Accounting Questions
What is the difference between organic and inorganic revenue growth?
Organic Growth: A company experiencing organic growth is expanding to new markets, enhancing its sales & marketing strategies, improving its product/service mix, or introducing new products. The focus is on continuously making operational improvements and bringing in revenue (e.g., set prices more appropriately post-market research, target right end markets). Inorganic Growth: Once the opportunities for organic growth have been maximized, a company may turn to inorganic growth, which refers to growth driven by M&A. Inorganic growth is often considered faster and more convenient than organic growth. Post-acquisition, a company can benefit from synergies, such as having new customers to sell to, bundling complementary products, and diversification in revenue.
Tell me about the revenue recognition and matching principle used in accrual accounting.
Revenue Recognition Principle: Revenue is recorded in the same period the good or service was delivered (and therefore "earned"), whether or not cash was collected from the customer. Matching Principle: The expenses associated with the production/delivery of a good or service must be recorded in the same period as when the revenue was earned.
How would you forecast working capital line items on the balance sheet?
See table
What are some ratios you would look at to perform credit analysis?
See table
What are the two types of credit ratios used to assess a company's default risk?
See table
What ratios would you look at to assess working capital management efficiency?
See table
Why are increases in accounts receivable a cash reduction on the cash flow statement?
Since the cash flow statement begins with net income and net income captures all of a company's revenue (not just cash revenue), an increase in accounts receivable means that more customers paid on credit during the period. Thus, a downward adjustment must be made to net income to arrive at the ending cash balance. Although the revenue has been earned under accrual accounting standards, the customers have yet to make the due cash payments and this amount will be sitting as receivables on the balance sheet.
How do you calculate retained earnings for the current period?
Retained earnings represent the total cumulative amount of net income held onto by a company since inception after accounting for any dividends paid out to its common and preferred shareholders. Current Period Retained Earnings = Prior Retained Earnings + Net Income -Dividends
What does return on assets (ROA) and return on equity (ROE) each measure?
Return on assets ("ROA") and return on equity ("ROE") are measures of profitability that show how effective a company's management team is at utilizing the resources it has on-hand (assets or equity). Return on Assets: ROA measures asset utilization and how efficiently a company's assets are used to generate earnings. A high ROA relative to a peer group indicates assets are being used near full capacity, whereas a low ROA means management may not be deriving the full potential benefit from its assets. $$Return on Assets (ROA) = \frac{Net Income}{(Average of Beginning and Ending Total Assets)}$$ Return on Equity: The ROE ratio gives insight into how efficiently a management team has been using the capital shareholders have contributed. A higher ROE means management is efficient at using the money raised from equity financing (and vice versa). $$Return on Equity (ROE) = \frac{Net Income}{(Average of Beginning and Ending Book Value of Equity)}$$
What is the difference between LIFO and FIFO, and what are the implications on net income?
FIFO and LIFO are two inventory accounting methods to estimate the value of inventory sold in a period. First In, First Out ("FIFO"): Under FIFO accounting, the goods that were purchased earlier would be the first ones to be recognized and expensed on the income statement. Last In, First Out ("LIFO"): Alternatively, LIFO assumes that the most recently purchased inventories are recorded as the first ones to be sold first See table
Give some examples of when the current ratio might be misleading?
- The cash balance used includes the minimum cash amount required for working capital needs - meaning operations could not continue if cash were to dip below this level. - Similarly, the cash balance may contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose. - Short-term investments that cannot be liquidated in the markets easily could have been included (i.e., low liquidity, cannot sell without a substantial discount). - Accounts receivable could include "bad A/R", but management refuses to recognize it as such.
What are some discretionary management decisions that could inflate earnings?
- Using excess useful life assumptions for new capital expenditures to reduce the annual depreciation -Switching from LIFO to FIFO if inventory costs are expected to increase, resulting in higher net income -Refusing to write-down impaired assets to avoid the impairment loss, which would reduce net income Changing policies for costs to be capitalized rather than expensed (e.g., capitalized software costs) -Repurchasing shares to decrease its share count and artificially increase earnings per share ("EPS") -Deferral of capex or R&D to the next period to show more profitability and cash flow in the current period -More aggressive revenue recognition policies in which the obligations of the buyer become less stringent
What are the two ways to calculate earnings per share (EPS)?
1. Basic EPS: Determines a company's earnings on a per-share basis, but allocable to only the basic shares outstanding (otherwise known as "common shares"). Basic EPS = (Net Income − Dividends on Preferred Stock) / Basic Weighted Average Shares Outstanding 2. Diluted EPS: Compares a company's earnings relative to its shares outstanding on a per-share basis but considers the impact of potentially dilutive securities such as options, warrants, and convertible securities. If an option is "in-the-money," the option holder can become a common shareholder at their choosing. Thus, diluted EPS is a more accurate depiction of ownership value per share. Diluted EPS = (Net Income − Dividends on Preferred Stock) / Diluted Weighted Average Shares Outstanding
Walk me through the three financial statements
1. Income Statement ("IS"): The income statement shows a company's profitability over a specified period, typically quarterly and annually. The beginning line item is revenue and upon deducting various costs and expenses, the ending line item is net income. 2. Balance Sheet ("BS"): The balance sheet is a snapshot of a company's resources (assets) and sources of funding (liabilities and shareholders' equity) at a specific point in time, such as the end of a quarter or fiscal year. 3. Cash Flow Statement ("CFS"): Under the indirect approach, the starting line item is net income, which will be adjusted for non-cash items such as D&A and changes in working capital to arrive at cash from operations. Cash from investing and financing activities are then added to cash from operations to arrive at the net change in cash, which represents the actual cash inflows/(outflows) in a given period.
