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CHAPTER 2
FINANCIAL STATEMENTS AND CASH
FLOW
Answers to Concept Questions
1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in
2. The recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be “booked” when the revenue process is essentially
3. The bottom-line number shows the change in the cash balance on the balance sheet. As such, it is not
a useful number for analyzing a company.
4. The major difference is the treatment of interest expense. The accounting statement of cash flows
treats interest as an operating cash flow, while the financial statement of cash flows treats interest as
a financing cash flow. The logic of the accounting statement of cash flows is that since interest appears
will have more to say about this in a later chapter. When comparing the two cash flow statements, the
financial statement of cash flows is a more appropriate measure of the company’s operating
performance because of its treatment of interest.
5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that
if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How
assets in market value.
6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly
productively, not whether cash flow from assets is positive or negative.
7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-
up, so it depends.
8. For example, if a company were to become more efficient in inventory management, the amount of
9. If a company raises more money from selling stock than it pays in dividends in a particular period, its
principal, its cash flow to creditors will be negative.
10. The adjustments discussed were purely accounting changes; they had no cash flow or market value
consequences.
Solutions to Questions and Problems
Basic
1. To find owners’ equity, we must construct a balance sheet as follows:
Balance Sheet
CA $6,800 CL $5,400
NFA 29,400 LTD 13,100
OE ??
TA $36,200 TL & OE $36,200
NWC = CA – CL = $6,800 – 5,400 = $1,400
2. The income statement for the company is:
Income Statement
Sales $528,600
Costs 264,400
Depreciation 41,700
Rearranging, we get:
Addition to retained earnings = Net income – Dividends
Addition to retained earnings = $131,170 – 27,000
Addition to retained earnings = $104,170
3. To find the book value of current assets, we use the NWC equation, that is:
NWC = CA – CL
Rearranging to solve for current assets, we get:
The market value of current assets is given, so the market value balance sheet is:
Market Value Balance Sheet
NWC $ 410,000
4. Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($328,500 – 100,000)
Taxes = $111,365
The average tax rate is the total tax paid divided by taxable income, so:
5. To calculate OCF, we first need the income statement:
Income Statement
Sales
$30,700
Costs
11,100
Depreciation expense
2,100
EBIT
$17,500
Interest expense
1,140
EBT
$16,360
Taxes (40%)
6,544
Net income
$ 9,816
Using the equation for OCF, we get:
OCF = EBIT + Depreciation – Taxes
OCF = $17,500 + 2,100 – 6,544
OCF = $13,056
6. The net capital spending is the increase in fixed assets, plus depreciation, so:
Net capital spending = NFAend – NFAbeg + Depreciation
Net capital spending = $1,095,000
7. The long-term debt account will increase by $9.5 million, the amount of the new long-term debt issue.
Since the company sold 4 million new shares of stock with a $1 par value, the common stock account
will increase by $4 million. The capital surplus account will increase by $22 million, the value of the
new stock sold above its par value. Since the company had a net income of $15.3 million, and paid
$3.1 million in dividends, the addition to retained earnings was $12.2 million, which will increase the
Long-term debt
$ 46,500,000
Total long-term debt
$ 46,500,000
Shareholders’ equity
Preferred stock
$ 2,100,000
Common stock ($1 par value)
12,900,000
Capital surplus
63,000,000
Accumulated retained earnings
87,500,000
Total equity
$ 165,500,000
8. The cash flow to creditors is the interest paid minus the change in long-term debt, so:
Cash flow to creditors = Interest paid – Net new borrowing
Cash flow to creditors = $187,000 – (LTDend – LTDbeg)
Cash flow to creditors = $57,000
9. The cash flow to stockholders is the dividends paid minus any new equity purchased by shareholders,
so:
Cash flow to stockholders = Dividends paid – Net new equity
Cash flow to stockholders = $270,000 – [(Commonend + APISend) – (Commonbeg + APISbeg)]
Note: APIS is the additional paid-in surplus.
