IBA: Accounting & 3 Financial Statements

What are the 3 financial statements, and why do we need them?

The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow

Statement.

The Income Statement shows the company's revenue, expenses, and taxes over a period and ends with Net Income, which represents the company's after-tax profits.

The Balance Sheet shows the company's Assets - its resources - as well as how it paid for those resources - its Liabilities and Equity - at a specific point in time. Assets must equal Liabilities plus Equity.

The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in

operating assets and liabilities (working capital), and then shows the company's cash from Investing or Financing activities; the last lines show the net change in cash and the company's ending cash balance.

You need these statements because there is a big difference between a company's Net Income and the cash it generates - the Income Statement alone doesn't tell what its cash flow is.

Remember the key valuation formula:

Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate)

How do the 3 statements link together?

To link the statements, make Net Income from the Income Statement the top line of the Cash Flow Statement.

Then, adjust this Net Income number for any non-cash items such as D&A and reflect changes to operational Balance Sheet items (such as Accounts Receivable) which may increase or decrease the company's cash flow depending on how they've changed. This gets you to Cash Flow from Operations.

Next, take into account investing and financing activities, which may increase or decrease cash

flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom.

Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net Income to Retained Earnings within the Equity category on the Balance Sheet.

Then, link each non-cash adjustment to the appropriate Asset or Liability; SUBTRACT links on the Assets side and ADD links on the L&E side. (Do the same w/ CFI & CFF items)

Check that Assets equals Liabilities plus Equity at the end; if this is not true, you did something wrong and need to re-check your work.

What's the most important financial statement?

The Cash Flow Statement is the most important single statement because it tells you how much cash a company is generating.

What if you could use only 2 statements to assess a company's prospects - which ones would you use, and why?

You would use the Income Statement and Balance Sheet because you can create the Cash Flow Statement from both of those

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

companies that use IFRS often start the Cash Flow Statement with something other than Net Income: Operating Income, Pre-Tax Income

There are also minor naming differences; for example, the Income Statement might be called the "Consolidated Statement of Earnings" or the "Profit & Loss Statement," and the Balance Sheet might be called the "Statement of Financial Position."

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

For modeling and valuation purposes, you should convert this Cash Flow Statement into one that starts with Net Income and makes the standard adjustments.

(Large companies should provide a reconciliation that shows you how to move from Net Income or Operating Income to Cash Flow from Operations and that lists the changes in Working Capital and other non-cash adjustments.)

If the company does NOT provide that reconciliation, you might have to stick with the CFS in the original format.

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

It must correspond to ONLY the period shown on the Income Statement.

It must affect the company's taxes.

How can you tell whether an item should be classified as an Asset, Liability, or Equity on the Balance Sheet?

An Asset will generate future cash flow for the company or can be sold for cash.

A Liability will cost the company cash in the future and cannot be sold because it represents payments the company owes.

Equity line items are similar to Liabilities because they represent funding sources for the company - but they will NOT result in future cash costs.

How can you tell whether or not an item should appear on the Cash Flow Statement?

It has already appeared on the Income Statement and affected Net Income, but it's non-cash, and you need to adjust for it to determine the company's real cash flow

It has NOT appeared on the Income Statement and it DOES affect the company's cash balance.

A company uses cash-based accounting rather than accrual accounting. A customer buys a TV from the company "on account" and receives the TV right away. How would the company record this transaction differently from a company that uses accrual accounting?

Under cash-based accounting, the revenue would not show up until the company collects the

cash from the customer - at which point it would add to Revenue on the Income Statement (and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet.

Under accrual accounting, the sale would show up as Revenue right away, but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is deposited in the company's bank account, it would move into Cash, and Accounts Receivable would decrease.

A company begins offering 12-month installment plans to customers so that they can pay for $500 or $1,000 courses over a year instead of all upfront. How will its cash flow change?

In the short term - during THIS year - the company's cash flow will decrease because some customers no longer pay upfront in cash.

So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on.

This situation corresponds to Accounts Receivable: The Asset on the Balance Sheet that represents owed future payments from customers.

The long-term impact depends on how much sales grow as a result of this change.

