Accounting Flashcards
(91 cards)
1
Q
Income Statement
A
The purpose of this this statement is to show the company’s profitability, which is equal to its revenue net of its costs and expenses.
It starts with net sales at the top (AKA revenue) and goes all the way down to after-tax profits, or net income (to Common), at the bottom.
2
Q
Cash Flow Statement
A
The cash flow statement reports the sources of a business’s cash inflows and outflows between two balance sheet dates.
It shows changes in a firm’s investments and financial structure.
It reconciles us from net income to actual change in cash.
3
Q
Balance Sheet
A
The balance sheet reports the balance of a company’s assets, liabilities and equity at a precise moment in time. It’s taken as a measure of the financial condition of a business.
4
Q
Income Statement: Revenue Recognition + Matching Principle
A
- Revenue recognition: Revenues recognized when goods are delivered or service is performed
- Matching principle: Expenses are matched to revenues
5
Q
Income Statement Layout
A
Total revenues -COGS Gross profit -SG&A Operating income -Interest expense \+Interest income Pretax income -Income taxes Net income --> the earnings that accumulate on BS; grow equity (but not actual cash flow)
6
Q
EBIT
A
EBIT is calculated by subtracting operating expenses (e.g. COGS, SG&A, R&D, etc.) from revenue.
EBIT is income before the effects of financing and taxes. So, we use EBIT to measure profitability independent of capital structure. Allows for operating comparability.
- note: there may be non-recurring items buried in COGS
7
Q
Cash Flow Statement
A
- Reconciles change in cash for the period
- Adjustments to net income to reflect sources and uses of cash
___
- Accounts for non-cash expenses
- Accounts for real-cash expenses not included on Income Statement (Dividends and PP&E)
8
Q
Cash Flow Statement Layout
A
Start: Net Income
Cash Flow from Operating Activities
-> cash generated from core business activities (add back D&A, factor in change in working capital)
Cash Flow from Investing Activities
-> shows where cash was used for investments (e.g. CapEx)
Cash Flow from Financing Activities
-> reports sources and uses of financing for operating and investing activities
Net change in cash + beg cash balance =
End: Ending cash balance
9
Q
EBITDA
A
EBITDA is calculated by adding D&A to EBIT.
EBITDA is a quick proxy for “operating” cash flow.
Weaknesses of EBITDA as a measure of cash flow: doesn’t include changes in working capital (operating), CapEx (operating), addtns to intangibles (investing), interest (financing), taxes (financing), dividends (financing), etc. …. most of these are outflows
10
Q
Activity Ratios
A
- measure the company’s efficiency in turning over its assets (more activity, means faster turnover)
- it’s better to turn over assets quickly because that means you are converting them into cash more quickly and increasing cash flow
11
Q
Liquidity Ratios
A
- liquidity measures the company’s ability to convert an asset into cash quickly
- assets a co can convert to cash quickly: A/R, inventory, investments / marketable securities
12
Q
Asset
A
- something that will result in a future benefit for the company, such as additional cash flow, ability to grow business, or a higher valuation due to IP
13
Q
Liability + Equity
A
- a liability (or equity) line item is something that will result in a future obligation for the company, such as a cash payment, delivery of product or service, or cash interest payments
- liability usually related to external parties, whereas equity is usually related to co’s internal operations
14
Q
Free Cash Flow
A
Free Cash Flow = Cash Flow from Operations - Capital Expenditures
- everything in a company’s operating activities section is required for its business (earning net income, paying for inventory, collecting receivables, etc.)
