Assignment | The primary reason the annual report is important in finance is that it is used by investors
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CH3:
Part 1: True or False
1. The primary reason the annual report is important in finance is that it is used by investors when
they form expectations about the firm's future earnings and dividends, and the riskiness of those
cash flows.
True
2. The amount shown on the December 31, 2015 balance sheet as "retained earnings" is equal to the
firm's net income for 2015 minus any dividends it paid
False
3. The income statement shows the difference between a firm's income and its costs--i.e., its
profits--during a specified period of time. However, not all reported income comes in the form of
cash, and reported costs likewise may not be consistent with cash outlays. Therefore, there may
be a substantial difference between a firm's reported profits and its actual cash flow for the same
period.
True
4. In finance, we are generally more interested in cash flows than in accounting profits. Free cash
flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital
expenditures and changes in net operating working capital.
True
5. To estimate the cash flow from operations, depreciation must be added back to net income
because it is a non-cash charge that has been deducted from revenue in the net income
calculation.
True
Part 2: Multiple Choice Questions
1. Which of the following statements is CORRECT?
a. Assets other than cash are expected to produce cash over time, and the amounts of cash
they eventually produce should be exactly the same as the amounts at which the assets
are carried on the books.
b. The primary reason the annual report is important in finance is that it is used by investors
when they form expectations about the firm's future earnings and dividends, and the riskiness
Part 1: True or False
1. The primary reason the annual report is important in finance is that it is used by investors when
they form expectations about the firm's future earnings and dividends, and the riskiness of those
cash flows.
True
2. The amount shown on the December 31, 2015 balance sheet as "retained earnings" is equal to the
firm's net income for 2015 minus any dividends it paid
False
3. The income statement shows the difference between a firm's income and its costs--i.e., its
profits--during a specified period of time. However, not all reported income comes in the form of
cash, and reported costs likewise may not be consistent with cash outlays. Therefore, there may
be a substantial difference between a firm's reported profits and its actual cash flow for the same
period.
True
4. In finance, we are generally more interested in cash flows than in accounting profits. Free cash
flow (FCF) is calculated as after-tax operating income plus depreciation less the sum of capital
expenditures and changes in net operating working capital.
True
5. To estimate the cash flow from operations, depreciation must be added back to net income
because it is a non-cash charge that has been deducted from revenue in the net income
calculation.
True
Part 2: Multiple Choice Questions
1. Which of the following statements is CORRECT?
a. Assets other than cash are expected to produce cash over time, and the amounts of cash
they eventually produce should be exactly the same as the amounts at which the assets
are carried on the books.
b. The primary reason the annual report is important in finance is that it is used by investors
when they form expectations about the firm's future earnings and dividends, and the riskiness
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of those cash flows.
c. The annual report is an internal document prepared by a firm's managers solely for the use of
its creditors/lenders.
d. The four most important financial statements provided in the annual report are the balance
sheet, income statement, cash budget, and statement of stockholders' equity.
Answer: a.
2. Other things held constant, which of the following actions would increase the amount of cash on
a company's balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their
bills.
e. The company purchases a new piece of equipment.
Answer: c.
3. Which of the following items cannot be found on a firm’s balance sheet under current liabilities?
a. Accounts payable.
b. Short-term notes payable to the bank.
c. Accrued wages.
d. Cost of goods sold.
e. Accrued payroll taxes.
Answer: d.
Part 3: Problems
Q1. The assets of Dallas & Associates consist entirely of current assets and
net plant and equipment. The firm has total assets of $2.5 million and net
plant and equipment equals $2 million. It has notes payable of $150,000,
long-term debt of $750,000, and total common equity of $1.5 million. The
firm does have accounts payable and accruals on its balance sheet. The firm
only finances with debt and common equity, so it has no preferred stock on
its balance sheet.
a. What is the company’s total debt? - $ 0.9 Million
b. What is the amount of total liabilities and equity that appears on the firm’s
balance
sheet? - $ 2.5 Million
c. What is the balance of current assets on the firm’s balance sheet? - $ 0.5 Million
d. What is the balance of current liabilities on the firm’s balance sheet? - $ 0.25
Million
c. The annual report is an internal document prepared by a firm's managers solely for the use of
its creditors/lenders.
d. The four most important financial statements provided in the annual report are the balance
sheet, income statement, cash budget, and statement of stockholders' equity.
Answer: a.
2. Other things held constant, which of the following actions would increase the amount of cash on
a company's balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock.
d. The company gives customers more time to pay their
bills.
e. The company purchases a new piece of equipment.
Answer: c.
3. Which of the following items cannot be found on a firm’s balance sheet under current liabilities?
a. Accounts payable.
b. Short-term notes payable to the bank.
c. Accrued wages.
d. Cost of goods sold.
e. Accrued payroll taxes.
