ACCOUNTING Flashcards
Walk me through the financial statements when a company’s Operating Expenses increase
by $100.
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.
A company’s Depreciation increases by $20. What happens to the financial statements?
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.
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?
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.
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?
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.
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 ADD ON TO IT. Its not Year 0 Year 1.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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?
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. Combine this step with the previous one.
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.
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.
A company issues $100 in common stock to new investors to fund its operations. How do
the statements change?
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.
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.
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.
What are the three main financial statements, and what does each one show?
The three main financial statements are:
Income Statement – Shows revenues, expenses, and net profit (or loss) over a period.
Balance Sheet – Presents assets, liabilities, and shareholders’ equity at a point in time.
Cash Flow Statement – Details the company’s cash inflows and outflows, categorized into operating, investing, and financing activities.
How are the three main financial statements interconnected?
The three financial statements are closely linked to provide a full picture of a company’s financial health.
Net Income from the Income Statement connects to both the Balance Sheet and the Cash Flow Statement. It flows into the Shareholders’ Equity section on the Balance Sheet under Retained Earnings, and it is the starting point for the Cash Flow Statement.
Changes in Balance Sheet items, such as inventory or accounts receivable, are reflected as adjustments in the operating activities section of the Cash Flow Statement.
Investing and financing activities, such as capital expenditures or issuing debt, affect Balance Sheet items like PP&E, debt balances, and Shareholders’ Equity.
The ending cash balance on the Cash Flow Statement flows back to the Balance Sheet, ensuring that all three statements reconcile.
How does net income flow into the Balance Sheet?
Net income from the Income Statement flows into the retained earnings line under Shareholders’ Equity.
The formula is:
New Retained Earnings = Previous Retained Earnings + Net Income – Dividends Paid
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.
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.
For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records
$40 in Depreciation. Walk me through the financial statements.
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.
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.
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 Write-
Down 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.
A company buys a factory for $200 using $200 of Debt. What happens INITIALLY on the statements?
One year passes. The company pays 10% interest on its Debt, and it depreciates 10% of the
factory. It also repays 5% of the Debt principal. What happens on the statements in this first year?
Income Statement: No changes.
* Cash Flow Statement: There’s no net change in cash because the $200 factory purchase
counts as CapEx, which reduces cash flow, and the $200 Debt issuance is a cash inflow.
* Balance Sheet: PP&E is up by $200, so the Assets side is up by $200, and Debt is up by
$200, so the L&E side is up by $200, and the Balance Sheet stays balanced.
Income Statement: You record $20 in Interest and $20 in Depreciation, so Pre-Tax
Income falls by $40, and Net Income falls by $30 at a 25% tax rate.
* Cash Flow Statement: Net Income is down by $30, but you add back the $20 of
Depreciation and record $10 in Debt Principal Repayments, so Cash at the bottom is
down by $20.
* Balance Sheet: Cash is down by $20, and Net PP&E is down by $20, so the Assets side is
down by $40. On the L&E side, Debt is down by $10 due to the principal repayment, and
CSE is down by $30 due to the reduced Net Income, so both sides are down by $40 and
balance.
At the end of this first year, the company sells its factories for $220 and uses the proceeds
to repay its remaining Debt principal, after realizing there is little demand for its products.
Walk through this step SEPARATELY from the previous two.
Assume that the Net PP&E balance is $180, and the Debt is $190 because of changes in the
previous step.
Income Statement: The Realized Gain of $40 increases Pre-Tax Income by $40 and Net
Income by $30 at a 25% tax rate.
Cash Flow Statement: Net Income is up by $30, but the $40 Gain is non-cash, so it’s
reversed in the CFO section. Then, in Cash Flow from Investing, the full sale proceeds of
$220 are recorded as a cash inflow. In Cash Flow from Financing, the $190 Debt
repayment is shown as a negative. So, Cash at the bottom is up by $20.
Balance Sheet: Cash is up by $20, and Net PP&E is down by $180, so Total Assets are
down by $160. On the L&E side, Debt is down by $190, and CSE is up by $30 because of
the increased Net Income, so both sides are down by $160 and balance.
Walmart orders $200 of Inventory and pays for it using Debt. What happens on the statements immediately after this initial transaction?
A year passes, and Walmart sells the $200 of Inventory for $400. However, it also has to
hire additional employees for $100 to process and deliver the orders (counted as OpEx).
The company also pays 4% interest on its Debt and repays 10% of the principal. What
happens on the statements over this year? Combine this step with the previous one and
explain the changes from beginning to end.
