Redbook Accounting

What is the primary purpose of US GAAP?

The SEC authorizes the Financial Accounting Standards Board (FASB) to set the accounting rules that US public companies follow, known as US Generally Accepted Accounting Principles. The purpose is standardization: if every company reports on a consistent, comparable basis, investors and lenders can evaluate companies against one another and are protected from misleading or arbitrary presentation.

What are the main sections of a 10-K?

Five main components. • Business Overview: divisions, strategy, products and services, seasonality, geographic footprint, key risk factors. • Management's Discussion and Analysis (MD&A): management's own commentary and analysis of fiscal year results. • Financial Statements: the "Core 3" (income statement, balance sheet, cash flow statement) plus the "Other 2" (statement of comprehensive income, statement of shareholders' equity). • Notes and supplementary disclosures: the detail behind the line items. • Other required items such as controls, legal proceedings, and executive matters.

What is the difference between the 10-K and the 10-Q?

The 10-K is the annual report; the 10-Q is the quarterly report. Three practical differences. • Depth: the 10-K is comprehensive (full business overview, risk factors, accounting policy changes); the 10-Q is condensed and focused on the quarter's financials with brief MD&A. • Audit: 10-Ks must be audited by an independent accounting firm; 10-Qs are only reviewed by CPAs and are unaudited. • Timing: 10-Ks are due roughly 60 to 90 days after fiscal year end; 10-Qs roughly 40 to 45 days after quarter end. A company files one 10-K and three 10-Qs per year.

Walk me through the three financial statements.

The income statement shows profitability over a period. It starts with revenue and, after deducting costs and expenses, ends at net income. The balance sheet is a snapshot at a single point in time of a company's resources (assets) and how those resources were funded (liabilities and shareholders' equity). Assets must equal liabilities plus equity. The cash flow statement reconciles accrual net income to the actual change in cash. Under the indirect method it starts at net income, adjusts for non-cash items such as D&A and for changes in working capital to reach cash from operations, then adds cash from investing and cash from financing to arrive at the net change in cash for the period.

Walk me through the income statement.

The income statement measures accrual-based profitability over a defined period. Top to bottom: Revenue, less COGS, equals Gross Profit. Less SG&A and R&D equals EBITDA. Less D&A equals Operating Income (EBIT). Less net interest expense equals Pre-Tax Income (EBT). Less tax expense equals Net Income, the bottom line. Note that in real filings EBITDA is not a presented line item; it is derived, because D&A is typically embedded within COGS and operating expenses.

Walk me through the balance sheet.

The balance sheet shows assets, liabilities, and equity at a point in time, governed by Assets = Liabilities + Shareholders' Equity. Assets had to be funded somehow, so the two sides must always tie. • Assets are listed in order of liquidity. Current assets (convertible to cash within a year) include cash, marketable securities, accounts receivable, prepaid expenses, and inventory. Long-term assets include PP&E, intangibles, goodwill, and long-term investments. • Liabilities are listed in order of how soon they come due. Current liabilities include accounts payable, accrued expenses, and short-term debt. Long-term liabilities include long-term debt, deferred revenue, deferred taxes, and lease obligations. • Shareholders' equity includes common stock, additional paid-in capital, treasury stock, retained earnings, and accumulated other comprehensive income.

What do assets, liabilities, and equity each actually represent?

Assets are resources with economic value that will produce future cash inflows or can be sold for cash: receivables are payments owed by customers, PP&E generates future revenue, cash and securities store value. Liabilities are unsettled obligations to third parties and represent external sources of capital that helped fund the assets. Unlike assets, they represent future cash outflows. Equity is the internal source of capital: money contributed by owners and investors plus the cumulative net profits kept in the business as retained earnings. Equity is the residual claim after all liabilities are settled.

What are the typical line items on the balance sheet?

Current assets: cash and cash equivalents; marketable securities; accounts receivable; inventories; prepaid expenses. Non-current assets: property, plant and equipment; intangible assets; goodwill; long-term investments. Current liabilities: accounts payable; accrued expenses; short-term debt and current portion of long-term debt. Non-current liabilities: long-term debt; deferred revenue (can be current or non-current); deferred taxes; lease obligations. Shareholders' equity: common stock; additional paid-in capital; preferred stock; treasury stock (negative); retained earnings; accumulated other comprehensive income.

Walk me through the cash flow statement.

The cash flow statement can be prepared using the direct or indirect method; the indirect method is far more common. It has three sections. • Cash from operations: begins at net income, adds back non-cash expenses such as D&A and stock-based compensation, then adjusts for changes in working capital. • Cash from investing: capital expenditures (usually the largest outflow), acquisitions, divestitures, and purchases or sales of securities. • Cash from financing: debt issuance and repayment, equity issuance, share repurchases, and dividends paid. The three sections sum to the net change in cash, which is added to the beginning cash balance to produce ending cash.

How are the three financial statements connected?

Income statement to cash flow statement: net income is the starting line of the cash flow statement. Cash flow statement to balance sheet: the cash flow statement tracks the period-over-period changes in balance sheet accounts (working capital, PP&E via capex, debt, treasury stock), and the ending cash balance at the bottom of the cash flow statement becomes the cash line on the balance sheet. Income statement to balance sheet: net income less dividends flows into retained earnings. Depreciation on the income statement reduces PP&E on the balance sheet. Interest expense on the income statement is calculated off the debt balances on the balance sheet.

If you already have the balance sheet and could only have one more statement, would you pick the income statement or the cash flow statement?

The income statement. Given beginning and ending balance sheets plus the income statement, I can reconstruct the cash flow statement myself from the year-over-year changes in balance sheet accounts. The reverse is not true: the cash flow statement plus balance sheets will not let me rebuild revenue, gross profit, or the full expense structure.

