IBIG 04 02 Accounting 3 Statements

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IB Interview Guide, Module 4: Accounting and the 3 Financial

Statements
Table of Contents:
Overview & Key Rules of Thumb ........................................................................................ 2
Key Rule #1: Why We Need the 3 Financial Statements ................................................ 2
Key Rule #2: How Longer-Term Items Affect Cash Flow .............................................. 10
Key Rule #3: The Income Statement ............................................................................. 24
Key Rule #4: The Balance Sheet .................................................................................... 26
Key Rule #5: Cash Flow Statement ............................................................................... 32
Key Rule #6: How to Link the Financial Statements ..................................................... 34
Key Rule #7: U.S. GAAP vs. IFRS and Different Financial Statements ........................... 36
Key Rule #8: How to Walk Through Accounting Interview Questions ......................... 39
Key Rule #9: Working Capital, Free Cash Flow, and Metrics and Ratios ...................... 53
Interview Questions .......................................................................................................... 64
Conceptual Accounting Questions ................................................................................ 64
Single-Step Changes on the Financial Statements........................................................ 75
Multi-Step Changes on the Financial Statements......................................................... 85
Working Capital, Free Cash Flow, and Other Metrics and Ratios ................................. 93
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Overview & Key Rules of Thumb

This guide introduces you to the most common accounting topics that will come up in
interviews and on the job. It also summarizes the accounting lessons in our financial modeling
courses.
You are almost guaranteed to receive questions on accounting, no matter your seniority or the
roles you’re applying for.
The most important topics include:
1. What the 3 financial statements are and why we need them (e.g., How do you decide
what goes on the Income Statement or Cash Flow Statement?).
2. How to walk through interview questions related to the financial statements (e.g., What
happens when Depreciation increases by $10?).
3. How to calculate metrics and ratios related to the 3 financial statements, such as
Working Capital and Free Cash Flow, and what they mean.
We focus on those topics in this guide, briefly explain each one, and then present interview
questions so you can test yourself at the end.
You need to review the accompanying “interview question” Excel model, as that file will make it
10x easier to understand everything.
We cover more advanced accounting topics, such as how to project the 3 statements, and how
to work with items like equity investments, non-controlling interests, and net operating losses
(NOLs) in the next guide.
Key Rule #1: Why We Need the 3 Financial Statements
Remember how everything in this course goes back to that formula in the last guide?
Company Value = Cash Flow / (Discount Rate – Cash Flow Growth Rate)
In finance, you need to understand the 3 financial statements to estimate a company’s cash
flow and cash flow growth rate so that you can use them in that formula.
The challenge is that the CASH FLOW a company generates is very different from its “profit”
according to the accountants.
And that’s the key reason we need a set of financial statements rather than just one: to tell us
how much cash flow a company is generating.
Let’s start with a simple example: imagine a company that offers online courses and coaching
(kind of like the company whose guide you’re reading).
You pay for the courses upfront, you gain
immediate access, and then you have lifetime
access after you sign up.
There are no factories or offices, minimal capital is
required, and we don’t have to order inventory
because there are no physical products to sell.
If we tracked the sales, expenses, and profits for
this business, it might look like the diagram on the
left.
“Revenue” represents our total sales across all
segments, and “Cost of Goods Sold” represents
expenses that can be linked to individual units sold
(such as the materials and shipping, or human labor
for services).
The Gross Margin tells you how much additional
profit you would earn from each sale before fixed
expenses like employees and rent.
Operating Expenses include items that can’t be
linked to individual products sold, such as
marketing, rent, employee salaries, and customer
support.
Operating Income tells you how much the business
earned before “side activities,” interest, and taxes,
and Net Income gives you the company’s bottom
line: how much it earned AFTER all taxes and
expenses in all categories.
Record-keeping is very simple because when we sell something, we get the actual cash for it,
and when we incur an expense, we pay it in cash.
In this simple case, Net Income – Profit After Taxes – is VERY close to the cash flow generated
each year.
But in real life, no company is this simple. Here are a few items that create a difference
between Net Income and Cash Flow Generated:
Installment Payments and Accounts Receivable
Instead of requiring 100% upfront cash payments, we start allowing customers to pay via
monthly installments. However, they still receive immediate access to the courses.
We need to recognize the courses sold as “revenue” upfront, even though we haven’t
received the full cash payment from customers yet.
That’s because revenue recognition is based on the delivery of the products or services.
Let’s say that a course costs $300, and you decide to pay in installments over 3 months. Here’s
what revenue vs. cash received looks like:
Let’s say that this idea takes off, and many customers decide to pay via installments.
We earn an extra $50,000 in revenue as a result of these installment plans.
Here’s what the Income Statement looks like before and after that extra $50K in revenue (Year
1 represents the “Before” state, and Year 2 represents the “After” state):
Since revenue is based on the delivery of the

courses, our revenue increases from $650K to
$700K.
And then our Net Income jumps up from

$195K to $225K.
But since we didn’t collect this $50K in

revenue in CASH, our cash balance has NOT
increased by $50K.
The “cash that we’re waiting on” is called

Accounts Receivable, and you have to reflect
it by adjusting the company’s Net Income:
So, installment payments create a difference between Net Income and Cash Generated. The
Income Statement says we earned $225K, but we earned only $175K in cash.
Each time someone signs up for the course but does NOT pay 100% upfront in cash, the
“Accounts Receivables” balance increases and our cash profits will be less than Net Income.
When this “Accounts Receivable” balance decreases, it means we’ve finally collected the cash.
When that happens, the Net Change in Cash will exceed Net Income.
Prepaying Expenses
Then we get another bright idea: we decide to negotiate better rates with our vendors,
suppliers, and landlord by offering to pay expenses in advance.
For example, if we normally pay $10,000 in rent each month, perhaps we can pay only $25,000
for 3 months, rather than $30,000, if we pay for those 3 months in advance.
Our Income Statement stays the same when we first make the cash payment because the
expense has not yet been incurred.
We start recording that rental expense only when we’ve begun to occupy the building for the
first of those 3 months.
But since we’ve made this cash payment

in advance, it creates another differential
between Net Income and Cash
Generated.
The “Change in Prepaid Expenses” is shown as a negative because it reduces our cash flow.
Vendor Negotiation, Accounts Payable, and Accrued Expenses
Then, we get the bright idea to do the opposite with other vendors, such as a marketing firm
we just hired.
We go to this firm and say, “Hey, please start working for us now… and accept a cash payment
from us at some later date. Trust us; we’ll pay you.”
This might sound insane, but it happens in real life all the time: you get an invoice for
something, the product or service is delivered, and then you pay after it’s delivered.
If this marketing firm’s services cost $15,000,

we’d have to record the expense on our Income
Statement as the services are delivered (see
the diagram on the left).
Our “Sales & Marketing” expense increases

from $150K to $165K as a result. Our Net
Income falls to $216K.
But remember: we haven’t paid in cash yet.
So, our Net Income to Cash Adjustments look

like this:
Since we did NOT pay for this expense in upfront cash, our “Net Change in Cash” has
increased.
You track these “owed payments” in line items called Accounts Payable and Accrued Expenses.
When they increase, your cash flow goes up because you’re “delaying payment.”
When they decrease, your cash flow goes down because you’re finally paying in cash.
At this point, you have to start tracking these items – Receivables and Payables – separately:
“Cash” is like cash in your bank account. Accounts

Receivable tracks the payments we’re owed.
Prepaid Expenses tracks what we’ve paid in
advance but have not yet incurred.
On the other side, Accounts Payable tracks what

we owe to other people. Debt is like credit card or
student loan debt, and “Equity” represents the
cumulative profits we’ve saved up over time.
Items like Cash, Accounts Receivable, and Prepaid Expenses are Assets because they deliver a
future benefit to us. For example, that Accounts Receivable balance of $50K means that we
should expect $50K in cash from customers in the future.
Items like Accounts Payable and Debt are Liabilities because they represent a future cost for us.
For example, the $15K Accounts Payable balance means that we’ll have to pay $15K in cash for
owed expenses in the future.
You can think of Equity as a funding source for the business that will NOT result in future cash
costs. It includes money contributed by the owners, money raised by selling ownership in the
business, and the company’s saved-up cumulative profits over time.
Monthly Subscriptions and Deferred Revenue
At this point, we get another brilliant idea and decide to start selling a monthly subscription
service where we interview bank CEOs.
But the catch is that customers will have to pay for a subscription in advance!
After all, we can’t afford to produce those interviews unless people commit to paying for them.
So, we open up pre-enrollments for this service, and we get $15,000 in payments from
customers.
We can’t recognize ANY of that as revenue yet because we haven’t delivered any of these
interviews!
So, our Income Statement does NOT change yet. Instead, we have to create an account called
“Deferred Revenue,” and reflect upfront cash collected there:
So once again, our Net Change in Cash is

quite different from Net Income.
It has changed yet again because of this

new situation – collecting cash payments
from customers before delivering
anything.
When “Deferred Revenue” (DR) increases, it means that we’ve collected cash but cannot yet
recognize it as revenue, and it boosts our cash balance.
When DR decreases, it means we can finally recognize that cash as revenue because we’ve
delivered the product or service to customers. And our cash balance decreases.
Selling Physical Products and Inventory
Next, we decide to expand by selling physical versions of the courses: books, printed guides,
and so on.
To do that, we need to buy the supplies and raw materials for those products before we sell
them.
Even though we have to pay for these supplies in cash, we cannot list them as expenses on
the Income Statement until we sell the products.
So, our Income Statement doesn’t change: Net Income is still $216K.
But our Net Change in Cash declines because of these Inventory Purchases, which we’ve set to
$30K here:
Because of all these items, there is

now a substantial difference between
the company’s Net Income and the
cash it generates.
Since we’re buying Inventory, we

reflect it with a negative; it reduces our
cash flow.
If Inventory decreased, it would be the opposite scenario: we’d list it under COGS on the
Income Statement, along with the revenue from selling the products, and the Change in
Inventory would be positive in the “Net Income to Cash Adjustments” section.
At this point, you can see why we need separate “financial statements”: because MANY items
create differences between Net Income and Cash Generated.
So, you can’t use just a simple Income Statement once a company grows beyond a certain
complexity level: You have to use two other “financial statements” to track everything.
You use the Balance Sheet to track a company’s Assets, Liabilities, and Equity. Here’s what our
simple Balance Sheet looks like so far:
You need this “Balance Sheet” because

of items like Accounts Receivable,
Inventory, and Prepaid Expenses – items
that represent differences between Net
Income and Cash Generated.
If we didn’t have any of those items, we

could get away with tracking the
company’s Cash, Debt, and Equity, and
not create a full Balance Sheet at all.
And then you use the Cash Flow Statement to track adjustments to a company’s Net Income:
Positive adjustments on the Cash Flow

Statement mean that we’ve generated
more cash than the company’s Net Income
suggests.
Negative adjustment means the opposite:

we’ve generated less cash than the
company’s Net Income suggests.
Return to Top.
Key Rule #2: How Longer-Term Items Affect Cash Flow
The section above explains why the 3 financial statements – the Income Statement, Balance
Sheet, and Cash Flow Statement – are necessary.
But there are many other items that could affect Net Income and Cash Generated.
Here’s a summary of the most important ones:
Capital Expenditures and Depreciation
Let’s say this company now wants to buy an office, or equipment such as computers for
employees.
Since these items are all useful for “the long term” – more than 1 year – you must record
them as “Capital Expenditures.”
You record Capital Expenditures only on the Cash Flow Statement initially, and then you
allocate their cost on the Income Statement gradually over time.
For example, if you spend $50K on equipment, and it’s expected to last for 5 years, you’ll record
a cash outflow of $50K on the CFS and “Depreciation” of $10 on the Income Statement each
year:
Capital Expenditures cause cash flow to decrease initially. Net Income also declines because of
this Depreciation expense, but Depreciation is recorded only starting in the first year after the
CapEx spending, so there isn’t an “immediate effect.”
Also, note that Depreciation is a non-cash expense, which is why it’s an adjustment on the Cash
Flow Statement above. It reduces the company’s taxes, but it doesn’t cost the company
anything in cash. As a result, it increases the company’s cash balance.
Investments and Investing Activities
If a company has extra cash, it may choose to spend it on short-term or long-term investments:
anything from government bonds to stocks to real estate.
As with Capital Expenditures, you record the initial impact only on the Cash Flow Statement
because these items do not impact a company’s taxes initially.
And also, as with Capital Expenditures, you will record the after-effect of these items – the
interest or investment income – on the Income Statement. That’s because the company must
pay taxes on the income it earns from these investments.
Here’s what it looks like:
Purchasing investments initially reduces a company’s cash flow, and the “after-effect” on the
Income Statement is very small.
But there’s one important difference compared with Capital Expenditures: there’s no
associated non-cash adjustment here.
That’s because the interest or investment income is earned in cash and incurs cash taxes.
Raising Debt and Equity
We mentioned in the first guide that companies have two basic options for raising money to
run and expand their businesses: debt and equity.
The trade-offs become clear once you understand how they appear on the financial statements.
When a company raises debt, it shows up only on the Cash Flow Statement because it doesn’t
affect the company’s taxes at all. Similarly, when it repays debt principal – the outstanding
balance – that also shows up only on the Cash Flow Statement.
However, the interest expense the company pays on that debt shows up on its Income
Statement because the interest expense affects the company’s taxes:
Raising debt boosts the company’s cash balance. Think about what happens when you take out
a student loan: you have to repay it in the future, but for now, you get more cash to pay for
tuition.
When a company raises equity, on the other hand, it’s shown as a simple cash inflow on the
Cash Flow Statement, and nothing ever shows up on the Income Statement.
It sounds much better than debt initially, but by doing this, the company sells part of itself to
outsiders. So, raising equity still “costs” the company something; it’s just that it’s not a direct
cash cost like interest on debt is.
For example, perhaps one investor group owns 50% of the company at first. But then the
company raises equity, and as a result of new investors coming in, the existing group will own
only 45% of the company afterward.
They will not be happy about this, and they might push back if the company wants to raise
equity.
They could also start making other demands of the company, such as specific financial goals, or
other “special favors.”
Dividends and Share Repurchases
Speaking of “special favors,” equity investors often want to be paid back.
They don’t receive interest payments like debt investors do, but the company can still pay them
in two ways: by issuing dividends to the equity investors, and by repurchasing shares from
them.
Dividends are like “small cash payments” to equity investors. For example, if you purchase a
share of a company for $10.00, in the future the company might issue you a dividend of $0.30.
In a share repurchase, the company buys back your shares so that you no longer own a
percentage of the company. For example, if you bought a share for $10.00, the company might
offer to buy it back for $12.00 or $13.00.
Neither dividends nor share repurchases affect a company’s taxes, so neither one shows up on
a company’s Income Statement.
Instead, they both appear as negatives on the Cash Flow Statement and reduce the company’s
cash flow:
There is one important difference between these two methods of paying equity investors:
share repurchases reduce the company’s share count and therefore give more ownership back
to the company.
We’re not showing the share count in these simple diagrams, but you’d have to show the
impact of share repurchases on the share count in real life.
Deferred Taxes
Just like an expense on the Income Statement does not necessarily mean the company has paid
that expense in cash, the same is true of taxes.
There are almost always “Current” and “Deferred” portions of the Income Taxes on a
company’s Income Statement.
The company pays the “Current” portion in cash in the period shown, but it “defers” the
Deferred portion to some future period.
This deferral happens for many reasons:
• Companies may use different Depreciation figures for tax purposes, mostly to reduce
their taxes in early years.
• Some expenses may not be deductible for tax purposes, even though they’re listed on
the Income Statement.
• The company might get tax credits from its research & development activities.
Deferred Taxes always make the same impact: You show the entire Income Tax expense on the
Income Statement, but on the Cash Flow Statement, you adjust for the non-cash portion:
If the opposite had happened – if the company had owed more in taxes than what its Income
Statement had implied – then we would have done the opposite and shown the extra cash
taxes with a negative next to “Deferred Income Taxes” on the CFS.
Gains, Losses, Impairments, and Write-Downs
Besides raising debt and equity, companies can also raise funds by selling assets.
For example, if the company has stock-market investments or physical equipment it doesn’t
need, and it wants extra cash, it could sell those assets.
Let’s say that a company sells a short-term investment for $85.
The $85 does show up on the Cash Flow Statement within the Investing Activities section, but
you also have to record a Gain or Loss, which shows up on the Income Statement.
If the company sells this item for less than its book value – its value on the Balance Sheet – it
will record a Loss. If it sells this item for more than its book value, it will record a Gain.
For example, if the investment is listed at $100 on the Balance Sheet and the company sells it
for $85, the company will record a Loss on the Income Statement:
You then have to reverse this Gain or Loss on the Cash Flow Statement because it’s non-cash.
When the company sells the investment for $85, it gets $85 in cash. It doesn’t “lose cash” on
the sale – and this is why we reverse the Loss at the top of the Cash Flow Statement.
And then, further down on the CFS, you show the $85 in proceeds within Cash Flow from
Investing.
If the company sells the investment for $115 instead, it would get $115 in cash, and we would
show a Gain of $15 on the Income Statement.
We would then reverse this Gain on the Cash Flow Statement, subtracting the $15, and show
the total proceeds ($115) within Cash Flow from Investing.
Recording Gains and Losses on the Income Statement is just like how you have to pay taxes on
capital gains and how you can deduct capital losses when you sell stocks.
Besides selling an asset at a different price, a company could also write down the value of an
asset.
For example, let’s say the company buys $100K of equipment, but then there’s a natural
disaster such as a tornado or hurricane, and some of the equipment is destroyed.
To accurately reflect its financial condition, the company should NOT show $100K for the
equipment’s value on the Balance Sheet anymore.
Instead, it should write down the value of the equipment that was destroyed.
This “write-down” is very similar to Depreciation: it’s an expense on the Income Statement that
reduces the company’s Pre-Tax Income and Net Income, you add it back as a non-cash expense
on the Cash Flow Statement, and it reduces the company’s “Plants, Property & Equipment
(PP&E)” on the Balance Sheet.
This write-down increases the company’s cash balance because of the tax savings: it reduces
the company’s taxes since it’s listed on the Income Statement, but the company doesn’t pay for
the expense in cash.
But the key difference is that this write-down is a one-time, or non-recurring, event.
Unlike Depreciation, the company does not expect to keep writing down its assets every year.
Stock-Based Compensation
Companies can pay their employees via salaries and bonuses, but they can also pay employees
with stock and stock options.
For example, if an employee earns $100,000 per year, the company might also grant 1,000
shares of the company’s stock to this employee each year as a bonus. Those shares give the
employee ownership of a very small percentage of the company.
Stock-based compensation shows up as an expense on the Income Statement and therefore

