Interview Questions Flashcards
List the line items in the cash flow statement.
The CFS is broken up into three sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. In cash flow from operating, the key items are net income, depreciation and amortization, equity in earnings, non-cash stock compensation, deferred taxes, changes in working capital and changes in other assets and liabilities. In cash flow from investing, the key items are capital expenditures and asset sales. In cash flow from financing, the key items are debt raised and paid down, equity raised, share repurchases and dividends.
If you could have only two of the three main financial statements, which would it be?
The balance sheet and income statement because as long as I have the balance sheet from the beginning and end of the period as well as the end of period income statement, I would be able to generate a statement of cash flows.
If you could have only one of the three main financial statements, which would it be?
The IS is definitely inappropriate to pick. Income statements are full of non-cash items, which work fine for theoretical purposes, like matching revenue to expenses in appropriate time periods, but if none of it could be liquidated then company is worth nothing.
Most pick SCF, because cash is king in determining a company’s health. SCF because it gives you a true picture of how much cash the company is actually generating, independent of all the non-cash expense a company might have.
One interviewer selected BS because you can back out the main components of the cash flow statement (capex via PP&E and depreciation, net income via retained earnings, etc.). The BS is also helpful in distressed situations to determine the company’s liquidation value.
What is the link between the balance sheet and income statement?
The main link between the two is profits from the IS are added to the BS as retained earnings. Next, the interest expense on the IS is charged on the debt that is recorded on the BS. D&A is a capitalized expense from the IS that will reduce the PP&E on the asset side of the BS.
If a company has seasonal working capital, is that a deal killer?
Working capital (“WC”) is current assets less current liabilities. Seasonal working capital applies to firms whose business is tied to certain time periods. When current assets are higher than current liabilities, this means more cash is being tied up instead of being borrowed. For instance, UGG mostly manufactures snow boots. In the winter, demand is higher, so the firm must build up inventories to meet this demand at this time, increasing current assets. Since more cash is tied up, this can increase the liquidity risk. If UGGs suddenly go out of fashion, then the company is stuck holding the inventory. Also, if people frequently pay with credit for the company’s products, the amount is listed as accounts receivable (“AR”), which represents future profits but is noncash. Therefore, if the company cannot collect this owed cash in time to pay its creditors, it runs of the risk of bankruptcy. This is an issue to note and watch, but it is not a deal killer if you have an adequate revolver and can predict the seasonal WC requirements with some clarity. In general, any recurring event is fine as long as it continues to perform as planned. The one-time massive surprise event is what can kill an investment.
If a company issues a PIK security, what impact will it have on the three statements?
PIK stands for “paid in kind,” another important non-cash item that refers to interest or dividends paid by issuing more of the security instead of cash. This can mean compounding profits for the lenders and flexibility for the borrower. For instance, a mezzanine bond of $100 million and 10 percent PIK interest will be added to the BS as $100 million as debt on the right side, and cash on the left side. On the CFS, cash flow from financing will list an increase of $100 million as debt raised.
When the PIK is triggered and all else is equal, interest on the IS will be increased by $10 million, which will reduce net income by $6 million (assuming a 40 percent tax rate). This carries over onto the CFS where net income decreases by $6 million and the $10 million of PIK interest is added back (since it is non-cash), resulting in a net cash flow of $4 million. On the BS, cash increases by $4 million, debt increases by $10 million (the PIK interest accretes on the balance sheet as debt) and shareholders equity decreases by $6 million.
If I increase AR by $10mm, what effect does that have on cash? Explain what AR is in layman terms.
There is no immediate effect on cash. AR is account receivable, which means the company received an IOU from customers. They should pay for the product or service at a later point in time. There will be an increase in cash of $10 million when the company collects on the account receivable.
Give examples of ways companies can inflate earnings.
(1) Switching from LIFO to FIFO. In a rising cost environment, switching from LIFO to FIFO will show higher earnings, lower costs and higher taxes.
* Or LIFO liquidation
(2) Switching from fair value to cash flow hedges. Changes in fair value hedges are in earnings, changes in cash flow hedges are in other comprehensive income. Having negative fair value hedges and then shifting them to cash flow hedges will increase earnings.
(3) Changing depreciation methods (e.g. useful life)
(4) Having a more aggressive revenue recognition policy. Accounts receivable will increase rapidly because they’re extending easier credit.
(5) Capitalizing interest or R&D that shouldn’t be capitalized, so you decrease expenses on the income statement
(6) Manipulating pre-tax or after-tax gains.
(7) Compensate employees with options rather than cash
(8) Asset sales or recognize one-time items on income statement
Is goodwill depreciated?
Not anymore. Accounting rules now state that goodwill must be tested once per year for impairment. Otherwise, it remains on the BS at its historical value. Note that goodwill is an intangible asset that is created in an acquisition, which represents the value between price paid and value of the company acquired.
What is a stock purchase and what is an asset purchase?
A stock purchase refers to the purchase of an entire company so that all the outstanding stock is transferred to the buyer. Effectively, the buyer takes the seller’s place as the owner of the business and will assume all assets and liabilities. In an asset deal, the seller retains ownership of the stock while the buyer uses a new or different entity to assume ownership over specified assets.
Which structure (stock purchase vs asset purchase) does the seller prefer and why? What about the buyer?
