Introduction to Corporate Finance: What Companies Do, 3rd Edition John Graham | Scott B. Smart solutions manual and test bank
Chapter 2—Financial Statement and Cash Flow Analysis
MULTIPLE CHOICE
1. Which of the following items can be found on an income statement?
| a. | Accounts receivable |
| b. | Long-term debt |
| c. | Sales |
| d. | Inventory |
ANS: C PTS: 1 DIF: E REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
2. If you only knew a company’s total assets and total debt, which item could you easily calculate?
| a. | Sales |
| b. | Depreciation |
| c. | Total equity |
| d. | Inventory |
ANS: C PTS: 1 DIF: E REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
3. How do we calculate a company’s operating cash flow?
| a. | EBIT - taxes + depreciation |
| b. | EBIT - taxes - depreciation |
| c. | EBIT + taxes + depreciation |
| d. | EBIT - Sales |
ANS: A PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
4. Holding all other things constant, which of the following represents a cash outflow?
| a. | The company sells a machine. |
| b. | The company acquires inventory. |
| c. | The company receives a bank loan. |
| d. | The company increases accounts payable. |
ANS: B PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
5. Which of the following is a liquidity ratio?
| a. | Quick ratio |
| b. | P/E- ratio |
| c. | Inventory turnover |
| d. | Equity multiplier |
ANS: A PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Bavarian Sausage, Inc.
Bavarian Sausage, Inc.
Bavarian Sausage, Inc. posted the following balance sheet and income statement.
| Balance Sheet | ||||
| Cash | $ 50,000 | Accounts Payable | $185,000 | |
| Accounts Receivable | 125,000 | Notes Payable | 125,000 | |
| Inventories | 225,000 | Long-term debt | 115,000 | |
| Net Plant and Equipment | 525,000 | Common Stock | 350,000 | |
| Retained earnings | 150,000 | |||
| Total Assets | $925,000 | Total liabilities and Stockholders’ Equity | $925,000 |
| Income Statement | ||
| Sales | $525,000 | |
| Cost of goods sold | 215,000 | |
| Depreciation | 65,000 | |
| Earnings before interest and taxes | 245,000 | |
| Interest expense | 35,000 | |
| Net profit before taxes | 210,000 | |
| Taxes (@ 40%) | 84,000 | |
| Net income | $126,000 |
NARREND
6. What is Bavarian Sausage, Inc.’s operating cash flow?
| a. | $394,000 |
| b. | $191,000 |
| c. | $212,000 |
| d. | $359,000 |
ANS: C
245(1-.4)+65=212
PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
7. What is Bavarian Sausage, Inc.’s quick ratio?
| a. | 0.5645 |
| b. | 1.2903 |
| c. | 1.9565 |
| d. | 0.8871 |
ANS: A
(CA-INV)/CL
175/310=.5645
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
8. What is Bavarian Sausage, Inc.’s average collection period?
| a. | 14.39 days |
| b. | 4.20 days |
| c. | 122.56 days |
| d. | 86.90 days |
ANS: D
ACP=AR/ADS
ADS=SALES/365==>525/365=1.4384
ACP=125/1.4384=86.90
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
9. Bavarian Sausage, Inc. has 100,000 shares of common stock outstanding, but no preferred stock. The current price of Bavarian’s common stock is $15. What is the company’s P/E-ratio?
| a. | 119.00 |
| b. | 1.26 |
| c. | 11.90 |
| d. | 12.60 |
ANS: C
P/E=Price/EPS
EPS=Earnings Av. Shareholders/# Shares Outstanding
EPS=126,000/100,000=1.26
P/E=15/1.26=11.90
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
10. What is Bavarian Sausage, Inc.’s net profit margin?
| a. | 40% |
| b. | 47% |
| c. | 15% |
| d. | 24% |
ANS: D
NPM=NI/Sales=126/525=.24
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
11. What is Bavarian Sausage, Inc.’s debt-equity ratio?
| a. | 0.23 |
| b. | 0.52 |
| c. | 1.25 |
| d. | 0.85 |
ANS: A
LTD/Eq.=115/(350+150)=.23
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
12. Calculate Bavarian Sausage, Inc.’s return on assets.
| a. | 25.20% |
| b. | 16.35% |
| c. | 13.62% |
| d. | 8.47% |
ANS: C
ROA=NI/TA=126/925=.1362
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
13. If Bavarian Sausage, Inc. has 100,000 shares outstanding, what is the book value per share?
| a. | $5.00 |
| b. | $9.25 |
| c. | $3.50 |
| d. | $1.50 |
ANS: A
BV/Share=(350+150)/100=5.00
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
14. Calculate Bavarian Sausage, Inc.’s inventory turnover.
| a. | 1.05 |
| b. | 0.96 |
| c. | 0.76 |
| d. | 1.51 |
ANS: B
Inv. Turn=CGS/Inv=215/225=.96
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
15. Calculate Bavarian Sausage, Inc.’s return on equity.
| a. | 24.00% |
| b. | 13.62% |
| c. | 15.74% |
| d. | 25.20% |
ANS: D
126/(150+350)=.2520
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
16. What is Bavarian Sausage, Inc.’s times interest earned ratio?
| a. | 3.60 |
| b. | 7.00 |
| c. | 15.00 |
| d. | 6.00 |
ANS: B
time interest earned=EBIT/Interest=245/35=7.00
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
17. If a company’s net profit margin is 5% and its total asset turnover is 3.5, what is its ROA?
| a. | 17.50% |
| b. | 1.43% |
| c. | 70.00% |
| d. | 12.53% |
ANS: A
ROA=Net profit margine * Invintory turnover
ROA=.05*3.5=.1750
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
18. You have the following information about a firm: total asset = $350,000; common stock equity = $175,000; ROE = 12.5%. What is the firm’s earnings available for common stockholders?
| a. | $43,750 |
| b. | $21,875 |
| c. | $50,000 |
| d. | $47,632 |
ANS: B
.125*175,000=21,875
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Tax table
Tax Table
| Taxable income over | Not over | Tax Rate |
| $ 0 | $ 50,000 | 15% |
| 50,000 | 75,000 | 25% |
| 75,000 | 100,000 | 34% |
| 100,000 | 335,000 | 39% |
| 335,000 | 10,000,000 | 34% |
| 10,000,000 | 15,000,000 | 35% |
| 15,000,000 | 18,333,333 | 38% |
| 18,333,333 | ............... | 35% |
NARREND
19. Refer to Tax Table. First Watch, Inc. has a pretax income of $3,755,250. What is the company’s average tax rate?
| a. | 25% |
| b. | 15% |
| c. | 39% |
| d. | 34% |
ANS: D PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
20. Refer to Tax Table. First Watch, Inc. has a pretax income of $3,755,250. What is the company’s tax liability?
| a. | $1,276,785 |
| b. | $1,390,571 |
| c. | $1,464,548 |
| d. | $563,288 |
ANS: A
Tax on excess over 335,000 => (3,755,250-335,000)*.34=1,162,885
Tax = 1,162,885+91,650+8,500+6,200+7,500=1,276,785
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
21. Refer to Tax Table. Bavarian Sausage, Inc. has a pretax income of $325,000. What is the company’s tax liability?
| a. | $126,750 |
| b. | $110,000 |
| c. | $81,250 |
| d. | $325,000 |
ANS: B
Tax on excess of 100,00=> (325,000-100,00)*.39=87,750
Tax = 87,75+8,500+6,250+7,500=110,000
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
22. Refer to Tax Table. Bavarian Sausage, Inc. has a pretax income of $325,000. What is the company’s marginal tax rate?
| a. | 34% |
| b. | 39% |
| c. | 35% |
| d. | 25% |
ANS: B PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
23. Refer to Tax Table. Bavarian Sausage, Inc. has a pretax income of $325,000. What is the company’s average tax rate?
| a. | 39.00% |
| b. | 29.55% |
| c. | 26.75% |
| d. | 33.85% |
ANS: D
Tax on excess of 100,00=> (325,000-100,00)*.39=87,750
Tax = 87,75+8,500+6,250+7,500=110,000
110/325=.3385
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
24. A company has an average collection period of 52 days and accounts receivables of $250,000. What are the company’s annual sales?
| a. | $2,234,756 |
| b. | $1,754,808 |
| c. | $1,543,823 |
| d. | $250,000 |
ANS: B
Annual Sales/365 = Av. daily sales
AR = ACP * Av. daily sales
250,000 = 52 * (Annual sales/365)
Annual sales = 1,754,807
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
25. Your company has an average collection period of 40 days and accounts receivables of $315,000. What are the company’s annual sales?
| a. | $12,600,000 |
| b. | $1,754,808 |
| c. | $2,874,375 |
| d. | $315,000 |
ANS: C
Annual Sales/365 = Av. daily sales
AR = ACP * Av. daily sales
315,000 = 40 * (Annual sales/365)
Annual sales = 2,874,375
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
26. A company has a total asset turnover of 2 and sales of $500,000. What is the company’s total assets?
| a. | $1,000,000 |
| b. | $250,000 |
| c. | $750,000 |
| d. | $500,000 |
ANS: B
500/2=250
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
27. You have the following information about a company: quick ratio = 0.85, inventory = $125,000 and current assets = $375,000. What is the company’s current ratio?
| a. | 0.85 |
| b. | 1.05 |
| c. | 2.56 |
| d. | 1.28 |
ANS: D
Current Ratio = CA/CL
Quick Ratio = (CA-Inv)/CL
.85=(375-125)/CL
CL=194
Current Ratio=375/194=1.28
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
28. You have the following information about a company: quick ratio = 0.9, inventory = $50,000 and current assets = $200,000. What is the company’s current ratio?
