BIWS 04-02: Accounting and the Three Financial Statements

What are the three financial statements, and why do we need them?

The three main statements are the income statement, cash flow statement, and balance sheet. We need them because valuing a company requires us to determine its cash flow, and that is different from net income.

The IS displays revenues, expenses, and taxes over a period of time, ending with net income.

The BS shows Assets (its resources), Liabilities and Equity (how they paid for those resources), at a point in time.

The CFS begins with Net Income, adjusts for non-cash line items and working capital, then shows the company’s CFI and CFF. The final line is the net change in cash and the company’s ending cash balance.

How do the financial statements link together?

Net income from the bottom of the IS flows to the top of the CFS. Then, adjust for non-cash items like D&A and working capital changes (operational BS items like AR) to get CFO.

Then, factor in investing and financing activities, before summing up CFO, CFI, and CFF to get the net change in cash at the bottom of the CFS.

Cash at the bottom of the CFS becomes Cash on the BS, and Net Income, Stock Issuances, Stock Repurchases, SBC, and Dividends link into CSE.

Then, link line items on the CFS to their corresponding BS line items; for example, CapEx and Depreciation link into Net PP&E.

When you’re on the Assets side of the BS, and you’re linking to the CFS, subtract CFS links; add them on the L&E side.

Finally, check that A = L + E at the end.

What’s the most important financial statement?

The cash flow statement. It shows what really matters to investors and valuation: cash. It also shows where a company is getting its cash from and where it is spending it

Could you use only two financial statements to construct the third one? If not, why?

To an extent, yes.

With the IS and the BS from the start and end of the period, you could construct the CFS. However, with things like Net PP&E you may not know exactly how to split up CapEx and Depreciation.

How might the financial statements of a company in the U.K. or Germany be different from those of a company based in the U.S.?

First of all, you might see different names, like “Turnover” instead of “Revenue”. But, the main differences come down to the CFS.

For IFRS, the CFS may not always start with Net Income, and may instead start with Operating Income or something else like pre-tax income instead. Next, line items can be scattered about in relatively “random” places compared to the GAAP CFS. Finally, the way operating leases are recorded differs between GAAP and IFRS, with the Lease Expense split into interest and depreciation under IFRS while GAAP just records a rental expense.

What should you do if a company’s CFS starts with something OTHER than Net Income, such as Operating Income or Cash Received?

Simply put, you need to try to adjust the line items and organization of the statements to have Net Income on the top of the CFS.

Larger companies will likely provide reconciliations that help with this. However, with smaller companies for you may have to adapt to the CFS in its original form for valuation and modelling purposes.

How do you know when a revenue or expense line item should appear on the IS?

It affects Net Income available to Common, and it occurs 100% in the period shown.

What’s the difference between Assets, Liabilities, and Equity line items on the BS?

Assets represent a resource that provides a future economic benefit for the company. This can take the form of a future cash flow, business growth, or potential tax savings.

Liability and equity line items represent how those resources were paid for, which create a future obligation like a cash payment or delivery of a product.

Typically, liabilities are more external (lenders, suppliers, gov’t) and equity is more so related to internal operations.

How can you tell whether or not an item should appear on the CFS?

If it represents a non-cash item or an adjustment to operating assets or liabilities (working capital), it should be recorded in CFO.

If it is a cash expenditure that pertains to the purchase or sale of long-term assets, it should appear in CFI.

If it has to do with raising or repaying cash (that will provide both a benefit and an obligation beyond just the current period) from/to investors or creditors, it should appear in CFF.

In summary, it is either non-cash, or affects cash but wasn’t on the IS.

A company uses cash accounting rather than accrual accounting.

A customer buys a TV from the company “on account” and received the TV right away. How would the company record this differently than a company that uses accrual accounting?

Instead of recording revenue from delivery of the product, they would have to wait until cash actually got collected. Once collected, Revenue on the IS and Cash on the BS go up. The accrual firm would record an increase to Revenue and AR, then once they collected a decrease in AR and an increase in Cash on the BS.

A company begins offering 12-month installment plans to customers so that that they can pay for $1000 products over a year instead of 100% upfront. How will its cash flow change?

Overall cash flow won’t change, unless this offering brings in more new customers. However, cash flow will now be spread out more over the year. The downside of this is customers defecting throughout the year and the lack of up-front capital to make new investments with.

A company decides to prepay its monthly rent by paying for an entire year upfront in cash, as the property owner has offered it a 10% discount for doing so.

Will this prepayment boost the company’s cash flow?

In the short term, cash flow will go down because the immediate outflow is much higher. However, in the long-term the company is saving 10% of the cash they would have spent, and so overall cash flow would be up.

Your friend is analyzing a company and says that you always have to look at the CFS to find the full amount of depreciation. Is he right?

He is right, because on the IS companies may have a D&A line item, but often part of the overall expense will be embedded within SG&A or operating expenses like R&D.

A company collects cash payments from customers for a monthly subscription service one year in advance. Why do companies do this, and what is the cash flow impact?

Companies do this because cash today is more valuable than cash tomorrow. By collecting upfront, they can invest in the meantime and earn a greater return on the large sum of cash. The short-term cash flow impact is higher cash flow through deferred revenue, but long-term you collect the same amount either way.

Why is AR an asset but Deferred Revenue is a liability?

Because AR represents a future economic benefit from receiving cash, whereas deferred revenue represents an obligation to deliver a good or service for which you have already received the cash for from the customer.

How are prepaid expenses, accounts payable, and accrued expenses different, and why are prepaid expenses an asset?

Prepaid expenses are an asset because they represent a future benefit: you paid cash for something in advance, and now as you expense that in the future (which is basically non-cash), your taxes will be reduced

Accounts payable are liabilities that arise from payments that a company is obligated to make, where the expense has already been incurred, but the cash hasn’t left the door. AP is used for specific, invoiced items.

