FINANCE NOTES

1) The three main financial statements:

Income Statement (Profit or loss)
Balance Sheet
Statement of Cash Flows

CAPITAL MARKET:
MARKET:

The market for securities, where companies and the government can raise
long-term funds. The capital market includes the stock market and the
bond market. It is a place where investors come together to buy and sell
shares.

Types of Capital Market?

Primary Market:
Market:
It deals with the issuance of new securities. Companies, governments or
public sector institutions can obtain funding through the sale of a new
stock or bond issue. (It deals with new co which makes the new issue of
the securities egg- shares, debenture etc.)

Secondary Market:
The financial market for trading of securities that have already been
issued in an initial public offering. It comprises of the stock exchanges
which provide a platform for the purchase and sale of securities.

Money market
The money market is the
Money market instruments
commercial paper, Federal
The common characteristic
have maturities of one year
market for short-term financial instruments.
include Treasury bills, banker’s acceptances,
funds, municipal notes, and other securities.
of money market instruments is that they all
or less, and often 30 days or less

Share market is a place where companies list their shares available to

common public for buying & selling. these shares are now mostly held in
demat form, i.e. electronic and not physical.

What is a Stock Exchange?

A common platform where buyers and sellers come together to transact
in stocks and shares.

Stock market-Stock market is a market for the trading of company

stock, and derivatives of same; both of these are securities listed on a
stock exchange as well as those only traded privately.
The term "stock market" refers to the business of buying and selling
stock.
Depository A system of computerized book-entry of securities. This
arrangement enables a transfer of shares through a mere book-entry
rather than the physical movement of certificates.
At present, there are two Depositories in India, National Securities
Depository Limited (NSDL) and Central Depository Services (CDS). NSDL
was the first Indian Depository.

How does the Depository System operate?

Holds securities in accounts
Transfers securities in accounts
Transfers without handling physical securities
Safekeeping of securities
All the holders must sign the instruction

NAV Formula
•
NAV – Net Asset Value:: The per share price of a mutual fund.

Formula of NAV:: Closing price of all securities owned + cash – liabilities

Number of outstanding shares

Derivatives
Financial instruments such as futures and options, which derive their
original value from underlying securities egg. Bonds, bills, currencies, and
equities.
Futures / Forwards:
Investment contracts which specify the quantity and price of a commodity
to be purchased or sold at a later date.

Options:
A contract that gives the owner the right to buy or sell a security at a
specific price within a specific time limit. Options can be further classified
as call option and put option. (They are generally available for 1 to 9
months, with some longer-term options (called LEAPS) also available for
selected securities)

 Call option:
An option to buy a certain asset by a certain date for a certain price.

 Put option:
An option to sell a certain asset by a certain date for a certain price.

(If you want in brief then read the following)

Call Option-A call option gives the owner the right, but not the obligation, to buy the underlying stock at a
given price (the strike price) by a given time (the expiration date). The owner of the call is speculating that the
underlying stock will go up in value, hence, increasing the value of the option

Put Option-A put option gives the owner the right, but not the obligation, to sell the underlying stock at a
given price (the strike price ) by a given time (the expiration date). The owner is speculating that the option will
go up in value and the underlying stock will go down in value
What Does Equity Mean? A stock or any other security representing an
ownership interest

What is equity? Funds brought into a business by its shareholders is

called equity. It is a measure of a stake of a person or group of persons
starting a business

Mutual Fund

Mutual Fund
Mutual Fund is a investment company that pools money from
shareholders and invests in a variety of securities, such as stocks,
bonds and money market instruments Most open-end mutual funds
continuously offer new shares to investors.

An open-ended Mutual fund is one that is available for subscription and

repurchase on a continuous basis. These Funds do not have a fixed
maturity period. Investors can conveniently buy and sell units at Net
Asset Value (NAV) related prices which are declared on a daily basis.
The key feature of open-end schemes is liquidity.

A close-ended Mutual fund has ----a stipulated maturity period e.g. 5-7
years. The fund is open for subscription only during a specified period at
the time of launch of the scheme. Investors can invest in the scheme at
the time of the initial public issue and thereafter they can buy or sell the
units of the scheme on the stock exchanges where the units are listed.