A stock deal generally favors the seller because of the tax advantage. An asset deal for a C corporation causes the seller to be double-taxed; once at the corporate level when the assets are sold, and again at the individual level when proceeds are distributed to the shareholders/owners. In contrast, a stock deal avoids the second tax because proceeds transfer directly to the seller. In non-C corporations like LLCs and partnerships, a stock purchase can help the seller pay transaction taxes at a lower capital gains rate (there is a capital gains and ordinary income tax difference at the individual level, but not at a corporate level). Furthermore, since a stock purchase transfers the entire entity, it allows the seller to completely extract itself from the business. A buyer prefers an asset deal for similar reasons. First, it can pick and choose which assets and liabilities to assume. This also decreases the amount of due diligence needed. Second, the buyer can write up the value of the assets purchased—known as a “step-up” in basis to fair market value over the historical carrying cost, which can create an additional depreciation write-off, becoming a tax benefit.
Please note there are other, lesser-known legal advantages and disadvantages to both transaction structures.
What is a 10-K?
It’s a report similar to the annual report, except that it contains more detailed information about the company’s business, finances, and management. It also includes the bylaws of the company, other legal documents and information about any lawsuits in which the company is involved. All publicly traded companies are required to file a 10-K report each year to the SEC.
What is Sarbanes-Oxley and what are the implications?
Sarbanes-Oxley was a bill passed by Congress in 2002 in response to a number of accounting scandals. To reduce the likelihood of accounting scandals, the law established new or enhanced standards for publicly held companies. Those in favor of this law believe it will restore investor confidence by increasing corporate accounting controls. Those opposed to this law believe it will hinder organizations that do not have a surplus of funds to spend on adhering to the new accounting policies.
What are the differences between extraordinary and special charges?
Extraordinary – unusual and infrequent; below the line after-tax (e.g. hurricane)
Special – unusual or infrequent; appear with income from continued operations pre-tax (e.g. employee layoffs, plant closing)
What is the definition of fair value?
Price that would be received to sell an asset or paid to transfer a liability in a transaction between market participants
What is the LIFO method?
Last in, first out. Inventory costs are those which were incurred earlier in the period and are stale relative to the end of the period. Results in a more accurate income statement and less accurate balance sheet
What is the FIFO method?
First in, first out. Inventory costs are those which were incurred later in the period and are more current relative to the end of the period. Results in a more accurate balance sheet and less accurate income statement
What is LIFO liquidation?
Dramatic decrease in inventory on hand causes a dip into LIFO layers and an increase in net income
What is the LIFO reserve?
Contra asset account for the excess of FIFO over LIFO inventory
What are the effects of using LIFO vs FIFO assuming rising prices?
LIFO: results in a more current income statement based on fair value but a stale balance sheet with understated inventory assets (i.e. lower income taxes but lower assets)
-IS: leads to higher COGS, thus lower pre-tax income
-CF: leads to higher COGS, thus lower taxes paid, thus higher cash flows
-BS: leads to lower inventory balance
FIFO: results in a more current balance sheet based on fair value but a stale income statement with understated cost of goods sold (i.e. higher income taxes but higher assets)
-IS: leads to lower COGS, thus higher pre-tax income
-CF: leads to lower COGS, thus higher taxes paid, thus lower cash flows
-BS: leads to higher inventory balance
If you had to choose between the LIFO or FIFO method, which would you choose?
If had a choice beween the two – in some ways it doesn’t matter b/c it’s just a trade-off between which financial statement is misrepresented (and investors are savy), but LIFO seems less manipulative to earnings (and minimized taxes) so I’d go with it
What is the allowance method?
Bases bad debt expense on an estimate of uncollectible accounts
Dr: Bad debt expense (estimate)
Cr. Allowance for doubtful accounts
What is the direct method?
Write down accounts receivable when actual customer default occurs
Dr. Bad debt expense (write-off)
Cr. Accounts receivable
What is a trading security?
Trade for profit potential with unrealized gains and losses reported in net income. It is carried on the balance sheet at fair value. Used for debt or equity
What is a held-to-maturity security?
Debt securities for which a company has a positive intent to hold until maturity. It is carried on the balance sheet at amortized cost. There are no unrealized gains
What is an available-for-sale security?
- Neither HTM nor trading
- Carried at market value
- Unrealized gains/losses are presented net of tax in “Other Comprehensive Income”
What is net debt?
Net Debt = Total Debt – Cash & Cash Equivalents
It represents the true amount of debt that a firm has, after it uses its existing cash to pay off current outstanding debt
How are the three financial statements connected?
- Beginning cash balance on statement of cash flows comes from balance sheet; net income in operating cash flows comes from income statement
- Adjustments made to net income on statement of cash flows using balance sheet accounts
- Ending balance of cash appears on balance sheet and statement of cash flows
- Net income increases shareholders equity through retained earnings
Other connections: interest expense, depreciation, change in working capital
What is the link between the balance sheet and statement of cash flows?
- SCF starts with beginning cash balance, which comes from the previous period’s balance sheet
- Cash from operations is derived using the changes in NWC from the balance sheet
- Depreciation comes from PPE which affects OCF
- Any change in PPE due to purchase or sale will affect ICF
- Net increase in cash goes back onto next year’s balance sheet
What is the link between the balance sheet and the income statement?
- Net income generated in the income statement are added to shareholders’ equity on the balance sheet as retained earnings
- Debt on the balance sheet is used to calculate interest expense on the income statement
- PPE will be used to calculated depreciation
What is the difference between the income statement and statement of cash flows? How are the two financial statements linked?
- Income statement is a record of revenue and expenses while statement of cash flows records the actual cash that has either come into or left the company during that time period
- SCF has OCF, ICF and FCF
- Interestingly, a company can be profitable as shown on the income statement but still go bankrupt if it does not have the cash to meet its interest payments
- Both statements are linked by net income
What is goodwill?
- An intangible asset that can be found on a company’s balance sheet.
- Goodwill can often arise when one company is purchased by another company. In an acquisition, the amount paid for the company over book value usually accounts for the target firm’s intangible assets.
