The Ultimate IBA Review Guide

What do Equity Value and Enterprise Value MEAN? Don't explain how you calculate them - tell me what they mean!

Equity Value represents the value of EVERYTHING the company has (i.e., ALL its Assets), but only to COMMON EQUITY INVESTORS (i.e., shareholders).

Enterprise Value represents the value of the company's CORE BUSINESS OPERATIONS (i.e., ONLY the Assets related to its core business), but to ALL INVESTORS (Equity, Debt, Preferred, and possibly others).

So why do you look at both of them? Isn't Enterprise Value always more accurate?

Neither one is "better" or "more accurate" - they represent different concepts

Enterprise Value and EV-based multiples have some advantages because they are not affected by changes in the company's capital structure as much as Equity Value and Equity Value-based multiples

However, common shareholders and institutional investors often focus on Equity Value because they care more about what a company's shares are worth.

And if you're valuing a public company, you'll always have to "back into" its Implied Equity Value and its Implied Share Price so you can compare that to its current share price.

What's the difference between Current Enterprise Value and Implied Enterprise Value?

Current Enterprise Value is what "the market" as a whole thinks the company's core business operations are worth to all investors; Implied Enterprise Value is what you think it's worth based on your analysis.

You calculate Current Enterprise Value for public companies by starting with Current Equity Value, subtracting non-core-business Assets, and adding Liability and Equity line items that represent different investor groups.

Implied Enterprise Value is found thru DCF, comps & precedents

Why might a company's Current Enterprise Value be different from its Implied Enterprise Value?

**** Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate) ****

You might disagree with the market on

the Discount Rate or Cash Flow Growth Rate.

In most cases, your view of a company's value will be different than the market's view because you believe its cash flow will grow at a faster or slower rate.

Everyone knows how you move from Equity Value to Enterprise Value. But WHY do you subtract Cash, add Debt, add Preferred Stock, and so on?

You subtract Assets when they represent non-core-business Assets. (Ex: cash & investments)

You add Liability & Equity line items when they represent different investor groups beyond the

common shareholders. (Ex: debt, preferred stock, unfunded pensions)

Let's say you're about to buy a house using a $600K mortgage and a $200K down payment. What are the real-world analogies for Equity Value and Enterprise Value in this case?

The "Enterprise Value" here is the $800K total value of the house, and it corresponds to just the "core value" of the house: The land, the foundation, the walls, rooms, etc.

The "Equity Value" is the $200K down payment you're making, and it corresponds to everything above PLUS any "non-core" Assets you get along with the house: Random tools and garden supplies, lawn chairs, or anything else that you're planning to sell immediately.

Can a company's Equity Value ever be negative?

A company's Current Equity Value cannot be negative because it is based on Shares Outstanding * Current Share Price

However, its Implied Equity Value can be negative because you use your assumptions to calculate that. So, if the company's Implied Enterprise Value is $0, for example, and it has more Debt than Cash, its Implied Equity Value will be negative.

Can a company's Enterprise Value ever be negative?

Yes. Both Current and Implied Enterprise Value could easily be negative.

Why do financing-related events such as issuing Dividends or raising Debt not affect Enterprise Value?

Issuing Dividends, issuing Stock, repurchasing Stock, issuing/repaying Debt, etc. do not impact a company's core business, so they do not affect Enterprise Value.

Let's say you determine a company's Implied Value with the cash flow formula: Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate).

Will this give you a company's Implied Equity Value or Implied Enterprise Value?

Depends on the type of cash flow used (Unlevered vs. Levered) & the type of discount rate used (WACC vs. Cost of Equity)

If financing-related events do not affect Enterprise Value, what DOES affect it?

Only changes to a company's core business will affect Enterprise Value.

(Ex: company wins a major new customer contract, or it announces higher-than-expected sales, or it

closes a factory, or it announces positive results from an expansion strategy)

If a company wins a major contract with a new customer, will ONLY Enterprise Value change? Or will Equity Value also change?

Equity Value will change as well. The whole point of Equity Value is that it is affected by BOTH operational and financial changes, whereas Enterprise Value is affected by ONLY operational changes (in theory).

Why does Enterprise Value NOT necessarily represent the "true cost" to acquire a company?

