THE INCOME STATEMENT

The income statement measures a company's profit (or loss) over a specific period of time. A business is generally required to report and record the sales it generates for tax purposes. And, of course, taxes on sales made can be reduced by the expenses incurred while generating those sales. Although there are specific rules that govern when and how those expense reductions can be utilized, there is still a general concept:

A company is taxed on profit. So:

However, income statements have grown to be quite complex. The multifaceted categories of expenses can vary from company to company. As analysts, we need to identify major categories within the income statement in order to facilitate proper analysis. For this reason, one should always categorize income statement line items into nine major categories:

1. Revenue (sales)
2. Cost of goods sold (COGS)
3. Operating expenses
4. Other income
5. Depreciation and amortization
6. Interest
7. Taxes
8. Nonrecurring and extraordinary items
9. Distributions

No matter how convoluted an income statement is, a good analyst would categorize each reported income statement line item into one of these nine groupings. This will allow the analyst to easily understand the major categories that drive profitability in an income statement and can further allow him or her to compare the profitability of several different companies—an analysis very important in determining relative valuation. We will briefly recap the line items.

REVENUE

Revenue is the sales or gross income a company has made during a specific operating period. It is important to note that when and how revenue is recognized can vary from company to company and may be different from the actual cash received. Revenue is recognized when “realized and earned,” which is typically when the products sold have been transferred or once the service has been rendered.

COST OF GOODS SOLD

Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold by a company. These are the costs most directly associated with the revenue. COGS is typically the cost of the materials used in creating the products sold, although some other direct costs could be included as well.

OPERATING EXPENSES

Operating expenses are expenses incurred by a company as a result of performing its normal business operations. These are the relatively indirect expenses related to generating the company's revenue and supporting its operations. Operating expenses can be broken down into several other major subcategories. The most common categories are:

• Selling, general, and administrative (SG&A). These are all selling expenses and all general and administrative expenses of a company. Examples are employee salaries and rents.
• Advertising and marketing. These are expenses relating to any advertising or marketing initiatives of the company. Examples are print advertising and Google Adwords.
• Research and development (R&D). These are expenses relating to furthering the development of the company's products or services.

Let's say in our car business we have employees who were paid $75,000 in total in the first quarter. We also had rents to pay of $2,500, and we ran an advertising initiative that cost us $7,500. Finally, let's assume we employed some R&D efforts to continue to improve the design of our car that cost roughly $5,000 in the quarter. Using the previous example, our simple income statement looks like this:

OTHER INCOME

Companies can generate income that is not core to their business. As this income is taxable, it is recorded on the income statement. However, since it is not core to business operations, it is not considered revenue. Let's take the example of the car company. A car company's core business is producing and selling cars. However, many car companies also generate income in another way: financing. If a car company offers its customers the ability to finance the payments on a car, those payments come with interest. The car company receives that interest. That interest is taxable and is considered additional income. However, as that income is not core to the business, it is not considered revenue; it is considered “other income.”

Another common example of other income is income from noncontrolling interests, also known as income from unconsolidated affiliates. This is income received when one company has a noncontrolling interest investment in another company. So when a company (Company A) invests in another company (Company B) and receives a minority stake in Company B, Company B distributes a portion of its net income to Company A. Company A records those distributions received as “other income.”

DEPRECIATION AND AMORTIZATION

Depreciation is the accounting for the aging and depletion of fixed assets over a period of time. Amortization is the accounting for the cost basis reduction of intangible assets (intellectual property such as patents, copyrights, and trademarks, for example) over their useful lives. It is important to note that not all intangible assets are subject to amortization.

INTEREST

Interest is composed of interest expense and interest income. Interest expense is the cost incurred on debt that the company has borrowed. Interest income is commonly the income received from cash held in savings accounts, certificates of deposit, and other investments.

Let's assume the car company has taken out $1 million in loans and incurs 10 percent of interest per year on those loans. So the car company has $100,000 in interest expense per year, or $25,000 per quarter. We can also assume that the company has $50,000 of cash and generates 1 percent of interest income on that cash per year ($500), or $125 per quarter.

Often, the interest expense is netted against the interest income as net interest expense.

