Accounting

What are the components of equity?

+ Common stock + Preferred stock - Treasury stock +Noncontrolling interests +APIC (Additional Paid in Capital) +Retained Earnings +Other direct gains/(losses)

Company A issues bonds at par for $100 million with a 10% coupon. Flow this through the three financial statements at Time 0 and Time 1. Assume that interest expense is paid in cash and assume a tax rate of 40%.

1. Time 0 I/S: No Effect SCF: Cash Flows from Financing will have a cash inflow of $100 million B/S: Debit Cash $100 million (Cash increases by $100 million) | Credit Bonds Payable $100 million (Bonds Payable increases by $100 million) 2. Time 1 I/S: Interest expense of $10 million. Net income decreases by $10 * (1 - 40%) = $6 million SCF: Cash Flows from Operations will have a cash outflow of $6 million. B/S: Debit Retained Earnings $6 million (Retained earnings decrease by $6 million) | Credit Cash $6 million (Cash decreases by $6)

If you have 1000 PP&E and have 100 depreciation. What is the PP&E at the end of the period?

1000. PP&E doesn't change. The Accumulated depreciation liability account does.

What is APIC?

Additional Paid In Capital Additional Paid In Capital (APIC) is the value of share capital above its stated par value and is an accounting item under Shareholders' Equity on the balance sheet. APIC can be created whenever a company issues new shares and can be reduced when a company repurchases its shares.

What about Net PP&E? (initial PP&E and 100 depreciation)

All things equal, net PP&E will be 1000-100 = 900

10. If Depreciation is a non-cash expense, why does it affect the cash balance?

Although Depreciation is a non-cash expense, it is tax-deductible. Therefore, an increase in Depreciation will reduce the amount of taxes you pay, which boosts your cash balance. The opposite happens if Depreciation decreases.

6. Let's say I have a new, unknown item that belongs on the Balance Sheet. How can I tell whether it should be an Asset or a Liability?

An Asset will result in additional cash or potential cash in the future - think about how Investments or Accounts Receivable will result in a direct cash increase, and how Goodwill or PP&E may result in an indirect cash increase in the future. A Liability will result in less cash or potential cash in the future - think about how Debt or Accounts Payable will result in a direct cash decrease, and how something like Deferred Revenue will result in an indirect cash decrease as you recognize additional taxes in the future from recognizing revenue. Ask what direction cash will move in as a result of this new item and that tells you whether it's an Asset or Liability.

How does retiring a bond at 10% lower than book value impact the three statements?

Assume Book value = 100 and retire at 90 I/S: add $+10 gain - tax@25% $-2.5 = $+7.5 CFS: Net income $+7.5 Non cash gain $-10 Cash paid for retirement of debt $-90. Net change in cash = $-92.5 B/S: Cash$ -92.5; Retiring bond $-100, Retained earning $+2.5

Why EBITDA does not equals cash flows?

Because it doesn't account for: - CAPEX - Changes in Working Capital - Interest expenses - Tax expenses - Dividends payed - Shares Buy Backs -obligation of payments (pensions)

Why is EBITDA used so much?

Because it is - Easily calculated - Get EBIT and add back Depreciation and Amortization Good for comparisons - Agnostic of capital structure (compares a firms operational capabilities) - Agnostic to tax jurisdictions - Agnostic to asset base Linked to cash flow -used for valuation (EV/EBITDA) - Lending analysis: leverage level (Debt/EBITDA) and exposure analysis (EBITDA/Interest Expense)

Why debt principal repayment does not appear in the Income Statement?

Because it is not tax deductible. In order to be in the income statement, it must be relative to the current period and it must be tax deductible. Some non-operational items can appear in the income statement, such as gain from sale of property

8. Let's say that you have a non-cash expense (Depreciation or Amortization, for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?

Because you want to reflect that you've saved on taxes with the non-cash expense. Let's say you have a non-cash expense of $10 and a tax rate of 40%. Your Net Income decreases by $6 as a result... but then you add back the entire non-cash expense of $10 on the CFS so that your cash goes up by $4. That increase of $4 reflects the tax savings from the non-cash expense. If you just added back the after-tax expense of $6 you'd be saying, "This non-cash expense has no impact on our taxes or cash balance."

