Linking the Financial Statements

In this lesson we're going to conclude our overview of the three financial statements for Apple
by going through the final step of the process, which is linking together those three statements.
In the previous videos we went through the income statement of Apple and how it showed the
revenue, the total sales, all the way down to the after tax profit, the net income at the end. We
went over how the balance sheet shows Apple's resources, their assets and then how they
acquired those assets, those resources, and the liabilities and shareholders' equity side of the
balance sheet. We also went over the cash flow statement and why we need this, because
unless we create a cash flow statement we have no know idea whether or not this business is
actually making any cash, actually generating cash, in their bank account. They could have a lot
of noncash charges and revenue that show up on the income statement, but which do not
actually reflect their cash situation.

[01:00]

Once you completed this much of a model like this, the last step here is to finish linking
together everything and to create our new version of the balance sheet, the current version
over here. Remember that the balance sheet shows the snapshot of a company's resources at
the beginning of a period and at the ending of a period. Normally what you do in a model like
this is you fill out the income statement first and project the items there. Then you go over and
project what you can on the balance sheet. So in this case, current assets we might be able to
project independently, and some parts of the current liabilities we might also be able to project
independently. Then you go and create the cash flow statement for the period that you're
looking at, and you use that to get to the cash at the bottom all the way down here. Then, once
you have all that in place, you go back to the balance sheet and you finish filling out the current
version, or the new version, of the balance sheet for the end of the period that you're looking
at.

[02:00]

Some of the key points to keep in mind when we actually link together the statements like this;
first off we're not going to do anything on the income statement. We're not going to do
anything on the cash flow statement. I have here no changes if everything is already filled out
because if we had not filled out, for example, the ending cash and cash equivalents right here at
the bottom, we would actually have to change parts of this, but we already have our cash flow
statement completed right here, so we don't need to do anything else in this particular section.
What we really have to do when linking the three statements is to focus on what happens on
the balance sheet.

http://breakingintowallstreet.com
I've gotten a lot of requests for universal rules that always apply when modifying the balance
sheet. Unfortunately, there are no rules that always apply in all situations without exceptions.
The closest we can come to that is exactly what I've laid out right here and highlighted for you,
that generally currently assets are estimated directly on the balance sheet. Long-term assets
correspond to cash flow from investing.

[03:00]

Current liabilities are estimated directly on the balance sheet. And then the last two long term
liabilities and shareholders' equity comes from cash flow from financing. Those are the general
rules, and as you see right here there are exceptions, so unfortunately we can't do anything
about that. Especially if you're new to finance and are learning this for the first time, don't
worry too much about the exceptions for now and just focus on the general concepts here and
use these as we go through and link together the three statements.

Generally, currently assets are going to be estimated directly on the balance sheet. These are
not going to flow in from the cash flow statement or the income statement. They may be
linked, for example, to income statement items, but ultimately they're going to be
independent, and you're going to make up your own numbers on these on the current version
of the balance sheet. The once exception is cash and cash equivalents. This one is going to flow
in from the bottom of our cash flow statement. So, for this one I am going to use the arrow keys
and control and jump down to get the ending cash and cash equivalents from the bottom of our
cash flow statement. This is always what you do in models like this.

[04:00]

We're going to take that from right here. That's the one exception to that rule. Everything else
normally you project by itself, independently, on the balance sheet. We'll get into how exactly
you do that in the next course on three statement models. That's the basic idea for now, that
the rest of these numbers are independent, whereas cash is going to come from the bottom of
your cash flow statement. We can add that up with Alt + =.

Then, for long-term assets, remember that long-term assets correspond to investing activities.
Again, there are exceptions to that. It doesn't always work directly like that, but that's one way
you can think about it, especially if you're new to finance and you haven't seen these before.
So, how do we get to our new version of the long-term assets right here? Well, it's pretty
straight forward. If you actually look at the names of all the different accounts lists, you can
pretty much match them up as you would expect.

http://breakingintowallstreet.com
[05:00]

So, for long-term investments, for example, we're going to start with our old number, and then
for our new number what's happening here? We're purchasing long-term investments, and
then we're also selling long-term investments. If we purchase investments, we want it to go up,
so we're going to use a negative sign in front of that. If we sell investments, we want to go
down, so we're also going to use a negative sign because this is a positive number. So, we're
adding that $10, and then we're subtracting that $5 effectively, so we get $15 right here. You
would take the same approach if you had any other type of investment. Even if you had a short-
term investment under current assets you would do the same thing, and you would probably
pull it in from investing activities and add any purchases, subtract any sales or maturities.

