Accounting Terms TIP

Primary purpose of US GAAP

Standardizes financial reporting to ensure statements are presented fairly and consistently, protecting investors and lenders

Main sections of a 10-K

Business Overview, Management’s Discussion & Analysis (MD&A), Financial Statements, and Notes/Disclosures

Explain 10-K vs 10-Q

10-K is annual, audited, and comprehensive; 10-Q is quarterly, unaudited, and condensed

Walk me through the 3 financial statements

Income Statement: Shows revenues, expenses, and net income over a period; Balance Sheet: Snapshot of assets, liabilities, and equity at a specific point in time; Cash Flow Statement: Reconciles net income through operating, investing, and financing cash flows to find the net change in cash

Walk me through the Income Statement

Revenue - COGS = Gross Profit; Gross Profit - Operating Expenses = EBIT/Operating Income; EBIT - Interest and Taxes = Net Income

Walk me through the Balance Sheet

Divided into Assets, Liabilities, and Equity, balancing as Assets = Liabilities + Equity

Context of Assets, Liabilities, and Equity

Assets generate future economic inflows; liabilities represent future cash outflows owed to third parties; equity is capital provided by owners plus accumulated retained earnings

Typical Balance Sheet line items

Assets: Cash, Accounts Receivable, Inventory, PP&E, Goodwill; Liabilities: Accounts Payable, Accrued Expenses, Debt; Equity: Common Stock, Retained Earnings, Treasury Stock

Walk me through the Cash Flow Statement

Cash from Operations: Net income adjusted for non-cash expenses; Cash from Investing: Capital expenditures and acquisitions/asset sales; Cash from Financing: Debt/equity issuances, debt paydown, share buybacks, and dividends

How the 3 statements link

Net Income from the IS flows to the top of the CFS and into Retained Earnings on the BS; ending cash on the CFS becomes Cash on the BS; changes in BS working capital and debt flow through the CFS

Balance Sheet given, choose IS or CFS

Choose the Income Statement, because with both IS and BS, you can calculate and build the entire CFS yourself

IS vs. CFS — Which is more important?

CFS, because it shows actual cash movement, true liquidity, and avoids accrual distortion

Pick one statement to analyze a company

Cash Flow Statement, because it reveals true operational liquidity and whether the firm generates real cash

Why IS is insufficient for liquidity

It is accrual-based—a company can report high net income but go bankrupt if it cannot collect cash from credit sales

Discretionary decisions to inflate earnings

Extending asset useful lives (lowers depreciation), switching to FIFO during inflation, capitalizing expenses instead of expensing, delaying capex/R&D, and aggressive revenue recognition

Revenue recognition & Matching principle

Revenue is recorded when earned regardless of cash receipt; expenses are matched in the same period as the revenues they helped generate

Accrual vs. Cash accounting

Accrual records transactions when earned/incurred; cash basis records transactions only when physical cash changes hands

COGS vs. Operating Expenses

COGS are direct costs tied to producing goods/services; Operating Expenses (SG&A, R&D) are indirect operational overhead

Capitalize vs. Expense

Capitalize if the asset provides economic benefit for more than one year; expense if the benefit is consumed immediately within the period

Depreciation impact on Net Income

It is a tax-deductible non-cash expense, so it reduces pre-tax income and lowers cash taxes paid

Straight-line vs. Accelerated depreciation preference

Straight-line depreciation spreads an asset's cost evenly across its useful life, while accelerated depreciation front-loads larger deductions into the early years

Depreciation & Salvage value

Depreciable base equals (Cost - Salvage Value); a zero salvage value maximizes yearly depreciation and tax savings

Do companies depreciate land?

No, land has an indefinite useful life

$10 increase in depreciation

Assuming a 30% tax rate, First, on the Income Statement: Operating income decreases by $10, but saves us $3 in taxes because of the tax shield assuming a 30% corporate tax rate. Therefore, Net Income drops by $7. Second, on the Cash Flow Statement: We start with that Net Income drop of $7. Since depreciation is a non-cash expense, we add back that $10. This means our Net Cash increases by $3. Finally, on the Balance Sheet: On the Assets side, Cash is up $3 from the Cash Flow Statement, but our PP&E drops by $10 due to the depreciation. This means Total Assets are down $7. On the other side, Shareholders' Equity is down $7 because Net Income dropped by $7. Both sides perfectly balance at negative $7."

Growth capex vs. Maintenance capex

Growth capex is discretionary spending to expand capacity/markets; maintenance capex is required spending to maintain existing assets

Intangibles that are amortized

Intangibles with finite useful lives (patents, copyrights, customer lists)

Goodwill definition & creation

Intangible asset created when purchase price exceeds the fair market value of net identifiable assets acquired

Can goodwill be amortized?

Public companies cannot amortize goodwill (must test annually for impairment); private companies can elect to amortize it

Going concern assumption

Assumes the business will operate indefinitely and will not liquidate in the foreseeable future

Principle of conservatism

Anticipates potential losses rather than gains—assets/revenues should not be overstated, and expenses/liabilities should not be understated

Why record at historical cost?

It provides objective and verifiable data based on real transaction prices

Fair-value accounting in subprime crisis

FAS-157 forced banks to mark illiquid mortgage assets to market, triggering steep write-downs, panic, and solvency contagion

Why internally developed intangibles are excluded from the BS

They cannot be objectively and reliably quantified without an observable market transaction

Share price increases 10% — BS impact

Zero change; the balance sheet records historical book value, not market capitalization

Does AR get captured on the IS?