What is the difference between the 10-K and 10-Q?
10-K: A 10-K is the annual report required to be filed with the SEC for any public company in the U.S. The report is comprehensive and includes a full overview of the business operations, commentary on recent performance by management, risk factors, disclosures on changes in accounting policies - and most importantly, the three core financial statements with supplementary data. 10-Q: A 10-Q refers to the quarterly report required to be filed with the SEC. Compared to the 10-K, this report is far more condensed in length and depth, with the focus being on the quarterly financials with brief sections for MD&A and supplementary disclosures. Additional Differences: A few more differences are 10-Ks are required to be audited by an independent accounting firm, but 10-Qs are only reviewed by CPAs and left unaudited. 10-Ks must also be filed ~60-90 days after the fiscal year ends, whereas 10-Qs must be submitted ~40-45 days after the quarter ends.
What are some shortcomings of the ROA and ROE metrics for comparison purposes?
A company's ROA and ROE ratios are benchmarked against competitors in the same industry to assess management efficiency and track historical trends. However, the ROA and ROE ratios are most useful when compared to a peer group of companies with similar growth rates, margin profiles, and risks. This approach would be best suited for established companies operating in mature, low-growth industries with many comparable companies to accurately track the management team's profitability and efficiency.
What does accounts payables turnover measure and is a higher or lower number preferable?
Accounts payable turnover measures how quickly a company pays its vendors. Generally, longer credit terms provide a company with more flexibility as it means the company has more cash-on-hand. A higher A/P turnover means the company pays off its A/P balance quickly, meaning the cash outflows occur faster. Accounts Payable Turnover = $$\frac{Cost of Goods Sold}{ (Average Beginning and Ending Accounts Payable)}$$
What does accounts receivables turnover measure?
Accounts receivable turnover is a metric used to measure the number of times per year that a company can collect its average accounts receivable from customers. The higher the turnover ratio, the better as it indicates the company is efficient at collecting its due payments from customers that paid on credit. Receivables Turnover = Revenue / (Average of Beginning and Ending Accounts Receivables)
How does accrual accounting differ from cash-basis accounting?
Accrual Accounting: For accrual accounting, revenue recognition is based on when it's earned and the expenses associated with that revenue are incurred in the same period Cash-Basis Accounting: Under cash-basis accounting, revenues and expenses are recognized once cash is received or spent, regardless of whether the product or service was delivered to the customer.
Which types of intangible assets are amortized?
Amortization is based on the same accounting concept as depreciation, except it applies to intangible assets rather than fixed tangible assets such as PP&E. Intangible assets include customer lists, copyrights, trademarks, and patents, which all have a finite life and are thus amortized over their useful life
What is an 8-K and when is it required to be filed?
An 8-K is a required filing with the SEC when a company undergoes a materially significant event and must disclose the details. Often called the "current report," 8-Ks are usually filed within four days of the event. The information contained within the report should be of high importance and pertinent to shareholders. Events that would trigger this filing would include previously unannounced plans for a new acquisition, disposal of assets, bankruptcy, a tender offer, the resignation of a senior-level manager or member of the board of directors, or disclosure that the company is under SEC investigation for alleged wrongdoing.
Why are increases in accounts payable shown as an increase in cash flow?
An increase in accounts payable would mean the company has been delaying payments to its suppliers or vendors, and the cash is currently still in the company's possession. The due payments will eventually be made, but the cash belongs to the company for the time being and is not restricted from being used. Thus, an increase in accounts payable is reflected as an inflow of cash on the cash flow statement.
How should an increase in inventory get handled on the cash flow statement?
An increase in inventory reflects a use of cash and should thus be reflected as an outflow on the cash from operations section of the cash flow statement. The inventory balance increasing from the prior period implies the amount of inventory purchased exceeded the amount expensed on the income statement
Could you give further context on what assets, liabilities, and equity each represent?
Assets: Assets are resources with economic value that can be sold for money or bring positive monetary benefits in the future. For example, cash and marketable securities are a store of monetary value that can be invested to earn interest/returns, accounts receivable are payments due from customers, and PP&E is used to generate cash flows in the future - all representing inflows of cash. Liabilities: Liabilities are unsettled obligations to another party in the future and represent the external sources of capital from third-parties, which help fund the company's assets (e.g., debt capital, payments owed to suppliers/vendors). Unlike assets, liabilities represent future outflows of cash. Equity: Equity is the capital invested in the business and represents the internal sources of capital that helped fund its assets. The providers of capital could range from being self-funded to outside institutional investors. In addition, the accumulated net profits over time will be shown here as "Retained Earnings."
If you have a balance sheet and must choose between the income statement or cash flow statement, which would you pick?
