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Chapter 2

Understanding Financial Statements, Taxes & Cash Flows

True/False

1. The income statement represents a snapshot of account balances at one point in time.

Difficulty: Easy

Keywords: financial statements, balance sheet

1. Total equity on the balance sheet increases as dividends paid increases.

Difficulty: Easy

Keywords: financial statements, balance sheet

1. Cash flows from assets will always be less than cash flows from financing due to dividends.

Difficulty: Moderate

Keywords: cash flow from assets, cash flow from financing

1. The marginal tax rate would equal the average tax rate for firms with earnings less than $50,000.

Difficulty: Moderate

Keywords: marginal tax rate, average tax rate

1. An income statement reports a firm’s profit relative to its total investment in plant and equipment.

Difficulty: Moderate

Keywords: income statement, profit

1. A balance sheet is a statement of the financial position of the firm on a given date, including its asset holdings, liabilities, and equity.

Difficulty: Easy

Keywords: balance sheet

1. The income statement describes the financial position of a firm on a given date.

Difficulty: Easy

Keywords: income statement

1. Under current accounting rules, plant and equipment appear on a company’s balance sheet valued at replacement value.

Difficulty: Easy

Keywords: balance sheet, fixed assets

1. The balance sheet describes the financial position of a firm on a given date.

Difficulty: Easy

Keywords: balance sheet

1. An advantage of balance sheet numbers is that assets reflect current market values.

Difficulty: Moderate

Keywords: balance sheet, market vs. book values

1. On an accrual basis income statement, revenues and expenses always match the firm’s cash flow.

Difficulty: Moderate

Keywords: income statement, accrual basis

1. Corporate income statements are usually compiled on an accrual, rather than cash, basis.

Difficulty: Moderate

Keywords: income statement, accrual basis

1. A firm’s balance sheet provides a representation of the current market value of the company.

Difficulty: Moderate

Keywords: balance sheet, market vs. book values

1. The balance sheet provides a statement of the firm’s financial position.

Difficulty: Easy

Keywords: balance sheet measurement

1. The income statement provides a statement of results for the firm’s operations.

Difficulty: Easy

Keywords: income statement measurement

1. The interest payments on corporate bonds are tax-deductible.

Difficulty: Easy

Keywords: tax-deductible expenses

1. Dividends paid to a firm’s stockholders, both preferred and common stockholders, are tax-deductible to the paying company.

Difficulty: Moderate

Keywords: tax-deductible expenses

Multiple Choice

1. Which of the basic financial statements is best used to answer the question, "How profitable is the business?"
2. Balance sheet
3. Statement of shareholder's equity
4. Income statement
5. Accounts receivable aging schedule

Difficulty: Easy

Keywords: income statement

1. What is sales revenue, minus cost of goods sold and operating expenses, known as for income statement purposes?
2. Net profit
3. Retained earnings
4. Net income available to preferred shareholders
5. EBIT

Difficulty: Moderate

Keywords: income statement structure, net income

1. Which of the following streams of income is not affected by how a firm is financed (whether with debt or equity)?
2. Net profit after tax but before dividends
3. Net working capital
4. Operating income
5. Income before tax

Difficulty: Moderate

Keywords: operating income

1. Which of the following is the least liquid current asset?
2. Accruals
3. Marketable securities
4. Accounts receivable
5. Inventory

Difficulty: Easy

Keywords: current assets

1. Who owns the retained earnings of a public firm?
2. The IRS
3. Common stockholders
4. Bondholders
5. Preferred stockholders

Difficulty: Moderate

Keywords: retained earnings, stockholders

1. Fixed assets includes which of the below?
2. Inventory
3. Patents
4. Land
5. Copyrights

Difficulty: Easy

Keywords: fixed assets

1. How does "free cash flow" differ from net profit?
2. It is determined by accrual basis accounting.
3. It takes into consideration a firm’s ongoing investment in working capital and fixed assets.
4. It ignores depreciation and taxes.
5. It is less expensive.

