IB Prep Flashcards
Walk me through the three financial statements:
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: This 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: 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 income stetement
Net Revenue
- COGS
= Gross Profit
-SG&A
-Research and development
= EBITDA
-Depreciation and amortization
=Operation income (EBIT)
-Interest expense, net pre-tax income
-Taxes
= Net income
Walk me trough the balnace sheet
Assets Section: Assets are organized in the order of liquidity, with “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” 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.
Shareholders’ Equity Section: The equity section consists of common stock, additional paid-in capital
(APIC), treasury stock, and retained earning
Define Assets
resources with economic value that can be sold for money or bring positive monetary benefits in the future. For example, cash and marketable securities are a store of monetary value that can be invested to earn interest/returns, accounts receivable are payments due from customers, and PP&E is
used to generate cash flows in the future – all representing inflows of cash.
Define Liabilities
Liabilities are 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). Unlike assets, liabilities represent future outflows of cash
Define Equity
Equity is the capital invested in the business and represents the internal sources of capital that
helped fund its assets. The providers of capital could range from being self-funded to outside institutional investors. In addition, the accumulated net profits over time will be shown here as “Retained Earnings.
Define Deferred revenue
Unearned revenue received in advance for goods or services not yet delivered to
the customer (can be either current or non-current)
Define goodwill
An intangible asset created to capture the excess of the purchase price over the
fair market value (“FMV”) of an acquired asset
Accured expenses
Accrued expenses are incurred expenses such as employee compensation or
utilities that have not been paid, often due to the invoice not being received
common stock
Common stock represents a share of ownership in a company and can be
issued when raising capital from outside investors in exchange for equity
Retained Earnings (or
Accumulated Deficit)
Represents the cumulative amount of earnings since the company was formed,
less any dividends paid out
Define the sections of the cash flow
- Cash from Operations: The cash from operations section starts with net income and adds back non-cash expenses such as depreciation & amortization and stockbased 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, the sum of the three sections will be the net change in cash for the period. This figure will then be added to the beginning-of-period cash balance to arrive at the ending cash balance.
How are the three financial statements connected?
IS ↔ CFS: The cash flow statement is connected to the income statement through net income, as net income is the starting line on the cash flow statement.
CFS ↔ BS: Next, the cash flow statement is linked to the balance sheet because 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 income statement and cash flow statement are both necessary, and any in-depth analysis would require
using both. However, 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?
In most cases, 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. Whether you’re an equity investor or lender, a company’s ability to generate sufficient free cash flow to reinvest into its
operations and meet its debt obligations comes first. At the end of the day, “cash is
king.”
However one factor that could switch the answer is the company’s profitability. For an unprofitable company, the income statement can be used to value the company based on a revenue multiple. The cash flow statement
becomes less useful for valuation purposes if the company’s net income, cash from operations, and free cash flow are all negative
Why is the income statement insufficient to assess the liquidity of a company?
The income statement can be misleading in the portrayal of a company’s health from a liquidity and solvency standpoint.
For example, 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.
Financial reporting under accrual accounting is also imperfect in the sense that it often relies on management discretion. This “wiggle room” for managerial discretion in reporting decisions increases the risk of earnings management and the misleading
depiction of a company’s actual operational performance.
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?
-Using excess useful life assumptions for new capital expenditures to reduce the annual depreciation
-Switching from LIFO to FIFO if inventory costs are expected to increase, resulting in higher net income
-Refusing to write-down impaired assets to avoid the impairment loss, which would reduce net income
-Changing policies for costs to be capitalized rather than expensed (e.g., capitalized software costs)
-Repurchasing shares to decrease its share count and artificially increase earnings per share (“EPS”)
-Deferral of capex or R&D to the next period to show more profitability and cash flow in the current period
-More aggressive revenue recognition policies in which the obligations of the buyer become less stringent
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: 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
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 taxdeductible 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. 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.
If the company is constantly acquiring new assets, the “flip” won’t occur until the company significantly scales
back capital expenditures.
What does an Investment bank do?
work as intermediaries between a corporation and the financial markets. That is, they help corporations issue shares of stock in an IPO or an additional stock offering. They also arrange debt financing for corporations by finding large-scale investors for corporate bonds.
Do companies depreciate land?
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
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 takeaway of
depreciation
despite
being a non-cash
expense, reduces
taxable income and has
a positive impact on the
ending cash
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?
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
What is goodwill and how is it created?
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.
NOTE:
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.
For any revenue or
expense to be
recognized, there must
be evidence of
occurrence with a
measurable monetary
amount
REMEMBER
Do accounts receivable get captured on the income statement?
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
Why are increases in accounts receivable a cash reduction on the cash flow statement?
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
Why is deferred revenue classified as a liability while accounts receivable is an asset?
Deferred Revenue: 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: A/R 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.
Why are increases in accounts payable shown as an increase in cash flow?
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
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
Do inventories get captured on the income statement?
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
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. The inventory balance increasing from the prior period implies the amount of inventory purchased exceeded the amount expensed on the income statement.
What is the difference between LIFO and FIFO, and what are the implications on net income?
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.
The impact on net income would depend on how inventory costs have changed over time:
