Finance Concepts Flashcards
(28 cards)
- Explain the time value of money. Is money today worth more than money next year due to inflation?
No. The time value of money means you could invest money today and earn something additional with it by next year.
Inflation also makes money less valuable over time, but the time value of money is about the
potential returns of an investment made today.
- What does the “Discount Rate” mean?
The Discount Rate represents your opportunity cost or “targeted annualized return.” In other words, if you don’t invest in this company, how much could you earn over the long term by investing in other, similar companies?
The Discount Rate represents the potential returns and the risk of other, similar opportunities.
If the Discount Rate is higher, both the potential returns and the risk are higher; the opposite is true if the Discount Rate is lower.
- Why is the Discount Rate higher if the potential returns are higher? Shouldn’t a company with higher potential returns have a lower Discount Rate, making it more valuable?
No. The Discount Rate is higher because the potential returns and the risk move together: If a stock could potentially go up by 10x, it’s much riskier than a stock that only has the potential to increase by 2x.
The point is that there’s no such thing as a “free lunch”: Higher potential returns also mean that your chances of losing money are higher.
- What is WACC?
WACC stands for the “Weighted Average Cost of Capital,” the most common Discount Rate used to value companies.
To calculate it, you multiply the % Equity in a company’s capital structure by the “Cost” of that Equity, multiply the % Debt in the company’s capital structure by the “Cost” of that Debt, and add them up (and, if applicable, Preferred Stock and other long-term funding sources).
For example, if a company uses 60% Equity and 40% Debt, its Cost of Equity is 10%, and its Cost of Debt is 5%, then its WACC is 60% * 10% + 40% * 5% = 8%.
WACC represents the average annualized return you’d expect to earn if you invested proportionally in the Debt AND Equity of a company and held them for the long term.
- How much would you pay for a company that generates $100 of cash flow every single year into eternity?
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate.
If the cash flow does not grow at all, Company Value = Cash Flow / Discount Rate. So, if your Discount Rate, or “targeted yield,” is 10%, you’d pay $100 / 10% = $1,000. But if your targeted yield is 20%, you’d pay only $100 / 20% = $500 for this company.
- A company generates $100 of cash flow today, and its cash flow is expected to grow at 5% per year for the long term.
You could earn 10% per year by investing in other, similar companies. How much would you pay for this company?
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow Growth Rate < Discount Rate.
So, this one becomes: $100 / (10% – 5%) = $2,000.
A higher Discount Rate makes a company less valuable, and a higher cash flow growth rate makes a company more valuable
- What does “Present Value” mean, and what makes it change? How does it differ from Net Present Value?
The Present Value (PV) of an asset or company equals its future cash flows discounted at the appropriate Discount Rate (e.g., ~10% for many stocks).
“Discount” means that you take a future cash flow, such as $100, and divide it by ((1 + Discount Rate) ^ Year #), assuming a constant Discount Rate in each period.
The PV tells you what a company or asset is worth today based on its potential future performance and your returns expectations.
The PV increases if the company’s expected future cash flow or growth rate increases or the Discount Rate decreases.
The PV decreases if the opposite happens.
“Net Present Value” means that you take the PV of these future cash flows and subtract the upfront cost or “asking price” of the company.
If the NPV is positive, the company is worth more than its current price.
- What does the internal rate of return (IRR) mean? How do you calculate it?
In technical terms, the IRR represents the Discount Rate at which the Net Present Value of an investment equals 0.
Colloquially, you can think of it as “the effective compounded rate of return on an investment.”
For example, if you invest $1,000 today and end up with $2,000 after 5 years, the IRR represents the return you’d have to earn on that $1,000, compounded each year, to reach
$2,000 in 5 years.
It’s 14.9% in this example, which you can verify with a calculator or Excel.
To calculate the IRR, enter the upfront investment as a negative in Excel and the future cash flows and sale value as positives and apply the IRR function to the whole range.
- What affects the IRR? How do these factors differ from the ones that affect the Present Value?
Many factors are the same: Higher cash flows, growth rates, or future sale values for the asset increase both the Present Value and the IRR. Lower values for these assumptions reduce both the Present Value and the IRR.
One major difference is that the Discount Rate does NOT affect the IRR – because you are
solving for the Discount Rate when you calculate the IRR!
The whole point of the calculation is that you can compare the IRR to the Discount Rate to determine if the investment is worth your time and money.
Another major difference is that the upfront price or “asking price” affects the IRR since it’s entered as a negative for the first value in the series, but it does not impact the Present Value.
You should compare the Present Value to this upfront price to see if the investment is worth more or less than its price.
- How do you use the IRR, Discount Rate, and Present Value to make investment decisions?
Normally, you calculate the IRR and compare it to the Discount Rate of a project, investment, or company.
If the IRR exceeds the Discount Rate, investing makes sense; if not, you should not invest.
Comparing the Present Value to the upfront price does the same thing: If the PV of the future cash flows exceeds this upfront price, invest; otherwise, do not invest.
- What are the three financial statements, and why do we need them?