| a. | 3.60 |
| b. | 1.80 |
| c. | 1.20 |
| d. | 1.28 |
ANS: C
Current Ratio = CA/CL
Quick Ratio = (CA-Inv)/CL
.9=(200-50)/CL
CL=166.67
Current Ratio=200/166.67=1.20
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
29. A company has sales of $1,250,000, cost of goods sold of $750,000, depreciation expenses of $250,000 and interest expenses of $55,000. If the company’s tax rate is 34% and the income statement is complete, what is this firm’s operating cash flow?
| a. | $183,700 |
| b. | $433,700 |
| c. | $165,000 |
| d. | $415,000 |
ANS: B
(1,250 -750 - 250)*(1-.34) + 250 = 415
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
30. A company has sales of $1,000,000, cost of goods sold of $700,000, depreciation expenses of $250,000 and interest expenses of $55,000. If the company’s tax rate is 34% and the income statement is complete, what is this firm’s operating cash flow?
| a. | $300,000 |
| b. | $246,700 |
| c. | $283,000 |
| d. | $33,000 |
ANS: C
(1,000 -700 - 250)*(1-.34) + 250 = 283
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
31. A company has sales of $250,000, cost of goods sold of $50,000, depreciation expenses of $250,000. If the company’s tax rate is 34% and the income statement is complete, what is this firm’s operating cash flow?
| a. | -$132,000 |
| b. | $118,000 |
| c. | $217,000 |
| d. | $283,000 |
ANS: C
(200*.66)+(250*.34)=217
alt
(250-50-250)*.66 + 250 =217
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
32. In a given year a company decreased its inventory by $250,000, increased its accounts receivable by $50,000 and increased its accounts payable by $100,000. What is the net change of the company’s cash?
| a. | $400,000 |
| b. | $300,000 |
| c. | $200,000 |
| d. | $100,000 |
ANS: A
250+50+100=400
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
33. In a given year a company decreased its inventory by $250,000, purchased $350,000 worth of fixed assets and took on a new $500,000 loan. What is the net change of the company’s cash as a result of these transactions?
| a. | $100,000 |
| b. | -$100,000 |
| c. | $400,000 |
| d. | -$400,000 |
ANS: C
250-350+500=400
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
34. Given the following information, calculate the company’s Current Assets.
| Current assets: | ??? |
| Current liabilities: | $ 50,000 |
| Net fixed assets: | $100,000 |
| Long term Debt | $100,000 |
| Total equity: | $180,000 |
| a. | $330,000 |
| b. | $230,000 |
| c. | $150,000 |
| d. | $50,000 |
ANS: D
TL=CL+LTD+TE
TL=50+100+180=330
TA=TL
TA=CA+NFA
TA=CA+100
330=CA+100
CA=230
PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
35. Given the following information, calculate the company’s long-term debt.
| Current assets: | $125,000 |
| Current liabilities: | $ 85,000 |
| Net fixed assets: | $250,000 |
| Total equity: | $200,000 |
| a. | $375,000 |
| b. | $50,000 |
| c. | $285,000 |
| d. | $90,000 |
ANS: D
Total Assets = 125+250=375
TA = TL + Equity
TL = CL + LTD
375 = 85 + LTD + 200
LTD = 90
PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
36. Financial professionals prefer to focus on an accounting approach that focuses on
| a. | governmental accounting methods. |
| b. | current and prospective cash flows. |
| c. | economically based accruals. |
| d. | international accrual accounting standards. |
ANS: B PTS: 1 DIF: E REF: Introduction
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
37. Generally accepted accounting principles are developed by
| a. | the Securities and Exchange Commission. |
| b. | the Financial Accounting Standards Board. |
| c. | Congress. |
| d. | the New York Stock Exchange. |
ANS: B PTS: 1 DIF: E REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
38. Which of the following statements is not required by the SEC for publicly traded firms?
| a. | the statement of cost of goods sold |
| b. | the statement of retained earnings |
| c. | the statement of cash flows |
| d. | the balance sheet |
ANS: A PTS: 1 DIF: E REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
39. The balance sheet entry that represents the cumulative total of the earnings that a firm has reinvested since its inception is
| a. | common stock. |
| b. | paid-in-capital. |
| c. | par value. |
| d. | retained earnings. |
ANS: D PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
40. Company X had sales of $120 with a cost of goods sold equal to 25% of sales. In addition, X had total other operating expenses of $50 with an interest expense of $20. If X pays a flat 40% of its pre-tax income in income taxes, what is X’s net income?
| a. | $20 |
| b. | $27 |
| c. | $12 |
| d. | none of the above |
ANS: C
(120-30-50-20)*.6=12
PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
41. If you are looking to review a firm’s sources and uses of cash flows over the year, the easiest place to find that information is
| a. | the Income Statement |
| b. | the Statement of Retained Earnings |
| c. | the Statement of Cash Flows |
| d. | the Balance Sheet |
ANS: C PTS: 1 DIF: E REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
42. In order to identify the amount of funds that a firm borrowed during the preceding year, what section is the best source within the Statement of Cash Flows?
| a. | operating flows |
| b. | investment flows |
| c. | financing flows |
| d. | total net cash flows |
ANS: C PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
43. If you start with earnings before interest and taxes and then subtract a firm’s tax expense while adding back the amount of depreciation expense for the firm during the year, the resulting figure is called
| a. | free cash flow |
| b. | operating cash flow |
| c. | net cash flow |
| d. | gross cash flow |
ANS: B PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
44. Emma Corp. had earnings before interest and taxes of $500,000 and had a depreciation expense of $200,000 this last year. If the firm was subject to an average tax rate of 30%, what was Emma’s operating cash flow for the year? If you need to, assume that Emma’s interest expense was zero for the year.
| a. | $175,000 |
| b. | $82,500 |
| c. | $25,000 |
| d. | It lost money |
ANS: B
(75k*.7)+(100k*.3)=82,500
PTS: 1 DIF: H REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
45. Edison Bagels had operating cash flow equal to $850 for 2012. If its earnings before interest and taxes was $1,000 while its tax bill was $300, what was Edison’s depreciation expense for the year?
| a. | $150 |
| b. | $550 |
| c. | $1,550 |
| d. | not enough information to calculate |
ANS: A
OCF = EBIT - Taxes + Depreciation
850 = 1,000 - 300 + Depreciation
150 = Depreciation
PTS: 1 DIF: H REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
46. When calculating a firm’s free cash flow from earnings before interest and taxes we must add back depreciation, amortization and depletion expense and allowances because
| a. | they are non-cash expenditures. |
| b. | the accounting method for reporting such expenses may be different from that reported to the taxing authority. |
| c. | they approximate the value of fixed asset purchases during the year. |
| d. | they are unrelated to the amount of taxes paid during the year. |
ANS: A PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
47. When calculating the dollar amount of fixed assets purchased during the year what information is required? Assume that no fixed assets were disposed of during the year.
| a. | the current and prior year’s gross fixed assets |
| b. | the current and prior year’s net fixed assets |
| c. | the current and prior year’s net fixed assets plus the firm’s depreciation expense for the year. |
| d. | either a or c will suffice |
ANS: D PTS: 1 DIF: H REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Cold Weather Sports
Cold Weather Sports, Inc. (CWS)
Cold Weather Sports, Inc. (CWS) just completed its 2012 fiscal year. During the year, CWS had sales of $10,000 and total expenses (no interest expenses were incurred) of $6,000. Assume that CWS pays 30% of its EBIT in taxes and that depreciation expense of $1,200 is included in the total expense number listed above. A list of some balance sheet items for CWS for end of fiscal year 2011 and 2012 is as below.
| 2011 | |
| Current Assets | $1,000 |
| Net Long-Term Assets | 5,000 |
| Accounts Payable | 600 |
| Accrued Expenses | 500 |
| Short-Term Debt | 2,000 |
| Long-Term Debt | 3,000 |
| 2012 | |
| Current Assets | $1,200 |
| Net Long-Term Assets | 5,600 |
| Accounts Payable | 800 |
| Accrued Expenses | 600 |
| Short-Term Debt | 2,100 |
| Long-Term Debt | 3,200 |
No fixed assets were disposed of during the year.
