Accounting

Question 1

Why do we need the three financial statements in the first place? Why can’t we just track a company’s revenue and expenses?

Conceptual Questions

Answer 1

a. Because customers may not always pay the company upfront in cash.
b. Because the company may not always pay its suppliers and vendors upfront in cash.
c. Because the company may spend cash on or receive cash from activities that do NOT appear on the Income Statement.
Explanation: Everything above is correct: We need the three financial
statements to track the company’s cash flow and to determine how its
Cash, Debt, and Working Capital change over time. The first answer
choice corresponds to Accounts Receivable, the second one corresponds
to Accrued Expenses and Accounts Payable, and the third choice
corresponds to activities such as CapEx and Equity/Debt Issuances and
Repayments.

Question 2

Which of the following conditions must be true for a revenue or expense line item to appear on the Income Statement?

Conceptual Questions

Answer 2

It must correspond 100% to the period shown, and it must affect the business
income available to common shareholders.
Explanation: The first answer choice is correct because these conditions
apply to everything on the Income Statement, from Revenue down to
Preferred Dividends (which reduce Net Income to Common, satisfying the
second part about affecting the business income available to common
shareholders). The second answer is false because Preferred Dividends
appear on the Income Statement but are not tax-deductible. The third
answer is false because items like Gains and Losses show up on the
Income Statement, but they are not related to core operations. The
fourth answer is false because non-cash revenue (i.e., from Accounts
Receivable increasing) and non-cash expenses (i.e., from Accrued
Expenses increasing) also appear on the Income Statement.

Question 3

What is the best way to distinguish Assets from Liabilities?

Conceptual Questions

Answer 3

Assets provide some future benefit, while Liabilities represent future
obligations.
Explanation: The third answer choice is correct because it’s the least
specific definition. The first answer is wrong because not all Assets result
in a direct cash inflow in the future – for example, Goodwill does not, and
Cash on the Assets side represents the company’s accumulated Cash
total, not its future cash inflows. The second answer is wrong because in
addition to Liabilities, the company’s Equity line items also act as funding
sources, and many companies generate cash flow without using their
Assets (e.g., a services company with minimal equipment and property).

Question 4

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

Conceptual Questions

Answer 4

a. If it has already appeared on the Income Statement and affected Net Income,
but it is non-cash.
b. If it has not appeared on the Income Statement, but it does affect the
company’s cash flow and Cash balance
Explanation: The first and second statements are both true, so the third
answer choice is correct. Examples of items in the first category are
Depreciation, Amortization, and Stock-Based Compensation; items in the
second category include CapEx, Dividends, and Equity and Debt
Issuances.

Question 5

A company mentions that it will start to collect cash payments from customers for a monthly subscription service one year in advance of service delivery. How will this practice impact the company’s cash flow?

Conceptual Questions

Answer 5

The company’s cash flow will increase because this practice will boost its
Deferred Revenue.
Explanation: The last answer choice is correct. Collecting cash payments
before a product or service has been delivered corresponds to Deferred
Revenue, and an increase in Deferred Revenue means that a company’s
cash flow also increases. This change has nothing to do with Accounts
Receivable (AR is the opposite situation, where the customers do not
pay upfront) or higher upfront expenses (expenses are still incurred when
the service is delivered), so the other answer choices are wrong.

Question 6

How are Prepaid Expenses and Accrued Expenses different?

Conceptual Questions

Answer 6

Prepaid Expenses have already been paid in cash but have not been incurred as expenses; Accrued Expenses have not yet been paid in cash but have been incurred as expenses
Explanation: The first answer choice is correct for the reasons stated:
Prepaid Expenses are for items the company has paid in cash but not yet
recognized as expenses on the Income Statement, while Accrued
Expenses are for the opposite scenario. The third answer reverses the
cash-flow impact, and the fourth answer is wrong because both these
items tend to be short-term.

Question 7

Deferred Revenue reflects Cash that a company has already collected for a product/service that it hasn’t yet delivered. Why is it a Liability? Isn’t an early receipt of Cash a positive for the company?

Conceptual Questions

Answer 7

a. Because it represents a future obligation to deliver this product or service.
b. Because the company will likely have to spend money to deliver this product or service in the future.
c. Because Liabilities represent future obligations and Assets represent future benefits – with Deferred Revenue, the company has already received the benefit.
Explanation: Everything above is correct. The third answer choice states
it most clearly: Liabilities represent future obligations, even if they’ve
provided benefits in the past. Once the company collects the Cash, it now
has to deliver the product or service, which costs time and money and
will also result in future taxes. Therefore, Deferred Revenue is a Liability.

Question 8

Which of the following is NOT an advantage of using Debt rather than Equity to fund a business?

Conceptual Questions

Answer 8

With Debt, there are no “required payments” to the investors
Explanation: The third answer is correct, i.e., this is NOT an advantage of
using Debt because Debt has required interest payments. Debt tends to
be cheaper than Equity because interest rates on Debt are lower than the
expected annualized returns on stocks, and interest on Debt is also taxdeductible. “Issuing Equity” means the company gives up some
ownership to new investors, but with Debt, it does not do so. Instead, it
has to pay interest on the Debt each year, which corresponds to the
“required payments” in the third answer choice. Debt can provide tax
benefits because interest paid on Debt is tax-deductible, while the
Common Dividends paid to Equity Investors are not.

Question 9

What is the main DIFFERENCE between Debt and Preferred Stock?

Conceptual Questions

Answer 9

The Interest Expense on Debt is tax-deductible, but Preferred Dividends are
not, so the Interest Expense reduces Net Income, and Preferred Dividends
reduce Net Income to Common.
Explanation: The third answer choice is correct. Interest Expense appears
as a deduction between Operating Income and Pre-Tax Income, reducing
Pre-Tax Income, Taxes, Net Income, and Net Income to Common. But
Preferred Dividends are not tax-deductible, so they appear below Net
Income and are deducted to calculate Net Income to Common. The first
answer is false because Preferred Dividends do not reduce Net Income,
the second answer is false because Preferred Dividends do not reduce
Preferred Stock on the Balance Sheet, and the last answer is false
because Interest Expense reduces both Net Income and Net Income to
Common since it appears above both lines.

Question 10

Which of the following statements describes the main DIFFERENCE between the U.S. GAAP and IFRS treatments of Operating Leases on the financial statements?

