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Chapter 2 - Reviewing Financial Statements
CHAPTER 2 – REVIEWING FINANCIAL STATEMENTS
questions
LG2-1 1. List and describe the four major financial statements.
The four basic financial statements are:
1. The balance sheet reports a firm’s assets, liabilities, and equity at a particular point in time.
2. The income statement shows the total revenues that a firm earns and the total expenses the
firm incurs to generate those revenues over a specific period of time—generally one year.
3. The statement of cash flows shows the firm’s cash flows over a given period of time. This
statement reports the amounts of cash the firm generated and distributed during a particular time
period. The bottom line on the statement of cash flows―the difference between cash sources and
uses―equals the change in cash and marketable securities on the firm’s balance sheet from the
previous year’s balance.
4. The statement of retained earnings provides additional details about changes in retained
earnings during a reporting period. This financial statement reconciles net income earned during
a given period minus any cash dividends paid within that period to the change in retained
earnings between the beginning and ending of the period.
LG2-1 2. On which of the four major financial statements (balance sheet, income statement, statement of
cash flows, or statement of retained earnings) would you find the following items?
a. earnings before taxes - income statement
b. net plant and equipment - balance sheet
c. increase in fixed assets - statement of cash flows
d. gross profits - income statement
e. balance of retained earnings, December 31, 20xx - statement of retained earnings and balance sheet
f. common stock and paid-in surplus - balance sheet
g. net cash flow from investing activities - statement of cash flows
h. accrued wages and taxes – balance sheet
i. increase in inventory - statement of cash flows
LG2-1 3. What is the difference between current liabilities and long-term debt?
Current liabilities constitute the firm’s obligations due within one year, including accrued wages and
taxes, accounts payable, and notes payable. Long-term debt includes long-term loans and bonds with
maturities of more than one year.
LG2-1 4. How does the choice of accounting method used to record fixed asset depreciation affect
management of the balance sheet?
Firm managers can choose the accounting method they use to record depreciation against their
fixed assets. Two choices include the straight-line method and the modified accelerated cost
recovery system (MACRS). Companies often calculate depreciation using MACRS when they
figure the firm’s taxes and the straight-line method when reporting income to the firm’s

Chapter 2 - Reviewing Financial Statements
stockholders. The MACRS method accelerates deprecation, which results in higher depreciation
expenses, lower taxable income, and lower taxes in the early years of a project’s life. The
straight-line method results in lower depreciation expenses, but also results in higher taxes in the
early years of a project’s life. Firms seeking to lower their cash outflows from tax payments will
favor the MACRS depreciation method.
LG2-1 5. What is bonus depreciation? How did the Tax Cuts and Jobs Act of 2017 temporarily extend
and modify bonus depreciation?
Since 2001, businesses have had the ability to immediately deduct a percentage of the acquisition
cost of qualifying assets as "bonus depreciation." This additional depreciation deduction was
allowed to encourage business investment. However, bonus depreciation was a temporary
provision; the rate would have been 50 percent in 2017, 40 percent in 2018, and 30 percent in
2019, before phasing out in 2020. The Tax Cuts and Jobs Act of 2017 extended and modified
bonus depreciation, allowing businesses to immediately deduct 100 percent of the cost of eligible
property in the year it is placed in service, through 2022. The amount of allowable bonus
depreciation will then be phased down over four years: 80 percent will be allowed for property
placed in service in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026.
MACRS or straight-line depreciation is applied to any costs that do not qualify for bonus
depreciation.
LG2-1 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.
LG2-2 7. Why can the book value and market value of a firm differ?
A firm’s balance sheet shows its book (or historical cost) value based on Generally Accepted
Accounting Principles (GAAP). Under GAAP, assets appear on the balance sheet at what the
firm paid for them, regardless of what assets might be worth today if the firm were to sell them.
Inflation and market forces make many assets worth more now than they were when the firm
bought them. So in most cases, book values differ widely from the market values for the same
assets—the amount that the assets would fetch if the firm actually sold them. For the firm’s
current assets—those that mature within a year―the book value and market value of any
particular asset will remain very close. For example, the balance sheet lists cash and marketable
securities at their market value. Similarly, firms acquire accounts receivable and inventory and
then convert these short-term assets into cash fairly quickly, so the book value of these assets is
generally close to their market value.
LG2-2 8. From a firm manager’s or investor’s point of view, which is more important―the book value of a
firm or the market value of the firm?

Chapter 2 - Reviewing Financial Statements
Balance sheet assets are listed at historical cost. Managers would thus see little relation between the
total asset value listed on the balance sheet and the current market value of the firm’s assets.
Similarly, the stockowners’ equity listed on the balance sheet generally differs from the true market
value of the equity—in this case, the market value may be higher or lower than the value listed on the
firm’s accounting books. So, financial managers and investors often find that balance sheet values are
not always the most relevant numbers.
LG2-3 9. How did the Tax Cuts and Jobs Act of 2017 change corporate tax laws?
The Tax Cuts and Jobs Act (TCJA) of 2017 is the most recent revision of corporate tax laws and
represents one of the most significant changes in more than 30 years. The Act permanently lowers
corporate taxes from a progressive schedule that saw tax rates as high as 35 percent to a flat 21
percent starting in 2018.
LG2-3 10. What is the difference between an average tax rate and a marginal tax rate?
A firm can figure the average tax rate as the percentage of each dollar of taxable income that the
firm pays in taxes. From your economics classes, you can probably guess that the firm’s marginal
tax rate is the amount of additional taxes a firm must pay out for every additional dollar of
taxable income it earns.
LG2-3 11. How did the Tax Cuts and Jobs Act of 2017 change the tax deductibility of corporate
interest in debt?
The Tax Cuts and Jobs Act of 2017 contains a new limitation on the deductibility of net interest
expense (interest expense minus interest income) that exceeds 30 percent of a firm’s “adjusted
taxable income” starting in 2018. For tax years beginning before January 1, 2022, “adjusted taxable
income” is measured as a business’ EBITDA. For subsequent tax years, “adjusted taxable income” is
measured as EBIT, no longer including an add-back for depreciation and amortization. Thus,
beginning in 2022, the new limitation will become more severe. Prior corporate tax laws generally
allowed full deduction of interest paid or accrued by businesses.
LG2-3 12. How does the payment of interest on debt affect the amount of taxes the firm must pay?
Corporate interest payments appear on the balance sheet as an expense item, so we deduct the
allowable portion of interest payments from operating income when the firm calculates taxable
income. But, any dividends paid by corporations to their shareholders are not tax deductible. This is
one factor that encourages managers to finance projects with debt financing rather than to sell more
stock. Suppose one firm uses mainly debt financing and another firm, with identical operations, uses
mainly equity financing. The equity-financed firm will have very little interest expense to deduct for
tax purposes. Thus, it will have higher taxable income and pay more taxes than the debt-financed
firm. The debt-financed firm will pay fewer taxes and be able to pay more of its operating income to
asset funders, i.e., its bondholders and stockholders. So, as long as interest on debt is under the 30
percent allowable cap for tax deduction, even stockholders prefer that firms finance assets primarily
with debt rather than with stock.