- Goodwill is seen as an intangible asset on the balance sheet because it is not a physical asset like buildings or equipment
- Goodwill typically reflects the value of intangible assets such as a strong brand name, good customer relations, good employee relations and any patents or proprietary technology.
How does goodwill affect the income statement?
- If an event occurs that diminishes the value of this intangible asset, the assets must be written down in a process called goodwill impairment
- Goodwill is then subtracted as a non-cash expense and therefore reduces net income
What are the components of the statement of cash flows?
Beginning cash
+Operating cash flow: cash generated from the normal operations of a company
+Investing cash flow: change in cash outside the scope of normal business (e.g. purchase of PPE and other investments not reflected in income statement); cash position resulting from any gains (or losses) from investments in the financial markets and operating subsidiaries, and changes resulting from amounts spent on investments in capital assets such as plant and equipment.
+Financing cash flow: cash from changes in liabilities and shareholders’ equity including any dividends that were paid out to investors in cash (e.g. issuance of debt or equity, share repurchases)
=Ending Cash
Walk me through the major line items of the income statement.
Revenue -COGS =Gross Profit -SG&A -D&A =Operating Income (EBIT) -Interest Expense =Income before Taxes - Taxes =Net Income
What is a capital lease?
- Non-callable
- And either:
(1) ownership of the asset is transferred to lesee at end of lease
(2) “bargain purchase” option exists
(3) lease term is greater than or equal to 75% of the useful life of the asset
(4) at inception of the lease, the present value of minimum payments of the lease is greater than or equal to 90% of the estimated fair market value - Requires asset and liability to be recorded
- Treated as debt
What is meant by recovery value?
Amount an investor receives in bankruptcy liquidation from his investment in a particular financial instrument.
Recovery rate is the associated percentage
Could you ever end up with negative shareholders’ equity? What would this imply?
Yes, it is possible.
(1) Dividend Recap. Shareholders’ equity turns negative immediately after dividend recapitalization in an LBO situation. Means that the owner of the company has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn the number negative (2) Continuous losses. It can also happen if the company has been losing money consistently and therefore has declining retained earnings, which is a portion of shareholders’ equity
*Does not “mean” anything in particular, but it can be a cause for concern and possibly demonstrate that the company is struggling
Why do companies report both GAAP and non-GAAP earnings?
These days, many companies have non-cash charges such as amortization of intangibles, stock-based compensation, deferred revenue write-downs on their income statement. Some argue that the income statement under GAAP no longer reflects how profitable a company is. Non-GAAP earnings are almost always higher because these expenses are excluded, which looks better to investors
What is a NINJA loan?
“No income, no job, no assets” – subprime loan, as it is typically made with little or no paperwork, generally to borrowers with less than average credit score
These types of loans were a sign of the impending subprime meltdown and deterioration of lending standards by banks and mortgage originators
These and other loans were packaged and sold as CDOs to investors. They were supposedly well diversified across different geographies, loan sizes, and income levels. The only way they would default is if there was a major collapse in the mortgage market due to oversupply and widespread economic slowdown
Under what circumstances would goodwill increase?
- If a company re-assesses its value and finds that it is worth more but that is rare
- What usually happens is:
(1) company gets acquired or bought out and goodwill changes as a result, since it is an account plug for the acquisition price
(2) company acquires another company and pays more than what its assets are worth, which is then reflected in goodwill
Why would goodwill be impaired and what does goodwill impairment mean?
- Usually happens when a company has been acquired and the acquirer re-assesses its intangible assets (e.g. brand, IP) and finds that they are not worth what they originally thought
- Buyer overpaid for the seller, which results in a large net loss (e.g. eBay / Skype)
How do you decide when to capitalize vs expense a purchase?
If the assets has a useful life over one year, it is capitalized on the balance sheet rather than expensed on the income statement. It is then depreciated (tangibles) or amortized (intangibles) over a certain number of years
PPE vs R&D
What is the difference between cash based and accrual based accounting?
Cash-Based Accounting:
- Recognize revenue and expenses when cash is actually received or paid out
- This delays revenue recognition
- There is a poor matching of true costs of generating revenue to the periods in which they are generated
Accrual-Based Accounting:
- Account for all transactions that economically occurred during a period
- Revenue principle: entity has delivered goods/services, evidence of arrangement for payment, price is fixed and collection of cash is reasonably assured
- Matching principle: revenue is matched with expense in the period in which they are incurred
*Most large firms use accrual accounting because paying with credit cards and lines of credit is so prevalent these days
If cash collected is not recorded as revenue, what happens to it?
Usually it goes to unearned revenue (balance sheet liability). Over time as services are performed, unearned revenue is debited and revenue is credited and it appears on the income statement
Give examples of when a company could collect cash from a customer and not record revenue.
(1) Web-based subscription software
(2) Cell phone carriers with annual contracts
(3) Magazine publishers that sell subscriptions
- Companies that agree to services in the future often collect cash upfront to ensure stable revenue. This makes investors happy as well since they can predict the company’s performance
- Only record revenue when you can actually perform the services
What is a credit default swap?
-Insurance on a company’s debt. It is a way to insure that an investor will not be hurt in the event of a default
-Sold over the counter in a completely unregulated market
-Can be used for hedging and speculating
CDS Seller: promises to pay buyer certain amount if company defaults; receives annual payments in exchange for insurance; sellers include banks, hedge funds, insurance companies
CDS Buyer: promises to pay seller annual payments; receives a large payout if the underlying company defaults; swap becomes more valuable if the underlying company becomes distressed
If depreciation is a non-cash expense, then why does it affect the cash balance?
