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CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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 a 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 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
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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
6. The amount shown on the December 31, 2015, balance sheet as "retained earnings" is equal to the firm's net income for
2015 minus any dividends it paid.
a.
True
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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
8. If we were describing the income statement and the balance sheet, it would be correct to say that the income statement
is more like a video while the balance sheet is more like a snapshot.
a.
True
b.
False
9. EBIT stands for earnings before interest and taxes, and it is often called "operating income."
a.
True
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
10. EBITDA stands for earnings before interest, taxes, debt, and assets.
a.
True
b.
False
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 up 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, and will result in a substantial amount of
retained earnings shown on the balance sheet.
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
a.
True
b.
False
13. 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.
a.
True
b.
False
14. The value of any asset is the present value of the cash flows the asset is expected to provide. The cash flows a business
is able to provide to its investors is its free cash flow. This is the reason that FCF is so important in finance.
a.
True
b.
False
15. If a firm is reporting its income in accordance with generally accepted accounting principles, then its net income as
reported on the income statement should be equal to its free cash flow.
a.
True
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
16. The fact that 70% of the interest income received by corporations is excluded from its taxable income encourages
firms to finance with more debt than they would in the absence of this tax law provision.
a.
True
b.
False
17. Both interest and dividends paid by a corporation are deductible operating expenses, hence they decrease the firm's
taxes.
a.
True
b.
False
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
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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
20. Net operating working capital is equal to current assets minus the difference between current liabilities and notes
payable. This definition assumes that the firm has no "excess" cash.
a.
True
b.
False
21. The next-to-last line on the income statement shows the firm's earnings, while the last line shows the dividends the
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
company paid. Therefore, the dividends are frequently called "the bottom line."
a.
True
b.
False
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 just like borrowing
money from a bank. An increase in accounts payable has 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
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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
25. The first major section of a typical statement of cash flows is "Operating Activities," and the first entry in this section
is "Net Income." Then, also in the first section, we show some items that represent increases or decreases to cash, and the
last entry is called "Net Cash Provided by Operating Activities." This number can be either positive or negative, but if it is
negative, the firm is almost certain to soon go bankrupt.
a.
True
b.
False
26. To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash
charge that has been deducted from revenue in the net income calculation.
a.
True
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
27. Two metrics that are used to measure a company's financial performance are net income and cash flow. Accountants
emphasize net income as calculated in accordance with generally accepted accounting principles. Finance people
generally put at least as much weight on cash flows as they do on net income.
a.
True
b.
False
28. Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid
out to stockholders as dividends. If the firm has sufficient retained earnings, it can purchase assets and pay for them with
cash from retained earnings.
a.
True
b.
False
29. The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of the
stockholders' claims against the firm's existing assets. Put another way retained earnings are stockholders' reinvested
earnings.
a.
True
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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
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, this would probably encourage companies to use more debt financing than they presently do, other
things held constant.
a.
True
b.
False
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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.
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
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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
Multiple Choice: Conceptual
Please note that some of the answer choices, or answers that are very close, are used in different questions. This has
caused us no difficulties, but please take this into account when you make up exams.
37. 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 needs tells us how much cash the firm will require during some future period, generally
a month or a year.
38. Which of the following statements is CORRECT?
a.
Assets other than cash are expected to produce cash over time, and the amounts of cash they eventually
produce should be exactly the same as the amounts at which the assets are carried on the books.
b.
The primary reason the annual report is important in finance is that it is used by investors when they form
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
expectations about the firm's future earnings and dividends, and the riskiness of those cash flows.
c.
The annual report is an internal document prepared by a firm's managers solely for the use of its
creditors/lenders.
d.
The four most important financial statements provided in the annual report are the balance sheet, income
statement, cash budget, and statement of stockholders' equity.
e.
Prior to the Enron scandal in the early 2000s, companies would put verbal information in their annual reports,
along with the financial statements. That verbal information was often misleading, so today annual reports can
contain only quantitative information: audited financial statements.
39. Which of the following statements is CORRECT?
a.
The balance sheet for a given year is designed to give us an idea of what happened to the firm during that year.
b.
The balance sheet for a given year tells us how much money the company earned during that year.
c.
The difference between the total assets reported on the balance sheet and the liabilities reported on this
statement tells us the current market value of the stockholders' equity, assuming the statements are prepared in
accordance with generally accepted accounting principles (GAAP).
d.
If a company's statements were prepared in accordance with generally accepted accounting principles
(GAAP), the market value of the stock equals the book value of the stock as reported on the balance sheet.
e.
The assets section of a typical company's balance sheet begins with cash, then lists the assets in the order in
which they will probably be converted to cash, with the longest lived assets listed last.
40. 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.
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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.
41. Which of the following items is NOT normally considered to be a current asset?
a.
Accounts receivable.
b.
Inventory.
c.
Bonds.
d.
