New Accounting Flashcards
Walk me through how Depreciation going up by $10 would affect the statements.
Income Statement: Operating Income and Pre-Tax Income would decline by $10 and, assuming a 40% tax rate, Net Income would go down by $6.
Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-cash expense that gets added back, so overall Cash Flow
from Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in Cash goes up by $4.
Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement.
Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders’ Equity on the Liabilities & Equity side is down by $6 and both sides of the Balance Sheet balance.
Intuition: We save on taxes with any non-cash charge, including Depreciation.
What happens when Accrued Expenses increases by $10?
For this question, remember that Accrued Expenses are recognized on the Income Statement but haven’t been paid out in cash yet. So this could correspond to payment being set aside for an employee, but not actually the employee in cash yet.
Income Statement: Operating Income and Pre-Tax Income fall by $10, and Net Income falls by $6 (assuming a 40% tax rate).
Cash Flow Statement: Net Income is down by $6, and the increase in Accrued Expenses will increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at the bottom is up by $4.
Balance Sheet: Cash is up by $4 as a result, so Assets is up by $4. On the Liabilities & Equity side, Accrued Expenses is a Liability so Liabilities is up by $10 and Shareholders’ Equity(Retained Earnings) is down by $6 due to the Net Income decrease, so both sides balance.
Intuition: We record an additional expense and save on taxes with it… but that expense hasn’t been paid in cash yet, so our cash balance is actually up.
- What happens when Accrued Expenses decreases by $10 (i.e. it’s now paid out in the form of cash)? Do not take into account cumulative changes from previous increases in Accrued Expenses.
Income Statement: There are no changes.
Cash Flow Statement: The change in Accrued Expenses in the CFO section is negative $10 because you pay it out in cash, and so the cash at the bottom decreases by $10.
Balance Sheet: Cash is down by $10 on the Assets side and Accrued Expenses is down by $10 on the other side, so it balances.
Intuition: This is a simple cash payout of previously recorded expenses.
Accounts Receivable increases by $10. Walk me through the 3 statements.
If AR “increases” by $10, it means that we’ve recorded revenue of $10 but haven’t received it in cash yet. For example, a customer has ordered a $10 product from us and we’ve delivered it, but we are still waiting on cash payment.
Income Statement: Revenue is up by $10 and so is Pre-Tax Income, which means that Net Income is up by $6 assuming a 40% tax rate.
Cash Flow Statement: Net Income is up by $6 but the AR increase is a reduction in cash (since we don’t have the cash yet), so we need to subtract $10, which results in cash at the bottom being down by $4.
Balance Sheet: On the Assets side, Cash is down by $4 and AR is up by $10, so the Assets side is up by $6. On the other side, Shareholders’ Equity is up by $6 because Net Income has increased by $6. Both sides balance.
Intuition: When AR increases, it means that we’ve paid taxes on additional revenue but haven’t received any of that revenue in cash yet… so our cash balance decreases by the additional amount of taxes we’ve paid.
Prepaid Expenses decreases by $10. Walk me through the statements. Do not take into account cumulative changes from previous increases in Prepaid Expenses
When Prepaid Expenses “decreases,” it means that expenses are now recognized on the Income Statement. For example, we’ve previously paid for an insurance policy in cash and have now recognized that same expense on the IS.
Income Statement: Pre-Tax Income is down by $10, and Net Income is down by $6.
Cash Flow Statement: Net Income is down by $6 but since Prepaid Expenses is an Asset, a decrease of $10 results in an increase of 10 in cash. At the bottom of the CFS, cash is up by $4 as a result.
Balance Sheet: On the Assets side Cash is up by $4 and Prepaid Expenses is down by $10, so the Assets side is down by $6 overall. On the other side, Shareholders’ Equity is down by $6 because of thereduced Net Income, so both sides balance.
Intuition: Here, we’re losing Net Income and paying additional taxes… but oh, wait, we’ve already paid out these expenses in cash previously! So our Cash balance goes up rather than down, despite the additional Income Statement expenses.
What happens when Inventory goes up by $10, assuming you pay for it with cash?
This really just means, “Walk me through what happens on the statements when you purchase $10 worth of Inventory with cash.”
Income Statement: No changes.
Cash Flow Statement: Inventory is an Asset so that reduces Cash Flow from Operations – it goes down by $10, as does the Net Change in Cash at the bottom.
Balance Sheet: On the Assets side, Inventory is up by $10 but Cash is down by $10, so the changes cancel out and Assets still equals Liabilities & Equity.
Intuition: We’ve spent cash to buy Inventory, but haven’t manufactured or sold anything yet.
A company sells some of its PP&E for $120. On the Balance Sheet, the PP&E is worth $100. Walk me through how the 3 statements change.
Income Statement: You record a Gain of $20 ($120 – $100), which boosts Pre-Tax Income by $20. At a 40% tax rate, Net Income is up by $12.
Cash Flow Statement: Net Income is up by $12, but you need to subtract out that Gain of $20, so Cash Flow from Operations is down by $8.Then, in Cash Flow from Investing, you record the entire amount of proceeds from the sale – $120 – so that section is up by $120. At the bottom of the CFS, cash is therefore up by $112.
Balance Sheet: Cash is up by $112, but PP&E is down by $100 since we’ve sold it, so the Assets side is up by $12. The other side is up by $12 as well, since Shareholders’ Equity is up by $12 due to the Net Income increase.
Intuition: Gains and Losses are not non-cash, but they are re-classified on the CFS. The cash increase here simply reflects the after-tax profit from the Gain – if we had sold the PP&E at its Balance Sheet value, there would be no change on the IS.
Walk me through what happens on the 3 statements when there’s an Asset Write-Down of $100.
