Changes to the Three Financial Statements- BIWS

In the second year, the acquisition goes horribly wrong, and your company realizes the acquired company is worth only about half of what it paid. So, it decides to write down half the Goodwill created in the deal - how do the 3 statements change, and what is the balance after the write-down?

$400 in Goodwill was created in this deal, so $200 will be left afterward. • Income Statement: You record a $200 Goodwill write-down, which reduces Pre-Tax Income by $200 and Net Income by $120 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $120, but you add back the $200 Goodwill write-down since it's non-cash, so cash at the bottom is up by $80. • Balance Sheet: Cash is up by $80, but Goodwill is down by $200, so the Assets side is down by $120. On the L&E side, Retained Earnings is down by $120 due to the reduced Net Income. There are no other changes, so both sides are down by $120 and balance. • Intuition: The Goodwill write-down is a non-cash expense that reduces the company's tax burden, which boosts its cash balance.

One year passes. The company pays 10% interest on its debt, and it depreciates $10 on the factory each year. It also repays $20 of the loan each year. What happens on the statements in this first year?

10% interest corresponds to $10 in interest since we use the beginning debt balance to calculate interest. So: • Income Statement: You record $10 in interest and $10 in Depreciation, so Pre-Tax Income falls by $20, and Net Income falls by $12 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but the $10 in Depreciation is non-cash, so you add it back. The $20 loan repayment counts as a cash outflow, so cash at the bottom of the CFS is down by $22. • Balance Sheet: Cash is down by $22, and PP&E is down by $10, so the Assets side is down by $32. On the L&E side, the Debt is down by $20 and Retained Earnings is down by $12 due to the reduced Net Income, so the L&E side is also down by $32 and both sides balance. • Intuition: Cash declines mostly because of the principal repayment; the interest expense is offset a bit by the tax savings from the Depreciation.

In its filings, a company states that its EBITDA is a reasonable "proxy" for its Cash Flow from Operations. The company's EBITDA has been positive and growing at 20% for the past three years. However, the company recently filed for bankruptcy. How could this have happened?

Although EBITDA is sometimes a "proxy" for CFO, it is not even close to a perfect representation of a company's cash flow. Think about all the items that EBITDA excludes: • CapEx - Very high CapEx spending might have pushed the company to bankruptcy. • Interest Expense and Debt Repayment Obligations - Same as above. In particular, if the company's debt all matures on one date and the company cannot refinance or does not have enough cash to pay for it, bankruptcy could result. • Working Capital - If the company is spending a massive amount on Inventory, to the point where it's losing heaps of money as it grows, that could have also played a role. • One-Time Charges - If EBITDA excludes large "one-time" expenses such as legal and restructuring charges, those could also affect the company's cash balance.

Why do you exclude cash, investments, and debt when calculating the Change in Working Capital on the Cash Flow Statement?

Although many of these items are Current Assets or Current Liabilities, you exclude them because: • Cash - The bottom of the CFS already calculates the Net Change in Cash and the ending Cash balance; if you did it within the Working Capital area, you'd be double-counting it. • Investments - Investment sales and purchases are considered investing activities, not operational ones, even if they're short-term. • Debt - Debt issuances and repayments are considered financing activities, not operational ones, even if the debt is short-term.

What happens on the statements after a year?

Although you subtract Preferred Dividends from Net Income to calculate Net Income to Common, the Preferred Dividends are NOT tax-deductible. • Income Statement: The company will record 10% * $100, or $10, in Interest Income on the real estate, so its Pre-Tax Income increases by $10. At a 40% tax rate, its Net Income goes up by $6. The $8 in Preferred Dividends are NOT tax-deductible, so they simply reduce Net Income by $8, and so "Net Income to Common" is down by $2. • Cash Flow Statement: Net Income to Common is down by $2. There are no other changes on the CFS in this period because there's no principal repayment of the Preferred Stock, and nothing changes with the long-term investments. So, cash at the bottom is down by $2. • Balance Sheet: Cash is down by $2, so the Assets side is down by $2. On the other side, Retained Earnings is down by $2, so the L&E side is also down by $2 and both sides balance. • Intuition: The point of this question is that taxes play a huge role in making investment decisions. Since the investment income on the real estate is taxable, whereas Preferred Dividends are not, the company LOSES money! The after-tax yield of the real estate is only 10% * (1 - 40%), or 6%, which is less than the 8% Preferred coupon.

