ACCOUNTING PREP:

Always start with

1. How are the three financial statements connected?

 IS ↔ CFS: The cash flow statement is connected to the income statement through net
income, as net income is the starting line on the cash flow statement.
 CFS ↔ BS: Next, the cash flow statement is linked to the balance sheet because it tracks the
changes in the balance sheet’s working capital (current assets and liabilities). The impact
from capital expenditures (PP&E), debt or equity issuances, and share buybacks (treasury
stock) are also reflected on the balance sheet. In addition, the ending cash balance from the
bottom of the cash flow statement will flow to the balance sheet as the cash balance for the
current period.
 IS ↔ BS: The income statement is connected to the balance sheet through retained
earnings. Net income minus dividends issued during the period will be added to the prior
period's retained earnings balance to calculate the current period’s retained earnings.
Interest expense on the income statement is also calculated off the beginning and ending
debt balances on the balance sheet, and PP&E on the balance sheet is reduced by
depreciation, which is an expense on the income statement

2. If depreciation is a non-cash expense, how does it affect net income?

 While depreciation is treated as non-cash and an add-back on the cash flow statement, the
expense is tax-deductible and reduces the tax burden. The actual cash outflow for the initial
purchase of PP&E has already occurred, so the annual depreciation is the non-cash
allocation of the initial outlay at purchase.

3. How would a $10 increase in depreciation flow through the financial statements?

The depreciation expense will be embedded within either the cost of goods sold or the operating
expenses line item on the income statement.

 IS: When depreciation increases by $10, EBIT would decrease by $10. Assuming a 30% tax
rate, net income will decline by $7.
 CFS: At the top of the cash flow statement, net income has decreased by $7, but the $10
depreciation will be added back since it's a non-cash expense. The net impact on the ending
cash balance will be a positive $3 increase.
 BS: PP&E will decrease by $10 from the depreciation, while cash will be up by $3 on the
assets side. On the L&E side, the $7 reduction in net income flows through retained
earnings. The balance sheet remains in balance as both sides went down by $7.
4. If the share price of a company increases by 10%, what is the balance sheet impact?

There would no change on the balance sheet as shareholders’ equity reflects the book value of
equity. Equity value, also known as “market capitalization," represents the value of a company’s
equity based on supply and demand in the open market. In contrast, the book value of equity is
the initial historical amount shown on the balance sheet for accounting purposes. This
represents the company's residual value belonging to equity shareholders once all of its assets
are liquidated and liabilities are paid off.
Book Value of Equity = Total Assets – Total Liabilities
The equity value recorded on the books will be significantly understated from the market value
in most cases.
For example, the book value of Apple’s common stock is only ~$51 billion as of its latest 10-K
filing for FY 2020, whereas its market value of equity is over $2 trillion as of this guide' publishing
date.

5. Do accounts receivable get captured on the income statement?

There is no accounts receivable line item on the income statement, but it gets captured, if only
partially, indirectly in revenue. Under accrual accounting, revenue is recognized during the
period it was earned, whether or not cash was received. The two other financial statements
would be more useful to understand what is happening to the accounts receivable balance since
the cash flow statement will reconcile revenue to cash revenue, while the absolute balance of
accounts receivable can be observed on the balance sheet

6. Why are increases in accounts receivable a cash reduction on the cash flow statement?
Since the cash flow statement begins with net income and net income captures all of a
company’s revenue (not just cash revenue), an increase in accounts receivable means that more
customers paid on credit during the period.
Thus, a downward adjustment (working capital) must be made to net income to arrive at the
ending cash balance. Although the revenue has been earned under accrual accounting
standards, the customers have yet to make the due cash payments and this amount will be
sitting as receivables on the balance sheet.