TAXES

Taxes are the financial charges imposed by the government on the company's operations. Taxes are imposed on earnings before taxes as defined previously. In the car example, we can assume the tax rate is 35 percent.

NONRECURRING AND EXTRAORDINARY ITEMS

Nonrecurring and extraordinary items or events are income or expenses that either are one-time or do not pertain to everyday core operations. Gains or losses on sales of assets or from business closures are examples of nonrecurring events. Such nonrecurring or extraordinary events can be scattered about in a generally accepted accounting principles (GAAP) income statement, so it is the job of a good analyst to identify these items and move them to the bottom of the income statement in order to have EBITDA, EBIT, and net income line items that represent everyday, continuous operations. We call this “clean” EBITDA, EBIT, and net income. However, we do not want to eliminate those nonrecurring or extraordinary items completely, so we move them to the section at the bottom of the income statement. From here on out we will refer to both nonrecurring and extraordinary items simply as “nonrecurring items” to simplify.

DISTRIBUTIONS

Distributions are broadly defined as payments to equity holders. These payments can be in the form of dividends or noncontrolling interest payments, to name the two major types of distributions.

Noncontrolling interest is the portion of the company or the company's subsidiary that is owned by another outside person or entity. If another entity (Entity A) owns a noncontrolling interest in the company (Entity B), Entity B must distribute a portion of Entity B's earnings to Entity A.

SHARES

A company's shares outstanding reported on the income statement can be reported as basic or diluted. The basic share count is a count of the number of shares outstanding in the market. The diluted share count is the number of shares outstanding in the market plus any shares that would be considered outstanding today if all option and warrant holders who are in-the-money decided to exercise on their securities. The diluted share count is best thought of as a what-if scenario. If all the option and warrant holders who could exercise would, how many shares would be outstanding now?

Earnings per Share (EPS)

Earnings per share (EPS) is defined as the net income divided by the number of shares outstanding. A company typically reports a basic EPS and a diluted EPS, divided by basic shares or diluted shares, respectively. It is important to note that each company may have a different definition of what exactly to include in net income when calculating EPS. In other words, is net income before or after noncontrolling interest payments? Or before or after dividends? For investors, it is common to use net income before dividends have been paid but after noncontrolling interest investors have been paid. However, we recommend backing into the company's EPS historically to identify the exact formula it is using.

THE CASH FLOW STATEMENT

The cash flow statement is a measure of how much cash a company has produced or spent over a period of time. Although an income statement shows profitability, that profit may or may not result in actual cash gain. This is because many income statement items that are recorded do not necessarily result in an effect on cash. For example, when a sale is made, a customer can pay in cash or on credit. If a company has $10 million in sales and all customers have paid in cash, then the company has actually generated $10 million in cash. But if a company has $10 million in sales on credit, then although the revenue has been recorded on the income statement, cash has not been received. The cash flow statement aims to determine how much cash the company actually generated, which is broken out into three segments:

1. Cash from operating activities
2. Cash from investing activities
3. Cash from financing activities

The sum of all the cash generated (or spent) from operating activities, from investing activities, and from financing activities results in the total amount of cash spent or received in a given period.

CASH FLOW FROM OPERATING ACTIVITIES

Cash flow from operating activities is a representation of how much cash has been generated from net income or profit. We explained earlier how revenue could be received in cash or on credit. As revenue is a source of income, if a portion of that revenue is on credit, we need to make an adjustment to net income based on how much of that revenue is actually cash. Similarly, expenses recorded on the income statement could be cash expenses (they have been paid) or noncash expenses (they have not been paid). Let's take a billing invoice on an operating expense such as office supplies as an example. Once the invoice is received (a bill we have to pay), we would need to record this on the income statement, even if we had not actually paid that bill yet. Having this expense on our income statement would bring our profitability down. But when looking at cash available, that bill should not be included, as we have not paid it. So, for cash flow from operations, we would add that expense back to the net income, effectively reversing the expense effects.

Example:

This should make logical sense. We've collected $10 million in cash from our sales; we received an invoice of $2 million, but we did not pay that invoice. The invoice is expensed properly on the income statement, but we do not want to include that in our cash analysis, as it did not yet affect our cash. So, we add that expense back to the net income. The cash from operations rightfully shows that we still have $10 million in cash.