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Chapter 2 - Reviewing Financial Statements
LG2-4 13. The income statement is prepared using GAAP. How does this affect the reported revenue and
expense measures listed on the balance sheet?
Company accountants must prepare firm income statements following GAAP principles. GAAP
procedures require that the firm recognize revenue at the time of sale, but sometimes the
company receives the cash before or after the time of sale. Likewise, GAAP counsels the firm to
show production and other expenses on the balance sheet as the sales of those goods take place.
So production and other expenses associated with a particular product’s sale only appear on the
income statement (for example, cost of goods sold and depreciation) when that product sells. Of
course, just as with the revenue recognition, actual cash outflows incurred with production may
occur at a very different point in time—usually much earlier than GAAP principles allow the
firm to formally recognize the expenses. Further, income statements contain several non-cash
entries, the largest of which is depreciation. Depreciation attempts to capture the non-cash
expense incurred as fixed assets deteriorate from the time of purchase to the point when those
assets must be replaced. Let’s illustrate the effect of depreciation: Suppose a firm purchases a
machine for $100,000. The machine has an expected life of five years and at the end of those five
years, the machine will have no expected salvage value. The firm lays out a $100,000 cash
outflow at the time of purchase. But the entire $100,000 does not appear on the income statement
in the year that the firm purchases the machine—in accounting terms, the machine is not
expensed in the year of purchase. Rather, if the firm’s accounting department uses the straight-
line depreciation method, it deducts only $100,000/5, or $20,000, each year as an expense. This
$20,000 equipment expense is not a cash outflow for the firm. The person in charge of buying the
machine knows that the cash flow occurred at the time of purchase—and it totaled $100,000
rather than $20,000. So, figures shown on an income statement may not represent the actual cash
inflows and outflows for a firm during a particular period.
LG2-4 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.
LG2-5 15. Which of the following activities result in an increase (decrease) in a firm’s cash?
a. Decrease fixed assets – increase in cash
b. Decrease accounts payable – decrease in cash
c. Pay dividends – decrease in cash
d. Sell common stock – increase in cash
e. Decrease accounts receivable – increase in cash

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Chapter 2 - Reviewing Financial Statements
f. Increase notes payable – increase in cash
LG2-5 16. What is the difference between cash flows from operating activities, cash flows from investing
activities, and cash flows from financing activities?
Cash flows from operations are those cash inflows and outflows that result directly from
producing and selling the firm’s products. These cash flows include: net income, depreciation,
and working capital accounts other than cash and operations-related short-term debt. Cash flows
from investing activities are cash flows associated with buying or selling of fixed or other long-
term assets. This section of the statement of cash flows shows cash inflows and outflows from
long-term investing activities—most significantly the firm’s investment in fixed assets. Cash
flows from financing activities are cash flows that result from debt and equity financing
transactions. These include raising cash by: issuing short-term debt, issuing long-term debt,
issuing stock, using cash to pay dividends, using cash to pay off debt, and using cash to buy back
stock.
LG2-5 17. What are free cash flows for a firm? What does it mean when a firm’s free cash flow is negative?
Free cash flows are the cash flows available to pay the firm’s stockholders and debtholders after the
firm has made the necessary working capital investments, fixed asset investments, and developed the
necessary new products to sustain the firm’s ongoing operations. If free cash flow is negative, the
firm's operations produce no cash flows available for investors.
LG2-6 18. What is earnings management?
Managers and financial analysts have recognized for years that firms use considerable latitude in
using accounting rules to manage their reported earnings in a wide variety of contexts. Indeed,
within the GAAP framework, firms can “smooth” earnings. That is, firms often take steps to
over- or understate earnings at various times. Managers may choose to smooth earnings to show
investors that firm assets are growing steadily. Similarly, one firm may be using straight-line
depreciation for its fixed assets, while another is using a modified accelerated cost recovery
method (MACRS), which causes depreciation to accrue quickly. If the firm uses MACRS
accounting methods, its managers write fixed asset values down quickly; assets will thus have
lower book value than if the firm used straight line depreciation methods. This process of
controlling a firm’s earnings is called earnings management.
LG2-6 19. What does the Sarbanes-Oxley Act require of firm managers?
The Sarbanes-Oxley Act, passed in June 2002, requires public companies to ensure that their
corporate boards’ audit committees have considerable experience applying generally accepted
accounting principles (GAAP) for financial statements. The Act also requires that any firm’s senior
management must sign off on the financial statements of the firm, certifying the statements as
accurate and representative of the firm’s financial condition during the period covered. If a firm’s
board of directors or senior managers fails to comply with Sarbanes-Oxley (SOX), the firm may be
delisted from stock exchanges.

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Chapter 2 - Reviewing Financial Statements
problems
basic 2-1 Balance Sheet You are evaluating the balance sheet for Goodman’s Bees Corporation.
problems From the balance sheet you find the following balances: cash and marketable securities =
LG2-1 $400,000, accounts receivable = $1,200,000, inventory = $2,100,000, accrued wages and taxes =
$500,000, accounts payable = $800,000, and notes payable = $600,000. Calculate Goodman Bees’
net working capital.
Net working capital = Current assets - Current liabilities.
Goodman’s Bees’ current assets =
Cash and marketable securities = $400,000
Accounts receivable = 1,200,000
Inventory = 2,100,000
Total current assets $3,700,000
and current liabilities =
Accrued wages and taxes = $500,000
Accounts payable = 800,000
Notes payable = 600,000
Total current liabilities $1,900,000
So the firm’s net working capital was $1,800,000 ($3,700,000 - $1,900,000).
LG2-1 2-2 Balance Sheet Casello Mowing & Landscaping’s year-end 2021 balance sheet lists current
assets of $435,200, fixed assets of $550,800, current liabilities of $416,600, and long-term debt of
$314,500. Calculate Casello’s total stockholders’ equity.
Recall the balance sheet identity in Equation 2-1: Assets = Liabilities + Equity. Rearranging this equation: Equity =
Assets – Liabilities. Thus, the balance sheets would appear as follows:
Book value Book value
Assets Liabilities and Equity
Current assets $ 435,200 Current liabilities $ 416,600
Fixed assets 550,800 Long-term debt 314,500
Stockholders’ equity 254,900
Total $ 986,000 Total $ 986,000
LG2-1 2-3 Income Statement The Fitness Studio, Inc.’s 2021 income statement lists the following income
and expenses: EBITDA = $650,000, EBIT = $538,000, interest expense = $63,000, and net income =
$435,000. Calculate the 2021 taxes reported on the income statement.
With $650,000 of EBITDA, The Fitness Studio is allowed to deduct $195,000 ($650,000 x 30 percent) in net interest
expense. The recorded interest expense of $63,000 is under this limit and is thus all tax deductible.
EBIT $538,000
Interest expense -63,000
EBT $ 475,000

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Chapter 2 - Reviewing Financial Statements
Taxes -40,000
Net income $435,000
LG2-1 2-4 Income Statement The Fitness Studio, Inc.’s 2021 income statement lists the following income
and expenses: EBITDA = $923,000, EBIT = $773,500, interest expense = $100,000, and taxes =
$234,500. The firm has no preferred stock outstanding and 100,000 shares of common stock
outstanding. Calculate the 2018 earnings per share.
With $923,000 of EBITDA, The Fitness Studio is allowed to deduct $276,900 ($923,000 x 30 percent) in net interest
expense. The recorded interest expense of $100,000 is under this limit and is thus all tax deductible.
EBIT $773,500
Interest expense -100,000
EBT $ 673,500
Taxes -234,500
Net income $439,000
Thus,
$439,000
Earnings per share (EPS) = —————— = $4.39 per share
100,000 shares
LG2-1 2-5 Income Statement Consider a firm with an EBIT of $850,000. The firm finances its assets
with $2,500,000 debt (costing 7.5 percent and is all tax deductible) and 400,000 shares of stock
selling at $5.00 per share. To reduce firm’s risk associated with this financial leverage, the firm
is considering reducing its debt by $1,000,000 by selling an additional 200,000 shares of stock.
The firm’s tax rate is 21 percent. The change in capital structure will have no effect on the
operations of the firm. Thus, EBIT will remain at $850,000. Calculate the change in the firm’s
EPS from this change in capital structure.
The EPS before and after this change in capital structure is illustrated below:
Before capital structure change After capital structure change
EBIT $850,000 $850,000
Less: Interest ($2,500,000 x 0.075) 187,500 ($1,500,000 x 0.075) 112,500
EBT 662,500 737,500
Less: Taxes (21%) 139,125 154,875
Net income $523,375 $582,625
Divide by # of shares 400,000 600,000
EPS $1.3084 $0.9710
The change in capital structure would decrease the stockholders EPS by $0.3374.
LG2-1 2-6 Income Statement Consider a firm with an EBIT of $550,000. The firm finances its assets
with $1,000,000 debt (costing 5.5 percent and is all tax deductible) and 200,000 shares of stock
selling at $12.00 per share. The firm is considering increasing its debt by $900,000, using the
proceeds to buy back 75,000 shares of stock. The firm’s tax rate is 21 percent. The change in
capital structure will have no effect on the operations of the firm. Thus, EBIT will remain at
$550,000. Calculate the change in the firm’s EPS from this change in capital structure.