- It is non-cash but it is tax-deductible and taxes are a cash expense
- Depreciation affects cash by reducing the amount of taxes paid
What is a collateralized debt obligation?
It is a broad asset class in which a number of interest paying assets are packaged together (securitized) and sold in the form of bonds that pay coupon payments based on the assets’ future cash flows. Investor pays market value for the CDO and then has the rights to the interest payments over time.
What is a mortgage-backed security?
A security that pays its holder a periodic payment based on the cash flows from the underlying mortgages that fund the security
- MBS allow investing community to lend money to homeowners with banks acting as middleman
- Many MBS were rated AAA because they were considered highly diversified, and it was though that the housing market would not collapse across the board
What is securitization?
An issuer bundles together a group of assets and creates a new financial instrument by combining those assets and reselling them in different tiers
What is a net operating loss?
Period in which a company’s allowable tax deductions are greater than its taxable income, resulting in negative taxable income
- Generally occurs when a company incurs more expenses than revenue in a period
- Can be used to recover past tax payments or reduce future tax payments
What is a loss carry forward?
Firm may carry net operating loss forward 20 years to offset any income earned in those years and therefore receive funds for the taxes paid
What is a loss carryback?
Firm may carry Net Operating Loss back two years to offset any income earned in those years and thereby receive funds for the taxes paid
What is the accounting for notes receivable?
Record at NPV of future cash flows
Premium: c > r (FV < PV)
Interest Revenue = r x (FV + Premium – Total Amortized)
Discount: c < r (FV > PV)
Interest Revenue = r x (FV – Discount – Total Amortized)
What is inventory?
Tangible property that is held for sale in the normal course of business or used to produce goods/services for sale
What is meant by mark-to-market and why is it so important?
Mark-to-market is the process by which securities are recorded on financial statements using current market prices, as opposed to purchase prices or accounting values
As the credit crisis unraveled, many banks/investors were forced to write-down assets to current market values
(1) Many banks used these assets as collateral to borrow against in order to make other investments. As asset values declined, they were able to borrow less
(2) As assets are marked down, investors are likely to sell their assets so that they do not keep losing value. Selling naturally depresses market values further
(3) In late 2008, this caused a panic and people moved their personal investments into cash and were willing to sell at any cost
Why is the income statement not affected by changes in inventory?
Expense is only recorded when goods associated with the inventory are sold -> COGS
Is an increase in accounts receivable a source or use of cash?
Accounts receivable is a use of cash because for every dollar that should be coming in the door from those that owe money for goods/services, that cash has been delayed by a collection time period
Is an increase in accounts payable a source or use of cash?
Accounts payable is a source of cash because companies have the ability to purchase items without immediately paying cash.
You misstated depreciation in your model. It should be $10 million higher. How does this affect the three financial statements?
Income Statement: $10 depreciation expense, 40% tax rate
-Reduction in net income of $10(1 – 40%) = $6
Statement of Cash Flows: reduction in net income flows to cash flow from operations
- Net income reduced by $6
- Depreciation increases by $10
- Net increase in cash from operations of $4
- Ending cash increase by $4
Balance Sheet: ending cash flows onto the balance sheet
- Cash increases by $4
- PPE loses $10 in value
- Net decrease in assets of $6, which matches the net drop in shareholders’ equity due to reduction of retained earnings from $6 drop in net income
If depreciation is non-cash, explain how a $10 pre-tax increase in depreciation causes cash to increase by $4.
The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.
A pen costs $10 dollars to buy. It has a life of ten years. How would you put it on the balance sheet?
On the left side, $10 as an asset. Assuming a straight-line depreciation for book and no salvage value at the end of its useful life, it would be worth $9 at the end of the first year, $8 the second year, and so on. Net income will be lowered every year by the tax-affected depreciation, so shareholders’ equity will be reduced by 60 cents, assuming a 40 percent tax rate.
A pen costs $10 dollars to buy. It has a life of ten years. At the end of the second year, you discover the pen is a rare collector’s item. How much is it on the balance sheet?
Still $8. You continue to depreciate it. Assets are recorded at historical values. Some traded financial instruments qualify for “mark to market accounting,” so those assets are valued at market, but this accounting practice has been severely criticized in recent times.
A pen costs $10 dollars to buy. It has a life of ten years. At the end of the second year, the pen runs out of ink and you have to throw it away. How much is it on the balance sheet?
Since the pen is worthless, you’ll need to write down the value of this equipment to $0. Due to the write down, net income declines by $4.8 based on a 40 percent tax rate, which flows to shareholders’ equity. The $8 write-down is noncash; on the CFS, it is added to the $4.8 decline in net income, resulting in a net cash flow of $3.2. Combined with the write-down of $8 for PP&E, net change in assets is a decrease of $4.8, which balances the $4.8 decrease in shareholder’s equity.
You sold an asset where you received $500 million in cash. How does this affect your three financial statements?
The key to this question is inquiring about the book value of the asset when sold. Ask the interviewer for this. For instance, if it is $400 million, then a $100 gain on sale of asset is recorded. Assuming a 40 percent tax rate, net income increases by $60 million. On the CFS, remember that assets are recorded at book value when sold. Therefore, you have a $400 million “sale of asset” under cash from investing activities. Your net cash flow is $460 million. On the BS, cash increases by $460 million and PP&E decreases by $400 million. The $60 million increase on the left side of the BS is offsest by the $60 million increase in shareholder’s equity on the right side.
How would a $10 million increase in depreciation in year four affect the DCF valuation of a company?