A company's ROA has INCREASED from 10% to 15% over the past five years, but its ROE has DECREASED from 13% to 10%. What could have caused this?

Both ROA and ROE have Net Income in the numerator, so it must be something in the denominators. Let's say that Net Income increased over this period. If that's the case, then the company's Total Assets must have increased by a lower percentage than Net Income. But if ROE decreased, then the company's Equity must have increased by a greater percentage than Net Income. So, one potential cause might be that the company has been continually issuing equity to fund its cash flow-negative business. When the company issues stock, it boosts its Equity on the Balance Sheet and prevents its cash balance from declining. But the company's Total Assets also don't change by much because the cash raised does not make it to the Balance Sheet - it offsets losses elsewhere in the business.

You're comparing two companies. Company A's Change in Working Capital as a % of the Change in Revenue is 10%, but Company B's is negative 5%. Which industries are these companies MOST likely to be in?

Company A is most likely in an industry without much upfront investment in Inventory required, such as professional services, software, or media and telecom. In these industries, customers often pay upfront for longer-term contracts and services, which makes the Change in Working Capital even more positive. Company B is likely in an industry with more upfront investment in Inventory required, such as retail or manufacturing. The company might also be in an industry where it has little power to "delay" payments to suppliers, meaning that its operational assets will tend to grow by more than its operational liabilities over time.

Your company wants to boost its EPS artificially, so it decides to issue debt and use the proceeds to buy back shares. Initially, the company has 100 shares outstanding at $100 per share, and a Net Income of $2,000. What happens IMMEDIATELY after your company raises $1,000 in long-term debt and uses it to repurchase $1,000 in stock?

First, note a few important facts about this scenario. Repurchasing $1,000 in stock at a share price of $100 per share means that the company will repurchase 10 shares. So, its share count drops from 100 to 90. Its EPS before this move was $2,000 / 100, or $20.00. Now, for the first part of this transaction: • Income Statement: No changes. • Cash Flow Statement: The $1,000 Debt issuance boosts cash flow by $1,000, but the $1,000 stock repurchase reduces it by $1,000, so there's no net change in cash. • Balance Sheet: There are no changes on the Asset side. On the L&E side, Debt is up by $1,000, but Treasury Stock within Equity is down by $1,000, so there's no net change, and the BS remains in balance. Intuition: These are simple cash inflows and outflows that cancel each other out and make no impact on the company's taxes.

A company has $1,000 in revenue, $200 in COGS, and $700 in operating expenses, and no other expenses. Walk through what happens on the 3 statements if half of the company's Income Taxes shift from current to deferred.

First, you have to calculate the company's total tax bill: $1,000 in revenue minus $200 in COGS minus $700 in operating expenses equals $100 in Pre-Tax Income and $40 in taxes at a 40% tax rate. • Income Statement: Nothing changes because you record BOTH current AND deferred taxes as part of the company's Income Taxes here. So, there's still $40 of Income Taxes. • Cash Flow Statement: Net Income stays the same, but now you have to add back $20 in the Deferred Income Tax line item because these taxes will be paid in some future period. Cash increases by $20 as a result • Balance Sheet: Cash is up by $20, and so the Assets side is up by $20. On the L&E side, the Deferred Tax Liability will increase by $20 because of this deferral, so both sides increase by $20 and the Balance Sheet balances. • Intuition: This is a simple deferral of a cash expense into a future period, so the company's cash increases in the short term.

Would you expect a retailer or an airline company to have a higher Asset Turnover Ratio?

Generally, the retailer will have a higher Asset Turnover Ratio (Revenue / Average Assets) because it is less dependent on assets to generate its sales. Yes, retailers need to sell Inventory to make money, but they don't necessarily need to own their own stores, factories, etc. - many retailers actually lease their stores. An airline will tend to have a lower Asset Turnover Ratio because it is completely dependent on PP&E to generate revenue: without its planes, it can't do much of anything. And yes, some airlines also lease their planes rather than owning them outright, but almost every major airline owns a decent percentage of its planes.

Your company just acquired another one for $1,000 in cash. The other company's Shareholders' Equity was $500, and you identified $100 in Other Intangible Assets with a useful life of 5 years. What happens on the 3 statements from just AFTER the acquisition closes to the end of the first year following the acquisition? Only factor in Goodwill and Other Intangible Assets.