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Chapter 2 - Reviewing Financial Statements
The EPS before and after this change in capital structure is illustrated below:
Before capital structure change After capital structure change
EBIT $550,000 $550,000
Less: Interest ($1,000,000 x 0.055) 55,000 ($1,900,000 x 0.055) 104,500
EBT 495,000 445,500
Less: Taxes (21%) 103,950 93,555
Net income $391,050 $351,945
Divide by # of shares 200,000 125,000
EPS $1.9552 $2.8156
The change in capital structure increases the stockholders EPS by $0.8604.
LG2-3 2-7 Corporate Taxes Oakdale Fashions, Inc., 2021 Income Statement is reported below.
2021
Net sales (all credit) $565,000
Less: Cost of goods sold 215,000
Gross profits 350,000
Less: Other operating expenses 90,000
Earnings before interest, taxes, depreciation, and amortization (EBITDA) 260,000
Less: Depreciation and amortization 15,000
Earnings before interest and taxes (EBIT) 245,000
Less: Interest 80,000
Earnings before taxes (EBT) 165,000
Less: Taxes
Net income $
Determine the firm’s 2021 tax liability, net income, average tax rate, and marginal tax rate.
(LG2-3)
With $260,000 of EBITDA, Oakdale Fashions is allowed to deduct only $78,000 ($260,000 x 30 percent) of its
$80,000 in net interest expense. Thus,
Taxable income = EBIT – Allowable interest deduction
= $245,000 - $78,000 = $167,000
Tax liability = 0.21x Taxable income
= 0.21($167,000) = $35,070
The 30 percent cap on the allowable interest deduction results in an increase in Oakdale Fashions’ tax liability of
$420 (0.21($80,000 - $78,000)).
Net income = EBT – Tax liability
= $165,000 - $35,070 = $129,930
The average tax rate for Oakdale Fashions Inc. comes to:
$35,070
Average tax rate = ———— = 21.00%
$167,000

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Chapter 2 - Reviewing Financial Statements
If Oakdale Fashions, Inc. earned $1 more of taxable income, it would pay 21 cents (its tax rate of 21 percent) more in
taxes. Thus, the firm’s marginal tax rate is 21 percent.
LG2-3 2-8 Corporate Taxes Everybody’s Fitness 2021 Income Statement is reported below (in
millions of dollars).
2021
Net sales (all credit) $885
Less: Cost of goods sold 440
Gross profits 445
Less: Other operating expenses 215
Earnings before interest, taxes, depreciation, and amortization (EBITDA) 230
Less: Depreciation and amortization 52
Earnings before interest and taxes (EBIT) 178
Less: Interest 75
Earnings before taxes (EBT) 103
Less: Taxes
Net income $
Determine the firm’s 2021 tax liability, net income, average tax rate, and marginal tax rate.
(LG2-3)
With $230,000,000 of EBITDA, Everybody’s Fitness is allowed to deduct only $69,000,000 ($230,000,000 x 30
percent) of its $75,000,000 in net interest expense. Thus,
Taxable income = EBIT – Allowable interest deduction
= $178,000,000 - $69,000,000 = $109,000,000
Tax liability = 0.21x Taxable income
= 0.21($109,000,000) = $22,890,000
The 30 percent cap on the allowable interest deduction results in an increase in Everybody’s Fitness’ tax liability of
$1,260,000 (0.21($75,000,000 - $69,000,000)).
Net income = EBT – Tax liability
= $103,000,000 - $22,890,000 = $80,110,000
The average tax rate for Everybody’s Fitness comes to:
$22,890,000
Average tax rate = —————— = 21.00%
$109,000,000
If Oakdale Fashions, Inc. earned $1 more of taxable income, it would pay 21 cents (its tax rate of 21 percent) more in
taxes. Thus, the firm’s marginal tax rate is 21 percent.
LG2-3 2-9 Corporate Taxes Hunt Taxidermy, Inc., is concerned about the taxes paid by the company
in 2021. In addition to $42.4 million of taxable income, the firm received $2,975,000 of interest

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Chapter 2 - Reviewing Financial Statements
on state-issued bonds and $1,000,000 of dividends on common stock it owns in Oakdale
Fashions, Inc. Calculate Hunt Taxidermy’s tax liability, average tax rate, and marginal tax rate.
In this case, interest on the state-issued bonds is not taxable and should not be included in taxable income. Further,
the first 50 percent of the dividends received from Oakdale Fashions is not taxable. Thus, only 50 percent of the
dividends received are taxed, so:
Taxable income = $42,400,000 + (0.5)$1,000,000 = $42,900,000
Now Hunt Taxidermy’s tax liability will be:
Tax liability = 0.21 ($42,900,000) = $9,009,000
The $1,000,000 of dividend income increased Hunt Taxidermy’s tax liability by $105,000 (0.5 x $1,000,000 x 0.21).
Hunt Taxidermy’s resulting average tax rate is:
Average tax rage = $9,009,000/$42,900,000 = 21.00%
Finally, if Hunt Taxidermy earned $1 more of taxable income, it would pay 21 cents (based upon its tax rate of 21
percent) more in taxes. Thus, the firm’s marginal tax rate is 21 percent.
LG2-3 2-10 Corporate Taxes Chapman & Power Inc., is concerned about the taxes paid by the
company in 2021. In addition to $135,000,000 of taxable income, the firm received $15,500,000
of interest on state-issued bonds and $12,000,000 of dividends on common stock it owns in Hunt
Taxidermy. Calculate Chapman & Power’s tax liability, average tax rate, and marginal tax rate.
In this case, interest on the state-issued bonds is not taxable and should not be included in taxable income. Further,
the first 50 percent of the dividends received from Hunt Taxidermy is not taxable. Thus, only 50 percent of the
dividends received are taxed, so:
Taxable income = $135,000,000 + (0.5)$12,000,000 = $141,000,000
Now Hunt Taxidermy’s tax liability will be:
Tax liability = 0.21 ($141,000,000) = $29,610,000
The $12,000,000 of dividend income increased Chapman & Power’s tax liability by $1,260,000 (0.5 x $12,000,000 x
0.21). Hunt Taxidermy’s resulting average tax rate is:
Average tax rage = $29,610,000/$141,000,000 = 21.00%
Finally, if Chapman & Power earned $1 more of taxable income, it would pay 21 cents (based upon its tax rate of 21
percent) more in taxes. Thus, the firm’s marginal tax rate is 21 percent.
LG2-4 2-11 Statement of Cash Flows Ramakrishnan Inc. reported 2021 net income of $15 million and
depreciation of $2,650,000. The top part of Ramakrishnan, Inc.’s 2021 and 2020 balance sheets is
listed below (in millions of dollars).
Current assets: 2021 2020 Current liabilities: 2021 2020
Cash and marketable Accrued wages and
securities $ 20 $ 15 taxes $ 19 $ 18
Accounts receivable 84 75 Accounts payable 51 45
Inventory 121 110 Notes payable 45 40

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Chapter 2 - Reviewing Financial Statements
Total $225 $200 Total $115 $103
Calculate the 2021 net cash flow from operating activities for Ramakrishnan, Inc.
Cash Flows from Operating Activities
Net income $15,000,000
Additions (sources of cash):
Depreciation 2,650,000
Increase in accrued wages and taxes 1,000,000
Increase in accounts payable 6,000,000
Subtractions (uses of cash):
Increase in accounts receivable -9,000,000
Increase in inventory -11,000,000
Net cash flow from operating activities: $4,650,000
LG2-4 2-12 Statement of Cash Flows In 2021, Usher Sports Shop had cash flows from investing activities
of -$4,364,000 and cash flows from financing activities of -$5,880,000. The balance in the firm’s
cash account was $1,615,000 at the beginning of 2021 and $1,742,000 at the end of the year.
Calculate Usher Sports Shop’s cash flow from operations for 2021.
Net change in cash and marketable securities = $1,742,000 - $1,615,000 = $127,000
Cash flows from operating activities = $10,371,000
Cash flows from investing activities = - 4,364,000
Cash flows from financing activities = - 5,880,000
Net change in cash and marketable securities = $127,000
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.
Fields and Struthers’ NOPAT was:
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.
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
= $53.98m. - $40m. = $13.98m.

