Accounting (Very Advanced) Flashcards
- Wal-Mart buys a $200 factory
but pays for it using debt. What happens on the
statements immediately after this transaction?
Then one year passes. The company pays 10% interest on its debt, and it depreciates $10 on the
factory each year. It also repays $20 of the loan each year. What happens on the statements
in this first year?
Income Statement: No changes.
• Cash Flow Statement: There’s no net change in cash because the $100 factory purchase
counts as CapEx, which reduces cash flow, and the $100 debt issuance is a cash inflow.
• Balance Sheet: PP&E is up by $100, so the Assets side is up by $100, and Debt is up by
$100, so the L&E side is up by $100, and the Balance Sheet stays balanced.
• Intuition: This is a simple debt issuance and PP&E purchase, neither of which affects the
company’s taxes.
Then,
10% interest corresponds to $10 in interest since we use the beginning debt balance to
calculate interest. So:
• Income Statement: You record $10 in interest and $10 in Depreciation, so Pre-Tax
Income falls by $20, and Net Income falls by $12 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $12, but the $10 in Depreciation is noncash, so you add it back. The $20 loan repayment counts as a cash outflow, so cash at
the bottom of the CFS is down by $22.
• Balance Sheet: Cash is down by $22, and PP&E is down by $10, so the Assets side is
down by $32. On the L&E side, the Debt is down by $20 and Retained Earnings is down
by $12 due to the reduced Net Income, so the L&E side is also down by $32 and both
sides balance.
• Intuition: Cash declines mostly because of the principal repayment; the interest
expense is offset a bit by the tax savings from the Depreciation.
- A year passes, and Wal-Mart sells the $200 of Inventory for $400. However, it also has to
hire additional employees for $100 to process the orders.
The company also pays 5% interest on its debt and repays 10% of the principal. What
happens on the statements over the course of THIS one year?
This question is the standard “Sell inventory for a certain amount of revenue” one, but there
are a few twists. For one, we also have to factor in $100 of additional Operating Expenses.
Also, we have to include the $10 interest expense on the debt ($200 * 5%) and the $20
principal repayment ($200 * 10%).
• Income Statement: Revenue is up by $400, but COGS is up by $200, and Operating
Expenses are up by $100 because of the extra employees. There is also $10 of additional
Interest Expense because of the 5% interest rate on $200 of debt, so Pre-Tax Income is
up by $90. Net Income is up by $54 at a 40% tax rate.
• Cash Flow Statement: Net Income is up by $54, and the company’s COGS decreasing by
$200 frees up an additional $200 of cash flow. So far, cash flow is up by $254. The
company also has to repay 10% * $200, or $20, of the debt principal, and so cash at the
bottom is up by $234.
• Balance Sheet: Cash is up by $234, but Inventory is down by $200, so the Assets side is
up by $34. On the L&E side, Debt is down by $20, and Retained Earnings is up by $54
because of the increased Net Income, so the L&E side is up by $34 and both sides
balance.
• Intuition: The company has bought goods, turned them into finished products, and
profited from the sale. The company’s cash goes up by less than expected because of
the debt principal repayment and interest.
- A company issues $100 in Preferred Stock to buy $100 in long-term investments in real
estate. The Preferred Stock has a coupon rate of 8%, and the long-term investments yield
10%. What happens on the statements after a year?
Although you subtract Preferred Dividends from Net Income to calculate Net Income to
Common, the Preferred Dividends are NOT tax-deductible.
• Income Statement: The company will record 10% * $100, or $10, in Interest Income on
the real estate, so its Pre-Tax Income increases by $10. At a 40% tax rate, its Net Income
goes up by $6. The $8 in Preferred Dividends are NOT tax-deductible, so they simply
reduce Net Income by $8, and so “Net Income to Common” is down by $2.
• Cash Flow Statement: Net Income to Common is down by $2. There are no other
changes on the CFS in this period because there’s no principal repayment of the
Preferred Stock, and nothing changes with the long-term investments. So cash at the
bottom is down by $2.