In this scenario, the "gap" between the purchase price and the other company's Shareholders' Equity is $500. $100 in Other Intangible Assets and $400 in Goodwill will be created. The Intangibles will amortize $20 per year over 5 years. • Income Statement: Amortization increases by $20, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but you add back the $20 in Amortization as a non-cash expense, so cash at the bottom is up by $8. • Balance Sheet: Cash is up by $8, but Other Intangible Assets are down by $20, so the Assets side is down by $12. On the L&E side, Retained Earnings is down by $12 due to the reduced Net Income, so both sides are down by $12. • Intuition: The non-cash Amortization expense increases the company's cash balance by reducing its tax burden.

Walk me through the 3 financial statements when a company's operating expenses increase by $100.

Income Statement: Operating Expenses are up by $100, so Pre-Tax Income is down by $100 and Net Income is down by $60 at a 40% tax rate. Cash Flow Statement: Net Income is down by $60. There are no other changes, so cash is down by $60 at the bottom. Balance Sheet: Cash is down by $60, so the Assets side is down by $60, and Retained Earnings on the L&E side is down by $60 due to the reduced Net Income, so both sides balance. Intuition: Nothing; it's a simple cash expense.

What does it mean if a company's FCF is growing, but its Change in Working Capital is more and more negative each year?

It means that the company's Net Income or non-cash charges are growing by more than its Change in WC is declining, or that its CapEx is becoming less negative (i.e., shrinking) by more than the Change in WC is declining. If a company's Net Income is growing for legitimate reasons, this is a positive sign. But if higher non-cash charges or artificially reduced CapEx are boosting FCF, both of those are negatives.

What does it say about a company if its Days Receivables Outstanding is ~5, but its Days Payable Outstanding is ~60?

It tells you that the company has quite a lot of market power to collect cash from customers quickly, but to delay paying its suppliers for a long time. Examples might be companies like Amazon and Wal-Mart that completely dominate their respective markets and that can coerce suppliers into agreeing to their terms.

A company seems to be boosting its ROE artificially by using leverage to fuel its growth. Which metrics or ratios could you look at to confirm or deny your suspicion?

Leverage can artificially boost ROE because Debt does not affect the denominator of ROE (Equity), and it makes only a small impact on the numerator (Net Income). To see if this is happening, you could check the company's Debt/EBITDA and EBITDA/Interest ratios - if they indicate that the company has been using more debt over time, it's a good bet that Debt has been at least partially responsible for the increased ROE.

A company's Working Capital has increased from $50 to $200. You calculate the Change in Working Capital by taking the new number, $200, and subtracting the old number, $50, and so the change is positive $150. But on the Cash Flow Statement, the company records the Change in Working Capital as negative $150. Is the company wrong?

No, the company is correct. On the Cash Flow Statement, the Change in Working Capital is equal to Old Working Capital - New Working Capital. Pretend that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to $200, that is clearly a use of cash that will reduce the company's cash flow, and as such, it should be shown as a negative $150 on the CFS. You can also think of this one by breaking down the individual components: Change in WC = Old WC - New WC Change in WC = (Old Current Assets - Old Current Liabilities) - (New Current Assets - New Current Liabilities) Change in WC = (Old Current Assets - New Current Assets) + (New Current Liabilities - Old Current Liabilities) So, like everything else on the Cash Flow Statement, if assets increase, they reduce the cash flow. And if liabilities increase, the opposite happens. When a company's Working Capital INCREASES, the company USES cash to do that; when Working Capital DECREASES, it FREES UP cash.

Another year passes. Again, the company pays 10% interest on its debt based on the balance at the start of the year, and it depreciates $10 on the factory, with $20 loan principal repayment. At the very END of the year, a dragon attacks the factory, and it falls apart. The company has to write down the factory's entire value and repay the remaining loan balance. Walk me through what happens on the statements from the BEGINNING of Year 2 to the END.

Remember that the company only has $80 in debt remaining at the start of Year 2, so the interest expense will be 10% * $80, or $8, rather than $10. The initial PP&E is $90, but $10 of that gets depreciated, and the remaining $80 is written down. Although there's $20 of debt repayment, it's better to think of this as $80 during the entire year because there's $20 in "normal" repayment and then $60 at the end of the year. 87 of 99 http://breakingintowallstreet.com • Income Statement: You record $10 in Depreciation, $8 in interest expense, and $80 for the PP&E write-down, so Pre-Tax Income falls by $98, and Net Income falls by $59 (technically $58.8, but we're rounding). • Cash Flow Statement: Net Income is down by $59, but the Depreciation and the Write-Down are both non-cash, so you add back a total of $90. Cash is up by $31 so far. Then you factor in the loan repayments - a total of $80 - and cash is therefore down by $49. • Balance Sheet: Cash is down by $49, and PP&E is down by $90, so the Assets side is down by $139. On the L&E side, Debt is down by $80 and Retained Earnings is down by $59 due to the reduced Net Income, so the L&E side is down by $139 and both sides balance. • Intuition: Again, cash is down significantly mostly because of the loan repayment; everything else makes a minor impact.

