Chapter 3 - Financial Statements, Cash Flow, and Taxes Flashcards
What provides a snapshot of a firm’s financial position at one point in time?
The Balance sheet
What summarizes a firm’s revenues and expenses over a given period of time?
The Income statement
What reports the impact of a firm’s activities on cash flows over a given period of time?
The Statement of cash flows
What shows how much of the firm’s earnings were retained, rather than paid out as dividends?
The Statement of stockholders’ equity
What is the difference between a company’s current assets and current liabilities?
Net working capital (NWC)
What does a positive NWC indicate?
The company has sufficient funds
What is the formula to find NWC?
Current assets - Current liabilities
Solve the problem:
If current assets are $100,000 and current liabilities are $60,000, what is the NWC?
100,000 - 60,000 = 40,000
What is the excess of operating current assets over operating current liabilities?
Net operating working capital (NOWC)
What is the formula to find NOWC?
(Current assets - Excess cash) - (Current liabilities - Notes payable)
What is the formula to find the net income after tax (NIAT)?
EBIT (1 - Tax rate)
What is the amount of leftover money in a company after all expenditures have been paid?
Free cash flow (FCF)
What doesn’t free cash flow consider?
Growth potential
What is the formula to find free cash flow if gross fixed assets is given?
[(EBIT(1-T)) + Depr & Amort] – [(GFA2019 - GFA2018) + change in NOWC]
What is the formula to find free cash flow if net fixed assets is given?
[EBIT (1 – T)] – [(NFA19 – NFA18) + change in NOWC]
Why are accounting statements insufficient for evaluating managers’ performance?
They do not reflect market values
List the 2 federal income tax systems
- Corporate taxes
2. Individual taxes
What is the formula to find NIAT using the statement of stockholders’ equity?
Dividends + the change in Retained Earnings
What is the formula to find the change in retained earnings?
Retained earnings 2019 - retained earnings 2018
What is the layout of the income statement?
Sales COGS EBITDA DA EBIT Interest EBT Tax NIAT (Net income after tax)
What is the formula to find EBT when the tax rate and net income are given?
Net income / (1 - tax rate)
List the 3 activities that are included in the Statement of Cash Flow
- Operating Activities
- Investing Activities
- Financing Activities
What type of structure does the corporate tax system have?
A progressive structure
Is the corporate tax system subject to state taxes?
Yes
What does EPS stand for?
Earning per share
What is the formula to find EPS?
NIAT / # of shares out
Fill in the Blank:
Tax deductible for corporations is limited to __% of operating income
30%
Is interest earned usually fully taxable?
Yes
What are the profits from the sale of assets not normally transacted in the normal course of business?
Capital gains
What are capital gains taxed as if they are held for a year or less?
Ordinary income
What are capital gains taxed as if they are held for more than a year?
Capital gains
True or False:
A tax loss isn’t necessarily a bad thing
True
Which code carries a tax loss from a business over to a future year of profit until they can offset the loss?
The Tax Loss Carry Forward Code
What removed the 2 year carryback and the 20 year carryforward provision?
The Tax Cuts and Jobs Act (TCJA)
What is the corporate tax system’s flat tax rate?
21%
Solve the problem:
In 2018, Collin Co. had taxable income of -$7,500,000. In 2019, the firm has taxable income of $10,000,000. Its corporate tax rate is 25%. Assume that the company takes full advantage of the Tax Code’s carry forward provision. What is Collins’ tax liability for 2019?
TI 2018 = -$7,500,000 (No tax)
TI 2019 = $10,000,000 (Tax)
TL = 25% x (-$7,500,000 + $10,000,000) TL = 25% x 2,500,000 TL = 625,000
True or False:
Only 50% of dividends received is subject to tax
True
What is the formula to find taxable income?
Operating Income + Interest Income - Interest Paid + (Dividends Received x 50%)
What is the formula to find taxable liability?
TL = Taxable income x tax rate
TI = OI + II - IP + (DR x 50%)
True or False:
You have to take dividends paid into consideration when calculating the taxable income
False
Solve the problem:
Your corporation has the following cash flows:
Operating income - $300,000 Interest received - $40,000 Interest paid - $45,000 Dividends received - $30,000 Dividends paid - $50,000
If the applicable income tax rate is 25% (federal and state combined), and if 50% of dividends received are exempt from taxes, what is the corporation’s tax liability?
TI = 300,000 + 40,000 - 45,000 + (30,000 x 50%) TI = 310,000
TL = 310,000 x 25% TL = 77,500
What percentage of municipal bonds is taxed?
0%
What percentage of corporate bonds is taxed?
100%
What percentage of preferred stock is taxed?
50%
What is the after tax return of a municipal bond investment equal to?
The municipal bond’s before tax return (yield)
What is the formula to find the after tax return of a corporate bond investment?
% yield (1 - corp tax rate)
What is the formula to find the after tax return of a preferred stock investment?
% yield [1 - (1 - % div exempt) (corp tax rate)]
Solve the problem:
A company with a 25% tax rate buys preferred stock in another company. The preferred stock has a before-tax yield of 6.00%. Assume a 50% dividend exclusion for tax on dividends. What is the preferred stock’s after-tax return?
AT Ret = % yield [1 - (1 - % div exempt) (corp tax rate)]
AT Ret = 0.06 [1 - (1 - .5) (.25)]
AT Ret = 5.52%
True or False:
The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow statement, and the statement of stockholders’ equity
True
True or False:
The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm’s future earnings and dividends and the riskiness of those cash flows
True
True or False:
On the balance sheet, total assets must always equal the sum of total liabilities and equity
True
True or False:
The amount shown on the December 31, 2019 balance sheet as “retained earnings” is equal to the firm’s net income for 2019 minus any dividends it paid
False
True or False:
The balance sheet represents a snapshot in time, whereas the income statement reports on operations over a period of time
True
True or False:
EBIT, often referred to as operating income, stands for “earnings before interest and taxes.”
