Chapter 10—Understanding a Firm’s Financial Statements
TRUE/FALSE
1. Total assets less outstanding debt equals ownership equity.
2. The income statement shows a firm’s financial position on a specific date.
3. Jan’s bank has asked her to show them how her firm’s financial position has changed in the past year.
She should provide the company’s balance sheet.
4. The income statement answers the question: “How profitable is the business?”
5. The terms earnings, profits and income refer to different amounts on the income statement.
6. Profits reward owners for investing in a company, but they do little to promote future growth.
7. Depreciation is the cost of a firm’s land and building allocated over its useful life.
8. Dividends to a firm’s owners are not considered an expense in the income statement.
9. The balance sheet shows a firm’s assets, liabilities, and owners’ equity at a specific point in time.
10. Assets that can be converted to cash relatively quickly are said to be liquid.
11. Accounts payable consist of payments due from a firm’s customers.
12. Accounts payable, accrued expenses, 2-year notes payable, and 90-day notes are all short-term
liabilities.
13. Ownership equity represents the owner’s investment in the company, which can be either his/her cash
invested in the company or money borrowed from a bank to purchase fixed assets.
14. Jane is determining the overall financial situation for her business. Since she has to report to a group
of investors, she should just give them the income statement.
15. The cash flow statement answers the questions “From where did the cash come?’ and “Where did the
cash go?”
16. A profitable company may not have positive cash flows.
17. A new business needs to manage cash flows carefully because if a firm runs out of cash, it is out of
business.
18. The major difference between cash-basis accounting and accrual-basis accounting is when the firm
recognizes revenue and profits.
19. The three activities that explain the cash inflows and outflows of a business are the selling, investment
and financing activities.
20. In order to determine the cash flows from day-to–day operations, the firm must convert the company’s
income statement from a cash basis to an accrual basis.
21. Liquidity represents the degree to which a firm can meet maturing short-term debt obligations with
available working capital.
22. The best financial ratio to determine a company’s ability to pay debt is the debt ratio.
23. A conventional measure of a firm’s liquidity is a comparison of current assets to current liabilities.
24. Net income is used to measure the return on the firm’s total assets.
25. To determine the debt ratio, the total debt is divided by the total income.
26. While increasing debt levels can increase the owner’s return on equity, it also reduces risk.
MULTIPLE CHOICE
1. Ignazio has just opened his business. One of the first things he should learn is:
a.
how to prepare the financial statements.
b.
which numbers are most important for him to watch and to watch them like a hawk.
c.
whether to pay closer attention to monthly sales or to cash flow.
d.
when to lease assets and when to buy them.
2. Kevin wants to open his own car repair shop. To do that he will need tools and other equipment.
The two methods Kevin can use to pay for these items are:
a.
cash flow and balance sheets.
b.
accounts receivable and accounts payable.
c.
assets and liabilities
d.
debt and equity.
3. Bernard has just learned that on the balance sheet, the assets must equal the ___________ plus the
_______________.
a.
money borrowed from others, money invested by the owners
b.
accounts receivable, accounts payable
c.
accumulated depreciation, asset value
d.
net profit, retained earnings
4. Cameron and Ashley bought $40 of “premium pink lemonade mix” and paper cups for their lemonade
stand. These items are considered:
a.
cash balance.
b.
fixed assets.
c.
inventory.
d.
cost of goods sold.
5. When Cameron and Ashley allow a customer to buy on credit, which account increases?
a.
debt
b.
inventory
c.
accounts payable
d.
accounts receivable
6. Walter knows the result of the equation “Sales–Expenses = Profits” can be found on the:
a.
cash flow
b.
income statement
c.
retained earnings
d.
balance sheet
7. Horace is reviewing a document that shows the results of his firm’s operations over a period of one
year. Horace is looking at the:
a.
income statement
b.
balance sheet
c.
statement of cash flow
d.
statement of financial position
8. Kate’s banker would like to know the profit of her business from January 1st through December 31.
She should show him the _______.
a.
cash flow statement.
b.
income statement.
c.
balance sheet.
d.
harvest plan.
9. To determine her company’s gross profits, Edith should:
a.
subtract cost of goods sold from sales.
b.
add interest paid and depreciation.
c.
subtract cost of goods sold from operating income.
d.
add taxes paid and income before taxes.
10. To calculate his company’s _______________, Edgar will subtract operating expenses from gross
profits.
a.
cost of goods sold
b.
profits before taxes
c.
operating income
d.
retained earnings
11. Marvin is preparing one of the annual financial statements and has asked you which of the following
should be included in operating expenses. You tell him it is:
a.
marketing-related expenses.
b.
the cost for independent dealers to prepare for the distribution of the product.
c.
interest on all loans.
d.
income taxes.
12. To determine her company’s profits before taxes, Marilyn will have to deduct the firm’s interest
expense from its ____ income.
a.
total
b.
projected
c.
net
d.
operating
13. From her sales income, Barbara has subtracted cost of goods sold, operating expenses, interest
expense, and taxes. What she has left is her company’s _____ income
a.
total
b.
projected
c.
net
d.
operating
14. The owners of ABC, Inc. may expect to be paid a share of the profits of the company. These
payments to owners are called:
a.
return on investment.
b.
dividends.
c.
current expenses.
d.
long-term debt.
15. The items on the income statement are expressed in dollars but the corresponding margins are
expressed as:
a.
incomes.
b.
expenses.
c.
profits.
d.
percentages.
