Random 3-Financial Statement Notes

Step 1: Project Revenue Step 2: Project Expenses and Margins Step 3: Project Operational Items on BS and Link them to CFS Step 4: Project Remaining CFS Line Items Step 5: Link Interest on IS and Everything on BS

Ultimately it's about Cash Flows, Their Growth and The Risk of Those Cash Flows. Always think about the bigger picture when projecting 3 statements. Little things matter less.

• Either saved the company taxes in cash (non-cash expense). Or company had to pay taxes in cash (non-cash).
• 3 Ways to Project Revenue (depending on time):

1. Simple % growth rate
2. Bottoms-up:

• Start with individual customers/products
• Estimate average sale value or customer value
• Growth rate in sales and sales value

1. Top-down

• Find overall market size
• Find company's market share
• Growth rate in market share, multiply by total market to get revenue
• To calculate sales in retail using (2):

1. Sales per store x Number of stores
2. Sales per square ft x Number of square ft

• For projecting costs, you project interest expense and interest income at the end, because you have to forecast the company's cash and debt balances first which you project from the BS/CFS

For Operational BS items:

• Link revenue-related operational BS items to Revenue, e.g. make AR and Deferred Revenue as a % of Revenue
• Link cost-related operational BS items to COGS/Opex, e.g. make AP, Prepaid Expenses and Accrued Expenses as a % of COGS
• So you project the above as a % of Revenue or Opex and then you multiply the % to the Revenue/Opex projections to get your final projections.
• Once you project the operational BS items, you link the changes to the CFS.
• You can forecast all 3 financial statements and project them in the future, that's what this is all about. So for IS, BS and even CFS you can project to future years.
• For capital intensive industries project depreciation and Capex in a separate schedule, for capital-light industries project amortization
• You link interest expense and income last because it depends on the company's Cash and Debt
• Line items on the CFS feed into the BS. EVERY SINGLE item on the BS must be linked to something on the CFS, can't leave one out or BS will go out of balance. If something can't be linked, just link it to equity (plug).
• Asset side use negative signs, L/E side use positive signs
• New PP&E = Old PP&E + Capex - Depreciation
• Operating Lease is rent and not on BS (under US GAAP, under IFRS both Operating and Finance leases are on BS). Capital Lease is asset and debt on BS, and then depreciation and interest expense, as well as principal repayment on CFS. It's more expensive to buy than rent in short-term, but opportunity for appreciation in buying.
• You use EBITDAR in US GAAP to compare companies with different types of leases; by adding back Rent, you can remove the impact that Rent has on Operating Lease only under US GAAP. Finance (Capital) Lease is Depreciation and Interest Expense, so EBITDA is before a Finance Lease is applied anyway.
• To capitalize operating leases, multiply annual rent by 7x or 8x in US GAAP. Add capitalised leases to Total Debt.
• When we used a ratio with EBITDAR, we have to include capitalized leases or include Rent with the interest/debt. So instead of EV/EBITDAR it's: (EV + Capitalised Operating Leases)/EBITDAR EBITDAR/(Interest Expense + Rent)
• Dividends a company pays out are not recorded on IS (not taxable) but dividends realized from investments are
• Remember on CFO, non-cash expense is added, but non-cash gain is subtracted.
• Pension Plan Assets (actual return on plan assets, employer contributions, benefit payments)
• Projected Benefit Liability (SERVICE COST, interest cost, benefit payments)
• Always add Unfunded Pension (Projected Benefit Liability > Pension Plan Assets) when moving from Equity Value to Enterprise Value. If company's contributions are tax-deductible, then Unfunded Pension(1-T).
• Service Cost is the only true operating expense.
• Defined Contribution Plans (easy, employee invest funds independently, company matches and 401(k) Matching Contributions shown as Opex on IS, no assets/liabilities created)
• Defined Benefit Pensions (hard, pension plan assets, projected benefit liabilities, service cost, Unfunded Pension (1-T) if company pays taxes on them, subtracted from Equity Value)
• Available For Sale Securities (AFS), are when you bought securities but don't know when you'll sell them BS: Long-term Investments up, OCI up
• Minority stake (20 < x < 50) is called an Equity Investment. Don't consolidate statements. Include % of other company's net income. Realized non-cash gain so add it on CFO. Equity Investment line item on assets side will increase by new net income recorded. Dividends reduce Equity Investment item, and ONLY the portion parent company receives added to CFO. Equity Investment not marked to market (written up).
• Majority Interest - NCI is portion of company you don't own (as a liability). You create goodwill, write up assets, write down seller's shareholder equity, consolidate statements and write down existing equity investment (if you had a minority stake previously). Only create NCI if you don't own 100%. Consolidate entirety of both IS, subtract out "Net Income Attributable to Noncontrolling Interests". Combine dividends on IS but remove those attributable to Parent.
• As in a normal M&A deal for 100% of a company, the Parent creates Goodwill, writes off the Associate Company's Common Book Value, writes up Assets which creates a Deferred Tax Liability
• Shareholder equity is synonymous to Target's Book Value
• Asset write-ups increase asset side, reducing goodwill. You write-up assets in acquisition.
• NCI is added to the Equity side of L&E. Remember NCI is only when you have a majority stake. If you own 100%, there is no NCI.
• Moving from Equity Value to Enterprise Value, add NCI, subtract Equity Investments.
• Net Operating Loss is just an operating loss. The NOL component within DTA/DTLs correspond to NOLs, and are calculated by Tax Rate x Cumulative NOLs. So NOL is a subsector within DTAs.
• NOL itself is an "off-Balance Sheet" item.
• If company earns positive Pre-Tax income, it uses up a portion of this NOL balance to reduce its Taxable Income.
• If a company earns negative Pre-Tax income, it adds to the NOL balance.
• Company still records income taxes normally, the above applies where it adds/subtracts to its NOL balance. You will get an NOL-adjusted Pre-Tax Income. Whichever one is less, the Pre-Tax Income or the NOL, is the amount of NOL you will apply to the Pre-Tax Income to get the NOL-adjusted Pre-Tax Income.
• You only pay cash taxes if NOL-adjusted Pre-Tax Income is positive. Negative NOL-adjusted Pre-Tax Income will create a DTA.
• If NOLs are used, the DTA will decrease to reflect their use. So the NOLs are used from like your bank of DTAs.
• If NOLs are created, the DTA will increase. Adding to your bank of DTAs.
• NOL doesn't show up on IS, just adjust on CFS.
• If DTA increases, because NOL is created, then company's cash flow decreases (subtract gain in assets, because gain in non-cash asset).
• If DTA decreases, because NOL is used, then company's cash flow increases (because using NOL is a non-cash expense that reduces company taxes).
• NOL is non-core asset, subtracted from Equity Value to Enterprise Value. In 3 statement model, only factor in NOL if materially significant:

1. Use Pre-Tax Income * Tax rate
2. Separate schedule for NOL, calculate NOLs created and used each year
3. Reflect increase or decrease on DTA on CFS, and on BS

• NOLs most important in credit analysis and leverage buyouts because they can significantly impact a company's debt repayment capacity
• DTAs means company will pay less in cash taxes in future
• DTLs mean company will pay more in cash taxes in future
• So if you paid more in cash taxes now than you should have, you get given a DTA
• DTLs are created in M&A deals when companies write-up assets, or accelerated depreciation as opposed to straight-line
• Income taxes receivable: refund because of overpayment in previous period
• Income taxes payable: just like AP due to pay taxes in e.g. a month
• Deferred Taxes are projected as % of Income Taxes
• If company is constantly deferring income taxes, reflect in model. Assume that deferred taxes as % of income taxes should decline over time.
• SBC recognised on IS, added back on CFO, DTA created (to get cash to 0) and subtracted from CFO, No net change in cash. BS: Deferred Tax up, Stock & APIC up, RE down.
• If SBC worth $50mn, but upon exercise worth $200mn, company records 40% x $150mn = $60mn as a positive entry, this corresponds to a DTA decrease.

Originally, company anticipated to deduct only 40% x $50mn = $20mn, which is "Tax benefits From Stock-Based Compensation".

Now the extra $60mn, is "Excess Tax Benefits From Stock-Based Compensation".

CFS: SBC add on of $20mn, DTA decrease of $60mn is added on, so cash up by $80mn. BS: Cash up $80mn, DTA down $60mn, Assets up $20mn. Common Stock & APIC up $20mn. Balanced.

• When projecting the above, very simply, just set SBC to 0 on CFS, and treat SBC like a normal cash expense.
• Interest expense in a cash expense
• PIK (Paid-In-Kind) Interest is a non-cash expense. It's still on IS. PIK is non-cash interest expense, added back onto CFO to make cash increase, and it accrues to the loan principal on BS. BS: Cash up, Debt up.
• PIK gives company a tax deduction, doesn't pay any cash interest. But creates a larger debt balance. In LBO, a tranche of debt might have PIK interest.

PIK: IS expense, add-back on CFS, add to loan balance on BS.

• Interest expense is still tax-deductible, it's just that it can be non-cash (PIK) or standard interest expense. Difference is in being cash/non-cash as opposed to tax.
• You project expenses and margins as a % of revenue. Or you could do it per-employee, per-location, per-unit etc.
• For quarterly projections, you use YoY projections to remove quarterly noise.
• Unrealised gains on AFS can prop-up a company's equity, could give impression more equity. It goes into OCI which is equity.
• Net income is lower under Capital Leases (because you have depreciation and interest expense), and Assets are higher
• For securities, always record Realized Gains and Losses on the IS for all types of investments, it's the treatment of Unrealised Gains and Losses that differs significantly
• For Equity Investments, you reverse the Equity Investment Earnings line item on the CFS, by subtracting the gain in earnings on the CFO
• What you need to know about Pensions:
1. Is the plan over-funded or under-funded
2. What assumptions were used to calculate the assets, liabilities, and the pension expense?
3. Have the assumptions changed recently?
4. How do pensions impact the IS expense vs cash generated on the CFS?