Wall Street Prep Redbook Accounting: Financial Statement Analysis
What do the phrases "above the line" and "below the line" mean?
"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 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
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.
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.
How does the relationship between depreciation and capex shift as companies mature?
As a company begins to mature and its growth stagnates, a greater proportion of its total capex will shift towards maintenance.
What is the difference between the current ratio and the quick ratio?
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. 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.
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 are some of the most common margins used to measure profitability?
Gross Margin: The percentage of revenue remaining after subtracting just COGS, the direct costs associated with the company's revenue generation (e.g., direct materials, direct labor). Net Profit Margin: The percentage of accrual profitability remaining after all expenses have been subtracted. Unlike operating margin, this measure is impacted by capital structure and taxes
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%.
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.
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
What are the two types of credit ratios used to assess a company's default risk?
Leverage Ratios Interest Coverage Ratios
What are some ratios you would look at to perform credit analysis?
Liquidity Ratios Coverage Ratios Leverage/Solvency Ratios
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. 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 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.
What does return on assets (ROA) and return on equity (ROE) each measure?
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 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)
Give some examples of when the current ratio might be misleading ?
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) 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
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)
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.
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 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).
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. DSCR = (EBITDA − Capex) / (Mandatory Principal Repayment + Interest Expense)
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) = (EBIT + Lease Charges) (Lease Charges + Interest Expense)
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"). In contrast, DIH is the average number of days it takes for a company to turn its inventory into revenue.
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 timin
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 decrease.
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)
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 cannot get favorable terms from suppliers and must pay cash for all inventories and supplies, the company can suffer from liquidity problems due to the timing mismatch of cash inflows and outflows Profitable companies with these types of working capital issues can usually secure financing, but if financing suddenly becomes unavailable (e.g., 2008 credit crisis), the company could be forced to declare bankruptcy Alternatively, a profitable company that took on far too much debt in its capital structure and could not service the interest payments may also default on its debt obligations
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
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. EOP PP&E = BOP PP&E + Capex − Depreciation To forecast intangible assets, management guidance becomes necessary as, unlike capex, there is usually no clear historical pattern that can be followed as these purchases tend to be inconsistent. 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. ***Despite the criticism regarding its drawbacks, EBITDA remains the most widely used proxy for operating cash flow in practice***
