Accounting concepts & financial statements

Question 1

What is main difference between net income and cash flow?

Answer 1

Net income does not reflect the cash that the business receives from its activities. For example, an increase in accounts receivable may be recorded on the income statement as revenue, even though the company has not actually received any cash for that product yet.

On the other hand, the cash flow statement focuses on the incoming and outgoing cash of a business

Question 2

When are revenues and expenses recorded on the income statement?

Answer 2

When the product/service has been delivered to the customer

Question 3

What are accrued expenses?

Answer 3

These are similar in nature to accounts payable, but instead of for COGS, they are things such as paid utilities, rent, employee wages etc.

These are expenses that have arisen but have not yet been paid or expensed on the income statement

Question 4

What are prepaid expenses?

Answer 4

Expenses that have already been paid but have not yet been expensed. This may happen if a company pays up-front for 5 years worth of things, and then will record it in fifths for the next 5 years

Question 5

What is deferred revenue?

Answer 5

This is income that has already been received from customers, but has not yet been expensed. This is likely to arise because a customer pays for a long-term subscription, and the revenue can only be recorded periodically as they use their subscription.

Question 6

How do businesses think about assets in terms of cash flow?

Answer 6

Assets are employed to generate cash flow

Question 7

How can you think about liabilities on the balance sheet?

Answer 7

Liabilities are future obligations

Question 8

How can you think about equity on the balance sheet, especially from a funding perspective?

Answer 8

A funding source for the business that will NOT result in future cash costs. It includes money contributed by the owners, money raised by selling ownership in the business and the company’s cumulative after-tax profits

Question 9

Why is investment in PP&E capitalised on the balance sheet rather than expensed on the income statement?

Answer 9

Because the assets arising from this cost are of a longer term nature (1+ year)

However, these costs will be allocated to the income statement in relevant proportions over time

Question 10

How does Capex affect the income statement, balance sheet, and cash flow statement in the first year?

How about in the second year?

Answer 10

First Year:
IS: Nothing, as Capex is capitalised not expensed
CF: Capex recorded in cash flow from investing
BS: PP&E goes up, and either cash drops if funded with cash, or equity/debt increases if funded through new capital

Second year:
IS: A portion of it is expensed under D&A, which reduces net income
CF: Reduced net income, but overall cash flow up as depreciation is added back
BS: Retained earnings down as net income is down, PP&E also down as portion has been expensed, whilst cash has increased from the cash flow statement

Question 11

Why do debt issuances/repayments not appear on the income statement?

Answer 11

Because debt is usually long term, the raising/repayment of it will not appear on the income statement

However, the income expense accrued over a certain reporting period will appear on the income statement

Question 12

Does preferred stock appear on the income statement?

Answer 12

Issuances and repayments do not, but interest accrued will

Question 13

What are the two main types of leases?

Answer 13

Operating and finance (previously called Capital) leases

Question 14

In 2019, US GAAP and IFRS changed their rules so that operating leases now appear as liabilities. What are operating liabilities, and what is the corresponding line item in the asset section of the balance sheet?

Answer 14

Operating leases arise when a company uses assets that are owned by another company. These assets are labelled on the balance sheet as ‘right-of-use assets’

Question 15

What is the difference between operating leases and financial leases?

Answer 15

Operating leases are only temporary - when the lease expires, the owner of the assets receives the asset back.

However, financial leases allow the company borrowing the asset to keep it after the lease expires. This is called an “ownership transfer”

Question 16

Look into the accounting treatment of financial and operating leases

Answer 16

seem difficult so need to spend some time

Question 17

When does the purchase or sale of financial investments appear on the income statement?

Answer 17

Only would appear if the company recorded a gain or loss on it

Question 18

Where does the deferred taxes line item come from?

Answer 18

Arises because of companies making two sets of financial statements: book purposes and tax purposes

Deferred taxes represents 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)

Question 19

Why does tax differ between book and tax financial statements?

Answer 19

Companies may use accelerated depreciation in earlier years to reduce their tax burden. However, they may use straight-line depreciation on the book financial statements because it keeps net income (and hence earnings per share) higher in earlier years , which is preferable to investors

Some expenses may not be deductible for tax purposes, even though they are listed on the income statement

The company may get tax credits from certain activities, such as R&D

Look into this more !!!!!!!

