accounting technicals
Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes, what would it mean?
It could happen if net income is negative, resulting in a decrease in retained earnings that is greater than the total amount of existing equity. This could also happened if an extremely large dividend is paid out to shareholders, as a dividend reduces retained earnings. This is usually a bad sign that indicates the company is not profitable or has an irresponsible dividend policy.
Do you have to look at cash flow statement to find the full amount of depreciation?
Yes because companies embed depreciation within other line items such as cogs or operating expesnes on the income statement.
How are a company's operations funded and how does that affect the financial statements?
Through debt and equity. Both will show up in the cash flow from financing section of cash flow statement. Cash will increase in the balance sheet and will be balanced by a note payable liability in the case of debt and contributed capital, which is common stock and additional paid in capital for public corporations, in the case of equity. For debt, there will also be interest payments each period, which will show up in the income statement.
A company seems to be boosting its ROE artificially by using leverage to fuel its growth. Which metrics or ratios could you look at to confirm or deny your suspicion?
To see if this is happening, you could check the company's Debt/EBITDA and EBITDA/Interest ratios - if they indicate that the company has been using more debt over time, it's a good bet that Debt has been at least partially responsible for the increased ROE.
How do the 3 financial statements link together?
We start with net income from the income statement and use that as the first line item in the cash flow statement. Using the indirect method, we would adjust the net income for non-cash items such as depreciation or impairment. Next, we would subtract the change in operating assets and add the change in operating liabilities to get cash flow from operations. We would add this number to the cash flows from investing and cash flows from financing to get net change in cash. We can add the net change in cash to the cash from the previous balance sheet's cash to get the new cash and do the same with net income to find the new retained earnings number. Lastly, we would adjust balance sheet items from last period based on the changes in the three cash flow statements and make sure that assets are balanced by liabilities and equity.
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 $X in dividends vs. $Y in shares repurchases.
Share repurchase increases treasury stock and thus reduces shareholder equity on balance sheet. Treasury stock is a contra equity item, so increasing repurchases increases treasury stock and thus reduces shareholder equity.
walk me through 3 statements with $100 interest expense (50% cash interest / 50% PIK interest) and $50 interest income
Starting on the IS... ● Net interest expense down 50, pre-tax income down by 50, NI down by 35 ■ Moving onto the SCF... ● NI down by 35, add back 50 from PIK interest in CFO, so cash at bottom is up by 15 ■ Finally, on the BS... ● A: Assets up 15, Cash up 15 ● L: Liabilities up 50, Long-term debt up 50 ● SE: Equity down 35, Retained earnings down 35 ■ ...and the Balance Sheet balances
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? 20% tax rate.
Starting with the income statement, the loss on a sale of an asset is recognized as an expense on the income statement. Thus, pre-tax income is down 20. Net income is down by 16 assuming a tax rate of 20%. On the cash flow statement, net income is the first line, which down by 16. The loss on a sale of an asset is a non-cash expense and thus needs to be added back. This means that cash flow from operations is up by 4. Under cash flow from investing, the sale of the asset generates $80. There is no cash flows from financing, so the net change in cash is $84. On the asset side of the balance sheet, cash is up by $84 whereas pp&e is down by 100, so assets decrease by 16. This is balanced on the liabilities and equity side by a decrease in retained earnings by $16 due to change in net income.
A company runs into financial distress and needs cash immediately. It sells a factory that's listed at 1000 on its Balance Sheet for 2000. What happens on the 3 statements? 20% tax rate.
Starting with the income statement, we recognized the asset sale as a gain in income of 1000. This means pretax income is up by 1000 and net income is up by 800 assuming as 20% tax rate. On the cash flow statement, net income is the first line and is up 800. The sale of an asset for a gain is not considered an operating activity, and thus its contributing revenue needs to be subtracted to get cash flow from operations. Thus, if net income is up 800 and we subtract the gain on asset sales, then cash flow from operations is down 200. Cash flow from investing is up 2000 due to the cash received from the PP&E sale, and there is no change to cash flows from financing, so cash is up by 1800 at the bottom of the cash flow statement. On the asset side the balance sheet, cash is up 1800, but pp&e is down by 1000., so assets are up by 800. On the liabilities and equity side, retained earnings is up 800 from the change in net income, so the balance sheet balances.
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?
Stock based compensation is a non-cash expense that reduces net income but it will be added back to the cash flow statement. While it does not cost cash, stock based compensation creates additional shares, and thus has dilutive effects, which makes existing shares less valauble for current investors.
What are the 3 financial statements, and why do we need them?