Income Statement: The $100 Write-Down reduces Pre-Tax Income by $100. With a 40% tax rate, Net Income declines by $60.
Cash Flow Statement: Net Income is down by $60 but the Write-Down is a non-cash expense, so we add it back – and therefore Cash Flow from Operations increases by $40. Cash at the bottom is up by $40.
Balance Sheet: Cash is now up by $40 and an Asset is down by $100 (it’s not clear which Asset since the question never stated it). Overall, the Assets side is down by $60.
On the other side, since Net Income was down by $60, Shareholders’ Equity is also down by $60 – and both sides balance.
Intuition: The same as any other non-cash charge: we save on taxes, so our Cash goes up, and something on the Balance Sheet changes in response
Explain what happens on the 3 statements when a company issues $100 worth of shares to investors
Income Statement: No changes (since this doesn’t affect taxes and since the shares will be around for years to come).
Cash Flow Statement: Cash Flow from Financing is up by $100 due to this share issuance, so cash at the bottom is up by $100.
Balance Sheet: Cash is up by $100 on the Assets side and Shareholders’ Equity (Common Stock & APIC) is up by $100 on the other side to balance it.
Intuition: This one does not affect taxes and does not correspond to the current period, so it doesn’t show up on the IS – just like similar items, all that changes is Cash and then something else on the Balance Sheet.
Let’s say we have the same scenario, but now instead of issuing $100 worth of stock to investors, the company issues $100 worth of stock to employees in the form of Stock-Based Compensation. What happens?
Income Statement: You need to record this as an additional expense because it’s now a tax-deductible and a current expense – Pre-Tax Income falls by $100 and Net Income falls by $60 assuming a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but you add back the SBC of $100 since it’s a non-cash charge, so cash at the bottom is up by $40.
Balance Sheet: Cash is up by $40 on the Assets side. On the other side, Common Stock & APIC is up by $100 due to the Stock-Based Compensation, but Retained Earnings is down by $60 due to the reduced Net Income, so Shareholders’ Equity is up by $40 and both sides balance.
Intuition: This is a non-cash charge, so like all non-cash charges it impacts the IS and affects one Balance Sheet item in addition to Cash and Retained Earnings – in this case, it flows into Common Stock & APIC because that one reflects the market value of stock at the time the stock was issued. The cash increase here simply reflects the tax savings.
A company decides to issue $100 in Dividends – how do the 3 statements change?
Income Statement: No changes. Dividends count as a financing activity and are not tax-deductible, so they never appear on the IS.
Cash Flow Statement: Cash Flow from Financing is down by $100 due to the Dividends, so cash at the bottom is down by $100.
Balance Sheet: Cash is down by $100 on the Assets side, and Shareholders’ Equity (Retained Earnings) is down by $100 on the other side so both sides balance.
Intuition: This is another non-operational CFS / BS item, so it is a simple use of cash and nothing else changes.
A company has recorded $100 in income tax expense on its Income Statement. All $100 of it is paid, in cash, in the current period. Now we change it and only $90 of it is paid in cash, with $10 being deferred to future periods. How do the statements change?
Income Statement: Nothing changes. Both Current and Deferred Taxes are recorded simply as “Taxes” and Net Income remains the same. Net Income changes only if the total amount of taxes changes.
Cash Flow Statement: Net Income remains the same but we add back the $10 worth of Deferred Taxes in Cash Flow from Operations – no other changes, so cash at the bottom is up by $10.
Balance Sheet: Cash is up by $10 and so the entire Assets side is up by $10. On the other side, the Deferred Tax Liability is up by $10 and so both sides balance.
Intuition: Deferred Taxes save us on cash in the current period, at the expense of additional cash taxes in the future.
Walk me through a $100 “bailout” of a company and how it affects the 3 statements.
Income Statement: No changes.
Cash Flow Statement: Cash Flow from Financing goes up by $100 to reflect this new investment, so the Net Change in Cash is up by $100.
Balance Sheet: Cash is up by $100 so the Assets side is up by $100; on the other side, Shareholders’ Equity goes up by $100 to make it balance (Common Stock & APIC for a normal equity investment or Preferred Stock for preferred).
Intuition: It’s the same as a normal stock issuance: no Income Statement changes because nothing affects the company’s taxes.
Walk me through a $100 Write-Down of Debt – as in OWED Debt, a Liability – on a company’s Balance Sheet and how it affects the 3 statements
This one is counter-intuitive. When a Liability is written down you record it as an addition on the Income Statement (with an asset write-down, it’s a subtraction).
Income Statement: Pre-Tax Income goes up by $100, and assuming a 40% tax rate, Net Income is up by $60.
Cash Flow Statement: Net Income is up by $60, but we need to subtract that Debt Write-Down because it was non-cash – so Cash Flow from Operations is down by $40, and Cash is down by $40 at the bottom.
Balance Sheet: Cash is down by $40 so the Assets side is down by $40. On the other side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and both sides balance.
Intuition: One way to think about this is that writing down Assets is “bad” for us because it reduces our ability to generate future cash flow, but writing down Liabilities is “good” because it reduces our future expenses… sort of. I don’t recommend presenting it like that in an interview.
Wait a minute – if writing down Liabilities boosts Net Income, why don’t companies just do it all the time? It helps them out!
This is like asking, “If declaring bankruptcy helps you relieve your obligations, why not do it whenever you rack up debt?!”
And the answer is similar: Because it may help in the short-term, but in the long-term it hurts the company’s credibility and ability to borrow in the future. If a company continually writes down its Liabilities, investors will stop trusting it – and the inability to borrow again will hurt it far more than a reduced Net Income would.
