M&I 400 Sample

Walk me through the 3 financial statements.

The 3 major financial statements are the

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

The Income Statement gives the company's revenue and expenses

at the end

you see the company's net change in cash.

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

Income Statement:

1. Revenue
2. COGS (cost of goods sold)
3. Gross Margin
4. Operating Expenses (R&D

How do the 3 statements link together?

1. The net income from the Income Statement

If I were stranded on a desert island

only had 1 statement and I wanted to review the overall health of a company-- which statement would I use and why?

Let's say I could only look at 2 statements to assess a company's prospects-- which 2 would I use and why?

The Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those.

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

Income Statement:
Operating Income would decline by $10 and assuming a 40% tax rate

If Depreciation is a non-cash expense

why does it affect the cash balance?

Where does Depreciation usually show up on the Income Statement?

It could be in a (1) separate line item

What happens when Accrued Compensation goes up by $10?

Assuming that accrued compensation is now being recognized as an expense

What happens when Inventory goes up by $10

assuming you pay for it with cash?

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

In the case of inventory

Let's say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of "Year 1

" before anything else happens?

Now let's go out 1 year

to the start of Year 2. Assume the debt is high-yield so no principal is paid off

At the start of Year 3

the factories all break down and the value of the equipment is written down to $0. The loan much also be paid back now. Walk me through the 3 statements.

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPad inventory

using cash on hand. They order the inventory

Now let's say they sell the iPads for revenue of $20

at a cost of $10. Walk me through the 3 statements under this scenario.

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

Yes. It is common to see this in 2 scenarios:

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

What is Working Capital? How is it used?

Working Capital= Current Assets-Current Liabilities

If it's positive

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

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

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

2. Retail and restaurant companies like Amazon

Recently

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

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

What type of "bailout" is this-- debt? equity? a combination?

The most common scenario here is an equity investment from the government.

Income Statement-
No Changes

Cash Flow Statement-
Cash Flow from Financing goes up by $100 to reflect the government's investment

Walk me through a $100 write-down of debt-- as in OWED debt

a liability-- on a company's balance sheet and how it affects the 3 statements.

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

3 examples:

1. Web-based subscription software
2. Cell phone carriers that sell annual contracts
3. Magazine publishers that sell subscriptions

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

Per the rules of accounting

If cash collected is not recorded as revenue

what happens to it?

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

Accounts receivable has not yet been collected in cash from customers

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

Generally the accounts receivable days are in the 30-60 day range

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

Cash-based accounting recognizes revenue and expense when cash is actually received or paid out

Accrual accounting recognizes revenue when collection is REASONABLY certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash.

Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days

very small businesses may use cash-based accounting to simplify their financial statements.

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

In cash-based accounting

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

If the asset has a useful life of over 1 year

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

These days

A company has had positive EBITDA for the past 10 years

but it recently went bankrupt. How could this happen?

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

1. Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers

Under what circumstances would Goodwill increase?

Technically

What is the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

LIFO= Last-In

How is GAAP accounting different from tax accounting?

1. GAAP is accrual-based but tax is cash-based.
2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation).
3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

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

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

Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven't actually paid that tax in cold

Deferred Tax Assets arise when you pay taxes in cash but haven't expensed them on the Income Statement yet.

They're most common with asset write-ups and write-downs in M&A deals-- an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset.

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

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

Bottoms-Up: Start with individual products/customers

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

To do a true bottoms-up build

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

Use estimates. For the revenue if you don't have enough information to look at separate product lines or divisions of the company

Walk me through the major items in Shareholders' Equity.

Common items include: (5)
-Common Stock: Simply the par value of however much stock the company has issued.

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

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

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

-Accumulated Other Comprehensive Income: This is a "catch-all" that includes other items that don't fit anywhere else

Walk me through what flows into Retained Earnings.

Retained Earnings= Old Retained Earnings Balance + Net Income - Dividend Issued

Walk me through what flows into Additional Paid-In Capital (APIC).

APIC= Old APIC + Stock-Based Compensation + Value of Stock Created by Option Exercises

What is the Statement of Shareholders' Equity and why do we use it?

