BIWS 400 Questions - All Technicals

You've never worked in finance before. How much do you know about what bankers actually do?

I've done a lot of research on my own.

Based on that, I know that bankers advise companies on transactions - buying and selling other companies, and raising capital. They are "agents" that connect a company with the appropriate buyer, seller, or investor.

The day-to-day work involves creating presentations, financial analysis and marketing materials such as Executive Summaries.

Let's say I'm working on an IPO for a client. Can you describe briefly what I would do?

You meet with the client and gather basic information - such as their financial details, an industry overview, and who their customers are. You meet with other bankers and the lawyers to draft the S-1 registration statement - which describes the company's business and markets it to investors. You receive some comments from the SEC and keep revising the document until it's acceptable. You spend a few weeks going on a "road show" where you present the company to institutional investors and convince them to invest. The company begins trading on an exchange once you've raised the capital from investors.

How much do you know about the lifestyle in this industry? Do you know how many hours you're going to work each week?

I've done my homework and I understand it's going to be an 80-100 hour per week job but I'm not afraid of that.

Can you tell me about the different product and industry groups at our bank?

Being a bulge bracket bank, Credit Suisse offers pretty much anything a client could ask for. Restructuring, M&A, LevFin, Debt and Equity Capital Markets. Some specific groups - Financial Sponsors, ECMS, DCMS, Ultra High Net Worth (UHNW). Some specific industries - healthcare, industrials (my previous interviewer), financial institutions, etc.

What's in a pitch book?

It depends.

1. Bank "credentials" (similar deals they've done to "prove" their expertise).

2. Summary of a company's options ("strategic alternatives" in banker-speak).

3. Valuation and appropriate financial models (for example, if you're pitching for an IPO you might show where the IPO proceeds would go).

4. Potential acquisition targets (buy-side M&A deal) or potential buyers (sell-side M&A deal). This is not applicable for equity/debt deals.

5. Summary and key recommendations.

How do companies select the bankers they work with?

Usually based on relationships. When it comes time to do a deal, the company calls different banks it has spoken with and asks them to "pitch" for the business. This is called a "bake-off" and the company selects the "winner" afterward

Walk me through the process of a typical sell-side M&A deal.

1. Meet with company, create initial marketing materials like the Executive Summary and Offering Memorandum (OM), and decide on potential buyers.

2. Send out Executive Summary to potential buyers to gauge interest.

3. Send NDAs (Non-Disclosure Agreements) to interested buyers along with more detailed information like the Offering Memorandum, and respond to any follow-up due diligence requests from the buyers.

4. Set a "bid deadline" and solicit written Indications of Interest (IOIs) from buyers.

5. Select which buyers advance to the next round.

6. Continue responding to information requests and setting up due diligence meetings between the company and potential buyers.

7. Set another bid deadline and pick the "winner."

8. Negotiate terms of the Purchase Agreement with the winner and announce the deal.

Walk me through the process of a typical buy-side M&A deal.

1. Spend a lot of time upfront doing research on dozens or hundreds of potential acquisition targets, and go through multiple cycles of selection and filtering with the company you're representing.

2. Narrow down the list based on their feedback and decide which ones to approach.

3. Conduct meetings and gauge the receptivity of each potential seller.

4. As discussions with the most likely seller become more serious, conduct more in-depth due diligence and figure out your offer price.

5. Negotiate the price and key terms of the Purchase Agreement and then announce the transaction.

Walk me through a debt issuance deal.

1. Meet with the client and gather basic financial, industry, and customer information.

2. Work closely with DCM / Leveraged Finance to develop a debt financing or LBO model for the company and figure out what kind of leverage, coverage ratios, and covenants might be appropriate.

3. Create an investor memorandum describing all of this.

4. Go out to potential debt investors and win commitments from them to finance the deal.

How are Equity Capital Markets (ECM) and Debt Capital Markets (DCM) different from M&A or industry groups?

ECM and DCM are both more "markets-based" than M&A. In M&A your job is to execute sell-side and buy-side transactions, whereas in ECM/DCM most of your tasks are related to staying on top of the market, following current trends, and making recommendations to industry and product groups for clients and pitch books.

In ECM/DCM you go more in-depth on certain parts of the deal process, but you don't get as broad a view as you might in other groups.