- Depreciation increases by $10, causing EBIT to decline by $10. The after-tax effect is a decline of $10(1 – 40%) = $6
- Depreciation of $10 must be added back to calculate FCF, which leads to a net increase of $4 in FCF
- Valuation will increase by the present value of $4, or $4 / (1 + WACC)4
Suppose you purchase $100 million of equipment on December 31, 2001 with a debt issuance. Walk me through the impact of this event on the three financial statements during 2001 and 2002.
2001
Income Statement: no effect because there is no depreciation and no interest expense
Statement of Cash Flows:
- Investing cash flows declines by $100 as capex
- Financing cash flows increases by $100 as debt issurance
- Zero net effect on cash
Balance Sheet:
- Increase in PPE by $100
- Increase in Debt by $100
2002
Income Statement:
*Assume useful life of 5 years, 40% tax rate, 10% interest rate and no amortization (zero coupon)
-$20 depreciation expense and $10 interest expense
-$30(1 – 40%) = $18 decrease in net income
Statement of Cash Flows:
- Net income down by $18 and depreciation up by $20
- Net increase in cash of $2
Balance Sheet:
- Increase in cash by $2
- Decrease in PPE by $20
- Decrease in RE by $18
*Could also consider interest payable increasing and debt decreasing
Suppose you purchase $100 million of equipment (5 year useful life) on December 31, 2001 with a debt issuance. On January 1, 2003, the equipment breaks down and is worthless. Walk me through the impact of this event on the three financial statements.
If the equipment breaks down and is worthless, the company must write it down to $0. On January 1, 2003, the equipment is on the books at $80 million and the company must pay back the entire loan.
Income Statement:
-$80 write down causes net income to decline by $80(1 – 40%) = $48
Statement of Cash Flows:
- Net income is down $48
- Add back the non-cash write-down of $80
- Cash from financing decreases by $100 when you pay back the loan; net cash declines by $68
Balance Sheet:
- Assets: Cash decreases by $68, PPE decreases by $80 = $148 decline
- Debt: Declines by $100
- RE: Declines by $48
Suppose you issue $80 worth of debt for $100 in cash. Walk me through the effect of this transaction on the three financial statements.
Dr. Cash 100
Cr. Debt 80
Cr. Gain 20
Income Statement: $20(1 – 40%) = $12 increase in net income
Statement of Cash Flows:
-$12 increase in net income
-Subtract $20 non-cash gain
-Add $100 of financing cash flow from debt issuance
-Net increase in cash of $92
Balance Sheet:
- Cash increases by $92
- Debt increases by $80
- RE increases by $12
Suppose you repurchase debt of $100 for $80 in cash. What is the effect of this transaction on the three financial statements?
Dr. Debt $100
Cr. Cash $80
Cr. Gain $20
Income Statement: $20(1 – 40%) = $12 increase in net income
Statement of Cash Flows:
-$12 increase in net income
-Subtract $20 non-cash gain
-Subtract $80 of financing cash flow from repurchase of debt
-Net decrease in cash of $88
Balance Sheet:
- Cash decreases by $88
- Debt decreases by $100
- RE increases by $12
Suppose you sell a pair of jeans for $20 that cost you $10. Walk me through the effect of this transaction on the three financial statements.
Income Statement:
-Revenue increases by $20 while COGS increases by $10
-Net income increases by $10(1 – 40%) = $6
Statement of Cash Flows:
-Net income increases by $6
-Decrease in inventory of $10 leads to a cash increase of $10
-Net increase in cash of $16
Balance Sheet:
-Cash increases by $16
-Inventory declines by $10
-RE increases by $6
If you purchase a building for $100 million in cash on December 31, how would it flow through the three financial statements this year and next year?
- Assume fiscal year ends December 31, which means no depreciation during first year
- Assume straight line over 5 years; 40% tax rate
Year 1 Income Statement: capex thus no expense; no depreciation first year; no effect Statement of Cash Flows: -$100 decrease in investing cash flows due to capex -Net decrease in cash of $100 Balance Sheet: -Increase PPE by $100 -Decrease cash by $100 -No net change in assets
Year 2 Income Statement: $20 depreciation causes net income to decline by $20(1 – 40%) = $12 Statement of Cash Flows: -Net income declines by $12 -Depreciation increases by $20 -Net increase in cash of $8 Balance Sheet: -Cash increases by $8 -PPE declines by $20 -RE declines by $12 from net income
What effect does an asset write-down of $100 million have on the three financial statements?
Income Statement: Net income declines by $100(1 – 40%) = $60
Statement of Cash Flows:
- Net income declines by $60
- Add back non-cash impairment of $100
- Net cash increase of $40
Balance Sheet:
- Cash increases by $40
- Asset declines by $100
- RE decreases by $60
How does a $10 million purchase of inventory from your supplier on credit flow through the three financial statements?
Income Statement: no effect until the inventory is sold
Statement of Cash Flows:
- Increase in inventory causes operating cash flow to decline by $10
- Increase in accounts payable causes operating cash flow to increase by $10
- No net effect on cash flow
Balance Sheet:
- Inventory increases by $10
- Accounts payable increases by $10
Suppose you buy $100 million of inventory. You sell half of the inventory at 50% gross margin. Using a 50% tax rate, walk me through the changes in the three financial statements.
Income Statement:
- Revenue increases by $200 and COGS increases by $100
- Net income increases by $100(1 – 50%) = $50
Statement of Cash Flows:
- Increase in net income of $50
- Decrease in inventory causes operating cash flow to increase by $100
- Net increase in cash flow of $150
Balance Sheet:
- Increase in cash of $150
- Decrease in inventory of $100
- Increase in RE of $50
Suppose you purchase a new fixed asset at $100 with 50% cash and 50% debt on December 31. Take me through how it affects all the financial statements.
