financial statements and accrual concepts Flashcards
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
- spending too much on CapEx which is not reflected in EBITDA
- The company has high interest expense and is no longer able to afford its debt.
How do you calculate the debt service coverage ratio (DSCR) and what does it measure?
- calculate whether debt can be repaid using cash flow
- greater than one means it can pay back debt
- DSCR = (EBITDA - CapEx) / (Principle repayment + interest)
How would raising capital through share issuances affect earnings per share (EPS)?
- dilute EPS and hence less EPS worth
- however the cash from issuing shares increases NI, which increases EPS
- butissuing shares still has bigger impact bcuz returns on excess cash generated are low
- so still decreases EPS worth
what does rentention ratio represent and how is it related to dividend payout ratio?
- retention ratio = (net income - net dividends) / Net Income
- Dividend payout ratio = Dividend paid/net income
How to forecast current assets in working capital?
- AR: grows in line w revenue, DOS/365 * forecasted revenue
- Inventory: grow in line w COGS, DIH /365 * forecasted COGS
- prepaid expenses: related to SG&A (% of SG&A or revenue)
- other current assets: assume to grow w revenue or straight line growth
what is the LIFO FIFO method and what are its implications on net income
- FIFO: goods purchased earlier would be the ones expensed first on IS
- LIFO: most recent purchase of inventorues are sold first
- If rising inv cost: FIFO would cause a decrease in COGS and higher NI, LIFO would cause increase in COGS and lower NI (vice versa for decrease inv costs)
How are the 3 financial statements linked
????
what flows into APIC?
APIC = old APIC + stock based compensation + stock created by option exercises
Is EBITDA a good proxy for operating cash flow?
- not rlly because it doesnt include CapEx, which is rlly important for a company’s operations
- also doesnt include working capital
- nee to include non cash and non-rucurring adjustments to asses company’s past financial performance
Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and what does Goodwill Impairment mean?
- if during acquisition the buyer paid for a lot more than what the company is worth, and after acquisition during recalculation they realise the company was overpaid for and cant be recognised thru synergies, they write it off as goodwill impairment (an expense)
- or if they stopped a division of athe company and hence has to write off the goodwill associated with that
why can current ratio be misleading soemtime?
- 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
- restricted cash and restricted marketable securities (need to be sold at discount)
- bad AR
how to calculate DSO
DSO = (AR/Revenue )*365
why woudl you use Net profit margin
- look at profitability of a company which is impacted by capitak structure and taxes
10-K and 10-Q differences
- 10-K is annual, 10-Q is quarterly. Both are required by SEC for public compaies
- 10-K is more detailed and in depth, and 10-Q normally only has quarter financials and other sectioons ar ekept brief
- 10-K is required to be audited by indepenent accounting firms like Big 4, whereas 10-Qs ae left unaudited and only reviewed by CPAs
why do we add back D&A, and impairment to cash flow statement
- because these are non-cash expenses—they reduce net income on the income statement but don’t actually involve any cash outflow.
- actual cash outflow for PP&E has already occured
key line items of income statement
- revenue
- (less) COGS, SG&A
- EBITDA
- (less) D&A
- operating income (EBIT)
- pre-tax income (EBT)
- net income
What is the relationship between return on assets (ROA) and return on equity (ROE)?
- they are tied through the use of debt
- increase in debt financing would increase assets and decrease equity used
- which would lead to an increase on ROE (bcuz less equity used) and decrease of ROA (asset akak cash increases while return on cash doesnt)
What does change in net working capital tell you about a company’s cash flows?
- if net working capital increases its operating assets have grown and/or its operating liabilities have shrunk from the prior year
- increase in operating asset is cash outflow, hence it means less cash flow for a company
why use EBITDA margin?
independent of capital structure, taxes and adjusted for non cash D&A and non recurring items
how to project balance sheet items like AR, AE?
- Accounts Receivable: % of revenue.
- Deferred Revenue: % of revenue.
- Accounts Payable: % of COGS.
- Accrued Expenses: % of operating expenses or SG&A.
Accrual vs cash based accounting
- Accrual: revenue recognised when its delivered, and expenses for that revenue are incurred in same period
- Cash based: revenue and expenses are recognised once cash is received or spent, regardless of when product was delivered
How should you project Depreciation & Capital Expenditures?
as a % of revenye or previous PP&E balance
What is difference between Common Stock, APIC, Preferred Stock, Treasury Stock
????
if company has negative retained earnings is that bad?
- yes in a lot of cases
- no if the company is a stratup and is not yet profitable
how do 3 statements link tgt?
- IS -> CFS: the net income flows into operating first line of cash flow statement
- CFS -> BS: changes in NWC (operating cash) (current assets and liabilities) is also reflected in the current liabilities and assets, impact of CapEx on (investing cash) also reflected in PP&E on balance sheet, ending cash balance in CFS will slow into the cash in balance sheet
- BS-> IS: PP&E D&A on BS is reflected on INcome statement as an expense, interest expense is also calculated off the balance sheet, Net Income (IS) minus dividend will give retained earnings (shareholder’s equoity) for current period
why would you want to use gross margins?
if you want to look at the revenue remaining (or profitabikity) subtract COGS (direct costs associated w company revenue)
why is Why are cash and debt excluded in the calculation of net working capital (NWC)?
