Accounting

Operating covers cash from running the business: net income, non-cash addbacks like depreciation and stock compensation, and changes in working capital. Investing covers buying and selling long-lived assets and businesses, so capex, acquisitions and disposals. Financing covers dealings with capital providers: raising or repaying debt, issuing or buying back shares, and paying dividends. The three sections sum to the change in cash for the period.

• Operating: net income, non-cash addbacks, working capital changes
• Investing: capex, acquisitions, disposals of long-lived assets
• Financing: debt raised or repaid, shares issued or repurchased, dividends
• The three sections sum to the net change in cash
• That change ties to the movement in the balance sheet cash line

Whether you close the loop to the balance sheet cash line. Naming three buckets without the tie-out is only half the answer.

The income statement covers a period and shows performance: revenue down to net income over a quarter or a year. The balance sheet is a single moment in time and shows position: what the company owns, what it owes, and what is left for owners. One is a video of the period, the other is a photograph at the end of it.

• Income statement covers a period, balance sheet is a point in time
• Income statement shows performance, balance sheet shows position
• Balance sheet must always satisfy assets equals liabilities plus equity
• Net income for the period flows into retained earnings on the balance sheet
• That retained earnings link is how the two connect

Whether you name the retained earnings link, which is the actual connection between them.

The income statement does not move, because issuing shares is not income. On the cash flow statement $150 comes in as a financing inflow, so cash rises $150. On the balance sheet cash is up $150 and shareholders equity is up $150, split into $10 of common stock at par and $140 of additional paid in capital. That split is presentational. Total equity is what matters, and the balance sheet balances.

• No income statement impact: a share issuance is not revenue or a gain
• Financing inflow of $150, cash up $150
• Total equity up $150
• Split is $10 common stock at par and $140 additional paid in capital
• The par versus paid in capital split carries no economic meaning

Whether you know equity issuance never touches the income statement, and whether the par value split throws you off the total.

The income statement shows profitability over a period, from revenue down to net income, on an accrual basis. The balance sheet is a snapshot at a point in time where assets equal liabilities plus equity. The cash flow statement bridges the two, reconciling net income to the actual change in cash across operating, investing, and financing activities.

• Income statement: a period, accrual basis, profitability
• Balance sheet: a point in time, assets = liabilities + equity
• Cash flow statement: reconciles net income to cash
• Name the three sections of the cash flow statement
• Say why you need all three: accrual profit is not cash

Whether you understand that net income is not cash, which is the reason the third statement exists at all.

Return on equity breaks into three pieces: net margin, which is net income over revenue, asset turnover, which is revenue over assets, and the equity multiplier, which is assets over equity. Multiply them and the revenue and asset terms cancel, leaving net income over equity. At a 10% margin, 1.2 times turnover and 2 times leverage, return on equity is 24%. Two firms with the same ROE can get there very differently.

• ROE equals net margin times asset turnover times the equity multiplier
• The intermediate terms cancel back to net income over equity
• Worked: 10% times 1.2 times 2 gives 24%
• It separates profitability, asset efficiency and leverage
• A high ROE driven by leverage is a different business from one driven by margin

Whether you use the decomposition to interpret rather than recite it. The value is in saying which of the three drivers is doing the work.

Days sales outstanding is receivables over revenue times 365, how long customers take to pay. Days inventory outstanding is inventory over cost of goods sold times 365, how long stock sits. Days payable outstanding is payables over cost of goods sold times 365, how long you take to pay suppliers. The cash conversion cycle is DSO plus DIO minus DPO. At 45, 60 and 30 days, that is 75 days.

• DSO: receivables over revenue times 365
• DIO: inventory over cost of goods sold times 365
• DPO: payables over cost of goods sold times 365
• Cash conversion cycle equals DSO plus DIO minus DPO
• It measures the days of cash tied up between paying suppliers and getting paid

Whether the denominators are right. Using revenue for inventory and payables instead of cost of goods sold is the standard slip.

