Financial statements that balance: earnings, cash and valuation

Learning goals

• Reconcile an income statement, two balance sheets and cash flows before using ratios.
• Distinguish accounting earnings, financing choices and cash available to investors.
• Write a reasoned conclusion with explicit assumptions and follow-up evidence.

Draft · approximately 90 minutes, excluding further revision.

Case file: two year-end balance sheets

The fictional manufacturer Lotus Components reports in millions of currency units. Opening balances: cash 80, trade receivables 120, inventory 100 and net property/plant/equipment (PPE) 400; total assets 700. Trade payables are 90, interest-bearing debt 250 and equity 360; liabilities plus equity are 700. Closing balances: cash 60, receivables 160, inventory 140 and net PPE 460; total assets 820. Payables are 110, debt 290 and equity 420; liabilities plus equity are 820. There are no other accounts.

Current-year sales are 1,000 (prior year 900), all on credit. Cost of goods sold is 600. Other operating expenses excluding depreciation are 220; depreciation is 40. Interest expense and cash interest paid are both 20. Income tax expense and cash taxes are both 30; the applicable tax rate is 25%. Cash capital expenditure is 100, net cash borrowing 40 and cash dividends 30. No disposals, acquisitions, foreign exchange effects, share issuance, lease additions, impairments or other comprehensive income occur. Inventory purchases are all on trade credit; there are no opening/closing interest or tax accruals.

Reporting convention: this teaching case uses the 2026 pre-IFRS-18 indirect presentation with interest and tax paid classified as operating cash flows and dividends paid as financing cash flows. This is an explicit case policy, not a universal rule for every jurisdiction or the 2027 curriculum. IFRS 18 applies to annual periods beginning on or after 1 January 2027, permitting earlier adoption; consequential IAS 7 amendments change the indirect-method starting subtotal and interest/dividend classification requirements. Check the reporting period and adopted framework before comparing companies.

Rebuild earnings and explain every bridge

Gross profit = 1,000 − 600 = 400; EBITDA = 400 − 220 = 180; EBIT = 180 − 40 = 140; profit before tax = 140 − 20 = 120; net income = 120 − 30 = 90. EBITDA is an analytical subtotal here; it is not a substitute for operating cash flow. Equity reconciles as 360 + 90 − 30 = 420. Net PPE reconciles as 400 + 100 − 40 = 460. Each bridge uses the stated absence of other changes.

Operating working capital excludes cash and interest-bearing debt: receivables + inventory − payables. It rises from 130 to 190, absorbing 60 of cash. CFO = net income 90 + depreciation 40 − increase in receivables 40 − increase in inventory 40 + increase in payables 20 = 70. Adding depreciation reverses a noncash expense; it does not create cash or erase the cash spent on replacement assets.

Cash flow from investing is −100 and from financing is 40 − 30 = 10. Total cash change = 70 − 100 + 10 = −20; opening cash 80 becomes 60. Under these assumptions, collections = sales − increase in receivables = 960. Inventory purchases = cost of goods sold + increase in inventory = 640; cash paid to suppliers = purchases − increase in payables = 620. The direct check is 960 − 620 − 220 − 20 − 30 = 70.

Ratios with defensible denominators

Use arithmetic averages of opening and closing stocks because income and sales span a year: average assets 760, average equity 390. Net margin = 90/1,000 = 9%; asset turnover = 1,000/760 = 1.3158; equity multiplier = 760/390 = 1.9487. DuPont ROE = 9% × 1.3158 × 1.9487 = 23.0769%, matching 90/390. ROA = 90/760 = 11.8421%. A higher ROE can come from leverage rather than better operations.

Assume a 365-day year. DSO = average receivables 140 / sales 1,000 × 365 = 51.10 days. DIO = average inventory 120 / COGS 600 × 365 = 73.00 days. With the stated convention of COGS as the DPO denominator, DPO = average payables 100 / 600 × 365 = 60.83 days; CCC = 63.27 days. If purchases 640 are used instead for DPO, it becomes 57.03 and CCC 67.07 days. Label the denominator and keep it consistent across peers. Two endpoint averages can miss seasonality.