For intangible assets and for other long-term assets, it's very, very similar. We simply add in the
purchases of these from the investing activities section of our cash flow statements. So, for
both of these, intangibles, we're going to take the $15, and then we're going to subtract the $5.
We're subtracting it because, remember, on the cash flow statement that ($5) is negative
because it represents a use of cash.

[06:00]

But on the balance sheet, when we use cash it's going to increase our assets. We're going to
subtract that. We're going to use a negative sign, and we get to $20. For other long-term assets,
we're going to take the old number and then subtract purchases of other long-term assets.
Sometimes in models you don't do it exactly like this.

There are other items that can come into play with both of these. Sometimes you actually hold
other long-term assets constant. But, again, for now I'm just introducing the concept and giving
you the overall idea of how you link together the three statements like this.

Now, we get to these two items here, both of which are exceptions, either entirely exceptions
or partial exceptions to this rule. For PP&E first, you might look at this $50 and say, we're just
going to subtract the capital expenditures here of $20. Effectively, we're going to add it to our
PP&E number, and there we go, we're set. There's one thing that we're overlooking though,
which is depreciation.

[07:00]

http://breakingintowallstreet.com
Depreciation, if you recall, just means that the property you own, or the plants, the equipment,
are being expensed (“losing value” sometimes) over time. Now on the balance sheet, we want
to reflect that. We want to reflect what we're paying for new PP&E and then also how much
we're allocating over time. What we have to do here is also take into account the depreciation.
I'm going to press F2 to enter the cell to modify the formula, and then enter the subtraction
sign and go up to depreciation on the cash flow statement. We're going to subtract it on the
cash flow statement right here.

This is a partial exception because depreciation for this line item is coming from the cash flow
from operations section. It is something to be aware of. If you had anything else in here that
modified PP&E in any way or was related to PP&E, you would also have to take it into account
and therefore pull it in from cash flow from operation. This will become clear and some of these
other items and their relationships will become more clear when we go through interview
questions and how the model will change based on interview questions after this.

[08:00]

Goodwill is another exception. Remember that Goodwill represents the amount you've paid for
a company over its value according to its balance sheet which we went over in the balance
sheet tutorials. You could also think of it as any type of intangible assets, like the brand name of
the company, customer relationships that are going to be good for a very long time; a time
period that you cannot actually estimate. Anything intangible that adds to the company's value.
Goodwill is usually kept constant, so I'm just going to link it to the old value right here. The
reason it's kept constant goes back to what I just said. It corresponds to assets that are going to
be good for a very, very long time to come, that are not going to clearly decrease in value over
time as, say, a factory would decrease in value over time as it wears down.

You don't always do this, and in the interview questions we're going to go over examples of
how you could actually modify goodwill in different scenarios. But for now, just keep in mind
that most of the time in models it will be held constant.

[09:00]

This is, in a sense, another exception in that it's not directly linked to anything in investing
activities right here. Let's add these up with "alt equals". Then, let's add up total assets right
here. I'm going to take total long-term assets, enter a plus sign and add in total current assets.
We get to $210. We know that on the other side of the balance sheet we must have $210
there; otherwise, we're going to be in trouble. Liabilities and shareholders' equity, these three

http://breakingintowallstreet.com
items under current liabilities are all projected independently so we don't have to do anything.
I've already filled those in.

The revolver here is the exception. If you go over to my rules on the right side right here, we
estimate these directly on the balance sheet. The exception is the revolver which is going to
flow in from the cash flow statement instead, under financing activities right here.

[10:00]

If you have different types of debt, you'll see an entry for each of these under financing
activities most of the time. In this case, we just have this one entry for the revolver for this
particular debt item under current liabilities. Remember the signs here. If we pay off revolver
it's a negative sign and our revolver balance goes down; if we issue more in revolver or we draw
on the revolver, we have a positive sign, and it goes up. In this case we are fine just taking the
old balance and simply adding this line item for the revolve right here. It goes down by 5 in this
case because we're using $5 of our cash to pay off this revolver. Now, let's add these up with
Alt + =. We get to $85.

Now, for long-term liabilities again, if you go over to my rules for how you project this, long-
term liabilities are generally going to come from the cash flow from the financing section. The
one exception here is deferred tax liabilities.

[11:00]

Another possible exception here is any kind of pension obligation for companies. In both cases,
deferred tax liabilities and for pension obligations, they are instead going to flow in from the
cash flow from operations section because they're more closely linked to the company's
operations than they are to their financing activities. So, that's the one exception here, but the
rest is pretty straight forward.