This statement shows the major items that comprise the Shareholders' Equity

What are examples of non-recurring charges we need to add back to a company's EBIT/EBITDA when looking at its financial statements?

-Restructuring Charges
-Goodwill Impairment
-Asset Write-Downs
-Bad Debt Expenses
-Legal Expenses
-Disaster Expenses
-Change in Accounting Procedures

Note: To be an "add-back" or "non-recurring" charge for EBITDA/EBIT purposes

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?

Normally you make very simple assumptions and assume these are percentages of revenue

How should you project Depreciation and Capital Expenditures?

The simple way: project each one as a % of revenue or previous PP&E balance.

The more complex way: create a PP&E schedule that splits out different assets by their useful lives

How do Net Operating Losses (NOLs) affect a company's 3 statements?

The "quick and dirty" way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year

What's the difference between capital leases and operating leases?

Operating leases are used for short-term leasing of equipment and property

they depreciate and incur interest payments

and are counted as debt.

A lease is a capital lease if any one of the following 4 conditions is true:

1. If there's a transfer of ownership at the end of the term.
2. If there's an option to purchase the asset at a bargain price at the end of the term.
3. If the term of the lease is greater than 75% of the useful life of the asset.
4. If the present value of the lease payments is greater than 90% of the asset's fair market value.

Why would the Depreciation & Amortization number on the Income Statement be different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens

What is the difference between the Income Statement and Cash Flow Statement?

A company's sales and expenses are recorded on its Income Statement.

The Cash Flow Statement records what cash is actually being used during the reporting period and where it is being spent. Other items included on the CF Statement could be issuance or repurchase of debt or equity and capital expenditures or other investments.

Amortization & depreciation will be reflected as expenses on the Income Statement

What is the link between the Balance Sheet and the Income Statement?

There are many links between the Balance Sheet and the Income Statement.

(3)

1. The major link is that any net income from the I.S.

What is the link between the Balance Sheet and the Cash Flow Statement?

(4)

1. Beginning cash on the CF Statement comes from the previous period's B.S.

2. Cash from Operations on the CF Statement is affected by the B.S.'s numbers for change in net working capital.

3. PP&E is another B.S. item that affects the CF Statement because depreciation is based on the amount of PP&E a company has. Any change due to purchase or sale of PP&E will affect cash from investing.

4. The CF Statement's ending cash balance becomes the beginning cash balance on the new B.S.

What is EBITDA?

EBITDA is an acronym for Earnings Before Interest

Walk me through a DCF.

A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.

1. You project out a company's financials using assumptions for revenue growth

Walk me through how you get from Revenue to Free Cash Flow in the projections.

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then

What's an alternate way to calculate Free Cash Flow aside from taking Net Income

adding back Depreciation

Why do you use 5 or 10 years for DCF projections?

That's usually about as far as you can reasonably predict into the future.

Less than 5 years would be too short to be useful

What do you usually use for the discount rate?

Normally

What is WACC and how do you calculate it?

WACC is the acronym for Weighted Average Cost of Capital. It is used as the discount rate in a discounted cash flow analysis to calculate the present value of a company's cash flows and terminal value. It reflects the overall cost of a company's raising new capital

How do you calculate the Cost of Equity?

Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium

The risk-free rate represents how much a 10-year or 20-year US Treasury should yield

Beta is calculated based on the "riskiness" of Comparable Companies and
the Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets.

Normally you pull the Equity Risk Premium from a publication called Ibbotson's.

Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be

you could also add in a "size premium" and "industry premium" to account for how much a company is expected to out-perform its peers is according to its market cap or industry.

Small company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others

How do you get to Beta in the Cost of Equity calculation?

You look up the Beta for each Comparable Company (usually on Bloomberg)

Why do you have to un-lever and re-lever Beta?

When you look up the Betas on Bloomberg (or whatever source you're using) they will be levered to reflect the debt already assumed by each company.

But each company's capital structure is different and we want to look at HOW "RISKY' A COMPANY IS REGARDLESS OF WHAT % DEBT OR EQUITY IT HAS.

To get that

Would you expect a manufacturing company or a technology company to have a higher Beta?