What's the difference between DCM and Leveraged Finance?

They're similar and there is some overlap but Leveraged Finance is more "modeling-intensive" and does more of the deal execution with industry and M&A groups on LBOs and debt financings. DCM, by contrast, is more closely tied to the markets and tracks trends and relevant data.

Explain what a divestiture is.

It's when a company decides to sell off a specific division rather than sell the entire company. The process is very similar to the sell-side M&A process, but it tends to be "messier" because you're dealing with a part of one company rather than the whole thing. Creating a "standalone operating model" for the particular division they're selling is extremely important, and the transaction structure and valuation are more complex than they would be for a "plain-vanilla" M&A deal.

Imagine you want to draft a 1-slide company profile for an investor. What would you put there?

"Put the name of the company in the header, then divide the slide into 4 equal parts. The top-left is for the business description, headquarters, and key executives. Put a stock chart and the key historical and projected financial metrics and multiples on the top right. The bottom left can have descriptions of products and services, and the bottom right should have key geographies with a color-coded map to make it look pretty."

Let's say you had $10 million to invest in anything. What would you do with it?

It depends.

1. Always ask what the investor or business goals are.

2. Always ask if there are any constraints, limitations, time horizons, or any other limiting factors.

If you owned a small business and were approached by a larger company about an acquisition, how would you think about the offer, and how would you make a decision on what to do?

The key terms to consider would be:

1. Price

2. Form of payment - cash, stock, or debt

3. Future plans for the company vis-à-vis your own plans.

Of course, there is much more to an M&A deal than this, but those are the key ones. To make a decision you'd have to weigh each one - there's no "magical" way to decide. You might also point out that if something is particularly important to you - such as retaining a role in the company - then a difference of intentions there could be a "deal-breaker."

Let's say you could start any type of business you wanted, and you had $1 million in initial funds. What would you do?

You probably want to say that you'd think about some type of niche business with high margins that requires little startup capital ($1 million is not enough to build 10 factories) and ongoing maintenance - those make it harder to turn a profit and sell the business one day.

Can you talk about a company you admire and what makes them attractive to you?

How would you analyze whether a company is viable?

To assess whether it's "viable," you have to determine whether you can make a profit with the business. Think about variables that would affect revenues and expenses and maintenance.

Tell me about an M&A deal that interested you recently.

Pitch me a stock.

1. Give the name and summarize what the company does.

2. Give a brief overview of its financials to indicate its size and how profitable it is.

3. State how it's undervalued or more attractive than its rivals, due to any competitive advantages it has.

4. Say how there is a long-term trend in its favor - it's not just looking good in the past month.

5. Talk about how the next 5-10 years will be really good for the company

The 2 most common mistakes:

1. Failing to list specific financial figures.

2. Saying how the company stacks up relative to its competition, and why its prospects are more favorable.

Can you explain to me, in simple terms, the subprime crisis?

In simple terms, banks made mortgage loans to people who were in no position to pay them off - or even meet monthly payments. Since interest rates were at historical lows, borrowing was easy.

At the same time, mortgages were no longer just loans made to individuals - they were sliced up, combined and "packaged" into securities that banks traded, acquired and sold to investors.

A typical "package" might contain mortgages given to both "credible" borrowers as well as mortgages granted to more risky borrowers - the more risky ones were labeled "subprime." Banks acquired these "packaged" assets on the argument that even if one "piece" of the asset was risky or likely to default, the rest still had value.

As it turns out, this was false and no one knew what any of these mortgage-related assets were worth - but as unqualified homeowners began defaulting, buyers disappeared overnight and the value of these assets plummeted to $0.

As a result, the value of many banks also approached $0 and quite a few failed or went bankrupt in the process - all because the securities were so complex that no one understood their value or the true risks involved.

Do you agree with the $700 billion bank bailout?

"Yes" because, as we witnessed with the bankruptcy of Lehman Brothers, if a financial institution that's large enough collapses, it can have ripple effects and bring down the rest of the economy and financial markets along with it.

What type of animal / vegetable would you be?

Animal - my friends always said in high school that I looked like a red panda when I smiled

Vegetable - Corn! it has blonde hair and I love carbs

Fruit - Georgia peach

What's your personal Beta?