3 Reasons:

the buyer may not necessarily have to repay the seller's Debt (in 99% of cases, they do, but there are exceptions.)

the buyer may not "get" the seller's entire Cash balance. The seller needs a certain minimum amount of Cash to continue operating, and so the seller's Cash may not reduce the effective purchase price 1-for-1.

the buyer has to pay additional fees for M&A advisory, accounting, legal services, and financing to acquire another company, and none of those is reflected in Enterprise Value.

In theory, if Companies A and B are the same in all respects, but Company A is financed with 100% Equity, and Company B is financed with 50% Equity and 50% Debt, their Enterprise Values will be the same.

Why is this NOT true in reality?

Because a company's capital structure impacts the

Discount Rate you use to calculate the Implied Enterprise Value.

Enterprise Value will be LESS affected by capital structure changes than Equity Value, but there will still be some impact even from relatively small changes.

P/E Ratio

price per share/earnings per share

A company issues $200 million in new shares. How do Equity Value, Enterprise Value, EV / EBITDA, and P / E change?

Equity Value: Increases $200 million (new shares)

Enterprise Value: No change

EV/EBITDA: No change

P/E: Increase

A company issues $200 million in new shares, but it will use $100 million from the proceeds to issue Dividends to shareholders. How does everything change?

Equity Value: Increases $100 million (200-100)

Enterprise Value: No change

EV/EBITDA: No change

P/E: Increase

A company issues $200 million in new shares, then acquires another business for $100 million instead. How does everything change?

Equity Value: Increases $200 million

Enterprise Value: Increase $100 million

EV/EBITDA: Increase

P/E: Increase

The same company still issues $200 million in new shares, but what if the company uses the $100 million to acquire an Asset rather than an entire company? How will everything change?

It depends on whether it is a core-business asset or not

If it is:

Equity Value: Increases $200 million

Enterprise Value: Increases $100 million

EV/EBITDA: Increase

P/E: Increase

If it is not:

Equity Value: Increase $200 million

Enterprise Value: No change

EV/EBITDA: No change

P/E: Increase

What if the company raises $200 million in Debt to purchase either a core or non-core asset?

The main difference is that Equity Value no longer changes, and so the P / E multiple no longer changes. Enterprise Value also doesn't change because the extra Cash and extra Debt cancel each other out.

However, if the company uses the Cash to acquire another company or other core-business Assets, Enterprise Value and EV / EBITDA both increase.

If the company raises $200 million of Debt to issue $100 million in Dividends, Enterprise Value and EV / EBITDA will stay the same through all of that, but Equity Value will decrease by $100 million because of the Dividends, and so the P/E multiple will also decrease.

Let's say the company raises $200 million in Debt to acquire another company for a purchase price of $200 million. The other company's Common Shareholders' Equity is exactly $200 million. How does everything change?

Equity Value: No change

Enterprise Value: Increase $200 million

EV/EBITDA: Increase

P/E: No change

How is this scenario different if the purchase price is still $200 million, but the other company has only $100 million in Common Shareholders' Equity?

The only difference is that now the company has to record $100 million of Goodwill (or Other Intangible Assets, or a combination of both) on its Balance Sheet.

However, both of those are core-business Assets, so Enterprise Value still increases by $200 million, and everything else is the same as in the previous question.

What happens to everything if a company issues $100 in Dividends?

Equity Value: Decrease $100 million

Enterprise Value: No change

EV/EBITDA: No change

P/E: Decrease

A company has a Current Equity Value of $200, $50 in Cash, and $100 in Debt. If the company spends $25 of its Cash balance to purchase PP&E, how does everything change?

Equity Value: No change

Enterprise Value: Increase $25

EV/EBITDA: Increase

P/E: No change

A company has excess Cash. What are the valuation implications if it uses that Cash to repurchase shares?

Equity Value: Decreases

Enterprise Value: No change

EV/EBITDA: No change

P/E: Decreases

A company has excess Cash. What are the valuation implications if it uses that Cash to repay debt?

Equity Value: No change

Enterprise Value: No change

EV/EBITDA: No change

P/E: No change

A CEO finds $100 of Cash on the street and adds it to the company's bank account. How do Equity Value and Enterprise Value change?

Equity Value: Increases $100

Enterprise Value: No change

A company issues a press release indicating that it expects its revenue to grow at 20% rather than its previous estimate of 10%. How does everything change?

