12/13/09

I've been asked the question in multiple finance interviews recently and have answered the cash flow b/c investors want to know how much cash a business generates to grow the company, payback debt, etc. However, some people think balance sheet is better cause it tells you the "financial health" of a company for which I can see the argument as well.

What do you guys think?

Comments (23)

12/13/09

There is no strict "correct" answer. You can make decent arguments for all three. It really depends on what the goal is in analyzing a company (are you trying to buy it? invest equity? buy its bonds?) But by convention, I think generally it goes something like this:

1) Cash flow
2) P/L
3) Balance Sheet

Cash flow is probably the most important because it allows you to see how readily a company can meet its debt and interest payments. A company can have a strong P/L, but at the end of the day, if a lot of the revenue generated is from accounts receivable, the company can still fail to meet its debt obligation. "Cash is king".

P&L is important because it gives you an idea how profitable the company is overall. Via P/L you can look at its margins and other ratios to see how it does in terms of generating profit relative to other players in the industry.

Balance sheet is probably the third statement you'd want to look at. It's more of a "long-term" view, or track record of how the company is doing.

fwiw, I think bankers tend to look at P/L the most when doing analysis of a company.

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12/13/09

It really depends on what you're looking for because, as you already know, no one statement tells the whole story. Although the information in the CF statement might be the most important (net profit without cash is useless, and cash flow determines value), you also have to remember that you technically don't need it separately because you can indirectly construct one using both the balance sheet and income statement (using beginning and ending balances from the BS). When they ask you to pick two, that's what they want you to say (i.e. pick BS and IS because you can make CF), but you can also probably mention that for this question too.

The "financial snapshot" feature of the balance sheet summarizes a company's capital structure, various account balances, and short term vs. long term items. The income statement statement tells you about its profitability (breakdown of revenues and expenses). You can tell both aspects are very important because ratios often use numbers from both statements. Overall, I think the interviewer is looking for your reasons/analysis more than the actual answer.

If you ask me (if eliminating CF statement): Although it depends on the nature of the business, I would say generally most investors care more about trends in the income statement items (sales, gross profit, operating profit/EBIT, income from continuing operations, net income, and EPS) compared to most balance sheet items. On the IS, it's easy to what's operating vs. non-operating, and of course to pinpoint which items are non-recurring.

12/13/09

If a restructuring banker is asking go with balance sheet. For everyone else, you'll be safe with cash flow. Also if you get asked for two go with balance sheet and income statement - you can derive cash flow from those two.

12/13/09

Cash is king baby. When looking at a company, you look at all three, however what you really look at for most deals is a modified cashflow combined with a debt structure.

That being said in an interview you can say any of them.

--There are stupid questions, so think first.
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12/13/09

Definitely Cash Flow

The income statement is prone to "errors" from accounting conventions.

For example, whenever Apple sells an iPhone --> it can only recognize 3/24 of the revenue for the phone in the current quarter.

However they are still being paid cash for the phones from AT&T (ignoring A/R).

So their net income on the P/L is grossly understated. Go look at Apple's Operating Cash Flow and compare it to net income. Look at "Change in Liabilities"...this is Deferred Revenue (i.e. iPhone Sales).

Another example is Burger King vs. McDonalds. Burger King trades at a discount to McDonalds based on forward earnings --> however you will see that Burger King spends most of its operating cash flow each year on Capex (building new restaurants)

Therefore, the actual cash flow available to investors is greatly diminished because Burger King depends on building new restaurants to boost earnings.

12/13/09

if you had only 1 choice of the 3. hands down - cash flows statement.

if you had a choice of 2 of the 3. income statement and balance sheet. you can construct the cash flows statement from the 2.

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12/13/09

wow guys all the responses in this thread have been very good and well articulated. Just wondering where everyone learned to articulate these ides/thoughts like this. Would a first year analyst be expected to lay out the logical reasoning in this fashion?

12/13/09
jason:

wow guys all the responses in this thread have been very good and well articulated. Just wondering where everyone learned to articulate these ides/thoughts like this. Would a first year analyst be expected to lay out the logical reasoning in this fashion?

you should be able to articulate this in an interview. I have definitely gotten this question a couple times.

