CHAPTER 2 Financial Statements and Cash Flow  ■■■  35

3. Accounting Statement of Cash Flows Looking at the accounting statement of cash flows,
what does the bottom-line number mean? How useful is this number for analyzing a company?
4. Cash Flows How do financial cash flows and the accounting statement of cash flows
differ? Which is more useful for analyzing a company?
5. Book Values versus Market Values Under standard accounting rules, it is possible for a
company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative.
Can this happen with market values? Why or why not?
6. Cash Flow from Assets Why is it not necessarily bad for the cash flow from assets to
be negative for a particular period?
7. Operating Cash Flow Why is it not necessarily bad for the operating cash flow to be
negative for a particular period?
8. Net Working Capital and Capital Spending Could a company’s change in net working
capital be negative in a given year? (Hint: Yes.) Explain how this might come about. What
about net capital spending?
9. Cash Flow to Stockholders and Creditors Could a company’s cash flow to stockholders
be negative in a given year? (Hint: Yes.) Explain how this might come about. What about
cash flow to creditors?
10. Firm Values In February 2017, Toshiba announced that it was writing off $6.3 billion
due to its acquisition of nuclear power plant construction firm CB&I Stone & Webster
only a year before. We would argue that Toshiba’s stockholders probably didn’t suffer as
a result of the reported loss. What do you think is the basis for our conclusion?

Questions and Problems

1. Building a Balance Sheet Alesha, Inc., has current assets of $4,300, net fixed assets of
$24,000, current liabilities of $2,900, and long-term debt of $10,700. What is the value
of the shareholders’ equity account for this firm? How much is net working capital?
BASIC
(Questions 1–10) 2. Building an Income Statement Gia, Inc., has sales of $473,000, costs of $275,000, depre-
ciation expense of $42,000, interest expense of $23,000, and a tax rate of 21 percent.
What is the net income for the firm? Suppose the company paid out $25,000 in cash
dividends. What is the addition to retained earnings?
3. Market Values and Book Values Klingon Cruisers, Inc., purchased new cloaking machin-
ery three years ago for $9.6 million. The machinery can be sold to the Romulans today for
$6.4 million. Klingon’s current balance sheet shows net fixed assets of $4.9 million, current
liabilities of $2.2 million, and net working capital of $850,000. If all the current accounts
were liquidated today, the company would receive $2.7 million cash. What is the book value
of Klingon’s assets today? What is the sum of NWC and market value of fixed assets?
4. Calculating Taxes Terri Simmons is single and had $189,000 in taxable income. Using
the rates from Table 2.3 in the chapter, calculate her income taxes. What is the average
tax rate? What is the marginal tax rate?
5. Calculating OCF Sheaves, Inc., has sales of $22,400, costs of $11,600, depreciation
expense of $2,200, and interest expense of $1,370. If the tax rate is 22 percent, what is
the operating cash flow, or OCF?
6. Calculating Net Capital Spending Earnhardt Driving School’s 2018 balance sheet showed
net fixed assets of $1.28 million, and the 2019 balance sheet showed net fixed assets of
$1.43 million. The company’s 2019 income statement showed a depreciation expense of
$146,000. What was the company’s net capital spending for 2019?
7. Building a Balance Sheet The following table presents the long-term liabilities and stock-
holders’ equity of Information Control Corp. from one year ago:
36  ■■■  PART I Overview

Long-term debt $ 45,000,000

Preferred stock    2,900,000
Common stock ($1 par value)   11,000,000
Accumulated retained earnings 107,000,000
Capital surplus   49,000,000