7. Why are increases in accounts payable shown as an increase in cash flow?

An increase in accounts payable would mean the company has been delaying payments to its
suppliers or vendors, and the cash is currently still in the company's possession. The due
payments will eventually be made, but the cash belongs to the company for the time being and
is not restricted from being used. Thus, an increase in accounts payable is reflected as an inflow
of cash on the cash flow statement
8. Which section of the cash flow statement captures interest expense?
The cash flow statement doesn't directly capture interest expense. However, interest expense is
recognized on the income statement and then gets indirectly captured in the cash from
operations section since net income is the starting line item on the cash flow statement

9. What happens to the three financial statements if a company initiates a dividend?

 IS: When a company initiates a dividend, there'll be no changes to the income
statement. However, a line below net income will state the dividend per share ("DPS") to
show the amount paid.
 CFS: On the cash flow statement, the cash from financing section will decrease by the
dividend payout amount and lower the ending cash balance at the bottom.
 BS: The cash balance will decline by the dividend amount on the balance sheet, and the
offsetting entry will be a decrease in retained earnings since dividends come directly out
of retained earnings.

10. How should an increase in inventory get handled on the cash flow statement?
An increase in inventory reflects a use of cash and should thus be reflected as an outflow on the
cash from operations section of the cash flow statement. The inventory balance increasing from
the prior period implies the amount of inventory purchased exceeded the amount expensed on
the income statement

11. How does the relationship between depreciation and capex shift as companies mature?
The more a company has spent on capex in recent years, the more depreciation the company
incurs in the near-term future. Therefore, when looking at high-growth companies spending
heavily on growth capex, their ratio between capex and annual depreciation will far exceed 1.

For mature businesses experiencing stagnating or declining growth, this ratio converges near 1,
as the only capex is related to routine maintenance capex (e.g., replace equipment, refurbish
store layouts)

12. What is working capital?

The working capital metric measures a company's liquidity and ability to pay off its current
obligations using its current assets. In general, the more current assets a company has relative to
its current liabilities, the lower its liquidity risk.
Current liabilities represent payments that a company needs to make within the year (e.g.,
accounts payable, accrued expenses), whereas current assets are resources that can be turned
into cash within the year (e.g., accounts receivable, inventory)
Working Capital = Current Assets − Current Liabilities

13. Why are cash and debt excluded in the calculation of net working capital (NWC)?
In practice, cash and other short-term investments (e.g., treasury bills, marketable securities,
commercial paper) and any interest-bearing debt (e.g., loans, revolver, bonds) are excluded
when calculating working capital because they're non-operational and don't directly generate
revenue.
 Net Working Capital (NWC) = Operating Current Assets − Operating Current Liabilities

Cash & cash equivalents are closer to investing activities since the company can earn a slight
return (~0.25% to 1.5%) through interest income, whereas debt is classified as financing. Neither
is operations-related, and both are thereby excluded in the calculation of NWC
14. Is negative working capital a bad signal about a company's health?
Further context would be required, as negative working capital can be positive or negative. For
instance, negative working capital can result from being efficient at collecting revenue, quick
inventory turnover, and delaying payments to suppliers while efficiently investing excess cash
into high-yield investments.
However, the opposite could be true, and negative working capital could signify impending
liquidity issues. Imagine a company that has mismanaged its cash and faces a high accounts
payable balance coming due soon, with a low inventory balance that desperately needs
replenishing and low levels of AR. This company would need to find external financing as early as
possible to stay afloat.

Another Answer: (or try to combine)

Not necessarily. It depends on the type of company and the specific situation – here are a few
different things it could mean:
1. Some companies with subscriptions or longer-term contracts often have negative Working
Capital because of high Deferred Revenue balances.
2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s often have
negative Working Capital because customers pay upfront – so they can use the cash
generated to pay off their Accounts Payable rather than keeping a large cash balance on-
hand. This can be a sign of business efficiency.
3. In other cases, negative Working Capital could point to financial trouble or possible
bankruptcy (for example, when customers don’t pay quickly and upfront and the company is
carrying a high debt balance).

15. What is the cash conversion cycle? (check appendices)

The cash conversion cycle ("CCC") measures the number of days it takes a company to convert its
inventory into cash from sales. Therefore, a lower cash conversion cycle is preferred as it implies
the company generates and collects cash in a shorter duration. As a general rule, companies with
lower CCCs operate efficiently, hold more negotiating power over suppliers, and have quicker
sales collection cycles
Cash Conversion Cycle = DIO + DSO –DPO

