IB Accounting Questions Flashcards
What is the primary purpose of US GAAP?
In the US, the Securities and Exchange Commission (“SEC”) authorizes the Financial
Accounting Standards Board (“FASB”) to determine the set of accounting rules followed by publicly traded companies.
Under FASB, financial statements are required to be prepared in accordance with US Generally Accepted Accounting Principles (“US GAAP”). Through the standardization of financial reporting and ensuring all financials are presented
on a fair, consistent basis – the interests of investors and lenders are protected.
What are the main sections of a 10-K?
Three core financial statements: the income statement, cash flow statement,
and balance sheet. There’ll also be a statement of shareholders’ equity, a statement of comprehensive income,
and supplementary data and disclosures to accompany the financials. (Main sections of a 10-k: Business overview, MD&A, Notes
What is the difference between the 10-K and 10-Q?
10-K is the annual report required to be filed with the SEC (audit required, filed within 60-90 days after the fiscal year) vs 10-Q refers to the quarterly report required to be filed with the SEC (only reviewed by CPAs, left unaudited, submitted 40-45 days after the quarter ends)
Walk me through the three financial statements.
Income Statement (“IS”): The income statement shows a company’s “profitability over a specified period”, typically quarterly and annually. The beginning line item is revenue and upon deducting various costs and expenses, the ending line item is net income.
Balance Sheet (“BS”): The balance sheet is a snapshot of a company’s resources (assets)
and sources of funding (liabilities and shareholders’ equity) “at a specific point in time”, such as the end of a quarter or fiscal year.
Cash Flow Statement (“CFS”): Under the indirect approach, the starting line item is net income, which will be adjusted for non-cash items such as D&A and changes in working capital to arrive at cash from operations. Cash from investing and financing activities are then added to cash from operations to arrive at the net change in cash, which represents the “actual cash inflows/(outflows) in a given period”.
Walk me through the balance sheet
Assets Section: Organized in the order of liquidity. “Current Assets” being assets that can be converted into cash within a year, such as cash itself, along with
marketable securities, accounts receivable, prepaid expenses, and inventories. “Long-Term Assets” include property, plant, and equipment (PP&E), intangible assets, goodwill, and long-term investments.
Liabilities Section: Liabilities are listed in the order of how close they’re to coming due. “Current
Liabilities: How close they’re to coming due. “Current Liabilities” include accounts payable, accrued expenses, and short-term debt, while “Long-Term Liabilities” include items such as long-term debt, deferred revenue, and deferred income taxes.
SHE: The equity section consists of common stock, additional paid-in capital (APIC), treasury stock, and retained earnings.
What do assets, liabilities, and equity each represent?
Assets: Resources with economic value that can be sold for money or bring positive monetary benefits in the future. - Inflow
Liabilities: Unsettled obligations to another party in the future and represent the external sources of capital from third-parties, which help fund the company’s assets (e.g., debt capital, payments owed to suppliers/vendors). - Outflow
Equity: Capital invested in the business and represents the internal sources of capital that helped fund its assets.
Walk me through the cash flow statement (indirect approach)
Cash from Operations: The cash from operations section starts with net income and adds back non-cash expenses such as depreciation & amortization and stock-based
Statement compensation, and then makes adjustments for changes in working capital.
- Cash from Investing: Next, the cash from investing section accounts for capital expenditures (typically
the largest outflow), followed by any business acquisitions or divestitures. - Cash from Financing: In the third section, cash from financing shows the net cash impact of raising capital from issuances of equity or debt, net of cash used for share repurchases, and repayments of debt.
The cash outflows from the payout of dividends to shareholders will be reflected here as well.
Together = Net Change in Cash for the Period
How are the three financial statements connected?
IS ↔ CFS: Connected through net income, as net income is the starting line on the cash flow statement.
CFS ↔ BS: CF is connected as it tracks
the changes in the balance sheet’s working capital (current assets and liabilities). The
impact from capital expenditures (PP&E), debt or equity issuances, and share buybacks (treasury stock) are also reflected on the balance sheet. In addition, the ending cash balance from the bottom of the cash flow statement will flow to the balance sheet as the cash balance for the current period.
