Accounting Fundamentals

Question 1

What are the three financial statements?

Answer 1

The three financial statements are the Income Statement, Cash Flow Statement and Balance Sheet. The Income Statement tells us the company’s profitability. The Cash Flow Statement tells us how much cash is coming in and going out of the company. And the Balance Sheet tells us what it owns and what it owes.

Question 2

Can you walk me through the three financial statements?

Answer 2

On the Income Statement, we start with Revenue. From here, we subtract Cost of Goods Sold to get Gross Profit. Then we subtract SG&A, R&D and other operating expenses to get Operating Income. Then we subtract Interest and Taxes to get Net Income. Net Income flows to the top of the Cash Flow Statement. The Cash Flow Statement has three main sections: Cash Flow from Operations, Cash Flow from Investing, and Cash Flow from Financing. The sum of these three types of cash flows gives us the Net Change in Cash. Net Change in Cash then flows to the top of the Balance Sheet. The Balance Sheet also has three sections: Assets, Liabilities and Equity. Assets must equal Liabilities plus Equity.

Question 3

If you can only pick one financial statement to analyze the financial attractiveness of a company and the statement would only display the numbers for a single year, which one would you pick and why?

Answer 3

I would pick the Cash Flow Statement because a company’s valuation is based on how much cash flow it can generate.

Question 4

If you can only pick one financial statement to analyze the financial attractiveness of a company and the statement would display the numbers for two years, which one would you pick and why?

Answer 4

I would still pick the Cash Flow Statement. Some people say that they would pick the Balance Sheet because by comparing how the numbers changed between two years, they can back out the Income Statement / Cash Flow Statement. That’s wrong.

Question 5

If you can pick two financial statements among the three, which two would you pick and why?

Answer 5

I would pick the Cash Flow Statement and the Balance Sheet. The former tells me how much cash flow the company can generate, which allows me to value the company. The latter tells me how much debt and cash it has, which allows me to bridge from Enterprise Value to Equity Value.

Question 6

What is the difference between calendar year and fiscal year?

Answer 6

Calendar Year is the 12-months period from January 1st to December 31st. Fiscal Year is the 12-months period that a company uses to report financials. The 12-month period may begin on any date, doesn’t have to be January 1st. Most companies’ Fiscal Year is the same as Calendar Year. Other companies have their Fiscal Year begin on a date other than January 1st and end on a date other than December 31st.

Question 7

What is seasonality?

Answer 7

Seasonality is when a company’s financials are meaningfully different in certain period within a year relative to other periods.

Question 8

Can you explain to me the difference between GAAP and Non-GAAP?

Answer 8

GAAP stands for Generally Accepted Accounting Principles. When we describe a metric or a set of financial statements as ‘GAAP’, we mean the numbers are based on the accounting standards set by the Financial Accounting Standards Board (FASB). By contrast, non-GAAP describes metrics that are not prepared in accordance to FASB’s standards.

Question 9

Can you provide some examples of GAAP and Non-GAAP metrics that analysts care about?

Answer 9

Some GAAP metrics that analysts care about are Revenue, Operating Income, Net Income, and EPS. Some non-GAAP metrics that analysts care about are EBITDA, Adjusted EBITDA, and Unlevered Free Cash Flow.

Question 10

What is the difference between cash-based accounting and accrual-based accounting?

Answer 10

Cash-based accounting records revenue and expenses based on when cash is received and paid. Accrual-based accounting records revenue and expenses based on revenue is accrued and expenses are incurred, regardless of whether cash is received or paid.

Question 11

What’s the difference between expensing an item versus capitalizing an item?

Answer 11

Expensing an item means recording a spending as an expense on the Income Statement. By contrast, capitalizing an item means recording a spending as an asset or a liability on the Balance Sheet.

Question 12

How do companies determine whether to expense an item versus to capitalize an item?

Answer 12

In general, companies should capitalize expenditures that provide benefits beyond the reporting period and expense ones for which the benefits were consumed during the reporting period.

Question 13

What is the Conservatism Principle in accounting?

Answer 13

The Conservatism Principle in accounting directs the accountant to choose the option that will result in lower profit and/or net asset in situations where there is more than one acceptable option to record a financial number.