The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement. The income statement shows a company's revenues, expenses, taxes over a period, and end with net income, which represents a company's profits during the period. The balance sheet contains a company's assets, which are its resources, which is equal in amount to its liabilities and equity, which are both ways of paying for those assets. The cash flow statement shows how much cash a company generates from its operations and how cash flows into or out of the company through investing and financing activities. All three are required since net income from the balance sheet is quite different than net cash flow from the cash flow statement, and the balance sheet provides a snapshot of a company's position while the other two statements show a company's performance over a period of time.
Why would a company purchase short and long term investments and how does it affect the financial 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.
What is Free Cash Flow, and what does it mean if it's positive or increasing?
A simple definition for free cash flow is cash flow from operations - capital expenditures. This is a company's discretionary cash flow, which is the cash it has remaining after required spending to maintain its business. I would define it this way as all cash flow from operations items are more or less mandatory, but the only investing or financing section items that are mandatory are capital expenditures. If free cash flow is positive and increasing, then the company has excess cash that can be spent to grow the business, pay off debt, or return money to shareholders.
How can you tell whether an item should be classified as an Asset, Liability, or Equity on the Balance Sheet?
An asset generates future benefits and can be sold for cash. A liability generates future obligations and will cost a company assets. Equity line items represent funding for a company that do not result in future obligations or payments.
What is the impact of a write-down on a company's financial statements? Why would it write down an asset?
An asset is written down if its value is no longer equal to the original value, perhaps due to damages. The write down is an expense on the income statement and added back to cash flow from operations in the net income adjustment on the cash flow statement.
How do Goodwill and Other Intangible Assets change over time? How do changes impact the financial statements?
Both goodwill and other intangible assets can be impaired. Goodwill is impaired if the acquirer realizes that the acquired company is worth less than calculated during the purchase. Impairments show up as expenses on the income statement and are added back to cash flow from operations as a non-cash expense. Intangible assets amortize over time, unless they have an indefinite life span. Amortization show up as periodic expenses on the income statement and are added back to cash flow from operations as a non-cash expense. The balance sheet value of the intangible assets decreases to zero, when the amortization is complete.
What does days receivable outstanding and days payable outstanding tell you?
Days receivable outstanding tells you how many days it takes for a company to receive money from customers and how many days it takes to pay suppliers. A company wants to collect cash quickly but delay payments, so low days receivable outstanding and a high days payable outstanding is desirable.
Walk me through 3 statements with ○ Debt write down of $100 with 5% interest attached
Debt write down of $100 with 5% interest attached ■ Starting on the IS... ● Pre-tax income up by $100, NI up by $70 ■ Moving onto the SCF... ● NI up by $70, subtract $100 since non-cash revenue ● Net change in cash = down by 30 ■ Finally, on the BS... ● A: Assets down by 30, cash down by 30 ● L: Debt down by 100 ● SE: NI up by 70 ■ ...and the Balance Sheet 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 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.?
Foreign companies are usually required to have cash flow statements that use the direct method while U.S. companies usually use the indirect method to create their cash flow statement. Additionally, the 3 financial statements might have different names across different regions.
What does it mean if free cash flow is negative or decreasing?
Free cash flow can be negative or decreasing for multiple reasons. If capital expenditure is unusually high one year, perhaps due to the purchase of a large factory that will last for multiple years, then free cash flow can be negative. However, free cash flow can also be negative if sales and income have been declining. If free cash flow decreases too much, a company may have to raise funds or restructure operations to continue.
What if you could use only 2 statements to assess a company's prospects - which ones would you use, and why?
I would use the income statement and balance sheet since you can create the cash flow statement using those two statements if given a beginning and ending balance sheet. You could use net income and the changes to the balance sheet items to figure out cash flows from operations, investing and financing. Theoretically, you could build an income statement from a balance sheet and cash flow statement but it would be much more difficult.
What does the change in working capital tell us?
If working capital increases over a period, then a company needs to spend in advance of its revenue generation. For instance, a retailer must buy inventory before it can sell it off for revenue. If working capital decreases over a period, that means a company usually collects cash before recognizing revenue. For instance, subscription-based companies collect annual fees upfront and then provide services over the course of a year.
6. 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?What happens on the statements after a year? 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?