Which is more important, the income statement or the cash flow statement?

Both are necessary and any real analysis uses both. If forced to choose, the cash flow statement is arguably more important because it reconciles accrual net income to what actually happened to cash. It surfaces liquidity problems, capex intensity, and financing activity that the accrual-based income statement can hide.

If you had to pick one statement to analyze a company, which would you pick?

In most cases the cash flow statement, because it reflects true liquidity and is less exposed to the discretionary accounting judgments that shape accrual earnings. Whether I am an equity investor or a lender, the company's ability to generate cash to reinvest and service debt comes first. The exception is an unprofitable company. If net income, cash from operations, and free cash flow are all negative, the cash flow statement becomes less useful and the income statement matters more because the company would be valued on a revenue multiple.

Why is the income statement insufficient to assess the liquidity of a company?

Because accrual accounting recognizes revenue when earned, not when collected. A company can report consistently positive net income while failing to collect from customers, and nothing on the income statement reveals that. Accrual reporting also depends heavily on management estimates and judgment, which creates room for earnings management. The cash flow statement exists to correct for both problems by reconciling net income to actual cash movement.

What are some discretionary management decisions that could inflate earnings?

Extending useful life assumptions on new capex to reduce annual depreciation. Switching from LIFO to FIFO when inventory costs are rising, which lowers COGS and raises net income. Refusing to write down impaired assets to avoid recognizing the loss. Changing policy to capitalize costs that were previously expensed, such as software development. Repurchasing shares to reduce share count and mechanically raise EPS. Deferring capex or R&D into the next period. Adopting more aggressive revenue recognition policies.

Explain the revenue recognition principle and the matching principle.

Revenue recognition: revenue is recorded in the period the good or service was delivered and therefore earned, regardless of whether cash was collected. Matching: the expenses associated with producing or delivering that good or service must be recorded in the same period as the revenue they generated. Together these two principles are what make accrual accounting a measure of economic performance rather than cash timing.

How does accrual accounting differ from cash-basis accounting?

Under accrual accounting, revenue is recognized when earned and the associated expenses are recognized in that same period, regardless of cash timing. Under cash-basis accounting, revenue and expenses are recognized only when cash physically moves, regardless of when the product or service was delivered. Public companies must use accrual accounting under GAAP; cash-basis is generally limited to small private businesses.

What is the difference between cost of goods sold and operating expenses?

COGS captures the direct costs of producing the good or delivering the service that generated revenue, such as direct materials and direct labor. Operating expenses such as SG&A and R&D are indirect costs not tied to a specific unit of production, such as rent, corporate payroll, commissions, advertising, and marketing. The distinction matters because it determines gross profit, and inconsistent classification across companies is a common reason gross margins are not directly comparable.

When do you capitalize versus expense an item under accrual accounting?

The deciding factor is useful life, meaning the estimated timing of the benefit. If an expenditure is expected to benefit the firm for more than one year, it is capitalized as an asset and expensed over time through depreciation or amortization. A building providing 15-plus years of benefit is capitalized. If the benefit is consumed within the period, it is expensed immediately. Employee wages are expensed when the services are provided.

If depreciation is a non-cash expense, how does it affect net income?

Depreciation reduces net income because it is a real expense on the income statement, and critically it is tax-deductible, so it reduces cash taxes paid. That tax shield is genuine cash savings. The reason it is added back on the cash flow statement is that the actual cash outflow already happened when the asset was purchased; annual depreciation is just the accounting allocation of that original outlay across the asset's useful life.

Do companies prefer straight-line or accelerated depreciation?

For GAAP reporting purposes most companies prefer straight-line, because it records lower depreciation in the early years of an asset's life than an accelerated method, producing higher reported net income and EPS in those years. Eventually the accelerated method produces lower depreciation, but companies weight near-term earnings more heavily. If the company keeps buying new assets, that crossover never arrives until capex slows materially. For tax purposes, companies do the opposite and use accelerated methods to defer cash taxes, which is what creates deferred tax liabilities.

What is the relationship between depreciation and the salvage value assumption?

Annual straight-line depreciation equals (historical cost minus salvage value) divided by useful life. The lower the salvage value assumption, the larger the depreciable base and the higher annual depreciation. Most companies assume a salvage value of zero, which maximizes annual depreciation and therefore maximizes the tax shield over the asset's life.

Do companies depreciate land?

No. Land is a long-term asset but is assumed to have an indefinite useful life, so depreciation is prohibited. If a company buys a building and the land beneath it, the purchase price must be allocated between the two, and only the building portion is depreciated.

How would a $10 increase in depreciation flow through the three statements? Assume a 30% tax rate.

Income statement: EBIT falls by $10, and after a 30% tax rate net income falls by $7. Cash flow statement: net income at the top is down $7, but the $10 of depreciation is added back as a non-cash expense, so ending cash increases by $3. Balance sheet: on the asset side, PP&E is down $10 and cash is up $3, a net decrease of $7. On the liabilities and equity side, retained earnings is down $7 from lower net income. Both sides fall by $7 and the balance sheet balances. The key takeaway is that depreciation, despite being non-cash, increases ending cash because it shields taxable income.

A company acquired a machine for $5 million and has since recorded $3 million of accumulated depreciation. The PP&E has a fair market value today of $20 million. Under GAAP, what value appears on the balance sheet?

$2 million, the net book value. Under the historical cost principle, assets are carried at historical cost less accumulated depreciation, not at fair market value. The exceptions are certain liquid financial assets that are marked to market. Under IFRS, upward revaluation of PP&E is permitted, but it is rarely used and I would not volunteer that in a US interview.

