Accounting - "Talking"

Walk me through the 3 financial statements & how they generally work

Income Statement - Profitability. (Revenue -> NI) Balance Sheet - Resources (Assets) & Sources of Funding (Liabilities & Equity). A = L+E Cash Flow Statement - Liquidity, starting with NI and adjusting for non-cash adjustments + investing & financing cash flow to get the free cash flow.

How do the three statements link together?

1) Net Income (IS) -> Retained Earnings, Shareholder Equity on Balance Sheet & top of Cash Flow Statement. 2) Changes to Short-term assets & liabilities in BS = working capital on Cash Flow Statement. HOW CFS IS AFFECTED: Investing & Financing activities from CFS affect Balance Sheet items such as PPE, Debt and Shareholder Equity. Finally, The change in cash (FCF) from the cash flow statement plus beginning cash balance = ending cash balance on Balance Sheet. **HARD - NEEDS GOOD STRUCTURE**

Walk me through the income statement

Rev (COGS) Gross Profit Gross (SG&A, D&A -> OpEx) -> EBIT/Operating Profit EBIT + D&A -> EBITDA, but (Interest Expense * 1-Tax) -> NI

Give me more details on assets, liabilities, and equity

Assets = represent future inflows. Resources that bring positive monetary benefits. Liabilities = unsettled obligations, external sources of capital that help fund assets. Represent future outflows of cash Equity = invested capital, can be internal sources like retained earnings

Walk me through the cash flow statement

OPERATING: NI + non-cash adjustments (D&A, OWC). INVESTING: CapEx FINANCING: Debt or Stock Purchase/Dividends Sum up the inflow & outflows of each to get FCF

Which statement is most important?

CFS, as it shows the liquidity of the company and its financial health. For example, you could, on paper, be making money with revenue but mainly as A/R. Cash flow is direct and shows if more cash is flowing in or out.

Why GAAP is important?

standardization, ensures financials are fair, consistent basis. allows investors to easily evaluate companies by reviewing their financial documents. helps companies gain insight into practices and performance

Explain the conservatism principle in accrual accounting

Must have evidence of occurrence & is base on the belief of downward bias (risk of understating revenue & understating expense & liabilities = minimized)

Why is fair value accounting used?

After 2008, make sure that illiquid securities are still marked-to-market to ensure they have accurate valuations instead sudden asset write-downs & a market collapse

Why know difference between IFRS & US GAAP?

Important for cross-border M&A, multinational companies, with globalization and with increasing demand for geographic diversification of investments

Above vs Below the Line

Refers to income statement, since anything taxable is reporting there. Above = operating. Below = non-operating items

How can a profitable firm go bankrupt?

Profit just means revenue > expense If company = ineffective at collecting cash flows from customers, company can suffer from liquidity problems due to timing mismatch between inflow & outflow (so can't pay debt in time)

What is the difference between EBIT and operating profit?

Generally, they're the same thing but given that EBITDA adds back interest and taxes instead of simply subtracting operating expenses, EBIT may include some non-core business expenses like "Loss on Sale of Equipment"

What is a DTL?

Deferred Tax Liability - whenever your earnings report shows a lower tax expense than the actual taxes you've paid (eg: from using straight-line vs accelerated depreciation)

What are some ratios used to perform credit analyses?

Liquidity (Quick, Current, Cash) Leverage (Debt-to-EBITDA, Assets, and Equity) Coverage (Times Interested, EBITDA Interest Coverage, DSCR, FCCR) Profitability (Gross, operating, net. ROE, ROA, ROIC)

How would share issuance affect EPS?

DECREASE 1) Share # increase from issuance. Since EPS = NI/Share #, when the Share # (denominator) increases, EPS decreases

If a company continuously incurs goodwill impairment, what can you take away?

Goodwill is unchanged unless impaired, so it suggests either unforeseen circumstances, overpaid/not able to recognize how the acquired company could contribute to its operations

**How do finance and operating leases work? ****How does it affect equity value/EV?

At first, is both a liability and asset. IFRS = Straight-line dep for asset. Often = constant cash outflow (set at like $20) with it being made up of interest expense (discount rate * outstanding debt) & principal paydown. Note that lease liability will not equal asset here. Finance = same as IFRS Operating = Similar, except depreciation is same as liability (is just principal paydown). NOTE: Depreciation is added back but not debt. In US, since same it doesn't matter but in other countries it can be problematic. **Add back when going from equity -> EV since excludes interest expense and D&A ****DCF - easiest is to not consider it a part of Cap Structure, so not part of WACC nor funding (include in BS, treat as normal expense - unlike in IS)

What is restricted cash?

cash not available for general use but rather, restricted for a special purpose (acquisition reserve, etc.)

