Financial Analyst Questions and Answers.

Financial Analyst Questions and Answers. How do you analyze the financial statements? Leverage: Debt-to-Equity Ratio = Total Liabilities / Shareholders Equity Liquidity: Current Ratio = Current Assets / Current Liabilities Liquidity: Quick Ratio= (Current Assets - Inventories)/ Current Liabilities Profitability: Return on Equity (ROE)= Net Income/Shareholder's Equity Efficiency: Net Profit Margin=Net Profit / Net Sales Aside from the financial statements, what else do you need to consider when analyzing a company? Risk: It is vital to manage and maintain. Credit Risk- the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. Interest Rate Risk - the risk that an investment's value will change as a result of a change in interest rates. Market Risk- the day-to-day fluctuations in a stock's price. What is the difference between discount rate and cap rate? Cap rate- the ratio of Net Operating Income (NOI) to property asset value/ current market value estimation for an investor's potential return on a real estate investment. Cap rate is most useful as a comparison of relative value of similar real estate investments Discount rate- the rate used in a discounted cash flow analysis to compute present values. The cap rate allows us to value a property based on a single year's NOI. The discount rate, on the other hand, is the investor's required rate of return. The discount rate is used to discount future cash flows back to the present to determine value and account's for all years in the holding period, not just a single year like the cap rate. What is the best way to get Earnings before interest and taxes (EBIT)? EBIT = Operating Revenue - Operating Expenses (OPEX) + Non-operating Income *Walk me through a DCF? Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the discounted cash flow (DCF) is above the current cost of the investment, the opportunity could result in positive returns. valuation method used to estimate the value of an investment based on its expected future cash flows. As a banker, it's more likely I'll lend a loan to a company that has a high DCF because they would be able to pay back my loan. The DCF has limitations, primarily that it relies on estimations on future cash flows, which could prove to be inaccurate. *Which financial statement would be the best to use to evaluate a company? Statement of Cash Flows. focuses solely on changes in cash inflows and outflows. allows you to see how readily a company can meet its debt and interest payments, fund investments This report presents a more clear view of a company's cash flows than the income statement- income statement prone to errors from accounting conventions Income statement: reveals the ability of a business to generate a profit. However, it does not reveal the amount of assets and liabilities required to generate a profit, and its results do not necessarily equate to the cash flows generated by the business. Also, the accuracy of this document can be suspect when the cash basis of accounting is used. Thus, the income statement, when used by itself, can be somewhat misleading. Balance sheet. The balance sheet is likely to be ranked third by many users, since it does not reveal the results of operations, and some of the numbers listed in it may be based on historical costs, which renders the report less informative. What are some growth drivers of the company? Strategic Priorities: Putting customers first- find and offer solutions to our customers financial needs. Growing revenue- 1) Earn more business from current customers, 2) Attract customers from competitors, 3) Buy or acquire a new company. Reducing expenses- Always look for ways to simplify operations, and make processes easier and streamlined. Building a connection with shareholders and our communities- Serve all of our customers, help them financially succeed and invest back into our communities. *What is an EBITDA or earnings before interest, taxes, depreciation, and amortization and what doesn't go into it? Why is it not a good measure? EBITDA measures the operating income of a company without the effects of capital structure (such as financing and accounting decisions). It can be used to measure a firm's financial performance and their ability to repay debt in a short period of time (few years). EBITDA is a widely used metric of corporate profitability!!!!!!! EBITDA can be used to compare companies against each other and industry averages. EBITDA is now commonly used to compare the financial health of companies and to evaluate firms with different tax rates and depreciation policies. not a substitute for analyzing a company's cash flow and can make a company look like it has more money to make interest payments than it really does. EBITDA also ignores the quality of a company's earnings and can make it look cheaper than it really is. It is a good proxy for profitability but NOT cash flow. It ignores working capital- the cash needed to cover day-to-day operations and also leaves out cash requirements that are needed to fund capital expenditures, which can be significant depending on the firm's