What is the difference between growth capex and maintenance capex?

Maintenance capex is the required spending to keep the business operating in its current state, such as repairing or replacing existing equipment. Growth capex is discretionary spending to expand: new facilities, new geographies, added capacity. The distinction matters in valuation and LBO analysis because maintenance capex is non-negotiable and must be funded, while growth capex can be cut in a downturn. Companies rarely disclose the split, so it usually has to be estimated.

Which types of intangible assets are amortized?

Intangibles with a finite useful life are amortized: customer lists, copyrights, patents, licenses, and certain trademarks. The concept mirrors depreciation but applies to non-physical assets. Intangibles with an indefinite life, most notably goodwill and some brand names, are not amortized under GAAP for public companies and are instead tested annually for impairment.

What is goodwill and how is it created?

Goodwill is an intangible asset recorded when an acquirer pays more than the fair market value of the target's identifiable net assets. It exists to plug the gap so that the acquirer's balance sheet stays in balance after the purchase price is recorded. If an acquirer pays $500 million for a company whose identifiable net assets are worth $450 million at fair value, $50 million of goodwill is created. Conceptually it captures what was paid for that is not separately identifiable, such as brand strength, workforce, and expected synergies.

Can companies amortize goodwill?

Public companies under GAAP cannot amortize goodwill, because it is assumed to have an indefinite life. Goodwill must instead be tested annually for impairment, and written down if the carrying value exceeds fair value. Private companies may elect to amortize goodwill over up to ten years as an accounting alternative, and for tax purposes in an asset deal goodwill can be amortized over 15 years under Section 197.

What is the going concern assumption?

Going concern assumes a company will continue operating into the foreseeable future rather than being liquidated. It underpins the entire accrual framework: it is why assets are carried at cost and depreciated over their useful lives rather than marked to liquidation value. It also underpins valuation, since a DCF assumes continued cash flow generation and typically a terminal value in perpetuity. If an auditor issues a going concern qualification, that is a serious distress signal.

Explain the principle of conservatism.

Conservatism requires accountants to verify carefully and exercise caution, producing a deliberate downward bias in estimates. The underlying belief is that it is safer to understate revenue and asset values than to overstate them, and safer to overstate expenses and liabilities than to understate them. For any revenue or expense to be recognized there must be evidence of occurrence with a measurable monetary amount. This is why contingent losses are accrued when probable but contingent gains are not recognized until realized.

Why are most assets recorded at historical cost?

The historical cost principle requires an asset's balance sheet value to reflect its original purchase price rather than current market value. Historical cost is objective and verifiable, requires no ongoing revaluation, and avoids injecting market volatility into the financial statements. The tradeoff is that book values can diverge dramatically from economic reality, particularly for long-held real estate and for internally developed intangibles.

What role did fair-value accounting play in the subprime mortgage crisis?

Mark-to-market accounting under FAS 157 required financial institutions to update the carrying value of illiquid securities to fair value. As prices for mortgage-backed securities and credit default swaps collapsed, banks were forced to record large write-downs, which eroded regulatory capital, triggered forced selling, and pushed prices lower still, creating a self-reinforcing spiral. The episode is the standard example of how fair-value accounting can amplify a downturn when markets become illiquid.

Why are the values of a company's intangible assets not reflected on its balance sheet?

The objectivity principle permits only verifiable, unbiased data in financial statements. Internally developed intangibles such as brand, trademarks, and intellectual property cannot be objectively quantified, so no value is recorded. A company can only put these on the balance sheet when a confirmable market transaction establishes the value, which is what happens in an acquisition: part of the purchase price is allocated to identifiable intangibles on the closing balance sheet. This is why Coca-Cola's brand is worth far more than the intangibles line in its filings.

If a company's share price increases by 10%, what is the balance sheet impact?

None. Shareholders' equity on the balance sheet is book value of equity, which equals total assets minus total liabilities and reflects historical accounting amounts. Share price drives market value of equity, or market capitalization, which is set by supply and demand in the open market and does not appear on the balance sheet. For most established companies market value substantially exceeds book value.

Do accounts receivable get captured on the income statement?

There is no accounts receivable line item on the income statement, but receivables are indirectly reflected in revenue, since accrual accounting recognizes revenue when earned whether or not cash was collected. To actually understand what is happening to receivables, use the other two statements: the balance sheet shows the absolute A/R balance, and the cash flow statement shows the period change, which reconciles accrual revenue to cash revenue.

Why is an increase in accounts receivable a reduction of cash on the cash flow statement?

Because the cash flow statement starts with net income, and net income already includes all revenue, not just cash revenue. If A/R increased, more customers bought on credit than paid down existing balances, meaning revenue was recognized without the cash arriving. A downward adjustment is therefore required to reconcile net income to actual cash. The general rule: an increase in an operating asset is a use of cash.

What is deferred revenue?

Deferred revenue, also called unearned revenue, is a liability representing cash collected from customers for goods or services not yet delivered. Examples include gift cards, prepaid service contracts, annual software subscriptions, and the implied right to future software updates bundled with a device sale. If a company sells a phone for $500 and allocates $480 to the hardware and $20 to future software upgrades, it collects $500 in cash but recognizes only $480 as revenue; the remaining $20 sits in deferred revenue until the upgrades are delivered.

Why is deferred revenue a liability while accounts receivable is an asset?

Deferred revenue is a liability because the company already took the customer's cash and still owes them a good or service, an unfulfilled obligation. Accounts receivable is an asset because the reverse is true: the company already delivered the good or service and is owed cash. The two are mirror images of the timing mismatch between delivery and payment.

