Chapter 3: Understanding Financial Statements and Cash Flows

Question 1

Income Statement (Profit and Loss Statement)

Answer 1

A basic accounting statement that measures the results of a firm’s operations over a specified period, commonly 1 year. The bottom line of the income statement, net profits (net income), shows the profit or loss for the period that is available for a company’s owners (shareholders).

Question 2

Cost of Goods Sold

Answer 2

The cost of producing or acquiring a product or service to be sold in the ordinary course of business.

Question 3

Gross Profit

Answer 3

Sales or revenue minus the cost of goods sold.

Question 4

Operating Expenses

Answer 4

Marketing and selling expenses, general and administrative expenses, and depreciation expense.

Question 5

Operating Income (Earnings Before interest and taxes)

Answer 5

Sales less the cost of goods sold less operating expense.

Question 6

Earnings Before Taxes (Taxable Income)

Answer 6

Operating income minus interest expense.

Question 7

Net Income (Net Profit, or Earnings Available to Common Stockholders)

Answer 7

The earnings available to the firm’s common and preferred stockholders.

Question 8

Earnings Per Share

Answer 8

Net income on a per share basis.

Question 9

Dividends Per Share

Answer 9

The amount of dividends a firm pays for each share outstanding.

Question 10

Common-Sized Income Statement

Answer 10

An income statement in which a firm’s expenses and profits are expressed as a percentage of its sales.

Question 11

Profit Margins

Answer 11

Financial rations (sometimes simply referred to as margins) that reflect the level of the firm’s profits relative to its sales. Examples include the gross profit margin (gross profit divided by sales), operating profit margin (operating income divided by sales), and the net profit margin (net income divided by sales).

Question 12

Gross Profit margin

Answer 12

Gross profit divided by net sales. It is a ration denoting the gross profit earned by the firm as a percentage of its net sales.

Question 13

Operating Profit Margin

Answer 13

Operating income divided by sales. This ratio serves as an overall measure of the company’s operating effectiveness.

Question 14

Net Profit Margin

Answer 14

Net income divided by sales. A ration that measures the net income of the firm as a percentage of sales.

Question 15

Fixed Costs

Answer 15

Costs that remain constant, regardless of any change in a firm’s activity.

Question 16

Semivariable Costs

Answer 16

Costs composed of a mixture of fixed and variable components.

Question 17

What can a firm’s net profits be viewed as?

Answer 17

Gross profit= sales - cost of goods sold

Question 18

Earnings Before Interest (Operating Profits) Equation

Answer 18

Gross profit - operating expenses

Question 19

Net Profit (Net Income) Equation

Answer 19

Earnings before interest and taxes (operating profits) - interest expense - taxes

Question 20

Which five activities determine a company’s net income?

Answer 20

1. The revenue derived from selling the company’s product or service.
2. The cost of producing or acquiring the goods or services to be sold.
3. The operating expenses related to (1) marketing and distributing the product or service to the customer and (2) administering the business.
4. The financing costs of doing business - namely, the interest paid to the firm’s creditors.
5. The payment of taxes.

Question 21

Profits Equation

Answer 21

Sales - expenses

Question 22

Balance Sheet

Answer 22

A statement that shows a firm’s assets, liabilities, and shareholder equity at a given point in time. It is a snapshot of the firm’s financial position on a particular date.

Question 23

Accounting Book Value

Answer 23

The value of an asset as shown on a firm’s balance sheet. It represents the depreciated historical cost of the asset rather than its current market value or replacement cost.

Question 24

Liquidity

Answer 24

The ability to convert an asset into cash quickly without a significant loss of its value.

Question 25

Current Assets (Gross Working Capital)

Answer 25

Current assets consist primarily of cash, marketable securities, accounts receivable, inventories, and prepaid expenses.

Question 26

Cash

Answer 26

Cash on hand, demand deposits, and short-term marketable securities that can quickly be converted into cash.

Question 27

Accounts Receivable

Answer 27

Money owed by customers who purchased goods or services from the firm on credit.

Question 28

Inventories

Answer 28

Raw materials, work in progress, and finished goods held by the firm for eventual sale.

Question 29

Other Current Assets

Answer 29

Other short-term assets that will benefit future time periods, such as prepaid expenses.

Question 30

Fixed Assets

Answer 30

Assets such as equipment, buildings, and land.

Question 31

Depreciation Expense

Answer 31

A noncash expense to allocate the cost of depreciable assets, such as plant and equipment, over the live of the asset.

Question 32

Accumulated Depreciation

Answer 32

the sum of all depreciation taken over the entire life of a depreciable asset.

Question 33

Gross Fixed Assets

Answer 33

The original cost of a firm’s fixed assets.

Question 34

Net Fixed Assets

Answer 34

Gross fixed assets minus the accumulated depreciation taken over the life to date of the assets.

Question 35

Debt

Answer 35

Liabilities consisting of such sources as credit extended by suppliers or a loan from a bank.

Question 36

Equity

Answer 36

Stockholders’ investment in the firm and the cumulative profits retained in the business up to the date of the balance sheet.

Question 37

Current Debt (Short-Term Liabilities)

Answer 37

Debt due to be paid within 12 months.

Question 38

Accounts Payable (Trade Credit)

Answer 38

Credit provided by suppliers when a firm purchases inventory on credit.

Question 39

Accrued Expenses

Answer 39

Expenses that have been incurred but not yet paid in cash.

Question 40

Short-Term Notes (Debt)

Answer 40

Amounts borrowed from lenders, mostly financial institutions such as banks, where the loan is to be repaid within 12 months.

