Financial Management (Chapter 3: Understanding Financial Statements, Taxes, and Cash Flows)

3.1   An Overview of the Firm's Financial Statements

1) Which of the basic financial statements is best used to answer the question, "How profitable is the business?"

A) Balance sheet

B) Statement of shareholder's equity

C) Income statement

D) Accounts receivable aging schedule

2) Who owns the retained earnings of a public firm?

A) The IRS

B) Common stockholders

C) Bondholders

D) Preferred stockholders

3) Which of the following represents an attempt to measure the earnings of the firm's operations over a given time period?

A) Balance sheet

B) Cash flow statement

C) Income statement

D) None of the above

4) Stock that is repurchased by the issuing company is called

A) paid in capital.

B) treasury stock.

C) retained capital.

D) par value stock.

5) Which of the basic financial statements is best used to answer the questions "What does the company own and how is it financed?"

A) Balance sheet

B) Statement of shareholder's equity

C) Income statement

D) Cash flow statement

6) Which of the basic financial statements is best used to answer the questions "Where did the company's money come from and how was it spent over the preceding year?"

A) Balance sheet

B) Statement of shareholder's equity

C) Income statement

D) Cash flow statement

7) Which of the basic financial statements is best used to answer questions about changes in owner's equity that are not explained by the income statement?

A) Balance sheet

B) Statement of shareholder's equity

C) Income statement

D) Cash flow statement

8) The income statement shows a company's earnings since it has been in business.

Answer:  FALSE

9) The balance includes information about the company's assets and liabilities.

Answer:  TRUE

10) The cash flow statement shows amounts that the company has earned but for which it has not yet received cash.

Answer:  FALSE

11) The cash flow statement is an alternative term for the balance sheet.

Answer:  FALSE

3.2   The Income Statement

1) On the income statement, sales revenue, minus cost of goods sold and operating expenses, equals which of the following?

A) Net profit

B) Retained earnings

C) Net income available to preferred shareholders

D) EBIT

2) Which of the following streams of income is not affected by how a firm is financed (whether with debt or equity)?

A) Net profit after tax but before dividends

B) Net working capital

C) Operating income

D) Income before tax

3) Which of the following is not included in computing EBT (earnings before taxes)?

A) Marketing expenses

B) Depreciation expense

C) Cost of goods sold

D) Dividends

4) Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm's EBIT?

A) $15,552,000

B) $58,000,000

C) $5,110,000

D) $4,630,000

5) Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm's gross profit?

A) $18,000,000

B) $15,225,000

C) $5,000,110

D) $6,632,000

6) Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $10,115,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm's income before tax?

A) $4,360,000

B) $750,000

C) $10,865,000

D) $25,115,000

7) Your firm has the following income statement items: sales of $50,250,000; income tax of $1,744,000; operating expenses of $8,750,000; cost of goods sold of $35,025,000; and interest expense of $750,000. What is the amount of the firm's net income?

A) $255,223

B) $4,731,000

C) $2,616,000

D) $7,775,000

8) Your firm has the following income statement items: sales of $52,000,000; income tax of $1,880,000; operating expenses of $9,000,000; cost of goods sold of $36,000,000; and interest expense of $800,000.  Compute the firm's gross profit margin.

A) 13.5%

B) 8.3%

C) 30.8%

D) 69.2%

                                                     Table 1

                                            Jones Company

                                      Financial Information

                                                                March 1995         March 1996

Net income                                             $1,500                    $3,000

Accounts receivable                                  750                         750

Accumulated depreciation                  1,125                      1,500

Common stock                                        4,500                      5,250

Capital surplus                                       7,500                      8,250

Retained earnings                                  1,500                      2,250

Accounts payable                                      750                         750

9) Based on the information given in Table 1, calculate the dividends paid in 1996.

A) $3,750

B) $3,000

C) $750

D) $2,250

                                                      Table 2

                                         Bird Industries, Inc.

                                              Balance Sheets

                                                                    2011                          2012

Cash                                                         $1,000                            $?

Accounts receivable                               5,000                      6,000

Inventories                                                6,500                      6,000

Land                                                         10,000                   12,000

Other fixed assets                                   8,000                      9,000

Accumulated depreciation                 (1,000)                   (1,600)

Total assets                                          $29,500                            $?