NARREND
48. What is Cold Weather Sports’ operating cash flow for 2012?
| a. | $2,400 |
| b. | $2,800 |
| c. | $4,000 |
| d. | none of the above |
ANS: C
10,000 sales - 6,000 expense = 4,000 EBIT
4,000 EBIT - 1,200 tax + 1,200 depreciation expense = 4,000
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
49. What was the dollar amount of fixed assets purchased during the year for Cold Weather Sports?
| a. | $600 |
| b. | $1,200 |
| c. | $1,800 |
| d. | none of the above |
ANS: C
5,600 - 5,000 + 1,200 = 1,800
PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
50. What is the amount of free cash flow generated by Cold Weather Sports in 2012?
| a. | $100 |
| b. | $2,100 |
| c. | $2,300 |
| d. | none of the above |
ANS: C
Change in CA = 1,200 - 1,000 = 200
Change in AP = 800 - 600 = 200
Change in Accrued = 600 - 500 = 100
OCF = 10,000 sales - 6,000 expense - 1,200 tax + 1,200 depreciation expense = 4,000
Change in FA = 5,600 - 5,000 + 1,200
FCF = OCF - Change FA - (Change in CA - Change in AP - Change in Accrued)
= 4,000 - 1,800 - (200 - 200 - 100) = 2,300
PTS: 1 DIF: H REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
51. The effect of an increase in a firm’s accounts payable during the year, assuming that the current asset portion of the balance sheet remains the same, is
| a. | an outflow of cash. |
| b. | an inflow of cash. |
| c. | neither an inflow nor an outflow of cash. |
| d. | a decrease in the equity of the firm. |
ANS: B PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
52. Roxy Corp. has total current liabilities of $22,000 and an inventory of $7,000. If its current ratio is 1.2, then what is Rocy’s quick ratio?
| a. | .88 |
| b. | .75 |
| c. | .64 |
| d. | .36 |
ANS: A
1.2 = CA/ 22,000
CA = 26,400
quick ratio = (CA - Inv)/CL
quick ratio = (26,4000 - 7,000)/22,000 = 2.0
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
53. Granny’s Jug Herbal Shop has total current liabilities of $2,000 and an inventory of $1,000. If its current ratio is 2.5, then what is its quick ratio?
| a. | 2.0 |
| b. | 2.5 |
| c. | 3.0 |
| d. | 3.5 |
ANS: A
2.5 = CA/ 2,000 ====> CA = 5,000
quick ratio = (CA - Inv)/CL = (5,000 - 1,000)/2,000 = 2.0
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
54. BadBanna Co. has an average age of inventory equal to 25 days. If its end of year inventory level is $8,500, then what does that imply for the cost of goods sold during the year? (round to the nearest dollar)
| a. | $582 |
| b. | $4964 |
| c. | $21,250 |
| d. | $124,100 |
ANS: C
25 = (365 / inventory turnover)
inventory turnover = 14.6
Inv. turn = (CGS/ inventory)
14.6 = (CGS/8500)
CGS = 21,250
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
55. Wunder Boy Bat Co. has an average age of inventory equal to 121.67 days. If its end of year inventory level is $4,000, then what does that imply for the cost of goods sold during the year? (round to the nearest dollar)
| a. | $1,333 |
| b. | $3,000 |
| c. | $12,000 |
| d. | $16,000 |
ANS: C
121.67 = (365 / inventory turnover) ===> inventory turnover = 2.9992
2.9992 = (CGS/ inventory) ===> 2.992 = (CGS/4,000) ====> CGS = 11,999.67 ===> 12,000
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
56. Emma Corp. had credit sales of $300,000 last year and on average had $25,000 in its accounts receivable during the year. What is its average collection period?
| a. | about 30 days |
| b. | about 12 days |
| c. | about 1 day |
| d. | about 3 days |
ANS: A
300,000 / 365 = 821.92 average sales per day
average collection period = 25,000 / 821.92 = 30.41 days
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
57. The firm that you work for had credit sales of $3,500,000 last year and on average had $33,000 in its accounts receivable during the year. What is its average collection period?
| a. | 3 days |
| b. | 3.44 days |
| c. | 3.5 days |
| d. | none of the above |
ANS: A
3,500,000 / 365 = 9,589.04 average sales per day ====>
average collection period = 33,000 / 9,589.04 = 3.44 days
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
58. In general, the more debt a firm uses in relation to its total assets
| a. | the less risk there is to the equity holders of the firm. |
| b. | the less financial leverage it uses. |
| c. | the greater the financial leverage it uses. |
| d. | the greater extent to which it uses equity. |
ANS: C PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
59. Devil Inc. has total liabilities equal to $3,500 and total assets equal to $5,000. What is Devil’s asset-to-equity ratio?
| a. | 1.43 |
| b. | 2.33 |
| c. | 3.33 |
| d. | none of the above |
ANS: C
TA = 5,000 ====> Equity = 5,000 - 3,500 = 1,500
asset-to-equity = 5,000/ 1,500 = 3.33
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
60. Roxy Corp has an operating profit of $15,000 produced from $12,000 in sales. If Roxy has no interest expense and currently pays 35% of its operating profits in taxes, what is Roxy’s net profit margin?
| a. | 81.25% |
| b. | 12.50% |
| c. | 1.25% |
| d. | 65.00% |
ANS: A
[15,000 - (.35 ´ 15,000)] / 12,000 = 81.25%
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
61. Straw Corp has an operating profit of $1,200 produced from $9,800 in sales. If Straw has no interest expense and currently pays 35% of its operating profits in taxes and $200 per year in preferred dividends, then what is Straw’s net profit margin?
| a. | 5.92% |
| b. | 7.96% |
| c. | 7.96% |
| d. | 10.20% |
ANS: A
[1,200 - (.35 ´ 1,200) - 200 ] / 9,800 = 5.92%
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
62. Straw Corp has an operating profit of $1,200 produced from $20,000 in total assets. If Straw has no interest expense and currently pays 35% of its operating profits in taxes and $200 per year in preferred dividends, then what is Straw’s net profit margin?
| a. | 2.90% |
| b. | 3.90% |
| c. | 5.0% |
| d. | none of the above |
ANS: A
[1,200 - (.35 ´ 1,200) - 200 ] / 20,000 = 2.90%
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Import
Import, Inc.
Import, Inc. has earnings available for common shareholders of $700 produced by sales of $10,000. It also has total assets of $20,000 and an assets to equity ratio of 2.5.
NARREND
63. What is Import Inc.’s return on assets?
| a. | 14% |
| b. | 7% |
| c. | 3.5% |
| d. | none of the above |
ANS: C
ROA = (earnings avail for common/sales) ´ (sales/TA)
= (700/10,000) ´ (10,000/20,000) = .035
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
64. What is Import Inc.’s return on common equity?
| a. | 7.0% |
| b. | 8.75% |
| c. | 17.5% |
| d. | none of the above |
ANS: A
ROE = (earnings avail for common/sales) ´ (sales/TA) ´ (TA/ equity)
= (700/10,000) ´ (10,000/20,000) ´ (20,000/8,000)= .0875
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
65. EmmaCor is currently selling for $22 per share. If it is selling at a P/E ratio of 12, calculate EmmaCor’s recent earnings per share.
| a. | $0.45 |
| b. | $0.55 |
| c. | $1.83 |
| d. | $2.20 |
ANS: C
P/E = market price per share / earnings per share
12 = 22/EPS
EPS = 1.83
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
66. FactorMax is currently selling for $75 per share. If it is selling at a P/E ratio of 50, calculate FactorMax’s recent earnings per share.
| a. | $.15 |
| b. | $.67 |
| c. | $1.50 |
| d. | none of the above |
ANS: C
P/E = market price per share / earnings per share
50 = 75/EPS ====> EPS = 1.50
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
67. What is the financial ratio that measures the price per share of stock divided by earnings per share?
| a. | Return on assets |
| b. | Return on equity |
| c. | Debt-equity ratio |
| d. | Price-earnings ratio |
ANS: D PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Stone Cold
Stone Cold Incorporated
| Balance Sheet: 12/31/12 | ||
| Assets | 2012 | 2011 |
| Cash and Marketable Securities | 10 | 80 |
| Accounts Receivable | 375 | 315 |
| Inventories | 615 | 415 |
| Total Current Assets | 1,000 | 810 |
| Net plant and equipment | 1,000 | 870 |
| TOTAL ASSETS | 2,000 | 1,680 |
| Liabilities and Equity | 2012 | 2011 |
| Accounts Payable | 60 | 40 |
| Notes Payable | 140 | 60 |
| Accruals | 110 | 130 |
| Total Current Liabilities | 310 | 230 |
| Long Term Bonds | 754 | 580 |
| TOTAL DEBT | 1,064 | 810 |
| Preferred Stock | 40 | 40 |
| Common Stock | 130 | 130 |
| Retained earnings | 766 | 700 |
| TOTAL COMMON EQUITY | 896 | 830 |
| TOTAL LIABILITIES AND EQUITY | 2,000 | 1,680 |
| Income Statement: 12/31/12 | 2012 | 2011 |
| Net Sales | 3,200 | 2,850 |
| Operating Costs (excludes Dep/Amortization) | 2,700 | 2,497 |
| EBITDA | 500 | 353 |
| Depreciation | 100 | 90 |
| Amortization | 0 | 0 |
| Depreciation and Amortization | 100 | 90 |
| EBIT | 400 | 263 |
| Less Interest | 88 | 60 |
| EBT | 312 | 203 |
| Taxes (40%) | 124.8 | 81.2 |
| NET INCOME (before Preferred Dividends) | 187.2 | 121.8 |
| Preferred Dividends | 4 | 4 |
| NET INCOME | 183.2 | 117.8 |
| Common Dividends | 117 | 53 |
| Addition to Retained Earnings | 66.2 | 64.8 |
NARREND
68. Refer to Stone Cold. For 2012, what was the return on assets?
| a. | 9.16% |
| b. | 12.40% |
| c. | 15.60% |
| d. | 20.00% |
ANS: A
=183.2/2000= 9.16%
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
69. Refer to Stone Cold. For 2012, what was the return on common equity?
| a. | 9.36% |
| b. | 12.40% |
| c. | 20.44% |
| d. | 20.90% |
ANS: C
183.2/896 = 20.44%
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
70. Refer to Stone Cold. For 2012, what was the debt-to-equity ratio?
| a. | 0.81 |
| b. | 0.84 |
| c. | 0.98 |
| d. | 1.19 |
ANS: A
=754/(896+40) = .81
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
71. Refer to Stone Cold. For 2012, what was the average collection period for the firm in 2004?
| a. | 6.84 days |
| b. | 8.77 days |
| c. | 42.77 days |
| d. | 51.22 days |
ANS: C
=3200/365 = 8.767
=375/8.767 = 42.77
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
72. Refer to Stone Cold. For 2012, what was the total asset turnover for 2012?
| a. | 0.80 |
| b. | 1.20 |
| c. | 1.40 |
| d. | 1.60 |
ANS: D
=3200/2000 = 1.60
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
73. Refer to Stone Cold. For 2012, what was the times interest earned ratio for 2012?
| a. | 2.13 |
| b. | 2.77 |
| c. | 3.55 |
| d. | 4.55 |
ANS: D
=400/88 = 4.55
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
74. What was the free cash flow in 2012 for Stone Cold Incorporated?
| a. | -$55.20 |
| b. | -$44.80 |
| c. | $145.20 |
| d. | $215.00 |
ANS: A
FCF = OCF - chFA – (chCA - chA/P - chAccruals) where
OCF = EBIT – Taxes + Depreciation
OCF = $400 - $124.8 + $100 = $375.2
chFA = Change in Gross Fixed Assets = Change in Net Fixed Assets + Depreciation
chFA =($1,000 - $870) + $100 = $230
chCA = Change in Current Assets
chCA =$1,000 - $810 = $190
chA/P = Change in A/P
chA/P = $60 - $40 - $20
chAccruals = Change in Accruals.