The three main financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement.
The Income Statement shows the company’s revenue, expenses, and taxes over a period and ends with Net Income, which represents the company’s after-tax profits.
The Balance Sheet shows the company’s Assets – its resources – and how it paid for those resources – its Liabilities and Equity – at a specific point in time. Assets must equal Liabilities plus Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in operating assets and liabilities (working capital), and shows the company’s Cash Flow from Investing and Financing activities; the last lines show the net change in cash and the company’s ending cash balance.
You need the financial statements because there’s always a difference between the company’s Net Income and the cash flow it generates, and the statements let you estimate and forecast the cash flow more accurately.
- How do the financial statements link together?
To link the statements, make Net Income from the Income Statement the top line of the Cash Flow Statement.
Then, adjust this Net Income number for non-cash items such as Depreciation & Amortization.
Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which may increase or reduce the company’s cash flow.
This gets you to Cash Flow from Operations.
Next, include the investing and financing activities, which may increase or reduce cash flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in cash and ending cash balance.
Cash at the bottom of the CFS becomes Cash on the Balance Sheet, and Net Income, Stock Issuances/Repurchases, Stock-Based Compensation, and Dividends link into Common Shareholders’ Equity.
Next, link the separate line items on the CFS to their corresponding Balance Sheet line items; for example, CapEx and Depreciation link into Net PP&E.
On the Assets side of the Balance Sheet, subtract CFS links; add them on the L&E side. Finally, check that Assets equals Liabilities plus Equity at the end.
- What’s the most important financial statement?
The Cash Flow Statement is the most important single statement because it tells you how much
cash a company generates, and almost all valuation is based on cash flow.
The Income Statement includes non-cash revenue, expenses, and taxes, and excludes cash spending on major items such as Capital Expenditures, so it does not accurately represent a company’s cash flow.
- How might the financial statements of a company in the U.K. or Germany be different from those of a company based in the U.S.?
Income Statements and Balance Sheets tend to be similar across different regions, but companies that use IFRS often start the Cash Flow Statement with something other than Net Income: Operating Income, Pre-Tax Income, or, if they are using the Direct Method, Cash Received and Cash Paid.
IFRS-based companies also tend to place items in more “random” locations on the CFS, so you may need to rearrange it.
Finally, the Operating Lease Expense is split into Interest and Depreciation elements under IFRS, but it’s recorded as a simple Rental Expense under U.S. GAAP.
- How do you know when a revenue or expense line item should appear on the Income Statement?
To appear on the Income Statement, an item must:
1) Correspond 100% to the period shown – Revenue and expenses are based on the
delivery of products or services, so an item delivered in Year 1 can count only in Year 1.
And if a company buys a factory, it can’t list the entire purchase price on the Income Statement in one year because it will be useful for many years. It corresponds to more than just this period.
2) Affect the business income available to common shareholders (Net Income to Common) – If something does not affect the owners of the business, it should not appear on the Income Statement.
The second point explains why Preferred Dividends appear on the Income Statement: They reduce the after-tax profits that could potentially go to common shareholders.
- A company collects cash payments from customers for a monthly subscription service one year in advance. Why do companies do this, and what is the cash flow impact?
A company collects cash payments for a monthly service long in advance if it has the market and pricing power to do so. Because of the time value of money, it’s better to collect cash today rather than several months or a year into the future.
This practice always boosts the company’s cash flow. It corresponds to Deferred Revenue, and on the CFS, an increase in Deferred Revenue is a positive entry that boosts cash flow.
When this cash is finally recognized as Revenue, Deferred Revenue declines, which appears as a negative entry on the CFS.
- Why is Accounts Receivable (AR) an Asset but Deferred Revenue (DR) a Liability?
AR is an Asset because it provides a future benefit to the company – the receipt of additional cash from customers in the future.
DR is a Liability because it represents future obligations for the company. The company has already collected the cash associated with the sale, so it must spend money in the future to deliver the product or service.
AR and DR are opposites: AR has not yet been collected in cash but has been delivered, whereas DR has been collected in cash but has not yet been delivered.
- What are “Deferred Taxes,” and how do they affect the statements?
“Deferred Taxes” represent cases where the “Book Taxes” shown on the Income Statement do not represent what the company pays in Cash Taxes to the government in the period.
They typically arise due to Income Statement expenses that are not tax-deductible despite appearing above Pre-Tax Income. In some cases, they arise because of additional amounts that are deductible beyond what is shown on the IS.
For example, items such as Stock-Based Compensation and Asset Impairments are not deductible for cash-tax purposes until “the second step” of the process (when employees exercise their options and receive shares or when an asset is sold at a loss).
So, these items initially create negative Deferred Taxes because the company pays more in Cash Taxes than its Income Statement suggests; later, they become deductible, and Deferred Taxes turn positive.
- A junior accountant in your department asks about how to fund the company’s operations via external sources and how they impact the financial statements. What do you say?
Debt and Equity are the two main methods of funding a company’s operations with outside money. Debt is initially cheaper for most companies, so most companies prefer to use Debt… up to a reasonable level.
