Ah, this is the $64,000 question, isn’t it? That’s why I saved it for last. The answer is, of course, that it depends. And what it depends on, of course, is you. Most of the folks interested in investment banking can be divided into three categories:
■ Recruiting for an analyst position as a stepping stone to the buy side.
■ Recruiting for an associate position as a stepping stone to the buy‐
side or some other career.
■ Considering investment banking as a long‐term career.
Let us discuss the pros and cons of investment banking for each group.
Recruiting for an analyst position as a stepping stone to the buy side
The surest way into private equity and well‐regarded hedge funds is to have been an investment banking analyst. In fact, there are very few other routes in. So, if you are looking for a career in private equity or hedge funds, if you want to be the next Henry Kravis or George Soros, then recruiting for an investment banking analyst
program out of an undergraduate institution is close to what we call a no‐brainer.
Your life for two years will be hard. But you are young, you have lots of energy, and you probably do not have a family yet. Hence, the sacrifices you will make are a little bit easier to swallow than they are for others. Plus, given that most analysts only stay for two years before moving on, there is a light at the end of the tunnel. Two years goes by pretty quickly, even while working 100‐hour weeks.
Moreover, the skills and experiences that you will receive as an ana- lyst will be valuable for anything you wind up doing professionally later in your career. This includes not just the finance skillset, but the work ethic, attention to detail, and ability to deal with difficult people.
Whether a long‐term career in private equity or hedge funds is worth it is a separate question altogether. While we will not discuss it directly, most of the factors you should take into account when considering a long‐term career in banking (see the following sec- tion) are similarly relevant.
Recruiting for an associate position as a stepping stone to another career
Each year, lots of MBA students recruit for investment banking as- sociate jobs. Some of them are interested in having a career as an investment banker. Others view banking as a bridge to another ca- reer, just as do prospective analysts. Then there are those that pur- sue banking because they do not know what else to do, or they get caught up in the prestige, or because it just seems like a cool thing to do. If you fit into the second or third groups, you need to really think about whether banking is worth it.
Similar to being an analyst, you will learn very valuable finance and life skills as an associate. You should also make pretty good money, which is especially helpful for the majority of associates who have graduated business school with large student loans. But, you need to understand that the exit opportunities as an associate are much more limited than those of an analyst, especially to the buy side. Please don’t expect to work two years as an associate and then go and do mega‐buyouts at KKR. The odds of that happening are slim indeed.
Furthermore, unlike the analyst program, which is typically two years in length, there is no obvious exit ramp as an associate. The minute you decide that you want out of banking, your performance will suffer, and you will have difficulties mustering the energy to do
the work and put up with the hours, lifestyle, and difficult people.
It will be hard to hide your lack of motivation from peers and su- periors alike. This can impact not only your compensation but also your ability to get a new job.
Lastly, keep in mind that the longer that you stay in banking, the harder it is to leave it. Not only do the exit opportunities diminish over time, but you also get accustomed to the level of compensa- tion, and the lifestyle and ego that the compensation affords. Few other jobs will be able to match this.
Considering investment banking as a long‐term career
Now, let’s talk about those of you who are considering being an investment banker as a career. You need to decide what is important to you. Long‐term, the primary reason to be an investment banker is for the money. As mentioned multiple times in this chapter, there are few careers that pay as well as investment banking. But you need to be willing to make many sacrifices.
Will you be able to take vacations, flying first class and staying at the Four Seasons? Probably. Will you be able to relax by the pool uninterrupted by conference calls? Probably not. Will you be able to send your children to the finest private schools? Probably. Will you be around to attend most of their soccer games and ballet recit- als? Probably not. You get the idea.
Money is not the only consideration if you are thinking about a career as an investment banker. You also need to like the work, the culture, and the people. Merely being able to tolerate these things is not enough. Finally, the most successful bankers are often what we call deal junkies. They get satisfaction and an ego boost out of clos- ing a deal—and then they move on to the next deal, the next client.
As for us, let’s move on to all of the knowledge and skills you will need to be an investment banker. That is what the rest of this book is about.
55
2
accounting Overview
It is often said that accounting is the “language” of business. To be truth- ful, one does not really need to be fluent in the language of accounting in order to start or even successfully operate a business. However, to analyze the financial performance of a business is a different story. And analyzing the financial performance of businesses is something that junior investment bankers spend more time doing than perhaps any other task.
Without a basic understanding of accounting principles, the job of an investment banker would be exceedingly difficult. Stated differently, an in- vestment banker without fundamental accounting knowledge will likely not be an investment banker for very long. Nor is it likely that a prospective investment banker without basic accounting knowledge will perform very well in the interview process.
This chapter is meant to provide you with an introduction to the prin- ciples of accounting and, as such, serves as a prerequisite for most of the remainder of this book and for many of the technical questions that you are likely to encounter in the investment banking interview process. However, as with the rest of this book, I have not assumed any prior experience. Even if you have never taken an accounting course before, you should be able to follow along and learn the essential basics of accounting by reading this chapter.