reduces a company’s Pre-Tax Income, but just like Depreciation, it is a non-cash expense that
you add back on the Cash Flow Statement.
So, the impact on cash is similar: the company’s cash flow goes up because it pays less in taxes.
However, there’s a critical difference between stock-based compensation and depreciation:

stock-based compensation creates extra shares and dilutes investors.
So, if the company had 1 million shares outstanding before the employee award above,
afterward it will have 1,001,000 shares outstanding.
In other words, by issuing stock (or options) to employees, the company is diluting itself.
Accounting rules require companies to show SBC as a non-cash expense on the Cash Flow
Statement.
But because of this dilution, you count it as a REAL cash expense when you estimate a
company’s cash flows – after all, it reduces the company’s value to investors.
Goodwill & Other Intangible Assets
The last two items in this section don’t relate to Net Income vs. Cash Generated, exactly, but
they are important to know for interviews.
Two assets on companies’ Balance Sheets – “Goodwill” and “Other Intangible Assets” – are
created primarily when one company buys another one.
Start by thinking about a simple question: If you buy another company, how do you record it
on your financial statements?
The answer is what you might expect: you combine the financial statements by adding the
other company’s statements to your own… with a few tweaks.
To keep things simple, let’s assume that you pay for this other company 100% in cash and that
this other company’s Balance Sheet looks like this:
So, the owner has contributed some money to start this

business, which explains the $100K in Equity, and has also
purchased some property and equipment.
Currently, there’s very little to this business: sales are

minimal, and we want to acquire it mostly to get valuable
intellectual property.
Even though the Balance Sheet says the company is worth

only $100K, the owner won’t sell for that amount.
Instead, he demands $250K for the business.
Since we really want this other business, we decide to

accept his terms and offer $250K for it.
Here’s what happens if we pay $250K in cash and combine

this other company’s Balance Sheet with ours:
Do you see the problem?
Whenever we pay more for a company than the Equity on its Balance Sheet says it’s worth,
the combined Balance Sheet will go out of balance.
That’s because the seller’s Equity gets wiped out, but we pay MORE than this wiped-out Equity.
The solution is to create two new Assets, Goodwill and Other Intangible Assets, to represent
the premium we pay for the other company.
Here’s what happens when we use those to “plug the gap”:
First, we check to see if the company has “Other Intangible Assets” that might be worth
something: patents, trademarks, intellectual property, and customer relationships would all
qualify.
An “Intangible Asset” is any asset that’s not a

physical asset and is also not a financial instrument.
We look at the company and value its Intangible

Assets at $50K (we’d value them by discounting their
expected future cash flows to their Present Value).
That’s fine, but we still have a gap of $100K:
To plug this gap, we create another Asset called Goodwill. It’s equal to the $100K “gap,” and it
represents the “miscellaneous value” of this premium we just paid.
On the financial statements, Goodwill doesn’t do much of anything.
It sits on the company’s Balance Sheet, and it might be written down or impaired in the future if
the buyer determine that the acquired company wasn’t worth so much.
The treatment is the same as the treatment for the PP&E Write-Down above: It’s an Income
Statement expense that gets added back as a non-cash adjustment on the Cash Flow
Statement.
Other Intangible Assets, however, amortize over time.
You create an item called the “Amortization of Intangible Assets” on the Income Statement,
and then you add it back as a non-cash charge on the Cash Flow Statement.
It reduces the Intangible Assets on the Balance Sheet each year until they reach $0:
The exact impact of an acquisition is complex and can’t be summed up in a simple rule.
However, the Amortization of Intangibles makes the same impact as Depreciation: the
company’s Net Income falls, but its cash flow increases because of the tax savings.
Return to Top.
Key Rule #3: The Income Statement
The Income Statement lists a company’s revenue, expenses, and taxes, with its after-tax profit
at the very bottom, over a period (one quarter, one month, or one year).
To appear on the Income Statement, each item must meet the following criteria:
1. It must correspond to ONLY the period shown on the Income Statement. If you’re
paying for an asset that will last for 10-20 years, the initial money spent would not
appear on a 1-year Income Statement. But your monthly rent would appear.
2. It must affect the company’s taxes. For example, interest paid on debt is tax-
deductible, so it appears on the Income Statement. But repaying debt principal is not
tax-deductible, so it does not appear on the Income Statement.
To the right, you can see a screenshot demonstrating
common items on the Income Statement.
Revenue and Cost of Goods Sold (COGS): Revenue is the
value of the products/services that a company sells in the
period, and COGS represents the expenses that are
linked directly to the sale of those products/services.
For example, if each widget you sell costs $10 to order
and ship, $10 * # Widgets Sold would show up within
COGS.
Operating Expenses: Costs that are not directly linked to
individual products sold – employee salaries, rent,
marketing, and research and development – show up
here.
Depreciation and Amortization (D&A): These items are
non-cash expenses related to allocating capital
purchases, such as spending on factories or equipment or
patents or anything else that lasts over 1 year, over time.
These items will be useful for many years, so you have to
allocate the initial amount spent over many years rather
than showing the entire amount on the Income
Statement.
In real life, Depreciation and Amortization are often embedded within COGS or Operating
Expenses. We show them separately for clarity, but they’ll rarely be separate in real life.
When D&A is embedded within other line items, you have to look at the Cash Flow Statement
to get the total number.
Stock-Based Compensation: This represents the cost of paying employees with stock or stock
options rather than cash. Companies estimate the value of these awards, and then record their
estimates on the Income Statement.
Like D&A, this is almost never shown separately in real life; it’s almost always embedded within
the company’s Operating Expenses.
Other Income and Expenses: Items such as Interest Income, Interest Expense, Gains and
Losses, Write-Downs, and Impairments show up here.
If a company has any “side activities” that aren’t part of its core business, income from those
activities will also show up here.
Everything in this section impacts a company’s taxes and represents SOMETHING in the
current period, but these items are NOT a part of the company’s core business of selling
products/services.
Some of these items – Gains and Losses, Write-Downs, and Impairments – are non-cash, which
means they reduce a company’s taxes but don’t result in a cash payment.
Taxes and Net Income: Net Income represents the company’s “bottom line” – how much in
after-tax profits it has earned.
As we described above, Income Taxes are split into Current and Deferred. In real life, it is very
rare to see the actual split on the Income Statement, but we have shown it for clarity.
A few other points on Income Statement revenue, expenses, and taxes:
1. They do not need to be related to a company’s operational activities – Gains and
Losses and Interest Expense all appear, but they are not related to selling products to
customers.
2. They do not need to be cash expenses or cash revenue – For example, Depreciation
and Amortization are both non-cash expenses. Also, companies often record revenue
and expenses here before they receive or pay them in cash, which is the whole reason
why the 3 financial statements exist in the first place.
3. Sometimes, items may be embedded within other items – For example, Depreciation is
often embedded within COGS or Operating Expenses; other times it is a separate item,
either wholly or partially. Stock-Based Compensation is almost always embedded within
Operating Expenses.
Here are a few more rules of thumb about what appears on the Income Statement:
• Always Appears: Revenue, COGS, Operating Expenses, Depreciation, Amortization,

Stock-Based Compensation, Interest Income and Expense, Gains / (Losses), Write-
Downs, Impairments, Other Income / (Expenses), Taxes, and Net Income.
• Never Appears: Capital Expenditures, Purchasing or Selling Investments or PP&E (Plants,

Property & Equipment), Dividends, Issuing or Repaying Debt Principal, Issuing or
Repurchasing Shares, and Changes to Balance Sheet Items such as Cash, Debt, Accounts
Receivable, or Accounts Payable.
The items on the “Always Appears” list meet the criteria above because:
1. They affect the company’s taxes (e.g., paying an employee’s salary reduces the
company’s taxable income); and
2. They correspond to the period shown on the Income Statement (e.g., monthly rent
corresponds only to what you’re incurring in that month).
The items on the “Never Appears” list fail the criteria above because:
1. They do not affect the company’s taxes (e.g., Dividends are not tax-deductible, and
neither is repaying debt); or
2. They do not correspond to the period shown on the Income Statement (e.g., Capital
Expenditures refers to purchasing Assets that often last for 10-20 years).
Return to Top.
Key Rule #4: The Balance Sheet
The Balance Sheet shows the company’s resources – its Assets – and how it paid for those
resources – its Liabilities & Equity – at a specific point in time.
Think about your personal Balance Sheet: maybe you’ve invested $50K in the stock market, you
have $30K in cash in your bank account, and you own a house that’s worth $500K.
Those are Assets because they can all be sold for cash, or they’ll deliver a cash benefit to you
in the future.
How did you pay for the cash, your house, and your investments?
First, you saved up money from your job. For example, maybe you’ve saved $200K,
cumulatively, after taxes, over many years.
You also borrowed money – the mortgage on your house, which is worth $380K – to pay for
some of it.
So, your “personal Balance Sheet” might look like this:
Here are the key Balance Sheet rules:

1. The Balance Sheet shows the company's resources (its Assets) and how it paid for those
resources – its Liabilities & Equity – at a specific point in time.
So, the Income Statement shows revenue and expenses from January 1, 20XX to December 31,
20XX, but the Balance Sheet only shows the company's resources ON January 1, 20XX or ON
December 31, 20XX.
2. Assets must always equal Liabilities + Equity – if the Balance Sheet does not balance, it's
wrong.
If you want a house – an asset – that costs $1 million, could you use a $380K mortgage and
$200K in saved-up income to pay for it?
No! The Balance Sheet would go out of balance!
You’d have to borrow or save more.
So, you either take out a mortgage for $800K, or you wait and save up an additional $620K.
3. An Asset is something that will result in, directly or indirectly, additional cash in the future,
or is something that can be sold for cash.
You typically split Assets into “Current” or “Short-Term” (anything that lasts for less than 1 year)
and “Non-Current” or “Long-Term” (anything that lasts for more than 1 year).
4. A Liability is something that will result in, directly or indirectly, less cash in the future.
Again, you typically split these into “Current” or “Short-Term” and then “Non-Current” or
“Long-Term.”
Liabilities are usually related to external parties – lenders, suppliers, or the government.
5. An “Equity” line item is a funding source, like a Liability, but it will not result in less cash in
the future.
Like Liabilities, the items in the “Equity” category are also funding sources.
Unlike Liabilities, the Equity line items don’t necessarily result in less cash in the future.
They also tend to relate more to the company’s internal operations and how it’s saving money
over time, whereas Liabilities relate more to external parties such as lenders.
Below, you’ll see a typical Balance Sheet, along with explanations of how each item meets the
definition of an Asset, a Liability, or an Equity line item:
Definitions of Key Assets:
• Cash: Just like cash in your bank account.
• Short-Term Investments: Anything that generates some interest income and is less
liquid than cash – a money-market account, for example.
• Accounts Receivable: The company has recorded this as revenue on its Income
Statement but hasn’t received it in cash yet. It’s like an “IOU” from a customer. And it
will turn into cash when the customer pays.
• Inventory: The physical parts and supplies that the company needs to manufacture and
sell products.
• Prepaid Expense: The company has paid these expenses in cash but hasn’t recorded
them as expenses on the Income Statement yet because they haven’t been incurred.
The most common Long-Term Assets include:
• Property, Plant & Equipment (PP&E): Factories, buildings, land, and equipment that will
be useful for more than a year and contribute to the company’s core business.
• Goodwill: The cumulative premiums that the company has paid over other companies’
Shareholders’ Equity when acquiring them.
• Other Intangible Assets: The cumulative values of patents, trademarks, and intellectual
property from acquired companies. Unlike Goodwill, this balance amortizes over time
because these items have fixed useful lives.
• Long-Term Investments: These also generate interest or investment income, but are
less liquid and longer-lasting than Cash or Short-Term Investments.
Definitions of Key Liabilities:
• Short-Term Debt or “Revolver”: Borrowing that incurs interest expense and that is
owed back in less than a year. It’s sort of like a credit card because it represents short-
term borrowing.
• Accounts Payable: The company has recorded these as expenses on the Income
Statement, but hasn’t yet paid them in cash – it’s used for one-time items with specific
invoices, such as legal services.
• Accrued Expenses: The company has recorded these as expenses on the Income
Statement, but hasn’t yet paid them in cash – it’s used for recurring monthly items
without invoices, such as employee wages, utilities, and rent.
• Deferred Revenue: The company has collected cash in advance from customers for
products/services that it has not yet delivered. It will recognize Deferred Revenue as
real revenue over time as it delivers the products/services.
The most common Long-Term Liabilities include:
• Deferred Tax Liability: This represents a timing difference in taxes. For some reason,
the company paid less in taxes than what it owed in some earlier period, and it must
make up the difference by paying more to the government in the future.
• Long-Term Debt: Similar to a mortgage, a car loan, or a student loan: debt that must be
repaid in over a year’s time.
Definitions of Key Equity Line Items:
• Common Stock & Additional Paid-In Capital (APIC): This item represents the market
value of shares at the time the company issued those shares. When a company goes
public, the total dollar value of shares issued shows up here. This does NOT change even
if the share price changes afterward. Non-U.S.-based companies call these items “Share
Capital” and “Share Premium.”
• Retained Earnings: This item represents the company’s saved-up, after-tax profits,
minus any dividends it has issued. This item is like the $200K you saved up, after taxes,
in the “personal Balance Sheet” example above.
• Treasury Stock: This item represents the cumulative value of shares the company has
repurchased from shareholders. Just like Common Stock & APIC, the values here are
based on the share prices at the time the company repurchased the shares. This value
does NOT change even if the company’s share price changes afterward.
• Accumulated Other Comprehensive Income (AOCI): This is a section for “miscellaneous

saved-up income” – items like the effect of foreign currency exchange rate changes go
here, as well as “unrealized” gains and losses on certain types of securities.
A few extra notes on this section:
With Common Stock & APIC, let’s say a company issues 100 million shares. The par value of
each share is $1.00, and the market value of each share is $10.00.
Common Stock would increase by 100 million * $1.00, or $100 million.
APIC would increase by 100 million * ($10.00 – $1.00), or $900 million.