Equity Value: Increase

Enterprise Value: Increase

EV/EBITDA: Increase

P/E: Increase

When there's an operational change, how can you determine whether Equity Value or Enterprise Value will change by more?

Generally, Enterprise Value will change by more because it is affected only by these operational

changes.

Since Equity Value is affected by both financial and operational changes, operational changes tend to make less of an impact.

Will operational changes impact a company's Current or Implied Enterprise Value by more?

Operational changes will tend to impact a company's Implied Enterprise Value - your estimate of the company's value based on your views - by more because you can immediately reflect your views by revising your calculations.

The market, or current, enterprise value may need more time to adjust...

Equity Value represents the value of ALL assets.

If that's the case, why doesn't a Debt issuance boost Equity Value? After all, if a company raises $100 in Debt, it gets $100 in extra Cash.

This is a trick question because the interviewer doesn't state the LAST PART of the definition: "The value of ALL assets but only to EQUITY INVESTORS."

When a company's Assets increase, if that increase is

funded by Debt (or any other non-equity investor), then Equity Value will not increase.

What IS a valuation multiple?

A valuation multiple is shorthand for a company's value based on its cash flows, cash flow growth rate, and Discount Rate.

You can also think of valuation multiples as "per square-foot" or "per-square-meter" values when buying a house: They help you compare houses, or companies, of different sizes and see how expensive or cheap similar houses, or companies, are.

A company trades at a valuation multiple of 13x EV/EBITDA (based on its Current Enterprise Value). What does that mean?

By itself, this number means nothing at all. It means something only in relation to other companies and their multiples.

If other, similar companies in the industry with similar growth profiles are trading at multiples of 10x EV/EBITDA, then this company might be overvalued.

But if those other companies are trading at multiples of 16x EV/EBITDA, then this company may be undervalued.

How can you use valuation multiples in real life?

The most common usage is to calculate valuation multiples for similar companies ("Comparable

Company Analysis" or "Public Company Comparable Analysis") and see how the company you're analyzing stacks up.

But you can also use valuation multiples to determine a company's yield. For example, if a company has a P/E multiple of 10x, that means you earn 1/10, or 10%, for each dollar you invest in its Equity.

Finally, you can use multiples to determine a company's implied FCF growth rate - the rate at which the market expects it to grow.

Suppose that you graph the EV / EBITDA multiples for a set of similar companies along with the revenue growth rates, EBITDA margins, and EBITDA growth rates.

Which operational metric will MOST LIKELY have the strongest correlation with the EV / EBITDA multiples?

Since a company's value depends on its cash flow, cash flow growth rate, and Discount Rate, the EV/EBITDA multiples are most likely to be correlated with the EBITDA growth rates.

Why do valuation multiples and growth rates often NOT display as much correlation as you might expect?

EBITDA growth and FCF growth are very different since FCF includes taxes, the Change in Working Capital, and the full CapEx amount, whereas EBITDA excludes these.

Company valuation is ultimately based on cash flow growth, so growth rates in revenue, EBITDA, EBIT, and Net Income are, at best, rough approximations of cash flow growth.

Also, not every comparable company necessarily has the same Discount Rate; perhaps the company you're analyzing is a lot riskier/less risky than the others.

Non-financial factors could also easily affect multiples.

You're valuing a mid-sized manufacturing company, and you're comparing it to peer companies in the same industry.

This company's EV / EBITDA multiple is 15x, and the median EV / EBITDA for the comparable companies is 10x. What's the MOST likely explanation?

The market expects the company's cash flows to grow more quickly than those of other companies.

The Discount Rate is unlikely to differ by a huge amount because these companies are all about the same size and are in the same industry, which means the risk should be similar.

Non-financial factors could also affect the multiple.

Would you rather buy a company trading at a 15x EV / EBITDA multiple, or one trading at a 10x multiple?

It's completely dependent on what peer companies are trading at and how this company compares.

When you're buying companies, you always try to find ones that are undervalued so that you can sell the stock for a higher price in the future.

Could a valuation multiple such as P / E or EV / EBITDA ever be negative? What would it mean?

Yes, it's possible for any valuation multiple to be negative (except for ones based on Revenue, which could be $0 but couldn't be negative).

If a company has a negative Net Income or negative EBITDA, the multiples will turn negative.

It means that this particular multiple is not meaningful for valuing the company, so you'll have to use other multiples or methodologies to value it.