• Balance Sheet: Cash is down by $2, so the Assets side is down by $2. On the other side,
Retained Earnings is down by $2, so the L&E side is also down by $2 and both sides
balance.
• Intuition: The point of this question is that taxes play a huge role in making investment
decisions. Since the investment income on the real estate is taxable, whereas Preferred
Dividends are not, the company LOSES money! The after-tax yield of the real estate is
only 10% * (1 – 40%), or 6%, which is less than the 8% Preferred coupon.
- What is Working Capital?
The official definition of Working Capital is “Current Assets minus Current Liabilities,” but the
more useful definition is:
Working Capital = Current Assets (Excluding Cash and Investments) – Current Liabilities
(Excluding Debt)
This one is sometimes called Operating Working Capital instead.
You may also include Long-Term Assets and Liabilities that are related to the company’s
business operations (Long-Term Deferred Revenue is a prime example).
Working Capital by itself tells you whether a company needs more in operational assets or
operational liabilities to run its business, and how big the difference is. But the Change in
Working Capital (see below) matters far more for valuation purposes.
- Why do you exclude cash, investments, and debt when calculating the Change in Working
Capital on the Cash Flow Statement?
Although many of these items are Current Assets or Current Liabilities, you exclude them
because:
• Cash – The bottom of the CFS already calculates the Net Change in Cash and the ending
Cash balance; if you did it within the Working Capital area, you’d be double-counting it.
• Investments – Investment sales and purchases are considered investing activities, not
operational ones, even if they’re short-term.
• Debt – Debt issuances and repayments are considered financing activities, not
operational ones, even if the debt is short-term.
- A company’s Working Capital has increased from $50 to $200. You calculate the Change in
Working Capital by taking the new number, $200, and subtracting the old number, $50, and
so the change is positive $150.
But on the Cash Flow Statement, the company records the Change in Working Capital as
negative $150. Is the company wrong?
No, the company is correct. On the Cash Flow Statement, the Change in Working Capital is
equal to Old Working Capital – New Working Capital.
Pretend that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to
$200, that is clearly a use of cash that will reduce the company’s cash flow, and as such, it
should be shown as a negative $150 on the CFS.
You can also think of this one by breaking down the individual components:
Change in WC = Old WC – New WC
Change in WC = (Old Current Assets – Old Current Liabilities) – (New Current Assets – New
Current Liabilities)
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Change in WC = (Old Current Assets – New Current Assets) + (New Current Liabilities – Old
Current Liabilities)
So like everything else on the Cash Flow Statement, if assets increase, they reduce the cash
flow. And if liabilities increase, the opposite happens.
When a company’s Working Capital INCREASES, the company USES cash to do that; when
Working Capital DECREASES, it FREES UP cash.
- What does the Change in Working Capital mean?
The Change in Working Capital tells you if the company needs to spend in ADVANCE of its
growth, or if it generates more money as a RESULT of its growth.
For example, the Change in Working Capital is almost always negative for retailers because they
must spend money on Inventory before being able to sell products.
But the Change in Working Capital is often positive for subscription-based companies that
collect cash from customers far in advance because Deferred Revenue increases whenever they
do that.
The Change in Working Capital directly increases or decreases Free Cash Flow, which, in turn,
directly affects the company’s valuation.
- You’re comparing two companies. Company A’s Change in Working Capital as a % of the
Change in Revenue is 10%, but Company B’s is negative 5%.
Which industries are these companies MOST likely to be in?
It means that the company’s Net Income or non-cash charges are growing by more than its
Change in WC is declining, or that its CapEx is becoming less negative (i.e., shrinking) by more
than the Change in WC is declining.
If a company’s Net Income is growing for legitimate reasons, this is a positive sign. But if higher
non-cash charges or artificially reduced CapEx are boosting FCF, both of those are negatives.
- What does it say about a company if its Days Receivables Outstanding is ~5, but its Days
Payable Outstanding is ~60?
It tells you that the company has quite a lot of market power to collect cash from customers
quickly, but to delay paying its suppliers for a long time. Examples might be companies like
Amazon and Wal-Mart that completely dominate their respective markets and that can coerce
suppliers into agreeing to their terms.
