Investment Banking - Accounting Questions

Walk me through the 3 financial statements

The 3 major statements are the income statement, balance sheet, cash flow statement. The income statement has revenue as the top line, subtracts out expenses, and goes down to net income. The balance sheet shows the companies assets (resources over time such as cash, inventory, PP&E) and its liabilities (debt and accounts payable) and its shareholders equity. Assets must equal liabilities plus shareholder's equity. Cash flow begins with net income and adjusts for non-cash expenses and changes in operating assets and liabilities, shows how the company has spent or received cash from investing or financing, and at the end gives the net change in cash.

Major line items on the income statement

Revenue, cost of goods sold, SG&A, operating income, pre-tax income, net income

Major line items on the balance sheet

Cash, accounts receivable, inventory, PP&E, accounts payable, accrued expenses, debt, shareholder's equity

Major line items on the cash flow statement

Cash flow from operations, cash flow from investing, cash flow from financing

Cash flow from operations

Net income, depreciation & amortization, stock based-compensation, changes in operating assets & liabilities

Cash flow from investing

Capital expenditures, sale of PP&E, sale/purchase of investments

Cash flow from financing

Dividends issued, debts raised/paid off, shares issued/repurchased

Which statement would you use to determine the overall health of a company?

Cash flow statement - it gives a true picture of how much cash the company s actually generating

How do the 3 statements flow together?

The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement.

In terms of the balance sheet, net income flows into stockholder's equity via retained earnings. Retained earnings is equal to the previous period's retained earnings plus net income from this period less dividends from this period.

In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations.

Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period.

If you could only use 2 statements to assess a company, which ones would you use?

Income statement and balance sheet because you can generate the cash flow statement from both of these

How can you tell if something is an asset or liability?

An asset will result in additional cash in the future, and a liability will result in less cash in the future

How can you tell if something should appear on the income statement?

It must correspond to something in the current period, and it must be tax-deductible

Why do you add back non-cash expenses to the cash flow statement?

Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.

How do you know when to capitalize or expense a purchase?

If the purchase corresponds to an asset with a useful life over 1 year, it is capitalized (put on the balance sheet rather than shown as an expense on the income statement). Examples of capitalized goods include factories, equipment, and land. Employee salaries and the cost of goods sold only last for the current period and therefore show up on the income statement as normal expenses instead.

If depreciation is a non-cash expense, why does it affect the cash balance?

Although it is a non-tax expense, it is tax-deductible. Therefore, an increase in depreciation decreases the amount of taxes you have to pay, which boosts cash

Where does depreciation appear on the income statement?

Could be a separate line item, or it could be embedded in COGS or operating expenses - it depends on the company. But the end result is always the same - depreciation reduces pre-tax income

Why don't inventory purchases affect the income statement?

The expense of purchasing inventory is only recorded on the income statement when the goods associated with it have been manufactured and sold. If it is just sitting in a warehouse, it doesn't count as COGS until the company makes it into a product and sells it

Debt repayments show up in cash flow from financing on the CFS, why don't interest payments show up here?

Interest payments correspond to the current period and are tax-deductible, so they are already recorded on the income statement. If you showed them on the CFS you'd be double counting them. Debt repayments are a true cash expense but don't appear on the income statement, so we need to adjust for them on the CFS.

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

Accounts payable is mostly for one-time expenses with invoices (paying for a law firm) whereas accrued expenses is mostly for recurring expenses without involves (employee wages, rent, utilities)

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

When a customer pays upfront for a product or service but the company hasn't delivered it yet. Happens with web subscription software, cell phone carriers, and magazine subscriptions

If cash collected is not recorded as revenue, what happens to it?

It goes into the deferred revenue balance on the balance sheet under liabilities. As the services or products are delivered, it turns into real revenue on the income statement and the deferred revenue balance decreases

Why is deferred revenue a liability?

It is a burden on us to deliver the product in question, and we will have to pay additional taxes and possibly additional future expenses when we record it as real revenue

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

1. accounts receivable hasn't been collected in cash from customers yet, and deferred revenue has

2. accounts receivable is for a product the company has already delivered but hasn't been paid for yet, whereas deferred revenue is for a product the company hasn't delivered yet

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

Usually in the 30-60 day range, but it can be higher for companies with higher-priced items, or lower for companies with lower-priced items for cash payments only

How are prepaid expenses and accounts payable different?

1. prepaid expenses have already been paid out in cash but haven't yet shown up on the income statement, whereas accounts payable haven't been paid out in cash but have shown up on the income statement

2. PE is for products that have not yet been delivered to the company, whereas AP is for products that have already delivered

What is income taxes payable on the liabilities side of a balance sheet?