- but almost every line item within Investing and Financing Activities is “optional,” except for Capital Expenditures
- FCF lets us quickly and easily assess a company’s ability to generate cash flow from its business, including the cost of servicing its Debt and other long-term funding
15
Q
Change in Working Capital
A
- AKA changes in operating assets and liabilities
- Working Capital is a part of a company’s FCF
- we care most about the change. Not WC itself
- The change in WC tells you whether “Cash Flow” is likely to be greater than or less than the company’s Net Income, and how much of a difference there may be
- Working Capital = Current Operational Assets - Current Operational Liabilities (excludes Cash, Financial Investments, and Debt)
- Change in Working Capital = Old Working Capital - New Working Capital
- if change is negative, it reduces Cash Flow, reducing co’s valuation; if it’s positive, it increases Cash Flow, increasing co’s valuation
- the change in WC as a percentage of Revenue tells you how significant it is for the company’s “cash flow”
16
Q
Four Primary Groups of Financial Metrics
A
1) “Cash Flow Proxy” Metrics - EBIT and EBITDA
2) Credit Metrics - Leverage Ratio (Total Debt / EBITDA) and the Coverage Ratio (EBITDA / Interest Expense) and their variations
3) Return-Based Metrics - Return on Equity (ROE), Return on Assets (ROA), and Return on Invested Capital (ROIC)
4) Cash Conversion Metrics - Days Sales Outstanding, Days Inventory Outstanding, Days Payable Outstanding, and the Cash Conversion Cycle
17
Q
Cash Flow Proxy Metrics
A
EBIT
- Operating Income on the Income Statement, adjusted for any non-recurring or one-time charges (e.g. Impairments or Write-Downs if they’ve affected Operating Income)
- Proxy for Free Cash Flow because both metrics reflect some or all of the impact of Capital Expenditures
- Gives you a co’s core, recurring business profitability before the impact of capital structure and taxes
EBITDA
- start with EBIT, then add back D&A, taken directly from Cash Flow Statement (NOT Income Statement)
- ignores CapEx and its after-tax effects (Depreciation)
- Gives you co’s core, recurring business cash flow from operations before the impact of capital structure and taxes
18
Q
Credit Metrics
A
Leverage Ratio (Total Debt / EBITDA)
- tells you how much Debt co has, relative to its ability to repay that Debt
- higher numbers riskier
Interest Coverage Ratio (EBITDA / Interest Expense)
- tells you how easily company could pay for its current interest expense on Debt
- higher is better bc indicates there’s more of a buffer in case business suffers and profits fall
19
Q
Returns-Based Metrics
A
Return on Assets, Return on Equity, and Return on Invested Capital all measure how efficiently a company is using it’s “capital” (debt, debt + equity, etc.) or assets to generate income
ROE = Net Income (to Common) / Average (Common) Shareholders’ Equity
ROA = Net Income (to Common) / Average Total Assets
ROIC = NOPAT / Average Invested Capital
20
Q
Cash Conversion Metrics
A
- measure how quickly it takes a company to collect receivables, sell inventory, or pay the amounts it owes to suppliers
Days Sales Outstanding = Accounts Receivable / Revenue * Days in Year
Days Inventory Outstanding = Inventory / COGS * Days in Year
Days Payable Outstanding = Accounts Payable / COGS * Days in Year
CCC = DIO + DSO - DPO
21
Q
Approach Financial Statements in following order when answering accounting questions:
A
1) Explain how Income Statement changes, if at all
2) Explain how Cash Flow Statement changes, if at all (including changes in Deferred Taxes)
3) Explain how the Balance Sheet changes and why it still balances
22
Q
Rule of thumb: Changes to Cash Items on the Income Statement
A
- Nothing on the Cash Flow Statement changes except for Net Income at the top and Cash at the bottom
23
Q
Rule of thumb: Changes to Operational Items on the Balance Sheet
e.g. Inventory, AR, AP, Accrued Expenses, Prepaid Expenses, Deferred Revenue, known collectively as “Working Capital”
A
- changes to these items will affect something on Balance Sheet besides Cash and CSE
Ask: Has co delivered the product or service? Or, has someone else delivered something to the co that it used in this period?
If yes, something on Income Statement will change. If not, nothing will change.
24
Q
Rule of thumb: Changes to Non-Cash Items on the Income Statement
e.g. Depreciation, Amortization, Stock-Based Compensation, Asset Write-Downs
A
Pre-Tax income and Net Income change, but you reverse the change on Cash Flow Statement since it’s non-cash
Cash and CSE change, and then something else on the Balance Sheet also changes
25
Rule of thumb: Changes to Leases on the Balance Sheet
For all leases under all accounting systems, when the lease is first signed, the Lease Asset and the Lease Liability both increase by the same amount on the Balance Sheet.