IS ↔ BS: The income statement is connected to the balance sheet through retained earnings. Net income minus dividends issued during the period will be added to the prior period’s retained earnings balance to
calculate the current period’s retained earnings. Interest expense on the income statement is also calculated off the beginning and ending debt balances on the balance sheet, and PP&E on the balance sheet
is reduced by depreciation, which is an expense on the income statement.
If you have a balance sheet and must choose between the income statement or cash flow
statement, which would you pick?
Assuming that I would be given both the beginning and end of period balance sheets, I would choose the income statement since I could reconcile the cash flow statement using the balance sheet’s year-over-year
changes along with the income statement.
Which is more important, the income statement or the cash flow statement?
The cash flow statement is arguably more important because it reconciles net income, (the accrual-based bottom line on the income statement) to what is actually occurring to cash. This means the actual movement of cash during the period is reflected on the cash flow statement. Thus, the
cash flow statement brings attention to liquidity-related issues and investments and financing activities that
don’t show up on the accrual-based income statement.
If you had to pick between either the income statement or cash flow statement to analyze a company, which would you pick?
Cash is king. The cash flow statement would be chosen since the cash flow statement reflects a company’s true liquidity and is not prone to the same discretionary accounting conventions used in accrual accounting.
Why is the income statement insufficient to assess the liquidity of a company?
A company can consistently show positive net income yet struggle to
collect sales made on credit. The company’s inability to retrieve payments from
customers would not be reflected on its income statement.
The solution to the shortcomings of the income statement is the cash flow statement, which reconciles net
income based on the real cash inflows/(outflows) to understand the true cash impact from operations,
investing, and financing activities during the period.
What are some discretionary management decisions that could inflate earnings (7)?
Extending asset useful lives: Overestimating capital expenditure lifespans reduces annual depreciation, boosting net income.
LIFO to FIFO switch: During rising inventory costs, FIFO lowers COGS, increasing reported profits.
Delaying asset write-downs: Avoiding impairment charges preserves equity and prevents income reduction.
Capitalizing vs. expensing: Classifying costs as long-term assets (e.g., software) spreads expenses over time, inflating short-term earnings.
Share buybacks: Reducing outstanding shares artificially raises EPS without operational improvement.
Deferring capex/R&D: Postponing investments temporarily enhances current-period profitability and cash flow.
Aggressive revenue recognition: Recognizing revenue prematurely inflates income by relaxing performance obligations.
Tell me about the revenue recognition and matching principle used in accrual accounting.
Revenue Recognition Principle: Revenue is recorded in the same period the good or service was delivered (and therefore “earned”), whether or not cash was collected from the customer.
Matching Principle: The expenses associated with the production/delivery of a good or service must be recorded in the same period as when the revenue was earned.
What is the difference between cost of goods sold and operating expenses?
Cost of Goods Sold: COGS represents the “direct costs associated with the production of the goods sold or the delivery of services to generate revenue”. Examples include direct material and labor costs.
Operating Expenses: Operating expenses such as SG&A and R&D are “not directly associated with the production of goods or services offered”. Often called indirect costs, examples include rent, payroll, wages,
commissions, meal and travel expenses, advertising, and marketing expenses.
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).
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: 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.
If depreciation is a non-cash expense, how does it affect net income?
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.
Do companies prefer straight-line or accelerated depreciation?
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.
What is the relationship between depreciation and the salvage value assumption?
Most companies will 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 residual 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.
How would a $10 increase in depreciation flow through the financial statements?
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.
(The depreciation expense will decrease the earnings, with a portion of this being the tax expense, which saved us $3, therefore the net effect is 7 net income, but then on the cash flow statement we then add back the depreciate, resulting in a ending cash balance of $3.)
A company acquired a machine for $5 million and has since generated $3 million in accumulated
depreciation. Today, the PP&E has a fair market value of $20 million. Under GAAP, what is the value
of that PP&E on the balance sheet?
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.
Under IFRS, the revaluation of PP&E to fair value is permitted. Even though permitted, it’s not widely used and
thus not even well known in the US. Don’t voluntarily bring this up in an interview on your own.