16. How would you forecast capex and D&A when creating a financial model?
 In the simplest approach, D&A can be projected as either a percentage of revenue or
capital expenditures, while capex is forecasted as a percentage of revenue.
 Re-investments such as capex directly correlate with revenue growth, thus historical
trends, management guidance, and industry norms should be closely followed.
  Alternatively, a depreciation waterfall schedule can be put together, which would require
more data from the company to track the PP&E currently in-use and the remaining
useful life of each.
 In addition, management plans for future capex spending and the approximate useful
life assumptions for each purchase will be necessary. As a result, depreciation from old
and new capex will be separately shown. For projecting amortization, useful life
assumptions would also be required, which can often be found in a separate footnote in
a company's financial reports

17. How would you forecast PP&E and intangible assets?

 When forecasting PP&E, the end of period balance will be calculated using the roll-
forward schedule shown below.
 Note, capex will input as a negative, meaning the PP&E balance should increase.
 Other factors that could affect the end-of-period PP&E balance are asset sales and write-
downs.
 PP&E Roll-Forward:
EOP PP&E = BOP PP&E + Capex − Depreciation

 To forecast intangible assets, management guidance becomes necessary as unlike capex,

there's usually no clear historical pattern that can be followed as these purchases tend
to be inconsistent.
 In most cases, it's best to rely on management if available, but in the absence of
guidance, it's recommended to assume no purchases.
 Intangible Assets Roll-Forward
EOP Intangibles = BOP Intangibles + Intangibles Purchases – Amortization

18. Is it bad if a company has negative retained earnings?

Not necessarily. Retained earnings can turn negative if the company has generated more
accounting losses than profits. For example, this is often the case for startups and early-stage
companies investing heavily to support future growth (e.g., high capex, sales & marketing
expenses, R&D spend).
Another component of retained earnings is the payout of dividends and share repurchases,
contributing to lower or even negative retained earnings. In these scenarios, the negative
retained earnings mean the company has returned more capital to shareholders than taken in

19. What does return on assets (ROA) and return on equity (ROE) each measure?
20. What is the relationship between return on assets (ROA) and return on equity (ROE)?
The relationship between ROA and ROE is tied to the use of leverage. In the absence of debt in
the capital structure, the two metrics would be equal. But if the company were to add debt to its
capital structure, its ROE would rise above its ROA due to increased cash, as total assets would
rise while equity decreases.

21. What is the return on invested capital (ROIC) metric used to measure?
The return on invested capital ("ROIC") metric is used to assess how efficient a management
team is at capital allocation. A company that generates an ROIC over its cost of capital (WACC)
suggests the management team has been allocating capital efficiently (i.e., investing in profitable
projects or investments) and if sustained over the long-run, this indicates a competitive
advantage. ROIC represents one of the most fundamental assessments of a company: "How
much in returns is the company earning for each dollar invested?"

NOPAT: Net operating profit after tax

22. How would raising capital through share issuances affect earnings per share (EPS)?
The impact on EPS is that the share count increases, which decreases EPS. But there can be an
impact on net income, assuming the share issuances generate cash because there would be
higher interest income, which increases net income and EPS. However, most companies' returns
on excess cash are low, so this doesn't offset the negative dilutive impact on EPS from the
increased share count. Alternatively, share issuances might affect EPS in an acquisition where
stock is the form of consideration. The amount of net income the acquired company generates
will be added to the acquirer’s existing net income, which could have a net positive (accretive) or
negative (dilutive) impact on EPS

23. What is the difference between a write-down and a write-off?

 Write-Downs: In a write-down, an adjustment is made to an asset such as inventory or
PP&E that has become impaired. The asset's fair market value (FMV) has fallen below its
book value; hence, its classification as an impaired asset. Based on the write-down
amount deemed appropriate, the value of the asset is decreased to reflect its true value
on the balance sheet. Examples of asset write-downs would include damages caused by
minor fires, accidents, or sudden value deterioration from lower demand.
 Write-Offs: Unlike a write-down in which the asset retains some value, a write-off
reduces an asset's value to zero, meaning the asset has been determined to hold no
current or future value (and should therefore be removed from the balance sheet).
Examples include uncollectible AR, "bad debt," and stolen inventory