Accounts payable                                 $3,200                  $ 6,800

Bonds                                                         4,000                      4,000

Common stock                                      17,000                   16,000

Retained earnings                                  5,300                      5,000

Total debt and equity                        $29,500                            $?

                                                             Bird Industries, Inc.

                                                               Income Statement

                                                Sales                                       $84,000

                                                Cost of goods sold                66,400

                                                Gross profit                          $17,600

                                                Operating expenses           (13,000)

                                                Depreciation                              (600)

                                                EBIT                                          $4,000

                                                Interest expense                        (500)

                                                EBT                                           $3,500

                                                Taxes                                         (1,500)

                                                Net Income                             $2,000

10) Based on the information contained in Table 2, what was the total amount of Bird Industries' common stock dividend for 2012?

A) $800

B) $2,300

C) $2,000

D) Cannot be determined with available information

11) Based on the information contained in Table 2, what was Bird Industries' operating profit margin for 22012?

A) 21%

B) 4.8%

C) 4.2%

D) 2.4%

                                                      Table 3

                                      Snark Enterprises, Inc.

                                              Balance Sheets

                                                                    2011                           2012

Cash                                                         $1,000                            $?

Accounts receivable                               8,000                      9,000

Inventories                                                4,000                      7,000

Land                                                         10,000                   10,000

Other fixed assets                                   5,000                      5,500

Accumulated depreciation                 (1,600)                   (2,000)

Total assets                                          $26,400                            $?

Accounts payable                                 $4,200                  $ 7,000

Bonds                                                         4,000                      4,000

Common stock                                      15,000                   16,000

Retained earnings                                  3,200                      3,800

Total debt and equity                        $26,400                            $?

                                                          Snark Enterprises, Inc.

                                                              Income Statement

                                                Sales                                       $44,900

                                                Cost of goods sold               (22,000)

                                                Gross profit                          $12,900

                                                Operating expenses            (10,000)

                                                Depreciation                               (400)

                                                EBIT                                          $2,500

                                                Interest expense                         (500)

                                                EBT                                           $2,000

                                                Taxes                                         (1,000)

                                                Net Income                             $1,000

12) Based on the information contained in Table 3, what was the total amount of Snark Enterprise's common stock dividend for 2012?

A) $0

B) $400

C) $600

D) Cannot be determined with available information

13) Based on the information contained in Table 3, what is Snark Enterprise's gross profit margin in 2012.

A) 5.6%

B) 4.5%

C) 29.7%

D) 2.2%

14) Which of the following best represents operating income?

A) Income after financing activities

B) Earnings before interest and taxes

C) Income from capital gains

D) Income from discontinued operations

15) Which of the following best represents the stream of income that is available to stockholders?

A) Net profit after tax

B) Earnings before interest, taxes and dividends

C) Gross profit

D) Operating profit

16) Which of the following is NOT included in operating income?

A) Cost of goods sold

B) Sales

C) Taxes

D) Operating expenses

17) Using the information provided, calculate net income for 2013. Assume a tax rate of 35 percent.

                Year                                                      2013

                Inventory                                         $5,000

                Revenues                                      200,000

                Depreciation expense                    5,000

                Cost of goods sold                      100,000

                Interest expense                            10,000

                Operating expenses                     30,000

A) $35,750

B) $44,000

C) $50,000

D) $19,250

18) The practice of shifting income from good years to poor years in order to show a record of steady growth is

A) known as earnings management and is considered unethical.

B) highly recommended but not required by GAAP.

C) a basic requirement of accrual accounting.

D) impossible if Generally Accepted Accounting Principles are followed.

19) Firms should compare their gross, operating and net profit margins to past years and other companies in order to

A) evaluate the firm's performance.

B) identify expenses that seem to be out-of-line

C) better manage the reporting of the firm's earnings.

D) Both A and B.

20) The income statement represents a snapshot of account balances at one point in time.

Answer:  FALSE

21) Generally Accepted Accounting Principles (GAAP) require companies to smooth earnings by shifting some profits from good years to bad years.

