Accounting - Knowledge

Why don't you depreciate land?

Depreciation = useful life - land has indefinite -> (not depreciable)

Can companies amortize goodwill?

Public companies = no (indefinite life, like land). Instead, tested for impairment. However, privately held companies may elect to amortize goodwill/over 15 years for tax.

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**

How does a $10 increase in Stock-Based Compensation (SBC) affect the 3 financial statements (assume 40% tax rate)?

IS: $10 increase in OpEx, so $6 post-tax decrease to NI CFS: Since non-cash, is $10 add-back ($4 increase) BS: - Assets - Cash increases by $4. - L&E - Retained Earnings = -6, but Shareholder Equity (excluding R/E) is $10, so Equity (and consequently L&E) up by $4

How does principal repayment affect the 3 statements?

Only CFS and BS - the cash decrease is equal to the liability decrease

What is trapped cash?

Overseas money in int'l companies that stays offshore to prevent repatriation taxes

What are intercompany investments and investment securities? How do they show up on the 3 statements?

Intercompany: Stock Investment/Investment in Security (<20, unrealized gains) Equity Investments (20-50, marked-to-market as unrealized gains. dividend reduces share, like NCI, NI increases) Consolidation (>50%, other share is NCI in stockholders' equity) Securities: 1) Trading (initial cost, unrealized = shown in IS) 2) AFS (initial, unrealized = equity) 3) HTM (historical, dividend = revenue)

If a company incurs $100 in PIK interest, how does it affect 3 statements (assuming 40% tax rate)

IS: $100 expense, $60 post-tax CFS: $-60 + 100 (non-cash adjustment), +$40 BS: Assets - Cash +$40, Liabilities = $100 Equity = -60 (R/E)

What is OID (original issue discount) in debt?

Allows investors to only pay less if they take on debt first (original issuers)

How to estimate share price (given current + projected growht rate) & calculate share count (given basic outstanding, issued and repurchased + share price)

Share price - Current * (1 + growth rate) Share count - Outstanding + Issued/Price - Repurchase/Price

How do you calculate EPS with P/E?

They are inverses (share price/EPS = P/E)

What is difference between defined contribution & benefit retirement plans?

1) Contribution = Contribute periodically expense stated 2) Defined Benefit = estimate on how much to satisfy post-retirement benefits and give an amount close to it. If higher, than DTA. If lower, DTL.

What are some ways to inflate earnings?

LIFO -> FIFO Refusal to write-down impaired assets Deferral of R&D/CapEx Capitalizing normal expenses Aggressive Revenue Recognition Policies

Capitalized vs Expensed

Capitalized = long-term. Expensed = used in that time period

What happens when share price = up by 10%?

Nothing (BS is historical value)

Retention ratio vs Dividend Ratio

RETENTION: Money kept (NI-Dividends)/NI DIVIDEND: Dividend/NI

When adjusting for non-recurring expenses, are litigation expenses always adjusted?

No - sometimes is discretionary. Pharma, for example, may choose not to (often has litigation)

What is the cash conversion cycle? What are the 3 parts of it? What do they mean?

CCC -> DIH (Inv/COGS), DSO (A/R, Rev), DPO (A/P / COGS) DIH - how long it takes for inventory to be turned into cash DSO - how long it takes to get A/R into cash DPO - how long it takes to pay off payables CCC - how long it takes to go from Inv -> Cash (from purchase to selling)

What ratios do you look at to assess working capital efficiency?

DIH, DSO, DPO

What are the working capital line items (8) ?

Assets: A/R, Inventory, Prepaid Expenses, Other current assets Liabilities: A/P, Deferred Revenue, Accrued Expenses, Other Liabilities

**What is ROA & ROE? If 50/50 D-to-E and 10% ROA, what is the ROE?

ROA: NI/Asset AVG, is how efficient a company utilize its assets to generate earnings. ROE: NI/Equity AVG, is how efficient a company utilizes the capital shareholders contribute to generate earnings. $10/50 = 20%

**What is ROIC? How do you calculate it?

Assesses how efficient a company is at capital allocation. Is >> WACC, is efficient. NOPAT/Invested Capital

What are the quick & current ratios?

Current: Short-term obligations (Current Assets/Liabilities) Quick: Liquid Assets (cash, A/R, short-term investments)/Current Liabilities Can be misleading if A/R is uncollectible or short-term asset is illiquid

**What are the asset, inventory, receivables, accounts payable turnovers? What do they mean?

Asset = Rev/Avg Asset Inv = COGS/Inv Receivables = Rev/AR A/P = COGS/AP

**What is the DSCR & FCCR? How to calculate? When are they used?

Debt Service Coverage Ratio - measures creditworthiness, whether a company can pay off their debt obligations. Usually used in distressed scenarios. - Formula: (EBITDA-CapEx)/(Mandatory Principal Repayment + Interest Expense) - Often must be 1.25/1.5x or higher (used in Rx & Real Estate) Fixed Charge Coverage Ratio - Assesses whether a company's earnings can over its fixed charges - Formula: (EBIT + Lease Charges)/(Lease Charges + Interest Expenses) - Often must be 1.25x/1.5x or higher. Note: Lease Charges is on top & bottom (since you're measuring cash before you pay vs how much you actually pay)

How does share repurchases affect the 3 statements?