Difficulty: Moderate

Keywords: free cash flow

1. Which of the following items is part of the computation of net operating working capital for purposes of determining free cash flow?
2. Accounts payable
3. Fixed assets
4. Interest expense
5. Dividend payments

Difficulty: Moderate

Keywords: net operating working capital

1. You are about to determine your corporation’s taxable income. Which of the below would not be included as a tax-deductible expense?
2. Marketing expenses
3. Depreciation expense
4. Cost of goods sold
5. Dividend expense

Difficulty: Moderate

Keywords: tax-deductible expenses

1. Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm’s EBIT?
2. $15,552,000
3. $58,000,000
4. $5,110,000
5. $4,630,000

Difficulty: Moderate

Keywords: operating income, EBIT

1. Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm’s gross profit?
2. $18,000,000
3. $15,225,000
4. $5,000,110
5. $6,632,000

Difficulty: Moderate

Keywords: gross profit

1. Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm’s income before tax?
2. $4,360,000
3. $750,000
4. $10,865,000
5. $25,115,000

Difficulty: Moderate

Keywords: earnings before tax

1. Your firm has the following balance sheet statement items: total current liabilities of $805,000; total assets of $2,655,000; fixed and other assets of $1,770,000; and long-term debt of $200,000. What is the amount of the firm’s total current assets?
2. $885,000
3. $1,550,000
4. $600,000
5. $325,000

Difficulty: Moderate

Keywords: current assets

1. Your firm has the following balance sheet statement items: total liabilities of $1,005,000; total assets of $2,655,000; fixed and other assets of $1,770,000; and long-term debt of $200,000. What is the amount of the firm’s total stockholder’s equity?
2. $3,650,885
3. $550,000
4. $1,650,000
5. $833,000

Difficulty: Moderate

Keywords: stockholder’s equity, components of equity

1. Your firm has the following balance sheet statement items: total current liabilities of $805,000; total assets of $2,655,000; fixed and other assets of $1,770,000; and long-term debt of $200,000. What is the amount of the firm’s net working capital?
2. $25,000
3. $325,000
4. $770,000
5. $80,000

Difficulty: Moderate

Keywords: net working capital

1. Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $8,750,000; cost of goods sold of $35,025,000; depreciation and amortization of $1,365,000; and interest expense of $750,000. For purposes of determining free cash flow, what is the amount of the firm’s after-tax cash flow from operations?
2. $255,223
3. $4,731,000
4. $2,385,000
5. $7,775,000

Difficulty: Moderate

Keywords: after-tax cash flow from operations

1. Your firm has the following income statement items: sales of $52,000,000; income tax of $1,880,000; operating expenses of $9,000,000; cost of goods sold of $36,000,000; depreciation and amortization of $1,500,000; and interest expense of $800,000. For purposes of determining free cash flow, what is the amount of the firm’s after-tax cash flow from operations?
2. $1,008,000
3. $3,600,000
4. $5,120,000
5. $750,000

Difficulty: Moderate

Keywords: after-tax cash flow from operations

1. Browning Cookware, Inc. has the following income statement items: sales of $50,250,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. If the firm’s income tax rate is 34%, what is the amount of the firm’s income tax liability?
2. $1,665,000
3. $725,000
4. $385,000

d. $1,482,400

Difficulty: Moderate

Keywords: income tax liability

1. Use the following information to answer the questions below. In 2004, A & K, Inc. expects operating income (earnings before interest and taxes) of $18,000,000. In addition, the corporation has $20,000,000 of debt outstanding with a 10 percent interest rate and will pay $1,000,000 in dividends to its common stockholders. Assume that A & K will receive no other sources of income during 2004. A & K’s taxable income for 2004 will be:
2. $18,000,000.
3. $17,000,000.
4. $16,000,000.
5. $15,000,000.

Difficulty: Moderate

Keywords: taxable income

1. A & K’s total tax liability for 1995 will be:
2. $5,488,250.
3. $5,530,000.
4. $5,600,000.
5. $6,080,000.

Difficulty: Moderate

Keywords: income tax liability

1. A & K’s marginal tax rate for 1995 will be:
2. 38 percent.
3. 35 percent.
4. 34 percent.
5. unknown because too little information is provided.