Accrued expenses also represent liabilities like AP, but they are used for monthly, recurring items that aren’t invoiced, like utilities.

Your CFO wants to start paying employees mostly in Stock-Based Compensation, under the logic that it will reduce the company’s taxes, but not “cost it” anything in cash.

Is the CFO correct? And how does Stock-Based Compensation impact the statements?

The CFO is incorrect.

SBC is an expense line-item on the IS under operating expenses, and it reduces pre-tax income. This means book taxes are lower, and we add this SBC expense back in CFO. But, we also have to factor in the DTA that gets created, because the IRS doesn’t let you deduce SBC from your cash tax taxable amount until it vests. So, you are still having to pay higher cash taxes that offset any “gain” in cash that you lower book taxes would have created.

Additionally, SBC dilutes shareholders by creating additional shares, which does, in fact, “cost” the company, and makes it different from traditional non-cash expenses like D&A, which doesn’t change the company’s capital structure

How does issuing SBC affect a company’s capital structure?

It increases equity by creating new shares, leaving debt untouched.

A junior accountant in your department asks about the different ways to fund the company’s operations via external sources and how they impact the financial statements.

What do you say?

There are two main ways to finance a company’s operations: debt and equity. Debt is cheaper than equity, so most companies prefer that route.

If you issue debt, creditors will lend you money to use in the meantime, creating a cash inflow in CFF. However, as compensation for the risk they are taking, they demand interest payments. This shows up as an “Interest Expense” line item on the IS. Then, the eventual obligation to pay back the creditors at maturity is represented by your long-term debt obligations on the liabilities part of the BS.

If you issue equity, you get the same CFF inflow, but you have no corresponding IS line item. On the BS, though, CSE is going to increase, which dilutes current ownership.

Your company decides to sell equipment for a market value of $85. The equipment was listed at $100 on your company’s Balance Sheet, so you have to record a Loss of $15 on the Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement.

Why is this Loss considered a “non-cash expense”?

It is considered a “non-cash expense” because “losing” money hear doesn’t actually mean cash left the door. You just received a lower inflow of cash than you had originally recorded that you would, so you have to recognize a loss in order to get that equipment off of your balance sheet.

The actual cash spent in prior periods to get the cash was higher, but non-cash adjustments are based on the current period.

Your company owns an old factory that’s currently listed at $1000 on its BS. Why would it choose to “write down” this factory’s value, and what is the impact on the financial statements?

It may have to write down the value of this factory if it becomes impaired (from something like an accident, a natural disaster, or a new technology rendering it obsolete) to the extent that the value of the future cash flows it will produce are lower than the current book value of the factory. In that cash, you have to write it down to its fair-value price and hold it at that cost on the balance sheet, which may cause you to have to write it down.

On the financial statements, this involves a write-down expense on the IS, added back as non-cash on the CFS. In most situations, write-downs are non cash-tax deductible, so you have to record a DTA as well. Finally, Net PP&E is down, DTA is up, on the L&E side of the BS, CSE goes down from the reduced Net Income.

The CFO of your firm recently announced plans to purchase “financial investments” (stocks and bonds). Why would she want to do this, and how will this activity affect the statements?

She may do this because the company has excess cash that they believe they can earn a better return on in the financial markets than in the business itself, or they could also be hedging risk.

On the statements, this causes a cash outflow in CFI. In the case of a bond, you now collect interest income on the IS. Both are recorded in your investments account, which increases the assets side of the balance sheet.

Could a company have negative CSE on the BS?

Theoretically yes, if the company had a large balance of treasury stock that they bought back. CSE could also turn negative if retained earnings became negative, because of either unprofitable conditions or too many dividends.

Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your department asks you why the company did this – how would you respond?

Goodwill and Other Intangible Assets are necessary to make the balance sheet of a company balance after an acquisition.

When an acquisition takes place, the seller’s CSE is written down, and then A & L are combined with the acquirer. The problem arises because usually you have to pay more than the exact value of the seller’s CSE to buy the seller. This premium means that the BS will be out of balance.

To fix this, you give a value to the seller’s “identifiable intangible assets” which are things like patents, trademarks, IP and customer relationships. Then, if there is still a gap on the BS, the rest just becomes Goodwill.

How do Goodwill and Other Intangible Assets change over time?

Goodwill is tested for impairment, like if the buyer realizes they paid more than what the company ended up actually being worth. This creates an expense on the IS and assets down on the BS.

Other Intangible Assets are amortized according to their underlying characteristics (patents amortized on a 20yr timeline until they run out). Like all amortization, it appears as an expense on the IS and a non-cash add-back on the CFS.

Neither of these can be deducted for Cash-taxes, so cash balance won’t change. But, DTAs or DTLs will be impacted.

How do Operating Leases and Finance Leases appear on the financial statements? Explain the high-level treatments as well as IFRS vs. U.S. GAAP differences.

Assets and Liabilities associated with leases that last for more than 12 months now appear directly on companies’ Balance Sheets. Operating Lease Assets are sometimes called “Right-of-Use Assets,” and Operating Lease Liabilities initially match them on the other side.

The rental expense for Finance Leases, which give companies an element of ownership or a “bargain purchase option” at the end, is split into Interest and Depreciation elements on the Income Statement.

On the Cash Flow Statement, Depreciation is added back, and under Cash Flow from Financing, the company records a negative for the “Repayment of Lease Principal” (or similar name).

On the Balance Sheet, both the Lease Assets and Lease Liabilities decrease each year until the lease ends.

Under IFRS, Operating Leases and Finance Leases are treated the same way, so the Operating Lease Expense is also split into Interest and Depreciation elements, and the same BS and CFS line items change.

For Operating Leases under U.S. GAAP, companies record a simple Lease or Rental Expense on the Income Statement, so there is no Depreciation/Interest split.

