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IB Interview Guide, Module 4: Accounting and the Three Financial
Statements
Table of Contents:
Overview & Key Rules of Thumb ....................................................................................... 2
Key Rule #1: The Income Statement and Working Capital ............................................ 2
Key Rule #2: CapEx, Depreciation, and Long-Term Business Funding ......................... 16
Key Rule #3: Operating Leases and Finance Leases ..................................................... 27
Key Rule #4: Financial Investments ............................................................................. 32
Key Rule #5: Deferred Taxes and Net Operating Losses (NOLs) .................................. 33
Key Rule #6: Gains, Losses, Impairments, and Write-Downs....................................... 40
Key Rule #7: Stock-Based Compensation .................................................................... 47
Key Rule #8: Goodwill and Other Intangible Assets from M&A Deals ......................... 51
Key Rule #9: U.S. GAAP vs. IFRS................................................................................... 57
Key Rule #10: Summary of the Three Financial Statements ........................................ 61
Key Rule #11: Linking and Projecting the Financial Statements .................................. 68
Key Rule #12: Free Cash Flow and the Change in Working Capital.............................. 77
Key Rule #13: Key Metrics and Ratios ......................................................................... 86
Key Rule #14: How to Answer Accounting Interview Questions ................................. 91
Interview Questions ...................................................................................................... 107
Conceptual Accounting Questions ............................................................................ 107
Single-Step Changes on the Financial Statements ..................................................... 119
Multi-Step Changes on the Financial Statements ...................................................... 130
Working Capital, Free Cash Flow, and Other Metrics and Ratios .............................. 139
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Overview & Key Rules of Thumb
This guide introduces you to the most common accounting topics that will come up in
interviews and on the job. It also summarizes the accounting lessons in our financial modeling
course.
You are guaranteed to receive questions on accounting, no matter your seniority or the roles
you’re applying for.
The most important topics include:
1. What the three financial statements are and why we need them (e.g., How do you
decide what goes on the Income Statement or Cash Flow Statement?).
2. How to answer interview questions related to the financial statements by walking
through how they change in response to events (e.g., What happens when Depreciation
increases by $10?).
3. How to calculate metrics and ratios related to the financial statements, such as Working
Capital, Free Cash Flow, and ROIC, and what they mean.
We focus on these topics in this guide, explain the main points, and then present interview
questions at the end so you can test yourself.
You also need to review the accompanying “Interview Question” Excel model, as that file will
make it 10x easier to understand everything.
We do cover some more advanced topics in this guide, such as Net Operating Losses and the
IFRS vs. U.S. GAAP treatment of Operating Leases, but the next guide focuses on these more
advanced topics.
Key Rule #1: The Income Statement and Working Capital
Everything in this course goes back to that formula in the previous guide:
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), Where Cash Flow
Growth Rate < Discount Rate
This formula is correct in the abstract sense, but the problem is that no company ever lists
“Cash Flow” explicitly in its public filings or annual reports.
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Instead, you need to review the filings and estimate the company’s “Cash Flow” by adding,
subtracting, and ignoring various line items.
To understand why you include certain items and ignore others, you need to understand the
three financial statements.
A company’s “Cash Flow” could be very, very different from the “Profit” it generates, and the
three financial statements help us understand that difference.
Let’s start with a simple example: imagine a company that offers online courses and coaching
(similar to the company whose guide you’re reading).
You pay for the courses upfront, you gain immediate
access, and then you have lifetime access after you
sign up.
There are no factories or offices, minimal capital is
required, and we don’t have to order Inventory
because there are no physical products.
If we tracked the sales, expenses, and profits for this
business, it might look like the example on the left.
“Revenue” represents our net sales across all
segments, and “Cost of Goods Sold” represents
expenses that can be linked to individual units sold
(such as materials and shipping for physical
products, or human labor for services).
The Gross Margin tells you how much additional
profit the company earns from each additional sale
before fixed expenses like employees and rent.
Operating Expenses include items that can’t be
linked to individual products sold, such as marketing,
rent, employee salaries, and customer support.
Operating Income tells you how much the business
earns before “side activities,” interest, and taxes,
and Net Income gives you the company’s bottom
line: how much it earns AFTER all expenses and
taxes.
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To appear on the Income Statement, an item must:
1) Correspond 100% to the period shown – So, 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.
And if we buy a factory, we can’t list that purchase on the Income Statement because it
will be useful for many years. It corresponds to MORE than just this current period.
2) Affect the business income available to common shareholders (Net Income here) – If
something does not affect the owners of the business, it should not appear on the
Income Statement. This rule will make more sense once we move into more advanced
items later in this guide.
If we funded this business with $1 million of our own Cash (shown as $1,000 here), we might
record the following for the company’s “Assets” (items that will provide some future benefit)
and its “Liabilities & Equity” (the company’s obligations, or how it paid for its Assets):
Each year, Cash will increase by the Net Income.
On the other side, Equity will also increase by the
Net Income.
Many other items could affect Cash and Equity,
but for a simple business like this one, Net Income
is the main factor.
Record-keeping is simple: when we sell something, we collect the cash for it immediately, and
when we incur an expense, we pay for it in cash immediately.
In this simple case, Net Income – Profit After Taxes – is the same as “Cash Flow.”
But in real life, no company is this simple. Here are a few items that create differences between
Net Income and Cash Flow:
Accounts Receivable
Our business does well in its first year, and we still have that initial $1 million of Cash we put in,
plus the $150K of Cash we generated in Year 1.
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As Year 2 approaches, we expect our business performance to be about the same as in Year 1.
A large customer – a Fortune 500 company or university – approaches us and offers to purchase
$100K in product licenses, but they do not want to pay upfront.
Instead, we’ll deliver the courses to this customer, but we will not receive cash payment from
them for up to 90 days.
That’s initially a negative because we don’t get the cash right away – but we do want to expand
our business in Year 2, so we agree to it.
This policy will create a “Receivable” and result in a temporary difference between Net Income
and Cash Flow.
Whenever we deliver a product or service to a customer, we must record Revenue for it.
But when we don’t receive the cash payment right away, we increase the “Accounts
Receivable” line item, within Assets, to reflect that.
Here’s what it looks like on the financial statements:
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Our Net Income increases from $150K to $225K, but since we did not receive this $100K in
CASH, the “Cash Flow Generated” decreases!
To reflect the $100K that we’re waiting to collect, we increase the Accounts Receivable (AR) line
item. This AR line item counts as an Asset because it provides a future benefit to us (cash).
In Step 2 of this process – when this large customer finally pays – the Income Statement stays
the same, but the Balance Sheet and Cash Flow Statement change as follows:
Now, “Cash Flow Generated” increases from $150K to $225K because we’ve finally collected
the cash from this customer. Accounts Receivable decreases by $100K, and Cash goes up by
$100K to reflect the collection.
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For large companies, these types of changes happen constantly across thousands or millions
of customer accounts, so the Accounts Receivable balance is always changing.
And when the AR balance increases or decreases, it creates a difference between Net Income
and “Cash Flow Generated.”
Accounts Payable and Accrued Expenses
As Year 2 approaches, we get another idea for business expansion: we decide to hire an online
marketing agency that will create paid advertising campaigns for us on Google, Facebook, and
other platforms.
We’ll pay them $20K for one quarter of their services, but we don’t have to pay upfront.
Instead, they’ll invoice us, and we’ll have 60 days to pay for these services.
So, we receive these services (or products, supplies, etc.), but we will not pay for them in cash
for up to 60 days.
This will create a "Payable" and result in a temporary difference between Net Income and Cash
Flow Generated.
We record an expense on the Income Statement whenever we receive a product/service from
another vendor, but when we don’t pay for it in cash right away, we increase the Accounts
Payable line item on the Balance Sheet (or, potentially, Accrued Expenses – see below).
NOTE: Accounts Payable is not always linked to a line item on the Income Statement because it
depends on the nature of the product/service ordered. You’ll see examples of this in some of
the Interview Questions later on.
For simplicity, in this case, we assume that Accounts Payable does correspond to an Income
Statement expense (Sales & Marketing).
So, in Step 1, the expense increases, but since we don’t pay for it upfront in cash, “Cash Flow
Generated” increases:
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“Cash Flow Generated” increases because we haven’t paid for the expense in cash yet, but we
have received a $5K tax benefit from it (since $20K * 25% = $5K).
Then, in Step 2, we finally pay the expense in cash, which changes the BS and CFS as follows:
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Large companies are constantly recording expenses for products/services but paying them
later, which means that Accounts Payable is always changing.
Accrued Expenses is similar, but companies tend to use it for regular, recurring expenses that
lack specific invoices, such as utilities, rent, employee wages, insurance premiums, and so on.
Prepaid Expenses
Year 2 is still looking quite similar to Year 1, and our business insurance company decides to
offer us a deal.
They’ll give us a discount on insurance premiums if we pay for the entire year upfront, at the
start of Year 2, rather than making a separate payment each month.
Insurance for the year normally costs $25K, but if we pay it 100% upfront in cash, we can get a
20% discount and pay only $20K for the entire year.
So, we pay for this service upfront in cash, but we will not receive the entire service right away
– only by the end of the year!
This will create a "Prepaid Expense," which will result in a temporary difference between Net
Income and Cash Flow Generated.
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This insurance expense normally shows up in General & Administrative, so here’s Step 1:
Cash Flow Generated decreases by $20K and is $20K lower than Net Income because of the
$20K upfront payment. In Step 2, we receive the service and recognize the expense:
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In this step, the “Prepaid Expenses” line item decreases, and Cash Flow Generated decreases by
$15K because of this new expense, which we finally pay in cash.
It’s a $15K decrease rather than a $20K decrease because Income Taxes also fall by $5K, saving
us money.
Deferred Revenue
Around this time, we get another idea: we’ll launch a new course but ask customers to pay for
it in advance.
We’ll then deliver it to customers when it’s ready.
We think we can pre-sell $50K worth of courses based on our traffic, so we’ll collect that $50K
upfront in cash and then deliver the product later.
This policy will create Deferred Revenue, which will result in a temporary difference between
Net Income and Cash Flow Generated.
Deferred Revenue is a Liability because it’s an obligation to deliver the product in the future.
We’ve already collected the cash, so we get no future benefits – just future expenses.
In Step 1, we record the $50K cash inflow, but nothing on the Income Statement changes since
there has been no delivery to customers:
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Cash Flow Generated is up by $50K, and it now exceeds Net Income. On the Balance Sheet,
Cash is up by $50K, and so is Deferred Revenue on the other side.
When we deliver the courses to the customers who pre-ordered them, we finally record $50K in
additional Revenue on the Income Statement:
Cash is still up from beginning to end because we’ve recorded $50K in additional Revenue. But
it’s up by less than before because Income Taxes are now up by $12.5K.
In real life, there would likely be other expenses associated with this delivery as well, but we
ignored additional COGS and OpEx here for simplicity.
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Inventory
Next, we decide to expand the business by selling physical versions of the courses: books,
printed guides, and so on.
To do that, we need to buy the supplies and raw materials for these products before we sell
them.
Even though we have to pay for these supplies in cash, we cannot list them as expenses on
the Income Statement until we deliver the products and record the Revenue for them.
This will create "Inventory," which will result in a temporary difference between Net Income
and Cash Flow Generated.
It will cost $60K to purchase all the supplies for these products, and we’ll be able to sell them
for $100K once they’re ready.
Inventory is linked to Cost of Goods Sold (COGS), and we can record an increase in COGS on the
Income Statement only when we deliver the finished products to customers.
Here’s Step 1, which has no changes on the Income Statement due to the lack of delivery:
Cash Flow Generated is down by $60K due to this upfront cash purchase of Inventory.
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In Step 2, we record $100K in additional Revenue as we sell and deliver the products and $60K
in additional COGS, as Inventory decreases by $60K:
Cash Flow Generated is up by $30K here because we earned $40K in additional Pre-Tax
Income, which is a $30K in Net Income, assuming a 25% tax rate.
Why Do We Need the Three Financial Statements?
So far, we've been assuming that when each change takes place, it reverses within a year (e.g.,
purchase Inventory, turn it into finished products, and sell/deliver them).
But in real life, companies are constantly performing these activities, so Cash Flow Generated
over an entire ear could be very different from Net Income!
For example, what if this company's Accounts Receivables and Inventory both increase as it
sells to bigger customers and sells more physical products?
Or what if its Deferred Revenue and Accounts Payable both increase as it pre-sells more courses
and waits to pay service providers?
Here’s what the Net Income vs. “Cash Flow Generated” picture might look like with many
changes that have not yet reversed by the end of the year:
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At this stage, we can no longer track
just Cash and Equity and 1-2 other
line items.
We need the full financial
statements – the Income Statement,
Balance Sheet, and Cash Flow
Statement – to track everything.
Our simple Cash Flow Statement is
shown above, and we went over the Income Statement at the start of this section.
Positive adjustments on the Cash Flow Statement increase “Cash Flow Generated” relative to
Net Income.
Negative adjustment means the opposite: the company has generated less cash than its Net
Income suggests.
This is our simple Balance Sheet with the changes shown above:
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We need this “Balance Sheet” because of items like Accounts Receivable, Inventory, and
Prepaid Expenses – items that represent timing differences between Net Income and Cash
Generated.
“Cash” is like the cash in your bank account; Accounts Receivable tracks the payments we’re
owed; Prepaid Expenses tracks what we’ve paid in advance but have not yet received; and
Inventory tracks goods we’ve ordered but haven’t yet delivered to customers.
On the other side, Accounts Payable and Accrued Expense track what we owe to other vendors.
Deferred Revenue tracks cash we’ve collected upfront for products and services that we have
not yet delivered; it’s our obligation to deliver them in the future, so it’s a Liability.
And “Equity” represents the initial amount we contributed to start the business, plus
cumulative after-tax profits that we’ve saved up over time.
Items like Cash, Accounts Receivable, and Prepaid Expenses are Assets because they will deliver
a future benefit. For example, that Accounts Receivable balance of $30K means that we should
expect $30K in cash from customers in the future.
Items like Accounts Payable and Accrued Expenses are Liabilities because they represent a
future obligation. For example, the $20K Accounts Payable balance means that we’ll have to
pay $20K in cash for owed expenses in the future.
You can think of Equity as a funding source for the business that will NOT result in future cash
costs. It includes money contributed by the owners, money raised by selling ownership in the
business, and the company’s cumulative after-tax profits over time.
Return to Top.
Key Rule #2: CapEx, Depreciation, and Long-Term Business Funding
The section above explains why the three financial statements – the Income Statement,
Balance Sheet, and Cash Flow Statement – are necessary: short-term timing differences.
But many longer-term items could also affect Net Income and Cash Flow.
“Longer-term” means that these items exist on the Balance Sheet for more than one year.
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The most important such items include Property, Plants & Equipment (PP&E) and long-term
business funding in the form of Debt, Equity, and Preferred Stock:
PP&E, Capital Expenditures, and Depreciation
Let’s say our company now wants to buy an office, furniture, or equipment such as computers
and monitors for employees.
Since these items are all useful for “the long term” – more than one year – we record them as
“Capital Expenditures.”
The initial spending does not correspond 100% to the current period, so it does not appear on
the Income Statement.
Instead, we record Capital Expenditures only on the Cash Flow Statement initially, and then we
allocate their cost on the Income Statement over time.
For example, if we spend $400K on new equipment at the end of Year 1, here are the changes:
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Cash decreases by $400K on the Assets side, and Net PP&E increases by $400K, so the Balance
Sheet remains in balance.
Then, to allocate that initial expense over time, we divide by its “Useful Life” (the number of
years these items are expected to last) and record it as Depreciation on the Income Statement.
If the Useful Life is 5 years, Depreciation = $400K / 5 = $80K per year.
Since we purchased this equipment at the
end of Year 1, the Depreciation will begin
in Year 2.
The Income Statement is shown on the
left: the $80K of Depreciation reduces PreTax Income by $80K.
At a 25% tax rate, Net Income is down by
$60K.
However, Depreciation is also a “noncash expense,” so we need to add it back
on the Cash Flow Statement.
It’s a non-cash expense in Year 2 because
we spent the cash on the CapEx in Year 1.
No cash spending took place in Year 2!
Yes, we’re recording this expense in Year 2, but it corresponds to cash spending from Year 1.
Here’s what Years 1 and 2 look like on the Balance Sheet and Cash Flow Statement:
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After initially falling by $400K to $900K, the Cash balance increases by $20K, reaching $920K
due to the tax savings from the $80K of Depreciation.
We can list the $80K on the Income Statement, but all it does is reduce Income Taxes by $20K,
which boosts Cash by $20K.
Net PP&E decreases by $80K, and on the other side, Equity is down by $60K because of the
reduced Net Income.
Capital Expenditures initially reduce Cash Flow (as shown above).
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.
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In real life, companies often embed Depreciation within other line items, such as COGS or
SG&A, so you should always look at the Cash Flow Statement to get the all-inclusive number.
Issuing Debt and Paying Interest On It
We mentioned in the “Core Concepts” guide that companies have two basic options for raising
money to operate and expand their businesses: Debt and Equity.
Companies often decide to issue Debt or Equity when they have to purchase a large, expensive
item that they cannot afford with their Cash balances.
When a company issues Debt, the Debt will last for many years – so the issuance does not
appear on the Income Statement.
Instead, we record the initial cash inflow from the Debt on the Cash Flow Statement under Cash
Flow from Financing, which increases the Debt line item on the Balance Sheet:
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Similarly, when a company repays Debt principal – the outstanding balance – that also shows
up only on the Cash Flow Statement.
The downside of issuing Debt is that companies must pay interest on it (similar to paying
interest on car loans or student loans).
Since the Debt issuance shown above happens at the end of Year 1, there is no Interest Expense
in Year 1.
The Interest Expense starts in Year 2, and if we assume a 4% interest rate on the Debt, it looks
like this:
Pre-Tax Income falls by $4, and Net Income falls by $3 at a 25% tax rate.
If we also assume there’s a $10 Debt Principal Repayment in Year 2, the Balance Sheet and Cash
Flow Statement look like this:
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The initial Debt issuance always boosts the company’s Cash balance, but Cash will decline over
time as the company pays more in Interest Expense and repays the Debt principal.
Issuing Equity and Paying Common Shareholders
When a company issues Equity, on the other hand, it appears as a simple cash inflow on the
Cash Flow Statement, and nothing ever shows up on the Income Statement.
Unlike Debt, Equity does not have any “required” cash payments like the Interest Expense.
However, the company also sells part of itself to outsiders.
So, raising Equity still “costs” the company something; it’s just that it’s not a direct cash cost like
the Interest Expense on Debt is.
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For example, perhaps one investor group owns 50% of the company. But then the company
raises Equity from new investors, so that group’s ownership falls to 45%.
They get “diluted,” which means:
1) They’ll receive less in cash proceeds if the company decides to pay its shareholders.
2) And if the company ever sells itself, they’ll also receive less from the sale.
