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Investment Banking 400 Questions Questions and answers
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Investment Banking 400 Questions Questions and answers
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Investment Banking 400 QuestionsQuestions and answers
Walk me through the 3 financial statements. - correct answer-"The 3 major financial
statements are the Income Statement, Balance Sheet and Cash
Flow Statement.
The Income Statement gives the company's revenue and expenses, and goes down to
Net Income, the final line on the statement.
The Balance Sheet shows the company's Assets - its resources - such as Cash, Inventory
and PP&E, as well as its Liabilities - such as Debt and Accounts Payable - and
Shareholders' Equity. Assets must equal Liabilities plus Shareholders' Equity.
The Cash Flow Statement begins with Net Income, adjusts for non-cash expenses and
working capital changes, and then lists cash flow from investing and financing activities;
at the end, you see the company's net change in cash."
Can you give examples of major line items on each of the financial statements? - correct
answer-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; Plants, Property & Equipment
(PP&E); 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.
How do the 3 statements link together? - correct answer-"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."
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? - correct
answer-You would use the Cash Flow Statement because it gives a true picture of how much
cash the company is actually generating, independent of all the non-cash expenses you
might have. And that's the #1 thing you care about when analyzing the overall financial
health of any business - its cash flow.
Let's say I could only look at 2 statements to assess a company's prospects - which 2
would I use and why? - correct answer-You would pick the Income Statement and Balance
Sheet, because you can create the
,Cash Flow Statement from both of those (assuming, of course that you have "before"
and "after" versions of the Balance Sheet that correspond to the same period the Income
Statement is tracking).
Walk me through how Depreciation going up by $10 would affect the statements. - correct
answer-Income Statement: Operating Income would decline by $10 and assuming a 40% tax
rate,
Net Income would go down by $6.
Cash Flow Statement: The Net Income at the top goes down by $6, but the $10
Depreciation is a non-cash expense that gets added back, so overall Cash Flow from
Operations goes up by $4. There are no changes elsewhere, so the overall Net Change in
Cash goes up by $4.
Balance Sheet: Plants, Property & Equipment goes down by $10 on the Assets side
because of the Depreciation, and Cash is up by $4 from the changes on the Cash Flow
Statement.
Overall, Assets is down by $6. Since Net Income fell by $6 as well, Shareholders' Equity
on the Liabilities & Shareholders' Equity side is down by $6 and both sides of the
Balance Sheet balance.
Note: With this type of question I always recommend going in the order:
1. Income Statement
2. Cash Flow Statement
3. Balance Sheet
This is so you can check yourself at the end and make sure the Balance Sheet balances.
Remember that an Asset going up decreases your Cash Flow, whereas a Liability going
up increases your Cash Flow.
If Depreciation is a non-cash expense, why does it affect the cash balance? - correct
answer-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.
Where does Depreciation usually show up on the Income Statement? - correct answer-It
could be in a separate line item, or it could be embedded in Cost of Goods Sold or
Operating Expenses - every company does it differently. Note that the end result for
accounting questions is the same: Depreciation always reduces Pre-Tax Income.
What happens when Accrued Compensation goes up by $10? - correct answer-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.
,What happens when Inventory goes up by $10, assuming you pay for it with cash? - correct
answer-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.
Why is the Income Statement not affected by changes in Inventory? - correct answer-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.
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? - correct
answer-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.
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? - correct answer-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.
, 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. - correct answer-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.
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? - correct
answer-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.
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. - correct answer-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.
Could you ever end up with negative shareholders' equity? What does it mean? - correct
answer-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
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