24. How would a $100 inventory write-down impact the three financial statements?
 IS: The $100 write-down charge will be reflected in the cost of goods line item. The expense
would decrease EBIT by $100, and net income would decline by $70, assuming a 30% tax rate.
 CFS: The starting line item, net income, will be down $70, but the $100 writedown is an add-
back since there's no actual cash outflow from the write-down. The net impact to the ending
cash will be a $30 increase.
 BS: On the asset side, cash is up $30 due to inventory being written down $100. This will be
offset by the decrease of $70 in net income that flows through retained earnings on the equity
section. Both sides of the balance sheet will be down by $70 and remain in balance

25. Walk me through a $100 write-down of debt – as in OWED debt, a liability – on a company’s
balance sheet and how it affects the 3 statements.
This is counter-intuitive.
 When a liability is written down you record it as a gain on the Income Statement (with
an asset write-down, it’s a loss) – so Pre-Tax Income goes up by $100 due to this write-
down. Assuming a 40% tax rate, Net Income is up by $60.
 On the Cash Flow Statement, Net Income is up by $60, but we need to subtract that debt
write-down – so Cash Flow from Operations is down by $40, and Net Change in Cash is
down by $40.
 On the Balance Sheet, Cash is down by $40 so Assets are down by $40. On the other
side, Debt is down by $100 but Shareholders’ Equity is up by $60 because the Net
Income was up by $60 – so Liabilities & Shareholders’ Equity is down by $40 and it
balances.

26. How does buying a building impact the three financial statements?
 IS: Initially, there'll be no impact on the income statement since the purchase of the building is
capitalized.
 CFS: The PP&E outflow is reflected in the cash from investing section and reduces the cash
balance.
 BS: The cash balance will go down by the purchase price of the building, with the offsetting entry
to the cash reduction being the increase in PP&E

Throughout the purchased building's useful life, depreciation is recognized on the income
statement, which reduces net income each year, net of the tax expense saved (since
depreciation is tax-deductible).

27. How does selling a building with a book value of $6 million for $10 million impact the three
financial statements?
 IS: If I sell a building for $10 million with a book value of $6 million, a $4 million gain from the
sale would be recognized on the income statement, which will increase my net income by $4
million.
 CFS: Since the $4 million gain is non-cash, it'll be subtracted from net income in the cash from
operations section. In the investing section, the full cash proceeds of $10 million are captured.
 BS: The $6 million book value of the building is removed from assets while cash increases by $10
million, for a net increase of $4 million to assets. On the L&E side, retained earnings will increase
by $4 million from the net income increase, so the balance sheet remains balanced.
However, the gain on sale will result in higher taxes, which will be recognized on the income statement.
This lowers retained earnings by $1 million and be offset by a $1 million credit to cash on the asset side.

28. If a company issues $100 million in debt and uses $50 million to purchase new PP&E, walk me
through how the three statements are impacted in the initial year of the purchase and at the
end of year 1. Assume a 5% annual interest rate on the debt, no principal paydown, straight-
line depreciation with a useful life of five years and no residual value, and a 40% tax rate.
Initial Purchase Year (Year 0)
 IS: There'll be no changes as neither capex nor issuing debt impact the income
statement.
 CFS: The $50 million outflow of capex will be reflected in the cash from investing section
of the cash flow statement, while the $100 million inflow from the debt issuance will be
reflected in the cash from financing section. The ending cash balance will be up by $50
million.
 BS: On the assets side, cash will be up by $50 million and PP&E will increase $50 million
from the PP&E purchase, making the assets side increase by $100 million in total. On the
L&E side, debt will be up $100 million, which will offset the increase in assets and the
balance sheet remains in balance
End of First Year (Year 1)
 IS: Since the capex amount was $50 million with a useful life assumption of five years
(straight-line to a residual value of zero), the annual depreciation will be $10 million.
Next, the interest expense will be equal to the $100 million in debt raised multiplied by
the 5% annual interest rate, which comes out to $5 million in annual interest expense.
The pre-tax income will be down by $15 million and assuming a 40% tax rate, net income
will be down $9 million.
 CFS: Net income will be down $9 million, but the non-cash depreciation of $10 million
will be added back, making the ending cash balance increase by $1 million.
 BS: On the assets side, cash is up by $1 million and PP&E will decrease by $10 million
because of the depreciation. Since equity is also down $9 million due to net income,
both sides will remain in balance.