Here’s Step 1 of the Equity Issuance process (no changes on the Income Statement):
Cash increases, and Equity on the Liabilities & Equity side increases to match the change.
In Step 2, the company might decide to issue Dividends or repurchase Stock.
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Dividends are cash payments made to shareholders, and they may be based on the company’s
Net Income, Share Price, or a figure such as $0.05 per share.
Dividends correspond to the current period, but they’re not on the IS because they do not
reduce the income available to common shareholders.
Instead, they are distributed out of that income, and they appear on the Cash Flow Statement
within Cash Flow from Financing.
With Stock Repurchases, the company offers to repurchase shares from existing investors at an
agreed-upon price, which is usually a premium to their original purchase price. Mechanically,
they’re very similar to Dividends:
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Both Dividends and Stock Repurchases are cash outflows on the CFS and reduce Cash and
Equity on the Balance Sheet.
The difference is that Stock Repurchases, unlike Dividends, they reduce the company’s Share
Count.
We repurchase $30K of Common Shares at a Share Price of $1.00 each, so the Common Shares
Outstanding falls by 30K, going from 1,100K to 1,070K.
The $55K of Common Dividends and the $30K of Stock Purchases together reduce the Equity
line item by $85K.
Issuing Preferred Stock and Paying Preferred Stockholders
In addition to standard Debt and Equity, an option “in the middle” is Preferred Stock, also
known as Preferred Equity.
Despite the name, it’s much closer to Debt than Equity because it carries a fixed coupon rate for
a “Preferred Dividend,” which appears as an expense on the Income Statement.
Also, issuing and repaying Preferred Stock does not affect the company’s Common Share Count
or existing investors’ ownership percentages.
Preferred Stock tends to be more expensive than Debt, but cheaper than Common Equity
because Preferred Coupon Rates tend to be higher than Interest Rates on Debt, but lower than
average annualized returns on stocks.
Also, unlike the Interest Expense on Debt, Preferred Dividends are not tax-deductible!
For these reasons, very few companies use Preferred Stock in real life.
Companies tend to use it only when lenders refuse to buy additional Debt issuances from them,
and Equity issuances are also not feasible.
As with Debt and Equity, issuances and repayments of Preferred Stock show up only on the
Cash Flow Statement.
Preferred Dividends appear on the Income Statement and are deducted from Net Income to
create Net Income to Common.
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They correspond 100% to the current period and, unlike Common Dividends, Preferred
Dividends do reduce the income available to the common shareholders:
Be careful about the treatment for Preferred Dividends – unlike what you might think, they
reduce Common Shareholders’ Equity!
Preferred Dividends reduce the income available to common shareholders because Preferred
investors get paid first, before the Common Equity investors. And any Preferred Dividends
reduce the amount of cash available for Common Dividends.
Return to Top.
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Key Rule #3: Operating Leases and Finance Leases
Besides PP&E and Debt, Equity, and Preferred Stock funding, companies can have other, longerterm items on their Balance Sheet as well.
One of the most common examples is the Operating Lease and its closely related cousin, the
Finance Lease (also called a “Capital Lease”).
For many decades, Operating Leases were not shown on companies’ Balance Sheets.
But the rules changed in 2019, and under both U.S. GAAP and IFRS (international accounting
rules), Operating Leases now appear as Liabilities, with their corresponding Assets (“Right-ofUse Assets” or “Operating Lease Assets”) on the other side of the Balance Sheet.
An “Operating Lease” refers to a standard rental contract where the company pays $X per year
to use office space, equipment, or other tools required to run its business.
There is no element of ownership, there are no bargain purchase options, and at the end of the
lease, the company returns the asset to its owners or rents it again.
Unfortunately, the Lease Expense itself is recognized differently under U.S. GAAP and IFRS, so
we’ll start with the U.S. GAAP treatment and then explain how the IFRS one differs.
When a company signs an Operating Lease, it records an Asset and Liability for that lease based
on the Present Value expected future rental payments.
For example, if it’s a 10-year lease for $20K per year, and the appropriate Discount Rate is 6%,
the Lease Liability might be $150K:
If the company signs this Lease at the end of Year 1 and pays the first $20K Rental Expense in
Year 2, here’s what it looks like under U.S. GAAP:
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In Year 1, the Operating Lease Assets and Operating Lease Liabilities both increase by $150K.
Then, in Year 2, the $20K Rental Expense appears on the Income Statement, which reduces
Operating Income and Pre-Tax Income by $20K.
Net Income falls by $15K at a 25% tax rate, so Cash on the Balance Sheet falls from $1,300K to
$1,285K.
Under U.S. GAAP, the Operating Lease Assets and Liabilities themselves DO NOT change in
this step – they change only when new leases are signed and when existing leases expire.
If a company signs a Finance Lease for the same property instead, it might still cost the
company $20K per year for 10 years.
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But in Finance Leases, there’s an “ownership transfer” option at the end, a “bargain
purchase” option, or something else that grants the benefits and risks of ownership.
Various criteria exist to categorize Leases; for example, if the Lease’s life exceeds 75% of the
Asset’s useful life, or if the PV of Lease Payments exceeds 90% of the Asset’s Fair Market Value,
it might be classified as a Finance Lease.
Like Operating Leases, Finance Leases also go directly on the Balance Sheet on both sides.
The difference is that the company records Interest on the Finance Lease and Depreciation on
the Leased Asset, along with a “Lease Principal Repayment” or “Repayment of the Capital
Element” in Cash Flow from Financing.
Rent for a single Operating Lease and (Interest + Depreciation) for a single Finance Lease, both
for the same Asset, will be similar, but not the same.
(Interest + Depreciation) on Finance Leases tends to start higher and end lower because the
Interest is based on the Lease Liability, which decreases each year.
Here’s an example of Finance Lease accounting, with the following assumptions:
•
•
•
•
New Lease Assets and Liabilities $150K
Annual Rent: $20K
Interest Rate on Finance Leases: 6%
Depreciation Period on New Assets: 10 Years
With these numbers, the initial Interest Expense is 6% * $150K = $9K, and the initial
Depreciation is $150K / 10 = $15K.
Here are the statements:
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The Interest and Depreciation reduce Pre-Tax Income by $24K on the Income Statement, so Net
Income falls by $18K.
On the CFS in Year 2, the Net Change in Cash is down by $18K because we add back the
Depreciation and then subtract the same amount in the “Repay Finance Leases” line.
On the Balance Sheet, this $150K in new Leased Assets, which shows up in Net PP&E, decreases
to $135K from the Year 2 Depreciation.
And on the other side, the Finance Leases decrease to $135K in Year 2, as a result of the “Repay
Finance Leases” line item on the CFS.
This happens each year until the Leased Assets and the Finance Leases both reach $0 in Year 10.
At that point, they remain at $0 if the company lets the Lease expire. If not, they’ll both
increase to some higher number based on the value of the Renewal Lease.
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Under IFRS, Operating Leases and Finance Leases are effectively the same.
The Rental Expense on Operating Leases is split into an “Interest Element” and a “Depreciation
Element,” and both appear as expenses on the Income Statement.
Then, we add back the Depreciation on the CFS and subtract it in the “Repayment of Operating
Lease Capital Element” line in Cash Flow from Financing.
On the Balance Sheet, both the Lease Assets and Lease Liabilities decrease each year.
Here’s what it looks like under IFRS, using slightly different numbers:
The main issue is that the IFRS treatment creates comparability issues if you’re analyzing both
U.S. and non-U.S. companies in the same set.
We discuss these problems in more detail and walk through common adjustments in the guide
to Equity Value, Enterprise Value, and Valuation Multiples.
Return to Top.
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Key Rule #4: Financial Investments
If a company has a substantial Cash balance, and management has no ideas for what to do with
it, one option is to purchase Financial Investments, such as stocks, bonds, and other assets that
pay interest or dividends.
Financial Investments may be short-term or long-term, but the accounting treatment is the
same either way.
The initial purchase shows up only on the Cash Flow Statement, and the Interest Income (or
other types) appears directly on the Income Statement.
Here’s what happens with a $100 purchase in Year 1, $2 in Interest Income in Year 2, and a $50
sale of the Investments at the end of Year 2:
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The initial purchase counts as a cash outflow that reduces the Cash balance by $100, and the $2
of Interest Income ($1.5 after taxes) increases both Net Income and Cash.
The Sale of Financial Investments appears on the Cash Flow Statement as a cash inflow because
it’s related to a longer-term item.
There would be an Income Statement impact only if the company recorded a Gain or Loss on
this sale (e.g., it purchased the Investments for $100 but sold them for $110 or $90).
One of the next sections covers this topic.
Return to Top.
Key Rule #5: Deferred Taxes and Net Operating Losses (NOLs)
An expense on the Income Statement does not necessarily mean the company has paid that
expense in cash, and the same is true of taxes.
In fact, all large companies prepare two sets of financial statements: one for “Book” purposes
(shown in annual and quarterly reports) and one for “Tax” purposes (for the government).
These sets of financial statements are similar, but not the same, for several reasons:
•
Companies may use accelerated Depreciation in earlier years to reduce their tax burden
(and better reflect reality, in some cases).
•
Some expenses may not be deductible for tax purposes, even though they’re listed on
the Income Statement.
•
The company might get tax credits from certain activities, such as research &
development.
When one of these events happens, another “timing difference” line item – Deferred Taxes –
gets created.
It 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).
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We show Income Taxes on the Income Statement based on Pre-Tax Income * Tax Rate and then
adjust them on the Cash Flow Statement to reflect Cash Taxes.
However, not all companies set it up like this, and you will see variations.
Here’s a simple example to illustrate how Deferred Taxes and the Deferred Tax Liability work on
the financial statements:
In the Income Statement on the left, the company records straight-line Depreciation for $100
per year.
But for tax purposes, the company records accelerated Depreciation, shown on the right-hand
side for $150, $100, and then $50 per year.
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As a result, the company’s Cash Taxes are lower than Book Taxes by $12.5 in Year 1, they equal
Book Taxes in Year 2, and Cash Taxes are $12.5 higher than Book Taxes in Year 3.
So, the Deferred Tax Liability initially increases to $12.5, stays at $12.5 in Year 2, and then
decreases to $0 in Year 3 once the Asset is fully depreciated.
If Cash Taxes exceed Book Taxes, Deferred Taxes on the CFS are negative because the company
is paying more than what is shown on its Income Statement; if Book Taxes exceed Cash Taxes,
then Deferred Taxes are positive.
The Deferred Tax Liability (DTL) on the Balance Sheet tracks these timing differences.
It increases when Book Taxes exceed Cash Taxes because that means the company 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.
If we make the following assumptions:
•
End of Year 1: Company spends $400 on CapEx
•
Year 2 Book Depreciation: $40 (Straight-line, useful life of 10 years)
•
Year 2 Tax Depreciation: $80 (Accelerated)
Then here’s what the financial statements look like, starting with the Income Statement and
Tax Schedule:
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On the Cash Flow Statement, Net Income is lower by $30, we add back the $40 of Book
Depreciation, and we record +$10 for Deferred Income Taxes.
Without these changes, the Net Change in Cash would have been $150; with these changes, it’s
$170 instead.
Cash by $20, so it increases from $900 to $920 on the Balance Sheet. Net PP&E decreases to
$360 ($400 minus $40 of Book Depreciation), the DTL increases by $10, and CSE is down by $30
because of the reduced Net Income.
Therefore, both sides are down by $20 and balance:
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In addition to Deferred Tax Liabilities, there are also Deferred Tax Assets (DTAs), which
represent potential future tax savings.
Deferred Tax Assets can include many items, but the most important one for financial modeling
and valuation purposes is the Net Operating Loss (NOL).
If a company has lost money (i.e., negative Pre-Tax Income) in previous years, it can reduce its
Cash Taxes in the future by applying these losses to reduce its Taxable Income.
For example, consider a company that has had negative Pre-Tax Income in the past two years.
It accumulates a “Net Operating Loss” balance of $100, which it can then use to reduce its
Taxable Income if its Taxable Income ever turns positive.
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If this company then earns negative Pre-Tax Income again, it will once again accumulate a Net
Operating Loss. Here’s a simple example:
The Deferred Tax Asset decreases when the company uses NOLs, and it increases when the
company accumulates NOLs due to negative Pre-Tax Income.
If the DTA decreases, the company’s cash flow increases because it’s using the NOL to reduce
its taxes; if the DTA increases, cash flow decreases.
Note that Net Operating Losses are NOT the same as Deferred Tax Assets!
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.
The full NOL is an “off-Balance Sheet” line item.
One problem on the financial statements is that there are both Deferred Tax Assets and
Deferred Tax Liabilities, but only one item on the CFS – Deferred Taxes – links into them.
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We typically get around this issue by creating a single “Net Deferred Tax Asset” (Net DTA) line
item by taking the DTA and subtracting the DTL (or Net DTL = DTL – DTA).
Here’s what the statements look like if the company experiences a loss one year, followed by an
application of NOLs the next year:
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On the Balance Sheet and Cash Flow Statement, there’s a negative adjustment for Deferred
Taxes in Year 1 and a positive one in Year 2, so the Net DTA increases and then decreases:
We introduce Deferred Taxes here because they’ll come up in the next few key rules, which
relate to Income Statement expenses that may not be deductible for Cash-Tax purposes.
Return to Top.
Key Rule #6: Gains, Losses, Impairments, and Write-Downs
In addition to raising funds via Debt and Equity, companies can also get Cash by selling Assets.
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For example, if a company has stock-market investments or physical equipment it doesn’t need,
and it wants extra Cash, it could sell those Assets.
To illustrate the simplest case, let’s assume that a company spent $400 on CapEx at the end of
Year 1, which boosted its Net PP&E balance to $400.
Then, it decides to sell $100 of that PP&E at the end of Year 2 to get extra Cash.
If it purchased this PP&E for $100 and it sells this same PP&E for $100, and we ignore
Depreciation for simplicity, here’s what it looks like on the statements:
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Nothing changes on the Income Statement because these Assets are longer-term in nature,
and the purchase and sale of PP&E do not affect income available to common shareholders.
Cash initially falls by $400, and Net PP&E increases by $400. Then, when the sale is completed,
the $100 of proceeds show up on the Cash Flow Statement, and Cash increases by $100 while
Net PP&E falls by $100.
On the other hand, if the company sells this $100 of PP&E for some amount that is not $100,
then it must record a Gain or Loss on the Income Statement.
If the company sells this PP&E for less than its Book Value – its value on the Balance Sheet – it
will record a Loss. If it sells this item for more than its Book Value, it will record a Gain.
For example, if the company sells this PP&E for $180, it will record a Gain of $80 on the Income
Statement (since it relates to an action or event in this current period only):
The Cash Flow Statement and Balance Sheet are more complex:
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Net Income is up by $60, but we reverse the Gain or Loss, which means subtracting the $80
Gain here.
In Cash Flow from Investing, though, we show the FULL proceeds from the sale, including the
Gain or Loss, which means +$180 here.
On the Balance Sheet, Cash is up by $160, and Net PP&E is down by $100. On the L&E side, CSE
is up by $60 due to the increased Net Income, so both sides are up by $60 and balance.
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We reverse the Gain or Loss on the CFS because, for example, if it’s a Loss, we don’t literally
“lose money” in Year 2.
We still get Cash from the sale of the PP&E; it’s just that we lose money over the course of Years
1 through 2.
You can also think of it as “re-classifying” the Gains and Losses out of CFO and into CFI because
they're not operational; they’re related to investing in long-term Assets.
Cash always increases from the sale of Assets such as PP&E. The exact amount depends on
whether there’s a Gain, Loss, or nothing at all:
Change in Cash = Book Value of PP&E Sold + Gain * (1 – Tax Rate) – Loss * (1 – Tax Rate).
Recording Gains and Losses on a company’s Income Statement is similar to individuals paying
taxes on capital gains and deducting capital losses when they sell stocks.
Besides selling an Asset such as PP&E for a different price, a company could also write down or
impair that Asset.
Continuing with this example of a company spending $400K on CapEx in Year 1, perhaps there
is a natural disaster at the end of Year 2 that breaks some of the equipment – or its value
changes due to new business requirements or regulations.
When Assets like this turn out to be worth less than expected, companies record write-downs
or impairment charges to reflect the change in value.
Technically, they can occur with any Asset – Inventory, Net PP&E, Financial Investments,
Accounts Receivable, Goodwill, etc. – but they are most common with Goodwill and Net PP&E.
From an accounting perspective, write-down and impairments are similar to depreciation: they
are non-cash expenses that reduce Pre-Tax Income and Net Income and then get added back on
the Cash Flow Statement, reducing the corresponding Asset.
The key difference is that unlike Depreciation, Impairments and Write-Downs are often NOT
deductible for Cash-Tax purposes.
That’s because they are not regular, predictable events; they happen infrequently, and
governments don’t want companies to manipulate their way into tax savings whenever
something unexpected happens.
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Here’s what a $100 PP&E Write-Down, along with $40 of Depreciation in the same year, looks
like, starting with the Income Statement:
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And here are the Balance Sheet and Cash Flow Statement:
We add back the PP&E Write-Down on the CFS, but we also record ($25) in Deferred Income
Taxes to represent the lack of Cash-Tax savings from this change.
Cash at the bottom is up by $10 because of the tax savings from the Depreciation.
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On the Balance Sheet, Cash is up by $10, Net PP&E is down by $140 ($100 Write-Down + $40
Depreciation), and the Net DTA is up by $25, so Total Assets are down by $105 and are listed at
$1,195 rather than $1,300.
On the other side, Common Shareholders’ Equity is also down by $105 due to the reduced Net
Income, so both sides are down by $105 and balance.
In an interview, you could skip the Deferred Income Tax changes and just say that “Cash
increase by $25” because of “Tax savings from the Write-Down.”
However, it’s not that much harder to give the correct explanation. The only difference on the
Balance Sheet is that the DTA, rather than Cash, increases.
You don’t even need a “Tax Schedule” to do this. Just think intuitively: If Taxes decrease by $25,
should they have decreased by $25?
If the expense that explains that decrease is not Cash-Tax deductible, then the Deferred Tax
Asset, rather than Cash, must increase.
Return to Top.
Key Rule #7: Stock-Based Compensation
Companies can pay their employees with salaries, bonuses, and benefits, and they can also pay
employees with stock and stock options.
For example, if an employee earns $100K per year, the company might decide to offer $70K in
base salary and pay the remaining $30K in stock, which grants the employee a small percentage
of ownership in the company.
This strategy helps the company because it reduces cash operating expenses, and it incentivizes
employees to stay for the long term.
If the company performs well, this Stock-Based Compensation is also a win for the employee
because that $30K could rise significantly in value (note the “if” and “could” here).
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Stock-Based Compensation is an Income Statement expense that reduces a company’s Pre-Tax
Income and Net Income, but like Depreciation, it is a non-cash expense that’s added back on
the Cash Flow Statement.
Similar to Impairments and Write-Downs, Stock-Based Compensation is not deductible for
Cash-Tax purposes when it is first issued to employees.