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Chapter 2 - Reviewing Financial Statements
In other words, in 2021, Fields and Struthers had cash flows of $13.98 million available to pay its stockholders and
debtholders.
LG2-5 2-14 Free Cash Flow Tater and Pepper Corp. reported free cash flows for 2021 of $39.1 million and
investment in operating capital of $22.1 million. Tater and Pepper incurred $13.6 million in
depreciation expense and paid $28.9 million in taxes on EBIT in 2021. Calculate Tater and Pepper’s
2021 EBIT.
Tater and Pepper’s free cash flow for 2021 was:
FCF = Operating cash flow – Investment in operating capital
$39.1m. = Operating cash flow - $22.1m.
So, operating cash flow = $39.1m. + $22.1m. = $61.2m.
Tater and Pepper’s operating cash flow was:
OCF = EBIT(1 – Tax rate) + Depreciation = EBIT – Taxes on EBIT + Depreciation
$61.2m. = EBIT – $28.9m. + $13.6m.
So, EBIT = $61.2m. + $28.9m. - $13.6m. = $76.5m.
LG2-1 2-15 Statement of Retained Earnings Mr. Husker’s Tuxedos, Corp. began the year 2021 with $256
million in retained earnings. The firm earned net income of $33 million in 2021 and paid dividends of
$5 million to its preferred stockholders and $10 million to its common stockholders. What is the year-
end 2021 balance in retained earnings for Mr. Husker’s Tuxedos?
The statement of retained earnings for 2021 is as follows:
Balance of retained earnings, December 31, 2020 $256m.
Plus: Net income for 2021 33m.
Less: Cash dividends paid
Preferred stock $5m.
Common stock 10m.
Total cash dividends paid 15m.
Balance of retained earnings, December 31, 2021 $274m.
LG2-1 2-16 Statement of Retained Earnings Use the following information to find dividends paid to
common stockholders during 2021.
Balance of retained earnings, December 31, 2020 $462m.
Plus: Net income for 2021 15m.
Less: Cash dividends paid
Preferred stock $1m.
Common stock _6m.
Total cash dividends paid 7m.
Balance of retained earnings, December 31, 2021 $470m.
Total cash dividends paid = $470m. - $15m. - $462m. = -$7m. Thus, common stock dividends paid = $7m. - $1m = $6m.
intermediate 2-17 Balance Sheet Mikey’s Bar and Grill has total assets of $15 million of which $5 million

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problems are current assets. Cash makes up 10 percent of the current assets and accounts receivable makes up
another 40 percent of current assets. Mikey’s gross plant and equipment has a book value of $11.5
million and other long-term assets have a book value of $500,000. Using this information, what is the
LG2-1 balance of inventory and the balance of depreciation on Mikey’s Bar and Grill’s balance sheet?
Current assets: (in millions)
Cash and marketable
securities $ 0.5 (0.1 x $5)
Accounts receivable 2.0 (0.4 x $5)
Inventory step 1. 2.5 ($5 - $0.5 - $2.0)
Total $5.0
Fixed assets:
Gross plant and
equipment $11.5
Less: Depreciation step 4. 2.0 ($11.5 - $9.5)
Net plant and
equipment step 3. $9.5 ($10.0 - $0.5)
Other long-term
assets 0.5
Total step 2. $10.0 ($15.0 - $5.0)
Total assets $15.0
LG2-1 2-18 Balance Sheet Sophie’s Tobacco Shop has total assets of $91.8 million. Fifty percent of these
assets are financed with debt of which $28.9 million is current liabilities. The firm has no preferred
stock, but the balance in common stock and paid-in surplus is $20.4 million. Using this information
what is the balance for long-term debt and retained earnings on Sophie’s Tobacco Shop’s balance
sheet? (in millions)
Total current liabilities $28.9
Long-term debt: step 3. 17.0 (= $45.9 - $28.9)
Total debt: step 2. $45.9 (= 0.5 x $91.8)
Stockholders’ equity:
Preferred stock $ 0.0
Common stock and
paid-in surplus 20.4
(20 million shares)
Retained earnings step 5. 25.5 (= $45.9 - $20.4)
Total step 4 $45.9 (= $91.8 - $45.9)
Total liabilities and equity step 1. $91.8 (= Total Assets)
LG2-2 2-19 Market Value versus Book Value Muffin’s Masonry, Inc’s balance sheet lists net fixed asset
as $14 million. The fixed assets could currently be sold for $19 million. Muffin’s current balance
sheet shows current liabilities of $5.5 million and net working capital of $4.5 million. If all the
current accounts were liquidated today, the company would receive $7.25 million cash after paying
the $5.5 million in current liabilities. What is the book value of Muffin’s Masonry’s assets today?
What is the market value of these assets?

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BOOK MARKET
VALUE VALUE
Assets
Current assets Step 1. $10m. Step 3. $12.75m.
Fixed assets 14m. 19.00m.
Total Step 2. $24m. Step 4. $31.75m.
Step 1. Net working capital (book value) = Current assets (book value) – Current liabilities (book value)
= $4.5m. = Current assets (book value) - $5.5m. => Current assets (book value) = $4.5m. + $5.5m. = $10m.
Step 2. Total assets (book value) = $10m. + $14m. = $24m.
Step 3. Net working capital (market value) = Current assets (market value) – Current liabilities (market value)
= $7.25m. = Current assets (market value) - $5.5m. => Current assets (market value) = $7.25m. + $5.5m. = $12.75m.
Step 4. Total assets (market value) = $12.75m. + $19m. = $31.75m.
LG2-2 2-20 Market Value versus Book Value Ava’s SpinBall Corp. lists fixed assets of $12 million
on its balance sheet. The firm’s fixed assets have recently been appraised at $16 million. Ava’s
SpinBall Corp.’s balance sheet also lists current assets at $5 million. Current assets were
appraised at $6 million. Current liabilities’ book and market values stand at $3 million and the
firm’s book and market values of long-term debt are $7 million. Calculate the book and market
values of the firm’s stockholders’ equity. Construct the book value and market value balance
sheets for Ava’s SpinBall Corp. (LG2)
Recall the balance sheet identity in Equation 2-1: Assets = Liabilities + Equity. Rearranging this equation: Equity =
Assets – Liabilities. Thus, the balance sheets would appear as follows:
BOOK MARKET BOOK MARKET
VALUE VALUE VALUE VALUE
Assets Liabilities and Equity
Current assets $ 5m. $ 6m. Current liabilities $ 3m. $ 3m.
Fixed assets 12m. 16m. Long-term debt 7m. 7m.
Stockholders’ equity 7m. 12m.
Total $17m. $22m. Total $17m. $22m.
LG2-1 2-21 Debt versus Equity Financing You are considering a stock investment in one of two firms
(NoEquity, Inc., and NoDebt, Inc.), both of which operate in the same industry and have
identical EBITDA of $37.7 million and operating income of $32.5 million. NoEquity, Inc.,
finances its $65 million in assets with $64 million in debt (on which it pays 10 percent interest
annually) and $1 million in equity. NoDebt, Inc., finances its $65 million in assets with no debt
and $65 million in equity. Both firms pay a tax rate of 21 percent on their taxable income.
Calculate the net income and return on asset-funders’ investment for the two firms.
With $37.7 million of EBITDA AllDebt Inc., may deduct up to $11.31 million ($37.7 x 30 percent) of interest
expense for tax purposes. Thus, AllDebt Inc., is allowed to deduct all of its interest expense.
NoEquity NoDebt
Operating income $32.500m $32.500m
Less: Interest ($64m. x 0.1) 6.400m 0.000m
Taxable income $26.100m $32.500m
Less: Taxes (21%) 5.481m 6.825m
Net income $20.619m $25.675m

