Breaking Into Wall Street - The 3 Financial Statements

($ in Thousands)

Concept: Now, we have a great idea to expand our business: we're going to add a monthly subscription service to the site

Idea is to offer interviews with experts and case studies each month to help students (you!) get more practice.

And although it's a monthly service, we have another brilliant idea: you'll only be able to pay for it with an ANNUAL or QUA
that you purchase upfront…

So you pay us upfront for 3 months or 12 months of membership to this new service… great for us, not as great for you.

This is another very common scenario: customers pay upfront for a product or service that gets delivered later on.

Think about: Your smartphone (if it's locked to a contract and subsidized by the carrier), insurance, annual subscriptions,
cable bills, gym memberships, and the list goes on.

And it's yet another "hole" in our assumption that Net Income = Cash Generated.

Now, we're collecting CASH from customers… but we can't record it as revenue! No product/service delivered yet!

Question: How does this affect the cash generated from this business? How does Net Income differ from cash generated n

If we're collecting cash payments from customers but can't recognize them as revenue, we get an account called "Deferred
that we also have to track over time.

If this "Deferred Revenue" goes UP, our cash also goes UP because we're getting cash money! It's just that we can't exactly
it as revenue yet… but our bank account is still going up.

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

On the other hand, if we HAVE a Deferred Revenue balance and then stop collecting cash payments, waiting to recognize t
the balance falls and cash generated will be LESS than Net Income…

Because we've *already* collected it in cash - revenue we recognize now doesn't actually arrive in cash form!

Here's an example of what happens:

Let's say we really do start this subscription business… but we decide to be nice and only ask for quarterly payments for ea

We get a good number of customers, and around $5,000 per month in subscription revenue coming in…

Deferred Revenue for Subscription Services: Paying for Subscription Services Each Month i
 Month 1 Month 2 Month 3
Cash Received: $ 15 $ - $ - Cash Paid:
Revenue Recognized: 5 5 5 Expense Recorded:

Big difference! Better for us, not as good for our new subscription customers…

Tax Rate: 40.0%

Subscription Revenue Paid Upfront in Cash: $ 15 <--- This represents the amount of quarterly paym
Operating Expenses Paid in Cash Later On: $ 15 that have NOT yet been recognized as revenue at
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% Prepaid Expenses:
Total Assets:
Operating Expenses:
Sales & Marketing: 150 165 Liabilities & Equity:
Research & Development: 75 75 Accounts Payable:
General & Administrative: 50 50 Deferred Revenue:
Total Operating Expenses: 275 290 Debt:
Equity:
Operating Income (EBIT): 305 340 Total Liabilities & Equity:
Operating Margin: 46.9% 48.6%
The "Deferred Revenue" balance goes up e
Other Income / (Expenses): 20 20 receives cash from customers but cannot re
Interest Income / (Expense): - - the Income Statement.

Pre-Tax Income (EBT): 325 360 It decreases when the company records it a

Income Taxes: (130) (144) It's always going up and down, but there wi
balance as long as the business continues to
Net Income (Profit After Taxes): $ 195 $ 216 revenue at different times. The balance at t
Net Income Margin: 30.0% 30.9% what the company will record as revenue in

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 that stops being true once the business gets more complex. Common "holes" include customers NOT paying upfron
company PREPAYS for expenses upfront, and when the company *delays* payment of expenses for products/services t
have already been delivered… and when the company COLLECTS cash but does not record it as revenue (the scenario h

Examples: Customers paying for a monthly subscription a year in advance… or paying for a product or service even a fe
weeks, or days in advance and then getting it delivered later on.

When this happens, we create a "Deferred Revenue" line item - and it's common for companies in almost all industries.

Here, we've assumed that we're getting cash upfront from customers who sign up for our monthly subscription service
work and products that we deliver in the future.

End Result: Our cash balance goes up by MORE than the Net Income in this period.

If this keeps happening over time, it's going to create an ongoing difference between our profits and how much cash we

And that is going to impact how we run the business, how much it's worth, and how we plan for the future.
 subscription service to the site!

) get more practice.

ay for it with an ANNUAL or QUARTERLY subscription

t for us, not as great for you.

gets delivered later on.

surance, annual subscriptions,

ct/service delivered yet!

me differ from cash generated now?

get an account called "Deferred Revenue"

ey! It's just that we can't exactly recognize

e on the IS…

ayments, waiting to recognize the revenue, then

rrive in cash form!

k for quarterly payments for each 3 months of service.

e coming in…

scription Services Each Month in Cash:

 Month 1 Month 2 Month 3
$ 5 $ 5 $ 5
5 5 5

ts the amount of quarterly payments for monthly subscriptions

been recognized as revenue at the end of the year.

ties & Equity: Net Income to Cash Adjustments:

Year 1 Year 2 Year 1 Year 2
Net Income: $ 195 $ 216
$ 300 $ 466 Change in Accounts Receivable: - (50)
- 50 Change in Prepaid Expenses: - (30)
- 30 Change in Accounts Payable: - 15
$ 300 $ 546 Change in Deferred Revenue: - 15
Net Change in Cash: $ 195 $ 166

$ - $ 15 Why is the Change in Deferred Revenue (DR) a positive here?

- 15
- - Because DR went up - when it goes up, that means that we COLLECTED
300 516 the cash but didn't record it as revenue… so therefore it didn't hit Net Income,
$ 300 $ 546 even though we received cash from customers.

ed Revenue" balance goes up each time the company Therefore, we need to adjust up to reflect how much cash we
h from customers but cannot record it as revenue on actually generated in this period.

If DR decreases, it would be the opposite scenario - cash would

when the company records it as revenue. decrease and the Net Change in Cash would be less than Net Income
(assuming no other changes, i.e. AR, PE, and AP did not change either).
oing up and down, but there will always be SOME
ong as the business continues to collect cash and recognize
different times. The balance at the end of Year 2 represents
mpany will record as revenue in the next few months.

ess generate in this period?"…

e customers NOT paying upfront, when the

expenses for products/services that
ord it as revenue (the scenario here).

r a product or service even a few months,

mpanies in almost all industries.

ur monthly subscription service - for

r profits and how much cash we're actually saving up.

plan for the future.

t we COLLECTED
it didn't hit Net Income,

an Net Income
t change either).