Conceptual Questions

Answer 10

Under IFRS, the Rental Expense is split into Interest and Depreciation elements, but under U.S. GAAP, it is recorded as a simple cash operating expense.
Explanation: The second answer choice is correct because it states the
main difference between the two accounting systems. Under both
systems, Operating Lease Assets and Liabilities go on the Balance Sheet,
so the first answer is wrong. The third answer is wrong because over a
large portfolio of leases with a mix of start and end dates, (Interest +
Depreciation) tends to be similar to the Rental Expense under U.S. GAAP,
even if it’s not the same. This statement may be true for an individual
lease, but not for an entire portfolio.

Question 11

A company that has earned negative Pre-Tax Income for the past 5 years turns itself around and starts earning positive Pre-Tax Income. How do its financial statements change in Year 6?

Conceptual Questions

Answer 11

The company’s Income Statement stays the same, but it records a positive
entry for Deferred Taxes on the Cash Flow Statement, which flows into the
Deferred Tax Asset on the Balance Sheet, reducing it.
Explanation: The second answer choice is correct. When a company
accumulates NOLs, the Deferred Tax Asset increases by approximately
Operating Losses * Tax Rate. Then, when the company applies the NOLs,
its Income Statement stays the same, but its Cash Taxes fall, so it records
a positive entry for Deferred Taxes on its Cash Flow Statement, and its
DTA decreases. The first answer is wrong because NOLs are not directly
applied on the Income Statement, the third answer is wrong because the
DTA decreases, and the fourth answer is wrong because NOLs do not
affect the DTL.

Question 12

Why are Losses on Asset Sales considered non-cash expenses that companies add back on the Cash Flow Statement?

Conceptual Questions

Answer 12

a. Because as long as the company has sold something in the current period, then it has not lost money in the current period.
b. Because a “Loss” just means that the company has sold the Asset for less than the Asset’s book value, which is based on activities in prior periods.
c. Because non-cash adjustments are based on what happens in the current
period only.
Explanation: Everything above is true. If a company sells an Asset for $80
after purchasing it for $100 in a prior period, it hasn’t lost money in the
current period; it has just lost money compared with the previous price
or book value. Adjustments for non-cash expenses such as depreciation
are always based on the company’s cash flow in the current period, not
the current period vs. previous periods

Question 13

Why does an initial issuance of Stock-Based Compensation not affect a company’s Cash balance?

Conceptual Questions

Answer 13

Because Stock-Based Compensation is a non-cash expense that is also not Cash-Tax Deductible when initially granted.
Explanation: The first answer choice is correct. SBC reduces Pre-Tax Income and Net Income, but it’s added back on the CFS, and the tax savings are reversed with a negative adjustment in the Deferred Taxes line on the CFS because SBC is not Cash-Tax Deductible when initially granted. The second answer is incomplete, the third answer is false because SBC does affect the company’s taxes eventually, and the fourth answer is wrong because SBC does appear on the Income Statement.

Question 14

Why is Goodwill almost always created in M&A deals?

Conceptual Questions

Answer 14

Goodwill is created if the acquirer pays a premium to the target’s Common
Shareholders’ Equity in an M&A deal; without it, the Combined Balance Sheet
won’t balance because the target’s CSE is written down.
Explanation: The second answer choice is the correct one. Goodwill is
created because the target’s Common Shareholders’ Equity is written
down in an M&A deal, so if the acquirer pays a premium to the target’s
CSE, the Balance Sheet will go out of balance. Goodwill fixes this issue. It
has nothing to do with the acquirer combining or not combining all the
target’s Assets and Liabilities, nor does it have anything to do with the
revaluation of the target’s Assets and Liabilities. Those may both
contribute to the amount of Goodwill created, but the second answer
choice explains the core reasons.

Question 15

You are analyzing an airline based in the U.S. and comparing it to peer companies in the U.K. and Germany. How are the financial statements of these companies MOST likely to be different?

Conceptual Questions

Answer 15

a. The companies in the U.K. and Germany most likely begin their Cash Flow
Statements with something other than Net Income.
b. The companies in the U.K. and Germany may place items on the Cash Flow
Statement in more “random” locations.
c. The companies in the U.K. and Germany split the Operating Lease Expense into Interest and Depreciation elements, while the airline in the U.S. records a simple Rental Expense for it.
Explanation: Everything above is correct. These three answer choices
represent the major, practical differences between U.S. GAAP and IFRS
on the financial statements: fairly similar Income Statements and Balance
Sheets, but more variable Cash Flow Statements and more complicated
accounting for Operating Leases under IFRS.

Question 16

Which of the following steps is NOT part of the process when you link the financial statements?

Conceptual Questions

Answer 16

Link non-cash adjustments and investing and financing items on the CFS to
their corresponding Balance Sheet line items, adding when you’re on the
Assets side and subtracting when you’re on the Liabilities & Equity side.
Explanation: The last answer choice is correct, i.e., it is NOT a step in this
process of linking the statements. The problem is that you subtract
items from the CFS when you’re on the Assets side of the Balance Sheet,
and you add items from the CFS when you’re on the L&E side. Think
about an Equity or Debt issuance on the CFS: you add both of those on
the L&E side because both increase the company’s available funding.
All the other answers above are correct steps in this process of linking the
statements.

Question 17

What’s the point of projecting a company’s financial statements?

Conceptual Questions

Answer 17

a. You can determine how much additional Debt a company can raise (and pay off) by calculating metrics such as Debt / EBITDA and EBITDA / Interest over time.
b. If you calculate metrics such as the IRR and Money-on-Money multiple, the
projections can indicate whether or not an investment in the company might
yield the returns you are targeting.
c. The projections can help you estimate a company’s future Free Cash Flow, which you can then use in a DCF analysis and elsewhere in a valuation.
Explanation: Everything above is correct: You project a company’s
financial statements to assess potential Debt or Equity investments in the
company and to value the company on a standalone basis. There are
other reasons to create projections, but these are some of the most
common ones.

Question 18

A company’s Depreciation increases by $20. How does its Cash balance change?

