Basic, lesson 1 of 3
Reading the statements as an owner
A banker reads the statements to build a model. An investor who will hold the stock for five years reads them to answer one question: how much cash does this business hand its owners, and how reliably?
9 min, 3 checks
1Three statements, three owner questions
Every public company files the same three statements. A sell side model treats them as inputs. A buy side analyst reads each one with a different question in mind, because the fund will own a slice of this business for years and live with whatever the numbers hide.
| Statement | The owner's question | Lines to read first |
|---|---|---|
| Income statement | How much does the business earn in a normal year, and is it growing? | Revenue growth, gross margin, operating margin, share count |
| Balance sheet | What does it take to run, and who else has a claim? | Debt, cash, working capital, goodwill, lease liabilities |
| Cash flow statement | Do the earnings turn into cash the owners could take out? | Cash from operations, capex, acquisitions, buybacks, dividends |
Read the cash flow statement first more often than not. It is the hardest statement to dress up, and it shows where the money went: back into the business, into acquisitions, or out to shareholders.
2Accrual earnings and cash earnings
Net income is an accrual number. Revenue counts when it is earned, not when it is collected, and costs are matched to that revenue. Cash from operations starts from net income and undoes the timing: it adds back non-cash charges such as depreciation and adjusts for money tied up in, or released from, working capital.
Cash from operations = Net income + Non-cash charges - Increase in working capital
Working capital here means receivables and inventory, less payables and deferred revenue.
Worked example
Marlow Instruments, one year
- 1Net income: 100. Depreciation and amortization: 30.
- 2Receivables rose 25: sales booked but not yet collected, a use of cash.
- 3Deferred revenue rose 10: customers paid ahead of delivery, a source of cash.
- 4Cash from operations: 100 + 30 - 25 + 10 = 115.
Marlow generated 115 of operating cash on 100 of net income. The accrual and the cash tell the same story, which is what an owner hopes to see.
Check 1
Net income is 60, depreciation is 15, inventory rose 20, and payables rose 5. What is cash from operations?
3Free cash flow: what the owners could take out
Cash from operations still has to pay for the equipment, stores, and software that keep the business running. Subtract capital expenditure and you get free cash flow, the cash that could go to debt holders and shareholders without shrinking the business.
Free cash flow = Cash from operations - Capital expenditure
Check 2
Marlow's cash from operations is 115 and capex is 45. What is its free cash flow?
Check 3
Revenue grew 6% but receivables grew 30%. What should an owner ask first?
Terms in this lesson: Buy side, Income statement, Gross margin, Balance sheet, Cash flow statement, Capital expenditures, Net income, Depreciation, Amortization.
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