Accounting Questions Flashcards

Question

When do you capitalize vs. expense items under accrual accounting?

Answer 1

The factor that determines whether an item gets capitalized as an asset or gets expensed in the period incurred is its useful life (i.e., estimated timing of benefits). Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for more than one year need to be capitalized and expensed over time. For example, PP&E such as a building can provide benefits for 15+ years and is therefore depreciated over its useful life. Expensed: In contrast, when the benefits received are short-term, the related expenses should be incurred in the same period. For example, inventory cycles out fairly quickly within a year, and employee wages should be expensed when the employee's services were provided.

Answer 2

While depreciation is treated as non-cash and an add-back on the cash flow statement, the expense is tax-deductible and reduces the tax burden. The actual cash outflow for the initial purchase of PP&E has already occurred, so the annual depreciation is the non-cash allocation of the initial outlay at purchase.

Answer 3

For GAAP reporting purposes, most companies prefer straight-line depreciation because lower depreciation will be recorded in the earlier years of the asset’s useful life than under accelerated depreciation. As a result, companies using straight-line depreciation will show higher net income and EPS in the initial years. Eventually, the accelerated approach will show lower depreciation into an asset's life than the straight-line method. However, companies still prefer straight-line depreciation because of the timing, as many companies are focused more on near-term earnings.

Answer 4

Most companies use a salvage value assumption in which the remaining value of the asset is zero by the end of the useful life. The difference between the cost of the asset and salvage value is known as the total depreciable amount. If the salvage value is assumed to be zero, the depreciation expense each year will be higher and the tax benefits from depreciation will be fully maximized. Straight Line Annual Depreciation = (Asset Historical Cost−Salvage Value) / Useful Life Assumption

Answer 5

While classified as a long-term asset on the balance sheet, land is assumed to have an indefinite useful life under accrual accounting, and therefore depreciation is prohibited.

Answer 6

The depreciation expense will be embedded within either the cost of goods sold or the operating expenses line item on the income statement. IS: When depreciation increases by $10, EBIT would decrease by $10. Assuming a 30% tax rate, net income will decline by $7. CFS: At the top of the cash flow statement, net income has decreased by $7, but the $10 depreciation will be added back since it's a non-cash expense. The net impact on the ending cash balance will be a positive $3 increase. BS: PP&E will decrease by $10 from the depreciation, while cash will be up by $3 on the assets side. On the L&E side, the $7 reduction in net income flows through retained earnings. The balance sheet remains in balance as both sides went down by $7.

Answer 7

The short answer is $2 million. Except for certain liquid financial assets that can be written up to reflect their fair market value (FMV), companies must carry the value of assets at their net historical cost.

Answer 8

Growth Capex: The discretionary spending of a business to facilitate new growth plans, acquire more customers, and expand geographically. Throughout periods of economic expansion, growth capex tends to increase across most industries (and the reverse during an economic contraction). Maintenance Capex: The required expenditures for the business to continue operating in its current state (e.g., repair broken equipment).

Answer 9

Amortization is based on the same accounting concept as depreciation, except it applies to intangible assets rather than fixed tangible assets such as PP&E. Intangible assets include customer lists, copyrights, trademarks, and patents, which all have a finite life and are thus amortized over their useful life.

Answer 10

Goodwill represents an intangible asset that captures the excess of the purchase price over the fair market value of an acquired business's net assets. Suppose an acquirer buys a company for a $500 million purchase price with a fair market value of $450 million. In this hypothetical scenario, goodwill of $50 million would be recognized on the acquirer’s balance sheet.

Answer 11

Under GAAP, public companies are prohibited from amortizing goodwill as it's assumed to have an indefinite life, similar to land. Instead, goodwill must be tested annually for impairment. However, privately held companies may elect to amortize goodwill and under some circumstances, goodwill can be amortized over 15 years for tax reporting purposes.

Answer 12

In accrual accounting, companies are assumed to continue operating into the foreseeable future and remain in existence indefinitely. The assumption has broad valuation implications, given the expectation of continued cash flow generation from the assets belonging to a company, as opposed to being liquidated.