It only becomes deductible later on, once employees exercise their options and receive their
shares – and since the timing is unpredictable, models often skip this second step.
Finally, unlike other non-cash expenses, Stock-Based Compensation (SBC) creates additional
shares outstanding.
If the company issues options to employees, which give them the right, but not the obligation,
to pay money for new shares in the future, those new shares won’t be created right away.
But the potential is always there, and the company’s “diluted share count” (a metric that
includes both actual shares and one that may be created from sources like employee stock
options) increases.
Since Stock-Based Compensation changes a company’s share count, you treat it differently from
“true” non-cash expenses such as Depreciation.
Issuing SBC reduces the company’s value to existing investors, so in valuations, you often count
it as a normal cash expense.
(For more on these points, please see the guides to Equity Value, Enterprise Value, and
Valuation Multiples, and Valuation and DCF Analysis.)
Here’s what $100 of SBC looks like, starting with the Income Statement:
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As with all non-cash expenses, SBC is added back on the Cash Flow Statement and links into the
matching Balance Sheet line item (Common Shareholders’ Equity).
If you pretend that SBC results in Cash-Tax savings, Cash increases by $25; if you use the correct
tax treatment, the Net DTA increases by $25:
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The initial issuance of SBC does not affect the Cash balance, and it increases the company’s
share count. These are major differences vs. standard non-cash expenses, such as Depreciation.
Return to Top.
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Key Rule #8: Goodwill and Other Intangible Assets from M&A Deals
If a company wants to grow, one option is to acquire other assets or companies.
The basic accounting for acquisitions is not that complicated: we combine the financial
statements of both companies and make a few adjustments.
For example, if the Acquirer uses Cash to make the acquisition, we reduce its Cash balance.
If it raises Debt, we increase the Debt balance, and if it issues Stock, we increase Common
Shareholders’ Equity.
We also wipe out or “write down” the Target’s Common Shareholders’ Equity since it no longer
exists as an independent entity.
Combining items like Revenue, Operating Expenses, and Accounts Receivable is simple (add the
Acquirer’s item and the Target’s item for each one).
The rules get trickier when the Acquirer pays a purchase price that’s different from the
Target’s Common Shareholders’ Equity.
In that case, there will be a “mismatch” that causes the Combined Balance Sheet to go out of
balance.
In real life, this happens in ~99% of mergers and acquisitions because companies are rarely
worth exactly what their Balance Sheets indicate.
For example, consider the scenario below, where the Target’s Common Shareholders’ Equity is
$150, and the Equity Purchase Price is $200.
If we reduce Cash by $200 and also write down the Target’s CSE when combining the Balance
Sheets, we run into a problem:
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To “plug the gap” and make the Balance Sheet balance, we create several new Assets:
•
Other Intangible Assets: This line item corresponds to identifiable assets, such as
contracts, patents, trademarks, customer relationships, and brand value.
•
Goodwill: This one corresponds to the remainder of the "gap" – anything that cannot be
linked to a concrete item, but which is part of the premium the Acquirer pays.
Normally, we make Other Intangible Assets a percentage of this Purchase Premium, and the
rest of the Purchase Premium goes into Goodwill:
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With these new Assets, the Combined Balance Sheet now balances correctly:
Other Intangible Assets amortize over time, just like how PP&E depreciates over time.
(Advanced Note: There are also “Indefinite-Lived Intangibles” that do not, but most Intangible
Assets amortize.)
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But Goodwill does not amortize! Instead, the company reviews it each year and records an
Impairment or Write-Down if its value has declined.
The Amortization of Intangible Assets and Goodwill Impairments and Write-Downs are typically
not deductible for Cash-Tax purposes.
Let’s start by looking at a simple scenario: a $200K acquisition in Year 1, with $140K of Acquired
Assets, $40K in Goodwill, and $20K in Other Intangible Assets:
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Cash is down by $200K, but Other Intangible Assets, Goodwill, and Assets from Acquisitions
increase by a total of $200K, so Total Assets stays the same.
Then, if we amortize $4 of the Other Intangibles (i.e., a 5-year amortization period) and record a
$20 Goodwill Impairment in Year 2:
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And then on the Balance Sheet and Cash Flow Statement:
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The most important point is that Cash does not change from just the Amortization of
Intangibles or Goodwill Impairment.
It changes only if you simplify, ignore Deferred Taxes, and say that Amortization and Goodwill
Impairment “reduce the company’s taxes.”
This specific scenario is a bit unrealistic because we haven’t recorded the additional Revenue
and Expenses from this acquired company.
Once you include them, the Cash balance will change because Net Income will be different.
This section is an introduction to the topic, so we’re not covering that scenario here, but some
of the multi-step interview questions explain the steps.
Return to Top.
Key Rule #9: U.S. GAAP vs. IFRS
There are two main accounting systems worldwide: U.S. GAAP (“Generally Accepted
Accounting Principles”) and IFRS (“International Financial Reporting Standard”).
Throughout this guide, we have been using the U.S. GAAP treatment for the financial
statements because these standards are not dramatically different.
Under both systems, the Income Statement, Balance Sheet, and Cash Flow Statement still exist;
Revenue is still recorded when the product/service is delivered, there are still Capital
Expenditures and PP&E and Depreciation, and so on.
The main differences are as follows:
1) Income Statement and Balance Sheet – The names of a few items might be different;
for example, U.K.-based companies often call Revenue “Turnover,” and the Balance
Sheet might be the “Statement of Financial Position.”
2) Cash Flow Statement – IFRS-based companies often start the CFS with Operating
Income or Pre-Tax Income rather than Net Income, or they use the Direct Method to
create the CFS. In other words, they show actual cash outflows and inflows rather than
starting with Net Income and adjusting it (the “Indirect Method”).
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3) Location of Items – IFRS-based companies often place items on the Cash Flow
Statement in more “random” locations, so you’ll see Dividends, Interest, and Taxes in
Cash Flow from Operations… or Cash Flow from Financing… or maybe even Cash Flow
from Investing.
4) Operating Leases – As you learned in the section on leases, the Operating Lease
expense is split into Interest and Depreciation elements under IFRS, but it’s a simple
Rental Expense within Operating Expenses under U.S. GAAP.
Here’s an example of a Cash Flow Statement for an IFRS-based company (EasyJet):
This statement is quite problematic.
First off, it’s impossible to link this to the
Balance Sheet since changes to items like
Accounts Receivable and Accounts Payable
are not shown.
Second, “Cash Generated from Operations”
doesn’t match anything on the Income
Statement.
Third, Dividends are listed in Cash Flow from
Operating Activities.
Fourth, it’s not ideal to show changes to
items like Money-Market Deposits and
Restricted Cash on the CFS; they should be
part of “Cash” on the Balance Sheet.
Finally, Net Interest and Taxes should appear
on the IS and then be adjusted on the CFS.
When you encounter this type of Cash Flow
Statement, you need to find a reconciliation
between “Cash Generated from Operations”
and Net Income or Operating Income, and
then modify the Cash Flow Statement.
Here’s an example for EasyJet:
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The company is still doing things
a bit differently because these
items are based on adjustments
to Operating Income, not Net
Income, but it’s good enough.
They’re giving us the non-cash
adjustments and changes in
operational Balance Sheet items,
which are all we need.
One remaining issue is that the
Interest Income, Interest
Expense, and Taxes on the Cash
Flow Statement do not match
those on the Income Statement.
This happens because portions of
these items on the Income
Statement may be non-cash, and
in some cases, the cash paid by the company may exceed the expenses shown on the Income
Statement.
You’ve already seen this with Deferred Taxes and the required adjustments there, but the same
thing can happen with Interest Income and Interest Expense as well.
So, we’ll record these differences in the Deferred Taxes line item and an “Other Adjustments”
line for everything else.
Here’s the revised Cash Flow Statement:
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This version is much easier to work with because it starts with Net Income.
Then, it makes the standard non-cash adjustments, including the Depreciation and
Amortization add-backs and Deferred Income Taxes.
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Next, it shows the changes in the operational Balance Sheet items, like Accounts Receivable and
Accounts Payable.
We moved the Dividends down to Cash Flow from Financing and removed the Money-Market
Deposits and Restricted Cash items, so they’re part of the “Net Change in Cash” instead.
We always make these adjustments when working with IFRS-based companies, or others
whose Cash Flow Statements do not start with Net Income.
All the remaining sections of this guide and the interview questions and answers follow this
treatment as well.
Return to Top.
Key Rule #10: Summary of the Three Financial Statements
The Income Statement shows a company’s revenue, expenses, and taxes over a period of time
(one quarter, one month, one year, etc.).
It starts with Net Sales at the top (AKA Revenue, Turnover, etc.) and goes all the way down to
after-tax profits, or Net Income (to Common), at the bottom.
To appear on the Income Statement, each item must meet the following criteria:
1. It must correspond ONLY to the period shown on the Income Statement. If a company
pays for an Asset that lasts for 10-20 years, the initial money spent does not appear on a
1-year Income Statement. But the rent for that one year does appear. This rule explains
why items like CapEx, Stock Issuances, Debt Issuances, etc., do not appear on the IS.
2. It must affect the business income available to common shareholders (Net Income to
Common). This rule explains why items like Preferred Dividends and Interest Expense do
appear on the Income Statement: Debt and Preferred Stock Investors get paid first,
which reduces the income available to the common shareholders.
Plenty of non-cash items, such as Depreciation, Amortization, and Stock-Based Compensation,
appear on the Income Statement because they meet the requirements above.
Even an item like Revenue may be “non-cash” if it corresponds to products/services that the
company has delivered but not yet collected in cash.
Therefore, the cash vs. non-cash distinction is irrelevant.
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The screenshot on the right demonstrates
common items on the Income Statement:
Revenue and Cost of Goods Sold (COGS):
Revenue is the total value of the
products/services that a company delivers
in the period, and COGS represents the
expenses that are linked directly to the
delivery of those products/services.
Operating Expenses: These include costs
that are not directly linked to individual
products sold, such as employee salaries,
rent, sales and marketing, and research
and development.
Depreciation and Amortization (D&A):
These are non-cash expenses that
represent the allocation of capital
purchases, such as spending on factories,
equipment, patents, or anything else that
will be useful for more than one year.
Since these items last for many years, we
allocate the initial amount spent over
many years on the Income Statement.
In real life, Depreciation and Amortization are often embedded within COGS or Operating
Expenses. We show them separately for clarity, but they’ll rarely be 100% separate in real life.
When D&A or other non-cash expenses are embedded within other line items, you have to look
at the Cash Flow Statement to get the all-inclusive number.
Stock-Based Compensation: This represents the cost of paying employees with stock or stock
options rather than cash salaries, benefits, and bonuses. Companies estimate the value of these
awards and then record their estimates on the Income Statement when initially granted.
Like D&A, this is rarely shown separately in real life; it’s usually embedded within Operating
Expenses.
Other Income and Expenses: Items such as Interest Income, Interest Expense, Gains and
Losses, Write-Downs, and Impairments show up here.
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If a company has “side activities” that aren’t part of its core business, income from those
activities also appears here.
Everything in this section corresponds 100% to activities in the current period, but these
items are NOT part of the company’s core business of selling and delivering its products and
services.
Some of these items, such as Gains and Losses, Write-Downs, and Impairments, are non-cash as
well.
Taxes and Net Income: Net Income (to
Common) represents the company’s
“bottom line” – how much it earned in
after-tax profits.
Taxes on the Income Statement are “Book
Taxes,” which means they do not
represent the company’s exact cash
payments to the government.
If Book Taxes and Cash Taxes both have
negative signs, then Cash Taxes = Book
Taxes + Deferred Taxes on the CFS.
For example, if Book Taxes are ($100) and
Deferred Taxes are +$40, the company
paid $40 less in Cash Taxes, so Cash Taxes
= ($100) + $40 = ($60).
Many items arising from acquisitions or one-time events are not fully deductible for Cash-Tax
purposes; the most common ones are shown above.
Balance Sheet Overview
The Balance Sheet shows the company’s resources – its Assets – and how it paid for those
resources – its Liabilities & Equity – on a specific date.
The Income Statement shows revenue and expenses from January 1, 20XX to December 31,
20XX, but the Balance Sheet only shows the company's resources ON January 1, 20XX or ON
December 31, 20XX.
Assets must always equal Liabilities + Equity – if the Balance Sheet does not balance, it's
wrong.
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For example, if a company has $50K in Cash and $450K in PP&E, its L&E side must also equal
$500K. So, maybe it has $300K of Equity and $200K of Debt, or $500K of Equity and $0 of Debt,
or anything else that results in a total of $500K.
An Asset is something that will result in a future benefit for the company, such as additional
cash flow (e.g., Accounts Receivable), the ability to grow the business (e.g., Net PP&E), or a
higher valuation due to intellectual property, brand names, or customer relationships (e.g.,
Other Intangible Assets).
“Future benefit” could even mean reducing future cash flows (e.g., Deferred Tax Assets).
Companies typically split Assets into “Current” or “Short-Term” (anything that lasts for less than
a year) and “Non-Current” or “Long-Term” (anything that lasts for more than a year).
A Liability or Equity line item is something that will result in a future obligation for the
company, such as a cash payment (Accounts Payable), delivery of a product or service (Deferred
Revenue), or cash interest payments and a final, large repayment to an external party (Debt).
Again, companies typically split these into “Current” or “Short-Term” and “Non-Current” or
“Long-Term.”
Liabilities usually involve external parties – lenders, suppliers, or the government – while Equity
line items are more related to the company’s internal operations.
Both Liabilities and Equity act as funding sources for the company’s resources (Assets), but
Equity line items do not result in direct, predictable cash outflows in quite the same way as
Liabilities.
For example, Debt, a Liability, results in real cash expenses due to the annual interest expense
and the final repayment upon maturity.
But if a company issues Equity via a common stock issuance, it doesn’t “have to” pay anything
in cash to the new shareholders who just bought the stock.
The company could issue Dividends to them in the future, and if the company sells itself, its
earlier investors will own less and, therefore, receive a lower percentage of the proceeds.
But these are not “direct cash costs” in the same way the ones associated with Liabilities are.
Here’s the Balance Sheet that we built up to in this course:
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We’re not going to redefine every single item here – if you’re not sure what these mean, please
refer to the previous sections on Working Capital, CapEx and Depreciation, and Leases.
One final note: we typically show Common Shareholders’ Equity in one single line rather than
splitting it up into components, as most companies do in their statements.
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We use this approach because showing the separate components makes no difference in
modeling and valuation.
If you want to know the individual components, however, here’s a summary:
•
Common Stock – This is used for the "par value" of shares issued times the number of
shares issued over time. For example, if the company has issued 1,000 shares total at a
par value of $1.00 each, Common Stock will be 1,000 * $1.00 = $1,000.
•
Additional Paid-In Capital (APIC) – This is used for (Market Value – Par Value) of shares
issued, times the number of shares in each issuance, cumulatively since the start of the
company’s existence. Following the example above, if the company issued shares once
at a market value of $10.00 per share, APIC = ($10.00 – $1.00) * 1,000 = $9,000. This
item does NOT change even if the company’s share price changes! It reflects only the
share price at the time of the stock issuance.
•
Retained Earnings – This one represents the company’s "saved-up, after-tax earnings.”
You add Net Income to Common and subtract Dividends each year.
•
Treasury Stock – This item represents the cumulative market value of shares the
company has repurchased from shareholders. Similar to APIC, the values here are based
on the share price at the time the company repurchased the shares. This value does
NOT change even if the company’s share price changes afterward.
•
Accumulated Other Comprehensive Income (AOCI) – This section is for “miscellaneous
saved-up income” – items like the effect of foreign currency exchange rate changes go
here, as well as certain hedging and translation reserves. Unrealized gains and losses on
certain security types may also flow into this line item.
Cash Flow Statement Overview
The Cash Flow Statement, like the Income Statement, shows changes over a period (one year,
one quarter, one month, etc.).
It exists for two main reasons:
1) The company may have recorded non-cash Revenue, Expenses, or Taxes on the
Income Statement. If it did, then it needs to make adjustments on the Cash Flow
Statement to reflect the actual amount of cash received or paid.
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2) There may be additional cash inflows and outflows that have NOT appeared on the
Income Statement. For example, Capital Expenditures and Dividends both impact a
company’s Cash balance, but neither one appears on the Income Statement.
Here’s the Cash Flow Statement we built, along with a summary of each section:
Cash Flow from Operations (CFO) – Starts
with Net Income (to Common) at the top,
adjusts for non-cash items, and then factors
changes in operational Balance Sheet items
change in the period.
Rough Proxy: Corresponds to Current Assets
and Current Liabilities… but not exactly since
Cash, Investments, and Debt do NOT show
up here, as they are non-operational. And
changes in Lease Assets and Liabilities (both
long-term items) may appear here!
So, it's better to think of this section as: "Net
Income, non-cash adjustments, and
operational Balance Sheet items."
If the company follows IFRS, you’ll have to
“convert” this section into one that starts
with Net Income (to Common).
Cash Flow from Investing (CFI) – Items
related to financial investments,
acquisitions, and PP&E appear here.
Purchases are negative because companies
spend cash on them, and sales are positive
because they result in more cash.
Rough Proxy: Corresponds to Long-Term
Assets… but not 100% because changes in
Lease Assets do not show up here, and
“Financial Investments” could be listed within Current Assets as well.
Cash Flow from Financing (CFF) – Items related to Debt, Dividends, and Issuing or Repurchasing
Shares show up here.
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Rough Proxy: Corresponds to Long-Term Liabilities and Equity… but this rule, again, is not
exactly true.
For example, long-term items such as Deferred Tax Liabilities are affected by adjustments in the
CFO section, not anything in CFF.
Meanwhile, Common Shareholders’ Equity is affected not only by the Equity Issuances shown
here but also by Net Income and Stock-Based Compensation in CFO.
And for U.S. GAAP-based companies, changes in Long-Term Lease Liabilities usually appear in
the CFO section instead.
These rough proxies are rules of thumb, at best. There are always exceptions, and companies’
financial statements vary significantly.
Return to Top.
Key Rule #11: Linking and Projecting the Financial Statements
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate), where Cash Flow
Growth Rate < Discount Rate.
We’ve been covering the financial statements to explain why “Cash Flow” is tricky to calculate,
even if you understand all the line items.
But what matters for valuation purposes is how Cash Flow will change in the future.
To estimate a company’s future Cash Flows, we project its financial statements using the
following 3-step process:
1) Simplify and consolidate the financial statements.
2) Project line items on the financial statements, such as Revenue, COGS, OpEx, CapEx,
and Accounts Receivable.
3) Link the financial statements so that the Balance Sheet balances each year, and so that
the correct line items change.
Step 1: Simplify and Consolidate the Financial Statements
If you try to project a company’s full financial statements as they appear in the annual reports,
you will go crazy.
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Many items are smaller and insignificant, and most do not affect a company’s valuation.
