Accounting

Question 1

What are the three financial statements, and why do we need them?

Answer 1

The three main financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.
The Income Statement shows the company’s revenue, expenses, and taxes over a period and ends with Net Income, which represents the company’s after-tax profits.
The Balance Sheet shows the company’s Assets (its resources) and Liabilities and Equity (how it paid for those resources) at a specific point in time. Assets must equal Liabilities plus Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities, and then shows the company’s Cash Flow from Investing and Financing activities; the last lines show the net change in cash and the company’s ending cash balance.
You need the financial statements because there’s always a difference between the company’s Net Income and the real cash flow it generates, and the statements let you estimate the cash flow more accurately.

Question 2

How do the financial statements link together?

Answer 2

To link the statements, make Net Income from the Income Statement the top line of the Cash Flow Statement. Then, adjust this Net Income number for non-cash items such as Depreciation & Amortization. Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or reduce the company’s cash flow. This gets you to Cash Flow from Operations. Next, include investing and financing activities, which may increase or reduce cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash at the bottom.
Cash at the bottom of the CFS becomes Cash on the Balance Sheet, and Net Income, Stock Issuances, Stock Repurchases, Stock-Based Compensation, and Dividends link into Common Shareholders’ Equity.
Next, link the separate line items on the CFS to their corresponding Balance Sheet line items; for example, CapEx and Depreciation link into Net PP&E. When you’re on the Assets side of the Balance Sheet, and you’re linking to the Cash Flow Statement, subtract CFS links; add them on the L&E side.
Finally, check that Assets equals Liabilities plus Equity at the end.

Question 3

What’s the most important financial statement?

Answer 3

The Cash Flow Statement is the most important single statement because it tells you how much cash a company is generating, and valuation is based on cash flow.
The Income Statement includes non-cash revenue, expenses, and taxes, and excludes cash spending on major items such as Capital Expenditures, so it does not accurately represent a company’s cash flow.

Question 4

Could you use only two financial statements to construct the third one? If not, why not?

Answer 4

It depends on which two statements you pick. For example, you could use the Income Statement and “Starting” and “Ending” Balance Sheets to construct the Cash Flow Statement, but there may be ambiguity (e.g., you know how Net PP&E changes, but you’re not sure of the CapEx vs. Depreciation split).
Potentially, you could also use the Income Statement and Cash Flow Statement to move from the “Starting” Balance Sheet to the “Ending” one (but also with some ambiguity).
However, it would be nearly impossible to construct the Income Statement starting with just the Balance Sheet and Cash Flow Statement because there aren’t enough direct links.

Question 5

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.?

Answer 5

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.
IFRS-based companies also tend to place items in more “random” locations on the CFS, so you may need to rearrange it.
Finally, the Operating Lease Expense is split into Interest and Depreciation elements under IFRS, but it’s recorded as a simple Rental Expense under U.S. GAAP.

Question 6

What should you do if a company’s Cash Flow Statement starts with something OTHER than Net Income, such as Operating Income or Cash Received?

Answer 6

For modelling and valuation purposes, you should convert this Cash Flow Statement into one that starts with Net Income and makes the standard adjustments.
Large companies should provide reconciliations that show you how to move from Net Income or Operating Income to Cash Flow from Operations and that list the Change in Working Capital and other non-cash adjustments.
If the company does NOT provide that reconciliation, you might have to use the CFS in its original format and use simpler methods to project it.

Question 7

What are reconciliations?

Answer 7

Reconciliation is an accounting process that compares two sets of records to check that figures are correct.

Question 8

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

Answer 8

To appear on the Income Statement, an item must:
1) Correspond 100% to the period shown – Revenue and expenses are based on the delivery of products or services, so an item delivered in Year 1 can count only in Year 1. And if a company buys a factory, it can’t list that purchase on the Income Statement because it will be useful for many years. It corresponds to more than just this period.
2) Affect the business income available to common shareholders (Net Income to Common) – If something does not affect the owners of the business, it should not appear on the Income Statement.
The second point explains why Preferred Dividends appear on the Income Statement: they reduce the after-tax profits that could potentially go to common shareholders.

Question 9

What’s the difference between Assets, Liabilities, and Equity line items on the Balance Sheet?

Answer 9

An Asset is something that will result in a future benefit for the company, such as future cash flow, business growth, or tax savings.
A Liability or Equity line item is something that will result in a future obligation for the company, such as a cash payment or the requirement to deliver a product. Liabilities are usually related to external parties – lenders, suppliers, or the government – while Equity line items are usually related to the company’s internal operations.
Both Liabilities and Equity act as funding sources for the company’s resources (Assets), but Equity line items tend not to result in direct cash outflows in the same way as Liabilities.

Question 10

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

Answer 10

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, so you need to adjust 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 items in Cash Flow from Investing and Financing, such as Capital Expenditures and Dividends.
Changes in Working Capital could fall into either category (e.g., an increase in AR is in category #1, but a decrease in AR is in category #2).

Question 11

A company uses cash accounting (i.e., it only records revenue when it is received in cash and only records expenses when they are paid in cash) rather than accrual accounting. A customer buys a TV from the company “on account” (i.e., without paying upfront in cash) and receives the TV right away. How would the company record this transaction differently from a company that uses accrual accounting?