Now, let's say of the $10 million in revenue, only $8 million was cash sales, and $2 million was sold on credit. The income statement looks exactly the same, but the cash flow statement is different. If we had collected only $8 million of that $10 million of revenue in cash, then we would need to subtract the $2 million of revenue we did not collect from the net income. So:

This analysis may seem trivial, but it is important to understand the methodology as we apply this to more complex income statements. In general, cash from operating activities is generated by taking net income and removing all the noncash items.

Or, in its most fundamental form, cash from operations as demonstrated is:

But it gets slightly more complex. To understand this completely, let's take a look at all of the components of an income statement and determine which items can be considered cash and which are noncash.

Taxes

Taxes can be deferred in some situations, which will be discussed later. The portion of taxes that we expensed but did not yet pay is referred to as “deferred taxes.”

Table 2.1 summarizes the most common income statement line items and the related accounts if they can be deferred.

Net Income Line Item	Possible Deferrable Items?	Effect on Cash from Operations
Revenue	Yes	Changes in accounts receivable
Cost of Goods Sold	Yes	Changes in inventory; changes in accounts payable
Operating Expenses	Yes	Changes in accrued expenses; changes in prepaid expenses
Depreciation	Yes	Depreciation
Interest	No	None (some exceptions)
Taxes	Yes	Deferred taxes

Keeping with the theme demonstrated previously, where we adjust the related revenue and expense items we did not pay or receive in cash from net income to get a measure of cash generated or spent, we can generalize this table toward cash flow from operating activities:

Although we will discuss this later, there is a definition for Changes in Accounts Receivable + Changes in Inventory + Changes in Accounts Payable + Changes in Accrued Expenses + Changes in Prepaid Expenses called “changes in operating working capital,” so we can rework the formula:

Note the actual changes in each individual line item could be positive or negative. This will be explained in the section on Working Capital later in this chapter.

To be complete, cash from operating activities should include adjustments based on any and all income statement line items that are noncash. So, you may see “+ Other Noncash Items” toward the end of the formula to capture those adjustments.

The important lesson here is to gain the conceptual understanding of how cash from operating activities is derived from the income statement. As we get into more complex case studies and analyses, and for due diligence purposes, you will learn that it is important to understand cash flow as derived from individual income statement line items, rather than memorizing a standard formula. This is especially important in leveraged buyouts when analyzing smaller private companies that maybe do not have a complete set of financials. The ability to derive an operating working capital schedule and cash flow from operations from an income statement will be useful. This is just the fundamental beginning of such analyses.

CASH FLOW FROM INVESTING ACTIVITIES

Now that we have a measure of cash generated from our operations, there are two other areas from which cash can be generated or spent: investing activities and financing activities. Cash flow from investing activities is cash generated or spent from buying or selling assets, businesses, or other investments or securities. More specifically, the major categories are:

• Capital expenditures (investments in property, plant, and equipment)
• Buying or selling assets
• Buying, selling, spinning off, or splitting off businesses or portions of business entities
• Investing in or selling marketable and nonmarketable securities

CASH FLOW FROM FINANCING ACTIVITIES

Cash flow from financing activities is defined as cash generated or spent from equity or debt. More specifically:

• Raising or buying back equity or preferred securities
• Raising or paying back debt
• Distributions to equity holders (noncontrolling interests and dividends)

The sum of the cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities gives us a total measure of how much cash is generated or has been spent over a given period.

THE BALANCE SHEET

The balance sheet is a measure of a company's financial position at a specific point in time. The balance sheet's performance is broken up into three major categories: assets, liabilities, and shareholders' equity; the company's total value of assets must always equal the sum of its liabilities and shareholders' equity:

ASSETS

An asset is a resource held to produce some economic benefit. Examples of assets are cash, inventory, accounts receivable, and property. Assets are separated into two categories: current assets and noncurrent assets.

Current Assets

A current asset is an asset whose economic benefit is expected to come within one year. Examples of common current assets follow.

Cash and Cash Equivalents

Cash is currency on hand. Cash equivalents are assets that are readily convertible into cash, such as money market holdings, short-term government bonds or Treasury bills, marketable securities, and commercial paper. Cash equivalents are often considered as cash because they can be easily liquidated when necessary.

