Accounting Fundamentals Flashcards
What are three financial statements?
Income statement, balance sheet and cash flow statement
What is income statement?
Income sheet tracks revenue and expenses over a period of time, with net income being at the bottom of the statement, which is what the company makes after paying expenses and taxes
What is balance sheet?
Balance sheet provides a snapshot of a company’s resources, which is on the asset side, and then how they acquired them, which is the liabilities and shareholders equity side. Assets must equal liabilities + sahreholders equity
What is cash flow statement?
Cash flow statement shows how a company’s cash balance changes over time. Start with net income, add back non-cash charges, factor in how working capital items and have changed, any investments the company made and any financing activities a company has particiapated in, an then at the bottom you get to how the companys cash balance has changed over time. The cash balance number follows through onto the new balance sheet.
Why is cash flow statement needed?
Income statement and balance sheet can be subject to accounting practices that hide true state of company. Cash flow statement provides true insight into cash flow of company.
How do they link together?
The way the statements link together is that you get net income on the bottom line of the income statement, which flows into the top item on the cash flow staememtn with any non cash expenses also reflected on the cash flow statement which are added back. Any changes in the current assets and liabilities from balance sheet are reflected in cash flow from operatin activities, any changes in long term assets show up in the investing activities part of cash flow statement, any changes to long-term liabilities or shareholders equity show up in the financing activities part of cash flow statements. Then at the end you get to increase/decrease in cash, which flows through into cash and cash& equivalents, with retained earnings also changing based on net income
What is depreciation?
Reflecting a fall in an assets value
How does $10 of depreciation affect statements?
If depreciation goes up by $10, operating income falls by $10, which means net income falls by $6 if we assume a 40% tax rate. Looking to cash flow statement, net income down by $6, depreciation up by $10, so cash flow from operations goes up by $4. Nothing changes in investing and financing activities, so overall increase of $4. On balance sheet, cash goes up by $4, but long-term asssets or property, plants and equipment down by $10, meaning total assets are down by $6. Retained earnings are then also down by $6, because of the $6 drop in net income, so total liabilities and shareholders equity is also down by $6, and the balance sheet balances.
How does $10 inventory increase change the financial statements? (with cash)
With cash: No changes to income statement, because it is not recorded on income statement until it is an expense. On cash flow statement, no changes to non cash expenses. However, changes in operating assets & liabilities because cash used to buy inventory, meaning the cash flow goes down by $10. No changes in cash flow in investing, and cash flow from financing is unchanged because hasn’t been financed by equity or debt. Moving to balance sheet, inventory gone up by $10, but cash anf cash equivalent gone down by $10 so nothing changes in total assets, and total liabilities and shareholders equity is also unchanged.
How does $10 inventory increase change financial statements? (with debt)
With debt: Nothing changes on income statement. On cash flow statement, inventory goes down by $10, because you have spent cash on inventory, so operating assets goes down by $10, meaning cash flow from operating activities goes up by $10. Cash flow from investing is unchanged, but cash flow from financing goes up by $10 with long term debt increasing. Overall, there is no change in cash, because debt has financed inventory. ON balance sheet, inventory goes up by $10, but long term debt also goes up, so balance sheet balances.
Difference between FIFO and LIFO and why it matters
First in first out/ last in last out.
Difference of how inventory is treated and matters because COGS may be different dependent on when inventory was purchased.
What is treasury stock method?
How you deal with convertibles being exercised, as when you receive the strike price, you buy back shares with it too.
What is minority interest?
Minority interest = the net income that belongs to minority shareholders in companies that are majority owned by a company. When someone owns majority of a company, its financial statements will record 100% of that companies income on the income sheet, even though they may own less than 100% of it. Minority interest will be negative or zero on an income statement.
What is preferred stock?
Preferred stock gives holders a guaranteed dividend from the company and have a higher claim than common stock. As preferred stock is closer to debt than equity, it is treated as debt and is hence added.
Why is cash subtracted from debt in EV calculation
Cash is subtracted from EV because it is a non-operating asset and equity value already implicitly accounts for it. So if you have equity value of $100, no debt and $20 of cash, EV would be $80, because even though you would pay $100 to acquire all equity of a company, you would receive $20 so the real cost would only be $80.
What metrics do you use to compare companies?
Geography, industry, financials (EV, EBITDA, Revenue)
Difference between operating income and EBIT
EBIT is close to operating income, although you may add back one-off to EBIT
Difference between EBIT and EBITDA and when would you use them?
EBIT and EBITDA are profitability metrics. EBIT is more common to use in industries where D&A are really important like manufacturing, because you want to take depreciation and amortisation into account when valuing companies with large capital bases
EBITDA more common for tech companies, when D&A are not huge expenses relative to revenue. Used more commonly when companies provide services or don’t use massive factory.
Examples of valuation multiples?
EV / EBIT, EV / Revenue, EV / EBITDA
What would you use for valuation of financial companies?