Answer 11

Under cash accounting, the Revenue would not show up until the company collects the cash from the customer – at which point it would increase Revenue on the Income Statement (and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet.
Under accrual accounting, the sale would show up as Revenue right away, but instead of increasing Cash on the Balance Sheet, it would increase Accounts Receivable at first. Then, once the company collects the cash payment from the customer, Accounts Receivable would decrease, and Cash would increase.

Question 12

A company begins offering 12-month instalment plans to customers so that they can pay for $1,000 products over a year instead of 100% upfront. How will its cash flow change?

Answer 12

In the short term, the company’s cash flow is likely to decrease because some customers will no longer pay 100% upfront. So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on. The long-term impact depends on how much sales grow as a result of this change. If sales grow substantially, that might be enough to offset the longer cash-collection process and increase the company’s overall cash flow.

Question 13

A company decides to prepay its monthly rent by paying for an entire year upfront in cash, as the property owner has offered it a 10% discount for doing so. Will this prepayment boost the company’s cash flow?

Answer 13

In the short term, no, because the company is now paying 12 * Monthly Rent in a single month rather than making one cash 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 record –12 * Monthly Rent under “Change in Prepaid Expenses” to represent the cash outflow. A 10% discount represents just over one month of rent, so the company’s cash flow in Month 1 will decrease substantially. Over an entire year, however, this prepayment will improve the company’s cash flow because there will be no additional cash rental payments after Month 1, and the total amount of rent paid in cash will be 10% less by the end of the year.

Question 14

Your friend is analysing 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?

Answer 14

Yes, your friend is correct. This happens because companies often embed Depreciation within other line items on the Income Statement, such as COGS and Operating Expenses. For example, employees in marketing, research, and customer support might all be using computers, so the Depreciation of computers would be embedded in expense categories like Sales & Marketing, Research & Development, and General & Administrative.

Question 15

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

Answer 15

A company collects cash payments for a monthly service long in advance if it has the market and pricing power to do so. Because of the time value of money, it’s better to collect cash today rather than several months or a year into the future. This practice always boosts a company’s cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue is 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.

Question 16

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

Answer 16

AR is an Asset because it provides a future benefit to the company – the receipt of additional cash from customers in the future. DR is a Liability because it results in future obligations for the company. The company has already collected all the cash associated with the sale, so now it must deliver the product or service, and it must spend something to do that. AR and DR 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.

Question 17

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

Answer 17

Prepaid Expenses have already been paid in cash but have not yet been incurred as expenses, so they have not appeared on the Income Statement. When they finally appear on the Income Statement, they’ll effectively be “non-cash expenses” that reduce the company’s taxes, which makes them an Asset.
By contrast, Accounts Payable have not yet been paid in cash. When the company finally pays them, its Cash balance will decrease, which makes AP a Liability. Accounts Payable and Accrued Expenses work the same way, but Accounts Payable is used for specific items with invoices (e.g., legal bills), while Accrued Expenses is used for monthly, recurring items without invoices (e.g., utilities). Accrued Expenses almost always result in an Income Statement expense before being paid in cash, and Accounts Payable often do as well. However, in some cases, Accounts Payable may correspond to items that have not yet appeared on the Income Statement, such as purchases of Inventory made on credit.

Question 18

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 the CFO correct? And how does Stock-Based Compensation impact the statements?

Answer 18

The CFO is correct on a superficial level, but not in reality. First, the full amount of Stock-Based Compensation is not deductible for Cash-Tax purposes when it is initially granted in most countries, so even if Book Taxes decrease, Cash Taxes may not change at all. The eventual tax deduction will take place much further into the future when employees exercise their options and/or receive their shares. But the other problem with the CFO’s claim is that Stock-Based Compensation creates additional shares, diluting existing investors and, therefore, “costing” the company something. That makes it quite different from non-cash expenses that do not change the company’s capital structure, such as Depreciation and Amortization.

Question 19

A junior accountant in your department asks about the different ways to fund the company’s operations via external sources and how they impact the financial statements. What do you say?

Answer 19

The two main methods of funding a company’s operations with outside money are Debt and Equity. Debt is initially cheaper for most companies, so most companies prefer to use Debt… up to a reasonable level. To do this, the company must be able to service its Debt by paying for the interest expense and
possible principal repayments; if it can’t do that, it must use Equity instead. Both Equity and Debt issuances show up only on the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company’s Cash balance. With Equity, the company’s share count increases immediately after issuance, which means that existing investors get diluted (i.e., they own a smaller 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 repay the full balance.

Question 20

Your company decides to sell equipment for a market value of $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”?

Answer 20

This Loss is a non-cash expense because you haven’t “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” or “spent” $15 in cash because you sold the equipment at a reduced price. The Loss means that you spent more than $85 to buy this equipment in a prior period. But non-cash adjustments are based on what happens in the CURRENT PERIOD.

Question 21

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?

Answer 21

A company might write down an Asset if its value has declined substantially, and its current Book Value (the number on the Balance Sheet) is no longer accurate. 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. Typically, these write-downs are not deductible for Cash-Tax purposes, so you also record a
negative adjustment under Deferred Taxes on the CFS.
Net PP&E decreases, and the Deferred Tax Asset increases. On the L&E side of the Balance Sheet, Common Shareholders’ Equity decreases due to the reduced Net Income.