Why is an increase in accounts payable shown as an increase in cash flow?

An increase in A/P means the company received goods or services but has not yet paid for them, so the cash is still in its possession. The obligation will be settled eventually, but for now the company has effectively received interest-free financing from its suppliers. The general rule: an increase in an operating liability is a source of cash.

Which section of the cash flow statement captures interest expense?

Interest expense does not appear as its own line on the cash flow statement. It is recognized on the income statement and is therefore already embedded in net income, which is the starting line of cash from operations. So under US GAAP, cash interest paid sits in cash from operations. Note that IFRS permits interest paid to be classified in either operating or financing.

What happens to the three financial statements if a company initiates a dividend?

Income statement: no impact. Net income is unchanged; dividends are a distribution of earnings, not an expense. A dividend per share figure may be disclosed below net income. Cash flow statement: cash from financing decreases by the dividend paid, reducing ending cash. Balance sheet: cash declines by the dividend amount, and the offsetting entry is a reduction in retained earnings, since dividends are paid out of retained earnings. Both sides fall by the same amount.

Do inventories get captured on the income statement?

There is no inventory line item on the income statement, but inventory is indirectly captured in COGS. When inventory is sold, its cost moves from the balance sheet into COGS. Inventory purchased but not yet sold stays on the balance sheet and never touches the income statement in that period. The balance sheet shows the ending balance and the cash flow statement shows the period change.

How should an increase in inventory be handled on the cash flow statement?

As an outflow within cash from operations. An increase in inventory means the company purchased more inventory than it expensed through COGS, so cash was spent building up stock that has not yet been sold. Inventory is an operating asset, and an increase in an operating asset is a use of cash.

What is the difference between LIFO and FIFO, and what are the implications for net income?

Both are cost-flow assumptions used to determine which inventory costs move into COGS. FIFO assumes the earliest-purchased inventory is sold first. LIFO assumes the most recently purchased inventory is sold first. If inventory costs are rising: under FIFO, the older cheaper costs flow to COGS, so COGS is lower and net income is higher. Under LIFO, the recent expensive costs flow to COGS, so COGS is higher and net income is lower. If inventory costs are falling: the results reverse. FIFO produces higher COGS and lower net income; LIFO produces lower COGS and higher net income. Note that LIFO is permitted under US GAAP but prohibited under IFRS.

What is the average cost method of inventory accounting?

Under the weighted average cost method, total production or purchase costs for the period are summed and divided by total units, and every unit is assigned that same average cost. It disregards the date of purchase entirely and is a middle ground between LIFO and FIFO. It works well for high-volume, identical, commoditized inventory but is inappropriate when individual products differ significantly in cost to produce and in sale price, where specific identification is more accurate.

How do you calculate retained earnings for the current period?

Ending retained earnings equals beginning retained earnings plus net income minus dividends paid to common and preferred shareholders. Retained earnings is the cumulative amount of net income the company has kept since inception, net of all distributions. Note that share repurchases can also reduce retained earnings depending on how the buyback is recorded.

What does the retention ratio represent and how does it relate to the dividend payout ratio?

The retention ratio is the proportion of net income kept in the business, calculated as (net income minus dividends) divided by net income. The dividend payout ratio is its inverse, dividends divided by net income. The two must sum to one. A high retention ratio signals a company reinvesting for growth; a high payout ratio signals a mature business returning capital.

What are the two ways to calculate earnings per share?

Basic EPS equals (net income minus preferred dividends) divided by the basic weighted average shares outstanding. It reflects only common shares actually outstanding. Diluted EPS equals (net income minus preferred dividends) divided by the diluted weighted average shares outstanding, which adds the effect of potentially dilutive securities such as in-the-money options, warrants, and convertibles. Diluted EPS is the more conservative and more accurate depiction of per-share ownership value, and it is the figure used in valuation. Note that both use weighted average share counts, not period-end counts, to match the income statement's period basis.

Where can you find the financial reports of public companies?

In the US, public companies file with the SEC and everything is available free through EDGAR: the annual 10-K, three quarterly 10-Qs, and 8-Ks for material events. Outside the US, requirements vary. Canada's SEDAR is the closest analogue to EDGAR, and in the UK, Companies House holds filings including those of private companies. In many jurisdictions analysts rely on paid data providers such as Capital IQ, FactSet, or Bloomberg.

What is a proxy statement?

The proxy statement, formally Form DEF 14A, is filed ahead of a shareholder meeting to solicit shareholder votes. It must disclose all material details of the matters being voted on so shareholders can make an informed decision. It is also where executive and board compensation is disclosed in detail, along with items such as changes to the articles of incorporation. In M&A, the merger proxy is a key source for deal background, financial advisor fairness opinions, and management projections.

What is an 8-K and when must it be filed?

An 8-K, the "current report," is filed when a company experiences a materially significant event that shareholders should know about before the next periodic filing. It is generally due within four business days of the event. Triggering events include a new acquisition or disposal of assets, bankruptcy, a tender offer, entry into or termination of a material agreement, the departure of a senior executive or director, auditor changes, or notice of an SEC investigation. Earnings releases are also furnished on 8-K.

Why has understanding the differences between US GAAP and IFRS become increasingly important?

Three reasons. Globalization has driven broad adoption of IFRS across more than 140 countries and created pressure toward a single global standard. Investors have broadened the geographic scope of their portfolios, including into emerging markets, which requires comparing companies reporting under different regimes. And cross-border M&A has become a standard growth strategy, which requires restating and reconciling targets reported under a different framework. Key differences include LIFO (allowed under GAAP, prohibited under IFRS), revaluation of PP&E (prohibited under GAAP, permitted under IFRS), and operating lease treatment.

