Accounting Basics

Question 1

Walk me through the 3 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 (property, plant, and equipment), 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

Can you give examples of major line items on each of the financial statements?

Answer 2

Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative Expenses); Operating Income; Pretax Income; Net Income.

Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.

Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation; Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.

Question 3

How do the 3 statements link together?

Answer 3

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.
https://www.youtube.com/watch?v=Mcj5ES2HDqY
https://corporatefinanceinstitute.com/resources/knowledge/accounting/3-financial-statements-linked/
https://igotanoffer.com/blogs/finance/investment-banking-interview-technical-questions#7

We’ll see if there’s a simplified answer

Question 4

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 4

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 analyzing the overall financial health of any business – its cash flow.

Question 5

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

Answer 5

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 6

Walk me through how Depreciation going up by $10 would affect the statements.

Answer 6

Income Statement: Operating Income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $6 ($10 x 40% tax rate = $6).
Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4.
Balance Sheet: Plants, Property & Equipment (PP&E) goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement.
Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Shareholders’ Equity side is down by $6 and both sides of the Balance Sheet balance.
Note: With this type of question I always recommend going in the order:
1. Income Statement
2. Cash Flow Statement
3. Balance Sheet
This is so you can check yourself at the end and make sure the Balance Sheet balances.
Remember that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash Flow.
https://www.youtube.com/watch?v=o1d-FhCRp68&t=21s

Question 7

If Depreciation is a non-cash expense, why does it affect the cash balance?

Answer 7

Although Depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.

Question 8

Where does Depreciation usually show up on the Income Statement?

Answer 8

It could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating Expenses – every company does it differently. Note that the end result for accounting questions is the same: Depreciation always reduces Pre-Tax Income.

Question 9

What happens when Accrued Compensation goes up by $10?
For this question, confirm that the accrued compensation is now being recognized as an expense (as opposed to just changing non-accrued to accrued compensation).

Answer 9

Assuming that’s the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4.
On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

Question 10

What happens when Inventory goes up by $10, assuming you pay for it with cash?

Answer 10

No changes to the Income Statement.
On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom.
On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Shareholders’ Equity.

Question 11

Why is the Income Statement not affected by changes in Inventory?

Answer 11

This is a common interview mistake – incorrectly stating that Working Capital changes show up on the Income Statement.
In the case of Inventory, the expense is only recorded when the goods associated with it are sold – so if it’s just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the company manufactures it into a product and sells it.

Question 12

Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?

Answer 12

At the start of “Year 1,” before anything else has happened, there would be no changes on Apple’s Income Statement (yet).
On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the investment activity. So the cash number stays the same.
On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is up by $100 as well and so both sides balance.

Question 13

Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of 10% per year. What happens?

Answer 13

After a year has passed, Apple must pay interest expense and must record the depreciation.
Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income would fall by $12.
On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2.
That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12.
On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance.
Remember, the debt number under Liabilities does not change since we’ve assumed none of the debt is actually paid back.

Question 14

At the start of Year 3, the factories all break down and the value of the equipment is written down to $0. The loan must also be paid back now. Walk me through the 3 statements.

Answer 14

After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year assumption. It is this $80 that we will write down in the 3 statements.
First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48.
On the Cash Flow Statement, Net Income is down by $48 but the write-down is a non-cash expense, so we add it back – and therefore Cash Flow from Operations increases by $32.
There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Investing falls by $100.
Overall, the Net Change in Cash falls by $68.
On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether.
On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities & Shareholders’ Equity are down by $148 and both sides balance.

Question 15

Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPad inventory, using cash on hand. They order the inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements?

Answer 15

No changes to the Income Statement.
Cash Flow Statement – Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10.
On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.

Question 16

Now let’s say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.

Answer 16

Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net Income is up by $6.
Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the inventory into real iPads), which is a net addition to cash flow – so Cash Flow from Operations is up by $16 overall.
These are the only changes on the Cash Flow Statement, so Net Change in Cash is up by $16.
On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is up by $6 overall.
On the other side, Net Income was up by $6 so Shareholders’ Equity is up by $6 and both sides balance.

Question 17

Could you ever end up with negative shareholders’ equity? What does it mean?

Answer 17

Yes. It is common to see this in 2 scenarios:
1. Leveraged Buyouts with dividend recapitalizations – it means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative.
2. It can also happen if the company has been losing money consistently and therefore has a declining Retained Earnings balance, which is a portion of Shareholders’ Equity.
It doesn’t “mean” anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling (in the second scenario).
Note: Shareholders’ equity never turns negative immediately after an LBO – it would only happen following a dividend recap or continued net losses.

Question 18

What is Working Capital? How is it used?

Answer 18

Working Capital = Current Assets – Current Liabilities.
If it’s positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is “sound.”
Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt).
The point of Operating Working Capital is to exclude items that relate to a company’s financing activities – cash and debt – from the calculation.

Question 19

What does negative Working Capital mean? Is that a bad sign?

Answer 19

Not necessarily. It depends on the type of company and the specific situation – here are a few different things it could mean:
1. Some companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances.
2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have negative Working Capital because customers pay upfront – so they can use the cash generated to pay off their Accounts Payable rather than keeping a large cash balance on-hand. This can be a sign of business efficiency.
3. In other cases, negative Working Capital could point to financial trouble or possible bankruptcy (for example, when customers don’t pay quickly and upfront and the company is carrying a high debt balance).

Question 20

Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me through what happens on the 3 statements when there’s a write-down of $100.

Answer 20

First, on the Income Statement, the $100 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $60.
On the Cash Flow Statement, Net Income is down by $60 but the write-down is a non-cash expense, so we add it back – and therefore Cash Flow from Operations increases by $40.
Overall, the Net Change in Cash rises by $40.