WALL STREET PREP UPDATED EXAM SCRIPT
QUESTIONS AND ANSWERS MARKED A+
✔✔Walk me through the cash flow statement. - ✔✔There are two methods by which
cash flow statements are organized: Direct and Indirect. The more common approach is
the indirect method, whereby the cash flow statement is broken out into three sections:
1. Cash from Operations: The cash from operations section starts with net income and
adds back non-cash expenses such as depreciation & amortization and stock based
compensation, and then makes adjustments for changes in working capital.
2. Cash from Investing: Next, the cash from investing section accounts for capital
expenditures (typically the largest outflow), followed by any business acquisitions or
divestitures.
3. Cash from Financing: In the third section, cash from financing shows the net cash
impact of raising capital from issuances of equity or debt, net of cash used for share
repurchases, and repayments of debt. The cash outflows from the payout of dividends
to shareholders will be reflected here as well.
Together, the sum of the three sections will be the net change in cash for the period.
This figure will then be added to the beginning-of-period cash balance to arrive at the
ending cash balance.
✔✔How are the three financial statements connected? - ✔✔IS ↔ CFS: The cash flow
statement is connected to the income statement through net income, as net income is
the starting line on the cash flow statement.
CFS ↔ BS: Next, the cash flow statement is linked to the balance sheet because it
tracks the changes in the balance sheet's working capital (current assets and liabilities).
The impact from capital expenditures (PP&E), debt or equity issuances, and share
buybacks (treasury stock) are also reflected on the balance sheet. In addition, the
ending cash balance from the bottom of the cash flow statement will flow to the balance
sheet as the cash balance for the current period.
IS ↔ BS: The income statement is connected to the balance sheet through retained
earnings. Net income minus dividends issued during the period will be added to the
prior period's retained earnings balance to calculate the current period's retained
earnings. Interest expense on the income statement is also calculated off the beginning
and ending debt balances on the balance sheet, and PP&E on the balance sheet is
reduced by depreciation, which is an expense on the income statement.
✔✔If you have a balance sheet and must choose between the income statement or
cash flow statement, which would you pick? - ✔✔Assuming that I would be given both
the beginning and end of period balance sheets, I would choose the income statement
since I could reconcile the cash flow statement using the balance sheet's year-over-year
changes along with the income statement.
,✔✔Which is more important, the income statement or the cash flow statement? -
✔✔The income statement and cash flow statement are both necessary, and any in-
depth analysis would require using both. However, the cash flow statement is arguably
more important because it reconciles net income, the accrual-based bottom line on the
income statement, to what is actually occurring to cash.
This means the actual movement of cash during the period is reflected on the cash flow
statement. Thus, the cash flow statement brings attention to liquidity-related issues and
investments and financing activities that don't show up on the accrual-based income
statement.
✔✔If you had to pick between either the income statement or cash flow statement to
analyze a company, which would you pick? - ✔✔In most cases, the cash flow statement
would be chosen since the cash flow statement reflects a company's true liquidity and is
not prone to the same discretionary accounting conventions used in accrual accounting.
Whether you're an equity investor or lender, a company's ability to generate sufficient
free cash flow to reinvest into its operations and meet its debt obligations comes first. At
the end of the day, "cash is king."
Although one factor that could switch the answer is the company's profitability. For an
unprofitable company, the income statement can be used to value the company based
on a revenue multiple. The cash flow statement becomes less useful for valuation
purposes if the company's net income, cash from operations, and free cash flow are all
negative
✔✔Why is the income statement insufficient to assess the liquidity of a company? -
✔✔The income statement can be misleading in the portrayal of a company's health from
a liquidity and solvency standpoint.
For example, a company can consistently show positive net income yet struggle to
collect sales made on credit. The company's inability to retrieve payments from
customers would not be reflected on its income statement.
Financial reporting under accrual accounting is also imperfect in the sense that it often
relies on management discretion. This "wiggle room" for managerial discretion in
reporting decisions increases the risk of earnings management and the misleading
depiction of a company's actual operational performance.
The solution to the shortcomings of the income statement is the cash flow statement,
which reconciles net income based on the real cash inflows/(outflows) to understand the
true cash impact from operations, investing, and financing activities during the period.