What is the difference between growth and maintenance capex?
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).
Which types of intangible assets are amortized?
Customer lists, copyrights, trademarks,
and patents, which all have a finite life and are thus amortized over their useful life.
What is goodwill and how is it created?
Goodwill is the
excess premium
paid over the fair
value, and is created
to “plug” this gap for
the balance sheet to
remain in balance.
“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.”
Can companies amortize goodwill?
Assumed to have an indefinite
life, similar to land. Instead, goodwill must be tested annually for impairment.
What is the “going concern” assumption used 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.
Explain the reasoning behind the principle of conservatism in accrual accounting.
For any revenue or
expense to be
recognized, there
must be evidence of
occurrence with a
measurable
monetary amount.
Why are most assets recorded at their historical cost under accrual accounting?
An asset’s value on the balance sheet must reflect the initial purchase price. This represents the most consistent measurement method since
there’s no need for constant revaluations and markups, thereby reducing market volatility.
What role did fair-value accounting have in the subprime mortgage crisis?
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.
Why are the values of a company’s intangible assets not reflected on its balance sheet?
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
If the share price of a company increases by 10%, what is the balance sheet impact?
There would no change on the balance sheet as shareholders’ equity reflects the book value of equity (Total Assets – Total Liabilities)
vs
Equity value, also known as the “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.
Do accounts receivable get captured on the income statement?
No accounts receivable line item on the income statement, but it gets captured, if only partially,
indirectly in revenue.
(The cash flow statement will reconcile revenue to cash revenue, while the absolute
balance of accounts receivable can be observed on the balance sheet.)
Why are increases in accounts receivable a cash reduction on the cash flow statement?
Increases in
working capital
assets are cash
outflows, whereas
increases in working
capital liabilities are
cash inflows.
What is deferred revenue?
Is cash payment was received upfront and the benefit to the customer will be delivered on a later date, i.e. gift card
Why is deferred revenue classified as a liability while accounts receivable is an asset?
Deferred Revenue (liability): Unfulfilled
obligations to the customers that paid in advance
A/R (asset): Already delivered the goods/services and all that remains is the collection of payments from the customers that paid on credit.
Why are increases in accounts payable shown as an increase in cash flow?
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.
Which section of the cash flow statement captures interest expense?
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.
What happens to the three financial statements if a company initiates a dividend?
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.
Do inventories get captured on the income statement?
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.
How should an increase in inventory get handled on the cash flow statement?
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.
What is the difference between LIFO and FIFO, and what are the implications on net income?
FIFO and LIFO are two inventory accounting methods to estimate the value of inventory sold in a period, effected by the change in inventory costs over time.
First In, First Out (“FIFO”): Under FIFO accounting, the goods that were purchased earlier would be the
first ones to be recognized and expensed on the income statement.
Last In, First Out (“LIFO”): Alternatively, LIFO assumes that the most recently purchased inventories are
recorded as the first ones to be sold first.
What is the average cost method of inventory accounting?
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,
How do you calculate retained earnings for the current period?
Current Period Retained Earnings = Prior Retained Earnings + Net Income – Dividends
What does the retention ratio represent and how is it related to the dividend payout ratio?
Represents the proportion of net income retained by the company, net of any dividends paid out to shareholders.
Retention Ratio =(Net Income − Dividends)/Net Income
Dividend Payout Ratio = Dividends Paid/Net Income
What are the two ways to calculate earnings per share (EPS)?
Basic EPS: Determines a company’s earnings on a per-share basis, but 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
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
Where can you find the financial reports of public companies?
SEC EDGAR, SEDAR database, Companies house (UK)
What is a proxy statement?
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.
What is an 8-K and when is it required to be filed?
When a company undergoes a materially significant event and must
disclose the details.
Examples: 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.
Why has understanding the differences between US GAAP and IFRS financial reporting become increasingly important? (5)
Globalization: As economies converge, pressure mounts for a unified global accounting standard, though immediate US adoption of IFRS remains unlikely.
Geographic Investment Diversification: Investors are expanding their portfolios internationally, including emerging markets, necessitating familiarity with different accounting standards.
