Accounting

Walk me through the 3 financial statements.

"The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement. -The Income Statement gives the company's revenue and expenses, and goes down to Net Income, the final line on the statement. -The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must equal Liabilities plus Shareholders' Equity. -The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's net change in cash."

Walk me through what flows into Retained Earnings.

-Retained Earnings = Old Retained Earnings Balance + Net Income - Dividends Issued -If you're calculating Retained Earnings for the current year, take last year's Retained Earnings number, add this year's Net Income, and subtract however much the company paid out in dividends.

How are the three financial statements connected?

- NI flows from Income Statement into cash flow from operations on Cash flow statement -NI minus Dividends is added to retained earnings from the prior period's balance sheet to come up with retained earnings on the current period's balance sheet -Beginning cash on the CF statement is cash from the prior period's Balance Sheet, and Ending Cash on the CF statement is Cash on the current period's Balance Sheet - Interest expense connected to long term debt on B/S - Deprecation expense calculated from PP&E - Change in working capital (CF) from the change in operating assets

Walk me through the major line items of an Income Statement.

- Revenues-COGS = Gross Profit - Gross Profit-Operating Expenses = Operating Income - Operating Income-Other Expenses-Income Taxes = Net Income

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 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. • Advanced Note: Write-downs of Goodwill created from acquisitions are often NOT deductible for cash-tax purposes, so a DTA/DTL might be involved in real life. Do NOT bring up this point voluntarily in an interview.

The CFO of your firm recently unveiled plans to purchase short and long-term investments. Why would she want to do this, and how would this activity affect the statements?

-A company might want to purchase investments if it has excess cash and cannot think of other ways to use it. -For example, the company can't reinvest the cash into hiring more employees, buying more equipment or factories, or acquiring other companies or assets, and it also doesn't want to distribute the cash to investors via dividends or repay its debt. -The initial purchase of these investments will show up only on the Cash Flow Statement and will reduce the company's cash flow. -Afterward, the Interest Income earned on these investments will appear on the Income Statement and boost the company's Pre-Tax Income, Net Income, and its Cash balance.

How do Net Operating Losses (NOLs) affect a company's 3 statements?

-The "quick and dirty" way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same). -The way you should do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet. -This method reflects the fact that you're saving on cash flow - since the DTL, a liability, is rising - but correctly separates the NOL impact into book vs. cash taxes.

Your company owns an old factory that's currently listed at $1,000 on its Balance Sheet. Why would it choose to "write down" this factory's value, and what is the impact on the financial statements?

-A company might write down an Asset if its value has declined substantially, and it's no longer accurate to reflect it at the original value on the Balance Sheet. -For example, maybe the factory is damaged by a hurricane or new technology makes the factory obsolete. -On the statements, you record this write-down as an expense on the Income Statement, but you add it back as a non-cash expense on the Cash Flow Statement. -The result is that the company's cash balance increases due to the tax savings. -On the Balance Sheet, Cash is up, this Asset's value is down, and Retained Earnings will balance the change on the Assets side because Net Income has decreased.

A company mentions that it collects cash payments from customers for a monthly subscription service a year in advance. Why would a company do this, and what is the cash flow impact?

-A company would collect cash payments for a monthly service long in advance if it has the market power do so. -It's always better to get cash earlier rather than later because of the time value of money, so if the market and customers support this plan, any company would do it. -Often, companies will provide an incentive, such as discounted pricing, a free bonus, or free services to incentivize customers to pay upfront. -This practice always boosts a company's cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue will be a positive entry that boosts a company's cash flow. -When this cash is finally recognized as revenue, Deferred Revenue declines, which appears as a negative entry on the CFS.

Walk me through what flows into Additional Paid-In Capital (APIC).

-APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises -If you're calculating it, take the balance from last year, add this year's stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.

Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?

-Accounts Receivable is an Asset because it corresponds to future cash payments that customers are expected to make. An Asset is something that will result in additional cash in the future, or that can be sold for cash, so AR qualifies. -Deferred Revenue is a Liability because it will cost the company cash in the future. -The company has already collected all the cash associated with this future revenue. So, in the future, when it finally delivers the product or service, it will have to spend something on the delivery and will also have to pay taxes on the revenue it records. -While AR and DR may seem similar, they are the opposites of each other: AR has not yet been collected in cash but has been delivered, whereas DR has been collected in cash, but has not yet been delivered.

Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens? Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens? At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

-After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements. -First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. -On the Cash Flow Statement, Net Income is down by $48 but the write-down is a noncash expense, so we add it back - and therefore Cash Flow from Operations increases by $32. -There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback - so Cash Flow from Investing falls by $100. -Overall, the Net Change in Cash falls by $68. -On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. -On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders' Equity is down by $48 as well. Altogether, Liabilities & Shareholders' Equity are down by $148 and both sides balance.

Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens? Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

-After a year has passed, Apple must pay interest expense and must record the depreciation. -Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense). -Assuming a tax rate of 40%, Net Income would fall by $12. -On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2. -That's the only change on the Cash Flow Statement, so overall Cash is down by $2. -On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. -On the other side, since Net Income was down by $12, Shareholders' Equity is also down by $12 and both sides balance. -Remember, the debt number under Liabilities does not change since we've assumed none of the debt is actually paid back.

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

-At the start of "Year 1," before anything else has happened, there would be no changes on Apple's Income Statement (yet). -On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same. -On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

What's the difference between cash-based and accrual accounting?

-Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain (i.e. after a customer has ordered the product) and recognizes expenses when they are incurred rather than when they are paid out in cash. -Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days; very small businesses may use cash-based accounting to simplify their financial statements.

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

-First, confirm what type of "bailout" this is - Debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here's what happens: -No changes to the Income Statement. On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the government's investment, so the Net Change in Cash is up by $100. -On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side, Shareholders' Equity would go up by $100 to make it balance.

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.

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there's a writedown of $100

-First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. -On the Cash Flow Statement, Net Income is down by $60 but the write-down is a noncash expense, so we add it back - and therefore Cash Flow from Operations increases by $40. -Overall, the Net Change in Cash rises by $40. -On the Balance Sheet, Cash is now up by $40 and an asset is down by $100 (it's not clear which asset since the question never stated the specific asset to write-down). -Overall, the Assets side is down by $60. On the other side, since Net Income was down by $60, Shareholders' Equity is also down by $60 - and both sides balance.

What happens when Accrued Compensation goes up by $10?

-For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation). -Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate). -On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4. -On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

How do Goodwill and Other Intangible Assets change over time?

-Goodwill remains constant unless it is "impaired," i.e., the acquirer decides that the acquired company is worth far less and therefore writes down the Goodwill. That appears as an expense on the Income Statement and a non-cash adjustment on the Cash Flow Statement. -Other Intangible Assets amortize over time (unless they are indefinite-lived), and that Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash Flow Statement. The balance decreases until it has amortized completely

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

-If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheet rather than shown as an expense on the Income Statement). Then it is depreciated (tangible assets) or amortized (intangible assets) over a certain number of years. -Purchases like factories, equipment and land all last longer than a year and therefore show up on the Balance Sheet. Employee salaries and the cost of manufacturing products (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.

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

-In cash-based accounting, the revenue would not show up until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account - at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet. -In accrual accounting, it would show up as Revenue right away but instead of appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company's bank account, it would "turn into" Cash.

A company decides to prepay its monthly rent - an entire year upfront - because it can save 10% by doing so. Will this prepayment boost the company's cash flow?

-In the short term, no, because the company is now paying 12 * Monthly Rent in a single month rather than making one payment per month. -On the Income Statement in Month 1, the company will still record only the Monthly Rent for that month. But on the Cash Flow Statement, it will list a negative 12 * Monthly Rent under "Change in Prepaid Expenses" to represent the cash outflow for the prepayment. -A 10% discount represents just over 1 month of rent, so the company's immediate cash flow will decrease substantially. -In the long term, this discount will improve the company's cash flow because the timing difference will go away after a year.

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

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

Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet - what happens to the 3 statements? Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

-Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6. -Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPods), which is a net addition to cash flow - so Cash Flow from Operations is up by $16 overall. -These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16. -On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. -On the other side, Net Income was up by $6 so Shareholders' Equity is up by $6 and both sides balance.