Single-Step Changes

Answer 18

Cash is up by $5.
Explanation: On the Income Statement, Pre-Tax Income decreases by
$20, and at a 25% tax rate, Net Income goes down by $15. On the CFS,
Net Income is down by $15 at the top, but you add back the $20 of
depreciation, so Cash at the bottom is up by $5. On the Balance Sheet,
Cash is up by $5 on the Assets side, PP&E is down by $20 due to the
depreciation, and so the Assets side is down by $15 total. On the other
side, Common Shareholders’ Equity is down by $15 because Net Income
was down by $15. Both sides are down by $15 and balance.
Intuition: Tax savings. Depreciation is a non-cash expense that reduces
the company’s taxes; that savings boosts the company’s Cash balance.

Question 19

Walmart decides to flex its muscles and make several key suppliers wait 60 days for cash payments after the suppliers have already delivered their products/services to Walmart.How does Walmart’s Cash balance change if it offers $400 in credit to the vendors and says that it will pay them in 60 days? Walk through only the INITIAL expense accrual.

Single-Step Changes

Answer 19

Cash is up by $100.
Explanation: This scenario corresponds to Accrued Expenses or Accounts
Payable increasing by $400. Operating Expenses or COGS on the IS
increases by $400, so Pre-Tax Income is down by $400, and Net Income is
down by $300 at a 25% tax rate. On the CFS, Net Income is down by
$300, but you add the $400 increase in AP/AE because the company
hasn’t paid these expenses yet. Cash at the bottom is up by $100. On the
BS, Cash is up by $100, so the Assets side is up by $100. On the L&E side,
AP/AE is up by $400, and Common Shareholders’ Equity is down by $300
because of the reduced Net Income, so the L&E side is up by $100, and
both sides balance.
Intuition: The expense here acts like a “non-cash charge” at this time
because it reduces the company’s taxes but doesn’t cost the company
anything in cash. Cash is up because of the tax reduction.

Question 20

Walmart must now pay its vendors $400 after making them wait for two months. How does its Cash balance change after it makes this owed payment to its suppliers? Combine this step with the previous one and explain how the company’s Cash balance changes from beginning to end.

Single-Step Changes

Answer 20

Cash is down by $300.
Explanation: There are no changes on the Income Statement compared
with the previous step, so Net Income is still down by $300. On the CFS,
Net Income is still down by $300, but now the Increase in AP/AE reverses,
so there’s no cash-flow impact from that item. As a result, Cash at the
bottom is down by $300. On the BS, Cash is down by $300 on the Assets
side, so the Assets side is down by $300. On the L&E side, AP/AE returns
to its original level, and CSE is still down by $300 from the previous step,
so both sides are down by $300 and balance.
Intuition: From beginning to end, it’s as if the company incurred a simple
$400 expense on its Income Statement, paid for it in cash, and received
the $100 of tax savings from it. As a result, Cash is down by $300 rather
than $400.

Question 21

General Motors orders $10,000 of Inventory and pays for it with Cash. It has not yet turned the Inventory into finished automobiles, sold them, or delivered them to customers. How does its Net Income change?

Single-Step Changes

Answer 21

Net Income does not change.
Explanation: When a company initially orders Inventory, nothing on the
Income Statement changes because the company recognizes expenses
only when the associated product/service has been sold and delivered to
the customer. So, in this step, the company’s Cash decreases, and its
Inventory increases (and those changes will be reflected on the Cash Flow
Statement), but nothing else happens.
Intuition: This step is a simple cash outflow for an expense that has not
yet been incurred.

Question 22

Now, General Motors takes its $10,000 of Inventory, turns it into a car, and sells and delivers the car for a selling price $20,000. How does its Cash balance change, factoring in BOTH the previous step (ordering Inventory) and this one?

Single-Step Changes

Answer 22

Cash is up by $7,500.
Explanation: On the Income Statement, Revenue is up by $20,000, COGS
is up by $10,000, and so Pre-Tax Income is up by $10,000, with Net
Income up by $7,500 at a 25% tax rate. On the CFS, Net Income is up by
$7,500, you reverse the Inventory Increase so that there’s no longer any
cash-flow impact from it, and so Cash at the bottom is up by $7,500. On
the Balance Sheet, Cash is up by $7,500, and Inventory goes back to its
original level, so Total Assets are up by $7,500. On the L&E side, CSE is up
by $7,500 due to the increased Net Income, so both sides are up by
$7,500 and balance.
Intuition: From beginning to end, this is a simple Pre-Tax Income increase
of $10,000, which results in $7,500 in additional Cash. The Inventory
increase and decrease represented a simple timing difference that went
away by the end.

Question 23

A customer orders a product for $100, receives it, but has not yet paid for it in cash. How does the company’s Cash balance change after just this one order?

Single-Step Changes

Answer 23

Cash is down by $25
Explanation: On the Income Statement, the company records additional
Revenue of $100 with no associated expenses, so Pre-Tax Income is up by
$100, and Net Income is up by $75 at a 25% tax rate. On the CFS, Net
Income is up by $75, but the company subtracts the $100 increase in
Accounts Receivable because the company has not yet received the cash
payment for this product. As a result, Cash is down by $25 at the bottom.
On the BS, Cash is down by $25, AR is up by $100, and the Assets side is
up by $75. The L&E side is also up by $75 because Common Shareholders’
Equity reflects the $75 increase in Net Income, so both sides balance.
Intuition: The company has to pay taxes on revenue it hasn’t yet received
in cash, so its Cash balance falls by the $25 in owed taxes.

Question 24

How does the company’s Cash balance change when it finally collects the $100 from this customer? Combine this step with the previous one and walk through the 2-step process from beginning to end.

Single-Step Changes

Answer 24

Cash is up by $75.
Explanation: On the Income Statement, Net Income is still up by $75
from the previous step. On the Cash Flow Statement, Net Income is still
up by $75, but now the company reverses the Increase in AR, so there are
no other changes on the CFS, and Cash is up by $75 at the bottom. On the
Balance Sheet, Cash is up by $75, AR returns to its original level, and 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: From start to finish, this is a simple $100 addition to Pre-Tax
Income, which results in $75 of Net Income at a 25% tax rate. So, Cash
increases by that same $75 at the end of the process

Question 25

You sign up for a monthly subscription on an e-learning site. To get a better deal, you pay $240 for an entire year’s subscription in advance. How does the company’s Cash balance change immediately after you sign up?