If a company has both Debt and Preferred Stock, why is it NOT valid to use Net Income rather than Net Income to Common when calculating its P / E multiple?

You can use Equity Value or Enterprise Value in multiples, but you shouldn't create "half-pregnant" multiples that are based on metrics in between Equity Value and Enterprise Value.

Also remember that if you do not include an expense in the denominator of a multiple, you have to include the Balance Sheet item corresponding to that expense in the numerator (and vice versa).

If a company's cash flow matters most, why do you use metrics like EBIT and EBITDA in valuation multiples rather than CFO or FCF?

For convenience and comparability.

CFO and FCF measure a company's cash flows more

accurately, but they also take more time to calculate since you need a full or partial Cash Flow Statement for them.

Also, the individual items within CFO and FCF vary a lot between companies, and vastly different figures for Deferred Taxes, Stock-Based Compensation, and the Change in Working Capital make it difficult to create meaningful comparisons.

What are the advantages and disadvantages of EV / EBITDA vs. EV / EBIT vs. P / E?

First, you should note that you never look at just one multiple when valuing companies. Think big picture.

With EV / EBITDA vs. EV / EBIT, EV / EBITDA is better in cases when you want to completely exclude the company's CapEx, Depreciation, and capital structure.

EV / EBIT is better when you want to exclude capital structure, but partially factor in CapEx & Depreciation. (common in industries, such as manufacturing, where those items are key value drivers for companies)

The P / E multiple is not terribly useful in most cases because it's affected by different tax rates, capital structures, non-core business activities, and more - so you use it primarily to be "complete" and ensure that you've covered all the common multiples.

Also, sometimes it is relevant in certain industries where you do want to factor in the interest income and expense (insurance firms, commercial banks)

What are the advantages and disadvantages of FCF vs. Unlevered FCF vs. Levered FCF?

The main advantage of Unlevered FCF is that it's capital structure-neutral, also it is easier and faster to calculate than the others.

You'd use FCF or Levered FCF if you want to take into account the company's capital structure, and you'd use Levered FCF to be slightly more accurate since it includes Mandatory Debt Principal Repayments.

You almost always use Unlevered FCF in a DCF analysis to value a company; FCF is more common for standalone financial statement analysis; and Levered FCF is rare, partially because no one agrees on how to calculate it.

When you use EBITDAR in the EV / EBITDAR multiple, how must you adjust Enterprise Value?

If the denominator of a valuation multiple excludes an expense, then the numerator should include the Balance Sheet item corresponding to that expense.

So, with EBITDAR and EV / EBITDAR, you have to capitalize the company's operating leases, usually by multiplying the annual lease expense by 7x or 8x, and then add the capitalized leases to Enterprise Value.

(There is no existing Balance Sheet item since operating leases are off-BS, so you must create a new Balance Sheet item by capitalizing these leases.)

Could Levered FCF ever be higher than Unlevered FCF?

Yes. Levered FCF includes Net Interest Expense, so if the company had a negative value for that figure, (i.e. it earned more in Interest Income than it spent on Interest Expense), and it also had minimal Debt principal repayments, then Levered FCF might be higher than Unlevered FCF.

*highly unlikely, but still possible*

If EBITDA decreases, how do Unlevered and Levered FCF change?

Think of what EBITDA includes: Only Revenue, COGS, and Operating Expenses. Unlevered FCF and Levered FCF also include all those items, plus more.

Both Levered FCF and Unlevered FCF should also decrease since the Operating Income that flows into both of them will also be lower.

What are some different ways you can calculate Unlevered FCF?

EBIT * (1 - Tax Rate) + Non-Cash Adjustments and Changes in Working Capital from CFS - CapEx.

(EBITDA - D&A) * (1 - Tax Rate) + Non-Cash Adjustments and Changes in Working Capital from CFS - CapEx.

CFO - (Net Interest Expense and Other Items Between Operating Income and Pre-Tax Income) * (1 - Tax Rate) - CapEx.

When you calculate Unlevered FCF starting with EBIT * (1 - Tax Rate), or NOPAT, you're not counting the tax shield from the interest expense. Isn't that incorrect?

Nope.

If you're excluding the impact of a company's capital structure, you have to exclude EVERYTHING related to its capital structure.

If you counted the tax benefits from the interest expense, you'd have to include the entire interest expense as well, which would turn it into Free Cash Flow rather than Unlevered FCF.