If sales grow substantially and the company's Revenue and Net Income increase, that might be enough to offset the reduced cash flow and make the company better off.

A company decides to prepay its monthly rent - an entire year upfront - because it can save 10% by doing so. Will this prepayment boost the company's cash flow?

In the short term, no, because the company is now paying 12 * Monthly Rent in a single month rather than making one payment per month.

On the Income Statement in Month 1, the company will still record only the Monthly Rent for that month. But on the Cash Flow Statement, it will list a negative 12 * Monthly Rent under "Change in Prepaid Expenses" to represent the cash outflow for the prepayment.

A 10% discount represents just over 1 month of rent, so the company's immediate cash flow will decrease substantially.

In the long term, this discount will improve the company's cash flow because the timing difference will go away after a year.

Your friend is analyzing a company and says that you always have to look at the Cash Flow Statement to find the full amount of Depreciation.

Is he right? And if so, what are the implications?

Yes, your friend is correct. This happens because companies often embed Depreciation within other line items, such as COGS and Operating Expenses, on the Income Statement.

First off, you CANNOT assume that the Depreciation listed on the Income Statement is the full amount.

Second, adding back the full amount on the CFS shows that Depreciation simply reduces the company's taxes without "costing" it anything in cash.

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

A company would collect cash payments for a monthly service long in advance if it has the market power do so.

It's always better to get cash earlier rather than later because of the time value of money.

This practice always boosts a company's cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue will be a positive entry that boosts a company's cash flow.

Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?

Accounts Receivable is an Asset because it corresponds to future cash payments that customers are expected to make.

Deferred Revenue is a Liability because it will cost the company cash in the future.

While AR and DR may seem similar, they are the opposites of each other

How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why are Prepaid Expenses an Asset?

Prepaid Expenses have already been paid out in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they do finally appear on the Income Statement, they'll reduce the company's future taxes, making them an Asset.

Accounts Payable have not yet been paid out in cash but have been incurred as expenses, so they have appeared on the Income Statement. When the company finally pays them in cash, Accounts Payable will reduce the company's cash, making them a Liability.

Accounts Payable and Accrued Expenses work in exactly the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), whereas Accrued Expenses is more for monthly, recurring items without invoices (e.g., utilities).

Your CFO wants to start paying employees mostly in stock-based compensation, under the logic that it will reduce the company's taxes, but not "cost it" anything in cash.

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

The CFO is partially correct. Yes, stock-based compensation is a non-cash expense that reduces a company's taxes but gets added back on the CFS, similar to Depreciation.

However, unlike Depreciation or Amortization, Stock-Based Compensation incurs a real cost to the company and its investors because it creates additional shares.

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

What do you tell him?

The two main methods of funding a company's operations are debt and equity. Debt is cheaper

for most companies, so most companies prefer to use debt... up to a reasonable level.

Both equity and debt issuances show up on only the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company's cash balance.

The only "after-effect" of equity is that the company's share count increases.

With debt, the company must pay interest, which will be recorded on its Income Statement, reducing its Net Income and Cash, and it must eventually pay back the full balance.

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

Why is this Loss considered a non-cash expense?

This Loss is a non-cash expense because you haven't actually "lost" anything in cash in the current period.

The "Loss" refers to how you previously spent more than $85 to buy this equipment in some prior period.

But that doesn't matter because non-cash adjustments

are based on what happens in the CURRENT PERIOD.

Your company owns an old factory that's currently listed at $1,000 on its Balance Sheet.

Why would it choose to "write down" this factory's value, and what is the impact on the financial statements?

A company might write down an Asset if its value has declined substantially, and it's no longer accurate to reflect it at the original value on the Balance Sheet.

On the statements, you record this write-down as an expense on the Income Statement, but you add it back as a non-cash expense on the Cash Flow Statement.

The result is that the company's cash balance increases due to the tax savings.

The CFO of your firm recently unveiled plans to purchase short and long-term investments. Why would she want to do this, and how would this activity affect the statements?

A company might want to purchase investments if it has excess cash and cannot think of other ways to use it.

The initial purchase of these investments will show up only on the Cash Flow Statement and will reduce the company's cash flow.