10. We know that the cash flow from assets must be equal to the cash flow to creditors plus the cash flow
to stockholders, so:
Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
Now, we can use the relationship between the cash flow from assets and the operating cash flow,
change in net working capital, and capital spending to find the operating cash flow. Doing so, we find:
Cash flow from assets = –$308,000 = OCF – Change in NWC – Net capital spending
–$308,000 = OCF – (–$65,000) – 640,000
Operating cash flow = $267,000
Intermediate
11. a. The accounting statement of cash flows explains the change in cash during the year. The
accounting statement of cash flows will be:
Statement of cash flows
Operations
Net income
$148
Depreciation
77
Changes in other current assets
–12
Change in accounts payable
6
Total cash flow from operations
$219
Investing activities
Acquisition of fixed assets
–$211
Total cash flow from investing activities
–$211
Financing activities
Proceeds of long-term debt
$44
Dividends
–40
Total cash flow from financing activities
$4
Change in cash (on balance sheet)
$ 12
b. The change in net working capital is the ending net working capital minus the beginning net
working capital, so:
c. To find the cash flow generated by the firm’s assets, we need the operating cash flow, and the
capital spending. Since there are no interest payments, EBIT is the same as EBT. Calculating
each of these, we find:
Operating cash flow
EBT
$246
Depreciation
77
–Taxes
98
Operating cash flow
$225
Capital spending
Ending fixed assets
$824
–Beginning fixed assets
690
Depreciation
77
Capital spending
$211
Now we can calculate the cash flow generated by the firm’s assets, which is:
Cash flow from assets
Operating cash flow
$225
–Capital spending
211
–Change in NWC
18
Cash flow from assets
–$4
Notice that the accounting statement of cash flows shows a positive cash flow, but the financial cash
flows show a negative cash flow. The financial cash flow is a better number for analyzing the firm’s
performance.
12. To construct the cash flow identity, we will begin cash flow from assets. Cash flow from assets is:
Cash flow from assets = OCF – Change in NWC – Net capital spending
So, the operating cash flow is:
OCF = EBIT + Depreciation – Taxes
Change in NWC = $5,622
Now, we can calculate the capital spending. The capital spending is:
Net capital spending = NFAend – NFAbeg + Depreciation
Net capital spending = $498,312 – 415,289 + 66,513
The cash flow to creditors is:
Cash flow to creditors = Interest paid – New long-term debt
Cash flow to creditors = Interest paid – (Long-term debtend – Long-term debtbeg)
Cash flow to creditors = $23,280 – ($179,400 – 165,300)
Cash flow to creditors = $9,180
The cash flow to stockholders is a little trickier in this problem. First, we need to calculate the new
equity sold. The equity balance increased during the year. The only way to increase the equity balance
is to add addition to retained earnings or sell equity. To calculate the new equity sold, we can use the
following equation:
Cash flow to stockholders = $10,273
The company paid $9,180 to creditors and $10,273 to its stockholders.
Finally, the cash flow identity is:
The cash flow identity balances, which is what we expect.
13. With the information provided, the cash flows from the firm are the capital spending and the change
in net working capital, so:
Cash flows from the firm
Capital spending
–$19,200
Additions to NWC
–2,700
Cash flows from the firm
–$21,900
Cash flows to investors of the firm
Sale of long-term debt
–$16,500
Sale of common stock
–2,700
Dividends paid
7,100
Cash flows to investors of the firm
–$12,100
14. a. The interest expense for the company is the amount of debt times the interest rate on the debt.
So, the income statement for the company is:
Income Statement
Sales
$757,000
Cost of goods sold
249,800
Selling expenses
146,000
Depreciation expense
87,000
EBIT
$274,200
Interest expense
40,500
EBT
$233,700
Taxes
81,795
Net income
$151,905
b. And the operating cash flow is:
15. To find the OCF, we first calculate net income.
Income Statement
Sales
$225,000
Costs
103,200
Other expenses
6,100
Depreciation expense
15,300
EBIT
$100,400
Interest expense
11,200
EBT
$89,200
Taxes
31,227
Net income
$57,973
Dividends
$18,100
Addition to retained earnings
$39,873
a. The operating cash flow was:
b. The cash flow to creditors is the interest paid minus any net new long-term debt, so:
c. The cash flow to stockholders is the dividends paid minus any net new equity, or:
d. We know that CFA = CFC + CFS, so:
CFA = $19,700 + 12,100
CFA = $31,800
CFA is also equal to (OCF – Net capital spending – Change in NWC). We already know OCF.
Net capital spending is equal to:
Net capital spending = Increase in NFA + Depreciation
Net capital spending = $33,000 + 15,300