chAccruals = $110 - $130 = -$20
FCF = OCF - chFA – (chCA - chA/P - chAccruals)
FCF = $375.2 - $230 - ($190 -$20 --$20)
FCF = $375.2 - $230 - $190
FCF = -$44.8
PTS: 1 DIF: H REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
75. Consider the following financial information for Classic City Ice Cream Corporation:
| 2012 Financial Data | |
| Net Income | $ 50,000 |
| Total Assets | $300,000 |
| Total Shareholder Equity | $200,000 |
| Net Sales | $100,000 |
What is the total asset turnover for the firm in 2012?
| a. | 16.67% |
| b. | 25.00% |
| c. | 33.33% |
| d. | 40.00% |
ANS: C
=100000/300000=33.33%
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
76. Consider the following financial information for Classic City Ice Cream Corporation:
| 2012 Financial Data | |
| Net Income | $ ???,??? |
| Total Assets | $250,000 |
| Total Shareholder Equity | $200,000 |
| Net Sales | $100,000 |
If the return on equity is 20%, what was Net Income for 2012?
| a. | $25,000 |
| b. | $40,000 |
| c. | $50,000 |
| d. | $65,000 |
ANS: B
.20 = X / $200,000
X= $40,000
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Titans Electronics
Titans Electronics
Titans Electronics reports the following data for the past year:
| EBIT | $1,000,000 | # of Common shares | 400,000 |
| Net Income | $ 480,000 | Total Dividends Paid | $120,000 |
| Interest Paid | $ 200,000 | Current Assets | $ 80,000 |
| Total Assets | $6,000,000 | Current Liabilities | $ 60,000 |
| Market Price of Common equity | $ 20 |
NARREND
77. What is the current P/E ratio for the Titans?
| a. | 8.00 |
| b. | 10.00 |
| c. | 15.50 |
| d. | 16.67 |
ANS: D
= $20/($480,000/400,000)=16.67
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
78. Titans Electronics is applying for a new line of credit from their banking partner. To issue the credit, the bank requires the following cutoffs for certain financial ratios:
TIE ratio of 4.25 Current Ratio of 1.50 ROA of 5%.
What is a likely response from the bank to the application?
| a. | The bank will have reservations, as the TIE ratio does not meet requirements. |
| b. | The bank will have concerns, as the current ratio does not meet requirements. |
| c. | The bank will have concerns, as the ROA is not high enough. |
| d. | The bank will have concerns, as two or more of the requirements are not met. |
ANS: B PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
NARRBEGIN: Exhibit 2-1
Exhibit 2-1
The tax schedule for corporate income is shown in the table below:
| Taxable Income Over | Not Over | Tax Rate |
| $ 0 | $ 50,000 | 15.00% |
| 50,000 | 75,000 | 25.00% |
| 75,000 | 100,000 | 34.00% |
| 100,000 | 335,000 | 39.00% |
| 335,000 | 500,000 | 34.00% |
| 10,000,000 | 15,000,000 | 35.00% |
| 15,000,000 | 18,333,333 | 38.00% |
| 18,333,333 | ............... | 35.00% |
NARREND
79. Refer to Exhibit 2-1. Pale Rider Corporation reports taxable income of $500,000 in 2011. What was their tax liability for the year?
| a. | $56,100 |
| b. | $91,650 |
| c. | $170,000 |
| d. | $200,000 |
ANS: C
=50000*.15+25000*.25+25000*.34+235000*.39+165000*.34=170000
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
80. Refer to Exhibit 2-1. Pale Rider Corporation reports taxable income of $500,000 in 2011. What was the average tax rate they paid for the year?
| a. | 23.25% |
| b. | 25.00% |
| c. | 29.40% |
| d. | 34.00% |
ANS: D
Taxes Paid=50000*.15+25000*.25+25000*.34+235000*.39+165000*.34=170000
170000/500000=.34
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
81. Refer to Exhibit 2-1. Big Diesel Incorporated reports taxable income of $200,000 in 2011. What was the average tax rate they paid for the year?
| a. | 25.00% |
| b. | 29.40% |
| c. | 30.63% |
| d. | 34.00% |
ANS: C
Taxes Paid=50000*.15+25000*.25+25000*.34+100000*.39=61250
61250/200000=.3063
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
82. Refer to Exhibit 2-1. Big Diesel Incorporated currently predicts taxable income of $200,000 for the next year. If this is their actual income, what will be the tax liability for Big Diesel?
| a. | $45,250 |
| b. | $56,500 |
| c. | $61,250 |
| d. | $91,650 |
ANS: C
Taxes Paid=50000*.15+25000*.25+25000*.34+100000*.39=61250
PTS: 1 DIF: E REF: 2.4 Corporate Taxes
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
83. What ratio measures the ability of the firm to satisfy its short term obligations as they come due?
| a. | Activity ratio |
| b. | Times interest earned ratio |
| c. | Current ratio |
| d. | Inventory turnover ratio |
ANS: C PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
84. The asset to equity ratio for a firm is 1.5, and the firm has total assets of $3,000,000. Last year, net income for the firm was $250,000, and the earnings per share for the firm was reported as $0.50. What is the current book value per share for the firm?
| a. | $2 |
| b. | $4 |
| c. | $6 |
| d. | $8 |
ANS: B
1.5=3,000,000/x; X=shareholder equity=$2,000,000
EPS=$0.50=$250,000/Y; Y= # of shares = 500,000
Book value per share = $2,000,000/500,000 = $4
PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
85. Which financial ratio measures the effectiveness of management in generating returns to common stockholders with its available assets?
| a. | Gross profit margin |
| b. | Return on equity |
| c. | Return on assets |
| d. | Current ratio |
ANS: C PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
86. When is the return on assets equal to the return on equity?
| a. | When the current ratio of the firm equals 1. |
| b. | When the firm issues equal amounts of long term debt and common stock. |
| c. | When the firm issues no dividends for a given time period. |
| d. | When the firm only issues equity to finance its borrowing. |
ANS: D PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
87. Consider the following working capital information for Full House Corporation:
| Year | 2011 | 2012 |
| Accounts Receivable | $ 0 | $100 |
| Inventory | $100 | $100 |
| Accounts Payable | $ 0 | $ 50 |
What was the effect on free cash flow for the firm this past year?
| a. | Increase of $100 |
| b. | Increase of $150 |
| c. | Decrease of $50 |
| d. | Decrease of $100 |
ANS: C
change in NWC = change in CA - change in CL
change in CA = ($200-$100)= $100
change in CL = ($50-$0) = $50
change in NWC = +$50
Effect on free cash flow = -$50
PTS: 1 DIF: H REF: 2.2 Cash Flow Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
88. A firm reports net income of $500,000 for 2011. The most recent balance sheet for the reports retained earnings of $2,000,000. The firm will pay out 25% of net income as dividends. What will the new balance be for retained earnings?
| a. | $1,875,000 |
| b. | $2,125,000 |
| c. | $2,375,000 |
| d. | $2,500,000 |
ANS: C
Addition to RE = $500,000*(1-.25)=$375,000
New RE = $2,000,000 + $375,000
PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
89. Emmacorp reports a current ratio of 2 and a quick ratio of 1.4. The firm has total current assets of $8,000. If Emmacorp reports cost of goods sold at $30,000 for the given year, what is Emmacorp’s inventory turnover?
| a. | 12.5 |
| b. | 15.5 |
| c. | 21.4 |
| d. | 5.2 |
ANS: A
Current = 2 = CA/CL = $8000/CL, CL=$4000
Quick = 1.4 = ($8000-INV)/$4000
INV = $2,400
Inventory turn = $30,000/$2400=12.5
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
90. A firm reports a current ratio of 2 and a quick ratio of 1.2. The firm has total current assets of $4,000. If the firm reports cost of goods sold at $25,000 for the given year, what is the average age of their inventory?
| a. | 12.35 days |
| b. | 15.63 days |
| c. | 18.24 days |
| d. | 23.36 days |
ANS: D
Current = 2 = CA/CL = $4000/CL, CL=$2000
Quick = 1.2 = ($4000-INV)/$2000
INV = $1,600
Inventory turn = $25000/$1600=15.625
Average age = 365/15.625=23.36
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
91. The average age of the inventory for a firm is 10 days old. If the current dollar amount of inventory is $1,000, what is a good estimate for the cost of goods sold over the last year?
