Accounting Fundamentals

Question 1

What are three financial statements?

Answer 1

Income statement, balance sheet and cash flow statement

Question 2

What is income statement?

Answer 2

Income sheet tracks revenue and expenses over a period of time, with net income being at the bottom of the statement, which is what the company makes after paying expenses and taxes

Question 3

What is balance sheet?

Answer 3

Balance sheet provides a snapshot of a company’s resources, which is on the asset side, and then how they acquired them, which is the liabilities and shareholders equity side. Assets must equal liabilities + sahreholders equity

Question 4

What is cash flow statement?

Answer 4

Cash flow statement shows how a company’s cash balance changes over time. Start with net income, add back non-cash charges, factor in how working capital items and have changed, any investments the company made and any financing activities a company has particiapated in, an then at the bottom you get to how the companys cash balance has changed over time. The cash balance number follows through onto the new balance sheet.

Question 5

Why is cash flow statement needed?

Answer 5

Income statement and balance sheet can be subject to accounting practices that hide true state of company. Cash flow statement provides true insight into cash flow of company.

Question 6

How do they link together?

Answer 6

The way the statements link together is that you get net income on the bottom line of the income statement, which flows into the top item on the cash flow staememtn with any non cash expenses also reflected on the cash flow statement which are added back. Any changes in the current assets and liabilities from balance sheet are reflected in cash flow from operatin activities, any changes in long term assets show up in the investing activities part of cash flow statement, any changes to long-term liabilities or shareholders equity show up in the financing activities part of cash flow statements. Then at the end you get to increase/decrease in cash, which flows through into cash and cash& equivalents, with retained earnings also changing based on net income

Question 7

What is depreciation?

Answer 7

Reflecting a fall in an assets value

Question 8

How does $10 of depreciation affect statements?

Answer 8

If depreciation goes up by $10, operating income falls by $10, which means net income falls by $6 if we assume a 40% tax rate. Looking to cash flow statement, net income down by $6, depreciation up by $10, so cash flow from operations goes up by $4. Nothing changes in investing and financing activities, so overall increase of $4. On balance sheet, cash goes up by $4, but long-term asssets or property, plants and equipment down by $10, meaning total assets are down by $6. Retained earnings are then also down by $6, because of the $6 drop in net income, so total liabilities and shareholders equity is also down by $6, and the balance sheet balances.

Question 9

How does $10 inventory increase change the financial statements? (with cash)

Answer 9

With cash: No changes to income statement, because it is not recorded on income statement until it is an expense. On cash flow statement, no changes to non cash expenses. However, changes in operating assets & liabilities because cash used to buy inventory, meaning the cash flow goes down by $10. No changes in cash flow in investing, and cash flow from financing is unchanged because hasn’t been financed by equity or debt. Moving to balance sheet, inventory gone up by $10, but cash anf cash equivalent gone down by $10 so nothing changes in total assets, and total liabilities and shareholders equity is also unchanged.

Question 10

How does $10 inventory increase change financial statements? (with debt)

Answer 10

With debt: Nothing changes on income statement. On cash flow statement, inventory goes down by $10, because you have spent cash on inventory, so operating assets goes down by $10, meaning cash flow from operating activities goes up by $10. Cash flow from investing is unchanged, but cash flow from financing goes up by $10 with long term debt increasing. Overall, there is no change in cash, because debt has financed inventory. ON balance sheet, inventory goes up by $10, but long term debt also goes up, so balance sheet balances.

Question 11

Difference between FIFO and LIFO and why it matters

Answer 11

First in first out/ last in last out.

Difference of how inventory is treated and matters because COGS may be different dependent on when inventory was purchased.

Question 12

What is treasury stock method?

Answer 12

How you deal with convertibles being exercised, as when you receive the strike price, you buy back shares with it too.

Question 13

What is minority interest?

Answer 13

Minority interest = the net income that belongs to minority shareholders in companies that are majority owned by a company. When someone owns majority of a company, its financial statements will record 100% of that companies income on the income sheet, even though they may own less than 100% of it. Minority interest will be negative or zero on an income statement.

Question 14

What is preferred stock?

Answer 14

Preferred stock gives holders a guaranteed dividend from the company and have a higher claim than common stock. As preferred stock is closer to debt than equity, it is treated as debt and is hence added.

Question 15

Why is cash subtracted from debt in EV calculation

Answer 15

Cash is subtracted from EV because it is a non-operating asset and equity value already implicitly accounts for it. So if you have equity value of $100, no debt and $20 of cash, EV would be $80, because even though you would pay $100 to acquire all equity of a company, you would receive $20 so the real cost would only be $80.