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

-Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative Expenses); Operating Income; Pretax Income; Net Income. -Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity. -Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

How might the financial statements of a company in the U.K. or Germany be different from those of a company based in the U.S.?

-Income Statements and Balance Sheets tend to be similar across different regions, but companies that use IFRS often start the Cash Flow Statement with something other than Net Income: Operating Income, Pre-Tax Income, or if they are using the Direct Method for creating the CFS, Cash Received or Cash Paid. -There are also minor naming differences; for example, the Income Statement might be called the "Consolidated Statement of Earnings" or the "Profit & Loss Statement," and the Balance Sheet might be called the "Statement of Financial Position." -Technically, U.S.-based companies that follow U.S. GAAP can also use the Direct Method for creating the CFS, but in practice, they tend to use the Indirect Method (i.e., they start with Net Income and make adjustments to determine the cash flow).

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

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

How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?

-Normally you make very simple assumptions here and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples: • Accounts Receivable: % of revenue. • Deferred Revenue: % of revenue. • Accounts Payable: % of COGS. • Accrued Expenses: % of operating expenses or SG&A. -Then you either carry the same percentages across in future years or assume slight changes depending on the company.

What's the difference between capital leases and operating leases?

-Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as operating expenses on the Income Statement. -Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt. -A lease is a capital lease if any one of the following 4 conditions is true: 1. If there's a transfer of ownership at the end of the term. 2. If there's an option to purchase the asset at a bargain price at the end of the term. 3. If the term of the lease is greater than 75% of the useful life of the asset. 4. If the present value of the lease payments is greater than 90% of the asset's fair market value.

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

Your CFO wants to start paying employees mostly in stock-based compensation, under the logic that it will reduce the company's taxes, but not "cost it" anything in cash. Is he correct? And how does Stock-Based Compensation impact the statements?

-The CFO is partially correct. Yes, stock-based compensation is a non-cash expense that reduces a company's taxes but gets added back on the CFS, similar to Depreciation. -However, unlike Depreciation or Amortization, Stock-Based Compensation incurs a real cost to the company and its investors because it creates additional shares. -In other words, if the existing investors own 99% of the company's shares, those investors might own only 97% or 98% after SBC is issued. -Thus, Stock-Based Compensation makes the company less valuable to the existing investors, even though, on paper, it seems to be just like any other non-cash expense.

How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why are Prepaid Expenses an Asset?

-The difference is very similar to the one above for AR and DR. -Prepaid Expenses have already been paid out in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they do finally appear on the Income Statement, they'll reduce the company's future taxes, making them an Asset. -Accounts Payable have not yet been paid out in cash but have been incurred as expenses, so they have appeared on the Income Statement. When the company finally pays them in cash, Accounts Payable will reduce the company's cash, making them a Liability. -Accounts Payable and Accrued Expenses work in exactly the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), whereas Accrued Expenses is more for monthly, recurring items without invoices (e.g., utilities).

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.

-The 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.

How should you project Depreciation & Capital Expenditures?

-The simple way: project each one as a % of revenue or previous PP&E balance. -The more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset's useful life, and then assumes capital expenditures based on what the company has invested historically.

A junior accountant in your department asks about the different ways to fund the company's operations and how they impact the financial statements. What do you tell him?

-The two main methods of funding a company's operations are debt and equity. Debt is cheaper for most companies (see the previous lessons and guides on WACC and the Discount Rate), so most companies prefer to use debt... up to a reasonable level. -Both equity and debt issuances show up on only the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company's cash balance. -The only "after-effect" of equity is that the company's share count increases. This happens because any investor who buys the company's equity now owns a percentage of the company. -With debt, the company must pay interest, which will be recorded on its Income Statement, reducing its Net Income and Cash, and it must eventually pay back the full balance.

Walk me through how you create a revenue model for a company.

-There are 2 ways you could do this: a bottoms-up build and a tops-down build. • Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in sales and sale values to tie everything together. • Tops-Down: Start with "big-picture" metrics like overall market size, then estimate the company's market share and how that will change in coming years, and multiply to get to their revenue. -Of these two methods, bottoms-up is more common and is taken more seriously because estimating "big-picture" numbers is almost impossible.