29. What happens when Accrued Compensation goes up by $10?

For this question, confirm that the accrued compensation is now being recognized as an expense
(as opposed to just changing non-accrued to accrued compensation).
 Assuming that’s the case, Operating Expenses on the Income Statement go up by $10,
Pre-Tax Income falls by $10, and Net Income falls by $6 (assuming a 40% tax rate).
 On the Cash Flow Statement, Net Income is down by $6, and Accrued Compensation will
increase Cash Flow by $10, so overall Cash Flow from Operations is up by $4 and the Net
Change in Cash at the bottom is up by $4.
 On the Balance Sheet, Cash is up by $4 as a result, so Assets are up by $4. On the
Liabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by $10
and Retained Earnings are down by $6 due to the Net Income, so both sides balance.

30. If a company has incurred $100 in PIK interest, how would the three-statements be impacted?
  IS: On the income statement, interest expense will increase by $100, which
causes EBIT to decrease by $100. Assuming a 30% tax rate, net income will
decrease by $70.
 CFS: On the cash flow statement, net income will be down by $70, but the $100
non-cash PIK interest will be added back. The ending cash balance will increase
by $30.
 BS: On the assets side of the balance sheet, cash will be up $30. Then on the
liabilities side, the debt balance will be up $100 (since the PIK accrues to the
debt’s ending balance), and net income is down $70. Therefore, both sides are
up by $30, and the balance sheet balances.

31. What happens when Inventory goes up by $10, assuming you pay for it with cash?
 No changes to the Income Statement.
 On the Cash Flow Statement, Inventory is an asset so that decreases your Cash Flow
from Operations – it goes down by $10, as does the Net Change in Cash at the bottom.
 On the Balance Sheet under Assets, Inventory is up by $10 but Cash is down by $10, so
the changes cancel out and Assets still equals Liabilities & Shareholders’ Equity.

32. Why is the Income Statement not affected by changes in Inventory?

 This is a common interview mistake – incorrectly stating that Working Capital changes
show up on the Income Statement.
 In the case of Inventory, the expense is only recorded when the goods associated with it
are sold – so if it’s just sitting in a warehouse, it does not count as a Cost of Good Sold or
Operating Expense until the company manufactures it into a product and sells it.

33. Could you ever end up with negative shareholders’ equity? What does it mean?
Yes. It is common to see this in 2 scenarios:
1. Leveraged Buyouts with dividend recapitalizations – it means that the owner of the
company has taken out a large portion of its equity (usually in the form of cash), which
can sometimes turn the number negative.
2. It can also happen if the company has been losing money consistently and therefore has
a declining Retained Earnings balance, which is a portion of Shareholders’ Equity.
 It doesn’t “mean” anything in particular, but it can be a cause for concern and possibly
demonstrate that the company is struggling (in the second scenario).
 Note: Shareholders’ equity never turns negative immediately after an LBO – it would
only happen following a dividend recap or continued net losses.

34. Accounts Receivable increases by $10 walk me through the 3 statements?

Accounts Receivable: when a company sells on credit to customers. Revenue has been recorded
on the income statement, but cash has not received yet
 Income Statement: Revenue goes up by $10 which increases Net income by $10(1-Tax Rate)
Assuming a 40% tax rate NI increases by $6.

Cash Flow Statement: $6 increase in Net income flows onto here and accounts receivable
increases by $10 under Cash flow from operations which is a cash outflow of $10. Your net
change in cash is a $4 decrease in cash.

Balance Sheet: Cash is down by $4 and Accounts receivable increases by $10 which is a net
increase of $6 on the assets side. The $6 increase from Net Income on the income statement
flows into retained earnings on the balance sheet to make everything balance

35. Prepaid Expenses decrease by $10. Walk me through the 3 financial statements
Prepaid Expenses: When a company pays for services in advance of using them (insurance,
property rental). The cash has been paid, but the expenses haven't been recorded on the income
statement

Income Statement: Operating expenses increase by $10 which means that Net income decreases
by $10 (1-Tax Rate) assuming a 40% tax rate your net income decreases by $6

Cash Flow Statement: Net Income Decreases by $6 and prepaid expenses go down by $10 which
is a cash inflow so your net change in cash is an increase of $4

Balance Sheet: Cash is up by $4 and prepaid expenses are down by $10 which is a net decrease
of $6 on the assets side. Net Income flows into retained earnings of a $6 decrease which
balances everything.

