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Investment Banking Interview T opic: Net Income vs Cash Flow

Posted on December 8, 2011 by Matan Feldman | Leave a comment

The technical side of the inv estment banking interv iew is often comprised of v aluation questions, capital markets questions, and accounting questions. When it comes to accounting, a fav orite interv iew topic is the relationship between cash flows and net income. It is almost inev itable that a candidate will encounter questions like these (answers at end of article): if cash flows from operations are consistently lower than net income, what could this be an indication of? * can a company showing increasing operating cash flows relativ e to net income be in financial distress? ** can a company showing negativ e cash flows be in great financial health? *** Stated more broadly , these questions are all essentially asking: whats the relationship between net income and cash flow? This mornings Wall Street Journal prov ided us with a great illustration of this relationship. The Journal contained an article that ex plained how Av ons ratio of cash flows to net income has been consistently low, and that it may be a harbinger of future problems:

analysts and accounting experts are particularly concerned about a long-term trend they say raises a red flag: The supply of cash Avon has available for such purposes as paying dividends, buying back stock and reducing debt has fallen short of its reported earnings for most of a decade. Avons stock has fallen more than 40% this year. The problem here is not that net income has div erged from cash flows recently , rather, its that the div ergence has been going on for nearly a decade. Temporary differences between cash flows and accounting based profit (net income) are normal. For ex ample, if Av on inv oices customers, y ou would ex pect rev enues to be greater than actual cash flows collected in certain periods. In addition, since inv estments like the purchase of PP&E and other assets are depreciated ov er time, thereby impacting net income more smoothly than the one-time hit of a large purchase on the cash flow statement, large dev iations in any giv en period are not necessarily nefarious. The problem emerges when the difference is persistent ov er time. In our ex ample, the inv oiced customers must at some point pay in cash and so if y ou dont see the cash coming in during the nex t period, it might be a red flag. Similarly , a major PP&E inv estment in one period would certainly ex plain lower cash flows than net income in that particular period, but in the subsequent period, y oud ex pect a swing back, since the net income is still capturing the depreciation ex pense from the prior-period purchase but there is no cash flow impact any more. There are many possible ex planations for persistent div ergences, most of which are not v ery good. For ex ample, if a company is aggressiv ely booking rev enues from customers that ultimately dont pay , y ou could potentially see sev eral y ears worth of higher rev enue than cash receipts before the jig is up. Similarly , if capital inv estment made in the past is not generating sufficient returns, this can be somewhat obfuscated with deprecation assumptions that dont accurately capture the v alue of the inv estment in net income. A more sinister ex planation is blatant earnings manipulation. In Av ons case, all of the abov e may be the culprit: The analysts and experts say w ide and persistent gaps betw een the tw o figures typically indicate that a companys investments arent paying off very w ell or that its net income doesnt fully reflect depreciation and other costs of those investments. Net income amounts to revenue minus costs and the depreciation of a companys assets. Since free cash flow and net income tend to balance out over the long run, persistent gaps betw een them can be a harbinger of asset w ritedow ns or drop-offs in profit. For students try ing to break into inv estment banking, equity research, priv ate equity , or asset management, ultimately the key to nav igating through these ty pes of questions is deeply understanding the relationship between the cash flow statement and the income statement.

* Av on is a perfect ex ample of this ty pe of scenario. Net income is high but cash flows are low. Reasons include: Low returns from PP&E inv estments and possible earnings manipulation. Read full article here. ** Y es, and this is not uncommon. As a company enters financial distress, it will hoard cash, not pay ing v endors, and collecting aggressiv ely from suppliers. In the meantime, it will reduce capital inv estments, and not pay creditors. *** Imagine Boeing secures sev eral key long term contracts to deliv er airplanes to major airliners. Depending on the agreement, cash flows from the airliners may come in after the company begins massiv e capital inv estments to serv ice the contracts. This would show a poor negativ e cash flow position, despite an income statement that captures those ex pected rev enues.
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This entry was posted in Inv estment Banking Interv iew Prep and tagged accounting, interv iew prep, inv estment banking. Bookmark the permalink.

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