The Illinois Investment Banking Academy:

Introduction to Accounting & Finance

March 13, 2015

Table of Contents
I.

Introduction to Accounting

II.

Balance Sheet Overview

III.

Income Statement Overview

IV.

Cash Statement Overview

V.

Key Financial Statement Metrics

VI.

Introduction to Finance

VII.

Net Present Value

VIII. Weighted Average Cost of Capital

Investment Banking Academy

Introduction to Accounting

Accounting

Financial
Accounting

How financial
information of a
business is recorded and
classified (i.e. financial
statements)

Primary focus for

investment banking

ACCY 201, 202, 301 &

303

Managerial
Accounting
Used by a company for
planning and decision
making amongst senior
managers

Tax Accounting
Branch of accounting
used to comply with tax
regulations
ACCY 405

ACCY 302 & 304

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Financial Accounting Standards Board (FASB)

GAAP

Financial Reporting

Developed Generally Accepted Accounting

Principles (GAAP)

Provides relevant and faithful representation

of operating performance

Includes standards, conventions and rules that

accountants follow when recording and
summarizing transactions

Helps investors assess amount, timing and

uncertainty of future cash flows

Summarize the economic resources (Assets)

and the claims to those resources (Equity)

Elaborate how an enterprise obtains and uses

cash (Cash Flow Statement)

GAAP is only required to be followed by the

United States
Potential convergence with International
Accounting Standards Board (IASB) for
universal accounting rules across all developed
countries

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Financial Statements
SEC Requirements

Annual Report Breakdown

In the United States, public companies are

required by the SEC to release financial
statements four times per a year

Annual report (10-K) that must be audited by

an accounting firm (E&Y, KPMG, Deloitte,
PwC)

Three quarterly reports (10-Q) that are

unaudited

Private companies are not required to report

annual or quarterly earnings to the public

Annual reports include:

Letter to the shareholders

Management discussion of companys

performance, management expectations, risk,
general operations, etc.

Financial Statements balance sheet (B/S),

income statement (I/S or P/L), cash flow
statement and statement of shareholders
equity

Footnotes detailing financial adjustments to

the 3 statements

The majority of the annual report is dense

and vague, requiring you to be an expert in
picking out the relevant, important
information

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Balance Sheet
Assets = Liabilities + Shareholders Equity

Presents the financial position of a firm at a particular moment in time

Contain three main sections: assets, liabilities and equity
Assets economic resources available that provide future economic benefit
Liabilities creditors claims on the assets of the firm
Shareholders Equity residual owners claim on the assets of the firm

The balancing equation:

Series of journal entries can adjust these accounts but Assets = Liabilities + Owners Equity
This equation must always hold true, hence the balance sheet

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Balance Sheet Example

Assets - economic
resources

Liabilities creditors
claims

Shareholders Equity
residual owner claims

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Assets
Recognition of Assets

Valuation of Assets

Recognition of Assets if:

Acquired rights to future use as a result of a

past transaction or exchange

Firm can measure or quantify future benefits

with a reasonable degree of precision

Accountants continuously assign and evaluate

the monetary amount to each asset in the
balance sheet

Methodologies:

While all assets represent future benefits, not

all future benefits are assets (i.e. human
capital)
Current Assets mature within one year
(cash, marketable securities, accounts
receivable, prepaid expenses)

Non-current takes over a year to mature

(PP&E, Investments, Other Assets)

Acquisition or Historical Cost: represents

the amount of cash paid in acquiring the asset

Current Replacement Cost: amount to

currently replace the asset

Current Net Realizable Value: cash received

if asset was sold minus any transaction costs

Present Value of Future Net Cash Flows:

future benefits of asset discounted back at the
appropriate discount rate

Checkpoint: What if the NPV of the asset is

less than the current book value?

