Part one of this series covered the basics of accounting: (i) the three most common financial statements, (ii) major line items on each financial statement, and (iii) how the three statements flow together. This article extends those lessons to focus on: (i) the nuances of the direct and indirect method of the cash flow statement, (ii) which financial statement might be considered the most important, and (iii) a practical example of how a change in depreciation might impact all three statements. The information covered herein are baseline real estate private equity skills. If you are interviewing for a real estate private equity job, you should be able to answer each of these questions cold.
Can you please explain the difference between the direct and indirect method for cash flow statements?
There are two methods to prepare a cash flow statement: the direct method and the indirect method. The direct method, though intuitive, is painful for anything but small companies to report and is thus far less common. The direct method begins with revenues and works its way down through expenses to arrive at net cash flow. It is called the direct method because it only considers cash transactions along the way.
The indirect method is far more common. The indirect method picks up where the income statement finishes: net income. Starting with net income, the indirect method adjusts for non-cash items such as depreciation, amortization, and unrealized gains. The indirect method is the quickest and easiest for accountants to calculate.
Which single financial statement is the most important to assess the health of a company?
The statement of cash flows is the single most important financial statement because it eliminates all of the accruals and non-cash items and shows how much cash the company is generating. Cash pays bills, services debt, and compensates investors. The cash flow statement also explains the hidden ways cash can be used up or freed up, or financing strategies that may mask the core operation’s ability to generate cash. In lay terms, you can get fancy with reported profits, but you cannot get fancy with cash.
How would a $10 increase in depreciation affect the financial statements?
As always, I will follow the flow of this change in the order of income statement to cash flow statement to balance sheet.
First on the income statement, a $10 increase in depreciation would decrease pre-tax income by $10. Assuming a 40% tax rate, post-tax net income would decrease by $6. Second, at the top of the cash flow statement, I would adjust net income by $10 for a net change in cash of $4. Finally, on the balance sheet, cash would be up $4 per the cash flow statement and my assets would be depreciated by $10 for a net change in assets of negative $6. On the other side, my shareholder equity would decrease by the $6 reduction in net income. Thus, my balance sheet balances and both sides are down $6.
Learn with Leveraged Breakdowns
Leveraged Breakdowns teaches the core real estate private equity skills you need to stand apart from the competition. Real estate private equity jobs are competitive and require ample preparation. From accounting advice to crash-course lessons in LBO modeling essentials, Leveraged Breakdowns has everything you need to take your career prep to the finish line.