Why are some assets exempt from the historical cost principle?

Their true economic value is better reflected by their current market price or expected cash realization

Why are intangible assets not in the balance sheet?

Not verifiable (unless acquired, which is verified by 3rd party and audits)

Why do we use the historical cost principle?

No constant re-evaluation, subjecting the company to increased price voltaility & more conservative in our estimates

What are non-recurring items? What do we generally do with them?

Items considered one-off in nature and include restructuring/inventory write-downs. They are added back when comparing companies as they aren't part of the business's core operations

What is the difference between organic vs inorganic growth?

Inorganic = M&A driven Organic = optimizing business operations (eg: internal efficiency boosts, expanding business operations, improving product mix)

How does CapEx & depreciation shift for mature vs new companies?

Mature = lower CapEx, higher depreciation New = reverse

What is working capital?

Measures company's liquidity & ability to pay off current obligations. it's the difference between current assets and current liabilities.

Why are effective & marginal tax rates often different? Can you give specific examples on why they might differ?

Effective = avg tax Marginal tax = tax paid on last dollar. **FIND BETTER ANSWER LATER**

What are some ways/metrics to compare companies?

Location Growth Metrics Size (Equity, Enterprise) Profitability/Revenue Metrics Debt/Capital Structure Metrics Other Metrics (depending on industry, like LTV, CAC for B2C SaaS Tech)

Walk me through a DCF

1) Forecast UFCF (defined UFCF - represents cash flow before leverage & should be forecase for 5-10 year period) 2) Calculate TV (defined as value of FCFs beyond the initial forecast. 2 methods: perpetual and exit multiple) 3) Discount Stage 1 & 2 CFs (the TV and UFCF sums) to Present Value (since it should reflect the value @ current date and not future, TV must be discounted with WACC) 4) Go from EV -> Equity Value, subtracting net debt & other shareholders' interests and adding back non-operating assets like cash 5) Calculate the intrinsic price per share by dividing by the diluted shares outstanding 6) Sensitivity Analysis -> Given the assumptions made in the DCF, see how altering the assumptions would change the implied share price

Conceptually, what does the discount rate represent?

Discount Rate = expected return on investment based on risk profile. Higher discount implies greater risk, so expects higher returns and means less valuable cash flows

What is the difference between Unlevered & Levered DCF? What are the discount rates used for?

Unlevered = Discounts UFCF to get to EV, you can then convert to equity value. Discount Rate = WACC. Levered = Discounts LFCF to Equity Value. DR = CoE

How do you determine the risk-free rate?

Theoretically reflects the YTM of default-free government bonds of equivalent maturity to duration of each discounted cash flow (so like year 1 = 1-year treasury note). NOTE: Not done for 3 reasons: 1) lack of liquidity on company's FCF (which is generally assumed to be re-invested in the company, making the time horizon longer) 2) the risk-free rate that is applied to the discount rate is also applied to the terminal value, which is long-term by nature 3) yield on 10-year treasury notes is less variable than a short-term (which fluctuates based on fed policy), making valuations more stable

What effect does a low interest-rate environment have on DCF valuations?

Makes it higher, as risk-free rate (& consequently discount rate) will be lower

Define the equity risk premium used in the CAPM formula.

The Equity Risk Premium measures incremental risk/excess return required for investing in equities vs risk-free securities Historically is around 4-6%

Explain the concept of beta.

Beta measures the systematic (i.e., non-diversifiable) risk of a security compared to the broader market - it's the correlation in a linear regression model of a security to the market. A company with a beta of 1.0 would expect to see returns consistent with the overall stock market returns. Thus, if the market has gone up 10%, the company should see a return of 10%. If beta is >1, more sensitive. If 0<1, less sensitive. If <0, inversely correlated with market.

What is the difference between systematic risk and unsystematic risk?