It is the annual report a US listed company files with the SEC, and it is the primary source for anything you model. The business section describes what the company sells and to whom. Risk factors are mostly boilerplate with a few real ones buried in them. Management's discussion, the MD&A, explains why the numbers moved. Then the three statements, and behind them the footnotes, which is where the detail lives. I go to the MD&A first for the story, then the footnotes for the truth.

• Item 1, business: what the company sells, to whom, and how it competes
• Item 1A, risk factors: mostly boilerplate, with a few disclosures that matter
• Item 7, MD&A: management's own explanation of the period
• Item 8: the financial statements and the footnotes behind them
• Read the MD&A for the narrative, the footnotes for the detail, and compare the two

Whether you know the document well enough to navigate it. Naming the MD&A and the footnotes, rather than the income statement, is the tell.

The idea that where there is genuine uncertainty you recognize losses early and gains late. You see it in inventory carried at the lower of cost or net realizable value, in impairments that write assets down but never back up under US GAAP, and in contingencies: a probable loss is accrued, a probable gain is not recognized until it is realized. The statements are biased downward on purpose.

• Recognize losses early, recognize gains only when realized
• Inventory carried at the lower of cost or net realizable value
• Impairments write down and cannot be reversed under US GAAP
• Contingent losses accrued when probable and estimable, gains are not
• The bias is deliberate, to protect the users of the statements

Whether you can name specific rules rather than describe a general attitude to risk.

It says you recognize an expense in the same period as the revenue it helped generate, not when the cash moves. Inventory is the clearest example: the cost of a unit sits on the balance sheet as an asset until the unit is sold, then drops into cost of goods sold in the same period the sale is recorded. Depreciation is the same idea, spread over an asset useful life.

• Expenses are recognized alongside the revenue they help generate
• Timing of the cash payment is irrelevant to recognition
• Inventory sits as an asset until sold, then becomes cost of goods sold
• Depreciation matches an asset cost to the periods that benefit from it
• It is the reason accrual profit and cash flow differ at all

Whether you can produce a concrete example unprompted. A definition on its own is unconvincing here.

Cash accounting records revenue and expenses when the cash actually moves. Accrual accounting records them when they are earned or incurred, whatever the cash does. So if you deliver a product in March and get paid in June, accrual books the revenue in March and creates a receivable. Public companies report on an accrual basis, which is precisely why the cash flow statement exists: to reconcile accrual profit back to real cash.

• Cash basis follows cash movement, accrual basis follows economic activity
• Accrual matches revenue to when it is earned and costs to when incurred
• The gap between the two shows up as receivables, payables and accruals
• Public reporting is accrual based under both US GAAP and IFRS
• The cash flow statement exists to bridge accrual profit back to cash

Whether you can say why the cash flow statement is needed at all. That link is the point of the question.

The expense has been incurred, so the income statement takes a $10 hit and net income falls by $10 times one minus the tax rate. On the cash flow statement you start from the lower net income and add back the increase in accrued liabilities, because no cash has left yet, so operating cash flow rises by the tax saving. On the balance sheet, cash is up by the tax saving, accrued liabilities are up $10, and retained earnings falls by the after-tax amount.

• The expense is recognized, so the income statement is hit
• Net income falls by $10 times one minus the tax rate
• Increase in an accrued liability is a source of cash
• Cash actually rises, by the tax shield
• Liabilities up $10, retained earnings down the after-tax amount

Whether you treat accrued expenses as a liability increase rather than a cash payment. The cash has not moved yet, which is the whole point of the account.

No income statement impact, because the revenue was already recognized when the sale was made. On the cash flow statement, an increase in receivables is a use of cash, so operating cash flow falls $10 and cash falls $10. On the balance sheet, receivables are up $10 and cash is down $10, so total assets are unchanged and it balances with no equity movement.