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Income available for asset funders $10.379m $25.675m
(= Operating income - Taxes)
Return on asset-funders’ investment $27.019m/$65m = 41.57% $25.675m/$65m = 39.50%
LG2-1 2-22 Debt versus Equity Financing You are considering a stock investment in one of two firms
(AllDebt, Inc., and AllEquity, Inc.), both of which operate in the same industry and have
identical EBITDA of $14.7 million and operating income of $12.5 million. AllDebt, Inc.,
finances its $25 million in assets with $24 million in debt (on which it pays 10 percent interest
annually) and $1 million in equity. AllEquity, Inc., finances its $25 million in assets with no debt
and $25 million in equity. Both firms pay a tax rate of 21 percent on their taxable income.
Calculate the income available to pay the asset funders (the debt holders and stockholders) and
resulting return on asset-funders’ investment for the two firms.
With $14.7 million of EBITDA AllDebt Inc., may deduct up to $4.41 million ($14.7 x 30 percent) of interest
expense for tax purposes. Thus, AllDebt Inc., is allowed to deduct all of its interest expense.
AllDebt AllEquity
Operating income $12.500m $12.500m
Less: Interest ($24m. x 0.1) 2.400m 0.000m
Taxable income $10.100m $12.500m
Less: Taxes (21%) 2.121m 2.625m
Net income $7.979m $9.875m
Income available for asset funders $10.379m $9.875m
(= Operating income - Taxes)
Return on asset-funders’ investment $10.379m./$25m. = 41.516% $9.875m./$25m. = 39.500%
LG2-1 2-23 Income Statement You have been given the following information for Corky’s Bedding Corp.:
a. Net sales = $11,250,000.
b. Cost of goods sold = $7,500,000.
c. Other operating expenses = $250,000.
d. Addition to retained earnings = $1,000,000.
e. Dividends paid to preferred and common stockholders = $495,000.
f. Interest expense = $850,000, all of which is tax deductible.
The firm’s tax rate is 35 percent. Calculate the depreciation expense for Corky’s Bedding Corp.
Net sales $11,250,000
Less: Cost of goods sold 7,500,000
Gross profits Step 4. $3,750,000
Less: Other operating expenses 250,000
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) Step 5. $3,500,000
Less: Depreciation Step 6. 350,000
Earnings before interest and taxes (EBIT) Step 3. $3,150,000
Less: Interest 850,000
Earnings before taxes (EBT) Step 2. $2,300,000
Less: Taxes (21%)

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Net income Step 1. $1,817,000
Less: Common and preferred stock dividends $ 817,000
Addition to retained earnings $1,000,000
Step 1. Net income = Common and preferred stock dividends + Addition to retained earnings =
$817,000 + $1,000,000 = $1,817,000
Step 2. EBT (1 – Tax rate) = Net income => EBT = Net income/(1 – Tax rate) = $1,817,000/(1 - 0.21) = $2,300,000
Step 3. EBIT – Interest = EBT => EBIT = EBT + Interest = $2,300,000 + $850,000 = $3,150,000
Step 4. Gross profits = Net sales – Cost of goods sold = $11,250,000 – 7,500,000 = $3,750,000
Step 5. EBITDA = Gross profits – Other operating expenses = $3,750,000 – 250,000 = $3,500,000
Step 6. EBITDA – Depreciation = EBIT => Depreciation = EBITDA – EBIT = $3,500,000 - $3,150,000 = $350,000
LG2-1 2-24 Income Statement You have been given the following information for Moore’s HoneyBee
Corp.:
a. Net sales = $32,000,000.
b. Gross profits = $18,700,000.
c. Other operating expenses = $2,500,000.
d. Addition to retained earnings = $4,700,000.
e. Dividends paid to preferred and common stockholders = $2,900,000.
f. Depreciation expense = $2,800,000.
The firm’s tax rate is 35 percent. The firm’s interest expense is all tax deductible. Calculate the
cost of goods sold and the interest expense for Moore’s HoneyBee Corp.
Net sales $32,000,000
Less: Cost of goods sold Step 1. 13,300,000
Gross profits $18,700,000
Less: Other operating expenses 2,500,000
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) Step 4. $16,200,000
Less: Depreciation 2,800,000
Earnings before interest and taxes (EBIT) Step 5. $13,400,000
Less: Interest Step 6. 1,700,000
Earnings before taxes (EBT) Step 3. $11,700,000
Less: Taxes (21%)
Net income Step 2. $ 9,243,000
Less: Common and preferred stock dividends $2,900,000
Addition to retained earnings $6,343,000
Step 1. Net sales - Cost of goods sold = Gross profits => Cost of goods sold = Net sales – Gross Profits =
$32,000,000 – $18,700,000 = $13,300,000
Step 2. Net income = Common and preferred stock dividends + Addition to retained earnings =
$2,900,000 + $6,343,000 = $9,243,000
Step 3. EBT (1 – Tax rate) = Net income => EBT = Net income/(1 – Tax rate) = $9,243,000/(1 - 0.21) = $11,700,000
Step 4. EBITDA = Gross profits – Other operating expenses = $18,700,000 – 2,500,000 = $16,200,000
Step 5. EBITDA – Depreciation = EBIT = $16,200,000 - $2,800,000 = $13,400,000
Step 6. EBIT – Interest = EBT => Interest = EBIT - EBT = $13,400,000 - $11,7000,000 = $1,700,000
LG2-1 2-25 Income Statement Consider a firm with an EBITDA of $1,100,000 and an EBIT of
$1,000,000. The firm finances its assets with $4,500,000 debt (costing 8 percent, all of which is

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Chapter 2 - Reviewing Financial Statements
tax deductible) and 200,000 shares of stock selling at $16.00 per share. To reduce risk associated
with this financial leverage, the firm is considering reducing its debt by $2,500,000 by selling
additional shares of stock. The firm’s tax rate is 21 percent. The change in capital structure will
have no effect on the operations of the firm. Thus, EBIT will remain at $1,000,000. Calculate the
change in the firm’s EPS from this change in capital structure.
With $1,100,000 of EBITDA, the firm may deduct up to $330,000 ($1,100,000 x 30 percent) of interest expense for
tax purposes. Thus, given the current capital structure, the firm may deduct only $330,000 of its $360,000 interest
expense ($4,500,000 x 0.08) for tax purposes. Thus,
Taxable income = EBIT – Allowable interest deduction
= $1,000,000 - $330,000 = $670,000
Tax liability = 0.21x Taxable income
= 0.21($670,000) = $140,700
With the proposed change in capital structure, the firm may deduct all of its $160,000 ($2,000,000 x 0.08) interest
expense for tax purposes.
Number of shares of stock that must be sold to raise $2,500,000:
$2,500,000/$16 = 156,250
=> number of shares of stock outstanding after refinancing = 200,000 + 156,250 = 356,250
The EPS before and after this change in capital structure is illustrated below:
Before capital structure change After capital structure change
EBIT $1,000,000 $1,000,000
Less: Interest ($4,500,000 x 0.08) 360,000 ($2,000,000 x 0.08) 160,000
EBT 640,000 840,000
Less: Taxes (21%) 140,700 176,400
Net income $499,300 $663,600
Divide by # of shares 200,000 356,250
EPS $2.4965 $1.8627
The change in capital structure will result in a decrease in the stockholders EPS by $0.6338.
LG2-1 2-26 Income Statement Consider a firm with an EBITDA of $13,00,000 and an EBIT of
$10,500,000. The firm finances its assets with $50,000,000 debt (costing 6.5 percent) and
10,000,000 shares of stock selling at $10.00 per share. The firm is considering increasing its debt
by $25,000,000, using the proceeds to buy back shares of stock. The firm’s tax rate is 21 percent.
The change in capital structure will have no effect on the operations of the firm. Thus, EBIT will
remain at $10,500,000. Calculate the change in the firm’s EPS from this change in capital
structure.
With $13,000,000 of EBITDA, the firm may deduct up to $3,900,000 ($13,000,000 x 30 percent) of interest expense
for tax purposes. Thus, given the current capital structure, the firm may deduct the full $3,250,000 ($50,000,000 x
0.065) of its interest expense for tax purposes. With the proposed change in capital structure, the firm may deduct
only $3,900,000 of its $4,875,000 interest expense ($75,000,000 x 0.065) for tax purposes. Thus,
Taxable income = EBIT – Allowable interest deduction
= $10,500,000 - $3,900,000 = $6,600,000