business. In addition, EBITDA adds back D&A. Interest and taxes are real expenses and should be considered when evaluating a company's ability to service their debt! What ratios would you use to judge a company? Leverage: Debt-to-Equity Ratio = Total Liabilities / Shareholders Equity Liquidity: Current Ratio = Current Assets / Current Liabilities Liquidity: Quick Ratio= (Current Assets - Inventories)/ Current Liabilities Profitability: Return on Equity (ROE)= Net Income/Shareholder's Equity Efficiency: Net Profit Margin=Net Profit / Net Sales *What is the most important line on the balance sheet? Cash, is the single most important item on the balance sheet. Cash is the fuel of a business. If you run out of cash, you are in serious trouble. What are some forms of valuation and explain them? 1) Asset-based approaches- total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis. 2) Earning value approaches - the idea that a business's true value lies in its ability to produce wealth in the future. Discounted future earnings is a popular approach where predicted future earnings are discounted to present value. 3) Market value approaches - attempt to establish the value of a business by comparing your business to similar businesses that have recently sold. Amortization Amortization is a method of spreading the cost of an intangible asset over a specific period of time, which is usually the course of its useful life. Intangible assets are non-physical assets that are nonetheless essential to a company, such as patents, trademarks, and copyrights. The goal in amortizing an asset is to match the expense of acquiring it with the revenue it generates. Depreciation depreciation is a method of spreading the cost of an asset over a specified period of time, typically the asset's useful life. The purpose of depreciation is to match the expense of obtaining an asset to the income it helps a company earn. Depreciation is used for tangible assets, which are physical assets such as manufacturing equipment, business vehicles, and computers. Depreciation is a measure of how much of an asset's value has been used up at a given point in time. How can cash flows still be positive with a negative income? Depreciation and Amortization expenses reduce a company's net income, but it does not involve a payment of cash in the current period. Therefore cash flows will be unaffected. If a company has positive cash flow, the company's liquid assets are increasing. Net income is the profit a company has earned, or the income that's remaining, after all expenses have been deducted. It is possible for a company to have positive cash flow while reporting negative net income. If net income is positive, the company is liquid. If a company has positive cash flow, it means the company's liquid assets are increasing. A company can post a net loss for a period but receive enough cash from borrowing or other cash inflows to offset the loss and create positive cash flow. borrowings of a credit facility along with additional cash from new long-term debt. In other words, the company still posted a loss for the period but received enough cash from borrowing to offset the loss and create positive cash flow. What are the most important things to consider when building an investment portfolio and why? 1) Age and time horizon 2) Investment objectives 3) Tax implications 4) Balancing risk and reward Age and time horizon Age is an important factor while making an investment. If you start investing early, you can have an aggressive investment strategy, since your risk taking ability is high. You can gradually shift to safer options as you grow older. If you are nearing retirement, your portfolio should consist mainly of fixed income products, as you cannot afford to take high risks during your later years. Investment objectives Before starting off with your investment, you need to be clear about your objective for investing. If you want more returns in the short-term, your investment strategy should be aggressive, and vice versa. Tax implications Many investment instruments provide substantial tax exemptions. If saving tax is your priority, your portfolio should contain more tax-saving instruments. You may also have to hold assets for a longer period to become eligible for long-term tax exemption. Balancing risk and reward One of the most important things to consider while building your investment portfolio is not taking unnecessary risks. There should be a balance between the amount invested in high-risk and low-risk options.Government bonds typically offer stable but unspectacular returns. Stocks, on the other hand, promise higher returns but also carry higher risks. A diversified portfolio can balance risks and returns. *Define 'Financial Statement' It consists of 4 documents stating the company's financial progress, performance, and law compliances. The documents are income statement, cash flow statement, balance sheet, and statement of changes in equity. *Define 'Balance Sheet' The balance sheet lists the assets and liabilities the company owns. Assets such as machinery, property. And liabilities, such as bank loans. Snapshot