Accounting, Finance and Valuation

Question 1

What are the three financial statements?

Answer 1

Income Statement, Balance Sheet and Statement of cash flows.
income statement shows a company’s revenue, costs and expenses that together yield net income.
Balance sheet shows a company’s assets, liabilities, and equity
Cash flow statement starts with net income from the income statement, then it shows adjustments for non-cash expenses, non expense purchases such as capital expenditures, changes in working capital, or debt repayments and issuance to calculate ending cash balance

Question 2

How are the three financial statements connected?

Answer 2

1. Net income flows from the IS into cash flow from operations on the CF statement
2. Net income - dividends is added to retained earning from last period’s balance sheet to get retained earnings on the current period’s balance sheet
3. beginning cash on the CF statement is cash from the prior period’s Balance sheet, and ending cash on the CF statement is cash on the current period’s balance sheet

Question 3

How are the three financial statements connected?

Answer 3

The three main financial statements show separate views, and together they createva whole picture of a company’s financial health. For example, the Income Statement closes with a net income figure that appears on the Cash Flow Statement as an addition to cash flow from operations. The Cash Flow Statement’s beginning cash balance comes from the Balance Sheet for the prior period. TheCash Flow Statement’s ending cash balance becomes the cash asset on the current period’s Balance Sheet.

Question 4

Walk me through the major line items of an income statement

Answer 4

The first line of the Income Statement represents revenues or sales. From that you subtract thecost of goods sold, which leaves gross profit. Subtracting operating expenses, depreciation andamortization from gross profit gives you operating income. From operating income you subtractinterest expense and any other expenses (or add other income) to get pre-tax income. Then subtract tax payments and what’s left is net income

Question 5

Name some assets on the balance sheet

Answer 5

Cash, short term investments, inventory, accounts receivable, prepaid expense, PP&E, intangible assts, goodwill, long-term investments

Question 6

Name some liabilities on the balance sheet

Answer 6

revolver, accounts payable, deferred revenue, accrued expenses, deferred tax liability, long-term debt

Question 7

Name some equity on the balance sheet

Answer 7

common stock, treasury stock, retained earnings

Question 8

What are the three components of the CF statement?

Answer 8

cash from operations, cash from investing, cash from financing

Question 9

If you could use only one financial statement to evaluate the financial state of a company, which would you choose?

Answer 9

CF statement so I could see the actual liquidity position of the business and how much cash it is using and generating. Income statement might be misleading because of the number of non-cash expenses that may not actually be affecting the overall business, and the balance sheet alone just shows a snapshot of the company at a point in time, without showing how operations are actually doing. So I would choose the CF statement because it will tell me the financial stability of the company based on if the company has a healthy cash balance and is generating enough cash flow

Question 10

What is the difference between the income statement and the cash flow statement?

Answer 10

statement of CF shows the amount of cash that is being used and spent, the IS shows a company’s sales and expenses and includes items such as depreciation and amortization, that are non cash expenses and are added back in the CF statement

Question 11

What is the link between the balance sheet and the income statement?

Answer 11

The main link between the BS and IS is that any net income from the IS, after the payment of dividends is added back to retained earnings. Also, debt in the balance sheet is used to calculate interest expense on the IS, and PP&E in the BS is used to calculate any depreciation expense

Question 12

What is the link between the BS and the CF?

Answer 12

Beginning cash on the CF statement comes from the previous period’s balance sheet. Cash from operation on the CF statement is affected by change in working capital ( current assets - liabilities). Any change because or purchase or sale of PP&E will affect cash from investing.
CF statement ending cash balance becomes the beginning cash balance on the new balance sheet

Question 13

What is deferred revenue and why is it a liability?

Answer 13

deferred revenue is cash that has been collected in advance for something that hasn’t yet been derived. For example, newspaper subcription
liability because revenue has not yet been recognised

Question 14

What is the difference between accounts payable and prepaid expenses?

Answer 14

Prepaid expenses are payments that have been made for products or services that will be delivered in the future. As the products or services are received they will be recognized as expenses on the income statement. Accounts payable is a liability for a good or service that has been received and recognized as an expense, but has not yet been paid for in cash.

Question 15

If depreciation is a non-cash expense, then how does it affect cash balance?

