Linking the 3 Statements to a DCF
Understand exactly how the Income Statement, Cash Flow Statement, and Balance Sheet flow into unlevered free cash flow — the engine of every DCF valuation.
Analyst Objective
Learn exactly how each statement feeds FCFF — the core driver of DCF valuation.
What You’ll Learn in This Lesson
1Income Statement → DCF
The Income Statement tells us how much profit the business generates, but a DCF requires unlevered free cash flow, not accounting earnings. This section shows the exact pathway from the IS to NOPAT and FCFF.
Why the Income Statement Matters for a DCF
• The Income Statement produces EBIT (Earnings Before Interest and Taxes), the starting point for NOPAT.
• DCF valuation uses EBIT(1 – Tax Rate) — because FCFF is pre-financing and excludes capital structure decisions.
• Non-cash charges like D&A appear on the IS but are added back in the CFS when converting to cash.
What is NOPAT and Why Do We Use It?
NOPAT stands for Net Operating Profit After Tax. It represents the profits a company generates from its core operations, after paying taxes, but before any financing costs (like interest expense).
Why NOPAT instead of Net Income?
Net income includes the effects of how a company is financed (interest on debt, etc.). But in a DCF, we want to value the entire business regardless of how it's financed. This is called an "unlevered" valuation.
NOPAT gives us operating profits after tax, but ignores capital structure — perfect for FCFF.
Think of it this way:
If you're valuing a company, you care about the cash the business generates, not whether it's funded with debt or equity. NOPAT isolates operating performance from financing decisions.
NOPAT Formula (Banker Format)
EBIT× (1 − Tax Rate)= NOPAT
Translation: Operating profit after paying taxes, but before interest expense
Numeric Example — IS → NOPAT
Revenue = 400M
EBIT Margin = 18%
EBIT = 72M
Tax Rate = 25%
NOPAT = 72 × (1 − 0.25) = 54M
This 54M represents the after-tax operating earnings available to all investors (debt and equity holders)
Common Interview Mistake
Never start FCFF from Net Income. Net Income includes interest expense, which makes it "levered" (affected by capital structure). Always start from EBIT × (1 − T) to get truly unlevered cash flow.
Starting Point: Income Statement
The Income Statement shows profit, but DCF requires cash flow
2Cash Flow Statement → DCF
The Cash Flow Statement converts accounting earnings into actual cash generated by the business. A DCF values **cash flows**, not net income — so the CFS is where most of the heavy lifting happens.
Why the CFS Matters for a DCF
• Converts NOPAT into operating cash flow (CFO).
• Adjusts for **non-cash** IS items (D&A, SBC).
• Adjusts for **working capital changes** (AR, AP, Inventory).
• Captures **CapEx** through CFI (critical for FCFF).
• Excludes financing flows — because FCFF is pre-financing.
CFO (Operating Cash Flow) — Analyst Format
NOPAT+ Depreciation & Amortization
+ Stock-Based Compensation
± Changes in Net Working Capital
± Deferred Taxes
= CFO
Understanding ΔNWC — The Hardest Part for Interns
AR ↑ → Cash ↓
Customers owe you → you haven’t received cash.
Inventory ↑ → Cash ↓
You purchased goods → cash outflow.
AP ↑ → Cash ↑
You delay payment → you keep cash longer.
Numeric Example — CFO Calculation
NOPAT = 54M
Depreciation = 20M
SBC = 5M
ΔNWC = (−12M) cash impact
Deferred Taxes = +3M
CFO = 54 + 20 + 5 − 12 + 3 = 70M
Starting Point: NOPAT
Net Operating Profit After Tax from the Income Statement
CapEx — The Most Important Cash Outflow in FCFF
CapEx is always a **cash outflow**. It reduces FCFF directly:
+ D&A
− CapEx
− ΔNWC
CapEx comes from **Cash Flow from Investing (CFI)**, not the IS.