Cross-Border M&A: Multinational companies engage in cross-border mergers and acquisitions to enter new markets and diversify revenue sources, requiring understanding of varied accounting practices.
Dual Reporting Challenges: Companies operating in multiple jurisdictions may need to navigate both US GAAP and IFRS, highlighting the importance of understanding key differences.
Stakeholder Confidence: With increasing concerns about financial reporting clarity, understanding these differences is crucial for maintaining investor and regulator trust.
What are some of the most common margins used to measure profitability?
Gross margin, operating margin, net profit margin,EBITDA margin (are are over revenue)
What do the phrases “above the line” and “below the line” mean?
Above line: reflects a company’s operational
performance before non-operational items such as interest and taxes.
Below 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.
Is EBITDA a good proxy for operating cash flow?
EBITDA remains the most
widely used proxy for operating cash
flow in practice.
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.
What are some examples of non-recurring items?
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.
When adjusting for non-recurring expenses, are litigation expenses always added back?
Whether an expense is non-recurring depends on the industryExpenses 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.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.
What is the difference between organic and inorganic revenue growth?
Organic growth is the optimization of a business from the internal efforts of management and their employees.
Inorganic Growth
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.
How does the relationship between depreciation and capex shift as companies mature?
As a company begins
to mature and its
growth stagnates, a
greater proportion
of its total capex will
shift towards
maintenance.
What is working capital?
Measures a company’s liquidity and ability to pay off its current obligations using
its current assets.
Working Capital = Current Assets − Current Liabilities
Assets>liabilities = lower the liquidity risk
Working capital = Resources that can be turned into cash within the year - payments that a company needs to make within the year
Why are cash and debt excluded in the calculation of net working capital (NWC)?
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
Classify in the cashflow statement: Cash & cash equivalents vs debt
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.
Is negative working capital a bad signal about a company’s health?
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.
vs
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.
What does change in net working capital tell you about a company’s cash flows?
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).
What ratios would you look at to assess working capital management efficiency?
Days Inventory Held (“DIH”), Days Sales Outstanding (“DSO”), Days Payable
Outstanding (“DPO”)
What is the cash conversion cycle?
Measures the number of days it takes a company to convert its inventory
into cash from sales.
Cash Conversion Cycle = DIO + DSO – DPO
How would you forecast working capital line items on the balance sheet (working capital forecast)?
A/R, inventories, prepaid expenses, other current assets, A/P, accrued expenses, deferred revenue, other current liabilities.
How would you forecast capex and D&A when creating a financial model?
D&A can be projected as either a percentage of revenue or CAPEX,
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.
Alternatives:
Depreciation Waterfall Schedule:
Requires granular data on existing PP&E (in-use assets, remaining useful life for each).
Depends on management’s future Capex plans and useful life assumptions for new purchases.
Separately tracks depreciation from old vs. new Capex, improving transparency.
Amortization Projections:
Relies on useful life assumptions for intangible assets (e.g., patents, trademarks).
Assumptions often disclosed in financial report footnotes under accounting policies.
This approach enables precise modeling of asset depreciation/amortization timelines and aligns with operational planning.
How would you forecast PP&E and intangible assets?
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
Current Assets
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
What is the difference between the current ratio and the quick ratio?
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.
Quick Ratio (only for highly liquid assets, convertible into cash in less than 90 days): 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.
How can a profitable firm go bankrupt?
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.
E.g. 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. or 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.
Give some examples of when the current ratio might be misleading?
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.
Is it bad if a company has negative retained earnings (two cases)?
Not necessarily. Retained earnings can turn negative if the company has generated more accounting losses than profits, payout of dividends and share repurchases, contributing to lower or even negative retained earnings.
Case 1: Startups and early-stage companies investing heavily to support future growth (e.g., high capex, sales & marketing expenses, R&D spend).
or
Case 2: Negative retained earnings mean the company has returned more capital to shareholders than taken in.
What does return on assets (ROA) and return on equity (ROE) each measure?
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.
Return on Equity: The ROE ratio gives insight into how efficiently a management team has been using the capital shareholders have contributed.
What is the relationship between return on assets (ROA) and return on equity (ROE)?
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.