Answer 15

Even though depreciation is a non-cash expense, it is still tax deductible. This means that it reduces your pre-tax income, and therefore reduces the amount of taxes a company must pay, whichincreases the company’s cash balance

Question 16

What is EBITDA?

Answer 16

Earnings before interest, taxes, depreciation and amortization. t’s a good high-level indicator of a company’s financial performance. Since it removes theeffects of financing and accounting decisions such as interest and depreciation, it’s a good way to comparethe performance of different companies. It serves as a rough estimate of free cash flow, and is used in theEV/EBITDA multiple to quickly establish a company’s high-level valuation

Question 17

How could a company have positive EBITDA and still go bankrupt?

Answer 17

Bankruptcy occurs when a company can’t make its interest or debt payments. SinceEBITDA is Earnings BEFORE Interest, if a required interest payment exceeds a company’s EBITDA, then ifthey have insufficient cash on hand, they would soon default on their debt and could eventually needbankruptcy protection

Question 18

What is enterprise value?

Answer 18

Enterprise Value is the value of a firm as a whole, to both debt and equity holders.To calculate Enterprise Value in its simplest form, you take the market value of equity (aka the company’smarket cap), add the debt and the value of outstanding preferred stock, add the value of any minorityinterests the company owns, and then subtract the cash the company currently holds

Question 19

Enterprise Value equation

Answer 19

Market Value of Equity + Debt + Preferred Stock + Minority Interest – Cash

Question 20

What is net debt?

Answer 20

net debt is a company’s total debt minus cash it has on the balance sheet. Net debt assumes the company pays off any debt it can with the excess cash on the balance sheet

Question 21

What is the difference between equity value and enterprise value?

Answer 21

equity value is a component of enterprise value. Enterprise value includes equity value, net debt, preferred stock, and minority interest

Question 22

When looking at the acquisition of a company, do you look at equity value or enterprise value?

Answer 22

because the company that is purchasing must buy both liabilities and equity in order to take over the business, the buyer needs to look at enterprise value that includes both equity and debt

Question 23

When calculating enterprise value, do you use the book value or the market value of equity?

Answer 23

when calculating a company’s enterprise value, you use the market value of equity because it represents the true supply-demand value of the company’s equity in the open market

Question 24

What are the two factors that affect market cap?

Answer 24

1. changes in the price of stock

2. if the company issues or repurchases shares of stock

Question 25

How does issuance of shares affect market cap?

Answer 25

decreases market cap, because company issuing new shares in the secondary market they have to issue at a discount or else nobody would buy it. Hence once they sell it at a discount, those in the primary markets are not willing to pay the previous price for it, hence decrease the price of the shares overall

Question 26

How does repurchase of shares affect the market?

Answer 26

repurchasing shares causes the number of outstanding shares on the market to decrease. When this happens, the relative ownership stake of each investor increases because there are fewer shares, or claims, on the earnings of the company

Question 27

What is valuation and what is it used for?

Answer 27

Valuation is the process of calculating the worth of an asset, security, company

Question 28

What are some ways you can value a company?

Answer 28

There are many ways that you can value a company. The simplest is probably market valuation, which is just the market cap of the company, or the enterprise value. The enterprise value, you add net debt, preferred stock, and any minority interest to the market cap and subtract cash. Other ways include comparable company analysis, precedent transactions, DCF, leverage buyout valuation and liquidation valuation

Question 29

Comparable Companies/ Multiples Analysis

Answer 29

• looking at companies that can be compared based on size, industry
• most common multiple is Enterprise value/EBITDA, other multiples are P/E, EV/EBIT, EV/Sales
  ex” comparable company A is trading at an EV/EBITDA multiple of 6.0x, and the company you are valuing has EBITDA of 100 million and your company’s EV would be valued at 600 million

Question 30

Precedent Transactions

Answer 30

• based on the idea that a company’s worth can be determined by looking at the prices paid for similar companies in similar situations
• involves researching historical transactions with similar transaction, includes looking at size of the companies involves, their industry, the economic context, premiums paid and purpose of the trasaction (strategic or financial)
• once analyst found list of transactions that are comparable they look how those companies were valued, and apply it to the following case

Question 31

Liquidation valuation

Answer 31

uses the value of the company if they simply sold all of its assets

Question 32

Sum of the parts valuation

Answer 32

this valuation should be used if the company has multiple divisions with different margins, growth rates, etc for instance, valuing apple for each of its different businesses, iPhone, iPad, MacBook, software and then combining the values of all those divisions

Question 33

Walk me through a DCF Model

Answer 33

First, project the company’s free cash flow for about 5 years using the formula EBIT(1-tax rate) + D&A - CAPEX - Change in working capital.