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Tax liability = 0.21x Taxable income
= 0.21($6,600,000) = $1,386,000
Number of shares of stock that can be repurchased with $25,000,000:
$25,000,000/$10 = 2,500,000
=> number of shares of stock outstanding after refinancing = 10,000,000 – 2,500,000 = 7,500,000
The EPS before and after this change in capital structure is illustrated below:
Before capital structure change After capital structure change
EBIT $10,500,000 $10,500,000
Less: Interest ($50,000,000 x 0.065) 3,250,000 ($75,000,000 x 0.065) 4,875,000
EBT 7,250,000 5,625,000
Less: Taxes (21%) 1,522,500 1,386,000
Net income $5,727,500 $4,239,000
Divide by # of shares 10,000,000 7,500,000
EPS $0.57275 $0.56520
The change in capital structure decreases the stockholders EPS by $0.00755. While interest on debt is tax deductible
up to 30 percent of EBITDA, in this case the change in the capital structure causes the firm to hit the tax deductible
cap. The tax benefits of additional debt do not apply once the firm hits the cap, causing debt to no longer be an
attractive option from stockholders viewpoint.
LG2-3 2-27 Corporate Taxes The Dakota Corporation had a 2021 taxable income of $33,365,000
from operations after all operating costs but before (1) interest charges of $8,500,000, all of
which is tax deductible; (2) dividends received of $750,000; (3) dividends paid of $5,250,000;
and (4) income taxes. The firm’s EBITDA is $tax rate is 21 percent.
a. Calculate Dakota’s income tax liability.
The first 50 percent of the dividends received is not taxable. Thus, only 50 percent of the dividends received are
taxed, so:
Taxable income = $33,365,000 - $8,500,000 + (0.5)$750,000 = $25,240,000
Now Dakota Corp.’s tax liability will be:
Tax liability = 0.21 ($25,240,000) = $5,300,400
b. What are Dakota’s average and marginal tax rates on taxable income?
Dakota Corp.’s average tax rate is:
Average tax rate = $5,300,400/$25,240,000 = 21.00%
Finally, if Dakota Corp earned $1 more of taxable income, it would pay 21 cents (based on its tax rate of 21 percent)
more in taxes. Thus, the marginal tax rate is 21 percent.
LG2-3 2-26 Corporate Taxes Suppose that in addition to $17.85 million of taxable income, Texas
Taco, Inc., received $1,105,000 of interest on state-issued bonds and $760,000 of dividends on
common stock it owns in ArizonaTaco, Inc.
a. Calculate Texas Taco’s income tax liability.

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Chapter 2 - Reviewing Financial Statements
Interest on the state-issued bonds is not taxable and should not be included in taxable income. Further, the first 50
percent of the dividends received from ArizonaTaco is not taxable. Thus, only 50 percent of the dividends received
are taxed, so:
Taxable income = $17,850,000 + (0.5)$760,000 = $18,230,000
Texas Taco’s tax liability will be:
Tax liability = 0.21 ($18,230,000) = $3,828,300
b. What are Texas Taco’s average and marginal tax rates on taxable income?
Texas Taco’s resulting average tax rate is:
Average tax rate = $3,828,300/$18,230,000= 21.00%
Finally, if Texas Taco earned $1 more of taxable income, it would pay 21 cents (based upon its tax rate of 21
percent) more in taxes. Thus, the marginal tax rate is 21 percent.
LG2-5 2-29 Statement of Cash Flows Use the balance sheet and income statement below to construct a
statement of cash flows for Clancy’s Dog Biscuit Corporation.
Clancy’s Dog Biscuit Corporation
Balance Sheet as of December 31, 2021and 2020
(in millions of dollars)
2021 2020 2021 2020
Assets Liabilities and Equity
Current assets: Current liabilities :
Cash and marketable Accrued wages and
securities $ 5 $ 5 taxes $ 10 $ 6
Accounts receivable 20 19 Accounts payable 16 15
Inventory 36 29 Notes payable 14 13
Total $ 61 $ 53 Total $ 40 $ 34
Fixed assets: Long-term debt: $ 57 $ 53
Gross plant and
equipment $106 $ 88
Less: Accumulated Stockholders’ equity:
depreciation 15 11 Preferred stock (2 million shares) $ 2 $ 2
Net plant and Common stock and
equipment $ 91 $ 77 paid-in surplus 11 11
Other long-term (5 million shares)
assets 15 15 Retained earnings 57 45
Total $106 $ 92 Total $ 70 $ 58
Total assets $167 $145 Total liabilities and equity $167 $145
Clancy’s Dog Biscuit Corporation
Income Statement for Years Ending December 31, 2021 and 2020
(in millions of dollars)
2021 2020
Net sales $ 76 $ 80
Less: Cost of goods sold 38 35
Gross profits $ 38 $ 45
Less: Other operating expenses 6 5
Earnings before interest, taxes, depreciation, and

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tization (EBITDA) $ 32 $ 40
Less: Depreciation 4 4
Earnings before interest and taxes (EBIT) $ 28 $ 36
Less: Interest 5 5
Earnings before taxes (EBT) $ 23 $ 31
Less: Taxes 5 7
Net income $18 $24
Less: Preferred stock dividends $ 1 $ 1
Net income available to common stockholders $17 $23
Less: Common stock dividends 5 5
Addition to retained earnings $12 $18
Per (common) share data:
Earnings per share (EPS) $3.00 $4.20
Dividends per share (DPS) $1.00 $1.00
Book value per share (BVPS) $13.60 $11.20
Market value (price) per share (MVPS) $14.25 $14.60
SOLUTION: Statement of Cash Flows for Year Ending December 31, 2021
(in millions of dollars)
2021
A. Cash flows from operating activities
Net income $18
Additions (sources of cash):
Depreciation 4
Increase accrued wages and taxes 4
Increase in accounts payable 1
Subtractions (uses of cash):
Increase in accounts receivable -1
Increase in inventory -7
Net cash flow from operating activities: $19
B. Cash flows from investing activities
Subtractions:
Increase fixed assets -$18
Increase in other long-term assets 0
Net cash flow from investing activities: -$18
C. Cash flows from financing activities
Additions:
Increase in notes payable $ 1
Increase in long-term debt 4
Increase in common and preferred stock 0
Subtractions:
Preferred stock dividends -1
Common stock dividends -5
Net cash flow from financing activities: - $1
D. Net change in cash and marketable securities -$ 0

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LG2-5 2-30 Statement of Cash Flows Use the balance sheet and income statement below to construct a
statement of cash flows for Valium’s Medical Supply Corporation.
Valium’s Medical Supply Corporation
Balance Sheet as of December 31, 2021 and 2020
(in thousands of dollars)
2021 2020 2021 2020
Assets Liabilities and Equity
Current assets: Current liabilities :
Cash and marketable Accrued wages and
securities $ 74 $ 73 taxes $ 58 $ 45
Accounts receivable 199 189 Accounts payable 159 145
Inventory 322 291 Notes payable 131 131
Total $ 595 $ 553 Total $ 348 $ 321
Fixed assets: Long-term debt: $ 565 $549
Gross plant and
equipment $1,084 $ 886
Less: Accumulated Stockholders’ equity:
depreciation 153 116 Preferred stock (6 thousand shares) $ 6 $ 6
Net plant and Common stock and
equipment $ 931 $ 770 paid-in surplus 120 120
Other long-term (100 thousand shares)
assets 130 130 Retained earnings 617 457
Total $1,061 $ 900 Total $ 743 $ 583
Total assets $1,656 $1,453 Total liabilities and equity $1,656 $1,453
Valium’s Medical Supply Corporation
Income Statement for Years Ending December 31, 2021 and 2020
(in thousands of dollars)
2021 2020
Net sales $ 888 $ 798
Less: Cost of goods sold 387 350
Gross profits $ 501 $ 448
Less: Other operating expenses 48 42
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) $ 453 $ 406
Less: Depreciation and amortization 37 35
Earnings before interest and taxes (EBIT) $ 416 $ 371
Less: Interest 46 40
Earnings before taxes (EBT) $ 370 $ 331
Less: Taxes 78 70
Net income $ 292 $ 261
Less: Preferred stock dividends $ 6 $ 6
Net income available to common stockholders $ 286 $ 255
Less: Common stock dividends 126 126
Addition to retained earnings $ 160 $ 129
Per (common) share data:

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Chapter 2 - Reviewing Financial Statements
Earnings per share (EPS) $2.86 $2.55
Dividends per share (DPS) $1.26 $1.26
Book value per share (BVPS) $7.37 $5.77
Market value (price) per share (MVPS) $8.40 $6.25
SOLUTION: Statement of Cash Flows for Year Ending December 31, 2021
(in thousands of dollars)
A. Cash flows from operating activities
Net income $292
Additions (sources of cash):
Depreciation and amortization 37
Increase in accrued wages and taxes 13
Increase in accounts payable 14
Subtractions (uses of cash):
Increase in accounts receivable -10
Increase in inventory -31
Net cash flow from operating activities: $315
B. Cash flows from investing activities
Subtractions:
Increase in fixed assets -$198
Increase in other long-term assets 0
Net cash flow from investing activities: -$198
C. Cash flows from financing activities
Additions:
Increase in notes payable $ 0
Increase in long-term debt 16
Increase in common and preferred stock 0
Subtractions:
Preferred stock dividends - 6
Common stock dividends -126
Net cash flow from financing activities: -$116
D. Net change in cash and marketable securities $ 1
LG2-5 2-31 Statement of Cash Flows Chris’ Outdoor Furniture, Inc., has net cash flows from
operating activities for the last year of $340 million. The income statement shows that net
income is $315 million and depreciation expense is $46 million. During the year, the change in
inventory on the balance sheet was $38 million, change in accrued wages and taxes was $15
million and change in accounts payable was $20 million. At the beginning of the year the
balance of accounts receivable was $50 million. Calculate the end-of-year balance for accounts
receivable.
A. Cash flows from operating activities (in millions)
Net income $315
Additions (sources of cash):
Depreciation 46

