You will be able to trace how profit, cash and the balance sheet connect from one year to the next.
Marcus has read Larkspur's income statement, balance sheet and cash flow statement many times now, but always as three separate pages. Each one made sense on its own. What he couldn't do was look at a number on one page and say where it came from on another. That is the skill a model rests on. Once you can trace every figure from one statement to the next, a forecast stops being a guess about three things and becomes a forecast about one business, seen three ways.
This lesson traces one year of Larkspur's made-up accounts, its fifth year of figures, called FY5 from here on. All amounts are in S$ millions.
The income statement covers a period. It starts with revenue of 400, takes away costs and ends with net profit of 48.
The balance sheet is a snapshot at the end of the period. Assets on one side, liabilities and equity on the other, and the two sides always match, because every asset is funded either by someone the company owes or by its shareholders.
The link between them is equity. Net profit belongs to shareholders, so it adds to equity, specifically to retained earnings. Dividends paid to shareholders take it away again. For Larkspur, equity at the end of FY4 was 255. Add the year's profit of 48, take away dividends of 18, and you get 285, which is exactly what the FY5 balance sheet shows.
If a company also issues or buys back shares, those change equity too, through share capital or a reserve. Larkspur did neither in FY5, so the bridge is simple: opening equity, plus profit, minus dividends, equals closing equity. Check it on any real company, and when it doesn't match, the equity statement in the report shows the other movements.
The balance sheet shows cash of 50 at the end of FY4 and 60 at the end of FY5. The cash flow statement explains the difference of 10, sorted into three groups.
Operating cash flow was 66. Investing cash flow was minus 24: 34 spent on equipment and buildings, partly offset by 10 received from selling a property. Financing cash flow was minus 32: 10 of bank debt repaid, 4 of lease principal paid and 18 of dividends. Add the three: 66 minus 24 minus 32 equals 10. Cash rose from 50 to 60.
That's the second link. The bottom of the cash flow statement must equal the change in the cash line on the balance sheet, every year, with no exceptions.
Profit and cash differ because some expenses don't use cash in the year they're charged, and some cash goes out without touching profit.
The biggest non-cash expense is depreciation: the cost of equipment spread over the years it's used. Larkspur charged 24 of depreciation in FY5, 20 on its equipment and 4 on the right-of-use assets from its leases. That 24 reduced profit but no cash left the company for it, because the cash went out when the equipment was bought. So operating cash flow starts with profit of 48 and adds back the 24.
Other adjustments run both ways. The property sale produced a gain of 6 in profit, but the cash from the sale belongs in investing, so the gain is taken out of operating cash flow to avoid counting it twice. Then come the changes in working capital, which lesson 7.3 explains in full: receivables rose by 5, which is profit not yet collected, so it's subtracted; inventory fell by 2, which released cash; payables rose by 3, meaning Larkspur held on to cash it owed suppliers.
So the operating line reads: 48 plus 24, minus 6, minus 5, plus 2, plus 3, equals 66. Every item in that sum is a change in a balance sheet line or a figure from the income statement. Nothing comes from nowhere.
The balance sheet ties up the same way. Equipment rose from 140 to 150: start at 140, add 34 of spending, take away 20 of depreciation and 4 for the book value of the property sold. Bank debt fell from 70 to 60 by the 10 repaid. Lease liabilities fell from 22 to 20: 2 of new leases signed, 4 of principal paid.
When you build a model, you'll link these lines with formulas so that a change in one flows through all three statements. Sooner or later the balance sheet won't balance. Assets will come out a few million higher than liabilities and equity, or lower.
The temptation is to add a line called "other" that makes up the difference. Don't. A gap means a link is missing: a cash flow that didn't reach the balance sheet, a balance sheet change that didn't reach the cash flow statement, or a sign the wrong way round. A plug hides the error, and every forecast built on top of it inherits it.
The fix is to hunt. Take the gap and look for a movement of the same size, or half the size if a sign is reversed. Check each balance sheet line's change against the cash flow statement, one by one. In Marcus's first attempt the gap was exactly 4, and it was the book value of the property sold, which he'd left out of the equipment line.
Take one year of your chosen company's accounts and trace it the same way: net profit through retained earnings to closing equity, and operating, investing and financing cash flow through to the change in cash.
Take one year of your chosen company's accounts and trace net profit through retained earnings and the cash flow statement.
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