FIN301 / CHAPTER 3

Financial Statements

Build your first statement, review the summary, then practice on your own.
Income statement

How much profit did the business earn?

Measures sales, expenses, and profit over a period.

01 / FIRST EXERCISE

Build your first income statement

10 guided lines

Follow the pulsing words and matching blanks from sales to net income. Get a short explanation and feedback at each step.

Go to summary ↓
02 / SUMMARY

What to remember

Use the income statement tool ↗

Income Statement (IS): what it tells investors

The income statement measures profitability over a period. It explains how revenue turns into operating profit and net income.
Structure (typical)
  • Revenue
  • − COGS = Gross Profit (product economics)
  • − Operating Expenses (SG&A, R&D, etc.) = Operating Income
  • ± other items = EBIT (operating performance, before financing/taxes)
  • − Interest = EBT
  • − Taxes = Net Income
Why EBIT is often more useful than Net Income
  • EBIT removes interest and income tax effects. Net income includes capital structure (interest) and tax effects.
  • Two firms can have similar operations but different interest expense → different net income.
  • Analysts compare operating performance using EBIT margin or operating margin.

Quick checks + common mistakes (IS)

Check #1 — Percent margins
Always convert to percentages: gross margin, operating margin, net margin. Dollars mislead when firm sizes differ.
Check #2 — One-time items
One-time items can affect both net income and EBIT. Identify unusual gains or expenses before comparing performance across years.

Mini practice (concept)

If revenue is flat but net income rises, what could be happening? (Hint: cost reductions, lower interest, lower taxes, fewer one-time expenses, etc. Fewer shares can raise EPS, but do not directly raise total net income.)

Exam Review — Practice Quiz

Income Statement Quiz

EBIT, EBITDA, net income, taxes, and retained earnings. 10 True/False questions with instant feedback.

Finished this statement?

Choose another statement above, or continue below to connect all three and complete the homework.

Choose a statement ↑All statements together ↓Go to homework ↓Tools / page end ↓
ALL THREE STATEMENTS

Read the three statements together

Big idea
Profit and cash measure different things. A company can earn revenue before collecting cash or buy an asset before recognizing the full cost as an expense. Investors read the three statements together to judge:
  • Profitability (IS)
  • Liquidity + solvency (BS)
  • Cash generation and use (CF)
One rule for Chapter 3
Never trust one statement alone.
Example: a firm can show net income but have negative CFO (cash stress), or rising cash only because it borrowed (financing inflow).
What you should be able to do
  • Explain why the balance sheet balances (A = L + E).
  • Explain when EBIT helps compare operating performance.
  • Explain sources vs uses of cash and why CFO quality matters.
  • Build an income statement, balance sheet, and cash flow statement using the guided first exercises.
Next: Homework ↓
HOMEWORK / INDEPENDENT PRACTICE

Practice on your own — Homework

Show work. Label steps. Use statement structure.
How to use Homework Hints: Try the question first. If you need help, place your mouse over Hint to reveal the equation or relationship. The hint does not show the final calculation. Compare your result with the short answer shown below each question. Keyboard users can press Tab to focus on Hint.