However, the Lease Assets and Lease Liabilities on the Balance Sheet still decrease each year based on the “Depreciation” and “Lease Principal Repayment” the company estimates

What’s the difference between DTAs and DTLs and how are NOLs related to both of them?

Deferred taxes mean there is a temporary difference between book and cash taxes.

A DTA means that cash taxes>book taxes, so you have to pay more cash now, but later on you’ll get a tax benefit from the IRS, hence the “asset”. This can occur from things like SBC that can get deducted for book-tax reasons but not cash-tax.

A DTL means that book taxes<cash taxes, so you pay less cash now, but later on you’ll have to pay more, hence the “liability”. These can arise when deprecation is accelerated for cash-tax purposes, and also in an acquisition.

An NOL occurs when a company’s pre-tax income is negative. They are able to use these losses to offset taxable gains in future periods. NOLs are a component of the DTA that arises when a company loses money. The size of the DTA is determined by NOL*(Tax Rate)

What are some of the items that are deductible for Book-Tax but not Cash-Tax purposes, and how do they affect the Deferred Tax line items.

• Stock based compensation (when first granted)

• Amortization of intangibles

• Write downs and Impairments (Goodwill, PP&E)

These reduce Book taxes, but don’t save on cash taxes. SO, Deferred Tax line item on the CFS will show a negative, which is an increase in the DTA, which reduces cash flow.

These items are only cash-tax deductible once they actually sell the PP&E that was written down, or employees exercise their SBC options.

Suppose that you’re analyzing a company, and you want to project its financial statements. Before projecting anything, how would you simplify its statements first?

IS - split up revenue and expenses differently, show D&A as a separate line item

CFS - consolidate smaller items between NI and Change in Working Capital. For CFI and CFF, combine smaller items and focus on the core: CapEx, Equity and Debt Issuances, Stock Repurchases, Debt Repayments, and Dividends.

BS - aim for 5-10 items on each side. Combine short and long-term line items, make a single deferred taxes line, just one CSE line, combine smaller line items

Walk me through Opex up by $100

IS - Pre-tax income down by $100, assuming 25% tax rate NI is down by $75.

CFS - No change, cash down by $75 at the bottom

BS - Assets down by $75 from cash balance being reduced. Equity down by $75 from net income reducing CSE.

Walk me through depreciation up by $20

IS - depreciation up by $20, pre-tax income down by $20, at a 25% tax rate NI is down by $15.

CFS - down by $15 at the top from NI, add back non-cash depreciation expense of $20, CFO up by $5 from the tax savings.

BS - cash up by $5, Net PP&E down by $20 because of accumulated depreciation, Assets down by $15. Equity down by $15 with NI causing CSE to be down.

So, A down 15, E down 15, balances.

A company runs into financial distress and needs Cash immediately. It sells a factory that’s listed at $100 on its Balance Sheet for $80. What happens to the statements?

IS - loss of $20 decreases pre-tax income by $20. At a 25% tax rate NI is down by $15.

CFS - Starts down $15. Add back the non-cash loss expense of $20 so CFO is up by $5; this represents the tax savings. Then, in CFI, record the inflow of $80 from selling the factory. CFI up by $85. Cash up by $85 total.

BS - Cash up by $85, but Net PP&E is down by $100. So, assets are down by $15. Equity is down by $15 from net income reducing CSE.

A company decides to CHANGE a key employee’s compensation by offering the employee stock options instead of a cash salary. The employee’s cash salary was $100, but she will receive $120 in stock options now. How do the statements change?

IS - OpEx is up by $20, which means pre-tax income is down by $20. Assuming a 25% tax rate, net income is down by $15.

CFS - Start with NI down by $15, add back the $120 of SBC. SBC isn’t cash-tax deductible, though, so assuming a 25% tax rate you have to subtract $30 from a decrease in deferred taxes (a $30 DTA). So, overall, cash is up by $75.

BS - On the Assets side, cash up by $75, DTA increases by $30, assets up by $105 total. No change to liabilities. NI down by $15, SBC increases CSE by $120, so Equity up by $105 total. Both sides balance.

Intuition: The company’s cash balance is up, but there’s no cash-tax savings

Walk through a customer ordering a product for $100 but not paying in cash, then walk through the cash collection combining it with the first step.

Initial Order:

IS - Revenue up by $100, pre-tax income up by $100, 25% tax rate means NI is up by $75

CFS - NI is up by $75, but AR up by $100 means cash is down by $25

BS - Assets up by $100 from accounts receivable, cash down by $25, so assets are net up $75. Equity up by $75 from NI in CSE.

Cash Collection:

IS - nothing changes

CFS - AR down by $100, cash up by $100

BS - On the assets side, AR is down by $100 and cash is up by $100, combined with the first step that means cash is up by $75, which continues to balance with equity being up $75

A company prepays $20 in utilities one month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens when the expense is recognized, combined with the first step.

First when the company prepays the expense:

IS - Nothing

CFS - Prepaid expenses up by $20, cash down by $20

BS - Assets up $20 from prepaid expenses, cash down $20, cancels out - net no change to the BS

Then when the expense is recognized:

IS - opex up by $20, pretax income down $20, NI down by $15

CFS - NI down by $15 to start, Prepaid Expenses go down $20, so cash goes up $20, net change in cash is positive $5

BS - On the Assets side, cash is up by $5, but prepaid expenses are down by $20, so net assets are down by $15. On the equity side, net income reduces CSE by $15. Both sides down $15, which balances

Intuition: Cash decreases by $15 because this represents the payment and recognition of a simple $20 cash expense, which reduces taxes by $5

Walmart buys $400 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600, combining it with the first step.

First the purchase of inventory:

IS - nothing

CFS - Inventory is up by $400, cash is down by $400

BS - Assets up by $400 from inventory, down by $400 from cash expenditure

Then the sale of the products:

IS - Revenue up by $600, COGS up by $400, gross profit up by $200, pre-tax income up by $200, at a 25% tax rate NI is up by $150.