Swaps
In finance, a swap is a derivative in which two counterparties agree to
exchange one stream of cash flows against another stream. These
streams are called the legs of the swap. THEYare contracts to exchange
cash (flows)

Fixed income securities

Bonds, preferred stock, and treasury bills that generate a specified
amount of income over a certain period., and are considered low-risk
investments. also called fixed income securities

The bond market

(also known as the debt, credit, or fixed income market) is a financial
market where participants buy and sell debt securities, usually in the form
of bonds
Types of Bonds
Government Bonds: These are fixed-income debt securities issued by the
government.
Municipal Bonds: These are debt securities issued by state governments
and their agencies.
Corporate Bonds: These are debt instruments issued by a company and
backed by its ability to generate profits

Hedge Funds : Hedge funds are basically investment funds, which

charge a performance fee. Hedge funds are different from the mutual
funds, pension funds and insurance companies. Hedge funds can deal
with the futures, swaps and other derivative markets.
Hedging: An investment strategy of lowering risk by buying securities
that have off-setting risk characteristics Hedge funds are investment
pools that are free to use any hedging techniques they desire and they
often make large bets in a relatively small number of different holdings.
Arbitrage:
Arbitrage: An act of buying securities in one market and selling in
another at higher prices. It takes advantage of a price differential existing
in the prices of the same commodity or security in two or more different
markets.
Speculation:
Speculation: An act to take high risks for high return. It gives liquidity to
the market

Collateral Management:
Management: Collateral management services are a method
of securing a loan with physical commodities. They are deposited as a
pledge or guarantee that the loan will be repaid at maturity; if not paid
the commodities may be sold to reimburse the lender.

Settlement Cycle
The period within which the settlement is made, i.e; The period within
which buyers receive their shares and sellers receive their money.

What is a settlement cycle?

On the NSE, the cycle begins on Wednesday and ends on the following
Tuesday, and on the BSE the cycle commences on Monday and ends on
Friday.

What settlement details are required on the delivery instruction

slip?
slip?
On every stock exchange various settlements are effected every day such
as weekly settlement, daily settlement, auction settlement etc. Each of
these settlements is identified by the combination of the market type and
the settlement number. You are required to mention the appropriate
settlement details on the delivery instruction slip while transferring the
shares to your broker's account. These settlement details are available on
the contract note issued by the broker.
What is T+2 rolling settlement cycle
T+2 means that trades are settled two working days after the day the
trade takes place. For instance, trades taking place on Monday are settled
on Wednesday, Tuesday's trades settled on Thursday and so on.

How many times can one buy and sell within a settlement cycle?
It's possible to by and sell within a settlement cycle many times, which is
what traders do. They settle only their net outstanding positions at the
end of the cycle. In other words, the settlement is made for the net
outstanding positions at the end of the settlement cycle.

Process of trade settlement (selling):

(selling):
 You sell securities in any of the stock exchanges linked to NSDL through
a broker
 You give instruction to your DP to debit your account and credit the
broker's [clearing member pool] account
 Before the pay-in day, your broker gives instruction to its DP for
delivery to clearing corporation
 Your broker receives payment from the stock exchange [clearing
corporation]

What is a rolling settlement---? The rolling settlement ensures that

each day's trade is settled by keeping a fixed gap, between a trade and
its settlement, of a specified number of working days. At present this is
five working days after the trading day.

What is corporate restructuring?

Corporate restructuring is necessary when a company needs to improve
its efficiency and profitability and it requires expert corporate
management. A corporate restructuring strategy involves the rebuilding of
areas within an organization that need special attention from the
management and CEO.

A corporate action is an event initiated by a public company that

affects the securities (equity or debt) issued by the company. Some
corporate actions such as a dividend (for equity securities) or coupon
payment (for debt securities (bonds)) may have a direct financial impact
on the shareholders.
Types
Corporate actions are classified as Voluntary, Mandatory and Mandatory
with Choice corporate actions.

Mandatory Corporate Action : A mandatory corporate action is an

event initiated by the corporation by the board of directors that affects all
shareholders. Participation of shareholders is mandatory for these
corporate actions. An example of a mandatory corporate action is cash
dividend. All holders are entitled to receive the dividend payments, and a
shareholder does not need to do anything to get the dividend. There is
nothing the Share holder has to do or does in a Mandatory Corporate
Action.
Voluntary Corporate Action : A voluntary corporate action is an action
where the share holders elect to participate in the action. An example of a
voluntary corporate action is a tender offer. A corporation may request
share holders to tender their shares at a pre-determined price. The
shareholder may or may not participate in the tender offer.