Single-Step Changes

Answer 25

Cash is up by $240.
Explanation: This scenario corresponds to an increase in Deferred
Revenue. On the Income Statement, nothing changes because no
products/services have been delivered yet. On the CFS, the increase in
Deferred Revenue boosts the company’s cash flow by $240, so Cash at
the bottom is up by $240. On the Balance Sheet, Cash is up by $240 on
the Assets side, and Deferred Revenue is up by $240 on the L&E side, so
both sides balance.
Intuition: This is a simple cash inflow for services the company has not
yet delivered. There is no tax effect because no products/services have
been delivered, so nothing changes on the Income Statement.

Question 26

Continuing with the previous scenario, assume that one month has now passed. The company has delivered one month of service to you and incurred $4 in Operating Expenses to do it.How does the company’s Cash balance change over ONLY this one month? Ignore the increase in Cash from the previous step.

Single-Step Changes

Answer 26

Cash is down by $8.
Explanation: Since an entire year of service costs $240, the company
records $240 / 12, or $20, in Revenue each month. In the first month,
Revenue is up by $20, and Operating Expenses are up by $4, so Pre-Tax
Income is up by $16, and Net Income is up by $12 at a 25% tax rate. On
the CFS, Net Income is up by $12, but Deferred Revenue has decreased
by $20, which reduces cash flow, so Cash at the bottom is down by $8.
On the Balance Sheet, Cash is down by $8, so the Assets side is down by
$8. On the other side, Deferred Revenue is down by $20, but CSE is up by
$12 due to the increased Net Income, so the L&E side is also down by $8,
and both sides balance.
Intuition: Cash decreases because the company now has to pay taxes on
non-cash revenue: It collected the Cash in a prior period, and now it
has to pay taxes on the Revenue minus the Operating Expenses in just
this one month

Question 27

A company decides to issue Common Stock to fund its operations. What happens on the financial statements immediately after it issues $100 of Common Stock?

Single-Step Changes

Answer 27

No changes on the Income Statement; Cash and Common Shareholders’ Equity are both up by $100 on the Balance Sheet.
Explanation: The first answer choice is correct. When a company issues
Common Stock, it is reflected as a cash inflow within Cash Flow from
Financing on the CFS. Cash at the bottom of the CFS goes up, and on the
Balance Sheet, Cash on the Assets side is up, and Common Shareholders’
Equity on the L&E side is up. Net Income does not change after
Common Stock is issued, and the Balance Sheet does change, so the
second, third, and fourth answers are wrong.
Intuition: A Common Stock issuance represents a longer-term item that
doesn’t correspond 100% to the period shown on the statements, so it
does not show up on the Income Statement and does not affect taxes.

Question 28

A company realizes that it has too much Cash. Management has no ideas, so they want to repurchase Common Shares or issue Common Dividends. How do these changes affect the financial statements differently?

Single-Step Changes

Answer 28

Both reduce Cash and Common Shareholders’ Equity, but Share Repurchases
also reduce a company’s share count and increase its EPS.
Explanation: The second answer choice is correct. Mechanically,
Dividends and Share Repurchases are nearly the same – both show up in
Cash Flow from Financing and reduce a company’s Cash and CSE. One
difference is that Dividends reduce a company’s Retained Earnings, while
Share Repurchases reduce its Treasury Stock, but this point is
unimportant in financial models. Another difference is that Dividends do
not change a company’s share count, but Share Repurchases reduce the
share count, boosting the EPS. The other answer choices misstate these
effects, so they are incorrect.
Intuition: No real intuition; these statements are the basic definitions of
Share Repurchases and Dividends

Question 29

Under IFRS, a company signs a 10-year Operating Lease worth $200. The annual cash rental expense is a fixed $30, and the Discount Rate is 6%. Walk through the full process of signing the lease and recording the first year’s expenses and explain how the TOTAL ASSETS of the company change.

Single-Step Changes

Answer 29

Total Assets are up by $158.
Explanation: The Interest element equals $200 * 6% = $12, and the
Depreciation element equals $200 / 10 = $20. The Lease Principal
Repayment = $30 – $12 = $18. On the Income Statement, Pre-Tax Income
is down by $32, so Net Income is down by $24 at a 25% tax rate.
On the CFS, Net Income is down by $24, the company adds back the $20
of Lease Depreciation, and it subtracts $18 for the Lease Principal
Repayment, so Cash is down by $22. The additions to Operating Lease
Assets and Liabilities cancel each other out.
On the BS, Cash is down by $22, and Operating Lease Assets are up by
$200 – $20 = $180, so Total Assets are up by $158. On the L&E side,
Operating Lease Liabilities are up by $200 – $18 = $182, and CSE is down
by $24 due to the reduced Net Income, so both sides are up by $158 and
balance.
Intuition: Cash is down by $22 rather than $24 because the $20 of
Depreciation is non-cash, and the Lease Principal Repayment is lower
than the Depreciation by $2. And Total Assets increase by the $180 of
increased Operating Lease Assets minus this Cash decrease of $22

Question 30

A company has recorded negative Pre-Tax Income in previous years, and it now has a $200 balance of Net Operating Losses. There are no other components of the company’s Deferred Tax Asset besides these NOLs. The company now records Pre-Tax Income of positive $100. How does this company’s Deferred Tax Asset (DTA) change?

Single-Step Changes

Answer 30

The DTA decreases from $50 to $25.
Explanation: Initially, the company’s DTA is Tax Rate * Net Operating
Losses = 25% * $100 = $50, so you can immediately rule out answer
choices 2 and 4.
The company records Pre-Tax Income of $100 and Net Income of $75. On
the Cash Flow Statement, its Net Income is up by $75. Since the company
had $200 in NOLs, it can apply them to reduce some of its Cash Taxes.
After applying the NOLs, its taxable income is MAX(0, 100 – 200) = 0, so it
pays $0 in Cash Taxes. Therefore, the company makes a positive
adjustment of $25 for the Deferred Income Tax line on the CFS. Cash at
the bottom is up by $100.
On the Balance Sheet, Cash is up by $100, and the DTA is down by $25
because the company has used half its NOL balance to reduce its taxes,
meaning that its DTA also falls by 50% (so, it goes from $50 to $25). Total
Assets are up by $75. On the L&E side, Common Shareholders’ Equity is
up by $75 due to the increased Net Income, so both sides are up by $75
and balance.
Intuition: The DTA starts at $200 * 25% = $50, and the company uses half
its NOL balance to reduce its Cash Taxes, so the DTA falls by 50%, to $25

Question 31

A company purchases a $100 Asset. It plans to depreciate the Asset on a straight-line basis over 5 years for book purposes. For tax purposes, it will use accelerated depreciation, with 40% of the Asset depreciated in Year 1, 30% in Year 2, and 10% each in Years 3, 4, and 5. How does the company’s Cash balance change over Year 1? IGNORE the initial cash outflow to purchase this $100 Asset.

