Accounting Case Study: The 3 Financial Statements – Breaking Into Wall Street Every accounting textbook ever published attempts to explain the 3 financial statements (the Income Statement,
Balance Sheet, and Cash Flow Statement). However, their explanations are often boring or overly academic. More importantly, they don’t explain why the financial statements are important to YOU , as a banker or financier. In this case study, we’ll approach the topic in a much different way and show you why and how the financial statements are necessary for companies. But first, a revelation: The 3 financial statements are actually NOT necessary for a very simple company with a straightforward business model.
To illustrate why, we’ll start with an example you’re quite familiar with: THIS company (Breaking Into Wall Street ). ). Although the business is more complex now, we started out with a very simple model: 1. You pay upfront for the courses we create, and you receive lifetime access to the courses immediately after you sign up. 2. You sign up for coaching / resume editing, and those services get delivered shortly after you sign up. No factories or large offices were required, the capital invested was minimal, and we did not have to worry about paying suppliers or other vendors because there was no physical inventory to sell. But once the business grows and starts selling different products and services in different ways, things change.
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Part 1: Income Statement Overview, and Why the Balance Sheet and Cash Flow Statement Are Necessary
In this part of the case study, you’ll learn about the key items on a company’s Income Statement, and you’ll learn what the revenue and expense line items might be for this BIWS business. Then, you’ll learn why it’s necessary to build a Balance Sheet and Cash Flow Statement once the company becomes more complex and starts introducing new policies and business models, and once it starts receiving payments and paying others in different ways. Initially, this business will only accept upfront cash payments from customers, and will deliver its products (online financial modeling courses) and services (coaching and resume editing) immediately since they’re digital. But in the next year, it enacts a number of changes in order to expand and win more customers: •
Installment Payments: Instead of requiring customers to pay 100% upfront, we allow
customers to pay via monthly installments but still receive immediate access to the courses. This will illustrate the concept of Accounts Receivable. •
Prepaying Expenses: Instead of paying our vendors, suppliers, or landlord right away,
we negotiate and win better rates by paying for these expenses several months in advance. This will illustrate the concept of Prepaid Expenses. •
Vendor Negotiation: Meanwhile, we do the opposite with other vendors, such as a
professional marketing firm we just hired. We push back and ask them to accept cash payment at a later date… for products and services they have already delivered to us. This will illustrate the concepts of Accounts Payable and Accrued Expenses. •
Monthly Subscriptions: Then, we get a brilliant idea and start selling a monthly BIWS
subscription service. The only catch is that customers will have to pay for a quarter to a year of the service in advance in order to use it. This will illustrate the concept of Deferred Revenue. •
Selling Physical Products: Next, we decide that we need to expand offline by selling
physical versions of the courses (i.e. in hardcover format). To do that, we need to buy the supplies and raw materials for those products before we sell them. This will illustrate the concept of Inventory. You will understand exactly why these policies, which are common at all sizable companies, require us to build a Balance Sheet and Cash Flow Statement for the expanding BIWS business.