Answer 13

The conservatism principle requires thorough verification and the use of caution by accountants when preparing financial statements, which leads to a downward measurement bias in their estimates. Central to accounting conservatism is the belief that it's better to understate revenue or the value of assets than to overstate it (and the reverse for expenses and liabilities). As a result, the risk of a company's revenue or asset values being overstated and expenses or liabilities being understated is minimized.

Answer 14

The historical cost principle states that an asset's value on the balance sheet must reflect the initial purchase price, not the current market value. This guideline represents the most consistent measurement method since there's no need for constant revaluations and markups, thereby reducing market volatility.

Answer 15

In the worst-case scenario, sudden drops in asset values could cause a domino effect in the market. An example was the subprime mortgage crisis, in which the meltdown's catalyst is considered to be FAS-157. This mark-to-market accounting rule mandated financial institutions to update their pricing of illiquid securities. Soon after, write-downs in financial derivatives, most notably credit default swaps (CDS) and mortgage-backed securities (MBS), ensued from commercial banks, and it was all downhill from there.

Answer 16

The objectivity principle of accrual accounting states that only verifiable, unbiased data can be used in financial filings, as opposed to subjective measures. For this reason, internally developed intangible assets such as branding, trademarks, and intellectual property will have no value recorded on the balance sheet because they cannot be accurately quantified and recorded. Companies are not permitted to assign values to these intangible assets unless the value is readily observable in the market via acquisition. Since there's a confirmable purchase price, a portion of the excess amount paid can be allocated towards the rights of owning the intangible assets and recorded on the closing balance sheet.

Answer 17

There would be no change on the balance sheet as shareholders’ equity reflects the book value of equity. Equity value, also known as "market capitalization," represents the value of a company’s equity based on supply and demand in the open market. In contrast, the book value of equity is the initial historical amount shown on the balance sheet for accounting purposes. This represents the company's residual value belonging to equity shareholders once all of its assets are liquidated and liabilities are paid off.

Answer 18

There is no accounts receivable line item on the income statement, but it gets captured, if only partially, indirectly in revenue. Under accrual accounting, revenue is recognized during the period it was earned, whether or not cash was received. The two other financial statements would be more useful to understand what is happening to the accounts receivable balance since the cash flow statement will reconcile revenue to cash revenue, while the absolute balance of accounts receivable can be observed on the balance sheet.

Answer 19

Since the cash flow statement begins with net income and net income captures all of a company’s revenue (not just cash revenue), an increase in accounts receivable means that more customers paid on credit during the period. Thus, a downward adjustment must be made to net income to arrive at the ending cash balance. Although the revenue has been earned under accrual accounting standards, the customers have yet to make the due cash payments and this amount will be sitting as receivables on the balance sheet.

Answer 20

Deferred revenue (or "unearned" revenue) is a liability that represents cash payments collected from customers for products or services not yet provided. Some examples are gift cards, service agreements, or implied rights to future software upgrades associated with a product sold. In all the examples listed, the cash payment was received upfront and the benefit to the customer will be delivered on a later date. For instance, a company that sells a smartphone for $500 might allocate $480 of the sale to the phone and the remaining $20 to the value of the customer’s right to future software upgrades. Here, the company would collect $500 in cash, but only $480 would be recognized as revenue. The remaining $20 will stay recognized as deferred revenue until the software upgrades are provided.

Answer 21

For deferred revenue, the company received payments upfront and has unfulfilled obligations to the customers that paid in advance, hence its classification as a liability. Accounts Receivable is an asset because the company has already delivered the goods/services and all that remains is the collection of payments from the customers that paid on credit.

Answer 22

An increase in accounts payable would mean the company has been delaying payments to its suppliers or vendors, and the cash is currently still in the company's possession. The due payments will eventually be made, but the cash belongs to the company for the time being and is not restricted from being used. Thus, an increase in accounts payable is reflected as an inflow of cash on the cash flow statement.

Answer 23

The cash flow statement doesn't directly capture interest expense. However, interest expense is recognized on the income statement and then gets indirectly captured in the cash from operations section since net income is the starting line item on the cash flow statement.