Answer: d.
Part 3: Problems
Q1. The assets of Dallas & Associates consist entirely of current assets and
net plant and equipment. The firm has total assets of $2.5 million and net
plant and equipment equals $2 million. It has notes payable of $150,000,
long-term debt of $750,000, and total common equity of $1.5 million. The
firm does have accounts payable and accruals on its balance sheet. The firm
only finances with debt and common equity, so it has no preferred stock on
its balance sheet.
a. What is the company’s total debt? - $ 0.9 Million
b. What is the amount of total liabilities and equity that appears on the firm’s
balance
sheet? - $ 2.5 Million
c. What is the balance of current assets on the firm’s balance sheet? - $ 0.5 Million
d. What is the balance of current liabilities on the firm’s balance sheet? - $ 0.25
Million
e. What is the amount of accounts payable and accruals on its balance sheet? [Hint:
Consider this as a single line item on the firm’s balance sheet.] - $ 0.1 Million
f. What is the firm’s net working capital? - $ 0.4 Million
g. What is the firm’s net operating working capital? – (1 – 0.1) = $ 0.9 Million
Q2. Pearson Brothers recently reported an EBITDA of $7.5 million and net
income of $2.1 million. It had $2 million of interest expense, and its
corporate tax rate was 30%. What was its charge for depreciation and
amortization? Hint : Deprec. = EBITDA – EBIT EBIT = EBT +
Interest EBT = Net Income / ( 1- T ) Interest = EBIT – EBT
Depreciation = EBITDA – EBIT
= $7.5 – EBIT
EBIT = EBT + Interest
= EBT + 2
EBT = Net income/ (1-t) = $ 2.1/ (1-.3) = 3
Thus, EBIT = 3 +2
= 5
And, hence, depreciation = EBITDA – EBIT
= $ (7.5-5) Mn
= $ 2.5 Mn
Q3. Harper Industries has $900 million of common equity on its balance
sheet; its stock price is $80 per share; and its Market Value Added (MVA) is
$50 million. How many common shares are currently outstanding?
A3:
Since the market value added for the stock price is $ 50 Million, of the issued
quantity, Thus, the number of common shares outstanding with the company
are $ 900/ $ (80-50) = 30 Million shares.
Q4. Hapmton Co. had $39,000 in cash at year-end 2015 and $11,000 in cash
at year-end 2016. The firm invested in property, plant, and equipment
totaling $210,000. Cash flow from financing activities totaled + $120,000.
a. What was the cash flow from operating activities?
Consider this as a single line item on the firm’s balance sheet.] - $ 0.1 Million
f. What is the firm’s net working capital? - $ 0.4 Million
g. What is the firm’s net operating working capital? – (1 – 0.1) = $ 0.9 Million
Q2. Pearson Brothers recently reported an EBITDA of $7.5 million and net
income of $2.1 million. It had $2 million of interest expense, and its
corporate tax rate was 30%. What was its charge for depreciation and
amortization? Hint : Deprec. = EBITDA – EBIT EBIT = EBT +
Interest EBT = Net Income / ( 1- T ) Interest = EBIT – EBT
Depreciation = EBITDA – EBIT
= $7.5 – EBIT
EBIT = EBT + Interest
= EBT + 2
EBT = Net income/ (1-t) = $ 2.1/ (1-.3) = 3
Thus, EBIT = 3 +2
= 5
And, hence, depreciation = EBITDA – EBIT
= $ (7.5-5) Mn
= $ 2.5 Mn
Q3. Harper Industries has $900 million of common equity on its balance
sheet; its stock price is $80 per share; and its Market Value Added (MVA) is
$50 million. How many common shares are currently outstanding?
A3:
Since the market value added for the stock price is $ 50 Million, of the issued
quantity, Thus, the number of common shares outstanding with the company
are $ 900/ $ (80-50) = 30 Million shares.
Q4. Hapmton Co. had $39,000 in cash at year-end 2015 and $11,000 in cash
at year-end 2016. The firm invested in property, plant, and equipment
totaling $210,000. Cash flow from financing activities totaled + $120,000.
a. What was the cash flow from operating activities?
The total cash flow from the firm is $ (39000 - 11,000), i.e. (28,000).
Total cashflow of a firm could come form three sources, which are:
1. Cash flow from operating activities
2. Cash flow from Investing activities - $ (210,000)
3. Cash flow from Financing activities - $ 120,000
Total cash flow = CF from operating activities + CF from investing
activities + cash flow from financing activities
28,000 = CF from operating activities + (210,000) +120,000
CF from operating activities = $ 118,000
b. If accruals increased by $15,000, receivables and inventories increased by
$50,000, and
depreciation and amortization totaled $25,000, what was the firm’s net
income?