For Operating Leases under U.S. GAAP, companies record a simple Rental Expense on the Income Statement, but they still "calculate" Interest Expense, Depreciation, and Lease Principal Repayment. Interest Expense = Discount Rate * Lease Liability. Depreciation = Cash Lease Expense - Interest Expense. And Lease Principal Repayment = Straight-Line Rental Expense on IS - Interest Expense.
26
Rule of thumb: Changes to Non-Operational Balance Sheet or Cash Flow Statement Items
- no immediate Income Statement changes
| - simple cash inflow or outflow on Cash Flow Statement, and both Cash and corresponding Balance Sheet line item change
27
How can you tell whether or not an item should appear on the Cash Flow Statement?
Include an item on CFS if:
1) It has already appeared on the Income Statement and affected Net Income, but it's non-cash, so you need to adjust to determine the company's real cash flow
2) It has NOT appeared on the Income Statement, and it DOES affect the company's cash balance
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Deferred Tax Assets, Deferred Tax Liabilities
Both DTAs and DTLs relate to temporary differences between the book basis and the tax basis of assets and liabilities. Deferred Tax Assets represent potential future cash-tax savings for the company, while Deferred Tax Liabilities represent additional cash-tax payments in the future. DTLs often arise because of different Depreciation methods, such as when companies accelerate Depreciation for tax purposes, reducing their tax burden in the near term but increasing it in the future. They may also be created in acquisitions. DTAs may arise when the company loses money (i.e., negative Pre-Tax Income) in the current
period and, therefore, accumulates a Net Operating Loss (NOL). They are also created when the
company deducts an expense for Book-Tax purposes but cannot deduct it at the same time for Cash-Tax purposes (e.g., Stock-Based Compensation).
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Items that always appear on Income Statement
1. Revenue
2. COGS
3. Operating Expenses
4. Depreciation, Amortization
5. Stock-Based Compensation
6. Interest, Gains / Losses
7. Write-Downs
8. Other Income-Expenses
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EPS
EPS = Net Income / Weighted Average Shares Outstanding
EPS is an extremely important metric of a company's value: it represents the profit generated by the company for each shareholder. It will be used extensively when working through valuation techniques such as Comparable Company Analysis and Precedent Transactions.
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Operating Assets, Operating Liabilities
Assets and Liabilities generated by the company as part of the functioning of its business operations.
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Key Asset Items
1. Cash
2. Short-Term Investments
3. Accounts Receivable
4. Prepaid Expense
5. Inventory
6. PP&E
7. Other Intangible Assets
8. Long-Term Investments
9. Goodwill
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Accounts Receivable
Company has recorded revenue on Income Statement but hasn't received cash yet.
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Prepaid Expense
Company has paid expenses in cash but hasn't recorded as expenses on the Income Statement yet. (Record on IS when they go down.)