At the end of the year, your company decides that it grossly overpaid for the other company, so it decides to write down the Goodwill and PP&E acquired from the other company by 50%. What happens on the statements, factoring in ONLY these write-downs and nothing else?

Remember that there's $200 in Goodwill and $600 in PP&E from the other company: • Income Statement: You record a total write-down of $400 ($200 / 2 + $600 / 2), so Pre-Tax Income is down by $400. Net Income is down by $240 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $240, but both these write-downs are non-cash, so you add back a total of $400. Cash is up by $160 at the bottom. • Balance Sheet: Cash is up by $160, but Goodwill is down by $100, and PP&E is down by $300, so the Assets side is down by $240. The L&E side is also down by $240 because Retained Earnings falls by $240 due to the reduced Net Income, and so both sides balance. • Intuition: This is a good example of how overpaying for an acquisition can hurt a company's Net Income and EPS, but boost its cash balance. This is why it's so important to look at BOTH Net Income and Cash Generated when analyzing a company.

What does the Change in Working Capital mean?

The Change in Working Capital tells you if the company needs to spend in ADVANCE of its growth, or if it generates more money as a RESULT of its growth. For example, the Change in Working Capital is almost always negative for retailers because they must spend money on Inventory before being able to sell products. But the Change in Working Capital is often positive for subscription-based companies that collect cash from customers far in advance because Deferred Revenue increases whenever they do that. The Change in Working Capital directly increases or decreases Free Cash Flow, which, in turn, directly affects the company's valuation.

A company's Current Ratio is 2x. Why is that NOT necessarily a positive sign?

The Current Ratio is defined as Current Assets / Current Liabilities, so it depends on what's in both those groups. For example, if the company's Current Assets consist primarily of Receivables and almost no Cash, and its Current Liabilities consist of Accrued Expenses, a Current Ratio of 2x is negative because it means the company is waiting on a lot of cash from customers and also has to pay a lot of cash in the future for expenses already incurred. On the other hand, if the company's Current Assets are primarily Cash and its Current Liabilities are primarily Deferred Revenue, this 2x ratio would be more positive because it means that the company has collected significant cash in advance of product/service delivery.

What is Working Capital?

The official definition of Working Capital is "Current Assets minus Current Liabilities," but the more useful definition is: Working Capital = Current Assets (Excluding Cash and Investments) - Current Liabilities (Excluding Debt) This one is sometimes called Operating Working Capital instead. You may also include Long-Term Assets and Liabilities that are related to the company's business operations (Long-Term Deferred Revenue is a prime example). Working Capital by itself tells you whether a company needs more in operational assets or operational liabilities to run its business, and how big the difference is. But the Change in Working Capital (see below) matters far more for valuation purposes.

What is Free Cash Flow, and what does it mean if it's positive and increasing?

There are different types of Free Cash Flow, but one simple definition is Cash Flow from Operations minus CapEx. FCF represents a company's "discretionary cash flow" - how much it has left for other areas after spending what's required for its business. You define it this way because pretty much everything in a company's "Cash Flow from Operations" section is required for its business - earning Net Income, paying for Inventory, collecting Receivables, etc. But almost every line item within the Investing and Financing Activities sections is "optional," except for Capital Expenditures. If FCF is positive and increasing, it means the company can spend its excess cash in different ways: it could hire more employees, spend more on Working Capital or CapEx, invest in other assets, repay debt, acquire other companies, or return money to shareholders with dividends or stock repurchases.

This same company now realizes that it has too much cash, so it wants to issue dividends or repurchase shares. How do they impact the 3 statements differently? Assume $100 in dividends vs. $100 in shares repurchases.