✔✔What are some discretionary management decisions that could inflate earnings? -
✔✔Using excess useful life assumptions for new capital expenditures to reduce the
annual depreciation
,Switching from LIFO to FIFO if inventory costs are expected to increase, resulting in
higher net income
Refusing to write-down impaired assets to avoid the impairment loss, which would
reduce net income
Changing policies for costs to be capitalized rather than expensed (e.g., capitalized
software costs)
Repurchasing shares to decrease its share count and artificially increase earnings per
share ("EPS")
Deferral of capex or R&D to the next period to show more profitability and cash flow in
the current period
More aggressive revenue recognition policies in which the obligations of the buyer
become less stringent
✔✔Tell me about the revenue recognition and matching principle used in accrual
accounting - ✔✔Revenue Recognition Principle: Revenue is recorded in the same
period the good or service was delivered (and therefore "earned"), whether or not cash
was collected from the customer.
Matching Principle: The expenses associated with the production/delivery of a good or
service must be recorded in the same period as when the revenue was earned.
✔✔How does accrual accounting differ from cash-basis accounting? - ✔✔Accrual
Accounting: For accrual accounting, revenue recognition is based on when it's earned
and the expenses associated with that revenue are incurred in the same period.
Cash-Basis Accounting: Under cash-basis accounting, revenues and expenses are
recognized once cash is received or spent, regardless of whether the product or service
was delivered to the customer.
✔✔What is the difference between cost of goods sold and operating expenses? -
✔✔Cost of Goods Sold: COGS represents the direct costs associated with the
production of the goods sold or the delivery of services to generate revenue. Examples
include direct material and labor costs.
Operating Expenses: Operating expenses such as SG&A and R&D are not directly
associated with the production of goods or services offered. Often called indirect costs,
examples include rent, payroll, wages, commissions, meal and travel expenses,
advertising, and marketing expenses.
, ✔✔When do you capitalize vs. expense items under accrual accounting? - ✔✔The
factor that determines whether an item gets capitalized as an asset or gets expensed in
the period incurred is its useful life (i.e., estimated timing of benefits).
Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for
more than one year need to be capitalized and expensed over time. For example, PP&E
such as a building can provide benefits for 15+ years and is therefore depreciated over
its useful life.
Expensed: In contrast, when the benefits received are short-term, the related expenses
should be incurred in the same period. For example, inventory cycles out fairly quickly
within a year and employee wages should be expensed when the employee's services
were provided.
✔✔If depreciation is a non-cash expense, how does it affect net income? - ✔✔While
depreciation is treated as non-cash and an add-back on the cash flow statement, the
expense is tax deductible and reduces the tax burden. The actual cash outflow for the
initial purchase of PP&E has already occurred, so the annual depreciation is the non-
cash allocation of the initial outlay at purchase.
✔✔Do companies prefer straight-line or accelerated depreciation? - ✔✔For GAAP
reporting purposes, most companies prefer straight-line depreciation because lower
depreciation will be recorded in the earlier years of the asset's useful life than under
accelerated depreciation. As a result, companies using straight-line depreciation will
show higher net income and EPS in the initial years.
Eventually, the accelerated approach will show lower depreciation into an asset's life
than the straight-line method. However, companies still prefer straight-line depreciation
because of the timing, as many companies are focused more on near-term earnings.
If the company is constantly acquiring new assets, the "flip" won't occur until the
company significantly scales back capital expenditures.
✔✔What is the relationship between depreciation and the salvage value assumption? -
✔✔Most companies will use a salvage value assumption in which the remaining value
of the asset is zero by the end of the useful life. The difference between the cost of the
asset and residual value is known as the total depreciable amount. If the salvage value
is assumed to be zero, the depreciation expense each year will be higher and the tax
benefits from depreciation will be fully maximized.
