Wall Street Mastermind Technical Questions - The Three Statements

Walk me through the 3 statements

The three statements include the income statement, cash flow statement, and balance sheet. First, the income statement shows a company’s profitability over a specified period. The beginning line item is revenue and upon deducting various costs and expenses incurred during the specified period, you get net income, which is the ending line item.

Second, the balance sheet is a snapshot of a company’s financials and can be broken down into assets, liabilities, and shareholders’ equity. Assets are the resources that the company has such as cash and inventory. Liabilities and shareholders’ equity represent the company’s sources of funding. Items in the liabilities section can include debt and accounts payable while shareholders’ equity can include common stock.

Finally, the cash flow statement shows you how much cash came in or out of the business during the same period of time as the income statement. The cash flow statement is divided into three sections, which includes cash flow from operating, investing and financing activities. By adding up the cash inflows and outflows for all three sections you will get the net change in cash for the period.

How do the 3 statements link together?

The 3 statements link together in numerous ways. First, the bottom line item of the income statement is net income and net income is also the first line on the cash flow statement. Second, to get to the cash flow from operations on the cash flow statement, you will need to adjust for any changes in operating working capital, which can be found on the balance sheet through line items such as accounts receivable or accounts payable. Third, capital expenditures under cash flow from investing is linked to PP&E on the balance sheet. Fourth, PP&E on the balance sheet will depreciate over time and that depreciation is reflected on the income statement. Fifth, the net change in cash, which is the bottom line of the cash flow statement, flows over to the cash balance on the balance sheet. And finally, net income on the income statement minus dividends issued during the period is added to the prior period’s retained earnings to get the current period’s retained earnings, which can be found on the balance sheet.

If I could only have one statement to evaluate a company, what would I choose?

I would choose the cash flow statement as it reflects a company’s true liquidity. Cash is also important because a healthy company needs to generate enough free cash flow to meet its debt obligations and reinvest into its operations. The income statement can skew the actual picture since it includes non-cash expenses and excludes real cash expenditures like capital expenditures.

If asked: assets like prepaid expenses may not be quickly convertible into cash so it may not reflect a company’s true liquidity

If I could only have two statements to evaluate a company, what would I choose?

I would pick the income statement and balance sheet as you would have enough information to recreate the cash flow statement.

How do I know when an expense should be on the income statement or not?

For an expense to be recorded on the income statement, it must match with the period that the income statement is covering. Moreover, any expense that appears on the income statement has to be tax-deductible since your pre-tax income is based on what’s on the income statement. Thus, expenses that are not tax-deductible, such as mandatory debt repayments, would not be included

How do I know when an expense should be capitalized rather than expensed?

An expense should be capitalized if the money is being used to buy an asset that has a useful life of over one year. (The reason is because you wouldn’t be able to expense it on the income statement since the asset is being used for more than a year and the income statement usually records for a time period of one year.)

If depreciation is a non-cash expense, why do we add it back to the cash flow statement? Does it affect cash?

We add it back to the cash flow statement because the cash flow statement is concerned with how much cash actually came in and out of the company. For non-cash expenses, we have to add it back since no cash was actually expensed.

Depreciation does affect cash because higher depreciation would lead to lower pre-tax income. Thus, you won’t have to pay as much taxes and this will have an impact on how much cash you have.

Where does depreciation usually show up on the income statement?

Depreciation usually shows up under either cost of goods sold or operating expenses. Where depreciation will show up is dependent on what is being depreciated. For example, if you are depreciating furniture being used at the headquarters of a company, that would show up in operating expenses.

When a company purchases inventory, does it affect the income statement? Why or why not?

It does not initially affect the income statement since it only does so when the inventory has been sold. This is because under GAAP accounting, you can only record expenses in the same period as when the revenue associated with that expense is considered to be earned.

Why do we see debt repayment under the cash flow from financing activity section but not interest payments?

Debt repayment shows up under the cash flow from financing activity section as it does not appear on the income statement since debt repayment is not tax-deductible. On the other hand, interest payments are tax-deductible and will therefore show up on the income statement. Thus, interest payments do not need to be in the cash flow from financing section since it has already been captured in net income at the top of the cash flow statement.