What’s the difference between LIFO and FIFO? Can you walk me through an example of how they differ?
First, note that this question does not apply to you if you’re outside the US because IFRS does not permit the use of LIFO. But you may want to read this anyway because it’s good to know in case you ever work with US-based companies.
LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out” – they are 2 different ways of recording the value of Inventory and the Cost of Goods Sold (COGS).
With LIFO, you use the value of the most recent Inventory additions for COGS, but with FIFO you use the value of the oldest Inventory additions for COGS.
Here’s an example: let’s say your starting Inventory balance is $100 (10 units valued at $10 each). You add 10 units each quarter for $12 each in Q1, $15 each in Q2, $17 each in Q3, and $20 each in Q4, so that the total is $120 in Q1, $150 in Q2, $170 in Q3, and $200 in Q4.
You sell 40 of these units throughout the year for $30 each. In both LIFO and FIFO, you record 40 * $30 or $1,200 for the annual revenue.
The difference is that in LIFO, you would use the 40 most recent Inventory purchase values – $120 + $150 + $170 + $200 – for the Cost of Goods Sold,
whereas in FIFO you would use the 40 oldest Inventory values – $100 + $120 + $150 + $170 – for COGS.
As a result, the LIFO COGS would be $640 and FIFO COGS would be $540, so LIFO would also have lower Pre-Tax Income and Net Income. The ending Inventory value would be $100 higher under FIFO and $100 lower under LIFO.
If Inventory is getting more expensive to purchase, LIFO will produce higher values for COGS and lower ending Inventory values and vice versa if Inventory is getting cheaper to purchase.
Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?
Income Statement: At the start of “Year 1,” there are no changes yet.
Cash Flow Statement: The $100 worth of Capital Expenditures would show up under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the additional $100 worth of Debt raised would show up as an addition to Cash Flow in Cash Flow from Investing, canceling out the investment activity. So the cash number stays the same, for now.
Balance Sheet: There is now an additional $100 worth of factories, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, Debt is up by $100, so the entire other side is up by $100 and both sides balance.
Now let’s go out one year, to the start of Year 2. Assume the Debt is high-yield, so no principal is paid off, and assume an interest rate of 10%. Also assume the factories Depreciate at a rate of 10% per year. What happens now?
(Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?)
Assume that we have already factored in the changes from Part 1 and are only tracking what happens AFTER those have taken place.
After a year has passed, Apple must pay Interest Expense and must record the Depreciation.
Income Statement: Operating Income decreases by $10 due to the 10% Depreciation charge each year, and the $10 in additional Interest Expense decreases the Pre-Tax Income by $20 altogether ($10 from the Depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income falls by $12.
Cash Flow Statement: Net Income at the top is down by $12. Depreciation is a non-cash expense, so you add it back and the end result is that Cash Flow from Operations is down by $2.
That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
Balance Sheet: On the Assets side, Cash is down by $2 and PP&E is down by $10 due to the Depreciation, so overall the Assets side is down by $12.
On the other side, since Net Income was down by $12, Shareholders’ Equity is also down by $12 and both sides balance.
Remember that the Debt number itself does not change since we’ve assumed that nothing is paid back.
At the end of Year 2, the factories all break down and their value is written down to $0. The loan must also be paid back now. Walk me through how the 3 statements ONLY from the start of Year 2 to the end of Year 2.
(Let’s say Apple is buying $100 worth of new iPad factories with debt. How are all 3 statements affected at the start of “Year 1,” before anything else happens?
Now let’s go out one year, to the start of Year 2. Assume the Debt is high-yield, so no principal is paid off, and assume an interest rate of 10%. Also assume the factories Depreciate at a rate of 10% per year. What happens now?)
After 2 years, the value of the factories is now $80 if we go with the 10% Depreciation per year assumption. It is this $80 that we will write down on the 3 statements. Also, don’t forget about the Interest Expense – it still needs to be paid in Year 2.
Income Statement: We have $10 worth of Depreciation and then the $80 Write-Down. We also have $10 of additional Interest Expense, so Pre-Tax Income is down by $100. Net Income is down by $60 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but the Write-Down and Depreciation are both non-cash expenses, so we add them back and cash flow is up by $30 so far.
There are no changes under Cash Flow from Investing, but under Cash Flow from Financing there is a $100 charge for the loan payback – so Cash Flow from Financing falls by $100.
Overall, cash at the bottom decreases by $70.
Balance Sheet: Cash is now down by $70, and PP&E has decreased by $90, so the Assets side is down by $160.
On the other side, Debt is down $100 since it was paid off, and since Net Income was down by $60, Shareholders’ Equity is down by $60. Both sides are down by $160 and balance.
NOTE: Be very careful with this type of question because there are many variations – when in doubt, always ask to clarify before you begin answering
Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPad Inventory, using cash on hand. They order the Inventory, but they have not manufactured or sold anything yet – what happens to the 3 statements?
Income Statement: No changes.
Cash Flow Statement: Inventory is up by $10, so Cash Flow from Operations decreases by $10. There are no further changes, so overall Cash is down by $10.
Balance Sheet: Inventory is up by $10 and Cash is down by $10 so the Assets number stays the same and the Balance Sheet remains in balance.
Now let’s say they sell the iPads for revenue of $20, at a cost of $10. Walk me through the 3 statements under this scenario.
Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit, Operating Income, and Pre-Tax Income are all up by $10. Assuming a 40% tax rate, Net Income is up by $6.
Cash Flow Statement: Net Income at the top is up by $6 and Inventory has decreased by $10 (since we just manufactured the Inventory into real iPads), which is a net addition to cash flow – so Cash Flow from Operations is up by $16 overall.
