Understanding Financial Statements and Cash Flows by clickmyadspleaseXOXO

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									CHAPTER 3

Understanding Financial Statements and Cash Flows
ANSWERS TO END-OF-CHAPTER QUESTIONS
3-1. a. The balance sheet represents an enumeration of a firm’s resources (assets) along with its liabilities and owners’ equity at a given date. The income statement summarizes the net results of operation of a firm over a specified time interval. The primary distinction between these two statements is that the balance sheet shows the financial condition of a firm at a given date, whereas the income statement deals with the revenues and expenses of the firm incurred during a specified period of time. b. The conventional cash flow statement as prepared by accountants provides the information we need to know about what has happened to the firm’s cash and why. But it does not present it in a way that makes clear the cash flows that are being provided by or contributed to the firm by the lenders and investors. Thus, we choose to reformat the presentation to show the firm’s free cash flows—the cash free to distribute to the investors. We are more interested in considering cash flows from the perspective of the firm’s shareholders and its investors, rather than from an accounting view. We instead measure the cash flow that is available to be distributed to the firm’s investors, both debt and equity investors. Thus, what we use is similar to a conventional cash flow statement presented as part of a company’s financial statements.

3-2.

Gross profit is sales less the cost of producing or acquiring the firm’s product or service. Operating profits is the gross profits less the operating expenses, which consist of distributing the product or service to the customer (namely, marketing expenses) and any general and administrative expenses in operating the business. Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income taxes. Interest expense is the cost of borrowing money from a banker or another lender. There typically is a fixed interest rate so that the interest expense in computed as the interest rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then our interest expense will be $60,000.

3-3.

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While interest is paid for the use of debt capital, dividends are paid to the firm’s stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred stockholder gets a constant dividend each year. Common stockholders, on the other hand, usually receives dividends only if management decides to pay a dividend instead of reinvesting the firm’s profits. However, typically once a dividend has been paid to common stockholders, management is reluctant to decrease it or pass up paying a dividend. 3-4. Once preferred shares are sold, dividends are paid or accrued each year based upon preferred dividends (i.e., the percentage of the preferred stock’s par value paid in dividends) agreed to at the selling date. However, these dividends affect the income statement only. Common stock dividends, which may vary from year to year, also affect the income statement; however, the investment of common shareholders varies with the net addition to (or reduction from) retained earnings from year to year. The net addition to retained earnings equals the difference in the period’s net income and common dividends paid. Thus, the common equity section of the balance sheet (par value of common stock, paid-in capital and retained earnings) varies from year to year due to changes in the retained earnings portion of the firm’s common equity.

3-5.

Net working capital is the firm’s gross working capital (current assets) less its short-term debt. It represents a firm’s investments in short-term assets less its short-term financing. As a business becomes larger, additional amounts of working capital will normally be required.

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3-6.

A firm could have positive cash flows but still be in trouble because it has negative cash flows from operations. The positive cash flows would then be the result of the firm reducing its investments in working capital or long-term assets. Such a situation means that the company is not earning a satisfactory rate of return on its investments. Another company could have very attractive rates of return on its assets but be growing so fast that the large investments in working capital and long-term assets result in negative cash flows. In this latter case, management is simply investing in the future. As quickly as the growth is reduced, positive cash flows will occur. Examining only the income statement and the balance sheet fails to tell us how the firm is using its cash, which is a critical issue for any company. Free cash flows equal the cash flows that are generated by the company that are then distributed to (if positive) or received from (if negative) the firm’s lenders and investors. It looks at cash flows from the firm’s perspective. Financing cash flows looks at the cash flows from the investors’ viewpoint. They indicate how the investor received (paid in) cash, from interest, dividends, lending more or less to the company, or buying or selling stock. But whatever the company does is the exact opposite of what the investor receives or pays. That is, if a company distributes $100 in cash to the investors, then the investors must receive $100 as well. They have to equal.

3-7. 3-8.

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SOLUTIONS TO END-OF-CHAPTER PROBLEMS
3-1. Belmond, Inc. Balance Sheet Year Ending 12/31/2005 ASSETS Current assets Cash Accounts receivable Inventory Total current assets Buildings and equipment Accumulated Depreciation Net buildings and equipment Total assets LIABILITIES AND EQUITY Liabilities Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities Equity Common stock Retained earnings Total equity Total liabilities and equity Belmond, Inc. Income Statement Year Ending 12/31/2005 Sales Cost of goods sold Gross profits General & admin expense Depreciation expense Total operating expense Operating income (EBIT) Interest expense Earnings before taxes Taxes Net income

$16,550 9,600 6,500 $32,650 122,000 34,000 $88,000 $120,650

$

600 4,800 $ 5,400 55,000 $ 60,400 $ 45,000 15,250 $ 60,250 $120,650

$ 12,800 5,750 $ 7,050 $ 850 500 $ 1,350 $ 5,700 900 $ 4,800 1,440 $ 3,360

Net working capital = current assets – current debt = $32,650 - $5,400 = $27,250 Debt ratio = total debt /total assets = $60,400/$120,650 = 0.50 or 50%

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3-2

Free Cash Flows Operating income Depreciation expense Income taxes After-tax cash flows from operations Increase in current assets Increase in current liabilities Increase in networking capital. Change in gross fixed assets* Firm’s Free Cash Flows $75 12 (17) 70 (50) 35 (15) (35) $20

* The change in gross fixed assets is equal to the change in net fixed assets ($23) plus the depreciation expense for the year of $12, resulting in a change in gross fixed assets of $35.

Financing Cash Flows: Interest expense Increase in common stock Dividend Financing Cash Flows ($25) 20 (15) ($20)

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3-3.