Free cash flow is not the dividend

Assume interest is deductible at 25%, its tax shield is usable now and debt cash flows are separate. FCFF = EBIT(1 − tax rate) + depreciation − capex − increase in operating working capital = 140×0.75 + 40 − 100 − 60 = −15. Reconcile from CFO: 70 + 20×0.75 − 100 = −15. FCFE = CFO − capex + net borrowing = 70 − 100 + 40 = 10. Reconcile FCFE = FCFF − after-tax interest + net borrowing = −15 − 15 + 40 = 10.

Dividends of 30 exceed FCFE of 10 by 20, matching the fall in cash. This is feasible once but does not prove a sustainable payout. Negative current FCFF can reflect growth investment; it does not alone imply negative enterprise value. Do not capitalize this one year mechanically. Forecast investment, margins, working capital and financing with a consistent horizon and discount rate.

Challenge earnings quality without inventing misconduct

Receivables rise 33.33% versus sales growth 11.11%, while CFO/net income is 70/90 = 0.7778. These are prompts to investigate collection timing and sales terms, not proof of fictitious revenue. Ask for receivables aging, post-year-end receipts, credit notes, return rights, inventory aging, supplier terms and cash-flow classification notes. Distinguish a legitimate growth investment from recurring weak cash conversion.

Sensitivity: hold all other income-statement items, tax cash flows, capex and financing fixed, but assume closing receivables are 180 instead of 160. Additional working-capital absorption is 20; CFO falls to 50, FCFF to −35 and FCFE to −10. Closing cash becomes 40. The extra receivable and lower cash offset in total assets. This is a timing scenario, not an automatic expense or an instruction to recognize impairment without evidence.

Separate contract exercise: cash received is not all revenue

This exercise is independent of the financial statements above. A separate contract charges 1,080 cash upfront for equipment delivered immediately and three years of distinct maintenance. Standalone selling prices are 900 for the equipment and 300 for all maintenance. Assume no financing component, variable consideration, returns or other obligations; maintenance transfers evenly and one full year has elapsed. Allocate the discount proportionally: equipment 1,080×900/1,200 = 810; total maintenance 270. First-year revenue = 810 + 270/3 = 900; remaining contract liability = 180.

The IFRS 15 framework ties revenue to satisfying the identified performance obligations and allocating transaction consideration, not merely collecting cash. The example fixes the obligations and transfer pattern; a real contract requires examining its terms before making those judgments. Do not add this separate exercise to Lotus’s figures.

Write the analyst memo

Model response: Lotus earns 90 but generates 70 of operating cash because 60 is invested in operating working capital after adding back 40 depreciation. Capex of 100 leaves FCFF of −15. Net borrowing of 40 supports FCFE of 10; dividends of 30 consume a further 20 of cash. ROE of 23.08% uses average equity and includes financial leverage. Investigate receivables growth and cash collection before extrapolating margins. A single synthetic year and endpoint averages cannot establish sustainable growth, fraud, fair value or an investment recommendation.

Self-check before seeing the answers: show both cash-flow bridges, the DuPont identity, FCFF from two starting points and the downside receivables scenario. State the reporting convention and distinguish the independent revenue exercise. A correct number without units, assumptions or interpretation is an incomplete analysis.

Formula and assumptions

CFO = NI + D&A − ΔAR − Δinventory + ΔAP; FCFF = CFO + interest(1−T) − capex; FCFE = CFO − capex + net borrowing

Reconciliation checklist

1. Check assets equal liabilities plus equity at both dates: 700 and 820.
2. Rebuild EBIT 140, net income 90, CFO 70 and ending cash 60; never use balancing cash as an unexplained plug.
3. Calculate FCFF −15, FCFE 10 and ROE 23.0769%; explain the difference between profit and distributable cash.

Errors to catch

• Double-counting depreciation or treating a rise in receivables as cash income.
• Mixing beginning equity, ending assets and annual averages without explaining the convention.
• Assuming reported cash-flow classifications are identical before and after IFRS 18 or across frameworks.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.ifrs.org
• Reference · www.ifrs.org
• Reference · www.ifrs.org