Financial Statement Overview: Which Statement is the Most Important?

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:

squawkbox - 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:

rrrrr01 - Investment Banking Associate:

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:

Source:http://www.ifrsbox.com/how-to-prepare-statement-of...

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Comments (39)

Dec 13, 2009

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.

Dec 13, 2009

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.

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Dec 13, 2009

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.

Dec 13, 2009

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.

Dec 13, 2009

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.

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Dec 13, 2009

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.

Dec 13, 2009

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?

Dec 13, 2009
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.

Dec 13, 2009

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.

Dec 13, 2009

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.

Dec 15, 2009

Cash flow for me here followed by BS

Dec 15, 2009

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?

Dec 15, 2009

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.

Dec 15, 2009

^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.

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Dec 15, 2009

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.

Dec 15, 2009

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

Dec 15, 2009

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

Dec 15, 2009

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.

Dec 15, 2009
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 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.

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.

Dec 15, 2009

Go with what models and bottles said. It's the most likely "canon" answer and if not his explanation is a solid justification.

Dec 15, 2009

I would generally disagree on EBITDA and cash earnings, but would note that this is really dependent on industry and company. I have a heavy retail/consumer bias because that's I spent all my time on those teams, but sales generally is where you spend most of your time. It's the highest quality driver of earnings and impacts everything else on all statements. EBITDA growth of 10% is not all the same; it really matters if that all came from profit, or from sales, or a mixture of the two, because it speaks to the sustainability of the growth. Going down the income statement and then to the other statements, my key ones would be:

  • sales (IS)
  • gross profit (IS)
  • SG&A (IS)
  • operating profit or EBITDA, depending on the company/industry (IS)
  • earnings per share/net income (IS)
  • operating cash flow (CF)
  • capex (CF)
  • cash (BS)

Answer that might get you more points would also be industry-specific metrics that would be in the model but obviously not on the company's income statement. For retailers, key metric would be same store sales, new store openings (again, depending on the company). Other examples: MAUs for FB, search queries and CPC rates for GOOGL.

Dec 15, 2009

depends what you mean by "important" but I think what you're getting at is the CF statement

  • IS is the "least important," it's all just projections
  • BS some line items remain constant, some change; pretty much just pulling assumptions and CF items
  • CF is the most labor-intensive to build (debt paydown, depr schedules, interest expense)
Dec 15, 2009

Not sure what the point of this question is...are you trying to avoid using one of the statements? Why wouldn't you look at any information available?

In any case, it depends on the type of deal. BS is relatively more important for asset backed deals, whereas IS is important for growth deals with no collateral. CFS is more important if there is something it tells you that you can't tell from the I/S & B/S (owner dividends, capex / depreciation).

Dec 15, 2009

"Look, you're my best friend, so don't take this the wrong way. In twenty years, if you're still livin' here, comin' over to my house to watch the Patriots games, still workin' construction, I'll fuckin' kill you. That's not a threat, that's a fact.

Dec 15, 2009

if your answer doesnt include some way of measuring cash flow and obligations, you doin it wrong imo
..

Dec 15, 2009

Depends on the company. For a bank, book value is pretty important. For some companies, not so much.

Dec 15, 2009

For a non bank I would say CFO and financing cash flows - this tells you about capital structure and operating activities.

Dec 15, 2009

i don't think there's one right answer for this (there are probably wrong answers). I think the question is difficult because it doesn't state an objective (like perhaps firm valuation or evaluating riskiness or capital intensity...) or an industry (banks vs. energy companies for example, where different metrics matter). It's also difficult because the way the question is asked, you may not get the two lines for all previous time periods, so you could evaluate the most important business trends (like revenue growth or margin expansion). I would think that more important than anything are those two things... revenue and EBIT. EBIT divided by revenue would give you the operating margins of the business (its underlying capital structure-agnostic profitability), but with tacking on an assumption about D&A using comparable companies (perhaps using comparable D&A as a % of revenue), you could get EBITDA, which could in turn be used with comparables to generate a quick and dirty estimate or range of estimates of enterprise value for the firm, using EV/EBITDA multiples. With CFO and D&A, you can't really value the firm in this way, using multiples. And if you can't get data for more than one time period, you can't do a dirty DCF either.

Under the time pressure, I think you were pretty smart taking something that tells you about cash flows from the actual operations of the company and D&A to understand the PP&E needs. It's a good response, at least you didn't say something out there. If you articulated your response thoughtfully, you should be ok. It's a tough question

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Dec 15, 2009

(i) Cash flow from ops (ii) interest expense

Dec 15, 2009

Depends on the industry imo - rev and ebitda would prbly make more sense for a tech company.

Dec 15, 2009

I assume the explanation of your answer is more important

D.Weiss

Dec 15, 2009

I'd say cfo and net change in cash.

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Dec 15, 2009

Probably look for two numbers that can help me calculate a ratio of some kind and provide a starting idea of what it's like as an investment...Net Income/Equity (ROE), CFO/Assets (CoCROA) etc.