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Foundations of Finance, 9e (Keown/Martin/Petty)
Chapter 3 Understanding Financial Statements and Cash Flows
Learning Objective 3.1
1) An income statement reports a firm’s cumulative revenues and expenses from the inception of the firm
through the income statement date.
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
2) Owners equity increases each period by the amount of the corporation’s positive net cash flow.
Keywords: Income Statement, Balance Sheet, Owners‘ Equity
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
3) If two companies have the same revenues and operating expenses, their net incomes will still be
different if one company finances its assets with more debt and the other company with more equity.
Keywords: Income Statement, EBIT, Financing Cost
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
4) Common-sized income statements are used to compare companies that have the same amount of
revenues.
Keywords: Common-Sized Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
5) Common-sized income statements restate the numbers in the income statement as a percentage of sales
to assist in the comparison of a firm’s financial performance across time and with competitors.
Keywords: Common-Sized Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
6) Net profit margin is equal to the gross profit margin times the operating profit margin.
Keywords: Net Profit Margin, Gross Profit Margin, Operating Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
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7) Earnings before taxes, or taxable income, is equal to operating income minus financing costs.
Keywords: Earnings Before Taxes, Operating Income, Financing Costs
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
8) The more debt a company uses to finance its assets, the lower will be its operating income due to
higher interest expense.
Keywords: Operating Income, EBIT
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
9) Changes in depreciation expense do not affect operating income because depreciation is a non-cash
expense.
Keywords: Depreciation, EBIT, Operating Income
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
10) Earnings available to common shareholders represents income that may be reinvested in the firm or
distributed to its owners.
Keywords: Earnings Available to Common Shareholders
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
11) Earnings available to common shareholders is equal to a corporation‘s positive net cash flow over a
given period, typically one year.
Keywords: Earnings Available to Common Shareholders
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
12) Profits-to-Sales relationships are defined as profit margins.
Keywords: Profit Margins
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
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13) Company A and Company B both report the same level of sales and net income. Therefore,
A) both A and B will report the same Earnings Per Share.
B) both A and B will report the same Gross Profit Margin.
C) both A and B will report the same Net Profit Margin.
D) both A and C are true.
Keywords: Earnings Per Share, Net Profit Margin, Gross Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
14) The 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 less than 20%.
B) the corporation’s net profit margin is greater than 20%.
C) the corporation‘s gross profit margin is greater than 20%.
D) the corporation’s gross profit margin is equal to 20% because gross profit is not affected by operating
expenses or financing costs.
Keywords: Operating Profit Margin, Gross Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
15) The basic format of an income statement is
A) Sales – Expenses = Profits.
B) Income – Expenses = EBIT.
C) Sales – Liabilities = Profits.
D) Assets – Liabilities = Profits.
Keywords: Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
16) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue’s gross profit is equal to
A) $770,000.
B) $1,070,000.
C) $1,100,000.
D) $1,500,000.
Keywords: Gross Profit
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
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17) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue’s operating income is equal to
A) $770,000.
B) $1,070,000.
C) $1,100,000.
D) $1,500,000.
Keywords: Operating Income, EBIT
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
18) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000. Rogue’s net profit margin is equal to
A) 25.67%.
B) 35.67%.
C) 36.67%.
D) 50.00%.
Keywords: Net Profit Margin
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
19) Rogue Industries reported the following items for the current year: Sales = $3,000,000; Cost of Goods
Sold = $1,500,000; Depreciation Expense = $170,000; Administrative Expenses = $150,000; Interest Expense
= $30,000; Marketing Expenses = $80,000; and Taxes = $300,000; Rogue’s operating profit margin is equal
to
A) 25.67%.
B) 35.67%.
C) 36.67%.
D) 50.00%.
Keywords: Operating Profit Margin, EBIT
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
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20) Use the following information to calculate the company‘s accounting net income for the year.
Credit Sales
$800,000
Cash Sales
$500,000
Operating Expenses on Credit
$200,000
Cash Operating Expenses
$700,000
Accounts Receivable (Beg. of Year)
$50,000
Accounts Receivable (End of Year)
$80,000
Accounts Payable (Beg. of Year)
$50,000
Accounts Payable (End of Year)
$100,000
Corporate Tax Rate
40%
A) $300,000
B) $240,000
C) $125,000
D) $120,000
Keywords: Net Income, Accrual Accounting, Income Statement
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
21) A corporation‘s operating profit margin is equal to
A) net income divided by sales.
B) EBIT divided by sales.
C) EBIT divided by net income.
D) sales divided by EBIT.
Keywords: Operating Profit Margin, EBIT
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
22) Which of the following statements concerning net income is MOST correct?
A) Net income represents cash available to pay dividends.
B) Net income represents sales minus operating expenses at a specific point in time.
C) Negative net income reduces a company‘s cash balance.
D) Net income represents income that may be reinvested in the firm or distributed to its owners.
Keywords: Net Income
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
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23) Which of the following represents an attempt to measure the net results of the firm’s operations
(revenues versus expenses) over a given time period?
A) balance sheet
B) statement of cash flows
C) income statement
D) sources and uses of funds statement
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
24) What information does a firm’s income statement provide to the viewing public?