5. How can a company have positive earnings and negative cash flow?

Cash flow is made up of three main components: operating cash flows, investing cash flows, and financing cash flows. As a result, positive earnings can occur even when there is a negative cash flow due to following three reasons: 1. Operating activity: Depending on accruals or non-cash/non-operating items, the operating cash flow can be negative. For example, if sales are comprised mostly of credit sales, there are large investments in inventory, or there is a decrease in accounts payable, the operating cash flow can be negative. 2. Investing activity: Large investments in PP&E can create large cash outflows. If the company is growing, it must be investing a lot on its PP&E, therefore, since investments are not part of your expenses (these are capitalized on the balance sheet and depreciated over the life of the asset), your earning could be positive while your total cash flow may be negative 3. Financing activity: Companies may decide to pay off debt, pay dividends, or participate in a share buyback program, resulting in a cash outflow

28. 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; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after an invoice has been sent to the customer and the customer has a track record of paying on time) and recognizes expenses when they are incurred rather than when they are paid out in cash. 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 (you no longer need a Cash Flow Statement if everything is cash-based).

industry with negative beta

Counter cyclical - e.g. gold

What is the relationship between EV and Equity value

EV = Equity Value + Net debt + Preferred Stocks + Minority Interests

What do you do if you understated depreciation by $100?

First, make an assumption on the tax rate (most people choose 40% because it makes the math easy. Then walk through how this change affects each statement. I/S: There is a $100 decrease in operating income by taking out an additional $100 in depreciation. However, taxes decrease by $40, partially offsetting the $100 drop in operating income. Net income decreases by $60. SCF: Net income is $60 lower to start, but the $100 in depreciation is added back, so cash flow from operations increases by $40. B/S: Shareholders' equity decreases by $60 as a result of the lower net income. Net PP&E decreases by an additional $100. The balance sheet is balanced by increasing cash by the $40 you get back in taxes. Be sure to also practice this question with different $ amounts. Some people were asked to calculate using non-round numbers, so make sure you aren't caught off guard when the number isn't a round $100. This question was also asked the opposite way in many interviews, so you'd have to calculate the numbers when depreciation was overstated by $100.

19. How long does it usually take for a company to collect its Accounts Receivable balance?

Generally the Accounts Receivable Days are in the 30-60 day range, though it can be higher for companies selling higher-priced items and it might be lower for companies selling lower-priced items with cash payments only.

A firm is using LIFO, and prices on supplies start decreasing. What are effects on IS, BS, and CFS?

I/S: Since costs are decreasing, the COGS will decrease. As a result, operating income is increasing. Net income increases by COGS*(1-t) SCF: There will be higher operating cash flow by COGS*(1-t) given the higher net income, so the BS will balance due to the matching increase in cash account and equity account. B/S: Retained Earnings is also higher by COGS*(1-t). Inventory will be based on the older inventory (which is becoming more expensive)

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

If the purchase corresponds to an Asset with a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is Depreciated (tangible assets) or Amortized (intangible assets) over a certain number of years. Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only "last" for the current period and therefore show up on the Income Statement as normal expenses instead. Note that even if you're paying for something like a multi-year lease for a building, you would not capitalize it unless you own the building and pay for the entire building in advance.

23. You see an "Investments in Equity Interests" (AKA Associate Companies) line item on the Assets side of a firm's Balance Sheet. What does this mean?

If you own over 20% but less than 50% of another company, this refers to the portion that you DO own. Example: Another company is worth $100. You own 25% of it. Therefore, there will be an "Investments in Equity Interests" line item of $25 on your Balance Sheet to represent the 25% that you own. NOTE: There are more questions on this topic in the Advanced section. At a basic level, you should just understand what it means.

22. You see a "Noncontrolling Interest" (AKA Minority Interest) line item on the Liabilities side of a company's Balance Sheet. What does this mean?

If you own over 50% but less than 100% of another company, this refers to the portion you do not own. Example: Another company is worth $100. You own 70% of it. Therefore, there will be a Noncontrolling Interest of $30 on your Balance Sheet to represent the 30% you do not own. NOTE: There are more questions on this topic in the Advanced section. At a basic level, you should just understand what it means.