Income taxes payable refers to normal income taxes that accrue and are then paid out in cash, similar to accrued expenses but for taxes instead

What does non controlling interest mean on the liabilities side of a balance sheet?

If you own over 50% but under 100% of another company, this refers to the portion you don't own

What does investments in equity interest mean on the assets side of a balance sheet?

If you own over 20% but under 50% of another company, this refers to the portion that you do own

When could you have negative shareholder's equity?

1. LBOs with dividend recaps - the owner of the company has taken out a large portion of its equity (usually in the form of cash) that can turn the number negative

2. can also happen if the company has been losing money consistently and therefore has a declining retained earnings balance, which is a portion of shareholder's equity

This doesn't mean anything in particular, but it may demonstrate that the company is struggling

What is working capital and how is it used?

Working capital=current assets - current liabilities

If it is positive it means that the company is able to pay off its short-term liabilities with short-term assets

What is operating working capital?

Operating working capital=(current assets excluding cash & investments)-(current liabilities excluding debt)

You would use this to exclude items that relate to a company's financing and investment activities. Operating working capital also appears on the CFS in the cash flow from operations and tells you how these operationally-related balance sheet items change over time

What does negative operating working capital mean?

Not necessarily bad. 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, Walmart, and McDonald's often have negative working capital because customer's pay upfront but the companies wait weeks or months to pay their suppliers - this is a sign of business efficiency and means they have healthy cash flow

3. negative working capital could also point to financial trouble or possible bankruptcy

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

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out, and accrual accounting recognizes revenue when collection is reasonably certain. All large companies use accrual accounting because it more accurately reflects the timing of revenue and expenses. Small businesses may use cash-based accounting to simplify their financial statements because they don't need CFSs if all of their accounting is done with cash

A company has had positive EBITDA for the last 10 years but recently went bankrupt, how could this happen?

1. if the company is spending too much on CapEx - these are not reflected in EBITDA but represent true cash expenses, so CapEx alone could make the company cash flow negative

2. the company has high interest expense can can't afford its debt anymore

3. the company's debt all matures on one date and it is unable to refinance due to a credit crunch - the company will run out of cash when paying back the debt

4. it has significant one-time charges that have been excluded from EBITDA and are high enough to bankrupt the company

Why would goodwill be impaired and what does this mean?

Usually happens when a company buys out another one and an acquirer reassesses what it really got out of the deal and find that those assets are worth significantly less than what they originally thought. Happens in acquisitions when the buyer overpaid for the seller and it can result in extremely negative net income on the income statement

How does depreciation going up by $10 affect the 3 statements?

Remember PP&E

How does accrued expenses going up by $10 affect the 3 statements?

Remember accrued expenses is a liability

How does accrued expenses going down by $10 affect the 3 statements?

This will not affect the income statement

Accounts receivable increases by $10. Walk me through the 3 statements

Remember don't actually have cash yet, have to subtract out AR

Prepaid expenses is down by $10. Walk me through the statement

Remember prepaid expenses is an asset

What happens when inventory goes up by $10 assuming you pay with cash?

Remember both cash and inventory is a liability

What happens when a company sells some of its PP&E for $120 but on the balance sheet it is worth $100?

Add a gain of $20 to income statement

Cash up by $12

Subtract gain of $20

Add back entire cash proceeds of $120

Cash up by $112

PP&E down by $100

Assets up by $12

Shareholder's equity up by $12 from net income

Walk me through the 3 statements when there's an asset write down of $100

Asset write downs are non-cash

Explain what happens when a company issues $100 worth of shares to investors?

Not on income statement. This will increase shareholder's equity

What happens when a company issues $100 in stock-based compensation?

Stock based compensation is a non-cash expense

Common stock & APIC in shareholder's equity up by 100

What happens when a company issues $100 in dividends?

Dividends are not on the income statement

Dividends make shareholder's equity go down

A company has recorded $100 in income tax expense on its income statement. All $100 is paid in cash in the current period. Now we change it and only $90 is paid in cash, with $10 being deferred to future periods. How do the statements change?

This won't change the income statement - everything is just recorded as taxes

If nothing changes, you can assume just $10 increase in cash

Deferred tax liability is a liability

Walk me through a $100 bailout of a company

Most common is an equity bailout

Walk me through a $100 write down of debt

When a liability is written down its recorded as an increase on the income statement

You subtract a debt write down on the cash flow statement

If writing down liabilities boosts net income why don't companies do it all the time?

It helps in the short term, but in the long permit hurts the company's credibility and ability to borrow in the future

What's the difference between LIFO and FIFO?

With LIFO, you use the value of the most recent inventory additions for COGS, but with FIFO you use the value of the oldest inventory additions for COGS