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Part 2: Longer-Term Items on the 3 Financial Statements
In this part of the case study, we’ll look at more complex items on the financial statements and see how a company changes as it invests capital into longer-term ventures. We’ll still work with the Balance Sheet and Cash Flow Statement, but now we’ll analyze items that have a multi-year impact. Here are the topics we’ll cover in this part of the case study: •
Buying Offices: We decide to expand the business to also offer in-person classroom
training, so we need to buy offices and other equipment to do that. This will illustrate the concepts of Plants, Property & Equipment (PP&E), Capital Expenditures (CapEx), and Depreciation. •
Playing the Stock Market: It turns out that our business is generating a lot of extra cash,
so we decide to start buying securities and other investments. This will illustrate the concepts of Short-Term and Long-Term Investments . •
Raising Debt: Inadvertently, we run low on cash because we spent too much on buying
securities and investments. We need a certain amount of cash to run the business, so we decide to raise funding via a debt issuance. This will illustrate the concepts of Debt Issuances and Repayments ; it will also demonstrate how Interest Expense and Principal Repayments work. •
Divesting Assets: It turns out the debt funding is still not enough, so we decide to sell
some of our investments in order to raise additional funds. This will illustrate the concept of Gains and Losses on Asset Sales . •
Raising Equity: Although we now have enough cash to run the business, we have the
opportunity to raise even more funds by accepting an outside investment. We will give up some ownership in the business by doing this, but the terms are favorable and we like the investors. This will illustrate the concept of Equity Issuances. •
Using Accounting Rules to Reduce Our Taxes: Our accountant comes to us in the midst
of all this, and points out that we might be able to reduce our tax bill by depreciating certain assets more quickly for tax purposes. So we decide to modify our policies and start following his recommendations. This will illustrate the concepts of Deferred Income Taxes and Deferred Tax Liabilities . •
Equity Investors Come Knocking: While our new outside investors are pleased with
their investment in BIWS, they know that the business generates cash flow that it is not using for anything. So they push us to repurchase shares from them or issue dividends –
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cash payments proportional to their ownership in the company. This will illustrate the concepts of Dividends and Share Repurchases. •
Employees Come Knocking: Our employees quickly find out about this, and they want a
“piece of the action” as well. They don’t own any of the company at the moment, but they want to own some of it. So we start issuing equity to them, in addition to paying their normal salaries and benefits. This will illustrate the concept of Stock-Based Compensation. •
Mergers & Acquisitions: We decide that we need to “bulk up” by acquiring a smaller
training company. The company has no revenue and no profits, but it does have valuable intellectual property (IP) assets that must be reflected on the Balance Sheet. This will illustrate the concepts of Goodwill and Other Intangible Assets . •
Not What We Bargained For: Shortly after acquiring this other company, however, we
discover that it’s not quite what we thought it was. Its IP is worth less than we expected, so we need to adjust the Balance Sheet after the deal closes. This will illustrate the concepts of Goodwill Impairments and PP&E Write-Downs. By the end of this segment, you’ll understand why accounting for large, public companies can get very complex and why we really need the 3 financial statements to properly describe them. The first segment of the case study focused on timing differences and current vs. deferred collections and payments, but this segment focuses more on the tax-deductibility of items and their useful lives. Part 3: Key Rules, Metrics, and Ratios on the 3 Financial Statements
In this final segment of the case study, we’ll take a step back and review everything we covered in the lesson, and give you some rules of thumb for analyzing the financial statements. In addition, we’ll also take a look at industry and regional differences and how the financial statements might differ under US GAAP vs. IFRS vs. other systems. We will also examine two metrics from the financial statements that are extremely important: Working Capital and Free Cash Flow. You’ll understand what they mean and how they impact
our analysis of companies later on in the course. We’ll wrap up by covering a few of the key metrics and ratios you might use to analyze the financial statements, from Liquidity Ratios to Growth and Profitability Ratios to Asset Management and Credit Ratios.
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•
Income Statement Rules and Summary: In this lesson, you’ll get concise rules for which
items go on the Income Statement and what they mean. •
Balance Sheet Rules and Summary: You’ll learn how to think about Assets and Liabilities
& Equity with a few simple rules of thumb in this tutorial. •
Cash Flow Statement Rules and Summary: You’ll get a summary of the Cash Flow
Statement, common line items, and how to think about the classifications here. •
Regional Differences – US GAAP vs. IFRS: Although accounting principles are the same
worldwide, the presentation and vocabulary may differ in certain regions. Here, we go through a few examples of how US GAAP differs from IFRS and what to expect when you’re working with companies outside the US. •
Industry Differences: Similarly, certain industries may present items di fferently on the
financial statements – so we go through a few examples of what to expect and common variations in this lesson. •
Working Capital and the Change in Working Capital: The concept of “Working Capital”
is often explained poorly. We use a different approach here and explain more precisely what it is, why companies care about it so much, and what the “change” in Working Capital really means. •
Free Cash Flow and What to Do With It: After a company reaches a certain size, it has
to make decisions about what to do with the cash flow it generates: Should it hire more employees? Invest in more assets? Issue dividends? Buy back shares? We explain how you can use its Free Cash Flow figures to decide between those different possibilities. •
Key Metrics and Ratios: We wrap up this segment of the case study by covering several
important financial metrics and ratios that you can use to analyze a company’s financial health. We do NOT cover every last metric in this lesson – just a few of the metrics and ratios you can understand based on the lessons so far.
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