Single-Step Changes

Answer 31

Up by $10.
Explanation: For book purposes, the company records $20 in
depreciation each year. For tax purposes, it records $40 in Depreciation
in Year 1, $30 in Year 2, and $10 in Years 3, 4, and 5. On the Year 1
Income Statement, Pre-Tax Income is down by $20, and Net Income is
down by $15 at a 25% tax rate.
On the Cash Flow Statement, Net Income is down by $15, but since the
company used $40 in depreciation for tax purposes, its Cash Taxes have
fallen by $40 * 25% = $10 rather than the $25 * 20% = $5 decrease on the
Book Income Statement. So, the company records an adjustment of
positive $5 in Deferred Taxes. The company also adds back the $20 of
depreciation, so Cash at the bottom is up by $10.
On the Balance Sheet, Cash is up by $10, 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 Common Shareholders’ Equity is down by $15, so
the L&E side is down by $10, and both sides balance.
Intuition: Normally, Cash increases by $5 because of the $5 tax savings
from $20 in depreciation. But for tax purposes, the depreciation is $40
rather than $20, so the tax savings is $10 rather than $5, and so Cash
increases by $10

Question 32

A large dragon appears and damages a company’s factory with its fire. The company is forced to sell the factory for $60, even though the factory is listed at $100 on its Balance Sheet. What happens to the company’s Cash balance immediately after this sale?

Single-Step Changes

Answer 32

Cash is up by $70.
Explanation: This change corresponds to a Realized Loss of $40. On the
Income Statement, Pre-Tax Income is down by $40, and Net Income is
down by $30 at a 25% tax rate. On the CFS, Net Income is down by $30,
the company adds back the $40 Loss, and then it records the $60 in total
proceeds in Cash Flow from Investing. Cash at the bottom is up by $70.
On the Balance Sheet, Cash is up by $70, and Net PP&E is down by $100,
so Total Assets are down by $30. On the L&E side, Common Shareholders’
Equity is down by $30 due to the reduced Net Income, so both sides are
down by $30 and balance.
Intuition: The company benefits from the tax savings on this Loss.
Normally, it would receive $60 in Cash when it sells a factory for $60, but
in this case, it receives $10 in extra Cash because it deducts the $40
Loss and reduces its taxes by $40 * 25% = $10 in the process.

Question 33

A company records $400 in Stock-Based Compensation on its Income Statement. How does the company’s Cash balance change?

Single-Step Changes

Answer 33

It does not change.
Explanation: The company’s Pre-Tax Income falls by $400, so Net Income
falls by $300 at a 25% tax rate. On the CFS, Net Income is down by $300,
but this SBC was non-cash, so the company adds back $400.
But the SBC was not deductible for Cash-Tax purposes, so the company
did not truly reduce its taxes; it records a negative $100 in Deferred Taxes
to reflect that. Cash at the bottom stays the same. On the Balance Sheet,
Cash stays the same, and the company’s DTA increases by $100, so the
Assets side is up by $100. On the L&E side, CSE is lower by $300 because
of the reduced Net Income, but CSE also increases by $400 because of
the SBC, so both sides are up by $100 and balance.

Question 34

A company orders $100 of Inventory “on credit,” and it does not sell or deliver the products associated with this Inventory. How does its Cash balance change?

Multi-Step Changes

Answer 34

Cash does not change.
Explanation: There’s no delivery, so nothing changes on the Income
Statement. On the Cash Flow Statement, Inventory and Accounts Payable
are both up by $100, offsetting each other, so Cash at the bottom is
unchanged. On the Balance Sheet, Inventory up by $100 on the Assets
side, and Accounts Payable is up by $100 on the L&E side, so both sides
are up by $100 and balance.
Intuition: Cash does not change because the company purchased the
Inventory on credit, meaning that its Accounts Payable increased, and the
company will have to pay the supplier in cash in the future.

Question 35

Next, the company sells this Inventory and delivers it to customers, recording $200 in Revenue in the process. The customers do not pay upfront in cash, so the company cannot pay its suppliers yet. How does Cash change if you combine this step with the previous one and walk through both together?

Multi-Step Changes

Answer 35

Cash is down by $25.
Explanation: On the Income Statement, Revenue is up by $200, and
COGS are up by $100, so Pre-Tax Income is up by $100, and Net Income is
up by $75 at a 25% tax rate. On the Cash Flow Statement, Net Income is
up by $75, and the increase in Inventory reverses because it was just
sold. However, the $100 increase in Accounts Payable is still there
because the suppliers haven’t been paid yet. And now there’s a $200
increase in Accounts Receivable, so Cash at the bottom changes by +$75
+ $100 – $200 = ($25).
On the Balance Sheet, Cash is down by $25, Inventory returns to its
previous level, and Accounts Receivable increases by $200, so Total
Assets are up by $175. On the other side, Accounts Payable is still up by
$100, and CSE is up by $75 from the increased Net Income, so both sides
are up by $175 and balance.
Intuition: The company earns $100 in additional Pre-Tax Income that it
must pay $25 in taxes on – but it hasn’t collected the cash payments from
customers yet. Therefore, the Cash balance decreases by $25 to reflect
these tax payments and the lack of cash receipts from customers.

Question 36

In the final step of this process, the company finally collects the $200 in owed cash payments from customers and then pays its suppliers the $100 it owes them. How does Cash change from beginning to end of this entire process (Steps 1 – 3)?

