Accounting

Question 1

Walk me through the three financial statements.

Answer 1

The 3 major financial statements are the Income Statement, Balance Sheet and Cash Flow Statement.

The Income Statement gives the company’s revenue and expenses, and goes down to Net Income, the final line on the statement.

The Balance Sheet shows the company’s Assets – its resources – such as Cash, Inventory and PP&E, as well as its Liabilities – such as Debt and Accounts Payable – and
Shareholders’ Equity. Assets must equal Liabilities plus Shareholders’ Equity.

The Cash Flow Statement begins with Net Income, adjusts for non‐cash expenses and
working capital changes, and then lists cash flow from investing and financing activities;
at the end, you see the company’s net change in cash.

Question 2

Walk me through the income statement.

Answer 2

The income statement shows a company’s profitability over a specified period of time by taking its revenue and subtracting out various expenses to arrive at net income.

*Revenue
*Less: Cost of Goods Sold (COGS)
Gross Profit
*Less: Sales, General, & Administrative (SG&A)
*Less: Research & Development (R&D)
*Earnings Before Interest and Taxes (EBIT)
*Less: Interest Expense
*Earnings Before Taxes (EBT)
Less: Income Tax
*Net Income

Question 3

Walk me through the balance sheet.

Answer 3

The balance sheet shows a company’s financial position – the carrying value of its assets, liabilities, and equity – at a specific point in time.

Since a company’s assets have to have been funded somehow, assets must always equal the sum of liabilities and shareholders’ equity.

• Current Assets: Highly liquid assets that can be converted into cash within a year, including cash and cash equivalents, marketable securities, accounts receivable, inventories, and prepaid expenses
• Non-Current Assets: Illiquid assets that would take over a year to be converted into cash, namely plant, property, & equipment (PP&E), intangible assets, and goodwill.
• Current Liabilities: Liabilities that become due in a year or less, including accounts payable, accrued expenses, and short-term debt
• Non-Current Liabilities: Liabilities that won’t become due for over a year, such as deferred revenue, deferred taxes, long-term debt, and lease obligations.
• Shareholders’ Equity: The capital invested into the business by owners, consisting of common stock, additional paid-in capital (APIC), and preferred stock, as well as treasury stock, retained earnings, and other comprehensive income (OCI)

Question 4

Walk me through the cash flow statement.

Answer 4

The cash flow statement summarizes a company’s cash inflows and outflows over a period of time. The CFS starts with net income, and then accounts for cash flows from operations, investing, and financing to arrive at the net change in cash.

• Cash Flow from Operating Activities: From net income, non-cash expenses are added back such as D&A and stock-based compensation, and then changes in net working capital
• Cash Flow from Investing Activities: Captures long-term investments made by the company, primarily capital expenditures (CapEx) as well as any acquisitions or divestitures
• Cash Flow from Financing Activities: Includes the cash impact of raising capital from issuing debt or equity net of any cash used for the repurchase of shares or the repayment of debt. Dividends paid to shareholders will also be recorded as an outflow in this section.

Question 5

How do the 3 statements link together?

Answer 5

To tie the statements together, Net Income from the Income Statement flows into Shareholders’ Equity on the Balance Sheet, and into the top line of the Cash Flow
Statement.

Changes to Balance Sheet items appear as working capital changes on the Cash Flow
Statement, and investing and financing activities affect Balance Sheet items such as
PP&E, Debt and Shareholders’ Equity. The Cash and Shareholders’ Equity items on the
Balance Sheet act as “plugs,” with Cash flowing in from the final line on the Cash Flow
Statement.

Question 6

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

Answer 6

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

Question 7

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

Answer 7

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

Question 8

What are some of the most common margins used to measure profitability?

Answer 8

• Gross Margin: The percentage of revenue remaining after subtracting the company’s direct costs (COGS)
  o Gross Margin = (Revenue – COGS) / (Revenue)
• Operating Margin: The percentage of revenue remaining after subtracting operating expenses such as SG&A from gross profit
  o Operating Margin = (Gross Profit – OpEx) / (Revenue)
• EBITDA Margin: The most commonly used margin is due to its usefulness in comparing companies with different capital structures (i.e. interest) and tax jurisdictions
  o EBITDA Margin = (EBIT + D&A) / (Revenue)
• Net Profit Margin: The percentage of revenue remaining after accounting for all of the company’s expenses. Unlike other margins, taxes and capital structure have an impact on the net profit margin
  o Net Margin = (EBT – Taxes) / (Revenue)