Afterward, the Interest Income earned on these investments will appear on the Income Statement and boost the company's Pre-Tax Income, Net Income, and its Cash balance.

Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes, what would it mean?

Yes. Think about a company that starts losing massive amounts of money, resulting in a negative Net Income. After many years, negative Net Income could easily turn the company's Equity negative.

This might also happen if the company issues a huge dividend to its owners (e.g., following a leveraged buyout) that turns Equity negative.

The "meaning" varies based on what has happened, but negative Equity is almost always a negative sign because it means the company has been unprofitable or has done something irresponsible with its dividends or share repurchases.

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

You need to create Goodwill and Other Intangible Assets after an acquisition takes place to ensure that the Balance Sheet balances.

In an acquisition, you write down the seller's Shareholders' Equity and then combine its Assets

and Liabilities with those of the acquirer. If you've paid exactly what the seller's Shareholders' Equity is worth, then there are no problems.

However, in real life, this almost never happens. Companies almost always pay premiums for companies they acquire, which means that the Balance Sheet will go out of balance.

To fix that problem, you start by allocating value to the seller's "identifiable intangible assets" such as patents, trademarks, intellectual property, and customer relationships.

If there's still a gap remaining after that, you allocate the rest to Goodwill.

How do Goodwill and Other Intangible Assets change over time?

Goodwill remains constant unless it is "impaired," (i.e., the acquirer decides that the acquired

company is worth far less and therefore writes down the Goodwill. That appears as an expense

on the Income Statement and a non-cash adjustment on the Cash Flow Statement.)

Other Intangible Assets amortize over time (unless they are indefinite-lived), and that Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash Flow Statement. The balance decreases until it has amortized completely.

Walk me through the 3 financial statements when Bobby Wasabi Dojo's operating expenses increase by $100.

IS: Operating Expenses up 100, PTI & OI down 100, Net Income down 60 (40% tax rate)

CFS: Net Income down 60, no other changes, net change in cash down 60

BS: Cash down 60, Assets down 60. Retained Earnings down 60, L+E down 60.

Maui Food Truck Inc. Depreciation increases by $10. What happens on the 3 financial statements?

IS: PTI down 10, Net Income down 6 (40% tax)

CFS: Net Income down 6, add back 10 for depreciation (non-cash), net change in cash up 4

BS: Cash up 4, PPE down 10, Assets side down 6. Retained earnings reduced by 6 (net income), L+E down 6.

A company runs into financial distress and needs cash immediately. It sells a factory that's listed at $100 on its Balance Sheet for $80. What happens on the 3 statements?

IS: Record loss of 20 on sale, PTI down 20, Net Income down 12 (40% tax)

CFS: Net Income down 12, add back 20 b/c loss is non-cash, record full proceeds from sale of 80, net change in cash up 88

BS: Cash up 88, PPE down 100, Assets down 12. Retained earnings down 12 (net income), L+E down 12.

A company decides to CHANGE a key employee's compensation. It will offer the employee stock options instead of a real salary. The employee's salary was formerly $100, but she will receive $120 in stock options now. How do the statements change?

IS: Operating expenses up 20, PTI down 20, Net Income down 12 (40% tax)

CFS: Net Income down 12, Add back 120 from SBC (non-cash), net change in cash up 108

BS: Cash up 108, Assets side up 108. Retained earnings down 12 (net income), Common Stock & APIC up 120, L+E up 108.

Your company just acquired another one for $1,000 in cash. The other company's Shareholders' Equity was $500, and you identified $100 in Other Intangible Assets with a useful life of 5 years.

What happens on the 3 statements from just AFTER the acquisition closes to the end of the first year following the acquisition? (Only factor in Goodwill and Other Intangible Assets.)

IS: Amortization expense up 20, PTI down 20, Net Income down 12 (40% tax)

CFS: Net income down 12, add back 20 from amortization (non-cash), net change in cash up 8

BS: Cash up 8, Intangible assets down 20, Assets down 12. Retained earnings down 12 (net income), L+E down 12.

Oh no! An acquisition goes horribly wrong... you must write down half of the $400 in Goodwill you have just created. How do the three statements change???