Computation of Net Income:
Particulars Amount
($)
Cash flow from operating activities 118,000
Less: Increase in accruals (15,000)
Add: Increase in inventory 50,000
Les: Depreciation and amortization (25,000)
Net Income 128,000
Part 4: Short Answers
Q1. Who are some of the basic users of financial statements, and how do
they use them?
A1.
Financial statements are used by many stakeholders in the company and
each of them has different area of focus in the financial statements. Some of
Total cashflow of a firm could come form three sources, which are:
1. Cash flow from operating activities
2. Cash flow from Investing activities - $ (210,000)
3. Cash flow from Financing activities - $ 120,000
Total cash flow = CF from operating activities + CF from investing
activities + cash flow from financing activities
28,000 = CF from operating activities + (210,000) +120,000
CF from operating activities = $ 118,000
b. If accruals increased by $15,000, receivables and inventories increased by
$50,000, and
depreciation and amortization totaled $25,000, what was the firm’s net
income?
Computation of Net Income:
Particulars Amount
($)
Cash flow from operating activities 118,000
Less: Increase in accruals (15,000)
Add: Increase in inventory 50,000
Les: Depreciation and amortization (25,000)
Net Income 128,000
Part 4: Short Answers
Q1. Who are some of the basic users of financial statements, and how do
they use them?
A1.
Financial statements are used by many stakeholders in the company and
each of them has different area of focus in the financial statements. Some of
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the basic users of financial statement and how they use them, is explained
as under:
i. Equity Investors:
Equity investors are also known as the owners of the company,
since they bear all the risks originating from the business of the
company. Equity owners are interested in the overall financial
position of the company, i.e. whether the company would be able to
meet its short term and long term debt obligations, further, equity
shareholders, are also interest in the profitability of the company,
i.e. whether the level of returns, that the operations of the company
are generating, are decent, as compared to the risk involved.
In addition to the financial information, equity investors are also
interested in Management discussion and analysis, which gives
them an idea as to the operations of the company in the past and
the future plans of the company.
ii. Debt holders:
Debt holders are interested in the financial statements of the
company, as they want to ensure the payment of their periodic
interest in a timely manner and also the repayment of their debt, as
and when it falls due.
They generally analyze, Debt-equity ratio, Debt service coverage
ratio, current ratio, etc.
iii. Suppliers:
Suppliers of the company use the financial statements to analyze
the financial position of the company, to determine, whether the
company would be able to pay off their dues on time.
Also, suppliers are interested in determining the growth rate of the
operations of the company, so that they can pitch their products
and services accordingly.
Q2. Financial statements are based on generally accepted accounting
principles (GAAP) and are
as under:
i. Equity Investors:
Equity investors are also known as the owners of the company,
since they bear all the risks originating from the business of the
company. Equity owners are interested in the overall financial
position of the company, i.e. whether the company would be able to
meet its short term and long term debt obligations, further, equity
shareholders, are also interest in the profitability of the company,
i.e. whether the level of returns, that the operations of the company
are generating, are decent, as compared to the risk involved.
In addition to the financial information, equity investors are also
interested in Management discussion and analysis, which gives
them an idea as to the operations of the company in the past and
the future plans of the company.
ii. Debt holders:
Debt holders are interested in the financial statements of the
company, as they want to ensure the payment of their periodic
interest in a timely manner and also the repayment of their debt, as
and when it falls due.
They generally analyze, Debt-equity ratio, Debt service coverage
ratio, current ratio, etc.
iii. Suppliers:
Suppliers of the company use the financial statements to analyze
the financial position of the company, to determine, whether the
company would be able to pay off their dues on time.
Also, suppliers are interested in determining the growth rate of the
operations of the company, so that they can pitch their products
and services accordingly.
Q2. Financial statements are based on generally accepted accounting
principles (GAAP) and are
audited by CPA firms. Do investors need to worry about the validity of those
statements?
Explain your answer.
Financial statements are prepared in accordance to the generally
accepted accounting principles (GAAP), which lays down the methods as to
how an item of the financial statements needs to be treated. It provides
detailed guidance in relation to measurement, recognition and disclosures
for various items of the financial statements.
Further, the financial statements of a corporation are audited by CPA firms,
who ensure compliance to the GAAP applicable on the corporations. These
firms, also in their audit reports, give a reasonable assurance that the
financial statements give a true and fair view of the financial position of the
company.
But, still investors can not rely on the financial statements, without doing
appropriate due diligence. As though financial statements have been
prepared based on GAAP, there could be more than one treatment for an
account balance in the GAAP and the entity, might have chosen the
favorable treatment, for earnings management. Further, auditors wouldn’t
have pointed it out, because, it is within the limitations of GAAP.