Question 41

Long-Term Debt

Answer 41

Loans from banks or other sources that lend money for longer than 12 months.

Question 42

Mortgage

Answer 42

A loan to finance real estate where the lender has the first claim on the property in the event the borrower is unable to repay the loan.

Question 43

Preferred Stockholders

Answer 43

Stockholders who have claims on the firm’s income and assets after creditors, but before common stockholders.

Question 44

Common Stockholders

Answer 44

Investors who own the firm’s common stock. Common stockholders are the residual owners of the firm.

Question 45

Common Stock

Answer 45

Shares that represent ownership in a corporation.

Question 46

Par Value

Answer 46

The arbitrary value a firm puts on each share of stock prior to its being offered for sale.

Question 47

Paid-In Capital

Answer 47

The amount a company receives above par value from selling stock to investors.

Question 48

Treasury Stock

Answer 48

The firm’s stock that has been issued and then repurchased by the firm.

Question 49

Retained Earnings

Answer 49

Cumulative profits retained in a business up to the date of the balance sheet.

Question 50

Common-Sized Balance Sheet

Answer 50

A balance sheet in which a firm’s assets and sources of debt and equity are expressed as a percentage of its total assets.

Question 51

Debt Ratio

Answer 51

A firm’s total liabilities divided by its total assets. It is a ratio that measures the extent to which a firm has been financed with debt.

Question 52

Net Working Capital

Answer 52

The difference between a firm’s current assets and its current liabilities. When the term working capital is used, it is frequently intended to mean net working capital.

Question 53

Total Assets Equation

Answer 53

Total Liabilities (Debt) + Total Shareholders’ Equity

Question 54

Ending Retained Earnings Equation

Answer 54

Beginning Retained Earnings + Net Income For the Year - Dividends Paid During the Year

Question 55

Common Equity Equation

Answer 55

Common Shareholders’ Investment + Cumulative Profits - Cumulative Dividends Paid to Common Stockholders

Question 56

Net Working Capital Equation

Answer 56

Current Assets - Current Liabilities

Question 57

Cash Flows

Answer 57

A firm’s profits are not an adequate measure of its cash flows. To measure a company’s cash flows requires that we look both at the income statement and the changes in the balance sheet. Examining the statement of cash flows helps us understand where cash came from and how it was used.

Question 58

Three Main Parts of a Statement of Cash Flows

Answer 58

1. Cash Flows from Operations
2. Cash Flows from Investing
3. Cash Flows from Financing

Question 59

Accrual Basis Accounting

Answer 59

A method of accounting whereby revenue is recorded when it is earned, whether or not the revenue has been received in cash. Likewise, expenses are recorded when they are incurred, even if the money has not actually been paid out.

Question 60

Cash Basis Accounting

Answer 60

A method of accounting whereby revenue is recorded when cash is actually received. Likewise, expenses are recorded when physical cash is paid out.

Question 61

Statement of Cash Flows

Answer 61

A statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities.

Question 62

Free Cash Flows

Answer 62

The amount of cash available from operations after the firm pays for the investments it has made in operating working capital and fixed assets. This cash is available to distribute to the firm’s creditors and owners.

Question 63

Financing Cash Flows

Answer 63

The amount of cash received from or distributed to the firm’s investors, usually in the form of interest, dividends, issuance of debt, or issuance or repurchase of stocks.

Question 64

Cash Collections Equation

Answer 64

Sales - Change in Accounts Receivable

Question 65

GAAP vs. IFRS

Answer 65

GAAP is rules-based and sets out rules that accountants must follow when preparing financial statements. IFRS is principles-based and sets out general principles. IFRS leaves more room for discretion than GAAP does, permitting managers to exercise their own judgment when deciding how to report in their financial statements, as long as they follow the spirit of the standards.

Question 66

Generally Accepted Accounting Principles (GAAP)

Answer 66

Rules-based accounting principles, standards, and procedures that companies use to compile their financial statements, These principles are issued by the Financial Accounting Standards Board (FASB).

Question 67

International Financial Reporting Standards (IFRS)

Answer 67

Principles-based set of international accounting standards starting how particular types of transactions and other events should be reported financial statements. IFRS are issued by the International Accounting Standards Board (IASB).

Question 68

Taxable Income Summary

Answer 68

For the most part, taxable income for the corporation is equal to the firm’s operating income plus capital gains less any interest expense. Tax consequences, particularly tax rates, have a direct bearing on the decisions of the financial manager.

Question 69

Taxable Income

Answer 69

Income from all sources, except for allowable exclusions, less any tax-deductible expenses.

Question 70

Capital Gains

Answer 70

Gains from selling any asset that is not part of the ordinary operations.

Question 71

Marginal Tax Rate

Answer 71

The tax rate that would be applied to the next dollar of income.

Question 72

Average Tax Rate

Answer 72

The tax rate on average that a company pays on its total taxable income.

Question 73

Limitations of Financial Statements

Answer 73

Accounting rules give managers discretion. Therefore what we see in financial statements may not exactly reflect the company’s financial situation. Sometimes, managers may even break the rules, which results in accounting malpractice/accounting fraud.

Question 74

Free Cash Flows Summary

Answer 74

Free cash flows and financing cash flows are important measurements in making financial decisions. Only by understanding these cash flows can managers truly know how well a company is doing.

Question 75

Free Cash Flow Equation

Answer 75

After-Tax Cash Flows from Operations - [Increase in net Operating Working Capital] OR + [Decrease in Net Operating Working Capital] and - [Increase in Long-Term Assets] OR + [Decrease in Long-Term Assets]