Question 22

The CFO of your firm recently announced plans to purchase “financial investments” (stocks and bonds). Why would she want to do this, and how will this activity affect the statements?

Answer 22

A company might purchase financial investments if it has excess Cash and cannot think of other
ways to use it. For example, the company can’t hire more employees, buy more equipment or factories, or
acquire other companies, and it also doesn’t want to issue Dividends to investors, repurchase stock, or repay Debt. The initial purchase of these investments will show up only on the Cash Flow Statement (in Cash Flow from Investing) 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.

Question 23

Could a company have negative Common Shareholders’ Equity (CSE) on its Balance Sheet? If no, why not? If yes, what would it mean?

Answer 23

Yes, it could. Just think about the main items that link into CSE: Net Income and Dividends. If a company’s Net Income is repeatedly negative, CSE will eventually turn negative. Negative Common Shareholders’ Equity is almost always a negative sign because it means the company has been unprofitable, repeatedly, or it has issued too much in Dividends or repurchased too many shares. It’s more acceptable for tech and biotech start-ups that lose significant money in their early years, so you will see negative CSE figures there, but eventually, they should turn positive

Question 24

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 – how would you respond?

Answer 24

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 Common Shareholders’ Equity and then combine its Assets and Liabilities with those of the acquirer. If you’ve paid exactly what the seller’s CSE is worth – e.g., you paid $1,000 in cash, and the seller has $1,000 in CSE, then there are no problems. The combined Cash balance decreases by $1,000, and so does the combined CSE. However, in real life, acquirers almost always pay premiums for target companies, which means that the Balance Sheet will go out of balance. For example, if the seller here had $400 in CSE, the Balance Sheet would have gone out of balance immediately because the Assets side would have decreased by $1,000, but the L&E side would have decreased by only $400. 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

Question 25

How do Goodwill and Other Intangible Assets change over time?

Answer 25

Goodwill remains constant unless it is “impaired,” i.e., the acquirer decides that the acquired company is worth less than it initially expected and 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. Neither Goodwill Impairment nor the Amortization of Intangibles is deductible for Cash-Tax purposes, so the company’s Cash balance won’t increase; instead, the Deferred Tax Asset or Deferred Tax Liability will change

Question 26

How do Operating Leases and Finance Leases (Capital Leases) appear on the financial statements? Explain the high-level treatment as well as IFRS vs. U.S. GAAP differences.

Answer 26

Assets and Liabilities associated with leases that last for more than 12 months now appear directly on companies’ Balance Sheets. Operating Lease Assets are sometimes called “Right-of-Use Assets,” and Operating Lease Liabilities initially match them on the other side. The rental expense for Finance Leases, which give companies an element of ownership or a
“bargain purchase option” at the end, is split into Interest and Depreciation elements on the Income Statement. On the Cash Flow Statement, Depreciation is added back, and under Cash Flow from Financing, the company records a negative for the “Repayment of Lease Principal” (or similar name). On the Balance Sheet, both the Lease Assets and Lease Liabilities decrease each year until the lease ends. Under IFRS, Operating Leases and Finance Leases are treated the same way, so the Operating Lease Expense is also split into Interest and Depreciation elements, and the same BS and CFS line items change. For Operating Leases under U.S. GAAP, companies record a simple Lease or Rental Expense on the Income Statement, so there is no Depreciation/Interest split. However, the Lease Assets and Lease Liabilities on the Balance Sheet still decrease each year based on the “Depreciation” and “Lease Principal Repayment” the company estimates.

Question 27

What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities, and how are Net Operating Losses (NOLs) related to both of them?

Answer 27

Both DTAs and DTLs relate to temporary differences between the book basis and the tax basis of assets and liabilities. Deferred Tax Assets represent potential future cash-tax savings for the company, while Deferred Tax Liabilities represent additional cash-tax payments in the future. DTLs often arise because of different Depreciation methods, such as when companies accelerate Depreciation for tax purposes, reducing their tax burden in the near term but increasing it in the future. They may also be created in acquisitions. DTAs may arise when the company loses money (i.e., negative Pre-Tax Income) in the current period and, therefore, accumulates a Net Operating Loss (NOL). They are also created when the company deducts an expense for Book-Tax purposes but cannot deduct it at the same time for Cash-Tax purposes (e.g., Stock-Based Compensation). NOLs are a component of the DTA; the NOL component of the DTA is approximately equal to the Tax Rate * NOL Balance.

Question 28

What are some items that are deductible for Book-Tax but not Cash-Tax purposes, and how do they affect the Deferred Tax line items?

Answer 28

Examples include Stock-Based Compensation (when initially granted), the Amortization of Intangibles, and various Write-Downs and Impairments (for Goodwill, PP&E, etc.). These items reduce a company’s Book Taxes (the number that appears on the Income
Statement), but they do not save the company anything in Cash Taxes. So, the Deferred Tax line item on the CFS will show a negative for these items, reducing the
company’s cash flow, and the DTA will increase. These items become Cash-Tax Deductible only when “Step 2” of the process happens – such as the company selling PP&E that has been written down, or the employees exercising their options and receiving their shares in the company.

