Investment Banking Bootcamp: Week 3 – Accounting

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

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. 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 Cash Flow Company Value 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 Revenue (Expenses) Net Income Cash Flow Statement Cash from operating activities Net income + non-cash charges - ΔWC Cash from investing activities Cash from financing activities Net Change in Cash Balance Sheet Assets Net Change in Cash Liabilities Stockholder’s Equity 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 Accrual vs. Cash-based accounting Depreciation and Amortization PP&E Inventory Accounts Payable Accrued Expenses Deferred Revenue Accounts Receivable Prepaid Expenses Non-controlling Interest Investments in Equity Interests Working Capital EBITDA Goodwill Dividends Stock-based Compensation Stock/Equity LIFO and FIFO Advanced Restructuring Charges/One-time Legal Expenses Goodwill Impairment Asset Write-Downs Disaster Expenses Changes in Accounting Policies Capital leases vs. Operating leases NOLs Tax Benefits from SBC Cost method vs. Equity method vs. Consolidated Statements Trading vs. AFS. Vs. Held-to-Maturity PIK interest Purchase Price Allocation Deferred Tax Asset/Liability

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!