Accounting - Basic

Question 1

Walk me through the 3 financial statements

Answer 1

The 3 major financial statements are the Income Statement, Balance Sheet, and Cash Flow Statement

The I.S. gives the firms revenue and expenses, and goes down to Net Income, the final line on the statement

The B.S. shows the firms assets, such as cash, inventory, and PP&E, as well as liabilities - such as debt and accounts payable - and shareholders equity. Assets must equal Liabilities plus shareholders equity

The C.F.S. begins with Net Income, adjusts for non-cash expenses and working capital changes, and the lists cash flow from investing and financing activities; at the end, you see the company’s net change in cash

Question 2

Can you give examples of major line items on each of the financial statements?

Answer 2

Income Statement: Revenue, Cost of Goods Sold, SG&A (Selling, General, Administrative Expenses), Operating Income, Pretax Income, Net Income

Balance Sheet: Cash, Accounts Receivable, Inventory, PP&E (Plants, Property & Equipment), Accounts Payable, Accrued Expenses, Debt, Shareholders Equity

Cash Flow Statement: Net Income, Depreciation & Amortization, Stock-Based Compensation, Changes in Operating Assets & Liabilities, Cash Flow from Operations, Capital Expenditures, Cash Flow from Investing, Sale/Purchase of Securities, Dividends Issued, Cash Flow from Financing

Question 3

How do the 3 statements link together?

Answer 3

To tie the statements together, Net Income from the Income Statement flows into Shareholders Equity on the Balance Sheet, and into the top line of the Cash Flow Statement

Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing and financing activities affect Balance Sheet items such as PP&E, debt, and Shareholders Equity. The Cash and Shareholders’ Equity items on the Balance Sheet act as “plugs”, with Cash flowing in from the final line on the Cash Flow Statement

Question 4

If I were stranded on a desert island, only had 1 statement and I wanted to review the overall health of a company - which statement would I use and why?

Answer 4

You would use the Cash Flow Statement, as it gives a true picture of how much cash the firm is generating, independent of all non-cash expenses you may have.

And that’s the prime thing you care about when analysing the health on any business - its cash flows

Question 5

Lets say I could only look at 2 statements to assess a company’s prospects - which 2 would I use and why?

Answer 5

You would pick the Income Statement and Balance Sheet, as you can create the Cash Flow Statement from both, assuming, of course, that you have the “before” and “after” versions of the Balance Sheet that correspond to the same period the Income Statement is tracking

Question 6

Walk me through how depreciation going up by £10 would affect the statements

Answer 6

Income: Operating Income would decline by $10, and if we assume a 20% tax rate, Net Income would go down by £8

Cash Flow: The Net Income at the top decreases by £8, but the £10 depreciation is a non-cash expense that gets added back, so overall Cash Flow from Operations goes up by £2. There are no changes elsewhere, so the overall Net Change in Cash goes up by £2

Balance: PP&E goes down by £10 on the assets side because of depreciation, and cash is up by £4 from the changes on the Cash Flow Statement

(Note to self: remember that and asset going up decreases your Cash Flow, whereas a Liability going up increases your cash flow)

Question 7

If Depreciation is a non-cash expense, why does it affect the cash balance?

Answer 7

Although Depreciation is a non-cash expense, it is tax deductible. Since taxes are a cash expense, Depreciation affects cash by reducing the amount of taxes you pay.