Accounting Flashcards
What is a Deferred Tax Asset (DTA)?
Asset on a company’s balance sheet that that occurs when a business overpays its taxes or pays its taxes in advance. The funds will eventually be returned to the firm in the form of tax relief)
What is a Net Operating Loss? How do they affect the 3 statements?
What is PIK Interest?
Interest that accrues on the ending debt balance (Principal). Allows interest expense to accrue rather than be paid in cash for the current year.
Non-Cash Expense that results in an increase to the debt balance on the Balance Sheet
Why do you use 20% of tax rate in accounting assumptions?
~20% is the federal corporate tax rate. State tax rates for corporations are ~5% but I’m assuming 20% for simplicity
What is a Deferred Tax Liability?
Liability on a company’s balance sheet that records taxes that are owed but not due to be paid until a future date.
If this number increases, No affect to I/S b/c total amount of taxes doesn’t change; needs to be added back in CFO
Deferred Taxes Save us on cash in current period at the expense of additional cash taxes in the future
Difference between capitalizing and expensing a purchase?
Capital (Finance) Lease v Operating Lease
Capital Lease represents a financed purchase where the lease term spans most of the asset’s useful life
Operating Lease represents a rental agreement in that the asset is used for a set time with a useful life remaining
What is the difference between Net Income and FCF?
FCF excludes non-cash expenses of the income statement and includes spending on equipment and assets (capex) as well as changes in working capital from the balance sheet
Why would a borrower prefer PIK Interest?
To help the borrower conserve cash since interest payments are pushed back to a later date.
Criteria for items to appear on Income Statement
1) Correspond 100% to Period Shown
2) Affect the business income available to common shareholders (Net Income)
Accounts Receivable
Goods/Services delivered but cash not received
Prepaid Expenses
Advanced payments of expenses not yet incurred
Inventory
Spending on parts and materials that have not yet been delivered to customers
Accrued Expenses and Accounts Payable
Recognition of an expense that has not yet been paid in cash
Accrued Expenses - companies tend to use for items that are regular and recurring and lack specific invoices (utilities, rent, employees wages, insurance premiums)
Deferred Revenue
Cash collection for sales that cannot yet be recognized as revenue
Equity on B/S
Funding source that will NOT result in future cash costs
Capital Expenditures
Show up for long-term items (useful life >1yr) and as a result do not correspond to the current year (not included on Income Statement)
CapEx changes show up on CFI in CFS
After the initial cash outflow, NI decreases in future years because of Depreciation but the cash balance will increase due to tax savings from that depreciation
Raising Equity Dilutes current shareholders. This means…
1) Shareholders receive less in cash proceeds if the firm decides to pay shareholders
2) If the company sells itself, they’ll also receive less cash from the sale
Dividends
Not on I/S (do not reduce income available available to common equity holders). Lower cash balance and retained earning in SE
Stock Repurchases
Mechanically very similar to dividends - reduce cash and Common Stock + APIC balance
Preferred Stock
Similar to issuing debt
Issuances and payments only show up on CFS and not I/S
Preferred Dividends
Show up on I/S but don’t reduce NI. They reduce NI to common shareholders
Operating Lease
Financing Leases
Has an “ownership transfer option” to purchase the asset as a “bargain price”. Gives the company the potential benefits and risks of ownership
When are Deferred Taxes created?
Created when there is a timing difference between Book Taxes and Cash Taxes
1) Companies may use accelerated depreciation
2) Some expenses may not be deductible for tax purposes
3) The company may get tax credits from certain activities such as R&D
What does Deferred Taxes represent?
The difference between the company’s Book Taxes (the number on the Income Statement) and its Cash Taxes (what the company pays to the government)
When is a DTL created?
When the Book Taxes exceed the Cash Taxes
Means company will have to pay higher Cash Taxes in the future
Example is Accelerated Depreciation –> Pay less in taxes now, pay more in the future
Compare Accelerated Depreciation to Straight-Line Depreciation
Deferred Tax balance decreases as you pay additional taxes in the future
When is a DTA created?
DTA represent potential future tax savings
Example: Net Operating Loss (if company has lost money in previous years it can reduce its Cash Taxes in the future by applying these losses to reduce its Taxable Income
NOL (balance) can be applied in the future to reduce Cash Taxes for positive taxable income (by reducing taxable income)
DTA decreases when company uses NOLs
Deferred Taxes
Links DTAs and DTLs (only one line item on the CFS)
Net DTL = DTL - DTA
*DTA increase is a negative balance on the CFS and reduces CF. B/c not really saving on the taxes from a cash-tax POV.
Write-Downs or Impairment Charges (NCE)
When you write down an asset, a DTA is created because even though book income taxes fall (write-downs decrease Pre-Tax Income reducing taxes paid), cash income taxes stay the same. Taxes did not truly decrease in cash terms, only book terms
*Write-downs are not cash deductible
so… the decrease in taxes paid on the book income taxes needs to be recorded as Deferred Income Taxes to represent the lack of cash tax savings from this change
Net DTA reduces cash on the CFS and increases asset (DTA) on the B/S
Stock Based Compensation (NCE)
Reduces pre-tax income and is added back on CFS like other NCEs
Not deductible for cash tax purposes when first issued to employees. Only becomes deductible later on. The initial “tax savings” when issued isn’t real so the “tax savings” it generated needs to get added as a DTA
Initial issuance does not affect the cash balance and it increases the company’s share count
Goodwill
Remainder of the “gap” between purchase price and targets SE. Anything that cannot be linked to a concrete item.
