How the three statements link: one company through all three
Follow a fictional furniture maker through one year: its profit, its cash, and the balance sheet at the start and the end.
Key takeaways
- The P&L shows profit over a period, the balance sheet shows what a company owns and owes on one day, and the cash flow statement explains how the cash on one balance sheet became the cash on the next.
- Common mistakes: Adding back depreciation and also subtracting capex for the same machine in the P&L (capex is never on the P&L; depreciation is its slow version).
- Net profit is the first line of the cash flow statement, and it is added to equity on the balance sheet.
- Depreciation lowers profit and lowers the value of equipment on the balance sheet, but no cash leaves the business, so the cash flow statement adds it back.
- When receivables or inventory grow, cash is tied up; when payables grow, suppliers are lending you cash.
Key idea
The P&L shows profit over a period, the balance sheet shows what a company owns and owes on one day, and the cash flow statement explains how the cash on one balance sheet became the cash on the next. Profit flows into equity; the cash flow statement explains the change in cash.
In Business basics you met each statement on its own. Here you follow one company through a whole year and see every link. Harbour Furniture is a fictional furniture maker in Malaysia; all figures are illustrative and in millions of Malaysian ringgit (MYR millions).
| Line | Amount |
|---|---|
| Revenue | 300 |
| Cost of goods sold | -180 |
| Gross profit | 120 |
| Operating expenses | -60 |
| EBITDA | 60 |
| Depreciation | -15 |
| EBIT (operating profit) | 45 |
| Interest on the bank loan | -5 |
| Profit before tax | 40 |
| Tax at 25 percent | -10 |
| Net profit | 30 |
So-what
The company earned MYR 30 million of profit. The next two exhibits show where that profit went.
| Line | Start of year | End of year |
|---|---|---|
| Cash | 20 | 5 |
| Receivables (money customers owe) | 30 | 40 |
| Inventory (stock) | 40 | 50 |
| Equipment, after depreciation | 110 | 120 |
| Total assets | 200 | 215 |
| Payables (money owed to suppliers) | 25 | 30 |
| Bank loan | 60 | 50 |
| Equity (the owners' part) | 115 | 135 |
| Total liabilities and equity | 200 | 215 |
So-what
Profit was MYR 30 million, yet cash fell from 20 to 5. The cash flow statement explains why.
The four links to remember
- Net profit is the first line of the cash flow statement, and it is added to equity on the balance sheet. Dividends paid to owners come out of equity; they are not a cost on the P&L.
- Depreciation lowers profit and lowers the value of equipment on the balance sheet, but no cash leaves the business, so the cash flow statement adds it back.
- When receivables or inventory grow, cash is tied up; when payables grow, suppliers are lending you cash. These changes in working capital sit in operating cash flow.
- Buying equipment (capex) is an investing cash flow and raises equipment on the balance sheet. Borrowing, repaying debt and paying dividends are financing cash flows. Operating plus investing plus financing equals the change in the cash line.
Worked case
Building the cash flow statement and checking the links
The prompt
Harbour Furniture made the profit shown in the P&L above. During the year it also bought new machines for MYR 25 million, repaid MYR 10 million of its bank loan and paid MYR 10 million of dividends. Build its cash flow statement and check that all three statements tie together.
The structure
- Change in cash = operating cash flow + investing cash flow + financing cash flow (this comes from the question: explain the move in cash)
- Operating: net profit, plus depreciation, minus the cash tied up in working capital
- Investing: the MYR 25 million of machines
- Financing: the loan repayment and the dividends
- Checks: closing cash, equipment and equity must match the balance sheet
Working it through
1. Net profit
Revenue 300 minus COGS 180, operating expenses 60, depreciation 15 and interest 5 gives 40 before tax. Keep 75 percent after tax.
Net profit (MYR millions):(300 - 180 - 60 - 15 - 5) × 0.75 = 302. Working capital
Receivables rose 10 and inventory rose 10, which ties up 20 of cash. Payables rose 5, which frees 5.
Cash effect of working capital (MYR millions):-(40 - 30) - (50 - 40) + (30 - 25) = -153. Operating cash flow
Net profit 30, plus depreciation 15, minus 15 for working capital.
Operating cash flow (MYR millions):30 + 15 - 15 = 304. Free cash flow
Operating cash flow minus the 25 spent on machines.
Free cash flow (MYR millions):30 - 25 = 55. Financing cash flow
The loan repayment of 10 and dividends of 10 both send cash out.
Financing cash flow (MYR millions):-10 - 10 = -206. Change in cash and closing cash
Operating 30, investing minus 25, financing minus 20 gives minus 15. Opening cash of 20 minus 15 leaves 5, the number on the closing balance sheet.
Closing cash (MYR millions):20 + 30 - 25 - 20 = 57. Equipment check
Opening equipment 110, plus new machines 25, minus depreciation 15.
Closing equipment (MYR millions):110 + 25 - 15 = 1208. Equity check
Opening equity 115, plus net profit 30, minus dividends 10.
Closing equity (MYR millions):115 + 30 - 10 = 1359. The balance sheet balances
Assets: 5 plus 40 plus 50 plus 120. Liabilities and equity: 30 plus 50 plus 135. Both come to 215.
Total assets minus total liabilities and equity (MYR millions):(5 + 40 + 50 + 120) - (30 + 50 + 135) = 0
The recommendation
The three statements tie together, and they show a profitable company whose cash fell from MYR 20 million to MYR 5 million. The reasons are that 15 million went into working capital, 25 million into new machines, and 20 million to the bank and the owners, against only 30 million of operating cash. This means free cash flow was just MYR 5 million, not enough to fund both the loan repayment and the dividend. The risk is that 5 million of cash is thin against 30 million owed to suppliers. As a next step, check whether the new machines will lift sales, and whether the dividend should wait until stock and receivables come down.
Risks: Cash of MYR 5 million leaves little room if a large customer pays late; Rising inventory may mean furniture that is not selling.
A company starts the year with equity of INR 500 crore, makes a net profit of INR 80 crore and pays INR 30 crore of dividends. It issues no new shares. What is its equity at the end of the year, in INR crore?
A retailer in Spain starts the year with EUR 60 million of cash. Operating cash flow is EUR 120 million, investing cash flow is minus EUR 70 million and financing cash flow is minus EUR 40 million. What is its cash at the end of the year, in EUR millions?
Adding back depreciation and also subtracting capex for the same machine in the P&L (capex is never on the P&L; depreciation is its slow version). Treating dividends as a cost. Forgetting that a balance sheet is a snapshot on one date while the P&L and cash flow cover a period. Getting the sign of a working capital change backwards: more receivables means less cash, more payables means more cash.
A company pays a dividend. Which statements change?
Depreciation for the year is 15. What happens on the three statements?
Receivables rose by 10 during the year. What does that do to operating cash flow?
Sources for this lesson (1)
- Recognized public explanations of case-interview concepts and terms
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