For long-term debt, again we just go over to the corresponding item on the cash flow
statement, and we issue or pay off long-term debt. In this case we're issuing additional debt so
our balance is going to go up. We take our old number right here, and then we add the issuance
right here.

Deferred tax liabilities. This is our exception. What we're going to do here is take our old
balance and then go up to our cash flow from operations and pull in the deferred income taxes
from here. Why are we doing this? Remember, by deferring income taxes it means we're
paying less right now and then in the future periods we're going to have to pay more.

http://breakingintowallstreet.com
[12:00]

We reflect that obligation to pay more with the deferred tax liabilities line item right here.
That's why it's going up in this case, because when we put off and postpone payment, it means
we're going to have to pay more in the future, and as a result, our balance is going to go up.

Other long-term liabilities is much more straight forward. We simply take the item and then
find the corresponding item in financing activities on the cash flow statement. In this case, it's
changing by 5, and we're just going to add that directly. Sometimes in models, other long-term
liabilities are actually held constant, so you will see that as well. Let's add these up now. Alt + =,
and then let's add up total liabilities. So we have that in place, $135. So far, we are still well
below our total assets of $210, but that's okay because we still have to fill in our shareholders'
equity right here.

[13:00]

Now under shareholders' equity you'll see that I've combined common stock and additional
paid-in capital. The reason I've combined them is, remember that common stock refers to the
book value of a company's shares. APIC refers to the market value of those shares. The reason
why I've combined them here is because in models it doesn't make a difference which account
you're dealing with. You can treat them as the same, because an item, like issuing common
stock, for example, is going to affect both of these proportionately, so from a modeling
perspective and from a time saving perspective, it helps us a lot to simply combine the items
here and to account for everything, all together, in the same spot.

If you remember, on Apple's financial statements as well, if you go to their balance sheet where
they've listed, right here, common stock, no par value, they are actually doing this very same
thing right here. What they're doing is combining common stock and APIC, and they're saying,
in their case, that the common stock actually has a par value of $0.00. No value on paper, so
they're solely listing the market value of the stock that's been issued right here. It's very
common to see in models, and that's why I'm modifying it slightly here.

[14:00]

What goes into common stock and APIC? Well, the most common item by far is any type of
common stock issuance. So if the company is going through an initial public offering, you would
add the funds from the IPO right here. That's where it would show up. If they're just issuing
stock to employees, for example, it would also show up here because they're creating new

http://breakingintowallstreet.com
shares in the market. If they're issuing a secondary offering; so, they're already public and
they're selling new shares to investors, that would also show up here. Those are all common
occurrences. For this one, we're going to take the old balance, and then we're going to add in
common stock issuances right here. Then the exception here is we actually have to go up to our
cash flow from operations and add in stock-based compensation.

Why are we adding stock-based compensation to this? I said before that APIC is to represent
the market value of the stock over what the book value is, at the time of its issuance.

[15:00]

In this case, it doesn't really make a whole lot of sense intuitively if you think about it because
it's not as if we've sold the stock to new investors per se, it's really that we've just granted
employees stock options or common stock, for example. So, why is it here?

The answer is that we want to reflect dilution to existing shareholders. Dilution just means that
existing shareholders' ownership goes down. In this case, if we have 20 shareholders originally,
and they each own one of our common stock in APIC, so 1/20th of the company, if we issue
shares to employees, for example, and we did not reflect it here, we would be undercounting
the dilution. Let's say, for example, that we only shared 25, then we might say, okay after the
fact, after we take into account this new issuance, the existing investors from before still own
1/25th of the company, but it's actually not what happens.

[16:00]

Because if we have additional shares that have been issues on top of that, they actually only
own 1/30th of the company now. That's the reason why we have to include stock-based
compensation under the APIC line item right here. Sometimes in investment banking they will
not even do that. They might just have a single line item for shareholders' equity, so that's
another possibility as well, but that's the basic idea behind why we include it here. I know it's a
little bit counter-intuitive, but that's how you can think about it.

Treasury stock - the purpose of treasury stock, remember, is that we want to reflect any stock
the company has repurchased. So, we take our old number and then we go to our cash flow
from financing section, because that's what corresponds to shareholders' equity, and we add in
common stock repurchase. By add in, I mean we want this balance to go down to become more
negative if they've repurchased any stock, which they have right here. Remember that this is
always shown with a negative sign because it's the opposite of common stock [and] APIC.

http://breakingintowallstreet.com
[17:00]

For retained earnings, remember retained earnings correspond to how much we've saved up
over time out of our after-tax profits, our net income, minus however much we've issued in
dividends. So, for this one, we're going to take our old number, and for this one we can actually
go the income statement or we can just pull it straight from the cash flow statement right here
and take our net income number directly from here, and then we want to take out any
dividends that we issue to those shareholders. Effectively this is showing us over time what
we've saved up from our after-tax profits minus however much we've paid out over time to our
investors in this company.

