Financial Statements 101

The purpose of this document is to develop a general understanding of financial statements and how these statements are used to develop valuation models. The general principles of financial statements will be presented and wherever possible linked to techniques incorporated in InValueAble.net's Intrinsic Valuation Modeler™ full financial statement approach to valuation.

Accounting is the gathering of a financial history of an organization. This requires a continual process of capturing financial data associated with operational activities, organizing this data into a useful set of accounting records and issuing periodic reports in compliance with accounting principles. There are two concentrations of accounting applied within organizations: Management Accounting (also known as Cost Accounting) used for internal decision making and Financial Accounting used for external reporting to users (investors, analysts, bankers, government, and other interested parties). Financial accounting's external reporting products are called financial statements. In the USA, financial statements are reported in accordance with Generally Accepted Accounting Principles (GAAP). In other parts of the world, financial statements are reported in accordance with International Financial Reporting Standards (IFRS). Recently, the Financial Accounting Standards Board (FASB), standard setting-body for GAAP, and the International Accounting Standards Board (IASB), standard setting-body for IFRS, have initiated a process to resolve differences between these two standards and move these standards toward convergence. This process could take many more years before it is complete, if ever. Currently, the historical financial statements for the US publicly traded firms within InValueAble.net's database and used by the Intrinsic Valuation Modeler™ to establish valuation models are based on GAAP as filed with the Securities and Exchange Commission (SEC).

Financial statements characterize the financial health of a company whereas the financial health of the company is a measure of value (or wealth) created by the firm's operations. Thus, the true nature of financial statements from an investor's perspective is to determine whether the firm is creating wealth or destroying wealth relative to its current market position. More will be discussed on this topic later. Let's introduce the financial statements used by and generated in the Intrinsic Valuation Modeler™.

There are four primary financial statements included in most companies annual reports (10-K). These are:

1. Income Statement: A statement that lists the resources aquired and consumed through an organization's operations over a time period, as expressed in terms of revenues, expenses, gains and losses, and ending with net income for the period.


2. Balance Sheet: A statement of financial position listing resources available, resources committed, and the difference between the two as expressed in terms of Assets, Liabilities, and Shareholders' Equity. The Balance Sheet is characterized by the fundamental identity:

Assets = Liabilities + Shareholders' Equity

3. Statement of Cash Flows: A statement of cash flows into and out of an organization over a period of time as classified by Operating, Investing and Financing activities. Companies may report operating activities with either the direct method (presenting cash flow in terms of their uses and sources) or indirect method (which starts with Net Income and makes adjustments in revenues not currently producing cash and expenses not currently consuming cash to get back to cash flows). The Intrinsic Valuation Modeler™ uses the indirect approach to derive the statement of cash flows.


4. Statement of Retained Earnings: A statement that reconciles the beginning-of-period and the end-of-period balances in the retained earnings account. It summarizes the effects of Net Income (earnings), dividend declarations, and prior-period adjustments. Recently, more companies are using the Statement of Shareholders' Equity instead of the Statement of Retained Earnings in their annual reports. The Statement of Shareholders' Equity contains a more detailed reconciliation of changes in the equity account. For valuation purposes, only the Statement of Retained Earnings is necessary for allocating dividends to shareholders and retained earnings to the equity account.

The diagram in Figure 1 shows a conceptual framework for the interaction of the financial statements over a period of time.

Figure 1: Financial Statement Conceptual Flow with Direct Method for Statement of Cash Flows

The diagram in Figure 1 demostrates the concept that "future economic benefits" are generated from the balance sheet through assets that generate revenue and the depletion of these assets which creates expenses and from this the Income Statement is derived. In turn, the Income Statement produces dividends to shareholders and increases retained earnings on the ending period balance sheet which is reinvested in the business in the form of assets to generate future earnings. The Statement of Cash Flows, in this case, is calculated by the direct method by directly recording the inflows and outflows of cash in the cash account and its associated sources and uses.

Figure 2: Financial Statement Conceptual Flow with Indirect Method for Statement of Cash Flows

The diagram in Figure 2 demostrates the concept that "future economic benefits" are generated from the balance sheet to produce the Income Statement. In turn, the Income Statement produces dividends to shareholders and increases retained earnings on the ending period balance sheet which is reinvested in the business in the form of assets to generate future earnings. The Statement of Cash Flows, in this case, is calculated by the indirect method by resolving inputs from the Income Statement, beginning and ending Balance Sheets, and Statement of Retained Earning to adjust Net Income into a cash flow from operations. The indirect method of determining cash flows is incorporated in the Intrinsic Valuation Modeler™ - but the method of generating Pro Forma financial statements from historical financial statements is shown in the diagram below.