Multi-Step Changes

Answer 36

Cash is up by $75.
Explanation: The easiest way to answer this question is to note that as a
result of receiving $200 in Cash and then paying $100 to suppliers, the
company’s Cash balance increases by just $100 in this step. So, it flips
from being down by $25 in the previous step to being up by $75.
Or, you could think of the entire process from beginning to end as a $100
increase in Pre-Tax Income, resulting in $75 in additional Net Income,
which flows straight into Cash once all the timing differences are
resolved. Therefore, Cash is up by $75.
For a more traditional walkthrough, the Income Statement is the same as
in the previous step: Net Income is up by $75. On the CFS, Net Income is
up by $75, the increase in AR reverses, and the increase in AP reverses, so
Cash is up by $75 at the bottom.
On the Balance Sheet, Cash is up by $75 on the Assets side, and AR
returns to its original level, so Total Assets are up by $75. On the L&E
side, AP returns to its original level, and CSE is up by $75 from the
increased Net Income, so both sides are up by $75 and balance.
Intuition: See the first parts of the explanation above.

Question 37

A company purchases a factory for $200 using Debt. It pays 4% Interest on the Debt, and it depreciates 10% of the factory’s initial purchase price each year. It also repays 20% of the initial Debt balance each year.How does the company’s Cash balance change over Year 1? Assume that the company has already accounted for the factory purchase and Debt issuance and walk through only the changes associated with the Interest Expense, Depreciation, and Debt Repayment.

Multi-Step Changes

Answer 37

Cash is down by $41.
Explanation: The company records 4% * $200 = $8 of Interest Expense on
its Income Statement, along with 10% * $200 = $20 for Depreciation. Its
Pre-Tax Income falls by $28, so its Net Income decreases by $21 at a 25%
tax rate.
On the CFS, its Net Income is down by $21, but it adds back the $20 of
depreciation since it is non-cash. The company repays 20% * $200 = $40
of Debt, so Cash at the bottom is down by $41. On the BS, Cash is down
by $41, and Net PP&E is down by $20, so the Assets side is down by $61.
On the L&E side, Common Shareholders’ Equity is down by $21 because
of the reduced Net Income, and Debt is down by $40 because of the
principal repayment, so both sides are down by $61 and balance.
Intuition: Cash declines by slightly more than $40 because of the Interest
and Depreciation; the depreciation reduces the company’s taxes by $5,
boosting its Cash balance, but the Interest Expense reduces Net Income
by $6, so Cash is down by $41.

Question 38

Another year passes. The company pays 4% Interest on the beginning Debt balance of $160 in this year, and it depreciates 10% of the factory’s initial $200 purchase price. It also repays 20% of the initial Debt balance of $200.
The factory comes online this year, and the company sells and delivers products worth $100, with Operating Expenses of $34. How does the company’s Cash balance change over Year 2? Walk through ONLY this step and ignore the previous one.

Multi-Step Changes

Answer 38

Cash is up by $10.
Explanation: On the Income Statement, Revenue is up by $100, and
Operating Expenses are up by $34, so we’re up by $66 so far. Then, the
company records $20 of depreciation and 4% * $160 = $6 of Interest
Expense, so Pre-Tax Income is up by $40, and Net Income is up by $30 at
a 25% tax rate.
On the Balance Sheet, Net Income is up by $30, the company adds back
the $20 of depreciation, and it repays $40 of Debt Principal, so Cash at
the bottom is up by $10. On the Balance Sheet, Cash is up by $10, Net
PP&E is down by $20, and Total Assets are down by $10. On the other
side, Debt is down by $40 due to the Principal Repayment, and Common
Shareholders’ Equity is up by $30 due to the increased Net Income, so
both sides are down by $10 and balance.
Intuition: The company’s Net Income is up by $30 from this process, and
it adds back $20 in depreciation, but its Cash balance is only up by $10
because of the $40 in Debt Principal Repayment.

Question 39

At the end of Year 2, the company decides that it no longer wants this factory. It issues $120 in Common Stock to repay the remaining Debt balance of $120, and it sells the factory for $200 (vs. a Book Value of $160).
What happens to its Cash balance immediately after these changes? Walk through ONLY this step of the process and ignore the previous ones.

Multi-Step Changes

Answer 39

Cash is up by $190.
Explanation: The company records a Gain of $40 on its Income
Statement, boosting its Pre-Tax Income by $40 and its Net Income by $30
at a 25% tax rate. On the Cash Flow Statement, Net Income is up by $30,
and the company subtracts the $40 Gain. Then, it adds the full $200 of
PP&E Sale Proceeds in Cash Flow from Investing. In Cash Flow from
Financing, the $120 Equity Issuance and $120 Debt Repayment offset
each other. So, Cash is up by $30 – $40 + $200 = $190.
On the Balance Sheet, Cash is up by $190, and Net PP&E is down by $160,
so the Assets side is up by $30. On the other side, Debt is down by $120,
and Common Shareholders’ Equity is up by $150 from the $30 of
increased Net Income and the $120 Common Stock Issuance. Both sides
are up by $30 and balance.
Intuition: The company sells the factory for $200, but it must pay taxes
on the portion that corresponds to the Gain: $40. Since $40 * 25% = $10,
the company receives only $190 in Cash proceeds rather than the full
$200.

Question 40

A dividend-paying company issues 100 Common Shares at a share price of $10.00 each to fund a new overseas expansion. Its Dividend Yield is 6%. In Year 1, right after this issuance, the company earns $100 in additional Revenue from this expansion, while paying $40 in additional Operating Expenses.
What happens to this company’s Cash balance over Year 1? Include both the initial Common Stock issuance and everything that follows.

Multi-Step Changes

Answer 40

Cash is up by $985.
Explanation: A Dividend Yield of 6% means that investors earn $0.06 in
Dividends for each $1.00 invested in the company. So, if the company’s
share price is $10.00, each share yields a Dividend of $0.60. 100 common
shares, therefore, results in a total Dividend of $60.
On the Income Statement, the company’s Pre-Tax Income increases by
($100 – $40), or $60, and its Net Income increases by $45 at a 25% tax
rate. On the CFS, Net Income is up by $45, the Common Stock Issuance
boosts cash flow by $1,000, and the Dividends reduce cash flow by $60,
so Cash is up by $985 at the bottom.
On the Balance Sheet, Cash is up by $985, so the Assets side is up by
$985. On the other side, Common Shareholders’ Equity increases by $45
from the Net Income, $1,000 from the Common Stock, and decreases by
$60 from the Dividends, so it is up by $985. Both sides are up by $985
and balance.
Intuition: The company’s After-Tax Yield on this expansion is $45 / $1,000
= 4.5%, but it’s paying a Dividend Yield of 6.0% to fund it. So, the
company’s Cash balance still increases because of the Common Stock
Issuance, but it is up by only $985 rather than $1,000 because the
company loses (6.0% – 4.5%) * $1,000 = $15 on the expansion, with the
cost of funding factored in.

