FIN301 • Chapter 3 — Financial Statements (BS + IS + CF)

How to think like an investor • concepts • in-class • homework (hints only)
BS Tool IS Tool CF Tool Ratio Tool CF Exercise A

How to think like an investor (Chapter 3)

Big idea
Accounting tells you what happened on paper. Cash tells you what happened in reality. Investors read the three statements together to judge:
  • Profitability (IS)
  • Liquidity + solvency (BS)
  • Cash engine (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 why EBIT is often more useful than net income.
  • Explain sources vs uses of cash and why CFO quality matters.
  • Build a basic IS + BS from raw inputs (Home Depot exercise).
Select statement: Tip: CF in-class answers are hidden (highlight to reveal).

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 isolates operations. 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.
Nike example: what to look for (concepts only)
When you open Nike’s financials:
  • Is revenue growing or flat? What is driving it?
  • Is gross margin stable? (pricing power vs costs)
  • Are operating expenses growing faster than revenue?
  • Is operating income consistent across years?

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 charges can distort net income. EBIT (and operating income) is often cleaner for trend analysis.

Mini practice (concept)

If revenue is flat but net income rises, what could be happening? (Hint: cost reductions, lower interest, lower taxes, fewer shares, etc.)

Balance Sheet (BS): what it tells investors

The balance sheet shows what the firm owns and owes at a point in time. It is a snapshot of resources (assets) and funding (liabilities + equity).
Why the balance sheet must balance
Assets = Liabilities + Equity because every asset is funded by either:
  • Borrowing (liabilities), or
  • Owner funding (equity: contributed capital + retained earnings)
Structure (typical)
  • Current Assets (cash, A/R, inventory) — turn to cash within ~1 year
  • Non-current Assets (PPE, intangibles) — long-term resources
  • Current Liabilities (A/P, short-term debt) — due within ~1 year
  • Long-term Liabilities (long-term debt)
  • Equity (common stock, retained earnings)
Nike example: what to look for (concepts only)
When you open Nike’s balance sheet:
  • Liquidity: cash, A/R, inventory vs current liabilities → current ratio
  • Leverage: debt relative to equity (risk + flexibility)
  • Inventory build-up: can signal demand issues or growth (need context)

Quick checks + common mistakes (BS)

Check #1 — Liquidity vs solvency
Liquidity = short-term ability to pay. Solvency = long-term ability to survive.
Check #2 — Working capital
NWC = Current Assets − Current Liabilities. NWC matters for day-to-day operations (inventory, receivables, payables).

Mini practice (concept)

If inventory rises and cash falls, what are two possible stories? (Hint: stocking for growth vs slower sales.)

Cash Flow Statement (CF): structure + why it matters

The cash flow statement explains why cash changed during the year. Investors care because profits can be “real” on paper while cash is weak.
Three sections
  • CFO — cash from operations (core business)
  • CFI — cash from investing (capex, asset sales)
  • CFF — cash from financing (debt, stock, dividends)
Identity: ΔCash = CFO + CFI + CFF (+ FX)
Key investor insight
A company can have “a lot of cash” because it borrowed (CFF). That is not the same as strong operations (CFO).
Healthy pattern (often): CFO positive, CFI negative (investment), CFF depends on strategy.
Source of cash vs Use of cash (rules)
Source of cash
  • Decrease in an Asset (sell inventory, collect receivables)
  • Increase in a Liability or Equity (borrow, issue stock)
Use of cash
  • Increase in an Asset (buy equipment, build inventory)
  • Decrease in a Liability or Equity (repay debt, buy back stock)
Cash Flow from Operations: Five Steps (Indirect Method)
  1. Add back depreciation.
  2. Subtract (add) any increase (decrease) in accounts receivable.
  3. Subtract (add) any increase (decrease) in inventory.
  4. Subtract (add) any increase (decrease) in other current assets.
  5. Add (subtract) any increase (decrease) in accounts payable and other accrued expenses.
Memory shortcut: CA↑ is a use; CL↑ is a source.

Quick Checks (CF)

Use these every time you build a cash flow statement.
Check #1 — Reconcile cash
Beginning cash + CFO + CFI + CFF (+ FX) must equal ending cash.
Check #2 — Working capital signs
A/R ↑ means you sold but didn’t collect cash yet ⇒ subtract. A/P ↑ means you delayed payment ⇒ add.
Reset instruction
Each time you attempt a new solve: refresh the page to reset your work.