at one moment of time. Represents state of finances. Assets, liabilities, income. *Define 'Income Statement' The income statement summarizes the company's financial performance such as sales, expenditures, and the company's profitability. Record of performance of a period of time. Total revenue + gains - (total expenses (primary and secondary) +losses) *Define 'Cash Flow Statement' The cash flow statement states how cash flows in and out of the company. The report explains how the company's operations are running, where its money is coming from, and how it is being spent. Cash generated and spent. How well company generates cash to pay off debt, fund operation expenses and fund investments *Define 'Statement of Changes in Equity' A record that states changes in company ownership between shareholders. *How do companies raise capital? What would they raise capital for? Would they prefer to raise debt or equity capital? Why? Companies can raise capital by taking a bank loan, issuing bonds for another company, or by selling a part of the company as shares to the public. They want to raise capital because they are looking to expanding their company by buying new machinery and property. It depends on their financial statements. If they want to accept a loan from the bank, I have to assess whether they qualify for one based on their cash flow. If the company makes enough profit in the forecast projected in its cash flow statement, then I would feel safe enough to issue them a loan because the company will stay in business long enough to pay me back. As for equity capital, it's a great way to earn a lot of money through an IPO if the company is looking to expand at a large scale. *5 C's of credit The 5 C's of credit are measurements bankers and lenders use to evaluate before issuing to a borrower. 1. Credit history - does the borrow have good or bad credit? paid on time? filed bankruptcy? 2. Capacity - being able to pay back. Does the borrower have enough money to make the payments? 3. Capital - how much risk a lender can make 4. Collateral - items that value equal or more to the loan if the borrower can't pay back 5. Conditions - financial conditions exist on the loan such as interest rates, general market conditions, principle amount *How does EBITA affect cash flow? EBITA ignores important cash items such as taxes and interests so it doesn't give a transparent view of the company's net income in comparison to cash flow statement because cash flow actually considers all costs such as taxes and interests. How do you underwrite a loan? In order to underwrite a loan, it's important to include 1. cash flow 2. credit history 3. job stability 4. assets 5. property appraisal EBITDA Earnings before Interest, Taxes, Depreciation, and Amortization 2 types of forecasting approaches Quantitative and Qualitative Quantitative approach to forecasting historical data from time series or correlation information Qualitative approach to forecasting opinions from experts, decision-makers, or customers 4 methods of quantitative forecasting 1. Naive 2. Moving averages 3. Exponential smoothing 4. Trend Projection 4 methods of qualitative forecasting 1. Executive opinion 2. Delphi method 3. Sales force estimates 4. Consumer surveys group opinion or decision by surveying a panel of experts. Experts respond to several rounds of questionnaires, and the responses are aggregated and shared with the group after each round. The experts can adjust their answer each round, based on how they interpret the "group response" provided to them. The ultimate result is meant to be a true consensus of what the group thinks. Linear regression Linear regression is a basic and commonly used type of predictive analysis. The overall idea of regression is to examine two things: (1) does a set of predictor variables do a good job in predicting an outcome (dependent) variable? (2) Which variables in particular are significant predictors of the outcome variable, and in what way do they-indicated by the magnitude and sign of the beta estimates-impact the outcome variable? These regression estimates are used to explain the relationship between one dependent variable and one or more independent variables. The simplest form of the regression equation with one dependent and one independent variable is defined by the formula y = c + b*x, where y = estimated dependent variable score, c = constant, b = regression coefficient, and x = score on the independent variable. What metrics can be used to evaluate companies in the financial services sector? (Link) Price/ Book = The P/B ratio measures the market's valuation of a company relative to its book value. The market value of equity is typically higher than the book value of a company, P/B ratio is used by value investors to identify potential investments. P/B ratios under 1 are typically considered solid investments. net difference between that company's total assets and total liabilities, where book value reflects the total value of a company's assets that shareholders of that company would receive if the company were to be liquidated. Price/ earnings relates a company's share price to its earnings per share. A high P/E ratio could mean that a company's stock is over-valued, or else that investors are expecting high growth rates in the future. Companies that have no earnings or that are losing money do not have a P/E ratio since there is nothing to put in the denominator. Two kinds of P/E ratios - forward and trailing P/E - are used in practice. 