Technical Flashcards
Walk me through 3 financial statements
- Income statement: Revenues vs expenses -> net income
- Balance sheet: Assets (its resources such as Cash, Inventory and PP&E) = Liabilities (Debt, Accounts payable) + Shareholder’s Equity
- Cash Flow statement: Net income, adjusts for non-cash expenses and change in working capital and then lists cash flows from investing and financing activities. You end up with the company’s net change in cash.
How do the financial statements link together?
- Net income from the income statement flows into shareholders’ equity on the balance sheet, and into the top line of the cash flow statement.
- Changes to B/S items appear as changes in WC on the CFS.
- Investing and financing activities affect B/S items such as PP&E, Debt and SE
- Cash and SE items on the B/S act as plugs, with cash flowing in from the final line on the CF statement.
Walk me through how depreciation going up by $10 would affect financial statements
- Income statement: operating income would decline by $10 and assuming a (40%) tax rate, net income would go down by $6.
- ***CF statement: 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.
- Balance sheet: PP&E 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.
If depreciation is a non-cash expense, why does it affect the cash balance?
• Although depreciation is a non-cash expense, it is tax-deductible. Since taxes are a cash expense, depreciation affects cash by reducing the amount of taxes you pay
What happens when inventory goes up by $10, assuming you pay for it with cash?
- No changes to the income statement
- On the CF statement, inventory is an asset so that decreases your cash flow from operations – goes down by $10, as does the net change in cash at the bottom.
- On the B/S under Assets, inventory is up by $10 but cash is down by $10. These cancel out.
Why is the income statement not affected by changes in inventory?
• In the case of inventory, the expense is only recorded when the goods associated with it are sold
Could you ever end up with negative shareholders’ equity? What does it mean?
- Leveraged buyouts with dividend recapitalizations – the owner of the company has taken out a large portion of its equity (usually cash), which can sometimes turn the number negative (would never turn negative immediately after an LBO)
- Can also happen if the company has been losing money consistently and therefore has a declining retained earnings balance, which is a portion of SE.
What’s the difference between cash-based and accrual accounting?
- Cash-based accounting recognizes revenue and expenses when cash is actually received or paid out; accrual accounting recognizes revenue when collection is reasonably certain and recognizes expenses when they are incurred rather than when they are paid out in cash.
- Most large companies use accrual accounting because paying with credit cards and lines of credit is so prevalent these days.
Take the payment for a TV with a credit card – how would this differ in terms of the two types of accounting?
- Cash-based: revenue would not show up until the company charges the customer’s credit card, receives authorization, and deposits the funds in its bank account – at which point it would show up as both Revenue on the Income Statement and Cash on the Balance Sheet
- Accrual: show up as revenue right away but instead of appearing in cash on the B/S, it would go into Accounts Receivable at first. Then, once the cash is actually deposited in the company’s bank account, it would “turn into” cash.
How do you decide when to capitalize rather than expense a purchase?
- If the asset has a useful life of over 1 year e.g. factories, equipment and land, it is capitalized (put on the balance sheet rather than shown as an expense on the Income Statement).
- Employee salaries and the cost of manufacturing (COGS) only cover a short period of operations and therefore show up on the Income Statement as normal expenses instead.
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
*EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time charges – and all of these could end up bankrupting the company
- Too much CapEx
- Very high interest expense
- Credit crunch
- Significant one-time charges e.g. from litigation
Under what circumstances would Goodwill increase?
- (usually rare, but…) The company gets acquired and the goodwill acts as the plug
- The company acquires another company and pays more than what its assets are worth
What are the three major valuation methodologies?
- Comparable companies
- Precedent transactions
- DCF analysis
Why would you not use DCF?
- Unstable or unpredictable cash flows
- *When debt and working capital serve a fundamentally different role. For example, banks and financial institutions do not re-invest debt and working capital is a huge part of their balance sheets
What are the (other) more unconventional valuation methodologies?
- Liquidity valuation – assuming assets are sold off and then subtracting liabilities to determine how much capital, if any, equity investors receive
- Replacement value – costs of replacing a company’s assets
- *LBO analysis – determining how much a PE firm could pay for a company to hit a “target” IRR, usually in the 20-25% range (used as floor).
- Sum of the Parts – when a company has different, completely unrelated divisions.