If a company has a ROA of 10% and a 50/50 debt-to-equity ratio, what is its ROE?
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%.
When using metrics such as ROA and ROE, why do we use averages for the denominator?
Because the denominator 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.
What are some shortcomings of the ROA and ROE metrics for comparison purposes?
ROA and ROE ratios are most useful when
compared to a peer group of companies with similar growth rates, margin profiles, and risks.
What is the return on invested capital (ROIC) metric used to measure?
“How much in returns is the company earning for each dollar invested?”
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.
ROCI = NOPAT/Invested capital
What does the asset turnover ratio measure?
“How many dollars in revenue does the company generate per dollar of assets?”
(How efficiently a company uses its assets to generate sales.)
Higher the better, suggests the company is generating more revenue per dollar of an asset owned
What does inventory turnover measure and how does it differ from days inventory held (DIH)?
Inventory turnover ratio: 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”).
VS
DIH is the average number of days it takes for a company to turn its inventory into revenue.
What does accounts payables turnover measure and is a higher or lower number preferable?
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.
What does accounts receivables turnover measure?
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.
What are some ratios you would look at to perform credit analysis?
Liquidity ratio (current, quick, cash)
Leverage/solvency ratios
Coverage ratios
Profitability ratios.
What are the two types of credit ratios used to assess a company’s default risk?
Leverage ratios, interest coverage ratios
How do you calculate the debt service coverage ratio (DSCR) and what does it measure?
A measure of creditworthiness that tests a company’s ability to pay
its current debt obligations using its current cash flows.
DSCR greater than 1.0 shows the
company is generating sufficient cash flows to pay down its debt.
How do you calculate the fixed charge coverage ratio (FCCR) and what does it mean?
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.
How would raising capital through share issuances affect earnings per share (EPS) (primary effects of share issuances on EPS, emphasizing the dilutive impact and potential scenarios.)?
Raising capital through share issuances affects EPS in the following ways:
Dilution: Increased share count directly decreases EPS.
Interest income: Cash from issuances may generate minimal interest, slightly offsetting EPS reduction.
Acquisition scenarios: Using stock for acquisitions can impact EPS:
Acquired company’s earnings added to acquirer’s
Result can be accretive or dilutive to EPS
Overall impact: Generally negative on EPS due to dilution outweighing potential benefits.
Share count effect: New issuances increase outstanding shares, reducing each share’s claim on earnings.
Market perception: Can signal company’s need for capital, potentially affecting stock price.
How would a share repurchase impact earnings per share (EPS)?
Share repurchase is a reduced share count, which increases EPS. However, there
would be an impact on net income, assuming the share repurchase was funded using excess cash. The interest
income that would have otherwise been generated on that cash is no longer available, causing net income and
EPS to decrease.
But the impact would be minor since the returns on excess cash are low, and would not offset the positive
impact the repurchase had on EPS from the reduced share count.
What is the difference between the effective and marginal tax rates?
Effective Tax Rate: The effective tax rate represents the percentage of taxable income corporations must pay in taxes. (Taxes paid/EBT)
Marginal Tax Rate: The marginal tax rate is the taxation percentage on the last dollar of a company’s taxable income (tiers).
Why is the effective and marginal tax rate often different?
Differ because the effective tax rate calculation uses pre-tax income from the
accrual-based income statement.
Could you give specific examples of why the effective and marginal tax rates might differ?
Effective tax rate reflects deductions/credits and timing differences, while marginal rate applies only to top-tier income.
Depreciation Methods, NOL Carryforwards, Bad Debt Write-Offs, Progressive Tax Brackets
What are deferred tax liabilities (DTLs)?
Temporary timing
differences in book
and tax accounting
lead to the creation
of DTAs/DTLs,
which will gradually
unwind to a balance
of zero.
Definition: Tax expenses recognized in GAAP statements but not yet paid to IRS, expected to be paid in future.
Common cause: Depreciation methods
Tax: Accelerated depreciation
GAAP: Straight-line depreciation
Early years: Higher tax depreciation creates DTLs
Inflection point: Tax depreciation becomes lower than GAAP depreciation
Cumulative effect: Total depreciation equal over asset’s life for both methods
Balance sheet impact: DTLs represent future tax obligations due to current timing differences
What are deferred tax assets (DTAs)?