What's the riskiest thing you've ever done?

I would say probably a high ropes course that really did not look safe. Granted, I'm terrified of heights. They kept telling us how safe the cables were and I couldn't stop thinking about how that wouldn't matter if the trees were rotted

How much do you know about what you actually do in Restructuring?

Restructuring bankers advised distressed companies - businesses going bankrupt, in the midst of bankruptcy, or getting out of bankruptcy - and help them change their capital structure to get out of bankruptcy, avoid it in the first place, or assist with a sale of the company depending on the scenario.

What are the 2 different "sides" of a Restructuring deal? Do you know which one we usually advise?

Bankers can advise either the debtor (the company itself) or the creditors (anyone that has lent the company) money. It's similar to sell-side vs. buy-side M&A - in one you're advising the company trying to sell or get out of the mess it's in, and in the other you're advising buyers and lenders that are trying to take what they can from the company.

How would a distressed company select its Restructuring bankers?

Restructuring / Distressed M&A requires extremely specialized knowledge and relationships. There are only a few banks with good practices, and they are selected on the basis of their experience doing similar deals in the industry as well as their relationships with all the other parties that will be involved in the deal process.

Why would company go bankrupt in the first place?

There are a lot of possibilities, but a few of the most common are

• A company cannot meet its debt obligations / interest payments.

• Creditors can accelerate debt payments and force the company into bankruptcy.

• An acquisition has gone poorly or a company has just written down the value of its assets steeply and needs extra capital to stay afloat (see: investment banking industry).

• There is a liquidity crunch and the company cannot afford to pay its vendors or suppliers.

What options are available to a distressed company that can't meet debt obligations?

1. Refinance and obtain fresh debt / equity.

2. Sell the company (either as a whole or in pieces in an asset sale).

3. Restructure its financial obligations to lower interest payments / debt repayments, or issue debt with PIK interest to reduce the cash interest expense.

4. File for bankruptcy and use that opportunity to obtain additional financing, restructure its obligations, and be freed of onerous contracts.

What are the advantages and disadvantages of each option for a distressed company that can't meet debt obligations?

1. Refinance - Advantages: Least disruptive to company and would help revive confidence; Disadvantages: Difficult to attract investors to a company on the verge of going bankrupt.

2. Sale - Advantages: Shareholders could get some value and creditors would be less infuriated, knowing that funds are coming; Disadvantages: Unlikely to obtain a good valuation in a distressed sale, so company might sell for a fraction of its true worth

3. Restructuring - Advantages: Could resolve problems quickly without 3rd party involvement; Disadvantages: Lenders are often reluctant to increase their exposure to the company and management/lenders usually don't see eye-to-eye

4. Bankruptcy - Advantages: Could be the best way to negotiate with lenders, reduce obligations, and get additional financing; Disadvantages: Significant business disruptions and lack of confidence from customers, and equity investors would likely lose all their money

From the perspective of the creditors, what different strategies do they have available to recover their capital in a distressed situation?

1. Lend additional capital / grant equity to company.

2. Conditional financing - Only agree to invest if the company cuts expenses, stops losing money, and agrees to other terms and covenants.

3. Sale - Force the company to hire an investment bank to sell itself, or parts of itself.

4. Foreclosure - Bank seizes collateral and forces a bankruptcy filing.

How are Restructuring deals different from other types of transactions?

They are more complex, involve more parties, require more specialized/technical skills, and have to follow the Bankruptcy legal code - unlike most other types of deals bankers work on. Also, unlike most standard M&A deals the negotiation extends beyond two "sides" - it's not just the creditors negotiating with the debtors, but also the different creditors negotiating with each other. Distressed sales can happen very quickly if the company is on the brink of bankruptcy, but those are different from Bankruptcy scenarios.

What's the difference between Chapter 7 and Chapter 11 bankruptcy?

A Chapter 7 bankruptcy is also known as a "liquidation bankruptcy" - the company is too far past the point of reorganization and must instead sell off its assets and pay off creditors. A trustee ensures that all this happens according to plan.

Chapter 11 is more of a "reorganization" - the company doesn't die, but instead changes the terms on its debt and renegotiates everything to lower interest payments and the dollar value of debt repayments.