| a. | $16,500 |
| b. | $26,500 |
| c. | $32,500 |
| d. | $36,500 |
ANS: D
10 = 365/Inv turn, Inventory turn = 36.5
36.5 = COGS/ INV = COGS / $1000
COGS = $36500
PTS: 1 DIF: H
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
92. Accountants:
| a. | generally construct financial statements using the cash-based approach |
| b. | generally construct financial statements using the accrual-based approach |
| c. | must apply Generally Accepted Accounting Principles to fairly portray how the firm has performed in the past |
| d. | must apply Generally Accepted Accounting Principles to fairly portray how the firm will perform in the future |
| e. | both (b) and (c) |
ANS: E PTS: 1 DIF: E REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
93. Which of the following statements is TRUE?
| a. | Financial professionals prefer the accrual-based approach as it focuses more attention on cash inflows and outflows |
| b. | Financial managers do not need to make any adjustments to financial statements for decision-making |
| c. | Financial managers must convert cash-based financial statements to accrual-based ones before they can begin analyzing a firm |
| d. | Financial professionals prefer the cash-based approach as it focuses more attention on cash inflows and outflows |
ANS: D PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
94. Which of the following statements is FALSE?
| a. | On the balance sheet a firm's assets are listed in ascending order of liquidity. |
| b. | In a common size balance sheet, all assets are expressed as a percentage of sales. |
| c. | Net property, plant and equipment represents the original value of all real property, structures and long-lived equipment owned by the corporation. |
| d. | all of the above statements are false |
ANS: D PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
95. The Statement of Retained Earnings
| a. | reconciles the net income earned during a given time period and any cash dividends paid with the change in Retained Earnings between the start and end of that period. |
| b. | shows a snapshot of the firm's financial position at a specific point in time |
| c. | reconciles the net income earned during a given time period and any cash dividends and interest on debt paid with the change in Retained Earnings between the start and end of that period |
| d. | shows the impact of Treasury Stock on the firm's Common Equity |
ANS: A PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
96. Which of the following statements is FALSE?
| a. | The Notes to Financial Statements provide little information that is relevant to professional security analysts. |
| b. | The Notes to Financial Statements provide additional information about a firm, including employee compensation plans, revenue recognition practices and leases. |
| c. | The Notes to Financial Statements provide detailed explanatory information that is keyed to various accounts on the financial statements. |
| d. | all of the above statements are true |
| e. | both (a) and (c) are false |
ANS: A PTS: 1 DIF: M REF: 2.1 Financial Statements
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
97. Which of the following is NOT a classification of a firm's cash flows:
| a. | investment flows |
| b. | financial flows |
| c. | operating flows |
| d. | capital flows |
ANS: D PTS: 1 DIF: E REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
98. Which of the following represents an inflow of cash?
| a. | A decrease in any liability |
| b. | Dividends paid |
| c. | Repurchase or retirement of stock |
| d. | An increase in any asset |
| e. | A decrease in any asset |
ANS: E PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
99. How is depreciation accounted for on the Statement of Cash Flows?
| a. | Depreciation is irrelevant for cash flow purposes and has no place on the Statement of Cash Flows. |
| b. | Depreciation expense is included in the operating activities section of the statement. |
| c. | As depreciation is deducted to determine Net Income there is no need to include it on the statement. |
| d. | None of the above |
ANS: B PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
100. The Statement of Cash Flows is helpful to financial managers in that:
| a. | It calls attention to unusual changes in either the major categories of cash flow or specific items so that the financial manager can pinpoint problems the firm may be having |
| b. | It calls attention to the expenses deducted to determine net income. |
| c. | Financial managers can create pro forma statements to determine whether or not the firm will need additional external financing. |
| d. | All of the above |
| e. | Both (a) and (c) |
ANS: E PTS: 1 DIF: M REF: 2.2 Cash Flow Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
101. Which of the following statements is FALSE?
| a. | A firm's creditors are primarily interested in a firm's Activity Ratios. |
| b. | Norms exist for all financial ratios that can be applied across all industries. |
| c. | Current and future stockholders are most interested in a firm's short-term liquidity ratios. |
| d. | All of the above statements are false. |
ANS: D PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
102. Which of the following statements is TRUE?
| a. | Net working capital is a firm’s current assets divided by its current liabilities. |
| b. | Net working capital is a firm's current assets minus its current liabilities. |
| c. | Net working capital measures a firm's ability to meet its short-term obligations. |
| d. | All of the above statements are false. |
ANS: B PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
103. The DuPont system:
| a. | breaks the ROA and ROE ratios into component pieces |
| b. | requires data from only the balance sheet |
| c. | evaluates ROA the product of a firm's profit on its sales and the efficiency of the firm to generate sales from its investment in its assets |
| d. | all of the above |
| e. | Both (a) and (c) |
ANS: E PTS: 1 DIF: M
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Reflective thinking
LOC: acquire knowledge of financial analysis and cash flows
104. Use the following information to determine Bill's Solvency Ratio.
Total net worth: $150,000
Cash surplus: $15,000
Income after taxes: 105,000
Total assets: $300,000
| a. | 14.29% |
| b. | 50% |
| c. | 2 |
| d. | None of the above |
ANS: B
150,000/300,000 = 50%
PTS: 1 DIF: E
REF: 2.3 Analyzing Financial Performance Using Ratio Analysis
NAT: Analytic skills
LOC: acquire knowledge of financial analysis and cash flows
Chapter 2 Financial Statement and Cash Flow Analysis
Chapter Overview
Financial statements document a firm’s performance during a fiscal year period for a firm. But how can firm know if a recovering economy is affecting the bottom line of the firm – its revenues? The opening segment of this chapter discusses one of the most widely used ratios – the DSO or Days Sales Outstanding. An excellent glance into an economy is to look at how well customers take to pay their bills. If the time has decreased – customers are taking less time to pay their bills. A recent study showed a decline in DSO from 42.6 to 37.5 days. The 5 day decline was a sure sign that the economy was turning around and people were paying their debt in a more timely fashion. Chapter 2 explains what the major financial statements are, what information they provide and introduces various measures of a firm’s cash flows. The chapter also shows the incredible value in using ratio analysis as was described in this introduction.
Opening Focus Discussion Questions:
1. Have the recent reduction in Days Sales Outstanding told us anything about the changes in credit policies of companies? Could the change in credit policies change the DSO?
2. What other ratios might be a good indicator of an improving or declining economy?
This chapter reviews:
1-1. Financial Statements
1-2. Cash Flow Analysis
1-3. Assessing Financial Performance Using Ratio Analysis
1-4. Corporate Taxes
Technology
1. Smart Practices Video. This video interviews Jon Olson, vice president of finance for Intel Corp. He talks about Intel’s use of accounting numbers and why accounting information is so important in financial analysis. Discussion question: What makes accounting knowledge and information so important to financial analysis?
2. Smart Ethics Video. This video quotes Frank Popoff, retired chairman of the board of Dow Chemical, that “Overstating or understating the performance of the enterprise is anathema…it’s just not on.” This video talks about the difficulty in communicating information to investors. The company wants to accurately represent its performance, neither overly optimistic nor pessimistic. However, this balance is hard to achieve in an uncertain business environment. Discussion question: What is the delicate balance that a company must achieve when communicating its financial results in the market?
3. Smart Ideas Video. This video interviews John Graham of Duke University about whether companies manage their earnings.
4. Smart Concepts. This video illustrates a DuPont analysis of Microsoft, Wal-mart and Kroger. Discussion questions: How does the DuPont formula illustrate why investors might put pressure on Microsoft to distribute some of its cash? In 2002, Microsoft and Wal-mart reported similar ROE ratios, but they achieved their results in very different ways. Explain.
5. Smart Solutions. Step-by-step solution to Problems 2-2 and 2-12, calculating cash flow from operations, operating cash flow, and free cash flow.
Lecture Guide
Accounting is the language of business. This means there are a lot of terms in this chapter, and the more familiar students are with the language, the easier this chapter will be. Accounting looks at historical numbers and paints a picture of a company’s financial situation at a given point in time. Finance is more dynamic and forward-looking, trying to determine what impact decisions have on wealth.
The financial accounting process is about recording transactions, summarizing what effect these have on a company’s financial position and finally transforming those effects into accounting statements. Transactions are any purchases, sales, or other exchanges that impact a company’s financial position.
The current hot accounting topic is whether or not to expense stock option grants to executives. Not required to do so, even by the recently-passed Sarbanes-Oxley Act, but many large companies, such as Coca Cola, IBM) have done so voluntarily.
Another area of interest is the rapid acceptance of International Financial and Reporting Standards (IFRS, formerly called International Accounting Standards). IFRS have been adopted by most of the world outside the U.S. and there is a good chance that the U.S. will abandon GAAP (Generally Accepted Accounting Principles) and adopt IFRS within the next two or three years. The European Union has mandated that all companies headquartered in Europe adopt IFRS by 2005, and China just announced they will do so as well. The main difference between GAAP and IFRS is that the first is rules-based and the second principles-based. There are also significant substantive differences, for example, IFRS prohibits LIFO (last in, first out) accounting of inventories and requires expensing of stock options.
2-1 Financial Statements
Regular financial statements:
· Make it easier to predict the future and make decisions
· Show a company’s liquidity
· Monitor the firm’s current condition
· Show the progress a firm has made over time
· Provide information to outsiders
Many interested parties, including shareholders, the government, and creditors, want to know if the firm is doing better or worse than it has in the past, how fast the business is growing and whether the firm will survive.