Mandatory with Choice Corporate Action : A Mandatory with Choice

corporate action is a mandatory corporate action where share holders are
given a chance to choose among several options. An example is
cash/stock dividend option with one of the options as default. Share
holders may or may not submit their elections. In case a share holder
does not submit the election, the default option will be applied..

A stock split or stock divide increases or decreases the number of

shares in a public company. The price is adjusted such that the before and
after market capitalization of the company remains the same and dilution
does not occur. Options and warrants are included.Take, for example, a
company with 100 shares of stock priced at $50 per share. The market
capitalization is 100 × $50, or $5000. The company splits its stock 2-for-1

Spin-Offs

A spin-off is a new organization or entity formed by a split from a larger

one, such as a television series based on a pre-existing one, or a new
company formed from a university research group or business incubator
The common definition of spin out is a division of a company or
organization that becomes an independent business.
 Accounting Terms

Reconciliation --is the adjusting of the difference between two items (e.g.,
balances, amounts, statements, or accounts) so that the figures are in agreement.
Often the reasons for the differences must be explained.
One example would be reconciling a checking account (bringing the checking
ledger and bank balance statement into agreement).

Reasons for Reconciliation:

1) Cheques deposited into bank but not recorded in the bank book.
2) Cheques issued but not presented in bank.
3) Bank charges directly debited from bank account not mentioned in bank book.
4) ECS, not mentioned in bank book.
5) Interested credited into bank account not mentioned in bankbook.
6) Cheques deposited not cleared.

Accounts Payable
This current liability account will show the amount a company owes for items or
services purchased on credit and for which there was not a promissory note.

Accounts Receivable
A current asset resulting from selling goods or services on credit (on account)

Naked call Definition-A short call option position in which the writer does not own
the corresponding number of shares of the underlier, or has not deposited in a cash
account an amount equal to the exercise value of the call. also called uncovered
call. opposite of covered call.

Intraday Trading
Intraday share trading refers to the buying and selling (or vise versa) of the same
script in the same trading session ( on the same day).

Blue Chip Companies:

A blue chip stock is the stock of a well-established company having stable earnings
and no extensive liabilities.

NASDAQ: An acronym for National Association of Security Dealers Automated

Quotations System, which is a nationwide network of computers and other electronic
equipment that connects dealers in the over-the-counter market across the U.S

National Stock Exchange (NSE) It is a nationwide screen-based trading network

using computers, satellite link and electronic media that facilitate transactions in
securities by investors across India

How many Exchanges are there in India? The Stock Exchange, Mumbai (BSE)
and the National Stock Exchange (NSE) are the country's two leading Exchanges.

Volatility
The measure of the tendency of prices to fluctuate widely. Prices of small companies
tend to be more volatile than those of large corporations. Beta is a measure of
volatility
Bear A person who expects share prices in general to decline and who is likely to
indulge in SHORT SALES. Bear Market A long period of declining security prices.
Bull A person who expects share prices in general to move up and who is likely to
take a long position in the stock mark.

Custodian
A financial institution that has the legal responsibility for a customer's securities.
This implies management as well as safekeeping.

Subprime
Subprime are the borrowers typically who have low credit scores due to prior
bankruptcy, missed loan payments, home repossession etc

What is electronic trading? Process in which. Brokers can trade from their
offices, using fully automated screen-based processes. Their workstations are
connected to a Stock Exchange's central computer via satellite using Very Small
Aperture Terminus (VSATs).

What is an Index? An Index is a comprehensive measure of market trends,

intended for investors who are concerned with general stock market price
movements

What is a contract note? A contract note describes the rate, date, time at which
the trade was transacted and the brokerage rate

What is a book-closure/record date? Book closure and record date help a

company determine exactly the shareholders of a company as on a given date

Split---- is book entry wherein the face value of the share is altered to create more
number of shares outstanding without calling for fresh capital or without altering the
share capital account. For example if a company announces a two-way split, it
means that a share of the face value of Rs.10 is split into two shares of face value
Rs.five each and a person holding one share now holds two shares.

What is an IPO? An IPO is an abbreviation for Initial Public Offer. When a company
goes public for the first time or issues a fresh stock of shares, it offers it to the public
directly.