To do this, the company must be able to service its Debt by paying for the interest expense and possible principal repayments; if it can’t, it must use Equity instead.
Both Equity and Debt issuances show up only on the Cash Flow Statement initially (in Cash Flow from Financing), and they boost the company’s Cash balance.
With Equity, the company’s share count increases immediately after issuance, which means that existing investors get diluted (i.e., they own a smaller percentage of the company).
With Debt, the company must pay interest, which will be recorded on its Income Statement, reducing its Net Income and Cash, and it must eventually repay the full balance.
- Your firm recently acquired another company for $1,000 and created Goodwill of $400 and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your department asks you why your firm did this – how would you respond?
You must create Goodwill and Other Intangible Assets after an acquisition to ensure the Balance Sheet remains in balance.
In an acquisition, you write down the seller’s Common Shareholders’ Equity and then combine its Assets and Liabilities with the acquirer’s.
If you’ve paid exactly what the seller’s CSE is worth – e.g., you paid $1,000 in cash, and the seller has $1,000 in CSE, there are no problems.
However, most acquirers pay premiums for target companies, meaning the Balance Sheet will go out of balance.
For example, if the seller had $400 in CSE, the acquirer’s Balance Sheet would go out of balance immediately because the Assets side would decrease by $1,000, but the L&E side would decrease by only $400.
To plug the gap, you create “Other Intangible Assets” to represent the values of items such as patents, trademarks, intellectual property, and customer relationships ($200 in this case).
Goodwill plugs the remaining gap of $400 and ensures that the Balance Sheet balances.
- Explain lease accounting on the financial statements under IFRS 16 / ASC 842, including the differences between Operating Leases and Finance Leases.
Assets and Liabilities associated with leases that last for more than 12 months now appear directly on companies’ Balance Sheets. Operating Lease Assets are sometimes called “Right-of- Use Assets,” and Operating Lease Liabilities initially match them (or are very close).
The rental expense for Finance Leases, which give companies an element of ownership or a “bargain purchase option” at the end, is split into Interest and Depreciation elements on the Income Statement.
On the Cash Flow Statement, Depreciation is added back, and under Cash Flow from Financing, the company records a negative for the “Lease Principal Repayments” (or a similar name).
On the Balance Sheet, the Lease Assets and Lease Liabilities decrease each year until the lease ends. These decreases are based on the Lease Depreciation and Lease Principal Repayments.
Under IFRS, Operating Leases and Finance Leases are treated the same way, so the Operating Lease Expense is also split into Interest and Depreciation elements, and the same BS and CFS line items change.
For Operating Leases under U.S. GAAP, companies record a simple Rental Expense on the Income Statement, so there is no Depreciation/Interest split.
However, the Lease Assets and Lease Liabilities on the Balance Sheet still decrease each year based on the company’s estimates for “Lease Depreciation” and “Lease Principal Repayments,” which do not appear explicitly on the statements under U.S. GAAP.
- What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities? How do Net Operating Losses (NOLs) factor in?
DTAs and DTLs relate to temporary differences between the book and tax bases 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 for Cash-Tax purposes (e.g., Stock-Based Compensation).
NOLs are a component of the DTA; they equal approximately the Tax Rate * NOL Balance.
- How do you calculate Free Cash Flow (FCF), and what does it mean?
There are different types of Free Cash Flow, but one simple definition is Cash Flow from Operations (CFO) minus CapEx.
FCF represents a company’s “discretionary cash flow” – how much cash flow it generates from its core business after paying for the cost of its funding sources, such as interest on Debt.
It’s defined this way because most items in CFO on the Cash Flow Statement are required, while most of the CFI and CFF sections are optional or non-recurring (except for CapEx).
A positive and growing FCF means the company doesn’t need outside funding sources to continue operating, and it could spend its cash flow in different ways: Hiring employees, re- investing in the business, acquiring other companies, or returning money to the shareholders with Dividends or Stock Repurchases.
Negative or declining FCF means the company may need to raise outside funding, restructure, cut expenses, or grow tremendously to survive.
- What is Working Capital? What does it mean if it’s positive or negative?
The official definition of Working Capital is “Current Assets minus Current Liabilities,” but the more useful definition is:
Working Capital = Current Operational Assets – Current Operational Liabilities
“Operational” means that you exclude items such as Cash, Investments, and Debt that are related to the company’s capital structure, not its core business.
This version is sometimes called Operating Working Capital.
It may also include Long-Term Assets and Liabilities related to the company’s business operations (Long-Term Deferred Revenue is a good example).
Working Capital tells you whether a company needs more in Operational Assets or Operational Liabilities to run its business, and how big the difference is.
The meaning of positive or negative Working Capital depends on why it has that sign. For example, if the company has minimal Inventory and Receivables but a large Deferred Revenue balance, that is usually seen as positive and indicates high efficiency.
But if Working Capital is positive because of a high Receivables balance due to difficulties collecting cash from customers, that is a bad sign.