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The Balance Sheet is a statement of financial position listing resources available, resources committed, and the difference between the two. It is composed of three primary categories that characterize the economic state of the firm (or entity). These are:

1. Assets: A probable future economic benefit obtained or controlled by an entity as a result of a past transaction or event. Assets are generally presented in six subcategories on the balance sheet.
• Current Assets: Are assets expected to be converted into cash and used within one year.
• Marketable Securities: Investments in other companies' stocks or bonds with the intent to sell within one year.
• Long-term Investments: Investments in other companies' stocks or bonds with the intent to hold beyond one year.
• Property, Plant and Equipment (PPE): Assets employed in the production of goods or services with a life greater than one year.
• Intangible Assets: Long-term assets that lack physical substance and arise from a right granted by goverment (patents, copyrights, trademarks, operating licenses, etc.) or by another company (franchise license). Intangibles must have been purchased in an arm's length transaction from a second party. Internally generated (organic) intangibles are expensed as incurred. Firms that undertake many acquisitions of other firms will usually exhibit high levels of Goodwill which can be the major contribution to intangibles.
• Deferred Charges: Are expeditures that have been incurred and deferred into the future because they represent an appropriate allocation of costs against future operations.


2. Liabilities: A probable future sacrifice of economic benefits arising from present obligations of an entity to transfer assets or provide services as a result of a past transaction or event. Liabilities are usually presented in two subcategories on the balance sheet.
• Current Liabilities: Obligations due in one year or less. These obligations will be satisfied out of current assets.
• Noncurrent Liabilities: Obligations with maturity greater than one year, such as Long-term Debt and Employee Benefit Plans.


3. Shareholders' Equity (Book Value of Equity or Net Worth): In essence, the difference between total assets and total liabilities, as long as Assets are valued at the present value of future economic benefits and Liabilities are valued at the present value of obligations to sacrifice economic benefits in the future; equity is the net benefit remaining for the owners of the firm. The Shareholders' Equity account is usually presented in five subcategories and a total to represent the entire account.
• Capital Stock: Total par value of all common stock issued.
• Preferred Stock: Hybrid security with dividends. Security can be converted into common stock.
• Paid in Capital (Common): Excess of par value received by the firm for all common stock issued.
• Retained Earnings: Is the accumulated earnings of the firm since its inception less dividends paid to shareholders.
• Treasury Stock: This is a contra-equity (subtracts from equity) account established under the Treasury Stock Method to facilitate a firm's purchase of its own stock to build a stock inventory that can be reissued on the market or reallocated when employees exercise their employee stock options.
• Total Equity: Is the sum of the above shareholder categories and is referred to as Shareholders' Equity. Other terms used for Shareholders' Equity are Owners' Equity, Book Value of Equity and Net Worth.

The Balance Sheet is characterized by the fundamental identity:

Assets = Liabilities + Shareholders' Equity
or as
Shareholders' Equity = Assets - Liabilities

Figure 3, below, shows the Intrinsic Valuation Modeler™ Balance Sheet format. This format is typical of all financial statements displayed by the Intrinsic Valuation Modeler™. The left most column contains the metrics (or line items) for the three balance sheet categories (Assets, Liabilities, and Shareholders' Equity) and their subcategories. Across the top of the spreadsheet is listed the fiscal years representing the balance sheets contained within the spreadsheet columns and is further divided into two sections: Historical and Projected. Historical refers to all columns to the left of the light-blue shaded field (Projected section) and represents the historic balance sheets as filed with the SEC (10-K: Annual Reports) by the firm being modeled. The Projected section, colored in light-blue, represents the forecasted (pro forma) balance sheets generated by applying the appropriate ratios from the "forecast ratios" page multiplied by a value driver (sales, cost of goods sold, average debt, etc.) to produce the values in the spreadsheet. More will be discussed on the Intrinsic Valuation Modeler™ generation of financial statements later in this overview.

Some account information has been consolidated to make the balance sheet, and other financial statements within Intrinsic Valuation Modeler™, into a more generic format in order to maintain a common format for all companies. It should be noted that all numbers in the spreadsheet in Figure 3 are in thousands as represented by "in $000s" in the Header of the spreadsheet. Thus, a number represented as 14,218,613 in the spreadsheet is actually 14,218,613,000.