Assuming that I would be given both the beginning and end of period balance sheets, I would choose the income statement since I could reconcile the cash flow statement using the balance sheet's year-over-year changes along with the income statement.
What is the average cost method of inventory accounting?
Besides FIFO and LIFO, the average cost method is the third most widely used inventory accounting method. Under this method, the assigned inventory costs are based on a weighted average, in which the total costs of production in a period are summed up and divided by the total number of items produced. Each product cost is treated equally and inventory costs are spread out evenly, disregarding the date of purchase or production. Thus, this method is viewed as a simplistic compromise between the two other methods, but would be improper to use if the products sold are each unique with significant variance in the cost to manufacture and the sale price (i.e., more applicable for high-volume, identical batches of inventory)
What are the main sections of a 10-K?
Business Overview: Overview of the company's business divisions, strategy, product or service offerings, seasonality, geographical footprint, and key risks. Management's Discussion & Analysis ("MD&A"): Commentary and summarized analysis of the company's fiscal year result from the perspective of the management team. Financial Statements: The "Core 3": Income Statement, Balance Sheet, Cash Flow Statement The "Other 2": Statement of Comprehensive Income, Statement of Shareholders' Equity Notes: Supplementary disclosures to the financial statements that provide more details about a company's recent financial performance.
What is the difference between cost of goods sold and operating expenses?
Cost of Goods Sold: COGS represents the direct costs associated with the production of the goods sold or the delivery of services to generate revenue. Examples include direct material and labor costs. Operating Expenses: Operating expenses such as SG&A and R&D are not directly associated with the production of goods or services offered. Often called indirect costs, examples include rent, payroll, wages, commissions, meal and travel expenses, advertising, and marketing expenses.
Why is deferred revenue classified as a liability while accounts receivable is an asset?
Deferred Revenue: For deferred revenue, the company received payments upfront and has unfulfilled obligations to the customers that paid in advance, hence its classification as a liability. Accounts Receivable: A/R is an asset because the company has already delivered the goods/services and all that remains is the collection of payments from the customers that paid on credit
What is deferred revenue?
Deferred revenue (or "unearned" revenue) is a liability that represents cash payments collected from customers for products or services not yet provided. Some examples are gift cards, service agreements, or implied rights to future software upgrades associated with a product sold. In all the examples listed, the cash payment was received upfront and the benefit to the customer will be delivered on a later date. For instance, a company that sells a smartphone for $500 might allocate $480 of the sale to the phone and the remaining $20 to the value of the customer's right to future software upgrades. Here, the company would collect $500 in cash, but only $480 would be recognized as revenue. The remaining $20 will stay recognized as deferred revenue until the software upgrades are provided.
Do companies prefer straight-line or accelerated depreciation?
For GAAP reporting purposes, most companies prefer straight-line depreciation because lower depreciation will be recorded in the earlier years of the asset's useful life than under accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income and EPS in the initial years. Eventually, the accelerated approach will show lower depreciation into an asset's life than the straight-line method. However, companies still prefer straight-line depreciation because of the timing, as many companies are focused more on near-term earnings. If the company is constantly acquiring new assets, the "flip" won't occur until the company significantly scales back capital expenditures
Why has understanding the differences between US GAAP and IFRS financial reporting become increasingly important?
For public companies in the US, the reporting rules and guidelines are set by the Financial Accounting Standards Board (FASB) and referred to as US Generally Accepted Accounting Principles (US GAAP). The International Accounting Standards Board (IASB) oversees the International Financial Reporting Standards (IFRS), which is followed by over 144 countries. Understanding the differences between US GAAP and IFRS has become more important because: Continuation of Globalization: Globalization is the gradual convergence of economies in different countries. The widespread adoption of IFRS has placed pressure on the US to adopt IFRS to have a single set of accounting standards and rules used worldwide, but it seems unlikely in the near-term. Geographic Diversification of Investments: In recent years, investment firms have been broadening their investments' geographic scope to consider more opportunities overseas. Nowadays, institutional investors are more open to making investments in emerging markets due to the prevalence of opportunities and as a strategy to re-risk their overall portfolio. Cross-Border M&A Activity: Cross-border mergers and acquisitions ("M&A") have emerged as a strategy for multinational companies to enter new markets, extend their reach to new potential customers, and diversify their revenue sources.
Is negative working capital a bad signal about a company's health?
Further context would be required, as negative working capital can be positive or negative. For instance, negative working capital can result from being efficient at collecting revenue, quick inventory turnover, and delaying payments to suppliers while efficiently investing excess cash into high-yield investments. However, the opposite could be true, and negative working capital could signify impending liquidity issues. Imagine a company that has mismanaged its cash and faces a high accounts payable balance coming due soon, with a low inventory balance that desperately needs replenishing and low levels of AR. This company would need to find external financing as early as possible to stay afloat.
What is goodwill and how is it created?
Goodwill represents an intangible asset that captures the excess of the purchase price over the fair market value of an acquired business's net assets. Suppose an acquirer buys a company for a $500 million purchase price with a fair market value of $450 million. In this hypothetical scenario, goodwill of $50 million would be recognized on the acquirer's balance sheet.
What is the difference between growth and maintenance capex?
