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?
What is a financial statement?
In US financial reporting there are four major financial statements: the income statement (sometimes referred to as the profit / loss statement), the balance sheet, the statement of cash flows, and the statement of stock holders equity.
These offer a financial, quantitative, look at different elements of the business.
Income Statement: Walks from revenue to net income on an accrual basis - valid over a given period (ex. Quarter 1).
Balance Sheet: Review of the assets, liabilities, and equity of a company at a given moment in time (ex. December 31st 2017). This is an overview of the financial position of the company.
Statement of Cash Flow: Overview of the cash generation of the business across a period of time (ex. Quarter 1).
Statement of Stockholder's Equity: Reviews in detail the issuance (purchase) of stock, net income, cash and stock dividends (across a period ex. Quarter 1).
Between the Income Statement, Balance Sheet, and Statement of Cash Flows, Which is the Most Important? (Interview Question)
This common interview question can have several answers if well defended; however, the statement of cash flows is the "correct answer" in most settings. The reason? "Cash is king."
When compared to the income statement - the statement of cash flow is prefered as explained by squawkbox, an investment banking analyst:
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 Apple's net income on the Income Statement 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.
When compared to the balance sheet - the statement of cash flows is prefered:
While the balance sheet offers a snap shot of the obligations and the assets of the business, assuming that you only have one balance sheet you do not know how profitable the business is each period.
However, rrrrr01, an investment banking associate, makes the valid case that:
If a restructuring banker is asking - you should go with balance sheet. For everyone else, you'll be safe with cash flow.
Of the three statements, which two are the most important? (Interview Question)
When facing this question - the answer should be the balance sheet and the income statement - because with those two filings you can create the statement of cash flows (assuming that you have the prior period and current period balance sheet).
Important to note - an increase in an asset is a cash draw and an increase in a liability is a cash bonus.
Statement of Cash Flows Build Up Examples
After answering that you can build the statement of cash flows - you may be asked to provide some of the ways you build the statement of cash flows - some examples are provided below:
- Net income flows to the statement of cash flows
- Change in operating assets and liabilities on the balance sheet are recorded on the SOCF
- Increase / decrease in property plant and equipment is capital expenditure in the investing section of the SOCF
- Increase in Common Stock and APIC on the balance sheet is reflected on the cash flows from financing
Steps to Build the Statement of Cash Flows
Step One - Find the change in Balance Sheet items between period 1 and period 2:
Step Two - Classify these changes on the Statement of Cash Flows:
Step Three - Adjust for non-cash charges and net income from the income statement for the period:
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