Breaking Into Wall Street - The 3 Financial Statements

($ in Thousands)

Concept: Now, we have an even better idea for a "business expansion" opportunity…

Instead of just selling online courses and coaching, we'll expand and also offer physical versions of all the courses!

Problem: to do this, we'll need to order the supplies for the physical versions of these courses.
Yes, we're going to build them, package them, and ship them in-house.

So now we run another problem with cash flows going "out of sync" with revenue and expenses.

Problem: We need to pay for all those supplies upfront, in cash… or at least pay something upfront in cash
since it's a new product line and the supplier doesn't quite trust us yet.

BUT we can't record that as an Income Statement expense right away because we haven't sold the products yet.

Can only record it as an expense when the products are actually sold… in which case, we then list what we paid
for these supplies under "Cost of Goods Sold" or "Cost of Revenue".

Question: How does this affect the cash generated from this business? How does Net Income differ from cash generated no

If we're paying cash upfront for these supplies but we can't recognize those payments as expenses yet, we get an account c
that we also have to track over time.

If this "Inventory" goes UP, our cash goes DOWN because we're paying out cash upfront! It's just that we can't exactly recog
it as an expense on the Income Statement yet… but the cash in our bank account is going down.

So if this keeps going up and up over time, cash generated will be *lower* than Net Income on the IS…

On the other hand, if we HAVE an Inventory balance and then we stop buying Inventory and wait to recognize the expenses
the balance falls and cash generated will be MORE than Net Income…

Because we've *already* paid for it in cash… so those expenses we just recognized are not real cash expenses in this period

Here's an example of what happens:

Let's say we order Inventory, but it takes us 3 months to finish turning all of it into finished products and actually sell it to cu

Inventory Paid for Upfront: Paying for Supplies Gradually Over Time:

Month 1 Month 2 Month 3

Cash Paid: $ 30 $ - $ - Cash Paid:
Expense Recorded: 10 10 10 Expense Recorded:
Do we really need to pay for it all upfront? Well… not always, but usually, yes, you have to place some type of "minimum o
there's still some amount of time lag between the cash purchase and recognizing the expense.

Tax Rate: 40.0%

Supplies Paid for Upfront in Cash: $ 30 <--- This represents our "Inventory Purchases" - we
Subscription Revenue Paid Upfront in Cash: $ 15 haven't turned them into finished products and sol
Operating Expenses Paid in Cash Later On: $ 15 hanging around at the end of the year, and we can'
Prepaid Operating Expenses: $ 30
Revenue NOT Received in Cash Upfront: $ 50

Income Statement: Assets and Liabilities & Equity:

Year 1 Year 2
Revenue: $ 650 $ 700 Assets:
Cost of Goods Sold (COGS): 70 70 Cash:
Gross Profit: 580 630 Accounts Receivable:
Gross Margin %: 89.2% 90.0% Inventory:
Prepaid Expenses:
Operating Expenses: Total Assets:
Sales & Marketing: 150 165
Research & Development: 75 75 Liabilities & Equity:
General & Administrative: 50 50 Accounts Payable:
Total Operating Expenses: 275 290 Deferred Revenue:
Debt:
Operating Income (EBIT): 305 340 Equity:
Operating Margin: 46.9% 48.6% Total Liabilities & Equity:

Other Income / (Expenses): 20 20 The "Inventory" balance goes up each time th

Interest Income / (Expense): - - pays for supplies / parts / components upfron
yet recognize it as an expense on the Income
Pre-Tax Income (EBT): 325 360
It decreases when the company recognizes th
Income Taxes: (130) (144)
It's always increasing and decreasing, but the
Net Income (Profit After Taxes): $ 195 $ 216 some balance if the business continues to op
Net Income Margin: 30.0% 30.9% ending balance represents what the compan
expenses (COGS) in the first few months of th
Key Takeaways from This Lesson:

In a very simple business, Net Income really DOES mean "How much cash did this business generate in this period?"…

But now you've seen all the ways in which that falls apart:
1) Customers not paying upfront.
Our idea to allow installment payments for the products…

2) Company pre-paying expenses in cash upfront.

Paying for our rent in quarterly installments, or paying employees upfront…

3) Company delaying payments for delivered products/services.

Pushing back and paying marketing services firm 90 days later after getting invoice…

4) Company collecting cash and not recording it as revenue.

Having customers make annual payments for a monthly subscription.

5) Company paying for supplies upfront and recognizing the expense later.
Deciding to offer physical versions of the products that you receive in the mail.

Over time, all of these issues create long-term differences between Net Income and cash generated.

As a result, once the business grows beyond a certain complexity level you need to track all of these changes.

To do that, you track all of these "balances" on the Balance Sheet.

And then you track the adjustments to Net Income on the Cash Flow Statement.
 rsions of all the courses!

g upfront in cash

sold the products yet.

hen list what we paid

ome differ from cash generated now?

expenses yet, we get an account called "Inventory"

It's just that we can't exactly recognize

me on the IS…

nd wait to recognize the expenses, then

t real cash expenses in this period.

products and actually sell it to customers.

plies Gradually Over Time:

Month 1 Month 2 Month 3

$ 10 $ 10 $ 10
10 10 10
o place some type of "minimum order," which means that

ts our "Inventory Purchases" - we've paid for these supplies, but

em into finished products and sold them yet… so they're still
t the end of the year, and we can't recognize them as expenses.

ties & Equity: Net Income to Cash Adjustments:

Year 1 Year 2 Year 1 Year 2
Net Income: $ 195 $ 216
$ 300 $ 436 Change in Accounts Receivable: - (50)
- 50 Change in Prepaid Expenses: - (30)
- 30 Change in Inventory: - (30)
- 30 Change in Accounts Payable: - 15
$ 300 $ 546 Change in Deferred Revenue: - 15
Net Change in Cash: $ 195 $ 136

$ - $ 15 Why is the Change in Inventory a negative here?

- 15
- - Because Inventory increased, meaning we spent cash but didn't yet
300 516 record it as an expense… so it didn't reduce our Net Income, even
$ 300 $ 546 though that cash is gone.

ory" balance goes up each time the company Therefore, we need to adjust down to reflect how much cash we
pplies / parts / components upfront in cash, but can't actually generated in this period.
ze it as an expense on the Income Statement.
If Inventory decreases, it would be the opposite scenario - cash would
s when the company recognizes those expenses. increase and the Net Change in Cash would be greater than Net Income
(assuming no other changes, i.e. AR, PE, AP, and DR did not change either).
ncreasing and decreasing, but there will always be
ce if the business continues to operate. The Year 2
nce represents what the company will recognize as
COGS) in the first few months of the next year.

ness generate in this period?"…

ash generated.

ck all of these changes.

but didn't yet
come, even

rio - cash would

r than Net Income
d not change either).