36. Accrued expenses increase by $10. Walk me through the 3 financial statements?
Accrued Expenses: Also money owed to vendors, suppliers, employees but the invoice has not
yet been received, Expense is usually recurring in nature, and has already been recorded on the
income statement. The balance owed is estimated or "accrued" until the invoice is received and
it becomes accounts payable

Income Statement: Operating expenses increase by $10 which decreases net income by $10 (1-
Tax Rate) which results in a decrease of $6

Cash Flow Statement: Net Income decreases by $6 and Accrued expenses increase by $10 which
is an increase of cash of $10 and net change in cash is up $4.

Balance Sheet: Cash is up by $4 on the assets side and Accrued expenses are up by $10 on the
liabilities side and Net Income from the Income Statement flows into retained earnings and
decreases by $6 to make everything balance
37. Deferred Revenue increases by $10, Walk me through the 3 financial statements?
Deferred Revenue: Cash collected from customers, product/service yet to be delivered
 Income Statement: No changes to the Income Statement

Cash Flow Statement: Deferred Revenue is up by $10 which is a cash inflow of $10 and your
change in cash is an increase of $10

Balance Sheet: Cash is up by $10 on the assets side and deferred Revenue is up by $10 on the
liabilities side to make everything balance
38. Capex Increases by $10. Walk me through the 3 financial statements?
Capex: Money spent by a business on acquiring or maintaining fixed assets, such as PP&E

Income Statement: No changes to the Income Statement

Cash Flow Statement: Capex increases by $10 which is a cash outflow of $10 and your change in
cash is a decrease of $10

Balance Sheet: Cash is down by $10 and PP&E is up by $10 on the assets side to balance
everything out

39. Walk me through a $100 “bailout” of a company and how it affects the 3 statements.

First, confirm what type of “bailout” this is – Debt? Equity? A combination? The most common
scenario here is an equity investment from the government, so here’s what happens:

 No changes to the Income Statement.

 On the Cash Flow Statement, Cash Flow from Financing goes up by $100 to reflect the
government’s investment, so the Net Change in Cash is up by $100.
 On the Balance Sheet, Cash is up by $100 so Assets are up by $100; on the other side,
Shareholders’ Equity would go up by $100 to make it balance.

40. A company has had positive EBITDA for the past 10 years, but it recently went bankrupt. How
could this happen?

Several possibilities:

1. The company is spending too much on Capital Expenditures – these are not reflected at
all in EBITDA, but it could still be cash-flow negative.
2. The company has high interest expense and is no longer able to afford its debt.
3. The company’s debt all matures on one date and it is unable to refinance it due to a
“credit crunch” – and it runs out of cash completely when paying back the debt.
4. It has significant one-time charges (from litigation, for example) and those are high
enough to bankrupt the company.

Remember, EBITDA excludes investment in (and depreciation of) long-term assets, interest and one-time
charges – and all of these could end up bankrupting the company.

41. Normally Goodwill remains constant on the Balance Sheet – why would it be impaired and
what does Goodwill Impairment mean?
  Usually this happens when a company has been acquired and the acquirer re-assesses
its intangible assets (such as customers, brand, and intellectual property) and finds that
they are worth significantly less than they originally thought.
 It often happens in acquisitions where the buyer “overpaid” for the seller and can result
in a large net loss on the Income Statement (see: eBay/Skype).
 It can also happen when a company discontinues part of its operations and must impair
the associated goodwill.

42. Under what circumstances would Goodwill increase?

Technically Goodwill can increase if the company re-assesses its value and finds that it is worth
more, but that is rare. What usually happens is 1 of 2 scenarios:

1. The company gets acquired or bought out and Goodwill changes as a result, since it’s an
accounting “plug” for the purchase price in an acquisition.
2. The company acquires another company and pays more than what its assets are worth –
this is then reflected in the Goodwill number.

43. How does increasing your payables today affect your cash position in the following years

Mainly the way I think about it is that an increase in my payables means that I am being able to delay
my payments making my cash flow healthier. So, an increase in payables implies a cash inflow.

Appendices:
Case Studies:

Case Study 1:

1. Let’s say Apple is buying $100 worth of new iPod factories with debt. How are all 3
statements affected at the start of “Year 1,” before anything else happens?