Answer:  FALSE

22) The income statement describes the financial performance of a firm over a fixed period such as a quarter or a year.

Answer:  TRUE

23) On an accrual basis income statement, revenues and expenses always match the firm's cash flow.

Answer:  FALSE

24) Corporate income statements are usually compiled on an accrual, rather than cash, basis.

Answer:  TRUE

25) The company's gross profit margin is EBIT divided by net sales.

Answer:  FALSE

                                                                  Table 4

                 Financial Data for Dooley Sportswear, December 31, 2013

                                Inventory                                            $206,250

                                Interest expense                                       5,000

                                Accumulated depreciation             442,500

                                Cash                                                       180,000

                                Net sales (all credit)                       1,500,000

                                Accounts receivable                          225,000

                                Operating expenses                           525,000

                                Cost of goods sold                              937,500

                                Accounts payable                              168,750

                                Prepaid insurance                                80,000

                                Accrued wages                                      65,000

                                Federal income taxes                             5,750

26) From the scrambled list of items presented in Table 4, prepare an income statement Dooley Sportswear Company.  Not all items from Table 4 will be used.

Answer:                 Dooley Sportswear Company Income Statement

                                          for the Year Ending December 31, 2013

                                Net sales (all credit)                             $1,500,000

                                Cost of goods sold                                      937,500

                                Gross profits                                                562,500

                                EBIT                                                                525,000

                                Net operating income                                 37,500

                                Interest expense                                               5,000

                                Net income before taxes                             32,500

                                Federal income taxes                                     5,750

                                Net income                                                   $26,750

3.3   Corporate Taxes

1) 2013 U.S. Corporate tax rates are shown below:

Taxable Income	Marginal Tax Rate
$0-$50,000	15%
$50,001-$75,000	25%
$75,001-$100,000	34%
$100,001-$335,000	39%
$335,001-$10,000,000	34%
$10,000,001-$15,000,000	35%
$15,000,001-$18,333,333	38%
Over $18,333,333	35%

RJH Inc. has earnings before taxes of $100,000 in 2013.  The company's tax expense will be

A) $22,250

B) $24,670

C) $25,000

D) $34,000

2) 2013 U.S. Corporate tax rates are shown below:

Taxable Income	Marginal Tax Rate
$0-$50,000	15%
$50,001-$75,000	25%
$75,001-$100,000	34%
$100,001-$335,000	39%
$335,001-$10,000,000	34%
$10,000,001-$15,000,000	35%
$15,000,001-$18,333,333	38%
Over $18,333,333	35%

Bouffard Co. has earnings before taxes of $100,000,000 in 2013.  The company's tax expense will be

A) $3,500,000

B) $36,500,000

C) $31,875,000

D) $35,000,000

3) A & K Co. expects to have earnings before taxes of $250,000 to $300,000.  The company's marginal tax rate is 39% and its average tax rate about 33%.  For every additional dollar of interest expense, A & K's taxes will

A) increase by 39 cents.

B) fall by 39 cents.

C) be unaffected.

D) fall by about 33 cents.

4) A & K Co. expects to have earnings before taxes of $250,000 to $300,000.  The company's marginal tax rate is 39% and its average tax rate about 33%.  For every additional dollar A & K pays out in common dividends, its income tax liability will

A) increase by 39 cents.

B) fall by 39 cents.

C) be unaffected.

D) fall by about 33 cents.

5) Tax tables are based on ________ tax rates.

A) marginal

B) average

C) implied

D) investment

6) The marginal tax rate would equal the average tax rate for firms with earnings less than $50,000 or more than $18,333,333.

Answer:  TRUE

7) The interest payments on corporate bonds are tax-deductible.

Answer:  TRUE

8) A corporation's average tax rate will always be lower than or equal to its marginal tax rate.

Answer:  TRUE

9) The highest marginal corporate tax rate is 35%.

Answer:  FALSE

10) When analyzing the cash flows from a new project proposal, a company should always use its marginal tax rate.