• No income statement effect, revenue was already booked
• Increase in a current asset is a use of cash
• Cash falls $10
• Receivables up $10, cash down $10, assets net flat
• Retained earnings untouched

Whether you resist adding revenue. The receivable IS the already-recognized revenue, not a new sale.

On the income statement, operating income falls $10 and net income falls $7.50 after tax. On the cash flow statement, you start with net income down $7.50 and add back the full $10 of non-cash depreciation, so cash increases by $2.50. On the balance sheet, cash is up $2.50 and net PP&E is down $10, so assets fall $7.50. Equity falls $7.50 through retained earnings, and it balances.

• Net income falls by $10 times one minus the tax rate, so $7.50
• Add back the full $10, not the after-tax amount
• Cash rises $2.50, which is exactly the tax shield
• Net PP&E falls $10
• Retained earnings falls $7.50, and assets equal liabilities plus equity

Whether you know depreciation is a non-cash tax shield, and whether you actually close the balance sheet out loud.

Dividends are not an expense, so the income statement is untouched. On the cash flow statement it is a $50 outflow from financing activities, so cash falls $50. On the balance sheet, cash is down $50 and retained earnings is down $50, so assets and equity both fall by $50 and it balances. Note this differs from preferred dividends, which do reduce net income available to common shareholders.

• Dividends are a distribution of profit, not an expense
• No income statement impact for common dividends
• Financing outflow of $50
• Cash down $50, retained earnings down $50
• Preferred dividends are the exception, they reduce income to common

Whether you volunteer the preferred dividend distinction. It is the follow-up almost every time.

Nothing happens on the income statement, because no expense has been incurred yet. On the cash flow statement net income is unchanged, and prepaid expenses, an asset, rise $60, which is a use of cash in working capital, so operating cash flow falls $60 and cash falls $60. On the balance sheet cash is down $60 and prepaid expenses are up $60. Assets are flat, so it balances.

• No income statement impact: the expense has not been incurred yet
• Prepaid expenses is an asset, so the increase is a use of cash
• Operating cash flow falls $60 and cash falls $60
• Balance sheet: cash down $60, prepaid up $60, total assets flat
• Over the next twelve months $5 a month moves from prepaid into rent expense

Whether you resist putting the payment on the income statement. Cash leaving and expense being recognized are separate events, and this is the cleanest test of that.

There is a $20 gain on sale, so pre-tax income rises $20, tax rises $5, and net income rises $15. On the cash flow statement, start at plus $15, subtract the $20 gain because it is not an operating item, giving minus $5 from operations, then show $100 of proceeds in investing. Cash rises $95. Assets rise $15 net, cash up $95 less equipment down $80, matching the $15 rise in equity.

• Gain equals proceeds less book value, so $20
• Net income rises $15 after $5 of tax
• Subtract the gain in operating cash flow to avoid double counting it
• The full $100 of proceeds sits in investing
• Cash up $95, property and equipment down $80, equity up $15

Whether you strip the gain out of operating cash flow. Leaving it in double counts the proceeds and is the single most common error on this question.

On a long contract you recognize revenue in proportion to progress, usually costs incurred against total estimated costs. On a $10 million contract with $8 million of expected costs, once you have spent $2 million you are 25% complete and book $2.5 million of revenue. The weakness is that total estimated cost is a management estimate. Understate it and you pull revenue forward, and the correction only lands when the contract finishes.

• Revenue recognized in line with progress, typically on a cost to cost basis
• Worked example: $2m of $8m expected costs is 25%, so $2.5m of revenue
• Total estimated cost is an estimate management itself controls
• Understating it accelerates revenue into earlier periods
• Watch contract assets or unbilled receivables growing faster than revenue

Whether you can compute the percentage and then say where the judgment sits. Naming the cost estimate as the soft spot is what earns the credit.

EBITDA is an income statement figure: operating profit with depreciation and amortization added back. Operating cash flow comes from the cash flow statement and starts from net income, so it is after interest and after cash taxes, and it includes the change in working capital. So the two differ by interest paid, taxes paid, working capital movements and other non-cash items like stock compensation. A business can show strong EBITDA and weak operating cash flow if receivables and inventory are absorbing the profit.