Definition: Financial assets representing future tax benefits due to temporary differences between GAAP and tax accounting.
Creation: Arise when GAAP tax expense is lower than actual tax payments to IRS.
Key source: Net Operating Losses (NOLs) carried forward against future income.
Example: $10 million pre-tax loss creates DTA for future tax benefit, not immediate refund.
GAAP treatment: Tax benefit recognized immediately on income statement, captured in DTAs.
Reversal: DTAs decrease as company uses NOLs to reduce future tax liabilities.
Other causes: Differences in revenue recognition between book (accrual) and tax (cash) rules.
Balance sheet: Listed as non-current assets, representing potential future tax savings.
Valuation: Based on expected future tax rates when the DTA will be utilized.
Expiration: DTAs don’t expire but reverse when timing differences end.
Difference between DTA and DTL
Key difference: DTAs represent future tax benefits (lower future taxes), while DTLs indicate future tax obligations (higher future taxes)
NOL, warranty provisions vs depreciation, instalment sales
Does a company truly not incur any costs by paying employees through stock-based compensation
rather than cash?
Stock-based compensation is a non-cash expense that reduces a company’s taxable income
and is added-back on the cash flow statement.
SBC incurs an actual cost to the issuer by creating additional shares for existing
equity owners. The issuing company, due to the dilutive impact of the new shares, becomes
less valuable on a per-share basis to existing shareholders.
Could you define contra-liability, contra-asset, and contra-equity with examples of each?
Contra-Liability:
Definition: Liability account with a debit balance, reducing the paired liability.
Example: Financing fees in M&A amortized over debt maturity, lowering tax burden.
Contra-Asset:
Definition: Asset account with a credit balance, reducing the paired asset’s value.
Example: Accumulated depreciation reduces fixed asset carrying value while offering tax benefits.
Contra-Equity:
Definition: Equity account with a debit balance, reducing total shareholders’ equity.
Example: Treasury stock decreases equity and appears as a negative on the balance sheet.
What is an allowance for doubtful accounts on the balance sheet?
Estimates the percentage of uncollectible accounts receivable (a contra asset)
Reduces the A/R balance on the balance sheet, providing a more realistic view of collectible amounts. This bad debt reserve represents management’s estimate of likely unpaid customer debts, aligning with the matching principle by recognizing potential losses in the same period as related revenues. The ADA helps prevent sudden A/R decreases by anticipating potential defaults, thus offering a more conservative and accurate picture of a company’s financial health. It’s typically calculated using methods like percentage of sales or A/R aging analysis, allowing businesses to present a more prudent view of their expected cash inflows
What is the difference between a write-down and a write-off?
Write-down: Value of the asset is decreased to reflect its true value on the balance sheet.
Write-Offs: Reduces an asset’s value
to zero, meaning the asset has been determined to hold no current or future value (and should therefore
be removed from the balance sheet).
How would a $100 inventory write-down impact the three financial statements?
Affect is the same as if it were depreciation. Only change is on the BS, cash is up 30 (thanks to lower tax) with inventory down by 70, offset by a decrease in RE by 70 since NI dropped by that amount.
How does buying a building impact the three financial statements?
IS: Initially, there’ll be no impact on the income statement since the purchase of the building is capitalized.
CFS: The PP&E outflow is reflected in the cash from investing section and reduces the cash balance.
BS: The cash balance will go down by the purchase price of the building, with the offsetting entry to the
cash reduction being the increase in PP&E.
Throughout the purchased building’s useful life, depreciation is recognized on the income statement, which
reduces net income each year, net of the tax expense saved (since depreciation is tax-deductible).
How does selling a building with a book value of $6 million for $10 million impact the three financial statements?
IS: If I sell a building for $10 million with a book value of $6 million, a $4 million gain from the sale would
be recognized on the income statement, which will increase my net income by $4 million.
CFS: Since the $4 million gain is non-cash, it’ll be subtracted from net income in the cash from operations
section. In the investing section, the full cash proceeds of $10 million are captured.
