Accounting Basics Flashcards
Walk me through the 3 financial statements
The Income statement gives a 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 shareholder’s 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.
Can you give me examples of major line items on each of the financial statements
Income statement: COGS, SG&A, Operating income, pretax income, net income.
Balance Sheet: Cash, accounts receivable, inventory, PP&E, accounts payable, accrued expenses, debt; shareholder equity.
Cash Flow Statement: Net Income, Depreciation & amortization, stock-based compensation, changes in operating assets and liabilities, cash flow from operations, capital expenditures, cash flow from investing, sale/ purchase of securities, dividends issues, cash flow from financing.
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?
Cash Flow statement because it gives a true picture of how much cash the company is 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.
If I could only look at 2 statements to assess a company’s prospects - which 2 would I use and why?
Income statement and the balance sheet, because you can create a cash flow statement from both of those assuming you have a before and after version that correspond with the period you are tracking.
Walk me through how Depreciation going up $10 would effect the statements .
Income Statement: Operating income would decline by $10 and assuming a 40% tax rate, Net Income would go down by $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. Net Change in cash goes up by $4
Balance sheet: PPE goes down by $10 on the assets side because of the depreciation and cash is up by $4. The retained earnings in liabilities and equity is down by $6 and both sides balance.
If depreciation is a non-cash expense, why does it effect the cash balance?
Although depreciation is a non-cash expense, it is tax deductible. Since taxes are paid with cash, depreciation affects cash by reducing the amount of taxes you pay.
What happens when accrued compensation goes up by $10?
Operating expense on the income statement goes up by $10, pretax income falls by $10, Net Income falls by $6. assuming a 40% tax rate.
On the cash flow statement, Net Income is down by $6, accrued compensation will increase cash flow by $10, so overall cash flow from operations is up by $4.
On the balance sheet, cash is up $4 as a result, so assets are up by $4. On the L&E side, accrued compensation is a liability so liabilities are up by $10 and retained earnings are down by $6 due to net income, so both sides balance.
Why is the income statement not affected by changes in inventory?
The expense is only recorded when the goods associated with it are sold - so if its just sitting in a warehouse, it does not count as a cost of goods sold or operating expenses until the company manufactures it into a product and sells it.
What is working capital? How is it used?
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 metrics 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).
What does negative Working Capital mean? Is that a bad sign?
Not necessarily. It depends on the type of company and the specific situation - here are a few different things it could mean:
- Some companies with subscription or longer-term contracts often have negative Working Capital because of high deferred revenue balances
- Retail and restaurant companies like Amazon, Wal-Mart, and McDonalds 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.
- In other cases, negative working capital could point to financial trouble or possible bankruptcy
Walk me through what happens on the 3 statements when there’s a write down of $100.
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 rise by $40.
On the Balance Sheet, Cash is now up by $40 and an asset is down by $100. Overall the assets side is down by $60.
On the other side, since Net Income was down by $60, Shareholders’ Equity is also down yb $60 - and both sides balance.
Walk me through a $100 “bailout” of a company and how it affects the 3 statements.
First confirm what type of “bailout” this is debt? Equity? A combination? The most common scenario here is an equity investment from the government, so here’s what happens:
No changes to income statement
Cash Flow statement: Cash flow from financing goes up by $100 to reflect the government’s investment, so the net change in change is up by $100
On the balance sheet, cash is up by $100 so assets are up by $100; on the other side, shareholders’ equity would go up by $100 to make it balance.
Walk me through a $100 write-down of debt - as in owned debt, a liability - on a company’s balance sheet and how it affects the 3 statements.
A liability is written down so you record it as a gain on the income statement - so the pre-tax income foes up by $100 due to this write-down. Assuming a 40% tax rate, Net Income is up by $60.
On the cash flow statement, net income is up by $60, but we need to subtract that debt write-down - so Cash Flow from operations is down by $40, and Net Change in Cash is down by $40.
On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other side, Debt is down by $100 but shareholders’ equity is up by $60 because the Net Income was up by $60 - so liabilities and shareholders equity is down by $40 and it balances.
If cash collected is not recorded as revenue, what happens to it?
Usually, it goes into the Deferred Revenue balance on the Balance Sheet Under liabilities.
Over time, as the services are performed, the Deferred Revenue balance “turns into” real revenue on the income statement.
What’s the difference between accounts receivable and deferred revenue?
Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.
