Chapter 2 Financial Statement, Taxes & Cash flow

I. True/ False

1. Net working capital equals to current assets minus current liabilities.

A. True
B. False
2. Equity holders get the first claim to the firm's cash flow
A. True
B. False
3. Retained earnings refer to the portion of a corporation's profits that are paid out to
shareholders
A. True
B. False
4. Depreciation is a noncash item, which is an expense charged against revenues that do not
directly affect cash flow
A. True
B. False
5. Cash flow from assets involves three components: operating cash flow, capital spending,
and change in net working capital
A. True
B. False

II. Short answer

1. Under standard accounting rules, a decrease in depreciation expense will decrease

net income and decrease the cash flow from asset? Why or why not?
A decrease in depreciation expense WILL NOT decrease net income and decrease
the cash flow from asset, because:
 Depreciation decrease => cost decreases (revenue is unchange) => net income
increases.
 Depreciation decrease => CAPEX decreases => Cash flow from asset increase
(Cash flow from asset = OCF – CAPEX – Change in net working capital)

2. Why might the revenue and cost figures shown on a standard income statement not
be representative of the actual cash inflows and outflows that occurred during a
period?
The recognition and matching principles in financial accounting call for revenues,
and the costs associated with producing those revenues, to be “booked” when the revenue
process is essentially complete, not necessarily when the cash is collected or bills are
paid. Note that this way is not necessarily correct; it’s the way accountants have chosen
to do it.

3. What makes net income be different from operating cash flow?

 Depreciation is a non-cash deduction that reflects adjustments made in asset
book values in accordance with the matching principle in financial accounting. Interest
expense is a cash outlay, but it’s a financing cost, not an operating cost.

4. If a company’s cash flow from asset is negative for a specific period. Does it signal
that this company is in a good or bad financial position?
During a period of rapid expansion, an already successful company might face a
situation of negative cash flow from assets due to large capital outlays. In short, as long
as the investments that the company has made are effective, positive or negative cash
flow from assets does not mean much.

III. Multiple Choice Question

1. What is the balance sheet?

A. A financial statement showing a firm's accounting value on a particular date
B. A financial statement showing a firm's accounting value over a period of time
C. A financial statement showing a firm's cash flow over a period of time
D. A financial statement showing a firm's revenue & expenses over a period of time
2. What is the income statement?
A. A financial statement summarizing a firm’s performance over a period of time
B. A financial statement summarizing a firm’s performance on a particular date
C. A financial statement showing a firm's cash flow over a period of time
D. A financial statement showing a firm's accounting value on a particular date

Information for question 3 & 4

3. What is the NWC of the firm given the information above?

A. 50
B. 40
C. 30
D. 10
4. What is the Shareholders’ Equity given the information above?
A. 300
B. 330
C. 350
D. 400

5. What is not included in Current Assets?

A. Account receivables
B. Inventory
C. Cash & cash equivalent
 D. Account payables

6. What would be the first thing reported on an income statement?

A. Revenue/Sales
B. Operating Expense
C. Interest expense
D. Taxes

7. Gross profit is calculated as:

A. Total sales - cost of goods sold - selling, general and administrative expenses -
depreciation and amortization
B. Total sales - cost of goods sold - selling, general and administrative expenses
C. Total sales - cost of goods sold
D. None of the above

8. In 2021, Firm A has done a great job and yielded a net income of 500,000 USD. The
company decides to give back to its shareholders 200,000 USD. What is the addition to
retained earning?
A. 100,000 USD
B. 200,000 USD
C. 300,000 USD
D. 400,000 USD

9. Use the following information for Firm B incorporated:

Assets $200 million
Shareholder Equity $100 million
Sales $300 million
Net Income $15 million
Interest Expense $2 million

If Firm B’s stock is currently trading at $24.00 and Firm B has 25 million shares
outstanding, then Firm B's market-to-book ratio is closest to:
A. 0.24
B. 4
C. 6
D. 30
10. How to calculate Cash flow from assets:
A. Operating cash flow + Net capital spending - Change in net working capital (NWC)
B. Operating cash flow - Net capital spending + Change in net working capital (NWC)
C. Operating cash flow - Net capital spending - Change in net working capital (NWC)
D. Operating cash flow + Net capital spending + Change in net working capital (NWC)

IV. Excersice
1. Papa Roach Exterminators, Inc., has sales of $586,000, costs of $247,000,
depreciation expense of $43,000, interest expense of $32,000, and a tax rate of 35
percent. What is the net income for this firm?

The income statement for the company is:

Income Statement
Sales $586,000
Costs 247,000
Depreciation 43,000
EBIT $296,000
Interest 32,000
EBT $264,000
Taxes(35%) 92,400
Net income $171,600

2. So Long, Inc., has sales of $27,500, costs of $13,280, depreciation expense of

$2,300, and interest expense of $1,105. If the tax rate is 35 percent, what is the
operating cash flow, or OCF?

To calculate OCF, we first need the income statement:

Income Statement
Sales $27,500
Costs 13,280
Depreciation 2,300
EBIT $11,920
Interest 1,105
Taxable income $10,815
Taxes (35%) 3,785
Net income $ 7,030

OCF = EBIT + Depreciation – Taxes = $11,920 + 2,300 – 3,785 =

$10,435
3. Jetson Spacecraft Corp. shows the following information on its 2009 income
statement: sales = $196,000; costs = $104,000; other expenses = $6,800; depreciation
expense = $9,100; interest expense = $14,800; taxes = $21,455; dividends = $10,400.
In addition, you’re told that the firm issued $5,700 in new equity during 2009 and
redeemed $7,300 in outstanding long-term debt.
a. What is the 2009 operating cash flow?
b. What is the 2009 cash flow to creditors?
c. What is the 2009 cash flow to stockholders?
d. If net fixed assets increased by $27,000 during the year, what was the addition to
NWC?