These changes both make a very similar impact; the main difference is that dividends do not reduce the shares outstanding, but a share repurchase does. • Income Statement: No changes. • Cash Flow Statement: Both of these will show up as negative $100 entries in Cash Flow from Financing, reducing the cash at the bottom of the CFS by $100. • Balance Sheet: Cash is down by $100, so the Assets side is down by $100; on the L&E side, dividends will reduce Retained Earnings by $100, whereas a share repurchase will reduce Treasury Stock by $100. But in either case, Equity is down by $100, so the L&E side is down by $100 and both sides balance. • Intuition: These are simple uses of cash that don't affect the company's taxes at all.

What happens after a year passes if the company pays 5% interest on the debt and repays 10% of the principal? Also, explain the EPS impact.

This question is a twist on the standard 3-statement accounting questions because you also have to calculate EPS and the change in EPS. • Income Statement: The company records 5% * $1,000, or $50, in interest expense, and so its Pre-Tax Income falls by $50. At a 40% tax rate, its Net Income is down by $30. The company now has 90 shares outstanding rather than 100, and has Net Income of $1,970 instead of $2,000, so its EPS increases to $21.89 (If you can't do that math in your head, you could just say that EPS "increases"). • Cash Flow Statement: Net Income is down by $30, and the company also has to repay 10% of the principal, or $100, so cash is down by $130 at the bottom. • Balance Sheet: Cash is down by $130, so the Assets side is down by $130. On the L&E side, Retained Earnings is down by $30 because of the reduced Net Income, and Debt is down by $100 because of the principal repayment, so the L&E side is down by $130 and both sides balance. • Intuition: This question illustrates how companies can artificially inflate their EPS numbers by making nonsensical moves, such as borrowing at high costs to fund share repurchases. Never trust EPS!

A year passes, and Wal-Mart sells the $200 of Inventory for $400. However, it also has to hire additional employees for $100 to process the orders. The company also pays 5% interest on its debt and repays 10% of the principal. What happens on the statements over the course of THIS one year?

This question is the standard "Sell inventory for a certain amount of revenue" one, but there are a few twists. For one, we also have to factor in $100 of additional Operating Expenses. Also, we have to include the $10 interest expense on the debt ($200 * 5%) and the $20 principal repayment ($200 * 10%). • Income Statement: Revenue is up by $400, but COGS is up by $200, and Operating Expenses are up by $100 because of the extra employees. There is also $10 of additional Interest Expense because of the 5% interest rate on $200 of debt, so Pre-Tax Income is up by $90. Net Income is up by $54 at a 40% tax rate. • Cash Flow Statement: Net Income is up by $54, and the company's COGS decreasing by $200 frees up an additional $200 of cash flow. So far, cash flow is up by $254. The company also has to repay 10% * $200, or $20, of the debt principal, and so cash at the bottom is up by $234. • Balance Sheet: Cash is up by $234, but Inventory is down by $200, so the Assets side is up by $34. On the L&E side, Debt is down by $20, and Retained Earnings is up by $54 because of the increased Net Income, so the L&E side is up by $34 and both sides balance. • Intuition: The company has bought goods, turned them into finished products, and profited from the sale. The company's cash goes up by less than expected because of the debt principal repayment and interest.

Amazon.com decides to pay several key vendors on credit and make them wait for the cash. It offers $200 in credit and says it will pay them in cash in a month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash?

This scenario corresponds to Accounts Payable or Accrued Expenses increasing by $200 and then decreasing by $200 when they're finally paid out in cash. • Income Statement: Operating Expenses increases by $200, so Pre-Tax Income is down by $200 and Net Income is down by $120, assuming a 40% tax rate. • Cash Flow Statement: Net Income is down by $120, but AP increasing by $200 results in higher cash flow since it means the expenses haven't been paid in cash yet. So, cash at the bottom is up by $80. • Balance Sheet: Cash is up by $80, so the Assets side is up by $80. On the L&E side, AP is up by $200, but Retained Earnings is down by $120 due to the reduced Net Income, so the L&E side is up by $80 and both sides balance. • Intuition: This expense is acting like a "non-cash charge" at this point because it reduces the company's taxes but doesn't cost them anything in cash. Cash is up because of the lower taxes. And then here's the next step (factoring in ONLY this step): • Income Statement: No changes. • Cash Flow Statement: Accounts Payable decreasing by $200 reduces the company's cash flow by $200, so cash at the bottom is down by $200. • Balance Sheet: Cash is down by $200, so the Assets side is down by $200, and AP is down by $200, so the L&E side is also down by $200 and both sides balance. • Intuition: This is a simple cash payment for an owed expense.

Walk me through what happens on the statements when a customer orders a product for $100 but doesn't pay for it in cash, and then what happens when the cash is finally collected.

