Chapter 02 - Reviewing Financial Statements

Unit 2 answers

CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS

Questions

LG1 6. What are the costs and benefits of holding liquid securities on a firm’s balance sheet?

The more liquid assets a firm holds, the less likely the firm will be to experience financial
distress. However, liquid assets generate little or no profits for a firm. For example, cash is
the most liquid of all assets, but it earns little, if any, return for the firm. In contrast, fixed
assets are illiquid, but provide the means to generate revenue. Thus, managers must consider
the trade-off between the advantages of liquidity on the balance sheet and the disadvantages
of having money sit idle rather than generating profits.

LG4 14. Why do financial managers and investors find cash flows to be more important than
accounting profit?

Financial managers and investors are far more interested in actual cash flows than they are in the
somewhat artificial, backward-looking accounting profit listed on the income statement. This is a
very important distinction between the accounting point of view and the finance point of view.
Finance professionals know that the firm needs cash, not accounting profit, to pay the firm’s
obligations as they come due, to fund the firm’s operations and growth, and to compensate the
firm’s ultimate owners: its shareholders. Thus, the statement of cash flows is a financial statement
that shows the firm’s cash flows over a given period of time. This statement reports the amounts
of cash that the firm generated and distributed during a particular time period.

Problems

LG2-5 2-13 Free Cash Flow You are considering an investment in Fields and Struthers, Inc., and
want to evaluate the firm’s free cash flow. From the income statement, you see that Fields
and Struthers earned an EBIT of $62 million, had a tax rate of 30 percent, and its
depreciation expense was $5 million. Fields and Struthers’ gross fixed assets increased by
$32 million from 2020 to 2020. The firm’s current assets increased by $20 million and
spontaneous current liabilities increased by $12 million. Calculate Fields and Struthers’
NOPAT, operating cash flow, investment in operating capital, and free cash flow for 2021.
b was:
Fields and Struthers’ NOPAT
NOPAT = EBIT(1 – Tax rate) = $62m.(1 – 0.21) = $48.98m.

Operating cash flow for 2021 was:

OCF = NOPAT + Depreciation
= $48.98m. + $5m. = $53.98m.

b
Investment in operating capital for 2021 was:
IOC = ΔGross fixed assets + ΔNet operating working capital
= $32m. + ($20m. - $12m.) = $40 m.

Accordingly, Fields and Struthers’ free cash flow for 2021 was:
FCF = Operating cash flow – Investment in operating capital
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 Chapter 02 - Reviewing Financial Statements

= $53.98m. - $40m. = $13.98m.

In other words, in 2021, Fields and Struthers had cash flows of $13.98 million available to pay its stockholders
and debtholders.

CHAPTER 3 – ANALYZING FINANCIAL STATEMENTS

Questions

LG1-LG5 1. Classify each of the following ratios according to a ratio category (liquidity ratio, asset
management ratio, debt management ratio, profitability ratio, or market value ratio).

a. Current ratio – Liquidity ratio

b. Inventory turnover – Asset management ratio
c. Return on assets – Profitability ratio
d. Average payment period – Asset management ratio
e. Times interest earned – Debt management ratio
f. Capital intensity – Asset management ratio
g. Equity multiplier – Debt management ratio
h. Basic earnings power – Profitability ratio

LG1 2. For each of the following actions, determine what would happen to the current ratio. Assume
nothing else on the balance sheet changes and that net working capital is positive.

a. Accounts receivable are paid in cash – Current ratio does not change
b. Notes payable are paid off with cash – Current ratio increases
c. Inventory is sold on account – Current ratio does not change
d. Inventory is purchased on account– Current ratio decreases
e. Accrued wages and taxes increase – Current ratio decreases
f. Long-term debt is paid with cash – Current ratio decreases
g. Cash from a short-term bank loan is received – Current ratio decreases

Problems

LG6 3-26 DuPont Analysis You are considering investing in Nuran Security Services. You have been
able to locate the following information on the firm: total assets are $24 million, accounts
receivable are $3.3 million, ACP is 25 days, net income is $3.5 million, and debt-to-equity is 1.2
times. Calculate the ROE for the firm.

Debt-to-equity
Vb = 1.2 = Total debt / Total equity = Total debt / (Total assets – Total debt)
1.2 = Total debt / ($24m – Total debt) => (1.2 x $24m) – 1.2 x Total debt = Total debt
=> $28.8m = 2.2 x Total debt => Total debt = $28.8m / 2.2 = $13.091m
=> Total equity = $24m – $13.091m = $10.909m
=> ROE = $3.5m / $10.909m = 32.08 percent
Vb

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Chapter 02 - Reviewing Financial Statements

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