Here, it's $48. Then accumulated other comprehensive income, this is for any other
miscellaneous changes that have not shown up elsewhere. We're going to take our old balance.
Then, the only other item that would go in here is the impact of the FX rate change. We're
going to add that in right here.

[17:55]

That's takes us to the end of how we link together a shareholders' equity. I know it's a little bit
confusing, some of the parts with stock-based compensation and maybe the concept of
retained earnings is a bit confusing if you haven't seen it used in a full model yet. Again, this is
just intended to be an introduction. Don't get hung up on all the specifics here. I'm just
introducing the concepts and showing you how to link these together generally.

Now, let's go back and add up everything and make sure our balance sheet actually balances
now. For totally shareholders' equity, I'm going to press Alt + = to add this up, and then we're
going to add the total shareholders' equity to the total liabilities. We get $210, which matches
assets, so our balance sheet balances. Let's just do a quick check and take total assets minus
total liabilities and shareholders' equity, and we get okay for our balance check. Our balance
sheet balances. This is something you should always do at the end when you've created a new
version of the balance sheet. Remember, assets always have to equal liabilities plus
shareholders' equity. If it's not true, if your balance sheet does not balance, your model is
completely wrong. That is how we go through and link together the three statements.

[19:00]

Just to recap everything we went over, generally you're not going to have to change anything
on the income statement or cash flow statement when you do this. It's really the balance sheet
that's going to change the most. For each of these balance sheet categories there is a general

http://breakingintowallstreet.com
rule which I have on the left, and then exceptions, which I have on the right. Current assets
generally estimate directly on the balance sheet, except for cash, which comes from the bottom
of the cash flow statement. Long-term assets generally coming in from cash flow from
investing, except for goodwill, which is usually held constant, and then PP&E which also, in
addition to CapEx, has to incorporate depreciation.

Current liabilities are generally estimated directly on the balance sheet except for debt, short-
term debt, and the revolver specifically here. Long-term liabilities, shareholders' equity, both
coming from cash flow from financing, except for deferred tax liability, sometimes pension-
related items, and then on shareholders' equity except for APIC which also draws in stock-
based comp, and then retained earnings which also incorporate net income from cash flow
from operations or directly from the income statement.

[20:00]

A general rule of thumb that is good to know is that each balance sheet item must be reflected
once, and only once, on the cash flow statement and vice versa. The only exception here is for
items that are held constant anyway, such as goodwill. As an illustration of this rule, if we go
back here and we look at depreciation for example, if we had listed depreciation on the cash
flow statement in two spots, so if we had it under changes in operating assets and liabilities for
some reason that would be a mistake because it only shows up once on the balance sheet for
property, plant and equipment here.

Likewise, let's say that we were reflecting the change in accounts receivable on the balance
sheet twice on our cash flow statement; once in changes in operating assets and liabilities and
then once in, say, investing activities. That would be another mistake because we're showing it
twice. The most common way you can make this mistake is if you forget to include something
altogether.

[21:00]

Let's say you're going through and you forget to include stock-based comp within shareholders'
equity. That is a very, very common mistake, so that's the most common problem that you see
here. Just watch out for that. When you're going through and checking your own work, that's
one test you can use to quickly check everything.

At the end, the balance sheet must balance; assets must equal liabilities plus shareholders'
equity. If it is not balanced, then your model is completely wrong. Later on we're going to get
into some details and some examples of how to actually error check your model and resolve

http://breakingintowallstreet.com
problems like this. For now, just keep in mind this general principal that always must apply to
your models.

Then, as one final note, don't worry too much about all the details. I realize we went through a
lot of material in these lessons, and especially if you're new to accounting and finance, it is a lot
of absorb. It's going to get much easier, and you'll understand it in much more detail when we
go through the interview questions and contextualize it, and when we go through the three
statement model and learn about how to make projections over a number of years. Don't worry
if you didn't get all this right now.

[22:00]

I know it can be confusing. I know there are many exceptions to the general rules that I just
gave, but just understand the general principals and why we need these three statements,
what they actually mean and where these items usually come from.

Coming up next, we're going to get into more detail and look at interview questions around the
topic of accounting and see how individual changes to line items on the statements affect all
the other statements. After that, we're going to get into the three statement modeling course
where we look at how to project the income statement, balance sheet, and cash flow
statement over a number of years into the future.

http://breakingintowallstreet.com