Straight Line Annual Depreciation = (Asset Historical Cost − Salvage Value)/ Useful Life
Assumption
✔✔Do companies depreciate land? - ✔✔While classified as a long-term asset on the
balance sheet, land is assumed to have an indefinite useful life under accrual
accounting, and therefore depreciation is prohibited
QUESTIONS AND ANSWERS MARKED A+
✔✔Walk me through the cash flow statement. - ✔✔There are two methods by which
cash flow statements are organized: Direct and Indirect. The more common approach is
the indirect method, whereby the cash flow statement is broken out into three sections:
1. Cash from Operations: The cash from operations section starts with net income and
adds back non-cash expenses such as depreciation & amortization and stock based
compensation, and then makes adjustments for changes in working capital.
2. Cash from Investing: Next, the cash from investing section accounts for capital
expenditures (typically the largest outflow), followed by any business acquisitions or
divestitures.
3. Cash from Financing: In the third section, cash from financing shows the net cash
impact of raising capital from issuances of equity or debt, net of cash used for share
repurchases, and repayments of debt. The cash outflows from the payout of dividends
to shareholders will be reflected here as well.
Together, the sum of the three sections will be the net change in cash for the period.
This figure will then be added to the beginning-of-period cash balance to arrive at the
ending cash balance.
✔✔How are the three financial statements connected? - ✔✔IS ↔ CFS: The cash flow
statement is connected to the income statement through net income, as net income is
the starting line on the cash flow statement.
CFS ↔ BS: Next, the cash flow statement is linked to the balance sheet because it
tracks the changes in the balance sheet's working capital (current assets and liabilities).
The impact from capital expenditures (PP&E), debt or equity issuances, and share
buybacks (treasury stock) are also reflected on the balance sheet. In addition, the
ending cash balance from the bottom of the cash flow statement will flow to the balance
sheet as the cash balance for the current period.
IS ↔ BS: The income statement is connected to the balance sheet through retained
earnings. Net income minus dividends issued during the period will be added to the
prior period's retained earnings balance to calculate the current period's retained
earnings. Interest expense on the income statement is also calculated off the beginning
and ending debt balances on the balance sheet, and PP&E on the balance sheet is
reduced by depreciation, which is an expense on the income statement.
✔✔If you have a balance sheet and must choose between the income statement or
cash flow statement, which would you pick? - ✔✔Assuming that I would be given both
the beginning and end of period balance sheets, I would choose the income statement
since I could reconcile the cash flow statement using the balance sheet's year-over-year
changes along with the income statement.
,✔✔Which is more important, the income statement or the cash flow statement? -
✔✔The income statement and cash flow statement are both necessary, and any in-
depth analysis would require using both. However, the cash flow statement is arguably
more important because it reconciles net income, the accrual-based bottom line on the
income statement, to what is actually occurring to cash.
This means the actual movement of cash during the period is reflected on the cash flow
statement. Thus, the cash flow statement brings attention to liquidity-related issues and
investments and financing activities that don't show up on the accrual-based income
statement.
✔✔If you had to pick between either the income statement or cash flow statement to
analyze a company, which would you pick? - ✔✔In most cases, the cash flow statement
would be chosen since the cash flow statement reflects a company's true liquidity and is
not prone to the same discretionary accounting conventions used in accrual accounting.
Whether you're an equity investor or lender, a company's ability to generate sufficient
free cash flow to reinvest into its operations and meet its debt obligations comes first. At
the end of the day, "cash is king."
Although one factor that could switch the answer is the company's profitability. For an
unprofitable company, the income statement can be used to value the company based
on a revenue multiple. The cash flow statement becomes less useful for valuation
purposes if the company's net income, cash from operations, and free cash flow are all
negative
✔✔Why is the income statement insufficient to assess the liquidity of a company? -
✔✔The income statement can be misleading in the portrayal of a company's health from
a liquidity and solvency standpoint.
For example, a company can consistently show positive net income yet struggle to
collect sales made on credit. The company's inability to retrieve payments from
customers would not be reflected on its income statement.
Financial reporting under accrual accounting is also imperfect in the sense that it often
relies on management discretion. This "wiggle room" for managerial discretion in
reporting decisions increases the risk of earnings management and the misleading
depiction of a company's actual operational performance.
The solution to the shortcomings of the income statement is the cash flow statement,
which reconciles net income based on the real cash inflows/(outflows) to understand the
true cash impact from operations, investing, and financing activities during the period.