If the company’s share price now goes from $10.00 to $25.00 or $100.00 or $1.00, COMMON
STOCK AND APIC DO NOT CHANGE.
We almost always combine these items into a single line item – Common Stock & APIC – to
streamline models.
With Treasury Stock, let’s say the company repurchases $500 million in shares at a price of
$50.00 per share.
You’d record that as a negative $500 million on the Cash Flow Statement and reduce Treasury
Stock by $500 million, making it even more negative.
If the share price then goes from $50.00 to $100.00 or $1.00, Treasury Stock does not change.
Return to Top.
Key Rule #5: Cash Flow Statement
The Cash Flow Statement, like the Income Statement, tracks changes over a period (one year,
quarter, month, etc.).
It exists for 2 main reasons:
1) You may have recorded non-cash revenue, expenses, or taxes on the Income
Statement. If you did, then you need to make an adjustment on the Cash Flow
Statement to reflect this.
Remember, these cash/non-cash differences are the whole reason why the 3 financial
statements exist in the first place!
2) There may be additional cash inflows and outflows that have NOT appeared on the
Income Statement. For example, Capital Expenditures and Dividends both impact a
company’s cash balance, but neither one appears on the Income Statement.
Here’s what a typical Cash Flow Statement looks like, along with a summary of each section:
Cash Flow from Operations (CFO) – Starts with Net

Income at the top, adjusts for non-cash items, and
then factors in how operational Balance Sheet items
change in that period.
Rough Proxy: Corresponds to Current Assets and
Current Liabilities… but that's not exactly true, since
cash, investments, and debt do NOT show up here,
whereas some longer-term items such as Deferred
Revenue do.
So, it's better to think of this section as: "Net Income,
non-cash adjustments, and operational Balance Sheet
items."
Cash Flow from Investing (CFI) – Anything related to
the company’s investments, acquisitions, and PP&E
shows up here.
Purchases are negative because they use up cash, and
sales are positive because they result in more cash.
Rough Proxy: Corresponds to Long-Term Assets… but
that’s not exactly true since investments within
Current Assets can also show up here.
Cash Flow from Financing (CFF) – Items related to
debt, dividends, and issuing or repurchasing shares
show up here.
Rough Proxy: Corresponds to Long-Term Liabilities
and Equity… but this is also not exactly true!
For example, items like Deferred Tax Liabilities are
impacted by adjustments in the CFO section.
Meanwhile, Common Stock & APIC, for example, is impacted not just by the equity issuances
shown here, but also by Stock-Based Compensation in the CFO section.
These rough proxies are useful for figuring out where most items go, but remember that there
are always exceptions and that companies’ financial statements vary TREMENDOUSLY.
Return to Top.
Key Rule #6: How to Link the Financial Statements
We cover this topic in more detail in the sections on how to project the financial statements,
but it’s helpful to understand these links for interview questions as well.
So, we’ll lay out the principles and then explain the step-by-step process.
Principle #1: Each item on the Balance Sheet must have a corresponding line item on the Cash
Flow Statement, and vice versa.
The change in each item on the Balance Sheet must be reflected once and only once on the
Cash Flow Statement.
When an Asset goes up, cash flow goes down, and when a Liability goes up, cash flow goes up,
and vice versa.
Think about what it means when an Asset like Inventory “goes up”: it means the company
spent cash to acquire more Inventory.
And then think about what it means when a Liability like Accounts Payable “goes up”: it means
the company has delayed cash payment, resulting in more cash.
Principle #2: The CFO section of the Cash Flow Statement is derived from the Income
Statement and operational items on the Balance Sheet, and the CFI and CFF sections are
projected directly on the CFS and then flow into the Balance Sheet.
So, you don’t “project” items like the Change in Accounts Receivable directly on the Cash Flow
Statement. Instead, these items are based on how the company’s Balance Sheet has changed
over time.
Principle #3: When you’re linking in items from the Cash Flow Statement to the Balance
Sheet, SUBTRACT when you're on the Assets side and ADD when you're on the Liabilities &
Equity side.
Here are a few examples:
• PP&E – Subtract both Depreciation and CapEx when you link them to the PP&E on the
Balance Sheet.
• Debt – Add both debt issuances and repayments when you link them to Debt.
• Investments – Subtract Gains and Losses, purchases, and proceeds from sales.
Here’s a diagram for the process of linking the statements:
And here’s the step-by-step process:

1) Project the entire Income Statement first and link in Net Income at the top of the CFS.
Link Net Income from the Income Statement in as the top line of the Cash Flow Statement.
2) Adjust for Non-Cash Items on the Income Statement.
For example, you’d make positive adjustments for Depreciation & Amortization, Stock-Based
Compensation, Impairments, and Write-Downs because they’re all non-cash expenses.
Items like Gains and Losses and Deferred Taxes might have either positive or negative signs.
3) Project the items in CFI and CFF separately.
You have to forecast the company’s CapEx and investing activities, and what it plans to do with
equity and debt issuances, share repurchases, and so on.
FX Rate Effects, if they exist, also fall into the “separate and independent” category.
4) Sum up all the sections to calculate the Net Change in Cash.
Add up CFO, CFI, CFF, and FX Rate Effects to calculate the Net Change in Cash at the bottom.
5) Link Net Income and the Net Change in Cash to the Balance Sheet.
Cash at the bottom of the Cash Flow Statement flows into Cash on the Balance Sheet, and Net
Income at the top of the CFS flows into Retained Earnings.
6) Link each Non-Cash Adjustment to the appropriate line item.
For example, link Depreciation to PP&E and the Amortization of Intangibles to Other Intangible
Assets.
On the ASSETS side, you subtract links, and on the LIABILITIES & EQUITY side, you add links.
7) Link each CFI and CFF item to the appropriate line item on the Balance Sheet.
You link many CFI items to Long-Term Assets, and you link many CFF items to Long-Term
Liabilities and Equity.
For example, you link CapEx under CFI to PP&E and you link Share Repurchases under CFF to
Treasury Stock.
On the ASSETS side, you subtract links, and on the LIABILITIES & EQUITY side, you add links.
8) Check that the Balance Sheet balances.
If it does not, review the line items on the BS and CFS and check that they satisfy all the
principles above.
Return to Top.
Key Rule #7: U.S. GAAP vs. IFRS and Different Financial Statements
So far, we have assumed that any company’s financial statements are similar to those of U.S.-
based companies.
However, there are many different accounting systems worldwide, and not all companies
present their financial statements in the same way.
The core concepts are the same. Companies in all countries and industries create the Income
Statement, Balance Sheet, and Cash Flow Statement to record their activities.
And the financial statements exist for the same basic reason: there’s a difference between Net
Income and Cash Generated.
The names of the statements may differ: For example, the Income Statement might be called
the “Consolidated Statement of Earnings” or the “Profit & Loss Statement,” and the Balance
Sheet might be called the “Statement of Financial Position.”
However, the MAIN difference, by far, is that companies outside the U.S. tend to use the
DIRECT METHOD to create the Cash Flow Statement rather than the INDIRECT METHOD.
With the Direct Method, companies record the actual cash received from customers and cash
paid out.
So, the Cash Flow Statement does NOT start with Net Income and then make adjustments for
other items.
Instead, it might start with “Cash Received” or “Cash Paid” and then list other items such as
Interest and Taxes separately.
Here’s an example of a Cash Flow Statement for a non-U.S.-based company:
This statement is quite problematic for several reasons.
First off, it’s almost impossible to link this to the Balance
Sheet since items like AR and AP are not shown.
Second, “Cash Generated from Operations” doesn’t match
any item on the Income Statement.
Third, Dividends are listed in Cash Flow from Operating
Activities, but they are financing-related.
Finally, Interest and Taxes should be on the Income
Statement. If a non-cash adjustment is required, the
adjustment can be shown on the CFS.
The Cash Flow from Investing and Financing sections are
mostly OK, so we don’t need to adjust much there.
When you encounter this type of Cash Flow Statement,
you need to find a reconciliation between “Cash
Generated from Operations” and Net Income or
Operating Income, and then change around the Cash
Flow Statement.
Here’s an example for this company:
The company is still doing things a bit differently

because these items are based on adjustments to
Operating Income, not Net Income, but it’s good
enough.
They’re giving us the non-cash adjustments and
changes in operational Balance Sheet items, which is
all we need.
At this point, we would take this information and
change the company’s Cash Flow Statement so that it
looks something like this:
This version of the Cash Flow Statement is much easier to
work with because it starts with Net Income.
Then, it makes the standard non-cash adjustments,
including a few items related to Deferred Taxes and
Interest (some interest can be non-cash as well).
Then it shows the changes in the operational Balance Sheet
items, like Accounts Receivable and Accounts Payable.
We didn’t change much in the Investing Activities and
Financing Activities sections, but we did move the
Dividends down to Cash Flow from Financing instead.
We always prefer to make these adjustments when we
work with companies that use the Direct Method on their
Cash Flow Statements.
All the interview questions and remaining sections of this
guide will assume this treatment as well.
This Cash Flow Statement setup makes it much easier to
walk through interview questions, and bankers also expect
you to use this setup when you explain these questions.
Return to Top.
Key Rule #8: How to Walk Through Accounting Interview Questions
Some of the most common interview questions are the ones about how a change affects the 3
financial statements.
For example:
• “Depreciation goes up by $10. What happens on the statements?”

• “A company buys $100 of Inventory. What happens on the statements?”
• “A company sells a factory that’s worth $100 on its Balance Sheet for $120. What
happens on the statements?”
For all these questions, you should look at our 3-statement “interview question” model.
The best way to understand these changes is to enter them in Excel and see firsthand how the
statements change.
With that said, we also wanted to give you rules of thumb you can use for the 5 major
categories of changes:
1. Changes to True Cash Items on the Income Statement.
2. Changes to Non-Cash or Re-Classified Items on the Income Statement.
3. Changes to Operational Items on the Balance Sheet.
4. Changes to Non-Operational Balance Sheet Items or Cash Flow Statement Items.
5. Multi-Step Scenarios and Changes on the Financial Statements.
In the sections below, we’ll explain each category using screenshots and examples.
We recommend going in this order when answering these questions:
1. Explain how the Income Statement changes, if at all.
2. Explain how the Cash Flow Statement changes, if at all.
3. Explain how the Balance Sheet changes and why it still balances, i.e. why Assets still
equal Liabilities + Equity.
1) Changes to True Cash Items on the Income Statement
For example, what happens if a company’s revenue increases by $100, or its COGS or Operating
Expenses increases by $100?
This category is easy because you don’t have to modify anything on the Cash Flow Statement.
All that happens is that revenue or expenses on the Income Statement change, Net Income
changes, and Cash and Retained Earnings on the Balance Sheet change.
Here’s an example of what happens when revenue increases by $100:
For this question, you could probably

skip the Cash Flow Statement because
all that happens is that Net Income
increases by $60 and Cash at the
bottom increases by $60.
If expenses increased by $100 instead,
the opposite would happen, and Net
Income, Cash, and Retained Earnings
would all be down by $60.
Here’s a summary of what happens:
• Examples: Revenue, COGS,

Operating Expenses, and Interest
Income / (Expense).
• What Changes as a RESULT of These Items Changing: Pre-Tax Income, Net Income,
Cash, and Retained Earnings.
• How the Balance Sheet Balances: Cash and Retained Earnings both change.
2) Changes to Non-Cash or Re-Classified Items on the Income Statement
These changes follow a set pattern: Pre-Tax Income and Net Income change, but you add back
or subtract the change on the Cash Flow Statement.
Cash and Retained Earnings change, and then something else on the Balance Sheet also
changes. The tricky part is what that “something else” is, but it is usually intuitive.
The classic example is Depreciation, but they could ask about plenty of other items in the same
category: Amortization, Stock-Based Compensation, or an Asset Write-Down.
Here’s a list of non-cash items and what they match up with on the Balance Sheet:
• Depreciation – PP&E.
• Amortization – Other Intangible Assets.
• Stock-Based Compensation – Common Stock & APIC.
• Gains / (Losses) on PP&E – PP&E.
• Write-Downs – The Asset you are writing down.
• Impairment Charges – The Asset you are
impairing.
Here’s what the classic question about Depreciation
increasing by $10 looks like on the right:
You record the $10 extra of Depreciation on the Income
Statement, which reduces the company’s Pre-Tax
Income by $10, and its Net Income by $6 (assuming a
40% tax rate).
Don’t even mention Operating Income – just simplify it
and say Pre-Tax Income declines by $10.
And then here are the Cash Flow Statement and Balance
Sheet:
So, in an interview, you could say: “On the Income Statement, Pre-Tax Income falls by $10, and
Net Income falls by $6, assuming a tax rate of 40%.
On the Cash Flow Statement, Net Income is down by $6, but you add back the $10 in
Depreciation, so cash is up by $4 at the bottom. On the Balance Sheet, cash is up by $4, PP&E is
down by $10, and so the Assets side is down by $6.
On the other side, Retained Earnings is down by $6 because Net Income was down by $6, so
both sides balance.”
• Examples: Depreciation (PP&E), Amortization (Other Intangible Assets), Stock-Based