Income Statement:
-No depreciation or interest during the first year
Statement of Cash Flows:
- Investing cash flow decreases by $100 due to capex
- Financing cash flow increases by $50 due to debt issuance
- Net decrease in cash of $50
Balance Sheet:
- Decrease in cash by $50
- Increase in PPE by $100
- Increase in Debt by $50
You own a hotdog business. (1) Assume that you buy a hot dog on credit for $1 and sell that hot dog to a person on credit for $3. (2) You receive cash from the party that bought the hot dog and you pay off your creditor. Explain the impact on the three financial statements of both events.
Event 1:
Dr. Inventory $1
Cr. Accounts Payable $1
Dr. Accounts Receivable $3
Cr. Revenue $3
Income Statement: increase net income by $2(1 – 40%) = $1.20
Statement of Cash Flows:
- Increase net income by $1.20
- Increase in inventory causes decline of operating cash by $1
- Increase in accounts receivable causes decline of operating cash by $3
- Increase in accounts payable causes increase of operating cash by $1
- Net decrease in cash of $1.80
Balance Sheet:
- Decrease in cash $1.80
- Increase inventory $1.00
- Increase accounts receivable $3.00
- Increase accounts payable $1.00
- Increase RE by $1.20
Event 2
Dr. Cash $3
Cr. Accounts Receivable $3
Dr. Accounts Payable $1
Cr. Cash $1
Income Statement: no effect due to accrual accounting
Statement of Cash Flows:
-Decrease in accounts receivable causes increase in operating cash of $3
-Decrease in accounts payable causes decrease in operating cash of $1
-Net increase in cash of $2
Balance Sheet:
- Increase in cash of $2
- Decrease accounts receivable $3
- Decrease accounts payable of $1
How would a change in gross margin affect the three financial statements?
*A decrease in gross margin causes gross profits to decline
Income Statement: likely pay lower taxes; if nothing else changed, lower net income
Statement of Cash Flows: less cash likely coming in; if nothing else changed, lower cash
Balance Sheet: less cash and lower RE to balance effect
How would a change in capex affect the three financial statements?
Income Statement: during the current year, there is no effect; however, depreciation expense is lower in subsequent years, which will increase net income and increase cash and RE in the future
Statement of Cash Flows: decrease in investing cash flow, which means more cash
Balance Sheet: more cash but lower PPE; total assets remains the same
Say you knew a company’s net income. What else would you need to figure out its cash flows?
D&A, other non-cash expenses (e.g. stock based compensation, impairment), changes in working capital accounts, capex, sale of PPE, debt issuance, debt repayments, equity issuance, stock repurchases, dividends
What is investing cash flows?
Reports aggregate change in cash resulting from gains/losses from investments in the financial markets and operating subsidiaries as well as changes resulting from capital expenditure investment
What is financing cash flows?
Accounts for external activities such as issuing cash dividends, issuing or repaying debt, or issuing or repurchasing stock
What is the balance sheet?
The balance sheet presents the financial position of a company at a given point in time
(1) Assets – economic resources of the company used to operate its business
- Usually obtains these resources by incurring debt (promise to pay), obtaining new investors (not guaranteed, more risky), or through operating earnings
(2) Liabilities – claims that creditors have on the company’s resources
- More senior than equity holdings and less risky, as it is paid back before distributions to equity-holders are made
(3) Equity – claims that investors have on the company’s resources after debt is paid off
What is the income statement?
The income statement presents the results of operations of a business over a specified period of time; it measures the success of the company’s operations and provides investors and creditors with information needed to determine the enterprise’s profitability and creditworthiness
(1) Revenue – source of income that normally results from the sale of goods or services and is recorded when earned
(2) Expenses – costs incurred by a business over a specified period of time to generate the revenue earned during that same period of time
Notes: a purchase is considered an asset if it provides future economic benefit to the company, while expenses only relate to the current period
What is the statement of retained earnings?
The statement of retained earnings is a reconciliation of the retained earnings account from the beginning of the year to the end of the year. Retained earnings is the amount of profit a company invests in itself (ie profit that is not used to pay back debt or distributed to shareholders as a dividend).
This financial statement provides additional information about what management is doing with the company’s earnings. Investors can use this information to align their investment strategy with the strategy of a company’s management (e.g. an investor that is more interested in growth and returns on capital may be more inclined to invest in a company that reinvests its resources into the company for the purpose of generating additional resources)
What is the statement of cash flows?
The statement of cash flows presents detailed summary of all cash inflows and outflows during the period
(1) Cash Flow from Operating Activities – includes the cash effects of transactions involved in calculating net income
(2) Cash Flow from Investing Activities – cash from non-operating activities or activities outside the normal scope of business; involves items classified as assets in the BS and includes the purchase/sale of equipment and investments
(3) Cash Flows from Financing Activities – involves items classified as liabilities and equity in the BS; includes the payment of dividends as well as issuing payment of debt or equity
What are deferred taxes?
As a quick refresher, deferred taxes are the result of the difference between MACRS deprecation rates and GAAP depreciation rates. As a result of the different depreciation amounts, actual taxes paid and book tax expense recorded in the financials will be different. The deferred tax account is meant to reconcile these two items.
Deferred taxes are kept on the balance sheet as an asset or liability and are meant to hold the place for future tax adjustments
DTA – if you paid more than you owe (i.e. if cash taxes paid to IRS > tax expense on financial reports); use to offset future taxes
DTL – if you paid less than you owe (i.e. if cash taxes paid to IRS < tax expense on financial statements); add to future tax payments
What is Days Inventory Outstanding and how is it calculated?