What are the most common margins used to measure profitability?

Gross margin equals gross profit divided by revenue: what remains after only the direct costs of production. Operating margin equals EBIT divided by revenue: profitability after operating expenses, independent of capital structure and taxes. Net profit margin equals net income divided by revenue: what remains after all expenses, including interest and taxes, so it is affected by capital structure. EBITDA margin equals EBITDA divided by revenue: the most widely used benchmarking margin because it is independent of capital structure, taxes, and non-cash D&A.

What do the phrases "above the line" and "below the line" mean?

"The line" refers to operating income, the dividing point between core ongoing operations and everything else. Metrics above the line, such as gross profit, EBITDA, and EBIT, reflect operating performance before financing and tax decisions, which is why they are used for comparability across companies with different capital structures. Metrics below the line, such as pre-tax income and net income, have absorbed non-operating income and expense, interest, and taxes, all of which are discretionary or jurisdiction-specific rather than reflective of the underlying business.

Is EBITDA a good proxy for operating cash flow?

It is the most widely used proxy in practice but it is imperfect. EBITDA adds back D&A, typically the largest non-cash expense, but it ignores capital expenditures entirely, which is a real cash cost for capital-intensive businesses, and it ignores changes in working capital, which can consume enormous cash in a growing business. Standard EBITDA also does not adjust for stock-based compensation, though adjusted EBITDA often adds it back, which is itself controversial since SBC is a real economic cost. EBITDA is a reasonable starting point, not a substitute for the cash flow statement.

What are some examples of non-recurring items?

Restructuring charges, litigation settlements or awards, inventory write-downs, asset impairments, goodwill impairments, gains or losses on asset sales, and costs related to a discrete event such as a natural disaster or a one-time acquisition. Adjusting for these is called scrubbing or normalizing the financials, and the purpose is to isolate sustainable operating performance so that a multiple applied to that earnings figure is meaningful.

When adjusting for non-recurring expenses, are litigation expenses always added back?

No. Whether an item is genuinely non-recurring depends on the industry and the specific company, and it is often a judgment call. For a pharmaceutical company facing constant patent and product liability litigation, legal expense is a recurring cost of doing business and should not be added back. For a manufacturer with a single unusual lawsuit in a decade, it should be. The test is whether the expense is expected to recur as a normal feature of operations.

What is the difference between organic and inorganic revenue growth?

Organic growth comes from the company's own operations: entering new markets, improving sales and marketing, refining pricing, expanding the product mix, or launching new products. It reflects internal execution by management and employees. Inorganic growth comes from M&A. It is faster and more convenient than organic growth and can bring synergies such as cross-selling, product bundling, and revenue diversification, but it is also more expensive, carries integration risk, and can mask deteriorating underlying performance. Investors generally pay a higher multiple for organic growth because it is more sustainable and requires less capital.

How does the relationship between depreciation and capex shift as a company matures?

For a high-growth company spending heavily on growth capex, capex substantially exceeds depreciation, so the capex-to-depreciation ratio is well above 1. As the company matures and growth stagnates, capex shifts increasingly toward maintenance, and the ratio converges toward 1, meaning the company is spending only enough to replace assets as they wear out. This convergence is a core DCF assumption: in the terminal year, capex should approximately equal depreciation, because a business growing at a stable perpetual rate cannot be reinvesting like a growth company forever.

What is working capital?

Working capital equals current assets minus current liabilities. It measures liquidity: whether a company can cover obligations coming due within the year using assets convertible to cash within the year. A higher figure generally implies lower near-term liquidity risk. Note that this accounting definition differs from the operating definition used in finance, which excludes cash and debt.

Why are cash and debt excluded from net working capital?

Because neither is operational. Net working capital equals operating current assets minus operating current liabilities. Cash and short-term investments are closer to an investing activity, since they earn a return and are not consumed in producing revenue. Debt and the current portion of long-term debt are a financing decision. Including them would make NWC a function of capital structure and cash management policy rather than a measure of how much cash the operations of the business tie up.

Is negative working capital a bad signal about a company's health?

It depends entirely on the driver, so I would want more context. Negative working capital can be a sign of excellent operating efficiency: fast collection of receivables, rapid inventory turnover, and favorable payment terms with suppliers. Restaurants, grocers, and subscription businesses often run structurally negative working capital because customers pay before suppliers are paid, which is effectively free financing. Conversely, it can signal distress: a large payables balance coming due, depleted inventory that needs replenishing, and thin receivables would mean the company needs outside financing quickly to stay solvent. The same number describes both situations; the composition tells you which.

What does the change in net working capital tell you about a company's cash flows?

It tells you how far cash flow will diverge from accrual net income. An increase in NWC means operating assets grew or operating liabilities shrank, which is a use of cash, so cash flow will come in below net income. A decrease in NWC is a source of cash and pushes cash flow above net income. This is why fast-growing companies can be profitable and still cash-hungry: growth builds receivables and inventory faster than it builds payables.

What ratios would you look at to assess working capital management efficiency?

Days inventory held equals inventory divided by COGS, times 365: the average days to sell inventory. Lower is generally better. Days sales outstanding equals A/R divided by revenue, times 365: the average days to collect on credit sales. Lower is better. Days payable outstanding equals A/P divided by COGS, times 365: the average days taken to pay suppliers. Higher generally indicates more supplier bargaining power, though extremely high DPO can signal liquidity strain.

What is the cash conversion cycle?

The cash conversion cycle equals DIH plus DSO minus DPO, and measures the number of days between paying for inventory and collecting cash from the sale of that inventory. A lower cycle is preferred because it means cash is tied up for less time. Companies with low or negative cycles operate efficiently, hold negotiating power over suppliers, and collect quickly, which reduces their need for external working capital financing.