A technology company because technology is viewed as a "riskier" industry than manufacturing.

Let's say that you use Levered Free Cash Flow rather than Unlevered FCF in your DCF-- what is the effect?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value

If I use Levered Free Cash Flow

what should you use as the Discount Rate?

How do you calculate the Terminal Value?

You can either apply an exit multiple to the company's Year 5 EBITDA

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

In banking

What's the appropriate growth rate to use when calculating the Terminal Value?

Normally you use the country's long-term GDP growth rate

How do you select the appropriate exit multiple when calculating Terminal Value?

Normally you look at the Comparable Companies and pick the median of the set

Which method of calculating Terminal Value will give you a higher valuation?

It's hard to generalize because both are highly dependent on the assumptions you make.

In general

What's the flaw with basing terminal multiples on what public company comparables are trading at?

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you're looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.

This method is particularly problematic with cyclical industries.

How do you know if your DCF is too dependent on future assumptions?

If significantly more than 50% of the company's Enterprise Value comes from its Terminal Value

Should Cost of Equity be higher for $5 billion or $500 million market cap company?

It should be higher for the $500 million company

What about WACC-- will it be higher for a $5 billion or $500 million (of market cap) company?

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. If the capital structure is the same in terms of percentages and interest rates and such

What's the relationship between debt and Cost of Equity?

More debt means the company is more risky

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company-- but what about dividends? Shouldn't we factor dividend yield into the formula?

Trick question.
Dividend yields are already factored into Beta

How can we calculate Cost of Equity WITHOUT using CAPM?

Cost of Equity= (Dividends per Share/Share Price)+Growth Rate of Dividends

This is less common than the "standard" formula but sometimes you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

Two companies are exactly the same

but one has debt and one does not-- which one will have the higher WACC?

Why do you project out free cash flows for the DCF model?

The reason you project FCF for the DCF is because FCF is the amount of actual cash that could hypothetically be paid out to debt holders and equity holders from the earnings of a company.

When would you not want to use a DCF?

If you have a company that has very unpredictable cash flows

What is Net Working Capital?

Net Working Capital= Current Assets - Current Liabilities

Net Working Capital is a measure of a company's ability to pay off its short term liabilities with its short-term assets.

A positive number means they can cover their short term liabilities with their short-term assets.
A negative number indicates that the company may have trouble paying off its creditors

What happens to Free Cash Flow if Net Working Capital increases?

You subtract the change in Net Working Capital when you calculate FCF

Which has a greater impact on a company's DCF evaluation-- a 10% change in revenue or a 1% change in the discount rate?

It depends

What about a 1% change in revenue vs. a 1% change in the discount rate?

In this case the discount rate is likely to have a bigger impact on the valuation.

How do you calculate WACC for a private company?

This is problematic because private companies don't have market caps or Betas. In this case

What should you do if you don't believe management's projections for a DCF model?

Few different approaches (3):

1. You can create your own projections.
2. You can modify management's projections downward to make them more conservative.
3. You can show a sensitivity table based on different growth rates and margins and show the values assuming managements' projections and assuming a more conservative set of numbers.

Why would you NOT use a DCF for a bank or other financial institution?

Banks use debt differently than other companies and do not re-invest in the business-- they use it to create their "products-- loans-- instead.

Also

What types of sensitivity analyses would we look at in a DCF?

Example sensitivities:

1. Revenue Growth vs. Terminal Multiple
2. EBITDA Margin vs. Terminal Multiple
3. Terminal Multiple vs. Discount Rate
4. Long-Term Growth Rate vs. Discount Rate

And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate

A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF?

Trick question.

You don't account for this AT ALL in an Unlevered DCF

Explain why we would use the mid-year convention in a DCF.

You use it to represent the fact that a company's cash flow does not come 100% at the end of each year-- instead

What discount period numbers would you use for the mid-year convention if I have a stub period -- e.g. Q4 of Year 1-- in my DCF?

The rule is that you divide the stub discount period by 2

How does the terminal value calculation change when we use the mid-year convention?

When you're discounting the terminal value back to the present value

If I'm working with a public company in a DCF

how do I calculate its per-share value?

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

The mechanics are the same as a DCF