M&I 400 Technical Questions (Basic) || A+ Certified Already.
Walk me through the 3 basic financial statements correct answers 1. Income Statement
- you list all of your revenues and your expenses and then you subtract total expenses from total
revenues to arrive at NET INCOME
2. Balance Sheet
- lists the company's assets, liabilities, and stockholders equity
- assets = liabilities + stockholders equity
3. Statement of Cash Flows
- start with net income, adjust for non-cash expenses and working capital changes, and then list
cash flow from investing and financing activities to arrive at NET CHANGE IN CASH (i.e.
company started with 100M in cash and ended with 5M, you net change must be -95M)
major line items for each of the financial statements correct answers IS:
revenue - COGS= gross profit - SG&A = net operating income - interest expense - other variable
expenses = pretax income - income taxes = net income
BS:
A- cash, AR, inventory, PPE. L- AP, accrued expenses and debt. SE- common stock, retained
earnings
SoCF:
Net Income, depreciation and amortization, stock-based compensation --> CASH FLOW FROM
OPERATIONS, capital expenditures -->CASH FLOW FROM INVESTING, sales/purchase of
securities, dividends issued --> CASH FLOW FROM FINANCING
How do the 3 statements link together? correct answers BegRE + NI = EndRE
net income from the income statement flows into SE on the Balance Sheet and the top line of the
SoCF
changes to balance sheet items show as working capital changes on the SoCF
investing and financing activities affect the BS accounts such as PPE, debt, and equity
If I were stranded on a desert island, only had 1 statement and I wanted to review the overall
health of a company - which statement would I use and why? correct answers SoCF because it
gives a true picture of how much money the company is ACTUALLY generating, independent
of all non-cash expenses that you might have. Cash flow is the #1 thing to look at when
evaluating the overall financial health of a business
Walk me through how depreciation going up by $10 would affect the statements? correct
answers IS: Operating income declines by $10 because depreciation goes into SG&A or COGS
which is subtracted from revenue to find NOI. if the tax rate was 40% then NI would decrease by
6
SoCF: the NI at the top of the SoCF would decrease by $6, but the $10 depreciation expense
would be added back, so OVERALL cash flows from operations increases by $4
BS: PPE asset decreases by $10 because of depreciation and cash increases by $4 because of the
changes to overall cash flow. Since NI decreased by $6, SE goes down by six, making sure both
sides balance
,If Depreciation is a non-cash expense, why does it affect the cash balance? correct answers
Because it is tax-deductible. Since taxes are a cash expense, depreciation decreases the amount
of taxes you pay
Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use
and why? correct answers IS and BS because you can create a SoCF from these two and the cash
flow is the most important thing to look at when examining the financial health of a business.
Where does depreciation usually show up on the IS? correct answers It could be its own line item
under expenses. It can also be embedded in COGS or Operating Expenses
DEPRECIATION ALWAYS REDUCES PRE-TAX INCOME
What happens when accrued compensation increases by $10? correct answers Operating
expenses on the IS go up by $10. Pre-tax income falls by $10, and assuming a 40% tax rate, NI
falls by $6
SoCF: NI is down by $6 and accrued compensation will increase cash from operating expenses
flow by 10 so there is an overall increase of 4
BS: Cash is up by 4 so assets are up by 4. Expenses are up by 10 and NI is down by 6 making a
total of +4 on the right-hand side
What happens when inventory goes up by $10, assuming that you pay for it with cash correct
answers IS: nothing happens to the IS
SoCF: decreases cash flow from operations by $10, so it decreases the net change in cash by that
amount too
BS: one asset inventory increases by 10 while the other asset, cash, decreases by 10 causing a net
change of zero to the BS
Why is the Income Statement not affected by changes in Inventory? correct answers The expense
associated with buying inventory is shown on the balance sheet as a decrease in cash or an
increase in accounts payable.
The expense is recorded when the goods associated with it are sold- so if inventory is just sitting
in a warehouse is is not in COGS on the IS. It is not in this until it is transformed into a product
and sold
Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements
affected at the start of "Year 1," before anything else happens? correct answers IS:
there would be no changes on the IS yet because nothing has been produced or sold.
