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Chapter 02 - Reviewing Financial Statements
CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS
questions
LG1 1. List and describe the four major financial statements.
LG1 2. On which of the four major financial statements (balance sheet, income statement, statement of
cash flows, or statement of retained earnings) would you find the following items?
LG1 3. What is the difference between current liabilities and long-term debt?
LG1 4. How does the choice of accounting method used to record fixed asset depreciation affect
management of the balance sheet?
Chapter 02 - Reviewing Financial Statements
LG1 5. What are the costs and benefits of holding liquid securities on a firm’s balance sheet?
LG2 6. Why can the book value and market value of a firm differ?
LG2 7. From a firm manager’s or investor’s point of view, which is more important―the book value of a
firm or the market value of the firm?
LG3 8. What do we mean by a “progressive” tax structure?
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LG3 9. What is the difference between an average tax rate and a marginal tax rate?
LG3 10. How does the payment of interest on debt affect the amount of taxes the firm must pay?
LG4 11. The income statement is prepared using GAAP. How does this affect the reported revenue and
expense measures listed on the balance sheet?
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Chapter 02 - Reviewing Financial Statements
LG4 12. Why do financial managers and investors find cash flows to be more important than accounting
profit?
LG5 13. Which of the following activities result in an increase (decrease) in a firm’s cash?
LG5 14. What is the difference between cash flows from operating activities, cash flows from investing
activities, and cash flows from financing activities?
Cash flows from operations are those cash inflows and outflows that result directly from
LG5 15. What are free cash flows for a firm? What does it mean when a firm’s free cash flow is negative?
Free cash flows are the cash flows available to pay the firm’s stockholders and debtholders after the
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LG6 16. What is earnings management?
LG6 17. What does the Sarbanes-Oxley Act require of firm managers?
problems
basic 2-1 Balance Sheet You are evaluating the balance sheet for Goodman’s Bees Corporation.
problems From the balance sheet you find the following balances: cash and marketable securities =
LG1 $400,000, accounts receivable = $1,200,000, inventory = $2,100,000, accrued wages and taxes =
$500,000, accounts payable = $800,000, and notes payable = $600,000. Calculate Goodman Bees’ net
working capital.
Net working capital = Current assets –Current liabilities.
Goodman’s Bees’ current assets =
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Chapter 02 - Reviewing Financial Statements
LG1 2-2 Balance Sheet Casello Mowing & Landscaping’s year-end 2015 balance sheet lists current
assets of $435,200, fixed assets of $550,800, current liabilities of $416,600, and long-term debt of
$314,500. Calculate Casello’s total stockholders’ equity.
LG1 2-3 Income Statement The Fitness Studio, Inc.’s 2015 income statement lists the following income
and expenses: EBIT = $538,000, interest expense = $63,000, and net income = $435,000. Calculate
the 2015 taxes reported on the income statement.
Using the setup of an income statement in Table 2.2:
LG1 2-4 Income Statement The Fitness Studio, Inc.’s 2015 income statement lists the following income
and expenses: EBIT = $773,500, interest expense = $100,000, and taxes = $234,500. The firm has no
preferred stock outstanding and 100,000 shares of common stock outstanding. Calculate the 2015
earnings per share.
Using the setup of an income statement in Table 2.2:
LG1 2-5 Income Statement Consider a firm with an EBIT of $850,000. The firm finances its assets
with $2,500,000 debt (costing 7.5 percent) and 400,000 shares of stock selling at $5.00 per share.
To reduce firm’s risk associated with this financial leverage, the firm is considering reducing its
debt by $1,000,000 by selling an additional 200,000 shares of stock. The firm is in the 40 percent
tax bracket. The change in capital structure will have no effect on the operations of the firm.
Chapter 02 - Reviewing Financial Statements
Thus, EBIT will remain at $850,000. Calculate the change in the firm’s EPS from this change in
capital structure.