4 types of budgets 1. Incremental 2. Activity-Based 3. Value proposition 4. Zero-Based SG + A Selling, General, and Administrative Expenses Understanding Affiliates There are several definitions of the term affiliate in the corporate, securities, and capital markets. In the first, an affiliate is a company that is related to another. The affiliate is generally subordinate to the other and has a minority stake or less than 50% in the affiliate. In some cases, an affiliate may be owned by a third company. Can you explain why financial reports do not list dividends on the income statement? "The income statement does not contain dividends because it shows only the company's income. If you want to look at the dividends, you will need to look at the shareholder equity section." What are key factors financial analysts should consider when evaluating prospective investments? Return on Investment Experience of achievement Desire to grow "It is crucial to calculate an asset's return on investment, consider the company's current portfolio and how the investment fits before recommending a new investment to a client." What is the best metric to use to analyze a company's stock? "I believe PEG (Price Earnings to Growth Ratio) is an ideal key performance indicator of a company's stock. In my years of experience in this field, I find it to be the most important metric to assess a business' financial health. This metric factors in the projected earnings growth for the company and is better than only using the price-earnings ratio." Which statements (income, balance, cash flow) would you reference to assess the company's liabilities and assets and why? his question evaluates a candidate's analytical and decision-making skills. The answer shows a candidate's understanding of financial statements and thought process. It is important to know this information because a financial analyst should understand the ideal statement to reference when analyzing a company's financial health. Answers to look for include: Balance sheet Income statement Reasons for selections "The balance sheet and income statement explain how much assets and liabilities the company has. Alternatively, the cash flow statement will only tell me the inflow of money." How does increasing accounts receivables impact the company's balance sheet? This question tests the candidate's analytical skills. The answer demonstrates knowledge of how different line items on the balance sheet relate to one another. This information is important to know because it impacts the decisions financial analysts must make. Look for answers, such as: Negative impact on cash flow Lowers company's net worth Reduces the value of assets "If the company's account receivables continue to increase it can adversely affect the cash flow, which means the company will not have enough money to operate." When a cash payment is received from the debtor, cash is increased and the accounts receivable is decreased. Walk me through how you would develop an investment recommendation for senior management. "First, I would seek to clearly understand what the end goals are for the investment. Do they want or need a quick ROI? Is it an investment that includes an acquisition? Second, I would collect the financial statements (balance sheet, income statements, and cash flow statements), and if they don't exist yet, I would work with the key stakeholders (business groups and other finance partners) to create them such that they are applicable to the project. Third, I would talk with the business partners to understand what caveats might need to be made. For example, cash flow will be xyz assuming that the widget comes to market in Q3 as planned. If it doesn't, this investment would become decidedly more risky. And lastly, I would make sure to have a few different investment options for the managers to consider, shifted primarily based on the various caveats and potential business conditions." What is an EBITDA and what isn't included in it? (Prepare for tough interview questions!) The specifics of this financial analyst interview question may not be common, but its preparedness spirit is. Whether it's a question about EBITDA or about how inventory fluctuations affect an income statement, the point is to be prepared for hard questions. Interviewers want to be sure you know your stuff! It pays to prepare. In the end, you can't fake what you do or don't know. If you get a hard question that you can't answer, don't fake it. Be honest: "That's a really great question, and while I know I covered that in my Accounting II course, I just can't remember the answer in this moment. I'm going to look that up after this interview so I know it moving forward!" Explain financial modeling "Financial modeling is a