Question 16

What metrics do you use to compare companies?

Answer 16

Geography, industry, financials (EV, EBITDA, Revenue)

Question 17

Difference between operating income and EBIT

Answer 17

EBIT is close to operating income, although you may add back one-off to EBIT

Question 18

Difference between EBIT and EBITDA and when would you use them?

Answer 18

EBIT and EBITDA are profitability metrics. EBIT is more common to use in industries where D&A are really important like manufacturing, because you want to take depreciation and amortisation into account when valuing companies with large capital bases

EBITDA more common for tech companies, when D&A are not huge expenses relative to revenue. Used more commonly when companies provide services or don’t use massive factory.

Question 19

Examples of valuation multiples?

Answer 19

EV / EBIT, EV / Revenue, EV / EBITDA

Question 20

What would you use for valuation of financial companies?

Answer 20

Dont use DCF, because need account for interest expense/received, would prefer to use DDM

Question 21

When should you use equity value instead of enterprise value?

Answer 21

If unlevered, interest expense / received not key, so use EV, if levered, use equity value

Question 22

Calculate equity value

Answer 22

Equity value = shares outstanding * market price

Question 23

Diluted equity value

Answer 23

Diluted equity value = diluted shares outstanding * market price

Question 24

Enterprise value formula?

Answer 24

What is enterprise value? Diluted equity value + debt – cash & equivalents + minority interest + preferred stock + other liabilities (like pension contributions). What is meant by it?

Question 25

Why is cash subtracted in EV?

Answer 25

You get cash for ‘free’, so it reduces the transaction value.

Question 26

Why is debt added in EV?

Answer 26

Have to repay it when you take the company over. If you bought all the equity in the company, you would still need to pay the debt holders.

Question 27

Should you use book value or market value of assets?

Answer 27

IF you can, market value

Question 28

How to get to diluted shares outstanding?

Answer 28

Basic shares outstanding + shares created by in the money options / convertibles

Question 29

Can you have negative market cap?

Answer 29

No, shares outstanding and share price cannot be negative

Question 30

Can you have negative enterprise value?

Answer 30

* Can have negative EV though, if cash balance is huge

Question 31

Difference between shareholders equity and market cap

Answer 31

* Shareholders equity is book value, where as market cap is value of company based on market’s valuation.

Question 32

When should you use revenue multiples instead of profitability?

Answer 32

* Revenue mutliples focused on early-stage companies

Question 33

Should you use equity or enterprise value in a multiple?

Answer 33

Depends if interest expense accounted for. If not accounted for, ie in EBIT/EBITDA, use EV, if accounted for, ie in FCF, use Equity value

Question 34

What does cash flow from operating activities correspond to on the three statements?

Answer 34

Current assets and current liabilities from balance sheet, as well as net income and non-cash expenses from income statement

Question 35

What does cash flow from investing activities correspond to on the three statements?

Answer 35

Long-term assets from balance sheet

Question 36

What does cash flow from financing activities correspond to on the three statements?

Answer 36

Long-term liabilities and shareholders equity from balance sheet

Question 37

Major line items on income statement

Answer 37

Revenue, COGS, non cash expenses, operating expenses, operating income, Taxes, net income

Question 38

How to get to net income

Answer 38

Revenue - COGS = Gross profit, deduct non cash expenses and operating expenses to get operating income, deduct interest expense / received and then deduct taxes to get net income

Question 39

Major line items on balance sheet?

Answer 39

Assets side split into current assets and current liabilities. Current assets include Cash & equivalents, accounts receivable and inventory, long-term assets include property, plants and equipment, goodwill and other intangibles. Liabilities and shareholders equity split into current liabilities, long-term liabilities and shareholders equity. Short term liabilities include revolver facility and accounts payable, long-term liabilities include long-term debt, shareholders equity include value of common stock, additional paid in capital, treasury stock etc

Question 40

Major line items cash flow statement

Answer 40

Split into operating activities, investing activities and financing activities. Operating: Net income, non cash expenses and current assets and liabilities. Investing: Long-term assets. Financing: Long-term liabilities and shareholders equity.

Question 41

If Depreciation is a non-cash expense, why does it affect the cash balance?

Answer 41

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.

Question 42

Why is income statement not affected by inventory changes?

Answer 42

Doesn't change until the inventory is sold, which would then be reflected as a COGS

Question 43

Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements affected at the start of "Year 1," before anything else happens?