Retained Earnings
Net profits kept to accumulate in a business after dividends are paid.

What is buy-back?---It is a process by which a company can buy-back its shares

from shareholders. A company may buy-back its shares in various ways from
existing shareholders on a proportionate basis through a tender offer
 from open market through book-building process
 from the Stock Exchange ,from odd lot holders
A company cannot buy-back its shares through negotiated deals, whether on or off
the Stock Exchange or through spot transactions or through any private
arrangement.
Bonus Shares-------Given as bonus free to existing equity shareholders.

What is short selling?----It is a sale of a security that the seller does not own, or
any sale that is completed by the delivery of a security borrowed by the seller. Short
selling is a legitimate trading strategy. Short sellers assume the risk that they will be
able to buy the stock at a more favourable price than the price at which they sold
short.

What is an auction?--- Auction is conducted for those securities that members fail
to deliver/short deliver during pay-in.

Demat ---is a commonly used abbreviation of Dematerialisation, which is a process

whereby securities like shares, debentures are converted from the "material" (paper
documents) into electronic data and stored in the computers of an electronic
Depository. You surrender material securities registered in your name to a
Depository Participant (DP).

What is the procedure for the dematerialisation of securities?---Check with a

DP as to whether the securities you hold can be dematerialised. Then open an
account with a DP and surrender the share certificates.

What is ALBM?--- ALBM is an acronym for automated lending/borrowing

mechanism. It is a stock- lending product introduced by NSCCL (National Securities
Clearing Corporation Limited) with the primary objective of providing a window for
trading members of NSE to borrow securities/funds to meet their pay-in obligations

What is Book Building? Book Building is a process used for marketing a public
offer of equity shares of a company and is a common practice in most developed
countries. Book Building is so- called because the collection of bids from investors
are entered in a "book".

What is an ex-dividend date?----The date on or after which a security begins

trading without the dividend (cash or stock) included in the contract price.

What is an ex-date?----The first day of the no-delivery period is the ex- date. If
there is any corporate benefits such as rights, bonus, dividend announced for which
book closure/record date is fixed, the buyer of the shares on or after the ex -date will
not be eligible for the benefits.

What is a no-delivery period?--Whenever a company announces a book closure

or record date, the Exchange sets up a no-delivery (ND) period for that security.

What is bad delivery?-- Bad delivery exists only when shares are transferred
physically. In "Demat" bad delivery does not exist.
What is EPS, P/E, BV and MV/BV? (P/E): Price earning multiple is ratio between
market value per share and earning per share.

Book Value (BV): (of a common share) The company's Net worth (which is paid-up
capital + reserves & surplus) divided by number of shares outstanding.

Market value to book value ratio (MV/BV ratio): It is the ratio between the
market price of a security and Book Value of the security.

Foreign exchange market (currency, forex, or FX) is where currency trading

takes place. It is where banks and other official institutions facilitate the buying and
selling of foreign currencies

What is a Commodity Market?

A commodity market is a place where the exchange of primary or raw products
happens in regulated commodity exchanges

Investment banking :. The role of the investment bank is to issue and sell
securities in the primary market on behalf of the international companies.

Net Present Value (NPV)

= (Present Value of Inflow of Cash)–(Present Value of Outflow of Cash)
NPV helps to measure the value of a currency today with that of the future, after
taking into consideration returns and inflation

Deflation: In economics, deflation is a decrease in the general price level of goods

and services.[1] Deflation occurs when the annual inflation rate falls below zero
percent, resulting in an increase in the real value of money — a negative inflation
rate

Nowadays shares are purchased and sold online which is called E-broking.

Immobilization of securities -----means shares are kept with depositary but

buying and selling of securities takes place without physical movement of securities

The Sensex is an "index". What is an index? An index is basically an indicator. It

gives you a general idea about whether most of the stocks have gone up or most of
the stocks have gone down.
The Sensex is an indicator of all the major companies of the BSE.
The Nifty is an indicator of all the major companies of the NSE.

5.The Liabilities side of the balance sheets shows the sources of income into the
business and the Assests side shows how the income has been utilized

6 How does one execute an order?

Select a broker of your choice and enter into a broker-client agreement and fill in the
client registration form. Place your order with your broker preferably in writing. Get a
trade confirmation slip on the day the trade is executed and ask for the contract
note at the end of the trade date.
Why does one need a broker?
As per SEBI (Securities and Exchange Board of India.) regulations, only registered
members can operate in the stock market. Deal can be done only through a
registered broker of a recognised Stock Exchange or through a SEBI- registered sub-
broker

What is the difference between book closure and record date?

