Accounting

Operating Working Capital

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.

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.

What is Working Capital? How is it used?

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 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.

Income Statement Major Line Items

Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative) Expenses; Operating Income; Pre-Tax Income; Net Income.

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. Those taxes increase the Income Taxes Payable account until they are paid out in cash, at which point Income Taxes Payable decreases.

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.

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.

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

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.

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

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.

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

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

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.

At the end of Year 2, the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements ONLY from the start of Year 2 to the end of Year 2.

After 2 years, the value of the factories is now $80 if we go with the 10% Depreciation per year assumption. It is this $80 that we will write down on the 3 statements. Also, don't forget about the Interest Expense - it still needs to be paid in Year 2. Income Statement: We have $10 worth of Depreciation and then the $80 Write- Down. We also have $10 of additional Interest Expense, so Pre-Tax Income is down by $100. Net Income is down by $60 at a 40% tax rate. Cash Flow Statement: Net Income is down by $60 but the Write-Down and Depreciation are both non-cash expenses, so we add them back and cash flow is up by $30 so far. There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback - so Cash Flow from Financing falls by $100. Overall, cash at the bottom decreases by $70. Balance Sheet: Cash is now down by $70, and PP&E has decreased by $90, so the Assets side is down by $160. On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $60, Shareholders' Equity is down by $60. Both sides are down by $160 and balance. NOTE: Be very careful with this type of question because there are many variations - when in doubt, always ask to clarify before you begin answering.

Now let's go out one year, to the start of Year 2. Assume the Debt is high yield, so no principal is paid off, and assume an interest rate of 10%. Also assume the factories Depreciate at a rate of 10% per year. What happens now?

After a year has passed, Apple must pay Interest Expense and must record the Depreciation. Income Statement: Operating Income decreases by $10 due to the 10% Depreciation charge each year, and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense). Assuming a tax rate of 40%, Net Income falls by $12. Cash Flow Statement: Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. That's the only change on the Cash Flow Statement, so overall Cash is down by $2. Balance Sheet: On the Assets side, Cash is down by $2 and PP&E is down by $10 due to the Depreciation, so overall the Assets side is down by $12. On the other side, since Net Income was down by $12, Shareholders' Equity is also down by $12 and both sides balance. Remember that the Debt number itself does not change since we've assumed that nothing is paid back.

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.

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 A Liability will result in less cash or potential cash in the future Ask what direction cash will move in as a result of this new item and that tellsyou whether it's an Asset or Liability.

Wait a minute - if writing down Liabilities boosts Net Income, why don't companies just do it all the time? It helps them out!

Because it may help in the short-term, but in the long term it hurts the company's credibility and ability to borrow in the future. If a company continually writes down its Liabilities, investors will stop trusting it - and the inability to borrow again will hurt it far more than a reduced Net Income would.

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.

Balance Sheet Major Line Items

Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity.

Cash Flow Statement Major Line Items

Cash Flow Statement: 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, Debt Raised / Paid Off, Shares Issued / Repurchased)

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.

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.

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.

Let's say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?

Income Statement: At the start of "Year 1," there are no changes yet. Cash Flow Statement: The $100 worth of Capital Expenditures would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of Debt raised would show up as an addition to Cash Flow in Cash Flow from Financing, canceling out the investment activity. So the cash number stays the same, for now. Balance Sheet: There is now an additional $100 worth of factories, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, Debt is up by $100, so the entire other side is up by $100 and both sides balance.

7. Now walk me through what happens at the end of Year 1, after the company has earned interest, paid interest, and paid back some of the debt principal.

Income Statement: Interest Income is $10 ($100 * 10%) and Interest Expense is $5 ($100 * 5%), so Pre-Tax Income increases by $5, and Net Income increases by $3 assuming a 40% tax rate. Cash Flow Statement: Net Income is up by $3. In Cash Flow from Financing, we repay $10 worth of debt ($100 * 10%), so cash at the bottom is down by $7. Balance Sheet: Cash on the Assets side is down by $7, so the Assets side is down by $7. On the other side, Debt is down by $10 due to the repayment and Shareholders' Equity (Retained Earnings) is up by $3 due to the Net Income, so this side is also down by $7 and the Balance Sheet balances.

Explain what happens on the 3 statements when a company issues $100 worth of shares to investors.

Income Statement: No changes (since this doesn't affect taxes and since the shares will be around for years to come). Cash Flow Statement: Cash Flow from Financing is up by $100 due to this share issuance, so cash at the bottom is up by $100. Balance Sheet: Cash is up by $100 on the Assets side and Shareholders' Equity (Common Stock & APIC) is up by $100 on the other side to balance it.