To find the OCF, we first calculate net income.

 Income Statement
Sales $196,000
Costs 104,000
Other expenses 6,800
Depreciation 9,100
EBIT $76,100
Interest 14,800
Taxable income $61,300
Taxes 21,455
Net income $39,845

Dividends $10,400
Additions to RE $29,445

a. OCF = EBIT + Depreciation – Taxes = $76,100 + 9,100 – 21,455 = $63,745

b. CFC = Interest – Net new LTD = $14,800 – (–7,300) = $22,100

Note that the net new long-term debt is negative because the company repaid part of
its long- term debt.

c. CFS = Dividends – Net new equity = $10,400 – 5,700 = $4,700

d. We know that CFA = CFC + CFS, so:

CFA = $22,100 + 4,700 = $26,800

CFA is also equal to OCF – Net capital spending – Change in NWC. We already
know OCF. Net capital spending is equal to:

Net capital spending = Increase in NFA + Depreciation = $27,000 + 9,100 =

$36,100

Now we can use:

CFA = OCF – Net capital spending – Change in NWC

$26,800 = $63,745 – 36,100 – Change in NWC

Solving for the change in NWC gives $845, meaning the company
increased its NWC by $845.

4. Prepare a 2009 balance sheet for Bertinelli Corp. based on the following
information: cash = $195,000; patents and copy- rights = $780,000; accounts
payable = $405,000; accounts receivable = $137,000; tangible net fixed assets =
$2,800,000; inventory = $264,000; notes payable = $160,000; accumulated retained
earnings = $1,934,000; long-term debt = $1,195,300.
 Balance Sheet
Cash $195,000 Accounts payable $405,000
Accounts receivable 137,000 Notes payable 160,000
Inventory 264,000 Current liabilities $565,000
Current assets $596,000 Long-term debt 1,195,300
Total liabilities $1,760,300
Tangible net fixed assets 2,800,000
Intangible net fixed assets 780,000 Common Stock ???
Accumulated ret. earnings 1,934,000
Total assets $4,176,000 Total liab. & owners’ equity $4,176,000

Total liabilities and owners’ equity is:

TL & OE = CL + LTD + Common stock + Retained earnings

Solving for this equation for equity gives us:

Common stock = $4,176,000 – 1,934,000 – 1,760,300 = $481,700

5. Dahlia Industries had the following operating results for 2009: sales =
$22,800; cost of goods sold = $16,050; depreciation expense = $4,050; interest
expense = $1,830; dividends paid = $1,300. At the beginning of the year, net fixed
assets were $13,650, current assets were $4,800, and current liabilities were $2,700.
At the end of the year, net fixed assets were $16,800, current assets were $5,930, and
current liabilities were $3,150. The tax rate for 2009 was 34 percent.
a. What is net income for 2009?
b. What is the operating cash flow for 2009?
c. What is the cash flow from assets for 2009? Is this possible? Explain.
d. If no new debt was issued during the year, what is the cash flow to creditors?
What is the cash flow to stockholders? Explain and interpret the positive and
negative signs of your answers in (a) through (d).

a.
Income Statement

Sales $22,800

Cost of goods sold 16,050

Depreciation 4,050

EBIT $ 2,700
 Interest 1,830

Taxable income $ 870

Taxes (34%) 296

Net income $ 574

b. OCF = EBIT + Depreciation – Taxes

= $2,700 + 4,050 – 296 = $6,454

c. Change in NWC = NWCend – NWCbeg

= (CAend – CLend) – (CAbeg – CLbeg)
= ($5,930 – 3,150) – ($4,800 – 2,700)
= $2,780 – 2,100 = $680

Net capital spending = NFAend – NFAbeg + Depreciation

= $16,800 – 13,650 + 4,050 = $7,200

CFA = OCF – Change in NWC – Net capital spending

= $6,454 – 680 – 7,200 = –$1,426

The cash flow from assets can be positive or negative, since it represents
whether the firm raised funds or distributed funds on a net basis. In this problem,
even though net income and OCF are positive, the firm invested heavily in both fixed
assets and net working capital; it had to raise a net $1,426 in funds from its
stockholders and creditors to make these investments.

d. Cash flow to creditors = Interest – Net new LTD = $1,830 – 0 = $1,830

Cash flow to stockholders = Cash flow from assets – Cash flow to creditors
= –$1,426 – 1,830 = –$3,256
We can also calculate the cash flow to stockholders as:

Cash flow to stockholders = Dividends – Net new equity

Solving for net new equity, we get:

Net new equity = $1,300 – (–3,256) = $4,556

The firm had positive earnings in an accounting sense (NI > 0) and had positive cash
flow from operations. The firm invested $680 in new net working capital and $7,200 in
new fixed assets. The firm had to raise $1,426 from its stakeholders to support this new
investment. It accomplished this by raising $4,556 in the form of new equity. After
paying out $1,300 of this in the form of dividends to shareholders and $1,830 in the form
of interest to creditors, $1,426 was left to meet the firm’s cash flow needs for investment.