Financial Statements/Accounting Questions

If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements?

1. Income Statement: depreciation is an expense so operating income (EBIT) declines by $10. --->Assuming a tax rate of 40%, net income declines by $6. 2. Cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. 3. Balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder's equity decreased $6. Why if non-cash, explain how this transaction caused cash to increase $4. --->Because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.

I buy a piece of equipment, walk me through the impact on the 3 financial statements.

1. Initially, there is no impact (income statement); 2. Cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement) 3. Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement).

Walk me through a cash flow statement.

1. Start with net income, go line by line through major adjustments (depreciation, changes in working capital and deferred taxes) to arrive at cash flows from operating activities. 2. Mention capital expenditures, asset sales, purchase of intangible assets, and purchase/sale of investment securities to arrive at cash flow from investing activities. 3. Mention repurchase/issuance of debt and equity and paying out dividends to arrive at cash flow from financing activities. 4. Adding cash flows from operations, cash flows from investments, and cash flows from financing gets you to total change of cash. 5. Beginning-of-period cash balance plus change in cash allows you to arrive at end-of-period cash balance.

What is a deferred tax asset and why might one be created?

: Deferred tax asset arises when a company actually pays more in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in revenue recognition, expense recognition (such as warranty expense), and net operating losses (NOLs) can create deferred tax assets.

Formula for Net Change in Cash Over the Period

Add up all the parts of Cash flow statement Net Change in Cash Over the Period = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities

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. (Assume $100 principal, 10% for depreciation and loan interest)

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year so that's what we will write down in the 3 statements. Income Statement: the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. Cash Flow Statement: Net Income is down by $48 but the write-down is a non-cash expense, so we add $80 back - and therefore Cash Flow from Operations increases by $32. Cash Flow from Investing: no change Cash Flow from Financing: $100 decrease for the loan payback Overall, the Net Change in Cash falls by $68. Balance Sheet: Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. Debt is down $100 since it was paid off, and since Net Income was down by $48 (Shareholders' Equity) Both sides down by $148 and both sides balance.

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? (principal is $100)

After a year has passed, Apple must pay interest expense and must record the depreciation: Income Statement: 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. 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 ($10-$12=-$2). . Balance Sheet: Assets- Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. Net Income was down by $12 (Shareholders' Equity)

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Annual Financial Report

Diff b/w COGS and SG&A

COGS are costs directly associated with the production of the goods sold while SG&A are costs indirectly associated with the production of the goods sold COGS- manufacturing, SG&A- marketing

Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc., do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings?

Capital expenditures are capitalized because of the timing of their estimated benefits - the lemonade stand will benefit the firm for many years. The employees' work, on the other hand, benefits the period in which the wages are generated only and should be expensed then. This is what differentiates an asset from an expense.

What is goodwill?

Captures excess of the purchase price over fair market value of an acquired business. Ex: Acquirer buys Target for $500m in cash. Target has 1 asset: PPE with book value of $100, debt of $50m, and equity of $50m = book value (A-L) of $50m. Acquirer records cash decline of $500 to finance acquisition Acquirer's PP&E increases by $100m Acquirer's debt increases by $50m Acquirer records goodwill of $450m Q:

most critical financial statement for overall health

Cash flow statement- we care most about the cash flow of a company and only it tells me how much cash the company has.

What's the difference between cash-based and accrual accounting? Which is more common?

Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out Accrual accounting recognizes revenue when collection is reasonably certain 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.

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

Cash-based: -No revenue until the company charges the customer's credit card, receives authorization, and deposits the funds in its bank account ---> shows up as both Revenue on the Income Statement and Cash on the Balance Sheet. Accrual accounting: -Shows up as Revenue right away --> go into Accounts Receivable at first. -Once the cash is actually deposited in the company's bank account, it would "turn into" Cash.

Diff b/w debt and equity

Debt- take out loans, fixed payment, the owner of debt has first priority for repayment Equity- shareholder now owns part of the business, likely more expensive than debt, not first priority of repayment

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

Deferred Revenue balance on the Balance Sheet under Liabilities. As the services are performed, the Deferred Revenue balance "turns into" real revenue on the Income Statement.

What is a deferred tax liability and why might one be created?

Deferred tax liability is a tax expense amount reported on a company's income statement that is not actually paid to the IRS in that time period, but is expected to be paid in the future. It arises because when a company actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in depreciation expense between book reporting (GAAP) and IRS reporting can lead to differences in income between the two, which ultimately leads to differences in tax expense reported in the financial statements and taxes payable to the IRS.

Cash from operating activities

Determine from 2 methods: direct and indirect Indirect(super common)- The indirect method starts with net income and includes the cash effects of transactions involved in calculating net income. Cash from operations= Net income (from income statement) + period-on-period increases in working capital liabilities + non-cash expenses - non-cash gains - period-on-period increases in working capital assets -For a stable, mature company a positive cash flow from operating activities is desirable Essentially, cash from operating activities is a reconciliation of net income (from the income statement) to the amount of cash the company actually generated during that period as a result of operations (think cash profits vs accounting profits). The adjustments to get from accounting profit (net income) to cash profits (cash from operations) are as follows:

Ending Retained Earnings formula

Ending Retained Earnings = Beginning Retained Earnings + Net Income - Dividends

Two companies both valued at $25 which is cheaper

I look at the earning of both the company and calculate the PE Multiple. The company whose PE multiple is higher is more expensive as I have to pay more price to earn a single Dollar.

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.

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

Income Statement and Balance Sheet- 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).

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. Balance Sheet: Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall. Net Income (Shareholders' Equity) was up by $6 so both sides balance.