Answer 24

IS: When a company initiates a dividend, there'll be no changes to the income statement. However, a line below net income will state the dividend per share (DPS) to show the amount paid. CFS: On the cash flow statement, the cash from financing section will decrease by the dividend payout amount and lower the ending cash balance at the bottom. BS: The cash balance will decline by the dividend amount on the balance sheet, and the offsetting entry will be a decrease in retained earnings since dividends come directly out of retained earnings.

Answer 25

There is no inventory line item on the income statement, but it gets indirectly captured, if only partially, in cost of goods sold (or operating expenses). For a specific period, regardless of whether the associated inventory was purchased during the same period, COGS may reflect a portion of the inventory used up. The two other financial statements would be more useful for assessing inventory as the cash flow statement shows the year-over-year changes in inventory, while the balance sheet shows the beginning and end-of-period inventory balances.

Answer 26

An increase in inventory reflects a use of cash and should thus be reflected as an outflow on the cash from operations section of the cash flow statement. The inventory balance increasing from the prior period implies the amount of inventory purchased exceeded the amount expensed on the income statement.

Answer 27

FIFO and LIFO are two inventory accounting methods to estimate the value of inventory sold in a period. Under First In, First Out (FIFO) accounting, the goods that were purchased earlier would be the first ones to be recognized and expensed on the income statement. Alternatively Last In, First Out (LIFO) assumes that the most recently purchased inventories are recorded as the first ones to be sold first. The impact on net income would depend on how inventory costs have changed over time: If inventory costs are rising: - FIFO would lower COGS since older (less expensive) inventory would be recognized. Increasing net income - LIFO would increase COGS because the newer (more expensive) inventory would be recognized. Lowering net income If inventory costs were decreasing: - FIFO would increase COGS because the older (more expensive) inventory would be recognized. Lowering net income - LIFO would decrease COGS because the recent (less expensive) inventory would be recognized. Increasing net income

Answer 28

Besides FIFO and LIFO, the average cost method is the third most widely used inventory accounting method. Under this method, the assigned inventory costs are based on a weighted average, in which the total costs of production in a period are summed up and divided by the total number of items produced. Each product cost is treated equally and inventory costs are spread out evenly, disregarding the date of purchase or production. Thus, this method is viewed as a simplistic compromise between the two other methods, but would be improper to use if the products sold are each unique with significant variance in the cost to manufacture and the sale price (i.e., more applicable for high-volume, identical batches of inventory).

Answer 29

Retained earnings represent the total cumulative net income a company has held since inception after accounting for any dividends paid out to its common and preferred shareholders. Current Period Retained Earnings=Prior Retained Earnings+Net Income –Dividends

Answer 30

The retention ratio represents the proportion of net income retained by the company, net of any dividends paid out to shareholders. The inverse of the retention ratio is the dividend payout ratio, which measures the proportion of net income paid out as dividends to investors. Retention Ratio=(Net Income−Dividends)/Net Income Dividend Payout Ratio=Dividends Paid/Net Income

Answer 31

1. Basic EPS: Determines a company's earnings on a per-share basis, but is allocable to only the basic shares outstanding (otherwise known as "common shares"). Basic EPS= (Net Income−Dividends on Preferred Stock)/Basic Weighted Average Shares Outstanding 2. Diluted EPS: Compares a company's earnings relative to its shares outstanding on a per-share basis but considers the impact of potentially dilutive securities such as options, warrants, and convertible securities. If an option is "in-the-money," the option holder can become a common shareholder at their choosing. Thus, diluted EPS is a more accurate depiction of ownership value per share. Diluted EPS=(Net Income−Dividends on Preferred Stock)Diluted Weighted Average Shares Outstanding

Answer 32

In the US, public companies are required to report periodic filings with the SEC, including an annual report (10-K) and three quarterly (10-Q) reports each year. These reports are available for free through SEC EDGAR.

Answer 33

The proxy statement, formally known as "Form 14A," is required to be filed before a shareholder meeting to solicit shareholder votes. The document must disclose all relevant details regarding the matter for shareholders to make an informed decision. In addition, the board of directors' compensation and other notable announcements such as changes to the company’s articles of incorporation are included.