Question 29

Suppose that you’re analysing a company, and you want to project its financial statements. Before projecting anything, how would you simplify its statements first?

Answer 29

On the Income Statement, you might split up Revenue and Expense differently or show Depreciation & Amortization as separate line items to make the projections easier. On the Balance Sheet, it’s best to aim for 5-10 items, at most, on each side. Combine “Short-Term” and “Long-Term” versions of items, make a single Net DTA or Net DTL, and list just one line for Common Shareholders’ Equity. Combine all smaller/diverse items. On the Cash Flow Statement, consolidate the smaller/diverse items between Net Income and the Change in Working Capital. You don’t want ~15 lines there; aim for D&A, Deferred Taxes, and maybe 1-2 others. In the CFI and CFF sections, combine smaller items related to purchasing and selling securities and paying fees on capital raised, and focus on the core items: CapEx, Equity and Debt Issuances, Stock Repurchases, Debt Repayments, and Dividends.

Question 30

Walk me through the financial statements when a company’s Operating Expenses increase by $100.

Answer 30

• Income Statement: Operating Expenses are up by $100, so Pre-Tax Income is down by $100, and Net Income is down by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75. There are no other changes, so Cash at the bottom is down by $75.
• Balance Sheet: Cash is down by $75, so the Assets side is down by $75, and CSE on the L&E side is down by $75 due to the reduced Net Income, so both sides balance.
• Intuition: Nothing; it’s a simple cash expense.

Question 31

A company’s Depreciation increases by $20. What happens to the financial statements?

Answer 31

• Income Statement: Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but you add back the $20 in Depreciation since it’s non-cash, so Cash at the bottom is up by $5.
• Balance Sheet: Cash is up by $5, but PP&E is down by $20 due to the Depreciation, so the Assets side is down by $15. The L&E side is also down by $15 because Net Income falls by $15, which reduces CSE, so both sides balance.
• Intuition: This non-cash expense does not “cost” the company anything, but it reduces the company’s taxes

Question 32

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 to the statements?

Answer 32

• Income Statement: You record a Loss of $20 on the Income Statement, which reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, 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 $85.
• Balance Sheet: Cash is up by $85, and PP&E is down by $100, so the Assets side is down by $15. The L&E side is also down by $15 because CSE falls by $15 due to the Net Income decrease, so both sides balance.
• Intuition: The company gets the $80 in Cash proceeds, but it also gets $5 in tax savings from the Loss, so its Cash goes up by $85 rather than $80.

Question 33

A company decides to CHANGE a key employee’s compensation by offering the employee stock options instead of a cash salary. The employee’s cash salary was $100, but she will receive $120 in stock options now. How do the statements change?

Answer 33

Operating Expenses go up by $20, but the company also records $120 in non-cash expenses that are not Cash-Tax Deductible:
• Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $15 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but you add back the $120 in SBC as a non-cash expense. However, this SBC is not truly Cash-Tax deductible, so there’s a Deferred Tax adjustment for ($30), since ($120) * 25% = ($30). The company did not reduce its Cash Taxes with this SBC. Cash at the bottom is up by $75.
• Balance Sheet: Cash is up by $75, and the Net DTA is up by $30 because of the Deferred Tax adjustment, so the Assets side is up by $105. On the L&E side, CSE is down by $15 because of the reduced Net Income, but it’s also up by $120 because of the SBC, so the L&E side is up by $105, and both sides balance.
• Intuition: The company increases its Cash balance by switching the employee to Stock-Based Compensation, but it doesn’t realize any Cash-Tax savings from doing that – so, Cash is up by $75.

Question 34

Walk me through the financial statements when a customer orders a product for $100 but doesn’t pay for it in cash. Then, walk through the cash collection, combining it with the first step.

Answer 34

The first step corresponds to Accounts Receivable increasing by $100, and the second step represents AR decreasing by $100. 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 $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $75, but the increase in AR reduces cash flow by $100, so Cash at the bottom is down by $25.
• Balance Sheet: Cash is down by $25, but AR is up by $100, so the Assets side is up by $75. On the L&E side, CSE is up by $75 due to the increased Net Income, so both sides are up by $75 and balance.
• Intuition: The company has to pay taxes on Revenue it hasn’t yet collected in cash, so its Cash balance falls by $25.
And when the AR is collected, combining it with the first step:
• Income Statement: The Net Income is still up by $75, and there are no other changes.
• Cash Flow Statement: Net Income is still up by $75, but now the AR increase reverses, so the Change in AR is $0. Therefore, Cash at the bottom is up by $75.
• Balance Sheet: Cash is now up by $75, and AR goes back to its original level, so the Assets side is up by $75. The L&E side is still up by $75 because of the CSE increase due to the increased Net Income in the first step, so both sides balance.
• Intuition: This is a simple cash collection of a $100 payment owed to the company. Cash goes from being down by $25 in the first step to being up by $75 to reflect this.

Question 35

A company prepays $20 in utilities one 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 recognized, combined with the first step.