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Long-term Assets
Recognition of Long-term Assets

Long-term or noncurrent assets are assets that

firms expect to hold or use for longer than
one year

Given the longer useful life, they are not

recorded as an expense, but instead capitalized
on the balance sheet

Asset Depreciation

Since long-term term assets are capitalized,

expenses are slowly incurred on the income
statement in the form of depreciation (PP&E)
or amortization (Intangibles)

CAN expense:

Examples include:

Property, Plant & Equipment (PP&E)

Land

Buildings

Machinery

Intangible Assets

Patents

Trademarks

Goodwill

Building

Machinery

Patents

CANT expense:

Land

Goodwill

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Liabilities
Classification of Liabilities

Liabilities are economic obligations and categorized as either:

Current matures in less than a year

Noncurrent takes more than a year to mature

Liabilities commonly include short-term and long-term debt

Obligations that require specific amounts of cash due in more than one year appear at the present value of the
future cash flows

Current Liabilities

Non-current

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Net Working Capital (NWC)

Net Working Capital = Current Operating Assets Current Operating Liabilities

What is net working capital?

Working capital is a key concept derived from the balance sheet and an important measure of the firms shortterm financial health

Factors into the free cash flow of a company

Current operating assets minus current operating liabilities

Current operating assets = current assets cash & cash equivalents

Current operating liabilities = current liabilities short-term debt

Current Assets
Current Liabilities
= NWC

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Shareholders Equity
Contributed Capital

Retained Earnings

Contributed capital represents the funds

invested by shareholders for an ownership
stake

Par Value value assigned to the stock

Additional Paid-in Capital funds contributed

in excess of par

This equity account increases if companies

issue more stock and decreases if companies
buy back stock

i.e. Apple just repurchased $14 billion worth

of stock, meaning the contributed capital
decreased

Stock repurchases increase a contra-equity

account known as Treasury stock which is
subtracted from contributed capital

Represents a firms earnings since its

formation less the dividends paid out to the
shareholders since formation

Net Income from income statement directly

increases retained earnings

Checkpoint: Is it possible for a company to

have negative retained earnings?

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Income Statement
Overview

Presents the results of the operating activities of a firm for a fiscal year (not always the same time
period as a calendar year)

Basic equation is Revenues Expenses = Net Income

Revenues represent inflows of assets from selling goods and services

Expenses represent outflows of assets used in generating revenues

Cash vs. Accrual Accounting

Cash Accounting: firm recognizes revenue and expenses from providing goods when cash is received
and paid out

Accrual Accounting: recognizes revenue in period that goods were sold and recognizes all relevant
costs associated with selling the goods in the same period

Checkpoint: What methods do the income statement and cash flow statement represent?

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Revenue
Revenue Recognition

Revenue is recognized when the following two conditions are met:

Firm performed all or most of the services expected to be provided

Received payment or payment is highly probable for the provided good or service

Checkpoint: What happens if cash is received before the firm performs the mandated service or
delivers the product?

Revenue Adjustments

On financial statements, companies always report revenue as net revenue

Net Revenue = Gross Revenue sales discounts, allowances, or returns

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Expenses
Expense Breakdown
COGS: costs related to
producing the good or
performing the service
SG&A: Advertising,
Salaries, Office
Expenses, Legal, &
Accounting
Net Interest =
Interest on debt
interest on cash
Income Taxes:
Corporate taxes at
around 35% - 40%

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Earnings
Earnings Breakdown
Gross Profit: Net sales
- COGS

Operating Income:
Earnings before
interest & taxes (EBIT)

EBT = Earnings
before taxes
Net Income: Final
income after deducting
all expenses (NI)

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Cash Flow Statement

Overview

The most important statement because CASH IS KING!

Represents the net cash flows relating to operating, investing and financing activities for a designated
period of time

Follows the cash-basis convention for accounting

Cash Flow Segments

Cash from Operations: cash received from selling goods and services less cash paid for providing
goods and services

Cash from Operations = Net Income + Depreciation & Amortization Changes in Net Working Capital

Cash from Investing: cash received from sales of investments and PP&E less cash paid for the
acquisition of investments and PP&E (capex)

Cash from Financing: cash received from the issuance of debt or equity less cash paid for dividends
and reacquisition of debt and equity

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Cash Flow Statement Example

Cash Flow Breakdown

Cash from Operations: Uses indirect

method by adjusting net income with D&A
and changes in operating assets and
liabilities

Cash from Investing: Subtract

investments in plant, property and
equipment (sourced from capital
expenditures) plus proceeds from selling
long-term assets
Cash from Financing: Changes to a firms
capital structure in order to raise cash from
debt/equity issuance or deplete cash from
paying down debt or repurchasing stock

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Key Financial Statement Metrics

Balance Sheet Ratios

Balance Sheet ratios revolve around a companys capital structure and liquidity
Current Ratio: Current Assets/Current Liabilities
Popular measure for a firms liquidity

Quick Ratio: (Cash & Marketable Securities + A/R)/Current Liabilities

Another popular measure for a firms liquidity
Checkpoint: Why does the quick ratio not include inventory?