BS: The $6 million book value of the building is removed from assets while cash increases by $10 million,
for a net increase of $4 million to assets. On the L&E side, retained earnings will increase by $4 million
from the net income increase, so the balance sheet remains balanced.
However, the gain on sale will result in higher taxes, which will be recognized on the income statement. This
lowers retained earnings by $1 million and be offset by a $1 million credit to cash on the asset side.
If a company issues $100 million in debt and uses $50 million to purchase new PP&E, walk me
through how the three statements are impacted in the initial year of the purchase and at the end of year 1. Assume a 5% annual interest rate on the debt, no principal paydown, straight-line
depreciation with a useful life of five years and no residual value, and a 40% tax rate.
IS: Since the capex amount was $50 million with a useful life assumption of five years (straight-line to a
residual value of zero), the annual depreciation will be $10 million. Next, the interest expense will be equal
to the $100 million in debt raised multiplied by the 5% annual interest rate, which comes out to $5 million
in annual interest expense. The pre-tax income will be down by $15 million and assuming a 40% tax rate,
net income will be down $9 million.
CFS: Net income will be down $9 million, but the non-cash depreciation of $10 million will be added back,
making the ending cash balance increase by $1 million.
BS: On the assets side, cash is up by $1 million and PP&E will decrease by $10 million because of the
depreciation. Since equity is also down $9 million due to net income, both sides will remain in balance.
For long-term projects, what are the two methods for revenue recognition?
Percentage of Completion Method: Revenue is recognized based on the percentage of work completed during the period.
Completed Contract Method: Recognizes revenue once the entire project has been completed.
If a company has continuously incurred goodwill impairment charges, what do you take away from seeing this in their financials?
History of overpaying for assets or their inability to integrate new acquisitions.
What is restricted cash and could you give me an example?
cash reserved for a specific purpose and not available for the company to use (Disclosed separately on the BS and said why)
E.g. Agreement to receive a line of credit, but the lender required the borrower to maintain 10% of the total loan amount at all times (i.e., “bank loan requirement”).
What is the accounting treatment for finance leases?
Finance lease accounting treats leases as if the lessee owns the asset, recognizing both an asset and a liability on the balance sheet. The initial recognition is based on the present value of future lease payments. Over the lease term, the asset is depreciated, and the liability accrues interest. On the income statement, instead of recording rent expense, the lessee records depreciation expense for the asset and interest expense for the liability. This approach provides a more transparent representation of a company’s lease obligations and assets on financial statements
What is the accounting treatment for operating leases?
Lease accounting changed significantly in 2019 for both US GAAP and IFRS, with US GAAP retaining the distinction between operating and finance leases. For operating leases under US GAAP, the initial balance sheet impact is the same as finance leases, with the lease recognized as a liability and the corresponding asset as a right-of-use asset. The income statement treatment differs, with operating leases simply recording the lease payment as an operating expense, while the cash flow statement reflects the lease payment through the net income line in the cash from operations section
What are the three different types of intercompany investments?
Investment in securities (passive investments): company invests in
another company’s equity, but the ownership percentage is less than 20%.
Equity investment method: When a company owns between 20-50% of another company, this is considered a significant level of influence. Under the equity method, an investment is initially measured at the acquisition price and recorded as an “Investment in Affiliate” (or “Investment in Associate”) on the assets side
Consolidation method: When the parent company has majority control over 50% ownership, the consolidation method is used. The target company’s
balance sheet is consolidated with the acquirer.
What is Non-Controlling Interests” (NCI)
To reflect that the acquirer owns less than 100% of the
consolidated assets and liabilities, a new equity line titled “Non-Controlling Interests” (NCI) is created,
which captures the value of equity in the consolidated business held by non-controlling (minority)
interests (other third parties).
What are the three sub-classifications of investment securities?
Trading securities: Debt or equity investments intended to generate short-term profits. Unrealized gain/(loss) will be recorded on the income statement
throughout the holding period until the realized gain/(loss) when sold.
Available-for-Sale Securities (“AFS”): Debt or equity securities held for the long-term but sold before maturity. (current or non current). Recorded as AOCI on the balance sheet.