SoCF:
the investment in factories is shown under the Cash Flow from Investing Activities section (a net
REDUCTION in cash flow by $100). The $100 worth of debt raised to buy these factories would
show up as an ADDITION to the cash flow, cancelling out the investment activity. CASH
NUMBER STAYS THE SAME
,BS:
PPE goes up by $100 (assets up by $100), debt is up by $100 too *liabilities up by 100* so both
sides balance
Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is
paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of
10% per year. What happens? correct answers Apple must pay the interest expense and record
the depreciation.
IS:Depreciation expense of $10 would show up on the IS, decreasing the net operating income
by $10
Interest Expense of $10 would also show up on the IS, decreasing the pre-tax income by another
$10
DECREASE OF 20$ in total. Assuming a tax rate of 40%, income after tax= $12
SoCF: $12 is the income that is plugged in at the top of the statement. Depreciation is a non-cash
expense so it is added back, bringing the cash flow up $10....overall decrease of $2
BS: Cash is down by 2 (assets), PPE is down by 10, so overall assets are down by 12. NI is down
by 12 on SE so the side
s balance ****DEBT UNDER LIABILITIES DOES NOT CHANGE BC WE ASSUME NONE
OF IT IS PAID BACK
At the start of Year 3, the factories all break down and the value of the equipment is written
down to $0. The loan must also be paid back now. Walk me through the 3 statements. correct
answers After 2 years, the factory value is $80 because of 2 years of 10% depreciation. this
means we will write-off $80 of PPE
IS: $80 write-off shows up on the pre-tax income line. Assuming 40% tax rate, NI becomes $48,
an overall decrease of $32
SoCF: Net income is DOWN BY $32 but the write-off is a NON CASH EXPENSE so it is added
back, so it increases by $80...overall increase of $48. Financing cash flows has a $100 charge for
the loan payback so it falls by $100. OVERALL change of -$52
BS: Cash is down by $52 (from SoCF) and PPE is down by 80 (total assets down by 132). Debt
is down 100 cuz it was paid off and NI (i.e. SE) was down by 32 so overall down 132. they
BALANCE
Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod
inventory, using cash on hand. They order the inventory, but they have not manufactured or sold
anything yet - what happens to the 3 statements? correct answers IS: no changes
SoCF: working capital changes (increase of $10 of inventory), decrease of $10 on Cash from
Operating Activities, so OVERALL cash flow is down by 10
BS: inventory (asset) up by 10, cash (asset) down by 10. it BALANCES
, Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3
statements under this scenario. correct answers IS: The sale of $10 worth of ipods is a COGS
expense. $20 is recorded as a revenue. Gross profit is up by $10. Assuming a 40% tax rate, profit
is up by $6
SoCF: Net income is up by $6. Inventory decreased by $10 so $10 cash inflow from operating
activities. so OVERALL increase of $16
BS: cash is up by $16, inventory is down by $10 ($6 increase in assets). Net income up by $6, so
the sides BALANCE
Could you ever end up with negative SE? What does that mean? correct answers Yes, 2
scenarios.
1. Leveraged buyouts with dividend recapitalizations. This means that the owner of the company
has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn
the number negative
2. It can also happen if the company has been losing money consistently and therefore has a
declining RE balance
*can be a cause for concern and demonstrate a struggling company
What is working capital? How is it used? correct answers Working Capital= current assets -
current liabilities
Positive- company can pay off its short-term liabilities with its short-term assets.
What does negative working capital mean? is that a bad sign? correct answers IT means that the
company does not have enough current assets to cover its current liabilities.
Not always a bad sign- depends on the situation.
1. companies with subscriptions or long-term contracts have negative WC because of high
DEFERRED REVENUE BALANCES
2. retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative
WC because customers pay upfront so they use this cash to pay off their AP rather than keeping
a large balance of cash on hand. Reveals business efficiency
3. other cases, it does indicate something is wrong- financial trouble and possible bankruptcy
(EX. customers don't pay quickly and upfront and the company has a high debt balance
Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me
through what happens on the 3 statements when there's a writedown of $100. correct answers IS:
$100 write-down shows up in the pre-tax income line. 40$ tax rate, NI declines by $60
SoCF: NI is down by $60 but the write-down is a non-cash expense, so $100 is added back for an
overall increase cash flow of $40
Walk me through the 3 basic financial statements correct answers 1. Income Statement
- you list all of your revenues and your expenses and then you subtract total expenses from total
revenues to arrive at NET INCOME
2. Balance Sheet
- lists the company's assets, liabilities, and stockholders equity
- assets = liabilities + stockholders equity
3. Statement of Cash Flows
- start with net income, adjust for non-cash expenses and working capital changes, and then list
cash flow from investing and financing activities to arrive at NET CHANGE IN CASH (i.e.