Answer 34

An 8-K is a required filing with the SEC when a company undergoes a materially significant event and must disclose the details. Often called the "current report," 8-Ks are usually filed within four days of the event. The information contained within the report should be of high importance and pertinent to shareholders. Events that would trigger this filing would include previously unannounced plans for a new acquisition, disposal of assets, bankruptcy, a tender offer, the resignation of a senior-level manager or member of the board of directors, or disclosure that the company is under SEC investigation for alleged wrongdoing.

Answer 35

For public companies in the US, the reporting rules and guidelines are set by the Financial Accounting Standards Board (FASB) and referred to as US Generally Accepted Accounting Principles (US GAAP). The International Accounting Standards Board (IASB) oversees the International Financial Reporting Standards (IFRS), which is followed by over 144 countries. Understanding the differences between US GAAP and IFRS has become more important because: Continuation of Globalization: Globalization is the gradual convergence of economies in different countries. The widespread adoption of IFRS has placed pressure on the US to adopt IFRS to have a single set of accounting standards and rules used worldwide, but it seems unlikely in the near term. Geographic Diversification of Investments: In recent years, investment firms have been broadening their investments' geographic scope to consider more opportunities overseas. Nowadays, institutional investors are more open to making investments in emerging markets due to the prevalence of opportunities and as a strategy to re-risk their overall portfolio. Cross-Border M&A Activity: Cross-border mergers and acquisitions ("M&A") have emerged as a strategy for multinational companies to enter new markets, extend their reach to new potential customers, and diversify their revenue sources.

Answer 36

Gross Margin - The percentage of revenue remaining after subtracting just COGS, the direct costs associated with the company's revenue generation (e.g., direct materials, direct labor). - Gross Margin=Gross Profit/Revenue Operating Margin - The percentage of profitability after subtracting operating expenses from gross profit. This measure is useful for comparisons due to being independent of capital structure and taxes. - Operating Margin=EBIT/Revenue Net Profit Margin - The percentage of accrual profitability remaining after all expenses have been subtracted. Unlike operating margin, this measure is impacted by capital structure and taxes. - Net Profit Margin=Net Income/Revenue EBITDA Margin - The most widely used profit margin for benchmarking due to being independent of capital structure and taxes, in addition to adjusted for non-cash expenses (D&A) and non-recurring items. - EBITDA Margin=EBITDA/Revenue

Answer 37

The expression "the line" is in reference to operating income, which represents the point that divides normal, ongoing business operations from non-operational line items. “Above the Line”: If a profitability metric is "above the line," it reflects a company's operational performance before non-operational items such as interest and taxes. Financing-related activities are an example of such non-operational items, as decisions on how to fund a company are discretionary (debt vs. equity). For example, a metric such as earnings before interest, taxes, depreciation, and amortization ("EBITDA") is considered “above the line." Hence, its widespread usage for comparative purposes since operational performance is portrayed while being independent of capital structure and taxes. “Below the Line”: In contrast, profitability metrics "below the line" have adjusted operating income for non-operating income and expenses, which are items classified as discretionary and unrelated to the core operations of a business. An example would be net income, since interest expense, non-operating income/(expenses), and taxes have all been accounted for in its ending value.

Answer 38

While EBITDA does add back D&A, typically the largest non-cash expense, it doesn't capture the full cash impact of capital expenditures ("capex") or working capital changes during the period. EBITDA also doesn't adjust for stock-based compensation, although an increasingly used “adjusted EBITDA” metric does add-back SBC. These non-cash and any non-recurring adjustments must be properly accounted for to assess a company's past operational performance and to accurately forecast its future cash flows.

Answer 39

Non-recurring items include legal settlements (gain or loss), restructuring expenses, inventory write-downs, or asset impairments. Often called "scrubbing" the financials, the act of adjusting for these non-recurring items is meant to normalize the cash flows and depict a company's true operating performance.

Answer 40

Not necessarily, as whether an expense is non-recurring depends on the industry. In many cases, it's a discretionary decision on whether an expense is a part of the normal operations of a company. For example, expenses related to litigation might not be added back for a research and development (R&D) oriented pharmaceutical company, given the prevalence of lawsuits in the industry.