This scenario corresponds to Accounts Receivable increasing by $100 and then decreasing by $100. First, here's what happens when it increases: • Income Statement: Revenue increases by $100, so Pre-Tax Income is up by $100 and Net Income is up by $60 at a 40% tax rate. • Cash Flow Statement: Net Income is up by $60, but the increase in AR reduces cash flow by $100, so cash at the bottom is down by $40. • Balance Sheet: Cash is down by $40, but AR is up by $100, so the Assets side is up by $60. On the L&E side, Retained Earnings is up by $60 due to the increased Net Income, so both sides are up by $60 and balance. • Intuition: The company has to pay taxes on revenue it hasn't yet received in cash, so its cash balance falls. And when the AR is collected (factoring in ONLY this step): • Income Statement: No changes. • Cash Flow Statement: AR decreases, which is a change of positive $100 since it means the company has collected the cash now. Cash at the bottom is up by $100. • Balance Sheet: Cash is up by $100, but AR is down by $100, so the Assets side doesn't change. The L&E side also doesn't change, so both sides remain in balance. • Intuition: This is a simple cash collection of a payment owed to the company.

Salesforce.com sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens on the statements?

This scenario corresponds to Deferred Revenue - collecting cash, but not being able to recognize it as revenue yet. The payment for the entire year is $1,200. • Income Statement: No changes. • Cash Flow Statement: DR increasing by $1,200 will boost the company's cash flow, so cash at the bottom is up by $1,200. • Balance Sheet: Cash is up by $1,200, so the Assets side is up by $1,200, and Deferred Revenue is up by $1,200, so the L&E side is up by $1,200, and both sides balance. • Intuition: This is a simple cash inflow for services the company has not yet delivered.

A company prepays its rent ($20 per month) a month in advance. Walk me through what happens on the statements when the company prepays the expense, and then what happens when the expense is incurred.

This scenario corresponds to Prepaid Expenses increasing and then decreasing. First, the increase: • Income Statement: No changes. • Cash Flow Statement: The $20 Increase in Prepaid Expense reduces the company's cash flow by $20, so cash at the bottom is down by $20. • Balance Sheet: Cash is down by $20, but Prepaid Expenses is up by $20, so the Assets side doesn't change. The L&E side also doesn't change, so the Balance Sheet remains balanced. • Intuition: This is a simple cash payment for expenses that have not yet been incurred. And then when Prepaid Expenses decrease (factoring in ONLY this step): • Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $12 assuming a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but the reduction in Prepaid Expenses boosts cash flow by $20, so cash at the bottom is up by $8. • Balance Sheet: Cash is up by $8, and Prepaid Expenses are down by $20, so the Assets side is down by $12. The L&E side is also down by $12 because Retained Earnings has dropped by $12 due to the reduced Net Income, so both sides balance. • Intuition: Cash goes up because this $20 expense is "non-cash" at this point - the company has paid for it in cash in a prior period - so it saves the company on taxes.

A company decides to CHANGE a key employee's compensation. It will offer the employee stock options instead of a real salary. The employee's salary was formerly $100, but she will receive $120 in stock options now. How do the statements change?

You can think of this one as operating expenses going up by $20, but the company also having $120 in additional non-cash expenses. • Income Statement: Operating expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $12 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but you add back the $120 in SBC as a non-cash expense, so cash at the bottom is up by $108. • Balance Sheet: Cash is up by $108, so the Assets side is up by $108. On the L&E side, Retained Earnings is down by $12 because of the reduced Net Income, but Common Stock & APIC is up by $120 because of the SBC, so the L&E side is up by $108 and both sides balance. • Intuition: The company saves a lot of cash by not paying the employee in cash anymore, and it also realizes tax savings. Just remember that its share count will also increase.

Your company decides to acquire another company for $1,000, using cash. The other company has $400 in Cash, $600 in PP&E, $250 in Accounts Payable, and $750 in Equity. What happens to your company's BALANCE SHEET immediately after this acquisition takes place? Assume that your company has identified $50 in Other Intangible Assets with a useful life of 10 years.

You combine the other company's Assets and Liabilities with your company's, and you write down the seller's Equity. So, in this case, the combined company's Cash balance goes down by $600 since you spent $1,000 in cash on the acquisition but got $400 in cash from the other company. PP&E is up by $600, so the Assets side hasn't changed so far. But the other side is up by $250 because of the Accounts Payable, so we have a problem. Since we paid $1,000 for Equity of $750, we must create a total of $250 in Goodwill and Other Intangible Assets. The question stated that there's $50 in Other Intangible Assets, so we create those on the Assets side, and then we create $200 of Goodwill. As a result, the L&E side is up by $250, the Assets side is up by $250, and the Balance Sheet balances.