Impaired over time
Other Intangible Assets
Corresponds to identifiable assets such as contracts, patents, trademarks, customer relationships, and brand value
Usually calculated as a % of the of the purchase premium. The remainder goes into Goodwill.
Amortized over time (similar to depreciation for physical assets)
Goodwill and Other Intangibles on Balance Sheet
Amoritization and Goodwill Impairment are not deductible for cash-tax purposes
They both reduce pre-tax income and net income but neither is deductible for cash tax purposes. So, this creates a DTA, negative balance in CFS for deferred taxes.
US GAAP v IFRS
Main difference comes down to the CFS
- IFRS often uses the Direct Method starting with CFO (show actual cash outflows and inflows)
- US GAAP uses the Indirect Method - starting with NI
Location of items also vary from one to the other
What does the Balance Sheet show?
Shows the company’s resources (assets) and how it paid for those resources (liabilities).
How is an asset defined?
Something that will result in a future benefit
How is a liability or equity line item defined?
Something that will result in a future obligation
Liabilities - involve external parties (debt)
Equity - related to internal obligations
Common Stock
Par Value * # of shares
Additional PIC
Market Value - Par Value
*This item doesn’t change even if the company’s share price changes. It only reflects the share price at the time of stock issuance
Accumulated Other Comprehensive Income
Miscellaneous saved-up income - items like foreign currency exchange rate
3 - Step Process to Project Financial Statements
1) Simplify and Consolidate
2) Project line items like Revenue, COGS, OpEx, CapEx, and AR
3) Link the Financial Statements
How to project financial statements
1) Always start with the Income Statement - Project Revenue, Expenses, and Taxes
2) Project Operational Balance Sheet Items - Inventory, AR, AP, Accrued Liab
3) Start w CFS (NI) and adjust for non-cash items
4) Project CFI and CFF based on revenue growth (capex) and funding needs (equity and debt)
5) Sum up all sections of CFS (and FX Rate Effects)
Free Cash Flow
Cash flow after the company pays for what it needs to run its business and avoid being shut down
FCF = CFO - CapEx
*Lets us quickly and easily assess a company’s ability to generate cash flow from its business, including the cost of servicing its debt and other long-term funding
FCF Interpretation
Generally, you want to see positive and growing FCF
If FCF is negative, that means that a company is not running a stable business and needs outside financing to stay afloat
If FCF is positive - need to determine why before interpreting whether it is a good thing or not
ex: FCF positive wouldn’t be good if it was because of cost cutting or reducing CapEx
Working Capital
Current Operating Assets - Current Operating Liabilities (excludes cash, debt, financial investments)
A component of FCF
What a company earns from core business activities and side-activities after expenses, taxes, and the cost of long term funding
Change in Working Capital
Change in Working Capital = Old Working Capital - New Working Capital
Negative - reduces CF, reduces the company’s valuation
Positive - increases CF, increases the company’s valuation
Tell us whether “Cash Flow” is likely to be greater than or less than the company’s Net Income, and how much of a difference there may be
In most cases it is always positive if revenue grows, otherwise, there is no pattern
Changes in working capital as a % of revenue tell you how significant it is for the company’s “Cash Flow”
Normally you project the change in working capital based on a percentage of the change in revenue
Interpreting Working Capital
Can’t tell if good or bad if working capital is negative each year. Need to understand why it is negative or positive each year
Ex: High deferred revenue balances (for subscription services) could be turning working capital negative
If change in WC / Revenue is a very low percentage, this tells us that it is not important to the company
What does the change in working capital mean?
The change in working capital tells us if the company really needs to spend in advance of its growth or if it generates more cash flow as a result of its growth
It is also a component of FCF and gives us an indication of how much “cash flow” will differ from Net Income and in what direction
What does it mean if the company’s FCF if growing, but its change in working capital is more and more negative each year?
Net Income or non-cash charges are growing by more than its change in WC is declining.
Or CapEx is becoming less negative by more than the change in WC is declining
Think of FCF formula = CFO - Capex and components
What does ROIC tell you?
How efficiently a company is using its capital from all sources (both external and internal to generate operating profits
ROE and ROA vs ROIC advantages and disadvantages
ROE and ROA
(+) Net Income is actual metric
(-) Impacted by capital structure
ROIC
(+) Capital Structure Neutral
(-) NOPAT is a hypothetical metric
How can a company artificially boost ROE? How can an investor check to determine if they’ve done so?
Artificially boost ROE by issuing debt instead of equity. Only has a minor impact on numerator through interest expenses in NI. Denominator would be unchanged
To check to see if a company is doing this, investors can check the Debt / EBITDA and EBITA / Interest Expense ratios (Leverage Ratio and Debt Coverage Ratio)
What does it tell you about a company if its receivable days outstanding are much less than its payable days outstanding?
Days it takes them to receive cash towards AR is much shorter than the time the pay their creditors in AP.
This type of firm would be expected to have high market power to collect cash from customers quickly and delay supplier payments for a long time
What is a Cash Conversion Cycle? What does it mean
Cash Conversion Cycle (CCC) = Days Sales Outstanding + Days Receivable Outstanding - Days Payable Outstanding
CCC tells you how much time it takes for a company to convert its inventory and short term assets into cash
*Lower is better