Answer:  TRUE

11) Pearls, Inc. had sales in 2013 of $2.1 million. The common stockholders received $600,000 in cash dividends.  Interest totaling $150,000 was paid on outstanding debts. Operating expenses totaled $300,000, and cost of goods sold was $500,000.  What is the tax liability of Pearls, Inc.? 2013 U.S. Corporate tax rates are shown below:

Taxable Income	Marginal Tax Rate
$0-$50,000	15%
$50,001-$75,000	25%
$75,001-$100,000	34%
$100,001-$335,000	39%
$335,001-$10,000,000	34%
$10,000,001-$15,000,000	35%
$15,000,001-$18,333,333	38%
Over $18,333,333	35%

Answer:  Pearls Taxable Income

Sales                                                          $2,100,000

Less:

Cost of goods sold                                    $500,000

Operating expenses                                  300,000

Earnings before interest & taxes       $1,300,000

Interest expense                                          150,000

Taxable income                                       1,150,000

Total taxes owed                                      $391,000

Taxes on operating earnings = (.15)(50,000) + (.25)(25,000) + (.34) 25,000) + (.39)(235,000) +.(34)(735,000)= 7,500 + 6,250 + 8500 + 91,650+277,100 = $391,000 or

                                Because taxable income is over $335,000

                                taxes can be computed 1,150,000 × .34 =

                                $391,000

12) Goodwin Enterprises had a gross profit of $2,500,000 for the year. Operating expenses and interest expense incurred in that same year were $595,000 and $362,000, respectively. Goodwin had 200,000 shares of common stock and 180,000 shares of preferred stock outstanding. Management declared a $2.50 dividend per share on the common and a $1.50 dividend per share on the preferred. Securities purchased at a cost of $37,500 in a previous year were resold at a price of $50,500. Compute the taxable income and the resulting tax liability for Goodwin Enterprises for the year.

Use the following tax rates:

                 Income                   Tax rate

              $0-$50,000                     15%

        $50,001-$75,000                25%

       $75,001-$100,000               34%

      $100,001-$335,000              39%

           over $335,001                  34%

Answer: 

Gross profit                    $2,500,000

Operating expenses        (595,000)

Interest expense               (362,000)

Income before tax         $1,543,000

Add: Gain on sales              13,000

Taxable Income             $1,556,000

        Income          Marginal Tax Rate             Tax Liability

       $50,000       ×                 15%                                   $7,500

       $25,000       ×                 25%                                   $6,250

       $25,000       ×                 34%                                   $8,500

     $235,000       ×                 39%                                $91,650

  $1,221,000       ×                 34%                              $415,140

  $1,556,000                                                                $529,040

By design, the marginal and the average tax rates are the same, 34%, for corporate incomes between $335,000 and $10,000,000.

3.4   The Balance Sheet

1) Which of the following is not a current asset?

A) Accounts payable

B) Marketable securities

C) Accounts receivable

D) Inventory

2) Net plant and equipment is

A) plant and equipment purchases less amount borrowed to finance purchases.

B) current year plant and equipment purchases less current year's depreciation expense.

C) gross plant and equipment less accumulated depreciation.

D) plant and equipment at current market valuations.

3) Your firm has the following balance sheet statement items: total current liabilities of $805,000; total assets of $2,655,000; fixed and other assets of $1,770,000; and long-term debt of $200,000. What is the amount of the firm's total current assets?

A) $885,000

B) $1,550,000

C) $600,000

D) $325,000

4) Your firm has the following balance sheet statement items: total current liabilities of $805,000; total assets of $2,655,000; fixed and other assets of $1,770,000; and long-term debt of $200,000. What is the amount of the firm's net working capital?

A) $25,000

B) $325,000

C) $770,000

D) $80,000

5) Which of the following best describes a balance sheet?

A) Reports cash receipts and cash disbursements for a specific accounting period

B) Reports investment activities for a specified accounting period

C) Reports revenues and expenses for a specific accounting period

D) Reports the amount and composition of assets and liabilities at a specified point in time

6) Which of the following would NOT be included as an asset on a corporate balance sheet?

A) Accounts receivable

B) Common stock

C) Inventory

D) Buildings

7) Which of the following would NOT be included as a liability in a corporate balance sheet?