These are the only changes on the CFS, so cash at the bottom is up by $16.
Balance Sheet: Cash is up by $16 and Inventory is down by $10, so the Assets side is up by $6 overall.
On the other side, Net Income was up by $6, so Shareholders’ Equity is up by $6 and both sides balance.
Intuition: This simply reflects the sale of products at a certain cost, and the after-tax profit from that. The only tricky part is how Cash increases by $16, not $6 – that just reflects the “release” you get from selling off the Inventory.
A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase.
Income Statement: No changes yet.
Cash Flow Statement: The $100 Purchase of Short-Term Securities shows up as a reduction of cash flow under Cash Flow from Investing, and the $100 Debt raise shows up as a $100 increase under Cash Flow from Financing. Cash at the bottom is unchanged
Balance Sheet: Short-Term Securities on the Assets side is up by $100, and Debt on the Liabilities side is up by $100 so both sides balance.
Now walk me through what happens at the end of Year 1, after the company has earned interest, paid interest, and paid back some of the debt principal.
(A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase.)
Income Statement: Interest Income is $10 ($100 * 10%) and Interest Expense is $5 ($100 * 5%), so Pre-Tax Income increases by $5, and Net Income increases by $3 assuming a 40% tax rate.
Cash Flow Statement: Net Income is up by $3. In Cash Flow from Financing, we repay $10 worth of debt ($100 * 10%), so cash at the bottom is down by $7.
Balance Sheet: Cash on the Assets side is down by $7, so the Assets side is down by $7. On the other side, Debt is down by $10 due to the repayment and Shareholders’ Equity (Retained Earnings) is up by $3 due to the Net Income, so this side is also down by $7 and the Balance Sheet balances.
Now let’s say that at the end of year 1, the company sells the $100 of Short-Term Securities but gets a price of $110 for them instead. It also uses the proceeds to repay the $90 worth of remaining Debt.
Walk me through the statements after ONLY these changes
(A company raises $100 worth of Debt, at 5% interest and 10% yearly principal repayment, to purchase $100 worth of Short-Term Securities with 10% interest attached. Walk me through how the 3 statements change IMMEDIATELY AFTER this initial purchase)
Income Statement: You record a Gain of $10 ($110 – $100), so Pre-Tax Income is up by $10 and Net Income is up by $6 with a 40% tax rate.
Cash Flow Statement: Net Income is up by $6 but you subtract the Gain of $10, so Cash Flow from Operations is down by $4.
Under Cash Flow from Investing, you record the $110 sale as an addition to cash flow, so cash is up by $106 so far.
Then, under Cash Flow from Financing, you pay off $90 worth of Debt, which reduces cash by $90. Overall, Cash at the bottom is up by $16.
Balance Sheet: Cash on the Assets side is up by $16 but Short-Term Securities is down by $100, so the Assets side is down by $84.
On the other side, Debt is down by $90 but Shareholders’ Equity (Retained Earnings) is up by $6 due to the Net Income increase, so that side is also down by $84 and both sides balance.
Explain what a Deferred Tax Asset or Deferred Tax Liability is. How do they usually get created?
A Deferred Tax Liability (DTL) means that you need to pay additional cash taxes in the future – in other words, you’ve underpaid on taxes and need to make up for it in the future.
A Deferred Tax Asset (DTA) means that you can pay less in cash taxes in the future – you’ve paid too much before, and now you get to save on taxes in the future.
Both DTLs and DTAs arise because of temporary differences between what a company can deduct for cash tax purposes and what they can deduct for book tax purposes.
You see them most often in 3 scenarios:
1. When companies record Depreciation differently for book and tax purposes (i.e. more quickly for tax purposes to save on taxes).
2. When Assets get written up for book, but not tax purposes, in M&A deals.
3. When pension contributions get recognized differently for book vs. tax purposes.
Wait a minute, then how can both DTAs and DTLs exist at the same time on a company’s Balance Sheet? How can they both owe and save on taxes in the future?
This one’s subtle, but you frequently see both of these items on the statements because a company can owe and save on future taxes – for different reasons.
For example, they might have Net Operating Losses (NOLs) because they were unprofitable in early years, and those NOLs could be counted as Deferred Tax Assets.
But they might also record accelerated Depreciation for tax purposes, but straight-line it for book purposes, which would result in a DTL in early years.
How do Income Taxes Payable and Income Taxes Receivable differ from DTLs and DTAs? Aren’t they the same concept?
They are similar, but not the same exact idea. Income Taxes Payable and Receivable are accrual accounts for taxes that are owed for the current year.
For example, if a company owes $300 in taxes at the end of each quarter during the year, on its monthly financial statements it would increment Income Taxes Payable by $100 each month until it pays out everything in the cash at the end of 3 months, at which point Income Taxes Payable would decrease once again.
By contrast, DTAs and DTLs tend to be longer-term and arise because of events that do NOT occur in the normal course of business.
Walk me through how you project revenue for a company.
The simplest way to do it is to assume a percentage growth rate – for example, 15% in year 1, 12% in year 2, 10% in year 3, and so on, usually decreasing significantly over time.
To be more precise, you could create a bottoms-up build or a tops-down build:
• Bottoms-Up: Start with individual products / customers, estimate the average sale value or customer value, and then the growth rate in customers / transactions and customer / transaction values to tie everything together.
• Tops-Down: Start with “big-picture” metrics like overall market size, and then estimate the company’s market share and how that will change in coming years and multiply to get to their revenue.
Of these two methods, bottoms-up is more common and is taken more seriously because estimating “big-picture” numbers is almost impossible.
Walk me through how you project expenses for a company.