Of course, this chapter is not meant to be as comprehensive as a semester‐long accounting class or an accounting textbook. You will not pass a CPA exam or be ready to be an auditor after reading this chapter.
But that’s okay. Investment bankers do not need to be accounting experts.
While possessing more accounting knowledge is certainly helpful, one can be a very successful banker knowing (and truly understanding) the basics.
This chapter is laid out as follows. We will start with a brief overview of the different types of accounting and some important general accounting principles. Then we will move on to a discussion of the three financial state- ments: the income statement, the balance sheet, and the statement of cash
flows. For each of the three statements, we will discuss the most important line items and principles relevant to an investment banker. The final section of this chapter discusses how the three financial statements are integrated and in- cludes a number of numerical examples to help demonstrate these interactions.
Of course, if you already have a strong accounting background, you may want to skim or even skip most of this chapter. However, regardless of the strength of your accounting background, I encourage you to read through the final section of this chapter. This section, and especially the examples, serve as a good test of whether you really understand accounting principles and are also helpful preparation for technical interviews. I have found through my own experience that even students with strong account- ing backgrounds often struggle with these types of questions, especially un- der the pressure of an interview.
IntrOduCtIOn tO aCCOuntIng
You may have heard the statement that companies keep three sets of
“books”: one for outside investors and lenders, one for the tax authorities, and one to help management run the business. These three books, or sets of financial statements, correspond to the three main types of accounting, which are:
■ Financial accounting.
■ Tax accounting.
■ Managerial accounting.
Financial accounting
Financial accounting is used to record and classify a business’s financial in- formation for use in analyzing the business’s performance by outsiders of the company. These outsiders include investors, lenders, and anyone else who needs to analyze or inspect the company’s financial performance. For pub- licly traded companies, financial accounting is used to put together the finan- cial statements that are contained in quarterly and annual financial reports.
(These financial reports will be one of the topics discussed in Chapter 4.) Investment bankers are primarily concerned with this type of accounting, and therefore it is financial accounting on which we will almost solely focus.
tax accounting
Tax accounting is used to comply with jurisdictional tax regulations and laws, such as local, state, or national tax authorities. Suffice it to say, tax
rules are highly complicated and are typically not something with which investment bankers need (or want) to understand or analyze in great detail.
However, there are certain circumstances where tax accounting does have an effect on financial accounting. We will discuss some of these instances, as they come up, throughout the book.
Managerial accounting
Managerial accounting is used within a company by management for the purposes of internal planning and decision making. For example, suppose that one division of a company produces material that is then used as an input to a product produced by another division. Managerial accounting deals with the sometimes complicated issues of how to price this material (known as transfer pricing) so that management can achieve an understand- ing of each division’s standalone profitability. Investment bankers are rarely concerned with managerial accounting, and, as such, we will not cover it any further in this book.
generally accepted accounting principles (gaap)
All developed countries have standards of financial accounting, which are known as generally accepted accounting principles, or GAAP. GAAP in- cludes the standards, conventions, and rules that accountants follow when recording and summarizing transactions, and in the preparation of financial statements.
It is important to be aware that these principles, as detailed as they often are, do not always provide accountants with clear rules for every situation.
Often there are leeway and ambiguity in the guidelines. This may sometimes lead to controversial accounting decisions and can leave room for the ma- nipulation of financial performance.
In the United States, the organization whose primary purpose is to de- velop these generally accepted accounting principles is known as the Fi- nancial Accounting Standards Board (FASB). Interestingly, the FASB is a private‐sector organization and not a government body.
The International Accounting Standards Board (IASB) is an organiza- tion that was founded in 2001 with the purpose of developing (and stand- ardizing) worldwide accounting standards. These standards are known as the International Financial Reporting Standards (IFRS). There have been many discussions and negotiations to have U.S. GAAP and IFRS rules con- verge, but to date this convergence has not fully occurred.
Even though there are some differences between U.S. GAAP and IFRS, the general accounting principles are the same. However, the financial
statements themselves can, and do, differ significantly country to country in both structure and order of line items, and in the terminology used to describe certain line items. A competent investment banker should be able to interpret financial statements of a company from any country with de- veloped financial reporting standards once they familiarize themselves with how those statements are structured.
the InCOMe StateMent
Before we introduce the income statement, we need to first discuss the method in which companies record their operating performance for the purpose of creating their financial statements. There are two account- ing approaches that a firm’s accountants can theoretically use to measure operating performance:
1. Cash basis.
2. Accrual basis.
Cash Basis of accounting
Under the cash basis of accounting, a company “books” or recognizes revenue from selling goods or providing services at the time in which it receives cash from customers. Correspondingly, the firm recognizes expenses at the time in which it pays for (i.e., makes cash expenditures) goods and services such as raw materials, office rent, salaries, taxes, and so forth.