CFS - NI starts up $150, the decrease in inventory increases cash flow by $400 (cash already left the door when it was bought), net change in cash is up by $550

BS - On the assets side, inventory is down by $400, cash is up by $550, net assets are up by $150. Equity is up by $150 from the increase in net income.

Amazon decides to pay several key vendors $200 on credit and says it will pay them in cash in one month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash? Combine the second step with the first one.

When the expense is incurred:

IS - OpEx up by $200, pretax income down by $200, at a 25% tax rate NI is down by $150.

CFS - NI starts down by $150, AP up by $200 increases cash flow, so Cash ending balance is up by $50 (which reflects the tax savings)

BS - Assets are up by $50 from the $50 increase in cash. Liabilities are up by $200 from AP. Equity is down by $150 from the net income going down. So, both sides of the balance sheet are net up $50

When the cash is paid:

IS - nothing

CFS - AP is down by $200, cash flow down by $200, ending cash balance down by $200

BS - Cash reduces assets by $200, AP going down reduces liabilities by $200. Both sides of the balance sheet are down by $200 and balance,

Salesforce sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens to the statements?

IS - Nothing

CFS - Deferred revenue up by $1200 representing an increase in cash flow. Ending cash balance up by $1200

BS - Assets up by $1200 from cash increasing. Liabilities up by $1200 from deferred revenue increasing. Both sides balance.

What happens after one month has passed, and the company has delivered one month of service for $100?

Assume that there are $20 in Operating Expenses associated with the delivery of the service for this one month. Combine this step with the previous one.

IS - revenue up by $100, OpEx up by $20, operating income up by $80, pre-tax income up by $80, assuming a 25% tax rate, NI up by $60.

CFS - NI starts up $60, deferred revenue is down by $60, decreasing cash flow by $60, so net change in cash is $0.

BS - nothing on the assets, liabilities down by $60 from decrease in deferred revenue, Equity up by $60 from Net income, so both A & L&E side are net changing $0.

A company issues $100 in common stock to new investors to fund its operations. How do the statements change?

IS - Nothing

CFS - $100 inflow in CFF, end cash balance up by $100

BS - Assets up by $100 from new cash, CSE in Equity up by $100 from common stock + APIC

This same company now realizes that it has too much Cash, so it wants to issue Dividends or repurchase common shares. How do they impact the three statements differently?

Compare $100 in Dividends with a $100 Stock Repurchase.

$100 in Dividends:

IS - Nothing

CFS - $100 cash outflow in CFF, ending cash balance is down by $100

BS - Cash down by $100, so assets are down by $100. Retained earnings are down by $100 from dividends, so CSE is down by $100, so Equity is down by $100. Both sides balance down $100.

Intuition: you essentially just make a cash payment out to shareholders.

$100 Stock Buyback:

IS - Nothing

CFS - Treasury stock purchase causes CFF to go down $100. Ending cash down $100.

BS - Cash down by $100, so assets are down by $100. Retained earnings are down by $100 from treasury stock, so CSE is down by $100, so Equity is down by $100. Both sides balance down $100.

A company that follows U.S. GAAP signs a 10-year, $1,000 Operating Lease on January 1 and pays a total of $100 in Rent throughout the year.

Assume a 6% Discount Rate, and walk me through the financial statements over this entire year in a single step

Company will record Operating Lease Assets and Liabilities on the BS, and record Rental Expense on the IS.

The 6% Discount Rate means that the initial “Interest Expense” is 6% * $1,000 = $60, so the “Depreciation” equals $100 – $60 = $40. Since the lease payments are constant, the “Lease Principal Repayment” equals the “Depreciation” here.

IS - OpEx up by $100 from the lease expense. Pre-tax income down by $100, assuming a 25% tax rate, NI is down by $75.

CFS - Cash is down by $75 from NI. Operating Lease Assets and Liabilities both increase by $1000, and then have a $40 decrease but that also offsets.

BS - On the assets side, cash is down by $75, but Operating Lease Assets are up by $960, leaving a net asset increase of $885. On the L&E side, liabilities are up by $960 from the Operating Lease Liability. Equity is down by $75 from the decrease in net income, balancing both sides of the A = L+E equation up by $885.

A company that follows IFRS signs a 10-year, $1,000 Operating Lease on January 1 and pays a total of $100 in Rent throughout the year.

Assume a 6% Discount Rate, and walk me through the financial statements over this entire year in a single step

Here, “rental expense” is split between interest and depreciation elements on the IS, then the actual rent payment gets shown on the CFS:

IS - Depreciation expense goes up by $100, Interest expense goes up by $60 (6%*1000). So, operating expenses are up by $160, which means pre-tax income is down by $160. Assuming a 25% tax rate, NI is down by $120.

CFS - NI starts down by $120, then you add back the depreciation of $100 since it is non-cash. You also record the $1000 additions to Finance Lease Assets and Liabilities, but they offset. Then, your lease principal repayment goes up by $40 (Depreciation-Interest). So, cash ends up down by $60.

BS - Cash is down by $60, Finance Lease Assets are up by $900 due to the $1000 increase and the $100 of depreciation, so assets side is up $840. For liabilities, finance lease liabilities are up by $960, and for Equity, CSE is down by $120, so both sides are up by $840 and they balance.

Intuition: Cash is down by $60 because there’s a total of $200 in new Lease Expenses, but $100 of them are non-cash, and $160 of them reduce the company’s taxes. So, ($200) + $100 + $160 * 25% = ($60).

For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records $40 in Depreciation. Walk me through the financial statements.

IS - Depreciation is up by $20, which makes pre-tax income $20 lower. At a 25% tax rate, taxes are $5 and NI is down by $15.

CFS - Start with NI down by $15. Add back non-cash depreciation ($20), cash is up by $5. But, a DTL of $10 gets created because, for tax purposes, the company had to record $40 in depreciation. So, net cash is up by $5.