In-Class Exercise A — Build the Cash Flow Statement (from given IS + BS)

Given inputs → compute changes → build CFO / CFI / CFF → reconcile cash. (Answers hidden; highlight to reveal.)
Given inputs (where the numbers come from)
2024 Income Statement (given)
LineAmountUse for
Net sales36,408context
Less: Cost of goods sold28,225context
Less: Depreciation1,760add-back in CFO
Earnings before interest and taxes (EBIT)6,423context
Less: Interest paid510context
Taxable income5,913context
Less: Taxes2,070context
Net income3,843starting line
2023 vs 2024 Balance Sheets (given)
We use these to compute changes (ΔA/R, ΔInventory, ΔA/P, ΔNFA, etc.).
Item20232024
Cash2,0601,003
Accounts receivable3,4114,218
Inventory18,77621,908
Net fixed assets (NFA)14,16014,080
Accounts payable7,2508,384
Long-term debt9,80011,500
Common stock15,00017,500
Retained earnings6,3573,825
Calculated changes (from the given balance sheets)
  • ΔA/R = 4,218 − 3,411 = +807 (A/R increased → use of cash in CFO)
  • ΔInventory = 21,908 − 18,776 = +3,132 (Inventory increased → use of cash in CFO)
  • ΔA/P = 8,384 − 7,250 = +1,134 (A/P increased → source of cash in CFO)
  • Capex cash outflow ≈ (End NFA − Begin NFA) + Depreciation = (14,080 − 14,160) + 1,760 = 1,680
  • Dividends = RE_begin + NI − RE_end = 6,357 + 3,843 − 3,825 = 6,375
Cash Flow Statement
LineAmount (highlight)Hint
Cash at the beginning of the year20602023 cash
Cash from operations (CFO)Indirect method
Net income3843From income statement
+ Depreciation1760Non-cash add-back
− Accounts receivable change-807A/R ↑ is use
− Inventory change-3132Inv ↑ is use
+ Accounts payable change1134A/P ↑ is source
Net cash from operations2798CFO subtotal
Cash from investing (CFI)Capex / fixed assets
− Net capital spending-1680(End NFA − Begin NFA) + Dep
Net cash from investing-1680CFI subtotal
Cash from financing (CFF)Debt, equity, dividends
+ Long-term debt170011,500 − 9,800
+ Common stock250017,500 − 15,000
− Dividends-6375RE_begin + NI − RE_end
Net cash from financing-2175CFF subtotal
Total net change in cash-1057CFO + CFI + CFF
Cash at the end of the year1003Matches 2024 cash
In-Class Exercise 1 — Source or Use? (MCQ)
Inventory increased from $18,776 to $21,908. Long-term debt increased from $9,800 to $11,500.
A
use; use
B
use; source
C
source; source
D
source; use
Answer : B
In-Class Exercise 2 — Build a cash flow statement from mini-data
Given information
  • Increase in accounts receivable: $20
  • Decrease in inventory: 10
  • Operating income (EBIT): 120
  • Interest expense: 20
  • Decrease in accounts payable: 20
  • Dividend: 10
  • Increase in common stock: 30
  • Increase in net fixed asset: 10
  • Depreciation: 5
  • Income tax: 10
  • Beginning cash: 100
Step 1: compute Net Income (starting line for CFO)
Use: NI = EBIT − Interest − Tax
NI (highlight): 90
Step 2: build CFO (indirect)
CFO = NI + Dep − ΔA/R − ΔInv + ΔA/P
(Remember: inventory decreased ⇒ ΔInv is negative ⇒ subtracting it becomes a plus.)
CFO (highlight): 65
Why is Investment Cash Flow = -$15?
Assume Net fixed assets = $10 in previous year. Depreciation = $5 → if the company did nothing, NFA would drop to $10 − $5 = $5. But NFA increased by $10 → NFA this year is $20. So capex spent = $20 − $5 = $15 → cash outflow → -15.
Solution cash flow statement (answers hidden — highlight)
LineAmountHint
Beginning Cash100Given
CFOIndirect method
Net income90EBIT − Int − Tax
+ Depreciation5Add-back
− Increase in A/R-20A/R ↑ is use
− (ΔInventory)+10Inventory ↓ is source
+ (ΔA/P)-20A/P ↓ is use
Net cash from operations65CFO subtotal
CFICapex
Net capital spending-15Given explanation
CFFStock & dividends
+ Increase in common stock30Source
− Dividends-10Use
Net cash from financing20CFF subtotal
Net change in cash7065 − 15 + 20
Ending cash170100 + 70

In-Class (Home Depot): Build Income Statement + Balance Sheet (given inputs)

Students produce full statement layouts from raw inputs (this is your “build IS+BS” skill).

Income Statement Inputs (HD, year ended Jan 30, 2011, $ millions)

  • Sales: 67,977
  • COGS: 44,693
  • Marketing, G&A: 15,885
  • Depreciation: 1,616
  • Interest expense: 530
  • Tax rate: 36.70%
  • Shares outstanding: 1,623
  • Dividends paid: 1,569
Task: build Sales → Gross Profit → EBIT → EBT → Taxes → Net Income.