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

Income Statement: Revenue - Cost of Goods Sold = Gross profit - SG&A (Selling, General & Administrative Expenses) = Operating Income - Interest expense (income) = Pretax Income - Income taxes = Net Income. Balance Sheet: Assets: Current Assets: Cash; Accounts Receivable; Inventory; Deferred income taxes; Prepaid expenses and other current assets; Plants, Property & Equipment (PP&E); Goodwill; Other intangible assets; Other Assets Liabilities: Current liabilities: Accounts payable; Current portion of long term debt; Notes payable; Accrued expenses; Long-term debt; Deferred income taxes; Other liabilities; Shareholders' Equity: Common stock; Additional paid-in capital; Retained earnings; Common stock in treasury; Accumulated other comprehensive loss; Noncontrolling interests Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

21. You're reviewing a company's Balance Sheet and you see an "Income Taxes Payable" line item on the Liabilities side. What is this?

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. Example: A company pays corporate income taxes in cash once every 3 months. But they also have monthly Income Statements where they record income taxes, even if they haven't been paid out in cash yet. Those taxes increase the Income Taxes Payable account until they are paid out in cash, at which point Income Taxes Payable decreases.

Disadvantages of raising debt

Interest expense, can get downgraded and control convenant

11. Where does Depreciation usually appear on the Income Statement?

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses - each company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

16. 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. Over time, as the services or products are delivered, the Deferred Revenue balance turns into real revenue on the Income Statement and the Deferred Revenue balance decreases.

20. How are Prepaid Expenses (PE) and Accounts Payable (AP) different?

It's similar to the difference between Accounts Receivable and Deferred Revenue above: 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 IS. 2. PE is for product/services that have not yet been delivered to the company whereas AP is for products/services that have already been delivered.

30. Why do companies report GAAP or IFRS earnings, AND non-GAAP / non- IFRS (or "Pro Forma") earnings?

Many companies have non-cash charges such as Amortization of Intangibles, Stock-Based Compensation, and Write-Downs on their Income Statements, all of which negatively impact their Net Income. Companies therefore report alternative "Pro Forma" metrics that exclude these expenses and paint a more favorable picture of their earnings, under the argument that these metrics better represent "true cash earnings."

14. What's the difference between Accounts Payable and Accrued Expenses?

Mechanically, they are the same: they're Liabilities on the Balance Sheet used when you've recorded an Income Statement expense for a product/service you have received, but have not yet paid for in cash. They both affect the statements in the same way as well (see the model). The difference is that Accounts Payable is mostly for one-time expenses with invoices, such as paying for a law firm, whereas Accrued Expenses is for recurring expenses without invoices, such as employee wages, rent, and utilities.

Does dividend has a tax shield in the US?

No

26. "Short-Term Investments" is a Current Asset - should you count it in Working Capital?

No. If you wanted to be technical you could say that it should be included in "Working Capital," as defined, but left out of "Operating Working Capital." But the truth is that no one lists Short-Term Investments in this section because Purchases and Sales of Investments are considered investing activities, not operational activities. "Working Capital" is an imprecise idea and we prefer to say "Operating Assets and Liabilities" because that's a more accurate way to describe the concept of operationally-related Balance Sheet items - which may sometimes be Long-Term Assets or Long-Term Liabilities (e.g. Deferred Revenue).

27. What does negative (Operating) Working Capital mean? Is that a bad sign?

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront, but they wait weeks or months to pay their suppliers - this is a sign of business efficiency and means that they always have healthy cash flow. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when the company owes a lot of money to suppliers and cannot pay with cash on-hand).

17. Wait a minute... Deferred Revenue reflects cash that we've already collected upfront for a product/service we haven't delivered yet. Why is it a Liability? That's great for us!

Remember the definitions of Assets and Liabilities: an Asset results in more future cash, and a Liability results in less future cash. Think about how Deferred Revenue works: not only is the burden on us to deliver the product/service in question, but we are also going to pay additional taxes and possibly recognize additional future expenses when we record it as real revenue. It's counter-intuitive, but that is why Deferred Revenue is a liability: it implies additional future expenses.

What are the 2 ways to calculate terminal value? Why is that important?

