Investment Banking Accounting Questions Quick Lesson
You can’t avoid accounting questions in an investment banking interview. Even if you’ve never taken an accounting class, chances are, you’ll be asked questions that require rudimentary accounting knowledge.
Wall Street Prep’s Accounting Crash Course is designed to give people with about 10 hours of time to kill a serious crash course in Accounting. But what if you only have 30 minutes? That’s what this quick lesson is for.
Accounting Quick Lesson
There are three financial statements that you should use to evaluate a company: Balance Sheet, Cash Flow Statement, Income Statement. There is actually a 4th statement, the Statement of Shareholder’s Equity, but questions about this statement are rare.
The four statements are published in periodic and annual filings for companies and are often accompanied with financial footnotes and management discussion & analysis (MD&A) to help investors better understand the specifics of each line item. It is critical that you take time to not only look at the four statements, but also read through the footnotes and MD&A carefully to better understand the composition of these numbers.
It is a snapshot of the company’s economic resources and funding for those economic resources at a given point in time. It is governed by the fundamental accounting equation:
Assets = Liabilities + Shareholders’ Equity
Assets are the resources a company uses to operate its business and includes cash, accounts receivable, property, plant & equipment (PP&E). Liabilities represent the company’s contractual obligations and include accounts payable, debt, accrued expenses, etc. Shareholders’ Equity is the residual – the value of the business available to the owners (shareholders) after debts (liabilities) have been paid off. So, equity is really assets less liabilities. The easiest way to intuitively understand this is to think of a house worth $500,000, financed with a $400,000 mortgage and a $100,000 down-payment. The asset in this case is the house, the liabilities are just the mortgage, and the residual is the value to the owners, the equity. One thing to note is that while both liabilities and equity represent sources of funding for the company’s assets, liabilities (like debt) are contractual obligations that have priority over equity. Equity holders, on the other hand, are not promised contractual payments. That being said, if the company increases its overall value, the equity investors realize the gain while the debt investors only receive their constant payments. The flip side is also true. If the value of the business drastically falls then equity investors take the hit. As you can see, equity investors’ investments are more risky than that of debt investors.
The income statement illustrates the profitability of the company over a specified period of time. In a very broad sense, the income statement shows revenue less expenses equaling net income.
Net Income = Revenue – Expenses
Revenue is referred to as the “top-line.” It represents the sale of goods and services. It is recorded when earned (even though cash may not have been received at the time of transaction).
Expenses are netted against revenue to arrive at net income. There are several common expenses among companies including: cost of goods sold (COGS); selling, general, and administrative (SG&A); interest expense; and taxes. 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. Interest expense represents expense related to paying debt holders periodic payments while taxes is an expense related to paying the government. Depreciation expense, a non-cash expense accounting for the use of plant, property and equipment, is often either imbedded within COGS and SG&A or shown separately.
Net Income is referred to as the “bottom-line.” It is revenue – expenses. It is the profitability available to common shareholder’s after debt payments have been made (interest expense).
Related to net income is earnings per share. Earnings per share (EPS) is the 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)
Diluted EPS expands on basic EPS by including shares of convertibles or warrants outstanding in the outstanding shares number.
A very important part of accounting is understanding how these financial statements are inter-related. The balance sheet is linked to the income statement through retained earnings in shareholder’s equity, specifically net income. This makes sense because net income is the profitability available to shareholders during a specific period and retained earnings is essentially undistributed profits. So, any profits not distributed to shareholders in the form of dividends should be accounted for in retained earnings. Getting back to the house example, if the house generates profits (via rental income), cash will go up and so will equity (via retained earnings).
Cash Flow Statement
The income statement discussed in the previous section is needed because it illustrates the company’s economic transactions. While cash is not necessarily received when a sale occurs, the income statement still records the sale. As a result, the income statement captures all the economic transactions of the business. The cash flow statement is needed because the income statement uses what is called accrual accounting. In accrual accounting, revenues are recorded when earned regardless of when cash is received. In other words, revenues include sales using cash AND made on credit (accounts receivable). As a result, net income reflects cash and non-cash sales. Since we also want to have a clear understanding of the cash position of a company, we need the statement of cash flows to reconcile the income statement to cash inflows and outflows.
The cash flow statement is divided into three subsections: cash from operating activities, cash from investing activities, and cash from financing activities.
Cash from operating activities can be reported using the direct method (uncommon) and indirect method (the predominant method). The indirect method starts with net income and includes the cash effects of transactions involved in calculating net income. 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:
Net income (from income statement)
+ non-cash expenses
– non-cash gains
– period-on-period increases in working capital assets (accounts receivable, inventory, prepaid expenses, etc.)
+ period-on-period increases in working capital liabilities (accounts payable, accrued expenses, etc.)
= Cash from operations
For a stable, mature, “plain vanilla” company, a positive cash flow from operating activities is desirable.
Cash from investment activities is cash related to investments in the business (i.e., additional capital expenditures) or divesting businesses (sale of assets). For a stable, mature, “plain vanilla” company, a negative cash flow from investing activities is desirable as this indicates that the company is trying to grow by buying assets.
Cash from financing activities is cash related to capital raising and payments of dividends. In other words, if the company issues more preferred stock, we will see such an increase in cash in this section. Or, if the company pays dividends, we will see a cash outflow related to such a payment. For a stable, mature, “plain vanilla” company, there is not a preference for positive or negative cash in this section. It ultimately depends on the cost of such capital relative to the investment opportunity schedule.
Net Change in Cash Over the Period = Cash Flow from Operating Activities + Cash Flow from Investing Activities + Cash Flow from Financing Activities
The cash flow statement is linked to the income statement in that net income is the top line of the cash flow from operations section when companies use indirect method (most companies use indirect). The cash flow statement is linked to the balance sheet in that it represents the net change in cash over the period (magnification of the cash account on the balance sheet). So, a previous period’s cash balance plus the net change in cash this period represents the latest cash balance on the balance sheet.
Statement of Shareholder’s Equity:
Bankers are rarely asked questions about this statement. Essentially, it is a magnification of the retained earnings account. It is governed by the formula below:
Ending Retained Earnings = Beginning Retained Earnings + Net Income – Dividends
The statement of shareholder’s equity (also called “statement of retained earnings”) is linked to the income statement in that it pulls net income from there and links to the balance sheet, specifically, the retained earnings account in equity.
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