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.

A company issues $100 in stock to new investors to fund its operations. How do the statements change? 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 are deferred tax assets/liabilities and how do they arise?

-They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes. -Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven't actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven't expensed them on the Income Statement yet. -The most common way they occur is with asset write-ups and write-downs in M&A deals - an asset write-up will produce a deferred tax liability while a write-down will produce a deferred tax asset (see the Merger Model section for more on this).

Your company sells equipment for $85. The equipment was listed at $100 on your company's Balance Sheet, so you have to record a Loss of $15 on the Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement. Why is this Loss considered a non-cash expense?

-This Loss is a non-cash expense because you haven't actually "lost" anything in cash in the current period. -When you sell equipment for $85, you get $85 in cash from the buyer. It's not as if you've "lost" $15 in cash because you sold the equipment at a poor price. -The "Loss" refers to how you previously spent more than $85 to buy this equipment in some prior period. -So, if you look at what you spent on the equipment many years ago and compare it to what you sold it for today, it seems like a "loss." But that doesn't matter because non-cash adjustments are based on what happens in the CURRENT PERIOD.

Why is the Income Statement not affected by changes in Inventory?

-This is a common interview mistake - incorrectly stating that Working Capital changes show up on the Income Statement. -In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

Walk me through a $100 write-down of debt - as in OWED debt, a liability - on a company's balance sheet and how it affects the 3 statements.

-This is counter-intuitive. When a liability is written down you record it as a gain on the Income Statement (with an asset write-down, it's a loss) - so Pre-Tax Income goes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60. -On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt write-down - so Cash Flow from Operations is down by $40, and Net Change in Cash is down by $40. -On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but Shareholders' Equity is up by $60 because the Net Income was up by $60 - so Liabilities & Shareholders' Equity is down by $40 and it balances. If this seems strange to you, you're not alone - see this Forbes article for more on why writing down debt actually benefits companies accounting-wise

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.

What is the Statement of Shareholders' Equity and why do we use it?

-This statement shows everything we went through above - the major items that comprise Shareholders' Equity, and how we arrive at each of them using the numbers elsewhere in the statement. -You don't use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.

Walk me through how you create an expense model for a company.

-To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward. -Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics. -Cost of Goods Sold should be tied directly to Revenue and each "unit" produced should incur an expense. -Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company's internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

Let's say we're trying to create these models but don't have enough information or the company doesn't tell us enough in its filings - what do we do?

-Use estimates. For the revenue if you don't have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years. -For the expenses, if you don't have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.

If cash collected is not recorded as revenue, what happens to it?

-Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities. -Over time, as the services are performed, the Deferred Revenue balance "turns into" real revenue on the Income Statement.

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

-Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought. -It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement (see: eBay/Skype). -It can also happen when a company discontinues part of its operations and must impair the associated goodwill.

What is working capital? How is it used?

-Working Capital = Current Assets - Current Liabilities. -If it's positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound." -Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt).

Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes, what would it mean?

-Yes, easily. Think about a company that starts losing massive amounts of money, resulting in a negative Net Income. After many years, negative Net Income could easily turn the company's Equity negative. -This might also happen if the company issues a huge dividend to its owners (e.g., following a leveraged buyout) that turns Equity negative. -The "meaning" varies based on what has happened, but negative Equity is almost always a negative sign because it means the company has been unprofitable or has done something irresponsible with its dividends or share repurchases. -Negative Equity is also common for tech and biotech startups that record massive losses in their early years due to high spending and no revenue.

Your friend is analyzing a company and says that you always have to look at the Cash Flow Statement to find the full amount of Depreciation. Is he right? And if so, what are the implications?

-Yes, your friend is correct. This happens because companies often embed Depreciation within other line items, such as COGS and Operating Expenses, on the Income Statement. -That's because portions of Depreciation might correspond to different functions in the company. For example, employees in sales & marketing, research & development, and customer support might all be using computers, so Depreciation of computers would show up in each of those categories. -This fact has several implications: First off, you CANNOT assume that the Depreciation listed on the Income Statement is the full amount. A company might list a portion of it as an explicit line item but embed other portions elsewhere. -Second, adding back the full amount on the CFS shows that Depreciation simply reduces the company's taxes without "costing" it anything in cash. -This is why Depreciation boosts the company's cash balance as well: the tax savings.