Terminal Multiple Multiply the terminal year operating metric and multiply it by the appropriate terminal multiple Perpetuity Growth UFCFn * (1+g)/(r-g) g = chosen perpetuity growth rate r = discount rate or WACC inflation < g < GDP growth (tipically between 2% and 5%) It matters because terminal value usually accounts for 60-80% of DCF value

Walk me through a DCF

The DCF measures the intrinsic value of a company by calculating the present value of future cash flows and the terminal value using WACC as a discount rate. 1. Project the companies free cash flows for about 5 years. Free cash flow is EBIT times 1 minus the tax rate plus depreciation and amortization, minus capital expenditures, minus the change in networking capital. 2. Predict free cash flows beyond 5 years using either a terminal value multiple or the perpetuity method. 3. To calculate perpetuity method, establish a terminal growth rate, usually about the rate of inflation or GDP growth, a low single digit percentage. 4. Now multiply the year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus the growth rate. 5. Discount rate is the WACC, use that rate to discount all your cash flows back to year zero. The same of the present values of all those cash flows is the estimated enterprise value of the firm according to the DCF.

13. Debt repayment shows up in Cash Flow from Financing on the Cash Flow Statement. Why don't interest payments also show up there? They're a financing activity!

The difference is that interest payments correspond to the current period and are tax-deductible, so they have already appeared on the Income Statement. Since they are a true cash expense and already appeared on the IS, showing them on the CFS would be double-counting them and would be incorrect. Debt repayments are a true cash expense but they do not appear on the IS, so we need to adjust for them on the CFS. If something is a true cash expense and it has already appeared on the IS, it will never appear on the CFS unless we are re-classifying it - because you have already factored in its cash impact.

12. Why is the Income Statement not affected by Inventory purchases?

The expense of purchasing Inventory is only recorded on the Income Statement when the goods associated with it have been manufactured and sold - so if it's just sitting in a warehouse, it does not count as Cost of Goods Sold (COGS) until the company manufactures it into a product and sells it.

18. Wait, so what's the difference between Accounts Receivable and Deferred Revenue? They sound similar.

There are 2 main differences: 1. Accounts Receivable has not yet been collected in cash from customers, whereas Deferred Revenue has been. 2. Accounts Receivable is for a product/service the company has already delivered but hasn't been paid for yet, whereas Deferred Revenue is for a product/service the company has not yet delivered. Accounts Receivable is an Asset because it implies additional future cash whereas Deferred Revenue is a Liability because it implies the opposite.

31. A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

There are several possibilities: 1. The company is spending too much on Capital Expenditures - 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 and is no longer able to afford its Debt. 3. The company's Debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash when paying back the Debt. 4. It has significant one-time charges (from litigation, for example) that have been excluded from EBITDA and those are high enough to bankrupt the company. Remember, EBITDA excludes investment in (and Depreciation of) Long-Term Assets, Interest, and Non-Recurring Charges - and any one of those could represent massive cash expenses.

If you buy $200 of equipment - 50% on credit, 50% in cash - and sell it for $300, walk me through the changes in the financial statements.

There are two parts to this question, so we will deal with each part separately. 1. Purchase of $200 of equipment - 50% on credit, 50% in cash I/S: No Effect SCF: Cash Flows from Investing will have a cash outflow of $100 B/S: Debit PP&E $200 (PP&E increases by $200) | Credit Cash $100 (Cash decreases by $100) | Credit Accounts Payable $100 (Accounts Payable increases by $100) 2. Sale of equipment at $300. (Assume that sale is made in all cash and tax rate of 40%) I/S: Gain on sale of equipment of $100. Net income increases by $100 (1 - 40%) = $60 SCF: Cash Flows from Operations will have the gain subtracted, resulting in a cash outflow of $40. Cash Flows from Investing will have a cash inflow of $300. The net cash flow is a net cash inflow of $260. B/S: Debit Cash $260 (Cash increases by $260) | Credit PP&E $200 (PP&E decreases by $200) | Credit Retained Earnings $60 (Retained Earnings increases by $60)

7. How can you tell whether or not an expense should appear on the Income Statement?

Two conditions MUST be true for an expense to appear on the IS: 1. It must correspond to something in the current period. 2. It must be tax-deductible. Employee compensation and marketing spending, for example, satisfy both conditions. Depreciation and Interest Expense also meet both conditions - Depreciation only represents the "loss in value" of PP&E (or to be more technically precise, the allocation of the investment in PP&E) in the current period you're in. Repaying debt principal does not satisfy both of these conditions because it is not tax-deductible. Advanced Note: Technically, "tax-deductible" here means "deductible for book tax purposes" (i.e. only the tax number that appears on the company's Income Statement) - see the Advanced Accounting section for more on this topic.