IS: No effect CFS: Financing Cash Outflow BS: Decrease in cash = decrease in equity

When can a company capitalize software development costs under accrual accounting?

2 possibilities: 1) App development stage (internal use) 2) Stage when "technologically feasibility" = reached (can be marketed) NOTE: All development costs are recognizes like a fixed asset purchase and capitalized/amortized over useful life

You buy a factory for $10M at the start of the year. It has a 10-year useful life. Then you sell it in the beginning of year 2 for $5M. Record the changes in the 3 statements in year 1 & year 2 assuming a 50% tax rate.

YEAR 1: IS: $1M Depreciation, so negative $500K to NI CFS: Operating is up $500K (1M adjustment), but investing is down $10M. In total, down 9.5M BS: Cash is down $9.5M, offset by $9M increase assets ($1M depreciation) & Equity is down $500K YEAR 2: IS: Loss on Sale of Equipment ($4M) -> negative $2M to NI CFS: $2M non-adjustment in CFS + $5M for investing, so +$7M in total BS: Cash up $7M but Assets down $9M. Offset by Equity, which is down $2M

What is the difference between Levered FCF & Unlevered FCF?

Unlevered FCF represents cash flow from core operations after OpEx & Investments. UFCF: EBIT* (1-Tax) +D&A-NWC Changes-CapEx LFCF: Cash from Operations - CapEx - Debt Principal Payments

If a company has no debt, what is its WACC? How is CoE calculated?

CoE = CAPM, so Risk Free Rate + Levered Beta * ERP

If a company had a 0% chance of defaulting, what would be its CoD, CoE, and WACC?

CoD = Risk-free rate (theoretically 0% since US gov bonds still have a chance like 0.01% of defaulting - since no risk then you shouldn't have to get compensated). CoE = Risk-free rate (since beta = 0, uncorrelated with market, again should be 0%) Thus, WACC = 0%

**What is the formula to go from Unlevered -> Levered Beta?

Unlevered = Levered/(1+D/E * (1-Tax)), Levered= Unlevered * (1+Tax Rate * D/E)

How do you estimate Cost of Debt?

If public, just use the yield on debt (avg interest expense/avg debt). If no public debt, create a synthetic/estimated rating of their debt & use the market credit spread (which you add to risk-free rate) to calculate yield

How are operating & financial leases treated in a DCF?

THE SIMPLE METHOD: GAAP: Operating leases are treated as operating expenses just expensed by the rent expense amount, and it's not treated as debt (so not added back) IFRS: Build a debt amortization/ROU asset depreciation schedule - see how much you're adjusting non-cash vs outflow for debt repayments. HARD METHOD (argued against since not really debt - principal repayments are tax-deductible): Treat Operating Leases as debt - thus, add-back all the changes and exclude from DCF, including it in your WACC at the end

A company takes on $1000 in operating leases to buy PP&E. How does Equity Value & Enterprise Value change?

Equity Value = unchanged, as it is an off-balance-sheet commitment Enterprise Value = increases. Operating leases is added back if you're using a EBITDAR or revenue multiple that excludes its capital structure effects (similar to how EBIT excludes interest expense from debt). Since ROU is an operating asset, it's included

How are operating & financial leases change over time? How does it differ from other types of debts?

Under GAAP (operating) you still pay fixed amount, but difference is that depreciation is same as principal repayment, so the CFS has no adjustments (you just pay the fixed amount). Asset goes down at same speed as liability. Under IFRS, you pay a fixed amount (say $20) for principal repayment & interest expense. Depreciation = straight-line. Thus, asset can go down faster than liability. Use schedule to calculate each separately

How are leases treated on the balance sheet?

Asset - ROU Asset. Liabilities = equal amount (lease liability)

How is TV calculated?

1) Perpetuitiy (Gordon Growth) - calculated by assuming perpetual growth after forecast period. It's the (projected cash flow for 1 year after forecast)/r-g 2) Exit Multiple - Calculated by applying a multiple assumption on a metric (usually EBITDA) in terminal year

How are options, restricted stock, convertible bonds and convertible preferred stock counted in share count/enterprise value?

If strike price is in-the-money, then count the share count and use the treasury stock method (options, convertible bonds & pref. stock). Restricted stock is generally counted (even if unvested under logic that they'll eventually vest)

** For the perpetuity approach for finding TV of a company, how do you determine the long-term growth rate?

Should be around 1-3% (up to 5%). The GDP of the country where the company is based is a good proxy, as it must slow down to less than that (if it was higher, then some day the company would grow larger than the country's whole economy)

How do you sanity-check the TV methods with each other?

Implied G: (TV(exit)*WACC-FCF)/ (TV(exit)+FCF) or just WACC - FCF/TV Implied EV/EBITDA multiple = TV (perpetual)/EBITDA

What are the 10 things to look for when building a comp set for companies?