What is debtor-in-possession (DIP) financing and how is it used with distressed companies?

It is money borrowed by the distressed company that has repayment priority over all other existing secured/unsecured debt, equity, and other claims, and is considered "safe" by lenders because it is subject to stricter terms than other forms of financing. Theoretically, this makes it easier for distressed companies to emerge from the bankruptcy process.

How would you adjust the 3 financial statements for a distressed company when you're doing valuation or modeling work?

Adjust Cost of Goods Sold for higher vendor costs due to lack of trust from suppliers.

Add back non-recurring legal / other professional fees associated with the restructuring and/or distressed sale process.

Add back excess lease expenses (again due to lack of trust) to Operating Income as well as excess salaries (often done so private company owners can save on taxes).

Working Capital needs to be adjusted for receivables unlikely to turn into cash, overvalued/insufficient inventory, and insufficient payables.

CapEx spending is often off (if it's too high that might be why they're going bankrupt, if it's too low they might be doing that artificially to save money).

If the market value of a distressed company's debt is greater than the company's assets, what happens to its equity?

The SHAREHOLDERS' EQUITY goes negative (which is actually not that uncommon and happens all the time in LBOs and when a company is unprofitable). A company's EQUITY MARKET CAP (which is different - that's just shares outstanding * share price) would remain positive, though, as that can never be negative.

In a bankruptcy, what is the order of claims on a company's assets?

1. New debtor-in-possession (DIP) lenders (see explanation above)

2. Secured creditors (revolvers and "bank debt")

3. Unsecured creditors ("high-yield" bonds)

4. Subordinated debt investors (similar to high-yield bonds)

5. Mezzanine investors (convertibles, convertible preferred stock, preferred stock, PIK)

6. Shareholders (equity investors)

How do you measure the cost of debt for a company if it is too distressed to issue additional debt (i.e. investors won't buy any debt from them)?

You'd have to look at the yields of bonds or the spreads of credit default swaps of comparable companies to get a sense of this. You could also just use the current yields on a company's existing debt to estimate this, though it may be difficult if the existing debt is illiquid.

How would a DCF analysis be different in a distressed scenario?

Even more of the value would come from the terminal value since you normally assume a few years of cash flow-negative turnaround. You might also do a sensitivity table on hitting or missing earnings projections, and also add a premium to WACC to make it higher and account for operating distress.

Let's say a distressed company approaches you and wants to hire your bank to sell it in a distressed sale - how would the M&A process be different than it would for a healthy company?

1. Timing is often quick since the company needs to sell or else they'll go bankrupt.

2. Sometimes you'll produce fewer "upfront" marketing materials (Information Memoranda, Management Presentations, etc.) in the interest of speed.

3. Creditors often initiate the process rather than the company itself.

4. Unlike normal M&A deals, distressed sales can't "fail" - they result in a sale, a bankruptcy or sometimes a restructuring.

Normally in a sell-side M&A process, you always want to have multiple bidders to increase competition. Is there any reason they'd be especially important in a distressed sale?

Yes - in a distressed sale you have almost no negotiating leverage because you represent a company that's about to die. The only real way to improve price for your client is to have multiple bidders.

The 2 basic ways you can buy a company are through a stock purchase and an asset purchase. What's the difference, and what would a buyer in a distressed sale prefer? What about the seller?

In a stock purchase, you acquire 100% of a company's shares as well as all its assets and liabilities (on and off-balance sheet). In an asset purchase, you acquire only certain assets of a company and assume only certain liabilities - so you can pick and choose exactly what you're getting.Companies typically use asset purchases for divestitures, distressed M&A, and smaller private companies; anything large, public, and healthy generally needs to be acquired via a stock purchase. A buyer almost always prefers an asset purchase so it can avoid assumption of unknown liabilities (there are also tax advantages for the buyer). A (distressed) seller almost always prefers a stock purchase so it can be rid of all its liabilities and because it gets taxed more heavily when selling assets vs. selling the entire business.

Sometimes a distressed sale does not end in a conventional stock/asset purchase - what are some other possible outcomes?