Therefore, it’s in your best interest to simplify the statements as much as possible by grouping
smaller items. Here’s a summary:
1) Income Statement – You shouldn't have to change much here. You may show more or fewer
categories for Revenue and Expenses, and you might split up D&A and show it separately from
everything else.
For example, here’s how we tweaked Target’s Income Statement:
2) Balance Sheet – Aim for 5-10 items on each side, at most.
Combine "Short-Term" and "Long-Term" versions of items like Debt, Deferred Revenue,
Investments, etc., as well as any smaller/miscellaneous items.
We prefer to create one single "Net" Deferred Tax line item – either a Net DTA or Net DTL –
rather than listing them separately because it’s easier to link the statements this way.
Don’t list the components of Common Shareholders’ Equity separately because it’s pointless for
modeling purposes. List the total amount and, if applicable, Preferred Stock and Noncontrolling
Interests separately.
Be ruthless about COMBINING smaller and less significant line items. If you have 20 items on
one side, that’s far too many – 10 is OK, and 5 is even better. Here’s an example for Target:
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3) Cash Flow Statement – Cash Flow from Operations should start with Net Income, add back
D&A, have a Deferred Tax line item, and not have too many other line items.
It’s OK to include a few additional lines and an "Other Adjustments” line, but you don't want
~15 items between Net Income and the Change in Working Capital section.
It’s also fine to add line items for changes in Operating Lease Assets and Liabilities here – not all
companies include these, but they’re convenient for modeling purposes under U.S. GAAP.
The Working Capital section should follow the company's statements, but if any lines
correspond to items you've consolidated on the Balance Sheet, you can do the same on the
CFS:
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In Cash Flow from Investing, you should combine all the line items related to purchasing and
selling investments into a single line, keep a line for CapEx, and maybe keep 1-2 other line
items, depending on the company's statements.
For example, Purchases of Intangibles and Acquisitions are fine to keep, and it's also fine to
group them with items like "Other Investments."
In Cash Flow from Financing, the main items should be Equity Issuances/Repurchases, Debt
Issuances/Repayments, and Dividends, with a few smaller items depending on the company:
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Step 2: Project the Financial Statements
Once you’ve simplified the financial statements, you can start projecting them. Here’s the
process we recommend:
1) Always Start with the Income Statement – Project Revenue, Expenses, and Taxes there first.
You can leave Interest Expense and Interest Income blank for now:
The projection methods vary; you could use simple percentage growth rates for Revenue, as we
do here, or # Units Sold * Average Selling Price, or Market Size * % Market Share.
2) Project Operational Balance Sheet Line Items – These differ a bit depending on the
company, but they should include items such as Inventory, Accounts Receivable, Accounts
Payable, and Accrued Liabilities.
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Under U.S. GAAP, they also include Operating Lease Assets and Liabilities, but under IFRS, you’ll
save these items until the end because of the Interest/Depreciation split.
These are usually percentages of Revenue, SG&A, COGS, and other Income Statement lines:
3) Start the CFS with Net Income (to Common) – It flows in from the Income Statement and
becomes the first line of the Cash Flow Statement.
4) Adjust for Non-Cash Items on the Income Statement – Add back D&A, SBC, Impairments,
Write-Downs, Deferred Taxes, and so on.
Changes in Operating Lease Assets and Liabilities can also go here (under U.S. GAAP), and you
should link the lines in the Change in Working Capital section to the corresponding Balance
Sheet line items:
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5) Project Cash Flow from Investing and Cash Flow from Financing – CapEx is often linked to
Revenue or Revenue Growth, and smaller items may use average percentages.
Equity Issuances, Debt Issuances, Debt Repayments, and Share Repurchases vary widely based
on the company and industry, but in more complex models, they should be linked to the
company’s funding needs.
We’re simplifying them here and assuming constant numbers:
With these assumptions set up, we can now fill out the CFI and CFF sections of the Cash Flow
Statement and complete the next step in the process.
6) Sum Up All Section of the Cash Flow Statement (and FX Rate Effects) – This will result in the
Net Change in Cash at the bottom of the CFS:
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Step 3: Link the Financial Statements
Start by linking Balance Sheet line items to the Cash Flow Statement.
For example, Cash at the bottom of the CFS becomes Cash on the Balance Sheet, and Net
Income, Stock Issuances, Stock Repurchases, SBC, and Dividends link into Common
Shareholders’ Equity.
Items like Debt Issuances and Debt Repayments link into Total Debt on the Balance Sheet.
CapEx and Depreciation both link into Net PP&E.
Deferred Income Taxes on the CFS link into the Net DTA or Net DTL.
And items such as “Other Adjustments” or “Other Changes” often link into “Other Long-Term
Assets” or “Other Long-Term Liabilities,” as they have nowhere else to go.
When you’re on the Assets side of the Balance Sheet, and you’re linking to the Cash Flow
Statement, subtract CFS links.
On the Liabilities & Equity side, add the CFS links.
If you’re confused about which items link where:
•
Cash Flow from Investing generally corresponds to Long-Term Assets.
•
Cash Flow from Financing generally corresponds to Long-Term Liabilities and Equity.
Each “change” should be reflected once and only once on the other statement.
So, if a BS line item increases, that increase should appear in only one spot on the CFS.
Our fully linked Balance Sheet looks like this:
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The main links to the Cash Flow Statement here are as follows:
•
Cash: Linked to Ending Cash at the bottom of the CFS.
•
Net PP&E: Take the previous Net PP&E number and subtract D&A, CapEx, and Proceeds
from PP&E Disposals. CapEx is negative, so subtracting it adds CapEx to Net PP&E.
•
Other Long-Term Assets: Take the previous Other Long-Term Assets and subtract
Acquisitions and Other Investments (it’s already negative, so it will add to Other LongTerm Assets).
•
Total Debt: Take the previous Total Debt and add Debt Issuances and Repayments.
•
Deferred Tax Liabilities: Take the previous DTL and add Deferred Income Taxes.
•
Other Long-Term Liabilities: Take the previous balance and add “Other Items” from the
non-cash adjustments section of the Cash Flow Statement.
Once you’ve done all this, check that the Balance Sheet balances.
If it does not, go back, review your work, and check the rules of thumb above. You may have to
go line-by-line and check off items to do this.
In this case, the Balance Sheet balances, so our “linking work” is done.
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Next, finish the model by filling in Interest Income and Interest Expense on the Income
Statement. These can be simple, fixed percentages linked to Investments and Debt.
Save these items until the end so that you can see the full numbers from the finished model and
verify that the Balance Sheet still balances:
Once you’ve finished the financial statement projections, you can move onto the next step:
financial statement analysis.
To do that, you’ll use the financial statements to calculate metrics such as Free Cash Flow,
Return on Equity (ROE), and Return on Invested Capital (ROIC) – and you’ll use those numbers
to reach conclusions about the company you’re analyzing.
Return to Top.
Key Rule #12: Free Cash Flow and the Change in Working Capital
We have the three financial statements, including the Cash Flow Statement, so it’s easy to
determine “Cash Flow”: we just take the “Net Change in Cash” from the bottom of the Cash
Flow Statement, right?
WRONG!
The problem is that companies can spend and receive their cash in many different ways, and
not all these methods are “required” and “recurring.”
For example, if a company issues Debt or Equity, both activities boost its cash flow – but neither
one is “required” for the business to keep operating.
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A company could spend cash buying Financial Investments, issuing Dividends, or repurchasing
shares, but all those activities are also “optional.”
To estimate the company’s discretionary cash flow, therefore, we need a more precise
definition.
“Discretionary cash flow” means “cash flow after the company pays for what it needs to run its
business and avoid being shut down by external parties such as lenders and the government.”
We can define this metric in different ways, but a simple one is Free Cash Flow:
•
Free Cash Flow = Cash Flow from Operations (CFO) – Capital Expenditures (CapEx)
There are other variations of Free Cash Flow, which we explore later in this course and the
other written guides.
But this initial definition is a good one because:
•
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.
CapEx is a required item because companies need buildings, factories, and equipment to house
employees, manufacture products, and sell them to customers.
Even companies that sell services or software need buildings and computer equipment, and
spending on both of them is considered CapEx.
Free Cash Flow 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.
One important note – especially under IFRS – is that this definition assumes that Cash Flow
from Operations deducts Net Interest Expense, Preferred Dividends, Taxes, and all Lease
Expenses.
So, if the company you’re analyzing has a CFO section that does not do that, you will need to
adjust it for comparability purposes.
For example, under IFRS, you should remove the Lease Depreciation add-back in CFO because
it’s not a true “non-cash expense.”
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The company still pays the full Lease Expense in cash; splitting it into Interest and Depreciation
elements does not change that.
Also, if CFO includes many items in the Non-Cash Adjustments section besides D&A and
Deferred Taxes, you may want to remove them to standardize the formula.
Here’s a quick comparison of Free Cash Flow for Best Buy (a U.S.-based retailer) and Zendesk (a
U.S.-based software company):
For Best Buy, the interpretation is as follows:
FCF is positive and growing, which is good, and the company doesn’t seem to be “playing
games” by artificially cutting CapEx or changing its Working Capital to boost its FCF.
In fact, the Change in Working Capital (“Changes in Operating Assets & Liabilities”) became
negative in Year 3, but FCF increased anyway.
Revenue is also growing each year, so it seems like Best Buy has a healthy business whose FCF is
based on growth in that core business.
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For Zendesk, FCF is also positive and growing, but far more quickly than its Revenue Growth in
two years.
One reason is that the Changes in Operating Assets & Liabilities are much less positive in Year 3,
so FCF gets less of a boost from that.
But there’s another red flag here as well: Zendesk’s Net Income is very negative, while its FCF
is positive. Look at its statements, and you can quickly tell why:
Generally, you want to see a positive and growing FCF.
If FCF is negative, that means the company is not running a sustainable business by itself – it's
relying on outside financing to stay afloat!
That’s OK for short periods, such as the first few years of a startup’s existence, but if a company
stays like that for a decade, it raises serious questions.
If FCF is negative, the first step is to ask, “Why? Is it temporary or permanent? Are the losses
decreasing as the company grows?”
If FCF is becoming more negative as the company grows, stay away.
If FCF is positive, you should also ask, “Why?” before assuming it’s a good thing.
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For example:
•
Is the company’s FCF growing because it’s capturing more of the market, selling more,
and achieving higher margins due to economies of scale? This is good.
•
Is the company’s FCF growing because of creative cost-cutting, or because it’s reducing
its annual CapEx spending? This is not so good.
•
Is the company’s FCF growing despite falling sales, because it’s playing games with
Working Capital or with CapEx and Depreciation? This is not good.
In real life, you use Free Cash Flow in the Discounted Cash Flow (DCF) analysis for valuing
companies, and also in the Leveraged Buyout (LBO) analysis for assessing the acquisition and
sale of a company.
You do not necessarily use the type of Free Cash Flow (CFO – CapEx) described here, but you do
use variations of it.
Components of Free Cash Flow: Working Capital
A big part of FCF is the company’s Net Income: what it earns from core-business activities and
“side activities” after expenses, taxes, and the cost of long-term funding.
Non-cash adjustments and Capital Expenditures also factor in, but those are fairly
straightforward to understand.
One less straightforward part is the company’s “Change in Working Capital,” otherwise known
as “Changes in Operating Assets and Liabilities.”
From the questions we’ve received over the years, it seems to be one of the most confusing
concepts in the history of human civilization.
But that’s not the case – it’s just that Working Capital and the Change in Working Capital are
poorly explained.
Also, they rarely make a huge difference in financial modeling and valuation, so if you're
obsessing over these concepts, you're probably over-thinking them.
We care most about the Change in Working Capital, not Working Capital itself, and it all goes
back to that valuation formula:
Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate), where Cash Flow
Growth Rate < Discount Rate
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The Change in Working Capital 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.
In most cases, the Change in WC follows a very obvious pattern (e.g., always positive as revenue
grows) or no pattern at all.
If it follows an obvious pattern, continue that pattern into the future; if not, just make sure it’s
a low percentage of the Change in Revenue or Revenue.
Traditionally, “Working Capital” is defined as “Current Assets minus Current Liabilities”:
But this definition is not that useful because it’s not how companies calculate the Change in
Working Capital on their Cash Flow Statements.
A better definition of Working Capital is Current Operational Assets – Current Operational
Liabilities, which excludes Cash, Financial Investments, and Debt.
This definition also matches what companies show on their Cash Flow Statements:
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If a company has longer-term operational items, such as Long-Term Deferred Revenue, they
may also be included in Working Capital.
Target’s Working Capital in each year of this model is as follows:
($2,874)
($3,863)
($2,999)
($3,960)
($4,001)
($3,518)
($3,642)
($3,751)
Is it “good” or “bad” if Working Capital is positive or negative each year?
You can’t say because you have to look at why Working Capital is positive or negative.
For example, it may be positive if a company has $100 in Accounts Receivable, $100 in
Inventory, and $500 in Deferred Revenue, because it means the company has collected a lot of
cash upfront before product/service delivery.
Yes, Working Capital is ($300), but this company’s business model is strong.
But if it has $100 in Accounts Receivable, $100 in Inventory, and $500 in Accounts Payable,
that’s less positive because it means the company owes significant cash to suppliers.
The Change in Working Capital is what appears on the Cash Flow Statement, and it’s defined
in a counterintuitive way:
•
Change in Working Capital = Old Working Capital – New Working Capital
To understand why, pretend that Working Capital consists of only one item: Inventory.
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If Inventory increases from $200 in Year 1 to $300 in Year 2, Working Capital also increases
from $200 to $300.
Therefore, the Change in Working Capital must be negative and reduce cash flow because the
company had to spend cash to buy this Inventory!
Yes, online definitions calculate the Change in WC in the opposite way, but those definitions do
not match its presentation on the Cash Flow Statement.
The Change in Working Capital tells you how much “Cash Flow” is likely to differ from Net
Income, and in which direction.
If it's negative, it reduces Cash Flow, reducing the company’s valuation.
If it's positive, it increases Cash Flow, also increasing the company’s valuation.
The sign depends on the company’s business policies. For example, many retailers have
negative Change in Working Capital figures because they must purchase Inventory before they
can sell anything to customers.
On the other hand, many subscription software companies have positive Change in WC figures
because they might collect cash upfront for months or years of their service before delivering it,
which boosts Deferred Revenue.
Note that in the historical periods, the Change in Working Capital does NOT match the
changes calculated manually on the Balance Sheet:
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This happens because companies often group items differently on the statements, change
accounting policies, and make acquisitions, and all those activities distort the numbers.
Just follow the historical Cash Flow Statement numbers and move on with your life.
Normally, you look at the Change in Working Capital relative to the company’s Revenue or
Change in Revenue.
The Change in Working Capital as a percentage of Revenue tells you how significant it is for the
company’s “Cash Flow.”
And you normally project the Change in WC based on a percentage of the Change in Revenue.
For example, here’s a comparison of the Change in Working Capital for Best Buy and Zendesk:
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Best Buy’s Change in WC / Revenue is a very low percentage, which tells us that it’s not that
important for the company.
Interestingly, even though Best Buy is a retailer, its Change in WC is not consistently negative,
nor is it negative as a percentage of the Change in Revenue in most years.
That’s probably because it has many other items within Working Capital that make as much, or
more, of an impact than Inventories.
For Zendesk, the Change in WC is more significant. As expected for a software company, it’s
positive each year because of the continual increases in Deferred Revenue.
For a growing software company, we expect AR and DR to increase each year, with AR reducing
cash flow and DR increasing it, and that is what happens here.
To project the Change in Working Capital for either company, we’d probably use a simple
historical average based on Change in WC / Change in Revenue.
This means that Change in WC / Change in Revenue for both companies should be in the 0-10%
range going forward.
Return to Top.
Key Rule #13: Key Metrics and Ratios
Once you have a company’s financial statements, you can calculate metrics and ratios to
analyze the company’s performance in more detail.
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These metrics and ratios let you compare a company's financial performance to its past
performance, and to that of other, similar companies to answer questions like:
1) Which company is using its capital more efficiently?
2) Which company is more dependent on Debt financing to grow?
3) Which company is more capable of repaying its Debt, even if its sales decline?
4) Which company is collecting cash more quickly, paying suppliers more quickly, or cycling
through Inventory more quickly?
Companies that use their capital more efficiently, that are not overly dependent on Debt, and
that have the best cash-flow management should be valued more highly than companies that
are worse at all of those.
While there are dozens, if not hundreds, of financial metrics, we focus on four primary groups
when analyzing and valuing companies:
1) “Cash Flow Proxy” Metrics – EBIT and EBITDA (and variations, such as EBITDAR).
2) Credit Metrics – The Leverage Ratio (Total Debt / EBITDA) and the Interest Coverage
Ratio (EBITDA / Interest Expense) and their variations.
3) Returns-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.
We cover many other metrics and ratios (see the guide to Equity Value, Enterprise Value, and
Valuation Multiples), but the ones above serve as the starting point.
“Cash Flow Proxy” Metrics
The most common ones here are EBIT (Earnings Before Interest and Taxes) and EBITDA
(Earnings Before Interest, Taxes, and Depreciation).
EBIT is simply 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).
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EBIT is often a "proxy" for Free Cash Flow because both metrics reflect some or all of the impact
of Capital Expenditures.
FCF directly deducts CapEx, and EBIT indirectly deducts part of it by subtracting Depreciation.
EBIT gives you a company’s core, recurring business profitability before the impact of capital
structure and taxes.
To calculate EBITDA, you start with EBIT and then add Depreciation & Amortization taken
directly from the Cash Flow Statement, not the Income Statement.
Remember that D&A could be embedded in various line items on the Income Statement, so you
might not see the full amount there. Therefore, you must retrieve it from the CFS.
EBITDA is more of a "proxy" for Cash Flow from Operations (CFO).
Both EBITDA and CFO completely ignore CapEx and its after-effects (Depreciation).
EBITDA gives you a company’s core, recurring business cash flow from operations before the
impact of capital structure and taxes.
With both these metrics, there are some complications under IFRS because of Operating Leases
(see the guide to Equity Value, Enterprise Value, and Valuation Multiples).
Credit Metrics
The two most important credit metrics are the Leverage Ratio and the Interest Coverage Ratio.
The Leverage Ratio (Total Debt / EBITDA) tells you how much Debt a company has, relative to
its ability to repay that Debt.
Higher numbers are riskier, and lower numbers are less risky.
The Interest Coverage Ratio (EBITDA / Interest Expense) tells you how easily the company could
pay for its current interest expense on the Debt.
Higher numbers are better because they indicate there’s more of a "buffer" in case the business
suffers and profits fall.
Returns-Based Metrics
ROA (Return on Assets), ROE (Return on Equity), and ROIC (Return on Invested Capital) all
measure how efficiently a company is using its "capital" or assets to generate income.
“Capital” could refer to Equity, Equity + Debt, or Equity + Debt + Preferred Stock + Other
Funding Sources.