Question 41

Your company decides to acquire another company for an Equity Purchase Price of $100, using 100% Debt. The other company has $60 in Assets, no Liabilities, and $60 in Common Shareholders’ Equity.
If 25% of the Purchase Premium is allocated to Other Intangible Assets, how much in Goodwill is created?

Multi-Step Changes

Answer 41

$30.
Explanation: The Purchase Premium equals the Equity Purchase Price
minus the Target’s Common Shareholders’ Equity, so it’s $100 – $60 =
$40. Other Intangible Assets = 25% * $40 = $10, so Goodwill = $40 – $10 =
$30.
Intuition: The Acquirer pays a $40 premium for the Target and allocates
25% of it, or $10, to Other Intangibles, with the remaining $30 going to
Goodwill.

Question 42

Multi-Step ChangesA year passes. The acquired company contributes $40 in Revenue and $20 in Operating Expenses. The Other Intangible Assets have a useful life of 5 years, and the company pays a 6% interest rate on its Debt.
Walk through the financial statements in just this step and explain how the
company’s Cash balance changes after recording the additional Revenue, Operating Expenses, Amortization, and Interest Expense. IGNORE the Book vs. Cash Tax impact of the Amortization.

Multi-Step Changes

Answer 42

Cash is up by $11.
Explanation: Revenue is up by $40 on the Income Statement, Operating
Expenses are up by $20, the Amortization is up by $10 / 5 = $2, and the
Interest Expense is up by $100 * $6 = $6, so Pre-Tax Income is up by $40
– $20 – $2 – $6 = $12. Net Income is up by $9 at a 25% tax rate.
On the CFS, Net Income is up by $9, the company adds back $2 for the
Amortization of Intangibles, and we’re ignoring the Book vs. Cash Tax
impact of Amortization, so there’s no Deferred Tax adjustment. At the
bottom, Cash is up by $11.
On the Balance Sheet, Cash is up by $11, and Other Intangibles are down
by $2 due to the Amortization, so Total Assets are up by $9. On the L&E
side, Common Shareholders’ Equity is up by $9 because of the increased
Net Income, so both sides are up by $9 and balance.
Intuition: Net Income is up by $9 due to this additional Operating Income
from the acquired company (and the financing costs and acquisition
effects), but since the Amortization is a non-cash expense of $2, Cash
increases by $11 rather than $9.

Question 43

A company records Pre-Tax Income of negative $400 for the year. How does its Cash balance change?

Multi-Step Changes

Answer 43

Cash is down by $400.
Explanation: On the Income Statement, the company records taxes
based on Tax Rate * Pre-Tax Income, so Book Taxes = 25% * ($400) =
($100), meaning the company records a tax benefit. Its Net Income is,
therefore, ($300) rather than ($400). On the Cash Flow Statement, Net
Income is down by $300, but in reality, the company did not save
anything in Cash Taxes. Instead, it paid nothing in Cash Taxes this year.
There’s an adjusting entry of negative $100 in Deferred Taxes to reflect
that, and Cash at the bottom is down by $400.
On the Balance Sheet, Cash is down by $400, and the DTA is up by $100,
so the Assets side is down by $300. On the L&E side, Common
Shareholders’ Equity is down by $300 from the reduced Net Income, so
both sides are down by $300 and balance.
Intuition: The company has a $400 Pre-Tax Loss, and this Loss provides
no tax benefits or tax savings in the current period. Instead, the company
simply pays nothing in Cash Taxes, and the losses may be used to offset
positive Pre-Tax Income in the future. So, Cash is down by $400.

Question 44

The next year, the company achieves profitability and earns Pre-Tax Income of positive $600 for the year. How does its Cash balance change? Assume initial off-Balance Sheet Net Operating Losses of $400 and an initial Deferred Tax Asset of $100.

Multi-Step Changes

Answer 44

Cash is up by $550.
Explanation: On the Income Statement, the company records Pre-Tax
Income of $600, Book Taxes of $150, and Net Income of $450. On the
CFS, Net Income at the top is up by $450. However, the company can use
the $400 in NOLs to reduce its taxable income, so it only pays Cash Taxes
on $200 of Taxable Income rather than $600. Therefore, its Cash Taxes
are $200 * 25% = $50 rather than $150.
You record this as a positive $100 in Deferred Taxes on the CFS, so Cash
at the bottom is up by $550. On the Balance Sheet, Cash is up by $550,
and the Deferred Tax Asset is down by $100, so Total Assets are up by
$450. On the L&E side, CSE is up by $450 due to the increased Net
Income, so both sides are up by $450 and balance.
Intuition: Normally, the company’s Cash would increase by $600 * 75% =
$450 from this change, but it reduces its Cash Taxes by $100 because of
the $100 DTA created in the previous step, so Cash is up by $550 instead.

Question 45

Why do we need to calculate Free Cash Flow instead of just using the Net Change in Cash on the Cash Flow Statement when valuing a company?

FCF, Working Capital, and Key Metrics/Ratios

Answer 45

a. Because the company might be raising significant outside funding (from Debt or Equity) or repaying that outside funding, which distorts the Net Change in Cash.
b. Because Free Cash Flow best represents the company’s “discretionary cash flow” after spending what’s required to run its business.
c. Because Cash Flow from Operations minus CapEx is a proxy for how much
recurring cash flow the company generates.
Explanation: Everything above is true: The Cash Flow Statement alone is
deceptive because a company might be raising Equity or Debt, paying off
Debt, repurchasing shares, or buying/selling securities, all of which are
non-core to the business but still affect its cash flow. Free Cash Flow,
defined as Cash Flow from Operations minus CapEx, better represents
the cash flow a company’s business generates after it pays for what it
needs to continue operating.

Question 46

What does it mean if a company’s Free Cash Flow has been negative for the past two years?