How would you forecast working capital line items on the balance sheet?

Drive each item off the operating metric it relates to, using historical ratios. • Accounts receivable: calculate historical DSO, assume a forward DSO based on the trend, then A/R equals (DSO divided by 365) times forecast revenue. • Inventory: calculate historical DIH, then inventory equals (DIH divided by 365) times forecast COGS. • Accounts payable: calculate historical DPO, then A/P equals (DPO divided by 365) times forecast COGS. • Prepaid expenses and accrued expenses: forecast as a percentage of SG&A, or of revenue if the driver is unclear. • Deferred revenue: forecast as a percentage of revenue. • Other current assets and liabilities: as a percentage of revenue, or straight-lined if not clearly tied to operations.

How would you forecast capex and D&A?

The simple approach forecasts capex as a percentage of revenue, anchored on historical trends, management guidance, and industry norms, and forecasts D&A as a percentage of revenue or of capex. The rigorous approach is a depreciation waterfall schedule, which requires the existing PP&E base with remaining useful lives, plus management's capex plans and useful life assumptions for new purchases. This separates depreciation on existing assets from depreciation on new capex and is more accurate when capex is lumpy. Amortization requires useful life assumptions for intangibles, generally disclosed in the footnotes.

How would you forecast PP&E and intangible assets?

Use roll-forward schedules. Ending PP&E equals beginning PP&E plus capex minus depreciation, adjusted for asset sales and write-downs. Ending intangibles equals beginning intangibles plus intangible purchases minus amortization. For intangibles, historical purchases tend to be lumpy and unpredictable, so management guidance is necessary. In the absence of guidance, the standard convention is to assume no future purchases.

What is the difference between the current ratio and the quick ratio?

Both measure near-term liquidity, but the quick ratio applies a stricter definition of what counts as liquid. Current ratio equals current assets divided by current liabilities. Above 1 generally implies the company can meet short-term obligations. Quick ratio, also called the acid-test ratio, equals (cash and equivalents plus marketable securities plus accounts receivable) divided by current liabilities. It excludes inventory and prepaid expenses because inventory may not convert to cash quickly or at full value, and prepaids cannot be converted to cash at all.

When might the current ratio be misleading?

The cash balance may include the minimum operating cash the business needs to function, which is not actually available to satisfy creditors. It may also include restricted cash held for a specific purpose. Short-term investments may be illiquid and only sellable at a substantial discount. Accounts receivable may include uncollectible balances that management has not yet written down. Inventory may be obsolete or slow-moving. In each case the numerator overstates genuinely available liquidity.

Is it bad if a company has negative retained earnings?

Not necessarily, and the cause matters. Retained earnings turn negative, called an accumulated deficit, when cumulative losses exceed cumulative profits. For a startup or early-stage company investing heavily in R&D, sales and marketing, and capex, that is expected and not alarming on its own. Retained earnings can also go negative because the company has returned more capital through dividends and buybacks than it has earned, which is common for mature companies with heavy buyback programs and says nothing negative about profitability.

How can a profitable firm go bankrupt?

Profitability is an accrual concept; bankruptcy is a cash event. A profitable company can fail if the timing of cash inflows and outflows is mismatched: receivables balloon because it cannot collect, or suppliers demand cash up front while customers pay on long terms. Normally such a company can bridge the gap with financing, but if credit markets seize up, as in 2008, that option disappears and it defaults. Alternatively, a profitable company can simply be over-levered. If EBIT is positive but insufficient to service interest and mandatory amortization, it defaults regardless of reported profits.

What do ROA and ROE each measure?

ROA equals net income divided by average total assets, and measures how efficiently the total asset base generates earnings, regardless of how those assets were funded. High ROA relative to peers suggests assets are being used near full productive capacity. ROE equals net income divided by average book value of equity, and measures how efficiently management deploys the capital shareholders have contributed. ROE is affected by leverage, which is the key difference.

What is the relationship between ROA and ROE?

The difference between them is leverage. With no debt in the capital structure, total assets equal equity and the two metrics are identical. As debt is added, assets exceed equity, so the ROE denominator becomes smaller relative to the ROA denominator and ROE rises above ROA. This is why ROE alone can be misleading: a high ROE may reflect operational excellence or may simply reflect an aggressively levered balance sheet, and DuPont analysis is used to decompose which.

If a company has an ROA of 10% and a 50/50 debt-to-equity ratio, what is its ROE?

Assume $100 of total assets. A 10% ROA implies $10 of net income. With a 50/50 debt-to-equity mix, equity is $50. ROE equals $10 divided by $50, or 20%. Note this simplification ignores the interest expense the debt would generate, which in reality would reduce net income and therefore the actual ROE.

Why do we use averages in the denominator for metrics like ROA and ROE?

Because of a timing mismatch. The numerator, net income, comes from the income statement and covers a full period. The denominator, assets or equity, comes from the balance sheet and is a snapshot at a single point in time. Averaging the beginning and ending balances approximates the level of assets or equity actually in place across the period the earnings were generated, which makes the ratio internally consistent.

What are some shortcomings of ROA and ROE for comparison purposes?

They are only meaningful against a peer group with similar growth rates, margin profiles, capital intensity, and risk, which limits them to mature industries with many true comparables. Both use net income, which is distorted by non-recurring items, capital structure, and tax jurisdiction. Both use book values in the denominator, which diverge from economic value, and can be badly distorted by acquisitions that add goodwill, or by heavy buybacks that shrink book equity and inflate ROE artificially. A company with negative book equity produces a meaningless ROE.