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

Income Statement: no change Cash Flow Statement: decreases your Cash Flow from by $10, as does the Net Change in Cash at the bottom. Balance Sheet: Assets increase by $10, but Cash is down by $10

What happens when Accrued Compensation goes up by $10?

Income Statement: no change Cash Flow Statement: increases your Cash Flow from by $10, as does the Net Change in Cash at the bottom b/c accrued compensation is a liablility under Changes in Working Capital Balance Sheet: Liabilities would go up by $10, cash also up by $10

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?

Income Statement: no change Cash Flow Statement: They pay for Inventory in cash, so Cash Flow from Operations decreases by $10. Cash is down by $10. Balance Sheet: Inventory is up by $10 and Cash is down by $10

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?

Income Statement: no change yet Cash Flow Statement: Cash Flow from Investing down by $100 from factories. Cash flow up by $100 from debt funding. Cash number stays the same. Balance Sheet: PPE (Assets) up by $100, accts payable (liabilities also up by $100

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 write down of $100.

Income Statement: the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60. Cash Flow Statement: Net Income is down by $60 but the write-down is a non-cash expense, so we add it ($100) back - and therefore Cash Flow from Operations increases by $40. Net Change in Cash rises by $40. Balance Sheet: Cash is now up by $40 and an asset is down by $100 -->the Assets side is down by $60. Net Income (Shareholders' Equity) was down by $60 both sides balance-- down by $60

How is the income statement linked to the balance sheet?

Net income flows into retained earnings.

Three sections of a cash flow statement

Operating Financing Investing

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Quarterly Financial Report

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 be cash-flow negative if CapEx spending is too high. 2. The company has very high interest ex pense 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.

Why are increases in accounts receivable a cash reduction on the cash flow statement?

Since our cash flow statement starts with net income, an increase in accounts receivable is an adjustment to net income to reflect the fact that the company never actually received those funds.

Why is the Income Statement not affected by changes in 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.

22. 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; companies like to present both sets of figures to look better to investors.

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

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).

How is it possible for a company to show positive net income but go bankrupt?

Yes, due to deterioration of working capital (i.e. increasing accounts receivable, lowering accounts payable),

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, not immediately after, but 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. Declining retained earnings- the company has been losing money consistently ---> May demonstrate that the company is struggling

Is it possible for a company to show positive cash flows but be in grave trouble?

Yes: 1. unsustainable improvements in working capital (a company is selling off inventory and delaying payables) 2. lack of revenues going forward.in the pipeline

Working Capital liabilities examples

accounts payable, accrued expenses, etc.

Working Capital assets examples

accounts receivable, inventory, prepaid expenses, etc.

What are the 3 financial statements?

cash flow statement, income statement, and the balance sheet.

Cash Flow Statement (big picture)

changes in cash over period of time

Common Expenses

cost of goods sold (COGS); selling, general, and administrative (SG&A); interest expense; deprecition; and taxes

What does balance sheet tell us?

dollar amounts of a company's assets, liabilities, and owner's equity

Balance Sheet (big picture)

financial condition at one point in time Assets= Liability + Shareholder's Equity

Name things EBIDTA excludes

investment in long term assets, depreciation of long-term assets, interest, and one-time charges

Income Statement (big picture)

profitability over time Net Income = Revenue - Expenses

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

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

P/E ratio

the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings.

How are the 3 financial statements linked? OR walk me through three financial statements

"The three financial statements are the income statement, balance sheet, and statement of cash flows. The income statement is a statement that illustrates the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year. Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity. Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating. Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year."

Why is the cash flow statement important and how does it compare to the income statement?

- Income statement accounting uses what is accrual accounting-- record revenue when earned and expenses when incurred. Pros: Accrual method= more accurate picture of the companies profitability. Cons: More easily to manipulate accounting profits than cash profits. Cons: Must see amount of cash-- not having a handle on cash can potentially make even a healthy company go bankrupt. -Solution: analyze both, they should corroborate.

Cash from financing activities

-Cash related to capital raising and payments of dividends. ---> Ex: company issues more preferred stock, we will see such an increase in cash in this section. ---->Ex: company pays dividends, we will see a cash outflow related to such a payment. -For a stable, mature, company, there is not a preference for positive or negative cash in this section. Depends on cost of capital vs.potential ROI

Cash from investment activities

-Cash related to investments in the business (i.e., additional capital expenditures) or divesting businesses (sale of assets). -For a stable, mature, company negative cash flow from investing activities is desirable b/c indicates that the company is trying to grow by buying assets.

How is cash flow statement linked to balance sheet?

-It represents the net change in cash over the period (magnification of the cash account on the balance sheet). -A previous period's cash balance plus the net change in cash this period represents the latest cash balance on the balance sheet.

Relate Balance Sheet to Income Statement

-Net income comes from income statement -Appears as retained earnings on Balance sheet in equity section

How is cash flow statement linked to income statement?

-Net income is the top line of the cash flow from operations section when companies use indirect method

What is working capital?

-Working Capital = Current assets - current liabilities; -Tells the financial statement user how much cash is tied up in the business through items such as receivables and inventories - Shows how much cash is going to be needed to pay off short term obligations in the next 12 months.

Earnings per share (EPS)

-portion of a company's profit allocated to each outstanding share of common stock. EPS = (net income - dividends on preferred stock) / weighted average shares outstanding)

Under what circumstances would Goodwill increase?

1. Company re-assesses its value and finds that it is worth more (very rare). 2. 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. 3. The company acquires another company and pays more than what its assets are worth - this is then reflected in the Goodwill number.