Not as a line item, but it is embedded in Revenue

Why increase in AR reduces cash on CFS

More sales were made on credit rather than cash, so revenue must be deducted to reflect actual cash collected

what is Deferred revenue

Cash collected upfront from a customer before goods or services have been delivered (a liability)

Deferred revenue liability vs. AR asset

Deferred revenue is an obligation to deliver future goods/services; AR is a legal right to receive future cash for goods already delivered

Why increase in AP increases cash flow

The company delayed cash outflows to vendors, keeping cash on hand longer

Where CFS captures interest expense

Embedded inside Net Income at the top of Cash from Operations

Dividend initiated — 3 statements

IS: No impact; CFS: Financing outflow lowers ending cash; BS: Cash decreases; Retained Earnings decreases

Does inventory get captured on the IS?

Not directly; only the inventory sold is recognized inside COGS

What does increase in inventory look like on CFS

Outflow in Cash from Operations because extra cash was spent purchasing stock

LIFO vs. FIFO net income impact (inflation)

FIFO produces lower COGS and higher Net Income; LIFO produces higher COGS and lower Net Income

Average cost method

Averages total production costs across all units produced, ignoring inventory purchase dates

Retained earnings formula

Beginning Retained Earnings + Net Income - Dividends

Retention ratio vs. Dividend payout ratio

Retention ratio is the share of earnings kept in the business; Dividend payout is the share paid out; they sum to 100%

Basic vs. Diluted EPS

Basic EPS uses common shares outstanding; Diluted EPS includes warrants, and convertible debt

Where to find public company filings

SEC EDGAR database

What is proxy statement (DEF 14A)

Filing before shareholder meetings detailing voting items, executive pay, and board composition

Form 8-K

Material event filing required within 4 business days of major corporate changes

Common profitability margins

Gross Margin, Operating (EBIT) Margin, EBITDA Margin, Net Profit Margin

Above the line vs. Below the line

The “line" is Operating Income (EBIT). Above the line measures core operations independent of capital structure; below the line accounts for non-operating items, interest, and taxes

Is EBITDA a good proxy for operating cash flow?

Flawed because it excludes capex, changes in working capital, and taxes, though widely used for fast benchmarking

Non-recurring items

Restructuring charges, litigation settlements, asset write-downs, and severance costs

Are litigation expenses always added back?

No; in sectors prone to routine litigation (like pharma), legal fees are regular operating costs

Organic vs. Inorganic growth

Organic comes from internal operational gains, new customers, and volume; inorganic comes from M&A

Depreciation vs. Capex shift as firms mature

High-growth firms have Capex > Depreciation; mature firms converge toward Capex = Depreciation

what is Working Capital

Current Assets - Current Liabilities; measures short-term operating liquidity

Why cash and debt are excluded from Net Working Capital

Cash is a liquid financial asset and debt is a financing structure—neither directly drives core daily operations

Is negative working capital bad?

Not necessarily; it can reflect high efficiency and customer collection power (e.g., Amazon, Walmart), or severe liquidity distress

What change in NWC (Net Working Capital) tells you

An increase in NWC is a cash outflow; a decrease in NWC is a cash inflow

Working capital efficiency ratios

Days Sales Outstanding (DSO), Days Inventory On Hand (DIO), Days Payable Outstanding (DPO)

Cash Conversion Cycle (CCC)

DIO (Days Inventory Outstanding) + DSO (Days Sales Outstanding) - DPO (Days Payable Outstanding); days taken to convert cash spent on inventory back into cash received from customers

Forecasting working capital

Project AR off DSO (days sold outstanding), Inventory off DIO (days inventory outstanding), AP off DPO (days payable outstanding), and other items as a percentage of revenue/SG&A

Forecasting capex & D&A

CapEx: multiply your projected revenue by the company's historical CapEx-to-revenue percentage; D&A: multiply that same period's estimated Net PP&E by its historical average depreciation rate

Current ratio vs. Quick ratio

Current ratio is Current Assets/Current Liabilities; Quick ratio excludes less liquid assets like inventory

When current ratio is misleading

When cash is restricted, inventory is obsolete, or AR consists of uncollectible bad debt

Is negative retained earnings bad?

Common for high-growth startups reinvesting heavily, or firms funding massive share buybacks/dividends

How a profitable firm goes bankrupt

Cash flow mismatch—ballooning uncollected AR and immediate vendor payables deplete cash before debt payments can be met

ROA (Return on Assets) vs. ROE (Return on Equity)

ROA measures net profit generated per dollar of total assets; ROE measures net profit generated per dollar of shareholder equity

Relationship between ROA (Return on Assets) vs. ROE (Return on Equity)

ROE exceeds ROA when debt leverage is added to the balance sheet

Shortcomings of ROA/ROE

Distorted by leverage differences, share buybacks, and historical asset depreciation differences across peers

ROIC (Return on Invested Capital) purpose

Measures operational return generated on all invested capital regardless of financing structure

Asset turnover ratio

Net Sales / Average Total Assets; measures how efficiently a company uses its assets to generate net sales or revenue

Inventory turnover vs. DIH (Days Inventory on Hand)

Turnover is how many times inventory sells out in a year; DIH is the average days taken to sell that inventory

AR turnover

Revenue/Average AR; measures how frequently a firm collects receivables annually

AP turnover (higher or lower better?)

lower is generally better because it means the company holds onto supplier cash longer

Ratios for credit analysis

Liquidity ratios, Leverage ratios, and Coverage ratios

Two main types of credit default ratios

Leverage Ratios (Total Debt / EBITDA) and Coverage Ratios (EBITDA / Interest Expense)

Debt Service Coverage Ratio (DSCR)

(EBITDA - Capex) / (Principal Repayment + Interest); measures cash available to cover all debt payments

Fixed Charge Coverage Ratio (FCCR)

(EBIT + Lease Charges) / (Lease Charges + Interest); evaluates ability to cover mandatory fixed obligations like leases and interest