While accounting is primarily concerned with historical statements, in finance it may be useful to create pro forma statements, predictions about how the firm’s statements will look in the future. These are used in valuation – to project the numbers used in multiples and cash flow valuations and in financing to determine the creditworthiness of the firm and how much financing a firm needs. These are also used to perform sensitivity analyses – how likely is a company to meet its goals? Pro forma statements are also used to help the company make strategic decisions; for example, will introducing a new product really increase shareholder value? The accuracy of the pro forma statements depends on the accuracy of the inputs.
Four Key Financial Statements
The three basic financial statements, the balance sheet, income statement and statement of retained earnings are used in the creation of the derivative statements, the statement of cash flows. The following sections go over each of the main statements used in financial analysis, presenting financial statements for Global Petroleum Corp.
2-1a Balance Sheet
Note that a firm’s assets are everything the firm owns. Current assets are those that are easy to sell and turn into cash, while fixed assets are physical assets like buildings and equipments. A company may also have intangible assets that may not appear on the balance sheet, like patents, copyrights or franchises. Assets include everything that can be used to benefit the business or give the company the right to receive benefits.
Liabilities are what the firm owes to others. Current liabilities are those that must be paid within a year, while long-term liabilities are due in more than a year, like mortgages or long-term loans. Shareholders’ equity is the owners’ residual share of the business, including their original investment plus any money the firm has made since its inception. Typically shareholders’ equity is divided into two accounts, capital stock, the amount of investment in the business that the owners made plus retained earnings, all of the past, accumulated net income minus dividends since the firm began.
Emphasize the basic balance sheet equation:
Assets = Liabilities + Shareholders Equity.
2-1b Income Statement
The income statement, or profit and loss statement shows what money a company has taken and spent during a specified time period. It is getting harder to accurately account for financial numbers with some new economy companies. For example, Priceline.com acts as a broker for customers wanting airline tickets and hotel rooms. Yet it claims as revenue the full price of the ticket or room. Priceline’s justification for this is that it does own the tickets, even if only for a nanosecond. This practice means the company could be seen as overstating its revenues. On the other hand, other companies routinely do something similar without being questioned. A department store sells clothing that is shipped to it by clothing manufacturers without changing the final product just as priceline.com does. Are these just two different versions of a store that adds value by providing a place for customers to find the product they are looking for?
When to report revenue is also an issue. For example, MicroStrategy had a three-year deal with a customer and claimed all of the revenue immediately. The SEC said this was not correct and required the company to restate its revenues, only listing revenues when the company expected them to occur. MicroStrategy lost 90% of its market value on the announcement of the restatements.
A company’s expenses are decreases in assets or increases in liabilities resulting from revenue –producing activities. They include costs of goods sold, how much inventory was used during the period, along with the labor needed to produce the product. Operating expenses include salaries of executives, marketing expenses, mortgage payments, utility costs, etc. Depreciation expense is how much value an asset loses as it ages. Point out that they can see the effects of depreciation in the want ads of any newspaper – a new car sells for a lot more than the same type of used car.
Note that not everything is necessarily reported on the company’s financial statements. For example, a company could have a lawsuit pending that has not yet impacted the financial statements. Typically, a company is required to disclose such potential effects in the notes to its financial statements which often contain a great deal of valuable information.
2-1c Statement of Retained Earnings
This statement is primarily used to see how the firm has made its investment/consumption decision. Is the firm reinvesting its earnings? If so, how much? Is the firm paying out its earnings as dividends? These decisions are recorded in the statement of retained earnings.
2-1d Statement of Cash Flows
Note that a statement of cash flows is an easy to see the cash flow – the lifeblood of a business – from each of the main area, operations, investment and financing. What did the company invest in? How did it finance its investment? Did its operations provide cash for future expansion, or did the company need to seek external financing?
2-2 Cash Flows Analysis
Cash is the lifeblood of a company, and the company’s statement of cash flows records what money has gone into and out of a firm because of its operations, investments and financing activities. A past statement of cash flows shows where the firm’s money came from and how it was used. Where these good sources and uses? In other words, did sources include substantial net profits, or did the firm need to borrow heavily because its profits were low? Are there any sources or uses that stand out? For example, did the firm greatly increase its cash? If so why? Does it not have any more productive use for its profits other than adding to its cash account? Did inventories increase? Why? Was there a production bottleneck that caused a buildup of inventories, or is this a reasonable increase given the firm’s sales increases?
In general, finance is more concerned with cash flows than with accounting earnings. While earnings and cash flows are highly correlated, they are not necessarily the same. Cash flows are used to provide the information for wealth increasing decisions. Profits must be converted into cash flows in order to make company investment decisions. Cash flow is how much cash actually moves through a business. How this cash flow is managed can mean the success or failure of the firm.
An important concept to stress here is that increasing an asset or decreasing a liability is a use of cash, while decreasing an asset or increasing a liability is a source of cash. Sources of cash include new loans, collecting accounts receivable or choosing to pay your creditors over a longer period of time. Uses of cash include buying new equipment, paying expenses, and allowing your creditors to take longer to pay you.
Explain to students why depreciation is not a cash flow, and that the company would be double counting its capital expenditures if it did not add back in depreciation to the cash flow equation.
Point out the differences between cash flow from operations and free cash flow. Cash flow from operations refers to revenues minus operating costs, depreciation and taxes, with depreciation added back in. Free cash flow takes cash flow from operations and subtracts (adds) incremental working capital or capital expenditure needs.
A statement of cash flows can be historical or forward looking. In other words, it can show how the company has spent money and where it has received money in the past, or it can be used to predict what funds will be needed in the future. A past sources and uses of funds statement will balance – the amount of sources will match the amount of uses of funds in the past. Unlike in accounting classes, a future statement of cash flows can be unbalanced; in other words, the company may have more sources than uses, and the difference shows how much new debt or equity financing the company will need in the future. Note that a student can simply move down the balance sheet to create this statement, by looking at how each account on the balance sheet has changed over the time period being studied, and whether this account has been a source of funds (increased liabilities or decreased assets) or a use of funds (decreased liability or increased assets).
2-3 Types of Financial Ratios
The instructor should note the main types of ratio and which groups are interested in which ratios. For example, creditors are primarily interested in liquidity ratios to assess a company’s current ability to pay, and in a company’s debt ratios to see if their overall debt load is manageable. Shareholders are interested in all ratios – they want to know how profitable the company is, whether it is using its assets efficiently and what is its market value. Ratios are used by many other interested parties. For example, the company’s unions might use the results of ratio analysis to help them negotiate a new contract. Regulators use ratios to set an allowed rate of return for regulated companies like utilities.
2-3a Financial Ratios
Financial ratio analysis is the use of ratios to analyze financial statements. They can be used to determine the company’s strengths and weaknesses, its historical performance and its present financial condition. Ratios are used to make it easier to make comparisons – between the company’s past and its present and between the company and its competitors. Managers use ratios to improve the company’s performance. Creditors use ratios to see whether the firm will be able to repay its debts, while stockholders want to predict what future dividends and earnings will be.
2-3b Liquidity Ratios
Point out to students that it is difficult to tell if a ratio is bad or good without additional information. For example, a lender would prefer high current and quick ratios, but when are these ratios “too high”?
(Answer: when a company has too much cash that it is not using productively.)
2-3c Activity Ratios
In general, a higher inventory turnover is an indication of greater efficiency, which is good for a company. When can a high inventory turnover ratio be negative for a company? (Answer: when the company is experiencing frequent stockouts because it can’t keep enough inventory to meet customer needs.)
2-3d Debt Ratios
When discussing debt ratios, relate debt to risk. More debt makes a company riskier. Why? What difference does variability in cash flows make? (Answer: if a company has very stable cash flows, it is more able to take on more debt.) If its cash flows are very variable, then it runs the risk of not being able to meet its debt obligations if it is experiencing a bad year. Note that a company usually can’t choose the riskiness of its assets – that is usually determined by the nature of the business, but it can choose the amount of financing risk that it takes on. Too much debt and too little cash flow can force a company into bankruptcy.
2-3e Profitability Ratios
The term “profits” is very vague. “Profits” may mean:
· Gross profits, sales minus cost of goods sold
· Operating profits, sales minus cost of goods sold minus operating expenses
· Pre-tax profit, operating profit plus non-operating income and minus non-operating expenses like interest
· Net profit, pretax profit minus taxes, also called net income or earnings.
Analysts need to look closely at how a company classifies its expenses. For example, Amazon.com has what it classifies as fulfillments costs, the expense associated with each order such as inspecting and warehousing inventories, packaging orders and responding to customer queries. These might seem like traditional cost of good sold, yet Amazon.com lists them as marketing expenses on its income statement. This means that the company’s gross profits are considerably higher than they would be without this accounting choice. The firm’s bottom line is the same – the costs are ultimately all expensed, but it could give a misleading view of the company’s profits from operations. In another example, the author of Indecent Proposal, Jack Engelhard, signed a contract giving him royalties from the hit movie starring Robert Redford and Demi Moore. In spite of the fact that the movie’s world-wide gross was $250 million, the studio is showing losses on the movie and refusing to pay the author more than the $120,000 he received upfront. Robert Redford reportedly earned $20 million for his role in the movie.
Note the relationship between return on assets and return on equity. ROA decreases if a company takes on a lot of debt, because interest will increase and net income or earnings available for common shareholders, the numerator of the ratio, will also decrease. But using debt financing reduces the amount of equity needed, and may raise return on equity, which is earnings available for common shareholders divided by common equity. Usually the use of debt financing increases value to shareholders, unless a company is taking on more debt than it can reasonably handle. You can illustrate this by using a housing example. Suppose you purchase a house for $100,000. You pay cash for the house. The house subsequently increases in value to $150,000, a profit of $50,000 and a return on assets of $50,000/$100,000 or 50%. Suppose instead you put down $10,000 in cash to purchase the house and borrowed $90,000 of the purchase price. The house increases in value to $150,000 providing you with the same $50,000 profit. Now, however, your return on equity is 50,000/10,000 or 500%. Using leverage has greatly increased your profits. This is a very simplified example, ignoring transactions costs and taxes.