The simplest method is to make each Income Statement expense a percentage of revenue and hold it fairly constant, maybe decreasing the percentages slightly (due to economies of scale), over time.
For a more complex method, you could start with each department of a company, the number of employees in each, the average salary, bonuses, and benefits, and then make assumptions for those going forward.
Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics.
Cost of Goods Sold should be tied directly to Revenue and each “unit” sold should incur an expense.
Other items such as rent, Capital Expenditures, and miscellaneous expenses are linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue in a simpler model.
How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses over several years in a 3-statement model?
Normally you assume that these are percentages of revenue or expenses, under the assumption that they’re all linked to the Income Statement:
• Accounts Receivable: % of Revenue.
• Prepaid Expense: % of Operating Expenses.
• Inventory: % of COGS.
• Deferred Revenue: % of Revenue.
• Accounts Payable: % of Operating Expenses.
• Accrued Expenses: % of Operating Expenses.
Then you either carry the same percentages across in future years or assume slight increases or decreases depending on the company.
You can also project these metrics using “days,” e.g. Accounts Receivable Days = Accounts Receivable / Revenue * 365, assume that the days required to collect AR stays relatively the same each year, and calculate the AR number from that.
How should you project Depreciation and Capital Expenditures?
You could use several different approaches here:
• Simplest: Make each one a % of revenue.
Alternative: Make Depreciation a % of revenue, but for CapEx average several years of previous CapEx, or make it an absolute dollar change (e.g. it increases by $100 each year) or percentage change (it increases by 2% each year).
• Complex: Create a PP&E schedule, where you estimate a CapEx increase each year based on management’s plans, and then Depreciate existing PP&E using each asset’s useful life and the straight-line method; also Depreciate new CapEx right after it’s added, using the same approach.
Let’s take a step back… there’s usually a “simple” and “complex” way of projecting a company’s financial statements. Is there a real advantage to using the complex method? In other words, does it give us better numbers?
In short, no. The complex methods give you similar numbers most of the time – you’re not using them to get better numbers, but rather to get better support for those numbers.
If you just say, “Revenue grows by 10% per year!” there isn’t much evidence to back up that claim.
But if you create a bottoms-up revenue model by segment, then you can say, “The 10% growth is driven by a 5% price increase in this segment, a 10% increase in units sold here, 15% growth in units sold in this geography” and so on.
What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when analyzing its financial statements?
Restructuring Charges • Goodwill Impairment • Asset Write-Downs • Bad Debt Expenses • One-Time Legal Expenses • Disaster Expenses • Changes in Accounting Policies
Note that to qualify as an “add-back” or “non-recurring” charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if one of these charges is “below the line,” then you do not add it back for the EBITDA / EBIT calculation.
Also note that you do add back Depreciation, Amortization, and sometimes Stock-Based Compensation when calculating EBITDA, but that these are not “non-recurring charges” because all companies have them every year – they’re just non-cash charges.
What’s the difference between capital leases and operating leases? How do they affect the statements?
Operating Leases are used for short-term leasing of equipment and property, and do not involve ownership of anything. Operating lease expenses show up as Operating Expenses on the Income Statement and impact Operating Income, Pre-Tax Income, and Net Income.
Capital Leases are used for longer-term items and give the lessee ownership rights; they Depreciate, incur Interest Expense, and are counted as Debt.
A lease is a capital lease if any one of the following 4 conditions is true:
1. If there’s a transfer of ownership at the end of the term.
2. If there’s an option to purchase the asset at a “bargain price” at the end of the term.
3. If the term of the lease is greater than 75% of the useful life of the asset.
4. If the present value of the lease payments is greater than 90% of the asset’s fair market value.
How do Net Operating Losses (NOLs) affect a company’s 3 statements?
The “quick and dirty” way: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pre-Tax Income number (which should stay thesame). Then you can deduct whatever you used up from the NOL balance (which should be a part of the Deferred Tax Asset line item).
A more complex way to do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you record the difference as an increase to the Deferred Tax Liability on the Balance Sheet.
This method reflects the fact that you’re saving on cash flow – since the DTL, a Liability, is rising – but correctly separates the NOL impact into book vs. cash taxes.
What’s the difference between Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation? How do they impact the statements?
Tax Benefits simply record what the company has saved in taxes as a result of issuing Stock-Based Compensation (e.g. they issue $100 in SBC and have a 40% tax rate so they save $40 in taxes).
Excess Tax Benefits are a portion of these normal Tax Benefits and represent the amount of taxes they’ve saved due to share price increases (i.e. the Stock-Based Compensation is worth more due to a share price increase since they announced plans to issue it).
Neither one is a separate item on the Income Statement.
On the Cash Flow Statement, Excess Tax Benefits are subtracted out of Cash Flow from Operations and added to Cash Flow from Financing, effectively “re-classifying” them. Basically you’re saying, “We’ve gotten some extra cash flow from our share price increasing, so let’s call it what it is: a financing activity.”
Also on the CFS, you add back the Tax Benefits in Cash Flow from Operations
You do that because you want them to accrue to Additional Paid-In Capital (APIC) on the Balance Sheet. You’re saying, “In addition to the additional value we created with this stock/option issuance, we’ve also gotten some value from the tax savings… so let’s make reflect that value along with the SBC itself under APIC.”
Let’s say you’re creating quarterly projections for a company rather than annual projections. What’s the best way to project revenue growth each quarter?
It’s best to split out the historical data by quarters and then to analyze the Year-over-Year (YoY) Growth for each quarter. For example, in Quarter 1 of Year 2 you would look at how much the company has grown revenue by in Quarter 1 of previous years.