Cash.
e.
Short-term, highly-liquid, marketable securities.
42. 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.
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
43. Which of the following statements is CORRECT?
a.
The focal point of the income statement is the cash account, because that account cannot be manipulated by
"accounting tricks."
b.
The reported income of two otherwise identical firms cannot be manipulated by different accounting
procedures provided the firms follow generally accepted accounting principles (GAAP).
c.
The reported income of two otherwise identical firms must be identical if the firms are publicly owned,
provided they follow procedures that are permitted by the Securities and Exchange Commission (SEC).
d.
If a firm follows generally accepted accounting principles (GAAP), then its reported net income will be
identical to its reported cash flow.
e.
The income statement for a given year is designed to give us an idea of how much the firm earned during that
year.
44. Below are the 2013 and 2014 year-end balance sheets for Tran Enterprises:
Assets:
2014
2013
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
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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 2013. As of the end of 2014, none of the principal on this debt had been repaid. Assume that the company's sales in
2013 and 2014 were the same. Which of the following statements must be CORRECT?
a.
The firm increased its short-term bank debt in 2014.
b.
The firm issued long-term debt in 2014.
c.
The firm issued new common stock in 2014.
d.
The firm repurchased some common stock in 2014.
e.
The firm had negative net income in 2014.
45. On its 12/31/14 balance sheet, Barnes Inc showed $510 million of retained earnings, and exactly that same amount
was shown the following year. Assuming that no earnings restatements were issued, which of the following statements is
CORRECT?
a.
If the company lost money in 2014, it must have paid dividends.
b.
The company must have had zero net income in 2014.
c.
The company must have paid out half of its 2014 earnings as dividends.
d.
The company must have paid no dividends in 2014.
e.
Dividends could have been paid in 2014, but they would have had to equal the earnings for the year.
46. Below is the common equity section (in millions) of Timeless Technology's last two year-end balance sheets:
2014
2013
Common stock
$2,000
$1,000
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
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 2014 was higher than in 2013.
b.
The firm issued common stock in 2014.
c.
The market price of the firm's stock doubled in 2014.
d.
The firm had positive net income in both 2013 and 2014, but its net income in 2014 was lower than it was in
2013.
e.
The company has more equity than debt on its balance sheet.
47. Which of the following statements is CORRECT?
a.
Typically, a firm's DPS should exceed its EPS.
b.
Typically, a firm's net income should exceed its EBIT.
c.
If a firm is more profitable than average, we would normally expect to see its stock price exceed its book value
per share.
d.
If a firm is more profitable than most other firms, we would normally expect to see its book value per share
exceed its stock price, especially after several years of high inflation.
e.
The more depreciation a firm has in a given year, the higher its EPS, other things held constant.
48. Which of the following statements is CORRECT?
a.
The more depreciation a firm reports, the higher its tax bill, other things held constant.
b.
People sometimes talk about the firm's cash flow, which is shown as the lowest entry on the income statement,
hence it is often called "the bottom line."
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
c.
Depreciation reduces a firm's cash balance, so an increase in depreciation would normally lead to a reduction
in the firm's cash flow.
d.
Operating income is derived from the firm's regular core business. Operating income is calculated as Revenues
less Operating costs. Operating costs do not include interest or taxes.
e.
Depreciation is not a cash charge, so it does not have an effect on a firm's reported profits.
49. Which of the following factors could explain why Michigan Energy's cash balance increased even though it had a
negative cash flow last year?
a.
The company sold a new issue of bonds.
b.
The company made a large investment in 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.
50. Analysts who follow Howe Industries recently noted that, relative to the previous year, the company's net cash
provided from operations increased, yet cash as reported on the balance sheet decreased. Which of the following factors
could explain this situation?
a.
The company cut its dividend.
b.
The company made large investments in fixed assets.
c.
The company sold a division and received cash in return.
d.
The company issued new common stock.
e.
The company issued new long-term debt.
CHAPTER 03—FINANCIAL STATEMENTS, CASH FLOW, AND TAXES
51. Austin Financial recently announced that its net income increased sharply from the previous year, yet its net cash
provided from operations declined. Which of the following could explain this performance?
a.
The company's dividend payment to common stockholders declined.
b.
The company's expenditures on fixed assets declined.
c.
The company's cost of goods sold increased.
d.
The company's depreciation expense declined.
e.
The company's interest expense increased.
52. Which of the following statements is CORRECT?
a.
The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or
selling fixed assets.
b.
The statement of cash flows shows where the firm's cash is located; indeed, it provides a listing of all banks
and brokerage houses where cash is on deposit.
c.
The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects
of changes in working capital.
d.
The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect
cash obtained by selling new common stock.
e.
The statement of cash flows shows how much the firm's cash, the total of currency, bank deposits, and short-
term liquid securities (or cash equivalents), increased or decreased during a given year.