LG1 2-6 Income Statement Consider a firm with an EBIT of $550,000. The firm finances its assets
with $1,000,000 debt (costing 5.5 percent) and 200,000 shares of stock selling at $12.00 per
share. The firm is considering increasing its debt by $900,000, using the proceeds to buy back
75,000 shares of stock. The firm is in the 40 percent tax bracket. The change in capital structure
will have no effect on the operations of the firm. Thus, EBIT will remain at $550,000. Calculate
the change in the firm’s EPS from this change in capital structure.
The EPS before and after this change in capital structure is illustrated as follows:
LG3 2-7 Corporate Taxes Oakdale Fashions, Inc., had $245,000 in 2015 taxable income. Using the
tax schedule in Table 2.3, calculate the company’s 2015 income taxes. What is the average tax
rate? What is the marginal tax rate?
From Table 2.3, the $245,000 of taxable income puts Oakdale Fashion, Inc. in the 39 percent tax bracket. Thus,
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Chapter 02 - Reviewing Financial Statements
LG3 2-8 Corporate Taxes Hunt Taxidermy, Inc., is concerned about the taxes paid by the company in
2015. In addition to $42.4 million of taxable income, the firm received $2,975,000 of interest on
state-issued bonds and $1,000,000 of dividends on common stock it owns in Oakdale Fashions,
Inc. Calculate Hunt Taxidermy’s tax liability, average tax rate, and marginal tax rate.
LG4 2-9 Statement of Cash Flows Ramakrishnan Inc. reported 2015 net income of $15 million and
depreciation of $2,650,000. The top part of Ramakrishnan, Inc.’s 2015 and 2014 balance sheets is
listed as follows (in millions of dollars).
Calculate the 2015 net cash flow from operating activities for Ramakrishnan, Inc.
LG4 2-10 Statement of Cash Flows In 2015, Usher Sports Shop had cash flows from investing activities
of -$4,364,000 and cash flows from financing activities of -$5,880,000. The balance in the firm’s
cash account was $1,615,000 at the beginning of 2015 and $1,742,000 at the end of the year.
Calculate Usher Sports Shop’s cash flow from operations for 2015.
Chapter 02 - Reviewing Financial Statements
LG5 2-11 Free Cash Flow You are considering an investment in Fields and Struthers, Inc., and want
to evaluate the firm’s free cash flow. From the income statement, you see that Fields and
Struthers earned an EBIT of $62 million, had a tax rate of 30 percent, and its depreciation
expense was $5 million. Fields and Struthers’ NOPAT gross fixed assets increased by $32 million
from 2014 to 2015. The firm’s current assets increased by $20 million and spontaneous current
liabilities increased by $12 million. Calculate Fields and Struthers’ NOPAT, operating cash flow,
investment in operating capital and free cash flow for 2015.
LG5 2-12 Free Cash Flow Tater and Pepper Corp. reported free cash flows for 2015 of $39.1 million and
investment in operating capital of $22.1 million. Tater and Pepper incurred $13.6 million in
depreciation expense and paid $28.9 million in taxes on EBIT in 2015. Calculate Tater and Pepper’s
2015 EBIT.
LG1 2-13 Statement of Retained Earnings Mr. Husker’s Tuxedos, Corp. began the year 2015 with $256
million in retained earnings. The firm earned net income of $33 million in 2015 and paid dividends of
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Chapter 02 - Reviewing Financial Statements
$5 million to its preferred stockholders and $10 million to its common stockholders. What is the year-
end 2015 balance in retained earnings for Mr. Husker’s Tuxedos?
The statement of retained earnings for 2015 is as follows:
LG1 2-14 Statement of Retained Earnings Use the following information to find dividends paid to
common stockholders during 2015.
intermediate 2-15 Balance Sheet Brenda’s Bar and Grill has total assets of $15 million of which $5 million
problems are current assets. Cash makes up 10 percent of the current assets and accounts receivable makes up
another 40 percent of current assets. Brenda’s gross plant and equipment has a book value of $11.5
million and other long-term assets have a book value of $500,000. Using this information, what is the
LG1 balance of inventory and the balance of depreciation on Brenda Bar and Grill’s balance sheet?
Current assets: (in millions)
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