1. Investment Banking Bootcamp: Week 3 – Accounting
Fall 2018
[whoever is presenting]

2. Agenda I. Accounting Basics II. The Financial Statements
III. 3 Statement Changes
IV. Free Cash Flow, Net Working Capital, Metrics and Ratios
V. Practice Questions
REMINDER: This session is not supposed to make you an expert in accounting, but a very quick crash course of the ideas you should know for investment banking interviews.
Please take notes and ask questions throughout. Decks will be available on our website.

3. I. Accounting Basics

4. Discount Rate – Cash Flow Growth Rate
What is Accounting?
Accounting is the recording of financial transactions pertaining to a business
It is the backbone of valuation
The 3 financial statements are used in conjunction to tell us how much CASH FLOW a company is generating
Company Value
Cash Flow
Discount Rate – Cash Flow Growth Rate

5. II. The Financial Statements

6. Income Statement
The income statement financial statement that reports a company's financial performance over a specific accounting period
Key Line Items
Revenue, Expenses, COGS, Gross Profit, Operating Expenses, Interest Expense, Pre-tax Income, Taxes, Net Income
Gives an overview of how the company has performed over a certain period of time

7. Balance Sheet
The balance sheet reports a company's assets, liabilities and shareholders' equity at a specific point in time, and provides a basis for computing rates of return and evaluating its capital structure
Gives a snapshot of what a company owns and owes, as well as amount owned by shareholders
Remember:
ASSETS = LIABILITIES - EQUITY

8. Statement of Cash Flows
The statement of cash flows summarizes the amount of cash that enters and leaves a company
Measures how well a company manages its cash position, meaning how well the company generates cash to pay its debt obligations and fund its operating expenses
Linked to income statement and balance sheet

9. How the 3 Statements Link
Income Statement
Cash Flow Statement
Balance Sheet
Revenue
Cash from operating activities
Assets
(Expenses)
Net income + non-cash charges - ΔWC
Net Income
Cash from investing activities
Liabilities
Cash from financing activities
Stockholder’s Equity
Net Change in Cash
Retained Earnings

10. III. 3 Statement Changes

11. 3 Statement Change Questions
One of the most commonly asked technical questions during interviews are about how a certain change will affect the 3 financial statements
“Walk me through what happens to the statements when XYZ occurs”
Step 1: Income Statement
Does the change affect the Income Statement?
Revenue » COGS » Operating Profit » Operating Expenses » Pre-tax Income » Taxes » Net Income
If tax rate not provided, assume a percentage like 20% or 40%
Example: Walk me through a $20 increase in depreciation.
A $20 increase in depreciation reduces pre-tax income by $20. Assuming a tax rate of 40%, net income is reduced by $12.

12. 3 Statement Change Questions (cont.)
Step 2: Cash Flow Statement
Does the change affect line items on the Income Statement?
Net income flows to top of the cash flow statement
Operating Activities » Investing Activities » Financing Activities
End result: Net Change in Cash
Example: Walk me through a $20 increase in depreciation.
Net income is down by $12, which flows to the top of the Operating Activities section. Since depreciation is a non-cash expense, $20 is added back, so cash is up $8. There are no changes in the Investing and Financing sections, so cash is up $8 at the bottom.

13. 3 Statement Change Questions (cont.)
Step 3: Balance Sheet
Does the change affect items on the Balance Sheet?
Assets = Liabilities + Equities
Net Income flows to Retained Earnings
Think of this as a check to see if what you said “balances”
Example: Walk me through a $20 increase in depreciation.
Assets: Cash is up by $8, PPE is down by $20 so Assets is down by $12
Liabilities & Equities: Net Income is down by $12
No other changes so the 3 statements balance

14. Key Terms Need to Know Advanced Accrual vs. Cash-based accounting
Restructuring Charges/One-time Legal Expenses
Depreciation and Amortization
Goodwill Impairment
PP&E
Asset Write-Downs
Inventory
Disaster Expenses
Accounts Payable
Changes in Accounting Policies
Accrued Expenses
Capital leases vs. Operating leases
Deferred Revenue
NOLs
Accounts Receivable
Tax Benefits from SBC
Prepaid Expenses
Cost method vs. Equity method vs. Consolidated Statements
Non-controlling Interest
Investments in Equity Interests
Trading vs. AFS. Vs. Held-to-Maturity
Working Capital
PIK interest
EBITDA
Purchase Price Allocation
Goodwill
Deferred Tax Asset/Liability
Dividends
Stock-based Compensation
Stock/Equity
LIFO and FIFO

15. IV. FCF, Net Working Capital, Metrics & Ratios

16. Free Cash Flow
Free cash flow (FCF) can be thought of what the company earns AFTER paying for items it truly needs to run the business
There are a couple of different types of FCF that are used for different purposes
Unlevered Free Cash Flow = EBIT(1-tax rate) + D&A – ΔWC – Capex
Used in DCF Analysis
Cash available to all investors
Levered Free Cash Flow = Net Income + D&A – ΔWC – Capex – Mandatory Debt Repayments
Used in LBO Analysis
Cash available to equity investors

17. Net Working Capital (NWC)
In accounting class, you’ll learn that NWC = Current Assets – Current Liabilities.
For FCF we care about only the operational changes, thus our formula for NWC = Current Assets (Excluding Cash and Investments) – Current Liabilities (Excluding Debt)
Since we are measuring the net change in cash, we need to use the CHANGE in NWC.
ΔNWC = New Net Working Capital – Old Net Working Capital
Key Rules
When a company’s NWC increases, the company USES cash
When a company’s NWC decreases, it FREES UP cash

18. Metrics & Ratios
In addition to the financial statements, there are several key metrics and ratios that help us analyze the financial performance of a company. Remember to keep things “apples to apples.”
Metrics
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
Most commonly used due to comparability with other companies
EBIT (Earnings Before Interest and Taxes)
NOPAT (Net Operating Profit After Taxes)
Ratios (usually a multiple, i.e., 8x)
Enterprise Value: EV / EBITDA
Leverage Ratio: Total Debt / EBITDA
Interest Coverage Ratio: EBITDA / Net Interest Expense
P/E Ratio: Price / Earnings Per Share or Market Cap / Net Income

19. V. Sample Questions

20. Sample Questions
Here are some questions that are commonly asked and would be good to understand for the technical portion of an interview.
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?
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.
Walk me through what happens when a $100 asset loses 40% of its value assuming a 40% tax rate.
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? Now what happens after a month of service?
How do I get from Revenue to Unlevered FCF? Levered FCF?
Leverage Ratio 15x and Interest Coverage Ratio 5x. What is my interest rate?

21. Thanks so much for coming, and see you next week!