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Increase accrued wages and taxes 15
Increase in accounts payable 20
Subtractions (uses of cash):
Increase in accounts receivable -18 (=$340 - $315 - $46 - $15 - $20 + $38)
Increase in inventory -38
Net cash flow from operating activities: $340
End-of-year balance for accounts receivable = $50m. + $18m. = $68m.
LG2-5 2-32 Statement of Cash Flows Dogs 4 U Corporation has net cash flow from financing
activities for the last year of $34 million. The company paid $178 million in dividends last year.
During the year, the change in notes payable on the balance sheet was $39 million, and change in
common and preferred stock was $0. The end-of-year balance for long-term debt was $315
million. Calculate the beginning-of-year balance for long-term debt.
C. Cash flows from financing activities (in millions)
Additions:
Increase in notes payable $ 39
Increase in long-term debt 173 (=$34 + $178 - $39)
Increase in common and preferred stock 0
Subtractions:
Stock dividends -178
Net cash flow from financing activities: $34
Beginning-of-year balance for long-term debt = $315m. - $173m = $142m.
LG2-5 2-31 Free Cash Flow The 2021 income statement for Duffy’s Pest Control shows that
depreciation expense was $197 million, EBIT was $440 million, and the tax rate was 21 percent.
At the beginning of the year, the balance of gross fixed assets was $1,562 million and net
operating working capital was $417 million. At the end of the year, gross fixed assets was $1,803
million. Duffy’s free cash flow for the year was $424 million. Calculate the end-of-year balance
for net operating working capital.
Duffy’s Pest Control’s operating cash flow was:
OCF = EBIT(1 – Tax rate) + Depreciation
= ($440m.(1 - 0.21) + $197m.) = $544.6m.
Duffy’s Pest Control’s free cash flow for 2021 was:
FCF = Operating cash flow – Investment in operating capital
$424m. = $544.6m. - Investment in operating capital
=> Investment in operating capital = $544.6m. - $424m. = $120.6m.
Accordingly, investment in operating capital for 2021 was:
IOC = ΔGross fixed assets + ΔNet operating working capital
$120.6m. = ($1,803m. - $1,562m.) + (Ending net operating working capital - $417m.)
=> Ending net operating working capital = $120.6m. - ($1,803m. - $1,562m.) + $417m. = $296.6m.
LG2-5 2-34 Free Cash Flow The 2021 income statement for Egyptian Noise Blasters shows that
depreciation expense is $85 million, NOPAT is $246 million. At the end of the year, the balance

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Chapter 2 - Reviewing Financial Statements
gross fixed assets was $655 million. The change in net operating working capital during the
year was $73 million. Egyptian’s free cash flow for the year was $190 million. Calculate the
beginning-of-year balance for gross fixed assets.
Egyptian Noise Blasters’ operating cash flow was:
OCF = NOPAT + Depreciation =
= ($246m. + $85m.) = $331m.
Egyptian Noise Blasters’ free cash flow for 2021 was:
FCF = Operating cash flow – Investment in operating capital
$190m. = $331m. - Investment in operating capital
= > Investment in operating capital = $331m. - $190m. = $141m.
Accordingly, investment in operating capital for 2021 was:
IOC = ΔGross fixed assets + ΔNet operating working capital
$141m. = ($655m. – Beginning of year gross fixed assets) + $73m.
=> Beginning of year gross fixed assets = $655m. - $141m. + $73m. = $587m.
LG2-1 2-35 Statement of Retained Earnings Thelma and Louie, Inc., started the year with a balance
of retained earnings of $543 million and ended the year with retained earnings of $589 million.
The company paid dividends of $35 million to the preferred stockholders and $88 million to
common stockholders. Calculate Thelma and Louie’s net income for the year.
Statement of Retained Earnings as of December 31, 2021
(in millions of dollars)
Balance of retained earnings, December 31, 2020 $543
Plus: Net income for 2021 169 (= $589 + $123 - $543)
Less: Cash dividends paid
Preferred stock $35
Common stock 88
Total cash dividends paid 123
Balance of retained earnings, December 31, 2021 $589
LG2-1 2-36 Statement of Retained Earnings Jamaica Tours, Inc., started the year with a balance of
retained earnings of $1,780 million. The company reported net income for the year of $284
million and paid dividends of $17 million to the preferred stockholders and $59 million to
common stockholders. Calculate Jamaica Tour’s end-of-year balance in retained earnings.
Statement of Retained Earnings as of December 31, 2018
(in millions of dollars)
Balance of retained earnings, December 31, 2017 $1,780
Plus: Net income for 2018 284
Less: Cash dividends paid
Preferred stock $17
Common stock 59
Total cash dividends paid 76
Balance of retained earnings, December 31, 2018 $1,988

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Chapter 2 - Reviewing Financial Statements
advanced 2-37 Income Statement Listed below is the 2021 income statement for Tom and Sue Travels, Inc.
problems
LG2-1
Tom and Sue Travels, Inc.
Income Statement for Year Ending December 31, 2021
(in millions of dollars)
Net sales $16.500
Less: Cost of goods sold 7.100
Gross profits 9.400
Less: Other operating expenses 3.200
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) 6.200
Less: Depreciation 2.900
Earnings before interest and taxes (EBIT) 3.300
Less: Interest 0.950
Earnings before taxes (EBT) 2.350
Less: Taxes 0.495
Net income $ 1.855
The CEO of Tom and Sue’s wants the company to earn a net income of $2.250 million in 2022.
Cost of goods sold is expected to be 60 percent of net sales, depreciation and other operating
expenses are not expected to change, interest expense is expected to increase to $1.416 million,
and the firm’s tax rate will be 21 percent. Calculate the net sales needed to produce net income
of $2.250 million.
Tom and Sue Travels, Inc.
Income Statement for Year Ending December 31, 2022
(in millions of dollars)
Net sales Step 5. $25.910
Less: Cost of goods sold Step 6. 15.546
Gross profits Step 4. 10.364
Less: Other operating expenses 3.200
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) Step 3. 7.164
Less: Depreciation 2.900
Earnings before interest and taxes (EBIT) Step 2. 4.264
Less: Interest 1.416
Earnings before taxes (EBT) Step 1. 3.214
Less: Taxes
Net income $ 2.250
Step 1. EBT (1-t) = Net income = $2.250m = EBT (1 - 0.21) => EBT = $2.250m./(1 - 0.21) = $2.848m.
Step 2. EBIT = EBT + Interest = $2.848m. + $1.416m. = $4.264m.
Step 3. EBITDA = EBIT + Depreciation = $4.264m. + $2.900m. = $7.164m
Step 4. Gross profits = EBITDA + Other operating expenses = $7.164m. + $3.200m. = $10.364m
Step 4. Net sales = Gross profits/(1-Cost of goods sold percent) = $10.364m./(1 - 0.6) = $25.910m.