IS: Goodwill write down of 200, PTI down 200, Net Income down 120 (40% tax rate)

CFS: Net income down 120, add back 200 from goodwill write down (non-cash), net change in cash up 80

BS: Cash up 80, Goodwill down 200, Assets down 120. Retained earnings down 120, L+E down 120.

Walk me through what happens on the statements when a customer orders a product for $100 but doesn't pay for it in cash, and then what happens when the cash is finally collected.

Part 1 (before cash collection):

IS: Revenue up 100, Net Income up 60 (40% tax)

CFS: Net Income up 60, Increase in AR decreases CFO by 100, net change in cash down 40.

BS: Cash down 40, AR up 100, Assets up 60. Retained earnings up 60 (due to increase in net income), L+E up 60.

Part 2 (Cash is collected):

IS: No changes

CFS: Decrease in AR boosts cash flow by 100, net change in cash up 100

BS: Cash up 100, AR down 100, balance maintained.

A company prepays its rent ($20 per month) a month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens

when the expense is incurred.

Part 1 (Company Prepays Expense):

IS: No changes

CFS: Prepaid expenses up 20, net change in cash down 20 (increase in asset)

BS: Cash down 20, Prepaid expenses up 20, Balance maintained.

Part 2 (Expense is incurred):

IS: PTI down 20, Net income down 12

CFS: Net income down 12, decrease in Prepaid expenses boosts cash flow by 20, net change in cash up 8.

BS: Cash up 8, Prepaid expenses down 20, Assets side down 12. Retained earnings down 12, L+E down 12

Jock Stu Suppliers buys $500 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600.

Part 1 (Initial Inventory Purchase):

IS: No changes

CFS: Inventory increase decreases CFO by 500, net change in cash down 500.

BS: Cash down 500, Inventory up 500, balance maintained.

Part 2 (Inventory is sold!):

IS: Revenue up 600, COGS up 500, PTI up 100, Net Income up 60 (assuming 40% tax rate)

CFS: Net income up 60, decrease in inventory boosts cash flow up 500, net change in cash up 560.

BS: Cash up 560, Inventory down 500, Assets up 60. Retained Earnings up 60 (due to increase in Net Income), L+E up 60.

Bobby Wasabi Dojo decides to pay several key vendors on credit and make them wait for the cash. It offers $200 in credit and says it will pay them in cash in a month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash?

Part 1 (Bobby Wasabi incurs the expense):

IS: PTI down 200, Net income down 120

CFS: Net income down 120, increase in AP boosts cash flow by 200, net change in cash up 80

BS: Cash up 80, Assets side up 80. Retained earnings down 120 (net income), AP up 200, L+E side up 80.

Part 2 (BobbyWasabi pays it off in CA$H):

IS: No changes

CFS: Reduction in AP decreases cash flow by 200, net change in cash down 200

BS: Cash down 200, Assets side down 200. AP down 200, L+E side down 200.

Jayson Tatum sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens on the statements initially? What happens after one month?

Part 1 (Tatum collects cash for year upfront):

IS: No changes

CFS: Increase in Deferred Revenue boosts cash flow by 1200, net change in cash up 1200

BS: Cash up 1200, Assets side up 1200. Deferred Revenue up 1200, L+E side up 1200.

Part 2 (Tatum delivers one month of service):

IS: Revenue up 100, PTI up 100, Net Income up 60 (40% tax rate)

CFS: Net Income up 60, decrease in Deferred Revenue reduces cash flow by 100, net change in cash down 40

BS: Cash down 40, Assets side down 40. Retained Earnings up 60 (increase in net income), Deferred Revenue down 100, L+E side down 40.

Rito Village Snow-Clothing issues $100 in stock to new investors to fund its operations. How do the statements change?

IS: No changes

CFS: CFF up 100, cash up 100 @ bottom

BS: Cash up 100, Assets up 100. Common stock & APIC up 100, L+E up 100.

Kenji Sushi has been rolling in the rice and seaweed as of late... so the company wants to issue $100 in dividends. Walk me through the 3 statements!!!

IS: No changes

CFS: CFF down 100, Cash down 100

BS: Cash down 100, Assets down 100. Retained Earnings down 100 (issuance of dividends), L+E down 100.