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Key Liability Items
1. Revolver
2. Accounts Payable
3. Accrued Expenses
4. Deferred Revenue
5. Deferred Tax Liability
6. Long Term Debt
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Goodwill
The premium the company pays over other company's Shareholders' Equity when acquiring it
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Accounts Payable
Company has recorded as expenses on the Income Statement, but hasn't yet paid them out in cash
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Accrued Expenses
Company has recorded these as expenses on the Income Statement, but hasn't paid them out in cash yet (employee wages, utilities, rent)
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Deferred Revenue
Company has collected cash in advance from customers for products/services yet to be delivered
Company will recognize this as real revenue over time
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Deferred Tax Liability
Company has paid lower taxes than what it really owes
Will pay additional taxes in future
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Key Equity Items
1. Common Stock and Additional Paid in Capital
2. Treasury Stock
3. Retained Earnings
4. Accumulated Other Comprehensive Income
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Common Stock and Additional Paid in Capital
Market value of shares at time of issuance (does not change with price)
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Treasury Stock
Cumulative value of shares the company has repurchased from investors
Does not change even if share price changes afterwards
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Retained Earnings
Company's saved up, after tax-profits (minus any dividends it has issued)
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Accumulated Other Comprehensive Income (AOCI)
- miscellaneous saved-up income
1) Effect of foreign currency exchange rate changes
2) Unrealized gains and losses on certain types of securities (i.e. if their values go up or down but the company has not yet sold them)
46
Cash Flow from Operations (CFO)
- Net income from the Income Statement flows in at the top
- Then adjust for non-cash expenses (take into account how operational Balance Sheet items like Accounts Receivable and Accounts Payable have changed)
= net income + D&A 0 Net Operating Working Capital
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Cash Flow from Investing (CFI)
- anything related to the company's investments, acquisitions, and PP&E
- purchases are negative because they use up cash, and sales are positive because they result in more of it
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Cash Flow from Financing (CFF)
The cash generated/used by a company's financing of its operations. This includes the Cash inflows from shareholders and lenders as well as the outflows of dividends and loan principal repayments.
Items found in this line include: Dividends Paid, Cash from Sales of Common Stock, and Repayments of Debt Obligations
49
Walk me through the 3 financial statements
INCOME STATEMENT gives company's revenue and expenses--down to NET INCOME(final line)
BALANCE SHEET gives company's Assets, Liabilities and Shareholders' Equity
CASHFLOW STATEMENT starts with Net Income, adjusts for non-cash expenses and working capital changes, and then lists cash flow from investing and financing activities; at the end, you see the company's NET CHANGE IN CASH
50
How do the 3 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 Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities are linked to Balance Sheet items such as PP&E, Debt and Shareholders' Equity
- Cash flows into the Balance Sheet from the final line on the Cash Flow Statement
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DELETE
How are the 3 financial statements connected?
- Last line item of INCOME STATEMENT is net income which is added to cash flow from operations on the cash flow statement.
- Beginning cash balance is cash from the balance sheet in the prior period. After making adjustments to Net Income for non-cash items, the cash flow from operations, investing and financing, the ending cash balance becomes the cash on the current period' s balance sheet under assets
- Net income (minus any dividends paid) flows from the income statement onto the retained earnings column (shareholder' s equity) of the balance sheet, causing the balance sheet to balance.
52
What is the link between the Balance Sheet and the Income Statement?
- any net income from the Income Statement, after the payment of any dividends, is added to retained earnings
- Debt on the BS is used to calculate interest expense on the Income Statement
- PP&E will be used to calculate any depreciation expense
53
What is the difference between the Income Statement and the Statement of Cash Flows?
- company's sales and expenses are recorded on their Income Statement
- CFS records what cash is actually being used and where it is being spent by the company during that time period
54
Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and why?
-Income Statement and Balance Sheet, because you can create the Cash Flow Statement from both of those (assuming, of course that you have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income Statement is tracking).
55
If depreciation is a non-cash expense, why does it affect the cash balance?
It is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay
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Why is the Income Statement not affected by changes in Inventory?
Expenses only recorded when the goods associated with it are sold
57
Meaning of negative Shareholders' Equity
2 Common Scenarios:
1. LBO with dividend recapitalizations - owner of the company has taken out a large portion of its equity (usually in the form of cash)
2. company has been losing money consistently- declining RE balance(part of SE)
58
Meaning of positive Working Capital
It means that a company is generating cash as it grows, and that it is capable of paying off its short-term liabilities with its short-term assets.
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Meaning of negative Working Capital
Companies with subscriptions or longer-term contracts often have negative Working Capital because of high Deferred Revenue balances
Could point to financial trouble or possible bankrupty (e.g. when customers don't pay quickly and upfront and the company is carrying a high debt balance)
60
DELETE
Operating Working Capital
OWC = (Current Assets - Cash and Equivalents) - (Current Liabilities - Debt)
61
3 situations a company collects cash from a customer and it's not recorded as revenue
1. Web-based subscription software
2. Cell phone carriers that sell annual contracts
3. Magazine publishers that sell subscriptions
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If cash collected is not recorded as revenue, what happens to it?