Could a company's EV / EBITDA multiple ever equal its P / E multiple?

Yes, it's possible because Enterprise Value, EBITDA, Equity Value, and Net Income could be almost any values.

(In practice, P / E multiples tend to be higher than EV / EBITDA multiples because Net Income is usually smaller than EBITDA by a greater percentage than Equity Value is smaller than Enterprise Value.)

Two companies have the same P / E multiples but different EV / EBITDA multiples. How can you tell which one has more Debt?

You can't answer this question because the companies could be very different sizes.

How do you decide whether to use Equity Value or Enterprise Value when you create valuation multiples?

You have to look at which group of investors this operational metric is available to: All the investor in the company or just common Equity investors?

One easy rule of thumb is to look at whether the metric includes Net Interest Expense. If it does, it pairs with Equity Value; if it does not, it pairs with Enterprise Value.

Should you use Equity Value or Enterprise Value with Free Cash Flow?

If it includes Net Interest Expense, i.e. it is just "Free

Cash Flow" or Levered FCF, you use Equity Value.

If it does not include the Net Interest Expense, i.e. it is Unlevered FCF, you use Enterprise Value.

Two companies have the same amount of Debt, but one company has Convertible Debt, and the other has traditional Debt.

Both companies have the same Operating Income, Tax Rate, and Equity Value. Which company will have a higher P / E multiple?

Since the interest rates on Convertible Debt are lower than the rates on traditional Debt, the company with Convertible Debt will have a lower interest expense and therefore a higher Net Income.

As a result, its P / E multiple will be lower.

A company is currently trading at 10x EV / EBITDA. It wants to sell an Asset for 2x the Asset's EBITDA. Will that sale increase or decrease the company's Enterprise Value?

Assuming that it is a core-business Asset, then the sale

will reduce the company's Enterprise Value because the company is trading away the Asset for Cash, which is a non-core-business Asset.

If it's not a core-business Asset, then the company's Enterprise Value won't change.

Even though the company's Enterprise Value decreases in the first case, its EV / EBITDA multiple increases b/c the Asset's multiple was lower than the multiple for the entire company.

This is why companies often sell under-performing divisions: To boost their valuation multiples and increase their stock prices.

Is it accurate to subtract 100% of the Cash balance when moving from Equity Value to Enterprise Value?

No, a portion of any company's Cash balance is a "core-business Asset" because the company needs a certain minimum amount of Cash to continue running its business.

So technically, you should subtract only the Excess Cash, but companies rarely disclose this number, and it is almost impossible to determine on your own, so in practice, everyone just subtracts the entire Cash balance.

Why do you NOT subtract Goodwill when moving from Equity Value to Enterprise Value? The company doesn't need it to continue operating its business.

Goodwill is a core-business Asset, so you should NOT subtract it when moving to Enterprise Value.

Why might you subtract only part of a company's Deferred Tax Assets (DTAs) when calculating Enterprise Value?

Deferred Tax Assets can contain many different items, some of which are related to simple timing differences or tax credits for operational items.

But you should subtract ONLY the Net Operating Losses (NOLs) that are in the DTA because those are non-operational in nature.

Why might someone argue that you should NOT add capital leases when moving from Equity Value to Enterprise Value?

Some people argue that capital leases are operational items since owning vs. renting buildings is an operational decision, not a financial one.

We disagree with this view because, in our opinion, all leases are financial in nature - they're similar to Debt since they require fixed payments for many years under non-cancelable contracts.

So, we treat capital leases as a Debt-like item, and we recommend capitalizing operating leases, especially in industries where some companies rent and others own property.

How do you factor in Working Capital when moving from Equity Value to Enterprise Value?

You don't. Remember that Equity Value represents the value of ALL the company's Assets but only to equity investors.

So, you subtract items only if they're non-core-business Assets, and you add Liability and Equity line items only if they represent different investor groups.

Why do you subtract Equity Investments, AKA Associate Companies, when moving from Equity Value to Enterprise Value?

Two reasons.

First, they're non-core-business Assets since the company could operate fine without them. You should, therefore, exclude them from Enterprise Value.

Second, you need to do this for comparability purposes. Metrics like EBITDA, EBIT, and Revenue

include 0% of these Equity Investments' financial contributions, but Equity Value implicitly includes the value of the stake.

