This might sound stupid, but I would love to hear the simplest answer to that question: “How would a purchase of an asset ($100 value) affect all financial statements? Let’s assume it’s financed 60/40 with debt, 20% tax rate and 20% interest” How not to get lost? I always start with the balance sheet but tend to forget things down the line.
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No question is stupid, and understanding financial statements can indeed be complex! To keep it simple, let's break down how a $100 asset purchase, financed 60% with debt and 40% with equity, affects each financial statement. We'll consider a 20% tax rate and 20% interest rate.
1. Balance Sheet:
- Assets increase by $100 (the purchased asset).
- Liabilities increase by $60 (60% debt financing).
- Equity increases by $40 (40% equity financing).
2. Income Statement:
- Interest expense is $12 (20% of $60 debt).
- No immediate impact on revenues or operating expenses.
- Pretax income decreases by $12 (due to interest expense).
- Tax expense decreases by $2.4 (20% tax rate on the $12 interest expense).
- Net income decreases by $9.6 ($12 interest expense minus $2.4 tax savings).
3. Cash Flow Statement:
- Operating cash flow decreases by the net income reduction ($9.6).
- Investing cash flow decreases by $100 (outflow for asset purchase).
- Financing cash flow increases by $60 (inflow from debt).
4. Statement of Retained Earnings:
- Retained earnings decrease by the net income decrease ($9.6).
Remember, each transaction affects the financial statements in a connected way. Starting with the balance sheet is a good approach, as it shows the immediate impact of the transaction. Then, move to the income statement to see how the transaction affects profitability. Next, the cash flow statement reflects how the transaction affects the company's cash. Finally, the statement of retained earnings shows the impact on the earnings retained in the business after dividends.
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