• Foreclosure (either official or unofficial)

• General assignment (faster alternative to bankruptcy)

• Section 363 asset sale (a faster, less risky version of a normal asset sale)

• Chapter 11 bankruptcy

• Chapter 7 bankruptcy

Normally M&A processes are kept confidential - is there any reason why a distressed company would want to announce the involvement of a banker in a sale process?

This happens even outside distressed sales - generally the company does it if they want more bids / want to increase competition and drive a higher purchase price.

Are shareholders likely to receive any compensation in a distressed sale or bankruptcy?

Technically, the answer is "it depends" but practically speaking most of the time the answer is "no." If a company is truly distressed, the value of its debts and obligations most likely exceed the value of its assets - so equity investors rarely get much out of a bankruptcy or distressed sale, especially when it ends in liquidation.

Let's say a company wants to sell itself or simply restructure its obligations - why might it be forced into a Chapter 11 bankruptcy?

In a lot of cases, aggressive creditors force this to happen - if they won't agree to the restructuring of its obligations or they can't finalize a sale outside court, they might force a company into Chapter 11 by accelerating debt payments.

Recently, there has been news of distressed companies like GM "buying back" their debt for 50 cents on the dollar. What's the motivation for doing this and how does it work accounting-wise?

The motivation is simple: use excess balance sheet cash to buy back debt on-the-cheap and sharply reduce interest expense and obligations going forward. It works because the foregone interest on cash is lower than whatever interest rate they're paying on debt - so they reduce their net interest expense no matter what. Accounting-wise, it's simple: Balance Sheet cash goes down and debt on the Liabilities & Equity side goes down by the same amount to make it balance.

What kind of companies would most likely enact debt buy-backs?

Most likely over-levered companies - ones with too much debt - that were acquired by PE firms in leveraged buyouts during the boom years, and now face interest payments they have trouble meeting, along with excess cash.

Why might a creditor might have to take a loss on the debt it loaned to a distressed company?

This happens to lower-priority creditors all the time. Remember, secured creditors always come first and get first claim to all the proceeds from a sale or series of asset sales; if a creditor is lower on the totem pole, they only get what's left of the proceeds so they have to take a loss on their loans / obligations.

What is the end goal of a given financial restructuring?

A restructuring does not change the amount of debt outstanding in and of itself - instead, it changes the terms of the debt, such as interest payments, monthly/quarterly principal repayment requirements, and the covenants.

What's the difference between a Distressed M&A deal and a Restructuring deal?

"Restructuring" is one possible outcome of a Distressed M&A deal. A company can be "distressed" for many reasons, but the solution is not always to restructure its debt obligations - it might declare bankruptcy, it might liquidate and sell off its assets, or it might sell 100% of itself to another company.

"Restructuring" just refers to what happens when the distressed company in question decides it wants to change around its debt obligations so that it can better repay them in the future.

What's the difference between acquiring just the assets of a company and acquiring it on a "current liabilities assumed" basis?

When you acquire the assets of a distressed company, you get literally just the assets. But when you acquire the current liabilities as well, you need to make adjustments to account for the fact that a distressed company's working capital can be extremely skewed. Specifically, "owed expense" line items like Accounts Payable and Accrued Expenses are often much higher than they would be for a healthy company, so you need to subtract the difference if you're assuming the current liabilities. This results in a deduction to your valuation - so in most cases the valuation is lower if you're assuming current liabilities.

How could a decline in a company's share price cause it to go bankrupt?

What actually happens: as a result of the share price drop, customers, vendors, suppliers, and lenders would be more reluctant to do business with the distressed company - so its revenue might fall and its Accounts Payable and Accrued Expenses line items might climb to unhealthy levels. All of that might cause the company to fail or require more capital, but the share price decline itself does not lead to bankruptcy

What happens to Accounts Payable Days with a distressed company?

They rise and the average AP Days might go well beyond what's "normal" for the industry - this is because a distressed company has trouble paying its vendors and suppliers.

Let's say a distressed company wants to raise debt or equity to fix its financial problems rather than selling or declaring bankruptcy. Why might it not be able to do this?

Debt: Sometimes if the company is too small or if investors don't believe it has a credible turnaround plan, they will simply refuse to lend it any sort of capital. Equity: Same as above, but worse - since equity investors have lower priority than debt investors. Plus, for a distressed company getting "enough" equity can mean selling 100% or near 100% of the company due to its depressed market cap.