Accounts Receivable

Accounts receivable (AR) are sales made on credit. The revenue for the sale has been recognized, but the customer did not pay for the sale in cash. An asset is recorded for the amount of the sale and remains until the customer has paid. If AR increases by $100, for example, then we must have booked a sale. So, revenue increases by $100.

Income Statement
Revenue	100.0
Taxes (@ 40%)	(40.0)
Net Income	60.0

The resulting net income increase of $60 flows to the cash flow statement. We then need to remove the $100 in AR, as an increase in AR of $100 results in an operating working capital cash outflow of $100. Combined with the net income increase of $60, we have a total cash change of –$40.

In the balance sheet, cash is reduced by $40, AR increases by $100, and retained earnings increases by $60. Note the relationship between the changes in accounts receivable on the cash flow statement and accounts receivable on the balance sheet: cash down, asset up. The balance sheet balances: Total assets (–$40 + $100 = $60) less liabilities ($0) equals retained earnings ($60).

When the customer finally pays, cash is received and the AR on the balance sheet is removed.

Inventory

Inventory is the raw materials and the goods that are ready for sale. When raw materials are acquired, inventory is increased by the amount of material purchased. Once goods are sold and recorded as revenue, the value of the inventory is reduced and a cost of goods sold (COGS) expense is recorded. Let's say, for example, we are selling chairs.

If inventory increases by $50, then we have most likely purchased inventory, resulting in a cash outflow. Cash is reduced by $50 and an inventory asset is created. Note the relationship between the changes in inventory on the cash flow statement and inventory on the balance sheet: cash down, asset up.

If inventory decreases by $50, it is most likely related to a sale of that inventory, which is expensed as COGS. Note that the additional expense affects taxes and the resulting net income is –$30. An asset sold results in a cash increase; when added to the –$30 of net income, it gives us a total $20 change in cash.

Income Statement
COGS	(50.0)
Taxes (@ 40%)	20.0
Net Income	(30.0)

Inventory is reduced by 50. Net income affects retained earnings. The balance sheet balances: Total assets ($20 – $50 = –$30) less liabilities ($0) equals retained earnings (–$30).

Prepaid Expense

Prepaid expense is an asset created when a company pays for an expense in advance of when it is billed or incurred. Let's say we decide to prepay rent expense by $100. Cash goes into a prepaid expense account. Note the relationship between the changes in prepaid expense on the cash flow statement and prepaid expense on the balance sheet: cash down, asset up.

When the expense is actually incurred, it is then expensed in the selling, general, and administrative (SG&A) account; after tax we get –$60 in net income.

Income Statement
SG&A	(100.0)
Taxes (@ 40%)	40.0
Net Income	(60.0)

The –$60 in net income flows into retained earnings on the balance sheet. The prepaid expense asset is reduced, causing a change in prepaid expense inflow.

The balance sheet balances: Total assets ($40 – $100 = –$60) less liabilities ($0) equals shareholders' equity (–$60).

LIABILITIES

A liability is any debt or financial obligation of a company. There are current liabilities and noncurrent liabilities.

Current Liabilities

Current liabilities are company debts or obligations that are owed within one year. Some examples of current liabilities follow.

Accounts Payable

Accounts payable are obligations owed to a company's suppliers. If a company, for example, purchases $500 in raw materials from its supplier on credit, the company incurs a $500 account payable. The company increases the accounts payable by $500 until it pays the supplier.

Once the supplier is paid, the account payable is reduced by $500, and cash on the balance sheet goes down by $500. Note the relationship between the changes in accounts payable on the cash flow statement and accounts payable on the balance sheet: cash up, liability up.

Accrued Liabilities

Accrued liabilities are expenses that have been incurred but have not yet been paid. If a company receives a utility bill of $1,000, for example, which is expensed under SG&A, an accrued liabilities account is also recorded for $1,000 in the balance sheet.

Income Statement
SG&A	(1,000.0)
Taxes (@ 40%)	400.0
Net Income	(600.0)

After taxes, the net income effect is –$600, which flows to cash flow. Note the relationship between the changes in accrued liabilities on the cash flow statement and accrued liabilities on the balance sheet: cash up, liability up.