What’s the difference between accounts payable and accrued expenses?

The fundamental difference is the invoice. Accounts payable is when you have received the official invoice/bill from the vendor, but you haven't paid it yet. Accrued expenses is when you have consumed the goods or services, but you have not received an invoice or paid for it yet.

What is deferred revenue? And what’s an example of when it would happen?

Deferred revenue is when the customer has paid you upfront for a product or service that you haven’t delivered to them yet. For example, you are a software company and you charge a customer upfront for the next 12 months. Each month, you will only be able to recognize 1/12 of the revenue from the customer that year and your deferred revenue will also decrease by 1/12 every month.

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

Deferred revenue is when we’ve collected the cash from the customers but haven’t delivered the product or service yet. On the other hand, accounts receivable is when we’ve delivered the product or service but haven’t received the payment from the customers yet.

What’s the difference between prepaid expenses and accounts payable?

Prepaid expenses are when you’ve already paid for a product or service that you haven’t used or received yet. On the other hand, accounts payable is when you’ve received or used a product or service but haven’t paid for it yet.

What is working capital? What about operating working capital?

Working capital is current assets minus current liabilities. This represents whether a company is able to pay off its short-term liabilities with its short-term assets.

Operating working capital is working capital excluding cash and cash equivalents minus your current liabilities excluding debt. Operating working capital only takes into account components that are part of the core operations of a company

Can a company have positive EBITDA but still go bankrupt? If so, how?

EBITDA is a profitability metric on the income statement and the income statement may not actually reflect the company’s cash position or how much cash was flowing in and out. For example, the company may have had significant cash outflow due to its capital expenditures but that would not be reflected on the income statement. (That’s why many people use EBITDA - CapEx to gain a better understanding of the company’s financial position).

A company might also not have enough money to pay its interest expenses or even one-time expenses such as a detrimental lawsuit. However, that would not be reflected in EBITDA since EBITDA is before interest expenses and non-recurring charges.

Walk me through the 3 statements if a company buys equipment for $100 (useful life is 5 years, tax rate is 40%)

At the time of purchase, there is no impact on the income statement as the equipment is capitalized due to it having a useful life of more than one year.

On the cash flow statement, under cash flow from investing, there will be a $100 outflow. As there is no impact on cash flow from operating or financing, the net change in cash will be a $100 outflow.

This will flow to your balance sheet where your cash balance will go down by $100. This will be balanced out with an increase in PP&E by $100.

If you fast forward one year, there will be an impact on the income statement through depreciation. Since the asset’s useful life is 5 years and we’re assuming straight-line depreciation, there will be a depreciation of $20 after that first year. $20 of depreciation will lower your pre-tax income by $20.

If the tax rate is 40%, that means that we’re going to pay $8 less in taxes since 40% of $20 is $8. Thus, the impact on your net income is a decrease in $12 since that is 20 minus 8.

We also know that net income flows to the top of the cash flow statement. At the top of the cash flow statement, we’re starting out with negative 12 and we need to add back any depreciation. In this case, that’s $20. Negative 12 plus 20 is 8 so under cash flow operating activities, we have an increase in $8. There’s no change in cash flow from investing or financing, which means the net change in cash is an inflow of 8 dollars.

This flows to the balance sheet as the cash balance will increase by $8. PP&E will decrease by $20 due to depreciation, leading to a $12 decrease on the assets side. To balance it out, we know that net income flows over to retained earnings under shareholders’ equity and we remember that net income decreased by $12. Therefore, shareholders’ equity will decrease by $12 and the balance sheet will balance out.

Walk me through the 3 statements if a company buys $100 of equipment with debt which needs to be paid back in 2 years (useful life is 5 years, interest expense is 10%, tax rate is 40%)

When you first borrow the $100, there is no impact on the income statement. On the cash flow statement, a $100 inflow will appear under the cash flow from financing section. With no changes in cash flow from operating and investing, this will lead to the cash flow statement showing a net change in cash of plus $100. This flows over to the balance sheet through an increase in both the cash balance and debt balance by $100.

