Hi. Welcome back to "Finance for Non-Finance Professionals". In this video, we're gonna give a very brief overview of the financial statements, the accounting statements that we're gonna use as our road map or treasure map for finding where cash is throughout the financial statements. We'll start off with a discussion of the balance sheet, we'll move to the income statement or the profit and loss statement, and we'll end with a discussion of the cash flow statement. Now these three financial statements are the three main statements that accountants use to communicate the financial condition of the company to investors or outsiders. The balance sheet answers a very basic question. It says, what have you got, what do you have, what does the firm own? Assets of the firm are listed on the balance sheet along with where those assets came from, the liabilities and the equity of the firm, the investors of the firm that purchased those assets. The second statement, the income statement, answers another very basic question. How is it going, with the stuff that you got? That income statement details whether the firm is making money or losing money by using the assets that it has on the balance sheet. Sometimes, because of the way accountants record things with the accrual method that we'll talk about briefly, it's hard to track cash between the balance sheet and the income statement, it's not always a direct comparison, and so the cash flow statement, the third financial statement, reconciles those two. It helps us track each dollar bill and how it moves between the financial statements of the balance sheet and the income statement. Let's start off our discussion with the balance sheet, the first financial statement. What does the firm own? How was it paid for? And that has to tie together with the equal sign in the middle. That's really the nature of the balance sheet is that equal sign in the middle. That equal sign says that the balance sheet has to balance. The assets have to be equal to where those assets came from. The left-hand side of the balance sheet lists everything that the firm has; the right-hand side of the balance sheet lists where everything came from. Everything was purchased by the firm by either equity holders or we used banks' money or bondholders' money, liabilities. So everything that the firm has, the assets, are owed to someone. They're either owed to bondholders or banks in liabilities or they're owed to the owners of the firm, the equity holders in the firm. Let's think of some of the assets on the balance sheet. There are current assets like cash and marketable securities. Accounts receivable is an asset. If I have money that is due to me, that's an asset even if I don't have the cash right now. Inventories, product and services that I have in the warehouse that I haven't sold yet, those go on the balance sheet under current assets. And then there are long-term assets, property, plant, equipment, machines, real estate that go down under PP&E or fixed assets. Land, machinery, depreciation expenses, all of those things accumulate under the assets on the balance sheet under property, plant and equipment. And then there are other assets like intangibles. Sometimes, in the financial statements we write down assets that are kind of hard to define. Like Coca-Cola, what's the value of its brand? That's a hard thing to write down as physical plant, and so we write it down under other assets, under things like intangibles or brand value. On the other side of the balance sheet, we have liabilities, short-term payables or current debt, what I owe the bank this month or what I owe my suppliers in payables. And then there's long-term deferred debt or long-term debt that I have on the balance sheet, long-term money that I owe to someone else. Both of these things are either short-term or long-term debt, money that I owe to other investors that have lent me their money. And then the other thing, if I borrowed the money from bondholders or the bank, that's liabilities, current or long term. And then there's the ownership of the company, the equity in the company. That also gets written down on the right-hand side of the balance sheet as shareholders' equity. That might be preferred or common stock listed at par value, and it could be retained earnings, money that the firm has earned but hasn't paid out to anybody yet, it's been retained inside the firm. That also gets written down as money that's owed to somebody else. Potentially that could go to either bondholders or shareholders – retained earnings under shareholders' equity. All right, let's move on to the second accounting statement, the income statement, the profit and loss statement. At the very top line, this statement is gonna track sort of whether the firm is making money or losing money with the assets that they have. The top line of the income statement is net revenues, net sales. How much did you sell? Price times quantity minus how much it cost me to generate those sales minus what we call selling and administrative expense – how much did I spend, say, on advertising or administrative costs? That gives me EBITDA, what accountants call earnings before interest, taxes, depreciation and amortization. EBITDA is our basic measure of profit. It's how much money I've made after I sort of get rid of the cost of producing those sales. If I take out depreciation and amortization or how much my assets have deteriorated in value, that gives me EBIT, which we sometimes call pre-tax operating profit, earnings before interest and taxes. Take out interest expense, that gives me taxable income. Take out income tax or any dividends if I'm paying any dividends to my shareholders, and that gives me net income or profit or earnings in the simplest accounting sense, the bottom line. So the income statement moves us from the top line, net revenues, to the bottom line, net income or how much profit did I make, earnings. OK, the statement of cash flows, our third main financial statement that accountants produce for us, deals with the accrual method of accounting, which is that I book sales before I actually get the money or the actual cash. And so the statement of cash flows helps us reconcile the fact that the income statement doesn't track actual dollar bills, but generates accrual revenues. OK, the statement of cash flows is gonna report on cash movements across operating expenses. It's gonna tell us how much net income and depreciation there was. Investing activities – it's gonna tell us how much we spent on new property, plant and equipment or capital expenditures. It's also gonna detail any assets that we sold that might have generated cash. And it's going to detail for us financing, the cash effects of financing. Maybe I paid out dividends, that's cash out. Maybe I issued new debt or new equity, that's cash back in. The statement of cash flows is gonna help us detail and track all of the cash that's coming in or out of the business through either operating, investing or financing activities. OK, and that's gonna reconcile cash movements between the balance sheet and the income statement. OK, to sum up, the three accounting statements, the balance sheet, the income statement and the statement of cash flows, give us a report on the financial condition of the company. The balance sheet, the income statement and the statement of cash flows gives us a nice apples-to-apples comparison. The fact that accountants produce these three financial statements makes it very easy to look at any company's audited financial statements and get a nice, clear, cogent, distilled report on the financial condition of the company. It follows generally accepted accounting principles. The thing is that these three financial statements really don't tell us exactly what cash was created through each of the quarters or each of the years. What we need to do, in finance, is use those three financial statements like a treasure map and hunt for cash creation through each of the three financial statements. The purpose of the accounting statements is to conform with accounting rules. It's not that accountants are trying to hide anything or not be transparent, they're following the accepted accounting principles, but the accepted accounting principles give a report on the financial condition of the company that might not exactly tie up to cash creation. Our job is to uncover where all the cash is. And what we're gonna do this week is focus on each one of those places where cash might be hidden and we're gonna seek through each of those financial statements and try to uncover where all the cash is. At the end of the week, we'll come up with our measure of free cash flow.