DK Summit Ski Resort has too much cash and it just doesn't know what to do with all of it! Not a bad problem to have, if you ask me. The CEO, Donkey Kong, decides to repurchase $100 of shares. Walk me through the three statements!

IS: No changes

CFS: CFF down 100, cash down 100

BS: Cash down 100, Treasury Stock down 100

Hawaiian Sun Inc has $1,000 in revenue, $200 in COGS, and $700 in operating expenses, and no other expenses. Walk through what happens on the 3 statements if half of the company's Income Taxes shift from current to deferred.

IS: PTI up 100, Net Income up 60 (40% tax rate is still applicable because BOTH current & deferred taxes are recorded here)

CFS: Net Income up 60, add back 20 (half of 40) for the half of the taxes that will be paid in some later period, cash up 80

BS: Cash up 80, Assets side up 80. Retained Earnings up 60, deferred tax liability up 20, L+E side up 80.

Potter Brooms buys a broom factory for $100 using $100 of debt. What happens INITIALLY on the statements?

IS: No changes

CFS: CFI down 100 (CapEx), CFF up 100 (raising debt), NO net change in cash

BS: PPE up 100, Assets up 100. Debt up 100, L+E up 100.

Potter Brooms has raised $100 in debt and purchased a factory for $100... but that has already been recorded and dealt with. One year passes. The company pays 10% interest on its debt, and it depreciates $10 on the factory each year. It also repays $20 of the loan each year. What happens on the statements in this first year?

IS: Interest expense up 10, depreciation expense up 10, PTI down 20, Net Income down 12 (40% tax rate)

CFS: Net Income down 12, add back depreciation expense of 10 (non-cash), CFO down 2... CFF down 20 (loan principal repayment), change in cash down 22

BS: Cash down 22, PPE down 10, Assets side down 32. Retained Earnings down 12, debt down 20, L+E side down 32.

Han Capital LLC now has a factory worth $90, and $80 in debt. Another year passes. Again, Han Capital pays 10% interest on its debt based on the balance at the start of the year, and it depreciates $10 on the factory, with $20 loan principal repayment.

At the very END of the year, Lammers Technologies attacks the factory, and it falls apart. Han Capital has to write down the factory's entire value and repay the remaining loan balance.

Walk me through what happens on the statements from the BEGINNING of Year 2 to the END.

IS: Interest expense up 8, depreciation expense up 10, write down factory worth 80, PTI down 98, Net income down 59

CFS: Net income down 59, add back 90 from depreciation and write down, CFO up 31. CFF down 80 (repayment of loan), net change in cash down 49

BS: Cash down 49, PPE down 90, Assets down 139. Retained earnings down 59, debt down 80, L+E down 139.

Lab Rats Technologies orders $200 of Inventory but pays for it using debt. What happens on the statements immediately after this transaction?

IS: No changes

CFS: Increase in inventory reduces cash flow by 200, CFF up 200 (debt raised), NO net change in cash

BS: Inventory up 200, Assets up 200. Debt up 200 L+E up 200.

Lab Rats Technologies has $200 in debt & $200 of inventory. Suddenly, CEO Leo Dooley decides to sell the $200 of Inventory for $400. However, he also has to hire additional employees for $100 to process the orders. Lab Rats Technologies also pays 5% interest on its debt and repays 10% of the principal. What happens on the statements over the course of THIS one year?

IS: Revenue up 400, COGS up 200, Operating Expenses up 100, Interest Expense up 10, PTI up 90, Net Income up 54 (40% tax rate)

CFS: Net Income up 54, decrease in inventory boosts cash flow by 200, CFO up 254, CFF down 20 (principal repayment), net change in cash up 234

BS: Cash up 234, Inventory down 200, Assets up 34. Retained Earnings up 54, debt down 20, L+E up 34.

Survivor 48 Cast. issues $100 in Preferred Stock to buy $100 in long-term investments in real estate. The Preferred Stock has a coupon rate of 8%, and the long-term investments yield

10%. What happens on the statements IMMEDIATELY after the initial purchase? What happens after a year?

