Chapter 2: Financial Statements, Taxes, and Cash Flows

Question 1

Operating Expense

Answer 1

Includes things such as marketing, administrative, selling, etc.

Question 2

Income Statement

Answer 2

Sometimes it is known as a profit/loss statement. It helps us understand the ability of a business to generate profits.
- It measures the result of firm’s operation over a specific period (usually is 1 year)

Sales (Revenue) - Expenses = Profits

Question 3

What is included in “Expenses” on the income statement?

Answer 3

• Cost of Goods Sold
• Operating Expenses
• Financing Costs
• Tax Expenses

Question 4

Marginal Tax Rates

Answer 4

The additional tax you pay for every dollar owned, done on a bracket/margin system. So, for example, if you have a taxable income between $0- $9,950, you would be taxed 10%. However, if you received an increase in income, putting you at $10,000, you would land in the next tax bracket ($9,950- $40,525) and any additional income above $9,950 would be taxed by 12%.

Question 5

Average Tax Rate

Answer 5

Total Tax/Taxable Income

Question 6

What is financing?

Answer 6

How you come up with money to finance your company.

Question 7

Income Statement Structure

Answer 7

Total Revenue (Sales)- COGS = Gross Profits. - Operating Expenses= Operating Income (EBIT) - Interest= Pre-Tax Income (Taxable Income) - Taxes = Net Income.

Question 8

EBIT

Answer 8

Earnings before interest and taxes.

Question 9

What is the equation for Earnings per Share (EPS?)

Answer 9

EPS= Net Income/# of Shares

Question 10

What is the equation for Dividend per Share (DPS)?

Answer 10

DPS= Dividends/# of Shares

Question 11

Balance Sheet

Answer 11

Provides a snapshot of a firm’s financial position at a particular date. It includes three main items: assets, liabilities, and shareholders’ equity (owner-supplied capital).

A = L + E

Question 12

Assets

Answer 12

Resources owned by the firm.

Question 13

Liabilities & Owner’s Equity

Answer 13

Indicate how those resources (assets) are financed.

Question 14

Book Value

Answer 14

The balance sheet value of the assets, liabilities, and equity (Transactional price).

Question 15

Market Value

Answer 15

True Value; the price at which the assets, liabilities, or equity can actually be bought or sold.

Question 16

Wy are market value and book value different?

Answer 16

Time value of money and depreciation play a large role in these differences.

Question 17

Which is more important to the decision-making process? Book value or market value?

Answer 17

Market value. People will bargain. Furthermore, as alluded to in the definition, this gives us the ‘true’ value that is determined by the market. Demand and supply.

Question 18

Current Assets

Answer 18

Cash and other assets expected to be exchanged for cash or consumed within a year.
- Cash
- Accounts Receivable
- Inventory
- Other current assets (prepaid expenses)

Question 19

Long-Term Assets

Answer 19

Assets that are expected to be used in business operations for longer than one year.
- Fixed Assets (PPE)
- Other Assets:
~ Long-term investments
~ Goodwill, patents, copyrights, and trademarks.

Question 20

Liquidity

Answer 20

The ease with which an asset can be converted into the economy’s medium of exchange (without losing too much of the value).

Question 21

Current Liability

Answer 21

Debt that must be paid within one year.
- Accounts Payable
- Short-term notes
- Other current liabilities:
~ Accrued wages, taxes payable, interest payable.

Question 22

Long-term Liability

Answer 22

• Long-term debt.
• Mortgages.

Question 23

Equity on the Balance Sheet

Answer 23

Preferred stock.
- They receive fixed dividends in perpetuity
- Cannot vote.
Common Stock
- Retained Earnings (cumulative)

Question 24

What is the equation for net working capital?

Answer 24

Net Working Capital= Current Assets - Current Liabilities

The larger the net working capital, the better the firm’s ability to repay its debt.

Question 25

What is the 1st principle of finance?

Answer 25

Profits DO NOT equal Cash Flows

Question 26

Accrual Basis

Answer 26

The principle of recording revenues when earned and expenses when incurred rather than when cash is received or paid. Thus, in the income statement:

Sales Revenue = Cash + Credit Sales
Inventory Purchases= Cash + Credit Purchases

Note that Depreciation is a noncash expense.

Question 27

Cash Basis Accounting

Answer 27

in this type of accounting, revenues are reported when cash is received, and expenses are recorded when they are paid. Thus, in the cash flow statement:

Sales Revenue= Cash
Inventory Purchases= Cash

Depreciation expense is a noncash expense -> We recognize equipment purchases rather than recording deprecation expense.

Question 28

What is the basic objective of a statement of cash flows?

Answer 28

The basic objective of this statement is to explain how much the cash balance of a business changed during a period and why it changed. It discloses other information including:
- How much cash earnings during the period, as contrasted with accrual earnings in the income statement.
- How much and where the company reinvested cash during the period to sustain and grow.
- How much cash it raised from or returned to its debt and equity investors.

Question 29

What parts are included in a ‘template’ for the statement of cash flows?

Answer 29

1) Cash flows from operations.
2) Cash flows from investing.
3) Cash flows from financing.

These combined tell us what our net changes in cash balance are.

