Understanding the three key financial statements and their impact on financial modeling and valuation

Understanding financial statements plays a key role in building robust financial models that can impact the potential valuation of your company.

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Financial statements are key to understanding the underlying drivers of a business—i.e., how your business is growing, what the margin profile is, how much cash it is generating and using and from which sources, what the key assets of the business are, and so on.

While the way of doing business and the nature of businesses have evolved a lot over the years, the three key financial statements and the fundamentals surrounding them have largely remained the same. Let’s take a deeper dive into what these three key financial statements are and how they potentially impact financial modeling and valuation.

THREE KEY FINANCIAL STATEMENTS

There are three key commonly known financial statements:

1. Income statement

Also sometimes known as a profit and loss statement, this statement records the revenues and expenses of the business operations and measures how much profit or loss the business made during the period under consideration.

2. Statement of cash flows

As the name suggests, this statement records the cash flows of a business, subcategorized into cash flow from operations, cash flow from investing, and cash flow from financing, eventually measuring the movement in cash during the period under consideration.

3. Balance sheet

The balance sheet records the different assets and liabilities of a business, measuring the equity capital of the business at a particular point in time (assets = liabilities + equity). Unlike the income statement and statement of cash flows that record activities for a particular period, the balance sheet shows the state of assets and liabilities at a given point in time.

Let’s take a look at a simple example to see how these three financial statements are linked to each other. If a business has an asset worth $100 that is subject to depreciation at the rate of 10% annually, we can see how a depreciation expense of $10 (10% of $100) affects all three statements.

• Income statement: Depreciation is a business expense item. Hence, $10 is recorded as an expense in the income statement and reduces the net profit by $10.

• Statement of cash flows: Depreciation is a non-cash expense and hence doesn’t affect the cash flows of the business. However, most statements of cash flows start from net profit. As depreciation is already deducted to arrive at the net profit, it is typically added back to the cash flow statement, i.e., $10 is added back to the cash flow from operations.

• Balance sheet: Depreciation reduces the value of asset, i.e., the asset is now valued at $90 (beginning value of $100 minus the annual depreciation of $10). Net profit from the income statement is carried over to the equity section of the balance sheet, and as the depreciation reduces the net profit, the overall equity of the business is reduced by $10. The equation assets = liabilities + equity balances itself out.

IMPACT ON FINANCIAL MODELING AND VALUATION

Valuing a company using different methods such as discounted cash flow, leveraged buyouts, etc., typically involves building a financial model using some assumptions that flow through the projected financial statements. In the case of a DCF, valuation is driven primarily based on projected cash flows.

Here are some examples of items and assumptions that impact the financial model and statement of cash flows:

• Net working capital: An assumption on days of sales outstanding, account payable turnover, or days of inventory on hand affects the cash flow statement and future potential cash flows, thereby directly impacting the valuation under a DCF method. For example, an aggressive assumption around the days of sales outstanding could result in faster cash flow generation, thereby accelerating the realization of cash flows to earlier periods. Meanwhile, a conservative assumption could have the opposite effect.

• Capital expenditure: Capex as a percentage of revenue or assets is another typical assumption commonly seen in financial models. A higher capex percentage drags down the cash flows, while a lower capex percentage has the opposite effect. Higher cash flows typically mean higher valuation and vice versa.

• Depreciation: As noted before, depreciation flows through all three statements. While it’s a non-cash expense and doesn’t impact the cash flow statement directly, it is still a tax-deductible item and can lead to lower taxes. Hence, an assumption on the rate of depreciation also impacts cash flows indirectly through taxes, and as a result, also impacts the valuation.

Similarly, other assumptions—including the ones noted above—also can flow through the income statement and balance sheet part of the financial model. This impacts the future profitability, capital structure, and asset mix of the business, which can be important when valuing the company under other methods (such as the comparables method using profitability ratios) or analyzing critical financial ratios such as margin profile, leverage, interest coverage, and so on. Regardless of the end purpose, understanding financial statements typically plays a key role in building robust financial models that can impact the potential valuation of your company.

The views expressed above are solely of the author and not of the author’s employer. The information and statements contained within this article are strictly for educational and informational purposes only and do not constitute investment advice, investment recommendations, investment research or an offer or solicitation to buy or sell any securities or instruments. Each recipient should seek investment, legal, tax and accounting advice based on his or her particular circumstances from independent advisors regarding the impact of the information or matters described herein.

Darshil Shah is an investment banking professional with a focus on mergers and acquisitions.

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