Balance Sheet Inputs (HD, year ended Jan 30, 2011, $ millions)

  • Cash: 545
  • Accounts receivable: 1,085
  • Inventories: 10,625
  • Other current assets: 1,224
  • Gross fixed assets: 38,471
  • Accum. depreciation: 13,411
  • Other fixed assets: 1,586
  • Accounts payable: 9,080
  • Short-term notes payable: 1,042
  • Long-term debt: 11,114
  • Common stock: 3,894
  • Retained earnings: 14,995
Task: compute totals and ensure Assets = Liabilities + Equity.
✅ Home Depot Solutions (click to expand)
All amounts are $ millions. EPS/DPS are $ per share. Taxes use the given 36.70% rate (rounded).
Income Statement (HD, year ended Jan 30, 2011)
LineAmountCalc
Sales67,977given
Less: COGS44,693given
Gross Profit23,28467,977 − 44,693
Less: Marketing, G&A15,885given
Less: Depreciation1,616given
EBIT5,78323,284 − 15,885 − 1,616
Less: Interest expense530given
EBT5,2535,783 − 530
Taxes (36.70%)1,9280.367 × 5,253
Net Income3,3255,253 − 1,928
Shares outstanding (millions)1,623given
EPS2.053,325 ÷ 1,623
Dividends paid1,569given
DPS0.971,569 ÷ 1,623
Addition to Retained Earnings1,756NI − Div
Balance Sheet (HD, year ended Jan 30, 2011)
SectionAmountCalc
ASSETS
Cash545given
Accounts receivable1,085given
Inventories10,625given
Other current assets1,224given
Total Current Assets13,479sum
Gross fixed assets38,471given
Less: Accumulated depreciation13,411given
Net fixed assets (PPE)25,06038,471 − 13,411
Other fixed assets1,586given
TOTAL ASSETS40,12513,479 + 25,060 + 1,586
LIABILITIES
Accounts payable9,080given
Short-term notes payable1,042given
Total Current Liabilities10,1229,080 + 1,042
Long-term debt11,114given
TOTAL LIABILITIES21,23610,122 + 11,114
EQUITY
Common stock3,894given
Retained earnings14,995given
TOTAL EQUITY18,8893,894 + 14,995
TOTAL LIABILITIES + EQUITY40,12521,236 + 18,889
Check: Assets (40,125) = Liabilities + Equity (40,125) ✅

Homework (Chapter 3) — Hints only

Show work. Label steps. Use statement structure.
Homework Questions (no answers)
  1. Firm AAA: Sales 2,000; COGS 1,000; Depreciation 200; Admin 180; Interest 30; Marketing 50; Taxes 200. Prepare an income statement.
    Hint Sales → COGS → GP → (Admin+Marketing+Dep) → EBIT → (−Interest) → EBT → (−Taxes) → NI.
  2. Current assets 2,000; fixed assets 3,000; A/R 300; A/P 300; cash 800. Inventory?
    Hint CA = cash + A/R + inventory (+ other CA if any).
  3. NWC 1,000; LTD 5,000; total assets 8,000; fixed assets 5,000. Total equity?
    Hint CA = TA − FA. CL = CA − NWC. Equity = TA − (CL + LTD).
  4. Andre’s Bakery: Sales 100,000; costs 50,000; interest 20,000; depreciation 10,000; tax rate 35%. Taxes paid?
    Hint Taxable income = (Sales − costs − dep) − interest. Taxes = 0.35 × taxable income.
  5. Same Andre’s Bakery + dividends 3,000. Retained earnings (change)?
    Hint ΔRE = Net income − Dividends.
  6. Blue Bonnet: NFA 2.2m → 2.6m; depreciation 1,000,000. Net capital spending?
    Hint Net cap spending = (End NFA − Begin NFA) + Dep.
  7. Inventory 500; fixed assets 1,860; A/R 190; A/P 210; cash 70. Current assets?
    Hint CA = cash + A/R + inventory (+ other CA if any).
  8. NWC 640; total liabilities 5,860; total assets 6,230; fixed assets 3,910. Long-term debt?
    Hint CA = TA − FA. CL = CA − NWC. LTD = Total liabilities − CL.
  9. Which is a use of cash?
    A. decrease A/R • B. decrease A/P • C. increase common stock • D. decrease inventory
    Hint Decrease in liabilities = use. Decrease in assets = source.
  10. Net income 878; depreciation 40; dividends 25; A/P ↓13; A/R ↑20; inventory ↓14; NFA ↓8. Net cash flow from operations?
    Hint CFO = NI + Dep − ΔAR − ΔInv + ΔAP (A/P ↓ ⇒ ΔAP negative).
  11. Teddy’s Pillows: beginning NFA 480; ending NFA 530; assets valued 300 sold; depreciation 40. Capital spending?
    Hint End NFA = Begin NFA + Capex − BV_sold − Dep.
  12. Art’s Boutique: Sales 640,000; costs 480,000; interest 40,000; depreciation 60,000; tax 34%. Net income?
    Hint EBIT = Sales − costs − dep. EBT = EBIT − interest. Taxes = 0.34×EBT. NI = EBT − Taxes.