It goes into the Deferred Revenue balance on the Balance Sheet under Liabilities
63
What's the difference between Accounts Receivable and Deferred Revenue?
AR has not yet been collected in cash from customers, whereas DR has been
AR represents how much revenue the company is waiting on, whereas DR represents how much it is waiting to record as revenue
64
Difference between cash-based and accrual accounting?
CBA: recognize rev and expenses when cash is actually received or paid out
AA: recognize rev after a customer has ordered the product and recognizes expenses when they are incurred
65
Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?
These days, many companies have "non-cash" charges such as Amortization of Intangibles, Stock-Based Compensation, and Deferred Revenue Write-down in their Income Statements. As a result, some argue that Income Statements under GAAP no longer reflect how profitable most companies truly are. Non-GAAP earnings are almost always higher because these expenses are excluded.
66
A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How could this happen?
1. The company is spending too much on Capital Expenditures - these are not reflected at all in EBITDA, but it could still be cash-flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3. The company's debt all matures on one date and it is unable to refinance it due to
a "credit crunch" - and it runs out of cash completely when paying back the debt.
4. It has significant one-time charges (from litigation, for example) and those are
high enough to bankrupt the company.
67
Normally Goodwill remains constant on the Balance Sheet - why would it be impaired and what does Goodwill Impairment mean?
Usually this happens when a company has been acquired and the acquirer re-assesses its intangible assets (such as customers, brand, and intellectual property) and finds that they are worth significantly less than they originally thought.
It often happens in acquisitions where the buyer "overpaid" for the seller and can result in a large net loss on the Income Statement (see: eBay/Skype).
It can also happen when a company discontinues part of its operations and must impair the associated goodwill.
68
To appear on the income statement, an item must:
1) correspond 100% to the period shown
e. g. if we deliver a product in year 2, we can't count the sale as Revenue in year 1, even if the customer orders and pays for it in year 1 ... revenue and expenses are based on the DELIVERY of products and services
2) affect the business income available to common shareholders (net income)
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Accounts Receivable
- co has recorded revenue on Income Statement but hasn't received cash yet
- results in a temporary difference between Net Income and Cash Flow
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Accounts Payable
- an expense on the Income Statement when we receive a product/service, but don't pay for it in cash right away
- results in a temporary difference between Net Income and Cash Flow (increases it)
71
Prepaid Expenses
- pay for service upfront, but don't receive it right away
| - results in a temporary difference between Net Income and Cash Flow
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Deferred Revenue
- collect cash upfront, deliver product/service later
| - results in temporary difference between Net Income and Cash Flow
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Inventory
- can't list as expenses on Income Statement until we deliver products and record the revenue for them
- results in a temporary difference between Net Income and Cash Flow
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Capital Expenditures
- purchase of items useful for > 1 yr
- initial spending doesn't correspond 100% to current pd, so it doesn't appear on IS
- instead, record CapEx only on CFS initially, and the allocate cost to IS over time
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CapEx / Cash Flow
Capital Expenditures initially reduce Cash Flow.
After the initial cash outflow, Net Income decreases in future years because of Depreciation -- but the Cash balance will increase due to the tax savings from that Depreciation.
76
Debt / Financial Statements
- when a co issues Debt, the Debt will last for many years, so the issuance does not appear on Income Statement
- instead, we record the initial cash outflow from the Debt on the Cash Flow Statement under Cash Flow from Financing, which increases the Debt line item on the Balance Sheet
- similarly, when a co repays Debt principal, outstanding balance also shows up only on CFS
77
Equity / Financial Statements
- when co issues Equity, it appears as simple cash inflow on Cash Flow Statement, and nothing ever shows up on Income Statement
78
Preferred Stock is cheaper than Equity but more expensive than Debt because?