6. A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase.

Income Statement: No changes yet. Cash Flow Statement: The $100 Purchase of Short-Term Securities shows up as a reduction of cash flow under Cash Flow from Investing, and the $100 Debt raise shows up as a $100 increase under Cash Flow from Financing. Cash at the bottom is unchanged. Balance Sheet: Short-Term Securities on the Assets side is up by $100, and Debt on the Liabilities side is up by $100 so both sides balance

Walk me through a $100 "bailout" of a company and how it affects the 3 statements. (preferred stock)

Income Statement: No changes. Cash Flow Statement: Cash Flow from Financing goes up by $100 to reflect this new investment, so the Net Change in Cash is up by $100. Balance Sheet: Cash is up by $100 so the Assets side is up by $100; on the other side, Shareholders' Equity goes up by $100 to make it balance

A company decides to issue $100 in Dividends - how do the 3 statements change?

Income Statement: No changes. Cash Flow Statement: Cash Flow from Financing is down by $100 due to the Dividends, so cash at the bottom is down by $100. Balance Sheet: Cash is down by $100 on the Assets side, and Shareholders' Equity (Retained Earnings) is down by $100 on the other side so both sides balance.

What happens when Inventory goes up by $10, assuming you pay for it with cash?

Income Statement: No changes. Cash Flow Statement: Inventory is an Asset so that reduces Cash Flow from Operations - it goes down by $10, as does the Net Change in Cash at the bottom. Balance Sheet: On the Assets side, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Equity.

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPad Inventory, using cash on hand. They order the Inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements?

Income Statement: No changes. Cash Flow Statement: Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10 Balance Sheet: Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.

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

Income Statement: Nothing changes. Both Current and Deferred Taxes are recorded simply as "Taxes" and Net Income remains the same. Net Income changes only if the total amount of taxes changes. Cash Flow Statement: Net Income remains the same but we add back the $10 worth of Deferred Taxes in Cash Flow from Operations - no other changes, so cash at the bottom is up by $10. Balance Sheet: Cash is up by $10 and so the entire Assets side is up by $10. On the other side, the Deferred Tax Liability is up by $10 and so both sides balance.

What happens when Accrued Expenses increases by $10?

Income Statement: Operating Income and Pre-Tax Income fall by $10, and Net Income falls by $6 (assuming a 40% tax rate). Cash Flow Statement: Net Income is down by $6, and the increase in Accrued Expenses will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. Balance Sheet: Cash is up by $4 as a result, so Assets is up by $4. On the Liabilities & Equity side, Accrued Expenses is a Liability so Liabilities is up by $10 and Shareholders' Equity(Retained Earnings) is down by $6 due to the Net Income decrease, so both sides balance.

Walk me through how Depreciation going up by $10 would affect the statements.

Income Statement: Operating Income and Pre-Tax Income would decline by $10 and, assuming a 40% tax rate, Net Income would go down by $6. Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow. from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4. Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement.Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the Liabilities & Equity side is down by $6 and both sides of the Balance Sheet balance.

Walk me through a $100 Write-Down of Debt - as in OWED Debt, a Liability - on a company's Balance Sheet and how it affects the 3 statements.

Income Statement: Pre-Tax Income goes up by $100, and assuming a 40% tax rate, Net Income is up by $60. Cash Flow Statement: Net Income is up by $60, but we need to subtract that Debt Write-Down because it was non-cash - so Cash Flow from Operations is down by $40, and Cash is down by $40 at the bottom. Balance Sheet: Cash is down by $40 so the Assets side is down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was up by $60 - so Liabilities & Shareholders' Equity is down by $40 and both sides balance.

Prepaid Expenses decreases by $10. Walk me through the statements. Do not take into account cumulative changes from previous increases in Prepaid Expenses.

Income Statement: Pre-Tax Income is down by $10, and Net Income is down by $6. Cash Flow Statement: Net Income is down by $6 but since Prepaid Expenses is an Asset, a decrease of $10 results in an increase of 10 in cash. At the bottom of the CFS, cash is up by $4 as a result. Balance Sheet: On the Assets side Cash is up by $4 and Prepaid Expenses is down by $10, so the Assets side is down by $6 overall. Net income down 6 as well to balance SE Equity.

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

Income Statement: Revenue is up by $10 and so is Pre-Tax Income, which means that Net Income is up by $6 assuming a 40% tax rate. Cash Flow Statement: Net Income is up by $6 but the AR increase is a reduction in cash (since we don't have the cash yet), so we need to subtract $10, which results in cash at the bottom being down by $4. Balance Sheet: On the Assets side, Cash is down by $4 and AR is up by $10, so the Assets side is up by $6. On the other side, Shareholders' Equity is up by $6 because Net Income has increased by $6. Both sides balance.

Now let's say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit, Operating Income, and Pre-Tax Income are all up by $10. Assuming a 40% tax rate, Net Income is up by $6. Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the Inventory into real iPads), which is a net addition to cash flow - so Cash Flow from Operations is up by $16 overall. These are the only changes on the CFS, so cash at the bottom is up by $16. Balance Sheet: Cash is up by $16 and Inventory is down by $10, so the Assets side is up by $6 overall. On the other side, Net Income was up by $6, so Shareholders' Equity is up by $6 and both sides balance. Intuition: This simply reflects the sale of products at a certain cost, and the aftertax profit from that. The only tricky part is how Cash increases by $16, not $6 - that just reflects the "release" you get from selling off the Inventory.

Walk me through what happens on the 3 statements when there's an Asset Write-Down of $100.