 At the start of “Year 1,” before anything else has happened, there would be no changes
on Apple’s Income Statement (yet).
 On the Cash Flow Statement, the additional investment in factories would show up
under Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is down by
$100 so far). And the additional $100 worth of debt raised would show up as an addition
to Cash Flow, canceling out the investment activity. So the cash number stays the same.
 On the Balance Sheet, there is now an additional $100 worth of factories in the Plants,
Property & Equipment line, so PP&E is up by $100 and Assets is therefore up by $100.
On the other side, debt is up by $100 as well and so both sides balance.

2. Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so no principal
is paid off, and assume an interest rate of 10%. Also assume the factories depreciate at a
rate of 10% per year. What happens?

 After a year has passed, Apple must pay interest expense and must record the
depreciation.
 Operating Income would decrease by $10 due to the 10% depreciation charge each
year, and the $10 in additional Interest Expense would decrease the Pre-Tax Income
by $20 altogether ($10 from the depreciation and $10 from Interest Expense).
 Assuming a tax rate of 40%, Net Income would fall by $12.
  On the Cash Flow Statement, Net Income at the top is down by $12. Depreciation is
a non-cash expense, so you add it back and the end result is that Cash Flow from
Operations is down by $2.
 That’s the only change on the Cash Flow Statement, so overall Cash is down by $2.
 On the Balance Sheet, under Assets, Cash is down by $2 and PP&E is down by $10
due to the depreciation, so overall Assets are down by $12.
 On the other side, since Net Income was down by $12, Shareholders’ Equity is also
down by $12 and both sides balance.
 Remember, the debt number under Liabilities does not change since we’ve assumed
none of the debt is actually paid back.

3. At the start of Year 3, the factories all break down and the value of the equipment is
written down to $0. The loan must also be paid back now. Walk me through the 3
statements.
 After 2 years, the value of the factories is now $80 if we go with the 10%
depreciation per year assumption. It is this $80 that we will write down in the 3
statements.
 First, on the Income Statement, the $80 write-down shows up in the Pre-Tax Income
line. With a 40% tax rate, Net Income declines by $48.
 On the Cash Flow Statement, Net Income is down by $48 but the write-down is a
noncash expense, so we add it back – and therefore Cash Flow from Operations
increases by $32.
 There are no changes under Cash Flow from Investing, but under Cash Flow from
Financing there is a $100 charge for the loan payback – so Cash Flow from Investing
falls by $100.
 Overall, the Net Change in Cash falls by $68.
 On the Balance Sheet, Cash is now down by $68 and PP&E is down by $80, so Assets
have decreased by $148 altogether.
 On the other side, Debt is down $100 since it was paid off, and since Net Income was
down by $48, Shareholders’ Equity is down by $48 as well. Altogether, Liabilities &
Shareholders’ Equity are down by $148 and both sides balance.

4. Now let’s look at a different scenario and assume Apple is ordering $10 of additional iPod
inventory, using cash on hand. They order the inventory, but they have not manufactured
or sold anything yet – what happens to the 3 statements?
 No changes to the Income Statement.
 Cash Flow Statement – Inventory is up by $10, so Cash Flow from Operations
decreases by $10. There are no further changes, so overall Cash is down by $10.
 On the Balance Sheet, Inventory is up by $10 and Cash is down by $10 so the Assets
number stays the same and the Balance Sheet remains in balance.
5. Now let’s say they sell the iPods for revenue of $20, at a cost of $10. Walk me through the
3 statements under this scenario.
 Income Statement: Revenue is up by $20 and COGS is up by $10, so Gross Profit is up
by $10 and Operating Income is up by $10 as well. Assuming a 40% tax rate, Net
Income is up by $6.
 Cash Flow Statement: Net Income at the top is up by $6 and Inventory has
decreased by $10 (since we just manufactured the inventory into real iPods), which
is a net addition to cash flow – so Cash Flow from Operations is up by $16 overall.
These are the only changes on the Cash Flow Statement, so Net Change in Cash is up
by $16.
 On the Balance Sheet, Cash is up by $16 and Inventory is down by $10, so Assets is
up by $6 overall. On the other side, Net Income was up by $6 so Shareholders’
Equity is up by $6 and both sides balance.