To improve ROA a firm needs to improve its cost control, for example, reducing labor costs, purchases and overhead. Or, the company needs to increase its revenue, say through higher pricing, changing its product mix or volumes. The firm might also be able to improve its capacity utilization, making more use of the same equipment. Or, it could improve its working capital management, collecting accounts receivable faster or paying its accounts payable more slowly.
2-3f Market Ratios
When discussing market ratios, note that price/earnings ratio is one of the most talked about ratios. It would be difficult to pick up a Wall Street Journal without seeing price-earnings ratio mentioned. Ask students what they think high or low P/E ratios would mean. Is a high (or low) P/E ratio good or bad? Note that in general low P/E ratio firms are considered to be lower growth companies while high P/E companies are considered to be high growth. Some investors think low P/E ratio companies are underpriced and therefore good values. High P/E ratios in general mean the market thinks the company will have high growth and high future earnings. Ask students what can make a P/E ratio high. It can be a high price or low earnings. Some extraordinarily high P/E ratios are the result of the company’s having extremely low earnings per share.
Give an example of how quickly and simply P/E ratio can be used. Suppose you go to your company’s annual stockholders’ meeting, enjoy the wine and cheese and wait for the CEO to give his speech about the prospects of the company. The CEO tells you that next year the company will earn $6.00 per share. The company’s historical P/E ratio has been 10 times. This says the stock should trade for $6 x 10 or $60 next year.
2-4 Corporate Taxes
Point out that average tax rate may not be representative of a firm’s overall tax rate; it could reflect temporary tax credits and may not be representative of the future. Marginal tax rate is generally more important to the financial analyst. One of the major decision made by managers is the capital budgeting decision – what projects should be accepted. Any profits resulting from these projects are incremental dollars, and will be taxed at the firm’s marginal tax rate, not the firm’s historical, average tax rate. Note that capital gains for individuals on their stock sales are treated differently than for corporations. Under the recently passed tax law, individuals’ capital gains and dividends are taxed at the maximum rate of 15%, not at the individual’s marginal personal income tax rate.
Ratios seldom can stand alone. It is generally more useful to compare a firm’s ratios to and industry average or an industry leader to see if the firm is underperforming or outperforming its peers. This is called an interfirm ratio analysis. An intrafirm, or trend analysis may also be helpful – has the firm been improving or declining over time?
Financial Statements and Financial Ratios Summary
Point out that market values and not accounting numbers are what count, even though the two can be related. As recent headlines have shown, accounting numbers can be manipulated. Accounting numbers, however, can provide information used in making wealth-increasing decisions. Accounting numbers serve as a proxy for cash flow, for example, net income. An accounting number is an important part of the cash flow equation.
Point out the limitations of ratio analysis. Most firms do not operate in a single industry, so it may be difficult to make industry comparisons. Average performance may not really be good, particularly if the entire industry is in a slump. Management can (legally and illegally) manipulate its financial statements, potentially distorting ratios. Typically ratio analysis is a starting point, not an answer to your questions about a firm’s financial health. Ratio analysis tells you what questions to ask and is the starting point of an analysis, not the ending point. It is usually part of a company analysis, but not the entire analysis.
Ratios need to be put into perspective. Ratios need to be compared to some standard, to a trend over time or compared to an industry average or industry leader.
Chapter 2 Resource Articles:
“Cash Flow Hocus Pocus”, Business Week, July 15, 2002. Finance says that the focus should be on a firm’s cash flows, not necessarily its accounting statements. This article points out ways that a firm can manipulate its cash flows, for example, through selling accounts receivable, classifying outstanding checks as accounts payable, trading securities and capitalizing certain expenses.
“Amazon is All Grown Up, Except for its Accounting,” Business Week, August 5, 2002. This article talks about the disfavor pro forma statements have fallen into because of recent accounting scandals. It looks at Amazon’s failure to use GAAP in its projections and skip pro forma projections.
“Brainpower on the Balance Sheet,” Business Week, August 26, 2002. This article looks at the increase in intangible assets like brand names and research and development and the difficulties in having accounting statements reflect a firm’s intangible value.
“Battle of the Accountants: Europe Tries to Win Over U.S.,” Wall Street Journal, July 16, 2002. This article looks at differences between GAAP and International Accounting Standards and mentions pressure on U.S. companies to adopt international standards.
Enrichment Exercises
1. Chapter 2 raises questions about accounting standards – GAAP standards vs. IAS standards. Ask students to find an article in their local newspapers, on the internet or on the Wall Street Journal or its web site, and ask them to:
a. Write up their opinion about the value of accounting standards – what needs to be reformed (if anything) and why? OR
b. Have a roundtable discussion with each student contributing information from his or her article, and reaching a group consensus.
2. Have students, either individually or in a group choose a company for which to perform a financial statement analysis. It’s best to choose a company that is primarily operating in one industry. Bank and financial service company accounting also can be very different and sometimes harder to interpret than traditional firm accounting. The financial statement analysis should involve calculating the ratios listed in the textbook for two years and comparing them to industry average ratios. Students could then see if the company’s ratios are trending up or down and how they compare to industry averages.
Some guidelines for the project could:
· Include a copy of your company’s most recent income statement and balance sheet. I recommend that you also transfer the values in these statements into an excel spreadsheet. It will make the subsequent calculations easier.
· Include a page with calculations of ratios for your company for one year. You should go through Ch. 2 of the textbook, list the ratios from the textbook on your spreadsheet, enter the formulas on your spreadsheet, and then have the spreadsheet calculate the values for your company. You may not be able to calculate all of the Ch. 2 ratios. For example, if your company is an all-equity company, you will not be able to compute a debt ratio. If ratio information is not available, just write N/A or not available by that ratio.
· Explain any trends you see in your company. Are its ratios becoming better or worse over time? How does your company compare to the industry average?
3. Have students each download financial statements from different companies. In a round table discussion, they could go through the statements, noting how companies use different terminology for the same parts of the statements. Ratios give very little information without something to compare it to – what would the students use to compare and why? Discuss the merit of using same company past ratios versus industry comparisons
4. Have students perform a two-minute ratio analysis. The article “Financial Statement Analysis – A Two-Minute Drill” by William L. Stone, Journal of Commercial Bank Lending, November 1983: 11-19, provides a framework for very quickly computing (without a calculator) current ratio, debt ratio, net profit margin, accounts receivable turnover, inventory turnover, and accounts payable turnover and making a decision about whether to extend a loan to the company. Students could take a company’s financial statements and perform the two-minute drill and then discuss their conclusions.
Answers to Concept Review Questions
1. The FASB is a nongovernmental, professional-standards body that examines controversial accounting topics and then issues “rulings” that have almost the force of law, at least in terms of their impact on accounting practices. In the U.S., the FASB has developed the GAAP (Generally Accepted Accounting Principles) as the set of accounting rules with which companies must comply as they prepare financial statements. The Securities and Exchange Commission (SEC) regulates publicly traded U.S. companies, as well as the nation’s stock and bond markets. The SEC ensures compliance of publicly traded companies with the GAPP. The four key financial statements, prepared according to GAAP principles and required by the SEC are (1) the balance sheet, (2) the income statement, (3) the statement of retained earnings, and (4) the statement of cash flows.
2. Companies prepare both balance sheets and income statements for the purpose of providing financial information about a company at a point in time, but they are used for slightly different purposes. A balance sheet provides a picture of the company’s assets and liabilities (or net worth) at a point in time and sums all of the company’s past earnings in the shareholder equity account. An income statement, on the other hand, provides a picture of the company’s revenues and expenses for a specified period of time. Both statements are very useful in analyzing the company’s past and future prospects.
3. Creditors would most likely be interested in the balance sheet, which states how much the company holds in liabilities, but they also would want to see an income statement, which indicates the company’s ability to meet its payment commitments. Shareholders will certainly be interested in the balance sheet and income statement, which will allow them to compute ratios for the company; in the statement of retained earnings, which states how much their share of the company has increased or decreased; and in the statement of cash flows, which describes where cash is coming in and going out of the company.
4. Depreciation and other non-cash charges are sources of cash to the firm. These charges are subtracted from the firm’s revenues, decreasing cash flow in order to get a correct estimate of taxes owed. They need to be added back to compute an accurate cash flow. These charges are not real cash flows – no dollars exchange hands when a company takes a depreciation expense – and are only subtracted because they reduce the company’s tax bill, and taxes are a real dollar cash flow. The tax code does not allow a company to expense its capital equipment in the year it was purchased. It requires companies to charge this expense over the lifetime of the equipment, taking a percentage of the total cost each year. For a profitable firm, it is better to depreciate assets as quickly as possible. The larger the depreciation expense, the lower the taxable income and the lower the taxes owed.
5. Operating cash flow (OCF) is earnings before interest and taxes (EBIT) less actual taxes plus depreciation. OCF is related to NOPAT because OCF can also be calculated as NOPAT plus depreciation. Free cash flow (FCF) is operating cash flow (revenues minus operating costs, depreciation and taxes, with depreciation added back in) minus changes in fixed assets minus changes in working capital (current assets minus operating current liabilities, accounts payable and accruals). Free cash flow takes operating cash flow and subtracts any short term and long term capital investments needed to support operating cash flow.