Answer 35

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 Expenses 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, combining it with the first step:
• Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20, and Net Income falls by $15, assuming a 25% tax rate.
• Cash Flow Statement: Net Income is down by $15, but the increase in Prepaid Expenses now reverses, and there are no other changes, so Cash at the bottom is down by $15.
• Balance Sheet: Cash is down by $15, and Prepaid Expenses return to their original level, so the Assets side is down by $15. The L&E side is also down by $15 due to the reduced Net Income that flows into CSE, so both sides balance.
• Intuition: Cash decreases by $15 because this represents the payment and recognition of a simple $20 cash expense, which reduces taxes by $5.

Question 36

Walmart buys $400 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, combining it with the first step.

Answer 36

The first step is a simple Inventory purchase. In the second step, the company has to record COGS and the Revenue associated with the product sales. Here’s the first step:
• Income Statement: No changes.
• Cash Flow Statement: The $400 Inventory increase reduces the company’s cash flow, so Cash at the bottom is down by $400.
• Balance Sheet: Cash is down by $400, but Inventory is up by $400, 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 second step, combining it with the changes in the first one:
• Income Statement: Revenue is up by $600, but COGS is up by $400, so Pre-Tax Income is up by $200, and Net Income is up by $150 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $150, the Inventory increase now reverses because the Inventory has been sold, and there are no other changes, so Cash at the bottom is up by $150.
• Balance Sheet: Cash is up by $150, and Inventory returns to its original level, so the Assets side is up by $150. The L&E side is also up by $150 because Net Income increases by $150 and flows into CSE, so both sides balance.
• Intuition: Cumulatively, this process is a simple $200 increase in Pre-Tax Income, which boosts Net Income by $150 at a 25% tax rate.

Question 37

Amazon decides to pay several key vendors $200 on credit and says it will pay them in cash in one month. What happens on the financial statements when the expense is incurred, and then when it is paid in cash? Combine the second step with the first one.

Answer 37

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 increase by $200, so Pre-Tax Income is down by $200, and Net Income is down by $150, assuming a 25% tax rate.
• Cash Flow Statement: Net Income is down by $150, 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 $50.
• Balance Sheet: Cash is up by $50, so the Assets side is up by $50. On the L&E side, AP is up by $200, but CSE is down by $150 due to the reduced Net Income, so the L&E side is up by $50, and both sides balance.
• Intuition: This expense is “non-cash” at this point because it reduces the company’s taxes but doesn’t cost anything in cash. Cash is up because of the reduced taxes.
And then here’s the second step, combined with the first step:
• Income Statement: Net Income is still down by $150. No other changes.
• Cash Flow Statement: Net Income is still down by $150, but now the AP increase reverses, so the Change in AP becomes $0. As a result, Cash at the bottom is down by $150.
• Balance Sheet: Cash is down by $150, so the Assets side is down by $150. On the other side, AP returns to its original level, and CSE is down by $150 because of the reduced Net Income, so both sides are down by $150 and balance.
• Intuition: From beginning to end, this is a simple $200 cash expense; Cash decreases by $150 rather than $200 due to the tax savings in the first step.

Question 38

Salesforce sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens to the statements?

Answer 38

This scenario corresponds to Deferred Revenue increasing because the company collects the Cash, but cannot yet recognize it as Revenue. The payment for the entire year is $1,200.
• Income Statement: No changes.
• Cash Flow Statement: DR increasing by $1,200 boosts 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 $1,200 cash inflow, with no taxes, for services the company has not yet delivered.

Question 39

Salesforce sells a customer a $100 per month subscription but makes the customer pay all in cash, upfront, for the entire year. What happens after one month has passed, and the company has delivered one month of service for $100? Assume that there are $20 in Operating Expenses associated with the delivery of the service for this one month.

Answer 39

• Income Statement: Revenue is up by $100, but Operating Expenses are up by $20, so Pre-Tax Income is up by $80, and Net Income is up by $60 at a 25% tax rate.
• Cash Flow Statement: Net Income is up by $60, and part of the DR increase now reverses, so the increase in DR is now $1,100 rather than $1,200. Cash at the bottom is up by $1,160.
• Balance Sheet: Cash is up by $1,160, so the Assets side is up by $1,160. On the L&E side, Deferred Revenue is now up by $1,100 instead of $1,200, and CSE is up by $60 due to the increased Net Income, so both sides are up by $1,160 and balance.
• Intuition: Cash is up by less than it was in the previous step because the company must pay expenses and taxes when part of the cash inflow is now recognized as Revenue.

Question 40

A company issues $100 in common stock to new investors to fund its operations. How do the statements change?

Answer 40

• 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 Shareholders’ Equity on the other side goes up by $100, so the L&E side is up by $100, and both sides balance.
• Intuition: This is a simple cash inflow that doesn’t impact the company’s taxes at all.

Question 41

A company issues $100 in common stock to new investors to fund its operations. This same company now realizes that it has too much Cash, so it wants to issue Dividends or repurchase common shares. How do they impact the three statements differently? Compare $100 in Dividends with a $100 Stock Repurchase.

Answer 41

These changes both make a similar impact; the main difference is that Dividends do not reduce the common shares outstanding, but a Stock Repurchase does.
• Income Statement: No changes.
• Cash Flow Statement: Both of these 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 reduce Retained Earnings within CSE by $100, while a Stock Repurchase reduces Treasury Stock within CSE by $100. But in either case, CSE is down by $100, so the L&E side is down by $100, and both sides balance.
• Intuition: These are simple cash outflows that don’t affect the company’s taxes at all. We can’t determine how the common shares outstanding change without information on the share price at which the Stock Repurchase takes place.

