The Investment Banking Analyst program: 30 days to fluent

Net income from the income statement is the first line of the cash flow statement and flows into retained earnings on the balance sheet. The cash flow statement adds back non-cash charges such as depreciation, adjusts for changes in working capital, then shows investing and financing flows; its ending cash is the cash on the balance sheet. Balance sheet items such as PP&E, debt and working capital are themselves changed by the capex, borrowing and operating flows on the cash flow statement, which is what keeps the sheet balanced.

Because the income statement is on an accrual basis: revenue is booked when earned and expenses when incurred, not when cash moves. A company can book sales that sit in receivables, buy inventory that has not been sold, pay down debt, or spend on capex, none of which hit net income immediately, while all of them drain cash. The cash flow statement exists to show exactly that gap, and the working capital section is where most of it lives.

Day one: cash is up $120 and deferred revenue, a liability, is up $120; nothing hits the income statement, so the balance sheet balances through the liability. On the cash flow statement the $120 shows as an increase in a working capital liability within operating cash flow. After one month: revenue of $10 is recognized, so net income rises by $10 less tax, deferred revenue falls by $10, and the cash flow statement shows the $10 reduction in the liability as a use of cash that offsets the higher net income, because the cash was already collected.

Operating margin expands, because the fixed costs are spread over more revenue while variable costs rise only in proportion. That is operating leverage. A company with 60 percent fixed costs and a 10 percent operating margin can see operating income grow far faster than 10 percent on a 10 percent revenue increase; the reverse is also true when revenue falls, which is why high operating leverage makes earnings volatile.

Income statement: operating income falls by $10, taxes fall by $2.50, net income falls by $7.50. Cash flow statement: net income is down $7.50, but depreciation is a non-cash expense so $10 is added back; cash from operations is up $2.50. Balance sheet: cash is up $2.50 on the asset side and PP&E is down $10 (accumulated depreciation), so assets are down $7.50; on the other side retained earnings are down $7.50. The company is better off in cash by the tax shield, which is the point of the question.

EBIT is operating profit after depreciation and amortization; EBITDA adds those non-cash charges back, which makes it a rough proxy for operating cash generation and makes companies with different asset bases and capital structures comparable. Net income is after interest and taxes. EBITDA misleads when capex is large and recurring (an airline or a telecom must keep spending what it depreciates), when leases or stock compensation are big, or when working capital swings consume the cash EBITDA implies. Interviewers like the line: EBITDA is not cash flow.

An NOL is a tax loss that can be used to offset taxable income in later years, so the company pays less cash tax when it returns to profit. In a model the NOL balance rolls forward: it increases when pre-tax income is negative and is used up, subject to any annual limit, when income is positive, which lowers taxes payable. On the balance sheet the future benefit is a deferred tax asset. Valuation-wise, the NOL has real value because it reduces future cash taxes, so buyers sometimes value it separately.

Purchase: no income statement effect; inventory is up $100 and cash is down $100 on the balance sheet; the cash flow statement shows a $100 increase in inventory as a use of operating cash. Sale: revenue $150 and cost of goods sold $100, so pre-tax income is up $50 and, at 25 percent tax, net income is up $37.50. Balance sheet: receivables up $150, inventory down $100, taxes payable up $12.50 (or cash down if paid), retained earnings up $37.50. Cash flow: net income up $37.50, plus the $100 inventory decrease, minus the $150 receivables increase; if the $12.50 of tax is accrued rather than paid, operating cash flow is exactly zero, which is the point: nothing has been collected yet.

Working capital in a model usually means operating current assets (receivables, inventory, prepaids) minus operating current liabilities (payables, accrued expenses, deferred revenue), excluding cash and debt. An increase in receivables means the company booked revenue it has not collected, so cash flow from operations is lower than net income by that increase; it appears as a negative adjustment. Growth companies often show rising net income and negative operating cash because receivables and inventory grow faster than payables.

Income statement: a $10 gain on sale is recorded below operating income; at 25 percent tax, net income is up $7.50. Cash flow statement: net income is up $7.50, the $10 gain is subtracted in operating cash flow because it is not operating cash and the full proceeds are shown in investing, so operating cash is down $2.50 and investing cash is up $50; net cash is up $47.50. Balance sheet: cash up $47.50, PP&E down $40, so assets are up $7.50, matched by retained earnings up $7.50.