Income Statement: No changes.
Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but
the Debt issuance boosts cash flow by $200, so Cash at the bottom stays the same.
Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E
side is also up by $200 because Debt is up by $200, so both sides balance.
Income Statement: Revenue is up by $400, but COGS is up by $200, and OpEx is up by
$100, so Operating Income is only up by $100. There’s $8 in Interest Expense as well, so
Pre-Tax Income is up by $92. At a 25% tax rate, Net Income is up by $69 (mental math:
$100 * 75% = $75, and $8 * 75% = $6, so take $75 and subtract $6).
* Cash Flow Statement: Net Income is up by $69. But now we reverse the previous
increase in Inventory, so the Change in Inventory is $0 once again. The $200 cash inflow
for Debt still exists, but now there’s also a $20 Debt Principal Repayment so Cash at the
bottom is up by $249.
* Balance Sheet: Cash is up by $249, and Inventory returns to its original level, so the
Assets side is up by $249. On the L&E side, Debt is up by $180, and CSE is up by $69 due
to the increased Net Income, so both sides are up by $249 and balance.
Walk through the same scenario, but assume that Walmart purchases the $200 of
Inventory on credit (i.e., Accounts Payable), sells it for $400, and still records $100 in
additional OpEx. Assume that it pays the suppliers in the second step of this process.
Income Statement: No changes.
* Cash Flow Statement: Accounts Payable increases, increasing cash flow by $200, and
Inventory also increases, reducing cash flow by $200; the changes offset each other, and
Cash at the bottom stays the same.
* Balance Sheet: Inventory on the Assets side is up by $200, and Accounts Payable on the
L&E side is up by $200, so both sides are up by $200 and balance.
Income Statement: Revenue is up by $400, COGS is up by $200, and OpEx is up by $100,
so Pre-Tax Income is up by $100. Net Income is up by $75 at a 25% tax rate.
* Cash Flow Statement: Net Income is up by $75, and the Change in Inventory and
Change in Accounts Payable both reverse now, so Cash at the bottom is up by $75.
* Balance Sheet: Cash is up by $75 on the Assets side, and Inventory 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 due to the increased Net Income, so both sides are up by $75 and
balance.
A company issues $200 in Preferred Stock to buy $200 in Financial Investments. The
Preferred Stock has a coupon rate of 8%, and the Financial Investments yield 10%. What
happens on the statements IMMEDIATELY after the initial purchase?
What happens on the statements after a year? Combine this step with the previous one, so
that you factor in the increases in Financial Investments and Preferred Stock.
Income Statement: No changes.
* Cash Flow Statement: The purchase of the Financial Investments counts as an Investing
Activity and reduces cash flow by $200, but the Preferred Stock issuance boosts cash
flow by $200 within CFF, so there’s no net change in cash.
* Balance Sheet: Financial Investments is up by $200, so the Assets side is up by $200, and
Preferred Stock on the other side is up by $200, so the L&E side is up by $200, and both
sides balance.
Income Statement: The company records 10% * $200 = $20 in Interest Income from the
Financial Investments, so Pre-Tax Income is up by $20, and Net Income is up by $15 at a
25% tax rate. The Preferred Dividends equal 8% * $200 = $16, so Net Income to
Common is down by $1 after subtracting these.
* Cash Flow Statement: Net Income to Common is down by $1, and the Financial
Investment and Preferred Stock increases still appear on the CFS and offset each other,
so Cash at the bottom is down by $1.
* Balance Sheet: Cash is down by $1, and Financial Investments are up by $200, so the
Assets side is up by $199. On the L&E side, Preferred Stock is still up by $200, and CSE is
down by $1 because of the reduced Net Income to Common, so both sides are down by
$199 and balance.
A company wants to boost its EPS artificially, so it decides to issue Debt and use the proceeds to repurchase common shares. Initially, the company has 1,000 shares outstanding at $1.00 per share and a Net Income of $300. What happens IMMEDIATELY after the company raises $200 in Debt and uses it to repurchase $200 in common stock?
What happens after a year passes if the company pays 4% interest on the Debt? Combine
this with the first step and explain the EPS impact.
Repurchasing $200 in stock at a share price of $1.00 per share means that the company
repurchases 200 shares, so its share count drops from 1,000 to 800.
Its EPS before this move was $300 / 1,000, or $0.30. For the first step:
* Income Statement: No changes.
* Cash Flow Statement: The $200 Debt issuance boosts cash flow by $200, but the $200
stock repurchase reduces it by $200, so there’s no net change in cash.