In the past, there have been various frauds, earnings management incidents,
mis reporting incidents, in the financial statements of the company, though,
those statements were audited by CPAs and were prepared in accordance to
the generally accepted accounting principles.
Q4. What is free cash flow? If you were an investor, why might you be more
interested in free
cash flow than net income?
A4.
Free cash flow is the amount of cash generated by the company, from its
operations after taking into considerations the amount required for
maintaining the capital assets of the company. Free cash flow doesn’t take
into account the non-cash expenses, such as depreciation, as its
compensated by considering the amount required to maintain the capital
assets.
statements?
Explain your answer.
Financial statements are prepared in accordance to the generally
accepted accounting principles (GAAP), which lays down the methods as to
how an item of the financial statements needs to be treated. It provides
detailed guidance in relation to measurement, recognition and disclosures
for various items of the financial statements.
Further, the financial statements of a corporation are audited by CPA firms,
who ensure compliance to the GAAP applicable on the corporations. These
firms, also in their audit reports, give a reasonable assurance that the
financial statements give a true and fair view of the financial position of the
company.
But, still investors can not rely on the financial statements, without doing
appropriate due diligence. As though financial statements have been
prepared based on GAAP, there could be more than one treatment for an
account balance in the GAAP and the entity, might have chosen the
favorable treatment, for earnings management. Further, auditors wouldn’t
have pointed it out, because, it is within the limitations of GAAP.
In the past, there have been various frauds, earnings management incidents,
mis reporting incidents, in the financial statements of the company, though,
those statements were audited by CPAs and were prepared in accordance to
the generally accepted accounting principles.
Q4. What is free cash flow? If you were an investor, why might you be more
interested in free
cash flow than net income?
A4.
Free cash flow is the amount of cash generated by the company, from its
operations after taking into considerations the amount required for
maintaining the capital assets of the company. Free cash flow doesn’t take
into account the non-cash expenses, such as depreciation, as its
compensated by considering the amount required to maintain the capital
assets.
Free cash flow can be computed through the statement of cash flows for the
company and also through the income statement and statement of financial
position of the company.
As an Investor, I would be more interested in Free cash flow than net income,
because, Free cash flow provides an amount, that is available with the
company, after paying off all the expenses in relation to the operations of
the company and also taking into consideration the amount required for
maintaining the capital assets of the company. Whereas, net income, is an
amount of income earned by the company, net of all the expenses, (cash
and non-cash), it provides an idea about the profitability of the company, but
doesn’t help in understanding the status of cash flows to the company, which
is a very relevant matric.
Q5. Would it be possible for a company to report negative free cash flow and
still be highly
valued by investors; that is, could a negative free cash flow ever be viewed
optimistically
by investors? Explain your answer.
A5.
Free cash flow, as explained above is the amount available with the company, after accounting for, the
operating expenses and the amount required to maintain the capital assets of the company. Negative
free cash flow of a company could be due to various reasons, if the negative free cash flow, is due to the
fact that the cash inflow from operations are not sufficient to cover the cash outflow in operations, then
it is viewed negatively.
Whereas, if the negative free cash flow is driven by the capital investment that the company is planning
to undertake/has undertaken, it will not be looked at negatively, as the company is making investment
in the capital assets, which would be generating a higher level of cash flows from operation, for the
company in future. Thus, a negative free cash flow, cannot always be viewed as a negative indicator, it
depends on the drivers of the free cash flow.
company and also through the income statement and statement of financial
position of the company.
As an Investor, I would be more interested in Free cash flow than net income,
because, Free cash flow provides an amount, that is available with the
company, after paying off all the expenses in relation to the operations of
the company and also taking into consideration the amount required for
maintaining the capital assets of the company. Whereas, net income, is an
amount of income earned by the company, net of all the expenses, (cash
and non-cash), it provides an idea about the profitability of the company, but
doesn’t help in understanding the status of cash flows to the company, which
is a very relevant matric.
Q5. Would it be possible for a company to report negative free cash flow and
still be highly
valued by investors; that is, could a negative free cash flow ever be viewed
optimistically
by investors? Explain your answer.
A5.
Free cash flow, as explained above is the amount available with the company, after accounting for, the
operating expenses and the amount required to maintain the capital assets of the company. Negative
free cash flow of a company could be due to various reasons, if the negative free cash flow, is due to the
fact that the cash inflow from operations are not sufficient to cover the cash outflow in operations, then
it is viewed negatively.
Whereas, if the negative free cash flow is driven by the capital investment that the company is planning
to undertake/has undertaken, it will not be looked at negatively, as the company is making investment
in the capital assets, which would be generating a higher level of cash flows from operation, for the
company in future. Thus, a negative free cash flow, cannot always be viewed as a negative indicator, it
depends on the drivers of the free cash flow.
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