BS - On the assets side, cash is up by $10, Net PP&E is down by $20 from accumulated depreciation. The DTL increases liabilities by $5. On the L&E side, NI is down by $15, so CSE inside of Equity is $15 lower. Both sides of the equation are down by $10.

A company has a factory shown at $200 on its Balance Sheet, but a hurricane hits the factory and destroys part of it, so the company records a $100 PP&E Write-Down. Walk me through the statements.

IS - record $100 write-down on the IS, reduces pre-tax income by $100. Assuming a 25% tax rate, pre-tax income is down by $75.

CFS - Start with NI down by $75, then add back the $100 write-down because it was a non-cash expense. But, the company didn’t actually save on cash taxes since there was no sale, so a DTA of $25 reduces cash flow by $25. Meaning, cash at the bottom doesn’t change.

BS - Net PP&E is down by $100, DTA is up by $25, Equity is down by $75. Both sides balance down $75.

A company buys a factory for $200 using $200 of Debt. What happens INITIALLY on the statements?

IS - nothing

CFS - Cash down $200 in CFI from the CapEx, but it’s up $200 in CFF. So net, no change in cash

BS - Net PP&E is up $200 on the assets side from the purchase of the factory. Liabilities are up $200 from the issuance of debt. Both sides up $200

Intuition: company raised capital for a direct purchase, meaning no cash actually changed

One year passes. The company pays 10% interest on its Debt, and it depreciates 10% of the factory. It also repays 5% of the Debt principal. What happens on the statements in this first year?

IS - depreciation expense up by $20, interest expense up by $20. Pre-tax income down by $40. Assuming a 25% tax rate, net Income is down by $30.

CFS - NI starts down $30, add back $20 depreciation because it’s non-cash. CFO down by $10. Then, under CFF, debt principal repayments of $10 reduces cash flow, so overall cash is down by $20

BS - On the Assets side, Net PP&E is down by $20 from the depreciation. Cash is down by $20 as well from the interest and the debt principal repayment, insulated a bit from taxes by the loss. On the Liabilities side, debt is down by $20 from the principal repayment, and equity is down by $20 from the loss of net income. So, both sides balance down $40

Intuition: Cash declines because of the Interest Expense and Debt Principal Repayment, offset by the tax savings from the Interest and Depreciation.

At the end of this first year, the company sells its factories for $220 and uses the proceeds to repay its remaining Debt principal, after realizing there is little demand for its products.

Walk through this step SEPARATELY from the previous two

IS - record a gain of $40, increases pre-tax income by $40, assuming 25% taxes, net income is up by $30.

CFS - reverse the $40 gain, resulting in a cash outflow of $40. CFO is down by $10, reflecting the taxes. Then, in CFI, record a cash inflow of $220 from the sale of the property. Cash is now up by $210. Then, use $190 to pay down the rest of the debt, ending cash is up by $20.

BS - On the assets side, net pp&e is down by $180, cash is up by $20, assets are down by $160. On the L&E side, liabilities are down by $190 from the principal repayment, equity is up $30 from net income. Both sides are down by $160.

Intuition: Cash is up because of the Gain, which boosts Cash by $30 after taxes. However, the full $30 does not flow into Cash because the Debt Repayment exceeds the reduction in Net PP&E by $10. As a result, Cash is up by $20 instead of $30.

Walmart orders $200 of Inventory and pays for it using Debt. What happens on the statements immediately after this initial transaction?

IS - Nothing

CFS - Inventory is up by $200, CFO down by $200. CFF is up $200 from the debt issuance. Net, there is no change in cash.

BS - Assets side is up $200 from the increase in inventory. Liabilities are up $200 from the debt issuance.

Intuition, the cash was used to pay directly for the inventory, so the balance of cash doesn’t change at all

A year passes, and Walmart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process and deliver the orders (counted as OpEx).

The company also pays 4% interest on its Debt and repays 10% of the principal. What happens on the statements over this year? Combine this step with the previous one and explain the changes from beginning to end.

IS - Revenue up $400, COGS up $200, Opex is up $100, Interest expense (a part of opex) is up $8, pre-tax income is up by $92, assuming 25% taxes net income is up by $69.

CFS - start with NI up by $69. Inventory down by $200 is a cash inflow, CFO is up by $269. Then, under CFF, there is a cash outflow of $20 for principal repayment. So, net, cash is up by $249.

BS - On the assets side, inventory is down by $200 and cash is up by $249, so the net change is assets up $49. On the L&E side, debt is down by $20, and net income is up by $69, so the net change is up $49. both sides balance up $49

Intuition: The company has bought goods, turned them into finished products, and recorded $75 in after-tax profits from the sale. However, its Cash balance increases by only $49 due to the Interest Expense on the Debt it used to purchase this Inventory as well as the Debt Principal Repayment

Walk through the same scenario, but assume that Walmart purchases the $200 of Inventory on credit (i.e., Accounts Payable), sells it for $400, and still records $100 in additional OpEx. Assume that it pays the suppliers in the second step of this process.

Step 1 - Buying the Inventory

IS - nothing

CFS - AP is up by $200, increasing cash flow. Inventory is up by $200, decreasing cash flow. Net, there is no change in cash.

BS - Assets up $200 from the inventory. Liabilities up by $200 from the AP

Step 2 - Selling the inventory and paying suppliers

IS - Revenue up by $400, COGS up by $200, $100 in additional opex, pre-tax income is up by $100. Assuming a 25% tax rate, NI is up by $75.

CFS - NI starts up $75, add back inventory decrease of $200, AP is down by $200 which is a cash outflow, net cash is up by $75.

BS - On the assets side, cash is up by $75, inventory is down by $200, net change is lower by $125. On the L&E side, AP reduction means liabilities are lower by $200, equity is up $75 from net income, which nets a $125 decrease. Both sides down $125 balances.