Answer 43

Doesn't change income statement. Cash flow from operating the same, cash flow from investing down by $100, cash flow from financing up by $100 so no change in cash flow statement. Long-term assets up on balance sheet, but so is long term debt, so both sides balance.

Question 44

What is working capital? How is it used?

Answer 44

Working Capital = Current Assets - Current Liabilities. If it's positive, it means a company can pay off its short-term liabilities with its short-term assets. It is often presented as a financial metric and its magnitude and sign (negative or positive) tells you whether or not the company is "sound." Bankers look at Operating Working Capital more commonly in models, and that is defined as (Current Assets - Cash & Cash Equivalents) - (Current Liabilities - Debt). Increases in NWC is bad, because it means cash is tied up (in things like accounts receivable)

Question 45

Where does write down / write up appear in income statement?

Answer 45

Pre-tax income, with other non cash expenses

Question 46

Run me through the statements with a $100 writedown on assets?

Answer 46

depreciation drops by $100, and with 40% tax rate, net income drops by $60. Top line of cash flow statement down by $60, but depreciation is added back, so cash flow from operating activities is up $40. No other changes, so overall cash is up $40 which boosts cash & equivalents on balance sheet, but the $100 write down reduces depreciation by $100, so assets side is down $60. $60 reduction in net income also flows into retained earnings in shareholder equity, so both sides balance.

Question 47

Run me through the statements with a $100 writedown on debt?

Answer 47

Everything goes the other way because you get off from paying debt.

Question 48

Why do companies report both GAAP and non-GAAP (or "Pro Forma") earnings?

Answer 48

Statements under GAAP dont show how profitable a company is.

Question 49

How do you decide when to capitalize rather than expense a purchase?

Answer 49

Length of time. Less than a year, its expense, greater than a year its capitalised

Question 50

Let's say a customer pays for a TV with a credit card. What would this look like under cash-based vs. accrual accounting?

Answer 50

Cash based wouldn't show up until card is charged, accrual shows up as revenue, but goes into accounts receivable rather than cash.

Question 51

How long does it usually take for a company to collect its accounts receivable balance?

Answer 51

30-60 days

Question 52

What's the difference between accounts receivable and deferred revenue?

Answer 52

Accounts receivable has not yet been collected in cash from customers, whereas deferred revenue has been. Accounts receivable represents how much revenue the company is waiting on, whereas deferred revenue represents how much it is waiting to record as revenue.

Question 53

If cash collected is not recorded as revenue, what happens to it?

Answer 53

Usually it goes into the Deferred Revenue balance on the Balance Sheet

Question 54

When would a company collect cash from a customer and not record it as revenue?

Answer 54

Subscription model where collected up front but would be put through over the year.

Question 55

What is depreciation

Answer 55

Accounting for the ageing of assets. Depreciation is an income tax reduction that allows a taxpayer to recover the cost of certain property. It is an annual allowance for wear and tear, detoriation of obsolesce of the property.

Question 56

Types of depreciation

Answer 56

Straight line depreciation or accelerated depreciation.

Question 57

What is straight line depreciation?

Answer 57

An asset being depreciated evenly over the number of years an asset is expected to be lost.

Question 58

What is residual value (in depreciation)?

Answer 58

Scrap value left over; usually has a sale value for scrap parts. Depreciation will be to the scrap value.

Question 59

What is accelerated depreciation

Answer 59

Depreciated quicker in early life of the asset.

Question 60

Types of accelerated depreciation

Answer 60

Declining balance, sum of the years digits, modified accelerated cost reduction system

Question 61

What is declining balance depreciation?

Answer 61

Declining 20% of asset value each year.

Question 62

What is the sum of the years digits depreciation?

Answer 62

Add up years consecutively, and then first year put numerator with largest year and denominator as sum of the years.

Question 63

What are deferred tax assets?

Answer 63

An asset that can be used to reduce income tax; most commonly created after receiving a net operating loss (NOL), which occurs when costs exceed sales.

Question 64

Examples of operating expenses

Answer 64

Selling, general & administrative, advertising + marketing, research & development

Question 65

Examples of extraordinary / non-recurring items on income statement

Answer 65

Asset write-ups/downs;

Question 66

What are prepaid expenses

Answer 66

Asset created when a company pays for an expense in advance of when it is billed or incurred.

Question 67

What are deferred tax assets?

Answer 67

Assets that may be used to reduce income tax expense. This is commonly created after receiving a net operating loss in a previous year. Net operating losses can be carried forward 20 years, or back two to five years.

Question 68

What is working capital formula?