Income Statement: The $100 Write-Down reduces Pre-Tax Income by $100. With a 40% tax rate, Net Income declines by $60. Cash Flow Statement: Net Income is down by $60 but the Write-Down is a non cash expense, so we add it back - and therefore Cash Flow from Operations increases by $40. Cash at the bottom is up by $40. Balance Sheet: Cash is now up by $40 and an Asset is down by $100. Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders' Equity is also down by $60 and both sides balance.

What happens when Accrued Expenses decreases by $10

Income Statement: There are no changes. Cash Flow Statement: The change in Accrued Expenses in the CFO section is negative $10 because you pay it out in cash, and so the cash at the bottom decreases by $10. Balance Sheet: Cash is down by $10 on the Assets side and Accrued Expenses is down by $10 on the other side, so it balances.

The company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens?

Income Statement: You need to record this as an additional expense because it's now a tax-deductible and a current expense - Pre-Tax Income falls by $100 and Net Income falls by $60 assuming a 40% tax rate. Cash Flow Statement: Net Income is down by $60 but you add back the SBC of $100 since it's a non-cash charge, so cash at the bottom is up by $40. Balance Sheet: Cash is up by $40 on the Assets side. On the other side, Common Stock & APIC is up by $100 due to the Stock-Based Compensation, but Retained Earnings is down by $60 due to the reduced Net Income, so Shareholders' Equity is up by $40 and both sides balance.

Now let's say that at the end of year 1, the company sells the $100 of Short- Term Securities but gets a price of $110 for them instead. It also uses the proceeds to repay the $90 worth of remaining Debt. Walk me through the statements after ONLY these changes.

Income Statement: You record a Gain of $10 ($110 - $100), so Pre-Tax Income is up by $10 and Net Income is up by $6 with a 40% tax rate. Cash Flow Statement: Net Income is up by $6 but you subtract the Gain of $10, so Cash Flow from Operations is down by $4. Under Cash Flow from Investing, you record the $110 sale as an addition to cash flow, so cash is up by $106 so far. Then, under Cash Flow from Financing, you pay off $90 worth of Debt, which reduces cash by $90. Overall, Cash at the bottom is up by $16. Balance Sheet: Cash on the Assets side is up by $16 but Short-Term Securities is down by $100, so the Assets side is down by $84. On the other side, Debt is down by $90 but Shareholders' Equity (Retained Earnings) is up by $6 due to the Net Income increase, so that side is also down by $84 and both sides balance.

A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change.

Income Statement: You record a Gain of $20 ($120 - $100), which boosts Pre-Tax Income by $20. At a 40% tax rate, Net Income is up by $12. Cash Flow Statement: Net Income is up by $12, but you need to subtract out that Gain of $20, so Cash Flow from Operations is down by $8.Then, in Cash Flow from Investing, you record the entire amount of proceeds from the sale - $120 - so that section is up by $120. At the bottom of the CFS, cash is therefore up by $112. Balance Sheet: Cash is up by $112, but PP&E is down by $100 since we've sold it, so the Assets side is up by $12. The other side is up by $12 as well, since Shareholders' Equity is up by $12 due to the Net Income increase.

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.

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.

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.

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

No. 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).

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

Not Always. 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).

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.

Walk me through the 3 financial statements.

The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. The Income Statement shows the company's revenue and expenses over a period of time, and goes down to Net Income, the final line on the statement. The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity - at a specific point in time. Assets must equal Liabilities plus Shareholders' Equity. The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and changes in operating assets and liabilities (working capital), and then shows how the company has spent cash or received cash from Investing or Financing activities; at the end, you see the company's net change in cash.

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.

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.

How do the 3 statements link together?

To tie the statements together, Net Income from the Income Statement becomes the top line of the Cash Flow Statement. Then, you add back any non-cash charges such as Depreciation & Amortization to this Net Income number. Next, changes to operational Balance Sheet items appear and either reduce or increase cash flow depending on whether they are Assets or Liabilities and whether they go up or down. That gets you to Cash Flow from Operations. Now you take into account investing and financing activities and changes to items like PP&E and Debt on the Balance Sheet; those will increase or decrease cash flow, and at the bottom you get the net change in cash. On the Balance Sheet for the end of this period, Cash at the top equals the beginning Cash number (from the start of this period), plus the net change in cash from the Cash Flow Statement. On the other side, Net Income flows into Shareholders' Equity to make the Balance Sheet balance. At the end, Assets must always equal Liabilities plus Equity.

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. You only record revenue when you actually deliver the products / services - so the company does not record cash collected as revenue right away.

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 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.

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 reassesses 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.

What's the difference between LIFO and FIFO? Can you walk me through an example of how they differ?

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.

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 that you have Beginning" and "Ending" Balance Sheets that correspond to the same period the Income Statement is tracking.

If I were stranded on a desert island and only had one financial statement and I wanted to review 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 - the Income Statement is misleading because it includes non-cash expenses and excludes actual cash expenses such as Capital Expenditures. And that's the #1 thing you care about when analyzing the financial health of any business - its true cash flow.