Why do you add Noncontrolling Interests when moving from Equity Value to Enterprise Value?

First, these Noncontrolling Interests represent another investor group: Another company that the Parent Company owns a majority stake in.

Second, you need to do this for comparability purposes. Since the financial statements are consolidated 100% when the Parent Company owns a majority stake in the Other Company, metrics like Revenue, EBIT, and EBITDA include 100% of the Other Company's financials.

If a company has $10,000 in convertible bonds with a par value of $2,000 and a conversion price of $20.00, how many diluted shares will there be?

There is not enough information to answer the question. You also need to know the current stock price of the company to see if the convertible bonds could convert and create additional shares.

A company has 100 shares outstanding, and its current share price is $10.00. It also has 10 options outstanding at an exercise price of $5.00 each. What is its Diluted Equity Value?

100*10 = 1,000 = Basic Equity Value

Options are IN the money

10*5 = 50

Now there are 110 shares, but with the 50 earned from the new shares, the company can buy back 5 shares. Diluted share count is 105.

105*10 = $1,050 = Diluted Equity Value

A company has 100 shares outstanding, and its current share price is $10.00. It also has 10 options outstanding at an exercise price of $15.00. What is its Diluted Equity Value?

1,000 = Basic Equity Value

Options are OUT of the money

$1,000 = Diluted Equity Value

A company has 1 million shares outstanding, and its current share price is $100.00. It also has $10 million of convertible bonds, with a par value of $1,000 and a conversion price of $50.00.

What are its diluted shares outstanding?

First, note that these convertible bonds are convertible because the company's share price is above the conversion price. So, you count them as additional shares rather than Debt.

Next, you divide the value of the convertible bonds - $10 million - by the par value - $1,000 - to figure out how many individual bonds there are:

$10 million / $1,000 = 10,000 convertible bonds.

Next, the number of shares per bond is the par value divided by the conversion price:

$1,000 / $50.00 = 20 shares per bond.

So, the convertibles create 20 * 10,000, or 200,000 new shares, and the diluted share count is 1.2 million.

A company has 10,000 shares outstanding and a current share price of $20.00. It has 100 options outstanding at an exercise price of $10.00. It also has 50 Restricted Stock Units (RSUs) outstanding.

Finally, it also has 100 convertible bonds outstanding at a conversion price of $10.00 and par value of $100.

What is its Diluted Equity Value?

Basic Equity Value = $200,000

Options are IN the money

100*10 = 1,000

Company can buy back 50 shares, new share count is 10,050

50 RSU's boosts share count back to 10,100

Diluted Equity Value (before bonds) = $202,000

100 (# of bonds) / 10 (conversion price) = 10 shares per bond

10*100 = 1,000 new shares

New Diluted Share Count is 11,100

Diluted Equity Value = $222,000

A company with an equity value of $222,000 also has Cash of $10,000, Debt of $30,000, and Noncontrolling

Interests of $15,000. What is its Enterprise Value?

222,000 - 10,000 + 30,000 + 15,000 = $257,000

Walk me through the 3 financial statements.

"The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement.

The Income Statement gives the company's revenue and expenses, and goes down to Net Income, the final line on the statement.

The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must equal Liabilities plus Shareholders' Equity.

The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash."

Can you give examples of major line items on each of the financial

statements?

Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General &

Administrative) Expenses; Operating Income; Pre-Tax Income; Net Income.

Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property &

Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders'

Equity.

Cash Flow Statement: Cash Flow from Operations (Net Income; Depreciation &

Amortization; Stock-Based Compensation; Changes in Operating Assets &

Liabilities); Cash Flow from Investing (Capital Expenditures, Sale of PP&E,

Sale/Purchase of Investments); Cash Flow from Financing (Dividends Issued,

Debt Raised / Paid Off, Shares Issued / Repurchased)

How do the 3 statements link together?

To tie the statements together, Net Income from the Income Statement becomes

the top line of the Cash Flow Statement.

Then, you add back any non-cash charges such as Depreciation & Amortization

to this Net Income number.

Next, changes to operational Balance Sheet items appear and either reduce or

increase cash flow depending on whether they are Assets or Liabilities and

whether they go up or down. That gets you to Cash Flow from Operations.