* Balance Sheet: There are no changes on the Asset side. On the L&E side, Debt is up by
$200, but Treasury Stock within CSE is down by $200, so there’s no net change, and the
BS remains in balance.
Income Statement: The company records 4% * $200 = $8 in Interest Expense, so Pre-Tax
Income is down by $8, and Net Income is down by $6 at a 25% tax rate. Net Income is
now $294 rather than $300, and the Share Count decreased from 1,000 to 800 in Step 1.
Therefore, EPS increases because the EPS numerator falls by 2%, but the denominator
falls by 20% (it’s a $0.07 increase, but you can just say, “EPS increases”).
* Cash Flow Statement: Net Income is down by $6, and the Debt Issuance and Stock
Repurchase still offset each other, so Cash at the bottom is down by $6.
* Balance Sheet: Cash is down by $6, so the Assets side is down by $6. On the L&E side,
Debt is still up by $200, CSE is down by $200 due to the Stock Repurchase, and then it
drops by another $6 due to the reduced Net Income, so the L&E side is also down by $6,
and both sides balance.
Your company decides to acquire another company for $500, using 50% Debt and 50%
Common Stock.
The other company has $300 in Assets, no Liabilities, and $300 in Common Shareholders’
Equity. Assume that the purchase premium is distributed 50/50 between Goodwill and Other
Intangible Assets.
What happens to your company’s financial statements immediately after this acquisition
takes place?
Now, walk through what happens on the statements in the one year following this
acquisition. The acquired company contributes $200 in Revenue and $100 in OpEx, and the
Interest Rate on Debt is 8%. Assume that the Other Intangible Assets have a useful life of 5
years.
Income Statement: No changes.
* Cash Flow Statement: You record a negative $500 for “Acquisitions” in Cash Flow from
Investing and a positive $250 for Debt Issuances and positive $250 for Common Stock
Issuances under Cash Flow from Financing. Cash at the bottom is unchanged.
* Balance Sheet: Cash stays the same, but you add the $300 in Acquired Assets, as well as
the $100 in Goodwill and $100 in Other Intangible Assets, so the Assets side is up by $500. On the other side, Debt is up by $250, and CSE is up by $250, so the L&E side is
also up by $500, and both sides balance.
Income Statement: Revenue is up by $200, but OpEx is up by $100, and there’s now
$100 / 5 = $20 of Amortization of Intangibles and $250 * 8% = $20 of Interest Expense.
So, Pre-Tax Income is up by $100 – $20 – $20 = $60. At a 25% tax rate, Net Income is up
by $45.
* Cash Flow Statement: Net Income is up by $45, and we add back the $20 of
Amortization of Intangibles since it was non-cash. However, we also make an
adjustment of ($5 =(100/5)*.25) in Deferred Income Taxes because this Amortization is not Cash-Tax
Deductible. So, Cash at the bottom is up by $45 + $20 – $5 = $60.
* Balance Sheet: Cash is up by $60, Other Intangibles are down by $20 due to the
Amortization, and the Net DTA is up by $5 due to the Deferred Income Tax adjustment,
so the Assets side is up by $45. On the L&E side, CSE is up by $45 due to the increased
Net Income, so both sides are up by $45 and balance.
Deferred Income Tax arises when..
Write Down, Amortization of Intangibles (-)
Deferred Income Asset arises when..
Write Down (Goodwill, PP&E, etc), Amortization of Intangibles (+)
What is Free Cash Flow (FCF), and what does it mean if it’s positive and increasing?
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 re-
investment 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.
What does FCF mean if it’s negative or decreasing?
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!
What is Working Capital?
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
(see below) matters far more for valuation purposes.
A company has negative Working Capital. Is that “good” or “bad”?
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.
What does it mean if a company’s FCF is growing, but its Change in Working Capital is more
and more negative each year?
It means that the company’s Net Income is 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.
How do you calculate Return on Invested Capital (ROIC), and what does it tell you?
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.
What are the advantages and disadvantages of ROE, ROA, and ROIC for measuring
company performance?
These metrics all measure how efficiently a company is using its Equity, Assets, or Invested
Capital to generate profits, but the nuances 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.
Company ABC decided to purchase a factory:
At 5x EBITDA, $20M EBITDA
Using 2.5x leverage
10% interest rate, paid annually
10-years useful life
40% Tax Rate
a. Walk me through the three financial statements after the first year
b. After the second year, the company decided to sell the factory:
$25M EBITDA
● Sold at 6x EBITDA
c. Walk me through the three financial statements after the second year