A) Notes payable

B) Accounts payable

C) Bonds

D) Accumulated Depreciation

8) Which of the following would NOT be included as equity in a corporate balance sheet?

A) Cash

B) Paid in capital

C) Retained earnings

D) Common stock

9) Patriot Corporation purchased manufacturing equipment with an expected useful life of five years.  The purchase of the machinery would be shown as

A) an expense on the balance sheet.

B) an expense on the income statement.

C) an asset on the balance sheet.

D) both an expense and an asset.

10) When a company pays a dividend on common stock, it appears as

A) an expense on the income statement.

B) a reduction in the amount of retained earnings.

C) a current liability on the balance sheet.

D) dividend payments have no effect on the financial statements.

11) Grass Gadgets had sales of $30 million and net income of $2 million in 2008. Grass paid a dividend of $1.5 million. Assuming that their beginning balance for retained earnings was $3 million, calculate their ending balance for retained earnings.

A) $2.5 million

B) $3 million

C) $3.5 million

D) $4 million

12) Total equity on the balance sheet increases as dividends paid increases.

Answer:  FALSE

13) A balance sheet is a statement of the financial position of the firm on a given date, including its asset holdings, liabilities, and equity.

Answer:  TRUE

14) Under current accounting rules, plant and equipment appear on a company's balance sheet valued at replacement value.

Answer:  FALSE

15) When a corporation sells common stock to investors, the amount is added to revenue on the income statement.

Answer:  FALSE

16) An advantage of balance sheet numbers is that assets reflect current market values.

Answer:  FALSE

17) A firm's balance sheet provides a representation of the current market value of the company.

Answer:  FALSE

18) Gross plant and equipment minus accumulated depreciation represents the fair market value of a company's fixed assets.

Answer:  FALSE

19) Balance sheet and other accounts for GPA are listed below in alphabetical order.  Use these accounts to construct GPA's balance sheet for 2013.  All balance sheet accounts are shown, but some accounts will not be used.  All amounts are in millions of dollars.

Accounts payable                 $1900

Accounts receivable                $661

Cash                                         $1,000

Common stock                     $2,000

EBIT                                         $1,968

Interest expense                      $8.00               

Inventories                             $1,620

Long-term debt                         $890

Net plant & equipment     $2,563

Other current assets                $645

Other long-term assets           $576

Retained earnings                $2,080

Short-term debt                        $195

Taxes                                           $778

Answer: 

Balance Sheet: GPA Inc.	2013
Cash	$1,000	Accounts payable	$1,900
Accounts receivable	661	Short-term debt	195
Inventories	1,620	Total current liabilities	$2,095
Other current assets	645	Long-term debt	890
Total current assets	$3,926	Common stock	2,000
Net plant & equipment	2,563	Retained earnings	2,080
Other long-term assets	576
Total assets	$7,065	Total liab. & equity	$7,065

3.5   The  Cash Flow Statement

1) Which of the following represents a source of cash?

A) A decrease in accounts payable

B) A decrease in accounts receivable

C) Payment of dividends

D) An increase in inventories

2) The change between a firm's beginning cash balance and ending cash balance would equal

A) cash flow from operations + cash flow from investing activities + cash flow from financing activities.

B) the change in current assets minus the change in current liabilities.

C) net income plus new borrowing minus asset purchases.

D) total assets minus total liabilities minus total stockholders' equity.

3) Which of the following does NOT represent cash outflows to the firm?

A) Taxes

B) Interest payments

C) Dividends

D) Depreciation

4) The ratio of ________ to ________ is an indicator of the quality of a firm's earnings.

A) cash flow from operations, net income

B) liabilities, assets

C) dividends, interest expense

D) cash flow from operations, capital expenditures

5) Operating cash flow will increase with a decrease in

A) inventories.

B) current liabilities.

C) depreciation expense.

D) capital expenditures.

6) In a growing business, negative cash flow from investing activities is normal.

Answer:  TRUE

7) Reducing a firm's debt will increase its cash flow.

Answer:  FALSE 

8) Beginning cash balance + cash flow from operations + cash flow from investing activities + cash flow from financing activities = ending cash balance.

Answer:  TRUE