Now similar to when you borrowed the $100, when you first buy the equipment, there is no impact on the income statement as the equipment is capitalized due to it having a useful life of more than one year. On the cash flow statement, a $100 outflow will be recorded under the cash flow from investing section as capital expenditures. This will lead to the cash flow statement showing a net change in cash of negative $100. This flows over to the balance sheet through a decrease in the cash balance by 100$ but an increase in PP&E by $100.

If you fast forward one year, there will be an impact on the income statement through depreciation. Since the asset’s useful life is 5 years and we’re assuming straight-line depreciation, there will be a depreciation of $20 after that first year. Moreover, since the interest expense is 10%, you would also have to pay $10 in interest after that first year. When you combine depreciation and the interest expense, your pre-tax income will decrease by $30

If the tax rate is 40%, that means that we’re going to pay $12 less in taxes since 40% of $30 is $12. Thus, the impact on your net income is a decrease in $18.

We also know that net income flows to the top of the cash flow statement. At the top of the cash flow statement, we’re starting out with negative 18 and we need to add back any depreciation. In this case, that’s $20. Negative 18 plus 20 is 2 so under cash flow operating activities, we have an increase in $2. There’s no change in cash flow from investing or financing, which means the net change in cash is an inflow of 2 dollars.

This flows to the balance sheet as the cash balance will increase by $2. PP&E will decrease by $20 due to depreciation, leading to a $18 decrease on the assets side. To balance it out, we know that net income flows over to retained earnings under shareholders’ equity and we remember that net income decreased by $18. Therefore, shareholders’ equity will decrease by $18 and the balance sheet will balance out.

Year 2 is similar to year one in terms of the impact of depreciation and interest expense. But another thing that will have to happen is the full repayment of debt. So under the cash flow from financing section, there will be a $100 outflow when you pay back the principal of the debt we borrowed. This flows to the balance sheet as both your cash balance and debt balance will decrease by $100.

Walk me through the 3 statements if a company buys 100$ of inventory with debt then sells it for $400 (interest expense is 10% and tax rate is 40%)

When you first borrow the $100, there is no impact on the income statement. On the cash flow statement, a $100 inflow will appear under the cash flow from financing section. With no changes in cash flow from operating and investing, this will lead to the cash flow statement showing a net change in cash of plus $100. This flows over to the balance sheet through an increase in both the cash balance and debt balance by $100.

Now similar to when you borrowed the $100, when you first buy the inventory, there is no impact on the income statement since you don’t recognize the cost of inventory until you sell it. On the cash flow statement, a $100 outflow will be recorded under the cash flow from operating section because you are paying $100 for inventory (inventory is under operating working capital). With no changes in cash flow from financing and investing, this will lead to the cash flow statement showing a net change in cash of negative $100. This flows over to the balance sheet through a decrease in the cash balance by 100$ but an increase in inventory by $100.

When you sell the inventory for $400, there will be an impact on the income statement. Revenue will be $400 and we will now recognize the cost of inventory under cost of goods sold. Thus, cost of goods sold will be $100 and your gross profit increases by $300. Since the interest expense is 10%, we also have to pay $10 in interest. Therefore our pre-tax income will increase by $290.

If the tax rate is 40%, we will have to pay $116 in tax since 40% of $290 is $116. Thus, our net income will increase by $174.

We also know that net income flows to the top of the cash flow statement. At the top of the cash flow statement, we’re starting out with $174. We will also add $100 to cash flow from operations since there was a $100 decrease in inventory. Thus, we have plus 274 under cash flow from operations. There’s no change in cash flow from investing or financing, which means the net change in cash is an inflow of 274 dollars.

This flows to the balance sheet as the cash balance will increase by 274. Inventory will decrease by $100 since we sold it, leading to a $174 increase on the assets side. To balance it out, we know that net income flows over to retained earnings under shareholders’ equity and we remember that net income increased by $174. Therefore, shareholders’ equity will increase by $174 and the balance sheet will balance out.