Profitability, Size/Growth Stage, Presence in Market, Geography, Business Model & Target Customer, Capital Structure, Growth Rate, Margin Profiel, Risks (financial and other)

A company reports $40M in SBC as a non-cash add-back. When projected UFCF in a DCF, how should SBC be treated?

As a real cash expense (no add-back). If it is added, increase diluted share count to reflect the new shares created

Acquirer A trades at a P/E of 20.0x with a 20% marginal tax rate. Target B trades at a P/E of 12.0x with a 25% marginal tax rate. Acquirer A buys Target B at a 30% premium using a consideration mix of 60% stock and 40% debt. The pretax cost of debt is 8.0%. Ignoring synergies and purchase price allocation (PPA) adjustments, is this transaction accretive or dilutive to Acquirer A's EPS, and by what net yield differential?

You want to compare yield vs WACC after acquisition

What are the 2 values to value if a transaction is accretive or dilutive & find the net yield differential?

1) Yield vs WACC (post-acquisition) - Calculate yield of the target by doing (1/ P/E) -> how much you're earning with respect to market cap of company - % paid in stock * (yield of acquirer) + % paid in debt * (1-tax rate) * (interest rate on debt) 2) EPS (pre and post acquisition) - (New-old EPS)/old EPS*100%

A company has 100 options currently valued @ $1. The strike price is $10. Assume a 40% tax rate. First, walk me through Year 1. (note: must be with flashcard 48)

IS: SBC expense of $100. Post-tax NI goes down by $60. Before calculating CFS, we know that SBC doesn't actually lead to a change in cash. So, we know that a DTA/DTL will be created to offset the remaining difference. CFS: The -$60 in NI has a $100 non-cash adjustment. The positive $40 is offset by a $40 DTA. So, cash stays the same. BS: (assets) DTA = $40. (L&E) APIC = $100, R/E = -$60

A company has 100 options currently valued @ $1. The strike price is $10. Assume a 40% tax rate. Walk me through Year 2 in 4 different scenarios: the stock price rises to $10.5 (and is exercised), rises to $14 (and is exercised)

Scenario 1: - Since the value of options at exercise is lower than the original valuation, we must account for the difference. Originally the options were valued at $100, but only worth $50 at the time of exercise. Thus, the IS has a $50*(40% tax rate), or $20 tax expense In CFS, in the OCF the $20 decrease is offset and re-balanced by the write-down of the DTA, leading to a $20 total increase in cash. In the financing CF the exercise leads to $1000 increase from the proceeds from exercise of options. In BS (assets) DTA = -$40, cash = $1020. (L&E) R/E = -$20, (slightly inaccurate) APIC = $1000 -> note it's slightly inaccurate since APIC is additional price paid above par value. If it's a warrant that generates new stock, then it should be "$1000-par value*# of shares" Scenario 2: - Since value of options is now higher, must account for difference. Originally options were valued at $100, but now worth $400. In IS: This is a tax saving. The saving amount is the change in options price * tax rate, so $300*40% = $120 that directly affects tax expense and increases NI by $120. In CFS: OCF: The $120 increase in NI is further increase by $40 by the reversal of the DTA. Thus, operating cash increases by $160 Financing Cash Flow: $1000 increase from proceeds from exercise of options Total: $1160 IN BS: (assets) Cash = $1160, DTA = -$40. (L&E) Equity: R/E = $120, APIC = $1000

A company has 100 options currently valued @ $1. The strike price is $10. Assume a 40% tax rate. Walk me through Year 2 in 4 different scenarios (cont..): (3) is not exercised & expires worthless, and (4) the employee quits & forfeits the options

Scenario 3: In IS: The income tax expense (note: directly affects the income tax line item) goes up by the DTA amount ($40). So, in the IS NI is down $40. In CFS the $40 decrease is offset by the DTA reversal. In BS (assets) DTA = -$40, (L&E) R/E = -$40, so it balances Scenario 4: APIC goes down by full amount ($100), OpEx also goes down by $100 (which means NI is up by $60) in IS. In CFS, NI up $60 and a DTA reversal of $40 offset when you go down by $100 from SBC-add back (which is negative) In BS (Assets) DTA is down by $40, (L&E) APIC is down by $100 but R/E is up $60, so it balances

Mentally tell me what would happen if the target IRR of your investment was 25%, while current revenue growth was 15% while EBITDA margin remained constant with no multiple expansion, what amount of debt will have to be taken to reach the targeted IRR. Feel free to ask any questions

Questions to ask: 1) What is the free cash flow conversion rate? 2) What is the entry/exit multiples? 3) What is the ECF sweep rate (% used to pay off existing debt)? Assuming no free cash flow conversion and same entry/exit, you'd know that 15% is your current IRR, while 25% is your target. So, then you can basically say rev growth is your yield (15%) and target IRR is the CoE (25%). I'd want to know cost of debt and use that to do a weighted average between 25% and my cost of debt to get to 15%, which is basically my WACC.