Interest depends on the average of opening and closing debt; closing debt depends on cash available to repay, which depends on net income, which depends on interest. That loop is a circular reference. Options: turn on iterative calculation with a circuit-breaker switch cell that sets interest to zero when the model blows up, compute interest on the opening balance only (no circularity, slightly less precise), or compute interest on average debt but on the prior period's cash sweep. Say which one you would use and why; most bank templates use average balances with a toggle.

Mandatory repayment is the scheduled amortization written into the loan agreement, paid regardless of cash generated. Optional repayment is additional paydown from excess cash. A cash sweep is the rule in a model that sends a set share (often 100 percent) of free cash flow after mandatory payments and a minimum cash balance to repay the most senior prepayable debt first. In an LBO the sweep is what deleverages the company and drives much of the equity return.

Tie each item to the driver it follows. Receivables from days sales outstanding: DSO times revenue over 365. Inventory from days inventory outstanding on cost of goods sold. Payables from days payable outstanding on COGS. Accrued expenses and deferred revenue as a percent of the relevant expense or revenue line. Hold the days constant at the historical average unless there is a reason to change them, then the change in net working capital falls out of the balance sheet and feeds the cash flow statement.

Start with net income. Add back non-cash expenses: depreciation, amortization, stock-based compensation, impairments. Subtract non-operating gains and add non-operating losses, since their cash sits in investing. Then adjust for working capital: subtract increases in operating assets (receivables, inventory, prepaids) and add increases in operating liabilities (payables, accrued expenses, deferred revenue). The result is cash from operations. Capex is not in it; that is investing, which is why free cash flow subtracts capex afterwards.

The revolver is the plug that keeps cash from going negative. Compute cash available before the revolver: opening cash plus cash flow before financing minus mandatory debt payments minus the minimum cash balance. If that is negative the model draws on the revolver by the shortfall; if it is positive it repays the outstanding revolver balance up to that amount. Interest on the revolver (on the average or opening balance) then feeds the income statement, and an unused commitment fee is common. The balance sheet balances because the draw is both cash and debt.

Cash and debt both go up by $95 at issue; the $5 original issue discount is amortized into interest expense over the life of the bond, so book interest expense exceeds cash interest each year and the carrying value of the debt accretes to $100 by maturity. On the cash flow statement the amortization is added back as a non-cash expense. Under US GAAP the discount is shown net against the debt rather than as a separate asset, and the same treatment applies to issuance costs.

Project unlevered free cash flow for five to ten years: EBIT times one minus the tax rate, plus depreciation and amortization, minus capex, minus the increase in net working capital. Discount each year at the weighted average cost of capital, using a mid-year convention if cash arrives through the year. Compute a terminal value by the Gordon growth method (final-year cash flow times one plus g, divided by WACC minus g) or by an exit multiple on terminal-year EBITDA, discount it back, and add it to the sum of discounted cash flows for enterprise value. Subtract net debt, preferred stock and minority interest and add non-operating assets to get equity value, then divide by diluted shares for a value per share.

Perpetuity growth: final-year unlevered free cash flow times one plus the long-term growth rate, divided by WACC minus growth, with growth at or below long-run nominal GDP (2 to 4 percent). Exit multiple: terminal-year EBITDA times a multiple taken from comparable companies. Cross-check each against the other: back out the EBITDA multiple implied by the growth method and the growth rate implied by the multiple method, and make sure neither is absurd. Also check what share of enterprise value comes from the terminal value; above roughly 75 percent means the result rests on the terminal assumptions more than on the forecast.

WACC equals the equity weight times the cost of equity plus the debt weight times the after-tax cost of debt (plus a preferred term if any), with weights at market values. Cost of equity comes from CAPM: risk-free rate plus beta times the equity risk premium. Peer betas reflect each peer's leverage, so you unlever them (beta divided by one plus debt-to-equity times one minus the tax rate), take the median asset beta, and relever it at the target company's capital structure. That gives a beta for the business risk at the right financial risk, which is what the cost of equity should reflect.

Equity value is what the shareholders own: share price times diluted shares. Enterprise value is the value of the operating business to all capital providers: equity value plus debt, preferred stock and minority interest, minus cash and non-operating assets. Raising $100 of debt and holding it as cash leaves enterprise value unchanged, because debt and cash rise together and the operations are the same; equity value is also unchanged. Using that cash to buy an asset that earns more than its cost raises enterprise value; paying a dividend lowers equity value and leaves enterprise value unchanged.