company started with 100M in cash and ended with 5M, you net change must be -95M)
major line items for each of the financial statements correct answers IS:
revenue - COGS= gross profit - SG&A = net operating income - interest expense - other variable
expenses = pretax income - income taxes = net income
BS:
A- cash, AR, inventory, PPE. L- AP, accrued expenses and debt. SE- common stock, retained
earnings
SoCF:
Net Income, depreciation and amortization, stock-based compensation --> CASH FLOW FROM
OPERATIONS, capital expenditures -->CASH FLOW FROM INVESTING, sales/purchase of
securities, dividends issued --> CASH FLOW FROM FINANCING
How do the 3 statements link together? correct answers BegRE + NI = EndRE
net income from the income statement flows into SE on the Balance Sheet and the top line of the
SoCF
changes to balance sheet items show as working capital changes on the SoCF
investing and financing activities affect the BS accounts such as PPE, debt, and equity
If I were stranded on a desert island, only had 1 statement and I wanted to review the overall
health of a company - which statement would I use and why? correct answers SoCF because it
gives a true picture of how much money the company is ACTUALLY generating, independent
of all non-cash expenses that you might have. Cash flow is the #1 thing to look at when
evaluating the overall financial health of a business
Walk me through how depreciation going up by $10 would affect the statements? correct
answers IS: Operating income declines by $10 because depreciation goes into SG&A or COGS
which is subtracted from revenue to find NOI. if the tax rate was 40% then NI would decrease by
6
SoCF: the NI at the top of the SoCF would decrease by $6, but the $10 depreciation expense
would be added back, so OVERALL cash flows from operations increases by $4
BS: PPE asset decreases by $10 because of depreciation and cash increases by $4 because of the
changes to overall cash flow. Since NI decreased by $6, SE goes down by six, making sure both
sides balance
,If Depreciation is a non-cash expense, why does it affect the cash balance? correct answers
Because it is tax-deductible. Since taxes are a cash expense, depreciation decreases the amount
of taxes you pay
Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use
and why? correct answers IS and BS because you can create a SoCF from these two and the cash
flow is the most important thing to look at when examining the financial health of a business.
Where does depreciation usually show up on the IS? correct answers It could be its own line item
under expenses. It can also be embedded in COGS or Operating Expenses
DEPRECIATION ALWAYS REDUCES PRE-TAX INCOME
What happens when accrued compensation increases by $10? correct answers Operating
expenses on the IS go up by $10. Pre-tax income falls by $10, and assuming a 40% tax rate, NI
falls by $6
SoCF: NI is down by $6 and accrued compensation will increase cash from operating expenses
flow by 10 so there is an overall increase of 4
BS: Cash is up by 4 so assets are up by 4. Expenses are up by 10 and NI is down by 6 making a
total of +4 on the right-hand side
What happens when inventory goes up by $10, assuming that you pay for it with cash correct
answers IS: nothing happens to the IS
SoCF: decreases cash flow from operations by $10, so it decreases the net change in cash by that
amount too
BS: one asset inventory increases by 10 while the other asset, cash, decreases by 10 causing a net
change of zero to the BS
Why is the Income Statement not affected by changes in Inventory? correct answers The expense
associated with buying inventory is shown on the balance sheet as a decrease in cash or an
increase in accounts payable.
The expense is recorded when the goods associated with it are sold- so if inventory is just sitting
in a warehouse is is not in COGS on the IS. It is not in this until it is transformed into a product
and sold
Let's say Apple is buying $100 worth of new iPod factories with debt. How are all 3 statements
affected at the start of "Year 1," before anything else happens? correct answers IS:
there would be no changes on the IS yet because nothing has been produced or sold.
SoCF:
the investment in factories is shown under the Cash Flow from Investing Activities section (a net
REDUCTION in cash flow by $100). The $100 worth of debt raised to buy these factories would
show up as an ADDITION to the cash flow, cancelling out the investment activity. CASH
NUMBER STAYS THE SAME
,BS:
PPE goes up by $100 (assets up by $100), debt is up by $100 too *liabilities up by 100* so both
sides balance
Now let's go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal is
paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a rate of
10% per year. What happens? correct answers Apple must pay the interest expense and record
the depreciation.
