M&I 400 Technical Questions (Basic) Exam
With Complete Solutions
Walk me through the 3 basic financial statements - ANSWER 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 - ANSWER 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? - ANSWER 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? -
ANSWER 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? - ANSWER 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? -
ANSWER 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? - ANSWER 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? - ANSWER 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? - ANSWER
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 - ANSWER 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? - ANSWER
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? -
ANSWER 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? - ANSWER 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. - ANSWER 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?
- ANSWER 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. - ANSWER 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? - ANSWER 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? - ANSWER Working Capital= current
assets - current liabilities
Positive- company can pay off its short-term liabilities with its short-term assets.
With Complete Solutions
Walk me through the 3 basic financial statements - ANSWER 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 - ANSWER 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? - ANSWER 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? -
ANSWER 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? - ANSWER 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? -
ANSWER 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? - ANSWER 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? - ANSWER 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? - ANSWER
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 - ANSWER 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? - ANSWER
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? -
ANSWER 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? - ANSWER 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. - ANSWER 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?
- ANSWER 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. - ANSWER 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? - ANSWER 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? - ANSWER Working Capital= current
assets - current liabilities
Positive- company can pay off its short-term liabilities with its short-term assets.