Question 42

A company that follows U.S. GAAP signs a 10-year, $1,000 Operating Lease on January 1 and pays a total of $100 in Rent throughout the year. Assume a 6% Discount Rate, and walk me through the financial statements over this entire year in a single step.

Answer 42

Initially, the company records the Operating Lease Assets and Liabilities on its Balance Sheet ($1,000 on both sides), and then it records the Rental Expense on the Income Statement. The 6% Discount Rate means that the initial “Interest Expense” is 6% * $1,000 = $60, so the “Depreciation” equals $100 – $60 = $40. Since the lease payments are constant, the “Lease Principal Repayment” equals the “Depreciation” here:
• Income Statement: Operating Expenses are up by $100 due to the Rent, so Pre-Tax Income falls by $100, and Net Income falls by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75, but Operating Lease Assets and Liabilities increase by $1,000, which offset each other. But then they both decrease by $40, which is also an offset. So, Cash is down by $75 at the bottom.
• Balance Sheet: On the Assets side, Cash is down by $75, and Operating Lease Assets are up by $960, so Total Assets are up by $885. On the L&E side, the Operating Lease Liabilities are up by $960, and CSE is down by $75, so this side is up by $885, and both
sides balance.
• Intuition: Cash is down by $75 because this is a simple $100 cash expense with $25 in tax savings, and the Lease Asset and Lease Liability change by the same amounts.

Question 43

A company that follows IFRS now signs a 10-year, $1,000 Operating Lease with a cash Rental Expense of $100 per year. Assume a 6% Discount Rate and walk me through the statements over the entire year.

Answer 43

Under IFRS, the company records Depreciation of $1,000 / 10 = $100 per year and an initial Interest Expense of $1,000 * 6% = $60.
The Lease Principal Repayment = Cash Rental Expense – Interest Expense = $100 – $60 = $40.
• Income Statement: Depreciation is up by $100, and the Interest Expense is up by $60, so Pre-Tax Income is down by $160, and Net Income falls by $120 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $120, but you add back the $100 of Depreciation and record the $1,000 additions to the Finance Lease Assets and Liabilities (which offset each other). Also, you record a negative $40 for the Lease Principal Repayment. Cash is down by $60 at the bottom.
• Balance Sheet: Cash is down by $60, and the Finance Lease Assets are up by $900 due to the initial $1,000 increase and the $100 of Depreciation, so Total Assets are up by $840. On the other side, the Finance Lease Liabilities are up by $960, and Common Shareholders’ Equity is down by $120, so both sides are up by $840 and balance.
• Intuition: Cash is down by $60 because there’s a total of $200 in new Lease Expenses, but $100 of them are non-cash, and $160 of them reduce the company’s taxes. So, - $200 + $100 + $160 * 25% = - $60.

Question 44

For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records $40 in Depreciation. Walk me through the financial statements.

Answer 44

You don’t need to walk through the Tax Schedule for this type of change because the numbers are simple:
• Income Statement: The $20 in increased Depreciation reduces Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate, so the company saves $5 in taxes.
• Cash Flow Statement: Net Income is down by $15, and you add back the $20 in Depreciation as a non-cash expense. However, the company recorded $40 of Depreciation for Cash-Tax purposes, so it actually reduced its Cash Taxes by $10, not $5. You record this additional $5 as a positive in the Deferred Income Taxes line on the CFS. Cash at the bottom is up by $10.
• Balance Sheet: Cash is up by $10 on the Assets side, and Net PP&E is down by $20, so the Assets side is down by $10. On the L&E side, the Deferred Tax Liability is up by $5, and CSE is down by $15 due to the reduced Net Income, so the L&E side is also down by $10, and both sides balance.
• Intuition: Cash is up by $10 rather than $5 or $0 because the company’s actual Cash-Tax savings equals $40 * 25% = $10.

Question 45

A company has a factory shown at $200 on its Balance Sheet, but a hurricane hits the factory and destroys part of it, so the company records a $100 PP&E Write-Down. Walk me through the statements.

Answer 45

Normally, PP&E Write-Downs are not Cash-Tax deductible, so the “correct” treatment is:
• Income Statement: The $100 PP&E Write-Down reduces Pre-Tax Income by $100, and Net Income falls by $75 at a 25% tax rate.
• Cash Flow Statement: Net Income is down by $75, but you add back the $100 WriteDown as a non-cash expense. In reality, however, the company saved nothing in Cash Taxes, so you also record a negative $25 in Deferred Income Taxes, and Cash at the bottom is unchanged.
• Balance Sheet: Cash does not change, but the Deferred Tax Asset increases by $25, and Net PP&E decreases by $100, so the Assets side is down by $75. The L&E side is also down by $75 because CSE falls due to the reduced Net Income, so both sides balance.
• Intuition: Cash does not change because Write-Downs are typically not Cash-Tax deductible, so the DTA, rather than Cash, increases.

Question 46

What is Free Cash Flow (FCF), and what does it mean if it’s positive and increasing?

