Chapter 03: Financial Statements, Cash Flow and Taxes
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This chapter has a lot of definitions. They are important, but we don’t like to make students memorize too many of them
early in the course. We let our students use the formula sheet that includes the key definitions.
Note that there is an overlap between the T/F and multiple-choice questions, as some of the T/F statements are used in
multiple-choice questions.
Multiple Choice: True/False
1. The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow
statement, and the statement of stockholders’ equity.
a. True
b. False
2. 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.
a. True
b. False
3. Companies typically provide four basic financial statements: the fixed income statement, the current income statement,
the balance sheet, and the cash flow statement.
a. True
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b. False
4. On the balance sheet, total assets must always equal the sum of total liabilities and equity.
a. True
b. False
5. Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be
higher or lower than the amounts at which the assets are carried on the books.
a. True
b. False
Chapter 03: Financial Statements, Cash Flow and Taxes
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6. 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
a. True
b. False
7. The income statement shows the difference between a firm’s income and its costs—i.e., its profits—during a specified
period of time. However, not all reported income comes in the form of cash, and reported costs likewise may not be
consistent with cash outlays. Therefore, there may be a substantial difference between a firm’s reported profits and its
actual cash flow for the same period.
a. True
b. False
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8. The balance sheet represents a snapshot in time, whereas the income statement reports on operations over a period of
time.
a. True
b. False
9. EBIT, often referred to as operating income, stands for “earnings before interest and taxes.”
a. True
b. False
10. EBITDA stands for “earnings before interest, taxes, debt, and assets.”
a. True
b. False
Chapter 03: Financial Statements, Cash Flow and Taxes
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11. Consider the following balance sheet for Games Inc. Because Games has $800,000 of retained earnings, we know that
the company would be able to pay cash to buy an asset with a cost of $200,000.
Cash $50,000 Accounts payable $100,000
Inventory $200,000 Accruals $100,000
Accounts receivable $250,000 Total CL $200,000
Total CA $500,000 Long-term debt $200,000
Net fixed assets $900,000 Common stock $200,000
Retained earnings $800,000
Total assets $1,400,000 Total L & E $1,400,000
a. True
b. False
12. Typically, the statement of stockholders’ equity starts with total stockholders’ equity at the beginning of the year, adds
net income, subtracts dividends paid, and ends with total stockholders’ equity at the end of the year. Over time, a
profitable company will have earnings in excess of the dividends it pays out, resulting in a substantial amount of retained
earnings shown on the balance sheet.
a. True
b. False
Chapter 03: Financial Statements, Cash Flow and Taxes
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18. The balance sheet measures the flow of funds into and out of various accounts over time, while the income statement
measures the firm’s financial position at a point in time.
a. True
b. False
19. Assume that two firms are both following generally accepted accounting principles. Both firms commenced operations
two years ago with $1 million of identical fixed assets, and neither firm sold any of those assets or purchased any new
fixed assets. The two firms would be required to report the same amount of net fixed assets on their balance sheets as
those statements are presented to investors.
a. True
b. False
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22. The statement of cash flows has four main sections, one each for operating, investing, and financing activities, and one
that shows a summary of the cash and cash equivalents at the end of the year.
a. True
b. False
23. An increase in accounts payable represents an increase in net cash provided by operating activities, an effect similar to
taking out a new bank loan. However, these two items show up in different sections of the statement of cash flows to
reflect the difference between operating and financing activities.
a. True
b. False
24. An increase in accounts receivable represents an increase in net cash provided by operating activities because
receivables will produce cash when they are collected.
a. True
b. False
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b. False
30. In finance, we are generally more interested in cash flows than in accounting profits. Free cash flow (FCF) is
calculated as after-tax operating income plus depreciation less the sum of capital expenditures and changes in net
operating working capital.
a. True
b. False
31. Free cash flow is the amount of cash that, if withdrawn, would harm the firm’s ability to operate and to produce future
cash flows.
a. True
b. False
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32. If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-
deductible expense, companies would be encouraged to use more debt financing than they presently do, other things held
constant.
a. True
b. False
33. Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This
treatment, other things held constant, tends to encourage the use of debt financing by corporations.
a. True
b. False
34. Because the U.S. tax system is a progressive tax system, a taxpayer’s marginal and average tax rates are the same.
Chapter 03: Financial Statements, Cash Flow and Taxes
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a. True
b. False
35. The alternative minimum tax (AMT) was created by Congress to make it more difficult for wealthy individuals to
avoid paying taxes through the use of various deductions.
a. True
b. False
36. The time dimension is important in financial statement analysis. The balance sheet shows the firm’s financial position
at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects
specific changes in accounts over that period of time.
a. True
b. False
Chapter 03: Financial Statements, Cash Flow and Taxes
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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.
45. Below is the common equity section (in millions) of Timeless Technology’s last two year-end balance sheets:
2019 2018
Common stock 2,000 1,000
Retained earnings 2,000 2,340
Total 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.