Dont use DCF, because need account for interest expense/received, would prefer to use DDM
When should you use equity value instead of enterprise value?
If unlevered, interest expense / received not key, so use EV, if levered, use equity value
Calculate equity value
Equity value = shares outstanding * market price
Diluted equity value
Diluted equity value = diluted shares outstanding * market price
Enterprise value formula?
What is enterprise value? Diluted equity value + debt – cash & equivalents + minority interest + preferred stock + other liabilities (like pension contributions). What is meant by it?
Why is cash subtracted in EV?
You get cash for ‘free’, so it reduces the transaction value.
Why is debt added in EV?
Have to repay it when you take the company over. If you bought all the equity in the company, you would still need to pay the debt holders.
Should you use book value or market value of assets?
IF you can, market value
How to get to diluted shares outstanding?
Basic shares outstanding + shares created by in the money options / convertibles
Can you have negative market cap?
No, shares outstanding and share price cannot be negative
Can you have negative enterprise value?
- Can have negative EV though, if cash balance is huge
Difference between shareholders equity and market cap
- Shareholders equity is book value, where as market cap is value of company based on market’s valuation.
When should you use revenue multiples instead of profitability?
- Revenue mutliples focused on early-stage companies
Should you use equity or enterprise value in a multiple?
Depends if interest expense accounted for. If not accounted for, ie in EBIT/EBITDA, use EV, if accounted for, ie in FCF, use Equity value
What does cash flow from operating activities correspond to on the three statements?
Current assets and current liabilities from balance sheet, as well as net income and non-cash expenses from income statement
What does cash flow from investing activities correspond to on the three statements?
Long-term assets from balance sheet
What does cash flow from financing activities correspond to on the three statements?
Long-term liabilities and shareholders equity from balance sheet
Major line items on income statement
Revenue, COGS, non cash expenses, operating expenses, operating income, Taxes, net income
How to get to net income
Revenue - COGS = Gross profit, deduct non cash expenses and operating expenses to get operating income, deduct interest expense / received and then deduct taxes to get net income
Major line items on balance sheet?
Assets side split into current assets and current liabilities. Current assets include Cash & equivalents, accounts receivable and inventory, long-term assets include property, plants and equipment, goodwill and other intangibles.
Liabilities and shareholders equity split into current liabilities, long-term liabilities and shareholders equity. Short term liabilities include revolver facility and accounts payable, long-term liabilities include long-term debt, shareholders equity include value of common stock, additional paid in capital, treasury stock etc
Major line items cash flow statement
Split into operating activities, investing activities and financing activities. Operating: Net income, non cash expenses and current assets and liabilities. Investing: Long-term assets. Financing: Long-term liabilities and shareholders equity.
If Depreciation is a non-cash expense, why does it affect the cash balance?
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.
Why is income statement not affected by inventory changes?
Doesn’t change until the inventory is sold, which would then be reflected as a COGS
Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?
Doesn’t change income statement. Cash flow from operating the same, cash flow from investing down by $100, cash flow from financing up by $100 so no change in cash flow statement. Long-term assets up on balance sheet, but so is long term debt, so both sides balance.
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 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).
Increases in NWC is bad, because it means cash is tied up (in things like accounts receivable)
Where does write down / write up appear in income statement?
Pre-tax income, with other non cash expenses
Run me through the statements with a $100 writedown on assets?
depreciation drops by $100, and with 40% tax rate, net income drops by $60. Top line of cash flow statement down by $60, but depreciation is added back, so cash flow from operating activities is up $40. No other changes, so overall cash is up $40 which boosts cash & equivalents on balance sheet, but the $100 write down reduces depreciation by $100, so assets side is down $60. $60 reduction in net income also flows into retained earnings in shareholder equity, so both sides balance.
Run me through the statements with a $100 writedown on debt?
Everything goes the other way because you get off from paying debt.
Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?
Statements under GAAP dont show how profitable a company is.
How do you decide when to capitalize rather than expense a purchase?
Length of time. Less than a year, its expense, greater than a year its capitalised
Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?
Cash based wouldn’t show up until card is charged, accrual shows up as revenue, but goes into accounts receivable rather than cash.
How long does it usually take for a company to collect its accounts receivable balance?
30-60 days
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.
If cash collected is not recorded as revenue, what happens to it?
Usually it goes into the Deferred Revenue balance on the Balance Sheet
When would a company collect cash from a customer and not record it as revenue?
Subscription model where collected up front but would be put through over the year.
What is depreciation
Accounting for the ageing of assets. Depreciation is an income tax reduction that allows a taxpayer to recover the cost of certain property. It is an annual allowance for wear and tear, detoriation of obsolesce of the property.
Types of depreciation
Straight line depreciation or accelerated depreciation.
What is straight line depreciation?
An asset being depreciated evenly over the number of years an asset is expected to be lost.
What is residual value (in depreciation)?
Scrap value left over; usually has a sale value for scrap parts. Depreciation will be to the scrap value.