Answer 46

There are different types of Free Cash Flow, but one simple definition is Cash Flow from Operations (CFO) minus CapEx. FCF represents a company’s “discretionary cash flow” – how much cash flow it generates from its core business after also paying for the cost of its funding sources, such as interest on Debt. It’s defined this way because most items in CFO are required to run the business, while most of the CFI and CFF sections are optional or non-recurring (except for CapEx). It’s generally a good sign if FCF is positive and increasing, as long as it’s driven by the company’s sales, market share, and margins growing (rather than creative cost-cutting or reduced reinvestment into the business). Positive and growing FCF means the company doesn’t need outside funding sources to stay afloat, and it could spend its cash flow in different ways: hiring more employees, re-investing in the business, acquiring other companies, or returning money to the shareholders with Dividends or Stock Repurchases.

Question 47

What does FCF mean if it’s negative or decreasing?

Answer 47

You have to find out why FCF is negative or decreasing first. For example, if FCF is negative because CapEx in one year was unusually high, but it’s expected to return to normal levels in the future, negative FCF in one year doesn’t mean much. On the other hand, if FCF is negative because the company’s sales and operating income have been declining each year, then the business is in trouble. If FCF decreases to the point where the company runs low on Cash, it will have to raise Equity or Debt funding ASAP and restructure to continue operating. Short periods of negative FCF, such as for early-stage startups, are acceptable, but if a company continues to generate negative cash flow for years or decades, stay away!

Question 48

Why might you have to adjust the calculation for FCF if you’re analysing a company that follows IFRS rather than U.S. GAAP?

Answer 48

The simple definition (Cash Flow from Operations minus CapEx) assumes that Cash Flow from Operations has deductions for the Net Interest Expense, Preferred Dividends (if applicable), Taxes, and all Lease Expenses. That is almost always the case under U.S. GAAP because CFO usually starts with Net Income (to Common), but under IFRS, the presentation of the Cash Flow Statement varies widely. So, if a company starts CFO with Operating Income or Pre-Tax Income instead, you’ll have to make adjustments to ensure that the proper items have been deducted. Also, you should not add back the Depreciation element of the Lease Expense in the non-cash adjustments section of CFO.

Question 49

What is Working Capital?

Answer 49

The official definition of Working Capital is “Current Assets minus Current Liabilities,” but the more useful definition is:
Working Capital = Current Operational Assets – Current Operational Liabilities
“Operational” means that you exclude items such as Cash, Investments, and Debt that are related to the company’s capital structure, not its core business. This version is sometimes called Operating Working Capital instead. You may also include Long-Term Assets and Liabilities that are related to the company’s
business operations (Long-Term Deferred Revenue is a good example). Working Capital tells you whether a company needs more in Operational Assets or Operational Liabilities to run its business, and how big the difference is. But the Change in Working Capital matters far more for valuation purposes.

Question 50

A company has negative Working Capital. Is that “good” or “bad”?

Answer 50

It depends on why the Working Capital is negative because different components mean different things.
For example, if the company has $100 in Accounts Receivable, $100 in Inventory, and $500 in Deferred Revenue, for ($300) in Working Capital, that’s considered positive because the high Deferred Revenue balance means it has collected significant cash before product/service delivery. But if that company has $100 in AR, $100 in Inventory, and $500 in Accounts Payable, that’s considered negative because it means the company owes a lot of cash to its suppliers and other vendors and collects no cash from customers in advance of deliveries.

Question 51

Should Changes in Operating Lease Assets and Liabilities be included in the Change in Working Capital? What difference does it make if they are included or not included?

Answer 51

Different companies set up their statements differently, so some companies list these items within the Change in WC, others list them outside of the Change in WC but within Cash Flow from Operations, and others do not list them on the CFS at all. Under U.S. GAAP, the exact treatment makes almost no difference because the Change in Operating Lease Assets tends to be very close to the Change in Operating Lease Liabilities, so changes to these items usually offset each other. Under IFRS, only increases in Operating Lease Assets and Liabilities could potentially appear within the Change in Working Capital because the Depreciation and Lease Principal Repayment parts are shown separately. Even though the Lease Assets and Liabilities decrease by different amounts each year under IFRS, they should increase by about the same amount. Therefore, the cash flows usually offset each other, and these items’ exact positions do not matter.

Question 52

A company’s Working Capital has increased from $50 to $200. You calculate the Change in Working Capital by taking the new number and subtracting the
old number, so $200 – $50 = positive $150. But on its Cash Flow Statement, the company records the Change in Working Capital as negative $150. Is the company wrong?

Answer 52

No, the company is correct. On the Cash Flow Statement, the Change in Working Capital equals Old Working Capital – New Working Capital. Pretend that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to $200, that will reduce the company’s cash flow because it means the company has spent Cash to purchase Inventory. Therefore, the Change in Inventory should be ($150) on the CFS, and if that’s the only component of Working Capital, the Change in WC should also be ($150). When a company’s Working Capital INCREASES, the company USES cash to do that; when Working Capital DECREASES, it FREES UP cash.

Question 53

What does the Change in Working Capital mean?