Will the adjusted EBITDA of a distressed company be higher or lower than the value you would get from its financial statements?

In most cases it will be higher because you're adjusting for higher-than-normal salaries, one-time legal and restructuring charges, and more.

Would you use Levered Cash Flow for a distressed company in a DCF since it might be encumbered with debt?

No. In fact, with distressed companies it's really important to analyze cash flows on a debt-free basis precisely because they might have higher-than-normal debt expenses.

Let's say we're doing a Liquidation Valuation for a distressed company. Why can't we just use the Shareholders' Equity number for its value? Isn't that equal to Assets minus Liabilities?

In a Liquidation Valuation you need to adjust the values of the assets to reflect how much you could get if you sold them off separately. You might assume, for example, that you can only recover 50% of the book value of a company's inventory if you tried to sell it off separately. Shareholders' Equity is equal to Assets minus Liabilities, but in a Liquidation Valuation we change the values of all the Assets so we can't just use the Shareholders' Equity number.

What kind of recovery can you expect for different assets in a Liquidation Valuation?

This varies A LOT by industry, company and the specific assets, but some rough guidelines:

Cash: Probably close to 100% because it's the most liquid asset.

Investments: Varies a lot by what they are and how liquid they are - you might get close to 100% for the ones closest to cash, but significantly less than that for equity investments in other companies.

Accounts Receivable: Less than what you'd get for cash because many customers might just not "pay" a distressed company.

Inventory: Less than Cash or AR because inventory is of little use to a different company.

PP&E: Similar to cash for land and buildings, and less than that for equipment.

Intangible Assets: 0%. No one will pay you anything for Goodwill or the value of a brand name - or if they will, it's near-impossible to quantify.

How would an LBO model for a distressed company be different?

The purpose of an LBO model here is not to determine the private equity firm's IRR, but rather to figure out how quickly the company can pay off its debt obligations as well as what kind of IRR any new debt/equity investors can expect. One structural difference is that a distressed company LBO is more likely to take the form of an asset purchase rather than a stock purchase.

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; Pretax Income; Net Income.

Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity.

Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

How do the 3 statements link together?

"To tie the statements together, Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders' Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash flowing in from the final line on the Cash Flow Statement."

If I were stranded on a desert island, only had 1 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, independent of all the non-cash expenses you might have. And that's the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.

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 (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).

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

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6.

Cash Flow Statement: 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.

Balance Sheet: 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 & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.

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. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

Where does Depreciation usually show up on the Income Statement?

It depends. It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

What happens when Accrued Compensation goes up by $10?

For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation). Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate). On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

What happens when Inventory goes up by $10, assuming you pay for it with cash?

No changes to the Income Statement.

On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations - it goes down by $10, as does the Net Change in Cash at the bottom. On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders' Equity.

Why is the Income Statement not affected by changes in Inventory?

This is a common interview mistake - incorrectly stating that Working Capital changes show up on the Income Statement. In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?

At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement (yet). On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same. On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?

No changes to the Income Statement.

Cash Flow Statement - Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10. On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.

Let's say Apple is buying $100 worth of new iPod factories with debt. Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

After a year has passed, Apple must pay interest expense and must record the depreciation.

Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense).

Assuming a tax rate of 40%, Net Income would fall by $12. On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That's the only change on the Cash Flow Statement, so overall Cash is down by $2.

On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12.

On the other side, since Net Income was down by $12, Shareholders' Equity is also down by $12 and both sides balance.

Let's say Apple is buying $100 worth of new iPod factories with debt. At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. On the Cash Flow Statement, Net Income is down by $48 but the write-down is a non- cash expense, so we add it back - and therefore Cash Flow from Operations increases by $32. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback - so Cash Flow from Investing falls by $100.

Overall, the Net Change in Cash falls by $68.

On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders' Equity is down by $48 as well. Altogether, Liabilities & Shareholders' Equity are down by $148 and both sides balance

Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6. Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPods), which is a net addition to cash flow - so Cash Flow from Operations is up by $16 overall. These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16. On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. On the other side, Net Income was up by $6 so Shareholders' Equity is up by $6 and both sides balance.

