WSP Red Book: Accounting Questions

What is the primary purpose of US GAAP?

The SEC authorizes FASB to make accounting rules to be followed by publicly traded companies.

Under FASB, financial statements must be prepared under GAAP.

GAAP ensures transparency, relevance, comparability, and timeliness in financial reporting for public companies.

What are the main sections of a 10-K?

The main sections of a 10-K are the Business Overview, Management Discussion and Analysis, the Financial Statements, and then the Notes to the Financial Statements.

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

• 10Ks - annual report filed with the SEC that is fully comprehensive, including business overview MD&A, performance by management, financial statements, notes, etc

  • Also must be audited by an independent and files within 60-90 days after the fiscal year ends

• 10Q - quarterly report with the SEC that is much more condensed with the focus mainly on the financials

  • Reviewed by CPAs and left unaudited, must be filed within 40-45 days after quarter ends

Walk me through the three financial statements.

You start with the income statement, which is based on the principals of accrual accounting, and begins with your revenues, cost of revenues, operating expenses and other expenses, taxes, and finally net income.

That net income flows onto the top of the cash flow statement, where you adjust for any non-cash items and working capital changes to get to your CFO. Then, you add an subtract different line items in CFI and CFF to get your net change in cash at the bottom.

For the balance sheet, you have your assets, or resources, for the company, and then your liabilities and stockholders’ equity, which represent the ways you acquired those resources. That cash from the CFS flows into the cash balance on the assets side of the balance sheet. The net income from the income statement also flows in to CSE in total stockholders’ equity. At the end, the balance sheet should balance by the fundamental equation: A = L + E

Walk me through the income statement.

The income statement starts with a company’s revenues based on all the products they sold in a period. Then, you subtract your COGS, which is mostly the recognition of inventory and labor related expenses that went into the products you sold. This gives you your gross profit. From there, you subtract operating expenses like SG&A and R&D. This gives you EBITDA. Then, you subtract D&A to get to operating income, or EBIT. Then, you add and subtract “other” items like interest expense, gains and losses. This gives you pre-tax income, which is then multiplied by (1-Tax Rate) to get Net income. If the company pays a preferred dividend, that will show up as a deduction to then get to Net Income Available to Common.

Walk me through the balance sheet.

The balance sheet has your assets on one side, and the liabilities and equity items on the other.

Assets are ordered by liquidity with two main types: current assets, which can be converted to cash within a year, like accounts receivable or inventories. Long-term assets, then, are items like PP&E or goodwill.

The same separation is true for liabilities, but they are ordered by the date they come due. Current liabilities due within a year include accounts payable or unearned revenue. Long term liabilities include long-term debt and leases.

Then, under equity, you have CSE, which is made up of retained earnings, dividends, treasury stock, common stock, and APIC. You also have items outside CSE like preferred stock and AFS securities.

Could you give further context on what assets, liabilities, and equity each represent?

Assets are a company’s resources. They will contribute to a future economic benefit to the company.

Liabilities and equity are what provided the company with those resources or the cash used to acquire those resources. The main difference is that a liability is typically an obligation to recoup an external party, which means it requires a future outflow of cash, while the equity is an internal obligation to those that funded the company by taking an ownership stake.

What are the typical line items you might find on the balance sheet?

Under assets, you’ll find items like accounts receivable, prepaid expenses, intangible assets, goodwill, PP&E, cash and marketable securities, inventory, equity investments, accumulated depreciation, leases and DTAs.

Under liabilities you will find items like accounts payable, deferred revenue, accrued expenses, DTLs, notes payable, long-term debt, leases, and PIK interest.

Under equity, you’ll find net income, common stock, APIC, treasury stock, preferred stock, and OCI, which includes unrealized gains and losses on AFS securities and currency translation adjustments.

Walk me through the cash flow statement.

The cash flow statement under U.S. GAAP with the direct method starts with NI and then adjusts for non-cash charges like D&A or SBC and working capital like AR and inventory to get to CFO.

Then, under CFI, you add line items like sales of PP&E and subtract purchases of PP&E to get your CFI.

Then, from CFF, you add line items like debt or common stock issuances and subtract items like dividends or principal repayment.

You sum CFO, CFI, and CFF to get the net change in cash for the period.

If you use the indirect method, then you have distinct line items that show where the inflows and outflows of cash are coming from instead of adjusting NI for working capital and non-cash charges to get to CFO. CFI and CFF remain the same.