True
True or False:
EBITDA stands for “earnings before interest, taxes, debt, and assets.”
False
True or False:
Free cash flow (FCF) is, essentially, the cash flow that is available for interest and dividends after the company has made the investments in current and fixed assets that are necessary to sustain ongoing operations
True
True or False:
Both interest and dividends paid by a corporation are deductible operating expenses, hence they decrease the firm’s taxes
False
True or False:
Net operating working capital is equal to current assets less excess cash minus the difference between current liabilities and notes payable
True
Which of the following statements is CORRECT?
a. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders’ equity.
b. The balance sheet gives us a picture of the firm’s financial position at a point in time.
c. The income statement gives us a picture of the firm’s financial position at a point in time.
d. The statement of cash flows tells us how much cash the firm must pay out in interest during the year.
e. The statement of cash flows tells us how much cash the firm will require during some future period, generally a month or a year.
b. The balance sheet gives us a picture of the firm’s financial position at a point in time.
Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their bills.
e. The company purchases a new piece of equipment.
c. The company issues new common stock.
Which of the following items is NOT normally considered a current asset?
a. Accounts receivable.
b. Inventory.
c. Bonds.
d. Cash.
e. Short-term, highly-liquid, marketable securities.
c. Bonds.
Which of the following items cannot be found on a firm’s balance sheet under current liabilities?
a. Accounts payable.
b. Short-term notes payable to the bank.
c. Accrued wages.
d. Cost of goods sold.
e. Accrued payroll taxes.
d. Cost of goods sold.
Below are the 2018 and 2019 year-end balance sheets for Tran Enterprises:
Assets: 2019 2018 Cash $ 200,000 $ 170,000 Accounts receivable 864,000 700,000 Inventories 2,000,000 1,400,000 Total current assets $3,064,000 $2,270,000 Net fixed assets 6,000,000 5,600,000 Total assets $9,064,000 $7,870,000
Liabilities and equity:
Accounts payable $1,400,000 $1,090,000
Notes payable to bank 1,600,000 1,800,000
Total current liabilities $3,000,000 $2,890,000
Long-term debt 2,400,000 2,400,000
Common stock 3,000,000 2,000,000
Retained earnings 664,000 580,000
Total common equity $3,664,000 $2,580,000
Total liabilities and equity $9,064,000 $7,870,000
The firm has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year, non-callable, long-term debt in 2018. As of the end of 2019, none of the principal on this debt had been repaid. Assume that the company’s sales in 2018 and 2019 were the same. Which of the following statements must be CORRECT?
a. The firm increased its short-term bank debt in 2019.
b. The firm issued long-term debt in 2019.
c. The firm issued new common stock in 2019.
d. The firm repurchased some common stock in 2019.
e. The firm had negative net income in 2018.
c. The firm issued new common stock in 2019.
Below is the common equity section (in millions) of Timeless Technology’s last two year-end balance sheets:
Balance Sheet: 2019 2018
Common stock 2,000 1,000
Retained earnings 2,000 2,340
Tot common equity $4,000 $3,340
The firm has never paid a dividend to its common stockholders. Which of the following statements is CORRECT?
a. The company’s net income in 2019 was higher than in 2018.
b. The firm issued common stock in 2019.
c. The market price of the firm’s stock doubled in 2019.
d. The firm had positive net income in both 2018 and 2019, but its net income in 2019 was lower than it was in 2018.
e. The company has more equity than debt on its balance sheet.
b. The firm issued common stock in 2019.
Which of the following factors would explain how a company’s cash balance could have increased even though the company had a negative cash flow last year?
a. The company sold a new issue of bonds.
b. The company made a large investment in a new plant and equipment.
c. The company paid a large dividend.
d. The company had high depreciation expenses.
e. The company repurchased 20% of its common stock.
a. The company sold a new issue of bonds.
Which of the following statements is CORRECT?
a. Corporations are allowed to exclude 50% of their interest income from corporate taxes.
b. Corporations are allowed to exclude 50% of their dividend income from corporate taxes.
c. Individuals pay taxes on only 30% of the income realized from municipal bonds.
d. Individuals are allowed to exclude 50% of their interest income from their taxes.
e. Individuals are allowed to exclude 50% of their dividend income from their taxes.
b. Corporations are allowed to exclude 50% of their dividend income from corporate taxes.
A loss incurred by a corporation:
a. Must be carried back 2 years before being carried forward for 5 years.
b. Can be carried forward indefinitely.
c. Can be carried back 5 years and forward 3 years.
d. Cannot be used to reduce taxes in other years except with special permission from the IRS.
e. Can be carried back 3 years or forward 10 years, whichever is more advantageous to the firm.
b. Can be carried forward indefinitely.
Which of the following statements is CORRECT?
a. Retained earnings, as reported on the balance sheet, represent the amount of cash a company has available to pay out as dividends to shareholders.
b. 50% of the interest received by corporations is excluded from taxable income.
c. 50% of the dividends received by corporations is excluded from taxable income.
d. Because taxes on long-term capital gains are not paid until the gain is realized, investors must pay the top individual tax rate on that gain.
e. The corporate tax system favors equity financing, as dividends paid are deductible from corporate taxes.
c. 50% of the dividends received by corporations is excluded from taxable income.