Compensation (Common Stock & APIC), Gains / (Losses) on PP&E (PP&E), Write-Downs
(The Asset you are writing down), and Impairment Charges (The Asset you are
impairing).
• What Changes as a RESULT of These Items Changing: Pre-Tax Income, Net Income,
Cash, Retained Earnings, and Something Else on the Balance Sheet.
• How the Balance Sheet Balances: Cash and Retained Earnings change, and something
else on the Balance Sheet makes up the difference.
3) Changes to Operational Items on the Balance Sheet
These consist of items like Inventory, Accounts Receivable, Accounts Payable, Accrued
Expenses, Prepaid Expenses, and Deferred Revenue.
Non-operational items such as Cash, Investments, and Debt are simpler and are part of
category #4 (next).
Just like category #2 above, changes in these items will also affect something on the Balance
Sheet besides Cash and Retained Earnings.
But these items are trickier because increases and decreases work differently.
To figure out what happens, ask yourself a simple question: “Have we delivered the product or
service to the customer? Or has someone else delivered something to us?”
If so, it will appear on the Income Statement. If not, it won’t be on the Income Statement.
Consider Accounts Receivable (AR). If AR increases, it means we’ve delivered a product or
service and are waiting for the cash. So, we record revenue on the Income Statement.
But if AR decreases, it means we’ve collected the cash but haven’t delivered anything – so this
change won’t show up on the IS.
Here’s a side-by-side comparison of all 3 statements so you can see how an AR increase is
different from an AR decrease:
IS – INCREASE in Accounts Receivable: IS – DECREASE in Accounts Receivable:
CFS – INCREASE in Accounts Receivable: CFS – DECREASE in Accounts Receivable:
BS – INCREASE in Accounts Receivable: BS – DECREASE in Accounts Receivable:
So if you’re walking through an increase in AR, you’d say: “On the Income Statement, revenue
increases by $100, and with no other changes, Pre-Tax Income increases by $100 and Net
Income is up by $60 at a 40% tax rate.
On the Cash Flow Statement, Net Income is up by $60, but the increase in AR reduces cash flow
by $100 because you haven’t received that revenue in cash. So cash is down by $40 at the
bottom.
On the Balance Sheet, cash is down by $40, but AR is up by $100, so the Assets side is up by $60.
On the other side, Retained Earnings is up by $60, so the L&E side is up by $60 and both sides
balance.”
If you’re walking through a decrease in AR, you’d say: “On the Income Statement, there are no
changes because a decrease in AR corresponds to a cash collection from customers.
On the Cash Flow Statement, the decrease in AR results in $100 of extra cash flow because the
company is collecting cash from customers, so cash is up by $100 at the bottom.
On the Balance Sheet, cash is up by $100 on the Assets side, and AR is down by $100, so the
Assets side doesn’t change, the L&E side doesn’t change, and the BS remains in balance.”
We’re not going to paste in Excel screenshots for every single possible change; please use the
Excel file to try that on your own.
Here’s a summary of the most common items:
• Accounts Receivable
o Increases: IS, BS, and CFS all change; represents recorded revenue.
o Decreases: Only the BS and CFS change; represents cash collection.
• Prepaid Expenses
o Increases: Only the BS and CFS change; represents payment for expenses not yet
incurred.
o Decreases: IS, BS, and CFS all change; represents recognition of an expense
previously paid in cash.
• Inventory
o Increases: Only the BS and CFS change; represents spending on goods that have
not yet been sold or delivered.
o Decreases: IS, BS, and CFS all change; represents recognition of an expense
previously paid in cash.
• Accrued Expenses and Accounts Payable
o Increases: IS, BS, and CFS all change; represents recognition of an expense that
has not yet been paid in cash.
o Decreases: Only the BS and CFS change; represents cash payment of an expense
that was previously recognized.
• Deferred Revenue
o Increases: Only the BS and CFS change; represents cash collection for sales that
cannot yet be recognized as revenue.
o Decreases: IS, BS, and CFS all change; represents recognition of revenue that has
already been collected in cash.
We strongly recommend that you review the 3-statement “interview question” model to
understand these questions.
4) Changes to Non-Operational Balance Sheet Items or Cash Flow Statement Items
These items are simple because there are no immediate Income Statement changes.
All that happens is that there’s a cash inflow or outflow on the Cash Flow Statement, and both
Cash and the corresponding Balance Sheet item change.
Here are examples of these changes and the Balance Sheet line items that will change:
• Capital Expenditures – PP&E and Cash will change.

• Purchasing or Selling Securities – Short/Long-Term Investments and Cash will change.
• Selling PP&E – PP&E and Cash will change.
• Raising or Paying Off Debt – Debt and Cash will change.
• Raising or Paying Off Preferred Stock – Preferred Stock and Cash will change.
• Issuing Stock – Common Stock & APIC and Cash will change.
• Repurchasing Stock – Treasury Stock and Cash will change.
• Issuing Dividends – Retained Earnings and Cash will change.
• Deferred Taxes – The Deferred Tax Liability and Cash will change.
• FX Rate Effects – Accumulated Other Comprehensive Income (AOCI) and Cash will
change.
Sometimes, it’s unclear whether or not there’s an Income Statement impact.
For example, Preferred Dividends do not impact a company’s Net Income, but they do impact
its “Net Income to Common.” Net Income to Common equals Net Income minus Preferred
Dividends and appears at the bottom of the Income Statement.
But for the most part, these changes are straightforward.
5) Multi-Step Scenarios and Changes on the Financial Statements
“Multi-step scenarios” in interviews are not complicated as long as you understand each
change individually.
With these questions, the interviewer might say something like: “A company buys a factory
using debt, and then starts manufacturing new products. Walk me through how its statements
change.”
So, it’s not just one change, such as raising debt, but multiple changes at once.
The 3-statement Excel model will be your best friend here, but let’s go through one example:
“You purchase a factory for $100 using $100 of debt. Walk me through the 3 financial
statements immediately after this transaction, and then walk me through what happens after a
year. Assume that the debt has a 10% interest rate and that $20 in principal is repaid each year.
The factories depreciate at $10 per year over 10 years.”
Immediately after this change, nothing happens on the Income Statement because Capital
Expenditures and Debt Issuances do not appear on the Income Statement.
Instead, you show a cash outflow and cash inflow on the Cash Flow Statement, and they cancel
each other out; on the Balance Sheet, PP&E is up by $100 on the Assets side, and Debt is up by
$100 on the L&E side, so it remains in balance:
For the next part – what happens after a year of

owning these factories – you have to factor in the
Interest Expense, the Depreciation, and the Debt
Principal Repayment.
All of those changes correspond to THIS period,
but only the Depreciation and Interest Expense
show up on the Income Statement because
they’re both tax-deductible, whereas the Debt
Repayment is not.
On the Income Statement, Pre-Tax Income falls by
$20, and so Net Income falls by $12 at a 40% tax
rate.
On the Cash Flow Statement, there are a few changes.

Net Income is down by $12, but the Depreciation is non-cash, so we add back the $10 in
Depreciation near the top. So far, cash is down by $2.
And then we also record the $20 repayment of long-term debt, which reduces cash flow by $20.
The net effect is that cash is down by $22.
On the Balance Sheet, cash is down by $22, and PP&E is down by $10, so the Assets side is
down by $32.
On the L&E side, Debt is down by $20 because of the principal repayment, and Retained
Earnings is down by $12 because of the reduced Net Income, so both sides are down by $32
and the Balance Sheet balances.
Here’s what it looks like:
At this point, the interviewer might turn to other topics – or he could also throw in a final twist.
For example, what if the factory breaks down and the company has to write down its full value
and repay the entire debt balance?
He has to specify whether you should walk through this change over the course of a year or just
before and after the change takes place.
If it’s over the course of an entire year, it will look like this:
Once again, we have to factor in the Depreciation

and Interest Expense, which both reduce the
company’s Pre-Tax Income.
But we also need to include the PP&E write-down.
It’s a write-down of $90 rather than $100 because
we’ve already depreciated $10 of this PP&E
throughout the year.
So, if disaster strikes on December 31st, there’s
only $90 of PP&E left to write down at that point.
As a result, Pre-Tax Income falls by $110, and Net
Income falls by $66 at a 40% tax rate.
On the Cash Flow Statement, Net Income is down by $66, but we have to make several non-
cash adjustments as well.
We still add back the $10 of Depreciation, and we also add back the $90 PP&E write-down
because write-downs are non-cash.
And then we record the $100 repayment of long-term debt near the bottom. It’s $100 because
we repay $20 during the year and then we repay the remaining $80 at the very end of the year.
So, cash is down by $66, up by $10, up by $90, and down by $100, and is therefore down a total
of $66.
On the Balance Sheet, Cash is down by $66 and PP&E is down by $100, so the Assets side is
down by $166.
On the L&E side, Debt is down by $100 and Retained Earnings is down by $66, so this side is
also down by $166 and both sides balance.
Here’s what it looks like on the CFS and BS:
Return to Top.
Key Rule #9: Working Capital, Free Cash Flow, and Metrics and Ratios
And now we return to the most important formula of all:

We have the 3 financial statements, including the Cash Flow Statement, so it’s easy to
determine “Cash Flow”: We just take the “Net Change in Cash” from the bottom of the Cash
Flow Statement, right?
WRONG!
The problem is that companies can spend their cash in tons of different ways, and not all
these methods of spending cash are truly “necessary.”
For example, if a company issues debt or equity, both activities boost its cash flow – but neither
one is “required” for the business to keep operating.
A company could spend cash buying investments, issuing dividends, or repurchasing shares, but
all those activities are also “optional.”
So, we need to estimate the company’s discretionary cash flow each year – what it earns after
paying for the items that it truly needs to run the business.
There are many definitions for “discretionary cash flow,” but here’s a very simple one: Cash
Flow from Operations minus Capital Expenditures (CapEx).
Many companies do define their “Free Cash Flow” like that.
Later on, we’ll look at other variations and learn why it’s not quite this simple when you value a
company. But this definition is a good starting point.
Cash Flow from Operations minus CapEx is a good initial definition because:
• Everything in a company’s “Operating Activities” section is assumed to be required for

its business – earning Net Income, paying for Inventory, collecting Receivables, etc.
• But almost every line item within Investing and Financing Activities is “optional,” except
for Capital Expenditures.
CapEx is a “required” item because companies need buildings, factories, and equipment to
manufacture products and sell them to customers.
Even companies that sell services or software need buildings and computer equipment, and
spending on both of them is considered CapEx.
If a company generates positive Free Cash Flow, it can spend it in many ways:
1) It could hire more employees, i.e. increase its Operating Expenses, to do more
marketing or develop new products.
2) It could spend more on “Working Capital” items like Inventory to get the materials and
parts it needs to grow in advance.
3) It could spend more on Capital Expenditures to acquire more equipment, which should
boost its long-term growth.
4) It could invest in other assets like stocks, bonds, or real estate so that it’s at least doing
“something” with its cash rather than earning 0% interest on it.
5) It could repay its debt to reduce its interest expense.
6) It could return money to shareholders by issuing dividends or repurchasing shares.
7) It could acquire other companies to expand into new markets or geographies.

Ideally, Free Cash Flow will be positive and growing each year, and it will be doing so because
the company’s sales and profits are growing.
If FCF is positive and growing, but the company’s sales are declining, it might mean that the
company is simply cutting expenses or “playing games” with its Working Capital or CapEx.
If FCF is negative or declining, you have to ask why before drawing conclusions.
For example, did FCF decline in just one year because of unusually high CapEx spending?
If so, that dip may not mean anything at all.
On the other hand, if FCF has been declining consistently because the company is becoming less
profitable over time, that’s a serious problem.
If a company gets into this situation and its cash balance starts to decline each year, it might
have to raise debt or equity, restructure itself, or otherwise cut costs to keep running.
In real life, you use Free Cash Flow in the Discounted Cash Flow (DCF) analysis for valuing
companies, and also in the Leveraged Buyout (LBO) analysis for assessing an acquisition and
sale of a company.
You do not use this type of Free Cash Flow (CFO – CapEx), exactly, but you do use variations
that are closely related to it.
Components of Free Cash Flow: Working Capital
To say much about a company’s Free Cash Flow, you have to look at its individual components.
A big part of FCF is the company’s Net Income: what it earns from core business activities and
“side activities” after expenses and taxes.
Non-cash adjustments and Capital Expenditures also factor in, but those are fairly
straightforward to understand.
One part that’s NOT so straightforward is the company’s “Working Capital.”
The official definition of Working Capital is “Current Assets minus Current Liabilities”:
But if you define Working Capital this way, it will NOT affect a company’s Free Cash Flow in a
way that makes logical sense and that is consistent with the financial statements.
This is because the Cash Flow from Operations section of a company’s Cash Flow Statement
shows only the CHANGE in Working Capital, and it excludes certain items within Current Assets
and Current Liabilities:
You exclude cash because the Net Change in Cash appears at the bottom of the Cash Flow
Statement.
You exclude items related to short and long-term investments because they’re part of the
company’s Investing Activities in the next section of the CFS.
And you exclude debt-related items because they’re part of a company’s Financing Activities.
So, the most USEFUL definition is:
Working Capital = Current Assets (Excluding Cash and Investments) – Current Liabilities
(Excluding Debt)
This definition is sometimes called “Operating Working Capital,” and you may also factor in
certain Long-Term Assets and Liabilities if they are related to the company’s operations.
And then you define the Change in Working Capital like this:
Change in Working Capital = Old Working Capital – New Working Capital
Normally, when you calculate a “Change,” you take the new number and subtract the old
number. So why is it different here?
To answer this question, pretend that a company’s Working Capital consists of only Inventory.
In Year 2, it has $200 in Inventory, and in Year 1, it had $100 in Inventory. It has no other
operationally-related Current Assets or Current Liabilities.
Therefore, its Working Capital was $100 in Year 1 and $200 in Year 2.
Since the company’s Working Capital increased and Working Capital consists of ONLY
Inventory, its Inventory must have increased. And if Inventory increased, the company must
have SPENT cash to do that.
But if you calculated Working Capital this way: New WC – Old WC, it would show up as a
positive $100 on the Cash Flow Statement, which is wrong.
So, to calculate the Change in Working Capital on the Cash Flow Statement, you must use Old
Working Capital – New Working Capital.
When a company’s Working Capital INCREASES, the company USES cash to do that.
When Working Capital DECREASES, it FREES UP cash.
If you add up all the items under “Change in Operating Assets & Liabilities” above, the sum is
negative $70.
Since this change is negative, it means that the company’s Current Assets (excluding cash and
investments) are increasing by MORE than its Current Liabilities (excluding debt):
If the Change in Working Capital were positive instead, it would mean that Current Liabilities
(excluding debt) have increased by more than Current Assets (excluding cash and investments).
The Change in Working Capital tells you whether a company has to spend money BEFORE it
can grow, or whether it generates extra money as a RESULT of its growth.
Companies such as retailers tend to have negative Changes in Working Capital because they
have to spend on Inventory upfront before being able to sell anything.
Companies such as subscription-based software companies tend to have positive Changes in
Working Capital because they collect cash from customers upfront, but take months or years to
recognize it as revenue.
A company might also have a positive Change in Working Capital if it waits a long time to pay its
suppliers, or if it has minimal Inventory or Accounts Receivable.
You can draw conclusions about a company’s business model by calculating its Change in
Working Capital and comparing it to the company’s revenue and change in revenue.
For example, here are Wal-Mart’s figures for one 3-year period:
As you can see, the company is spending a huge amount on Inventory, which is the main reason
why its Change in Working Capital is negative each year.
Its Accounts Payable balance keeps increasing, resulting in positive cash flow, because it keeps
suppliers waiting a fair bit before paying them.
When you compare the Change in Working Capital to the Change in Revenue, the negative
percentage indicates that Wal-Mart must SPEND additional cash to fuel its growth.
This percentage is quite small, so it’s not concerning, but it also means that the company
doesn’t get any “bonus” from growth. This negative Change in Working Capital will also reduce
the company’s Free Cash Flow, making it less valuable.
The Change in Working Capital tells you if the company needs to spend in ADVANCE of its
growth, or if it generates extra money as a RESULT of its growth – and as a direct result, the
company’s Free Cash Flow is lower, making it less valuable, or higher, making it more
valuable.
Once you have the individual components of a company’s Free Cash Flow, you can start
analyzing it and drawing conclusions about the company. Here’s an example for Wal-Mart:
Even though the company’s revenue is growing, its Free Cash Flow (FCF) and Cash Flow from
Operations (CFO) have both declined because the Change in Working Capital was far more
negative in Year 3.
Capital Expenditures also fluctuate quite a bit, sometimes increasing and sometimes decreasing
when the company’s sales grow.
Like most retailers, Wal-Mart needs to spend in advance of its growth because of its Inventory
requirements. Those requirements aren’t massive since the Change in Working Capital is a
relatively small percentage of the Change in Revenue.
The Year 3 result seems to be an anomaly because Accrued Taxes suddenly became a large,
negative number, indicating that the company made an owed tax payment. So, the change
from Year 1 to Year 2 may be more representative of the company as it grows.
Key Metrics and Ratios on the Financial Statements
Once you have a company’s 3 financial statements, you can also calculate metrics and ratios to
analyze them in more detail.
You already know one of these metrics: Free Cash Flow, or Cash Flow from Operations – CapEx.
Net Income, which represents the company’s after-tax profits, is another important one.
A few others include:
• EBIT (Earnings Before Interest and Taxes): This is simply the company’s Operating
Income on the Income Statement, sometimes with “adjustments.”
o Meaning: It’s sometimes a “proxy” for Free Cash Flow since, like FCF, it reflects
the company’s capital spending (as Depreciation appears somewhere above
Operating Income on the Income Statement).
• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): Operating
Income plus Depreciation and Amortization taken from the Cash Flow Statement.
o Meaning: It’s sometimes a “proxy” for Cash Flow from Operations since, like
CFO, it adds back D&A and does not include Capital Expenditures at all.
• NOPAT (Net Operating Profit After Taxes): Operating Income * (1 – Tax Rate).
o Meaning: What would a company’s After-Tax Profits be if you ignored its interest
income and expense, income from side activities, write-downs, and
impairments?
Once you calculate these metrics, you can pair them up with the company’s Equity, Assets, and
Liabilities. A few examples:
• Return on Equity (ROE): Net Income / Average Equity

