Investment Banking - Accounting Questions with complete expert solutions

Walk me through the 3 financial statements The 3 major statements are the income statement, balance sheet, cash flow statement. The income statement has revenue as the top line, subtracts out expenses, and goes down to net income. The balance sheet shows the companies assets (resources over time such as cash, inventory, PP&E) and its liabilities (debt and accounts payable) and its shareholders equity. Assets must equal liabilities plus shareholder's equity. Cash flow begins with net income and adjusts for non-cash expenses and changes in operating assets and liabilities, shows how the company has spent or received cash from investing or financing, and at the end gives the net change in cash. Major line items on the income statement Revenue, cost of goods sold, SG&A, operating income, pre-tax income, net income Major line items on the balance sheet Cash, accounts receivable, inventory, PP&E, accounts payable, accrued expenses, debt, shareholder's equity Major line items on the cash flow statement Cash flow from operations, cash flow from investing, cash flow from financing Cash flow from operations Net income, depreciation & amortization, stock based-compensation, changes in operating assets & liabilities Cash flow from investing Capital expenditures, sale of PP&E, sale/purchase of investments Cash flow from financing Dividends issued, debts raised/paid off, shares issued/repurchased Which statement would you use to determine the overall health of a company? Cash flow statement - it gives a true picture of how much cash the company s actually generating How do the 3 statements flow together? The bottom line of the income statement is net income. Net income links to both the balance sheet and cash flow statement. In terms of the balance sheet, net income flows into stockholder's equity via retained earnings. Retained earnings is equal to the previous period's retained earnings plus net income from this period less dividends from this period. In terms of the cash flow statement, net income is the first line as it is used to calculate cash flows from operations. Also, any non-cash expenses or non-cash income from the income statement (i.e., depreciation and amortization) flow into the cash flow statement and adjust net income to arrive at cash flow from operations. Any balance sheet items that have a cash impact (i.e., working capital, financing, PP&E, etc.) are linked to the cash flow statement since it is either a source or use of cash. The net change in cash on the cash flow statement and cash from the previous period's balance sheet comprise cash for this period. If you could only use 2 statements to assess a company, which ones would you use? Income statement and balance sheet because you can generate the cash flow statement from both of these How can you tell if something is an asset or liability? An asset will result in additional cash in the future, and a liability will result in less cash in the future How can you tell if something should appear on the income statement? It must correspond to something in the current period, and it must be tax-deductible Why do you add back non-cash expenses to the cash flow statement? Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense. How do you know when to capitalize or expense a purchase? If the purchase corresponds to an asset with a useful life over 1 year, it is capitalized (put on the balance sheet rather than shown as an expense on the income statement). Examples of capitalized goods include factories, equipment, and land. Employee salaries and the cost of goods sold only last for the current period and therefore show up on the income statement as normal expenses instead. If depreciation is a non-cash expense, why does it affect the cash balance? Although it is a non-tax expense, it is tax-deductible. Therefore, an increase in depreciation decreases the amount of taxes you have to pay, which boosts cash Where does depreciation appear on the income statement? Could be a separate line item, or it could be embedded in COGS or operating expenses - it depends on the company. But the end result is always the same - depreciation reduces pre-tax income Why don't inventory purchases affect the income statement? The expense of purchasing inventory is only recorded on the income statement when the goods associated with it have been manufactured and sold. If it is just sitting in a warehouse, it doesn't count as COGS until the company makes it into a product and sells it Debt repayments show up in cash flow from financing on the CFS, why don't interest payments show up here? Interest payments correspond to the current period and are tax-deductible, so they are already recorded on the income statement. If you showed them on the CFS you'd be double counting them. Debt repayments are a true cash expense but don't appear on the income statement, so we need to adjust for them on the CFS. What's the difference between accounts payable and accrued expenses? Accounts payable is mostly for one-time expenses with invoices (paying for a law firm) whereas accrued expenses is mostly for recurring expenses without involves (employee wages, rent, utilities) When would a company collect cash from a customer and not record it as revenue? When a customer pays upfront for a product or service but the company hasn't delivered it yet. Happens with web subscription software, cell phone carriers, and magazine subscriptions If cash collected is not recorded as revenue, what happens to it? It goes into the deferred revenue balance on the balance sheet under liabilities. As the services or products are delivered, it turns into real revenue on the income statement and the deferred revenue balance decreases Why is deferred revenue a liability? It is a burden on us to deliver the product in question, and we will have to pay additional taxes and possibly additional future expenses when we record it as real revenue What's the difference between accounts receivable and deferred revenue? 1. accounts receivable hasn't been collected in cash from customers yet, and deferred revenue has 2. accounts receivable is for a product the company has already delivered but hasn't been paid for yet, whereas deferred revenue is for a product the company hasn't delivered yet How long does it take for a company to collect its accounts receivable balance? Usually in the 30-60 day range, but it can be higher for companies with higher-priced items, or lower for companies with lower-priced items for cash payments only