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

Typically this happens when the customer pays upfront, in cash, for months or years of a product/service, but the company hasn't delivered it yet. Cases where you see this: 1. Web-based subscription software. 2. Cell phone carriers that sell annual contracts. 3. Magazine publishers that sell subscriptions. You only record revenue when you actually deliver the products / services - so the company does not record cash collected as revenue right away.

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

Under cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - 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, it 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 actually deposited in the company's bank account, it would move into the Cash line item and Accounts Receivable would go down.

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

Usually this happens when a company buys another one and the acquirer re- assesses what it really got out of the deal - customer relationships, brand name, and intellectual property - and finds that those "Assets" are worth significantly less than they originally thought. It often happens in acquisitions where the buyer "overpaid" for the seller and it can result in extremely negative Net Income on the Income Statement. It can also happen when a company discontinues part of its operations and must impair the associated Goodwill.

Walk me through the 3 financial statements.

We start with the income statement that measures a company's profitability over a period of time. It starts with revenues from which we subtract operating, interest and tax expenses, arriving at the net income. Net Income is what starts the Cash Flow statement, which measures the firm's inflows and outflows of cash over a period of time and has 3 sections: Cash Flow from Operating, Investing and Financial activities. The cash flow statements gives us the net change in cash over that period of time and gives the cash balance. Which kicks off the Balance sheet. The balance sheet measures a firm's financial accounts at a snap shot in time and has 3 sections: Assets (future economic benefits), Liabilities (sacrifices to those benefits) and the residual of assets and liabilities is equity, which is also impacted by net income

. Walk me through the effect on all 3 statements of retiring a bond at a discount, assuming 40% tax rate.

When retiring a bond at a discount, the debt balance is reduced by the notional amount of the retired debt, but the cost to the firm is less than this amount, resulting in an accounting gain. This gain must be flowed through the three financial statements. Let's assume the debt retired has a notional amount of $100, and it is retired at $90. I/S: Non-operating activity gain of $10 reported, resulting in $6 increase in net income (after tax). SCF: Net income has increased by $6, but the $10 gain in the income statement is a non-cash item, so it must be removed and operating cash flow is reduced by $4. Cash from financing activities is reduced by $90 for the retirement of debt, so the overall change in cash is a reduction by $94. B/S: Cash is reduced by $94, long term debt is reduced by $100, and the equity balance is increased by $6 via retained earnings. Assets are reduced by $94, and liabilities are also reduced by $94, so the change is balanced on both sides.

25. What is Working Capital? How is it used?

Working Capital = Current Assets - Current Liabilities. If it's positive, it means a company can pay off its short-term Liabilities with its short-term Assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound." You use Operating Working Capital more commonly in finance, and that is defined as (Current Assets Excluding Cash & Investments) - (Current Liabilities Excluding Debt). The point of Operating Working Capital is to exclude items that relate to a company's financing and investment activities - Cash, Investments, and Debt - from the calculation. "Changes in Working Capital" (more commonly called "Changes in Operating Assets and Liabilities") also appears on the Cash Flow Statement in Cash Flow from Operations and tells you how these operationally-related Balance Sheet items change over time.

24. Could you ever have negative Shareholders' Equity? What does it mean?

Yes. It is common in 2 scenarios: 1. Leveraged Buyouts with dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative. 2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders' Equity. It doesn't "mean" anything in particular, but it might demonstrate that the company is struggling (in the second scenario). Note: Note that EQUITY VALUE - AKA Market Cap - is different from Shareholders' Equity and that Equity Value can never be negative.

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

You would pick the Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).

If I were stranded on a desert island, only had 1 statement and I wanted to the overall health of a company - which statement would I use and why?

You would use the Cash Flow Statement because it gives a true picture of how much cash the company is actually generating, independent of all the non-cash expenses you might have. And that's the #1 thing you care about when analyzing the overall financial health of any business - its cash flow.

WACC formula

cost of equity*%equity + (1-t) cost of debt*%debt in structure

industry with beta equal zero

gambling machine, anything related to chance (correlation = 0)