Difficulty: Easy

Keywords: marginal tax rate

Table 1

Jones Company

Financial Information

March 1995 March 1996

Net income $1,500 $3,000

Accounts receivable 750 750

Accumulated depreciation 1,125 1,500

Common stock 4,500 5,250

Capital surplus 7,500 8,250

Retained earnings 1,500 2,250

Accounts payable 750 750

1. Based on the information given in Table 1, calculate the dividends paid in 1996.
2. $3,750
3. $3,000
4. $750
5. $2,250

Difficulty: Hard

Keywords: dividends paid

Table 2

Bird Industries, Inc.

Balance Sheets

1995 1996

Cash $ 1,000 $?

Accounts receivable 5,000 6,000

Inventories 6,500 6,000

Land 10,000 12,000

Other fixed assets 8,000 9,000

Accumulated depreciation (1,000) (1,600)

Total assets $29,500 $?

Accounts payable $3,200 $ 6,800

Bonds 4,000 4,000

Common stock 17,000 16,000

Retained earnings 5,300 5,000

Total debt and equity $29,500 $?

Bird Industries, Inc.

Income Statement

Sales $84,000

Cost of goods sold 66,400

Gross profit $17,600

Operating expenses (13,000)

Depreciation (600)

EBIT $ 4,000

Interest expense (500)

EBT $ 3,500

Taxes (1,500)

Net Income $ 2,000

1. Based on the information contained in Table 2, what was the total amount of Bird Industries’ common stock dividend for 1996?
2. $800
3. $2,300
4. $2,000
5. Cannot be determined with available information

Difficulty: Hard

Keywords: dividends paid

1. Based on the information contained in Table 2, what was Bird Industries’ cash balance as of December 31, 1996?
2. $300
3. $400
4. $100
5. $1,100

Difficulty: Moderate

Keywords: cash balances

Table 3

Snark Enterprises, Inc.

Balance Sheets

1996 1996

Cash $ 1,000 $?

Accounts receivable 8,000 9,000

Inventories 4,000 7,000

Land 10,000 10,000

Other fixed assets 5,000 5,500

Accumulated depreciation (1,600) (2,000)

Total assets $26,400 $?

Accounts payable $4,200 $ 7,000

Bonds 4,000 4,000

Common stock 15,000 16,000

Retained earnings 3,200 3,800

Total debt and equity $26,400 $?

Snark Enterprises, Inc.

Income Statement

Sales $44,900

Cost of goods sold (22,000)

Gross profit $12,900

Operating expenses (10,000)

Depreciation (400)

NOI $ 2,500

Interest expense (500)

EBT $ 2,000

Taxes (1,000)

Net Income $ 1,000

1. Based on the information contained in Table 3, what was the total amount of Snark Enterprise’s common stock dividend for 1996?
2. $0
3. $400
4. $600
5. Cannot be determined with available information

Difficulty: Hard

Keywords: stock dividend

1. Based on the information contained in Table 3, what is Snark Enterprise’s cash balance as of December 31, 1996?
2. $1,100
3. $900
4. $1,300
5. None of the above

Difficulty: Moderate

Keywords: cash balances

1. Which of the following represents an attempt to measure the earnings of the firm’s operations over a given time period?
2. Balance sheet
3. Cash flow statement
4. Income statement
5. None of the above

Difficulty: Easy

Keywords: income statement measurement

1. Which of the following best represents operating income?
2. Income after financing activities
3. Earnings before interest and taxes
4. Income from capital gains
5. Income from discontinued operations

Difficulty: Moderate

Keywords: operating income, EBIT

1. Which of the following best represents the stream of income that is available to common stockholders?
2. Net profit after tax and after preferred dividend payments
3. Earnings before interest and taxes
4. Gross profit
5. Operating profit

Difficulty: Moderate

Keywords: income available to shareholders

1. Which of the following best describes a balance sheet?
2. Reports cash receipts and cash disbursements for a specific accounting period.
3. Reports investment activities for a specified accounting period.
4. Reports revenues and expenses for a specific accounting period.
5. Reports the amount and composition of assets and liabilities at a specified point in time.