Now you take into account investing and financing activities and changes to

items like PP&E and Debt on the Balance Sheet; those will increase or decrease

cash flow, and at the bottom you get the net change in cash.

On the Balance Sheet for the end of this period, Cash at the top equals the

beginning Cash number (from the start of this period), plus the net change in

cash from the Cash Flow Statement.

On the other side, Net Income flows into Shareholders' Equity to make the

Balance Sheet balance.

If I were stranded on a desert island and only had one financial statement

and I wanted to review the overall health of a company, which statement

would I use and why?

You would use the Cash Flow Statement because it gives a true picture of how

much cash the company is actually generating

Let's say I could only look at 2 statements to assess a company's prospects -

which 2 would I use and why?

You would pick the Income Statement and Balance Sheet because you can create

the Cash Flow Statement from both of those

Let's say I have a new, unknown item that belongs on the Balance Sheet.

How can I tell whether it should be an Asset or a Liability?

An Asset will result in additional cash or potential cash in the future, while a Liability will result in less cash or potential cash in the future

How can you tell whether or not an expense should appear on the Income

Statement?

1. It must correspond to something in the current period.

2. It must be tax-deductible.

Let's say that you have a non-cash expense (Depreciation or Amortization,

for example) on the Income Statement. Why do you add back the entire

expense on the Cash Flow Statement?

Because you want to reflect that you've saved on taxes with the non-cash

expense.

How do you decide when to capitalize rather than expense a purchase?

If the purchase corresponds to an Asset with a useful life of over 1 year (ex: factory, and, equipment), it is

capitalized, then it is Depreciated or Amortized over a certain number of years. Otherwise it is expensed on the I.S. (ex: employee salaries, COGS)

If Depreciation is a non-cash expense, why does it affect the cash balance?

Although Depreciation is a non-cash expense, it is tax-deductible. Therefore, an

increase in Depreciation will reduce the amount of taxes you pay, which boosts

your cash balance.

Where does Depreciation usually appear on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold

or Operating Expenses - each company does it differently.

Why is the Income Statement not affected by Inventory purchases?

The expense of purchasing Inventory is only recorded on the Income Statement when the goods associated with it have been manufactured and sold-- it does not count as COGS until the company manufactures it into a product and sells it.

Debt repayment shows up in Cash Flow from Financing on the Cash Flow

Statement. Why don't interest payments also show up there? They're a

financing activity!

The difference is that interest payments correspond to the current period and are tax-deductible, so they have already appeared on the Income Statement.

Debt repayments are a true cash expense but they do not appear on the IS, so we

need to adjust for them on the CFS.

If something is a true cash expense and it has already appeared on the IS, it will

never appear on the CFS unless we are re-classifying it

What's the difference between Accounts Payable and Accrued Expenses?

The difference is that Accounts Payable is mostly for one-time expenses with

invoices, such as paying for a law firm, whereas Accrued Expenses is for

recurring expenses without invoices, such as employee wages, rent, and utilities.

When would a company collect cash from a customer and not record it as

revenue?

this happens when the customer pays upfront, in cash, for months or

years of a product/service, but the company hasn't delivered it yet. (ex: Web-based subscription software, Cell phone carriers that sell annual contracts)

If cash collected is not recorded as revenue, what happens to it?

It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. (Will change as product/service I provided)

Deferred Revenue reflects cash that we've already

collected upfront for a product/service we haven't delivered yet. Why is it a

Liability?

a Liability results in less future cash-- not only is the burden on us to deliver the product/service in question, but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as

real revenue.

Wait, so what's the difference between Accounts Receivable and Deferred Revenue? They sound similar.

1. Accounts Receivable has not yet been collected in cash from customers,

whereas Deferred Revenue has been.

2. Accounts Receivable is for a product/service the company has already

delivered but hasn't been paid for yet, whereas Deferred Revenue is for a

product/service the company has not yet delivered.

How long does it usually take for a company to collect its Accounts Receivable balance?

Generally the Accounts Receivable Days are in the 30-60 day range, though it can be higher for companies selling higher-priced items and it might be lower for

companies selling lower-priced items with cash payments only.

How are Prepaid Expenses (PE) and Accounts Payable (AP) different?

1. Prepaid Expenses have already been paid out in cash, but haven't yet shown up on the Income Statement, whereas Accounts Payable haven't

been paid out in cash but have shown up on the IS.