How are the three financial statements connected?

The income statement is connected through the cash flow statement with NI, which flows onto the top of the CFS.

The CFS is connected to the balance sheet with dividends, which flow into CSE, and it also connects through the impacts of equity and debt issuances, PP&E, and treasury stock. Finally, the net change in cash is on the bottom, which flows into the assets side.

Then, the IS is connected to the balance sheet through net income, which is included in CSE. The interest income/expense line item is also calculated using the debt balance on the BS. BS PP&E is reduced by D&A, which shows up on the IS.

If you have a balance sheet and must choose between the income statement or cash flow statement, which would you pick?

Assuming I had the balance sheet for the beginning and the end of the period, since the BS is just a snapshot, I would choose the income statement.

Because, with the BS and IS, you can make most of the CFS by looking at the NI on the bottom of the IS, and then changes to different accounts on the BS. Like, if you looked at the common stock on the balance sheet and took the end of period - start of period, you could get the equity issuance inflow for the year potentially.

However, with items like Net PP&E, you might not be able to break out the actual CapEx versus the accumulated depreciation since the income statement depreciation line isn’t necessarily the full amount as some companies allocate depreciation to COGS or SG&A.

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

The cash flow statement. The cash flow statement is the most important statement because it allows you to see how much cash a company is actually generating and calculate their cash flow, which is how investors determine the company’s value.

The cash flow statement is also more revealing so far as the investments and financing the company is requiring to operate, which can help answers questions about liquidity risks or CapEx requirements.

If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick?

I would pick the cash flow statement because I can calculate cash flow to value it, asses investment needs for growth, and look at their financing to determine liquidity risk or needs to fuel the business.

The one caveat is that, if the company was unprofitable, then having the cash flow from the cash flow statement wouldn’t be as useful.

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

The only debt-related line item on the income statement are the ones related to interest expense. While this can be slightly informative, it says nothing about how much debt the company is having to issue, how fast and how much it is having to pay back.

Additionally, revenues and net income can look good, the actual working capital behind the scenes is obscured. Net income can grow, but if the company cannot actually collect the cash for some reason, then it doesn’t really matter.

What are some discretionary management decisions that could inflate earnings?

• Share buybacks

• SBC

• Selling assets for a gain

• Switching between LIFO and FIFO

• No writing down assets

• Deferring R&D

• More favorable terms for purchasers using credit

• Longer useful lives for PP&E so D&A is lower

Tell me about the revenue recognition and matching principle used in accrual accounting.

The revenue recognition principle essentially states that revenues must be recognized in the period that the service of product is actually delivered.

The matching principle says that, when you recognize that revenue, you have to recognize the expenses used to generate that revenue in the same period it is recognized. That’s why we don’t expense inventory until the product is actually sold and the revenue is generated.

How does accrual accounting differ from cash-basis accounting?

Accrual accounting focuses on when the action occurs, like actual delivery of a product, cash-basis accounting just focuses on when the cash changes hands.

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

Cost of goods sold are expenses directly related to the manufacturing and selling of a product, including any direct labor involved in getting it to its final form.

Operating expenses are expenses that can’t be or would be difficult to tie to the production of a specific item or service. Things like corporate salaries, sales, and marketing expenses would fit here.

When do you capitalize vs. expense items under accrual accounting?

Typically, you capitalize an item if it will provide a benefit to a company for longer than a year. Like PP&E, where a factory might be making products for 15 years.

An expense, then, is a short-term expenditure, like a wage expense or inventory that cycles in and out quickly.

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

While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has already occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase.

Do companies prefer straight-line or accelerated depreciation?

For GAAP reporting purposes, most companies prefer straight-line depreciation because lower depreciation will be recorded in the earlier years of the asset’s useful life than under accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income and EPS in the initial years.

Eventually, the accelerated approach will show lower depreciation into an asset's life than the straight-line method. However, companies still prefer straight-line depreciation because of the timing, as many companies are focused more on near-term earnings.

If the company is constantly acquiring new assets, the “flip” won’t occur until the company significantly scales back capital expenditures.

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

You depreciate an asset from its initial book value to its salvage value over its useful life. The salvage value is the book value you prescribe the asset once its useful life is over and depreciation stops.

The lower the salvage value at the same useful life, the higher the tax benefits from depreciation.

Do companies depreciate land?

No, companies are not allowed to depreciate land because, unlike most other PP&E, land is considered to have an indefinite useful life.