Growth Capex: The discretionary spending of a business to facilitate new growth plans, acquire more customers, and expand geographically. Throughout periods of economic expansion, growth capex tends to increase across most industries (and the reverse during an economic contraction). Maintenance Capex: The required expenditures for the business to continue operating in its current state (e.g., repair broken equipment).
How are the three financial statements connected?
IS ↔ CFS: The cash flow statement is connected to the income statement through net income, as net income is the starting line on the cash flow statement. CFS ↔ BS: Next, the cash flow statement is linked to the balance sheet because it tracks the changes in the balance sheet's working capital (current assets and liabilities). The impact from capital expenditures (PP&E), debt or equity issuances, and share buybacks (treasury stock) are also reflected on the balance sheet. In addition, the ending cash balance from the bottom of the cash flow statement will flow to the balance sheet as the cash balance for the current period. IS ↔ BS: The income statement is connected to the balance sheet through retained earnings. Net income minus dividends issued during the period will be added to the prior period's retained earnings balance to calculate the current period's retained earnings. Interest expense on the income statement is also calculated off the beginning and ending debt balances on the balance sheet, and PP&E on the balance sheet is reduced by depreciation, which is an expense on the income statement.
What happens to the three financial statements if a company initiates a dividend?
IS: When a company initiates a dividend, there'll be no changes to the income statement. However, a line below net income will state the dividend per share ("DPS") to show the amount paid. CFS: On the cash flow statement, the cash from financing section will decrease by the dividend payout amount and lower the ending cash balance at the bottom. BS: The cash balance will decline by the dividend amount on the balance sheet, and the offsetting entry will be a decrease in retained earnings since dividends come directly out of retained earnings.
If a company has a ROA of 10% and a 50/50 debt-to-equity ratio, what is its ROE?
Imagine a company with $100 in total assets. A 10% return on assets (ROA) would imply $10 in net income. Since the debt-to-equity mix is 50/50, the return on equity (ROE) is $10/$50 = 20%.
What is the "going concern" assumption used in accrual accounting?
In accrual accounting, companies are assumed to continue operating into the foreseeable future and remain in existence indefinitely. The assumption has broad valuation implications, given the expectation of continued cash flow generation from the assets belonging to a company, as opposed to being liquidated.
If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick?
In most cases, the cash flow statement would be chosen since the cash flow statement reflects a company's true liquidity and is not prone to the same discretionary accounting conventions used in accrual accounting. Whether you're an equity investor or lender, a company's ability to generate sufficient free cash flow to reinvest into its operations and meet its debt obligations comes first. At the end of the day, "cash is king." Although one factor that could switch the answer is the company's profitability. For an unprofitable company, the income statement can be used to value the company based on a revenue multiple. The cash flow statement becomes less useful for valuation purposes if the company's net income, cash from operations, and free cash flow are all negative.
Why are cash and debt excluded in the calculation of net working capital (NWC)?
In practice, cash and other short-term investments (e.g., treasury bills, marketable securities, commercial paper) and any interest-bearing debt (e.g., loans, revolver, bonds) are excluded when calculating working capital because they're non-operational and don't directly generate revenue. $$Net Working Capital (NWC) = Operating Current Assets − Operating Current Liabilities$$ Cash & cash equivalents are closer to investing activities since the company can earn a slight return (~0.25% to 1.5%) through interest income, whereas debt is classified as financing. Neither is operations-related, and both are thereby excluded in the calculation of NWC
Where can you find the financial reports of public companies?
In the US, public companies are required to report periodic filings with the SEC, including an annual report (10- K) and three quarterly (10-Q) reports each year. These reports are available for free through SEC EDGAR. In other countries, reporting requirements will vary, but most countries will require at least an annual report, while some will require an interim filing (i.e., a report in the middle of the company's fiscal year). Only a few countries make company filings easily accessible through a central database, forcing analysts to rely on expensive financial data providers or dig through company websites manually to collect data. The closest database to EDGAR in breadth and ease of use is Canada's SEDAR database. In the United Kingdom, the closest EDGAR equivalent is Companies House, where private companies must also report their financials.
What is the primary purpose of US GAAP?
In the US, the Securities and Exchange Commission ("SEC") authorizes the Financial Accounting Standards Board ("FASB") to determine the set of accounting rules followed by publicly traded companies. Under FASB, financial statements are required to be prepared in accordance with US Generally Accepted Accounting Principles ("US GAAP"). Through the standardization of financial reporting and ensuring all financials are presented on a fair, consistent basis - the interests of investors and lenders are protected.
How would you forecast capex and D&A when creating a financial model?
In the simplest approach, D&A can be projected as either a percentage of revenue or capital expenditures, while capex is forecasted as a percentage of revenue. Re-investments such as capex directly correlate with revenue growth, thus historical trends, management guidance, and industry norms should be closely followed. Alternatively, a depreciation waterfall schedule can be put together, which would require more data from the company to track the PP&E currently in-use and the remaining useful life of each. In addition, management plans for future capex spending and the approximate useful life assumptions for each purchase will be necessary. As a result, depreciation from old and new capex will be separately shown. For projecting amortization, useful life assumptions would also be required, which can often be found in a separate footnote in a company's financial reports.
What role did fair-value accounting have in the subprime mortgage crisis?