Question 30

What does ‘cash flows from operations’ include?

Answer 30

Net cash flow from operations, after taxes and interest expenses. You can find it in changes in current assets and non-debt current liabilities.

Question 31

What does ‘cash flows from investing’ include?

Answer 31

Net cash flow from:
- Issue or repurchase of equity.
- Issue or repayment of debt.
- Dividend payments

You can find it in changes in short- and long-term debit, common stock, and dividends (Equity).

Question 32

What are sources of cash?

Answer 32

Decrease in an Asset.
- For example, selling inventories or collecting receivables provides cash.

Increase in a Liability or Equity
- For example, borrowing funds or selling stock provides the firm with cash.

Question 33

What are uses of cash?

Answer 33

Increases in an Asset
- For example, investing in fixed assets or buying more inventories uses cash.

Decreases in a Liability or Equity
- For example, paying off a loan or buying back stock uses cash.

Question 34

Converting accrual basis accounting to cash basis:

Answer 34

Cash flow from operations: start with net income.
1) Add back depreciation.
2) Changes in current assets
- Cash, accounts receivable, inventory, other current assets.
3) Changes in non-debt current liabilities.
- Accounts payable, accrued liabilities.

Question 35

What is the goal of free cash flow?

Answer 35

The goal is to find out cash flow available to investors.

Question 36

What are two alternative ways to measure cash flows?

Answer 36

1) Free Cash Flows (Cash Flow from Assets)
2) Financing Cash Flows (Cash Flow to Creditors & Stockholders)

Question 37

Free Cash Flows

Answer 37

The amount of cash available from operations after the firm pays for all its investments. This remaining cash is free to be distributed to the creditors and shareholders.

Question 38

Financing Cash Flows

Answer 38

The amount of cash received from or distributed to the firms’ investors (e.g., interest, dividends, issuance of debt, debt repayment, issuance or repurchase of stock).

Question 39

What is the ‘template’ for finding free cash flows?

Answer 39

Start with:
1) Operating Cash Flow
2) Subtract Changes in Long-Term Assets (Capital Spending)
3) Subtract Changes in Net Working Capital
= Free Cash Flows

Question 40

Operating Cash Flow

Answer 40

Start with Operating Income (EBIT), add back in depreciation expense (noncash items), subtract income taxes, and you will get the operating cash flow. Note that this is not the same as the ‘cash flow from operations’.
- When we construct cash flow statements, we start with net income. here, we are starting with the EBIT.

Question 41

Changes in Long-Term Assets:

Answer 41

Calculated by taking Ending Period Gross Fixed Assets and subtracting Beginning Gross Fixed Assets.

Question 42

Changes in Net Working Capital

Answer 42

Changes in NWC = Ending NWC - Beginning NWC

Dr. Du suggests calculating it by:
Changes in Current Assets- Changes in Current Liabilities.

Question 43

Is paying interest to lenders a cash inflow or outflow?

Answer 43

This would be a cash outflow.

Question 44

Is an increase in debt a cash inflow or outflow?

Answer 44

This would be a cash inflow. You are barrowing money.

Question 45

Is a decrease in debt a cash inflow or outflow?

Answer 45

This is a cash outflow. You are paying off debt.

Question 46

Is paying out dividends to stockholders a cash inflow or outflow?

Answer 46

This is a cash outflow.

Question 47

Is the issuance of stock to new shareholders a cash inflow or outflow?

Answer 47

An increase in stock is an inflow.

Question 48

Is the repurchase of stock from current investors a cash inflow or outflow?

Answer 48

This would be a cash outflow.

Question 49

What are some accounting malpractice and limitations of financial statements?

Answer 49

1) Financial statements are interim reports, reflecting historical costs for a certain time period. (Time issue).
2) Since accounting rules give managers discretionary powers, it is possible that two firms with similar financial performance may report different results without violating GAAP. (Earnings Management)
3) There have been several cases of accounting malpractice where rules have been broken.
- E.g., Lehman Brothers uses Repo 105 to manipulate financial statements (2008)

Question 50

A corporation has an operating profit margin of 20%, operating expenses of $500,000, and financing costs of $15,000. Therefore:

A) The corporation’s gross profit margin is equal to 20% because gross profit is not affected by operating expenses or financing costs.
B) The corporation’s gross profit margin is less than 20%.
C) The corporation’s gross profit margin is greater than 20%.
D) The corporate’s net profit margin is greater than 20%.

Answer 50

The corporation’s gross profit margin is less than 20%

Question 51

Owner’s equity increases each period by the amount of the corporation’s positive net cash flow. True or False?

Answer 51

False. It should increase by the amount of retained earnings.

Question 52

Which of the following is an example of a firm’s financing costs?

A) Interest Expense
B) Depreciation Expense
C) Cost of Goods Sold
D) Advertising Expense

Answer 52

Interest Expense

Question 53

All of the following statements about balance sheets are true EXCEPT:

A) A balance sheet reports a company’s financial position at a specific point in time.
B) Balance sheets show average asset balances over a one-year period.
C) Assets are reported at historical cost.
D) Assets - Liabilities = Shareholders’ Equity

Answer 53

Balance sheets show average asset balances over a one-year period.