How would a $10 increase in depreciation flow through the financial statements?

IS - pre-tax income down by $10, assuming a 30% tax rate, net income is down by $7.

CFS - Net income starts down by $7, add back non-cash depreciation expense of $10, CFO is up by $3. No other changes, so cash is up by $3.

BS - On the assets side, cash is up by $3, but net PP&E is down by $10. On the L&E side, CSE is down by $7 from the reduction in net income. So, both sides balance down $7.

A company acquired a machine for $5 million and has since generated $3 million in accumulated depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value of that PP&E on the balance sheet?

The book value of the PP&E is the Historical Cost minus any accumulated depreciation. So, it would be $2M. Under GAAP, firms cannot write up to fair value except for in the case of FMV investments.

***Under IFRS companies could re-evaluation PP&E, but most choose not to. Don’t bring this up in an interview, just know it.

What is the difference between growth and maintenance capex?

The difference is that maintenance CapEx is done for the sake of continuing current business operations, like a large repair on a factory.

Growth CapEx is done with the intention of expanding the business’ operations, like buying a new coal mine to add incremental revenue and net income.

Which types of intangible assets are amortized?

All intangible assets except for the rare case of one with an indefinite useful life are amortized.

Amortizable assets include customer lists, copyrights, and patents.

What is goodwill and how is it created?

Goodwill is created in an acquisition, when a company pays more for another company than the value of the balance sheet would suggest. Because they have to write CSE down to 0 for the seller, it puts the balance sheet out of balance.

Goodwill represents an intangible asset that captures the excess of the purchase price over the fair market value of an acquired business's net assets.

Can companies amortize goodwill?

No, companies cannot amortize goodwill, rather they test it for impairment over time and may have to write it down if they deem the premium they paid for the acquisition was not justified.

Privately owned companies can amortize goodwill, and sometimes that is over a useful life of 15 years for tax reporting purposed.

***This is done because the expenses related to valuing goodwill may be cumbersome for a private company so it simplifies their expenses and accounting.

What is the “going concern” assumption used in accrual accounting?

The going concern assumption is that a business entity will continue to exist into perpetuity. This is important in valuation, where you have to assume that cash flows persist indefinitely instead of an eventual liquidation.

Explain the reasoning behind the principle of conservatism in accrual accounting.

The conservatism principle requires thorough verification and use of caution by accountants when preparing financial statements, which leads to a downward measurement bias in their estimates.

Central to accounting conservatism is the belief that it's better to understate revenue or the value of assets than to overstate it (and the reverse for expenses and liabilities). As a result, the risk of a company's revenue or asset values being overstated and expenses or liabilities being understated is minimized.

Why are most assets recorded at their historical cost under accrual accounting?

This is in-line with the principle of conservatism. Most assets aside from FMV securities are hard to value because they don’t have an actively trading market with a bunch of participants. Think of a 3 year old forklift, for example, how many comps are there for that? The valuation is going to be fairly speculative, so in order to not overstate the value of a company’s net assets, they must record it at the price the paid for it.

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

Because the mortgages were being held at historical cost for an extended period of time and weren’t actively re-valued to an actual fair market value, the value of the assets was grossly overstated. So, CDOs for example looked like they were securitized by more valuable assets than they actually were. Once, the marks were updated with FAS-157, things started to unwind as people realized their balance sheets were much less safe than they had assumed.

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

They aren’t reflected on the balance sheet because they are very hard to value, and the objectivity principle says that only verifiable, unbiased data can be used. So, you can’t just value your own internally created trademarks.

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

There is no impact because shareholders’ equity represents the book value of equity, not the actual market value. That’s because the book equity represents the residual value to shareholders only after all the company’s assets are liquidated and liabilities are paid off.

Do accounts receivable get captured on the income statement?

Actual accounts receivable do not get captured on the income statement, however, growth in accounts receivable would coincide with additional revenue since it is created by the delivery of a product or service, which would show up on the IS.

Why are increases in accounts receivable a cash reduction on the cash flow statement?

It is a cash reduction on the CFS because even though you have recognized the revenue related to delivering a product or service, you haven’t actually collected the cash for it yet. So, you have to adjust your net income number that would have incorporated that additional revenue to show the cash isn’t there.

What is deferred revenue?

Deferred revenue is an account created when a company has received cash for a product or service, but not actually delivered it. So, this created a future obligation that is recorded as a liability on the balance sheet.