In the worst-case scenario, sudden drops in asset values could cause a domino effect in the market. An example was the subprime mortgage crisis, in which the meltdown's catalyst is considered to be FAS-157. This mark-tomarket accounting rule mandated financial institutions to update their pricing of illiquid securities. Soon after, write-downs in financial derivatives, most notably credit default swaps ("CDS") and mortgage-backed securities ("MBS"), ensued from commercial banks, and it was all downhill from there.
What is the relationship between depreciation and the salvage value assumption?
Most companies will use a salvage value assumption in which the remaining value of the asset is zero by the end of the useful life. The difference between the cost of the asset and residual value is known as the total depreciable amount. If the salvage value is assumed to be zero, the depreciation expense each year will be higher and the tax benefits from depreciation will be fully maximized. Straight Line Annual Depreciation = (Asset Historical Cost − Salvage Value) / Useful Life Assumption
What are some examples of non-recurring items?
Non-recurring items include legal settlements (gain or loss), restructuring expenses, inventory write-downs, or asset impairments. Often called "scrubbing" the financials, the act of adjusting for these non-recurring items is meant to normalize the cash flows and depict a company's true operating performance.
When adjusting for non-recurring expenses, are litigation expenses always added back?
Not necessarily, as whether an expense is non-recurring depends on the industry. In many cases, it's a discretionary decision on whether an expense is a part of the normal operations of a company. For example, expenses related to litigation might not be added back for a research and development (R&D) oriented pharmaceutical company, given the prevalence of lawsuits in the industry
Is it bad if a company has negative retained earnings?
Not necessarily. Retained earnings can turn negative if the company has generated more accounting losses than profits. For example, this is often the case for startups and early-stage companies investing heavily to support future growth (e.g., high capex, sales & marketing expenses, R&D spend). Another component of retained earnings is the payout of dividends and share repurchases, contributing to lower or even negative retained earnings. In these scenarios, the negative retained earnings mean the company has returned more capital to shareholders than taken in
What does the asset turnover ratio measure?
The asset turnover ratio is a metric used to understand how efficiently a company uses its assets to generate sales. The asset turnover ratio answers the question, "How many dollars in revenue does the company generate per dollar of assets?" The higher the ratio, the better, as this suggests the company is generating more revenue per dollar of an asset owned. But it has shortfalls in being distorted by capital expenditures and asset sales. Asset Turnover Ratio = Revenue / (Average of Beginning and Ending Total Assets)
Walk me through the balance sheet.
The balance sheet shows a company's assets, liabilities, and equity sections at a specific point in time. The fundamental accounting equation is: Assets = Liabilities + Shareholders' Equity. The assets belonging to a company must have been funded somehow, so assets will always be equal to the sum of liabilities and equity. Assets Section: Assets are organized in the order of liquidity, with "Current Assets" being assets that can be converted into cash within a year, such as cash itself, along with marketable securities, accounts receivable, prepaid expenses, and inventories. "Long-Term Assets" include property, plant, and equipment (PP&E), intangible assets, goodwill, and long-term investments. Liabilities Section: Liabilities are listed in the order of how close they're to coming due. "Current Liabilities" include accounts payable, accrued expenses, and short-term debt, while "Long-Term Liabilities" include items such as long-term debt, deferred revenue, and deferred income taxes. Shareholders' Equity Section: The equity section consists of common stock, additional paid-in capital (APIC), treasury stock, and retained earnings.
What is the cash conversion cycle?
The cash conversion cycle ("CCC") measures the number of days it takes a company to convert its inventory into cash from sales. Therefore, a lower cash conversion cycle is preferred as it implies the company generates and collects cash in a shorter duration. As a general rule, companies with lower CCCs operate efficiently, hold more negotiating power over suppliers, and have quicker sales collection cycles. Cash Conversion Cycle = DIO + DSO -DPO
Which section of the cash flow statement captures interest expense?
The cash flow statement doesn't directly capture interest expense. However, interest expense is recognized on the income statement and then gets indirectly captured in the cash from operations section since net income is the starting line item on the cash flow statement.
What does change in net working capital tell you about a company's cash flows?
The change in net working capital is important because it gives you a sense of how much a company's cash flows will deviate from its accrual-based net income. Change in Net Working Capital = NWC Prior Period − NWC Current Period If a company's NWC has increased year-over-year, its operating assets have grown and/or its operating liabilities have shrunk from the prior year. Since an increase in an operating asset is a cash outflow, it should be intuitive why an increase in NWC means less cash flow for a company (and vice versa).
Explain the reasoning behind the principle of conservatism in accrual accounting.
The conservatism principle requires thorough verification and use of caution by accountants when preparing financial statements, which leads to a downward measurement bias in their estimates. Central to accounting conservatism is the belief that it's better to understate revenue or the value of assets than to overstate it (and the reverse for expenses and liabilities). As a result, the risk of a company's revenue or asset values being overstated and expenses or liabilities being understated is minimized.
What is the difference between the current ratio and the quick ratio?