Held-to-Maturity Securities (“HTM”): Long-term investments in debt securities held until the end of their term. Applies only to debt instruments, typically government bonds, certificates of deposit (CDs), and investment-grade corporate bonds, as they have fixed payment schedules and maturity dates. Original cost is recorded on the balance sheet (reported at amortized cost). However, the value of the investment is not adjusted
following changes in its FMV due to the HTM classification.
Could you name an example of an asset that’s exempt from the cost principle rule?
Mark-to-market accounting would record the asset at its current fair market value and then adjust the value to reflect what an asset would sell for today (except marketable securities, which are highly liquid and traded on stock exchanges.)
What is trapped cash and what benefit does it provide to companies?
Refers to the accumulation of cash overseas by multinational companies. While not illegal,
companies keep this cash offshore to avoid certain repatriation taxes if brought back to the US.
When can a company capitalize software development costs under accrual accounting?
The application development stage for software intended for internal use such as coding
The stage when the software’s “technological feasibility” has been reached and can be marketed
What is PIK interest?
PIK (Payment-in-Kind) Interest: This refers to interest that is added to the principal balance of a loan instead of being paid in cash. The borrower essentially defers the interest payment by increasing the outstanding debt
What is a PIK toggle note?
This is a more flexible instrument that allows the issuer to choose between paying interest in cash or as PIK for each interest period. If the PIK option is chosen, it typically comes with a higher interest rate
The key difference is that PIK interest always adds to the principal, while a PIK toggle note gives the issuer the option to pay in cash or add to the principal, providing greater flexibility in managing cash flow
If a company has incurred $100 in PIK interest, how would the three-statements be impacted?
IS: On the income statement, interest expense will increase by $100, which causes EBIT to decrease by
$100. Assuming a 30% tax rate, net income will decrease by $70.
CFS: On the cash flow statement, net income will be down by $70, but the $100 non-cash PIK interest will
be added back. The ending cash balance will increase by $30.
BS: On the assets side of the balance sheet, cash will be up $30. Then on the liabilities side, the debt
balance will be up $100 (since the PIK accrues to the debt’s ending balance), and net income is down $70. Therefore, both sides are up by $30, and the balance sheet balances.
What is the purpose of the original issue discount feature of debt?
An original issue discount (OID) is a feature of debt financing where bonds are issued at a price below their face value, making them more attractive to investors by offering higher returns. This discount is essentially a form of interest that is realized at maturity, when the investor receives the full face value of the bond. OID bonds are often used to entice investors, especially in cases where the issuer might face challenges raising capital due to credit concerns or market conditions
An original issue discount (“OID”) is a feature of debt meant to make the issuance more appealing to investors
as a “deal sweetener.” Typically, the reduction is 1-2% of the debt issuance.
Why are circularities created in financial models?
Circularities in financial models are created when a cell’s calculation depends on its own output, either directly or indirectly. The most common example is the calculation of interest expense and income:
Interest expense is calculated using the average debt balance, which includes the beginning and ending balances.
The ending debt balance is affected by cash flow, which in turn is impacted by interest expense.
This creates a loop where interest expense affects the debt balance, which then affects the interest expense calculation.
This interdependence between variables leads to a circular reference, making the model challenging to resolve without special techniques or Excel settings
How would you forecast a company’s basic and diluted share count?
The number of share issuance and repurchases can be calculated using the
formula shown below:
Basic Share Count EOP = Basic Share Count BOP + (Shares issued/est share price)-(Share repurchases/est share price)
The estimated share price used above can be approximated using the formula below:
Share Price Estimate = Prior Period Share Price × (1 + Current Period Consensus EPS Growth Rate)
To calculate the impact of dilutive securities:, Take the difference between the basic and diluted share count in historical periods can be looked at and this amount can be straight-lined into the future
Serves as a decent proxy for how potentially dilutive securities such as options,
warrants, and convertible debt will impact the diluted share count.
How can you forecast a company’s implied share price using its EPS?
Take the forecasted EPS figure and then multiplying it by a P/E ratio assumption.
This estimated share price can be sanity checked by using the consensus EPS annual growth rate as a proxy for
share price growth.