Could you ever end up with negative shareholders' equity? What does it mean?

Yes. It is common to see this 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.

It doesn't "mean" anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario).

Note: Shareholders' equity never turns negative immediately after an LBO - it would only happen following a dividend recap or continued net losses.

What is working capital? How is it used?

Working Capital = Current Assets - Current Liabilities.

If it's positive, it means a company can pay off its short-term liabilities with its short- term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound." Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt)

What does negative 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 - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.

3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don't pay quickly and upfront and the company is carrying a high debt balance).

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a write- down of $100.

First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. On the Cash Flow Statement, Net Income is down by $60 but the write-down is a non- cash expense, so we add it back - and therefore Cash Flow from Operations increases by $40. Overall, the Net Change in Cash rises by $40. On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it's not clear which asset since the question never stated the specific asset to write-down). Overall, the Assets side is down by $60.

On the other side, since Net Income was down by $60, Shareholders' Equity is also down by $60 - and both sides balance.

Walk me through a $100 "bailout" of a company and how it affects the 3 statements.

First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens: No changes to the Income Statement. On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders' Equity would go up by $100 to make it balance.

Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a company's balance sheet and how it affects the 3 statements.

This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down - so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was up by $60 - so Liabilities & Shareholders' Equity is down by $40 and it balances.

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

Three examples come to mind:

1. Web-based subscription software

2. Cell phone carriers that cell annual contracts

3. Magazine publishers that sell subscriptions

Companies that agree to services in the future often collect cash upfront to ensure stable revenue - this makes investors happy as well since they can better predict a company's performance.

Per the rules of GAAP (Generally Accepted Accounting Principles), you only record revenue when you actually perform the services - so the company would not record everything as revenue right away.

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

Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.

Over time, as the services are performed, the Deferred Revenue balance "turns into" real revenue on the Income Statement.

What's the difference between accounts receivable and deferred revenue?

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.

How long does it usually take for a company to collect its accounts receivable balance?

Generally the accounts receivable days are in the 40-50 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction- value companies.

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 a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash.

Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.

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

In 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 show up as both Revenue on the Income Statement and Cash on the Balance Sheet.

In 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 "turn into" Cash.

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

If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?

These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.

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

Several possibilities:

1. The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be 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 completely when paying back the debt.

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

Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges - and all of these could end up bankrupting 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 has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought.

It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement (see: eBay/Skype). It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

Under what circumstances would Goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios:

1. The company gets acquired or bought out and Goodwill changes as a result, since it's an accounting "plug" for the purchase price in an acquisition.

2. The company acquires another company and pays more than what its assets are worth - this is then reflected in the Goodwill number.

How is GAAP accounting different from tax accounting?

1. GAAP is accrual-based but tax is cash-based.

2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).

3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

What are deferred tax assets/liabilities and how do they arise?

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.

Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven't actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven't expensed them on the Income Statement yet.

The most common way they occur is with asset write-ups and write-downs in M&A deals - an asset write-up will produce a deferred tax liability while a write-down

Walk me through how you create a revenue model for a company.

There are 2 ways you could do this: a bottoms-up build and a tops-down build.

Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together. Bottoms-up is more common and is taken more seriously because estimating "big-picture" numbers is almost impossible.

Tops-Down: Start with "big-picture" metrics like overall market size, then estimate the company's market share and how that will change in coming years, and multiply to get to their revenue.

Walk me through how you create an expense model for a company.

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward.

Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics.

Cost of Goods Sold should be tied directly to Revenue and each "unit" produced should incur an expense.

Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company's internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

Let's say we're trying to create these models but don't have enough information or the company doesn't tell us enough in its filings - what do we do?

Use estimates. For the revenue if you don't have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years. For the expenses, if you don't have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.

Walk me through the major items in Shareholders' Equity.

Common Stock - Simply the par value of however much stock the company has issued.

Retained Earnings - How much of the company's Net Income it has "saved up" over time.

Additional Paid in Capital - This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering.

Treasury Stock - The dollar amount of shares that the company has bought back.

Accumulated Other Comprehensive Income - This is a "catch-all" that includes other items that don't fit anywhere else, like the effect of foreign currency exchange rates changing.