CFA topics - financial reporting and analysis (iv)

Having known what the three financial statements are and having understood how the three statements are linked, the next step is to understand the key items on financial statements.

Apparently there are many important items on the financial statement, and I cannot go through each and every single one in this post. Do leave a comment if you have question on any particular financial terminologies. In this post, I will introduce a selected few key items:

EBITDA (income statement): Earnings before interest, tax, depreciation and amortization. It is a proxy of the operating cashflow of a company, that can be used for capital expenditure and distribution to lenders / shareholders. 

By ignoring interest, tax, and depreciation, EBITDA allows financial analysts to compare the profitability of companies with different leverage ratios, different tax structures, or different depreciation policy. A more in-depth explanation can be found on investopedia.

EBIT (income statement): Earnings before interest and tax. Similar to EBITDA, but the difference is that EBIT includes depreciation and amortization. EBIT is commonly referred to as the "operating profit" of a company.

Working capital change (cashflow statement)

Working capital = operating current asset – operating current liabilities
Working capital change = increase in op. current asset – increase in op. current liabilities

An example. Company A sold a car to Company B for USD 500 on credit on 15th December 2015. Two accounting entries are: i) revenue increases USD 500, and ii) account receivables increases USD 500.

As at YE 2015, Company B has not settled the bill: no cash received, no account entries. So, in Company A's 2015 income statement, you are going to see a USD 500 operating profit. However, Company A’s operating cashflow should be zero (and logically so because Company A has not received any cash by year end).

How did I arrive at an operating cashflow of zero? I adjust Company A’s EBIT for working capital change. Since account receivables increases by USD 500 (while other current assets / liabilities remain unchanged), working capital change is USD 500.

Operating cashflow = EBITDA – tax – working capital changes

Assume, for simplicity, there is no tax and no depreciation expense; then operating cashflow = USD 500 – USD 0 – USD 500 = USD 0. If you want another case study on working capital changes, I’d recommend you take a look at investopedia.