Answer 41

Organic Growth: A company experiencing organic growth is expanding to new markets, enhancing its sales & marketing strategies, improving its product/service mix, or introducing new products. The focus is on continuously making operational improvements and bringing in revenue (e.g., set prices more appropriately post-market research, target right end markets). Inorganic Growth: Once the opportunities for organic growth have been maximized, a company may turn to inorganic growth, which refers to growth driven by M&A. Inorganic growth is often considered faster and more convenient than organic growth. Post-acquisition, a company can benefit from synergies, such as having new customers to sell to, bundling complementary products, and diversification in revenue.

Answer 42

The more a company has spent on capex in recent years, the more depreciation the company incurs in the near-term future. Therefore, when looking at high-growth companies spending heavily on growth capex, their ratio between capex and annual depreciation will far exceed 1. For mature businesses experiencing stagnating or declining growth, this ratio converges near 1, as the only capex is related to routine maintenance capex (e.g., replace equipment, refurbish store layouts).

Answer 43

The working capital metric measures a company's liquidity and ability to pay off its current obligations using its current assets. In general, the more current assets a company has relative to its current liabilities, the lower its liquidity risk. Current liabilities represent payments that a company needs to make within the year (e.g., accounts payable, accrued expenses), whereas current assets are resources that can be turned into cash within the year (e.g., accounts receivable, inventory). Working Capital=Current Assets−Current Liabilities

Answer 44

In practice, cash and other short-term investments (e.g., treasury bills, marketable securities, commercial paper) and any interest-bearing debt (e.g., loans, revolver, bonds) are excluded when calculating working capital because they're non-operational and don't directly generate revenue. Net Working Capital (NWC)=Operating Current Assets−Operating Current Liabilities Cash & cash equivalents are closer to investing activities since the company can earn a slight return (~0.25% to 1.5%) through interest income, whereas debt is classified as financing. Neither is operations-related, and both are thereby excluded in the calculation of NWC.

Answer 45

Further context would be required, as negative working capital can be positive or negative. For instance, negative working capital can result from being efficient at collecting revenue, quick inventory turnover, and delaying payments to suppliers while efficiently investing excess cash into high-yield investments. However, the opposite could be true, and negative working capital could signify impending liquidity issues. Imagine a company that has mismanaged its cash and faces a high accounts payable balance coming due soon, with a low inventory balance that desperately needs replenishing and low levels of AR. This company would need to find external financing as early as possible to stay afloat.

Answer 46

The change in net working capital is important because it gives you a sense of how much a company's cash flows will deviate from its accrual-based net income. Change in Net Working Capital = NWC Prior Period − NWC Current Period If a company's NWC has increased year-over-year, its operating assets have grown and/or its operating liabilities have shrunk from the prior year. Since an increase in an operating asset is a cash outflow, it should be intuitive why an increase in NWC means less cash flow for a company (and vice versa).

Answer 47

Days Inventory Held ("DIH") - DIH measures the average number of days it takes for a company to sell off its inventory. - Companies strive to minimize their DIH and sell their inventory as soon as possible. - DIH=(Inventory/COGS)×365 Days Days Sales Outstanding ("DSO") - DSO represents the average number of days it takes for a company to collect payments made on credit. - Lower DSOs mean less time is needed to retrieve cash from sales made on credit. - DSO=(AR/Revenue)×365 Days Days Payable Outstanding ("DPO") - DPO refers to the average number of days it takes for a company to pay back its suppliers. - Higher DPOs indicate the company has more bargaining power over its suppliers. - DPO=(AP/COGS)×365 Days

Answer 48

The cash conversion cycle ("CCC") measures the number of days it takes a company to convert its inventory into cash from sales. Therefore, a lower cash conversion cycle is preferred as it implies the company generates and collects cash in a shorter duration. As a general rule, companies with lower CCCs operate efficiently, hold more negotiating power over suppliers, and have quicker sales collection cycles. Cash Conversion Cycle=DIO+DSO–DPO

Answer 49

- A/R typically grows along with revenue and should remain in-line with historical periods. - DSO often gradually decreases over time as companies become more efficient in payment collection. - DSO should be calculated for historical periods (DSO = A/R ÷ Revenue x 365) - Assumptions for DSO in future periods will be based on historical trends or an average. - Forecasted A/R can be calculated by (DSO assumption ÷ 365) x forecasted revenue.