Figure 3: Balance Sheet as presented in the Intrinsic Valuation Modeler™

Other features to be highlighted in Figure 3 are:

1. Firm Being Modeled: This field shows the active firm loaded into the Intrinsic Valuation Modeler™.
2. Ticker Input Field: This field allows the user to input a company's ticker (ie "goog", "aapl", "sbux", "ge", and over 5000 more tickers) in order to load that company's historical financial statements into the Intrinsic Valuation Modeler™ where the default valuation model will be generated for the company.
3. Intrinsic Value per Share: The Intrinsic Value per share is based on the Free Cash Flow to Equity (FCFE) Model using the current model parameters as defined in the "Projected" input section of the "Forecast Ratios" tab and calculated based on the discounted cash flow (dcf) and residual income (ri) valuation approaches.
4. Market Price per Share: If the user is connected to the internet, the Intrinsic Valuation Modeler™ will retrieve a recent market price per share for the Firm being Modeled. During market hours on a trading day (US Markets), the market price will reflect a 20 minute delayed quote. Otherwise, market price will reflect the close price on the last trading day.
5. Cost of Equity and Forecast Horizon Input Fields: These fields can be changed by the user. The Cost of Equity is set at a default value of 10% and is the factor used to discount the cash flows in the FCFE model. The Forecast Horizon field allows the user to define a period from 3 to 20 years. Forecast Horizon is defined as the time period required for a firm to reach steady-state cost structure, capital structure and sales growth.
6. Valuation Date: All new valuations are determined to Today's Date unless changed by the user. The date can be changed by clicking on the date field to bring up a calendar. Select the desired valuation date and then close the calendar window by clicking on the X box in the right hand corner of the calendar window to continue modeling.
7. Statement Date: Statement Date refers to the last fiscal year-end financial statements date in InValueAble.net's historical database for the firm being valued.

These features are standard for the Intrinsic Valuation Modeler™ environment. Also, all financial statements are accessible from the Financial Statements tab. There are four toggle-links at the top of the Financial Statements page (Income Statement, Balance Sheet, Cash Flows, and Retained Earnings). These toggle-links allow the user to activate or deactivate a statement just by clicking on the appropriate link. The user can chose to have only one statement displayed, any combination of statements displayed or all statements displayed simultaneously.

Figure 4, below, displays an enlarged version of the balance sheet metrics.

Figure 4: Balance Sheet Line Items as presented in the Intrinsic Valuation Modeler™

A brief explanation of the line items in Figure 4 is provided below.

1. Assets:
• Operating Cash and Marketable Securities: Cash is money in the form of currency or deposits and marketable securities are investments in short-term assets. Internally, firms employ cash management practices and models, such as the Miller-Orr model to efficiently manage their cash positions.
• Receivables: Amounts due from customers in payment of goods delievered or services rendered by the firm.
• Inventories: Stockpile of goods to be used in the firm's operations.
• Other Current Assets: These are usually Prepaid Expenses and Deferred Income Taxes.
• Total Current Assets: Sum of the line items above.
• Property, Plant and Equipment: Represents the land, buildings, manufacturing equipment, vehicles and other assets employed to the firm's economic advantage.
• Investments: These are equity holdings owned by the firm in other companies.
• Intangibles: Long-term assets that lack physical substance and arise from a right granted by goverment (patents, copyrights, trademarks, operating licenses, etc.) or by another company (franchise license). Intangibles must have been purchased in an arm's length transaction from a second party. Internally generated (organic) intangibles are expensed as incurred. Firms that undertake many acquisitions of other firms will usually exhibit high levels of Goodwill which can be the major contribution to intangibles.
• Other Assets: Some firms may include long-term receivables, pension assets or even patents, trademarks and other intangibles if not deemed significant to itemize separately.


• Total Assets: Sum of the line items between Total Current Assets and Other Assets as listed above.


2. Liabilities:
• Current Debt: Debt maturing in less than one year.
• Accounts Payable: Represents the amount owed to suppliers for goods previouly delivered or services previously rendered.
• Income Tax Payable: This line item is an accrued liability that captures the accumulated tax obligation that has occurred in the course of the firm's economic transactions until it is partially reduced through periodic payments in compliance with the tax code.
• Other Current Liabilities: Represents accrued liabilities for wages, rent and other delayed expense items.
• Total Current Liabilities: Sum of the current liabilities.
• Long-term Debt: Represents debt and bonds issued with maturity greater than one year.
• Other Liabilities: Represents unearned revenues, employee benefit plan liabilities, etc.
• Deferred Taxes: Represents the timing differences between the accelerated depreciation of an asset for tax purposes and the useful life of the asset for production purposes.
• Minority Interest: Represents the firm's partial ownership (less than 50% ownership) in other companies.