2. PE is for product/services that have not yet been delivered to the

company, whereas AP is for products/services that have already been

delivered.

You're reviewing a company's Balance Sheet and you see an "Income Taxes Payable" line item on the Liabilities side. What is this?

Income Taxes Payable refers to normal income taxes that accrue and are then paid out in cash, similar to Accrued Expenses... but for taxes instead.

You see a "Noncontrolling Interest" (AKA Minority Interest) line item on the Liabilities side of a company's Balance Sheet. What does this mean?

If you own over 50% but less than 100% of another company, this refers to the

portion you do not own.

Example: Another company is worth $100. You own 70% of it. Therefore, there will be a Noncontrolling Interest of $30 on your Balance Sheet to represent the 30% you do not own.

You see an "Investments in Equity Interests" (AKA Associate Companies) line item on the Assets side of a firm's Balance Sheet. What does this mean?

If you own over 20% but less than 50% of another company, this refers to the portion that you DO own. Example: Another company is worth $100. You own 25% of it. Therefore, there will be an "Investments in Equity Interests" line item of $25 on your Balance

Sheet to represent the 25% that you own.

Could you ever have negative Shareholders' Equity? What does it mean?

Yes. It is common in 2 scenarios:

1. Leveraged Buyouts with dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative.

2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of

Shareholders' Equity.

What is Working Capital? How is it used?

Working Capital = Current Assets - Current Liabilities.

You use Operating Working Capital more commonly in finance, and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities

Excluding Debt). The point of Operating Working Capital is to exclude items that relate to a

company's financing and investment activities - Cash, Investments, and Debt -from the calculation.

"Short-Term Investments" is a Current Asset - should you count it in

Working Capital?

No. If you wanted to be technical you could say that it should be included in "Working Capital," as defined, but left out of "Operating Working Capital."

But the truth is that no one lists Short-Term Investments in this section because Purchases and Sales of Investments are considered investing activities, not operational activities.

What does negative (Operating) Working Capital mean? Is that a bad sign?

Not necessarily. It depends on the type of company and the specific situation -here are a few different things it could mean:

1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.

2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront, but

they wait weeks or months to pay their suppliers - this is a sign of business efficiency and means that they always have healthy cash flow.

3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when the company owes a lot of

money to suppliers and cannot pay with cash on-hand).

What's the difference between cash-based and accrual accounting?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after an invoice has been sent to the customer and the customer has a track record of paying on time) and recognizes expenses when they are incurred rather than when they are paid out in cash.

Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Under cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits

the funds in its bank account - at which point it would add to Revenue on the Income Statement (and Pre- Tax Income, Net Income, etc.) and Cash on the

Balance Sheet.

Under accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company's bank account, it would move into the Cash line item and Accounts Receivable would go down.

Why do companies report GAAP or IFRS earnings, AND non-GAAP / non-IFRS (or "Pro Forma") earnings?

Many companies have non-cash charges such as Amortization of Intangibles, Stock-Based Compensation, and Write-Downs on their Income Statements, all of which negatively impact their Net Income. Companies therefore report alternative "Pro Forma" metrics that exclude these expenses and paint a more favorable picture of their earnings, under the

argument that these metrics better represent "true cash earnings."

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

1. The company is spending too much on Capital Expenditures - these are not reflected in EBITDA but represent true cash expenses, so CapEx alone

could make the company cash flow-negative.

2. The company has high Interest Expense and is no longer able to afford its

Debt.

3. The company's Debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash when paying back the Debt.

4. It has significant one-time charges (from litigation, for example) that have been excluded from EBITDA and those are high enough to bankrupt the

company.

Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?

Usually this happens when a company buys another one and the acquirer re-assesses what it really got out of the deal - customer relationships, brand name,

and intellectual property - and finds that those "Assets" are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and it

can result in extremely negative Net Income on the Income Statement.

It can also happen when a company discontinues part of its operations and must

impair the associated Goodwill.

Walk me through how Depreciation going up by $10 would affect the statements.

I.S.: Operating Income and Pre-Tax Income would decline by $10 and, assuming a 40% tax rate, Net Income would go down by $6.

CFS: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4.

B.S.: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement. Overall, Assets is down by $6. Since

Net Income fell by $6 as well, Shareholders' Equity on the Liabilities & Equity side is down by $6 and both sides of the Balance Sheet balance.