Objectives

Section Learning Objectives

2.1

The Income Statement as the Starting Point

πŸ“– Key Concept

The Income Statement (IS) is always the first statement you build in a three-statement model. It's the most intuitive: Revenue minus expenses equals profit. But every line item on the IS has a downstream impact on the BS and CF.

πŸ“Š Simplified Income Statement with Linkage Points

Line Item IS Amount Links To Impact
Revenue $500M BS: Accounts Receivable AR increases if not all cash collected
(βˆ’) COGS ($300M) BS: Inventory, AP Inventory decreases; AP may increase
Gross Profit $200M β€” Subtotal only
(βˆ’) Selling, General, and Administrative (SGA) Expenses ($60M) BS: Prepaid expenses, accrued liabilities Working capital adjustments
(βˆ’) Depreciation & Amortization ($25M) BS: PP&E / Intangibles; CF: Add back Reduces assets; non-cash add-back
EBIT (Operating Income) $115M β€” Key profitability metric
(βˆ’) Interest Expense ($15M) BS: Debt schedule; CF: Already in NI From debt schedule; not repeated in CF
(βˆ’) Tax Expense ($25M) BS: Deferred tax; CF: Tax paid adjustment May differ from cash taxes paid
Net Income $75M BS: Retained Earnings; CF: Starting point The master link
2.2

Revenue β†’ Accounts Receivable β†’ Cash Flow

πŸ“ˆ Revenue and Cash Collection

Not all revenue is collected in cash during the period. The difference becomes Accounts Receivable.

Revenue (IS) = $500M
Cash Collected = Revenue βˆ’ Ξ”AR
Ξ”AR = Ending AR βˆ’ Beginning AR
If Ξ”AR > 0: Revenue exceeded cash collected β†’ cash outflow in CF
If Ξ”AR < 0: Collected more than revenue β†’ cash inflow in CF
πŸ’‘Excel Implementation

Forecast AR: AR = Revenue Γ— (DSO / 365)
Cash Impact: = Prior AR βˆ’ Current AR (positive = inflow)

2.3

COGS & Expenses β†’ Inventory, AP β†’ Cash Flow

πŸ“¦ Cost of Goods Sold and Working Capital

COGS drives inventory usage and accounts payable changes.

Inventory (BS) = COGS Γ— (DIO / 365)
Ξ” Inventory = Ending Inv βˆ’ Beginning Inv
β†’ Increase in Inventory = cash outflow (consumed cash)

Accounts Payable (BS) = COGS Γ— (DPO / 365)
Ξ” AP = Ending AP βˆ’ Beginning AP
β†’ Increase in AP = cash inflow (delayed payment)
⚠️Sign Convention

This is where most students make mistakes. Remember:
β€’ Asset increase (AR↑, Inv↑) = Cash OUTFLOW β†’ subtract
β€’ Liability increase (AP↑, Accrued↑) = Cash INFLOW β†’ add
Mnemonic: "Assets are bad for cash, liabilities are good for cash"

2.4

Depreciation β†’ PP&E and Cash Flow Add-Back

πŸ”§ Depreciation's Triple Appearance

Depreciation is unique because it appears on all three statements:

Income Statement

Reduces operating income as an expense

EBIT = Revenue βˆ’ COGS βˆ’ SGA βˆ’ D&A
Balance Sheet

Reduces net PP&E through accumulated depreciation

Net PP&E = Beg PP&E + CapEx βˆ’ Depreciation
Cash Flow Statement

Added back to net income (non-cash expense)

Op CF = Net Income + Depreciation + Ξ” NWC
πŸ’‘Why Is Depreciation Added Back?

Depreciation reduces net income but doesn't use cash. The cash outflow happened earlier when the asset was purchased (CapEx). By adding D&A back to net income, we reverse the non-cash expense to find true operating cash flow. This avoids double-counting the CapEx outflow.

2.5

Interest Expense β†’ Debt Schedule

🏦 Interest Expense Flow

Interest expense links the IS to the debt schedule built in Lecture 7.

Interest Expense (IS) = Average Debt Balance Γ— Interest Rate
= (Beg Debt + End Debt) / 2 Γ— Rate

Simplified: = Beg Debt Γ— Rate (avoids circular reference)

Cash Flow Impact: Interest is already in Net Income.
Do NOT show it again in Financing section of CF.
Only PRINCIPAL repayment goes in Financing CF.
2.6

Tax Expense β†’ Deferred Taxes and Cash Taxes

πŸ›οΈ Tax in the Three Statements

Book tax expense (IS) may differ from actual cash taxes paid.

Tax Expense (IS) = EBT Γ— Tax Rate
Cash Taxes Paid (CF) = Tax Expense βˆ’ Ξ” Deferred Tax
Deferred Tax (BS) = Tax Expense βˆ’ Cash Taxes Paid

If DTL increases: Less cash tax paid than book tax β†’ cash inflow
If DTA increases: More cash tax paid than book tax β†’ cash outflow
πŸ’‘Simplification

In many models, we assume Tax Expense = Cash Taxes Paid (no deferred tax changes). This simplification works when there are no significant timing differences between book and tax accounting.

2.7

Net Income: The Master Link

πŸ”— Net Income Touches Every Statement

  • IS: The bottom line β€” Revenue minus all expenses
  • BS: Added to Retained Earnings (minus dividends)
  • CF: Starting point for the indirect cash flow statement
Retained Earnings (BS) = Prior RE + Net Income βˆ’ Dividends
Operating CF (CF) = Net Income + D&A + Ξ” NWC
Net Income connects IS output to BS equity and CF operations
Practice

Hands-on Exercises: Working Capital & Depreciation

Two short exercises to practice Income Statement linkages to working capital and depreciation. Download the CSVs and follow the condensed instructions below. Full step-by-step solutions are hidden and revealed via the Show / Hide Solution Steps button.

Download Working Capital CSV Download Depreciation CSV Download Full Guide (includes solutions)

Exercise A β€” Working Capital
  1. Open the Working Capital CSV in Excel.
  2. Compute AR = Revenue Γ— (DSO / 365), Inventory = COGS Γ— (DIO / 365), AP = COGS Γ— (DPO / 365).
  3. Calculate the change (Current βˆ’ Prior) and determine the cash flow sign for each item.
Exercise B β€” Depreciation & PP&E
  1. Open the Depreciation CSV in Excel.
  2. Use CapEx and Useful Life to validate Depreciation and build the PP&E roll-forward: Ending PP&E = Beg PP&E + CapEx βˆ’ Depreciation.
  3. Confirm Depreciation flows to IS (expense), reduces Net PP&E on BS, and is added back on CF.
Summary

Key Takeaways

  • Revenue links to AR; COGS links to Inventory and AP on the BS
  • Depreciation appears on all three statements β€” expense, asset reduction, and add-back
  • Interest comes from the debt schedule and is already captured in Net Income
  • Tax expense may differ from cash taxes β€” the difference creates deferred tax
  • Net Income is the master link: it feeds both the BS (retained earnings) and CF (starting point)
← Previous Section Next: Balance Sheet Links β†’