✔✔What are some discretionary management decisions that could inflate earnings? -
✔✔Using excess useful life assumptions for new capital expenditures to reduce the
annual depreciation
,Switching from LIFO to FIFO if inventory costs are expected to increase, resulting in
higher net income
Refusing to write-down impaired assets to avoid the impairment loss, which would
reduce net income
Changing policies for costs to be capitalized rather than expensed (e.g., capitalized
software costs)
Repurchasing shares to decrease its share count and artificially increase earnings per
share ("EPS")
Deferral of capex or R&D to the next period to show more profitability and cash flow in
the current period
More aggressive revenue recognition policies in which the obligations of the buyer
become less stringent
✔✔Tell me about the revenue recognition and matching principle used in accrual
accounting - ✔✔Revenue Recognition Principle: Revenue is recorded in the same
period the good or service was delivered (and therefore "earned"), whether or not cash
was collected from the customer.
Matching Principle: The expenses associated with the production/delivery of a good or
service must be recorded in the same period as when the revenue was earned.
✔✔How does accrual accounting differ from cash-basis accounting? - ✔✔Accrual
Accounting: For accrual accounting, revenue recognition is based on when it's earned
and the expenses associated with that revenue are incurred in the same period.
Cash-Basis Accounting: Under cash-basis accounting, revenues and expenses are
recognized once cash is received or spent, regardless of whether the product or service
was delivered to the customer.
✔✔What is the difference between cost of goods sold and operating expenses? -
✔✔Cost of Goods Sold: COGS represents the direct costs associated with the
production of the goods sold or the delivery of services to generate revenue. Examples
include direct material and labor costs.
Operating Expenses: Operating expenses such as SG&A and R&D are not directly
associated with the production of goods or services offered. Often called indirect costs,
examples include rent, payroll, wages, commissions, meal and travel expenses,
advertising, and marketing expenses.
, ✔✔When do you capitalize vs. expense items under accrual accounting? - ✔✔The
factor that determines whether an item gets capitalized as an asset or gets expensed in
the period incurred is its useful life (i.e., estimated timing of benefits).
Capitalized: Expenditures on fixed and intangible assets expected to benefit the firm for
more than one year need to be capitalized and expensed over time. For example, PP&E
such as a building can provide benefits for 15+ years and is therefore depreciated over
its useful life.
Expensed: In contrast, when the benefits received are short-term, the related expenses
should be incurred in the same period. For example, inventory cycles out fairly quickly
within a year and employee wages should be expensed when the employee's services
were provided.
✔✔If depreciation is a non-cash expense, how does it affect net income? - ✔✔While
depreciation is treated as non-cash and an add-back on the cash flow statement, the
expense is tax deductible and reduces the tax burden. The actual cash outflow for the
initial purchase of PP&E has already occurred, so the annual depreciation is the non-
cash allocation of the initial outlay at purchase.
✔✔Do companies prefer straight-line or accelerated depreciation? - ✔✔For GAAP
reporting purposes, most companies prefer straight-line depreciation because lower
depreciation will be recorded in the earlier years of the asset's useful life than under
accelerated depreciation. As a result, companies using straight-line depreciation will
show higher net income and EPS in the initial years.
Eventually, the accelerated approach will show lower depreciation into an asset's life
than the straight-line method. However, companies still prefer straight-line depreciation
because of the timing, as many companies are focused more on near-term earnings.
If the company is constantly acquiring new assets, the "flip" won't occur until the
company significantly scales back capital expenditures.
✔✔What is the relationship between depreciation and the salvage value assumption? -
✔✔Most companies will use a salvage value assumption in which the remaining value
of the asset is zero by the end of the useful life. The difference between the cost of the
asset and residual value is known as the total depreciable amount. If the salvage value
is assumed to be zero, the depreciation expense each year will be higher and the tax
benefits from depreciation will be fully maximized.
Straight Line Annual Depreciation = (Asset Historical Cost − Salvage Value)/ Useful Life
Assumption
✔✔Do companies depreciate land? - ✔✔While classified as a long-term asset on the
balance sheet, land is assumed to have an indefinite useful life under accrual
accounting, and therefore depreciation is prohibited