There are two big advantages to cash basis accounting. First, under the cash basis, financial statements are relatively easy to compile. The company, or its accountants, need simply to monitor and record the inflows and out- flows of cash. Profitability is also easy to measure, as it is essentially the dif- ference each period between incoming cash and outgoing cash.
For example, suppose a company receives from its customers $100 this month from the sale of its products. Further suppose that the company paid
$80 this month to its suppliers for the raw materials that are used to make the company’s products. Assuming no other cash transactions, it is easy to calculate that the company’s profit that month is $20.
The second advantage of the cash basis of accounting is that, as stated, it measures the inflows and outflows of cash. While an obvious statement, its significance is large. That is because the generation of cash is the ultimate true purpose of for‐profit companies, as we will see when we discuss valu- ation in Chapter 5. The theoretical value of a company is the sum of its (present valued) cash flow stream. In other words, cash is king.
Unfortunately, the cash basis of accounting suffers from some large dis- advantages. In fact, these disadvantages almost always outweigh the two benefits that we’ve already discussed. The first and most significant down- side to cash basis accounting is that the costs of generating revenues are not properly “matched” with the benefits. Without such matching, it is very difficult to analyze whether the company’s operations are truly profitable, or to measure the extent of that profitability. Moreover, this mismatch of revenues and costs can make it extremely difficult to compare operational performance from one period to the next.
For example, suppose that in Year 1, a company pays for $100 worth of inventory, and then in Year 2 the company sells all of that inventory for
$200. Under the cash basis of accounting, and assuming no other transac- tions either year, the company would report a loss of $100 in Year 1 ($0 of revenue and $100 of costs) and a profit of $200 in Year 2 ($200 of revenue and $0 of costs). As you can probably tell, this form of accounting distorts any reasonable measure of profitability. A more meaningful measure of prof- itability would have been $100 ($200 of revenue and $100 of costs).
A further disadvantage of the cash basis of accounting is that it is some- what easier for a company to manipulate its operating performance by tim- ing sales and purchases. That is, an employee of the company might be able to delay payment to a vendor from December to January (thus reducing the company’s costs in Year 1) or ask a friendly customer to prepay for an order in December that isn’t supposed to ship until January (thus increasing sales in Year 1), either of which would result in higher profits (and perhaps a higher bonus for the employee) in the first year.
accrual Basis of accounting
The alternative method of measuring and recording performance is known as the accrual basis of accounting. The accrual basis of accounting is based on an important concept, known as the matching principle. This match- ing principle dictates that revenue is recognized when a firm sells goods or provides services, not when the money is actually received from a customer.
Even more importantly, the costs of the assets used to produce those goods or provide those services (known as the direct costs) are recognized and recorded at the exact same time. For a manufacturer, these direct costs typically include such things as the raw materials used to make the product, the packaging, and the direct labor involved.
For example, let’s assume that a company sells $100 of widgets. At the exact same time of the sale, the company will also recognize an expense for the direct costs that went into producing those widgets (let’s say $80). This holds true even if those widgets were actually produced or the raw materials were actually paid for in a previous fiscal period.
Cost of assets used that do not easily match up with particular rev- enues (referred to as the indirect costs) are recognized when those assets are
“used.” These indirect costs includes things such as marketing and advertis- ing, rent on the company’s headquarters, and management salaries. Since these types of costs cannot be directly matched to the production and sale of widgets, the company will expense them as incurred.
The advantages of accrual accounting over cash‐based accounting are significant. Most importantly, operating performance is much easier to com- pare from one period to another using the accrual method. In addition, there are fewer opportunities for the firm to distort or manipulate earnings due to deliberate timing decisions. Of course, as periodic accounting scandals show us, regardless of accounting systems, there will always be opportunities for devious management to manipulate financial statements and mislead lend- ers and investors.
For these reasons, nearly all medium‐sized to large companies, includ- ing all publicly traded companies and even many small companies, use the accrual basis of accounting. In fact, it is unusual for an investment banker to ever encounter a company that does not use the accrual method. As such, in this book we will always assume the use of this method of accounting.
Income Statement Overview
The income statement presents the results of the operating activities of a firm for a specified period of time. By operating activities, we mean the company’s revenue, costs and profits. The specific period time could be any period of time, such as one day, three weeks, seven months, and so on. How- ever, most of the time, investment bankers are using and analyzing audited financial statements, which are typically produced using three‐month inter- vals (a fiscal quarter) or 12‐month intervals (a fiscal year).
The basic income statement looks as follows:
Revenue
Less: Cost of Goods Sold (COGS)
= Gross Profit
Less: Selling, General and Administrative (SG&A)
= Operating Income (EBIT) Less: Net Interest Expense
= Earnings Before Taxes (EBT) Less: Income Tax Expense
= Net Income