Net change: Cash is up by $75, inventory and AP back to normal, equity is up by $75, it balances at the end of the period.

A company issues $200 in Preferred Stock to buy $200 in Financial Investments. The Preferred Stock has a coupon rate of 8%, and the Financial Investments yield 10%. What happens on the statements IMMEDIATELY after the initial purchase?

IS - nothing

CFS - nothing in CFO, CFI is down by $200 for the purchase of Financial Investments, CFF is up by $200 from the issuance of common stock. Net there is no change in cash.

BS - Assets up by $200 from investments. Equity up by $200 from issuance of preferred stock.

What happens on the statements after a year? Combine this step with the previous one, so that you factor in the increases in Financial Investments and Preferred Stock.

Important to remember that preferred dividends are not tax-deductible.

IS - Financial investments yield 10% on $200, so interest income is up by $20, meaning pre-tax income is up by $20. Assuming taxes are 25%, net income is up by $15. But, preferred dividends are paid out of net income before net income to common, so preferred dividends of $15 must be subtracted, meaning NI to Common is down by $1.

CFS - NI is down by $1 to start. The initial increase in preferred stock and financial investments appear on the CFS, but offset eachother. So, net change is cash is down by $1.

BS - On the assets side, cash is down by $1, financial investments are up by $200, so net change is up by $199. On the L&E side, equity is up by $200 from the preferred stock, bu down by $1 from net income, meaning net change is up by $199. So, both sides balance up by $199.

Intuition: The point of this question is that the tax treatment of funding sources can make a significant impact on the statements. Since the Preferred Dividends are not taxdeductible, the company’s Cash balance falls; if they had been tax-deductible, its Cash balance would have risen. Also, note that Preferred Dividends do not reduce Preferred Stock – they reduce Common Shareholders’ Equity

A company wants to boost its EPS artificially, so it decides to issue Debt and use the proceeds to repurchase common shares.Initially, the company has 1,000 shares outstanding at $1.00 per share and a Net Income of $300.

What happens IMMEDIATELY after the company raises $200 in Debt and uses it to repurchase $200 in common stock?

Shares outstanding decreases to 800

IS - nothing

CFS - CFF up by $200 from debt issuance, CFF down by $200 from purchase of treasury stock. net, no change in cash.

BS - No change to assets. Liabilities up by $200 from the issuance of debt, equity down by $200 from the purchase of treasury stock.

What happens after a year passes if the company pays 4% interest on the Debt? Combine this with the first step and explain the EPS impact

Originally, EPS was $0.30/share. Now, only 800 shares are outstanding.

IS - interest expense of $8 decreases pre-tax income, assuming 25% taxes NI is down by $6. So, total Net income is only $294, now.

CFS - NI starts down by $6, treasury stock purchase and debt issuance still offset, cash is down by $6.

BS - Assets down by $6 from the cash, on the L&E side, liabilities remain up by $200 from the debt issuance, equity is down $6 from NI, but down $200 from the purchase of treasury stock. So, both sides balance down by $6.

The EPS change is from the original $0.30 to now being $0.37, so EPS does increase from this change.

Your company decides to acquire another company for $500, using 50% Debt and 50% Common Stock.

The other company has $300 in Assets, no Liabilities, and $300 in Common Shareholders’ Equity. Assume that the purchase premium is distributed 50/50 between Goodwill and Other Intangible Assets.

What happens to your company’s financial statements immediately after this acquisition takes place?

First, you have to combine the Assets and Liabilities, and write down CSE to $0.

IS - no changes

CFS - CFI decreases by $500 from the acquisition, CFF is up by $500 from a $250 debt issuance and a $250 stock issuance. Net, there is no change in cash.

BS - Assets are up by $300 from the acquisition, and another $200 from the premium paid, split between $100 for goodwill, and $100 for intangibles. Liabilities are up by $250 from the debt issuance, and equity is up by $250 from the stock issuance, meaning both sides balance up by $200.

Now, walk through what happens on the statements in the one year following this acquisition. The acquired company contributes $200 in Revenue and $100 in OpEx, and the Interest Rate on Debt is 8%. Assume that the Other Intangible Assets have a useful life of 5 years.

Walk through ONLY THIS STEP, and do not worry about tracking the cumulative changes with the previous one.

IS - Revenue up by $200, interest expense up by $20, amortization up by $20, OpEx up by an additional $100. So, pre-tax income is up by $60. Assuming 25% taxes, NI is up by $45

CFS - NI starts up by $45, add back non-cash amortization of $20. CFO is up by $65. Total cash up by $65.

BS - Assets up by $65 from the cash, but Other intangible assets are down by $20, so net Assets are up by $45. On the L&E side, Equity is up by $45 from net income. So both, sides balance up by $45.

On December 31 of Year 1, this same company now decides that this acquired company is worth far less than expected, so it writes down the entire $100 balance of Goodwill.

Walk through JUST THIS STEP BY ITSELF, ignoring the cumulative changes in the previous two steps

IS - $100 impairment charge reduces pre-tax income by $100, assuming 25% BOOK taxes NI is down by $75.

CFS - NI is down by $75, but add back the $100 non-cash impairment, and then a DTA of $25 gets created, because you don’t get a cash-tax deduction for impairments. So, net you cash does not change.

BS - On the assets side, goodwill is down by $100, but DTA is up by $25, so assets are total down by $75. On the L&E side, Net income being down by $75 reduces Net Income by $75. Both sides balance down $75

What is Free Cash Flow (FCF), and what does it mean if it's positive and increasing?

Free cash flow represents a company’s “discretionary” cash flow: what the business generates before factoring in how the business was funded.

If FCF is growing and positive, that is typically what you would like to see, but you must carefully analyze the financial statements to ensure that there’s no engineering going on, like inflating payables or cutting capex.