Question 20

What are deferred tax assets?

Answer 20

Potential future tax savings, which usually arise from net operating losses (NOLs)

Question 21

What are NOLs?

Answer 21

If a company has lost money (i.e. had negative pre-tax income) in previous years, it can reduce its cash taxes in the future by applying these losses to reduce its taxable income.

Note that NOLs are NOT the same as deferred tax assets; deferred tax assets are just the savings from the NOL

Question 22

Difference between NOL and deferred tax assets?

Answer 22

Deferred tax assets arise from NOLs, i.e. they will be a percentage of them

Question 23

When do asset sales appear on the income statement? When do they not?

Answer 23

They do not when you sell them for the same price as you bought them for (i.e. the recorded book value)

If the value is different, the gain or loss will need to be recorded on the income statement

Question 24

How are write-downs and impairments treated from an accounting perspective? What is the difference between the treatment of these and depreciation?

Answer 24

Similarly to depreciation; they are non-cash expenses thet reduce pre-tax income and net income, but then get added back on the cash flow statement, reducing the corresponding asset on the balance sheet

The key difference is that unlike depreciation, impairments and write-downs are usually not deductible for cash-tax purposes. They create a deferred tax asset, which can then be realised once the asset is sold.

Question 25

How are impairments different to depreciation on the income statement? What does this create?

Answer 25

The key difference is that unlike depreciation, impairments and write-downs are usually not deductible for cash-tax purposes

They create a deferred tax asset, which can then be realised once the asset is sold.

Question 26

How does goodwill arise?

Answer 26

In an M&A transaction, if the acquirer pays a different purchase price to the book value listed on the target’s common shareholder equity

Question 27

In an M&A transaction, an additional line item called ‘goodwill’ is created for the balance sheet. What is the other line item that is also created?

Answer 27

‘Other intangible assets’

This line item corresponds to identifiable assets, such as contracts, patents, trademarks, customer relationships and brand value

Goodwill is then plugs the remainder of the gap that has not been bridged by other intangible assets line item

Question 28

Do intangible assets and goodwill amortise?

Answer 28

Other intangible assets amortise similar to how PP&E depreciates; however, goodwill does not amortise, instead it can only be impaired if value has been adjudged to have decreased

Question 29

Under IFRS, the cash flow statement may not start with net income, instead beginning with something along the lines of ‘cash generated from operations’. How can you reconcile this from net income?

Answer 29

Should be able to work from operating income/net income, add back the non cash expenses, and then accounting for changes in NWC and other operational items to come to the figure under cash generated from operations

You need to be starting with net income at the top, so good habit to get into is reconciling the differences

Question 30

How should you be combining line items on the financial statements for modelling purposes?

Answer 30

Try and be as ruthless as possible - much better to combine quite a few of them and have less line items, and then build them out if need be

Question 31

If you had to group the line items in the cash flow from operations section, what would you label the groups?

Answer 31

Net income, non-cash adjustments and operational balance sheet items

Question 32

What is a simple way of understanding free cash flow?

Answer 32

It is the cash flow available for distribution after the company pays for what it needs to run its business and avoid being shut down by external parties such as lenders and the government

Question 33

What is the formula for free cash flow?

Answer 33

Cash flow from operations (CFO) - Capital Expenditures (Capex)

Question 34

In the formula for free cash flow, why do we exclude cash flow from financing or investing activities?

Answer 34

For the most part, these activities are optional, except for Capex (hence why it is included)

Question 35

Why is negative free cash flow over the long term a bad thing?

Answer 35

It means that the company has to rely on external financing for it to stay afloat in the long term

Question 36

What is the best formula for working capital? Why is this the best formula?

Answer 36

Current operational assets - current operational liabilities

This is a better formula than the more ‘simple’ formula of ‘current assets - current liabilities’, because cash and short term liabilities come under current assets and current liabilities respectively, which are actually omitted in the change in working capital line item in the cash flow statement

Question 37

Is it good or bad if working capital is positive or negative each year?

Answer 37

Entirely depends, and it may be neither. One way it can be really bad is if grows exponentially positive, as it highlights that there could be a collection issue and long-term the company may run into cash flow issues

If the change YoY is small, or the overall working capital is a small % of revenue, most of the time it does not matters although projecting a positive working capital or one that does not change that much over time is the conservative approach for valuation

Question 38

Will the change in working capital from the balance sheet match up with that on the cash flow statement?