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The main difference is that Equity may be generated internally or raised externally, while
sources such as Debt and Preferred Stock must be raised from outside investors.
The calculations are as follows:
•
•
•
ROE = Net Income (to Common) / Average (Common) Shareholders' Equity
ROA = Net Income (to Common) / Average Total Assets
ROIC = NOPAT / Average Invested Capital
In the ROIC calculation, NOPAT equals EBIT * (1 - Tax Rate) because it reflects income available
to *all* investors, after taxes.
Therefore, it must exclude Net Interest Expense and Preferred Dividends.
That also explains why it pairs with Invested Capital (Equity + Debt + Preferred Stock + Other
Investor Groups).
There is some disagreement about whether or not you should subtract Cash in the Invested
Capital calculation and add items like Operating Leases.
For companies that follow U.S. GAAP, we normally use the standard definition above.
Cash Conversion Metrics
These metrics all measure how quickly it takes a company to collect receivables, sell inventory,
or pay the amounts it owes to suppliers.
Similar to superheroes or videogame bosses, three of these metrics can combine into a “super
metric” as well:
•
•
•
Days Sales Outstanding (DSO) = Accounts Receivable / Revenue * Days in Year
Days Inventory Outstanding (DIO) = Inventory / COGS * Days in Year
Days Payable Outstanding (DPO) = Accounts Payable / COGS * Days in Year
You could use the average AR, average Inventory, or average AP over the period as well.
It doesn’t make a huge difference if these numbers stay in similar ranges, and the company is
only growing at a moderate pace.
Together, these metrics create the “Cash Conversion Cycle” (CCC): DIO + DSO – DPO
This CCC tells you how long it takes a company to convert its Inventory and other short-term,
operational Assets, such as Accounts Receivable, into cash flows.
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Lower numbers are better because they mean the company is selling its Inventory and
collecting Cash from customers more quickly.
Here’s how Best Buy and Target compare across these metrics:
One final note: these companies are both mature, offline retailers with low-single-digit growth
rates, so this comparison is valid.
You can’t use these metrics to compare completely different types of companies, such as an
industrials conglomerate and a biotech startup.
Return to Top.
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Key Rule #14: How to Answer Accounting Interview Questions
Some of the most common interview questions are ones about how a change affects the three
financial statements.
For example:
•
•
•
“Depreciation goes up by $10. What happens on the statements?”
“A company buys $100 of Inventory. What happens on the statements?”
“A company sells a factory listed at $100 on its Balance Sheet for $120. What happens
on the statements?”
For all these questions, you should look at our 3-statement “interview question” model.
The best way to understand these changes is to enter them in Excel and see firsthand how the
statements change.
That said, there are also rules of thumb that you can use for the major categories:
1.
2.
3.
4.
5.
6.
Changes to Cash Items on the Income Statement.
Changes to Operational Items on the Balance Sheet.
Changes to Non-Cash Items on the Income Statement.
Changes to Leases on the Balance Sheet.
Changes to Non-Operational Balance Sheet or Cash Flow Statement Items.
Multi-Step Scenarios and Changes.
In the sections below, we’ll explain these categories.
You should move in the following order when answering these questions:
1. Explain how the Income Statement changes, if at all.
2. Explain how the Cash Flow Statement changes, if at all (including changes in Deferred
Taxes).
3. Explain how the Balance Sheet changes and why it still balances, i.e., why Assets still
equal Liabilities + Equity.
1) Changes to Cash Items on the Income Statement
For example, what happens if a company’s Revenue increases by $100, or its COGS or
Operating Expenses increase by $100?
This category is easy because nothing on the Cash Flow Statement changes except for Net
Income at the top and Cash at the bottom.
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For example, if Revenue increases by $100, and the Tax Rate is 25%:
•
On the IS, Revenue is up by $100, so Pre-Tax Income is up by $100, and Net Income is up
by $75.
•
On the CFS, Net Income is up by $75, so Cash at the bottom is up by $75.
•
On the BS, Cash is up by $75 on the Assets side, CSE is up by $75 on the other side, and
nothing else changes, so both sides are up by $75 and balance.
If expenses increased by $100 instead, Net Income, Cash, and CSE would all decrease by $75
instead. Here’s a summary:
•
Examples: Revenue, COGS, Operating Expenses, and Interest Income / (Expense).
•
What Changes as a RESULT of These Items Changing: Pre-Tax Income, Net Income,
Cash, and Common Shareholders’ Equity (CSE).
•
How the Balance Sheet Balances: Cash and CSE both change.
2) Changes to Operational Items on the Balance Sheet
These consist of items like Inventory, Accounts Receivable, Accounts Payable, Accrued
Expenses, Prepaid Expenses, and Deferred Revenue, known collectively as “Working Capital.”
The main differences compared with the first category are:
1) Changes to these items will affect something on the Balance Sheet besides Cash and
Common Shareholders’ Equity.
2) Increases and decreases work differently for these items.
To figure out what happens, ask yourself a simple question: “Has the company delivered the
product or service to the customer? Or, has someone else delivered something to the company
that it used in this period?”
If so, something on the Income Statement will change. If not, nothing will change.
Consider Accounts Receivable (AR). If AR increases, it means the company delivered a product
or service and is waiting for the cash. So, Revenue increase son the Income Statement.
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But if AR decreases, it means the company has collected the cash without delivering anything –
so this change won’t show up on the Income Statement.
Whenever AR decreases, it must have increased previously due to a product/service delivery;
here’s the first step of the process (a $100 increase in AR):
On the Balance Sheet, Cash is down by $25, and AR is up by $100, so the Assets side is up by $75.
On the L&E side, CSE is up by $75 because of the increased Net Income, so both sides balance.
Here’s an excerpt of the Balance Sheet:
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In the next step of this process – the cash collection – nothing changes on the Income
Statement because no additional delivery has taken place.
Instead, the increase in AR on the CFS is reversed, so Cash now increases by $75.
On the Balance Sheet, Cash is up by $75, and AR remains at its original level (since the increase
is reversed), which means the Assets side is still up by $75, matching the increase on the L&E
side.
Here are the Cash Flow Statement and Balance Sheet in this second step:
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The intuition is that over both steps, the company eventually records $100 in Revenue and pays
$25 in Taxes on it, so its Cash and CSE both increase by $75.
We’re not going to show Excel screenshots for every possible change; please use the Excel file
to try that on your own.
Here’s a summary of the most common items:
•
•
Accounts Receivable
o Increases: IS, BS, and CFS all change; represents recorded revenue.
o Decreases: Only the BS and CFS change; represents cash collection.
Prepaid Expenses
o Increases: Only the BS and CFS change; represents advance payments for
expenses not yet incurred.
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•
•
•
o Decreases: IS, BS, and CFS all change; represents recognition of an expense
previously paid in cash.
Inventory
o Increases: Only the BS and CFS change; represents spending on parts and
materials that have not yet been delivered to customers.
o Decreases: IS, BS, and CFS all change; represents recognition of an expense
previously paid in cash. This one is accompanied by an increase in Revenue to
represent the sale of the goods, so Revenue and COGS on the IS change.
Accrued Expenses and Accounts Payable
o Increases: IS, BS, and CFS all change; represents recognition of an expense that
has not yet been paid in cash (see the important note at the bottom).
o Decreases: Only the BS and CFS change; represents cash payment of an expense
that was previously recognized.
Deferred Revenue
o Increases: Only the BS and CFS change; represents cash collection for sales that
cannot yet be recognized as revenue.
o Decreases: IS, BS, and CFS all change; represents recognition of revenue that has
already been collected in cash.
We strongly recommend using the 3-statement “interview question” model to understand
these questions.
One Final Note: An increase in Accounts Payable doesn’t necessarily correspond to an expense
appearing on the IS.
For example, if the company purchases Inventory on credit, Inventory on the Assets side and AP
on the L&E side will both increase, and nothing on the Income Statement will change.
That’s because in this case, the company has not yet delivered the products to customers, so
nothing on the IS can change.
3) Changes to Non-Cash Items on the Income Statement
These changes follow a set pattern: Pre-Tax Income and Net Income change, but you reverse
the change on the Cash Flow Statement since it’s non-cash.
Cash and CSE change, and then something else on the Balance Sheet also changes.
The classic example here is Depreciation, but they could ask about plenty of other, similar
items: Amortization, Stock-Based Compensation, or Asset Write-Downs, for example.
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Here’s a list of non-cash items and their corresponding Balance Sheet line items:
•
•
•
•
•
•
Depreciation – Net PP&E.
Amortization – Other Intangible Assets.
Stock-Based Compensation – CSE.
Gains / (Losses) on PP&E – Net PP&E.
Write-Downs – The Asset you are writing down.
Impairments – The Asset you are impairing.
Some of these items, such as SBC, Amortization, Write-Downs, and Impairments, are not
deductible for Cash-Tax purposes.
So, instead of saying that Cash increases, it’s better to say that the Deferred Tax Asset increases
(or, equivalently, the DTL decreases).
If you feel comfortable explaining this point, you can give the “proper” walkthrough. If not, try
the simplified one first, and if they ask about taxes, mention that you understand how, in
reality, Cash would not change due to the lack of Cash-Tax savings.
The classic question of Depreciation increasing by $100 looks like this:
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In an interview, you could walk through it like
this: “On the Income Statement, Pre-Tax
Income falls by $100, and Net Income falls by
$75, assuming a tax rate of 25%.
On the Cash Flow Statement, Net Income is
down by $75, but you add back the $100 in
Depreciation, so Cash is up by $25 at the
bottom. On the Balance Sheet, Cash is up by
$25, PP&E is down by $100, and so the Assets
side is down by $75.
On the other side, Common Shareholders’
Equity is down by $75 because Net Income
was down by $75, so both sides balance.”
The intuition is that the Cash balance
increases because of the $25 in tax savings
from this Depreciation.
If this non-cash expense were not Cash-Tax
Deductible, then the Net DTA, rather than
Cash, would increase by $25.
•
Examples: Depreciation (Net PP&E), Amortization (Other Intangible Assets), Stock-Based
Compensation (CSE), Gains / (Losses) on PP&E (Net PP&E), Write-Downs (The Asset you
are writing down), and Impairments (The Asset you are impairing).
•
What Changes as a RESULT of These Items Changing: Pre-Tax Income, Net Income,
Cash, CSE, Something Else on the Balance Sheet, and the DTA for Non-Cash-TaxDeductible expenses (if you give the proper tax treatment).
•
How the Balance Sheet Balances: Cash and CSE change, another Asset or L&E line item
changes, and the DTA may change for certain non-cash expenses.
4) Changes to Leases on the Balance Sheet
For Operating Leases under U.S. GAAP, these questions are very simple:
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•
When a company initially signs an Operating Lease, the Lease Asset (or “Right-of-Use
Asset”) and Lease Liability both increase by the Present Value of future lease payments.
There are no changes on the Income Statement.
•
Once the company starts paying rent, the Lease Expense appears as a normal, cash
expense on the Income Statement that reduces Pre-Tax Income and Net Income. The
Lease Assets and Liabilities on the BS do not change.
•
The Lease Assets and Liabilities are both removed if the lease ends, and the company
decides not to renew it.
Under IFRS, and for Finance Leases (Capital Leases) under U.S. GAAP, the treatment is more
complex because the Lease Expense is split into Interest and Depreciation elements.
Here’s what happens if a company takes out a Lease for $400 on January 1 and pays $20 in
Interest and $20 in Depreciation on it, so that the total Lease Expense is $40 in Year 1 (this
could be an Operating Lease or Finance Lease under IFRS or a Finance Lease under U.S. GAAP):
Pre-Tax Income on the Income Statement
falls by $40, and Net Income decreases by
$30 at a 25% tax rate.
The Interest vs. Depreciation split does not
matter because they both make the same
impact on the IS.
There may be a very small Book vs. Cash Tax
difference here, but it’s so tiny that you can
ignore it in interview questions.
Here’s what the Cash Flow Statement and
Balance Sheet look like:
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Net Income is down by $30 on the CFS, you add back the $20 of Depreciation, but then you
subtract that same amount in the “Repayment of Capital Element of Leases” (or similar) line
item, so that Cash at the bottom is down by $30.
The CapEx or “Acquisition of Lease Asset” line and the Lease Issuance offset each other.
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On the Balance Sheet, Cash is down by $30, and Net PP&E is up by $380 due to the initial Asset
acquisition and $20 of Depreciation, so the Assets side is up by $350.
On the L&E side, the Lease Liability is up by $380 due to the initial issuance followed by the $20
Repayment, and CSE is down by $30 due to the reduced Net Income, so the L&E side is also up
by $350, and the BS balances.
There’s no real “summary” for these types of questions because they’re always the same: you
just need to understand how Leases work in both accounting systems.
5) Changes to Non-Operational Balance Sheet or Cash Flow Statement Items
These items are simple because there are no immediate Income Statement changes.
There’s a simple cash inflow or outflow on the Cash Flow Statement, and both Cash and the
corresponding Balance Sheet line item change.
Here are examples of these changes:
•
•
•
•
•
•
•
•
•
•
•
Capital Expenditures – PP&E and Cash will change.
Purchasing or Selling Financial Investments – Financial Investments (may be short-term
or long-term) and Cash will change.
Selling PP&E for Book Value – PP&E and Cash will change.
Raising or Paying Off Debt – Debt and Cash will change.
Raising or Paying Off Preferred Stock – Preferred Stock and Cash will change.
Issuing Common Stock – CSE and Cash will change.
Repurchasing Common Stock – CSE and Cash will change.
Issuing Common Dividends – CSE and Cash will change.
Acquisitions – Acquired Assets, Goodwill, Other Intangibles, and Cash will change.
Deferred Taxes – The Deferred Tax Asset or Liability and Cash will change.
FX Rate Effects – CSE and Cash will change.
There are a few “borderline” items, such as Preferred Dividends (they don’t affect Net Income,
but they do reduce Net Income to Common), but most of these changes are simple.
Also, note that in most cases, there is an “after-effect” following these changes, such as
Depreciation after CapEx spending, or Interest Expense after a Debt Issuance.
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6) Multi-Step Scenarios and Changes on the Financial Statements
“Multi-step scenarios” in interviews are usually not complicated as long as you understand each
change individually. Examples of multi-step scenarios include:
•
Buying Inventory (with cash or credit), turning it into products, and selling and delivering
it to customers.
•
Issuing Debt to pay for Common Stock Repurchases (stock buybacks).
•
Buying factories with Debt or Equity and operating them over a year, with a sale or
write-down at the end.
•
Issuing Debt and Equity to acquire other companies.
With these types of questions, ask the interview right away if they want you to go through all
the changes CUMULATIVELY or each change SEQUENTIALLY.
For complex scenarios, it’s not reasonable to walk through everything cumulatively, but it is
plausible for simpler ones, such as the first two examples above.
Let’s take the main example covered in the course:
“A company purchases $200 of factories with Debt on January 1, and it operates them for an
entire year while paying interest and principal on its Debt, and depreciating the factories.
At the end of Year 1, it decides it no longer needs the factories because its new product line has
not generated much in pre-orders.
So, it decides to sell its factories for $220, a 10% premium to the original purchase price, and it
uses the proceeds to repay the remaining Debt principal.
Walk through the statements in EACH STEP of the process separately, and assume Depreciation
for 10% of the initial purchase price, an Interest Rate of 10% on the Debt, 5% Principal
Repayment, and no additional revenue or expenses from the factories in Year 1.”
The first step – the initial purchase – is easy because nothing appears on the Income Statement.
The $200 of CapEx and $200 Debt Issuance both appear on the Cash Flow Statement, offsetting
each other, and Cash at the bottom is unchanged.
On the Balance Sheet, PP&E is up by $200 on the Assets side, and Debt is up by $200 on the L&E
side, so the BS remains in balance.
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For the second step – what happens after a year of
owning these factories – you include the Interest
Expense, the Depreciation, and the Debt Principal
Repayment.
All of these changes correspond to THIS period, but
only the Depreciation and Interest Expense show
up on the Income Statement.
The Depreciation is 10% * $200 = $20, the Interest
Expense is 10% * $200 = $20, and the Debt Principal
Repayment is 5% * $200 = $10.
So, Pre-Tax Income falls by $40 on the Income
Statement, and Net Income is down by $30 at a 25%
tax rate.
We’ll assume no Book vs. Cash Tax differences here
and move to the CFS.
On the Cash Flow Statement, Net Income is down by $30, you add back the $20 of
Depreciation, and you show a negative $10 for the Debt Principal Repayment, so Cash at the
bottom is down by $20.
And then on the Balance Sheet, Cash is down by $20 on the Assets side, and Net PP&E is down
by $20 from the Depreciation, so Total Assets are down by $40.
On the other side, Debt is down by $10 due to the Principal Repayment, and CSE is down by $30
due to the Net Income reduction, so both sides are down by $40 and balance.
Here’s what it looks like:
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The intuition is that Cash is down by $20 rather than $50 because of $10 in tax savings from the
Depreciation + Interest, and the fact that Depreciation is non-cash.
For the final step in this process – the sale of the factory for $220 – remember that:
•
•
The Net PP&E is down to $180 by the end of the year, so there will be a Gain of $40.
The Debt Principal is down to $190, so there will be a Principal Repayment of $190.
We prefer to walk through this step in isolation because doing it with all the other changes
above will make it difficult to remember all the numbers.
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This $40 is a Realized Gain, so it always
appears on the Income Statement, increasing
Pre-Tax Income by $40 and Net Income by
$30 at a 25% tax rate.
Realized Gains and Losses rarely, if ever,
affect Book vs. Cash Taxes, so we ignore any
possible Deferred Tax impact here.
Moving on, Net Income is up by $30 on the
CFS, but we reverse the $40 Gain by
subtracting it and then “reclassify it” under
CFI.
We also put the $180 Book Value of Net PP&E
under CFI so that the Total Proceeds of $220
show up there.
And then we record a Debt Principal
Repayment of $190 under CFF.
As a result, Cash at the bottom is up by $20
($30 – $40 + $220 – $190 = $20).
On the Balance Sheet, Cash is up by $20, and Net PP&E decreases by its Book Value of $180, so
Total Assets are down by $160.
On the other side, Debt is down by $190, and CSE is up by $30, so the L&E side is down by $160,
and both sides balance.
Here’s what it looks like on the CFS and BS:
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Interview Questions
You NEED to know accounting to have a shot at winning job offers.
Accounting interview questions come up not just in investment banking interviews, but also in
interviews for private equity, corporate development, investor relations, and many other roles.
Many bankers also have weak knowledge of accounting, so these questions are a quick way to
evaluate how much you understand vs. how much you’ve memorized.
Conceptual Accounting Questions
1. 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 – as well as 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 then 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 real cash flow it generates, and the statements let you estimate the cash
flow more accurately.
2. 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.
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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 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 at
the bottom.
Cash at the bottom of the CFS becomes Cash on the Balance Sheet, and Net Income, Stock
Issuances, Stock 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.