Answer 50

- Inventory will grow in-line with COGS in most cases. - DIH can decrease over time as companies become more efficient at selling their inventory. - DIH would be calculated for historical periods (DIH = Inventory ÷ COGS x 365) - Historical trends or an average of past periods should be used for the DIH assumptions. - Forecasted inventory balance will be equal to the (DIH assumption ÷ 365) x forecasted COGS.

Answer 51

- Prepaid expenses will typically be SG&A related, but can grow with revenue if it's unclear. - Historical prepaid expenses would be calculated as a % of SG&A (or revenue). - Forecasted prepaid expenses will be equal to the % assumption x forecasted revenue.

Answer 52

- Other current assets normally grow along with revenue, assuming they're tied to operations. - Otherwise, can be straight-lined - Other current assets for past periods would be calculated by dividing past amounts by revenue. - Forecasted OCA would be equal to the % assumption x forecasted revenue.

Answer 53

- A/P will typically grow with COGS, especially if the company sells goods (i.e., inventory payment delays). - DPO can be assumed to gradually increase if the company might have more buyer power in the future. - DPO for past periods will be calculated (DPO = A/P ÷ COGS x 365). - Historical trends would be followed or an average can be taken for the assumption. - Forecasted A/P will be equal to the (DPO assumption ÷ 365) x COGS.

Answer 54

- Accrued expenses usually relate to operating expenses, thus it will grow along with SG&A (or revenue if it's unclear). - Accrued expenses as a percentage of SG&A will first be calculated for historical periods. - Forecasted accrued expenses will be the % SG&A assumption x current period SG&A.

Answer 55

- Deferred revenue is typically forecasted to grow with the revenue, as it's likely a part of the company's business model. - Deferred revenue as a % of revenue will be calculated for historical periods. - Forecasted D/R will be equal to the % of revenue assumption x forecasted revenue.

Answer 56

- Current liabilities are usually forecasted to grow with revenue - If the driver is unclear, it can be straight-lined. - Current liabilities as a % of revenue will be calculated for previous periods. - Forecasted OCL will be equal to the % of revenue assumption x current period revenue.

Answer 57

In the simplest approach, D&A can be projected as either a percentage of revenue or capital expenditures, while capex is forecasted as a percentage of revenue. Re-investments such as capex directly correlate with revenue growth, thus historical trends, management guidance, and industry norms should be closely followed. Alternatively, a depreciation waterfall schedule can be put together, which would require more data from the company to track the PP&E currently in-use and the remaining useful life of each. In addition, management plans for future capex spending and the approximate useful life assumptions for each purchase will be necessary. As a result, depreciation from old and new capex will be separately shown. For projecting amortization, useful life assumptions would also be required, which can often be found in a separate footnote in a company's financial reports.

Answer 58

- When forecasting PP&E, the end-of-period balance will be calculated using the roll-forward schedule shown below. Note, capex will input as a negative, meaning the PP&E balance should increase. Other factors that could affect the end-of-period PP&E balance are asset sales and write-downs. - PP&E Roll-Forward: EOP PP&E = BOP PP&E + Capex − Depreciation -To forecast intangible assets, management guidance becomes necessary as unlike capex, there's usually no clear historical pattern that can be followed as these purchases tend to be inconsistent. In most cases, it's best to rely on management if available, but in the absence of guidance, it's recommended to assume no purchases. - Intangible Assets Roll-Forward: EOP Intangibles = BOP Intangibles + Intangibles Purchases – Amortization