Part 1 (issues the preferred stock and purchases the long term investments):

IS: No changes

CFS: CFI down 100 (purchase of investment), CFF up 100 (issuance of stock), NO net change in cash

BS: Long term investments up 100, Assets up 100. Preferred stock up 100, L+E up 100.

Part 2 (One year later...):

IS: Interest revenue up 10, PTI up 10, Net Income up 6 (40% tax rate), subtract out 8 (preferred stock dividend repayment), Net Income down 2

CFS: Net Income down 2, no other changes, cash down 2

BS: Cash down 2, Assets down 2. Retained earnings down 2, L+E down 2.

Another year passes, and prices in this real estate market double. Big Fons Inc. decides to sell its $100 in long-term investments for $200 at the end of Year 2. It then uses the proceeds to repay its $100 in Preferred Stock.

What happens on the statements from the BEGINNING of Year 2, including the interest/investment income (10% of 100) and Preferred Dividends (8% coupon rate), to the END of Year 2?

IS: Interest income up 10, gain on sale of investments up 100, PTI up 110, Net income up 66. Subtract preferred stock dividend repayment of 8, Net Income up 58

CFS: Net Income up 58, subtract out gain of 100 (non-cash), CFO down 42. CFI up 200, CFF down 100, net change in cash up 58

BS: Cash up 58, Long term assets down 100, Assets down 42. Retained earnings up 58, Preferred stock down 100, L+E down 42.

WBBA. wants to boost its EPS artificially, so it decides to issue debt and use the proceeds to buy back shares.

Initially, the company has 100 shares outstanding at $100 per share, and a Net Income of $2,000.

What happens IMMEDIATELY after your company raises $1,000 in long-term debt and uses it to repurchase $1,000 in stock?

IS: No changes

CFS: CFF up 1000, CFF down 1000, NO net change in cash

BS: Debt up 1000, Treasury Stock down 1000, balance maintained

Still dealing w/ WBBA, What happens after a year passes if the company pays 5% interest on the $1,000 debt and repays

10% of the principal? Also, explain the EPS impact (initially $2,000 in net income & 90 shares outstanding)

IS: Interest expense up 50, PTI down 50, Net income down 30 (40% tax rate)

CFS: Net income down 30, CFF down 100, net change in cash down 130

BS: Cash down 130, Assets down 130. Retained earnings down 30, debt down 100, L+E down 130.

EPS: $2,000 - $30 = $1,970 >>> $1,970 / 90 = $21.89

The Chocolate Emporium at Universal Citywalk decides to acquire Lard Lads Donuts for $1,000, using cash. The other company has $400 in Cash, $600 in PP&E, $250 in Accounts Payable, and $750 in Equity.

What happens to your company's BALANCE SHEET immediately after this acquisition takes place?

Assume that your company has identified $50 in Other Intangible Assets with a useful life of 10 years.

Cash is down 600 (paid 1,000 but Big Fons Inc. had 400), PPE up 600, Assets side remains unchanged for now.

AP is up 250... 50 in intangible assets leaves a 200 difference between L+E & Assets... create 200 in Goodwill so that the balance sheet balances.

A year passes. What happens on Choco Emporiums financial statements, factoring in ONLY the newly created items ($50 in intangible assets (10-yr life), $200 in Goodwill) from the acquisition and the cash ($1,000) used to acquire the company?

Assume a 2% foregone interest rate on cash, and assume that the company loses interest on the FULL $1,000 of cash used in the acquisition, not just the net cash reduction of $600.

IS: Interest expense up $20 (1,000*2%), Amortization expense up 5 (50/10), PTI down 25, Net Income down 15

CFS: Net income down 15, add back 5 for amortization (non-cash), net change in cash down 10

BS: Cash down 10, Intangible assets down 5, Assets down 15. Retained earnings down 15, L+E down 15.

At the end of the year, Choco Emporium decides that it grossly overpaid for Big Fons Inc., so it decides to write down the Goodwill ($200) and PP&E ($600) acquired from the other company by 50%.

What happens on the statements, factoring in ONLY these write-downs and nothing else?