IS:Depreciation expense of $10 would show up on the IS, decreasing the net operating income
by $10
Interest Expense of $10 would also show up on the IS, decreasing the pre-tax income by another
$10
DECREASE OF 20$ in total. Assuming a tax rate of 40%, income after tax= $12
SoCF: $12 is the income that is plugged in at the top of the statement. Depreciation is a non-cash
expense so it is added back, bringing the cash flow up $10....overall decrease of $2
BS: Cash is down by 2 (assets), PPE is down by 10, so overall assets are down by 12. NI is down
by 12 on SE so the side
s balance ****DEBT UNDER LIABILITIES DOES NOT CHANGE BC WE ASSUME NONE
OF IT IS PAID BACK
At the start of Year 3, the factories all break down and the value of the equipment is written
down to $0. The loan must also be paid back now. Walk me through the 3 statements. correct
answers After 2 years, the factory value is $80 because of 2 years of 10% depreciation. this
means we will write-off $80 of PPE
IS: $80 write-off shows up on the pre-tax income line. Assuming 40% tax rate, NI becomes $48,
an overall decrease of $32
SoCF: Net income is DOWN BY $32 but the write-off is a NON CASH EXPENSE so it is added
back, so it increases by $80...overall increase of $48. Financing cash flows has a $100 charge for
the loan payback so it falls by $100. OVERALL change of -$52
BS: Cash is down by $52 (from SoCF) and PPE is down by 80 (total assets down by 132). Debt
is down 100 cuz it was paid off and NI (i.e. SE) was down by 32 so overall down 132. they
BALANCE
Now let's look at a different scenario and assume Apple is ordering $10 of additional iPod
inventory, using cash on hand. They order the inventory, but they have not manufactured or sold
anything yet - what happens to the 3 statements? correct answers IS: no changes
SoCF: working capital changes (increase of $10 of inventory), decrease of $10 on Cash from
Operating Activities, so OVERALL cash flow is down by 10
BS: inventory (asset) up by 10, cash (asset) down by 10. it BALANCES
, Now let's say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the 3
statements under this scenario. correct answers IS: The sale of $10 worth of ipods is a COGS
expense. $20 is recorded as a revenue. Gross profit is up by $10. Assuming a 40% tax rate, profit
is up by $6
SoCF: Net income is up by $6. Inventory decreased by $10 so $10 cash inflow from operating
activities. so OVERALL increase of $16
BS: cash is up by $16, inventory is down by $10 ($6 increase in assets). Net income up by $6, so
the sides BALANCE
Could you ever end up with negative SE? What does that mean? correct answers Yes, 2
scenarios.
1. Leveraged buyouts with dividend recapitalizations. This means that the owner of the company
has taken out a large portion of its equity (usually in the form of cash), which can sometimes turn
the number negative
2. It can also happen if the company has been losing money consistently and therefore has a
declining RE balance
*can be a cause for concern and demonstrate a struggling company
What is working capital? How is it used? correct answers Working Capital= current assets -
current liabilities
Positive- company can pay off its short-term liabilities with its short-term assets.
What does negative working capital mean? is that a bad sign? correct answers IT means that the
company does not have enough current assets to cover its current liabilities.
Not always a bad sign- depends on the situation.
1. companies with subscriptions or long-term contracts have negative WC because of high
DEFERRED REVENUE BALANCES
2. retail and restaurant companies like Amazon, Wal-Mart, and McDonald's often have negative
WC because customers pay upfront so they use this cash to pay off their AP rather than keeping
a large balance of cash on hand. Reveals business efficiency
3. other cases, it does indicate something is wrong- financial trouble and possible bankruptcy
(EX. customers don't pay quickly and upfront and the company has a high debt balance
Recently, banks have been writing down their assets and taking huge quarterly losses. Walk me
through what happens on the 3 statements when there's a writedown of $100. correct answers IS:
$100 write-down shows up in the pre-tax income line. 40$ tax rate, NI declines by $60
SoCF: NI is down by $60 but the write-down is a non-cash expense, so $100 is added back for an
overall increase cash flow of $40