What is accelerated depreciation
Depreciated quicker in early life of the asset.
Types of accelerated depreciation
Declining balance, sum of the years digits, modified accelerated cost reduction system
What is declining balance depreciation?
Declining 20% of asset value each year.
What is the sum of the years digits depreciation?
Add up years consecutively, and then first year put numerator with largest year and denominator as sum of the years.
What are deferred tax assets?
An asset that can be used to reduce income tax; most commonly created after receiving a net operating loss (NOL), which occurs when costs exceed sales.
Examples of operating expenses
Selling, general & administrative, advertising + marketing, research & development
Examples of extraordinary / non-recurring items on income statement
Asset write-ups/downs;
What are prepaid expenses
Asset created when a company pays for an expense in advance of when it is billed or incurred.
What are deferred tax assets?
Assets that may be used to reduce income tax expense. This is commonly created after receiving a net operating loss in a previous year. Net operating losses can be carried forward 20 years, or back two to five years.
What is working capital formula?
Current assets - current liabilites
How is operating working capital different to working capital?
(Current assets - cash & equivalents) - (Current liabilities - short term debts)
Rationale is removing things that are ‘unfair’
Common operating working capital items
Assets: Accounts receivable, inventory, prepaid expenses
Liabilities: Accounts payable, accrued expenses
What is accrued expenses?
Expenses that are owed but have not yet paid in cash
What is operating working capital used for?
Tracking how well a company is managing its cash generating from day-to-day operations.
What is a debt schedule
Designed to track every major type of debt a company has, and the associated interest and payment schedules for each. It also helps track the cash available that could be used to pay down those debts and any interest income that could be generated from cash or cash & equivalents available.
EBITDA is $500mn. Which of the following has the greatest impact on EBITDA?
Costs increase by $10mn, pricing increases by 10% or volume increases by 10%
Answer is pricing, because revenue is a product of pricing and volume, but volume includes price - costs
What is the difference between net income and cash flow?
Net income measures profitability whose components may or may not have impacted cash. Cash flow tracks just the cash impacts generated or received from operations, investing and financing activities.
How does maintenance Capex differ from growth capex
Maintenance Capex is the fund expanded to extend the useful life of existing assets, whereas expansion Capex is the purchase of new assets to grow the business.
Why is EBITDA used in valuation?
EBITDA is used as a valuation metric as it removes external accounting factors and non-operating expenses from view, focuses on the operating performance of the business and takes into consideration an approximate value of company cash flow.
What is a deferred tax liability? How is such a liability created?
A tax balance that has not yet been paid in cash, which arises because of timing differences between GAAP and tax accounting.
If I had one statement, what would I have?
Cash flow statement as provides a true measure of cash produced bu the business, as income statement includes non-cash items.
If I had two statements, which would I have?
Income statement and balance sheet, because the cash flow statement can be created from the income statement and two years of balance sheet.
If accounts receivable increases by $10, what at the effects on the statements?
Net Income up $6, Change in cash down $4, A+L/E up $6
If accounts receivable decreases by $10, what are the effects on the statements?
NO change to income statement, cash flow up $10, A +/- 0
What are the accrued expenses
Expenses that are owed but have not yet paid in cash
We are in the business of buying and selling widgets, and we have just started the company. We can purchase these wdiegsts for $100 each if we are buying in bulk of 50 and the purchase can be deferred an account payable. We have not yet made any sales. Please explain the effects on the income statements, cash flow statements and balance sheet.
xxx
If you sell 15 items for $500 each on credit, what happens to the financial statements? Assume 40% tax rate
xxx
- Now let’s say we want to purchase property for $15,000. Since we don’t have 15,000 in cash on our balance sheet, we will first raise debt to fund the difference. Let’s say we raise $3,000, allowing some cushion for interest payments. The debt has an interest rate of 10%. Please explain the effects on the income statement, cash flow statement, and balance sheet of the debt raise. Focus on just the debt raise; we will handle the interest impact later.
xxx
- f accounts receivable increases by $15, please explain the effects on the income statement, cash flow statement, and balance sheet (assume 40% tax rate).
Revenue +$15, taxes -$6, Net iNcome +$9. Cash down $6, On balance sheet, accounts receivable up $15 counters down cash to balance.
- If inventory increases by $20, please explain the effects on the income statement, cash flow statement, and balance sheet.
xxx
- If inventory decreases by $20, please explain the effects on the income statement, cash flow statement, and balance sheet (assume a 40% tax rate).
Cogs down $20, so net income down $12. Change in cash up $8. Both sides of BS down $12.
- If accrued expenses increase by $50, please explain the effects on the income state- ment, cash flow statement, and balance sheet. Assume accrued expenses are related to operating expenses. Assume a 40% tax rate.
xxx
- If depreciation expense increases by $75, please explain the effects on the income statement, cash flow statement, and balance sheet. Assume a 40% tax rate.
xxx