A) an itemization of all of a firm’s assets and liabilities for a defined period of time
B) a complete listing of all of a firm’s cash receipts and cash expenditures for a defined period of time
C) a report of revenues and expenses for a defined period of time
D) a report of investments made and their cost for a specific period of time
Keywords: Income Statement, Revenues, Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
25) California Retailing Inc. has sales of $4,000,000; the firm‘s cost of goods sold is $2,500,000; and its total
operating expenses are $600,000. What is California Retailing’s EBIT?
A) $850,000
B) $875,000
C) $900,000
D) $1,300,000
Keywords: EBIT, Operating Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
26) California Retailing Inc. has sales of $4,000,000; the firm‘s cost of goods sold is $2,500,000; and its total
operating expenses are $600,000. The firm‘s interest expense is $250,000, and the corporate tax rate is 40%.
What is California Retailing’s net income?
A) $288,000
B) $350,000
C) $377,000
D) $390,000
Keywords: Net Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
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27) Corporation B reported earnings per share of $10. Corporation B has 100,000 shares of common stock
outstanding and reported an increase in owners’ equity of $400,000 for the period. Corporation B paid
$50,000 in interest expense during the period. Corporation B paid dividends per share of
A) $6.00.
B) $5.50.
C) $6.50.
D) $14.003.
Keywords: Earnings Per Share, Dividends Per Share, Income Statement
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
28) The increase in owners’ equity for a given period is equal to
A) positive net cash flow minus dividends.
B) net income minus dividends.
C) sales minus dividends.
D) gross profit minus distributions to shareholders.
Keywords: Owners Equity, Income Statement, Dividends
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
29) A firm‘s financing costs include
A) depreciation expense.
B) interest expense
C) costs of goods sold.
D) both A and B.
Keywords: Financing Costs, Interest Exposure
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
30) Corporation A decides to borrow $1,000,000 and use the money to buy back $1,000,000 of its common
stock. The corporation pays 6% interest on its borrowed funds which exactly equals the amount of the
dividend it used to pay on the common stock it repurchased. Therefore,
A) Corporation A’s operating income will decrease due to higher interest expense.
B) Corporation A’s net income will increase due to the tax deductibility of interest expense.
C) Corporation A will have no change in its operating income since the interest expense exactly offsets
the prior dividend payment.
D) Corporation A’s gross profit will decrease.
Keywords: Income Statement, Financing Costs, Net Income
Learning Obj.: L.O. 3.1
AACSB: Analytical Thinking
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31) Gross profit is equal to
A) profits plus depreciation.
B) revenues – expenses.
C) earnings before taxes minus taxes payable.
D) sales – cost of goods sold.
Keywords: Gross Profit, Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
32) An income statement may be represented as follows:
A) Sales – Liabilities = Profits.
B) Revenues – Liabilities = Net Income.
C) Sales – Expenses = Retained Earnings.
D) Sales – Expenses = Profits.
Keywords: Income Statement
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
33) All of the following are income statement items EXCEPT
A) accrued expenses.
B) depreciation expense.
C) cost of goods sold.
D) interest expense.
Keywords: Income Statement, Accrued Expenses
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
34) Two companies have identical assets and operating activities. Which of the follow statements is true?
A) Both companies have the same net income.
B) The company with more debt will have lower operating income due to interest expense.
C) The company with more debt will have higher operating income due to leverage.
D) The company with more debt will have lower net income due to interest expense.
Keywords: Operating Income, Net Income, Interest Expense
Learning Obj.: L.O. 3.1
AACSB: Reflective Thinking
35) Prepare an income statement using the information given below. Make sure to identify gross profit,
operating income, and net income.
Inventories
$50,000
Cost of Goods Sold
$250,000
Administrative Expenses
$50,000
Accumulated Depreciation
$150,000
Sales
$600,000
Depreciation Expense
$25,000
Selling Expenses
$150,000
Common Stock Dividends
$8,000
Interest Expense
$8,000
Corporate Tax Rate
40%
Cost of Goods Sold
Gross Profit
Selling Expenses
Administrative Expenses
Depreciation Expense
25,000
Interest Expense
Earnings Before Taxes (EBT)
117,000
Taxes (40%)
Net Income
$70,200
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Learning Objective 3.2
1) Common-sized balance sheets show each account as a percentage of total sales to help analysts in
comparing companies of difference sizes.
Keywords: Common-Sized Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking
2) The balance sheet equation is Total Assets = Total Revenues – Total Liabilities.
Keywords: Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking
3) The accounting book value of an asset represents the historical cost of the asset rather than its current
market value or replacement cost.
Keywords: Accounting Book Value, Market Value
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking
are impossible to value objectively.
Keywords: Intangible Assets, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking
5) Additional Paid in Capital on the balance sheet equals the amount paid by investors for the company‘s
common stock that exceeds the market price of the stock at the time of purchase.
Keywords: Additional Paid in Capital, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking
6) A firm‘s income statement reports the results from operating the business for a period of time, while the
firm’s balance sheet provides a snapshot of the firm’s financial position at a specific point in time.
Keywords: Income Statement, Balance Sheet
Learning Obj.: L.O. 3.2
AACSB: Reflective Thinking