Question 14

What is the Matching Principle in accounting?

Answer 14

The Matching Principle requires firms to recognize expenses that coincide with Revenue in the same period they recognize Revenue.

Question 15

What is the Accrual Principle in accounting?

Answer 15

The Accrual Principle requires firms to record transactions in the time period they occur, regardless of when cash flows for the transaction are received or paid.

Question 16

How is the Income Statement organized? / What are the major line items on the Income Statement?

Answer 16

The Income Statement starts with Revenue. From here, we subtract Cost of Goods Sold to get Gross Profit. From here, we subtract SG&A, R&D and other operating expenses to calculate Operating Income. Then we subtract Interest Expense and Taxes to get Net Income.

Question 17

In a 10-K, how many years does the Income Statement typically show?

Answer 17

The 10-K Income Statement usually shows 3 years.

Question 18

What does ‘Top-Line’ and ‘Bottom-Line’ mean on the Income Statement?

Answer 18

‘Top-Line’ means Revenue or Sales while ‘Bottom-Line’ means Net Income.

Question 19

Can you explain to me how Revenue is recognized on the Income Statement?

Answer 19

Under US GAAP (and IFRS for jurisdictions outside the US), companies recognize Revenue on an accrual basis.

Question 20

What is EBITDA and why do we use it?

Answer 20

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It measures the business profitability. We use EBITDA because it removes discretionary accounting and financing decisions that often vary based on management choices.

Question 21

What are some flaws of using EBITDA?

Answer 21

One criticism is that we add back non-cash items but we don’t subtract cash items.

Question 22

Walk me through at least three different ways to calculate EBITDA.

Answer 22

1st way: EBIT + Depreciation + Amortization. 2nd way: Net Income + Taxes + Net Interest Expense + Depreciation + Amortization. 3rd way: Revenue x EBITDA Margin %.

Question 23

What are some common adjustments we make to EBITDA to calculate Adjusted EBITDA?

Answer 23

Some common adjustments are Restructuring Charges, Asset Impairment, Gains & Losses, and Stock-Based Compensation.

Question 24

Why doesn’t EBITDA appear on companies’ Income Statements?

Answer 24

Income Statement is GAAP while EBITDA is a non-GAAP metric. Companies don’t include non-GAAP items on GAAP documents.

Question 25

Since D&A is an expense, how come some companies don’t show it on the Income Statement?

Answer 25

That’s because some companies embed D&A into other cost buckets, such as COGS, SG&A, and R&D.

Question 26

What do people mean when they say Depreciation is a non-cash expense?

Answer 26

They mean that this is not an expense companies pay with cash.

Question 27

If D&A is a non-cash expense, does it affect Net Income? Why and why not?

Answer 27

Yes, it still affects Net Income. Net Income does not measure cash flow. It measures profitability.

Question 28

What is the difference between straight-line depreciation and accelerated depreciation? Which one do companies prefer?

Answer 28

Straight-line depreciation spreads the depreciation expense over an asset’s lifespan evenly throughout the years. Accelerated depreciation records disproportionally high depreciation expense in the early years and disproportionally low depreciation expense in the final years of an asset’s lifespan.

Question 29

When you bridge from EBIT to EBITDA, where should you obtain the D&A amount?

Answer 29

You should obtain the D&A amount from the Cash Flow Statement, under Cash Flow from Operations.

Question 30

What are some examples of 'extraordinary items'?

Answer 30

Extraordinary items are impacts to the company’s financials that are extraordinary in nature. Some examples of 'extraordinary items' are litigation expenses, natural disaster expenses, and restructuring charges.

Question 31

What are the different line items that you may need to add or subtract from Operating Income to calculate Pre-Tax Income?

Answer 31

From Operating Income, we add Interest Income, add Other Incomes, subtract Interest Expense, and subtract Other Expenses.

Question 32

What is Inventory Impairment / Goodwill Impairment / Asset Impairment? What causes this to happen?

Answer 32

These are write-downs to the value of the company’s assets on the Balance Sheet. Companies recorded these assets on the Balance Sheet at certain values.