If it is growing and positive, it means the company has more cash on hand, which reduces the need for outside funding and enables flexibility in how management can deploy cash for growth and innovation.

What does FCF mean if it’s negative or decreasing?

This means that the company is spending more cash than it is bringing in before accounting for outside funding (which they may be depending on).

This could mean that revenue is decreasing or costs are increasing upstream, which is bad. But, it can be more nuanced. Receivables could be inflated, which is good for a company pre-selling subscriptions, but could be bad for a retailer that can’t collect cash. Also, capex spending could be large, which can lead to future growth with effective capital deployment, or it could present a huge risk to a company

Either way, you really just have to look deeper.

Why might you have to adjust the calculation for FCF if you’re analyzing a company that follows IFRS rather than U.S. GAAP?

IFRS financial statements may use different terminology, like “turnover” instead of revenue. And, they cash flow statements can be organized in a more haphazard way, so it takes more diligence to actually organize them into a way that FCF can be calculated.

What is Working Capital?

Working Capital, or current operating assets - current operating liabilities. Because it is operating, you don’t include cash, investments, or debt since those aren’t apart of the core business.

Working capital lets you determine if a company needs more operational assets or liabilities to run its business, and what the gap may look like.

Change in working capital is what is actually important.

A company has negative Working Capital. Is that “good” or “bad”?

Neither, it means the company has more operating liabilities than operating assets.

This could be good because the company gets to hold onto their cash for longer, which is useful because of the time value of money.

However, this could be bad if the company doesn’t have the capacity to pay for these liabilities, which could represent operational risk for the business.

Should Changes in Operating Lease Assets and Liabilities be included in the Change in Working Capital? What difference does it make if they are included or not included?

Truthfully, it depends on the company. Some do, some don’t, some don’t even list leases on the CFS.

Following U.S. GAAP, it doesn’t really matter what you do, because the change in operating lease assets and liabilities are very close, so they generally offset.

Under IFRS, since depreciation and lease principal repayment are show separately, only increases in the assets or liabilities could even appear within the Change in Working Capital. While decreases are by different amounts, increases should be by about the same, so they would still offset likely.

A company's Working Capital has increased from $50 to $200.

You calculate the Change in Working Capital by taking the new number and subtracting the old number, so $200 – $50 = positive $150.

But on its Cash Flow Statement, the company records the Change in Working Capital as negative $150. Is the company wrong?

The company is right, for the CFS, you have to calcualte the change in working capital as Old Working Capital - New Working Capital. This way, it will show the cash flow impact properly because, if working capital increases, the company uses cash, when working capital decreases, it frees cash up.

What does the change in working capital mean?

It allows you to determine whether the company needs to spend in ADVANCE of growth, or if it generates more cash flow as a RESULT of its growth. Additionally, it is a component of FCF.

For retailers, the change in working capital is often negative, because they need to spend money buying inventory before they can sell it and make money.

For a subscription company, though, they collect subscription revenue up front, before incurring the costs of providing the service, so their change in working capital would be positive.

What does it mean if a company’s FCF is growing, but its Change in Working Capital is more and more negative each year?

Either Net Income or non-cash charges are growing by more than the decline in Change in WC, or CapEx is becoming less negative than the amount Change in WC is declining.

IF cutting CapEx or increasing non-cash charges is the mechanism by which this occurs, it may be unhealthy. Conversely, if it is because net income is going up, that would be positive.

In its filings, a company states that EBITDA is a “proxy” for its Cash Flow from Operations.

The company’s EBITDA has been positive and growing at 20% for the past three years.

However, the company recently ran low on Cash and filed for bankruptcy. How could this have happened?

A few ways:

• the company could have been highly levered and bleeding cash from an unsustainable capital structure that left it with a high interest expense

• An unfavorable tax structure

• Extremely high CapEx needs

• Unsuccessful acquisition

• Change in Working capital needs that made the company collect cash slower or have to pay suppliers quicker

• One-time, excluded charges from legal expenses or restructuring charges

How do you calculate ROIC and what does it tell you?

• Calculation: (NOPAT *(1-TaxRate))/Invested Capital

  • Invested Capital - Equity + Debt + Preferred Stock + other Long-Term Funding Sources

What it tells you: How efficiently a company uses all of its external and internal capital to generate operating profits

If two companies are similar, the one with a higher ROIC offers a theoretically better proposition to investors because an investment produces higher returns.

What are the advantages and disadvantages of ROE, ROA, and ROIC for measuring company performance?

• ROE

  • Only takes into account equity, is useful for stock investors, applicable across industries

• ROA

  • Useful for companies that need their assets to generate a return

ROE and ROA are a bit more tangible since they use Net Income to Common, not Operating profit

.A company seems to be boosting its ROE artificially by using leverage to fuel its growth.

Which metrics or ratios could you look at to see if this is true?

• EBITDA/Interest Expense

• Debt/EBITDA

Increasing debt doesn’t increase the denominator while only making a small impact on returns through the interest expense. So, look at how EBITDA compares to the debt level and interest expense to see if the coverage may be decreasing as Debt/EBITDA is increasing, which may signal they aren’t getting more returns for the additional leverage

What does it say about a company if its Days Receivables Outstanding is ~5, but its Days Payable Outstanding is ~60?

The company collects quickly, and has enough power over suppliers to hold onto cash longer before paying. This is a great dynamic.

What is the Cash Conversion Cycle (CCC), and what does it mean if, among a group of similar companies, one company’s CCC is 5, and another’s is 30?

The CCC is DSO + DIO - DPO, and it tells you how much time it takes a company to convert inventory and short-term assets like AR into Cash. Shorter is better, because you hold onto cash longer and collect it fast.

What are the components of Common Shareholders' Equity?

Common shareholders’ equity is made up of

• Retained Earnings

• APIC

• Common stock

• treasury stock

  • Accumulated Other Comprehensive Income

Do APIC and Treasury Stock change when the company's share price moves?

