The Three Core Financial Statements
Income Statement
Shows profitability over a period. Structure:
- Revenue (Net Revenue = Gross Revenue − Returns, Discounts)
- − Cost of Goods Sold (COGS) = Gross Profit
- − Operating Expenses (SG&A, R&D, D&A) = Operating Income (EBIT)
- ± Non-Operating Items (Interest income, interest expense) = EBT (Earnings Before Tax)
- − Income Tax = Net Income
Revenue Recognition (IFRS 15 / ASC 606): Recognise revenue when (or as) performance obligations are satisfied. Key: point-in-time vs over-time recognition.
Balance Sheet
Snapshot at a point in time. Assets = Liabilities + Equity.
- Current Assets: Cash, Accounts Receivable, Inventory, Prepaid Expenses (convertible to cash within 12 months)
- Non-Current Assets: PP&E, Intangibles, Investments, Goodwill
- Current Liabilities: Accounts Payable, Short-Term Debt, Accrued Liabilities
- Non-Current Liabilities: Long-term bonds, deferred tax liabilities, lease obligations
- Equity: Common stock + Additional paid-in capital + Retained earnings + AOCI (Accumulated Other Comprehensive Income) − Treasury stock
Cash Flow Statement
Tracks actual cash movements — the most difficult to manipulate.
- Operating (CFO): Cash from core operations. Indirect method: Net Income ± Non-cash items (add back D&A) ± Changes in working capital.
- Investing (CFI): Purchase/sale of PP&E, investments, acquisitions. Usually negative for growing firms.
- Financing (CFF): Debt issuance/repayment, equity issuance, dividends paid, share buybacks.
IFRS vs US GAAP — Key Differences for Level 1
| Item | IFRS | US GAAP |
|---|---|---|
| LIFO Inventory | Not permitted | Permitted |
| Inventory write-down reversal | Permitted (to NRV) | Not permitted |
| Development costs | Capitalised if criteria met | Expensed (except software) |
| Property revaluation | Revaluation model permitted | Historical cost only |
| Interest paid (CF classification) | Operating or Financing | Operating only |
| Dividends paid (CF classification) | Operating or Financing | Financing only |
| Interest received (CF classification) | Operating or Investing | Operating only |
| Dividends received (CF classification) | Operating or Investing | Operating only |
| Goodwill impairment | Annual impairment test (no amortisation) | Annual impairment test (no amortisation) |
Inventory Methods — FIFO vs LIFO vs Weighted Average
Inventory method affects COGS, gross profit, inventory balance, and taxes.
| In Rising Price Environment | FIFO | LIFO | Weighted Average |
|---|---|---|---|
| COGS | Lowest | Highest | Middle |
| Gross Profit | Highest | Lowest | Middle |
| Inventory (Balance Sheet) | Highest (most current) | Lowest (oldest costs) | Middle |
| Tax Liability | Highest | Lowest (US GAAP only) | Middle |
LIFO Reserve: US GAAP firms using LIFO disclose the LIFO reserve. To compare with FIFO firms: Adjust Inventory = LIFO Inventory + LIFO Reserve. Adjust COGS = LIFO COGS − Change in LIFO Reserve.
Key Financial Ratios
Liquidity Ratios
- Current Ratio = Current Assets / Current Liabilities (>1 = can cover short-term obligations)
- Quick Ratio = (Cash + ST Investments + AR) / Current Liabilities (excludes inventory)
- Cash Ratio = (Cash + ST Investments) / Current Liabilities (most conservative)
Solvency (Leverage) Ratios
- Debt-to-Equity = Total Debt / Total Equity
- Interest Coverage = EBIT / Interest Expense (>3 = comfortable; <1.5 = distress risk)
- Debt-to-Assets = Total Debt / Total Assets
Profitability Ratios
- Gross Margin = Gross Profit / Revenue
- Operating Margin = EBIT / Revenue
- Net Profit Margin = Net Income / Revenue
- ROA = Net Income / Average Total Assets
- ROE = Net Income / Average Equity
DuPont Analysis of ROE
3-factor: ROE = Net Margin × Asset Turnover × Equity Multiplier
5-factor: ROE = Tax Burden × Interest Burden × EBIT Margin × Asset Turnover × Leverage
Use DuPont to identify whether ROE improvement is driven by profitability (margin), efficiency (turnover), or leverage — important for quality of earnings analysis.