400 Investment Banking Exam UPDATED
ACTUAL QUESTIONS AND CORRECT
ANSWERS
Walk me through the 3 financial statements. - CORRECT ANSWER "The 3 major financial
statements are the Income Statement, Balance Sheet and Cash Flow Statement.
The Income Statement gives the company's revenue and expenses, and goes down to Net Income, the
final line on the statement.
The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as
well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must
equal Liabilities plus Shareholders' Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital
changes, and then lists cash flow from investing and financing activities; at the end, you see the
company's net change in cash."
How do the 3 statements link together? - CORRECT ANSWER "To tie the statements together,
Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and
into the top line of the Cash Flow Statement.
Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and
investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders'
Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash
flowing in from the final line on the Cash Flow Statement."
Can you give examples of major line items on each of the financial statements? - CORRECT
ANSWER Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General &
Administrative Expenses); Operating Income; Pretax Income; Net Income.
Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E);
Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity.
,Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation;
Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash
Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.
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 ANSWER You would use the
Cash Flow Statement because it gives a true picture of how much cash the company is actually
generating, independent of all the non-cash expenses you might have. And that's the #1 thing you care
about when analyzing the overall financial health of any business - its cash flow.
Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and
why? - CORRECT ANSWER You would pick the Income Statement and Balance Sheet,
because you can create the Cash Flow Statement from both of those (assuming, of course that you
have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income
Statement is tracking).
Walk me through how Depreciation going up by $10 would affect the statements. - CORRECT
ANSWER Income Statement: Operating Income would decline by $10 and assuming a 40%
tax rate, Net Income would go down by $6.
Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-
cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no
changes elsewhere, so the overall Net Change in Cash goes up by $4.
Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the
Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement.
Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the
Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.
Note: With this type of question I always recommend going in the order:
1. Income Statement
2. Cash Flow Statement
3. Balance Sheet
,This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember
that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash
Flow.
If Depreciation is a non-cash expense, why does it affect the cash balance? - CORRECT ANSWER
Although Depreciation is a non-cash expense, it is tax deductible. Since taxes are a cash
expense, Depreciation affects cash by reducing the amount of taxes you pay.
Where does Depreciation usually show up on the Income Statement? - CORRECT ANSWER It
could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating
Expenses - every company does it differently. Note that the end result for accounting questions is the
same: Depreciation always reduces Pre-Tax Income.
What happens when Accrued Compensation goes up by $10? - CORRECT ANSWER For this
question, confirm that the accrued compensation is now being recognized as an expense (as opposed
to just changing non-accrued to accrued compensation).
Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income
falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase
Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at
the bottom is up by $4.
On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity
side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down
by $6 due to the Net Income, so both sides balance.
What happens when Inventory goes up by $10, assuming you pay for it with cash? - CORRECT
ANSWER No changes to the Income Statement.
On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations
- it goes down by $10, as does the Net Change in Cash at the bottom.
On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes
cancel out and Assets still equals Liabilities & Shareholders' Equity.
, Why is the Income Statement not affected by changes in Inventory? - CORRECT ANSWER
This is a common interview mistake - incorrectly stating that Working Capital changes show
up on the Income Statement.
In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if
it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the
company manufactures it into a product and sells it.
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 ANSWER At the
start of "Year 1," before anything else has happened, there would be no changes on Apple's Income
Statement (yet).
On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow
from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the
additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the
investment activity. So the cash number stays the same.
On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property &
Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is
up by $100 as well and 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 ANSWER After a year has passed, Apple must pay interest
expense and must record the depreciation.
Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10
in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the
depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income would fall by $12.
On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash
expense, so you add it back and the end result is that Cash Flow from Operations is down by $2.
ACTUAL QUESTIONS AND CORRECT
ANSWERS
Walk me through the 3 financial statements. - CORRECT ANSWER "The 3 major financial
statements are the Income Statement, Balance Sheet and Cash Flow Statement.
The Income Statement gives the company's revenue and expenses, and goes down to Net Income, the
final line on the statement.
The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory and PP&E, as
well as its Liabilities - such as Debt and Accounts Payable - and Shareholders' Equity. Assets must
equal Liabilities plus Shareholders' Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and working capital
changes, and then lists cash flow from investing and financing activities; at the end, you see the
company's net change in cash."
How do the 3 statements link together? - CORRECT ANSWER "To tie the statements together,
Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and
into the top line of the Cash Flow Statement.
Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and
investing and financing activities affect Balance Sheet items such as PP&E, Debt and Shareholders'
Equity. The Cash and Shareholders' Equity items on the Balance Sheet act as "plugs," with Cash
flowing in from the final line on the Cash Flow Statement."
Can you give examples of major line items on each of the financial statements? - CORRECT
ANSWER Income Statement: Revenue; Cost of Goods Sold; SG&A (Selling, General &
Administrative Expenses); Operating Income; Pretax Income; Net Income.