FCF, Working Capital, and Key Metrics/Ratios

Answer 46

You have to determine why FCF has been negative before you reach any
conclusions.
Explanation: The second answer choice is correct. Before reaching any
conclusions, you have to see what’s driving this negative FCF: If it’s
something temporary, the company’s long-term value might be higher
even if cash flow declines in the short term. But if the company’s revenue
and operating income have been declining, and nothing else explains this
negative FCF, that’s more of a negative sign.
The third answer is false because if the company has a large enough Cash
balance, it doesn’t necessarily need to raise Equity or Debt to keep
operating. The last answer is false because the company could still be
worth a substantial amount if its FCF turns positive and eventually grows.
Remember that company valuation is based on expected future cash
flows, not historical performance.

Question 47

What does the Change in Working Capital mean?

FCF, Working Capital, and Key Metrics/Ratios

Answer 47

a. It’s a component of Free Cash Flow, and it indicates how much FCF will differ from the company’s Net Income (and in which direction).
b. It gives you an indication of the company’s business model and how much Cash it is collecting or paying upfront vs. how much it is deferring to future periods.
c. By comparing the Change in WC to the Change in Revenue, you can see if a company has to spend extra to grow, or if it generates extra cash flow from its growth.
Explanation: Everything above is true. These are all part of the meaning
of the Change in Working Capital, and they represent different ways to
interpret it.

Question 48

Your friend looks at a company’s financial statements and sees that the company had $100 in Inventory and $50 in Deferred Revenue last year. This year, in its most recent report, the company had $150 in Inventory and $60 in Deferred Revenue.Your friend calculates the company’s Change in Working Capital as ($150 – $60) – ($100 – $50) = $90 – $50 = $40. Is this calculation correct?

FCF, Working Capital, and Key Metrics/Ratios

Answer 48

The arithmetic is correct, but this number is NOT the one shown on the
company’s Cash Flow Statement for the Change in Working Capital.
Explanation: The third answer is the correct choice: On the Cash Flow
Statement and in the Free Cash Flow calculation, you use Old Working
Capital – New Working Capital to calculate the Change in Working
Capital. You do this because the company needs to spend Cash to
increase its Working Capital (imagine that the only item in Working
Capital is Inventory – if Inventory goes up, and nothing else changes, the
company must spend Cash to do so).
The second answer is false because you should not include nonoperational items in this number. The fourth answer is also false because
Working Capital equals Operational Assets minus Operational Liabilities.
The first answer is correct arithmetically, but it’s not the best answer
because it doesn’t explain that the Change in WC is calculated the
opposite way on the Cash Flow Statement.

Question 49

A company’s Free Cash Flow is growing each year, but its Change in Working Capital is increasingly negative. What could that mean?

FCF, Working Capital, and Key Metrics/Ratios

Answer 49

a. Its Net Income might be increasing by more than its Change in Working Capital is decreasing.
b. Its non-cash adjustments might be increasing by more than its Change in
Working Capital is decreasing.
c. Its Capital Expenditures might be decreasing by more than its Change in Working Capital is decreasing.
Explanation: Any of the statements above might explain this trend. Free
Cash Flow equals Net Income + Non-Cash Adjustments +/- Change in
Working Capital – CapEx. Therefore, increased Net Income, increased
Non-Cash Adjustments, or reduced CapEx could all boost FCF, even if the
Change in WC becomes more negative.

Question 50

A technology company has negative Net Income, with losses of over $100 million each year historically. However, its historical Free Cash Flow is positive, in the range of $25 –$50 million per year.Which of the following is the MOST LIKELY explanation?

FCF, Working Capital, and Key Metrics/Ratios

Answer 50

The company has a huge, positive adjustment for Stock-Based Compensation in its Cash Flow from Operations.
Explanation: The first answer is the best choice here because most, if not
all, technology companies use Stock-Based Compensation to incentivize
employees. This SBC is a positive non-cash adjustment on the CFS, and it
can make FCF positive even if Net Income is negative. The second answer
choice is possible but less likely because the Change in Working Capital is
usually not that significant for tech companies. The third answer is wrong
because Proceeds from PP&E Sales are not part of Free Cash Flow, and
the fourth answer is wrong because FCF has been in a similar range each
year; it’s not as if it was lower, but then it turned higher after the
company began reducing its CapEx spending.

Question 51

A company’s Return on Invested Capital (ROIC) is steadily increasing, its Debt / EBITDA is also increasing, and its EBITDA / Interest Expense is staying about the same. What is the most reasonable quick analysis of this company?

FCF, Working Capital, and Key Metrics/Ratios

Answer 51

The company’s core business is growing, it is increasingly using Debt to fund its growth, and the interest rates on that Debt may be falling.
Explanation: ROIC = NOPAT / Average Invested Capital, so if ROIC is
increasing, then NOPAT must be rising by a higher percentage than
Average Invested Capital, which indicates that the core business is
growing. That eliminates the first answer choice. If Debt / EBITDA is
rising, the company is probably not using an even mix of Debt and Equity
to fund its growth – it’s probably using a higher percentage of Debt,
which eliminates the second answer.
Therefore, the third answer is the best choice because the other two do
not seem reasonable. If Debt / EBITDA is rising, then the company’s Debt
is increasing by a higher percentage than its EBITDA. But if EBITDA /
Interest Expense is staying about the same, then both EBITDA and the
Interest Expense are rising at about the same rate. The simplest
explanation is that the company is paying lower interest rates on its rising
Debt balance.

Question 52

Company A has Days Sales Outstanding (DSO) of 10, Days Inventory Outstanding (DIO) of 30, and Days Payable Outstanding (DPO) of 30. Company B has DSO of 40, DIO of 20, and DPO of 50. How are these companies different?

FCF, Working Capital, and Key Metrics/Ratios

Answer 52

While both companies convert short-term Assets into cash flows in about the
same time frame, Company B takes much longer to collect cash from
customers and pay suppliers, but cycles through Inventory more quickly.
Explanation: The second answer choice is the best one. The Cash
Conversion Cycle = DSO + DIO – DPO, so it is 10 days for both companies,
meaning that the time frame to convert Inventory and AR into Cash is
similar for both. However, Company B’s DSO and DPO are both much
higher, so it takes more time to collect cash from customers and to pay
its suppliers. Just because the CCC is the same doesn’t mean the
companies are the same, so the first answer is wrong. The third answer is
wrong because Company A isn’t necessarily “much more efficient,” and
we know nothing about the revenue growth rates, margins, or cash flows,
so it’s hard to say anything valuation-wise. The fourth answer isn’t the
best choice because it’s possible to make a few simple inferences without
knowing each company’s industry.