What does FCF mean if it's negative or decreasing?

You have to find out why FCF is negative or decreasing first. For example, if FCF is negative because CapEx in one year was unusually high, but it's expected to return to much lower levels in the future, it doesn't mean much. On the other hand, if FCF is negative because the company's sales and operating income have been declining each year, that indicates that the business may be troubled. If FCF decreases to the point where the company runs low on cash, it will have to raise equity or debt funding ASAP and restructure its operations to continue running.

Wal-Mart buys $500 in Inventory for products it will sell next month. Walk me through what happens on the statements when they first buy the Inventory, and then when they sell the products for $600.

he first part is a simple Inventory purchase, and the second part is more of a "multi-step scenario" where the company has to record COGS and the revenue associated with the product sales. Here's the first part: • Income Statement: No changes. • Cash Flow Statement: The $500 Inventory increase reduces the company's cash flow, so cash at the bottom is down by $500. • Balance Sheet: Cash is down by $500, but Inventory is up by $500, so the Assets side doesn't change. The L&E side also doesn't change, so the Balance Sheet remains in balance. • Intuition: This is a simple cash purchase for an expense that has not yet been incurred. And then here's the next part (factoring in ONLY this step): • Income Statement: Revenue is up by $600, but COGS is up by $500, so Pre-Tax Income is up by $100 and Net Income is up by $60 at a 40% tax rate. • Cash Flow Statement: Net Income is up by $60, but the decrease in Inventory increases cash flow by $500, so cash at the bottom is up by $560. • Balance Sheet: Cash is up by $560, but Inventory is down by $500, so the Assets side is up by $60. The L&E side is also up by $60 because Net Income was up by $60, and so Retained Earnings was up by $60; therefore, both sides balance. • Intuition: Look at the CUMULATIVE change - if you trace through both steps 1 and 2, cash is up by $60 from start to finish. And that increase corresponds to the company's after-tax profit from a $100 pre-tax profit on the sale of these goods.

Another year passes, and prices in this real estate market double. The company decides to sell its $100 in long-term investments for $200 at the end of Year 2. It then uses the proceeds to repay its Preferred Stock. What happens on the statements from the BEGINNING of Year 2, including the interest/investment income and Preferred Dividends, to the END of Year 2?

• Income Statement: Everything from the previous part still applies, so there's still $10 in Investment Income. But now the company also records a Gain of $100 on the sale of the real estate, so Pre-Tax Income is up by $110, and Net Income is up by $66 at a 40% tax rate. There's still $8 in Preferred Dividends, so Net Income to Common is up by $58. • Cash Flow Statement: Net Income to Common is up by $58, but the $100 Gain is non-cash, so you subtract it out and then show the Total Proceeds Received, $200, within Cash Flow from Investing. You also have to show the $100 repayment of the Preferred Stock, so cash at the bottom is up by $58. • Balance Sheet: Cash is up by $58, but the company's long-term investments have decreased by $100, so the Assets side is down by $42. The L&E side is also down by $42 because Retained Earnings increased by $58 due to the increased Net Income to Common, but Preferred Stock decreased by $100, so both sides balance. • Intuition: This question demonstrates why this investment strategy might make sense: capital gains.

Wal-Mart orders $200 of Inventory but pays for it using debt. What happens on the statements immediately after this transaction?

• Income Statement: No changes. • Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but the debt issuance boosts cash flow by $200, so there's no net change in cash. • Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E side is also up by $200 because Debt is up by $200, so both sides balance. • Intuition: This is a simple cash payment for an expense not yet incurred, combined with a debt issuance that offsets the cash outflow.

A company issues $100 in stock to new investors to fund its operations. How do the statements change?

• Income Statement: No changes. • Cash Flow Statement: The $100 stock issuance is a cash inflow in Cash Flow from Financing, and there are no other changes, so cash at the bottom goes up by $100. • Balance Sheet: Cash is up by $100, so the Assets side is up by $100, and Common Stock & APIC on the other side goes up by $100, so the L&E side is up by $100 and the BS balances. • Intuition: This is a simple cash inflow that doesn't impact the company's taxes at all.