In case of a record date, the company does not close its register of security holders.
Record date is the cut off date for determining the number of registered members
who are eligible for the corporate benefits. In case of book closure, shares cannot be
sold on an Exchange bearing a date on the transfer deed earlier than the book
closure.

What are company objections?

A list documenting reasons by a company for not transferring a share in the name of
an investor is called company objections. Rejection occurs due to a signature
difference, or fake shares.

What are micro-cap, small-cap, mid-cap, large-cap companies?THE CO

WHICH HAS MARKET CAPITALISATION OF eg -$50 - $300 million is Micro cap,---
Small Cap: $300 million - $2 billion,--- Mid Cap: $2 - $10 billion, Big Cap: $10 -
200 billion ----- Mega Cap: $200+ billion

Who is a Depository Participant?

In India, a Depository Participant (DP) is described as an agent of the depository.
They are the intermediaries between the depository and the investors. Similar to the
brokers who trade on your behalf in and outside the Stock Exchange;

What is the difference between book closure and record date?

In case of a record date, the company does not close its register of security holders.
Record date is the cut off date for determining the number of registered members
who are eligible for the corporate benefits. In case of book closure, shares cannot be
sold on an Exchange bearing a date on the transfer deed earlier than the book
closure.

Closing stock in trial balance

The reason why closing stock is not taken into account in a trial balance is because a
trial balance is a balance of all ledger account a given point in time.It records only
transactions which have a two way effect But closing stock is not a transaction
having a two way effect any given point in time.It is only an indication of the goods
lying in the factory at the end of the year

Window Dressing
A strategy used by mutual fund and portfolio managers near the year or quarter end
to improve the appearance of the portfolio/fund performance before presenting it to
clients or shareholders.

Outstanding checks are checks that have been written and recorded in the
company's Cash account, but have not yet cleared the bank account.
An NSF check is a check that was not honored by the bank due to insufficient funds
NSF is the acronym for not sufficient funds.
Notes Receivables are assets of a company. When notes come due, the company
might ask its bank to collect the note receivable

Deposits in transit are amounts already received and recorded by the company,
but are not yet recorded by the bank. For example, a retail store deposits its cash
receipts of August 31 into the bank's night depository at 10:00 p.m. on August 31.
The bank will process this deposit on the morning of September 1. As of August 31
(the bank statement date) this is a deposit in transit.

Financial Statements
The Balance Sheet lists the balances in all Asset, Liability and Owners' Equity
accounts.

The Income Statement lists the balances in all Revenue and Expense accounts.

The Accounting Equation really is:

The accounting equation can be expressed in 3 ways:

1. Assets = Liabilities + Owners' Equity

2. Liabilities = Assets - Owners' Equity
3. Owners' Equity = Assets – Liabilities

There are 5 types of Accounts.

1) Assets 2) Liabilities 3) Owners' Equity (Stockholders' Equity for a corporation)
4) Revenues 5) Expenses

FREEZE------ A demat account holder may freeze the account only for debits by
submitting a freeze instruction to its DP. On execution of the freeze instruction by
the DP, the status of the account will change to `Suspended for Debit'.

What is GAAP? -
-Generally Accepted Accounting Principles
What kinds of items are posted in the Income statement?
statement?

Income statement, also called profit and loss statement (P&L) and Statement of
Operations, is a company's financial statement that indicates how the revenue () is
transformed into the net income all income,expences and loses are posted in
income statement.

What is depreciation and the method?

Depreciation is the wear and tear use of the asset.
Types are: Straight line Method and Written down value method
How is SENSEX calculated?
calculated?
Sensex is an index which shows whether the stocks have gone up or gone down and
accordingly the sensex is calculated.

What are the types of cash flows?

The Statement of Cash Flows is the third financial statement required by GAAP, for
full disclosure. The Cash Flow statement shows the inflows and outflows of Cash
over a period of time, usually one year.