Difficulty: Moderate

Keywords: balance sheet measurement

1. Which of the following would not be included as an asset on a corporate balance sheet?
2. Accounts receivable
3. Common stock
4. Inventory
5. Buildings

Difficulty: Easy

Keywords: balance sheet assets

1. Which of the following would not be included as a liability in a corporate balance sheet?
2. Accruals
3. Notes payable
4. Accounts payable
5. Bonds
6. Depreciation

Difficulty: Easy

Keywords: balance sheet liabilities

1. Which of the following would not be included as equity in a corporate balance sheet?
2. Cash
3. Paid in capital
4. Preferred stock
5. Retained earnings
6. Common stock

Difficulty: Easy

Keywords: balance sheet equity

1. Which of the following does NOT represent cash outflows to the firm?
2. Taxes
3. Interest payments
4. Dividends
5. Purchase of plant and equipment
6. Depreciation

Difficulty: Moderate

Keywords: cash outflows

1. Which of the following is NOT included in operating income?
2. Cost of goods sold
3. Sales
4. Taxes
5. Operating expenses

Difficulty: Easy

Keywords: income statement, operating income

1. Which of the following is NOT considered a fixed asset?
2. Land
3. Equipment
4. Patents
5. Building

Difficulty: Easy

Keywords: balance sheet accounts, fixed assets

1. Holding all other variables constant, which of the following will decrease total equity? An increase in:
2. common stock issued
3. dividends paid
4. net income
5. interest expense

Difficulty: Moderate

Keywords: balance sheet accounts, equity

1. Using the information provided, calculate net income for 2002. Assume a tax rate of 40 percent.

Year 2002

Inventory $5,000

Revenues 200,000

Depreciation expense 5,000

Cost of goods sold 100,000

Interest expense 10,000

Operating expenses 30,000

1. $33,000
2. $44,000
3. $55,000
4. $66,000

Difficulty: Moderate

Keywords: income statement

1. Based on the following selected financial information for Sheets Metalworks, calculate net income for 2003.

2002 2003

Dividends paid $400 $700

Accts. payable/accr. 300 500

Long-term debt 2,300 2,000

Common stock 2,200 3,000

Retained earnings 6,150 6,350

1. $100
2. $300
3. $500
4. $700
5. $900

Difficulty: Moderate

Keywords: income statement

1. Grass Gadgets had sales of $30 million and net income of $2 million in 2002. Grass paid a dividend of $1.5 million. Assuming that their beginning balance for retained earnings was $3 million, calculate their ending balance for retained earnings.
2. $2.5 million
3. $3 million
4. $3.5 million
5. $4 million

Difficulty: Easy

Keywords: retained earnings, equity

1. Tax tables are based on ______ tax rates.
2. marginal
3. average
4. implied
5. investment

Difficulty: Easy

Keywords: tax tables, tax rates

1. Which of the following is NOT included in the calculation of free cash flows?
2. Interest expense
3. Operating income
4. Depreciation
5. Net operating working capital

Difficulty: Moderate

Keywords: free cash flows

1. Which of the following would be included in the calculation of net operating working capital?
2. Accounts payable
3. Accruals
4. Short-term notes payable
5. Both a and b
6. All of the above

Difficulty: Moderate

Keywords: net operating working capital

1. Free cash flow will increase with a decrease in __________.
2. tax rate
3. accruals
4. depreciation expense
5. both a and c

Difficulty: Moderate

Keywords: free cash flow

1. Stock that is repurchased by the issuing company is called:
2. paid in capital.
3. treasury stock.
4. retained capital.
5. par value stock.

