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For this question, confirm that the accrued compensation is now being recognized as anexpense (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 Compensationwill increase Cash Flow by 10, so overall Cash Flow from Operations is up by 4 and theNet 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 theLiabilities & Equity side, Accrued Compensation is a liability so Liabilities are up by 10and Retained Earnings are down by 6 due to the Net Income, so both sides balance.10. 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 fromOperations – 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, sothe changes cancel out and Assets still equals Liabilities & Shareholders’ Equity.11. Why is the Income Statement not affected by changes in Inventory?This is a common interview mistake – incorrectly stating that Working Capital changesshow up on the Income Statement.In the case of Inventory, the expense is only recorded when the goods associated with itare sold – so if it’s just sitting in a warehouse, it does not count as a Cost of Good Sold orOperating Expense until the company manufactures it into a product and sells it.12. Let’s say Apple is buying 100 worth of new iPad factories with debt. How are all3 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 changeson Apple’s Income Statement mergersandinquisitions.com9

On the Cash Flow Statement, the additional investment in factories would show upunder Cash Flow from Investing as a net reduction in Cash Flow (so Cash Flow is downby 100 so far). And the additional 100 worth of debt raised would show up as anaddition to Cash Flow, canceling out the investment activity. So the cash number staysthe 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.13. Now let’s go out 1 year, to the start of Year 2. Assume the debt is high-yield so noprincipal is paid off, and assume an interest rate of 10%. Also assume the factoriesdepreciate at a rate of 10% per year. What happens?After a year has passed, Apple must pay interest expense and must record thedepreciation.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 20altogether ( 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 anon-cash expense, so you add it back and the end result is that Cash Flow fromOperations 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 dueto the depreciation, so overall Assets are down by 12.On the other side, since Net Income was down by 12, Shareholders’ Equity is alsodown by 12 and both sides balance.Remember, the debt number under Liabilities does not change since we’ve assumednone of the debt is actually paid ergersandinquisitions.com10

14. At the start of Year 3, the factories all break down and the value of the equipmentis written down to 0. The loan must also be paid back now. Walk me through the 3statements.After 2 years, the value of the factories is now 80 if we go with the 10% depreciation peryear 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 fromFinancing there is a 100 charge for the loan payback – so Cash Flow from Investing fallsby 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 Assetshave decreased by 148 altogether.On the other side, Debt is down 100 since it was paid off, and since Net Income wasdown by 48, Shareholders’ Equity is down by 48 as well. Altogether, Liabilities &Shareholders’ Equity are down by 148 and both sides balance.15. Now let’s look at a different scenario and assume Apple is ordering 10 ofadditional iPad inventory, using cash on hand. They order the inventory, but theyhave 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 decreasesby 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 Assetsnumber stays the same and the Balance Sheet remains in w.mergersandinquisitions.com11

16. Now let’s say they sell the iPads for revenue of 20, at a cost of 10. Walk methrough 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 isup 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 iPads), which is a net addition tocash 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 upby 6 overall.On the other side, Net Income was up by 6 so Shareholders’ Equity is up by 6 andboth sides balance.17. 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 ofthe company has taken out a large portion of its equity (usually in the form ofcash), which can sometimes turn the number negative.2. It can also happen if the company has been losing money consistently andtherefore has a declining Retained Earnings balance, which is a portion ofShareholders’ Equity.It doesn’t “mean” anything in particular, but it can be a cause for concern and possiblydemonstrate that the company is struggling (in the second scenario).Note: Shareholders’ equity never turns negative immediately after an LBO – it would onlyhappen following a dividend recap or continued net losses.18. What is Working Capital? How is it ergersandinquisitions.com12

Working Capital Current Assets – Current Liabilities.If it’s positive, it means a company can pay off its short-term liabilities with its shortterm assets. It is often presented as a financial metric and its magnitude and sign(negative or positive) tells you whether or not the company is “sound.”Bankers look at Operating Working Capital more commonly in models, and that isdefined as (Current Assets – Cash & Cash Equivalents) – (Current Liabilities – Debt).The point of Operating Working Capital is to exclude items that relate to a company’sfinancing activities – cash and debt – from the calculation.19. What does negative Working Capital mean? Is that a bad sign?Not necessarily. It depends on the type of company and the specific situation – here area few different things it could mean:1. Some companies with subscriptions or longer-term contracts often have negativeWorking Capital because of high Deferred Revenue balances.2. Retail and restaurant companies like Amazon, Wal-Mart, and McDonald’s oftenhave negative Working Capital because customers pay upfront – so they can usethe cash generated to pay off their Accounts Payable rather than keeping a largecash balance on-hand. This can be a sign of business efficiency.3. In other cases, negative Working Capital could point to financial trouble orpossible bankruptcy (for example, when customers don’t pay quickly and upfrontand the company is carrying a high debt balance).20. Recently, banks have been writing down their assets and taking huge quarterlylosses. Walk me through what happens on the 3 statements when there’s a writedown of 100.First, on the Income Statement, the 100 write-down shows up in the Pre-Tax Incomeline. With a 40% tax rate, Net Income declines by 60.On the Cash Flow Statement, Net Income is down by 60 but the write-down is a noncash expense, so we add it back – and therefore Cash Flow from Operations increases by 40.Overall, the Net Change in Cash rises by gersandinquisitions.com13

On the Balance Sheet, Cash is now up by 40 and an asset is down by 100 (it’s not clearwhich asset since the question never stated the specific asset to write-down). Overall, theAssets side is down by 60.On the other side, since Net Income was down by 60, Shareholders’ Equity is alsodown by 60 – and both sides balance.21. Walk me through a 100 “bailout” of a company and how it affects the 3statements.First, confirm what type of “bailout” this is – Debt? Equity? A combination? The mostcommon scenario here is an equity investment from the government, so here’s whathappens:No changes to the Income Statement. On the Cash Flow Statement, Cash Flow fromFinancing goes up by 100 to reflect the government’s investment, so the Net Change inCash 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.22. Walk me through a 100 write-down of debt – as in OWED debt, a liability – on acompany’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 theIncome 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 debtwrite-down – so Cash Flow from Operations is down by 40, and Net Change in Cash isdown 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 wasup by 60 – so Liabilities & Shareholders’ Equity is down by 40 and it balances.If this seems strange to you, you’re not alone – see this Forbes article for more on whywriting down debt actually benefits companies ttp://www.mergersandinquisitions.com14

ting-markets-equities-fasb.html23. When would a company collect cash from a customer and not record it as revenue?Three examples come to mind:1. Web-based subscription software.2. Cell phone carriers that sell annual contracts.3. Magazine publishers that sell subscriptions.Companies that agree to services in the future often collect cash upfront to ensure stablerevenue – this makes investors happy as well since they can better predict a company’sperformance.Per the rules of accounting, you only record revenue when you actually perform theservices – so the company would not record everything as revenue right away.24. If cash collected is not recorded as revenue, what happens to it?Usually it goes into the Deferred Revenue balance on the Balance Sheet under Liabilities.Over time, as the services are performed, the Deferred Revenue balance becomes realrevenue on the Income Statement and the Deferred Revenue balance decreases.25. What’s the difference between accounts receivable and deferred revenue?Accounts receivable has not yet been collected in cash from customers, whereas deferredrevenue has been. Accounts receivable represents how much revenue the company iswaiting on, whereas deferred revenue represents how much it has already collected incash but is waiting to record as revenue.26. How long does it usually take for a company to collect its accounts receivablebalance?Generally the accounts receivable days are in the 30-60 day range, though it’s higher forcompanies selling high-end items and it might be lower for smaller, lower transactionvalue www.mergersandinquisitions.com15

27. What’s the difference between cash-based and accrual accounting?Cash-based accounting recognizes revenue and expenses when cash is actually receivedor paid out; accrual accounting recognizes revenue when collection is reasonably certain(i.e. after a customer has ordered the product) and recognizes expenses when they areincurred rather than when they are paid out in cash.Most large companies use accrual accounting because paying with credit cards and linesof credit is so prevalent these days; very small businesses may use cash-basedaccounting to simplify their financial statements.28. Let’s say a customer pays for a TV with a credit card. What would this look likeunder cash-based vs. accrual accounting?In cash-based accounting, the revenue would not show up until the company chargesthe customer’s credit card, receives authorization, and deposits the funds in its bankaccount – at which point it would show up as both Revenue on the Income Statementand Cash on the Balance Sheet.In accrual accounting, it would show up as Revenue right away but instead of appearingin Cash on the Balance Sheet, it would go into Accounts Receivable at first. Then, oncethe cash is actually deposited in the company’s bank account, it would “turn into” Cash.29. How do you decide when to capitalize rather than expense a purchase?If the asset has a useful life of over 1 year, it is capitalized (put on the Balance Sheetrather than shown as an expense on the Income Statement). Then it is depreciated(tangible assets) or amortized (intangible assets) over a certain number of years.Purchases like factories, equipment and land all last longer than a year and thereforeshow up on the Balance Sheet. Employee salaries and the cost of manufacturingproducts (COGS) only cover a short period of operations and therefore show up on theIncome Statement as normal expenses instead.30. Why do companies report both GAAP and non-GAAP (or “Pro Forma”) earnings?These days, many companies have “non-cash” charges such as Amortization ofIntangibles, Stock-Based Compensation, and Deferred Revenue Write-down in theirIncome Statements. As a result, some argue that Income Statements under GAAP ersandinquisitions.com16

longer reflect how profitable most companies truly are. Non-GAAP earnings are almostalways higher because these expenses are excluded.31. A company has had positive EBITDA for the past 10 years, but it recently wentbankrupt. How could this happen?Several possibilities:1. The company is spending too much on Capital Expenditures – these are notreflected 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 toa “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 arehigh 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.32. Normally Goodwill remains constant on the Balance Sheet – why would it beimpaired and what does Goodwill Impairment mean?Usually this happens when a company has been acquired and the acquirer re-assesses itsintangible assets (such as customers, brand, and intellectual property) and finds thatthey are worth significantly less than they originally thought.It often happens in acquisitions where the buyer “overpaid” for the seller and can resultin 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 impairthe associated goodwill.33. Under what circumstances would Goodwill increase?Technically Goodwill can increase if the company re-assesses its value and finds that it isworth 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 //www.mergersandinquisitions.com17

2. The company acquires another company and pays more than what its assets areworth – this is then reflected in the Goodwill number.34. What’s the difference between LIFO and FIFO? Can you walk me through anexample of how they differ?First, note that this question does not apply to you if you’re outside the US as IFRS doesnot permit the use of LIFO. But you may want to read this anyway because it’s good toknow in case you ever work with US-based companies.LIFO stands for “Last-In, First-Out” and FIFO stands for “First-In, First-Out” – they are 2different ways of recording the value of inventory and the Cost of Goods Sold (COGS).With LIFO, you use the value of the most recent inventory additions for COGS, butwith FIFO you use the value of the oldest inventory additions for COGS.Here’s an example: let’s say your starting inventory balance is 100 (10 units valued at 10 each). You add 10 units each quarter for 12 each in Q1, 15 each in Q2, 17 each inQ3, and 20 each in

LBO Model Questions & Answers – Advanced . 85 Brain Teaser Questions & Answers . 92 Introduction. This guide has one purpose: to help you answer the most important “fit” and technical . you’re serious about finance – but what if you didn’t? What if you’re mak