There are 3 types of cash flow (CF):

1) Operating CF generated by normal business operations

2) Investing - CF from buying/selling assets: buildings, real estate, investment
portfolios, equipment.
3) Financing - CF from investors or long-term creditors

Types of Cash Flow Statement There are two types of Cash Flow Statement which
you will come across, these are:
 Actual Cash Flow Statements,-- these show an historic view, showing the
actual flows of cash into and out of a business that have occurred over a previous
trading period, e.g. 6 months, or 1 year.
 Or a Forecast Cash Flow Statement --showing the expected flows of cash into
and out of a business over a trading period in the immediate future, e.g. next 6
months or year.

19.What is ISIN?
An (ISIN) ISIN stands for International Security Identification Number. An account
holder may freeze a particular ISIN (security of a specific company) from being
debited from the account, without freezing the whole.

What is Insider Trading?

Insider trading is the trading of a corporation's stock or other securities (e.g. bonds
or stock options) by individuals with potential access to non-public information about
the company. In most countries, trading by corporate insiders such as officers, key
employees, directors, and large shareholders may be legal, if this trading is done in
a way that does not take advantage of non-public information.

What is transposition-cum-demat?
Transposition-cum-demat facility enables an investor to transpose names of the joint
holders in desired order along with the process of dematerialisation of certificates.
Illustratively
egg . if A owns a security, which he holds in the joint names of ABC, ACB, etc. he
can first transpose them in the name of, say, ABC in which order demat account
might have been opened. No new name can be added through transposition
process. Similarly, existing names cannot be deleted.

What is transmission-cum-demat?
transmission-cum-demat?
Transmission-cum-demat facility enables an investor to dematerialize securities held
in joint names in a BO account opened in the names of same joint holders in the
event of death of a joint holder.
What do you mean by 'Market Trades' and 'Off Market Trades'?
Any trade settled through a clearing corporation is termed as the 'Market Trade'.
These trades are done through stock brokers on a stock exchange.
'Off Market Trade' is one which is settled directly between two parties without the
involvement of clearing corporation.
Walk me through the three financial statements.
The balance sheet shows a company’s assets, its liabilities, and shareholders’ equity (put
another way: what it owns, what it owes, and its net worth). The income
statement outlines the company’s revenues, expenses, and net income. The cash flow
statement shows cash inflows and outflows from three areas: operating activities,
investing activities, and financing activities.

If I could use only one statement to review the overall health of a company,
which statement would I use and why?
Cash is king. The statement of cash flows gives a true picture of how much cash the
company is generating. Ironically, it often gets the least attention. You can probably
pick a different answer for this question, but you need to provide a good justification
(e.g. the balance sheet because assets are the true driver of cash flow; or the income
statement because it shows the earning power and profitability of a company on a
smoothed out accrual basis).

If it were up to you, what would our company’s budgeting process look like?
This is somewhat subjective. A good budget is one that has buy-in from all departments
in the company, is realistic yet strives for achievement, has been risk-adjusted to allow
for a margin of error, and is tied to the company’s overall strategic plan. In order to
achieve this, the budget needs to be an iterative process that includes all departments.
It can be zero-based (starting from scratch each time) or building off the previous year,
but it depends on what type of business you’re running as to which approach is better.
It’s important to have a good budgeting/planning calendar that everyone can follow.

When should a company consider issuing debt instead of equity?

A company should always optimize its capital structure. If it has taxable income, then it
can benefit from the tax shield of issuing debt. If the firm has immediately steady cash
flows and is able to make the required interest payments, then it may make sense to
issue debt if it lowers the company’s weighted average cost of capital.

How do you calculate the WACC?

WACC (stands for Weighted Average Cost of Capital) is calculated by taking the
percentage of debt to total capital, multiplied by the debt interest rate, multiplied by one
minus the effective tax rate, plus the percentage of equity to capital, multiplied by the
required return on equity. Learn more in CFI’s free Guide to Understanding WACC.

Which is cheaper, debt or equity?

Debt is cheaper because it is paid before equity and has collateral backing it. Debt ranks
ahead of equity on liquidation of the business. There are pros and cons to financing with
debt vs equity that a business needs to consider. It is not automatically better to use
debt financing simply because it’s cheaper. A good answer to the question may highlight
the tradeoffs if there is any followup required. Learn more about the cost of
debt and cost of equity.