Important: there can be TWO signs. Δ means CHANGE; it does not mean decrease.
Step 1 — Find the account change: Δ = Ending − Beginning. Increase → positive change (+). Decrease → negative change (−).
Step 2 — Apply the sign in the cash-flow formula. If the formula says −ΔInventory and inventory decreased 14, then ΔInventory = −14, so:
−ΔInventory = −(−14) = +14
Why is −(−14) = +14? The minus sign outside the parentheses means “take the opposite.” The opposite of −14 is +14.
Business meaning: when an operating asset such as A/R or Inventory goes down, less cash is tied up in that asset, so cash flow goes up. When the asset goes up, more cash is tied up, so cash flow goes down.
Homework Questions — Hints + Answers
  1. Firm AAA: Sales 2,000; COGS 1,000; Depreciation 200; Admin 180; Interest 30; Marketing 50; Taxes 200. Prepare an income statement.
    HintSales → COGS → GP → (Admin+Marketing+Dep) → EBIT → (−Interest) → EBT → (−Taxes) → NI.
    1,000; 570; 540; 340
  2. Current assets 2,000; fixed assets 3,000; A/R 300; A/P 300; cash 800. Inventory?
    HintCA = cash + A/R + inventory (+ other CA if any).
    900
  3. NWC 1,000; LTD 5,000; total assets 8,000; fixed assets 5,000. Total equity?
    HintCA = TA − FA. CL = CA − NWC. Equity = TA − (CL + LTD).
    1,000
  4. Andre’s Bakery: Sales 100,000; costs 50,000; interest 20,000; depreciation 10,000; tax rate 35%. Taxes paid?
    HintTaxable income = (Sales − costs − dep) − interest. Taxes = 0.35 × taxable income.
    7,000
  5. Same Andre’s Bakery + dividends 3,000. Retained earnings (change)?
    HintΔ means change, not decrease.ΔRE = Ending RE − Beginning RE = Net income − Dividends.If ΔRE is positive, retained earnings increased; if negative, retained earnings decreased.
    10,000
  6. Blue Bonnet: NFA 2.2m → 2.6m; depreciation 1,000,000. Net capital spending?
    HintNFA changed from 2.2m to 2.6m. Read the story before using the formula. Step 1 — Find the change in the asset.ΔNFA = Ending NFA − Beginning NFA
    = 2.6m − 2.2m = +0.4m    The + sign means net fixed assets are 0.4m higher at year-end.     Step 2 — Remember what depreciation did.Depreciation reduced the book value of NFA by 1.0m even though depreciation itself is not a cash purchase. To finish the year with NFA 0.4m higher after losing 1.0m to depreciation, the firm had to buy enough fixed assets to replace the 1.0m depreciation and create the extra 0.4m increase. Step 3 — Use the formula.Net capital spending = ΔNFA + Depreciation
    = +0.4m + 1.0m    Think: replace the asset value lost to depreciation + add the growth in NFA.
    1,400,000
  7. Inventory 500; fixed assets 1,860; A/R 190; A/P 210; cash 70. Current assets?
    HintCA = cash + A/R + inventory (+ other CA if any).
    760
  8. NWC 640; total liabilities 5,860; total assets 6,230; fixed assets 3,910. Long-term debt?
    HintCA = TA − FA. CL = CA − NWC. LTD = Total liabilities − CL.
    4,180
  9. Which is a use of cash?
    A. decrease A/R • B. decrease A/P • C. increase common stock • D. decrease inventory
    HintTranslate each account change into a real cash story. A. A/R decreases.Accounts receivable is money customers owe us. If A/R goes down, customers are paying old receivables. We are turning an asset (A/R) into cash.A/R ↓ → operating asset ↓ → cash comes IN → SOURCE of cash B. A/P decreases.Accounts payable is money we owe suppliers. If A/P goes down, we paid suppliers. Paying them uses our cash.A/P ↓ → liability ↓ → cash goes OUT → USE of cash C. Common stock increases.The company issued stock and investors paid the company.Stock issued ↑ → cash comes IN → SOURCE of cash D. Inventory decreases.Less inventory is sitting on the shelf. Think of inventory being sold/used without replacing all of it: less cash remains tied up in inventory. If the sale was on credit, the A/R adjustment handles the collection part separately.Inventory ↓ → operating asset ↓ → cash is RELEASED → SOURCE of cash
    B
  10. Net income 878; depreciation 40; dividends 25; A/P ↓13; A/R ↑20; inventory ↓14; NFA ↓8. Net cash flow from operations?
    HintDo NOT jump straight to the formula. Translate each arrow into a business story, then do the signs. CFO formula: CFO = NI + Dep − ΔA/R − ΔInventory + ΔA/P For CFO, ignore dividends and NFA here. Dividends are financing cash flow; NFA belongs to investing cash flow. 1) A/R ↑20 — customers owe us MORE.We recognized sales in net income, but an extra 20 has not been collected in cash yet. So cash is 20 lower than net income suggests.ΔA/R = +20
    −ΔA/R = −(+20) = −20    Plain English: A/R increased → cash not collected → subtract 20.     2) Inventory ↓14 — LESS inventory is sitting on the shelf.Think of inventory being sold or used while the company did not spend enough to replace all 14. Less money is tied up in inventory, so this decrease releases 14 of cash relative to net income. (If sales were on credit, A/R handles the uncollected part separately.)ΔInventory = −14
    Formula says: −ΔInventory
    = −(−14)
    = +14    Why does −(−14) become +14? The outside “−” means take the opposite. The opposite of −14 is +14. So a decrease in an operating asset is ADDED to CFO.     3) A/P ↓13 — we owe suppliers LESS.A/P falls when we pay suppliers more than the new credit purchases added to A/P. Paying suppliers takes cash out of the company.ΔA/P = −13
    Formula says: +ΔA/P
    = +(−13)
    = −13    Plain English: liability decreased → we paid cash → subtract 13.     4) Now substitute one line at a time.CFO = 878 + 40 − (+20) − (−14) + (−13)
    = 878 + 40 − 20 + 14 − 13    Notice the key algebra: −(−14) = +14.     Memory check: Operating asset ↑ → cash ↓. Operating asset ↓ → cash ↑. Operating liability ↑ → cash ↑. Operating liability ↓ → cash ↓.
    899
  11. Teddy’s Pillows: beginning NFA 480; ending NFA 530; assets valued 300 sold; depreciation 40. Capital spending?
    HintFollow what makes the NFA account go UP and DOWN. Beginning NFA = 480.Capital spending adds new fixed assets, so it makes NFA go up. Selling an old asset removes its book value, so it makes NFA go down. Depreciation also makes book NFA go down. Write the NFA roll-forward.Ending NFA = Beginning NFA + Capex − BV sold − Depreciation
    530 = 480 + Capex − 300 − 40     Why are sale and depreciation negative?Both remove value from the NFA account: the sold asset is no longer owned, and depreciation reduces the remaining assets' book value. Solve for Capex.Capex = 530 − 480 + 300 + 40When we move “−300” and “−40” to the other side, they become “+300” and “+40.” Another way to think about it: new purchases had to cover the 300 asset sold, the 40 depreciation, and still leave NFA 50 higher than it started.
    390
  12. Art’s Boutique: Sales 640,000; costs 480,000; interest 40,000; depreciation 60,000; tax 34%. Net income?
    HintEBIT = Sales − costs − dep. EBT = EBIT − interest. Taxes = 0.34×EBT. NI = EBT − Taxes.
    39,600