• Total Liabilities: Sum of the line items between Total Current Liabilities and Minority Interest as listed above.


3. Shareholder Equity:
• Preferred Stock: Hybrid security with dividends. Security can be converted into common stock.
• Paid in Common Capital (Net): Net value of common stock at par, paid in capital, treasury stock, and unrealized gains and losses.
• Retained Earnings: Represents the cumulative earnings of the firm net of any cumulative dividend distributions.
• Total Common Equity: Sum of Paid in Common Capital (net) and Retained Earnings.


• Total Liabilities and Equity: Sum of Total Liabilities, Preferred Stock and Total Common Equity.

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The Income Statement lists the resources aquired and consumed through an organization's operations over a time period, as expressed in terms of revenues, expenses, gains and losses, and ending with net income for the period. Figure 5, below, shows the Intrinsic Valuation Modeler™ Income Statement format.

Figure 5: Income Statement as presented in the Intrinsic Valuation Modeler™

Figure 6, below, displays an enlarged version of the Income Statement metrics.

Figure 6: Income Statement Line Items as presented in the Intrinsic Valuation Modeler™

A brief explanation of the line items in Figure 6 is provided below.

1. Sales: Represents the net of gross sales reduced by cash/trade discounts and returned sales and allowances.
2. Cost of Goods Sold (COGS): Represents all costs allocated to production for the period.
3. Gross Profit: Calculated as Sales (net) plus Cost of Goods Sold (where COGS is represented as a negative value in the Intrinsic Valuation Modeler™.
4. Research and Development (R&D): Represents all costs allocated to the development of new products and services.
5. Sales, General and Administrative: Represents all other expenses not allocated to COGS or R&D for the period. These expenses are marketing, sales staff, distribution costs, staff salaries, executive salaries, office equipment depreciation, and other expenses.
6. EBITDA: Represents the Earnings before interest, taxes, depreciation and amortization. Calculated as Gross Profit plus R&D plus SG&A where R&D and SG&A are represented as negative values in the Intrinsic Valuation Modeler™.
7. Depreciation and Amortization: Represents non-cash charges for the periodic write-off of PP&E and Intangibles.
8. EBIT: Represents the Earnings before interest and taxes. Calculated as EBITDA plus Depreciation and Amortization where Depreciation and Amortization are represented as negative values in the Intrinsic Valuation Modeler™.
9. Interest: Depending on how the firm reports its interest in the annual report this could represent just interest expense on debt (negative value) or net interest (interest expense net of interest income - could be positive [interest income is greater] or negative value [debt interest expense is greater]).
10. Non-Operating Income: Represents net amount of income or expense items not directly related to the normal business operations of the firm.
11. EBT: Represents the Earnings before taxes and is used as the denominator in historical financial statements to determine the effective tax rate. Calculated as EBIT plus Interest expense plus Non-Operating Income.
12. Income Tax: Effective tax paid on EBT and represents all taxes imposed by federal, state and foreign taxing entities. Is represented as a negative value in the Intrinsic Valuation Modeler™.
13. Minority Interest: Represents the portion of income from consolidated subsidiaries that is attributable to minority stockholders in the subsidaries.
14. Other Income: Represents miscellaneous non-operating income or expenses that are reported on a after tax basis.
15. Net Income Before Extra Items: Measure of the firm's operational performance before extra items and preferred dividends are considered.
16. Extra Items: Represents income statement effects of extraordinary items, discontinued operations, and accounting changes.
17. Preferred Dividends: Represents total value of dividends paid or to be paid on preferred stock.
18. Net Income to Common: Represents total earnings to common stockholders. Calculated as Net Income Before Extra Items plus Extra Items (negative value) plus Preferred Dividends (negative value).

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The Statement of Cash Flows reports the cash into and out of an organization over a period of time as classified by Operating, Investing and Financing activities. Companies may report operating activities with either the direct method (presenting cash flow in terms of their uses and sources) or indirect method (which starts with Net Income and makes adjustments in revenues not currently producing cash and expenses not currently consuming cash to get back to cash flows). The Intrinsic Valuation Modeler™ uses the indirect approach to derive the statement of cash flows. Figure 7, below, shows the Intrinsic Valuation Modeler™ Statement of Cash Flows format.

