IBD - Accounting Flashcards
Walk me through the three financial statements.
The income statement, the cash flow statement, and the balance sheet are the core financial statements. The income statement is a measure of profitability—revenue less expenses is taxed and creates net income. The cash flow statement tracks how
much cash has been spent or generated from three major areas: operating activities, investing activities, and financing activities. The balance sheet is a snapshot of a
company’s resources (assets), its obligations (liabilities), and equity. The assets must always equal the sum of a company’s equity and liabilities.
Walk me through an income statement
The income statement always starts with revenue, a company’s sales, and builds
down to net income. Cost of goods sold is the costs most directly associated to the
revenue and is reduced from the revenue to produce gross profit (revenue – COGS = gross profit). Operating expenses are the next series of costs and consist of sales, general, and administrative expenses, and marketing and advertising expenses, to name the two most common. Gross profit less operating expenses make EBITDA. Depreciation and amortization are the costs related to the aging of tangible and intangible assets respectively. EBITDA less D&A makes EBIT. Interest expense is
reduced from EBIT to get EBT. EBT is then tax affected to get net income.
Walk me through a cash flow statement (more detailed).
The cash flow statement is a measure of how much cash is generated or spent over a
given period. The statement is broken up into three major sections: cash flow from
operating activities, cash flow from investing activities, and cash flow from financing
activities. Cash flow from operating activities is the cash generated from net income, or the net income less all non-cash items from the income statement. This consists of net income plus depreciation and amortization, deferred taxes, other non-cash items, and changes in working capital. Cash flow from investing activities is cash generated or spent from investments. This includes capital expenditures, acquisitions
and divestitures, and purchases and sales of securities to name the major few. Cash flow from financing activities is cash generated or spent from debt, equity, or distributions. This consists mainly of monies raised from or used to pay debts, monies
received from equity and other securities, monies spent from share buybacks, and monies spent from dividend and other equity distributions. The sum of these three cash flow components completes the cash flow statement.
What is cash flow from operations?
Cash flow from operations is defined by net income + D&A + deferred taxes + other
non-cash items + changes in working capital.
Why would an investor care about cash flow versus net income?
An investor is more apt to base his investment using the cash flow statement as it
tracks the “true” measure of how much cash has been generated or spent over a
period. Net income may report profitability, but how much of that profitability had actually been converted into cash? If none, for example, the investor would be less
likely to see his investment returned. “Cash is king” holds true in this context. And this is why we more commonly look at cash flow in a discounted cash flow analysis as opposed to net income.
How does maintenance CAPEX differ from growth CAPEX?
Maintenance CAPEX is the funds expended to extend the useful life of existing assets, whereas expansion CAPEX is the purchase of new assets to grow the business.
Walk me through a balance sheet (more detailed).
The balance sheet is a measure of a company’s assets, liabilities, and shareholder’s
equity at a given point in time. The company’s assets, a resource with economic
value that is expected to provide some future benefit, is broken up into current
and non-current. Current assets are resources whose economic benefit is expected to come due within one year. Examples of current assets are cash, accounts receivable, and inventories. Examples of long-term assets are property, plant and equipment (PP&E), goodwill, intangible assets, and investments in securities. A liability is a debt or obligation and is also broken up into current and non-current sections. Current liabilities are debts or obligations the come due within one year. Examples of current
liabilities are accounts payable, accrued expenses, and short-term debts. Examples of long-term liabilities are long-term debts and deferred tax liabilities. Shareholder’s equity consists of retained earnings and share capital less Treasury shares. The sum
of the shareholder’s equity and the total liabilities must equal the total value of assets:
Total Assets = Total Liabilities + Shareholder’s Equity
How do the three statements link together?
Note there can be many ways to answer this question. Here is a suggested solution:
Net income from the income statement flows into the top of the cash flow statement and into the shareholder’s equity section of the balance sheet. Each and every
line item in the cash flow statement impacts a line item in the balance sheet: an asset, liability, or shareholder’s equity. Total cash and cash equivalents at the bottom of the cash flow statement impacts the cash line item at the top of the balance sheet. Depreciation created on its own schedule flows into the income statement, into the
cash flow statement, and impacts PP&E on the balance sheet. Changes in each working capital line item from the working capital schedule flow into the working capital
section of the cash flow statement, and subsequently impact each respective balance sheet line item. Interest expense and interest income, derived from the debt schedule,
flows into the income statement. Finally, any debt issuances or paydowns depicted in the debt schedule flow into the financing activities in the cash flow statements and
further into the respective debt balances on the balance sheet.
Walk me through the circular reference in a model.
A circular reference can begin in the debt schedule with some issuance or paydown
of debt. When debt is paid down, for example, the interest expense is reduced.
This reduction in interest expense flows into the income statement and increases net
income. The increase in net income flows into the cash flow statement and increases
the cash flow before debt paydown balance. Cash flow before debt paydown flows
back into the debt schedule, increasing the amount of funds that can be used to pay
down debt. If we have more funds, we can pay down more debt, interest expense
will reduce further, impact the income statement, increase net income, increase the
cash balance further, and the cycle will continue.
What is working capital used for?
Working capital is a measure of a company’s current assets less its current liabilities. Working capital is often looked at as a measure of a company’s near-term liquidity or operating efficiency as current assets (resources that will be converted into cash
within a year) less liabilities (debt or obligations due within one year) can help determine if there will be enough cash in the short term to cover a company’s upcoming liabilities or obligations.
How does operating working capital differ from working capital?
Operating working capital is a company’s current assets excluding cash and current
liabilities excluding debts. Bankers often look at operating working capital as by eliminating cash and debts, you are left with line items most closely related to a company’s core operations (e.g., accounts receivable, inventories, accounts payable).
What is a deferred tax liability? How is such a liability created?
A deferred tax liability is a tax balance due that has not yet been paid in cash.
Deferred tax liabilities are created from timing differences between book accounting (GAAP) and tax accounting.
How is a deferred tax asset created?
A deferred tax asset can be created if a business has a net operating loss (NOL).
An asset can also be created by receiving government tax credits (investing in certain
energy, for example).
If you had to choose only one of the three core statements to determine the financial
viability of a company, which statement would you choose?
The cash flow statement provides a true measure of cash produced by the business as opposed to an income statement, which may or may not include non-cash items. To an investor, cash is the true measure of performance. This is partially why the discounted cash flow is a valuable valuation method.
If I had to choose only two statements to assess a company’s performance, which two would I use?
The income statement and the balance sheet. A cash flow statement can be created from an income statement and two years of a balance sheet.