Debt/Equity: (Long + Short Debt)/Total Equity

An index for a firms capital structure saying how many dollars of debt the company has for a
dollar of equity investment

Market/Book: Market Capitalization/Book Value of Equity

Measures the publics perception of firms worth against the stated book value

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Key Financial Statement Metrics

Income Statement Ratios

Income Statement ratios revolve around a companys operational performance

Gross Profit Margin: Gross Profit/Total Sales
Measure for a firms typical markup on products or services

Net Income Margin: Net Income/Total Sales

Measure for a firms typical profit on a dollar of sales

Return on Assets: Net Income/Total Assets

An index for how efficiently a company is using assets in order to generate profit

Return on Equity: Net Income/Total Equity

An index for how efficiently a company is using shareholders investments and retained
earnings to generate profit
Most commonly looked at financial ratio for investors

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Key Financial Statement Metrics

Additional Financial Metrics

Inventory Turnover: COGS/Inventory

How many times a company can turnover its entire inventory

Asset Turnover: Total Sales/Total Assets

How many times a company can turnover all of its assets

Days Payable Outstanding: Accounts Payable/COGS*365

Used as a metric for balance sheet projections to estimate future changes in net working
capital

Days Receivable Outstanding: Accounts Receivable/Sales*365

Used as a metric for balance sheet projections to estimate future changes in net working
capital

DuPont Equation: ROE = NI/Total Sales * Total Sales/Assets * Assets/Equity

Breaks down a companys return on equity into operational profitability, asset use efficiency
and financial leverage
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Introduction to Finance

Finance

Net Present Value (NPV)

WACC

Net Present Value of a certain

number of cash flows projected
out into the future

Weighted Average Cost of Capital

(i.e. the discount rate for
companys future cash flows)

Net Present Value implies a

certain discount rate to apply to
future cash flows

Represents the value of a dollar

today against the value of a dollar
next year

A dollar today is WORTH

MORE than a dollar tomorrow

WACC is the bare minimum

return a company should make on
an investment

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Net Present Value

Free Cash Flow

Discounting

Free cash flow is the amount of cash

generated in a year through a companys
operations and investments

FCF = EBIT(1-T) + Depreciation &

Amortization Changes in Net Working
Capital Capital Expenditures

EBITDA is often a proxy for a companys free

cash flow

Everyone demands a certain return on

investment and the same is true with
companies

Like a bank account earning interest

Internal Rate of Return = discount rate that

makes the NPV of future free cash flows
equal zero

Net Present Value

NPV = FCF1*(1+R)^1+FCF2*(1+R)^2+FCF3*(1+R)^3+

Accept a project if the NPV is greater than 0 and the IRR is greater than the discount rate

Checkpoint: Why do companies look at both NPV and IRR?

Checkpoint: Why would companies decline a project with an IRR greater than the discount rate?

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Weighted Average Cost of Capital

Cost of Capital

Companies raise capital to fund projects and investments through either debt or equity

WACC = proportion of debt funding * cost of debt + proportion of equity funding * cost of equity

In calculating the proportion of funding from debt or equity, divide by total capital funding which is the
sum of total debt and the market capitalization

Cost of Debt

Cost of Equity

Incremental interest rate a company pays to a

lender for borrowing cash is the before-tax
cost of debt

After-tax cost of debt = before-tax cost of

debt * (1-T)

Checkpoint: Why do you make the cost of

debt tax-effective?

Cost of equity derived from the Capital Asset

Pricing Model (CAPM)

Represents required return new equity

investors expect upon purchase of companys
stock

RoE = Rf + B (RM RF)

Checkpoint: What are appropriate indices to

gauge Rf and RM?

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The Illinois Investment Banking Academy:

To Be Continued
Introduction to Valuation & Modeling
March 15, 2015