Understanding "Unlevered" Free Cash Flow
The term "unlevered" means before financing. Unlevered cash flow (FCFF) ignores how the company is financed:
✓ Included in FCFF:
- Operating profits (NOPAT)
- Working capital changes
- CapEx investments
- Depreciation add-backs
✗ Excluded from FCFF:
- Interest expense
- Debt repayments
- Dividends
- Equity issuances
Why does this matter?
When you value a company using FCFF, you're valuing the entire enterprise (debt + equity). Then you subtract net debt to get equity value. This way, your valuation doesn't change based on whether the company uses debt or equity financing.
CFS → FCFF Summary
• CFO (Cash Flow from Operations) converts NOPAT into actual cash by adjusting for non-cash items and working capital.
• CapEx (Capital Expenditures) is cash spent on PP&E — it reduces FCFF directly.
• ΔNWC (Change in Net Working Capital) can increase or decrease cash depending on AR/AP/Inventory movements.
• CFF (Cash Flow from Financing) is ignored because FCFF must be unlevered (pre-financing).
3Balance Sheet → DCF
The Balance Sheet drives cash flow through changes in working capital, PP&E, and tax assets/liabilities. Even though the BS is a “snapshot,” its movements determine CapEx, D&A, cash taxes, and the cash available for the business.
Why the Balance Sheet Matters for a DCF
• Working capital items drive ΔNWC → CFO → FCFF.
• PP&E determines depreciation (add-back) and CapEx (cash outflow).
• NOLs on the BS reduce cash taxes.
• Debt appears on the BS but is excluded from FCFF (unlevered).
Working Capital Mechanics (AR, AP, Inventory)
Accounts Receivable
AR ↑ → cash ↓ (customer hasn’t paid)
AR ↓ → cash ↑
Inventory
Inventory ↑ → cash ↓ (you purchased goods)
Inventory ↓ → cash ↑
Accounts Payable
AP ↑ → cash ↑ (you delayed paying)
AP ↓ → cash ↓
Numeric Example — ΔNWC Impact
AR ↑ by 10M → cash impact = −10M
Inventory ↑ by 5M → cash impact = −5M
AP ↑ by 4M → cash impact = +4M
ΔNWC Cash Impact = −10 − 5 + 4 = −11M
PP&E → Depreciation & CapEx → FCFF
+ CapEx
− Depreciation
= Ending PP&E
• Depreciation reduces EBIT but is added back in CFO.
• CapEx is a real cash outflow → reduces FCFF.
• The PP&E roll-forward links the IS, CFS, and BS together.
CapEx = 40M
Depreciation = 25M
Ending PP&E = 250 + 40 − 25 = 265M
NOLs → Cash Taxes → FCFF
Net Operating Losses reduce taxable income, which reduces cash taxes paid — which increases FCFF.
− NOL Used
= Taxable Income After NOL
Numeric Example — NOL Impact
Taxable Income = 60M
NOL Available = 15M
Taxable Income After NOL = 45M
Cash Taxes at 25% = 11.25M
Why Debt Doesn’t Affect FCFF
Unlevered free cash flow ignores capital structure. Interest, principal repayments, and debt balances do NOT impact FCFF. They matter only after the valuation (for equity value).
4Full 3-Statement Model → FCFF (Complete Numeric Example)
In this section, we build a simplified but fully linked 3-statement model and trace exactly how operating performance converts intounlevered free cash flow (FCFF). This is the core mechanic behind every DCF.