- preferred coupon rates tend to be higher than interest rates on debt, but lower than average annualized returns on stocks
- also, unlike Interest Expense on Debt, Preferred Dividends are not tax-deductible
79
Finance Leases, Operating Leases
- For both Finance Leases and Operating Leases, companies record Interest and Depreciation on the Income Statement, add back Depreciation on the Cash Flow Statement, and subtract the Lease Principal Repayment further down on the CFS
- The Lease Asset and Lease Liability decrease each year until the lease ends, but they decrease by slightly different amounts because the Lease Depreciation is constant, while the Lease Principal Repayment changes each year
* Note: There are differences in acctg treatment that I did not capture
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Financial Investments
- stocks, bonds, and other assets that pay interest or dividends
- initial purchase shows up only on Cash Flow Statement, and the Interest Income appears directly on the Income Statement
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Deferred Tax Liabilities
- represents the difference between the company's Book Taxes (the number on the Income Statement) and its Cash Taxes (what the company pays to the government)
- if Book Taxes exceed Cash Taxes, then Deferred Taxes on CFS are positive; if Cash Taxes exceed Book Taxes, then Deferred Taxes are negative
- Deferred Tax Liability increases when Book Taxes exceed Cash Taxes because that means the co will need to pay higher Cash Taxes in the future (and it decreases when Cash Taxes exceed Book Taxes because that represents the company now paying those higher Cash Taxes, reducing its liability)
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Deferred Tax Assets
- represent potential future tax savings
- the most important DTA is the Net Operating Loss (NOL): if a co has lost money (i.e. negative pre-tax income) in previous yrs, it can reduce its Cash Taxes in the future by applying these losses to reduce its taxable income
- if DTA decreases, co's cash flow increases because it's using the NOL to reduce its taxes; if DTA increases, cash flow decreases
- NOLs are NOT the same as DTAs. The DTA represents only the tax-savings potential from NOLs, so a $100 NOL would be recorded as a $25 DTA at a 25% tax rate
83
Selling at a gain or loss / Financial Statements
- CFS: if you sell for a gain, you subtract gain from Net Income, but you add FULL proceeds from sale to Cash Flow from Investing, including the gain or loss
- Change in Cash = Book Value of PP&E Sold + Gain * (1 - Tax Rate) - Loss * (1 - Tax Rate)
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Impairment, Write-Down
- when assets turn out to be worth less than expected, companies record write-downs or impairment charges to reflect the change in value
- non-cash expenses that reduce Pre-Tax Income and Net Income and then get added back on CFS
- unlike Depreciation, Impairments and Write-Downs are usually NOT deductible for cash-tax purposes
85
Stock Based Compensation
- Income Statement expense that reduces a company's Pre-Tax Income and Net Income, and like depreciation, it is a non-cash expense that's added back on the CFS
- creates additional shares outstanding
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Goodwill
- part of premium payed by Acquirer
- does not Amortize
- company reviews it each year and records an Impairment if its value has decreased
87
Other Intangible Assets
- amortize over time, just like how PP&E depreciates over time
88
Do you want to see a positive and growing FCF?
Generally, yes. If FCF is negative, that means co is not running a sustainable business by itself -- it is relying on outside financing to stay afloat.
But positive FCF is not always a good thing. It IS good if FCF is growing b/c co is capturing more market share, selling more, and achieving higher margins due to economies of scale.
It is bad if FCF is growing because of creative cost cutting or because co is reducing its annual CapEx spending.
89
What are some items that are deductible for Book-Tax but not Cash-Tax purposes, and how do they affect the Deferred Tax line items?
Examples include Stock-Based Compensation (when initially granted), the Amortization of Intangibles, and various Write-Downs and Impairments (for Goodwill, PP&E, etc.).
These items reduce a company’s Book Taxes (the number that appears on the Income
Statement), but they do not save the company anything in Cash Taxes.
So, the Deferred Tax line item on the CFS will show a negative for these items, reducing the company’s cash flow, and the DTA will increase.
These items become Cash-Tax Deductible only when “Step 2” of the process happens – such as
the company selling PP&E that has been written down, or the employees exercising their options and receiving their shares in the company.
90
Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?
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How do you decide to capitalize a purchase, rather than expense it?
- useful life of > 1 yr