Walk me through the 3 statements if a company buys $100 of short-term securities by issuing debt (interest expense is 5%, 20% of principal needs to be repaid each year, interest income from short-term securities is 10%, tax rate is 40%

When you first borrow the $100, there is no impact on the income statement. On the cash flow statement, a $100 inflow will appear under the cash flow from financing section. With no changes in cash flow from operating and investing, this will lead to the cash flow statement showing a net change in cash of plus $100. This flows over to the balance sheet through an increase in both the cash balance and debt balance by $100.

Now similar to when you borrowed the $100, when you first buy the short-term securities, there is no impact on the income statement. On the cash flow statement, a $100 outflow will be recorded under the cash flow from investing section because you are buying securities. With no changes in cash flow from financing and investing, this will lead to the cash flow statement showing a net change in cash of negative $100. This flows over to the balance sheet through a decrease in the cash balance by 100$ but an increase in short-term securities by $100.

Now after the first year, we’re going to have an interest expense of $5 since the interest expense is 5% of 100. At the same time, we also earned $10 since the interest income from the short-term securities was 10% of 100. Thus, we have a $5 increase in pre-tax income. 

If the tax rate is 40%, we will have to pay $2 in tax since 40% of $5 is $2. Thus, our net income will increase by $3.

We also know that net income flows to the top of the cash flow statement. At the top of the cash flow statement, we’re starting out with $3. Since we need to pay back 20% of principal every year, there will be a cash outflow of $20 under the cash flow from financing section. With no change in the cash flow from investing section, the net change in cash is a cash outflow of 17 dollars.

This flows to the balance sheet as the cash balance will decrease by $17 and the debt balance will decrease by $20. To balance it out, we know that net income flows over to retained earnings under shareholders’ equity and we remember that net income increased by $3. Therefore, shareholders’ equity will increase by $3 and the balance sheet will balance out.

3 statement impact - Depreciation (-10$):

• Work through the income statement first until you get to net income

  • From there, transition to the cash flow statement. Work on the cash flow statement until you reach the change in cash

  • From there, take the net income you got from the income statement and move it to retained earnings on the balance sheet. At the same time, take the change in cash you got from the cash flow statement and move it to cash on the balance sheet

• Depreciation decreases profits before tax by 10. If our income is lower, we would multiply 10 by 20 percent and we would get a 2 dollar benefit because we created an expense that isn’t a real cash charge but it lowers our taxable income

• On the cash flow statement, add back D&A to net income.

  • You will notice that the cash flow from operations is equal to the tax savings that you received from the non-cash expense

• Alongside retained earnings and cash, on the balance sheet, depreciation will also decrease PP&E by 10

  • You have to make sure the assets side balances out with the liabilities + shareholders’ equity side

3 statement impact - Debt:

Net income impact is zero

When you issue debt, money comes through the door but there is no interest incurred yet

Cash flows from financing:

Debt increases by 100

Balance sheet:

Debt on the liabilities side increases by 100

3 statement impact - Purchase of inventory/PP&E (+100 in inventory):

Until a good or service has been sold, it does not hit the income statement

On the cash flow from operations, the change in working capital would show a 100$ outflow since you bought inventory

The purchase of PP&E would be reflected in cash flow from investing

3 statement impact - Gains/losses from sale of PP&E (Sale 150$, original price 100$, gain 50$, 20% tax rate):

• Always make sure to ask what the tax rate is

• Income statement:

  • +50 gain on profits before tax

  • -10 due to taxes

  • +40 on net income due to 20% tax rate

• Cash flow from operations:

  • +40 on net income

  • Remove -50 from gain since it is a non-cash item (the sale of PP&E will be shown on cash flow from investing)

    • However, the gain on the sale of PP&E is not an operating cash flow—it’s an accounting gain that has already boosted net income. The corresponding actual cash from selling the asset will show up in the cash flow from investing section.

    • Because net income includes this gain, you must subtract it (i.e., remove it) in the operating section so you don't “double count” that cash. Put differently, if you didn’t subtract the gain, you’d overstate your operating cash flow.