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,

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.

Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your department asks you why the company did this - what would you tell him?

-You need to create Goodwill and Other Intangible Assets after an acquisition takes place to ensure that the Balance Sheet balances. -In an acquisition, you write down the seller's Shareholders' Equity and then combine its Assets and Liabilities with those of the acquirer. -If you've paid exactly what the seller's Shareholders' Equity is worth - e.g., you paid $1,000 in cash and the seller has $1,000 in Equity, then there are no problems. -The combined cash balance will decrease by $1,000, and so will the combined Equity. -However, in real life, this almost never happens. Companies almost always pay premiums for companies they acquire, which means that the Balance Sheet will go out of balance. -For example, if the seller here had $400 in Equity instead, the BS would go out of balance immediately because we wipe out $400 in Equity but spend $1,000 in cash. -To fix that problem, you start by allocating value to the seller's "identifiable intangible assets" such as patents, trademarks, intellectual property, and customer relationships. In this case, we allocated $200 to these items. -If there's still a gap remaining after that, you allocate the rest to Goodwill, which explains the $400 in Goodwill here

How is GAAP accounting different from tax accounting?

1. GAAP is accrual-based but tax is cash-based. 2. GAAP uses straight-line depreciation or a few other methods whereas tax accounting is different (accelerated depreciation). 3. GAAP is more complex and more accurately tracks assets/liabilities whereas tax accounting is only concerned with revenue/expenses in the current period and what income tax you owe.

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

What's the difference between accounts receivable and deferred revenue?

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.

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

Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

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.

What are the three components of the Statement of Cash Flows?

Cash from Operations, Cash from Investing, and Cash from Financing.

What is the link between the BS and CF?

Changes in some accounts of the BS are added back/subtracted in the operations sections of the CF (NWC). Additionally, the change in cash from the CF is added to the beginning cash balance from the BS to get the ending cash balance. Depreciation is also added back (not cash expense) to the operations section of the CF. Changes in PPE are also accounted for in the investing section of the CF.

How would a $10 increase in depreciation expense affect the three financial statements?

Depreciation is an expense, so we would add $10 in depreciation expense. This would decrease our earnings before taxes by $10. Assuming a 40% tax rate, our NI only decreases by $6, and our depreciation actually creates a tax shield. Next, the Cash flow statement first line of NI decreases by $6. However, we add back depreciation as it is a non-cash expense (in the operating section), so our change in cash is up $4. Lastly, net PPE will decrease by $10, the ending cash balance will increase by this $4, and retained earnings will decrease by $6 (the BS balances).

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.

How long does it usually take for a company to collect its accounts receivable balance?

Generally the accounts receivable days are in the 40-50 day range, though it's higher for companies selling high-end items and it might be lower for smaller, lower transaction value companies.

What are the three financial statements?

Income Statement (Revenue-COGS-Expenses = NI), Balance Sheet (Assets = Liabilities + Stockholders' Equity), and the Cash Flow Statement (Beginning Cash + Cash from Operations + Cash from Investing + Cash from Financing = Ending Cash)

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.

Where does Depreciation usually show up on the Income Statement?

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

What is the link between the BS and IS?

Net income from the IS (minus any dividends paid to shareholders) flows to the retained earning section of the BS. Debt on the BS is also used to calculated interest expense on the IS, and PPE on the BS is used to calculated depreciation expense on the IS.

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

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

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

Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean: 1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances. 2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative Working Capital because customers pay upfront - so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency. 3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don't pay quickly and upfront and the company is carrying a high debt balance).

What are the components of each of the items on the statement of cash flows?

Operations (Cash made from doing business), financing (paying off debt, issuing new equity), and investing (buying PP&E).

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

Several possibilities: 1. The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be cash-flow negative. 2. The company has high interest expense and is no longer able to afford its debt. 3. The company's debt all matures on one date and it is unable to refinance it due to a "credit crunch" - and it runs out of cash completely when paying back the debt. 4. It has significant one-time charges (from litigation, for example) and those are high enough to bankrupt the company. -Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges - and all of these could end up bankrupting the company.

