Basic Accounting Qs

Question 1

Walk me through the 3 financial statements

Answer 1

IS, BS and CFS
IS: show’s the company’s revenue and expenses over a period of time, down to net income
CFS: begins with net income, adjust non-cash expenses, and changes in working capital for CFO, then shows how company has received or spent cash in CFF and CFI, to see company’s net change in cash
BS: shows company’s assets, liabilities and equity at a given point in time/

Question 2

If stranded on a desert island, and only had one financial statement to review overall health of a company, use which one

Answer 2

Use CFS as it gives a true picture of how much cash the company is actually generating, IS includes non-cash expenses and excludes actual cash expenditures like CapEx.

Question 3

If i could only look at 2 statements, which?

Answer 3

IS and BS as you can create the CFS from both of those, assuming that you have beginning and ending balance sheets which correspond to the same period the IS is tracking.

Question 4

How can you tell whether or not an expense should appear on the IS?

Answer 4

1. Must correspond to something in the current period
2. Must be tax deductible.

Question 5

Let’s say that you have a non-cash expense (Depreciation or Amortization, for example) on the Income Statement. Why do you add back the entire expense on the Cash Flow Statement?

Answer 5

Because you want to reflect that you’ve saved on taxes with the non-cash expense.

Non cash expense of 10 is a $4 tax save.

Question 6

How do you decide when to capitalize rather than expense a purchase

Answer 6

If purchase corresponds to an asset with a useful life of over 1 year, capitalised - put on BS as an asset rather than as an expense on the IS, then it is depreciated - tangible assets, or amortised - intangible assets, over a certain number of years

E.g. factories

Question 7

If Depreciation is a non-cash expense, why does it affect the cash balance?

Answer 7

It is tax deductible, so an increase in depreciation will reduce amount of taxes paid - increasing cash balance

Question 8

Where does Depreciation usually appear on the Income Statement

Answer 8

Could be in a separate line item, or embedded in COGS or Operating Expenses - depends on company.

End result is the same, always reduces Pre-Tax income.

Question 9

Why is the Income Statement not affected by Inventory purchases?

Answer 9

Only recorded on IS when the goods associated with it have been manufactured and sold, under COGS.

Question 10

Debt repayments show up in CFF, why not interest payments, that is inanciang

Answer 10

Interest payments correspond to current period and are tax deductible, so already have appeared on the IS. Would be double counting

Question 11

so what’s the difference between Accounts Receivable and Deferred Revenue?

Answer 11

1. Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue
2. Accounts revenue is an asset, deferred revenue is a liability.

Question 12

How long does it usually take for a company to collect its Accounts Receivable balance?

Answer 12

Usually between 30-60 years, but can be higher for companies selling higher-priced items and it might be lower for companies selling lower-priced items with cash payments only.

Question 13

You’re reviewing a company’s Balance Sheet and you see an “Income Taxes Payable” line item on the Liabilities side. What is this?

Answer 13

ITP refers to normal income taxes that accrue and are then paid out in cash, like accrued expenses, but for taxes instead

E.g. company pays corporate tax in cash every 3 months, but also have monthly IS where they record income taxes, even if they havent been paid out in cash yet, which increase ITP account until they are paid out in cash.

Question 14

You see a “Noncontrolling Interest” (AKA Minority Interest) line item on the Liabilities side of a company’s Balance Sheet. What does this mean?

Answer 14

If you own 50<x<100% of another company, refers to the portion you do not own

Question 15

You see an “Investments in Equity Interests” (AKA Associate Companies) line item on the Assets side of a firm’s Balance Sheet. What does this mean?

Answer 15

If you own 20-50% of another company, refers to the portion you do own

Question 16

Could you ever have negative SE?

Answer 16

Yes
- LBO with dividend recapitalisation, means the owner has taken out a large portion of its equity, which can sometimes turn the number negative
- can also happen if the company has been losing money consistently, and thus has a declining RE balance, which is a portion of SE

Question 17

What is Working Capital? How is it used?

Answer 17

Working capital = current assets - current liabilities

Positive means a company can payoff its ST liabilities with its ST assets, often presented as a financial metric and its magnitude + sign tells you whether or not the company is sound.

Question 18

What is operating working capital?

Answer 18

Used more commonly in finance, defined as current assets excluding cash and investments - currently liabilities excluding debt
- point is to exclude items which relate to a company’s financing and investment activities - cash, investments and debt from the calculation

Question 19

Short-Term Investments” is a Current Asset – should you count it in Working Capital?

Answer 19

If you wanted to be technical, should be left in working capital, but left out of operating working capital.
- but in reality, no one lists ST investments in this section because purchases and sales of investments are considered investing activities, not operational activities.

Question 20

What does negative (Operating) Working Capital mean? Is that a bad sign?

Answer 20

Not always, depends:
1. Some companies with subscriptions or long term contacts may have negative working capital because of high deferred revenue balances.
2. Amazon and them have negative WC in general, as customers pay upfront, then wait to receive their goods.
3. But in some cases, could point to financial troubles, like lots of debt

Question 21

Let’s say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Answer 21

Under cash based: revenue would not show up until company sharpens customer’s credit card, receives authorisation and deposits funds in its bank - straight to revenue on IS and cash on BS

On accrual: show up as revenue right away, but go to accounts receivable on BS, once paid, move from accounts receivable to cash

Question 22

Why do companies report GAAP or IFRS earnings, AND non-GAAP / non- IFRS (or “Pro Forma”) earnings?

Answer 22

Many companies have non-cash charges like amortisation of intangibles, write downs, etc on income statements, which negatively impact net income

So report alternative pro forma metrics which exclude these expenses and paint a more favourable picture of earnings, arguing these metrics better represent true cash earnings.

Question 23

A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?

Answer 23

Lots of possibilities:
- spending too much on CapEx, not reflected in EBITDA, but could make company cash flow- negative
- high interest expense and no longer able to pay debt
- company’s debt all matures on one date, and unable to refinance it due to a credit crunch - runs out of cash when paying back the debt
- significant one time charges excluded from EBITDA, high enough to bankrupt the company.

Question 24

Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?

Answer 24

Goodwill is paying a premium for what it really got out of the deal, impairment happens when buyer feels they overpaid for the seller, can result in extremely negative net income on the IS.