A company issues $100 in Preferred Stock to buy $100 in long-term investments in real estate. The Preferred Stock has a coupon rate of 8%, and the long-term investments yield 10%. What happens on the statements IMMEDIATELY after the initial purchase?

• Income Statement: No changes. • Cash Flow Statement: The purchase of the long-term investments counts as an Investing activity and reduces cash flow by $100, but the Preferred Stock issuance boosts cash flow by $100, so there's no net change in cash. • Balance Sheet: Long-Term Investments is up by $100, so the Assets side is up by $100, and Preferred Stock on the other side is up by $100, so the L&E side is up by $100 and both sides balance. Intuition: This is a simple cash purchase of investments funded by a Preferred Stock issuance, and neither event affects the company's taxes.

A company buys a factory for $100 using $100 of debt. What happens INITIALLY on the statements?

• Income Statement: No changes. • Cash Flow Statement: There's no net change in cash because the $100 factory purchase counts as CapEx, which reduces cash flow, and the $100 debt issuance is a cash inflow. • Balance Sheet: PP&E is up by $100, so the Assets side is up by $100, and Debt is up by $100, so the L&E side is up by $100, and the Balance Sheet stays balanced. • Intuition: This is a simple debt issuance and PP&E purchase, neither of which affects the company's taxes.

A company's Depreciation increases by $10. What happens on the 3 financial statements?

• Income Statement: Pre-Tax Income falls by $10, and Net Income falls by $6 assuming a 40% tax rate. • Cash Flow Statement: Net Income is down by $6, but you add back the $10 in Depreciation since it's non-cash, so cash flow is up by $4, and cash at the bottom is up by $4. • Balance Sheet: Cash is up by $4, but PP&E is down by $10 due to the added Depreciation, so the Assets side is down by $6. The L&E side is also down by $6 because Net Income fell by $6, which reduced Retained Earnings, so both sides balance. • Intuition: The company saves on taxes with a non-cash expense.

Now what happens after one month has passed, and the company has delivered one month of service? Assume there are no associated COGS or Operating Expenses, and walk through what happens ONLY in this month.

• Income Statement: Revenue is up by $100, so Pre-Tax Income is up by $100 and Net Income is up by $60, assuming a 40% tax rate. • Cash Flow Statement: Net Income is up by $60, but the decrease in Deferred Revenue reduces cash flow by $100, so cash at the bottom is down by $40. • Balance Sheet: Cash is down by $40, so the Assets side is down by $40. On the L&E side, DR is down by $100, but Retained Earnings is up by $60 because of the increased Net Income, so the L&E side is down by $40 and the Balance Sheet balances. • Intuition: Cash goes down because the company now has to pay taxes on non-cash revenue: it collected the cash in some prior period, and now it has to pay taxes on it.

A year passes. What happens on the financial statements, factoring in ONLY the newly created items from the acquisition and the cash used to acquire the company? Assume a 2% foregone interest rate on cash, and assume that the company loses interest on the FULL $1,000 of cash used in the acquisition, not just the net cash reduction of $600.

• Income Statement: The company's interest income decreases by 2% * $1,000, or $20. There will also be Amortization of Intangibles of $50 / 10, or $5. So, Pre-Tax Income falls by $25, and Net Income declines by $15 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $15, but you add back the $5 in Amortization as a non-cash charge, so the company's cash is down by $10. • Balance Sheet: Cash is down by $10, and Other Intangible Assets are down by $5, so the Assets side is down by $15. On the other side, Retained Earnings is down by $15 because of the reduced Net Income, so the L&E side is down by $15 and both sides balance. • Intuition: The main point here is that all acquisitions "cost" the company something -cash from lost interest or additional interest expense, or additional shares that dilute the existing shareholders.

A company runs into financial distress and needs cash immediately. It sells a factory that's listed at $100 on its Balance Sheet for $80. What happens on the 3 statements?

• Income Statement: You record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate. • Cash Flow Statement: Net Income is down by $12, but you add back the $20 Loss since it's non-cash. You also show the full proceeds received, $80, in Cash Flow from Investing, so cash at the bottom is up by $88. • Balance Sheet: Cash is up by $88, but PP&E is down by $100, so the Assets side is down by $12. The L&E side is also down by $12 because Retained Earnings fell by $12 due to the Net Income decrease, so both sides balance. • Intuition: The company gets the $80 in cash proceeds, but it also gets $8 in tax savings from the Loss, so its cash goes up by $88 rather than $8.