When you’re on the Assets side of the Balance Sheet, and you’re linking to the Cash Flow
Statement, subtract CFS links; add them on the L&E side.
Finally, check that Assets equals Liabilities plus Equity at the end.
3. 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 is generating, and 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.
4. Could you use only two financial statements to construct the third one? If not, why not?
It depends on which two statements you pick. For example, you could use the Income
Statement and “Starting” and “Ending” Balance Sheets to construct the Cash Flow Statement,
but there may be ambiguity (e.g., you know how Net PP&E changes, but you’re not sure of the
CapEx vs. Depreciation split).
Potentially, you could also use the Income Statement and Cash Flow Statement to move from
the “Starting” Balance Sheet to the “Ending” one (but also with some ambiguity).
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However, it would be nearly impossible to construct the Income Statement starting with just
the Balance Sheet and Cash Flow Statement because there aren’t enough direct links.
5. 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 for creating
the CFS, Cash Received or 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.
6. What should you do if a company’s Cash Flow Statement starts with something OTHER
than Net Income, such as Operating Income or Cash Received?
For modeling and valuation purposes, you should convert this Cash Flow Statement into one
that starts with Net Income and makes the standard adjustments.
Large companies should provide reconciliations that show you how to move from Net Income
or Operating Income to Cash Flow from Operations and that list the Change in Working Capital
and other non-cash adjustments.
If the company does NOT provide that reconciliation, you might have to use the CFS in its
original format and use simpler methods to project it.
7. 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.
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And if a company buys a factory, it can’t list that purchase on the Income Statement
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.
8. What’s the difference between Assets, Liabilities, and Equity line items on the Balance
Sheet?
There’s no precise, universal definition, but an Asset is something that will result in a future
benefit for the company, such as future cash flow, business growth, or tax savings.
A Liability or Equity line item is something that will result in a future obligation for the
company, such as a cash payment or the requirement to deliver a product.
Liabilities are usually related to external parties – lenders, suppliers, or the government – while
Equity line items are usually related to the company’s internal operations.
Both Liabilities and Equity act as funding sources for the company’s resources (Assets), but
Equity line items tend not to result in direct cash outflows in the same way as Liabilities.
9. How can you tell whether or not an item should appear on the Cash Flow Statement?
You list an item on the Cash Flow Statement if:
1) It has already appeared on the Income Statement and affected Net Income, but it’s noncash, so you need to adjust to determine the company’s real cash flow; OR
2) It has NOT appeared on the Income Statement, and it DOES affect the company’s cash
balance.
In category #1 are items such as Depreciation and Amortization; Category #2 includes items in
Cash Flow from Investing and Financing, such as Capital Expenditures and Dividends.
Changes in Working Capital could fall into either category (e.g., an increase in AR is in category
#1, but a decrease in AR is in category #2).
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10. A company uses cash accounting (i.e., it only records revenue when it is received in cash
and only records expenses when they are paid in cash) rather than accrual accounting.
A customer buys a TV from the company “on account” (i.e., without paying upfront in cash)
and receives the TV right away. How would the company record this transaction differently
from a company that uses accrual accounting?
Under cash accounting, the Revenue would not show up until the company collects the cash
from the customer – at which point it would increase Revenue on the Income Statement (and
Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet.
Under accrual accounting, the sale would show up as Revenue right away, but instead of
increasing Cash on the Balance Sheet, it would increase Accounts Receivable at first. Then, once
the company collects the cash payment from the customer, Accounts Receivable would
decrease, and Cash would increase.
11. A company begins offering 12-month installment plans to customers so that they can pay
for $1,000 products over a year instead of 100% upfront. How will its cash flow change?
In the short term, the company’s cash flow is likely to decrease because some customers will no
longer pay 100% upfront.
So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on.
The long-term impact depends on how much sales grow as a result of this change.
If sales grow substantially, that might be enough to offset the longer cash-collection process
and increase the company’s overall cash flow.
12. A company decides to prepay its monthly rent by paying for an entire year upfront in
cash, as the property owner has offered it a 10% discount for doing so.
Will this prepayment boost the company’s cash flow?
In the short term, no, because the company is now paying 12 * Monthly Rent in a single month
rather than making one cash payment per month.
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On the Income Statement in Month 1, the company will still record only the Monthly Rent for
that month. But on the Cash Flow Statement, it will record –12 * Monthly Rent under “Change
in Prepaid Expenses” to represent the cash outflow.
A 10% discount represents just over one month of rent, so the company’s cash flow in Month 1
will decrease substantially.
Over an entire year, however, this prepayment will improve the company’s cash flow because
there will be no additional cash rental payments after Month 1, and the total amount of rent
paid in cash will be 10% less by the end of the year.
13. Your friend is analyzing a company and says that you always have to look at the Cash Flow
Statement to find the full amount of Depreciation. Is he right?
Yes, your friend is correct. This happens because companies often embed Depreciation within
other line items on the Income Statement, such as COGS and Operating Expenses.
For example, employees in marketing, research, and customer support might all be using
computers, so the Depreciation of computers would be embedded in expense categories like
Sales & Marketing, Research & Development, and General & Administrative.
14. 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 a company’s cash flow. It corresponds to Deferred Revenue, and on
the CFS, an increase in Deferred Revenue is a positive entry that boosts a company’s cash flow.
When this cash is finally recognized as Revenue, Deferred Revenue declines, which appears as a
negative entry on the CFS.
15. 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.
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DR is a Liability because it results in future obligations for the company. The company has
already collected all the cash associated with the sale, so now it must deliver the product or
service, and it must spend something to do that.
AR and DR are the opposites of each other: 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.
16. How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why
are Prepaid Expenses an Asset?
Prepaid Expenses have already been paid in cash but have not yet been incurred as expenses,
so they have not appeared on the Income Statement.
When they finally appear on the Income Statement, they’ll effectively be “non-cash expenses”
that reduce the company’s taxes, which makes them an Asset.
By contrast, Accounts Payable have not yet been paid in cash.
When the company finally pays them, its Cash balance will decrease, which makes AP a Liability.
Accounts Payable and Accrued Expenses work the same way, but Accounts Payable is used for
specific items with invoices (e.g., legal bills), while Accrued Expenses is used for monthly,
recurring items without invoices (e.g., utilities).
Accrued Expenses almost always result in an Income Statement expense before being paid in
cash, and Accounts Payable often do as well.
However, in some cases, Accounts Payable may correspond to items that have not yet
appeared on the Income Statement, such as purchases of Inventory made on credit.
17. Your CFO wants to start paying employees mostly in Stock-Based Compensation, under
the logic that it will reduce the company’s taxes, but not “cost it” anything in cash.
Is the CFO correct? And how does Stock-Based Compensation impact the statements?
The CFO is correct on a superficial level, but not in reality.
First, the full amount of Stock-Based Compensation is not deductible for Cash-Tax purposes
when it is initially granted in most countries, so even if Book Taxes decrease, Cash Taxes may
not change at all.
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The eventual tax deduction will take place much further into the future when employees
exercise their options and/or receive their shares.
But the other problem with the CFO’s claim is that Stock-Based Compensation creates
additional shares, diluting existing investors and, therefore, “costing” the company something.
That makes it quite different from non-cash expenses that do not change the company’s capital
structure, such as Depreciation and Amortization.
18. A junior accountant in your department asks about the different ways to fund the
company’s operations via external sources and how they impact the financial statements.
What do you say?
The two main methods of funding a company’s operations with outside money are Debt and
Equity. 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 do that, 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.
19. Your company decides to sell equipment for a market value of $85. The equipment was
listed at $100 on your company’s Balance Sheet, so you have to record a Loss of $15 on the
Income Statement, which gets reversed as a non-cash expense on the Cash Flow Statement.
Why is this Loss considered a “non-cash expense”?
This Loss is a non-cash expense because you haven’t “lost” anything in cash in the current
period.
When you sell equipment for $85, you get $85 in cash from the buyer. It’s not as if you’ve “lost”
or “spent” $15 in cash because you sold the equipment at a reduced price.
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The Loss means that you spent more than $85 to buy this equipment in a prior period.
But non-cash adjustments are based on what happens in the CURRENT PERIOD.
20. Your company owns an old factory that’s currently listed at $1,000 on its Balance Sheet.
Why would it choose to “write down” this factory’s value, and what is the impact on the
financial statements?
A company might write down an Asset if its value has declined substantially, and its current
Book Value (the number on the Balance Sheet) is no longer accurate.
For example, maybe the factory is damaged by a hurricane, or new technology makes the
factory obsolete.
On the statements, you record this write-down as an expense on the Income Statement, but
you add it back as a non-cash expense on the Cash Flow Statement.
Typically, these write-downs are not deductible for Cash-Tax purposes, so you also record a
negative adjustment under Deferred Taxes on the CFS.
Net PP&E decreases, and the Deferred Tax Asset increases. On the L&E side of the Balance
Sheet, Common Shareholders’ Equity decreases due to the reduced Net Income.
21. The CFO of your firm recently announced plans to purchase “financial investments”
(stocks and bonds). Why would she want to do this, and how will this activity affect the
statements?
A company might purchase financial investments if it has excess Cash and cannot think of other
ways to use it.
For example, the company can’t hire more employees, buy more equipment or factories, or
acquire other companies, and it also doesn’t want to issue Dividends to investors, repurchase
stock, or repay Debt.
The initial purchase of these investments will show up only on the Cash Flow Statement (in
Cash Flow from Investing) and will reduce the company’s cash flow.
Afterward, the Interest Income earned on these investments will appear on the Income
Statement and boost the company’s Pre-Tax Income, Net Income, and its Cash balance.
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22. Could a company have negative Common Shareholders’ Equity (CSE) on its Balance Sheet?
If no, why not? If yes, what would it mean?
Yes, it could. Just think about the main items that link into CSE: Net Income and Dividends. If a
company’s Net Income is repeatedly negative, CSE will eventually turn negative.
Negative Common Shareholders’ Equity is almost always a negative sign because it means the
company has been unprofitable, repeatedly, or it has issued too much in Dividends or
repurchased too many shares.
It’s more acceptable for tech and biotech startups that lose significant money in their early
years, so you will see negative CSE figures there, but eventually, they should turn positive.
23. 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 the company did this – how would you respond?
You need to create Goodwill and Other Intangible Assets after an acquisition takes place to
ensure that the Balance Sheet balances.
In an acquisition, you write down the seller’s Common Shareholders’ Equity and then combine
its Assets and Liabilities with those of the acquirer.
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, then there are no problems.
The combined Cash balance decreases by $1,000, and so does the combined CSE.
However, in real life, acquirers almost always pay premiums for target companies, which
means that the Balance Sheet will go out of balance.
For example, if the seller here had $400 in CSE, the Balance Sheet would have gone out of
balance immediately because the Assets side would have decreased by $1,000, but the L&E side
would have decreased by only $400.
To fix that problem, you start by allocating value to the seller’s “identifiable intangible assets”
such as patents, trademarks, intellectual property, and customer relationships. In this case, we
allocated $200 to these items.
If there’s still a gap remaining after that, you allocate the rest to Goodwill, which explains the
$400 in Goodwill here.
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24. How do Goodwill and Other Intangible Assets change over time?
Goodwill remains constant unless it is “impaired,” i.e., the acquirer decides that the acquired
company is worth less than it initially expected and writes down the Goodwill. That appears as
an expense on the Income Statement and a non-cash adjustment on the Cash Flow Statement.
Other Intangible Assets amortize over time (unless they are indefinite-lived), and that
Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash
Flow Statement. The balance decreases until it has amortized completely.
Neither Goodwill Impairment nor the Amortization of Intangibles is deductible for Cash-Tax
purposes, so the company’s Cash balance won’t increase; instead, the Deferred Tax Asset or
Deferred Tax Liability will change.
25. How do Operating Leases and Finance Leases (Capital Leases) appear on the financial
statements? Explain the treatment at a high level as well as IFRS vs. U.S. GAAP differences.
Both 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-ofUse Assets,” and Operating Lease Liabilities match them on the other side.
For Operating Leases (simple rental agreements with no ownership element) under U.S. GAAP,
companies keep the Operating Lease Asset and Liability as-is during the lease period and record
a simple Rental Expense on the Income Statement.
Finance Leases, which give companies an element of ownership or a “bargain purchase option”
at the end, are split into Interest and Depreciation elements on the Income Statement.
On the Cash Flow Statement, Depreciation is added back, but then under Cash Flow from
Financing, the company records a negative number in the same amount for “Repayment of
Capital Element of Leases” (or similar name).
On the Balance Sheet, both the Lease Assets and Lease Liabilities decrease each year the lease
is active because of these line items on the CFS.
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 BS line items
change in the same way.
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26. What’s the difference between Deferred Tax Assets and Deferred Tax Liabilities, and how
are Net Operating Losses (NOLs) related to both of them?
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).
NOLs are a component of the DTA; the NOL component of the DTA is approximately equal to
the Tax Rate * NOL Balance.
27. 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 many Write-Down 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 (alternatively, the DTL could decrease).
28. Suppose that you’re analyzing a company, and you want to project its financial
statements. Before projecting anything, how would you *simplify* its statements first?
On the Income Statement, you might split up Revenue and Expense differently or show
Depreciation & Amortization as separate line items to make the projections easier.
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On the Balance Sheet, it’s best to aim for 5-10 items, at most, on each side. Combine “ShortTerm” and “Long-Term” versions of items, make a single Net DTA or Net DTL, and list just one
line for Common Shareholders’ Equity. Combine all smaller/miscellaneous items.
On the Cash Flow Statement, consolidate the smaller/miscellaneous items between Net Income
and the Change in Working Capital. You don’t want ~15 lines there; aim for D&A, Deferred
Taxes, and maybe 1-2 others.
In the CFI and CFF sections, combine smaller items related to purchasing and selling securities
and paying fees on capital raised, and focus on the core items: CapEx, Equity and Debt
Issuances, Stock Repurchases, Debt Repayments, and Dividends.
Return to Top.
Single-Step Changes on the Financial Statements
These questions are straightforward if you’ve been using our 3-statement “interview question”
Excel model to try different scenarios.
Remember the five main categories of changes:
1. Changes to Cash Items on the Income Statement – Straightforward since Net Income,
Cash, and Common Shareholders’ Equity (CSE) change.
2. Changes to Operational Items on the Balance Sheet – These are trickier because
different items change when an item decreases and when it increases, so you have to
understand what the change means.
3. Changes to Non-Cash Items on the Income Statement – Net Income, Cash, and CSE
change, but something on the Balance Sheet also changes. There may also be a Book vs.
Cash Tax effect, so the DTA or DTL may change as well.
4. Changes to Leases on the Balance Sheet – These require you to know the simple rules
for lease accounting.
5. Changes to Non-Operational Balance Sheet Items or Cash Flow Statement Items –
These are simple since there’s no immediate Income Statement impact; something on
the CFS will change, Cash will change, and something on the Balance Sheet will change.
We recommend going in this order when answering these questions:
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1. Explain how the Income Statement changes, if at all.
2. Explain how the Cash Flow Statement changes, if at all.
3. Explain how the Balance Sheet changes and why it still balances, i.e., why Assets still
equal Liabilities + Equity.
You can assume a 25% tax rate to simplify the math, but make sure you state that when you
explain your answer.
1. Walk me through the financial statements when a company’s Operating Expenses increase
by $100.
•
Income Statement: Operating Expenses are up by $100, so Pre-Tax Income is down by
$100, and Net Income is down by $75 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $75. There are no other changes, so Cash
at the bottom is down by $75.
•
Balance Sheet: Cash is down by $75, so the Assets side is down by $75, and CSE on the
L&E side is down by $75 due to the reduced Net Income, so both sides balance.
•
Intuition: Nothing; it’s a simple cash expense.
2. A company’s Depreciation increases by $20. What happens to the financial statements?
•
Income Statement: Pre-Tax Income falls by $20, and Net Income falls by $15, assuming
a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $15, but you add back the $20 in
Depreciation since it’s non-cash, so Cash at the bottom is up by $5.
•
Balance Sheet: Cash is up by $5, but PP&E is down by $20 due to the Depreciation, so
the Assets side is down by $15. The L&E side is also down by $15 because Net Income
falls by $15, which reduces CSE, so both sides balance.
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•
Intuition: This non-cash expense does not “cost” the company anything, but it reduces
the company’s taxes.
3. A company runs into financial distress and needs Cash immediately. It sells a factory that’s
listed at $100 on its Balance Sheet for $80. What happens to the statements?
•
Income Statement: You record a Loss of $20 on the Income Statement, which reduces
Pre-Tax Income by $20 and Net Income by $15 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $15, but you add back the $20 Loss since
it’s non-cash. You also show the full proceeds received, $80, in Cash Flow from
Investing, so cash at the bottom is up by $85.
•
Balance Sheet: Cash is up by $85, and PP&E is down by $100, so the Assets side is down
by $15. The L&E side is also down by $15 because CSE falls by $15 due to the Net
Income decrease, so both sides balance.
•
Intuition: The company gets the $80 in Cash proceeds, but it also gets $5 in tax savings
from the Loss, so its Cash goes up by $85 rather than $80.
4. A company decides to CHANGE a key employee’s compensation by offering the employee
stock options instead of a cash salary. The employee’s cash salary was $100, but she will
receive $120 in stock options now. How do the statements change?
Operating Expenses go up by $20, but the company also records $120 in non-cash expenses
that are not Cash-Tax Deductible:
•
Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20,
and Net Income falls by $15 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $15, but you add back the $120 in SBC as
a non-cash expense. However, this SBC is not truly Cash-Tax deductible, so there’s a
Deferred Tax adjustment for ($30), since ($120) * 25% = ($30). The company did not
reduce its Cash Taxes with this SBC. Cash at the bottom is up by $75.
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•
Balance Sheet: Cash is up by $75, and the Net DTA is up by $30 because of the Deferred
Tax adjustment, so the Assets side is up by $105. On the L&E side, CSE is down by $15
because of the reduced Net Income, but it’s also up by $120 because of the SBC, so the
L&E side is up by $105, and both sides balance.
•
Intuition: The company increases its Cash balance by switching the employee to StockBased Compensation, but it doesn’t realize any Cash-Tax savings from doing that – so,
Cash is up by $75 rather than $120, $90, or some other, larger number.
If you don’t feel comfortable with the tax part, you could skip the Deferred Tax adjustment and
just say that Cash, rather than the Net DTA, increases by $30.
5. Walk me through the financial statements when a customer orders a product for $100 but
doesn’t pay for it in cash. Then, walk through the cash collection, combining it with the first
step.
The first step corresponds to Accounts Receivable increasing by $100, and the second step
represents AR decreasing by $100. Here’s what happens when it increases:
•
Income Statement: Revenue increases by $100, so Pre-Tax Income is up by $100, and
Net Income is up by $75 at a 25% tax rate.
•
Cash Flow Statement: Net Income is up by $75, but the increase in AR reduces cash flow
by $100, so Cash at the bottom is down by $25.