Balance Sheet: Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E);
Accounts Payable; Accrued Expenses; Debt; Shareholders' Equity.
,Cash Flow Statement: Net Income; Depreciation & Amortization; Stock-Based Compensation;
Changes in Operating Assets & Liabilities; Cash Flow From Operations; Capital Expenditures; Cash
Flow From Investing; Sale/Purchase of Securities; Dividends Issued; Cash Flow From Financing.
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 ANSWER You would use the
Cash Flow Statement because it gives a true picture of how much cash the company is actually
generating, independent of all the non-cash expenses you might have. And that's the #1 thing you care
about when analyzing the overall financial health of any business - its cash flow.
Let's say I could only look at 2 statements to assess a company's prospects - which 2 would I use and
why? - CORRECT ANSWER You would pick the Income Statement and Balance Sheet,
because you can create the Cash Flow Statement from both of those (assuming, of course that you
have "before" and "after" versions of the Balance Sheet that correspond to the same period the Income
Statement is tracking).
Walk me through how Depreciation going up by $10 would affect the statements. - CORRECT
ANSWER Income Statement: Operating Income would decline by $10 and assuming a 40%
tax rate, Net Income would go down by $6.
Cash Flow Statement: The Net Income at the top goes down by $6, but the $10 Depreciation is a non-
cash expense that gets added back, so overall Cash Flow from Operations goes up by $4. There are no
changes elsewhere, so the overall Net Change in Cash goes up by $4.
Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side because of the
Depreciation, and Cash is up by $4 from the changes on the Cash Flow Statement.
Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity on the
Liabilities & Shareholders' Equity side is down by $6 and both sides of the Balance Sheet balance.
Note: With this type of question I always recommend going in the order:
1. Income Statement
2. Cash Flow Statement
3. Balance Sheet
,This is so you can check yourself at the end and make sure the Balance Sheet balances. Remember
that an Asset going up decreases your Cash Flow, whereas a Liability going up increases your Cash
Flow.
If Depreciation is a non-cash expense, why does it affect the cash balance? - CORRECT ANSWER
Although Depreciation is a non-cash expense, it is tax deductible. Since taxes are a cash
expense, Depreciation affects cash by reducing the amount of taxes you pay.
Where does Depreciation usually show up on the Income Statement? - CORRECT ANSWER It
could be in a separate line item, or it could be embedded in Cost of Goods Sold or Operating
Expenses - every company does it differently. Note that the end result for accounting questions is the
same: Depreciation always reduces Pre-Tax Income.
What happens when Accrued Compensation goes up by $10? - CORRECT ANSWER For this
question, confirm that the accrued compensation is now being recognized as an expense (as opposed
to just changing non-accrued to accrued compensation).
Assuming that's the case, Operating Expenses on the Income Statement go up by $10, Pre-Tax Income
falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will increase
Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net Change in Cash at
the bottom is up by $4.
On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the Liabilities & Equity
side, Accrued Compensation is a liability so Liabilities are up by $10 and Retained Earnings are down
by $6 due to the Net Income, so both sides balance.
What happens when Inventory goes up by $10, assuming you pay for it with cash? - CORRECT
ANSWER No changes to the Income Statement.
On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow from Operations
- it goes down by $10, as does the Net Change in Cash at the bottom.
On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so the changes
cancel out and Assets still equals Liabilities & Shareholders' Equity.
, Why is the Income Statement not affected by changes in Inventory? - CORRECT ANSWER
This is a common interview mistake - incorrectly stating that Working Capital changes show
up on the Income Statement.
In the case of Inventory, the expense is only recorded when the goods associated with it are sold - so if
it's just sitting in a warehouse, it does not count as a Cost of Good Sold or Operating Expense until the
company manufactures it into a product and sells it.
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 ANSWER At the
start of "Year 1," before anything else has happened, there would be no changes on Apple's Income
Statement (yet).
On the Cash Flow Statement, the additional investment in factories would show up under Cash Flow
from Investing as a net reduction in Cash Flow (so Cash Flow is down by $100 so far). And the
additional $100 worth of debt raised would show up as an addition to Cash Flow, canceling out the
investment activity. So the cash number stays the same.
On the Balance Sheet, there is now an additional $100 worth of factories in the Plants, Property &
Equipment line, so PP&E is up by $100 and Assets is therefore up by $100. On the other side, debt is
up by $100 as well and 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 ANSWER After a year has passed, Apple must pay interest
expense and must record the depreciation.
Operating Income would decrease by $10 due to the 10% depreciation charge each year, and the $10
in additional Interest Expense would decrease the Pre-Tax Income by $20 altogether ($10 from the
depreciation and $10 from Interest Expense).
Assuming a tax rate of 40%, Net Income would fall by $12.
On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is a non-cash
expense, so you add it back and the end result is that Cash Flow from Operations is down by $2.