Answer 68

Current assets - current liabilites

Question 69

How is operating working capital different to working capital?

Answer 69

(Current assets - cash & equivalents) - (Current liabilities - short term debts) Rationale is removing things that are ‘unfair’

Question 70

Common operating working capital items

Answer 70

Assets: Accounts receivable, inventory, prepaid expenses Liabilities: Accounts payable, accrued expenses

Question 71

What is accrued expenses?

Answer 71

Expenses that are owed but have not yet paid in cash

Question 72

What is operating working capital used for?

Answer 72

Tracking how well a company is managing its cash generating from day-to-day operations.

Question 73

What is a debt schedule

Answer 73

Designed to track every major type of debt a company has, and the associated interest and payment schedules for each. It also helps track the cash available that could be used to pay down those debts and any interest income that could be generated from cash or cash & equivalents available.

Question 74

EBITDA is $500mn. Which of the following has the greatest impact on EBITDA? Costs increase by $10mn, pricing increases by 10% or volume increases by 10%

Answer 74

Answer is pricing, because revenue is a product of pricing and volume, but volume includes price - costs

Question 75

What is the difference between net income and cash flow?

Answer 75

Net income measures profitability whose components may or may not have impacted cash. Cash flow tracks just the cash impacts generated or received from operations, investing and financing activities.

Question 76

How does maintenance Capex differ from growth capex

Answer 76

Maintenance Capex is the fund expanded to extend the useful life of existing assets, whereas expansion Capex is the purchase of new assets to grow the business.

Question 77

Why is EBITDA used in valuation?

Answer 77

EBITDA is used as a valuation metric as it removes external accounting factors and non-operating expenses from view, focuses on the operating performance of the business and takes into consideration an approximate value of company cash flow.

Question 78

What is a deferred tax liability? How is such a liability created?

Answer 78

A tax balance that has not yet been paid in cash, which arises because of timing differences between GAAP and tax accounting.

Question 79

If I had one statement, what would I have?

Answer 79

Cash flow statement as provides a true measure of cash produced bu the business, as income statement includes non-cash items.

Question 80

If I had two statements, which would I have?

Answer 80

Income statement and balance sheet, because the cash flow statement can be created from the income statement and two years of balance sheet.

Question 81

If accounts receivable increases by $10, what at the effects on the statements?

Answer 81

Net Income up $6, Change in cash down $4, A+L/E up $6

Question 82

If accounts receivable decreases by $10, what are the effects on the statements?

Answer 82

NO change to income statement, cash flow up $10, A +/- 0

Question 83

What are the accrued expenses

Answer 83

Expenses that are owed but have not yet paid in cash

Question 84

We are in the business of buying and selling widgets, and we have just started the company. We can purchase these wdiegsts for $100 each if we are buying in bulk of 50 and the purchase can be deferred an account payable. We have not yet made any sales. Please explain the effects on the income statements, cash flow statements and balance sheet.

Answer 84

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Question 85

If you sell 15 items for $500 each on credit, what happens to the financial statements? Assume 40% tax rate

Answer 85

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Question 86

* Now let’s say we want to purchase property for $15,000. Since we don’t have 15,000 in cash on our balance sheet, we will first raise debt to fund the difference. Let’s say we raise $3,000, allowing some cushion for interest payments. The debt has an interest rate of 10%. Please explain the effects on the income statement, cash flow statement, and balance sheet of the debt raise. Focus on just the debt raise; we will handle the interest impact later.

Answer 86

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Question 87

* f accounts receivable increases by $15, please explain the effects on the income statement, cash flow statement, and balance sheet (assume 40% tax rate).

Answer 87

Revenue +$15, taxes -$6, Net iNcome +$9. Cash down $6, On balance sheet, accounts receivable up $15 counters down cash to balance.

Question 88

* If inventory increases by $20, please explain the effects on the income statement, cash flow statement, and balance sheet.

Answer 88

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Question 89

* If inventory decreases by $20, please explain the effects on the income statement, cash flow statement, and balance sheet (assume a 40% tax rate).

Answer 89

Cogs down $20, so net income down $12. Change in cash up $8. Both sides of BS down $12.

Question 90

* If accrued expenses increase by $50, please explain the effects on the income state- ment, cash flow statement, and balance sheet. Assume accrued expenses are related to operating expenses. Assume a 40% tax rate.

Answer 90

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Question 91

* If depreciation expense increases by $75, please explain the effects on the income statement, cash flow statement, and balance sheet. Assume a 40% tax rate.

Answer 91

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