The current ratio and quick ratio are used to assess a company's near-term liquidity position. The two ratios are both used to determine if a company can meet its short-term obligations using just its short-term assets at the present moment. Current Ratio: A current ratio greater than 1 implies that the company is financially healthy in terms of liquidity and can meet its short-term obligations. $$Current Ratio = \frac{Current Assets}{ Current Liabilities}$$ Quick Ratio: Otherwise known as the acid-test ratio, the quick ratio measures short-term liquidity, but uses stricter policies on what classifies as a liquid asset. Therefore, it includes only highly liquid assets that could be converted to cash in less than 90 days with a high degree of certainty. $$Quick Ratio = \frac{(Cash & Cash Equivalents + AR + Short Term Investments)}{ Current Liabilities}$$
How do you calculate the debt service coverage ratio (DSCR) and what does it measure?
The debt service coverage ratio (DSCR) is a measure of creditworthiness that tests a company's ability to pay its current debt obligations using its current cash flows. As a general rule, a DSCR greater than 1.0 shows the company is generating sufficient cash flows to pay down its debt. But a DSCR below 1.0 could be a cause of concern, as it suggests the company might have insufficient cash flows to handle the debt it currently holds. There are various methods to calculate the DSCR, but one commonly used example is shown below: $$DSCR = \frac{(EBITDA − Capex)}{(Mandatory Principal Repayment + Interest Expense)}$$
How would a $10 increase in depreciation flow through the financial statements?
The depreciation expense will be embedded within either the cost of goods sold or the operating expenses line item on the income statement. IS: When depreciation increases by $10, EBIT would decrease by $10. Assuming a 30% tax rate, net income will decline by $7. CFS: At the top of the cash flow statement, net income has decreased by $7, but the $10 depreciation will be added back since it's a non-cash expense. The net impact on the ending cash balance will be a positive $3 increase. BS: PP&E will decrease by $10 from the depreciation, while cash will be up by $3 on the assets side. On the L&E side, the $7 reduction in net income flows through retained earnings. The balance sheet remains in balance as both sides went down by $7
What do the phrases "above the line" and "below the line" mean?
The expression "the line" is in reference to operating income, which represents the point that divides normal, ongoing business operations from non-operational line items. "Above the Line": If a profitability metric is "above the line," it reflects a company's operational performance before non-operational items such as interest and taxes. Financing-related activities are an example of such non-operational items, as decisions on how to fund a company are discretionary (debt vs. equity). For example, a metric such as earnings before interest, taxes, depreciation and amortization ("EBITDA") is considered "above the line." Hence, its widespread usage for comparative purposes since operational performance is portrayed while being independent of capital structure and taxes. "Below the Line": In contrast, profitability metrics "below the line" have adjusted operating income for non-operating income and expenses, which are items classified as discretionary and unrelated to the core operations of a business. An example would be net income, since interest expense, non-operating income/(expenses), and taxes have all been accounted for in its ending value.
When do you capitalize vs. expense items under accrual accounting?
The factor that determines whether an item gets capitalized as an asset or gets expensed in the period incurred is its useful life (i.e., estimated timing of benefits). Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for more than one year need to be capitalized and expensed over time. For example, PP&E such as a building can provide benefits for 15+ years and is therefore depreciated over its useful life. Expensed: In contrast, when the benefits received are short-term, the related expenses should be incurred in the same period. For example, inventory cycles out fairly quickly
How do you calculate the fixed charge coverage ratio (FCCR) and what does it mean?
The fixed charge coverage ratio (FCCR) is used to assess if a company's earnings can cover its fixed charges, which can include rent, utilities, and interest expense. The higher the ratio, the better the creditworthiness. Fixed charges can include expenses such as rent or lease payments, and utility bills. $$Fixed Charge Coverage Ratio (FCCR) = \frac{(EBIT + Lease Charges)}{(Lease Charges + Interest Expense)}$$
Why are most assets recorded at their historical cost under accrual accounting?
The historical cost principle states that an asset's value on the balance sheet must reflect the initial purchase price, not the current market value. This guideline represents the most consistent measurement method since there's no need for constant revaluations and markups, thereby reducing market volatility.
Which is more important, the income statement or the cash flow statement?
The income statement and cash flow statement are both necessary, and any in-depth analysis would require using both. However, the cash flow statement is arguably more important because it reconciles net income, the accrual-based bottom line on the income statement, to what is actually occurring to cash. This means the actual movement of cash during the period is reflected on the cash flow statement. Thus, the cash flow statement brings attention to liquidity-related issues and investments and financing activities that don't show up on the accrual-based income statement.
Why is the income statement insufficient to assess the liquidity of a company?
The income statement can be misleading in the portrayal of a company's health from a liquidity and solvency standpoint. For example, a company can consistently show positive net income yet struggle to collect sales made on credit. The company's inability to retrieve payments from customers would not be reflected on its income statement. Financial reporting under accrual accounting is also imperfect in the sense that it often relies on management discretion. This "wiggle room" for managerial discretion in reporting decisions increases the risk of earnings management and the misleading depiction of a company's actual operational performance. The solution to the shortcomings of the income statement is the cash flow statement, which reconciles net income based on the real cash inflows/(outflows) to understand the true cash impact from operations, investing, and financing activities during the period.
Walk me through the income statement.