IS: Write-down of 400, PTI down 400, Net Income down 240

CFS: Net income down 240, add back write downs of 400 (non-cash), net change in cash up 160

BS: Cash up 160, Goodwill down 100, PPE down 300, Assets side down 240. Retained earnings down 240, L+E down 240.

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

Free Cash Flow is ***Cash Flow From Operations minus CapEx***

This is because pretty much everything in a company's CFO section is required for its business, But almost every line item within the CFI & CFF Activities sections is "optional," except CapEx

If FCF is positive and increasing, it means the company can spend its excess cash in different

ways (hiring employees, investing in assets, CapEx)

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

First look at WHY it is negative/decreasing:

Ex: If FCF is negative because CapEx in one year was unusually high, but it's expected to return to normal in the future, it doesn't mean much.

Ex: if FCF is negative because the company's sales and operating income have been declining each year, the business may be troubled.

What is Working Capital?

Current Assets - Current Liabilities

Operating Working Capital is more relevant:

Current Assets (excluding cash & investments) - Current Liabilities (excluding debt)

Working Capital by itself tells you whether a company needs more in operational assets or operational liabilities to run its business, and how big the difference is.

Why do you exclude cash, investments, and debt when calculating the Change in Working Capital on the Cash Flow Statement?

Exclude cash because net change in cash is already calculated on the CFS; can't double count it

Exclude purchases/sales of investments because they are considered investing activities, not operational

Exclude debt issuances/repayments because they are considered financing activities, not operational

Rowlet Owl Shop's Working Capital has increased from $50 to $200. You calculate the Change in Working Capital by taking the new number, $200, and subtracting the old number, $50, and so the change is positive $150.

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

No, Rowlet is not wrong because...

Change in WC = Old WC - New WC

if assets increase, they reduce the cash flow. And if liabilities increase, the opposite happens.

When a company's Working Capital INCREASES, the company USES cash to do that; when Working Capital DECREASES, it FREES UP cash.

What does the Change in Working Capital mean?

It tells you if the company needs to spend in ADVANCE of its growth, or if it generates more money as a RESULT of its growth.

Change in Working Capital is almost always negative for retailers because they must spend money on Inventory before being able to sell products.

Change in Working Capital is often positive for subscription-based companies that collect cash from customers far in advance because Deferred Revenue increases whenever they do that.

Why is the Change in Working Capital important?

The Change in Working Capital directly increases or decreases Free Cash Flow, which, in turn, directly affects the company's valuation.

You're comparing two companies. Company A's Change in Working Capital as a % of the Change in Revenue is 10%, but Company B's is negative 5%.

Which industries are these companies MOST likely to be in?

Company A is likely to be in the tech/software industry, or one that requires little upfront investment in inventory.

Company B is likely to be in the retail industry, or one that requires heavy upfront investment in inventory.

A company's Current Ratio is 2x. Why is that NOT necessarily a positive sign?

Current Ratio = Current Assets/Current Liabilities

So, what is in each the numerator and denominator is what is most important.

If the assets are mostly comprised of receivables and the liabilities are comprised of accrued expenses, that is not a good sign. (Company is waiting on a lot of money and owes money to others)

If the assets are mostly cash and the liabilities are mostly deferred revenue, that is a good sign (Company has collected lots of cash up front (TVM))

Would you expect a retailer or an airline company to have a higher Asset Turnover Ratio?

Asset Turnover Ratio = Revenue/Average Assets

Generally, the retailer will have a higher asset turnover ratio. Why? Because it its less dependent on its assets to generate sales.

Yes, it must own lots of inventory, but it does not necessarily need to own its physical stores, factories, trucks, etc... those can be LEASED.

Airlines are completely dependent on its PP&E (the mf airplanes lol) to generate their sales, so it will have a lower ratio

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

This company must have a lot of market power... because it gets their money from customers A$AP but makes the people they owe wait to get paid.

ROA Formula

Net Income/Total Assets

ROE Formula

Net Income/Shareholder's Equity

A company's ROA has INCREASED from 10% to 15% over the past five years, but its ROE has DECREASED from 13% to 10%. What could have caused this?