Once the bill has been paid, the accrued liabilities is reduced, and cash in the balance sheet goes down by $1,000.

Short-Term Debts

Short-term debts are debts that come due within one year.

DEPRECIATION

Depreciation is accounting for the aging of assets.

In other words, as a company owns and utilizes an asset, its value will most likely decrease. As discussed in the balance sheet chapter, if an asset value decreases, there must be another change to one of the other line items in the balance sheet to offset the asset reduction. Accounting rules state that the reduction in asset value can be expensed, with the idea being that the asset's aging or wear and tear is partly due to utilization of the asset to produce or generate revenue. If the item is expensed, net income is reduced, which in turn will reduce the retained earnings in the shareholders' equity section of the balance sheet.

Let's take an example of an asset that has a depreciation expense of $5,000. Depreciation expense reduces net income after taxes, as shown. Net income drives the cash flow statement, but since depreciation is a noncash expense it is added back to cash.

In the balance sheet, net income drives retained earnings. Depreciation will lower the value of the asset being depreciated (the plant, property, and equipment [PP&E]).

There are several methods allowed to depreciate assets. Each has its benefits under certain conditions. In this chapter we will learn about the most popular methods and how they are utilized. The two major categories are:

1. Straight-line depreciation
2. Accelerated depreciation

STRAIGHT-LINE DEPRECIATION

The straight-line method of depreciation evenly ages the asset by the number of years that asset is expected to last—it's useful life. For example, if we purchase a car for $50,000 and that car has a useful life of 10 years, the depreciation would be $5,000 per year. So next year the asset will have depreciated by $5,000 and its value would be reduced to $45,000. In the following year, the asset will be depreciated by another $5,000 and be worth $40,000. By year 10, the asset will be worth $0 and have been fully depreciated.

One can also assign a residual value (also known as scrap value) to an asset, which is some minimal value an asset can be worth after the end of its useful life. So, for example, if the car after year 10 can be sold for $1,000 for spare parts, then $1,000 is the residual value. In this case, by year 10, the value of the car should be $1,000, not $0. In order to account for residual value in the depreciation formula, we need to depreciate the value of the car less this residual value, or $50,000 minus $1,000, which is $49,000. The depreciation will now be $4,900 per year, which means the next year the value of the car will be $44,100. And by year 10, the final value of the car will be $1,000. So the definition for straight-line depreciation is:

ACCELERATED DEPRECIATION

Accelerating depreciation allows a greater depreciation expense earlier in the life of the asset, and a lower depreciation in the later years. The most common reason for accelerating depreciation is that a higher depreciation expense will produce a lower taxable net income, and therefore lower taxes. There are several methods of accelerating depreciation, the most common of which are:

• Declining balance
• Sum of the year's digits
• Modified Accelerated Cost Recovery System (MACRS)

Declining Balance

The declining balance method takes a percentage of the net property balance each year. The net property balance is reduced each year by the depreciation expensed in that particular year.

The percentage applied is calculated by dividing 1 by the life of the asset times an accelerating multiplier:

The multiplier is most commonly 2.0 or 1.5.

In the car example, the asset has a life of 10 years. If we assume 2.0 as the accelerating multiplier, then the declining balance percentage is:

We will apply 20 percent to the net property balance each year to calculate the accelerated depreciation of the car. So, 20 percent of $50,000 is $10,000. The net balance is $40,000 ($50,000 – $10,000). In year 2 we will apply 20 percent to the $40,000, which gives us $8,000. The new net balance is $32,000 ($40,000 – $8,000). And in year 3, we will apply 20 percent to the $32,000 to get $6,400. (See Table 2.2.)

Period Ending December 31	2016E	2017E	2018E	2019E	2020E
Net property, plant & equipment	50,000.0	40,000.0	32,000.0	25,600.0	20,480.0
Accelerated depreciation (%)	20%	20%	20%	20%	20%
Depreciation expense	10,000.0	8,000.0	6,400.0	5,120.0	4,096.0

Sum of the Year's Digits

To use the sum of the year's digits method, we first take the sum of the digits from 1 to the life of the asset. For example, an asset with a useful life of 10 years will have a sum of 55: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10. For year 1, the percentage will be 10/55 or 18.18 percent (rounded to the hundredth place). For year 2, the percentage will be 9/55 or 16.36 percent. For year 3 it is 8/55 or 14.55 percent, and so on. This percentage is applied to the base value of the asset and is not reduced by the depreciation each year like in the declining balance method.