It wouldn’t make much sense to use Quarter-over-Quarter growth (i.e. Quarter 1 over Quarter 4 in the previous year) because many companies are seasonal.
The same applies for expenses as well: always make sure you take into account seasonality with quarterly projections.
What’s the purpose of calendarizing financial figures?
“Calendarizing” means “Rather than using a company’s normal fiscal year figures, let’s use another year-long period during the year and calculate their revenue, expenses, and other key metrics for that period.”
For example, a company’s fiscal year might end on December 31 – if you calendarized it, you might look at the period from June 30 in the previous year to June 30 of this year rather than the traditional January 1 – December 31 period.
You do this most frequently with public comps (see the section on Valuation), because companies often have “misaligned” fiscal years. If one company’s year ends December 31, another’s ends June 30, and another’s ends September 30, you need to adjust and use the same period for all of them – otherwise you’re comparing apples to oranges because the financial figures are all from different time periods.
What happens to the Deferred Tax Asset / Deferred Tax Liability line item if we record accelerated Depreciation for tax purposes, but straight-line Depreciation for book purposes?
If Depreciation is higher on the tax schedule in the first few years, the Deferred Tax Liability will increase because you’re paying less in cash taxes initially and need to make up for it later.
Then, as tax Depreciation switches and becomes lower in the later years, the DTL will decrease as you pay more in cash taxes and “make up for” the early tax savings.
If you own over 50% but less than 100% of another company, what happens on the financial statements when you record the acquisition?
This scenario refers to a Noncontrolling Interest (AKA Minority Interest): you consolidate all the financial statements and add 100% of the other company’s statements to your own.
It’s similar to a 100% acquisition where you do the same thing, but you also create a new item on the Liabilities & Equity side called a Noncontrolling Interest to reflect the portion of the other company that you don’t own (e.g. if it’s worth $100 and you own 70%, you would list $30 here).
Just like with normal acquisitions, you also wipe out the other company’s Shareholders’ Equity when you combine its statements with yours, and you still allocate the purchase price (see the Merger Model section for more on that).
You also subtract Net Income Attributable to Noncontrolling Interests on the Income Statement – in other words, the other company’s Net Income * Percentage You Do Not Own. But then you add it back on the Cash Flow
Statement in the CFO section. That is just an accounting rule and has no cash impact.
On the Balance Sheet, the Noncontrolling Interest line item increases by that number (Net Income Attributable to Noncontrolling Interests) each year. Retained Earnings decreases by that same number each year because it reduces Net Income, so the Balance Sheet remains in balance.
What about if you own between 20% and 50% of another company? How do you record this acquisition and how are the statements affected?
This case refers to an Equity Interest (AKA Associate Company) – here, you do not consolidate the statements at all.
Instead, you reflect Percentage of Other Company That You Own * Value of Other Company and show it as an Asset on the Balance Sheet (Investments in Equity Interests). For example, if the other company is worth $200 and you own 30% of it, you record $60 for the Investments in Equity Interests line item.
You also add Other Company’s Net Income * Percentage Ownership to your own Net Income on the Income Statement, and then subtract it on the Cash Flow Statement because it’s a non-cash addition.
Each year, the Investments in Equity Interests line item increases by that number, and it decreases by any dividends issued from that other company to you. On the other side, Retained Earnings will also change based on the change in Net Income, so everything balances.
What if you own less than 20% of another company?
This is where it gets inconsistent. Some companies may still apply the Equity Interest treatment in this case, especially if they exert “significant influence” over the other company
But sometimes they may also classify it as a simple Investment or Security on their Balance Sheet (see the next few questions), acting as if they have simply bought a stock or bond and ignoring the other company’s financials.
What are the different classifications for Securities that a company can use on its Balance Sheet? How do they differ?
Trading: These Securities are very short-term and you count all Gains and Losses on the Income Statement, even if they’re unrealized (i.e. you haven’t sold the Securities yet).
• Available for Sale (AFS): These Securities are longer-term and you don’t report Gains or Losses on the Income Statement – they appear under Accumulated Other Comprehensive Income (AOCI). The Balance Sheet values of these Securities also change over time because you mark them to market.
• Held-to-Maturity (HTM): These Securities are even longer-term, and you don’t report unrealized Gains or Losses anywhere. Gains and Losses are only reported when they’re actually sold.
You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated.
Walk me through how you would recognize Net Income Attributable to Noncontrolling Interests, and how it affects the 3 statements.
Income Statement: You show a line item for “Net Income Attributable to Noncontrolling Interests” near the bottom. You subtract $3 (Other Company Net Income of $10 * 30% You Don’t Own) to reflect the 30% of the other company’s Net Income that does not “belong” to you.
At the bottom of the Income Statement, the “Net Income Attributable to Parent” line item is down by $3.
Cash Flow Statement: Net Income is down by $3 as a result, but you add back this same charge because you do, in fact, receive this Net Income in cash when you own over 50% of the other company.
So cash at the bottom of the CFS remains unchanged.
Balance Sheet: There are no changes on the Assets side. On the other side, the Noncontrolling Interests line item (included in Shareholders’ Equity) is up by $3 due to this Net Income, but Retained Earnings is down by $3 because of the reduced Net Income at the bottom of the Income Statement, so this side doesn’t change and the Balance Sheet remains in balance.
Let’s continue with the same example, and assume that this other company issues Dividends of $5. Walk me through how that’s recorded on the statements.
(You own 70% of a company that generates Net Income of $10. Everything above Net Income on your Income Statement has already been consolidated.
Walk me through how you would recognize Net Income Attributable to Noncontrolling Interests, and how it affects the 3 statements)
Income Statement: There are no changes because Dividends never show up on the Income Statement.