Both have Net Income in the numerator, so:

Assuming Net Income increased:

Net income must have increased by a higher percentage than the total assets, & the decrease in ROE means that the equity must have increased by a higher percentage than the net income

One potential cause may be that the company has been continually issuing equity to fund its cash flow-negative business.

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

Which metrics or ratios could you look at to confirm or deny your suspicion?

Debt/EBITDA and EBITDA/Interest ratios:

If they indicate that the company has been using more debt over time, it's a good bet that debt has been at least partially responsible for the increased ROE.

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

This could mean:

Net income or non-cash charges are growing by more than the Change in WC is declining (Net income is atop the CFS, non-cash charges get added back at beginning of CFS... both would increase CFO)

OR

CapEx is shrinking by more than the change in WC is declining (FCF = CFO - CapEx)

EBITDA is a good proxy for cash flow. Even so, how could a company file for bankruptcy?

It is at best, an estimate:

High capex since EBITDA excludes

All debt matures on a single date

Massive negative working capital

One time charges that EBITDA excludes (legal/restructuring)

What is the FIFO method?

First in, first out.

FIFO is an Inventory recognition principle in Accounting where inventory bought EARLIEST is prioritized as an expense on the income statement as Cost of Goods Sold.

Shows you how much a company historically paid for its inventory.

What is LIFO?

Last in, first out.

LIFO is an accounting method in which inventory bought LATEST is prioritized as an expense on the income statement as Cost of Goods sold.

Shows how much a company most recently paid for its inventory.

Will FIFO or LIFO result in a higher net income and cash flow?

If inventory costs are rising:

FIFO: higher net income, higher eps, lower cash flow (since inventory added back is higher)

LIFO: lower net income, lower eps, higher cash flow

If inventory costs are falling:

FIFO: lower net income, lower eps, higher cash flow

LIFO: higher net income, higher eps, lower cash flow

What is a capital lease?

A capital lease is very similar to having ownership rights on an asset.

You record the leased asset on the balance sheet.

You record the capital lease as a liability on the balance sheet.

You record the depreciation/amortization of the asset as an expense on the income statement.

You record the interest payments on the capital lease as interest expense.

You record the principal payments of the capital lease as a cash outflow on the cash flow statement.

Capital leases are for long term purposes.

What is an operating lease?

An operating lease is very similar to renting an asset.

Not recorded as an asset on the balance sheet, nor a liability.

Simply accounted for via rent expense on the income statement.

Operating leases are typically for short term purposes.

How do you compare companies when one uses all operating leases, and the other uses all capital leases?

Typically use EV/EBITDAR. Since it excludes the full impact of rental expense and leases.

When in terms of Enterprise Value, you typically capitalize operating leases by multiplying by 7 or 8x and then adding it to Enterprise Value when using an EV/EBITDAR multiple.

How would a companies net income and cash flow from operations change if it moved from operating leases to capital leases?

Net income would likely decrease since the depreciation and interest expense would outweigh the rent expense. However, since the depreciation would be added back as a non cash expense on the cash flow statement, cash flow from operations would increase.

What is a Deferred Tax Asset? (DTA)

A deferred tax asset is a future tax benefit recorded as an asset on the balance sheet.

The reason it comes up is because of temporary timing differences that occur when income is recognized for tax purposes vs accounting purposes.

When a company has a LOWER Book income relative to taxable income, you create a DTA, as it represents that you overpaid taxes in this period and anticipate a future tax benefit where you will pay less in cash taxes.

Pay less in cash taxes in the future.

What is a deferred tax liability (DTL) ?

A deferred tax liability is a future tax obligation recorded as a liability on the balance sheet.

Deferred tax liabilities arise due to temporary timing differences that occur when income is recognized for tax vs accounting purposes.

When a company has a HIGHER book income relative to taxable income you create a DTL, as it represents that you underpaid taxes in this period and are expected to pay more in cash taxes in a future period.

Pay more in cash taxes in the future.

What is a net operating loss (NOL)?

Occurs when a companies tax deductible expenses EXCEEDS its taxable revenue in a given period.

NOL are able to be carried back indefinitely and forward indefinitely (offset up to 80% of taxable income)

They appear as a non-core asset on the balance sheet, so you subtract it when moving from equity value to enterprise value.