quantitative analysis commonly used for either asset pricing or general corporate finance. Essentially, hypothetical variables are used in a formula to determine the likely impact on market behavior, profitability, or economic conditions." Financial modeling is a representation in numbers of some or all aspects of a company's operations. Financial models are used to estimate the valuation of a business or to compare businesses to their peers in the industry. Various models exist that may produce different results. A model is also only as good as the inputs and assumptions that go into it. What do you think is the single best metric for analyzing a company's stock? operating profit margin, and you prefer this metric because it provides not only an indication of basic profitability but of how well-managed the company is overall. Alternately, you could say the price/earnings to growth ratio (PEG) is the most complete equity valuation metric because it factors in the projected earnings growth rate, making it superior to the commonly used price/earnings ratio (P/E). he PEG ratio is considered to be an indicator of a stock's true value, and similar to the P/E ratio, a lower PEG may indicate that a stock is undervalued. What are the 3 financial statements? cash flow statement, income statement, and the balance sheet. How are the 3 financial statements linked? OR walk me through three financial statements "The three financial statements are the income statement, balance sheet, and statement of cash flows. The income statement is a statement that illustrates the profitability of the company. It begins with the revenue line and after subtracting various expenses arrives at net income. The income statement covers a specified period like quarter or year. Unlike the income statement, the balance sheet does not account for the entire period and rather is a snapshot of the company at a specific point in time such as the end of the quarter or year. The balance sheet shows the company's resources (assets) and funding for those resources (liabilities and stockholder's equity). Assets must always equal the sum of liabilities and equity. Lastly, the statement of cash flows is a magnification of the cash account on the balance sheet and accounts for the entire period reconciling the beginning of period to end of period cash balance. It typically begins with net income and is then adjusted for various non-cash expenses and non-cash income to arrive at cash from operating. Cash from investing and financing are then added to cash flow from operations to arrive at net change in cash for the year." Balance Sheet (big picture) financial condition at one point in time Assets= Liability + Shareholder's Equity Income Statement (big picture) profitability over time Net Income = Revenue - Expenses Relate Balance Sheet to Income Statement -Net income comes from income statement -Appears as retained earnings on Balance sheet in equity section Cash Flow Statement (big picture) changes in cash over period of time Why is the cash flow statement important and how does it compare to the income statement? - Income statement accounting uses what is accrual accounting-- record revenue when earned and expenses when incurred. Pros: Accrual method= more accurate picture of the companies profitability. Cons: More easily to manipulate accounting profits than cash profits. Cons: Must see amount of cash-- not having a handle on cash can potentially make even a healthy company go bankrupt. -Solution: analyze both, they should corroborate. What does balance sheet tell us? dollar amounts of a company's assets, liabilities, and owner's equity Diff b/w debt and equity Debt- take out loans, fixed payment, the owner of debt has first priority for repayment Equity- shareholder now owns part of the business, likely more expensive than debt, not first priority of repayment Three sections of a cash flow statement Operating Financing Investing Working Capital assets examples accounts receivable, inventory, prepaid expenses, etc. Cash from operating activities Determine from 2 methods: direct and indirect Indirect(super common)- The indirect method starts with net income and includes the cash effects of transactions involved in calculating net income. Cash from operations= Net income (from income statement) + period-on-period increases in working capital liabilities + non-cash expenses - non-cash gains - period-on-period increases in working capital assets -For a stable, mature company a positive cash flow from operating activities is desirable Essentially, cash from operating activities is a reconciliation of net income (from the income statement) to the amount of cash the company actually generated during that period as a result of operations (think cash profits vs accounting profits). The adjustments to get from accounting profit (net income) to cash profits (cash from operations) are as follows: Working Capital liabilities examples accounts payable, accrued expenses, etc. Walk me through a cash flow statement. 1. Start with net income, go line by line through major adjustments (depreciation, changes in working capital and deferred taxes) to arrive at cash flows from operating activities. 