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Chapter 12 Review
✓ What is the usefulness of the statement of cash flows? What does information
contained in the statement of cash flows help investors, creditors, and others assess?
✓ Define operating, investing, and financing activities. Give an example of each.
✓ List the phases of the product life cycle. How is a company’s cash flow affected by each
phase in the product’s life cycle?
✓ Prepare a statement of cash flows using one of two approaches: (a) the indirect method
or (b) the direct method (covered in the appendix).
✓ Use the ratios discussed in this chapter to evaluate a company. Be sure you understand
the difference in the ratios that are accrual-based and those that are cash-based. In
which of the ratios would you place more confidence, the accrual-based ratios or the
cash based ratios?
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Vocabulary Quiz Name ______________________ Date
_____________
Chapter 12
1. A basic financial statement that provides information about the cash
receipts and cash payments of an entity during a period, classified as
operating, investing, and financing activities, in a format that reconciles
the beginning and ending cash balances.
2. A method of determining net cash provided by operating activities by
adjusting each item in the income statement from the accrual basis to
the cash basis.
3. Cash flow activities that include the cash effects of transactions that
create revenues and expenses and thus enter into the determination of
net income.
4. A cash-basis ratio used to evaluate solvency, calculated as net cash
provided by operating activities divided by average total liabilities.
5. Cash flow activities that include (a) acquiring and disposing of
investments, property, plant, and equipment, and (b) lending money
and collecting the loans.
6. A series of phases in a product’s sales and cash flows over time; these
phases, in order of occurrence, are introductory, growth, maturity, and
decline.
7. A method of preparing a statement of cash flows in which net income
is adjusted for items that do not affect cash, to determine net cash
provided by operating activities.
8. A cash-basis ratio used to evaluate liquidity, calculated as net cash
provided by operating activities divided by average current liabilities.
9. Describes the cash remaining from operations after adjustment for
capital expenditures and dividends.
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10. Cash flow activities that include (a) obtaining cash from issuing debt
and repaying the amounts borrowed and (b) obtaining cash from stock–
holders, repurchasing shares and paying dividends.
Solutions to Vocabulary Quiz
Chapter 12
1. Statement of cash flows
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Multiple Choice Quiz Name _____________________ Date
___________
Chapter 12
1. The statement of cash flows classifies cash receipts and cash payments into which
of the following activities?
a. Investing activities
b. Financing activities
c. Operating activities
d. All of these answer choices are correct.
2. Cash flow activities that include the cash effects of transactions that create revenues
and expenses and thus enter into the determination of net income are referred to as
a. investing activities
b. financing activities
c. operating activities
d. all of these answer choices are correct.
3. The source of cash generally considered to be the best measure of whether a
company can generate sufficient cash to continue as a going concern and to expand
is provided by
a. investing activities
b. financing activities
c. operating activities
d. all of these answer choices are correct.
4. Cash outflows to acquire purchase property, plant, and equipment; to acquire
investments; to make loans to other entities are examples of
a. investing activities
b. financing activities
c. operating activities
d. all of these answer choices are correct.
5. Significant noncash activities include:
a. conversion of bonds into common stock.
b. payment of bank note.
c. exchanges of plant assets.
d. both the conversion of bonds into common stock and the exchange of plant
assets.
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6. During which phase in the product life cycle will the company be spending
considerable amounts to purchase productive assets, but not generating positive
cash from operations?
a. Introductory phase
b. Growth phase
c. Maturity phase
d. Decline Phase
7. The information in a statement of cash flows should help investors, creditors, and
others evaluate all of the following aspects of the firm’s financial position except:
a. The entity’s ability to generate future cash flows.
b. The entity’s ability to pay dividends and meet obligations.
c. The reasons for the differences between net income and net cash provided
(used) by financing activities.
d. The cash investing and financing transactions during the period.
8. All of the following are used in preparing a statement of cash flows except:
a. a trial balance.
b. comparative balance sheet.
c. current income statement.
d. additional information.
9. Which of the following is not correct concerning the indirect method of preparing the
statement of cash flows?
a. It is easier to prepare.
b. It is required by the FASB.
c. It focuses on the differences between net income and net cash flow from
operating activities.
d. It tends to reveal less company information to competitors.