Answer 59

The current ratio and quick ratio are used to assess a company’s near-term liquidity position. The two ratios are both used to determine if a company can meet its short-term obligations using just its short-term assets at the present moment. - Current Ratio: A current ratio greater than 1 implies that the company is financially healthy in terms of liquidity and can meet its short-term obligations. - Current Ratio=Current Assets / Current Liabilities - Quick Ratio: Otherwise known as the acid-test ratio, the quick ratio measures short-term liquidity, but uses stricter policies on what classifies as a liquid asset. Therefore, it includes only highly liquid assets that could be converted to cash in less than 90 days with a high degree of certainty. - Quick Ratio = (Cash & Cash Equivalents + AR + Short Term Investments)/Current Liabilities

Answer 60

- The cash balance used includes the minimum cash amount required for working capital needs – meaning operations could not continue if cash were to dip below this level. - Similarly, the cash balance may contain restricted cash, which is not freely available for use by the business and is instead held for a specific purpose. - Short-term investments that cannot be liquidated in the markets easily could have been included (i.e., low liquidity, cannot sell without a substantial discount). - Accounts receivable could include “bad A/R", but management refuses to recognize it as such.

Answer 61

Not necessarily. Retained earnings can turn negative if the company has generated more accounting losses than profits. For example, this is often the case for startups and early-stage companies investing heavily to support future growth (e.g., high capex, sales & marketing expenses, R&D spend). Another component of retained earnings is the payout of dividends and share repurchases, contributing to lower or even negative retained earnings. In these scenarios, the negative retained earnings mean the company has returned more capital to shareholders than taken in.

Answer 62

To be profitable, a company must generate revenues that exceed expenses. However, if the company is ineffective at collecting cash from customers and allows its receivables to balloon, or if it cannot get favorable terms from suppliers and must pay cash for all inventories and supplies, the company can suffer from liquidity problems due to the timing mismatch of cash inflows and outflows. Profitable companies with these types of working capital issues can usually secure financing, but if financing suddenly becomes unavailable (e.g., 2008 credit crisis), the company could be forced to declare bankruptcy. Alternatively, a profitable company that took on far too much debt in its capital structure and could not service the interest payments may also default on its debt obligations.

Answer 63

Return on assets ("ROA") and return on equity ("ROE") are measures of profitability that show how effective a company’s management team is at utilizing the resources it has on-hand (assets or equity). - Return on Assets: ROA measures asset utilization and how efficiently a company's assets are used to generate earnings. A high ROA relative to a peer group indicates assets are being used near full capacity, whereas a low ROA means management may not be deriving the full potential benefit from its assets. - Return on Assets (ROA) =Net Income / (Average of Beginning and Ending Total Assets) - Return on Equity: The ROE ratio gives insight into how efficiently a management team has been using the capital shareholders have contributed. A higher ROE means management is efficient at using the money raised from equity financing (and vice versa). - Return on Equity (ROE) = Net Income / (Average of Beginning and Ending Book Value of Equity)

Answer 64

The relationship between ROA and ROE is tied to the use of leverage. In the absence of debt in the capital structure, the two metrics would be equal. But if the company were to add debt to its capital structure, its ROE would rise above its ROA due to increased cash, as total assets would rise while equity decreases.

Answer 65

Imagine a company with $100 in total assets. A 10% return on assets (ROA) would imply $10 in net income. Since the debt-to-equity mix is 50/50, the return on equity (ROE) is $10/$50 = 20%.

Answer 66

The numerator, usually net income, comes from the income statement. The denominator, either assets or equity, comes from the balance sheet. The income statement covers a specific period, whereas the balance sheet is a snapshot at one particular point in time. Thus, the average between the beginning and ending balance of the denominator is used to adjust for this mismatch in timing.

Answer 67

A company's ROA and ROE ratios are benchmarked against competitors in the same industry to assess management efficiency and track historical trends. However, the ROA and ROE ratios are most useful when compared to a peer group of companies with similar growth rates, margin profiles, and risks. This approach would be best suited for established companies operating in mature, low-growth industries with many comparable companies to accurately track the management team's profitability and efficiency.