16. The income statement answers the question:
a.
How much cash did the firm generate?
b.
How profitable was the business?
c.
How much money does the company owe?
d.
How much money did the owners invest?
17. For investment purposes, Wilma needs a snapshot of the firm’s financial position at a specific point in
time. She should look at the
a.
marketing plan.
b.
statement of cash flows.
c.
balance sheet.
d.
income statement.
18. Xavier wants to know how much his company owns and how much it owes. He should look at the:
a.
balance sheet.
b.
income statement.
c.
cash flow statement.
d.
asset list.
19. If an asset can quickly be converted to cash, it is considered to be a(n):
a.
current asset.
b.
fixed asset.
c.
short-term asset.
d.
other asset.
20. When Darla prepares her company’s balance sheet, she should include ___________ in the list of
current assets.
a.
equipment.
b.
land.
c.
leased property.
d.
accounts receivable.
21. Denver wants to make sure he puts his company’s assets in the correct categories. Which of the
following is an example of a current asset?
a.
Land
b.
Inventories
c.
Equipment
d.
Buildings
22. Richard has in his warehouse some raw materials and finished goods that he has ready to fill customer
orders. These are two types of _____.
a.
accounts payable.
b.
accounts receivable.
c.
cost of goods.
d.
inventories.
23. Eugenia’s company bought a delivery truck to deliver merchandise to customers. This truck should
appear as ___________ on the balance sheet.
a.
a current asset
b.
inventory
c.
a fixed asset
d.
a short-term investment
24. Candace purchased a car for her company’s exclusive use. The value of this car:
a.
is constant over time.
b.
increases with each use of the asset.
c.
decreases over time.
d.
increases over time.
25. Astoria is using a software application to prepare the balance sheet. She wasn’t sure which of the
following should be included in the fixed asset category. What would you tell her?
a.
Land
b.
Copyrights
c.
Contingency funds
d.
Goodwill
26. A two year-old asset has a depreciable life of 10 years. Its initial purchase cost was $450,000 and it is
depreciated by 10 percent annually. What is the remaining depreciable value of the asset?
a.
$ 0.00
b.
$90,000
c.
$200,000
d.
$360,000
27. Some assets don’t seem to fit neatly into any category so accountants created a category called “other.”
Which asset would considered an other asset?
a.
Land
b.
Machinery
c.
Contingency funds
d.
Goodwill
28. Stephanie ordered merchandise from one of her vendors but she doesn’t have to pay for it right away.
The amount of this purchase will increase Stephanie’s:
a.
accounts receivable
b.
assets
c.
balance sheet
d.
accounts payable
29. XYC Corporation pays its taxes quarterly but withholds payroll taxes from its employees’ paychecks
each week. Until the taxes are actually paid to the IRS, they appear on the balance sheet as:
a.
an asset..
b.
an account receivable.
c.
a liability.
d.
a long-term debt.
30. Ignatio applied for a loan for his business that he will repay in 9 months. The best way to describe
this loan is as a(n):
a.
account payable.
b.
accrued expense.
c.
short-term note.
d.
long-tern debt.
31. The debts that Rhonda’s company will repay within the next ______________ are considered to be
current debt.
a.
2 years
b.
6 months
c.
1 quarter
d.
12 months
32. Raul needed an expensive piece of equipment to expand his business. He borrowed the money from
the bank and pledged the equipment as ___________. If Raul does not repay the loan, the bank can
take his equipment.
a.
a promissory note
b.
collateral
c.
asset in escrow
d.
long term debt
33. Martina invested her savings into her business when she started it. Later she added more capital and
she has kept some of her profits. Together these are known as:
a.
debt capital.
b.
accrued expenses.
c.
owners’ long-term debt.
d.
owners’ equity.
34. For Webster to understand how his company performed during calendar year 2012, he must begin with
firm’s financial position on:
a.
January 1, 2012.
b.
July 1, 2013.
c.
September 30, 2010.
d.
June 30, 2011.
35. The balance sheet and income statement are separate reports, but actually
a.
complement each other.
b.
contradict each other.
c.
display information for the same time duration.
d.
display vision and mission statements for the company.
36. For any business, both the _______ and ________ are needed to determine a firm’s financial position.
a.
income statement; balance sheet
b.
income statement; cash flow
c.
balance sheet; line of credit
d.
cash flow; balance sheet
37. It is important for Heather to monitor her cash flow because:
a.
if she borrowed money to finance her business, the lenders will want to make sure she
used the money wisely.
b.
her investors will want to make sure they get their money back.
c.
cash flow is a measure of her success.
d.
a business can go bankrupt with negative cash flows even though the income statement
shows a profit.
38. The cash flow statement measures cash flows on
a.
an annual basis.
b.
an accrual basis.
c.
a cash basis.
d.
a normalized basis.
39. Natalya is confused about the difference between cash-basis and accrual-basis accounting. So you tell
her that the:
a.
cash method is easier to use.
b.
cash method matches revenue and expenses better.
c.
point of recognition of revenue and expenses is different.
d.
cash method involves less record keeping.
40. Coronado cannot use the income statement as a measure of cash flows because it is calculated on a(n)
_______ rather than a(n) _______ basis.
a.
annual; cash
b.
annual; accrual
c.
accrual; cash
d.
cash; accrual
41. Lucille is preparing the _____, which shows all cash receipts and payments involved in operating the
business and managing its financial activities.
a.
income statement
b.
balance sheet
c.
cash flow statement