The income statement shows a company's accrual-based profitability over a specified time period and facilitates the analysis of its historical growth and operational performance. The table below lists the major income and expense components of the income statement: Net Revenue (or Sales) — The income statement begins with revenue (often called the "top line"), which represents the total value of all sales of goods and delivery of services throughout a specified period. Less: Cost of Goods Sold — COGS represents the costs directly tied to producing revenue, such as the costs of materials and direct labor. Gross Profit — Revenues - Cost of Goods Sold = Gross Profit Less: Selling, General & Administrative ("SG&A") — Operating expenses that are not directly associated with the good or service being sold (e.g., payroll, wages, overhead, advertising, and marketing). Less: Research & Development ("R&D") —R&D refers to developing new products or procedures to improve their existing product/service offering mix. EBITDA — Gross Profit - SG&A - R&D = EBITDA EBITDA stands for: Earnings Before Interest, Taxes, Depreciation & Amortization. Less: Depreciation & Amortization ("D&A") — D&A is a non-cash expense that estimates the annual reduction in the value of fixed and intangible assets Operating Income ("EBIT") — EBITDA - D&A = Operating Income (or EBIT) EBIT stands for: Earnings Before Interest and Taxes. Less: Interest Expense, net — Interest expense from debt, net of interest income generated from investments. Pre-Tax Income ("EBT")— EBIT - Interest Expense, net = Pre-Tax Income (or "Earnings Before Tax") Less: Tax Expense — Tax liability recorded by a company for book purposes. Net Income — EBT - Tax Expense = Net Income (referred to as the "bottom line")
What does inventory turnover measure and how does it differ from days inventory held (DIH)?
The inventory turnover ratio is how often a company has sold and replaced its inventory balance throughout a specified period (i.e., the number of times inventory was "turned over"). $$Inventory Turnover = \frac{Cost of Goods Sold}{(Average of Beginning and Ending Inventory)}$$ In contrast, DIH is the average number of days it takes for a company to turn its inventory into revenue.
How does the relationship between depreciation and capex shift as companies mature?
The more a company has spent on capex in recent years, the more depreciation the company incurs in the near-term future. Therefore, when looking at high-growth companies spending heavily on growth capex, their ratio between capex and annual depreciation will far exceed 1. For mature businesses experiencing stagnating or declining growth, this ratio converges near 1, as the only capex is related to routine maintenance capex (e.g., replace equipment, refurbish store layouts).
When using metrics such as ROA and ROE, why do we use averages for the denominator?
The numerator, usually net income, comes from the income statement. The denominator, either assets or equity, comes from the balance sheet. The income statement covers a specific period, whereas the balance sheet is a snapshot at one particular point in time. Thus, the average between the beginning and ending balance of the denominator is used to adjust for this mismatch in timing
Why are the values of a company's intangible assets not reflected on its balance sheet?
The objectivity principle of accrual accounting states that only verifiable, unbiased data can be used in financial filings, as opposed to subjective measures. For this reason, internally developed intangible assets such as branding, trademarks, and intellectual property will have no value recorded on the balance sheet because they cannot be accurately quantified and recorded. Companies are not permitted to assign values to these intangible assets unless the value is readily observable in the market via acquisition. Since there's a confirmable purchase price, a portion of the excess amount paid can be allocated towards the rights of owning the intangible assets and recorded on the closing balance sheet.
What is a proxy statement?
The proxy statement, formally known as "Form 14A," is required to be filed before a shareholder meeting to solicit shareholder votes. The document must disclose all relevant details regarding the matter for shareholders to make an informed decision. In addition, the board of directors' compensation and other notable announcements such as changes to the company's articles of incorporation are included.
What is the relationship between return on assets (ROA) and return on equity (ROE)?
The relationship between ROA and ROE is tied to the use of leverage. In the absence of debt in the capital structure, the two metrics would be equal. But if the company were to add debt to its capital structure, its ROE would rise above its ROA due to increased cash, as total assets would rise while equity decreases.
What does the retention ratio represent and how is it related to the dividend payout ratio?
The retention ratio represents the proportion of net income retained by the company, net of any dividends paid out to shareholders. The inverse of the retention ratio is the dividend payout ratio, which measures the proportion of net income paid out as dividends to investors. Retention Ratio = (Net Income − Dividends) / Net Income Dividend Payout Ratio = Dividends Paid / Net Income
What is the return on invested capital (ROIC) metric used to measure?
The return on invested capital ("ROIC") metric is used to assess how efficient a management team is at capital allocation. A company that generates an ROIC over its cost of capital (WACC) suggests the management team has been allocating capital efficiently (i.e., investing in profitable projects or investments) and if sustained over the long-run, this indicates a competitive advantage. ROIC represents one of the most fundamental assessments of a company: "How much in returns is the company earning for each dollar invested?" $$Return on Invested Capital (ROIC) = \frac{NOPAT}{Invested Capital}$$
A company acquired a machine for $5 million and has since generated $3 million in accumulated depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value of that PP&E on the balance sheet?
The short answer is $2 million. Except for certain liquid financial assets that can be written up to reflect their fair market value ("FMV"), companies must carry the value of assets at their net historical cost. Under IFRS, the revaluation of PP&E to fair value is permitted. Even though permitted, it's not widely used and thus not even well known in the US. Don't voluntarily bring this up in an interview on your own.
