The balance sheet shows what a company owns and owes at a point in time, the income statement shows what it earned over a period, and the cash flow statement reconciles net income to the cash actually generated [1]. Free cash flow to the firm (FCFF) is the cash left after taxes and reinvestment but before any debt payments, while free cash flow to equity (FCFE) is what remains after debt flows too [2]. Choosing the right one — and the right discount rate to match — is the foundation of every DCF.
In this lesson you will
- Describe what each of the three main financial statements shows
- Trace how net income, depreciation, capital spending, and borrowing move through all three statements
- Calculate FCFF and FCFE from a set of financial statements
- Match each free cash flow measure to its correct discount rate
The three statements
The SEC's investor guide lists four main financial statements: the balance sheet, the income statement, the cash flow statement, and the statement of shareholders' equity [1]. Balance sheets show what a company owns and what it owes at a fixed point in time, while income statements and cash flow statements cover a period of time [1]. Valuation work leans on the first three.
- Balance sheet: assets, liabilities, and shareholders' equity, organized around the identity Assets = Liabilities + Shareholders' Equity [1].
- Income statement: revenue at the top, then cost of sales, operating expenses, and depreciation, arriving at operating profit before interest and taxes; interest and income tax are then deducted to reach net income [1].
- Cash flow statement: inflows and outflows of cash, divided into operating, investing, and financing activities [1].
How the statements link
The statements are not independent reports; they are three views of the same activity. The operating section of the cash flow statement reconciles net income from the income statement to the cash the company actually received, adding back non-cash items such as depreciation and adjusting for changes in other operating assets and liabilities [1]. Purchases of property, plant, and equipment appear as investing outflows, and borrowing or repaying loans appears in financing [1]. Shareholders' equity on the balance sheet equals what owners invested plus or minus the company's earnings or losses since inception, less distributions such as dividends [1]. The SEC guide notes that cash flows are related, but not equivalent, to net income [1].
- Net income flows from the bottom of the income statement to the top of the cash flow statement and into retained earnings (part of equity) on the balance sheet.
- Depreciation reduces net income but not cash, so it is added back in operating cash flow; on the balance sheet it reduces net property, plant, and equipment.
- Capital expenditures do not hit the income statement immediately; they leave cash through investing activities and increase net PP&E.
- An increase in working capital (say, more receivables or inventory) uses cash, so it is subtracted in operating cash flow.
- Net borrowing raises cash through financing activities and raises debt on the balance sheet.
- The ending cash on the cash flow statement must equal cash on the balance sheet. If it does not, the model is broken.
FCFF versus FCFE
Damodaran defines free cash flow to the firm as after-tax operating income minus (capital expenditures minus depreciation) minus the change in non-cash working capital — a cash flow after taxes and reinvestment needs but before any debt payments [2]. Because it belongs to all capital providers, it is discounted at the cost of capital, which reflects the cost of both debt and equity in proportion to their use, and the result is the value of the entire firm [2]. Free cash flow to equity is the cash left after all reinvestment needs and debt payments: net income plus depreciation, minus capital expenditures, minus the change in non-cash working capital, minus (new debt issued minus debt repayments) [2]. Because it belongs only to shareholders, it is discounted at the cost of equity to value just the equity stake [2].
- FCFF = EBIT × (1 − tax rate) + depreciation & amortization − capital expenditures − increase in working capital.
- FCFE = net income + depreciation & amortization − capital expenditures − increase in working capital + (new borrowing − repayments).
- Bridge between them: FCFE = FCFF − interest × (1 − tax rate) + net borrowing.
Worked example: one year, three statements, two cash flows
Take a company with $500M of revenue. The U.S. federal corporate income tax is 21 percent of taxable income, so we use 21% for simplicity and ignore state taxes [3].
- Income statement: revenue $500M − cost of sales $300M − operating expenses $100M − depreciation $20M = EBIT $80M. Less interest $10M = pre-tax income $70M. Tax at 21% = $14.7M. Net income = $55.3M.
- Other facts for the year: capital expenditures $35M, working capital up $8M, new borrowing $5M, no dividends.
- FCFF = $80M × (1 − 0.21) + $20M − $35M − $8M = $63.2M + $20M − $35M − $8M = $40.2M.
- FCFE = $55.3M + $20M − $35M − $8M + $5M = $37.3M.
- Check the bridge: $40.2M − $10M × (1 − 0.21) + $5M = $40.2M − $7.9M + $5M = $37.3M. ✓
- Cash flow statement: operating = $55.3M + $20M − $8M = $67.3M; investing = −$35M; financing = +$5M. Net change in cash = $37.3M (equal to FCFE here because nothing was paid to shareholders).
- Balance sheet check: assets rise by cash $37.3M + net PP&E ($35M − $20M = $15M) + working capital $8M = $60.3M. Liabilities and equity rise by debt $5M + retained earnings $55.3M = $60.3M. The sheet balances. ✓
Why the distinction matters in practice
Firm valuation treats lenders and shareholders as partners who both supply capital; lenders have prior claims to fixed cash flows and equity investors have residual claims [2]. That is why FCFF works well for companies whose leverage will change — such as in a buyout — since changes in the financing mix can be built into the discount rate rather than the cash flows [2]. FCFE, by contrast, implicitly assumes the cash is paid out (or at least not wasted), and Damodaran notes that using it for a public firm assumes a reasonably strong corporate governance system [2].
Once you can build FCFF reliably, the rest of a DCF is about two judgments: how fast those cash flows grow, and what rate to discount them at. The next lesson takes on both.
Key terms
- Balance sheet
- A snapshot of a company's assets, liabilities, and shareholders' equity at a point in time.
- Income statement
- A report of revenue, expenses, and net income or loss over a period.
- Cash flow statement
- A report of cash inflows and outflows over a period, split into operating, investing, and financing activities.
- Working capital
- Current assets minus current liabilities; increases consume cash and decreases release it.
- Capital expenditures (capex)
- Cash spent on long-lived assets such as property, plant, and equipment.
- Free cash flow to the firm (FCFF)
- Cash flow after taxes and reinvestment but before any payments to lenders or shareholders; discounted at the WACC.
- Free cash flow to equity (FCFE)
- Cash flow left for shareholders after reinvestment and all debt flows; discounted at the cost of equity.
- EBIT
- Earnings before interest and taxes; operating profit.
Check your understanding
Sources
- [1]U.S. Securities and Exchange Commission, “Beginners' Guide to Financial Statements,” February 6, 2017.
- [2]Aswath Damodaran, NYU Stern School of Business, “Valuation Approaches and Metrics: A Survey of the Theory and Evidence,” November 2006.
- [3]Legal Information Institute, Cornell Law School, “26 U.S. Code § 11 - Tax imposed,” Accessed November 2026.
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