Answer 38

No, because companies often group items differntly on the financial statements, change accounting policies, and make acquisitions, all all those activities distort the numbers

Question 39

How might the financial statements of a company in the UK or Germany be different to those of a company based in the US?

Answer 39

Income statements and balance sheets tend to be similar across different regions, but companies that use IFRS often start the cash flow statement with something other than Net income: operating income, pre-tax income, or cash flow from operations are all common

Question 40

How might the financial statements of a company in the UK or Germany be different to those of a company based in the US?

Answer 40

Income statements and balance sheets tend to be similar across different regions, but companies that use IFRS often start the cash flow statement with something other than Net income: operating income, pre-tax income, or cash flow from operations are all common

Ina addition, IFRS-based companies also tend to place items in more “random” locations on tech CFS, so you may need to rearrange it

Question 41

What are the four primary groups of metrics when analysing/valuing companies?

Answer 41

Cash flow proxy metrics, such as EBIT, EBITDA, and EBITA

Credit metrics, such as leverage ratio and interest coverage

Returns based metrics, such as ROE, ROA, and ROIC

Cash conversion metrics, such as DSO, DIO, DPPO, and the cash conversion cycle

Question 42

Can you give some examples of cash flow proxy metrics?

Answer 42

Most common ones are EBIT and EBITDA

EBIT is simply operating income on the income statement, adjusted for any non-recurring or one-time charges (e.g. impairments or write=-downs if they have affected operating income)

Question 43

What is EBITDA and EBIT typically a proxy of and why?

Answer 43

EBITDA is usually used as a proxy for cash flow from operations, as both EBITDA and CFO completly ignore Capex and its after effects (depreciation).

EBIT is often a proxy for free cash flow, because both metrics reflect some or all of the impact of Capex. This is because FCF directly decides Capex, and EBIT indirectly deducts part of it by subtracting depreciation.

Question 44

In words, what does EBIT give you?

Answer 44

EBIT give you a company’s core, recurring business profitability before the impact of capital structure and taxes

Question 45

In words, what does EBITDA give you?

Answer 45

EBITDA gives you a company’s core, recurring business cash flow from operations before the impact of capital structure and taxes

Question 46

What is the leverage ratio formula?

Answer 46

Total debt / EBITDA

This will usually be financial debt, i.e. that raised to fund business operations, rather than operating debt (like accounts payable)

Question 47

What is the interest coverage ratio formula?

Answer 47

EBITDA / Interest expense, and highlights how many times over a businesses cash flow can ‘cover’ its interest payments

Question 48

In financial ratios, how can return based metrics be interpreted?

Answer 48

They all tell. you how efficiently a company is using its capital or assets to generate income

Question 49

What is the ROIC formula?

Answer 49

NOPAT / Average invested capital

NOPAT = EBIT * (1- Tax rate), because it reflects income available to all investors after taxes. This also makes sense as to why it is paired with average invested capital, which will include equity, debt, preferred stock, as well as any other sources of long term capital / investor groups)

Question 50

What is the cash conversion cycle?

Answer 50

Combines all cash conversion metrics, which is the amount of time a company takes to ‘sort out’ its operating working capital, into one formula

Cash conversion cycle = DIO + DSO - DPO

Lower numbers are better, because this means that the company is selling its inventory and collecting cash from its customers more quickly,

Question 51

Why were the accounting rules changed in respect to the treatment of operating and capital leases being listed on the balance sheet?

Answer 51

Previously, companies could structure leases as off-balance sheet operating leases, which resulted in lower leverage ratios and better return metrics (ROA, ROIC) for the company.

Question 52

Under the new accounting rules, how are leases treated?

Answer 52

Capitalised leases on the balance sheet as an intangible asset (right to use property) and debt

Question 53

Under the new 2019 accounting rules, how does the treatment of leases differ between GAAP and IFRS?

Answer 53

IFRS requires all leases to be treated as capital type leases. Therefore, unlike the US rules, even “operating” leases would receive incomes statement treatment similar to finance leases comprising of asset depreciation expense and interest expense.

Question 54

What is work in progress and where would you see it on the balance sheet?

Answer 54

Contained within the inventory line item.

WIP describes goods that are in the process of being produced.