4A. Mini-Model Assumptions
We will build a Year 1 model using the following assumptions:
Operating Assumptions
Revenue: 500M
Growth: 6%
EBIT Margin: 17%
Tax Rate: 25%
Cash Flow Items
D&A: 30M
CapEx: (40M)
ΔAR: (12M)
ΔAP: +10M
ΔInv: (8M)
4B. Build Simplified 3-Statement Outputs
Income Statement (Year 1)
EBIT Margin = 17%
EBIT = 85
Taxes (25%) = 21.25
NOPAT = 63.75
Cash Flow Statement (Year 1)
+ D&A = 30
− ΔAR = (12)
− ΔInventory = (8)
+ ΔAP = +10
CFO = 83.75
− CapEx = (40)
CFI = (40)
Balance Sheet (Key Items)
ΔInventory = +8
ΔAP = −10
ΔPP&E = CapEx − D&A = (40) − 30 = −10
4C. Extract FCFF From the 3-Statement Model
+ D&A
− CapEx
− ΔNWC
+ D&A = 30
− CapEx = (40)
− ΔNWC = (12 + 8 − 10) = (10)
FCFF = 63.75 + 30 − 40 − 10 = 43.75
4D. Shock Analysis — How Changes Flow Through the Model
A key analyst skill: knowing how a single line item affects all three statements and FCFF. Let’s run five common shocks:
1. Revenue increases by +10
NOPAT ↑ by 1.275
CFO ↑ by 1.275
FCFF ↑ by 1.275
2. CapEx increases by +5
FCFF ↓ by 5
3. AR increases by +7
FCFF ↓ by 7
4. AP decreases by −4
FCFF ↓ by 4
5. Depreciation increases by +3
NOPAT ↓ by 2.25
+ D&A add-back offsets it
FCFF = no change
4E. Model Diagnostics — Does the Model Work?
1. Cash Reconciliation
Ending Cash should equal CFO + CFI + CFF.
2. PP&E Roll-Forward
ΔPP&E must always equal CapEx − D&A.
3. NWC Consistency
ΔNWC must match AR/Inv/AP movements exactly.
4. FCFF Stability
FCFF trends should follow revenue & margins realistically.
5Key Takeaways — How the 3 Statements Feed a DCF
• The Income Statement provides EBIT, which we convert to NOPAT — the starting point for FCFF.
• The Cash Flow Statement converts NOPAT into cash via non-cash add-backs, ΔNWC, and then subtracts CapEx.
• The Balance Sheet drives ΔNWC, PP&E roll-forward, NOL usage, and the cash position that reconciles everything.
• FCFF is always:EBIT × (1 − T) + D&A − CapEx − ΔNWC
• Debt and financing flows appear on the BS and CFS, but they donot affect FCFF because DCF valuation is performed on anunlevered basis.
Senior Analyst Insight
Most candidates can recite the FCFF formula, but very few can trace how a change in AR, CapEx, or D&A propagates through all three statements into free cash flow. That is the difference between “textbook DCF” and real modeling skill.
6Interview Prep: Statement Linkage & FCFF Questions
These questions are calibrated for summer analyst and first-year analyst interviews at top banks. If you can answer them clearly, you truly understand the link between the 3 statements and DCF.
1. Walk me from Revenue to FCFF in a DCF.
2. Why do we start from EBIT(1 − T) instead of net income?
3. How does an increase in AR affect FCFF?
4. How does an increase in AP affect FCFF?
5. How does higher CapEx affect FCFF and the Balance Sheet?
6. Why is depreciation added back in the CFS but still matters in the DCF?
7. How does a change in inventory impact FCFF?
8. Explain ΔNWC in your own words and how it affects cash.
9. How do NOLs affect cash taxes and FCFF?
10. Why do we ignore interest expense when calculating FCFF?
11. What is the relationship between PP&E, CapEx, and depreciation?
12. What line items on the Balance Sheet most directly affect FCFF?
13. If revenue grows but working capital grows faster, what happens to FCFF?
14. How does a one-time gain on asset sale affect FCFF?
15. How would you check if a 3-statement model is correctly linked?
16. What’s the difference between FCFF and CFO?
17. In what situations might FCFF be negative even if the company is profitable?
18. Why is FCFF independent of capital structure?
19. How does deferred revenue affect cash flow and FCFF?
20. Explain in one sentence why FCFF is the “engine” of a DCF.