6. Financial managers must concern themselves very much with the statement of cash flows, because cash flows are the lifeblood of the firm. A firm that does not have sufficient cash flow to meet its obligations will soon face financial difficulty. Analysts, banks and creditors use cash flows to value the firm. The firm wants to maximize cash flows in order to maximize firm value.
7. a. Existing and prospective lenders would be most interested in liquidity ratios (how much in liquid assets the firm has to pay its bills) and debt ratios (how much of a commitment the firm has overall to debt).
b. Existing and prospective shareholders will be interested in most ratios. In particular, they will want to know the activity ratios (how efficiently the company is using its assets), profitability ratios and market ratios.
c. The firm’s management should be interested in all ratios, identifying the firm’s strengths and weaknesses and looking at how to continue the strengths and improve the weak areas.
8. Cash inflow and outflow data can be used to improve the accuracy of liquidity and debt coverage ratios over the previously presented methods because we would be using direct data rather than estimated ratios. For example, times interest earned is earnings before interest and taxes divided by interest. If cash flow were used instead, it could provide a more accurate measure of how much cash the firm had available to pay its interest expense. Debt ratios could be calculated using market value numbers rather than book value numbers, as the share price represents the discounted value of all future cash flows to the company.
9. a. Cash outflow
b. Cash inflow—decrease in inventory
c. Cash outflow—increase in AR
d. Cash inflow—increase in AP; decrease in inventory
e. No effect on cash—just a shifting of financing sources because total assets don't change
f. Cash inflow, because although sales are unchanged, profit in dollars will increase
10. The DuPont system evaluates the impact of the different ratios on the company’s ROE, we need to decompose the ROE by means of the DuPont system. ROE = Profit margin * Asset turnover * Equity multiplier. If the company has an above-average net profit margin and an average leverage, the only way that the company can have a below-average ROE is for its asset turnover to be lower (slower) than the industry average.
11. Investors may not get excited about a stock with an above-average M/B ratio and a below-average P/E ratio, especially if the firm is an older one. Since the M/B ratio compares market and book values, it is possible that the ratio is high not so much due to high market price as due to a low book value. The M/B ratio shows how investors view the company’s past and how they project it to the company’s future. Therefore, a high M/B and a low P/E do not necessarily mean that there is a discrepancy in the investors’ expectations. It may be explained by the fact that because investors do not expect the company to perform well in the future, they are willing to pay less for its earnings thus bringing the P/E ratio down. In the same time, however, if the company has existed for a long time it may have initially sold its shares at a low for the current period value. Therefore, a low value of common stock on the company’s books combined with decreasing retained earnings, leads to a high M/B ratio due to the small denominator of the ratio.
12. Ordinary corporate income is income resulting from the sale of the firm’s goods and services. Under current tax laws, the applicable tax rates are subject to progressive tax rate schedule much as individuals in the U.S. are subject to increasing tax brackets as their incomes rise. Corporate average tax rates are calculated by dividing the company’s tax liability by its pretax income. The firm’s marginal tax rate is the tax rate applicable to the firm’s next dollar of earnings.
13. Capital gains occur when companies sell capital assets, such as equipment or stock held as an investment, for more than the asset’s original purchase price. The amount of the capital gain would be equal to the difference between the sale price and initial purchase price. If the sale price is less than the initial purchase price, the difference is called capital loss. Under current tax law, corporate capital gains are merely added to operating income and taxed at the ordinary corporate tax rates. The tax treatment of capital losses on depreciable business assets involves a deduction from pretax ordinary income, whereas any other capital losses must be used to offset capital gains.
Answers to Self-Test Problems
ST2-1. Use the financial statements below to answer the questions concerning M&M Manufacturing’s financial position at the end of the calendar year 2012.
a. How much cash and near cash does M&M have at year-end 2012?
b. What was the original cost of all of the firm’s real property that is currently owned?
c. How much in total liabilities did the firms have at year-end 2012?
d. How much did M&M owe for credit purchases at year-end 2012?
e. How much did the firm sell during 2012?
f. How much equity did the common stockholders have in the firm at year-end 2012?
g. What is the cumulative total of earnings reinvested in the firm from its inception through the end of 2012?
h. How much operating profit did the firm earn during 2012?
i. What is the total amount of dividends paid out by the firm during the year 2012?
j. How many shares of common stock did M&M have outstanding at year-end 2012?
M&M Manufacturing, Inc.
Balance Sheet
At December 31, 2012 ($000)
| Assets | Liabilities and Equity | ||
| Current assets | Current liabilities | ||
| Cash | $ 140,000 | Accounts payable | $ 480,000 |
| Marketable securities | 260,000 | Notes payable | 500,000 |
| Accounts receivable | 650,000 | Accruals | 80,000 |
| Inventories | 800,000 | Total current liabilities | $1,060,000 |
| Total current assets | $1,850,000 | Long-term debt | |
| Fixed assets | Bonds outstanding | $1,300,000 | |
| Gross fixed assets | $3,780,000 | Bank debt (long-term) | 260,000 |
| Less: Accumulated depreciation | 1,220,000 | Total long-term debt | $1,560,000 |
| Net fixed assets | $2,560,000 | Total Liabilities | $2,620,000 |
| Total assets | $4,410,000 | Shareholders’ equity | |
| | Preferred stock | $ 180,000 | |
| | | Common stock (at par) | 200,000 |
| Paid-in capital in excess of par | 810,000 | ||
| Retained earnings | 600,000 | ||
Total shareholders’ equity | $1,790,000 | ||
Total liabilities and equity | $4,410,000 |
M&M Manufacturing, Inc.
Income Statement for year ended December 31, 2012 ($000)
| Sales revenue | $6,900,000 | |
| Less: Cost of goods sold | | 4,200,000 |
| Gross profits | $2,700,000 | |
| Less: Operating expenses | ||
| Sales expense | $ 750,000 | |
| General and administrative expense | 1,150,000 | |
| Leasing expense | 210,000 | |
| Depreciation expense | 235,000 | |
| Total operating expenses | | $2,345,000 |
| Earnings before interest and taxes | $ 355,000 | |
| Less: Interest expense | | 85,000 |
| Net profit before taxes | $ 270,000 | |
| Less: Taxes | | 81,000 |
| Net profits after taxes | | $ 189,000 |
| Less: Preferred stock dividends | | 10,800 |
| Earnings available for common stockholders | | $ 178,200 |
| Less: Dividends | | 75,000 |
| To retained earnings | | $ 103,200 |
| Per share data: | ||
| Earnings per share (EPS) | $1.43 | |
| Dividends per share (DPS) | $0.60 | |
| Price per share | $15.85 |
A: a. $400,000 (only cash and marketable securities should be included $140,000 + $260,000)
b. $3,780,000 (net asset position + depreciation)
c. $2,620,000 (current liabilities + long-term debt)
d. $480,000 (accounts payable)
e. $6,900,000 (sales)
f. $1,610,000 (common stock at par + paid-in capital + retained earnings)
g. $600,000 (retained earnings)
h. $355,000 (EBIT)
i. $85,800 (preferred + common stock dividends)
j. 124,615 shares outstanding ($178,200/$1.43)
ST2-2. The partially complete 2012 balance sheet and income statement for Challenge Industries are given below, followed by selected ratio values for the firm based on its completed 2012 financial statements. Use the ratios along with the partial statements to complete the financial statements. Hint: Use the ratios in the order listed to calculate the missing statement values that need to be installed in the partial statements.
Challenge Industries, Inc.
Balance Sheet
At December 31, 2012
(in $ thousands)
|
Assets |
|
Liabilities and Equity | |
| Current assets | Current liabilities | ||
| Cash | $ 52,000 | Accounts payable | $150,000 |
| Marketable securities | 60,000 | Notes payable | ? |
| Accounts receivable | 200,000 | Accruals | 80,000 |
| Inventory | ? | Total current liabilities | ? |
| Total current assets | ? | Long-term debt | 425,000 |
| Fixed assets (gross) | ? | Total liabilities | ? |
| Less: Accumulated depreciation | 240,000 | Shareholders’ equity | |
| Net fixed assets | ? | Preferred stock | ? |
| Total assets | ? | Common stock (at par) | 150,000 |
| | Paid-in capital in excess of par | ? | |
| | | Retained earnings | 390,000 |
| | | Total shareholders’ equity | ? |
Total liabilities and shareholders’ equity |
|
Challenge Industries, Inc.
Income Statement
For the Year Ended December 31, 2012
(in $ thousands)
| Sales revenue | $ 4,800,000 | |
| Less: Cost of goods sold | | ? |
| Gross profits | ? | |
| Less operating expenses: | ||
| Selling expense | $690,000 | |
| General and administrative expense | 150,000 | |
| Depreciation | 120,000 | |
| Total operating expenses | | $1,560,000 |
| Earnings before interest and taxes | ? | |
| Less: Interest expense | | 35,000 |
| Earnings before taxes | ? | |
| Less: Taxes | ? | |
| Net income (Net profits after taxes) | ? | |
| Less: Preferred dividends | | 15,000 |
| Earnings available for common stockholders | ? | |
| Less: Dividends | | 60,000 |
| To retained earnings | ? |
Challenge Industries, Inc.
Ratios for the Year Ended December 31, 2012
| Ratio | Value |
| Total asset turnover | 2.00 |
| Gross profit margin | 40% |
| Inventory turnover | 10 |
| Current ratio | 1.60 |
| Net profit margin | 3.75% |
| Return on common equity | 12.5% |
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