What does return on invested capital measure?

ROIC equals NOPAT divided by invested capital, where NOPAT is EBIT times (1 minus tax rate) and invested capital is total debt plus equity less cash, or equivalently net working capital plus net fixed assets. It answers the fundamental question: how much return does the company earn per dollar of capital invested in the business? It is the cleanest of the return metrics because it is capital-structure neutral on both sides: an operating profit measure over the full capital base. If ROIC persistently exceeds WACC, the company is creating value and likely has a competitive advantage; if ROIC is below WACC, growth actually destroys value.

What does the asset turnover ratio measure?

Asset turnover equals revenue divided by average total assets, and measures how many dollars of revenue the company generates per dollar of assets. Higher generally indicates more efficient asset utilization. It varies enormously by industry, so it is only useful within a sector: a grocery chain will show high turnover on thin margins, while a utility shows very low turnover on high margins. It can also be distorted by the timing of large capex or asset sales.

What does inventory turnover measure and how does it differ from days inventory held?

Inventory turnover equals COGS divided by average inventory, and measures how many times the company sold and replaced its inventory during the period. DIH is the same relationship expressed in days rather than times: DIH equals 365 divided by inventory turnover, or inventory divided by COGS times 365. Higher turnover and lower DIH both indicate faster inventory movement.

What does accounts receivable turnover measure?

A/R turnover equals revenue divided by average accounts receivable, and measures how many times per year the company collects its average receivable balance. Higher is generally better because it indicates efficient collection from credit customers. It is the inverse expression of DSO, where DSO equals 365 divided by A/R turnover.

What does accounts payable turnover measure, and is a higher or lower number preferable?

A/P turnover equals COGS divided by average accounts payable, and measures how quickly the company pays its suppliers. A higher turnover means the company pays faster, so cash leaves sooner. From a working capital perspective, a lower turnover, meaning longer payment terms, is generally preferable because the company retains cash longer and is effectively receiving interest-free supplier financing. However, an unusually low turnover can also indicate the company cannot pay its bills, so it needs context.

What ratios would you look at to perform credit analysis?

Four categories. • Liquidity ratios test the ability to meet current obligations with current assets: current ratio, quick ratio, cash ratio. • Leverage or solvency ratios compare debt to earnings, assets, or capital: debt-to-EBITDA, debt-to-assets, debt-to-equity, debt-to-total capitalization. • Coverage ratios test the ability to service interest and other fixed obligations from cash flow: times interest earned, EBITDA-to-interest, debt service coverage ratio, fixed charge coverage ratio. • Profitability ratios show whether the company can consistently generate the earnings needed to service debt: margins, ROE, ROA, ROIC.

What are the two main types of credit ratios used to assess default risk?

Leverage ratios compare the quantum of debt to a cash flow or capital measure: total debt to EBITDA, senior debt to EBITDA, net debt to EBITDA, total debt to equity, and total debt to total capitalization. These answer how much debt the company carries relative to its ability to repay. Coverage ratios compare a cash flow measure to the required payments: EBIT to interest expense, EBITDA to interest expense, EBITDA to cash interest expense, and (EBITDA minus capex) to interest expense. These answer whether the company can service the debt. Higher coverage is better, with above roughly 2.0x generally considered comfortable.

How do you calculate the debt service coverage ratio and what does it measure?

DSCR measures whether current cash flows are sufficient to cover all current debt obligations, meaning both interest and mandatory principal amortization. One common formulation is (EBITDA minus capex) divided by (mandatory principal repayment plus interest expense). A DSCR above 1.0 means cash flows cover debt service; below 1.0 signals the company may be unable to meet its obligations from operations. Definitions vary across credit agreements, so in practice you use the definition specified in the relevant loan documents.

How do you calculate the fixed charge coverage ratio and what does it mean?

FCCR tests whether earnings can cover all fixed obligations, not just interest. A common formulation is (EBIT plus lease charges) divided by (lease charges plus interest expense). Fixed charges typically include rent or lease payments and interest, and sometimes utilities and other contractual commitments. It is a stricter and often more informative test than interest coverage for businesses with substantial lease obligations, such as retailers and restaurant chains, where rent is functionally as unavoidable as interest.

How would raising capital through a share issuance affect earnings per share?

The share count increases, which is dilutive and decreases EPS. There is a small partial offset: if the issuance raises cash, that cash generates interest income, which increases net income and EPS. In practice, returns on excess cash are low enough that this offset does not come close to neutralizing the dilution. A separate case is issuing stock as acquisition consideration. There the acquirer takes on the target's net income alongside the new shares, so the deal can be accretive or dilutive depending on the relative multiples and financing mix.

How would a share repurchase impact earnings per share?

The share count decreases, which is accretive and increases EPS. The partial offset is that if the buyback is funded with excess cash, the company forgoes the interest income that cash was generating, reducing net income. If funded with debt, it incurs interest expense, a larger offset. In most cases the reduction in share count dominates and EPS rises, which is precisely why buybacks are a common tool for managing reported EPS.

What is the difference between the effective and marginal tax rates?

The effective tax rate is the actual percentage of book pre-tax income recorded as tax expense, backed out as taxes paid divided by earnings before tax. It reflects the blended reality of the company's tax position including credits, NOLs, and foreign income mix. The marginal tax rate is the statutory rate applied to the next dollar of taxable income in the relevant jurisdiction. In a DCF you generally use the marginal rate for the projection period and trend the effective rate toward the marginal rate over time, since the temporary differences causing the gap eventually unwind.

Why are the effective and marginal tax rates usually different?