Days Inventory Outstanding = (Inventory / COGS) x 365 = 365 / Turnover
Definition: A financial measure of a company’s performance that gives investors an idea of how long it takes a company to turn its inventory (including goods that are work in progress, if applicable) into sales. Generally, the lower (shorter) the DSI the better, but it is important to note that the average DSI varies from one industry to another.
Inventory Turnover = COGS / Inventory
Definition: ratio showing how many times company’s inventory is sold and replaced over period
- Note: turnover should be compared against industry averages. Low ratio implies poor sales and, therefore, excess inventory. High ratio implies either strong sales or ineffective buying.
- Note: high inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.
Inventory = (DIO / 365) x COGS
What is Days Receivables Outstanding and how is it calculated?
Days Receivables Outstanding = (Receivables / Sales) x 365= 365 / Turnover
Definition: A measure of the average number of days that a company takes to collect revenue after a sale has been made. A low DSO number means that it takes a company fewer days to collect its accounts receivable. A high DSO number shows that a company is selling its product to customers on credit and taking longer to collect money.
Receivables Turnover = Sales / Receivables
Definition: An accounting measure used to quantify a firm’s effectiveness in extending credit as well as collecting debts. The receivables turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets.
*Note: by maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients. A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient. A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm.
Receivables = (DRO / 365) x Sales
What is Days Payable Outstanding and how is it calculated?
Days Payable Outstanding = (Accounts Payable / COGS) x 365 = 365 / Turnover
Definition: A company’s average payable period
AP Turnover = COGS / Accounts Payables
Definition: A short-term liquidity measure used to quantify the rate at which a company pays off its suppliers. Accounts payable turnover ratio is calculated by taking the total purchases made from suppliers and dividing it by the average accounts payable amount during the same period.
*Note: The measure shows investors how many times per period the company pays its average payable amount. For example, if the company makes $100 million in purchases from suppliers in a year and at any given point holds an average accounts payable of $20 million, the accounts payable turnover ratio for the period is 5 ($100 million/$20 million). If the turnover ratio is falling from one period to another, this is a sign that the company is taking longer to pay off its suppliers than it was before. The opposite is true when the turnover ratio is increasing, which means that the company is paying of suppliers at a faster rate.
Accounts Payable = (DPO / 365) x COGS
What is the cash conversion cycle and how do you calculate it?
A metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows. The cash conversion cycle attempts to measure the amount of time each net input dollar is tied up in the production and sales process before it is converted into cash through sales to customers. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties.
Calculated as: CCC = Days Inventory Outstanding + Days Receivable Outstanding – Days Payable Outstanding
Usually a company acquires inventory on credit, which results in accounts payable. A company can also sell products on credit, which results in accounts receivable. Cash, therefore, is not involved until the company pays the accounts payable and collects accounts receivable. So the cash conversion cycle measures the time between outlay of cash and cash recovery.
This cycle is extremely important for retailers and similar businesses. This measure illustrates how quickly a company can convert its products into cash through sales. The shorter the cycle, the less time capital is tied up in the business process, and thus the better for the company’s bottom line.
What is asset turnover and how is it calculated?
Asset Turnover = Revenue / Assets
The amount of sales generated for every dollar’s worth of assets. It is calculated by dividing sales in dollars by assets in dollars.
Asset turnover measures a firm’s efficiency at using its assets in generating sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.
Explain the time value of money.
The “Time Value of Money” suggests that a dollar today is worth more than a dollar tomorrow because a dollar today can be invested at a risk-free interest rate. A dollar tomorrow is worth less because it has missed out on the interest you would have earned on that dollar had you invested it today. Additionally, inflation diminishes the buying power of future money
A discount rate is the rate that is chosen to discount the future value of your money; it is a measure of risk
Why is inflation important?
(1) Affects future purchasing power of money and affects real interests rates
(2) Creates uncertainty about the future in terms of purchasing power
Company A has assets of $100 million versus Company B which has $10 million. Both have the same dollar earnings. Which company is better?
Company B has a higher return on assets (“ROA”) given that both company had the same earnings but Company B was able to generate it with fewer assets and is, thus, more efficient. Something to think more about is if Company A was entirely debt financed whereas Company B was entirely equity financed. From a return on equity or investment (“ROE” & “ROI”) perspective, Company A might be a better company but it would be riskier from a bankruptcy perspective so the “better” company would be less black and white in this situation. The interviewer is probably looking for the simple answer, though; that Company B is better because it is more efficient with its assets.
What is the treasury stock method? Walk through the calculation.
The treasury stock method assumes that acquirers will use option proceeds to buy back exercised options at the offered share price. New shares = common shares + in the money options – (options x strike/offered price).
A product’s life cycle is now mature. What happens to the net working capital?
The net working capital needs should decrease as the business matures, which increases cash flows. As the business develops, it becomes more efficient; investment requirements are lower.
Why is bank debt maturity shorter than subordinated debt maturity?
Bank debt will usually be cheaper (lower interest rate) because of its seniority. This is because it’s less risky, since its needs to be paid back before debt tranches below it. To make it less risky to the lenders, a shorter maturity helps, usually less than 10 years. Secondly, bank deposits tend to have shorter maturities, so this aligns the cash flows of the bank business. You’ll often see bank debt as the line item “Term Loan A” or “Term Loan B.”
What is LIBOR? How is it often used?
The London Interbank Offered Rate tracks the daily interest rates at which banks borrow unsecured funds from banks in the London wholesale money market, and is roughly comparable to the Fed Funds rate. LIBOR is used as a reference rate for several financial instruments, such as interest rate swaps or forward rate agreements, and they provide the basis for some of the world’s most liquid and active interest rate markets.
What is a PIK?