•
Balance Sheet: Cash is down by $25, but AR is up by $100, so the Assets side is up by
$75. On the L&E side, CSE is up by $75 due to the increased Net Income, so both sides
are up by $75 and balance.
•
Intuition: The company has to pay taxes on Revenue it hasn’t yet collected in cash, so its
Cash balance falls by $25.
And when the AR is collected, combining it with the first step:
•
Income Statement: The Net Income is still up by $75, and there are no other changes.
•
Cash Flow Statement: Net Income is still up by $75, but now the AR increase reverses,
so the Change in AR is $0. Therefore, Cash at the bottom is up by $75.
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•
Balance Sheet: Cash is now up by $75, and AR goes back to its original level, so the
Assets side is up by $75. The L&E side is still up by $75 because of the CSE increase due
to the increased Net Income in the first step, so both sides balance.
•
Intuition: This is a simple cash collection of a $100 payment owed to the company. Cash
goes from being down by $25 in the first step to being up by $75 to reflect this.
6. A company prepays $20 in rent one month in advance. Walk me through what happens on
the statements when the company prepays the expense, and then what happens when the
expense is recognized, combined with the first step.
This scenario corresponds to Prepaid Expenses increasing and then decreasing. First, the
increase:
•
Income Statement: No changes.
•
Cash Flow Statement: The $20 increase in Prepaid Expenses reduces the company’s
cash flow by $20, so Cash at the bottom is down by $20.
•
Balance Sheet: Cash is down by $20, but Prepaid Expenses is up by $20, so the Assets
side doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains
balanced.
•
Intuition: This is a simple cash payment for expenses that have not yet been incurred.
And then when Prepaid Expenses decrease, combining it with the first step:
•
Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20,
and Net Income falls by $15, assuming a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $15, but the increase in Prepaid Expenses
now reverses, and there are no other changes, so Cash at the bottom is down by $15.
•
Balance Sheet: Cash is down by $15, and Prepaid Expenses return to their original level,
so the Assets side is down by $15. The L&E side is also down by $15 due to the reduced
Net Income that flows into CSE, so both sides balance.
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•
Intuition: Cash decreases by $15 because this represents the payment and recognition
of a simple $20 cash expense, which reduces taxes by $5.
7. Walmart buys $400 in Inventory for products it will sell next month. Walk me through what
happens on the statements when they first buy the Inventory, and then when they sell the
products for $600, combining it with the first step.
The first step is a simple Inventory purchase. In the second step, the company has to record
COGS and the Revenue associated with the product sales. Here’s the first step:
•
Income Statement: No changes.
•
Cash Flow Statement: The $400 Inventory increase reduces the company’s cash flow, so
Cash at the bottom is down by $400.
•
Balance Sheet: Cash is down by $400, but Inventory is up by $400, so the Assets side
doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains in
balance.
•
Intuition: This is a simple cash purchase for an expense that has not yet been incurred.
And then here’s the second step, combining it with the changes in the first one:
•
Income Statement: Revenue is up by $600, but COGS is up by $400, so Pre-Tax Income
is up by $200, and Net Income is up by $150 at a 25% tax rate.
•
Cash Flow Statement: Net Income is up by $150, the Inventory increase now reverses
because the Inventory has been sold, and there are no other changes, so Cash at the
bottom is up by $150.
•
Balance Sheet: Cash is up by $150, and Inventory returns to its original level, so the
Assets side is up by $150. The L&E side is also up by $150 because Net Income increases
by $150 and flows into CSE, so both sides balance.
•
Intuition: Cumulatively, this process is a simple $200 increase in Pre-Tax Income, which
boosts Net Income by $150 at a 25% tax rate.
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8. Amazon decides to pay several key vendors $200 on credit and says it will pay them in cash
in one month. What happens on the financial statements when the expense is incurred, and
then when it is paid in cash? Combine the second step with the first one.
This scenario corresponds to Accounts Payable or Accrued Expenses increasing by $200 and
then decreasing by $200 when they’re finally paid out in cash.
•
Income Statement: Operating Expenses increase by $200, so Pre-Tax Income is down by
$200, and Net Income is down by $150, assuming a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $150, but AP increasing by $200 results in
higher cash flow since it means the expenses haven’t been paid in cash yet. So, Cash at
the bottom is up by $50.
•
Balance Sheet: Cash is up by $50, so the Assets side is up by $50. On the L&E side, AP is
up by $200, but CSE is down by $150 due to the reduced Net Income, so the L&E side is
up by $50, and both sides balance.
•
Intuition: This expense is “non-cash” at this point because it reduces the company’s
taxes but doesn’t cost anything in cash. Cash is up because of the reduced taxes.
And then here’s the second step, combined with the first step:
•
Income Statement: Net Income is still down by $150. No other changes.
•
Cash Flow Statement: Net Income is still down by $150, but now the AP increase
reverses, so the Change in AP becomes $0. As a result, Cash at the bottom is down by
$150.
•
Balance Sheet: Cash is down by $150, so the Assets side is down by $150. On the other
side, AP returns to its original level, and CSE is down by $150 because of the reduced
Net Income, so both sides are down by $150 and balance.
•
Intuition: From beginning to end, this is a simple $200 cash expense; Cash decreases by
$150 rather than $200 due to the tax savings in the first step.
9. Salesforce sells a customer a $100 per month subscription but makes the customer pay all
in cash, upfront, for the entire year. What happens to the statements?
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This scenario corresponds to Deferred Revenue increasing because the company collects the
Cash, but cannot yet recognize it as Revenue. The payment for the entire year is $1,200.
•
Income Statement: No changes.
•
Cash Flow Statement: DR increasing by $1,200 boosts the company’s cash flow, so Cash
at the bottom is up by $1,200.
•
Balance Sheet: Cash is up by $1,200, so the Assets side is up by $1,200, and Deferred
Revenue is up by $1,200, so the L&E side is up by $1,200, and both sides balance.
•
Intuition: This is a simple $1,200 cash inflow, with no taxes, for services the company
has not yet delivered.
10. What happens after one month has passed, and the company has delivered one month of
service for $100?
Assume that there are $20 in Operating Expenses associated with the delivery of the service
for this one month. Combine this step with the previous one.
•
Income Statement: Revenue is up by $100, but Operating Expenses are up by $20, so
Pre-Tax Income is up by $80, and Net Income is up by $60 at a 25% tax rate.
•
Cash Flow Statement: Net Income is up by $60, and part of the DR increase now
reverses, so the increase in DR is now $1,100 rather than $1,200. Cash at the bottom is
up by $1,160.
•
Balance Sheet: Cash is up by $1,160, so the Assets side is up by $1,160. On the L&E side,
Deferred Revenue is now up by $1,100 instead of $1,200, and CSE is up by $60 due to
the increased Net Income, so both sides are up by $1,160 and balance.
•
Intuition: Cash is up by less than it was in the previous step because the company must
pay expenses and taxes when part of the cash inflow is now recognized as Revenue.
11. A company issues $100 in common stock to new investors to fund its operations. How do
the statements change?
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•
Income Statement: No changes.
•
Cash Flow Statement: The $100 stock issuance is a cash inflow in Cash Flow from
Financing, and there are no other changes, so Cash at the bottom goes up by $100.
•
Balance Sheet: Cash is up by $100, so the Assets side is up by $100, and Common
Shareholders’ Equity on the other side goes up by $100, so the L&E side is up by $100,
and both sides balance.
•
Intuition: This is a simple cash inflow that doesn’t impact the company’s taxes at all.
12. This same company now realizes that it has too much Cash, so it wants to issue Dividends
or repurchase common shares. How do they impact the three statements differently?
Compare $100 in Dividends with a $100 Stock Repurchase.
These changes both make a similar impact; the main difference is that Dividends do not reduce
the common shares outstanding, but a Stock Repurchase does.
•
Income Statement: No changes.
•
Cash Flow Statement: Both of these show up as negative $100 entries in Cash Flow from
Financing, reducing the Cash at the bottom of the CFS by $100.
•
Balance Sheet: Cash is down by $100, so the Assets side is down by $100; on the L&E
side, Dividends reduce Retained Earnings within CSE by $100, while a Stock Repurchase
reduces Treasury Stock within CSE by $100. But in either case, CSE is down by $100, so
the L&E side is down by $100, and both sides balance.
•
Intuition: These are simple cash outflows that don’t affect the company’s taxes at all.
We can’t determine how the common shares outstanding change without information on the
share price at which the Stock Repurchase takes place.
13. A company that follows U.S. GAAP signs a $1,000 Operating Lease on January 1 and pays a
total of $100 in Rent throughout the year.
Walk me through the financial statements over this entire year in a single step.
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Initially, the company places the Operating Lease Assets and Liabilities on its Balance Sheet
($1,000 on both sides), and then it records the Rental Expense on the Income Statement:
•
Income Statement: Operating Expenses are up by $100 due to the Rent, so Pre-Tax
Income falls by $100, and Net Income falls by $75 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $75, but Operating Lease Assets and
Liabilities both increase by $1,000, which offset each other. Cash is down by $75 at the
bottom.
•
Balance Sheet: On the Assets side, Cash is down by $75, and Operating Lease Assets are
up by $1,000, so the Assets side is up by $925. On the L&E side, the Lease Liabilities are
up by $1,000, and CSE is down by $75 due to the reduced Net Income, so both sides are
up by $925 and balance.
•
Intuition: Cash is down by $75 because this is a simple $100 cash expense with $25 in
tax savings.
14. Now, a company that follows IFRS does the same thing. Assume that it splits the Rental
Expense into 60% Interest and 40% Depreciation and walk me through the statements over
the year, also in one step.
Under IFRS, this $100 Rental Expense is split into $60 of Interest and $40 of Depreciation:
•
Income Statement: Depreciation is up by $40, and the Interest Expense is up by $60, so
Pre-Tax Income falls by $100, and Net Income falls by $75 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $75, but you add back the $40 of
Depreciation. Operating Lease Assets and Liabilities both increase by $1,000, offsetting
each other on the CFS. In Cash Flow from Financing, you subtract the $40 of
Depreciation in the “Repayment of the Capital Element” line. So, Cash at the bottom is
down by $75.
•
Balance Sheet: Cash is down by $75, and Operating Lease Assets are up by $960 due to
the initial $1,000 increase and $40 of Depreciation, so Assets are up by $885. On the
L&E side, the Lease Liabilities are up by $960 due to the initial $1,000 increase and the
$40 Capital Element Repayment. CSE is down by $75 due to the reduced Net Income, so
the L&E side is up by $885, and both sides balance.
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•
Intuition: Cash is down by $75 because this is a $100 cash expense that also reduces the
company’s taxes by $25. The Lease Assets and Liabilities also change under IFRS because
of the Depreciation and Capital Element Repayment lines that flow in.
15. For Book purposes, a company records $20 in Depreciation. For Tax purposes, it records
$40 in Depreciation. Walk me through the financial statements.
You don’t need to walk through the Tax Schedule for this type of change as long as the numbers
are relatively simple:
•
Income Statement: The $20 in increased Depreciation reduces Pre-Tax Income by $20
and Net Income by $15 at a 25% tax rate, so the company saves $5 in taxes.
•
Cash Flow Statement: Net Income is down by $15, and you add back the $20 in
Depreciation as a non-cash expense. However, the company recorded $40 of
Depreciation for Cash-Tax purposes, so it actually reduced its Cash Taxes by $10, not $5.
You record this additional $5 as a positive in the Deferred Income Taxes line on the CFS.
Cash at the bottom is up by $10.
•
Balance Sheet: Cash is up by $10 on the Assets side, and Net PP&E is down by $20, so
the Assets side is down by $10. On the L&E side, the Deferred Tax Liability is up by $5,
and CSE is down by $15 due to the reduced Net Income, so the L&E side is also down by
$10, and both sides balance.
•
Intuition: Cash is up by $10 rather than $5 or $0 because the company’s actual Cash-Tax
savings equals $40 * 25% = $10.
16. A company has a factory shown at $200 on its Balance Sheet, but a hurricane hits the
factory and destroys part of it, so the company records a $100 PP&E Write-Down. Walk me
through the statements.
Normally, PP&E Write-Downs are not Cash-Tax deductible, so the “correct” treatment is:
•
Income Statement: The $100 PP&E Write-Down reduces Pre-Tax Income by $100, and
Net Income falls by $75 at a 25% tax rate.
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•
Cash Flow Statement: Net Income is down by $75, but you add back the $100 WriteDown as a non-cash expense. In reality, however, the company saved nothing in Cash
Taxes, so you also record a negative $25 in Deferred Income Taxes, and Cash at the
bottom is unchanged.
•
Balance Sheet: Cash does not change, but the Deferred Tax Asset increases by $25, and
Net PP&E decreases by $100, so the Assets side is down by $75. The L&E side is also
down by $75 because CSE falls due to the reduced Net Income, so both sides balance.
•
Intuition: Cash does not change because Write-Downs are typically not Cash-Tax
deductible, so the DTA, rather than Cash, increases.
Return to Top.
Multi-Step Changes on the Financial Statements
These questions get tricky because you have to keep track of more numbers.
If you don’t feel comfortable doing that, you can ask the interviewer if it’s OK to write down a
few figures as you’re moving along. It’s better to do that than to make a mistake.
You should also ask whether you need to give the CUMULATIVE change – i.e., what happens
after all events have passed, from beginning to end – or just the change after a single event.
We tend to use the cumulative change for simpler scenarios, but we switch to single-step
changes for more complex ones.
1. A company buys a factory for $200 using $200 of Debt. What happens INITIALLY on the
statements?
•
Income Statement: No changes.
•
Cash Flow Statement: There’s no net change in cash because the $200 factory purchase
counts as CapEx, which reduces cash flow, and the $200 Debt issuance is a cash inflow.
•
Balance Sheet: PP&E is up by $200, so the Assets side is up by $200, and Debt is up by
$200, so the L&E side is up by $200, and the Balance Sheet stays balanced.
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•
Intuition: An Asset increases and a Liability increases to balance it, and there are no tax
effects.
2. One year passes. The company pays 10% interest on its Debt, and it depreciates 10% of the
factory. It also repays 5% of the Debt principal. What happens on the statements in this first
year?
A 10% interest rate means $20 in Interest Expense, the 10% depreciation means $200 * 10% =
$20 of Depreciation, and 5% * $200 = $10 of the Debt principal is repaid. So:
•
Income Statement: You record $20 in Interest and $20 in Depreciation, so Pre-Tax
Income falls by $40, and Net Income falls by $30 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $30, but you add back the $20 of
Depreciation and record $10 in Debt Principal Repayments, so Cash at the bottom is
down by $20.
•
Balance Sheet: Cash is down by $20, and Net PP&E is down by $20, so the Assets side is
down by $40. On the L&E side, Debt is down by $10 due to the principal repayment, and
CSE is down by $30 due to the reduced Net Income, so both sides are down by $40 and
balance.
•
Intuition: Cash declines because of the Interest Expense and Debt Principal Repayment,
offset by the tax savings from the Interest and Depreciation.
3. At the end of this first year, the company sells its factories for $220 and uses the proceeds
to repay its remaining Debt principal, after realizing there is little demand for its products.
Walk through this step SEPARATELY from the previous two.
Assume that the Net PP&E balance is $180, and the Debt is $190 because of changes in the
previous step.
The Net PP&E selling price is $220, and its Book Value is $180, so we record a Gain of $40:
•
Income Statement: The Realized Gain of $40 increases Pre-Tax Income by $40 and Net
Income by $30 at a 25% tax rate.
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•
Cash Flow Statement: Net Income is up by $30, but the $40 Gain is non-cash, so it’s
reversed in the CFO section. Then, in Cash Flow from Investing, the full sale proceeds of
$220 are recorded as a cash inflow. In Cash Flow from Financing, the $190 Debt
repayment is shown as a negative. So, Cash at the bottom is up by $20.
•
Balance Sheet: Cash is up by $20, and Net PP&E is down by $180, so Total Assets are
down by $160. On the L&E side, Debt is down by $190, and CSE is up by $30 because of
the increased Net Income, so both sides are down by $160 and balance.
•
Intuition: Cash is up because of the Gain, which boosts Cash by $30 after taxes.
However, the full $30 does not flow into Cash because the Debt Repayment exceeds the
reduction in Net PP&E by $10. As a result, Cash is up by $20 instead of $30.
4. Walmart orders $200 of Inventory and pays for it using Debt. What happens on the
statements immediately after this initial transaction?
•
Income Statement: No changes.
•
Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but
the Debt issuance boosts cash flow by $200, so Cash at the bottom stays the same.
•
Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E
side is also up by $200 because Debt is up by $200, so both sides balance.
•
Intuition: This is a simple cash payment for an expense not yet incurred, combined with
a Debt issuance that offsets the cash outflow.
5. A year passes, and Walmart sells the $200 of Inventory for $400. However, it also has to
hire additional employees for $100 to process and deliver the orders (counted as OpEx).
The company also pays 4% interest on its Debt and repays 10% of the principal. What
happens on the statements over this year? Combine this step with the previous one and
explain the changes from beginning to end.
This question is the standard “Sell Inventory for a certain amount of Revenue” one, but there
are a few twists. For one, there’s also $100 in additional Operating Expenses.
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Also, you need to factor in the $8 Interest Expense on the Debt ($200 * 4%) and the $20 Debt
Principal Repayment ($200 * 10%).
•
Income Statement: Revenue is up by $400, but COGS is up by $200, and OpEx is up by
$100, so Operating Income is only up by $100. There’s $8 in Interest Expense as well, so
Pre-Tax Income is up by $92. At a 25% tax rate, Net Income is up by $69 (mental math:
$100 * 75% = $75, and $8 * 75% = $6, so take $75 and subtract $6).
•
Cash Flow Statement: Net Income is up by $69. But now we reverse the previous
increase in Inventory, so the Change in Inventory is $0 once again. The $200 cash inflow
for Debt still exists, but now there’s also a $20 Debt Principal Repayment so Cash at the
bottom is up by $249.
•
Balance Sheet: Cash is up by $249, and Inventory returns to its original level, so the
Assets side is up by $249. On the L&E side, Debt is up by $180, and CSE is up by $69 due
to the increased Net Income, so both sides are up by $249 and balance.
•
Intuition: The company has bought goods, turned them into finished products, and
recorded $75 in after-tax profits from the sale. However, its Cash balance increases by
only $49 due to the Interest Expense on the Debt it used to purchase this Inventory as
well as the Debt Principal Repayment.
6. Walk through the same scenario, but assume that Walmart purchases the $200 of
Inventory on credit (i.e., Accounts Payable), sells it for $400, and still records $100 in
additional OpEx. Assume that it pays the suppliers in the second step of this process.
Remember that Accounts Payable is not necessarily linked to a specific Income Statement line
item in a case like this! It could just correspond to the company paying for Inventory on credit.
In the first step:
•
Income Statement: No changes.
•
Cash Flow Statement: Accounts Payable increases, increasing cash flow by $200, and
Inventory also increases, reducing cash flow by $200; the changes offset each other, and
Cash at the bottom stays the same.