2. Mention capital expenditures, asset sales, purchase of intangible assets, and purchase/sale of investment securities to arrive at cash flow from investing activities. 3. Mention repurchase/issuance of debt and equity and paying out dividends to arrive at cash flow from financing activities. 4. Adding cash flows from operations, cash flows from investments, and cash flows from financing gets you to total change of cash. 5. Beginning-of-period cash balance plus change in cash allows you to arrive at end-of-period cash balance. Cash from investment activities -Cash related to investments in the business (i.e., additional capital expenditures) or divesting businesses (sale of assets). -For a stable, mature, company negative cash flow from investing activities is desirable b/c indicates that the company is trying to grow by buying assets. Cash from financing activities -Cash related to capital raising and payments of dividends. --- Ex: company issues more preferred stock, we will see such an increase in cash in this section. ----Ex: company pays dividends, we will see a cash outflow related to such a payment. -For a stable, mature, company, there is not a preference for positive or negative cash in this section. Depends on cost of capital tial ROI Formula for Net Change in Cash Over the Period Add up all the parts of Cash flow statement Net Change in Cash Over the Period = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities How is cash flow statement linked to income statement? -Net income is the top line of the cash flow from operations section when companies use indirect method 10 K Annual Financial Report How is cash flow statement linked to balance sheet? -It represents the net change in cash over the period (magnification of the cash account on the balance sheet). -A previous period's cash balance plus the net change in cash this period represents the latest cash balance on the balance sheet. 10 Q Quarterly Financial Report What is working capital? -Working Capital = Current assets - current liabilities; -Tells the financial statement user how much cash is tied up in the business through items such as receivables and inventories - Shows how much cash is going to be needed to pay off short term obligations in the next 12 months. Is it possible for a company to show positive cash flows but be in grave trouble? Yes: 1. unsustainable improvements in working capital (a company is selling off inventory and delaying payables) 2. lack of revenues going the pipeline How is it possible for a company to show positive net income but go bankrupt? Yes, due to deterioration of working capital (i.e. increasing accounts receivable, lowering accounts payable), I buy a piece of equipment, walk me through the impact on the 3 financial statements. 1. Initially, there is no impact (income statement); 2. Cash goes down, while PP&E goes up (balance sheet), and the purchase of PP&E is a cash outflow (cash flow statement) 3. Over the life of the asset: depreciation reduces net income (income statement); PP&E goes down by depreciation, while retained earnings go down (balance sheet); and depreciation is added back (because it is a non-cash expense that reduced net income) in the cash from operations section (cash flow statement). Why are increases in accounts receivable a cash reduction on the cash flow statement? Since our cash flow statement starts with net income, an increase in accounts receivable is an adjustment to net income to reflect the fact that the company never actually received those funds. How is the income statement linked to the balance sheet? Net income flows into retained earnings. What is goodwill? Captures excess of the purchase price over fair market value of an acquired business. Ex: Acquirer buys Target for $500m in cash. Target has 1 asset: PPE with book value of $100, debt of $50m, and equity of $50m = book value (A-L) of $50m. Acquirer records cash decline of $500 to finance acquisition Acquirer's PP&E increases by $100m Acquirer's debt increases by $50m Acquirer records goodwill of $450m Q: What is a deferred tax liability and why might one be created? Deferred tax liability is a tax expense amount reported on a company's income statement that is not actually paid to the IRS in that time period, but is expected to be paid in the future. It arises because when a company actually pays less in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in depreciation expense between book reporting (GAAP) and IRS reporting can lead to differences in income between the two, which ultimately leads to differences in tax expense reported in the financial statements and taxes payable to the IRS. What is a deferred tax asset and why might one be created? : Deferred tax asset arises when a company actually pays more in taxes to the IRS than they show as an expense on their income statement in a reporting period. Differences in revenue recognition, expense recognition (such as warranty expense), and net operating losses (NOLs) can create deferred tax assets. Two companies both valued at $25 which is cheaper I look at the earning of both the company and calculate the PE Multiple. The company whose PE multiple is higher is more expensive as I have to pay more price to earn a single Dollar. If a company takes out $100 million of debt and uses it all to finance a stock buyback, how does it affect the 3 financial statements both now and a year in the future? Common Expenses cost of goods sold (COGS); selling, general, and administrative (SG&A); interest expense; deprecition; and taxes If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements? 