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

Accounts receivable is an asset because it represents a resource that will provide a future economic benefit to the firm. Unearned revenue is a liability because it represents a future obligation of the firm to an external party and will require the future outlay of cash to deliver on.

Why are increases in accounts payable shown as an increase in cash flow?

An AP arises when a company owes money to an external party like a supplier or vendor. But, the cash hasn’t actually been paid out yet, meaning the company retains it. So, the adjustment must be made on the CFS as an inflow.

Which section of the cash flow statement captures interest expense?

Interest expense is captured via net income on the IS, which flows into the top of the CFS in CFO.

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

IS - Nothing

CFS - Cash outflow under CFF

BS - reduction in cash and CSE

Do inventories get captured on the income statement?

They get captured not when they are bought, but when they are sold as products through the COGS line item.

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

An increase in inventory is a decrease in cash because acquiring inventory would require an outlay of cash.

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

The difference comes down to what inventory you are recognizing as sold.

Under LIFO, the most recent inventory you acquired will be sold. This usually means COGS is higher and ending inventory balance is lower because inventory prices go up over time.

Under FIFO, the furthest back inventory you acquired will be sold. This usually means COGS is lower and ending inventory balance is higher because inventory prices go up over time.

Typically, in a rising prices environment, LIFO will lead to higher cash flow because of the tax savings.

What is the average cost method of inventory accounting?

The average cost method of accounting takes a weighted average of all the inventory you’ve purchased at all the different price points to determine an average price per unit.

The COGS and ending inventory for this method is going to be in between LIFO and FIFO.

Only really applicable for high volume, identical inventory.

How do you calculate retained earnings for the current period?

To calculate retained earnings, you take last period’s retained earnings, add net income, and subtract dividends.

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

The retention ratio represents the proportion of net income retained by the company, net of any dividends paid out to shareholders. The inverse of the retention ratio is the dividend payout ratio, which measures the proportion of net income paid out as dividends to investors.

What are the two ways to calculate earnings per share (EPS)?

There are two types of EPS, basic and diluted.

To calculate basic EPS, you take the current period’s net income and divide by the number of common outstanding shares.

To calculate diluted EPS, you take the period’s net income, and divide it by taking the basic shares outstanding and then adding in the impact of dilutive securities like options, warrants, and convertibles. For example, if an option is ‘in-the-money’ then the holder can exercise it at any time and dilute current owners.

Where can you find the financial reports of public companies?

SEC.gov, BAMSEC, SEC EDGAR, on the company’s investor relations webpage.

What is a proxy statement?

The proxy statement, formally known as "Form 14A," is required to be filed before a shareholder meeting to solicit shareholder votes. The document must disclose all relevant details regarding the matter for shareholders to make an informed decision.

In addition, the board of directors' compensation and other notable announcements such as changes to the company’s articles of incorporation are included.

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

An 8-K is an ad-hoc report that must be filed when an event happens that materially changes or impacts the company’s operations or finances.

Could be the announcement of an acquisition, a bankruptcy, the resignation of a C-suite official, or announcement that they are under investigation.

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

As the US equity market has become crowded, it has also become a lot more efficient. That means it is hard to add value at a desirable price point.

By going international into less saturated markets, investors and advisors can find opportunities that may be more under the radar. With technology, infrastructure, and transportation, these opportunities are also a lot more feasible and available.

IFRS is overseen by the IASB.

What are some of the most common margins used to measure profitability?

Gross margin, EBITDA and EBIT margin, and net income margin.

What do the phrases “above the line” and “below the line” mean?

The line refers to operating income, or EBIT, which separates line items that are above and core to a business’ operations, like EBITDA or revenue from line items that are below and non-operational, like interest expenses, taxes, and non-operating income like gains or losses.

Is EBITDA a good proxy for operating cash flow?

EBITDA is a good proxy for operating cash flow because it removes some of the impacts of non-cash charges like D&A, which also reduces some of the impact of CapEx, and is also capital structure neutral, meaning it doesn’t include the affects of financing.

CFO sits above CFF and CFI, so it is capital structure neutral except for the interest expense, and doesn’t include the impacts of CapEx.

***While EBITDA does add back D&A, typically the largest non-cash expense, it doesn't capture the full cash impact of capital expenditures ("capex") or working capital changes during the period. EBITDA also doesn't adjust for stock-based compensation, although an increasingly used “adjusted EBITDA” metric does add-back SBC. These non-cash and any non recurring adjustments must be properly accounted for to assess a company's past operational performance and to accurately forecast its future cash flows.