Cash Flow Statement: There’s an additional Dividend of $5 under Cash Flow from Financing on the CFS, so cash is down by $5.
Balance Sheet: The Assets side is down by $5 as a result and Shareholders’ Equity (Retained Earnings) is also down by $5.
Remember that the other company’s financial statements are consolidated with your own when you own over 50% – you only split out Net Income separately.
So there’s no need to multiply by ownership percentages or anything when factoring in the impact of Dividends, or really any item other than Net Income.
Now let’s take the opposite scenario and say that you own 30% of another company. The other company earns Net Income of $20. Walk me through the 3 statements after you record the portion of Net Income that’s you’re entitled to.
Here, nothing has been consolidated because we own less than 50% of the other company. So nothing on the statements yet reflects this other company.
Income Statement: We create an item “Net Income from Equity Interests” (or something similar) below our normal Net Income at the bottom, which results in our real Net Income (Net Income Attributable to Parent) increasing by $6 ($20 * 30%).
Cash Flow Statement: Net Income is up by $6, but we subtract this $6 of additional Net Income because we haven’t really received it in cash when we own less than 50% - it’s not as if we control the other company and can just “take it.” Cash remains unchanged.
Balance Sheet: The Investments in Equity Interests item on the Assets side increases by $6 to reflect this Net Income, so the Assets side is up by $6. On the other side, Shareholders’ Equity (Retained Earnings) is up by $6 to reflect the increased Net Income, so both sides balance.
Now let’s assume that this 30% owned company issues Dividends of $10. Taking into account the changes from the last question, walk me through the 3 statements again and explain what’s different now.
(You own 30% of another company. The other company earns Net Income of $20. Walk me through the 3 statements after you record the portion of Net Income that’s you’re entitled to)
Income Statement: It’s the same: Net Income is up by $6 at the bottom.
Cash Flow Statement: Net Income is up by $6 and we then subtract out the $6 that’s attributable to the Equity Interests…
And then we ADD $3 ($10 * 30%) in the Cash Flow from Operations section to reflect the Dividends that we receive from these Equity Interests.
So cash at the bottom is up by $3.
Balance Sheet: Cash is up by $3 on the Assets side, and the Investments in Equity Interests line item is up by $6… but it falls by $3 due to those Dividends, so the Assets side is up by $6 total.
On the other side, Net Income is up by $6 so Shareholders’ Equity (Retained Earnings) is up by $6 and both sides balance.
The Investments in Equity Interests line item is like a “mini-Shareholder’s Equity” for companies that you own less than 50% of – you add however much Net Income you can “claim,” and then subtract your portion of the Dividends.
Remember that only the Dividends the parent company itself issues show up in the Cash Flow from Financing section – Dividends received from other companies (such as what you see in this example) do not.
What if you now only own 10% of this company? Would anything change?
(Dividends and Net Income)
In theory, yes, because when you own less than 20%, the other company should be recorded as a Security or Short-Term Investment and you would only factor in the Dividends received but not the Net Income from the Other Company.
In practice, however, treatment varies and some companies may actually record this scenario the same way, especially if they exert “significant influence” over the 10% owned company.
Walk me through what happens when you pay $20 in interest on Debt, with $10 in the form of cash interest and $10 in the form of Paid-in-Kind (PIK) interest.
Income Statement: Both forms of interest appear, so Pre-Tax Income falls by $20 and Net Income falls by $12 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $12 but you add back the $10 in PIK interest since it’s non-cash, so Cash Flow from Operations is down by $2. Cash at the bottom is also down by $2 as a result.
Balance Sheet: Cash is down by $2 so the Assets side is down by $2. On the other side, Debt increases by $10 because PIK interest accrues to Debt, but Shareholders’ Equity (Retained Earnings) falls by $12 due to the reduced Net Income, so this side is also down by $2 and both sides balance.
PIK Interest is just like any other non-cash charge: it reduces taxes but must affect something on the Balance Sheet – in this case, that’s the existing Debt number.
Due to a high issuance of Stock-Based Compensation and a fluctuating stock price, a company has recorded a significant amount of Tax Benefits from Stock-Based Compensation and Excess Tax Benefits from Stock-Based Compensation.
Assume that it records $100 in Tax Benefits from SBC, with $40 of Excess Tax Benefits from SBC, and walk me through the 3 statements. Ignore the original Stock-Based Compensation issuance.
Income Statement: No changes
Cash Flow Statement: You add back the $100 in Tax Benefits from SBC in Cash Flow from Operations, and subtract out the $40 in Excess Tax Benefits, so CFO is up by $60.
Then, under Cash Flow from Financing, you add back the $40 in Excess Tax Benefits, so Cash at the bottom is up by $100.
Balance Sheet: Cash is up by $100, so the Assets side is up by $100. On the other side, Common Stock & APIC is up by $100 because Tax Benefits from SBC flow directly into there.
The rationale: Essentially we’re “re-classifying” the Tax Benefits OUT of Cash Flow from Operations and saying that they should accrue to the company’s Shareholders’ Equity. And we are also saying that Excess Tax Benefits (which arise due to share price increases) should be counted as a Financing activity but should not impact cash, since they’re already a part of the normal Tax Benefits.
A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3.
Walk me through what happens on the BOOK financial statements in Year 1.
Income Statement: On the Book Income Statement you list the Book Depreciation number, so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate.
On the Tax Income Statement, Depreciation was $15 so Net Income fell by $9 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes, Pre-Tax Income was $100 and Taxes were $40… Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $85. Book Taxes were $36 and Cash Taxes were $34, so Book Taxes fell by $4 and Cash Taxes fell by $6).