•
Balance Sheet: Inventory on the Assets side is up by $200, and Accounts Payable on the
L&E side is up by $200, so both sides are up by $200 and balance.
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•
Intuition: The company receives the parts and materials, but has not paid for them in
cash yet, so the Balance Sheet changes but Cash stays the same.
And then in the second step:
•
Income Statement: Revenue is up by $400, COGS is up by $200, and OpEx is up by $100,
so Pre-Tax Income is up by $100. Net Income is up by $75 at a 25% tax rate.
•
Cash Flow Statement: Net Income is up by $75, and the Change in Inventory and
Change in Accounts Payable both reverse now, so Cash at the bottom is up by $75.
•
Balance Sheet: Cash is up by $75 on the Assets side, and Inventory returns to its original
level, so Total Assets are up by $75. On the L&E side, AP returns to its original level, and
CSE is up by $75 due to the increased Net Income, so both sides are up by $75 and
balance.
•
Intuition: From beginning to end, this is a simple increase of $100 in Pre-Tax Income, so
the company’s Cash balance goes up by $75 due to taxes.
7. A company issues $200 in Preferred Stock to buy $200 in Financial Investments. The
Preferred Stock has a coupon rate of 8%, and the Financial Investments yield 10%. What
happens on the statements IMMEDIATELY after the initial purchase?
•
Income Statement: No changes.
•
Cash Flow Statement: The purchase of the Financial Investments counts as an Investing
Activity and reduces cash flow by $200, but the Preferred Stock issuance boosts cash
flow by $200 within CFF, so there’s no net change in cash.
•
Balance Sheet: Financial Investments is up by $200, so the Assets side is up by $200, and
Preferred Stock on the other side is up by $200, so the L&E side is up by $200, and both
sides balance.
•
Intuition: This is a simple cash purchase of investments funded by a Preferred Stock
issuance, and neither event affects the company’s taxes.
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8. What happens on the statements after a year? Combine this step with the previous one, so
that you factor in the increases in Financial Investments and Preferred Stock.
Although you subtract Preferred Dividends from Net Income to calculate Net Income to
Common, the Preferred Dividends are NOT tax-deductible:
•
Income Statement: The company records 10% * $200 = $20 in Interest Income from the
Financial Investments, so Pre-Tax Income is up by $20, and Net Income is up by $15 at a
25% tax rate. The Preferred Dividends equal 8% * $200 = $16, so Net Income to
Common is down by $1 after subtracting these.
•
Cash Flow Statement: Net Income to Common is down by $1, and the Financial
Investment and Preferred Stock increases still appear on the CFS and offset each other,
so Cash at the bottom is down by $1.
•
Balance Sheet: Cash is down by $1, and Financial Investments are up by $200, so the
Assets side is up by $199. On the L&E side, Preferred Stock is still up by $200, and CSE is
down by $1 because of the reduced Net Income to Common, so both sides are down by
$199 and balance.
•
Intuition: The point of this question is that the tax treatment of funding sources can
make a significant impact on the statements. Since the Preferred Dividends are not taxdeductible, the company’s Cash balance falls; if they had been tax-deductible, its Cash
balance would have risen. Also, note that Preferred Dividends do not reduce Preferred
Stock – they reduce Common Shareholders’ Equity!
9. A company wants to boost its EPS artificially, so it decides to issue Debt and use the
proceeds to repurchase common shares.
Initially, the company has 1,000 shares outstanding at $1.00 per share and a Net Income of
$300.
What happens IMMEDIATELY after the company raises $200 in Debt and uses it to repurchase
$200 in common stock?
Repurchasing $200 in stock at a share price of $1.00 per share means that the company
repurchases 200 shares, so its share count drops from 1,000 to 800.
Its EPS before this move was $300 / 1,000, or $0.30. For the first step:
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•
Income Statement: No changes.
•
Cash Flow Statement: The $200 Debt issuance boosts cash flow by $200, but the $200
stock repurchase reduces it by $200, so there’s no net change in cash.
•
Balance Sheet: There are no changes on the Asset side. On the L&E side, Debt is up by
$200, but Treasury Stock within CSE is down by $200, so there’s no net change, and the
BS remains in balance.
•
Intuition: These are simple cash inflows and outflows that cancel each other out and
make no impact on the company’s taxes.
10. What happens after a year passes if the company pays 4% interest on the Debt? Combine
this with the first step and explain the EPS impact.
This question is a twist on the standard 3-statement accounting questions because you also
have to calculate the change in EPS:
•
Income Statement: The company records 4% * $200 = $8 in Interest Expense, so Pre-Tax
Income is down by $8, and Net Income is down by $6 at a 25% tax rate. Net Income is
now $294 rather than $300, and the Share Count decreased from 1,000 to 800 in Step 1.
Therefore, EPS increases because the EPS numerator falls by 2%, but the denominator
falls by 20% (it’s a $0.07 increase, but you can just say, “EPS increases”).
•
Cash Flow Statement: Net Income is down by $6, and the Debt Issuance and Stock
Repurchase still offset each other, so Cash at the bottom is down by $6.
•
Balance Sheet: Cash is down by $6, so the Assets side is down by $6. On the L&E side,
Debt is still up by $200, CSE is down by $200 due to the Stock Repurchase, and then it
drops by another $6 due to the reduced Net Income, so the L&E side is also down by $6,
and both sides balance.
•
Intuition: Companies can artificially inflate their EPS with these tactics, so they may
“look better” even if their cash flow and Cash balances both decrease. Don’t trust EPS!
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11. Your company decides to acquire another company for $500, using 50% Debt and 50%
Common Stock.
The other company has $300 in Assets, no Liabilities, and $300 in Common Shareholders’
Equity. Assume that the purchase premium is distributed 50/50 between Goodwill and Other
Intangible Assets.
What happens to your company’s financial statements immediately after this acquisition
takes place?
You combine the other company’s Assets and Liabilities with your company’s, and you write
down the seller’s Common Shareholders’ Equity:
•
Income Statement: No changes.
•
Cash Flow Statement: You record a negative $500 for “Acquisitions” in Cash Flow from
Investing and a positive $250 for Debt Issuances and positive $250 for Common Stock
Issuances under Cash Flow from Financing. Cash at the bottom is unchanged.
•
Balance Sheet: Cash stays the same, but you add the $300 in Acquired Assets, as well as
the $100 in Goodwill and $100 in Other Intangible Assets, so the Assets side is up by
$500. On the other side, Debt is up by $250, and CSE is up by $250, so the L&E side is
also up by $500, and both sides balance.
•
Intuition: Immediately after the deal closes, the main changes take place on the Balance
Sheet; Cash does not change because the acquisition was funded completely with Debt
and a Stock Issuance.
12. Now, walk through what happens on the statements in the one year following this
acquisition. The acquired company contributes $200 in Revenue and $100 in OpEx, and the
Interest Rate on Debt is 8%. Assume that the Other Intangible Assets have a useful life of 5
years.
Walk through ONLY THIS STEP, and do not worry about tracking the cumulative changes with
the previous one.
•
Income Statement: Revenue is up by $200, but OpEx is up by $100, and there’s now
$100 / 5 = $20 of Amortization of Intangibles and $250 * 8% = $20 of Interest Expense.
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So, Pre-Tax Income is up by $100 – $20 – $20 = $60. At a 25% tax rate, Net Income is up
by $45.
•
Cash Flow Statement: Net Income is up by $45, and we add back the $20 of
Amortization of Intangibles since it was non-cash. However, we also make an
adjustment of ($5) in Deferred Income Taxes because this Amortization is not Cash-Tax
Deductible. So, Cash at the bottom is up by $45 + $20 – $5 = $60.
•
Balance Sheet: Cash is up by $60, Other Intangibles are down by $20 due to the
Amortization, and the Net DTA is up by $5 due to the Deferred Income Tax adjustment,
so the Assets side is up by $45. On the L&E side, CSE is up by $45 due to the increased
Net Income, so both sides are up by $45 and balance.
•
Intuition: The acquired company contributes $100 in Operating Income, but it’s not a
straight $75 increase to Cash because of the new Amortization and Interest Expense,
which make it to a $45 increase instead.
13. On December 31 of Year 1, this same company now decides that this acquired company is
worth far less than expected, so it writes down the entire $100 balance of Goodwill.
Walk through JUST THIS STEP BY ITSELF, ignoring the cumulative changes in the previous two
steps.
This one is a simple non-cash expense that is also not Cash-Tax Deductible:
•
Income Statement: Record a $100 Goodwill Impairment, which reduces Pre-Tax Income
by $100 and Net Income by $75 at a 25% tax rate.
•
Cash Flow Statement: Net Income is down by $75, and you add back the $100 Goodwill
Impairment. Also, since it was not Cash-Tax Deductible, record a ($25) adjustment in
Deferred Income Taxes. Cash at the bottom is unchanged.
•
Balance Sheet: Cash is unchanged, Goodwill is down by $100, and the Net DTA is up by
$25, so Total Assets are down by $75. On the L&E side, CSE is down by $75 due to the
reduced Net Income, so both sides are down by $75 and balance.
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•
Intuition: Impairments and write-downs are rarely, if ever, Cash-Tax deductible. So,
when they occur, they increase the company’s DTA or Net DTA rather than increasing its
Cash balance.
Return to Top.
Working Capital, Free Cash Flow, and Other Metrics and Ratios
Questions on these topics are not common in investment banking interviews; key metrics and
ratios are more important in public-markets roles such as equity research.
Still, questions on Working Capital, Free Cash Flow, and financial ratios could come up, so we
present a few examples here.
1. What is Free Cash Flow (FCF), and what does it mean if it's positive and increasing?
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 also paying for the cost of its funding sources, such as interest on Debt.
It’s defined this way because most items in CFO are required to run the business, while most of
the CFI and CFF sections are optional or non-recurring (except for CapEx).
It’s generally a good sign if FCF is positive and increasing, as long as it’s driven by the company’s
sales, market share, and margins growing (rather than creative cost-cutting or reduced reinvestment into the business).
Positive and growing FCF means the company doesn’t need outside funding sources to stay
afloat, and it could spend its cash flow in different ways: hiring more employees, re-investing in
the business, acquiring other companies, or returning money to the shareholders with
Dividends or Stock Repurchases.
2. What does FCF mean if it's negative or decreasing?
You have to find out why FCF is negative or decreasing first. For example, if FCF is negative
because CapEx in one year was unusually high, but it’s expected to return to normal levels in
the future, negative FCF in one year doesn’t mean much.
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On the other hand, if FCF is negative because the company’s sales and operating income have
been declining each year, then the business is in trouble.
If FCF decreases to the point where the company runs low on Cash, it will have to raise Equity
or Debt funding ASAP and restructure to continue operating.
Short periods of negative FCF, such as for early-stage startups, are acceptable, but if a company
continues to generate negative cash flow for years or decades, stay away!
3. Why might you have to adjust the calculation for FCF if you’re analyzing a company that
follows IFRS rather than U.S. GAAP?
The simple definition (Cash Flow from Operations minus CapEx) assumes that Cash Flow from
Operations has deductions for the Net Interest Expense, Preferred Dividends (if applicable),
Taxes, and all Lease Expenses.
That is almost always the case under U.S. GAAP because CFO usually starts with Net Income (to
Common), but under IFRS, the presentation of the Cash Flow Statement varies widely.
So, if a company starts CFO with Operating Income or Pre-Tax Income instead, you’ll have to
make adjustments to ensure that the proper items have been deducted.
Also, you should not add back the Depreciation element of the Lease Expense in the non-cash
adjustments section of CFO.
4. What is Working Capital?
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 instead.
You may also include Long-Term Assets and Liabilities that are related to the company’s
business operations (Long-Term Deferred Revenue is a good example).
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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. But the Change in Working Capital
(see below) matters far more for valuation purposes.
5. A company has negative Working Capital. Is that “good” or “bad”?
It depends on why the Working Capital is negative because different components mean
different things.
For example, if the company has $100 in Accounts Receivable, $100 in Inventory, and $500 in
Deferred Revenue, for ($300) in Working Capital, that’s considered positive because the high
Deferred Revenue balance means it has collected significant cash before product/service
delivery.
But if that company has $100 in AR, $100 in Inventory, and $500 in Accounts Payable, that’s
considered negative because it means the company owes a lot of cash to its suppliers and other
vendors and collects no cash from customers in advance of deliveries.
6. Should Changes in Operating Lease Assets and Liabilities be included in the Change in
Working Capital? What difference does it make if they are included or not included?
Different companies set up their statements differently, so some companies list these items
within the Change in WC, others list them outside of the Change in WC but within Cash Flow
from Operations, and others do not list them on the CFS at all.
The exact treatment makes almost no difference because the Change in Operating Lease
Assets should equal, or be very close to, the Change in Operating Lease Liabilities each year,
so the cash flows offset each other.
Note that this principle applies under both U.S. GAAP and IFRS, even though the Lease Expense
is recorded differently under each system.
7. A company's Working Capital has increased from $50 to $200.
You calculate the Change in Working Capital by taking the new number and subtracting the
old number, so $200 – $50 = positive $150.
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But on its Cash Flow Statement, the company records the Change in Working Capital as
negative $150. Is the company wrong?
No, the company is correct. On the Cash Flow Statement, the Change in Working Capital
equals Old Working Capital – New Working Capital.
Pretend that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to
$200, that will reduce the company’s cash flow because it means the company has spent Cash
to purchase Inventory.
Therefore, the Change in Inventory should be ($150) on the CFS, and if that’s the only
component of Working Capital, the Change in WC should also be ($150).
When a company’s Working Capital INCREASES, the company USES cash to do that; when
Working Capital DECREASES, it FREES UP cash.
8. What does the Change in Working Capital mean?
The Change in Working Capital tells you if the company needs to spend in ADVANCE of its
growth, or if it generates more cash flow as a RESULT of its growth.
It’s also a component of Free Cash Flow and gives you an indication of how much “Cash Flow”
will differ from Net Income, and in which direction.
For example, the Change in Working Capital is often negative for retailers because they must
spend money on Inventory before being able to sell products.
But the Change in Working Capital is often positive for subscription companies that collect cash
from customers far in advance because Deferred Revenue increases when they do that, and
increases in Deferred Revenue boost cash flow.
The Change in Working Capital increases or decreases Free Cash Flow, which directly affects the
company’s valuation.
9. What does it mean if a company's FCF is growing, but its Change in Working Capital is more
and more negative each year?
It means that the company’s Net Income or non-cash charges are growing by more than its
Change in WC is declining, or that its CapEx is becoming less negative by more than the Change
in WC is declining.
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If a company’s Net Income is growing for legitimate reasons, this is a positive sign. But if higher
non-cash charges or artificially reduced CapEx are boosting FCF, both are negative.
10. In its filings, a company states that EBITDA is a “proxy” for its Cash Flow from Operations.
The company’s EBITDA has been positive and growing at 20% for the past three years.
However, the company recently ran low on Cash and filed for bankruptcy. How could this
have happened?
Although EBITDA can be a “proxy” for CFO, it is not a perfect representation of a company’s
cash flow. Think about all the items that EBITDA excludes, but which affect the company’s Cash
balance:
•
CapEx – Unnecessarily high CapEx spending might have pushed the company to
bankruptcy.
•
Acquisitions – Or, maybe the company spent a fortune on companies that turned out to
be worthless.
•
Interest Expense and Debt Repayment Obligations – A “positive and growing EBITDA”
could have hidden a “massively growing Interest Expense.”
•
Change in Working Capital – Maybe the company became less efficient in collecting
cash from customers, or it had to start paying its suppliers more quickly.
•
One-Time Charges – If EBITDA excludes large “one-time” expenses such as legal and
restructuring charges, it might paint a far rosier picture than reality.
11. How do you calculate Return on Invested Capital (ROIC), and what does it tell you?
ROIC is defined as NOPAT / Average Invested Capital, where NOPAT (Net Operating Profit After
Taxes) = EBIT * (1 – Tax Rate), and Invested Capital = Equity + Debt + Preferred Stock + Other
Long-Term Funding Sources.
It tells you how efficiently a company is using its capital from all sources (both external and
internal) to generate operating profits.
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Among similar companies, ones with higher ROIC figures should, in theory, be valued more
highly because all the investor groups earn more for each $1.00 invested into the company.
12. What are the advantages and disadvantages of ROE, ROA, and ROIC for measuring
company performance?
These metrics all measure how efficiently a company is using its Equity, Assets, or Invested
Capital to generate profits, but the nuances are slightly different.
ROE and ROA are both affected by capital structure (the company’s Cash and Debt and Net
Interest Expense) because they use Net Income (to Common) in the numerator.
However, they’re also “closer to reality” because Net Income (to Common) is an actual metric
that appears on companies’ financial statements and affects the Cash balance.
By contrast, since NOPAT is a hypothetical metric that doesn’t appear on the statements, ROIC
is further removed from the company’s Cash position, even though it has the advantage of
being capital structure-neutral.
In terms of ROE vs. ROA, ROA tends to be more useful for companies that depend heavily on
their Assets to generate Net Income (e.g., banks and insurance firms), while ROE is more of a
general-purpose metric that applies to many industries.
13. A company seems to be boosting its ROE artificially by using leverage to fuel its growth.
Which metrics or ratios could you look at to see if this is true?
Companies can artificially boost their ROE by continually issuing Debt rather than Equity
because Debt doesn’t affect the denominator, and the Interest Expense from Debt only makes
a small impact on the numerator (Net Income).
And this small impact is usually outweighed by the additional Operating Income the company
generates from the assets it buys with the proceeds from the Debt issuances.
To see if this is happening, you could check the company’s Debt / EBITDA and EBITDA / Interest
ratios and see how they’ve been trending. If Debt / EBITDA keeps increasing while EBITDA /
Interest keeps decreasing, the company may be relying on leverage to boost its ROE.
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14. What does it say about a company if its Days Receivables Outstanding is ~5, but its Days
Payable Outstanding is ~60?
It tells you that the company has quite a lot of market power to collect cash from customers
quickly and to delay supplier payments for a long time. Examples might be companies like
Amazon and Walmart that dominate their respective markets and that often make suppliers
“offers they can’t refuse.”
15. What is the Cash Conversion Cycle (CCC), and what does it mean if, among a group of
similar companies, one company’s CCC is 5, and another’s is 30?
The Cash Conversion Cycle is defined as Days Sales Outstanding (DSO) + Days Inventory
Outstanding (DIO) – Days Payable Outstanding (DPO), and it tells you how much time it takes a
company to convert its Inventory and other short-term Assets, such as Accounts Receivable,
into Cash.
Lower is better for this metric because it means the company “converts” these items into cash
flow more quickly, so a CCC is 5 is better than a CCC of 30.
This one also depends heavily on the industry: the CCC is often low (under 10) for large
retailers, but it may be over 100 (or more!) in an industry like spirits, where Inventory may sit
on the Balance Sheet for months, years, or decades.
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