Answer 68

The return on invested capital ("ROIC") metric is used to assess how efficient a management team is at capital allocation. A company that generates an ROIC over its cost of capital (WACC) suggests the management team has been allocating capital efficiently (i.e., investing in profitable projects or investments) and if sustained over the long-run, this indicates a competitive advantage. ROIC represents one of the most fundamental assessments of a company: "How much in returns is the company earning for each dollar invested?" Return on Invested Capital (ROIC) = NOPAT / Invested Capital - NOPAT: net operating profit after tax

Answer 69

The asset turnover ratio is a metric used to understand how efficiently a company uses its assets to generate sales. The asset turnover ratio answers the question, "How many dollars in revenue does the company generate per dollar of assets?" The higher the ratio, the better, as this suggests the company is generating more revenue per dollar of an asset owned. But it has shortfalls in being distorted by capital expenditures and asset sales. Asset Turnover Ratio = Revenue / (Average of Beginning and Ending Total Assets)

Answer 70

The inventory turnover ratio is how often a company has sold and replaced its inventory balance throughout a specified period (i.e., the number of times inventory was "turned over"). Inventory Turnover = Cost of Goods Sold / (Average of Beginning and Ending Inventory) In contrast, DIH is the average number of days it takes for a company to turn its inventory into revenue.

Answer 71

Accounts receivable turnover is a metric used to measure the number of times per year that a company can collect its average accounts receivable from customers. The higher the turnover ratio, the better as it indicates the company is efficient at collecting its due payments from customers that paid on credit. Receivables Turnover = Revenue / (Average of Beginning and Ending Accounts Receivables)

Answer 72

Accounts payable turnover measures how quickly a company pays its vendors. Generally, longer credit terms provide a company with more flexibility as it means the company has more cash-on-hand. A higher A/P turnover means the company pays off its A/P balance quickly, meaning the cash outflows occur faster. Accounts Payable Turnover = Cost of Goods Sold / (Average Beginning and Ending Accounts Payable)

Answer 73

Liquidity Ratios - Assesses a company’s ability to meet its current obligations using its current assets. - Current Ratio, Quick Ratio, Cash Ratio Leverage/Solvency Ratios - Compares a company's use of debt to assets, equity, earnings, and total capitalization to evaluate if its debt obligations can be met. - Debt-to-EBITDA, Debt-to-Assets, Debt-to-Equity Coverage Ratios - Measures a company's ability to service interest payments and other debt-related obligations using a cash flow metric. - Times Interest Earned, EBITDA Interest Coverage Ratio, Debt Service Coverage Ratio, Fixed Charge Coverage Ratio Profitability Ratios - Conveys a company's ability to consistently generate profits, enabling it to meet its debt obligations. - Gross, Operating, Net Profit, and EBITDA Margins % - ROE, ROA, and ROIC

Answer 74

Leverage Ratios - Leverage ratios compare the amount of debt held by a company to a specific cash flow metric, most often EBITDA. - Total Debt/EBITDA, Senior Debt/EBITDA, Net Debt/EBITDA, Total Debt/Equity, Total Debt/Total Capital Interest Coverage Ratios - Interest coverage ratios measure a company’s ability to cover its interest payments using its cash flows. The higher the interest coverage ratio, the better (ideally, >2.0x). - EBIT/Interest Expense, EBITDA/Interest Expense, EBITDA/Cash Interest Expense, (EBITDA-Capex)/Interest Expense

Answer 75

The debt service coverage ratio (DSCR) is a measure of creditworthiness that tests a company’s ability to pay its current debt obligations using its current cash flows. As a general rule, a DSCR greater than 1.0 shows the company is generating sufficient cash flows to pay down its debt. But a DSCR below 1.0 could be a cause of concern, as it suggests the company might have insufficient cash flows to handle the debt it currently holds. There are various methods to calculate the DSCR, but one commonly used example is shown below: - DSCR = (EBITDA− Capex) / (Mandatory Principal Repayment+ Interest Expense)

Answer 76

The fixed charge coverage ratio (FCCR) is used to assess if a company's earnings can cover its fixed charges, which can include rent, utilities, and interest expense. The higher the ratio, the better the creditworthiness. Fixed charges can include expenses such as rent or lease payments, and utility bills. Fixed Charge Coverage Ratio (FCCR) = (EBIT+Lease Charges) / (Lease Charges+Interest Expense)