o Meaning: For each $1.00 of equity raised or saved up, how much in after-tax
profits does the company generate?
• Return on Assets (ROA): Net Income / Average Total Assets
o Meaning: For each $1.00 in assets created or generated, how much in after-tax
profits does the company generate?
• Return on Invested Capital (ROIC): NOPAT / Average Equity + Debt
o Meaning: For each $1.00 of debt and equity raised, how much in after-tax
Operating Income does the company generate? This metric measures how much
it costs the business to grow.
You have to use averages for Balance Sheet figures when you mix them with Income Statement
figures because the Balance Sheet represents only a snapshot in time, but the Income
Statement represents an entire period.
You use these metrics to compare peer companies in the same industry.
For example, if a company’s sales are growing at 20% and it has a ROE of 15%, but another
company’s sales are growing at 10%, and it has a ROE of 25%, that stands out.
The first company might be spending a lot more to grow, or it might be using more debt to fuel
that growth, resulting in a higher interest expense and lower Net Income.
But you don’t know until you look at each company’s financial statements in depth; these
metrics and ratios are like the clues in a murder mystery – not the full solution.
A few other metrics and ratios include:
• Leverage Ratio: Total Debt / EBITDA

o Meaning: How much debt does a company have relative to its ability to repay
that debt?
o A variation is Net Debt / EBITDA; you subtract cash and investments from Debt
to get “Net Debt,” which paints a rosier picture of the company’s obligations.
• Interest Coverage Ratio: EBITDA / Net Interest Expense
o Meaning: How easily can a company pay the interest on its debt?
• Dividend Payout Ratio: Dividends / Net Income
o Meaning: How much of the company’s after-tax profits is it returning to
shareholders?
You could also look at items like CapEx as percentages of revenue, or Depreciation as a
percentage of CapEx; these don’t have “official names,” but they’re useful for comparing
companies’ spending patterns.
Finally, there are a few useful Balance Sheet-based ratios.
You already know one of them: Working Capital or Operating Working Capital, which
measures a company’s cash requirements as its business grows. Others include:
• Asset Turnover Ratio: Revenue / Average Total Assets

o Meaning: How dependent is a company on its assets to generate sales? A lower
ratio indicates greater dependency.
• Current Ratio: Current Assets / Current Liabilities
o Meaning: Can a company pay off its Current Liabilities using its Current Assets?
The meaning is VERY different depending on what’s in these categories.
• Inventory Turnover: COGS / Average Inventory
o Meaning: How many times does a company turn its entire Inventory balance into
finished products and sell them each year?
o A related metric is Days Inventory Outstanding, which is 365 / Inventory
Turnover. It tells you how many days the Inventory balance remains outstanding.
• Receivables Turnover: Revenue / Average Accounts Receivable
o Meaning: How many times does a company collect the entire Receivables
balance from customers each year?
o A related metric is Days Receivables Outstanding, which is 365 / Receivables
Turnover. It tells you how many days the Receivables balance remains
outstanding.
• Payables Turnover: COGS or OpEx / Average Accounts Payable
o Meaning: How many times does a company pay the full balance of invoices and
owed payments each year?
o A related metric is Days Payables Outstanding, which is 365 / Payables Turnover.
It tells you how many days the Payables balance remains outstanding.
You don’t need to memorize every single metric; the most important ones for interviews are
EBIT and EBITDA.
You can use these metrics to analyze and compare companies. Here’s an example for Wal-Mart:
These metrics and ratios point you in the direction of items you should investigate in more
detail, but they’re just a starting point for that process – like clues in a murder mystery.
To complete the process, you’d have to calculate the same metrics and ratios for similar
companies in the industry, dig into the companies’ financial statements, and see what might be
causing the outcomes above.
Return to Top.
Interview Questions
You REALLY need to know accounting to have a shot at winning job offers.
Accounting interview questions come up not just in investment banking interviews, but also in
interviews for private equity, corporate development, investor relations, and all sorts of other
exit opportunities.
Many bankers have fairly weak knowledge of accounting, so these questions are a quick way to
evaluate how much you understand vs. how much you’ve memorized.
Conceptual Accounting Questions
1. What are the 3 financial statements, and why do we need them?

The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow
Statement.
The Income Statement shows the company’s revenue, expenses, and taxes over a period and
ends with Net Income, which represents the company’s after-tax profits.
The Balance Sheet shows the company’s Assets – its resources – as well as how it paid for those
resources – its Liabilities and Equity – at a specific point in time. Assets must equal Liabilities
plus Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash items and changes in
operating assets and liabilities (working capital), and then shows the company’s cash from
Investing or Financing activities; the last lines show the net change in cash and the company’s
ending cash balance.
You need these statements because there is a big difference between a company’s Net Income
and the cash it generates – the Income Statement alone doesn’t tell what its cash flow is.
Remember the key valuation formula:
The 3 financial statements let you estimate the “Cash Flow” part, which helps you value the
company more accurately.
2. How do the 3 statements link together?
To link the statements, make Net Income from the Income Statement the top line of the Cash
Flow Statement.
Then, adjust this Net Income number for any non-cash items such as Depreciation &
Amortization.
Next, reflect changes to operational Balance Sheet items such as Accounts Receivable, which
may increase or decrease the company’s cash flow depending on how they’ve changed.
This gets you to Cash Flow from Operations.
Next, take into account investing and financing activities, which may increase or decrease cash
flow, and sum up Cash Flow from Operations, Investing, and Financing to get the net change in
cash at the bottom.
Link Cash on the Balance Sheet to the ending Cash number on the CFS, and add Net Income to
Retained Earnings within the Equity category on the Balance Sheet.
Then, link each non-cash adjustment to the appropriate Asset or Liability; SUBTRACT links on
the Assets side and ADD links on the L&E side.
And then link each CFI and CFF item to the matching item on the Balance Sheet, using the same
rule as above.
Check that Assets equals Liabilities plus Equity at the end; if this is not true, you did something
wrong and need to re-check your work.
3. What’s the most important financial statement?

The Cash Flow Statement is the most important single statement because it tells you how much
cash a company is generating. The Income Statement is misleading because it includes non-cash
revenue and expenses and excludes cash spending such as Capital Expenditures.
4. What if you could use only 2 statements to assess a company’s prospects – which ones
would you use, and why?
You would use the Income Statement and Balance Sheet because you can create the Cash Flow
Statement from both of those (assuming there are “Beginning” and “Ending” Balance Sheets
that correspond to the same period shown on the Income Statement).
It would be MUCH harder to “construct” an Income Statement from the Balance Sheet and
Cash Flow Statement (for example).
5. How might the financial statements of a company in the U.K. or Germany be different from
those of a company based in the U.S.?
Income Statements and Balance Sheets tend to be similar across different regions, but
companies that use IFRS often start the Cash Flow Statement with something other than Net
Income: Operating Income, Pre-Tax Income, or if they are using the Direct Method for creating
the CFS, Cash Received or Cash Paid.
There are also minor naming differences; for example, the Income Statement might be called
the “Consolidated Statement of Earnings” or the “Profit & Loss Statement,” and the Balance
Sheet might be called the “Statement of Financial Position.”
Technically, U.S.-based companies that follow U.S. GAAP can also use the Direct Method for
creating the CFS, but in practice, they tend to use the Indirect Method (i.e., they start with Net
Income and make adjustments to determine the cash flow).
6. What should you do if a company’s Cash Flow Statement starts with something OTHER
than Net Income, such as Operating Income or Cash Received?
For modeling and valuation purposes, you should convert this Cash Flow Statement into one
that starts with Net Income and makes the standard adjustments.
Large companies should provide a reconciliation that shows you how to move from Net Income
or Operating Income to Cash Flow from Operations and that lists the changes in Working
Capital and other non-cash adjustments.
If the company does NOT provide that reconciliation, you might have to stick with the CFS in
the original format.
7. How do you know when a revenue or expense line item should appear on the Income
Statement?
Two conditions MUST be true for an item to appear on the Income Statement:
1. It must correspond to ONLY the period shown on the Income Statement. This is why
monthly rent shows up, but paying for a factory that will last for 10 years does not.
2. It must affect the company’s taxes. Interest on debt is tax-deductible, so it shows up,
but repayment of debt principal is not, so it does not show up.
Whether or not something is received or paid in cash has nothing to do with this classification
– companies pay taxes on non-cash revenue (e.g., receivables) and save on taxes from non-cash
expenses (e.g., depreciation) all the time.
Advanced Note: Technically, in point #2 we should say, “It must affect the company’s BOOK
taxes” (i.e., only the tax number that appears on the Income Statement). Many items that are
not deductible for cash-tax purposes still appear on the IS and affect book taxes.
8. How can you tell whether an item should be classified as an Asset, Liability, or Equity on
the Balance Sheet?
An Asset will generate future cash flow for the company or can be sold for cash. Think about
how AR means the company should receive more cash in the future.
A Liability will cost the company cash in the future and cannot be sold because it represents
payments the company owes. Think about Debt or Accounts Payable and how they represent
owed payments.
Equity line items are similar to Liabilities because they represent funding sources for the
company – but they will NOT result in future cash costs.
They relate to funds the company has saved up on its own or funds that it has raised from
outside investors with no cash cost (i.e., equity).
9. How can you tell whether or not an item should appear on the Cash Flow Statement?
You list an item on the Cash Flow Statement if:
1) It has already appeared on the Income Statement and affected Net Income, but it’s non-
cash, and you need to adjust for it to determine the company’s real cash flow; OR
2) It has NOT appeared on the Income Statement and it DOES affect the company’s cash
balance.
In category #1 are items such as Depreciation and Amortization; Category #2 includes most of
the items in Cash Flow from Investing and Financing, such as Capital Expenditures and
Dividends.
Changes in Working Capital could fall into either category depending on the change (e.g., an
increase in AR is in category #1, but a decrease in AR is in category #2).
10. A company uses cash-based accounting (i.e., it only records revenue when it is received in
cash and only records expenses when they are paid in cash) rather than accrual accounting.
A customer buys a TV from the company “on account” (i.e., without paying upfront in Cash)
and receives the TV right away. How would the company record this transaction differently
from a company that uses accrual accounting?
Under cash-based accounting, the revenue would not show up until the company collects the
cash from the customer – at which point it would add to Revenue on the Income Statement
(and Pre-Tax Income, Net Income, etc.) and Cash on the Balance Sheet.
Under accrual accounting, the sale would show up as Revenue right away, but instead of
appearing in Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then,
once the cash is deposited in the company’s bank account, it would move into Cash, and
Accounts Receivable would decrease.
11. A company begins offering 12-month installment plans to customers so that they can pay
for $500 or $1,000 courses over a year instead of all upfront. How will its cash flow change?
In the short term – during THIS year – the company’s cash flow will decrease because some
customers no longer pay upfront in cash.
So, a $1,000 payment in Month 1 now turns into $83 in Month 1, $83 in Month 2, and so on.
This situation corresponds to Accounts Receivable: The Asset on the Balance Sheet that
represents owed future payments from customers.
The long-term impact depends on how much sales grow as a result of this change.
If sales grow substantially and the company’s Revenue and Net Income increase, that might be
enough to offset the reduced cash flow and make the company better off.
12. A company decides to prepay its monthly rent – an entire year upfront – because it can
save 10% by doing so. Will this prepayment boost the company’s cash flow?
In the short term, no, because the company is now paying 12 * Monthly Rent in a single month
rather than making one payment per month.
On the Income Statement in Month 1, the company will still record only the Monthly Rent for
that month. But on the Cash Flow Statement, it will list a negative 12 * Monthly Rent under
“Change in Prepaid Expenses” to represent the cash outflow for the prepayment.
A 10% discount represents just over 1 month of rent, so the company’s immediate cash flow
will decrease substantially.
In the long term, this discount will improve the company’s cash flow because the timing
difference will go away after a year.
13. Your friend is analyzing a company and says that you always have to look at the Cash Flow
Statement to find the full amount of Depreciation.
Is he right? And if so, what are the implications?
Yes, your friend is correct. This happens because companies often embed Depreciation within
other line items, such as COGS and Operating Expenses, on the Income Statement.
That’s because portions of Depreciation might correspond to different functions in the
company. For example, employees in sales & marketing, research & development, and
customer support might all be using computers, so Depreciation of computers would show up
in each of those categories.
This fact has several implications: First off, you CANNOT assume that the Depreciation listed on
the Income Statement is the full amount. A company might list a portion of it as an explicit line
item but embed other portions elsewhere.
Second, adding back the full amount on the CFS shows that Depreciation simply reduces the
company’s taxes without “costing” it anything in cash.
This is why Depreciation boosts the company’s cash balance as well: the tax savings.
14. A company mentions that it collects cash payments from customers for a monthly
subscription service a year in advance. Why would a company do this, and what is the cash
flow impact?
A company would collect cash payments for a monthly service long in advance if it has the
market power do so.
It’s always better to get cash earlier rather than later because of the time value of money, so if
the market and customers support this plan, any company would do it.
Often, companies will provide an incentive, such as discounted pricing, a free bonus, or free
services to incentivize customers to pay upfront.
This practice always boosts a company’s cash flow. It corresponds to Deferred Revenue, and on
the CFS, an increase in Deferred Revenue will be a positive entry that boosts a company’s cash
flow.
When this cash is finally recognized as revenue, Deferred Revenue declines, which appears as a
negative entry on the CFS.
15. Why is Accounts Receivable (AR) an Asset, but Deferred Revenue (DR) a Liability?
Accounts Receivable is an Asset because it corresponds to future cash payments that
customers are expected to make. An Asset is something that will result in additional cash in the
future, or that can be sold for cash, so AR qualifies.
Deferred Revenue is a Liability because it will cost the company cash in the future.
The company has already collected all the cash associated with this future revenue. So, in the
future, when it finally delivers the product or service, it will have to spend something on the
delivery and will also have to pay taxes on the revenue it records.
While AR and DR may seem similar, they are the opposites of each other: AR has not yet been
collected in cash but has been delivered, whereas DR has been collected in cash, but has not yet
been delivered.
16. How are Prepaid Expenses, Accounts Payable and Accrued Expenses different, and why
are Prepaid Expenses an Asset?
The difference is very similar to the one above for AR and DR.
Prepaid Expenses have already been paid out in cash but have not yet been incurred as
expenses, so they have not appeared on the Income Statement. When they do finally appear on
the Income Statement, they’ll reduce the company’s future taxes, making them an Asset.
Accounts Payable have not yet been paid out in cash but have been incurred as expenses, so
they have appeared on the Income Statement. When the company finally pays them in cash,
Accounts Payable will reduce the company’s cash, making them a Liability.
Accounts Payable and Accrued Expenses work in exactly the same way, but Accounts Payable is
used for specific items with invoices (e.g., legal bills), whereas Accrued Expenses is more for
monthly, recurring items without invoices (e.g., utilities).
17. Your CFO wants to start paying employees mostly in stock-based compensation, under
the logic that it will reduce the company’s taxes, but not “cost it” anything in cash.
Is he correct? And how does Stock-Based Compensation impact the statements?
The CFO is partially correct. Yes, stock-based compensation is a non-cash expense that reduces
a company’s taxes but gets added back on the CFS, similar to Depreciation.
However, unlike Depreciation or Amortization, Stock-Based Compensation incurs a real cost
to the company and its investors because it creates additional shares.
In other words, if the existing investors own 99% of the company’s shares, those investors
might own only 97% or 98% after SBC is issued.
Thus, Stock-Based Compensation makes the company less valuable to the existing investors,
even though, on paper, it seems to be just like any other non-cash expense.
18. A junior accountant in your department asks about the different ways to fund the
company’s operations and how they impact the financial statements. What do you tell him?
The two main methods of funding a company’s operations are debt and equity. Debt is cheaper
for most companies (see the previous lessons and guides on WACC and the Discount Rate), so
most companies prefer to use debt… up to a reasonable level.
Both equity and debt issuances show up on only the Cash Flow Statement initially (in Cash Flow
from Financing), and they boost the company’s cash balance.
The only “after-effect” of equity is that the company’s share count increases. This happens
because any investor who buys the company’s equity now owns a percentage of the company.
With debt, the company must pay interest, which will be recorded on its Income Statement,
reducing its Net Income and Cash, and it must eventually pay back the full balance.
19. Your company sells equipment for $85. The equipment was listed at $100 on your
company’s Balance Sheet, so you have to record a Loss of $15 on the Income Statement,
which gets reversed as a non-cash expense on the Cash Flow Statement.
Why is this Loss considered a non-cash expense?
This Loss is a non-cash expense because you haven’t actually “lost” anything in cash in the
current period.
When you sell equipment for $85, you get $85 in cash from the buyer. It’s not as if you’ve “lost”
$15 in cash because you sold the equipment at a poor price.
The “Loss” refers to how you previously spent more than $85 to buy this equipment in some
prior period.
So, if you look at what you spent on the equipment many years ago and compare it to what you
sold it for today, it seems like a “loss.” But that doesn’t matter because non-cash adjustments
are based on what happens in the CURRENT PERIOD.
20. Your company owns an old factory that’s currently listed at $1,000 on its Balance Sheet.
Why would it choose to “write down” this factory’s value, and what is the impact on the
financial statements?
A company might write down an Asset if its value has declined substantially, and it’s no longer
accurate to reflect it at the original value on the Balance Sheet.
For example, maybe the factory is damaged by a hurricane or new technology makes the
factory obsolete.
On the statements, you record this write-down as an expense on the Income Statement, but
you add it back as a non-cash expense on the Cash Flow Statement.
The result is that the company’s cash balance increases due to the tax savings.
On the Balance Sheet, Cash is up, this Asset’s value is down, and Retained Earnings will balance
the change on the Assets side because Net Income has decreased.
21. The CFO of your firm recently unveiled plans to purchase short and long-term
investments. Why would she want to do this, and how would this activity affect the
statements?
A company might want to purchase investments if it has excess cash and cannot think of other
ways to use it.
For example, the company can’t reinvest the cash into hiring more employees, buying more
equipment or factories, or acquiring other companies or assets, and it also doesn’t want to
distribute the cash to investors via dividends or repay its debt.
The initial purchase of these investments will show up only on the Cash Flow Statement and will
reduce the company’s cash flow.
Afterward, the Interest Income earned on these investments will appear on the Income
Statement and boost the company’s Pre-Tax Income, Net Income, and its Cash balance.
22. Could a company ever have negative Equity on its Balance Sheet? If no, why not? If yes,
what would it mean?
Yes, easily. Think about a company that starts losing massive amounts of money, resulting in a
negative Net Income. After many years, negative Net Income could easily turn the company’s
Equity negative.
This might also happen if the company issues a huge dividend to its owners (e.g., following a
leveraged buyout) that turns Equity negative.
The “meaning” varies based on what has happened, but negative Equity is almost always a
negative sign because it means the company has been unprofitable or has done something
irresponsible with its dividends or share repurchases.
Negative Equity is also common for tech and biotech startups that record massive losses in their
early years due to high spending and no revenue.
23. Your firm recently acquired another company for $1,000 and created Goodwill of $400
and Other Intangible Assets of $200 on the Balance Sheet. A junior accountant in your
department asks you why the company did this – what would you tell him?
You need to create Goodwill and Other Intangible Assets after an acquisition takes place to
ensure that the Balance Sheet balances.
In an acquisition, you write down the seller’s Shareholders’ Equity and then combine its Assets
and Liabilities with those of the acquirer.
If you’ve paid exactly what the seller’s Shareholders’ Equity is worth – e.g., you paid $1,000 in
cash and the seller has $1,000 in Equity, then there are no problems.
The combined cash balance will decrease by $1,000, and so will the combined Equity.
However, in real life, this almost never happens. Companies almost always pay premiums for
companies they acquire, which means that the Balance Sheet will go out of balance.
For example, if the seller here had $400 in Equity instead, the BS would go out of balance
immediately because we wipe out $400 in Equity but spend $1,000 in cash.
To fix that problem, you start by allocating value to the seller’s “identifiable intangible assets”
such as patents, trademarks, intellectual property, and customer relationships. In this case, we
allocated $200 to these items.
If there’s still a gap remaining after that, you allocate the rest to Goodwill, which explains the
$400 in Goodwill here.
24. How do Goodwill and Other Intangible Assets change over time?
Goodwill remains constant unless it is “impaired,” i.e., the acquirer decides that the acquired
company is worth far less and therefore writes down the Goodwill. That appears as an expense
on the Income Statement and a non-cash adjustment on the Cash Flow Statement.
Other Intangible Assets amortize over time (unless they are indefinite-lived), and that
Amortization shows up on the Income Statement and as a non-cash adjustment on the Cash
Flow Statement. The balance decreases until it has amortized completely.
Return to Top.
Single-Step Changes on the Financial Statements
These questions are straightforward if you’ve been using our 3-statement “interview question”
Excel model to try different scenarios.
Remember the 4 main categories of changes:
1. Changes to True Cash Items on the Income Statement – Straightforward since Net
Income, Cash, and Retained Earnings change.
2. Changes to Non-Cash or Re-Classified Items on the Income Statement – Net Income,

