Flow)
- Depreciation → Accumulated Depreciation
- Cash Flow → Cash (Balance Sheet)
Lecture 5: Financial Ratios & Analysis
We'll dive deeper into ratio analysis - liquidity, profitability, efficiency, and leverage ratios. These tools help evaluate company performance and financial health.
Reading: Pignataro, Ch. 5