10. A cash–basis ratio used to evaluate liquidity, calculated as net cash provided by
operating activities divided by average current liabilities is the
a. capital expenditure ratio.
b. free cash flow.
c. cash return on sales ratio.
d. current cash debt coverage ratio.
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Solutions to Multiple Choice Quiz
Chapter 12
1. d
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Exercise 1 – Cash Flow Communication Activity
Chapter 12
Renee Ashay is the sole proprietor of Renee’s School of Cosmetology. Renee intends to
expand her course curriculum to include an esthetician program (skin care). Renee must
hire a certified instructor, purchase a line of skin care products, purchase additional
equipment, and promote the new program. In order to secure a loan to finance her
expansion, Renee’s banker asked her for a complete set of financial statements, including
a cash flow statement. Renee is able to prepare her accrual-basis income statement,
statement of owner’s equity, and balance sheet from her trial balance. However, she has
come to you because she is unfamiliar with the statement of cash flows, and does not
understand the need for this statement. Prepare a letter to Renee explaining the usefulness
of the cash flow statement and why the banker is interested in this financial statement.
Solution:
Dear Renee:
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Exercise 2 – Creative Cash Flow Activity
Chapter 12
Financial statement preparers have two choices in preparing the statement of cash flows:
the indirect method and the direct method. The indirect method is used extensively in
practice even though the FASB has expressed a preference for the direct method
1. List two similarities and one difference of the direct and indirect methods.
2. What are the advantages of using the indirect method?
3. What are the advantages of using the direct method?
Solutions:
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Exercise 3 – Library or World Wide Web Research and Financial Statement
Analysis Activity
Chapter 12
Wyeth and Merck are large pharmaceutical companies operating in the United States.
Research your school library or the Internet to find current annual reports for Wyeth and
Merck. If researching the web go to http://www.wyeth.com to find information for Wyeth.
Merck can be found at http://www.merck.com. Using information contained in the annual
reports compute the following cash-based measures for Wyeth and Merck:
1. Free cash flow
2. Current cash debt coverage ratio
3. Cash debt coverage ratio
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Exercise 4 – Library or World Wide Web Research and Cash Flow Activity
Chapter 12
Home Depot is a large retailer of building materials and home improvement products with
headquarters in Atlanta. Locate the most recent annual report for Home Depot in your
school library or on the World Wide Web. Visit Home Depot on the web at
http://www.homedepot.com. Using the Consolidated Statement of Cash Flows provide a
narrative of Home Depot’s activities for the year.
Solutions: Information available on website.
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Exercise 5 – Library or World Wide Web Research Activity
Chapter 12
Cash management is an important issue for all businesses. To learn more about cash
management, go to the Internet and find an article about corporate cash management.
Read and summarize one of the leading articles on cash management. Be sure and note
the source of this article.
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Exercise 6 – Ethics Activity
Chapter 12
We-Tow-U Wrecker Service recently purchased three new wreckers by signing a $250,000
note at the local bank. When you prepare the financial statements for We-Tow-U, the
owner, Mike Mounds, confronts you about the information you included in the statement of
cash flows. Mike is outraged that you showed non-cash items on the statement. He insists
that providing his competitors with the information about the cost of wreckers will have a
negative effect on his business. He goes on to explain that he negotiated with the wrecker
dealer to get the new wreckers at a price well below the price that his competitors would
have to pay. He also explains that he assured the dealer that he would not let anyone know
what a great deal he got on the wreckers. How would you respond to Mike’s demand that
you provide only cash information on the statement of cash flows?
Solution:
You should explain to Mike that generally accepted accounting principles require
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Exercise 7 – Product Life Cycle Activity
Chapter 12
All products go through a series of phases called the product life cycle. The product life
cycle has a direct impact on a company’s cash flows.
1. Summarize the four phases (in order of their occurrence) in the product life cycle.
2. For each of the four phases, explain the impact of the cycle on a company’s cash
flow.
Solutions:
1. The four phases are often referred to as follows:
a. Introductory phase – occurs at the beginning of a company’s life, when it is
purchasing fixed assets and beginning to produce and sell products.
2. Each phase impacts a company’s cash flow differently:
a. Introductory phase – we expect cash from operations to be negative, cash
from investing to be negative, and cash from financing to be positive. Cash
used in operations will exceed cash generated by operations. The company