Next, predict free cash flows beyond 5 years using either a terminal value multiple or the perpetuity model. To calculate perpetuity, establish a terminal growth rate, about the rate of inflation or GDP growth.

Now multiply the Year 5 cash flow by 1 plus the growth rate and divide that by your discount rate minus the growth rate.
Your discount rate is the WACC.

Use that rate to discount all your cash flows back to year zero.

The sum of all present values of all those cash flows is the estimated present Enterprise Value of the firm

Question 34

Which valuation methodologies will result in the highest valuation?

Answer 34

of the four main valuation techniques (market value, market comps, precedent transactions and DCF) the highest valuation will normally come from the Precedent transaction because a company will pay a premium for the projected synergies coming from the merger. A DCF analysis would be the second highest valuation because normally those building the model tend to optimistic about their assumptions and projections. Market comparable and market value will normally produce the lowest valuations

Question 35

How do you calculate a firm’s terminal value?

Answer 35

terminal value determines the value of the business beyond the project period, can be calculated using the exit multiple or perpetual growth.

The exit multiple uses the EBITDA or EBIT and multiples it to the Year 5 projections to get the terminal value

The perpetual growth where you chose a growth rate, usually based on inflation rate or GDP, and assume that the company can grow at this rate forever. You then multiple the FCF for Year 5 by 1 plus the growth rate and divide that number by the discount rate - assumed growth rate

Question 36

What is WACC and how do you calculate it?

Answer 36

WACC stands for Weighted Average Cost of Capital, it is used as a discount rate in a DCF analysis to calculate the present value of the projected cash flows and terminal value
represents the overall cost of a company’s raising new capital, and riskiness of investing in the company
WACC = % equity in the capital structure x cost of equity + %debt in the capital structure x cost of debt x (1-tax rate) + % preferred stock x cost of preferred stock

Question 37

Should the cost of equity be higher for a company with 100 million market cap or a company with 100 billion market cap?

Answer 37

Normally, a smaller company is expected to produce greater returns than a larger company, meaning the smaller company is more risky and therefore would have a higher cost of equity

Question 38

How do you calculate free cash flow?

Answer 38

EBIT(1-tax rate) + D&A - CAPEX - net change in WC

Question 39

Why do you project out free cash flows for the DCF model?

Answer 39

because FCF is the amount of cash that would hypothetically paid out to debt holders and equity holders from the earnings of a company

Question 40

When would you not want to use a DCF?

Answer 40

when you have a company with very unpredictable cash flows, so attempting to project those cash flows and create a DCF model would be effective or accurate, so you would want to use comparable multiple or precedent transactions analysis

Question 41

What is net working capital?

Answer 41

net working capital is current assets minus current liabilities. It is a measure of a company’s ability pay off its short-term liabilities with their short-term assets. A negative number indicates that the company may have trouble paying off its creditors

Question 42

What happens to FCF if net working capital increases?

Answer 42

If net working capital increases, FCF decreases. You can think of working capital as the net dollars tied up to run the business, as more cash is tied up (accounts receivable, inventory, etc) fcf will be reduced
if an asset goes up its a use of cash, if a liability goes up it is a source of cash

Question 43

How do you determine which valuation methodology to use?

Answer 43

because each method has a unique ability to provide useful information, you don’t choose just one. The best way to value a company is to use a combination of valuation techniques.

Question 44

What is a primary market and what is a secondary market?

Answer 44

Primary market is where an investment bank sells new securities before they go to market. With an IPO or bond issuance the majority of buyers are insititutional investors who purchase large amounts of the security. The secondary market is the market on which a stock or bond trades after the primary offering, New York Stock Exchange, Nasdaq

Question 45

What is Profit Margin?

Answer 45

The amount by which revenue from sales exceeds costs in a business