What is working capital?
The working capital metric measures a company's liquidity and ability to pay off its current obligations using its current assets. In general, the more current assets a company has relative to its current liabilities, the lower its liquidity risk. Current liabilities represent payments that a company needs to make within the year (e.g., accounts payable, accrued expenses), whereas current assets are resources that can be turned into cash within the year (e.g., accounts receivable, inventory). Working Capital = Current Assets − Current Liabilities
Walk me through the cash flow statement.
There are two methods by which cash flow statements are organized: Direct and Indirect. The more common approach is the indirect method, whereby the cash flow statement is broken out into three sections: 1. Cash from Operations: The cash from operations section starts with net income and adds back non-cash expenses such as depreciation & amortization and stock based compensation, and then makes adjustments for changes in working capital. 2. Cash from Investing: Next, the cash from investing section accounts for capital expenditures (typically the largest outflow), followed by any business acquisitions or divestitures. 3. Cash from Financing: In the third section, cash from financing shows the net cash impact of raising capital from issuances of equity or debt, net of cash used for share repurchases, and repayments of debt. The cash outflows from the payout of dividends to shareholders will be reflected here as well. Together, the sum of the three sections will be the net change in cash for the period. This figure will then be added to the beginning-of-period cash balance to arrive at the ending cash balance.
Do accounts receivable get captured on the income statement?
There is no accounts receivable line item on the income statement, but it gets captured, if only partially, indirectly in revenue. Under accrual accounting, revenue is recognized during the period it was earned, whether or not cash was received. The two other financial statements would be more useful to understand what is happening to the accounts receivable balance since the cash flow statement will reconcile revenue to cash revenue, while the absolute balance of accounts receivable can be observed on the balance sheet.
Do inventories get captured on the income statement?
There is no inventory line item on the income statement, but it gets indirectly captured, if only partially, in cost of goods sold (or operating expenses). For a specific period, regardless of whether the associated inventory was purchased during the same period, COGS may reflect a portion of the inventory used up. The two other financial statements would be more useful for assessing inventory as the cash flow statement shows the year-over-year changes in inventory, while the balance sheet shows the beginning and end-of-period inventory balances.
If the share price of a company increases by 10%, what is the balance sheet impact?
There would no change on the balance sheet as shareholders' equity reflects the book value of equity. Equity value, also known as the "market capitalization," represents the value of a company's equity based on supply and demand in the open market. In contrast, the book value of equity is the initial historical amount shown on the balance sheet for accounting purposes. This represents the company's residual value belonging to equity shareholders once all of its assets are liquidated and liabilities are paid off. Book Value of Equity = Total Assets - Total Liabilities The equity value recorded on the books will be significantly understated from the market value in most cases For example, the book value of Apple's common stock is only ~$51 billion as of its latest 10-K filing for FY 2020, whereas its market value of equity is over $2 trillion as of this guide's publishing date.
How can a profitable firm go bankrupt?
To be profitable, a company must generate revenues that exceed expenses. However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it is unable to get favorable terms from suppliers and must pay cash for all inventories and supplies, what can occur is that despite a profitable income statement, the company suffers from liquidity problems due to the timing mismatch of cash inflows and outflows. While reliably profitable companies who simply have these working capital issues can usually secure financing to deal with it, theoretically, if financing becomes unavailable for some reason (the 2008 credit crisis is an example where even profitable companies couldn't secure financing), even a profitable company could be forced to declare bankruptcy.
Can companies amortize goodwill?
Under GAAP, public companies are prohibited from amortizing goodwill as it's assumed to have an indefinite life, similar to land. Instead, goodwill must be tested annually for impairment. However, privately held companies may elect to amortize goodwill and under some circumstances, goodwill can be amortized over 15 years for tax reporting purposes.
How would you forecast PP&E and intangible assets?
When forecasting PP&E, the end of period balance will be calculated using the roll-forward schedule shown below. Note, capex will input as a negative, meaning the PP&E balance should increase. Other factors that could affect the end-of-period PP&E balance are asset sales and write-downs. PP&E Roll-Forward EOP PP&E = BOP PP&E + Capex − Depreciation To forecast intangible assets, management guidance becomes necessary as unlike capex, there's usually no clear historical pattern that can be followed as these purchases tend to be inconsistent. In most cases, it's best to rely on management if available, but in the absence of guidance, it's recommended to assume no purchases. Intangible Assets Roll-Forward EOP Intangibles = BOP Intangibles + Intangibles Purchases - Amortization
Is EBITDA a good proxy for operating cash flow?
While EBITDA does add back D&A, typically the largest non-cash expense, it doesn't capture the full cash impact of capital expenditures ("capex") or working capital changes during the period. EBITDA also doesn't adjust for stock-based compensation, although an increasingly used "adjusted EBITDA" metric does add-back SBC. These non-cash and any non-recurring adjustments must be properly accounted for to assess a company's past operational performance and to accurately forecast its future cash flows.
Do companies depreciate land?
While classified as a long-term asset on the balance sheet, land is assumed to have an indefinite useful life under accrual accounting, and therefore depreciation is prohibited.
If depreciation is a non-cash expense, how does it affect net income?
While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has already occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase.