Cash, and Retained Earnings change, but something on the Balance Sheet also changes.
3. Changes to Operational Items on the Balance Sheet – These are trickier because the
effects are different when an item decreases vs. when it increases, so you have to
understand what the change means.
4. Changes to Non-Operational Balance Sheet Items or Cash Flow Statement Items –

These are simple since there’s no immediate Income Statement impact; something on
the CFS will change, Cash will change, and something on the Balance Sheet will change.
We recommend going in this order when answering these questions:
1. Explain how the Income Statement changes, if at all.
2. Explain how the Cash Flow Statement changes, if at all.
3. Explain how the Balance Sheet changes and why it still balances, i.e. why Assets still
equal Liabilities + Equity.
You can always assume a 40% tax rate to simplify the math, but make sure you state that when
you explain your answer.
1. Walk me through the 3 financial statements when a company’s operating expenses

increase by $100.
• Income Statement: Operating Expenses are up by $100, so Pre-Tax Income is down by

$100 and Net Income is down by $60 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $60. There are no other changes, so cash
is down by $60 at the bottom.
• Balance Sheet: Cash is down by $60, so the Assets side is down by $60, and Retained
Earnings on the L&E side is down by $60 due to the reduced Net Income, so both sides
balance.
• Intuition: Nothing; it’s a simple cash expense.
2. A company’s Depreciation increases by $10. What happens on the 3 financial statements?
• Income Statement: Pre-Tax Income falls by $10, and Net Income falls by $6 assuming a
40% tax rate.
• Cash Flow Statement: Net Income is down by $6, but you add back the $10 in
Depreciation since it’s non-cash, so cash flow is up by $4, and cash at the bottom is up
by $4.
• Balance Sheet: Cash is up by $4, but PP&E is down by $10 due to the added
Depreciation, so the Assets side is down by $6. The L&E side is also down by $6 because
Net Income fell by $6, which reduced Retained Earnings, so both sides balance.
• Intuition: The company saves on taxes with a non-cash expense.
3. A company runs into financial distress and needs cash immediately. It sells a factory that’s
listed at $100 on its Balance Sheet for $80. What happens on the 3 statements?
• Income Statement: You record a Loss of $20 on the Income Statement, which reduces
Pre-Tax Income by $20 and Net Income by $12 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $12, but you add back the $20 Loss since
it’s non-cash. You also show the full proceeds received, $80, in Cash Flow from
Investing, so cash at the bottom is up by $88.
• Balance Sheet: Cash is up by $88, but PP&E is down by $100, so the Assets side is down
by $12. The L&E side is also down by $12 because Retained Earnings fell by $12 due to
the Net Income decrease, so both sides balance.
• Intuition: The company gets the $80 in cash proceeds, but it also gets $8 in tax savings
from the Loss, so its cash goes up by $88 rather than $8.
4. A company decides to CHANGE a key employee’s compensation. It will offer the employee
stock options instead of a real salary. The employee’s salary was formerly $100, but she will
receive $120 in stock options now. How do the statements change?
You can think of this one as operating expenses going up by $20, but the company also having
$120 in additional non-cash expenses.
• Income Statement: Operating expenses increase by $20, so Pre-Tax Income falls by $20,
and Net Income falls by $12 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $12, but you add back the $120 in SBC as
a non-cash expense, so cash at the bottom is up by $108.
• Balance Sheet: Cash is up by $108, so the Assets side is up by $108. On the L&E side,
Retained Earnings is down by $12 because of the reduced Net Income, but Common
Stock & APIC is up by $120 because of the SBC, so the L&E side is up by $108 and both
sides balance.
• Intuition: The company saves a lot of cash by not paying the employee in cash anymore,
and it also realizes tax savings. Just remember that its share count will also increase.
5. Your company just acquired another one for $1,000 in cash. The other company’s
Shareholders’ Equity was $500, and you identified $100 in Other Intangible Assets with a
useful life of 5 years.
What happens on the 3 statements from just AFTER the acquisition closes to the end of the
first year following the acquisition? Only factor in Goodwill and Other Intangible Assets.
In this scenario, the “gap” between the purchase price and the other company’s Shareholders’
Equity is $500. $100 in Other Intangible Assets and $400 in Goodwill will be created. The
Intangibles will amortize $20 per year over 5 years.
• Income Statement: Amortization increases by $20, which reduces Pre-Tax Income by

$20 and Net Income by $12 at a 40% tax rate.
Amortization as a non-cash expense, so cash at the bottom is up by $8.
• Balance Sheet: Cash is up by $8, but Other Intangible Assets are down by $20, so the
Assets side is down by $12. On the L&E side, Retained Earnings is down by $12 due to
the reduced Net Income, so both sides are down by $12.
• Intuition: The non-cash Amortization expense increases the company’s cash balance by
reducing its tax burden.
6. In the second year, the acquisition goes horribly wrong, and your company realizes the
acquired company is worth only about half of what it paid.
So, it decides to write down half the Goodwill created in the deal – how do the 3 statements
change, and what is the balance after the write-down?
$400 in Goodwill was created in this deal, so $200 will be left afterward.
• Income Statement: You record a $200 Goodwill write-down, which reduces Pre-Tax
Income by $200 and Net Income by $120 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $120, but you add back the $200 Goodwill
write-down since it’s non-cash, so cash at the bottom is up by $80.
• Balance Sheet: Cash is up by $80, but Goodwill is down by $200, so the Assets side is
down by $120. On the L&E side, Retained Earnings is down by $120 due to the reduced
Net Income. There are no other changes, so both sides are down by $120 and balance.
• Intuition: The Goodwill write-down is a non-cash expense that reduces the company’s
tax burden, which boosts its cash balance.
• Advanced Note: Write-downs of Goodwill created from acquisitions are often NOT
deductible for cash-tax purposes, so a DTA/DTL might be involved in real life. Do NOT
bring up this point voluntarily in an interview.
7. Walk me through what happens on the statements when a customer orders a product for
$100 but doesn’t pay for it in cash, and then what happens when the cash is finally collected.
This scenario corresponds to Accounts Receivable increasing by $100 and then decreasing by
$100. First, here’s what happens when it increases:
• Income Statement: Revenue increases by $100, so Pre-Tax Income is up by $100 and

Net Income is up by $60 at a 40% tax rate.
• Cash Flow Statement: Net Income is up by $60, but the increase in AR reduces cash flow
by $100, so cash at the bottom is down by $40.
• Balance Sheet: Cash is down by $40, but AR is up by $100, so the Assets side is up by
$60. On the L&E side, Retained Earnings is up by $60 due to the increased Net Income,
so both sides are up by $60 and balance.
• Intuition: The company has to pay taxes on revenue it hasn’t yet received in cash, so its
cash balance falls.
And when the AR is collected (factoring in ONLY this step):
• Income Statement: No changes.
• Cash Flow Statement: AR decreases, which is a change of positive $100 since it means
the company has collected the cash now. Cash at the bottom is up by $100.
• Balance Sheet: Cash is up by $100, but AR is down by $100, so the Assets side doesn’t
change. The L&E side also doesn’t change, so both sides remain in balance.
• Intuition: This is a simple cash collection of a payment owed to the company.
8. A company prepays its rent ($20 per month) a month in advance. Walk me through what
happens on the statements when the company prepays the expense, and then what happens
when the expense is incurred.
This scenario corresponds to Prepaid Expenses increasing and then decreasing. First, the
increase:
• Cash Flow Statement: The $20 Increase in Prepaid Expense reduces the company’s cash
flow by $20, so cash at the bottom is down by $20.
• Balance Sheet: Cash is down by $20, but Prepaid Expenses is up by $20, so the Assets
side doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains
balanced.
• Intuition: This is a simple cash payment for expenses that have not yet been incurred.
And then when Prepaid Expenses decrease (factoring in ONLY this step):
• Income Statement: Operating Expenses increase by $20, so Pre-Tax Income falls by $20,
and Net Income falls by $12 assuming a 40% tax rate.
• Cash Flow Statement: Net Income is down by $12, but the reduction in Prepaid
Expenses boosts cash flow by $20, so cash at the bottom is up by $8.
• Balance Sheet: Cash is up by $8, and Prepaid Expenses are down by $20, so the Assets
side is down by $12. The L&E side is also down by $12 because Retained Earnings has
dropped by $12 due to the reduced Net Income, so both sides balance.
• Intuition: Cash goes up because this $20 expense is “non-cash” at this point – the
company has paid for it in cash in a prior period – so it saves the company on taxes.
9. Wal-Mart buys $500 in Inventory for products it will sell next month. Walk me through
what happens on the statements when they first buy the Inventory, and then when they sell
the products for $600.
The first part is a simple Inventory purchase, and the second part is more of a “multi-step
scenario” where the company has to record COGS and the revenue associated with the product
sales. Here’s the first part:
• Cash Flow Statement: The $500 Inventory increase reduces the company’s cash flow, so
cash at the bottom is down by $500.
• Balance Sheet: Cash is down by $500, but Inventory is up by $500, so the Assets side
doesn’t change. The L&E side also doesn’t change, so the Balance Sheet remains in
balance.
• Intuition: This is a simple cash purchase for an expense that has not yet been incurred.
And then here’s the next part (factoring in ONLY this step):
• Income Statement: Revenue is up by $600, but COGS is up by $500, so Pre-Tax Income