• EBITDA is operating profit before D&A, from the income statement
• Operating cash flow is after interest and cash taxes, from the cash flow statement
• Operating cash flow includes working capital movements, EBITDA ignores them
• Neither one deducts capex, which is why free cash flow exists
• A wide gap between the two usually means working capital is absorbing the profit

Whether you can list what sits between the two. Candidates know they differ and cannot say by what.

The first suspect is working capital. If receivables and inventory grow faster than revenue, every extra sale consumes cash before it produces any, so a fast growing company can be genuinely profitable and still starve. After that I would look at heavy capex, which barely touches the income statement in year one, debt principal repayments, which sit below the operating line entirely, and profit that was never cash to begin with, like a gain on an asset sale.

• Working capital build is the most common answer
• Growth itself consumes cash when the cash conversion cycle is long
• Capex hits cash immediately but the income statement only via depreciation
• Principal repayments are a financing outflow, invisible in net income
• Non-cash gains inflate net income without producing any cash

Whether working capital is your first instinct. It is the single most useful reflex in accounting interviews.

First I would ask which leg moved. Longer DSO means customers are paying slower, or terms were loosened to buy growth, or revenue is being pulled forward. Longer DIO means stock is building against slowing demand. A shorter DPO usually means suppliers have tightened terms, which is a credit warning. Then I would size it: at a million a day of revenue, thirty extra days has absorbed roughly thirty million of cash.

• Decompose first: work out which of the three legs actually moved
• Rising DSO: slower collection, looser terms, or pulled forward revenue
• Rising DIO: inventory building ahead of demand, or obsolescence
• Falling DPO: suppliers tightening, which is a distress signal
• Quantify the cash absorbed, roughly extra days times daily revenue

Whether you decompose and then quantify. Saying it is bad without doing either is the weak answer, and it is the common one.

Operating working capital is receivables plus inventory less payables, the money tied up in running the business day to day. An increase is a use of cash: you have either extended more credit to customers, built more inventory, or paid suppliers faster. A growing company usually consumes working capital, which is why revenue growth and cash generation can move in opposite directions.

• Receivables plus inventory less payables
• Exclude cash and short-term debt, they are financing not operating
• An increase is a use of cash
• Growth typically consumes working capital
• Negative working capital is a genuine advantage, customers fund the business

Whether you know the direction. An increase in a working capital asset consumes cash, which candidates reverse constantly.

It is an operating expense on the income statement, reducing pre-tax income and net income. On the cash flow statement it is added back in full, because no cash left the business. On the balance sheet, cash is unchanged, additional paid-in capital rises by the expense, and retained earnings falls by the after-tax amount, so equity nets out to roughly the tax effect and the sheet balances.

• Operating expense, reduces net income
• Added back as non-cash on the cash flow statement
• Cash is unchanged
• APIC increases, retained earnings decreases
• It is a real economic cost even though it is non-cash, because it dilutes owners

Whether you push back on the idea that adding it back makes it free. Dilution is the cost, and it lands on shareholders.

Income statement: $5 of depreciation and $5 of interest cut pre-tax income by $10, so net income falls $8. Cash flow: start at negative $8, add back the $5 of depreciation, so operating cash flow is negative $3. The $100 truck purchase is investing and the $50 of debt plus $50 of equity is financing, and those net to zero in year one. Balance sheet: cash down $3, net PP&E up $95, debt up $50, equity down $8 from the loss plus $50 raised.

• Depreciation is $100 over 20 years, so $5
• Interest is 10% of $50, so $5
• Pre-tax income falls $10, net income falls $8 at a 20% rate
• Only depreciation gets added back, interest is a real cash cost
• Say the balance check out loud: assets up $92 against debt up $50 and equity up $42

Whether you separate the financing decision from the asset purchase, and whether you remember interest is cash while depreciation is not.