1. Income Statement: depreciation is an expense so operating income (EBIT) declines by $10. ---Assuming a tax rate of 40%, net income declines by $6. 2. Cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. 3. Balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder's equity decreased $6. Why if non-cash, explain how this transaction caused cash to increase $4. ---Because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense. Ending Retained Earnings formula Ending Retained Earnings = Beginning Retained Earnings + Net Income - Dividends Diff b/w COGS and SG&A COGS are costs directly associated with the production of the goods sold while SG&A are costs indirectly associated with the production of the goods sold COGS- manufacturing, SG&A- marketing Earnings per share (EPS) -portion of a company's profit allocated to each outstanding share of common stock. EPS = (net income - dividends on preferred stock) / weighted average shares outstanding) P/E ratio the price-earnings ratio indicates the dollar amount an investor can expect to invest in a company in order to receive one dollar of that company's earnings. Why do capital expenditures increase assets (PP&E), while other cash outflows, like paying salary, taxes, etc., do not create any asset, and instead instantly create an expense on the income statement that reduces equity via retained earnings? Capital expenditures are capitalized because of the timing of their estimated benefits - the lemonade stand will benefit the firm for many years. The employees' work, on the other hand, benefits the period in which the wages are generated only and should be expensed then. This is what differentiates an asset from an expense. most critical financial statement for overall health Cash flow statement- we care most about the cash flow of a company and only it tells me how much cash the company has. I could only look at 2 statements to assess a company's prospects - which 2 would I use and why? Income Statement and Balance Sheet- 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). If Depreciation is a non-cash expense, why does it affect the cash balance? t is tax-deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay. What happens when Inventory goes up by $10, assuming you pay for it with cash? Income Statement: no change Cash Flow Statement: decreases your Cash Flow from by $10, as does the Net Change in Cash at the bottom. Balance Sheet: Assets increase by $10, but Cash is down by $10 What happens when Accrued Compensation goes up by $10? Income Statement: no change Cash Flow Statement: increases your Cash Flow from by $10, as does the Net Change in Cash at the bottom b/c accrued compensation is a liablility under Changes in Working Capital Balance Sheet: Liabilities would go up by $10, cash also up by $10 Why is the Income Statement not affected by changes in 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? Income Statement: no change yet Cash Flow Statement: Cash Flow from Investing down by $100 from factories. Cash flow up by $100 from debt funding. Cash number stays the same. Balance Sheet: PPE (Assets) up by $100, accts payable (liabilities also up by $100 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? (principal is $100) After a year has passed, Apple must pay interest expense and must record the depreciation: Income Statement: 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. 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 ($10-$12=-$2). . Balance Sheet: Assets- Cash is down by $2 and PP&E is down by $10 due to the depreciation, so overall Assets are down by $12. Net Income was down by $12 (Shareholders' Equity) 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. (Assume $100 principal, 10% for depreciation and loan interest) After 2 years, the value of the factories is now $80 if we go with the 10% depreciation per year so that's what we will write down in the 3 statements. Income Statement: the $80 write-down shows up in the Pre-Tax Income line. With a 40% tax rate, Net Income declines by $48. Cash Flow Statement: Net Income is down by $48 but the write-down is a non-cash expense, so we add $80 back - and therefore Cash Flow from Operations increases by $32. Cash Flow from Investing: no change Cash Flow from Financing: $100 decrease for the loan payback Overall, the Net Change in Cash falls by $68. Balance Sheet: Cash is now down by $68 and PP&E is down by $80, so Assets have decreased by $148 altogether. Debt is down $100 since it was paid off, and since Net Income was down by $48 (Shareholders' Equity) Both sides down by $148 and both sides balance.