As previously noted in the accounting chapter, PIK stands for “paid in kind,” another important non-cash item, which refers to interest or dividends is paid by issuing more of the security instead of cash. It can be “toggled on” at a particular time, often times at the option of the issuer. It became popular with PE firms, who could pay more aggressive prices by assuming more debt.
Flipping on PIK may be an indicator that the company is nearing default on interest payments due to lack of cash because of a deteriorating business. It is a dangerous crutch for companies; PIK can dramatically increase the debt burden on the company at a time when it is already showing signs of difficulty with the existing levels.
What is a PIPE?
With the cost of credit rising, private investments in public equity, (“PIPEs”), have become more popular. This is an alternative way for companies to raise capital; PIPEs are made by qualified investors (HF, PE, mutual funds, etc.) who purchase stock in a company at a discount to the current market value. The financing structure became prevalent due to the relative cheapness and efficiency in time versus a traditional secondary offering. There are less regulatory requirements as there is no need for an expensive roadshow. The most visible PIPE transaction of 2008: Bank of America’s $2 billion investment in convertible preferreds of mortgage lender Countrywide Financial.
If you put $100 in the bank and got back $2 every year for the next 19 years and then in the 20th year, received $102, what is your IRR?
2 percent. The duration of the investment does not matter.
What is a coverage ratio? What is a leverage ratio?
Coverage ratios are used to determine how much cash a company has to pay its existing interest payments. This formula usually comes in the form of EBITDA/interest. Leverage ratios are used to determine the leverage of a firm, or the relation of its debt to its cash flow generation. There are many forms of this ratio. A standard leverage ratio would be debt/EBITDA or net debt/EBITDA. Debt/equity is another form of a leverage ratio; it measures the relation of debt to equity that a company is using to finance its operations.
How do you think about the credit metric: (EBITDA – Capex)/interest expense?
It represents how many times a company can cover its interest burden while still being able to reinvest into the company.
You have a company with $100 million in sales. Which makes the biggest impact? A) Volume increases by 20 percent B) price increases by 20 percent C) expenses decrease by $15 million.
The answer is B) price by 20 percent. Think about how EBITDA is affected by all three scenarios. It’s not C because EBITDA will only increase by $15 million. Volume will increase the revenue to $120 million but variable costs will increase proportionally. By increasing price, you will capture the entire $20 million impact.
If a company’s revenue grows by 10 percent, would its EBITDA grow by more than, less than or the same percent?
Unless there are no fixed costs, EBITDA will grow more. This is because fixed costs will stay the same, so total costs will not increase as much as revenue. Note this is similar to the previous question, but now looking at it in terms of percentage.
Why should the fair market value of a company be the higher of its liquidation value and its going-concern value?
Liquidation value is the amount of money that a firm could quickly be sold for immediately, usually at a discount. The fair market value, the rightful value at which the assets should be sold, is higher. Basically a liquidation value implies the buyer of the assets has more negotiating power than the seller, while fair market value assumes a meeting of the minds. The going-concern value is the firm’s value as an operating business to a potential buyer, so the excess of goingconcern value over liquidation value is booked as goodwill in acquisition accounting. If positive goodwill exists, i.e., the company has intangible benefits that allow it to earn better profits than another company with the same assets; the going-concern value should be higher than the fair market value.
How will a decrease in financial leverage affect a company’s cost of equity capital, if at all?
A decrease in financial leverage lowers the beta which lowers the cost of equity capital. With less debt, the firm has a reduced risk of defaulting. This change causes equity investors to expect a lower premium for their investments and therefore reduce the cost of equity.
Which corporate bond would have a higher coupon, a AAA or a BBB? What are the annual payments received by the owner of a five year zero coupon bond?
The corporate bond with a rating of BBB will have a higher coupon because it is perceived to have a higher risk of defaulting. To compensate investors for this higher perceived risk, lower rated bonds offer higher yields. The owner of a fiveyear zero coupon bond receives no annual payments. Instead, the owner will pay a discount upfront and then receive the face value at the time of maturity.
Let’s say that I have a bond with a 5 percent coupon. What happens to the market price when the prevailing interest rates rise to 8 percent? How are the coupons affected?
When the prevailing interest rates rise to 8 percent, the market price of the coupon bond decreases. This happens because the investor can obtain a higher interest rate on the market than what the bond is currently yielding. To make the bond appealing to potential investors, the market price decreases. This causes the bond’s return to increase at maturity as a means of compensating for the decreased value of coupon payments. The coupons themselves remain constant; the new market price instead balances the yield to keep it neutral with the current market.
What’s the difference between IRR, NPV and payback?
IRR measures the return per year on a given project and is the discount rate that makes NPV equal to zero. NPV measures whether or not a project can add additional or equal value to the firm based on its associated costs. Payback measures the amount of time it takes for a firm to recoup the initial costs of a project without taking into account the time value of money.
Why would a company repurchase its own stock? What signals (positive and negative) does this send to the market?
A company repurchases its own stock if it perceives the market is undervaluing its equity. Since the management has more information on the company than the general public, when the management perceives the company as undervalued, it sends a creditable signal to the rest of the market.
If you were to advise a company to raise money for an upcoming project, what form would you raise it with (debt versus equity)?
The right answer is “it depends.” First and foremost, companies should seek to raise money from the cheapest source possible. However, there might exist certain conditions, limitations or implications of raising money in one form or another. For example, although the cheapest form of debt is typically the most senior (corporate loans), the loan market might not have any demand. Or the company might not have the cash flow available to make interest payments on new debt. Or the equity markets might better receive a new offering from this company than the debt markets. Or the cost of raising an incremental portion of debt might exceed that of raising equity. All of this should be considered when answering this question. Be prepared to ask more clarifying questions—your interviewer will most likely be glad you did.