Answer 53

The Change in Working Capital tells you if the company needs to spend in ADVANCE of its growth, or if it generates more cash flow as a RESULT of its growth. It’s also a component of Free Cash Flow and gives you an indication of how much “Cash Flow” will differ from Net Income, and in which direction. For example, the Change in Working Capital is often negative for retailers because they must spend money on Inventory before being able to sell products. But the Change in Working Capital is often positive for subscription companies that collect cash from customers far in advance because Deferred Revenue increases when they do that, and increases in Deferred Revenue boost cash flow. The Change in Working Capital increases or decreases Free Cash Flow, which directly affects the
company’s valuation.

Question 54

What does it mean if a company’s FCF is growing, but its Change in Working Capital is more and more negative each year?

Answer 54

It means that the company’s Net Income or non-cash charges are growing by more than its Change in WC is declining, or that its CapEx is becoming less negative by more than the Change in WC is declining. If a company’s Net Income is growing for legitimate reasons, this is a positive sign. But if higher non-cash charges or artificially reduced CapEx are boosting FCF, both are negative.

Question 55

In its filings, a company states that EBITDA is a “proxy” (substitute) for its Cash Flow from Operations. The company’s EBITDA has been positive and growing at 20% for the past three years. However, the company recently ran low on Cash and filed for bankruptcy. How could this
have happened?

Answer 55

Although EBITDA can be a “proxy” for CFO, it is not a perfect representation of a company’s cash flow. Think about all the items that EBITDA excludes, but which affect the company’s Cash balance:
• CapEx – Unnecessarily high CapEx spending might have pushed the company to bankruptcy.
• Acquisitions – Or, maybe the company spent a fortune on companies that turned out to be worthless.
• Interest Expense and Debt Repayment Obligations – A “positive and growing EBITDA” could have hidden a “massively growing Interest Expense.”
• Change in Working Capital – Maybe the company became less efficient in collecting cash from customers, or it had to start paying its suppliers more quickly.
• One-Time Charges – If EBITDA excludes large “one-time” expenses such as legal and restructuring charges, it might paint a far rosier picture than reality.

Question 56

How do you calculate Return on Invested Capital (ROIC), and what does it tell you?

Answer 56

ROIC is defined as NOPAT / Average Invested Capital, where NOPAT (Net Operating Profit After Taxes) = EBIT * (1 – Tax Rate), and Invested Capital = Equity + Debt + Preferred Stock + Other Long-Term Funding Sources.
It tells you how efficiently a company is using its capital from all sources (both external and internal) to generate operating profits. Among similar companies, ones with higher ROIC figures should, in theory, be valued more
highly because all the investor groups earn more for each $1.00 invested into the company.

Question 57

What are the advantages and disadvantages of ROE (return on equity), ROA (returns on assets), and ROIC(return on invested capital) for measuring company performance?

Answer 57

These metrics all measure how efficiently a company is using its Equity, Assets, or Invested Capital to generate profits, but are slightly different.
ROE and ROA are both affected by capital structure (the company’s Cash and Debt and Net Interest Expense) because they use Net Income (to Common) in the numerator. However, they’re also “closer to reality” because Net Income (to Common) is an actual metric that appears on companies’ financial statements and affects the Cash balance. By contrast, since NOPAT is a hypothetical metric that doesn’t appear on the statements, ROIC is further removed from the company’s Cash position, even though it has the advantage of being capital structure-neutral. In terms of ROE vs. ROA, ROA tends to be more useful for companies that depend heavily on their Assets to generate Net Income (e.g., banks and insurance firms), while ROE is more of a general-purpose metric that applies to many industries.

ROA = Net Income/Total assets

Question 58

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 see if this is true?

Answer 58

Companies can artificially boost their ROE by continually issuing Debt rather than Equity because Debt doesn’t affect the denominator, and the Interest Expense from Debt only makes a small impact on the numerator (Net Income). And this small impact is usually outweighed by the additional Operating Income the company generates from the assets it buys with the proceeds from the Debt issuances. To see if this is happening, you could check the company’s Debt / EBITDA and EBITDA / Interest ratios and see how they’ve been trending. If Debt / EBITDA keeps increasing while EBITDA / Interest keeps decreasing, the company may be relying on leverage to boost its ROE.

ROE = Net Income/Shareholder’s equity

Question 59

What does it say about a company if its Days Receivables Outstanding is ~5, but its Days
Payable Outstanding is ~60?

Answer 59

Days Receivables Outstanding measures the number of days it takes a company to collect cash generated from sales. Days payable outstanding measures the average number of days a company takes to pay its suppliers

It tells you that the company has quite a lot of market power to collect cash from customers quickly and to delay supplier payments for a long time. Examples might be companies like Amazon and Walmart that dominate their respective markets and that often make suppliers “offers they can’t refuse.”

Question 60

What is the Cash Conversion Cycle (CCC), and what does it mean if, among a group of similar companies, one company’s CCC is 5, and another’s is 30?

Answer 60

The Cash Conversion Cycle is defined as Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payable Outstanding (DPO), and it tells you how much time it takes a company to convert its Inventory and other short-term Assets, such as Accounts Receivable, into Cash. Lower is better for this metric because it means the company “converts” these items into cash flow more quickly, so a CCC is 5 is better than a CCC of 30. This one also depends heavily on the industry: the CCC is often low (under 10) for large retailers, but it may be over 100 (or more!) in an industry like spirits, where Inventory may sit on the Balance Sheet for months, years, or decades.