Difficulty: Easy

Keywords: treasury stock

Table 4

Financial Data for Dooley Sportswear, December 31, 1996

Inventory $206,250

Long-term debt 300,000

Interest expense 5,000

Accumulated depreciation 442,500

Cash 180,000

Net sales (all credit) 1,500,000

Common stock 800,000

Accounts receivable 225,000

Operating expenses 525,000

Notes payable-current 187,500

Cost of goods sold 937,500

Plant and equipment 1,312,500

Accounts payable 168,750

Marketable securities 95,000

Prepaid insurance 80,000

Accrued wages 65,000

Retained earnings-current-year ?

Federal income taxes 5,750

1. From the scrambled list of items presented in Table 4, prepare an income statement and a balance sheet for Dooley Sportswear Company.

Dooley Sportswear Company Income Statement

for the Year Ending December 31, 1996

Net sales (all credit) $1,500,000

Cost of goods sold 937,500

Gross profits 562,500

Operating expenses 525,000

Net operating income 37,500

Interest expense 5,000

Net income before taxes 32,500

Federal income taxes 5,750

Net income $26,750

Dooley Sportswear Company Balance Sheet

December 31, 1996

Assets

Current assets

Cash $180,000

Marketable securities 95,000

Accounts receivable 225,000

Inventory 206,250

Prepaid insurance 80,000

Total current assets $786,250

Fixed assets

Plant and equipment $1,312,500

Less: accumulated depreciation 442,500

Net plant and equipment 870,000

Total assets $1,656,250

Liabilities and owner's equity

Current liabilities

Accounts payable $168,750

Accounts payable 187,500

Accrued wages 65,000

Total current liabilities $421,250

Noncurrent liabilities

Long-term debt 300,000

Owner's equity

Common stock 800,000

Retained earnings 135,000

Total owner's equity $935,000

Total liabilities & owner's equity $1,656,250

Difficulty: Hard

Keywords: balance sheet, income statement, financial statement construction

1. Pearls, Inc. had sales in 1993 of $2.1 million. The common stockholders received $400,000 in cash dividends and preferred stockholders were paid $200,000. Interest totaling $150,000 was paid on outstanding debts. Operating expenses totaled $300,000, and cost of goods sold was $500,000. Stock that had been purchased for $50,000 in 1987 was sold for $70,000. What is the tax liability of Pearls, Inc.?

Pearls Taxable Income

Sales $2,100,000

Less:

Cost of goods sold $500,000

Operating expenses 300,000

Operating profit $1,300,000

Other income (Security Sale) 20,000

Earnings before interest & taxes $1,320,000

Interest expense 150,000

Taxable income 1,170,000

Total taxes owed $397,800

Taxes on operating earnings = (.15)(50,000) + (.25)(25,000) + (.34)

(1,095,000)+(.05)(235,000) = 7,500 +

6,250 + 372,300 + 11,750 = $397,800 or

Because taxable income is over $335,000

taxes can be computed 1,170,000 × .34 =

$397,800

Difficulty: Hard

Keywords: tax liability

1. Goodwin Enterprises had a gross profit of $2,500,000 for the year. Operating expenses and interest expense incurred in that same year were $595,000 and $362,000, respectively. Goodwin had 200,000 shares of common stock and 180,000 shares of preferred stock outstanding. Management declared a $2.50 dividend per share on the common and a $1.50 dividend per share on the preferred. Securities purchased at a cost of $37,500 in a previous year were resold at a price of $50,500. Compute the taxable income and the resulting tax liability for Goodwin Enterprises for the year.

Use the following tax rates:

Income Tax rate

$0-$50,000 15%

$50,001-$75,000 25%

$75,001-$100,000 34%

$100,001-$335,000 39%

over $335,001 34%

Gross profit $2,500,000

Operating expenses (595,000)

Interest expense (362,000)

Income before tax $1,543,000

Add: Gain on sales 13,000

Taxable Income $1,556,000

Income Marginal Tax Rate Tax Liability

$50,000 × 15% $7,500

$25,000 × 25% $6,250

$25,000 × 34% $8,500

$235,000 × 39% $91,650

$1,221,000 × 34% $415,140

$1,556,000 $529,040

Difficulty: Hard

Keywords: tax liability