A company has learned that due to a new accounting rule, it can start
capitalizing R&D costs instead of expensing them.
This question has four parts to it:
Part I) What is the impact on the company’s EBITDA?
Part II) What is the impact on the company’s Net Income?
Part III) What is the impact on the company’s cash flow?
Part IV) What is the impact on the company’s valuation?
Answer:
Part I) EBITDA increases by the exact amount of R&D expense that is capitalized.
Part II) Net Income increases, and the amount depends on the depreciation method and
tax treatment.
Part III) Cash flow is almost unimpacted – however, cash taxes may be different due to
changes in depreciation expense, and therefore cash flow could be slightly different.
Part IV) Valuation is essentially constant – except for the cash taxes impact/timing impact
on the net present value (NPV) of cash flows.

What, in your opinion, makes a good financial model?

It’s important to have strong financial modeling principles. Wherever possible, model
assumptions (inputs) should be in one place and distinctly colored (bank models typically
use a blue font for model inputs). Good Excel models also make it easy for users to
understand how inputs are translated into outputs. Good models also include error
checks to ensure the model is working correctly (e.g., the balance sheet balances, the
cash flow calculations are correct, etc.). They contain enough detail, but not too much,
and they have a dashboard that clearly displays the key outputs with charts
and graphs. For more, check out CFI’s complete guide to financial modeling.

What happens on the income statement if inventory goes up by $10?

Nothing. This is a trick question – only the balance sheet and cash flow statements are
impacted by the purchasing of inventory.

What is working capital?

Working capital is typically defined as current assets minus current liabilities. In banking,
working capital is normally defined more narrowly as current assets (excluding cash) less
current liabilities (excluding interest-bearing debt). Sometimes it’s even more narrowly
defined as accounts receivable plus inventory minus accounts payable. By knowing all
three of these definitions you can provide a very thorough answer.

What does negative working capital mean?

Negative working capital is common in some industries such as grocery retail and the
restaurant business. For a grocery store, customers pay upfront, inventory moves
relatively quickly, but suppliers often give 30 days (or more) credit. This means that the
company receives cash from customers before it needs the cash to pay suppliers.
Negative working capital is a sign of efficiency in businesses with low inventory and
accounts receivable. In other situations, negative working capital may signal a company
is facing financial trouble if it doesn’t have enough cash to pay its current liabilities.
In the answer to this interview question, it’s important to consider the company’s
normal working capital cycle.

When do you capitalize rather than expense a purchase?

If the purchase will be used in the business for more than one year, it is capitalized
and depreciated according to the company’s accounting policies.
How do you record PP&E and why is this important?
There are essentially four areas to consider when accounting for Property, Plant &
Equipment (PP&E) on the balance sheet: (I) initial purchase, (II) depreciation, (III)
additions (capital expenditures), and (IV) dispositions. In addition to these four, you may
also have to consider revaluation. For many businesses, PP&E is the main capital asset
that generates revenue, profitability, and cash flow.

How does an inventory write-down affect the three financial statements?

This is a classic finance interview question. On the balance sheet, the asset account of
inventory is reduced by the amount of the write-down, and so is shareholders’
equity. The income statement is hit with an expense in either cost of goods sold
(COGS) or a separate line item for the amount of the write-down, reducing net income.
On the cash flow statement, the write-down is added back to cash from operating
activities, as it’s a non-cash expense (but must not be double counted in the changes of
non-cash working capital). Read more about an inventory write-down.

Why would two companies merge? What major factors drive mergers and
acquisitions?
There are many reasons companies go through the M&A process: to
achieve synergies (cost savings), enter new markets, gain new technology, eliminate a
competitor, and because it’s “accretive” to financial metrics. Learn more
about accretion/dilution in M&A.
[Note: Social reasons are important too, but you have to be careful about mentioning
them, depending on who you’re interviewing with. These include: ego, empire building,
and to justify higher executive compensation.]

If you were CFO of our company, what would keep you up at night?
This is one of the great finance interview questions. Step back and give a high-level
overview of the company’s current financial position, or the position of companies in that
industry in general. Highlight something on each of the three financial statements.
 Income statement: growth rates, margins, and profitability.
 Balance sheet: liquidity, capital assets, credit metrics, liquidity ratios, leverage,
return on assest (ROA), and return on equity (ROE).
 Cash flow statement: short-term and long-term cash flow profile, any need to
raise money or return capital to shareholders.
 Non-financial statement: company culture, government regulation, conditions in
the capital markets.