Notice in Table 2.3 that we are basing the future depreciation on the original balance each year. This differs from the declining balance method, where we calculate depreciation on the net property balance each year (property net of depreciation).

Period Ending December 31	2016E	2017E	2018E	2019E	2020E
Net property, plant & equipment	50,000.0
Accelerated depreciation (%)	18.18%	16.36%	14.55%	12.73%	10.91%
Depreciation expense	9,090.0	8,180.0	7,275.0	6,365.0	5,455.0

DEFERRED TAXES

A deferred tax asset is defined as an asset on a company's balance sheet that may be used to reduce income tax expense. A deferred tax asset is most commonly created after receiving a net operating loss (NOL), which occurs when a company's expenses exceed its sales. The IRS allows a company to offset the loss against taxable income in another year. The NOL can be carried back two to five years or carried forward up to 20 years. Note that the amount of years a company can carry back or carry forward a loss depends on several business factors that need to be considered by the IRS on a case-by-case basis. More information on the specific criteria can be found at www.irs.gov. It is always strongly recommended to verify treatment of NOLs with a certified accountant or tax professional.

Deferred Tax Liability

A deferred tax liability is caused by temporary accounting differences between the income statement filed for GAAP purposes and the income statement for tax purposes. One common cause of a deferred tax liability is having differing methods of depreciation in a GAAP income statement versus that in a tax income statement. A company can produce a GAAP set of financials using straight-line depreciation, for example, yet have a tax set of financials using the MACRS method of depreciation. This causes a deferred tax liability, reducing taxes in the short term.

Let's take a simple example of a company with $100,000 in earnings before interest, taxes, depreciation, and amortization (EBITDA). For GAAP purposes let's assume we will use the straight-line depreciation of $5,000 ($50,000/10). Let's also say we have decided to accelerate the depreciation for tax purposes using the MACRS method of depreciation. For an asset with a 10-year useful life, the depreciation is $8,750 (17.5% × $50,000). This will create the income statements shown in Table 2.7 for GAAP purposes and for tax purposes.

	GAAP	Tax
Income Statement	(Straight-Line Depreciation)	(MACRS Depreciation)
EBITDA	$100,000.0	$100,000.0
Depreciation	(5,000.0)	(8,750.0)
EBIT	95,000.0	91,250.0
Interest	0.0	0.0
EBT	95,000.0	91,250.0
Taxes (@ 40%)	(38,000.0)	(36,500.0)
Net Income	$57,000.0	$54,750.0

The GAAP income statement in the left column shows a lower depreciation expense and shows $95,000 in earnings before taxes (EBT). The right column, however, the tax income statement, shows a higher depreciation expense because it has been accelerated. This creates a lower EBT of $91,250, and results in $1,500 ($38,000 – $36,500) of lower taxes. Now, the GAAP-reported taxes of $38,000, which is the larger amount, is the tax number we see in a company's annual report or 10-K. The lower amount of taxes filed for tax purposes is the amount of taxes filed to the IRS that the company actually has to pay this year. So, the difference between the taxes reported and the taxes paid ($1,500) becomes a noncash item. Just like any expense that the company did not yet pay in cash, this noncash portion of taxes is added back to net income in the cash flow statement. This is a deferred tax liability.

Note that this is a great method to use in order to free up cash in the short term. The deferred tax amount of $1,500 calculated previously can also be calculated by subtracting the accelerated depreciation expense from the straight-line depreciation and multiplying by the tax rate:

or

In modeling, we build a projected straight-line depreciation schedule and, if needed, an accelerated depreciation schedule. We then subtract the projected straight-line depreciation from the accelerated depreciation and multiply by the tax rate to estimate deferred tax.

WORKING CAPITAL

Working capital is a measure of a company's current assets less its current liabilities. However, for modeling purposes, we focus on a narrower definition of working capital called operating working capital (OWC). Operating working capital is also defined as current assets less current liabilities. However, OWC does not include cash and cash equivalents as part of current assets, and does not include debts as part of current liabilities.