Because the effective rate is calculated off accrual-based book pre-tax income, while actual taxes are computed on taxable income per the tax return, and the two figures differ. GAAP and the tax code use different rules for depreciation, revenue recognition, bad debt, and many other items. As a result the tax provision on the income statement rarely matches cash taxes paid to the IRS. Foreign income taxed at different rates, tax credits, and NOL usage widen the gap further.

Give specific examples of why effective and marginal tax rates differ.

Companies typically use straight-line depreciation for book reporting but accelerated methods for tax, so tax depreciation exceeds book depreciation early in an asset's life, creating deferred tax liabilities that reverse later. Companies with prior losses apply NOL carryforwards to reduce cash taxes in profitable years without a matching reduction in book tax expense. Bad debt and uncollectible receivables are expensed for book purposes when estimated but only deductible for tax when actually written off, creating deferred tax assets. Other drivers include tax credits such as R&D credits, foreign earnings taxed at different rates, and permanently non-deductible items such as certain fines and a portion of meals and entertainment.

What are deferred tax liabilities?

A DTL is created when book tax expense recognized on the GAAP income statement exceeds the cash taxes actually owed to the IRS in that period, because of a temporary timing difference. The company owes the difference in the future, hence a liability. The classic driver is depreciation: accelerated depreciation for tax purposes produces a larger early deduction than straight-line book depreciation, so taxable income is lower than book income and cash taxes are lower than the book provision. The cumulative depreciation is identical under both methods over the asset's life, so at some point the relationship inverts and the DTL unwinds toward zero. DTLs are also created in acquisitions when assets are written up for book purposes without a corresponding step-up in tax basis.

What are deferred tax assets?

A DTA is created when the cash taxes owed to the IRS exceed the book tax expense recognized on the GAAP income statement, again from a temporary difference. The company has effectively prepaid tax and will benefit in the future, hence an asset. The most common driver is net operating losses. A company reporting a $10 million pre-tax loss receives no immediate refund; it carries the loss forward against future income. Under GAAP the future tax benefit is recognized immediately, and that difference is captured as a DTA that reverses as the NOLs are used. Other drivers include differences in revenue recognition timing, warranty and bad debt reserves, and deferred compensation. If it becomes more likely than not that a DTA will not be realized, a valuation allowance is recorded against it.

What are the current rules for net operating loss carryforwards? (Updated - the Redbook's CARES Act answer is obsolete.)

Under the TCJA framework still in effect, NOLs arising in tax years after 2017 can be carried forward indefinitely but generally cannot be carried back, and their use in any year is limited to 80% of taxable income. The CARES Act temporarily allowed a five-year carryback for NOLs arising in 2018 through 2020; that relief has expired and does not apply to current-year losses. Separately, Section 382 limits the annual usable amount of a target's NOLs following an ownership change, roughly equal to the equity value of the target at the time of the change multiplied by a published long-term tax-exempt rate. This is why acquirers rarely pay full value for a target's NOL balance.

What are the notable recent changes in US corporate tax policy? (Updated - replaces the Redbook's 2021 proposed-tax-plan question.)

The federal statutory corporate rate remains 21%. The Inflation Reduction Act introduced a 15% corporate alternative minimum tax on adjusted financial statement income for very large corporations, and a 1% excise tax on net share repurchases, which is relevant when evaluating buyback programs. The One Big Beautiful Bill Act, enacted July 2025, made 100% bonus depreciation permanent for qualifying property, restored immediate expensing of domestic research and experimentation costs under Section 174A, and reverted the Section 163(j) business interest deduction limitation to an EBITDA-based calculation rather than EBIT-based. The 163(j) change is the one most relevant to leveraged transactions, since it increases the amount of interest expense that is deductible. Verify current figures before an interview, since tax law moves.

Does a company truly incur no cost by paying employees in stock rather than cash?

No, it incurs a real cost, it is just not a cash cost. Stock-based compensation is recorded as an expense that reduces book income, and it is added back on the cash flow statement because no cash left the company. But issuing new shares dilutes existing shareholders: the same claim on future earnings is now spread across more shares, so each existing share is worth less. The cost is borne by shareholders through dilution rather than by the company through cash. This is why adding SBC back to arrive at "adjusted EBITDA" is contentious, and why sophisticated investors treat SBC as a genuine economic expense.

Define contra-liability, contra-asset, and contra-equity with an example of each.

A contra-asset is an asset account carrying a credit balance, which reduces the gross asset it offsets. Accumulated depreciation is the standard example, reducing gross PP&E to net PP&E. The allowance for doubtful accounts is another. A contra-liability is a liability account carrying a debit balance, which reduces the gross liability. Debt issuance costs and original issue discount are examples: they are netted against the carrying value of the debt and amortized over its term. A contra-equity account carries a debit balance and reduces total shareholders' equity. Treasury stock is the standard example and appears as a negative figure within the equity section.

What is the allowance for doubtful accounts?

It is a contra-asset that represents management's estimate of the portion of accounts receivable unlikely to be collected, sometimes called the bad debt reserve. It reduces gross A/R to a net figure that more realistically reflects the cash the company expects to actually receive. Establishing the reserve prevents sudden large drops in the A/R balance when specific accounts are eventually written off, since the write-off is charged against the existing allowance rather than hitting the income statement at that moment.

What is the difference between a write-down and a write-off?

A write-down partially reduces an asset's carrying value when its fair market value falls below book value, meaning the asset is impaired but retains some value. Examples include inventory that has become obsolete or damaged, or PP&E after an accident or a decline in demand. A write-off reduces an asset's value to zero and removes it from the balance sheet entirely, because it has been determined to have no current or future value. Examples include uncollectible receivables and stolen inventory. A write-off is the extreme case of a write-down.