Cash Flow Statement: On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and you add back $2 worth of
Deferred Taxes – that represents the fact that Cash Taxes were lower than Book Taxes in Year 1.
At the bottom, Cash is up by $6.
Balance Sheet: Cash is up by $6 but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $4.
On the other side, the Deferred Tax Liability increases by $2 due to the Book / Cash Tax difference, but Shareholders’ Equity (Retained Earnings) is down by $6 due to the lower Net Income, so both sides are down by $4 and balance.
Now let’s move to Year 2. What happens?
(A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3.
Walk me through what happens on the BOOK financial statements in Year 1.)
This one’s easy, because now Book and Tax Depreciation are the same.
Income Statement: Pre-Tax Income is down by $10 so Net Income falls by $6.
Cash Flow Statement: Net Income is down by $6 and you add back the $10 of Depreciation on the CFS, but there are no changes to Deferred Taxes because Book Depreciation = Tax Depreciation and therefore Book Taxes = Cash Taxes this year. Cash at the bottom increases by $4.
Balance Sheet: Cash is up by $4 but PP&E is down by $10, so the Assets side is down by $6. The other side is also down by $6 because Shareholders’ Equity (Retained Earnings) is lower due to the reduced Net Income.
And finally, let’s move to Year 3 – walk me through what happens on the statements now.
(A company records Book Depreciation of $10 per year for 3 years. On its Tax financial statements, it records Depreciation of $15 in year 1, $10 in year 2, and $5 in year 3.
Walk me through what happens on the BOOK financial statements in Year 1.)
Income Statement: On the Book Income Statement, you use the Book Depreciation number so Pre-Tax Income falls by $10 and Net Income falls by $6 with a 40% tax rate.
On the Tax Income Statement, Depreciation was $5 so Net Income fell by $3 rather than $6. Taxes fell by $2 more on the Tax version (assume that prior to the changes, Pre-Tax Income was $100 and Taxes were $40… Book Pre-Tax Income afterward was therefore $90 and Tax Pre-Tax Income was $95. Book Taxes were $36 and Cash Taxes were $38, so Book Taxes fell by $4 and Cash Taxes fell by $2).
Cash Flow Statement: On the Book Cash Flow Statement, Net Income is down by $6, but you add back the Depreciation of $10 and you subtract out $2 worth of additional Cash Taxes – that represents the fact that Cash Taxes were higher than Book Taxes in Year 1 (meaning that you’re now paying extra to make “catch-up payments”).
At the bottom, Cash is up by $2.
Balance Sheet: Cash is up by $2 but PP&E is down by $10 due to the Depreciation, so the Assets side is down by $8.
On the other side, the Deferred Tax Liability decreases by $2 due to the Book/Cash Tax difference and Shareholders’ Equity (Retained Earnings) is down by $6 due to the reduced Net Income, so both sides are down by $8 and balance
A company you’re analyzing records a Goodwill Impairment of $100. However, this Goodwill Impairment is NOT deductible for cash tax purposes. Walk me through how the 3 statements change.
Income Statement: You still reduce Pre-Tax Income by $100 due to the Impairment, so Net Income falls by $60 at a 40% tax rate – when it’s not tax-deductible, you make that adjustment via Deferred Tax Liabilities or Deferred Tax Assets.
On the Tax Income Statement, Pre-Tax Income has not fallen at all and so Net Income stays the same… which means that Cash Taxes are $40 higher than Book Taxes.
Cash Flow Statement: Net Income is down by $60, but we add back the $100 Impairment since it is non-cash.
Then, we also subtract $40 from Deferred Taxes because Cash Taxes were higher than Book Taxes by $40 – meaning that we’ll save some cash (on paper) from reduced Book Income Taxes in the future. Adding up all these changes, there are no net changes in Cash.
Balance Sheet: Cash is the same but Goodwill is down by $100 due to the Impairment, so the Assets side is down by $100.
On the other side, the Deferred Tax Liability is down by $40 and Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides are down by $100 and balance.
Intuition: When a charge is not truly tax-deductible, a firm pays higher Cash Taxes and either “makes up for” owed future tax payments or gets to report lower Book Taxes in the future.
Remember that DTLs get created when additional future cash taxes are owed – when additional future cash taxes are paid, DTLs decrease
How can you tell whether or not a Goodwill Impairment will be tax-deductible?
There’s no way to know for sure unless the company states it, but generally Impairment on Goodwill from acquisitions is not deductible for tax purposes.
If it were, companies would have a massive incentive to start writing down the values of their acquisitions and saving on taxes from non-cash charges – which the government wouldn’t like too much.
Goodwill arising from other sources may be tax-deductible, but it’s rare to see significant Impairment charges unless they’re from acquisitions.
A company has Net Operating Losses (NOLs) of $100 included in the Deferred Tax Asset (DTA) line item on its Balance Sheet because it has been unprofitable up until this point.
Now, the company finally turns a profit and has Pre-Tax Income of $200 this year. Walk me through the 3 statements and assume that the NOLs can be used as a direct tax deduction on the financial statements.
Income Statement: The company can apply the entire NOL balance to offset its Pre-Tax Income, so Pre-Tax Income falls by $100 and Net Income falls by $60 at a 40% tax rate.
Cash Flow Statement: Net Income is down by $60 but the company hasn’t truly lost anything – it has just saved on taxes. So you add back this use of NOLs and label it “Deferred Taxes” – it should be a positive $100, which means that Cash at the bottom is up by $40.
Balance Sheet: Cash is up by $40 and the Deferred Tax Asset is down by $100, so the Assets side is down by $60. On the other side, Shareholders’ Equity (Retained Earnings) is down by $60 due to the reduced Net Income, so both sides balance.