Systematic = undiversifiable (inherent within equity market), thus built into price of securities Unsystematic = can be reduced via portfolio diversification. Market doesn't reward you with extra returns if you have this kind of risk

** (THINK) Does a higher beta lead to a lower or higher valuation?

Lower valuation, as a higher beta = more risk (more volatility vs the market) and thus a higher discount rate will be used

** (THINK ON SPOT) What types of sectors have higher/lower beta?

Lower beta = still wanted in recession, so consumer & hospital. Higher beta = cyclical (auto, restaurants)

** (CONCEPT) What is industry beta? What is the benefit of using an industry beta?

This approach looks at unlevered betas of comparable peer groups to a valued company & applies a median beta to the target. Helps reduce company-specific noise. Can also help find industry-derived beta for private companies (who often don't have a readily accessible beta)

** (HARD) What are the flaws of regression beta?

1) Backward-looking (it's a linear regression model based on historical stock returns vs an index) 2) Large Standard Error (sensitive to assumptions used, include index it's compared against. Company-specific events can also lead to inexplicable deviations) 3) Constant capital structure (since based on past D/E ratios it's flawed for forecasting purposes)

** (SEMI HARD THINK ON SPOT) What is the impact of leverage on the beta of a company?

Firstly, leverage only affects levered beta (unlevered beta = capital structure neutral). Amount of leverage = increases financial risk. Thus, in general, with higher leverage, the higher the levered beta.

** (HARD - THINK OF DIFFERENT COMPANIES) What is the relationship between beta & the amount of leverage used?

In general, if more mature, will have lower beta and higher leverage & if higher beta, then they're more reluctant to have higher leverage as borrowing is less favorable for their capital structure.

** (HARD - CONCEPT) Which is typically higher, cost of debt or cost of equity? Why?

Cost of Equity: 1) Cost of Debt is tax-deducitable (thus has a tax shield), 2) Equity Investors are last in line when bankrupt, so need a premium to compensate

** If Cost of Equity is higher than Debt, why not only use debt?

Because at some point, when you have too much debt, you will be highly levered, which will increase your bankruptcy risk and lead lenders to demand a higher interest rate on their loans. As a result, your capital structure will not be optimized and your cost of debt will exceed cost of equity. This can be seen in the "WACC smile", a curve that plots WACC against % of Debt in Capital Structure

** (WEIRD) What is the difference between IRR and WACC?

IRR = projected return on a project's expenditures. Given an initial cost, possible intermediate cash flows & exit value, it's the implied interest rate you'd need from your initial investments to get the same amount in returns as your projected project returns. WACC = minimum required IRR for debt & equity providers to invest in your company

** (THINK ON FEET) Which would have more of an impact on a DCF, discount rate or sales growth rate? Why?

Sales growth rates impacts revenue, but only one of many factors that impacts the FCF. Discount rate directly affects FCF, so its impact is larger.

** What is the argument against using the exit multiples approach in a DCF?

In theory, DCF = intrinsic cash flows, to be independent of market. By using an exit multiple, relative valuations are brought in, defeating the purpose of a DCF (but now used since easier to discuss & defend)

** What is the purpose of the mid-year convention? When would mid-year be inappropriate?

Full-year is an inaccurate representation of a company since cash flows = generated steadily. Thus, with mid-year, cash flows are received earlier, thereby also increasing the valuation Would be inappropriate when it's a highly seasonal company (especially a winter clothing brand like Canada Goose)

How would raising additional debt impact a DCF analysis?

Theoretically, nothing as DCF uses UFCF and should be capital-structure neutral. However, additional debt/leverage often means a higher cost of debt & equity, which leads to a higher WACC & discount rate and lower valuation

** (THINK) Imagine that 2 companies had the same leverage ratio (with the same FCF & profit margins). Are their default risks the same?

No because traditional leverage ratios like debt/EBITDA doesn't consider cash. Yet, more cash obviously means they're better positioned to finance the debt. Thus, Net Debt/EBITDA is often also considered for this reason

**When is a DCF inappropriate?

When you don't have access to the financial statements - if you only have revenue & EBIT data, public comparables are easier to implement. Also unfeasible when a company is not expected to generate positive cash flows in the foreseeable future

If 80% of a DCF valuation comes from the terminal value, what should be done?

Check forecast period - perhaps it's not long enough Check terminal value - perhaps assumptions are too aggressive and don't reflect stable growth

**(CONCEPT) For forecasting purposes, do you use effective or marginal tax rate?

Boils down to the tax assumption paid into perpetuity. Marginal is based on last dollar paid, so is often a forward-looking number. Often not used short-term, as it over-estimated the taxes. Instead, effective is used short--term, as that is the historical average and we often want to delay more taxes. It's hard to do long-term, though, as it creates DTA and DTLs. Thus, it's easiest to assume that effective tax rate is used at the beginning & normalizes to marginal tax rate as time passes

How does a DDM differ from a DCF? Why don't we use the DDM model/ what are the disadvantages of using the DDM?