No, because they are based on the historical cost of shares at the time the purchase of shares took place. APIC reflects the price when the shares were issued, treasury stock reflects the price when the shares were repurchased.

What's the roll-forward for Retained Earnings each period?

The roll-forward is the fact that the past period’s retained earnings are “rolled” into the present period, where the new net income will be added to it, and the new dividends will be subtracted from the persisting balance.

What goes into Accumulated Other Comprehensive Income (AOCI)?

Accumulated Other Comprehensive Income is comprised of miscellaneous income that doesn’t get included in Net Income:

• Forex rate effects

• unrealized gains and losses on certain financial investments

How do you calculate EBIT and EBITDA, and why must D&A come from the Cash Flow Statement?**

EBIT, also called operating income, is Revene - COGS - Operating expenses excluding interest. Or, pre-tax income + interest.

EBITDA is pre-tax income + interest + D&A from the CFS. You have to get the D&A from the cash flow statement because elements of it are usually baked into other line items like SG&A or COGS on the IS.

Why is EBIT a proxy for Free Cash Flow while EBITDA is a proxy for Cash Flow from Operations?

EBIT is a proxy for FCF because it includes the effects of CapEx through D&A (though not the full strip-out)

EBITDA is a proxy for CFO because it subtracts the impact of CapEx

Both, though, strip out capital structure and taxes to try to get a deeper look at core operating performance

In a Finance Lease, how do the Interest Expense, Depreciation, and Lease Principal Repayment each move over the lease's life?**

Interest (Discount Rate × Lease Liability) declines as the liability is paid down; Depreciation

(Initial Lease Asset / Term) stays constant; Lease Principal Repayment (Cash Payment −

Interest) grows as interest shrinks. Same total cash each year — like a mortgage, the split

just shifts

Unlike an operating lease where you have a single rental expense line item on the IS, payments on a finance lease are split between interest expense (lease liability * discount rate) and depreciation (lease asset amount/lease life flat lined).

On the CFS, you then have to add back the non-cash depreciation charge and account for the cash going out for the lease repayment in CFF.

On the BS, the lease asset and liability are going to move down by different amounts as the interest expense goes down and the depreciation stays flat

Over the full life of the lease, is the total Income Statement expense higher under a finance lease or an operating lease? And what about in Year 1 specifically?

Over the full life of the lease, the total income statement expense is that same across both leases, it’s just about which line items you allocate them to.

In year 1, the finance lease is going to typically cost more because of the interest expense on a high liability amount.

Eventually, as the lease liability declines, you will see a lower interest expense and the finance lease will have a smaller hit on the IS.

Under U.S. GAAP operating leases, do the Lease Asset and Lease Liability decrease by the same amount each year — and how does that differ from Finance leases and IFRS

Under GAAP, yes the Lease Asset and Lease Liability decrease by the same amount each year: the amount of the lease principal repayment.

With a finance lease, or an operating lease under GAAP, the decrease in the lease asset is the same each year since it’s based on flat line depreciation. The decline in the lease liability, though, is based on the formula (lease liability * discount rate). Since the lease liability decreases each year, the decline in the lease liability slows as the interest expense drops.

Why do you create a single "Net DTA" or "Net DTL" line, and how?

You do this for simplicity purposes in a financial model. You net up your DTAs and DTLs on the CFS into a single “deferred taxes line”. If it’s negative, you have more DTAs than DTLs, and so your deferred taxes balance will be an asset on the BS, and vice versa.

When a company with accumulated NOLs turns profitable, how much can it apply in a given year?

They can apply whatever is lower: their remaining NOL balance of that year’s pre-tax income. If pre-tax income remains negative, you apply $0 and continue to accumulate more NOLs.

What's the formula for the Change in Cash when a company sells an asset like PP&E?**

Change in Cash = Book Value of PP&E Sold + Gain × (1 − Tax) − Loss × (1 − Tax). Book value always

returns as cash; a gain adds after-tax cash, a loss subtracts less than its face value because of

the tax saving. Cash always rises from a sale — only the amount varies.

When does selling Financial Investments hit the Income Statement, and where do unrealized value changes go?**

The sale itself only hits the IS if there is a realized gain or loss. The sale itself is recorded as a CFI inflow.

While the investment is still being held, interest/dividend income flows through the IS, but unrealized changes for certain securities go straight to AOCI within equity and never touch the IS.

Where does Preferred Stock sit in cost between Debt and Common Equity, and why do so few companies use it?

Preferred Stock sits on the equity part of a balance sheet, but really it is a hybrid between debt and equity. So few companies use it because it is debt-like, but more expensive (though less expensive that equity).

It’s dividends, though, aren’t tax-deductible which makes it more expensive. It really only happens when lender’s won’t buy more debt and raising equity isn’t viable.

After a company spends cash on CapEx, what happens to Net Income and Cash in the following years, and why do they move opposite ways?

Net Income goes down while cash goes up because of the non-cash nature of depreciation. Depreciation helps reduce taxes, actually, which can improve short-term cash flow as well.

What lives in the "Other Income / (Expenses)" section below Operating Income, and what do those items share

• Interest income/expense

• Gains and Losses

• Write downs

• Impairments

These all correspond to the current period but aren’t apart of the core business.

What's the difference between Gross Profit, Operating Income, and Pre-Tax Income — what does each subtotal tell you?

Gross Profit (Revenue − COGS) = profit per incremental sale before fixed costs. Operating Income

(− OpEx) = what the core business earns before side activities, interest, and taxes. Pre-Tax

Income (± Other Income/Expenses) = everything earned this period, core and non-core, before tax.

Each step layers in another cost.

Is the cash-vs-non-cash distinction relevant to whether an item belongs on the Income Statement?

No, all that matters if whether it corresponds to the current period and whether it affects NI to Common.