Pick companies with the same business model, end markets, size, growth and margins, in that order of importance, usually five to ten of them, then take the median and the quartiles rather than the mean. EV/EBITDA compares the whole business regardless of leverage, tax jurisdiction and depreciation policy, so it works across companies with different capital structures. P/E is after interest and tax, so it is distorted by leverage and one-off tax items, though it is still standard for banks and insurers, where interest is the business, and it is the multiple equity investors quote.

A sponsor buys a company using a large share of debt, typically 50 to 70 percent of the purchase price, and a smaller equity check. Sources and uses: purchase price plus fees and refinanced debt on the uses side; new debt tranches, sponsor equity and rolled management equity on the sources side. Over the hold period, usually five years, the company's cash flow pays interest and repays debt; the model projects the three statements with the new capital structure and a cash sweep. At exit the company is sold at a multiple of EBITDA, debt is repaid from proceeds, and the remaining equity goes to the sponsor. Returns are measured as IRR and multiple of money, and the deal works if cash flows cover the debt and the exit equity is a multiple of the entry equity.

Three levers: debt paydown (cash flow repays debt, so equity owns more of the same enterprise value), EBITDA growth (revenue growth, margin expansion) and multiple expansion (selling at a higher multiple than paying). Multiple of money is exit equity divided by entry equity and ignores time; IRR is the annualized rate that discounts the exit equity (and any interim dividends) back to the entry check. A 2.0x over three years is about a 26 percent IRR; the same 2.0x over five years is about 15 percent. Sponsors quote both because a fast small gain can show a high IRR with little money made.

When the acquirer's cost of the acquisition is lower than the target's earnings yield. For an all-cash deal, compare the after-tax interest rate on the new debt (or the after-tax return given up on cash) with the target's net income divided by the purchase price; if the target yields more, the deal is accretive. For an all-stock deal, compare the acquirer's P/E with the price paid for the target as a P/E: paying a lower P/E than your own is accretive. Synergies, amortization of new intangibles and transaction fees move the answer, and interviewers expect you to mention them.

Purchase price $800; debt $480, equity $320. EBITDA by year five is $150, so exit enterprise value is $1,200. Debt paydown: assume free cash flow of roughly 40 percent of EBITDA after interest, taxes and capex, so cumulative cash over five years on EBITDA of 110, 120, 130, 140, 150 is about $260, leaving debt of about $220. Exit equity is $1,200 minus $220, about $980. Multiple of money is about 3.1x, and 3.1x over five years is an IRR of roughly 25 percent (3.1 to the power of one fifth is about 1.25). State the free cash flow assumption out loud; the interviewer is checking the method, not the decimals.

Income statement: cost of goods sold (or a separate impairment line) rises by $100, so pre-tax income falls $100 and net income falls $75 at a 25 percent tax rate. Cash flow statement: net income is down $75, but the write-down is non-cash, so $100 is added back; cash from operations is up $25, the tax saving. Balance sheet: inventory is down $100 and cash is up $25, so assets are down $75; retained earnings are down $75. Under US GAAP the write-down is not reversed later even if the inventory recovers.

The mid-year convention assumes cash flows arrive evenly through the year, so a year-n cash flow is discounted by n minus 0.5 periods instead of n; it raises the valuation slightly and is more realistic than year-end timing. A stub period is the fraction of the current year left after the valuation date: scale the first year's cash flow by the stub fraction and discount it at half the stub, then discount later years at stub plus 0.5, stub plus 1.5 and so on. Under the Gordon method the terminal value is discounted with the same mid-year factor as the final year's cash flow, while under an exit multiple it is discounted at year-end timing, since the sale happens at the end of the last year.

A 3x multiple over six years. Use the rule of 72 in reverse: doubling takes 72 divided by the rate; tripling takes about 1.6 doublings. 3x in six years is around 20 percent (1.2 to the sixth is about 2.99). Have a few anchors memorized: 2x in five years is about 15 percent, 2x in three years is about 26 percent, 3x in five years is about 25 percent, 3x in six is about 20 percent. Give the estimate first, then say how you got it.

Start with historical income statement and balance sheet, three years. Project revenue from a growth driver, costs as margins, depreciation from a PP&E schedule with capex, interest from a debt schedule. Build the balance sheet: working capital items from days, PP&E from the roll-forward, debt from the schedule, equity from retained earnings plus net income less dividends. Build the cash flow statement from the changes in those balances; ending cash goes back to the balance sheet, and the revolver plugs any shortfall. Check that the balance sheet balances in every year, then add a scenario switch and sensitivity tables. Say that you build it in that order every time, because that is what they want to hear.