“Cash equivalents” are assets that are readily convertible into cash, such as money market holdings, short-term government bonds and Treasury bills, marketable securities, and commercial paper. Cash equivalents are often considered as cash because they can be easily liquidated when necessary.

So, removing cash and cash equivalents, we are left with the following for current assets:

• Accounts receivable
• Inventory
• Prepaid expenses

And removing debts, we are left with the following for current liabilities:

• Accounts payable
• Accrued expenses

Note that there are other possible current assets or current liabilities; the aforementioned are just a few of the most common examples.

Each of these line items is most closely related to the company's operations. For example, accounts receivable is the portion of revenue we did not collect in cash, and accrued expenses is the portion of expenses we did not yet pay in cash. For this reason, operating working capital is a good measure of how much cash is coming in from the day-to-day operations. Another way to look at this is: Operating working capital helps track how well a company is managing its cash generating from day-to-day operations. In contrast, working capital, because it includes cash, cash equivalents, and debts, may not give the clearest measure of just the day-to-day operations.

How do we know if the individual operating working capital items are really performing well? If we see accounts receivable, for example, increasing year over year, this could mean we have an ever-growing collections problem. However, this could also mean that the receivables are growing because the revenue is growing, which would be a good indicator of strong business growth. So it is not enough to look at these operating working capital line items independently in order to determine their performance; we need to compare these line items to some related income statement line item. We use a measure called “days” to track how well we are collecting our receivables or paying our payables. Days are measured by dividing the receivable or payable by their related income statement item and multiplying by 360.

For example, let's say in 2015 the accounts receivable balance is $25,000 and the revenue is $100,000.

The accounts receivable divided by the revenue gives us 25 percent. So, 25 percent of our 2015 revenue has not yet been collected. We multiply this percentage by the number of days in one year to get an equivalent number representing how many days these receivables have been left outstanding; 25% × 360 = 90, so of the 2015 revenue, 90 days are outstanding. As a rule of thumb, many companies require customer receipts to be paid within 30 days. However, depending on the business, 60, 90, or even more days could be acceptable. Ninety could be considered high or it could be okay, depending on the business model and the product sold. Notice that we have used 360 days instead of 365. Either way is acceptable; however, we more commonly use 360 because this is divisible by 12, which would make the modeling simpler if we ever wanted to break the year column down into 12 months:

It is important to note that we have made a simplifying assumption in this formula for clarity. We took the last year's accounts receivable balance as the numerator in the calculation. In the actual analysis, it is important to take an average of the ending balances from the year being analyzed and the previous year. Because balance sheet items are balances at a specific point in time, averaging the current year's and previous year's performances gives a better indicator of measurement for the entire year. Income statement and cash flow items actually give us total performance over an entire period, so averaging does not apply. The complete formula for accounts receivable days in 2015 is:

Let's take another example using a liability: accrued expenses. Let's say the accrued expenses balance in 2015 is $15,000, and is made up of unpaid office rent. The 2015 income statement expense is $85,000. The accrued expenses of $15,000 divided by $85,000 gives us 17.6 percent. So, 17.6 percent of our 2015 expenses have not yet been paid. We multiply this percentage by the number of days in one year to get an equivalent number representing how many days these payables have been left outstanding; 17.6% × 360 = 63.4, so of the 2015 expense, 63.4 days are still outstanding, which could be considered too high in this case, especially considering that rent should typically be paid every 30 days.

We again simplified the example for purposes of instruction. When performing the actual analysis, we take the average of the accrued expenses balance in the year being analyzed and in the prior year:

In modeling, we use the calculated historical days to predict future working capital line items. You can get more information on the specific modeling in the book Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity.

DEBT SCHEDULE

The debt schedule is designed to track every major type of debt a company has, and the associated interest and payment schedules for each. It also helps track the cash available that could be used to pay down those debts and any interest income that could be generated from cash or cash equivalents available. Simply put, a debt schedule helps us better track the debt and interest. There is also a very important “circular reference” that is created once the debt schedule is complete and properly linked through the rest of the model. This circular reference is crucial in helping us determine various debt situations, such as the absolute maximum amount of debt a company can raise while making sure there is still enough cash to meet the interest payments. You can get more information on the specific modeling in the book Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity.