There have been a lot of "moral support" threads lately (here, here, here and here if you missed them the first time), so I thought I'd post on skills development (how you can actually "get better").
I'm sure people have their favorites, but these three technical questions are the most common I've seen across banks:
1. Walk me through a DCF
2. My M&A questions (level 1 and 2)
3. Three Statement Capex Question
Since I've gone over the first two in other posts (DCF and M&A), I thought I'd give some advice on another popular question.
Question Three: Three Statement Capex
Assume a company purchases a piece of equipment. Walk me through the effects on the three financial statements for:
1. When the actual purchase is made using (debt / equity) financing
2. When the machine has been used for one full year
Again, as usual, the trick is structuring your thoughts well.
My first piece of advice is flow the three statements together. Too often, I've seen eager candidates jump right into capex, then mention depreciation, then mention interest expense for debt. Because they are shouting out things as they think of them, they are almost 100% guaranteed to miss something. May I respectfully recommend the following flow:
IS --> CFS --> BS
Why? Top to bottom
1. Income Statement: Starts at Revenue, ends at Net Income
2. Cash Flow Statement: Starts at Net Income, ends at Change in Cash
3. Balance Sheet: Starts at Cash and ends at Retained Earnings
If you use this progression, you are systematically less likely to miss something.
Other Hints
- The pure act of purchasing the machine (without having used it) has no effect on income statement because you haven't used it yet. There is no change to CFO. Only CFI (for capex) and CFF (debt or equity raise).
- Pick numbers that are easy (but not too easy) and reasonable (Equipment is worth $100. Interest rate of 8%, tax rate of 30%)
- State your assumptions out loud ("straight line depreciation over 10 years with no salvage value")
- Make sure your balance sheet balances when you're done (say it out loud as you confirm your math) otherwise you're missing something
- PRACTICE
Good luck!
good stuff thanks man, will frontpage today or tomorrow
Great post! I think your last bullet point ("PRACTICE") is the most important takeaway from this. You will never get an offer from answering technicals correctly, but you surely will get dinged for messing up. Technicals exist as an easy way to weed out non-serious candidates, as well whittle down those massive resume piles. You only get good at technicals from going over them time and time again and (most importantly) understanding the concepts behind them.
Would it make more sense to go: IS --> BS --> CFS? Because net income is credited to retained earnings.
No. You're just making your life more difficult. IS>CFS>BS is the easiest way to answer these.
EDIT: I figured I'd explain why. The reason you need to go IS>CFS>BS is because you will most likely be adding back non-cash items on the CFS. If you go straight from the IS to the BS, you may forget this (the $10 depreciation question is a great example of this).
Gotcha. That makes sense.
I still don't know if I follow this. The CFS is perfunctory once a P&L and B/S are pulled together. To get operating cash flow, you need to show changes in B/S accounts (change in NWC) and therefore need the B/S before the CFS.
Let me take a crack at this.
Assumptions: - Cost of the machine is $100 - Machine is purchased with 50% cash and 50% debt - Interest on debt is 50% - Tax rate for the company is 50% - Useful life for machine is 1 year
Are any of these assumptions "too aggressive" to make in an interview? I tried to answer this before reading your hints section (I figured I would just look at that part when/if I get stuck), so I didn't see that you recommended more realistic numbers. Would my assumptions make this too "easy"?
QUESTION 1:
Income Statement: The machine was just bought, so there is no change. There is no "Depreciation and Amortization (D&A)" since it has not had time to depreciate. As such, there is no net income change either. There is also no interest expense, since I am assuming that the debt was taken out at the same time as the machine was bought, so we have not reached the point in time for the first payment of interest. Again, this means net income stays the same.
Cash Flow Statement: No change in the "Operations Activities" section (there is no change in net income, so this section is the same). Under the "Investing Activities" section, you would have a $100 expense, so the "Cash from Investing Activities" line would be lower by $100. For the "Financing Activities" section, you would have an increase of $50 for the "Cash from Financing Activities" line. Overall, your "Increase in Cash and Cash Equivalents" line would go down by $50.Your "Cash and Cash Equivalents at End of Period" line would also go down by $50.
Balance Sheet: Under the "Assets" section, your "Cash" line would go down by $50, so your "Current Assets" line would also go down by $50. Your "Poperies, Plant, and Equipment" line would go up by $100. Your "Total Assets" would go up by $50". Under the "Liabilities" section, your "Long-Term" debt line would go up by $50, so your "Total Liabilities" line would also go up by $50. Since ne income did not change, the "Equity" section will not change. This means our A=L+E equation is balance, since assets on the left side went up by $50, and liabilities on the right side went up by the same amount.
QUESTION 2:
Income Statement: After 1 year, the machine has reached the end of it's useful life, so the "D&A" line goes up by $100. The "Operating Profit" line would then go down by $100. The "Interest Expense" line would go up by $25. The "Income Before Tax" line would go down by $125. "Tax Expense" line would go down by $62.50, and "Net Income" would then go down by $62.50 (125-62.50=62.50).
Cash Flow Statement: The "Net Income" line at the start of the "Operations Activities" section would go down by $62.50. The "D&A" line would go up by $100. The "Cash from Operating Activities" line would go up by $37.50.
Note 1: I think I've made a mistake here. I thought that the "Cash from Operating Activities" should not change, since there has not been any increase or decrease in cash due to the normal operations of our business. The fact that I got an increase in cash does not seem right, since we are paying out interest and have D&A, so I am not sure why we would "generate" $37.50 in cash. I'm pretty sure I've done something wrong, but I'll continue from here. If you have time, please let me know what I messed up, and I'll try to go back and fix it. Thanks.
Under the "Investing Activities" section, you would not have any changes (since there is no new CAPEX), so the "Cash from Investing Activities" line would be the same. For the "Financing Activities" section, you also have no changed (no new money was borrowed, and the debt remains on the books), so the "Cash from Financing Activities" line stays the same. Overall, your "Increase in Cash and Cash Equivalents" line would go up by $37.50. Your "Cash and Cash Equivalents at End of Period" line would also go up by $37.50.
Balance Sheet: The "Cash" line would go down by $25, but also by $62.50 due to the money saved from taxes, so overall, the "Cash" line would go up $37.50 (as predicted by the cash flow statement adjustments), so the the "Current Assets" section would also go up by $37.50. The "Accumulated Depreciation" line would go up by $100, so the "Poperies, Plant, and Equipment" line would go down by $100. Your "Total Assets" would go down by $62.50". Under the "Liabilities" section, your "Long-Term" debt line would not change, so your "Total Liabilities" line would also not change. Under the "Equity" section, "Retained Earnings" would go down by $62.50 and the equation balances again (the left side and right side both went down by $62.50).
Note 2: I am looking back at confusion I had about the "Cash from Operating Activities" going up by $37.50. I actually think that it makes sense now. I believe that it went up, because the money saved from taxes due to the interest is built into it since it starts off with "Net Income" as the first line. Does that make sense?
Thanks again for the question. I hope I'm on the right track with some of this. Doing this took me way longer than it should have, and I needed to have samples of the financial statements open in front of me so I can remember the line names. This was definitely good practice, but I clearly have a lot of work to do. If you (or anyone) has a second to check my work (or post an answer framework), that would be very much appreciated.
Thanks!
OPINION 1. All else being equal, in Income Statement you have pre-tax income of -125. So, you don't need to pay taxes in this period, which produces NI of -125 and not -62.5. Consequently, your Cash Flow statement will be -25 and so on. The Balance sheet will balance. But there will be no effect of the tax in any of these statements.
In the next period, when you have positive proft before tax, you will decrease this number by 125 (accumulated loss from the previous period) and will calculate tax expense. This tax expense will be 62.5 less than originally calculated for this period.
OPINION 2. Maybe you are right, when you recognise positive tax expense, so the NI is only -62.5. I'm not very experienced with things like that. Maybe somebody else could comment.
Anyway your approach requires some corrections.
Income Statement: Everything is like you said. NI is -62.5.
Cash flow: Only one change to the Operating cash flow. NI=-62.5 ad DA=+100 adj Tax=-62.5 (as I've written earlier, it's non-cash in this period) Total Operating cash flow = -25. The other cash flows are 0. So, if we have Opening cash flow = -50, the resulting Closing cash flow for the period will be = -50 -25 = -75.
Balance sheet: Assets. Cash=-75 PPE=0 (=+100-100, after total depreciation) Deferred tax asset=+62.5 Total assets=-12.5
Liabilities. Debt=50 Equity=0-62.5=-62.5. Total liabilities=-12.5.
The balance balances =)
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