Immediately is straightforward. After a year: 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. Cash flow statement: Net income is up $6. No other changes to net income so cash flow from operations are $6. The dividends payment to the preferred stockholders will be a cash flow from financing acvititiy and will be a decrease in $8, since there is a 8% yield on $80 in total of common stock. Thus net change in cash will be a decrease in $2. Balance Sheet: Cash is down by $2, so the Assets side is down by $2. On the other side, Retained Earnings is up by $6 from net income but the dividend repayment would reduce retianed earnings by $8, so the net change in retained earnings is down $2. This means the L&E side is also down by $2 and both sides balance. After 2 years: 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. Cash Flow Statement: Net Income is up by $66, but the $100 Gain is noncash, so you subtract it out to get a decrase in cash flow from operations by $34. Total Proceeds Received from the sale of investments is $200, which would increase Cash Flow from Investing. You also have to show the $100 repayment of the Preferred Stock and the $8 dividend payment, so cash flows from financing will decrease by $108. The net change in cash when you add the three changes in cash flow is an increase in cash by 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. On the liabilities and equity side, retained Earnings increased by $66 due to the increased Net Income but decreased by $8 due to the dividend payment, so the net change in retained earnings is an increase by $58. However, preferred Stock decreased by $100, so equity is decreased by $42 in total which would be equal to the change in assets and thus balance everything since there are no changes to liabilities.
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.
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?
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.
Amazon.com decides to pay several key vendors on credit and make them wait for the cash. It offers $X 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?
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.
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? 40% tax rate.
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.
Is a high current ratio always a good thing?
More current assets than current liabilities is a positive but its important to dig deeper into what makes up the current assets and liabilities. For instance, if the current assets are mostly receivables with little cash then the company may struggle to pay upcoming expenses when due since its waiting for cash collection from customers.
A company issues $100 in stock to new investors to fund its operations. How do the statements change?
Plug into Excel model.
A company prepays its rent ($X 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.
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Wal-Mart buys $X 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 $Y.
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Walk me through what happens on the statements when a customer orders a product for $X but doesn't pay for it in cash, and then what happens when the cash is finally collected.
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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? 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.
Plug into excel bust first make sure numbers are correct. Don't forget 3 EPS calculations (no change, immediate, after a year)
Wal-Mart orders $X of Inventory but pays for it using debt. What happens on the statements immediately after this transaction? A year passes, and Wal-Mart sells the $X of Inventory for $W. However, it also has to hire additional employees for $Y to process the orders. The company also pays Z% interest on its debt and repays A% of the principal. What happens on the statements over the course of THIS one year?
Plug into excel.
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?
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A company's Depreciation increases by X. What happens on the 3 financial statements?
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What happens to 3 statements when operating expenses increase by $X. Assume Y% tax rate.
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What's the most important financial statement?
The cash flow statement is the most important because it tells you how much cash a company is generating. The income statement includes non-cash revenue and expenses as well as excludes cash spending for things like capital expenditure. Since cash is the unit of monetary value, cash flow is best measure of overall financial health compared to net income. The balance sheet is not as useful since you can not see a company's performance over a period of time.
How is the change in working capital calculated and shown on the cash flow statement?
The change in working capital in the cash flow statement refers to the change in current operating assets being subtracted from net income and the change in operating liabilities being added back to net income. But since working capital is current assets minus current liabilities, which is the opposite of what is being done in the cash flow statement, the change in working capital for the cash flow statement would be calculated as old working capital minus new working capital.
A company's EBITDA has been positive and growing at 20% for the past three years. However, the company recently filed for bankruptcy. How could this have happened?
The company could have filed bankruptcy since it ran out of cash. The cash flow statement would be a better statement to look at. If a company is spending a lot on capital expenditure or inventory, which wont show up on the income statement as expenses, then they could run out of money.
A company's ROA has INCREASED from 10% to 15% over the past five years, but its ROE has DECREASED from 13% to 10%. What could have caused this?
The company is using equity to fund its operations. The company is issuing shares in exchange for cash and the cash is used to pay for expenses. Thus, equity increases but assets does not. If net income is increasing, then ROA would increase and ROE would decrease if equity is growing at a faster rate than net income.
What is the more useful definition of working capital?
The more useful definition of working capital would be defining it as operating working capital which is current assets (excluding cash and investments) - current liabilities (excluding debt). Raising debt and purchasing investments are excluded as they are financing and investing activities. Cash is a current asset but not counted since the total change in cash is not affected only by operating actitivites, but also investing and financing activities. Operating working capital is more useful since it gives insight into the cash inflows and outflows for items necessary for a company to function.
How do you know when a revenue or expense line item should appear on the Income Statement?
The revenue or expense would need to have been recognized during the same period as the income statement and needs to affect a company's taxes since a company's taxes are based on income.
What does it mean if free cash flow is growing but working capital is negative each year and becoming more negative?
This might mean the company's current operating liabilities could be growing. Since the change in working capital is subtracted to get free cash flow, increasing operating liabilities would increase free cash flow and decrease working capital
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. 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. 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?
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. Second and third questions are straightforward
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?
Z and W < X. Put into Excel.