is up by $100 and Net Income is up by $60 at a 40% tax rate.
• Cash Flow Statement: Net Income is up by $60, but the decrease in Inventory increases
cash flow by $500, so cash at the bottom is up by $560.
• Balance Sheet: Cash is up by $560, but Inventory is down by $500, so the Assets side is
up by $60. The L&E side is also up by $60 because Net Income was up by $60, and so
Retained Earnings was up by $60; therefore, both sides balance.
• Intuition: Look at the CUMULATIVE change – if you trace through both steps 1 and 2,
cash is up by $60 from start to finish. And that increase corresponds to the company’s
after-tax profit from a $100 pre-tax profit on the sale of these goods.
10. Amazon.com decides to pay several key vendors on credit and make them wait for the
cash. It offers $200 in credit and says it will pay them in cash in a month. What happens on
the financial statements when the expense is incurred, and then when it is paid in cash?
This scenario corresponds to Accounts Payable or Accrued Expenses increasing by $200 and
then decreasing by $200 when they’re finally paid out in cash.
• Income Statement: Operating Expenses increases by $200, so Pre-Tax Income is down

by $200 and Net Income is down by $120, assuming a 40% tax rate.
• Cash Flow Statement: Net Income is down by $120, but AP increasing by $200 results in
higher cash flow since it means the expenses haven’t been paid in cash yet. So, cash at
the bottom is up by $80.
• Balance Sheet: Cash is up by $80, so the Assets side is up by $80. On the L&E side, AP is
up by $200, but Retained Earnings is down by $120 due to the reduced Net Income, so
the L&E side is up by $80 and both sides balance.
• Intuition: This expense is acting like a “non-cash charge” at this point because it reduces
the company’s taxes but doesn’t cost them anything in cash. Cash is up because of the
lower taxes.
And then here’s the next step (factoring in ONLY this step):
• Cash Flow Statement: Accounts Payable decreasing by $200 reduces the company’s
cash flow by $200, so cash at the bottom is down by $200.
• Balance Sheet: Cash is down by $200, so the Assets side is down by $200, and AP is
down by $200, so the L&E side is also down by $200 and both sides balance.
• Intuition: This is a simple cash payment for an owed expense.
11. Salesforce.com sells a customer a $100 per month subscription but makes the customer
pay all in cash, upfront, for the entire year. What happens on the statements?
This scenario corresponds to Deferred Revenue – collecting cash, but not being able to
recognize it as revenue yet. The payment for the entire year is $1,200.
• Cash Flow Statement: DR increasing by $1,200 will boost the company’s cash flow, so
cash at the bottom is up by $1,200.
• Balance Sheet: Cash is up by $1,200, so the Assets side is up by $1,200, and Deferred
Revenue is up by $1,200, so the L&E side is up by $1,200, and both sides balance.
• Intuition: This is a simple cash inflow for services the company has not yet delivered.
12. Now what happens after one month has passed, and the company has delivered one
month of service?
Assume there are no associated COGS or Operating Expenses, and walk through what
happens ONLY in this month.
• Income Statement: Revenue is up by $100, so Pre-Tax Income is up by $100 and Net

Income is up by $60, assuming a 40% tax rate.
• Cash Flow Statement: Net Income is up by $60, but the decrease in Deferred Revenue
reduces cash flow by $100, so cash at the bottom is down by $40.
• Balance Sheet: Cash is down by $40, so the Assets side is down by $40. On the L&E side,
DR is down by $100, but Retained Earnings is up by $60 because of the increased Net
Income, so the L&E side is down by $40 and the Balance Sheet balances.
• Intuition: Cash goes down because the company now has to pay taxes on non-cash
revenue: it collected the cash in some prior period, and now it has to pay taxes on it.
13. A company issues $100 in stock to new investors to fund its operations. How do the
statements change?
• Cash Flow Statement: The $100 stock issuance is a cash inflow in Cash Flow from
Financing, and there are no other changes, so cash at the bottom goes up by $100.
• Balance Sheet: Cash is up by $100, so the Assets side is up by $100, and Common Stock
& APIC on the other side goes up by $100, so the L&E side is up by $100 and the BS
balances.
• Intuition: This is a simple cash inflow that doesn’t impact the company’s taxes at all.
14. This same company now realizes that it has too much cash, so it wants to issue dividends
or repurchase shares. How do they impact the 3 statements differently? Assume $100 in
dividends vs. $100 in shares repurchases.
These changes both make a very similar impact; the main difference is that dividends do not
reduce the shares outstanding, but a share repurchase does.
• Cash Flow Statement: Both of these will show up as negative $100 entries in Cash Flow
from Financing, reducing the cash at the bottom of the CFS by $100.
• Balance Sheet: Cash is down by $100, so the Assets side is down by $100; on the L&E
side, dividends will reduce Retained Earnings by $100, whereas a share repurchase will
reduce Treasury Stock by $100. But in either case, Equity is down by $100, so the L&E
side is down by $100 and both sides balance.
• Intuition: These are simple uses of cash that don’t affect the company’s taxes at all.
15. A company has $1,000 in revenue, $200 in COGS, and $700 in operating expenses, and no
other expenses. Walk through what happens on the 3 statements if half of the company’s
Income Taxes shift from current to deferred.
First, you have to calculate the company’s total tax bill: $1,000 in revenue minus $200 in COGS
minus $700 in operating expenses equals $100 in Pre-Tax Income and $40 in taxes at a 40% tax
rate.
• Income Statement: Nothing changes because you record BOTH current AND deferred
taxes as part of the company’s Income Taxes here. So, there’s still $40 of Income Taxes.
• Cash Flow Statement: Net Income stays the same, but now you have to add back $20 in
the Deferred Income Tax line item because these taxes will be paid in some future
period. Cash increases by $20 as a result.
• Balance Sheet: Cash is up by $20, and so the Assets side is up by $20. On the L&E side,
the Deferred Tax Liability will increase by $20 because of this deferral, so both sides
increase by $20 and the Balance Sheet balances.
• Intuition: This is a simple deferral of a cash expense into a future period, so the
company’s cash increases in the short term.
Return to Top.
Multi-Step Changes on the Financial Statements
These questions get tricky because you have to keep track of more numbers in your head.
If you don’t feel comfortable doing that, you can ask the interviewer if it’s OK to write down a
few figures as you’re moving along. It’s better to do that than to make a mistake.
Sometimes, it is not clear whether you have to state the CUMULATIVE change – i.e., what
happens after 2 years have passed, from beginning to end – or just the change in a single year
or after a single event.
When in doubt, always ask the interviewer to confirm the treatment.
1. A company buys a factory for $100 using $100 of debt. What happens INITIALLY on the
statements?
• Cash Flow Statement: There’s no net change in cash because the $100 factory purchase
counts as CapEx, which reduces cash flow, and the $100 debt issuance is a cash inflow.
• Balance Sheet: PP&E is up by $100, so the Assets side is up by $100, and Debt is up by
$100, so the L&E side is up by $100, and the Balance Sheet stays balanced.
• Intuition: This is a simple debt issuance and PP&E purchase, neither of which affects the
company’s taxes.
2. One year passes. The company pays 10% interest on its debt, and it depreciates $10 on the
factory each year. It also repays $20 of the loan each year. What happens on the statements
in this first year?
10% interest corresponds to $10 in interest since we use the beginning debt balance to
calculate interest. So:
• Income Statement: You record $10 in interest and $10 in Depreciation, so Pre-Tax
Income falls by $20, and Net Income falls by $12 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $12, but the $10 in Depreciation is non-
cash, so you add it back. The $20 loan repayment counts as a cash outflow, so cash at
the bottom of the CFS is down by $22.
• Balance Sheet: Cash is down by $22, and PP&E is down by $10, so the Assets side is
down by $32. On the L&E side, the Debt is down by $20 and Retained Earnings is down
by $12 due to the reduced Net Income, so the L&E side is also down by $32 and both
sides balance.
• Intuition: Cash declines mostly because of the principal repayment; the interest
expense is offset a bit by the tax savings from the Depreciation.
3. Another year passes. Again, the company pays 10% interest on its debt based on the
balance at the start of the year, and it depreciates $10 on the factory, with $20 loan principal
repayment.
At the very END of the year, a dragon attacks the factory, and it falls apart. The company has
to write down the factory’s entire value and repay the remaining loan balance.
Walk me through what happens on the statements from the BEGINNING of Year 2 to the END.
Remember that the company only has $80 in debt remaining at the start of Year 2, so the
interest expense will be 10% * $80, or $8, rather than $10. The initial PP&E is $90, but $10 of
that gets depreciated, and the remaining $80 is written down.
Although there’s $20 of debt repayment, it’s better to think of this as $80 during the entire year
because there’s $20 in “normal” repayment and then $60 at the end of the year.
• Income Statement: You record $10 in Depreciation, $8 in interest expense, and $80 for
the PP&E write-down, so Pre-Tax Income falls by $98, and Net Income falls by $59
(technically $58.8, but we’re rounding).
• Cash Flow Statement: Net Income is down by $59, but the Depreciation and the Write-
Down are both non-cash, so you add back a total of $90. Cash is up by $31 so far. Then
you factor in the loan repayments – a total of $80 – and cash is therefore down by $49.
• Balance Sheet: Cash is down by $49, and PP&E is down by $90, so the Assets side is
down by $139. On the L&E side, Debt is down by $80 and Retained Earnings is down by
$59 due to the reduced Net Income, so the L&E side is down by $139 and both sides
balance.
• Intuition: Again, cash is down significantly mostly because of the loan repayment;
everything else makes a minor impact.
4. Wal-Mart orders $200 of Inventory but pays for it using debt. What happens on the
statements immediately after this transaction?
• Cash Flow Statement: Inventory is up by $200, which reduces cash flow by $200, but
the debt issuance boosts cash flow by $200, so there’s no net change in cash.
• Balance Sheet: The Assets side is up by $200 because Inventory is up by $200. The L&E
side is also up by $200 because Debt is up by $200, so both sides balance.
• Intuition: This is a simple cash payment for an expense not yet incurred, combined with
a debt issuance that offsets the cash outflow.
5. A year passes, and Wal-Mart sells the $200 of Inventory for $400. However, it also has to
hire additional employees for $100 to process the orders.
The company also pays 5% interest on its debt and repays 10% of the principal. What
happens on the statements over the course of THIS one year?
This question is the standard “Sell inventory for a certain amount of revenue” one, but there
are a few twists. For one, we also have to factor in $100 of additional Operating Expenses.
Also, we have to include the $10 interest expense on the debt ($200 * 5%) and the $20
principal repayment ($200 * 10%).
• Income Statement: Revenue is up by $400, but COGS is up by $200, and Operating

Expenses are up by $100 because of the extra employees. There is also $10 of additional
Interest Expense because of the 5% interest rate on $200 of debt, so Pre-Tax Income is
up by $90. Net Income is up by $54 at a 40% tax rate.
• Cash Flow Statement: Net Income is up by $54, and the company’s COGS decreasing by
$200 frees up an additional $200 of cash flow. So far, cash flow is up by $254. The
company also has to repay 10% * $200, or $20, of the debt principal, and so cash at the
bottom is up by $234.
• Balance Sheet: Cash is up by $234, but Inventory is down by $200, so the Assets side is
up by $34. On the L&E side, Debt is down by $20, and Retained Earnings is up by $54
because of the increased Net Income, so the L&E side is up by $34 and both sides
balance.
• Intuition: The company has bought goods, turned them into finished products, and
profited from the sale. The company’s cash goes up by less than expected because of
the debt principal repayment and interest.
6. A company issues $100 in Preferred Stock to buy $100 in long-term investments in real
estate. The Preferred Stock has a coupon rate of 8%, and the long-term investments yield
10%. What happens on the statements IMMEDIATELY after the initial purchase?
• Cash Flow Statement: The purchase of the long-term investments counts as an

Investing activity and reduces cash flow by $100, but the Preferred Stock issuance
boosts cash flow by $100, so there’s no net change in cash.
• Balance Sheet: Long-Term Investments is up by $100, so the Assets side is up by $100,

and Preferred Stock on the other side is up by $100, so the L&E side is up by $100 and
both sides balance.
• Intuition: This is a simple cash purchase of investments funded by a Preferred Stock

issuance, and neither event affects the company’s taxes.
7. What happens on the statements after a year?

Although you subtract Preferred Dividends from Net Income to calculate Net Income to
Common, the Preferred Dividends are NOT tax-deductible.
• Income Statement: The company will record 10% * $100, or $10, in Interest Income on
the real estate, so its Pre-Tax Income increases by $10. At a 40% tax rate, its Net Income
goes up by $6. The $8 in Preferred Dividends are NOT tax-deductible, so they simply
reduce Net Income by $8, and so “Net Income to Common” is down by $2.
• Cash Flow Statement: Net Income to Common is down by $2. There are no other
changes on the CFS in this period because there’s no principal repayment of the
Preferred Stock, and nothing changes with the long-term investments. So, cash at the
bottom is down by $2.
• Balance Sheet: Cash is down by $2, so the Assets side is down by $2. On the other side,
Retained Earnings is down by $2, so the L&E side is also down by $2 and both sides
balance.
• Intuition: The point of this question is that taxes play a huge role in making investment
decisions. Since the investment income on the real estate is taxable, whereas Preferred
Dividends are not, the company LOSES money! The after-tax yield of the real estate is
only 10% * (1 – 40%), or 6%, which is less than the 8% Preferred coupon.
8. Another year passes, and prices in this real estate market double. The company decides to
sell its $100 in long-term investments for $200 at the end of Year 2. It then uses the proceeds
to repay its Preferred Stock.
What happens on the statements from the BEGINNING of Year 2, including the
interest/investment income and Preferred Dividends, to the END of Year 2?
• Income Statement: Everything from the previous part still applies, so there’s still $10 in
Investment Income. But now the company also records a Gain of $100 on the sale of the
real estate, so Pre-Tax Income is up by $110, and Net Income is up by $66 at a 40% tax
rate. There’s still $8 in Preferred Dividends, so Net Income to Common is up by $58.
• Cash Flow Statement: Net Income to Common is up by $58, but the $100 Gain is non-
cash, so you subtract it out and then show the Total Proceeds Received, $200, within
Cash Flow from Investing. You also have to show the $100 repayment of the Preferred
Stock, so cash at the bottom is up by $58.
• Balance Sheet: Cash is up by $58, but the company’s long-term investments have
decreased by $100, so the Assets side is down by $42. The L&E side is also down by $42
because Retained Earnings increased by $58 due to the increased Net Income to
Common, but Preferred Stock decreased by $100, so both sides balance.
• Intuition: This question demonstrates why this investment strategy might make sense:
capital gains.
9. Your company wants to boost its EPS artificially, so it decides to issue debt and use the
proceeds to buy back shares.
Initially, the company has 100 shares outstanding at $100 per share, and a Net Income of
$2,000.
What happens IMMEDIATELY after your company raises $1,000 in long-term debt and uses it
to repurchase $1,000 in stock?
First, note a few important facts about this scenario. Repurchasing $1,000 in stock at a share
price of $100 per share means that the company will repurchase 10 shares. So, its share count
drops from 100 to 90.
Its EPS before this move was $2,000 / 100, or $20.00. Now, for the first part of this transaction:
• Cash Flow Statement: The $1,000 Debt issuance boosts cash flow by $1,000, but the
$1,000 stock repurchase reduces it by $1,000, so there’s no net change in cash.
• Balance Sheet: There are no changes on the Asset side. On the L&E side, Debt is up by
$1,000, but Treasury Stock within Equity is down by $1,000, so there’s no net change,
and the BS remains in balance.
• Intuition: These are simple cash inflows and outflows that cancel each other out and
make no impact on the company’s taxes.
10. What happens after a year passes if the company pays 5% interest on the debt and repays
10% of the principal? Also, explain the EPS impact.
This question is a twist on the standard 3-statement accounting questions because you also
have to calculate EPS and the change in EPS.
• Income Statement: The company records 5% * $1,000, or $50, in interest expense, and
so its Pre-Tax Income falls by $50. At a 40% tax rate, its Net Income is down by $30. The
company now has 90 shares outstanding rather than 100, and has Net Income of $1,970
instead of $2,000, so its EPS increases to $21.89 (If you can’t do that math in your head,
you could just say that EPS “increases”).
• Cash Flow Statement: Net Income is down by $30, and the company also has to repay
10% of the principal, or $100, so cash is down by $130 at the bottom.
• Balance Sheet: Cash is down by $130, so the Assets side is down by $130. On the L&E
side, Retained Earnings is down by $30 because of the reduced Net Income, and Debt is
down by $100 because of the principal repayment, so the L&E side is down by $130 and
both sides balance.
• Intuition: This question illustrates how companies can artificially inflate their EPS
numbers by making nonsensical moves, such as borrowing at high costs to fund share
repurchases. Never trust EPS!
11. Your company decides to acquire another company for $1,000, using cash. The other
company has $400 in Cash, $600 in PP&E, $250 in Accounts Payable, and $750 in Equity.
What happens to your company’s BALANCE SHEET immediately after this acquisition takes
place?
Assume that your company has identified $50 in Other Intangible Assets with a useful life of
10 years.
You combine the other company’s Assets and Liabilities with your company’s, and you write
down the seller’s Equity.
So, in this case, the combined company’s Cash balance goes down by $600 since you spent
$1,000 in cash on the acquisition but got $400 in cash from the other company.
PP&E is up by $600, so the Assets side hasn’t changed so far.
But the other side is up by $250 because of the Accounts Payable, so we have a problem.
Since we paid $1,000 for Equity of $750, we must create a total of $250 in Goodwill and Other
Intangible Assets.
The question stated that there’s $50 in Other Intangible Assets, so we create those on the
Assets side, and then we create $200 of Goodwill.
As a result, the L&E side is up by $250, the Assets side is up by $250, and the Balance Sheet
balances.
12. A year passes. What happens on the financial statements, factoring in ONLY the newly
created items from the acquisition and the cash used to acquire the company?
Assume a 2% foregone interest rate on cash, and assume that the company loses interest on
the FULL $1,000 of cash used in the acquisition, not just the net cash reduction of $600.
• Income Statement: The company’s interest income decreases by 2% * $1,000, or $20.