Under what circumstances would Goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth more, but that is rare. What usually happens is 1 of 2 scenarios: 1. The company gets acquired or bought out and Goodwill changes as a result, since it's an accounting "plug" for the purchase price in an acquisition. 2. The company acquires another company and pays more than what its assets are worth - this is then reflected in the Goodwill number.

What is the difference between the income statement and cash flow statement?

The income statement list all forms of payment for both revenues and expenses, whereas the cash flow statement only includes those which strictly include cash (accounts receiveable/payable would not be on the CF while it would be on the IS). CF has what cash is being used and what cash is being earned.

Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?

These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded

Why would the Depreciation & Amortization number on the Income Statement be different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you're undercounting D&A.

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

Three examples come to mind: 1. Web-based subscription software 2. Cell phone carriers that cell annual contracts 3. Magazine publishers that sell subscriptions -Companies that agree to services in the future often collect cash upfront to ensure stable revenue - this makes investors happy as well since they can better predict a company's performance. -Per the rules of GAAP (Generally Accepted Accounting Principles), you only record revenue when you actually perform the services - so the company would not record everything as revenue right away.

How do you know when a revenue or expense line item should appear on the Income Statement?

Two conditions MUST be true for an item to appear on the Income Statement: 1. It must correspond to ONLY the period shown on the Income Statement. This is why monthly rent shows up, but paying for a factory that will last for 10 years does not. 2. It must affect the company's taxes. Interest on debt is tax-deductible, so it shows up, but repayment of debt principal is not, so it does not show up. -Whether or not something is received or paid in cash has nothing to do with this classification - companies pay taxes on non-cash revenue (e.g., receivables) and save on taxes from non-cash expenses (e.g., depreciation) all the time. -Advanced Note: Technically, in point #2 we should say, "It must affect the company's BOOK taxes" (i.e., only the tax number that appears on the Income Statement). Many items that are not deductible for cash-tax purposes still appear on the IS and affect book taxes.

Could you ever end up with negative shareholders' equity? What does it mean?

Yes. It is common to see this in 2 scenarios: 1. Leveraged Buyouts with dividend recapitalizations - it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative. 2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders' Equity. It doesn't "mean" anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario). Note: Shareholders' equity never turns negative immediately after an LBO - it would only happen following a dividend recap or continued net losses.

How can you tell whether or not an item should appear on the Cash Flow Statement?

You list an item on the Cash Flow Statement if: 1) It has already appeared on the Income Statement and affected Net Income, but it's noncash, and you need to adjust for it to determine the company's real cash flow; OR 2) It has NOT appeared on the Income Statement and it DOES affect the company's cash balance. -In category #1 are items such as Depreciation and Amortization; Category #2 includes most of the items in Cash Flow from Investing and Financing, such as Capital Expenditures and Dividends. -Changes in Working Capital could fall into either category depending on the change (e.g., an increase in AR is in category #1, but a decrease in AR is in category #2).

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

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

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

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

Walk me through the major items in Shareholders' Equity.

• Common Stock - Simply the par value of however much stock the company has issued. • Retained Earnings - How much of the company's Net Income it has "saved up" over time. • Additional Paid in Capital - This keeps track of how much stock-based compensation has been issued and how much new stock employees exercising options have created. It also includes how much over par value a company raises in an IPO or other equity offering. • Treasury Stock - The dollar amount of shares that the company has bought back. • Accumulated Other Comprehensive Income - This is a "catch-all" that includes other items that don't fit anywhere else, like the effect of foreign currency exchange rates changing.

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 noncash, 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 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.

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.

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? 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.

What are examples of non-recurring charges we need to add back to a company's EBIT / EBITDA when looking at its financial statements?

• Restructuring Charges • Goodwill Impairment • Asset Write-Downs • Bad Debt Expenses • Legal Expenses • Disaster Expenses • Change in Accounting Procedures -Note that to be an "add-back" or "non-recurring" charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges "below the line" then you do not add it back for the EBITDA / EBIT calculation. -Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation for EBITDA / EBIT, but that these are not "non-recurring charges" because all companies have them every year - these are just non-cash charges.