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Chapter 2 - Reviewing Financial Statements
Step 5. Cost of goods sold = Net sales – Gross profits = $25.910m. - $10.364 = $15.546m.
LG2-1 2-38 Income Statement You have been given the following information for PattyCake’s
Athletic Wear Corp. for the year 2021:
a. Net sales = $38,250,000.
b. Cost of goods sold = $22,070,000.
c. Other operating expenses = $5,300,000.
d. Addition to retained earnings = $2,195,500.
e. Dividends paid to preferred and common stockholders = $1,912,000.
f. Interest expense = $1,785,000.
g. The firm’s tax rate is 21 percent.
In 2022:
h. net sales are expected to increase by $9.75 million.
i. Cost of goods sold is expected to be 60 percent of net sales.
j. Depreciation and other operating expenses are expected to be the same as in 2021.
k. Interest expense is expected to be $2,004,367.
l. The tax rate is expected to be 21 percent of EBT.
m. Dividends paid to preferred and common stockholders will not change.
Calculate the addition to retained earnings expected in 2022.
Income Statement for Year Ending December 31, 2021
(in millions of dollars)
Net sales $38,250,000
Less: Cost of goods sold 22,070,000
Gross profits 16,180,000
Less: Other operating expenses 5,300,000
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) 10,880,000
Less: Depreciation $10,880,000 - $6,984,367 3,895,633
Earnings before interest and taxes (EBIT) $5,199,367 + $1,785,000 6,984,367
Less: Interest 1,785,000
Earnings before taxes (EBT) $4,107,500 / (1 - 0.21) 5,199,367
Less: Taxes
Net income $4,107,500
Less: Preferred and common stock dividends $1,912,000
Addition to retained earnings $2,195,500
Income Statement for Year Ending December 31, 2022
(in millions of dollars)
Net sales (all credit) $38,250,000 + $9,750,000 $48,000,000
Less: Cost of goods sold 0.6 x $48,000,000 28,800,000
Gross profits 19,200,000
Less: Other operating expenses 5,300,000

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Chapter 2 - Reviewing Financial Statements
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) 13,900,000
Less: Depreciation 3,895,633
Earnings before interest and taxes (EBIT) 10,004,367
Less: Interest 2,004,367
Earnings before taxes (EBT) 8,000,000
Less: Taxes (21%) 1,680,000
Net income $6,320,000
Less: Preferred and common stock dividends $1,912,000
Addition to retained earnings $4,408,000
LG2-5 2-39 Free Cash Flow Rebecky’s Flowers 4U, Inc., had free cash flows during 2021 of $43
million, NOPAT of $85 million, and depreciation of $14 million. Using this information, fill in
the blanks on Rebecky’s balance sheet below.
Rebecky’s operating cash flow for 2021 was:
OCF = NOPAT + Depreciation = ($85m. + $14m.) = $99m.
Rebecky’s free cash flow was:
FCF = Operating cash flow – Investment in operating capital
$43m. = $99m. - Investment in operating capital
So, Investment in operating capital = $99m. - $43m. = $56m.
IOC = ΔGross fixed assets + ΔNet operating working capital
$56m. = ($333m. - $300m.) + ΔNet operating working capital
=> ΔNet operating working capital = $56m. - ($333m. - $300m.) = $23m.
ΔNet operating working capital = $23m. = ∆Current assets - ∆Current liabilities
$23m. = ($221m. - $190m.) - ∆Current liabilities
=> ∆Current liabilities = ($221m. - $190m.) - $23m. = $8m.
=> 2021 Current liabilities = $110m. + $8m. = $118m.
and 2021 Current liabilities = Accrued wages and taxes + Accounts payable + Notes payable
$118m. = $17m. + Accounts payable + $45m.
=> Accounts payable = $118m. - $17m. - $45m. = $56m.
=> Long-term debt = $550m. - $118m. - $237m. = $195m.
Rebecky’s Flowers 4U, Inc.
Balance Sheet as of December 31, 2021 and 2020
(in millions of dollars)
2021 2020 2021 2020
Assets Liabilities and Equity
Current assets: Current liabilities :
Cash and marketable Accrued wages and
securities $ 28 $ 25 taxes $ 17 $ 15
Accounts receivable 75 65 Accounts payable 56 50
Inventory 118 100 Notes payable 45 45
Total $221 $190 Total $118 $110
Fixed assets: Long-term debt: $195 $190
Gross plant and
equipment $333 $300

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Chapter 2 - Reviewing Financial Statements
Less: Accumulated Stockholders’ equity:
depreciation 54 40 Preferred stock (5 million shares) $ 5 $ 5
Net plant and Common stock and
equipment $279 $260 paid-in surplus 40 40
Other long-term (20 million shares)
assets 50 50 Retained earnings 192 155
Total $329 $310 Total $237 $200
Total assets $550 $500 Total liabilities and equity $550 $500
LG2-5 2-38 Free Cash Flow Vinny’s Overhead Construction had free cash flow during 2021 of $25.4
million. The change in gross fixed assets on Vinny’s balance sheet during 2021 was $7.0 million
and the change in net operating working capital was $8.4 million. Using this information, fill in
the blanks on Vinny’s income statement below.
IOC = ΔGross fixed assets + ΔNet operating working capital
=> IOC = $7.0m. + $8.4m. = $15.4m.
FCF = Operating cash flow – Investment in operating capital
=> $25.4m. = OCF – $15.4m.
=> OCF = $25.4m. + $15.4m. = $40.8m.
OCF = EBIT(1 – 0.21) + Depreciation
Using the numbers below: $40.8m. = EBIT(1 – 0.21) + $10.2m.
=> EBIT = ($40.8m. - $10.2m.)/(1 – 0.21) = $38.73m
Vinny’s Overhead Construction, Corp.
Income Statement for Year Ending December 31, 2021
(in millions of dollars)
Net sales $ 182.10 Step 1. (= $66.00 + $116.10)
Less: Cost of goods sold 116.10
Gross profits $ 66.00
Less: Other operating expenses 17.07 Step 7. (= $66.00 - $48.93)
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) 48.93 Step 6. (= $38.73 + $10.20)
Less: Depreciation 10.20
Earnings before interest and taxes (EBIT) $ 38.73 Step 2. (from above)
Less: Interest 3.73 Step 5. (= $38.73 - $35.00)
Earnings before taxes (EBT) $ 35.00 Step 3. (= $27.65 / (1 – 0.21)
Less: Taxes (21% from above) 7.35 Step 4. (= $35.00 - $27.65)
Net income $27.65
research it! Reviewing Financial Statements
Go the web site of Wal-Mart Stores, Inc. at www.walmartstores.com and get the latest
financial statements from the annual report using the following steps.

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Chapter 2 - Reviewing Financial Statements
Go to Wal-Mart Stores, Inc.’s Web site at www.walmartstores.com. Click on Investors, then
select Annual Reports; next choose Annual Reports & Proxies. This will bring the file onto your
computer that contains the relevant data. Locate the total assets, total equity, net sales, net
income, dividends paid, cash flows from operating activities, and cash flows from investing
activities for the last two years. How have these items changed over the last two years?
SOLUTION: The solution will vary with the year annual report is accessed. However, the
annual report for each year summarizes the financial information necessary to evaluate key
information used by firm managers, who make financial decisions, and by investors, who decide
whether or not to invest in the firm.

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Chapter 2 - Reviewing Financial Statements
integrated mini-case: Working with Financial Statements
Shown below are partial financial statements for Garners’ Platoon Mental Health Care, Inc. Fill in the
blanks on the four financial statements.
Garners’ Platoon Mental Health Care, Inc.
Balance Sheet as of December 31, 2021 and 2020
(in millions of dollars)
2021 2020 2021 2020
Assets Liabilities and Equity
Current assets: Current liabilities :
Cash and marketable Accrued wages and
securities $ 421 $____ taxes $ 316 $ 242
Accounts receivable ____ 1,020 Accounts payable 867 791
Inventory 1,760 1,581 Notes payable ____ 714
Total $3,290 $____ Total $2,055 $1,747
Fixed assets: Long-term debt: $3,090 $____
Gross plant and
equipment $____ $4,743
Less: Accumulated Stockholders’ equity:
depreciation 840 640 Preferred stock (30 million shares) $ 60 $ 60
Net plant and Common stock and
equipment $4,972 $____ paid-in surplus 637 ___
Other long-term assets ____ 790 (200 million shares)
Total $5,864 $4,893 Retained earnings 3,312 2,440
Total $4,009 $3,137
Total assets $____ $7,889
Total liabilities and equity $9,154 $7,889
Garners’ Platoon Mental Health Care, Inc.
Income Statement for Years Ending December 31, 2021 and 2020
(in millions of dollars)
2021 2020
Net sales $4,980 $
Less: Cost of goods sold 2,035
Gross profits $2,734 $2,313
Less: Other operating expenses 125 100
Earnings before interest, taxes, depreciation, and
amortization (EBITDA) 2,609 2,213
Less: Depreciation 200 191
Earnings before interest and taxes (EBIT) $2,409 $
Less: Interest (21 percent) 285
Earnings before taxes (EBT) $2,094 $1,737
Less: Taxes _____
Net income $1,654 $1,372

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