There will also be Amortization of Intangibles of $50 / 10, or $5. So, Pre-Tax Income falls
by $25, and Net Income declines by $15 at a 40% tax rate.
Amortization as a non-cash charge, so the company’s cash is down by $10.
• Balance Sheet: Cash is down by $10, and Other Intangible Assets are down by $5, so the
Assets side is down by $15. On the other side, Retained Earnings is down by $15
because of the reduced Net Income, so the L&E side is down by $15 and both sides
balance.
• Intuition: The main point here is that all acquisitions “cost” the company something –
cash from lost interest or additional interest expense, or additional shares that dilute
the existing shareholders.
13. At the end of the year, your company decides that it grossly overpaid for the other
company, so it decides to write down the Goodwill and PP&E acquired from the other
company by 50%.
What happens on the statements, factoring in ONLY these write-downs and nothing else?
Remember that there’s $200 in Goodwill and $600 in PP&E from the other company:
• Income Statement: You record a total write-down of $400 ($200 / 2 + $600 / 2), so Pre-
Tax Income is down by $400. Net Income is down by $240 at a 40% tax rate.
• Cash Flow Statement: Net Income is down by $240, but both these write-downs are
non-cash, so you add back a total of $400. Cash is up by $160 at the bottom.
• Balance Sheet: Cash is up by $160, but Goodwill is down by $100, and PP&E is down by
$300, so the Assets side is down by $240. The L&E side is also down by $240 because
Retained Earnings falls by $240 due to the reduced Net Income, and so both sides
balance.
• Intuition: This is a good example of how overpaying for an acquisition can hurt a
company’s Net Income and EPS, but boost its cash balance. This is why it’s so important
to look at BOTH Net Income and Cash Generated when analyzing a company.
Return to Top.
Working Capital, Free Cash Flow, and Other Metrics and Ratios
Questions on these topics are NOT terribly common in investment banking interviews; you
focus on this analysis more in public markets roles such as equity research.
Still, questions on Working Capital, Free Cash Flow, and returns-based ratios can come up, so
we wanted to cover a few examples here.
1. What is Free Cash Flow, and what does it mean if it's positive and increasing?
There are different types of Free Cash Flow, but one simple definition is Cash Flow from
Operations minus CapEx. FCF represents a company’s “discretionary cash flow” – how much it
has left for other areas after spending what’s required for its business.
You define it this way because pretty much everything in a company’s “Cash Flow from
Operations” section is required for its business – earning Net Income, paying for Inventory,
collecting Receivables, etc.
But almost every line item within the Investing and Financing Activities sections is “optional,”
except for Capital Expenditures.
If FCF is positive and increasing, it means the company can spend its excess cash in different
ways: it could hire more employees, spend more on Working Capital or CapEx, invest in other
assets, repay debt, acquire other companies, or return money to shareholders with dividends
or stock repurchases.
2. What does FCF mean if it's negative or decreasing?

You have to find out why FCF is negative or decreasing first. For example, if FCF is negative
because CapEx in one year was unusually high, but it’s expected to return to much lower levels
in the future, it doesn’t mean much.
On the other hand, if FCF is negative because the company’s sales and operating income have
been declining each year, that indicates that the business may be troubled.
If FCF decreases to the point where the company runs low on cash, it will have to raise equity or
debt funding ASAP and restructure its operations to continue running.
3. What is Working Capital?

The official definition of Working Capital is “Current Assets minus Current Liabilities,” but the
more useful definition is:
Working Capital = Current Assets (Excluding Cash and Investments) – Current Liabilities
(Excluding Debt)
This one is sometimes called Operating Working Capital instead.
You may also include Long-Term Assets and Liabilities that are related to the company’s
business operations (Long-Term Deferred Revenue is a prime example).
Working Capital by itself tells you whether a company needs more in operational assets or
operational liabilities to run its business, and how big the difference is. But the Change in
Working Capital (see below) matters far more for valuation purposes.
4. Why do you exclude cash, investments, and debt when calculating the Change in Working
Capital on the Cash Flow Statement?
Although many of these items are Current Assets or Current Liabilities, you exclude them
because:
• Cash – The bottom of the CFS already calculates the Net Change in Cash and the ending
Cash balance; if you did it within the Working Capital area, you’d be double-counting it.
• Investments – Investment sales and purchases are considered investing activities, not
operational ones, even if they’re short-term.
• Debt – Debt issuances and repayments are considered financing activities, not
operational ones, even if the debt is short-term.
5. A company's Working Capital has increased from $50 to $200. You calculate the Change in
Working Capital by taking the new number, $200, and subtracting the old number, $50, and
so the change is positive $150.
But on the Cash Flow Statement, the company records the Change in Working Capital as
negative $150. Is the company wrong?
No, the company is correct. On the Cash Flow Statement, the Change in Working Capital is
equal to Old Working Capital – New Working Capital.
Pretend that Working Capital consists of ONLY Inventory. If Inventory increases from $50 to
$200, that is clearly a use of cash that will reduce the company’s cash flow, and as such, it
should be shown as a negative $150 on the CFS.
You can also think of this one by breaking down the individual components:
Change in WC = Old WC – New WC
Change in WC = (Old Current Assets – Old Current Liabilities) – (New Current Assets – New
Current Liabilities)
Change in WC = (Old Current Assets – New Current Assets) + (New Current Liabilities – Old
Current Liabilities)
So, like everything else on the Cash Flow Statement, if assets increase, they reduce the cash
flow. And if liabilities increase, the opposite happens.
When a company’s Working Capital INCREASES, the company USES cash to do that; when
Working Capital DECREASES, it FREES UP cash.
6. What does the Change in Working Capital mean?

The Change in Working Capital tells you if the company needs to spend in ADVANCE of its
growth, or if it generates more money as a RESULT of its growth.
For example, the Change in Working Capital is almost always negative for retailers because they
must spend money on Inventory before being able to sell products.
But the Change in Working Capital is often positive for subscription-based companies that
collect cash from customers far in advance because Deferred Revenue increases whenever they
do that.
The Change in Working Capital directly increases or decreases Free Cash Flow, which, in turn,
directly affects the company’s valuation.
7. You’re comparing two companies. Company A’s Change in Working Capital as a % of the
Change in Revenue is 10%, but Company B’s is negative 5%.
Which industries are these companies MOST likely to be in?
Company A is most likely in an industry without much upfront investment in Inventory
required, such as professional services, software, or media and telecom. In these industries,
customers often pay upfront for longer-term contracts and services, which makes the Change in
Working Capital even more positive.
Company B is likely in an industry with more upfront investment in Inventory required, such as
retail or manufacturing. The company might also be in an industry where it has little power to
“delay” payments to suppliers, meaning that its operational assets will tend to grow by more
than its operational liabilities over time.
8. What does it mean if a company's FCF is growing, but its Change in Working Capital is more
and more negative each year?
It means that the company’s Net Income or non-cash charges are growing by more than its
Change in WC is declining, or that its CapEx is becoming less negative (i.e., shrinking) by more
than the Change in WC is declining.
If a company’s Net Income is growing for legitimate reasons, this is a positive sign. But if higher
non-cash charges or artificially reduced CapEx are boosting FCF, both of those are negatives.
9. In its filings, a company states that its EBITDA is a reasonable “proxy” for its Cash Flow
from Operations. The company’s EBITDA has been positive and growing at 20% for the past
three years.
However, the company recently filed for bankruptcy. How could this have happened?
Although EBITDA is sometimes a “proxy” for CFO, it is not even close to a perfect representation
of a company’s cash flow. Think about all the items that EBITDA excludes:
• CapEx – Very high CapEx spending might have pushed the company to bankruptcy.
• Interest Expense and Debt Repayment Obligations – Same as above. In particular, if the
company’s debt all matures on one date and the company cannot refinance or does not
have enough cash to pay for it, bankruptcy could result.
• Working Capital – If the company is spending a massive amount on Inventory, to the

point where it’s losing heaps of money as it grows, that could have also played a role.
• One-Time Charges – If EBITDA excludes large “one-time” expenses such as legal and
restructuring charges, those could also affect the company’s cash balance.
10. A company’s ROA has INCREASED from 10% to 15% over the past five years, but its ROE
has DECREASED from 13% to 10%. What could have caused this?
Both ROA and ROE have Net Income in the numerator, so it must be something in the
denominators.
Let’s say that Net Income increased over this period. If that’s the case, then the company’s
Total Assets must have increased by a lower percentage than Net Income.
But if ROE decreased, then the company’s Equity must have increased by a greater percentage
than Net Income.
So, one potential cause might be that the company has been continually issuing equity to fund
its cash flow-negative business.
When the company issues stock, it boosts its Equity on the Balance Sheet and prevents its cash
balance from declining. But the company’s Total Assets also don’t change by much because the
cash raised does not make it to the Balance Sheet – it offsets losses elsewhere in the business.
11. A company seems to be boosting its ROE artificially by using leverage to fuel its growth.
Which metrics or ratios could you look at to confirm or deny your suspicion?
Leverage can artificially boost ROE because Debt does not affect the denominator of ROE
(Equity), and it makes only a small impact on the numerator (Net Income).
To see if this is happening, you could check the company’s Debt/EBITDA and EBITDA/Interest
ratios – if they indicate that the company has been using more debt over time, it’s a good bet
that Debt has been at least partially responsible for the increased ROE.
12. A company's Current Ratio is 2x. Why is that NOT necessarily a positive sign?
The Current Ratio is defined as Current Assets / Current Liabilities, so it depends on what’s in
both those groups.
For example, if the company’s Current Assets consist primarily of Receivables and almost no
Cash, and its Current Liabilities consist of Accrued Expenses, a Current Ratio of 2x is negative
because it means the company is waiting on a lot of cash from customers and also has to pay a
lot of cash in the future for expenses already incurred.
On the other hand, if the company’s Current Assets are primarily Cash and its Current Liabilities
are primarily Deferred Revenue, this 2x ratio would be more positive because it means that the
company has collected significant cash in advance of product/service delivery.
13. Would you expect a retailer or an airline company to have a higher Asset Turnover Ratio?
Generally, the retailer will have a higher Asset Turnover Ratio (Revenue / Average Assets)
because it is less dependent on assets to generate its sales. Yes, retailers need to sell Inventory
to make money, but they don’t necessarily need to own their own stores, factories, etc. – many
retailers actually lease their stores.
An airline will tend to have a lower Asset Turnover Ratio because it is completely dependent on
PP&E to generate revenue: without its planes, it can’t do much of anything.
And yes, some airlines also lease their planes rather than owning them outright, but almost
every major airline owns a decent percentage of its planes.
14. What does it say about a company if its Days Receivables Outstanding is ~5, but its Days
Payable Outstanding is ~60?
It tells you that the company has quite a lot of market power to collect cash from customers
quickly, but to delay paying its suppliers for a long time. Examples might be companies like
Amazon and Wal-Mart that completely dominate their respective markets and that can coerce
suppliers into agreeing to their terms.
Return to Top.

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IB Interview Guide, Module 4: Accounting and the 3 Financial

Overview & Key Rules of Thumb

We earn an extra $50,000 in revenue as a result of these installment plans.

Since revenue is based on the delivery of the

And then our Net Income jumps up from

But since we didn’t collect this $50K in

The “cash that we’re waiting on” is called

But since we’ve made this cash payment

Vendor Negotiation, Accounts Payable, and Accrued Expenses

If this marketing firm’s services cost $15,000,

Our “Sales & Marketing” expense increases

But remember: we haven’t paid in cash yet.

So, our Net Income to Cash Adjustments look

“Cash” is like cash in your bank account. Accounts

On the other side, Accounts Payable tracks what

Monthly Subscriptions and Deferred Revenue

So once again, our Net Change in Cash is

It has changed yet again because of this

Selling Physical Products and Inventory

Because of all these items, there is

Since we’re buying Inventory, we

You need this “Balance Sheet” because

If we didn’t have any of those items, we

Positive adjustments on the Cash Flow

Negative adjustment means the opposite:

Key Rule #2: How Longer-Term Items Affect Cash Flow

Here’s a summary of the most important ones:

Capital Expenditures and Depreciation

Investments and Investing Activities

Here’s what it looks like:

Raising Debt and Equity

Dividends and Share Repurchases

Speaking of “special favors,” equity investors often want to be paid back.

This deferral happens for many reasons:

Gains, Losses, Impairments, and Write-Downs

Let’s say that a company sells a short-term investment for $85.

Stock-based compensation shows up as an expense on the Income Statement and therefore

However, there’s a critical difference between stock-based compensation and depreciation:

Goodwill & Other Intangible Assets

So, the owner has contributed some money to start this

Currently, there’s very little to this business: sales are

Even though the Balance Sheet says the company is worth

Instead, he demands $250K for the business.

Since we really want this other business, we decide to

Here’s what happens if we pay $250K in cash and combine

Do you see the problem?

Here’s what happens when we use those to “plug the gap”:

An “Intangible Asset” is any asset that’s not a

We look at the company and value its Intangible

That’s fine, but we still have a gap of $100K:

On the financial statements, Goodwill doesn’t do much of anything.

Other Intangible Assets, however, amortize over time.

Key Rule #3: The Income Statement

• Always Appears: Revenue, COGS, Operating Expenses, Depreciation, Amortization,

• Never Appears: Capital Expenditures, Purchasing or Selling Investments or PP&E (Plants,

Here are the key Balance Sheet rules:

Definitions of Key Assets:

• Cash: Just like cash in your bank account.

• Accumulated Other Comprehensive Income (AOCI): This is a section for “miscellaneous