Figure 7: Statement of Cash Flows as presented in the Intrinsic Valuation Modeler™

Figure 8, below, displays an enlarged version of the Statement of Cash Flows metrics.

Figure 8: Statement of Cash Flows Line Items as presented in the Intrinsic Valuation Modeler™

A brief explanation of the line items in Figure 8 is provided below.

1. Cash from Operations:
• Net Income: Calculated on the Income Statement.
• + Depreciation and Amortization: Period Depreciation and Amortization costs.
• + Increase in Deferred Taxes: Balance Sheet Beginning period minus Ending period Deferred Taxes.
• + Increase in Other Liabilities: Balance Sheet Beginning period minus Ending period Other Liabilities.
• + Increase in Minority Interest: Balance Sheet Beginning period minus Ending period Minority Interest.
• + Preferred Dividends: Period Preferred Dividend obligations.
• = Funds From Operations: Funds generated by the production or service activities of the firm.
• - Increase in Receivables: Balance Sheet Beginning period minus Ending period Receivables.
• - Increase in Inventories: Balance Sheet Beginning period minus Ending period Inventories.
• - Increase in Other Current Assets: Balance Sheet Beginning period minus Ending period Other Current Assets.
• + Increase in Accounts Payable: Balance Sheet Beginning period minus Ending period Accounts Payable.
• + Increase in Taxes Payable: Balance Sheet Beginning period minus Ending period Taxes Payable.
• + Increase in Other Current Liabilities: Balance Sheet Beginning period minus Ending period Other Current Liabilities.
• = Cash From Operations: Net cash provided by Operating Activities.


2. Cash From Investing:
• Current Debt: Ending period Current Debt.
• - Capital Expenditures: Balance Sheet Beginning period minus Ending period PP&E.
• - Increase in Investments: Balance Sheet Beginning period minus Ending period Investments.
• - Purchases of Intangibles: Balance Sheet Beginning period minus Ending period Intangibles.
• - Increase in Other Assets: Balance Sheet Beginning period minus Ending period Other Assets.
• = Cash From Investing: Net cash provided by Investing activities.


3. Cash From Financing:
• + Increase in Debt: Balance Sheet Beginning period minus Ending period debt (current and long-term).
• - Dividends Paid on Preferred: Period Preferred Dividend obligations.
• + Increase in Preferred Stock: Balance Sheet Beginning period minus Ending period Preferred Stock.
• - Dividends Paid on Common Stock: Period Dividends on Common Stock.
• + Net Common Stock Issued: Balance Sheet Beginning period minus Ending period Equity.
• +/- Clean Surplus: Prior period equity adjustments; ignore for valuation purposes.
• = Cash From Financing: Net cash provided by Financing activities.


4. Cash Balance:
• + Beginning Cash Balance: Cash balance from Beginning Period Balance Sheet.
• + Net Change in Cash: Sum of Cash from Operations, Investing and Financing.
• = Ending Cash Balance: Sum of Beginning Cash Balance and Net Change in Cash.

The calculation of Free Cash Flow to Equity is the heart of the Intrinsic Valuation Modeler™ valuation methodology. This calculation is shown at the bottom of the Statement of Cash Flows and is shown in Figure 9, below. Three different methods are used to calculate Free Cash Flow to Equity and each method has insight into how value can be generated and transferred to equity holders.

Figure 9: Free Cash Flow to Equity as presented in the Intrinsic Valuation Modeler™

Figure 10, below, displays an enlarged version of the Free Cash Flow to Equity metrics.

Figure 10: Free Cash Flow to Equity Line Items as presented in the Intrinsic Valuation Modeler™

A brief explanation of the line items in Figure 10 is provided below.

