Financial Statements, Cash Flow, and Taxes
Answers to End-of-Chapter Questions
The four financial statements contained in most annual reports are the balance sheet, income statement, statement of
stockholders’ equity, and statement of cash flows.
Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or in which
to invest, managers need financial statements to operate their businesses efficiently, and taxing authorities need them to
taxes in a reasonable way.
No, because the $20 million of retained earnings would probably not be held as cash.
The retained earnings figure
represents the reinvestment of earnings by the firm.
Consequently, the $20 million would be an investment in all of the
The balance sheet shows the firm’s financial position on a specific date, for example, December 31, 2008.
It shows each
account balance at that particular point in time.
For example, the cash account shown on the balance sheet would represent
the cash the firm has on hand and in the bank on December 31, 2008.
The income statement, on the other hand, reports on
the firm’s operations over a period of time, for example, over the last 12 months.
It reports revenues and expenses that the
firm has incurred over that particular time period.
For example, the sales figures reported on the income statement for the
period ending December 31, 2008, would represent the firm’s sales over the period from January 1, 2008, through
December 31, 2008, not just sales for December 31, 2008.
Investors need to be cautious when they review financial statements.
While companies are required to follow GAAP,
managers still have quite a lot of discretion in deciding how and when to report certain transactions.
firms in exactly the same operating situation may report financial statements that convey different impressions about their
Some variations may stem from legitimate differences of opinion about the correct way to record
In other cases, managers may choose to report numbers in a way that helps them present either higher
earnings or more stable earnings over time.
As long as they follow GAAP, such actions are not illegal, but these
differences make it harder for investors to compare companies and gauge their true performances.
Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent statements.
Indeed, a number of high-profile executives have faced criminal charges because of their misleading accounting practices.
Free cash flow is the amount of cash that could be withdrawn from the firm without harming its ability to operate and to
produce future cash flows.
It is calculated as after-tax operating income plus depreciation less capital expenditures and the
change in net working capital.
It is more important than net income because it shows the exact amount available to all