DDM = present value based on future dividends & growth rate. Since dividends is exclusive to shareholders, it is discounted via CoE and an equity value exit multiple (like P/E) is often used. Disadvantage: 1) Sensitive to dividend growth, payout ratio (how much of NI is paid out in dividends), and required rate of retunr 2) Neglects share buybacks (which many companies opt for now) 3) Poorly run companies can have high dividend payout ratios 4) Can't be used on high-growth companies (often low dividend + growth > required return rate)

**How does a lower tax rate impact DCF valuations?

1) Greater FCF (as lower tax = less taxes paid & higher NOPAT) 2) Higher Cost of Debt (tax shield, of (1-t) = lower) 3) Higher Levered Beta (same reason, as levered beta

**Is it better to have $100M more in revenue or have a $100M lower in OpEx? Why?

Increased revenue doesn't actually mean NI grows by the same amount (as, with margin staying the same, it also means higher expenses). Lower margins, however, directly impacts NI, leading to a direct increase in NI.

A company holds Trading securities that rise from $50 to $100 (40% tax rate). What is the immediate effect on pre-tax income and the 3 balance sheet more broadly?

Pre-tax goes up by $30. Since it's a non-cash gain, CFS will adjust down by $50, so -$20 in total. BS: Assets is up by $30 (50 in securities - $20 cash). Equity = up $30 from retained earnings

Company A owns 80% of Company B and consolidates it. B earns $200M of net income. On A's income statement, the 20% A does not own is

Deducted as "Net Income Attributable to Noncontrolling Interests" ($40M), because A consolidates 100% of B but owns only 80%.

Versus an operating lease with the same economics, a finance (capital) lease will generally make a company's EBITDA

Higher, because the lease cost splits into depreciation (inside EBIT) and interest (below EBIT) rather than a single operating rent expense. Finance - split, operating - consolidate

How does a gain in trading securities affect the 3 statements? What about AFS? What about HTM? How do they differ?

Trading gains - unrealized is still IS AFS gains - OCI (stockholders' equity & BS) until realized HTM - dividend income is IS

A company grants an executive $10M of RSUs at a 40% tax rate. Please describes the immediate accounting that follows

(fully vested) Just simple SBC (stock-based compensation) - stock-based compensation line item each year (offset by APIC)

A parent company owns 30% of an "Associate" company, and the stake shows up as an Equity Investment on the parent's Balance Sheet. When moving from the parent's Equity Value to its Enterprise Value to build a clean EV / EBITDA multiple, why do you subtract the value of the Equity Investment?

Because Equity Investments are non-core-business assets, and — critically — the parent's EBITDA does not reflect any contribution from associates it owns under 50% (is instead accounted for in shareholders' equity), so the numerator must be scrubbed for comparability.

How are equity method investments recorded on the parent company on the 3 statements?

Equity method investment(20-50%) is recorded as an asset. When the investments reports a positive NI, it is added to the bottom below NI (to get NI attributable to shareholders). Since non-cash, is adjusted back. So, equity method investment asset gain = equity gain thru retained earnings. **Note: You do % * Equity Method Investment** When investments issue a dividend, you do the opposite (based on dividend amount)

Suppose a CEO literally finds $100 of cash on the street and deposits it into the company's bank account. Ignoring the strangeness of the scenario, what is the immediate impact on Equity Value, Enterprise Value, and the P / E multiple?

Equity Value rises by $100. Enterprise Value is unchanged, P / E rises (since equity value rises)

Why does issuing dividends lower the P/E multiple and gaining cash increase the P/E multiple?

P/E is also Market Cap or Equity Value/Total Earnings. When you get more cash, your equity value increases (as you have more total assets). Since your denominator is higher, P/E is higher.

How does the consolidation method work? Say you had 80% of the company, how would you record that?

First, on the balance sheet, you simply record all of the subsidiary's assets & liabilities as you own. To then accurately represent the minority portion of the company you don't own, multiply net assets (assets - liabilities) by minority share is written as Non-Controlling Interests (in a line item under Shareholders' Equity that gets you to "Total Consolidated Equity") On the income statement, you subtract that % you don't own * the net income of the subsidiary after you calculate the consolidated net income (assuming 100% of both companies) to get to Net Income Attributable to Parent

Why do you add back non-controlling interests when moving from equity to enterprise value?

Although not a direct shareholder in the parent company, a minority or non-controlling interest in a subsidiary represent a shareholder in the fully combined company. And thus, must be included when adding all shareholders to get from equity to enterprise value.

A company grants an executive $10M of stock options (valued with the Black-Scholes method) at a 40% tax rate. Please describes the immediate accounting that follows & what might happen after

A $10M M non-cash expense is booked and added back on the CFS, a $4M Deferred Tax Asset arises since the tax deductions (and resulting cash flow each year comes later.