    • The cash flow from operations is capturing the income impact of the transaction, which is -10 of incremental tax

• Cash flow from investing:

  • +150 from the sale of PP&E

• Change in cash = 150 + (-10) = 140

  • 150 is the sale of PP&E and (-10) is the taxes paid 

• Balance sheet:

  • Cash increase of 140

  • PP&E decrease of 100 since that was its original price

  • Retained earnings increase of 40

3 statement impact - Gains/losses from sale of PP&E (Original price 150$, sale 100$, loss 50$, 20% tax rate):

• Always make sure to ask what the tax rate is

• Income statement:

  • -50 loss before tax

  • +10 due to tax savings

  • -40 on net income 

• Cash flow from operations:

  • -40 on net income

  • Add back 50 from loss since it is a non-cash item 

  • The cash flow from operations is capturing the income impact of the transaction, which is +10 of tax savings

• Cash flow from investing:

  • +100 from the sale of PP&E

• Change in cash = 100 + 10 = 110

  • 100 is the sale of PP&E and +10 is the taxes saved

• Balance sheet:

  • Cash increase of 110

  • PP&E decrease of 150 since that was its original price

  • Retained earnings decrease of 40

3 statement impact - $10 PIK interest

• PIK interest reduces profits before tax by 10

  • Net income decreases by 8 due to 20% tax rate

• Cash flow from operations:

  • Net income is -8

  • Add back PIK interest by 10 since it is a non-cash charge

    • The cash flow from operations is +2, which is our tax savings. We unwinded all of our non-cash items

• Cash flow from financing is zero because unlike debt, PIK interest is a non-cash item

• Balance sheet:

  • Debt went up by 10

  • Cash went up by 2

  • Retained earnings decreased by 8

3 statement impact - Stock-based compensation

• SBC reduces profits before tax by 10

  • Net income decreases by 8 due to 20% tax rate

• Cash flow from operations:

  • Net income is -8

  • Add back SBC interest by 10 since it is a non-cash charge

    • The cash flow from operations is +2, which is our tax savings. We unwinded all of our non-cash items

• Cash flow from financing is zero because unlike debt, SBC interest is a non-cash item

• Balance sheet:

  • Additional paid-in capital went up by 10

  • Cash went up by 2

  • Retained earnings decreased by 8

3 statement impact - $10 increase in deferred revenue

• Income Statement: No impact (no revenue recognized yet)

• Cash Flow Statement: +$10 in Cash Flow from Operations

  • Cash inflow appears under “Changes in Operating Assets and Liabilities”

• Balance Sheet: +$10 to Cash and +$10 to Deferred Revenue

3 statement impact - $10 decrease in deferred revenue

• Cash flow statement:

  • Deferred Revenue is a liability. A decrease of $10 in this liability is a use of cash (in the working capital reconciliation)

    • So you subtract $10 on the Cash Flow Statement under changes in “Deferred Revenue” or “Working Capital.”

  • Cash flow from operations:

    • Starting impact: +$6 from higher net income

    • Working capital adjustment: –$10 from the decrease in deferred revenue

    • Overall change in cash from operations: –$4

  • Balance sheet:

    • Left side (Assets): –$4 change in Cash

    • Right side (Liabilities & Equity): –$10 in Deferred Revenue and +$6 in Retained Earnings.

3 statement impact - $200m increase in PIK debt with 10% interest rate:

1. Income Statement

• Interest Expense: Increases by +$20m.

• Pre-Tax Income: Decreases by -$20m.

• Tax Expense: Decreases by -$6m (30% tax shield on the $20m interest expense).

• Net Income: Decreases by -$14m.

2. Cash Flow Statement

• Net Income: Starts at -$14m.

• Cash Flow from Operations (CFO): Add back the +$20m of PIK interest. Why? Because it is a non-cash expense; no actual cash left the company to pay it.

• Net Change in Cash: Increases by +$6m (-$14m Net Income + $20m add-back).

Note: Even though the company incurred an expense, its cash position actually increased by $6m due to the tax shield savings.

3. Balance Sheet

• Assets: Cash increases by +$6m (carried over from the Cash Flow Statement).

• Liabilities: PIK Debt increases by +$20m (the $20m interest is tacked onto the principal balance).

• Equity: Retained Earnings decreases by -$14m (driven by the decline in Net Income).