Net Working Capital (NWC) = Operating Current Assets − Operating Current Liabilities
- because they are non operational and dont generate revenue
walk me through 3 financial statements
- Income Statement: balance sheet, cash flow statements
- Income (aka PnL): revenue and expenses, goes down from revenue to net income (annual)
- balance sheet: shows assets (cash, inventory, PPE), liabilities ( accounts payable, debt) and shareholders equity. split into current and non-current. Assets = liabilities + shareholders equity (annual)
- Cash flow statement: begin w net income, adjust for non chase, and change in working capitral, then shows cahs flow from operating, financing and investing. end: see net change in cash (snapshot)
what are some profitability margins?
- Gross margins: Gross profit (just subtract COGS only)/rev
- Operating Margin: EBIT/Revenue
- Net Profit Margin: Net Income/Revenue
- EBITDA margin: EBITDA/Revenue
What does negative Working Capital mean? Is that a bad sign?
- depends
- company which have a lot of long term contract often have negative NWC cuz of high deferred revenue (counts as liability), amazon customers pay upfront before they send it out, to generate cash to pay accounts payable rather than keeping cash on hand - business efficiency
- however, NWC can mean financial trouble if customers dont pay quicky and company is alr carrying high debt balance
How do you calculate the fixed charge coverage ratio (FCCR) and what does it mean?
- 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.
- higher ratio = better credit
- FCRR = (EBIT+lease charge) / (lease charge + interest expense)
When do you capitalize vs. expense items under accrual accounting?
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).
- item dependes on whether being capitalized as an asset or gets expensed in the period incurred is its useful life (i.e., estimated timing of benefits).
- if item is long term benefit to company (PP&E), then lifetime depreciation, hence capitalized and expensed over time
- if item is short term and benefits are short term, then the related expense should be done in the same period. (i.e expense for wages needs to be in same period as employee doing the work)
please break down the line items of assets in Balance sheet
- Current Assets (in order of liquidity)
1. Cash and Cash Equivalents: cahs + short term gov bonds
2. Marketable securities: short term debt or equity securities than can be liquidated quickly
3. Accounts receivable: payments owed to bsuiness by its customers for product/service which is alr been delivered (like IOU)
4. Inventories: raw materials, unfinished/finished goods waiting to be sold + direct costs associated to producing these goods
5. Prepaid expenses: prepaid expenses in advance for good/services to be provided at a later date (i.e insurance, rent) - Non -current assets (hard to liquidate)
1. PP&E Property Plant and Equiptment:
2. Intangble Assets: non-physical assets such as IP or patents
3. Goodwill: Intangible asset to account for the extra purchase price of a fair market value of an acquired asset
major lines for cash flow statment
- 3 sections: cash from operations, cash from investing, cash from financing
- operating: Net income + non cash expense (D&A), stock based compensation, change in NWC
- investing: CapEx, business acquisitions or divestitures,
- financing: (shows raising capital from issuing debt or equity): cash from repurchase of shares, repayement of debt, dividend of shareholders
- some of each section = total net change in cash
- add to begining of period cash (retained Earnings) = ending cash balance
how is goodwill increased?
- normally when u reassess the intangible asset of a company (but v rare)
- more generally it acts as a plug for when you purchase a company for a lot of money over its fair market value, the extra money will be written as goodwill on acquirers balance sheet
operating lease vs capital lease
- operating lease shows up in operating expense: short term lease of PP&E, do not involve ownership of anything
- Capital lease are longer term items and give the lessee ownershio rights, they cand depreciate and incur interest payments. Counted as debt.
- counts as capital lease if: can be bought at the end term w bargain price, is a transfer of ownership at end term, term of the lease is >75% of the useful life of an asset,
what are some non cahs expenses that need to be added back during CFS
- D&A
- goodwill write down
- asset writedown
- stock based compensation
what are some ratios to use to perform credit analysis
- liquidity ratios: ability for company to meet is obligations using current assets. current ratio, quick ratio, cash ratio
- leverage ratios: looks at how company uses debt and whether these debt obligations can be met. Debt/EBITDA, Debt/Assets, Debt/Equity
- coverage ratios: company ability to pay interest, pay off debt, and other debt related obligations using cash flow metric. EBITDA Interest, Debt service coverage ratio, fixed charge coverage ratio
- Profitability ratios: whether company can consitantly generate profit. Gross, operating, net profit margins, EBITDA margins, ROE, ROA, ROIC
are intangible assets on balance sheet
- internally developed IP cannot be recorded on BS, no value can be asisgned to IPs
what is current ratio and quick ratio
- both used to see if company can meet its short term obligations w short term assets in present moments, greater than 1 means it is financially healthy
- current ratio = Current assets/current liabilities.
- quick ratio = (cash & cash eqivalents + AR + short term investments)/ current liabilities
- quick ratio measures short term liquidity
limitatiosn of using ROE and ROA for company comparison?
- only suitable if the compared company are in same industry, w similar growth, and risks
- so not suitable in looking at companies which have v differet growth rates risks or are at different stages of the cycle (starup vs mature)