What are some examples of non-recurring items?

Expenses related to a restructuring, asset impairments, extraordinary gains, or legal settlements. They are removed from some key financial metrics to try to better get at the underlying core business operations.

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

Not necessarily always, only if it is a one-off event. If it is a company that constantly deals with legal problems year after year, then it might not be appropriate to classify it as non-recurring. It may just be a natural consequence of their core business at that point.

What is the difference between organic and inorganic revenue growth?

Organic growth - expanding to new markets, enhancing sales and marketing, improving mix, making new products. Continuous operational improvements

Inorganic growth - M&A driven growth, often faster and more convenient. Gives the company synergies, new customers, complementary products, and diversified revenue streams.

How does the relationship between depreciation and capex shift as companies mature?

When a company is first growing, they may need to spend a lot on CapEx, which means they will have heavier depreciation in the near-term.

As the company matures, CapEx and depreciation will typically slow down and begin converging as older, more expensive PP&E keeps depreciation elevated but new, lower CapEx reduces that line item. Eventually, once the only CapEx is routine maintenance, depreciation will also fall.

What is working capital?

Working capital is the difference between the current assets and current liabilities of a company. It gives you insight into how liquid a company is and whether it can pay off its current obligations with the assets that it can easily liquidate.

Why are cash and debt excluded in the calculation of net working capital (NWC)?

Cash and debt are excluded because working capital is intended to reflect operational current assets and liabilities.

Cash and debt are considered non-operational, as they don’t contribute to the day-to-day running or performance of the business. Now, you need some cash on hand, but company’s typically won’t tell you how much they exactly need, so you just exclude all of it.

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

It depends what is driving it.

If a company has negative working capital because it has a large sum of unearned revenue that it knows it can deliver on, then that is a constructive thing. This might be prevalent in a subscription-based software company.

If a company has negative working capital because it has a bunch of accounts payable that have ballooned since they can’t generate cash flow, then that would be a negative.

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

It helps tell you how a company is generating its cash flows. Does it require the outlay of cash to fuel growth, which would be a positive change, which is subtracted from free cash flow. Or, does it use growth to generate cash, which would be a negative change, which is added to free cash flow.

**The change in net working capital is important because it gives you a sense of how much a company's cash flows will deviate from its accrual-based net income.

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

I would look at ratios like:

• DIO: (Average Inventory/COGS) X 365 days

  • average number of days to sell off inventory

• DSO: (Averaged AR/Revenue) X 365 days

  • average time to collect payment on credit

• DPO: (Average AP/COGS) X 365 days

  • average number of days to pay back suppliers

What is the cash conversion cycle?

The cash conversion cycle measures how quickly a company converts their inventory into cash through sales, and is calculated by:

• CCC = DSO + DIO - DPO

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

• AR - Tied to revenue

• Inventory - tied to COGS

• Prepaid expenses - tied to SG&A

• Other current assets - tied to revenue if a part of operations, or straight-lined

• AP - tied to COGS

• Accrued Expenses - tied to SG&A

• Deferred Revenue - tied to revenue

• Other current liabilities - tied to revenue or straight-lined

How would you forecast capex and D&A when creating a financial model?

You may look at the company’s historical CapEx and D&A, and make a PP&E schedule based on your assumptions and management’s discussion about their future growth and maintenance plans and needs.

For simplicity, though, you could tie D&A and CapEx to revenue. CapEx should directly correlate to revenue growth.

How would you forecast PP&E and intangible assets?

For PP&E:
Ending PP&E = Beginning PP&E + CapEx - Depreciation

For Intangibles: Need management guidance since these are more one-offs and no pattern will be found in the historicals. With no guidance, assume no intangibles.

Ending Intangibles = Beginning Intangibles + intangible Purchases - amortization

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

• Current Ratio = Current Assets/Current Liabilities

• Quick Ratio = (Cash + ST Investments + Accounts Receivable)

  • only counts highly liquid assets that could very likely be turned to cash in less than 90 days

Give some examples of when the current ratio might be misleading?

• Current Assets are made up of Aged AR that may not be collected

• Short-term investments that cannot be liquidated in the markets easily could have been included (i.e., low liquidity, cannot sell without a substantial discount).

• Similarly, the cash balance may contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose.

• The cash balance used includes the minimum cash amount required for working capital needs – meaning operations could not continue if cash were to dip below this level.

Is it bad if a company has negative retained earnings?