12/13/09

If you have the option to choose 2 of the 3, be sure to ask the clarifying question: "Do I have access to the 2 statements I choose for all time periods?" You can't create a cash flow statement from the IS and a single balance sheet.

CompBanker

12/13/09

Cash Flow is king!!! Also, most balance sheets go out for like 2 periods so I'm sure you'd have enough to construct a cash flow statement.

12/15/09

Cash flow for me here followed by BS

12/15/09

Ok sounds like cash flow has won this debate. But WHY? Some people were hitting on the idea that it provides a more thorough picture of a company than the IS, such as in the burger king vs mcdonalds example. Is this assesment correct?

12/15/09

The goal of a company, at the end of the day is to make money and provide value for its shareholders.

The only way to really do that is to have strong cash flow. There are a lot of accounting things you can do to make Income Statement appear very strong. For example, a lot of your turnover maybe are made on credit (accounts receivable). You can still go bankrupt if your customers fail to pay or if you run out of cash to pay your creditors.

Cash flow is the most accurate, most conservative assessment of a company's short-term health and ability to meet debt obligations.

12/15/09

^That's a good way to put it.
However, this is not to suggest that CF cannot be misleading either. CF from Operations depends heavily on the working capital accounts, which is an accounting measurement. For example, an increase in accounts payable is calculated as a "source of cash" since the company technically gets to hold on to cash if AP increases. Unusual changes in working capital should definitely be noted. Also you have to be careful of companies that report positive net cash only because they sold PPE (a positive CF from Investing Activities, which normally is negative). These are more a result of actual company operations, not accounting conventions, so of course it's not really as GAAP-influenced as the other statements. CF overall does a good job of capturing the cash inflow/outflow of a business, so that's why analysts and investors find it reliable. But even CF should be looked at in detail, not taken at face value.

12/15/09

your answers are right, but am not sure on the reasoning. For one, net income generated in a given period is not necessarily the cash at the beginning. Generally the change in retained earnings on the BS should be equal to the net income generated in a certain period. Very simply put, CFS for question 1 is correct because it shows the movement of hard cash within a company for various purposes and tells us how the company did in a given period. Very crucial. For question 2, IS and BS is correct because by using the 2, you can actually create a CFS on your own. Combinations of CFS/BS and CFS/IS would not give the complete financial picture of the company. Again bear in mind all 3 are vital, but that is not the question.

12/15/09

Out of curiosity, did this question come up for a FT or SA position?

12/15/09

FT position:
I think that the n1 is ebitda but the other are more difficult.....

12/15/09

Easy answer for me: cash flow statement. A cash flow statement will tell you a few things:

1) How have headline and cash earnings have evolved over time
2) What type of cash conversion does this company have --> is the business capital intensive?
3) It tells you some about the balance sheet. If the company is levered it will indirectly show up in the cash flow statement.
4) You will get a sense of their capital allocation priorities, i.e. organic CAPEX, M&A, dividends and share buybacks, etc.

I think that the n1 is ebitda

EBITDA is possibly the stupidest metric on the street. EBITDA tells you nothing about how capital intensive a business is, what its ROIC is, and how truly profitable the business is. People love it though because they don't have to think through the harder issues.

12/15/09
models_and_bottles:

Easy answer for me: cash flow statement. A cash flow statement will tell you a few things:1) How have headline and cash earnings have evolved over time2) What type of cash conversion does this company have --> is the business capital intensive?3) It tells you some about the balance sheet. If the company is levered it will indirectly show up in the cash flow statement.4) You will get a sense of their capital allocation priorities, i.e. organic CAPEX, M&A, dividends and share buybacks, etc. I think that the n1 is ebitdaEBITDA is possibly the stupidest metric on the street. EBITDA tells you nothing about how capital intensive a business is, what its ROIC is, and how truly profitable the business is. People love it though because they don't have to think through the harder issues.

When I saw the "EBITDA" comment, wanted to write something along the same lines as above. Just for argument's sake - I guess EBITDA is an OK metric if, for example, you're doing some company comps and you assume similar capital intensity, similar leverage and can confirm that the D&A assumptions are broadly in line - then it's a good cash flow proxy and a nice shortcut to avoid the hassle.

12/15/09
12/15/09
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