WALL STREET PREP ACCOUNTING
QUESTIONS & VERIFIED ANSWERS
RATED 100% CORRECT
What are the 3 financial statements, and why do we need them? - CORRECT
ANSWER The 3 major 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
from
Investing or Financing activities; the last lines show the net change in cash and the
company's
ending cash balance.
You need these statements because there is a big difference between a company's Net
Income
and the cash it generates - the Income Statement alone doesn't tell what its cash flow
is.
Remember the key valuation formula:
Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate)
The 3 financial statements let you estimate the "Cash Flow" part, which helps you value
the
company more accurately.
How do the 3 statements link together? - CORRECT ANSWER 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 any non-cash items such as Depreciation &
Amortization.
Next, reflect changes to operational Balance Sheet items such as Accounts Receivable,
which
may increase or decrease the company's cash flow depending on how they've changed.
,This gets you to Cash Flow from Operations.
Next, take into account investing and financing activities, which may increase or
decrease cash
flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net
change in
cash at the bottom.
Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net
Income to
Retained Earnings within the Equity category on the Balance Sheet.
Then, link each non-cash adjustment to the appropriate Asset or Liability; SUBTRACT
links on
the Assets side and ADD links on the L&E side.
And then link each CFI and CFF item to the matching item on the Balance Sheet, using
the same
rule as above.
Check that Assets equals Liabilities plus Equity at the end; if this is not true, you did
something
wrong and need to re-check your work
What's the most important financial statement? - CORRECT ANSWER The Cash Flow
Statement is the most important single statement because it tells you how much
cash a company is generating. The Income Statement is misleading because it includes
non-cash
revenue and expenses and excludes cash spending such as Capital Expenditures.
What if you could use only 2 statements to assess a company's prospects - which ones
would you use, and why? - CORRECT ANSWER You would use the Income Statement
and Balance Sheet because you can create the Cash Flow
Statement from both of those (assuming there are "Beginning" and "Ending" Balance
Sheets
that correspond to the same period shown on the Income Statement)
It would be MUCH harder to "construct" an Income Statement from the Balance Sheet
and
Cash Flow Statement (for example).
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.? - CORRECT ANSWER 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.
, There are also minor naming differences; for example, the Income Statement might be
called
the "Consolidated Statement of Earnings" or the "Profit & Loss Statement," and the
Balance
Sheet might be called the "Statement of Financial Position."
Technically, U.S.-based companies that follow U.S. GAAP can also use the Direct
Method for
creating the CFS, but in practice, they tend to use the Indirect Method (i.e., they start
with Net
Income and make adjustments to determine the cash flow).
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? - CORRECT
ANSWER 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 a reconciliation that shows you how to move from Net
Income
or Operating Income to Cash Flow from Operations and that lists the changes in
Working
Capital and other non-cash adjustments.
If the company does NOT provide that reconciliation, you might have to stick with the
CFS in
the original format.
How do you know when a revenue or expense line item should appear on the Income
Statement? - CORRECT ANSWER Two conditions MUST be true for an item to appear
on the Income Statement:
It must correspond to ONLY the period shown on the Income Statement. This is why
monthly rent shows up, but paying for a factory that will last for 10 years does not.
2. It must affect the company's taxes. Interest on debt is tax-deductible, so it shows up,
but repayment of debt principal is not, so it does not show up.
Whether or not something is received or paid in cash has nothing to do with this
classification
- companies pay taxes on non-cash revenue (e.g., receivables) and save on taxes from
non-cash
expenses (e.g., depreciation) all the time.
Advanced Note: Technically, in point #2 we should say, "It must affect the company's
BOOK
taxes" (i.e., only the tax number that appears on the Income Statement). Many items
that are
not deductible for cash-tax purposes still appear on the IS and affect book taxes.
How can you tell whether an item should be classified as an Asset, Liability, or Equity
on
QUESTIONS & VERIFIED ANSWERS
RATED 100% CORRECT
What are the 3 financial statements, and why do we need them? - CORRECT
ANSWER The 3 major 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
from
Investing or Financing activities; the last lines show the net change in cash and the
company's
ending cash balance.
You need these statements because there is a big difference between a company's Net
Income
and the cash it generates - the Income Statement alone doesn't tell what its cash flow
is.
Remember the key valuation formula:
Company Value = Cash Flow / (Discount Rate - Cash Flow Growth Rate)
The 3 financial statements let you estimate the "Cash Flow" part, which helps you value
the
company more accurately.
How do the 3 statements link together? - CORRECT ANSWER 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 any non-cash items such as Depreciation &
Amortization.
Next, reflect changes to operational Balance Sheet items such as Accounts Receivable,
which
may increase or decrease the company's cash flow depending on how they've changed.
,This gets you to Cash Flow from Operations.
Next, take into account investing and financing activities, which may increase or
decrease cash
flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net
change in
cash at the bottom.
Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net
Income to
Retained Earnings within the Equity category on the Balance Sheet.
Then, link each non-cash adjustment to the appropriate Asset or Liability; SUBTRACT
links on
the Assets side and ADD links on the L&E side.
And then link each CFI and CFF item to the matching item on the Balance Sheet, using
the same
rule as above.
Check that Assets equals Liabilities plus Equity at the end; if this is not true, you did
something
wrong and need to re-check your work
What's the most important financial statement? - CORRECT ANSWER The Cash Flow
Statement is the most important single statement because it tells you how much
cash a company is generating. The Income Statement is misleading because it includes
non-cash
revenue and expenses and excludes cash spending such as Capital Expenditures.
What if you could use only 2 statements to assess a company's prospects - which ones
would you use, and why? - CORRECT ANSWER You would use the Income Statement
and Balance Sheet because you can create the Cash Flow
Statement from both of those (assuming there are "Beginning" and "Ending" Balance
Sheets
that correspond to the same period shown on the Income Statement)
It would be MUCH harder to "construct" an Income Statement from the Balance Sheet
and
Cash Flow Statement (for example).
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.? - CORRECT ANSWER 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.
, There are also minor naming differences; for example, the Income Statement might be
called
the "Consolidated Statement of Earnings" or the "Profit & Loss Statement," and the
Balance
Sheet might be called the "Statement of Financial Position."
Technically, U.S.-based companies that follow U.S. GAAP can also use the Direct
Method for
creating the CFS, but in practice, they tend to use the Indirect Method (i.e., they start
with Net
Income and make adjustments to determine the cash flow).
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? - CORRECT
ANSWER 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 a reconciliation that shows you how to move from Net
Income
or Operating Income to Cash Flow from Operations and that lists the changes in
Working
Capital and other non-cash adjustments.
If the company does NOT provide that reconciliation, you might have to stick with the
CFS in
the original format.
How do you know when a revenue or expense line item should appear on the Income
Statement? - CORRECT ANSWER Two conditions MUST be true for an item to appear
on the Income Statement:
It must correspond to ONLY the period shown on the Income Statement. This is why
monthly rent shows up, but paying for a factory that will last for 10 years does not.
2. It must affect the company's taxes. Interest on debt is tax-deductible, so it shows up,
but repayment of debt principal is not, so it does not show up.
Whether or not something is received or paid in cash has nothing to do with this
classification
- companies pay taxes on non-cash revenue (e.g., receivables) and save on taxes from
non-cash
expenses (e.g., depreciation) all the time.
Advanced Note: Technically, in point #2 we should say, "It must affect the company's
BOOK
taxes" (i.e., only the tax number that appears on the Income Statement). Many items
that are
not deductible for cash-tax purposes still appear on the IS and affect book taxes.
How can you tell whether an item should be classified as an Asset, Liability, or Equity
on