Not necessarily, startup firms usually have negative net income.

Also, management could be returning a lot of capital to shareholders with buybacks and dividends.

How can a profitable firm go bankrupt?

• Large CapEx needs

• Debt maturity wall that they are unable to meet

• Ballooning AR but no cash actually coming in

• Must pay for all inventories and supplies in cash, so working capital is diminished because suppliers won’t give them favorable credit terms

What does return on assets (ROA) and return on equity (ROE) each measure?

• ROA: $s of NI generated per $ in total assets the company has. Measures how well they are using their assets to generate earnings, which is relevant for a manufacturer or company with a lot of PP&E

• ROE: $s of NI generated per $ of equity invested. Shows how well the company is allocating the capital they have raised from common shareholders.

What is the relationship between return on assets (ROA) and return on equity (ROE)?

The relationship has to do with the the sources of funding for the company. If they have no debt, then their equity will equal their assets and the two ratios will be the same.

But, if there is debt, the ROE will be higher than the ROA because there will be more assets that equity as the debt funding contributed to acquiring some of the asset base.

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

Imagine a company with $100 in total assets. A 10% return on assets (ROA) would imply $10 in net income. Since the debt-to-equity mix is 50/50, the return on equity (ROE) is $10/$50 = 20%.

When using metrics such as ROA and ROE, why do we use averages for the denominator?

You use averages to smooth out volatility in the inventory amount over the year from large purchases or large sales since the denominators come from the balance sheet which is a snapshot of a particular point in time.

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

Issues come up with comparability:

ROE - if the company is financed mostly with debt, not very indicative of how equity investments are contributing to returns

ROA - if a company doesn’t have a lot of assets that it uses to drive returns, like say a software company, then this metric won’t be very impactful

So, you need to ensure that two companies you are valuing with metrics like these actually have similar growth, margin, and capital structure profiles.

Also, for both of them, net income is not actual cash flow, so it doesn’t directly tie to the value of the business.

What is the return on invested capital (ROIC) metric used to measure?

ROIC = NOPAT/(Equity + Debt + Preferred - Cash)

It shows how effectively the company has generated post-tax operating returns from all sources of funding that have been invested. If ROIC, the return of an investment, exceeds WACC, the cost of an investment, then it is an efficient and profitable allocation of capital. Being able to do this long-term is a signal of a competitive advantage.

What does the asset turnover ratio measure?

Asset Turnover Ratio = Revenue/(Average Total Assets)

It measures how effectively and efficiently a company is using its asset base to drive sales.

It can be distorted by CapEx and Asset Sales.

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

Inventory Turnover = COGS/Average Inventory

Measures how many times in a period that a company sells through its average inventory balance. The difference is that it does not calculate a set number of days for one of these cycles like DIH does.

What does accounts receivables turnover measure?

AR Turnover = Revenue/Avg. AR

Measures how many times in a period a company converts its average AR balance into actually collected cash.

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

AP Turnover = COGS/Avg. AP

Measures the amount of times that a company has to pay off its AP with cash per period. You prefer this to be as low as possible, typically, because it means you have stronger control on credit terms and can hold onto cash longer.

What are some ratios you would look at to perform credit analysis?

• Liquidity Ratios (current, quick, and cash ratios)

  • assess ability to meet current obligations using current assets

• Leverage/Solvency (Debt/EBITDA, Debt/Assets, Debt/Equity)

  • Evaluate if debt obligations can be met

• Coverage Ratios (Times interest earned, EBITDA interest coverage, debt service coverage, fixed charge coverage)

  • measures ability to service interest payments and other debt-related obligations using a cash flow metric

• Profitability Ratios (Gross, Operating, Net Profit, EBITDA margin, ROA, ROE, ROIC

  • Looks at company’s ability to consistently generate profits, which allows it to meet debt obligations

What are the two types of credit ratios used to assess a company's default risk?

Leverage ratios, how much debt does it have compared to cash flows, and coverage ratios, can cash flows cover interest payments on the debt.

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

DSCR = (EBITDA-CapEx)/(Mandatory Principal Repayment + Interest Expense)

Tests company’s ability to pay current debt obligations using cash flow. >1 is sufficient, <1 is concerning.

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

Fixed Charge Coverage Ratio = (EBIT + Fixed Charges)/(Fixed charges +interest expense)

Can a company’s earnings cover its fixed charges, like rent, utilities, and interest expense. Higher the ratio the better.