Basic, lesson 1 of 3
The three statements through a lender's eyes
An equity investor starts with growth and margins. A lender starts with cash: how much comes in, what it must pay, and what is owed ahead of it.
9 min, 3 checks
1What a lender reads first
A lender's question is simple: will this company pay interest every quarter and repay principal at maturity? Earnings help answer it, but cash answers it directly. So a credit analyst usually opens the cash flow statement first, then the debt footnote, then the balance sheet, and reads the income statement last.
| Statement | Equity investor asks | Lender asks |
|---|---|---|
| Income statement | How fast is revenue growing, and are margins expanding? | How stable is EBITDA, and how much of it is real? |
| Cash flow statement | How much cash is left to reinvest or return? | Does operating cash cover interest, capex, and required principal? |
| Balance sheet | What is book value and return on capital? | How much debt is ahead of me, how much cash and revolver is left, what is the collateral? |
| Debt footnote | Rarely read closely | Every tranche, rate, maturity, and covenant. The first page a lender opens. |
Check 1
Which disclosure tells a lender the rate, maturity, and ranking of every tranche of existing debt?
2Cash versus accrual
The income statement is built on accrual accounting: revenue is booked when it is earned, expenses when they are incurred, whatever the timing of the cash. A company can report a profit while its bank balance falls, because customers have not paid yet, because it bought inventory it has not sold, or because it spent heavily on equipment.
Worked example
Fernwood Supply: profitable on paper, short of cash
- 1Net income: $30m.
- 2Add back depreciation and amortization: +$25m.
- 3Receivables rise by $20m (sales booked, cash not collected): -$20m.
- 4Inventory rises by $15m: -$15m.
- 5Payables rise by $5m: +$5m.
- 6Cash from operations: $30m + $25m - $20m - $15m + $5m = $25m.
- 7Capital expenditures: -$20m.
Free cash flow is $25m - $20m = $5m against net income of $30m. A lender sizing debt off the $30m would be wrong by a factor of six.
Check 2
Net income is $40m, D&A is $10m, receivables rise $12m, inventory falls $4m, and payables fall $2m. What is cash from operations, in $m?
3Where debt and interest show up
- Interest expense sits on the income statement below operating income. Under US GAAP, interest paid is part of cash from operations.
- Principal is not an expense. Repaying a term loan is a financing outflow; drawing a revolver or issuing a bond is a financing inflow.
- PIK interest is expensed on the income statement but paid in more debt, so it is added back in cash from operations and the loan balance grows.
- Debt sits on the balance sheet split into current (due within a year, including required amortization) and long term.
Check 3
A borrower draws $30m on its revolver to fund a seasonal inventory build. Where does the $30m appear on the cash flow statement?
Terms in this lesson: Cash flow statement, Balance sheet, Income statement, EBITDA, Capital expenditures, Revolving credit facility, Covenant, Accrual accounting, Net income, Depreciation, Amortization, Operating income.
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