Warner Company Balance Sheet 12/31/2005 ASSETS Cash Accounts receivables Inventories Prepaid expenses Total current assets Gross buildings & equipment Accumulated depreciation Net fixed assets Total assets LIABILITIES & EQUITY Liabilities Notes payable Accounts payable Taxes payable Accrued expenses Total current liabilities Long-term debt Total liabilities Equity Common stock Retained earnings Total equity Total liabilities and equity Warner Company Income Statement Year Ending 12/31/2006 Sales Cost of goods sold Gross profits General & admin. expense Depreciation expense Total operating expense Operating income (EBIT) Interest expense Earnings before taxes Taxes Net income $ 573,000 297,000 $ 276,000 $ 79,000 66,000 $ 145,000 $ 131,000 4,750 $ 126,250 50,500 $ 75,750

$ 225,000 153,000 99,300 14,500 $ 491,800 $ 895,000 263,000 632,000 $1,123,800

$

75,000 102,000 53,000 7,900 $ 237,900 334,000 $ 571,900 $ 289,000 262,900 $ 551,900 $1,123,800

Net working capital = current assets – current debt = $491,800 - $237,900 = $253,900 Debt ratio = total debt /total assets = $571,900/$1,123,800 = 0.51or 51%

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3-4.

Westlake Corporation generated a positive cash flow from operations ($855), but even a greater amount was used to invest in additional working capital ($439) and in fixed assets ($1,064), which resulted in a negative free cash flow overall. Thus, the firm required its investors to make up the difference, which they did by loaning money to the company and buying more stock. Free Cash Flows: Operating income Depreciation expense Income taxes After-tax cash flows from operations Increase in current assets Increase in current liabilities Increase in net working capital Increase in gross fixed assets Free Cash Flows Financing Cash Flows: Interest expense Increase in common stock Dividend Financing Cash Flows ($50) 27 (25) ($48) $215 20 (45) $190 ($135) 48 (87) (55) $48

3-5

3-6.

The Maness Corporation had three sources of cash flows that contributed to its distributing money to the investor. It had positive cash flows from operations, and the firm was being downsized by reducing its investments in working capital and fixed assets. Whether it is a good decision to reduce the asset base depends on the rate of return being earned on the assets being released to the firm’s investors. We will learn more about this decision later in our studies of finance.

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3.7.

Pamplin, Inc. Free Cash Flows: Operating income Depreciation Income taxes After-tax cash flows from operations Increase in current assets Increase in current liabilities Decrease in net working capital Increase in gross fixed assets Free Cash Flows Financing Cash Flows: Interest expense Dividend* Financing Cash Flows ($64) (78) ($142) $360 200 (118) $442 $0 100 100 (400) $142

*Note: The dividends were computed by comparing net income to the change in retained earnings. Net income was $178, but retained earnings increased only by $100; thus the balance was distributed in the form of dividends. 3.8. Waterhouse Co. In this problem, we have to take a modified approach to computing after-tax cash flows from operations. Several items have been combined into the operating expenses, specifically, depreciation expense, amortization of goodwill (a non-cash expense similar to depreciation), and interest expense. Most companies when reporting their income separate these out so that we can know how much they are. But occasionally a firm will abbreviate the income presentation as done in this problem. Then the only way to compute after tax cash flows from operations is to begin with net income and add back not only depreciation and goodwill, but also interest expense. However, we do not have to subtract income taxes since they have already been deducted to compute net income. Free Cash Flows : step 1: After-tax cash flows from operations Net income Depreciation expense Amortization of good will Interest expense After-tax cash flows from operations 57

$

$

34,500 34,500 9,000 6,000 84,000

Step 2: Change in net working capital Decrease in current assets Decrease in current debt Decrease in net working capital Step 3: Change in long-term assets Increase in gross fixed assets Free Cash Flows Financing Cash Flows: Decrease in long-term debt (mort. payable) Common stock dividends Increase in preferred stock Interest expense Financing Cash Flows:

$

6,000 (4,500) 1,500

(142,500) ($57,000)

($150,000) (18,000) 231,000 (6,000) $57,000

The firm had negative free cash flows, which means that, in net, it had to receive cash from investors. The negative free cash flows resulted from the large purchase of fixed assets. The company received a large sum of cash from its issuance of preferred stock. 3-9. T.P. Jarmon Free Cash Flows : After-tax cash flows from operations Operating income (EBIT) Depreciation expense Tax expense After-tax cash flows from operations Change in net working capital Increase in current assets Increase in current debt Increase in net working capital Net cash used for investments in long-term assets Free Cash Flows

$80,000 30,000 (27,100) $82,900

($23,100) 6,000 (17,100) (14,000) $51,800

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Financing Cash Flows: Interest expense Decrease in long-term debt Common stock dividends Financing Cash Flows: 3-10. Abrams Manufacturing Abrams Mfg. Company Cash Flows For the Year Ended December 31, 2006: Step 1: After-tax cash flows from operations Operating income (EBIT) Depreciation expense Income taxes After-tax cash flows from operations Step 2: Compute the change in net working capital: Increase in current assets Change in current debt Change in net working capital ($5,000) 0 (5,000) ($10,000) (10,000) (31,800) $51,800

$54,000 26,000 (16,000) $64,000

Step 3: Compute the change in fixed assets and other assets: Purchase of fixed assets Free cash flows (sum of above three steps) Financing Cash Flows: Interest expense Repayment of long-term debt Increase in preferred stock Preferred stock dividends Common stock dividends Financing cash flows

(73,000) ($14,000)

($4,000) (70,000) 120,000 (10,000) (22,000) $14,000

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$ (53,500)

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