Accounting Flashcards
What is working capital?
Current Assets - Current Liabilities
Current liabilities are payments due within a year. Current assets are convertible into cash within a year (A/R, inventory, cash), working capital is used as a measure of company liquidity. Higher the ratio of c. assets to liabilities, the more liquid a business is
What is goodwill?
An asset that captures excess of the purchase price over fair market value of the net assets of an acquired business.
Often, in the preliminary phase of analysing acquisitions, the fair market value is unknown and the target’s book value is used instead.
Do you amortise intangible assets?
Intangibles that have a finite life (customer lists, copyrights, patents) are amortised, while others like trademarks and goodwill are considered to have indefinite lives so are not amortised.
A company acquired a machine for £5m in 2003 and has since generated £3m in accumulated depreciation. The PP&E now has a fair value of $20m. What is the value of the PP&E on the company’s balance sheet?
£2m.
Except for certain liquid financial assets which can be written up to reflect fair market value, companies must carry the value of assets at their historical cost.
How do you calculate EPS?
EPS = net income / weighted average shares outstanding
Can measure as Basic (net income/actual shares) or Diluted (net income/actual shares and shares from potentially dilutive securities such as options, restricted stock, convertible bonds)
What are some examples of non-recurring items?
Legal settlements (gain or loss), restructuring expenses, inventory writedowns, asset impairments
How are the 3 financial statements connected?
The income statement is connected directly to the balance sheet through retained earnings. Specifically, net income flows through retained earnings as an increase each period less dividends issued.
The offsetting balance sheet adjustments to this increase impacts a variety of line items on the balance sheet, including cash, working capital, fixed assets.
The cash flow statement is connected to the income statement through net income as well, which is the staring line of the cash flow statement.
Lastly, the cash flow statement is connected to the balance sheet because the cash impact of changes in balance sheet line items like working capital, PP&E (via capex), debt, equity and treasury stock are all reflected in the cash flow statement. In addition, net change in cash is directly connected to the balance sheet as the change in cash between years.
Is EBITDA a good proxy for cash flow?
No. Even though EBITDA does add back D&A (non-cash) it does not capture any working capital adjustments. It also does not capture cash outflows such as tax or interest. Those adjustments would need to be made to get to operating cash flows. EBITDA also does not capture stock-based compensation expenses required to get to operating cash flows.
How does selling a building for £10m that has a book value of £6m on the balance sheet impact the 3 statements?
Recognise a £4m gain on sale on the income statement which will (ignoring taxes) increase my net income by £4m.
On the CFS, since the £4m gain is non-cash, it will be subtracted out from net income in the cash from operations section. In the investing section, the full cash proceeds of the £10m sale are captured. On the balance sheet, the £6m book value of the building is removed, while retained earnings increases by £4m. The net credit of £10m is offset by a £10m debit to cash that came from the CFS.
Further: However, the gain on sale will also result in higher taxes. Assuming t = 25%, I will pay £1m in tax, which will be recognised on the income statement. This lowers retained earnings by £1m and is offset by a £1m credit to cash.
How does buying a building impact the 3 statements? (non-numerical)
Cash goes down by the purchase price and is reflected in the cash from investing section. On the balance sheet, the offsetting entry to the cash reduction is an increase in PP&E. There is no immediate impact on the income statement.
Over the life of the asset, depreciation expense from the building is recognised on the income statement and reduces net income by the amount of depreciation expense net of tax expense saved due to the depreciation expense. That’s because depreciation is generally tax deductible.
On the CFS, depreciation is added back since it is non-cash. on the BS, PP&E is reduced by the depreciation and is offset by a reduction to retained earnings for the depreciation expense.
Which section of the CFS captures interest expense?
Interest expense is recognised on the income statement and thus gets indirectly captures in the cash from operations section.
Do accounts receivable get captured on the income statement?
No, but changes to accounts receivable are partially recognised in revenue.
The CFS reconciles revenue to cash revenue while the absolute balance of accounts receivable can be observed on the balance sheet.
Do inventories get captured on the income statement?
No, but it is partially recognised in COGS (and potentially other operating expenses.
E.g. COGS is recognised on the income statement, regardless of whether the associated inventory was purchased during the same period. That means that a portion of the COGS line on the income statement will likely reflect a portion of inventory used up.
The CFS shows the year-on-year changes in inventory, while the absolute balance of beginning and end-of-period inventory can be observed on the balance sheet.
How should increases in inventory be handled on the CFS?
Increases in inventory, as well as any other working capital assets, reflect a usage of cash and should thus be reflected as an outflow on the cash from operations section of the cash flow statement.
Why are increases in accounts receivable a cash reduction on the CFS?
Since cash flow statements start with net income, and net income captures all of a company’s revenue - not just cash revenue - an increase in accounts receivable suggests more customers paid with credit during the period and so an adjustment down needs to be made to net income when arriving at cash since the company never actually received those funds - they’re still sitting on the balance sheet as receivables.