1. Free Cash Flow to Common Equity (Operations Approach):
• Net Income: Calculated on the Income Statement.
• - Net Increase in Common Equity: Balance Sheet Beginning period minus Ending period Equity.
• +/- Clean Surplus: Prior period equity adjustments; ignore for valuation purposes.
• = Free Cash Flow to Common Equity


2. Free Cash Flow to Common Equity (Investments Approach):
• + Cash From Operations: Calculated on Statement of Cash Flows.
• - Increase in Operating Cash: Balance Sheet Beginning period minus Ending period Operating Cash.
• + Cash From Investing: Calculated on Statement of Cash Flows.
• + Increase in Debt: Balance Sheet Beginning period minus Ending period debt (current and long-term).
• - Dividends Paid on Preferred: Period Preferred Dividend obligations.
• + Increase in Preferred Stock: Balance Sheet Beginning period minus Ending period Preferred Stock.
• +/- Clean Surplus: Prior period equity adjustments; ignore for valuation purposes.
• = Free Cash Flow to Common Equity


3. Free Cash Flow to Common Equity (Financing Approach):
• + Dividends Paid on Common Stock:: Period Dividends on Common Stock.
• - Net Common Stock Issued: Balance Sheet Beginning period minus Ending period Equity.
• = Free Cash Flow to Common Equity

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The Statement of Retained Earnings reconciles the beginning-of-period and the end-of-period balances in the retained earnings account. It summarizes the effects of Net Income (earnings), dividend declarations, and prior-period adjustments.

Figure 11: Statement of Retained Earnings as presented in the Intrinsic Valuation Modeler™

A brief explanation of the line items in Figure 11 is provided below.

1. Beginning Retained Earnings: Start of period total accumulated earnings not distributed as dividends.
2. + Net Income: Calculated on the Income Statement.
3. - Common Dividends: Period Dividends on Common Stock.
4. +/- Clean Surplus: Prior period equity adjustments; ignore for valuation purposes.
5. = Ending Retained Earnings: End of period total accumulated earnings not distributed as dividends.

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The diagram in Figure 12 shows the concept that future (Pro Forma) financial statements can be generated from the previous period's financial statements. This is accomplished by reformulating the previous period's financial statements into ratio statements based on the key driver of that financial statement line item (metric). The Intrinsic Valuation Modeler™ incorporates this techniques on its Forecast Ratios page and is shown below.

Figure 12: Financial Statement Conceptual Flow as implemented in the Intrinsic Valuation Modeler™

The Forecast Ratios page formulates historic and projected financial statements in the form of ratios that are used to generate future financial statements (Income Statement and Balance Sheet; other statements are derived from these two statements for valuation modeling purposes). The ratios consist of the term to be modeled (sales, cost of goods sold, SG&A, etc.) which is in the numerator divided by a key driver (in the denominator) that has the most influence on that term. Figure 13, below, shows the Intrinsic Valuation Modeler™ Forecast Ratios page.

Figure 13: Forecast Ratios page as presented in the Intrinsic Valuation Modeler™

The diagram in Figure 13 shows the concept that future (Pro Forma) financial statements can be generated from the previous period's financial statements. This is accomplished by reformulating the previous period's financial statements into ratio statements based on the key driver of that financial statement line item (metric). The Intrinsic Valuation Modeler™ incorporates this techniques on its Forecast Ratios page and is shown below.

Figure 14, below, displays an enlarged version of the Forecast Ratio metrics.

Figure 14: Forecast Ratios Line Items as presented in the Intrinsic Valuation Modeler™

The ratios in the historical portion of the Forecast Ratios page are generated from the historic financial statements of the firm. The Projected ratios are derived from the historical ratios and used to calculate the Projected Financial Statements. It should be noted that the Intrinsic Valuation Modeler™ uses a sales-driven approach to generating the financial statements. This means that Sales is the major driver (either directly or indirectly) for the majority of the items on the Income Statement and Balance Sheet. So, sales is always the first item to be modeled in the financial statements. The left-most Sales cell in the Projected field should be modeled first, since subsequent year Sales are dependent on previous year's Sales. Thus, edit the Sales row from left to right up to the terminal year. For editing the projected financial statements, you should apply the following process (valid for either ratio editing or direct financial statement editing):

1. Select the proper forecast horizon
2. Model the Sales cells from left to right up to the terminal year
3. Model all Balance Sheet cells (if modeling on the Forecast Ratios page also known as "Assets and Liabilities relative to operation" and "Leverage and Other non-Common Interest")
4. Model all Income Statement cells to complete the modeling process (if modeling on the Forecast Ratios page also known as "Margin Structure and non-Common Impacts to Earnings")

This process must be followed for direct financial statement editing since some income statement items are dependent on balance sheet values (Depreciation & Amortization is dependent on Average PPE and Intangibles; Interest Expense is dependent on Average Debt). For ratio editing, this approach is optional but is still a good practice to follow. The line items in Figure 14 are briefly discussed below as to the actions that take place in order to generate the values in the financial statements.