During the past year, the company issued 4.5 million shares of new stock at a total price
of $58 million, and issued $30 million in new long-term debt. The company generated
$7.5 million in net income and paid $1.7 million in dividends. Construct the current bal-
ance sheet reflecting the changes that occurred at the company during the year.
8. Cash Flow to Creditors The 2018 balance sheet of Spieth’s Golf Shop, Inc., showed
long-term debt of $1.565 million, and the 2019 balance sheet showed long-term debt of
$1.645 million. The 2019 income statement showed an interest expense of $170,000.
What was the firm’s cash flow to creditors during 2019?
9. Cash Flow to Stockholders The 2018 balance sheet of Spieth’s Golf Shop, Inc., showed
$490,000 in the common stock account and $3.4 million in the additional paid-in surplus
account. The 2019 balance sheet showed $525,000 and $3.75 million in the same two
accounts, respectively. If the company paid out $335,000 in cash dividends during 2019,
what was the cash flow to stockholders for the year?
10. Calculating Cash Flows Given the information for Spieth’s Golf Shop, Inc., in the previ-
ous two problems, suppose you also know that the firm’s net capital spending for 2019
was $735,000 and that the firm reduced its net working capital investment by $96,000.
What was the firm’s 2019 operating cash flow, or OCF?
INTERMEDIATE 11. Cash Flows Ritter Corporation’s accountants prepared the following financial statements
(Questions 11–22) for year-end 2019:
a. Explain the change in cash during 2019.
b. Determine the change in net working capital in 2019.
c. Determine the cash flow generated by the firm’s assets during 2019.

RITTER CORPORATION
Income Statement 2019

Revenue $797
Expenses 576
Depreciation 92
Net income $ 129
Dividends $ 97

RITTER CORPORATION
Balance Sheet December 31

Assets 2018 2019

Cash $ 63 $ 84
Other current assets 175 192
Net fixed assets 398 417
Total assets $636 $693
Liabilities and Equity
Accounts payable $ 129 $ 146
Long-term debt 155 163
Stockholders’ equity 352 384
Total liabilities and equity $636 $693
 CHAPTER 2 Financial Statements and Cash Flow  ■■■  37

12. Financial Cash Flows The Stancil Corporation provided the following current information:

Proceeds from long-term borrowing $16,400

Proceeds from the sale of common stock   4,000
Purchases of fixed assets 29,000
Purchases of inventories   2,400
Payment of dividends 13,1 00

Determine the total cash flows spent on fixed assets and NWC. What are the cash flows
to investors of the firm?
13. Building an Income Statement During the year, the Senbet Discount Tire Company had
gross sales of $865,000. The firm’s cost of goods sold and selling expenses were $455,000
and $210,000, respectively. The company also had notes payable of $680,000. These notes
carried an interest rate of 4 percent. Depreciation was $105,000. The tax rate was
21 percent.
a. What was the company’s net income?
b. What was the company’s operating cash flow?
14. Calculating Total Cash Flows Schwert Corp. shows the following information on its 2019
income statement: sales = $246,000; costs = $135,000; other expenses = $7,100; depre-
ciation expense = $19,100; interest expense = $10,000; taxes = $18,876; dividends =
$9,800. In addition, you’re told that the firm issued $7,900 in new equity during 2019
and redeemed $6,800 in outstanding long-term debt.
a. What is the 2019 operating cash flow?
b. What is the 2019 cash flow to creditors?
c. What is the 2019 cash flow to stockholders?
d. If net fixed assets increased by $41,900 during the year, what was the addition to net
working capital (NWC)?
15. Using Income Statements Given the following information for O’Hara Marine Co., calcu-
late the depreciation expense: sales = $54,000; costs = $29,500; addition to retained
earnings = $5,300; dividends paid = $1,720; interest expense = $2,050; tax rate =
21 percent.
16. Residual Claims Stark, Inc., is obligated to pay its creditors $10,700 very soon.
a. What is the market value of the shareholders’ equity if assets have a market value of
$11,900?
b. What if assets equal $9,400?
17. Net Income and OCF During 2019, Rainbow Umbrella Corp. had sales of $630,000.
Cost of goods sold, administrative and selling expenses, and depreciation expenses were
$465,000, $85,000, and $135,000, respectively. In addition, the company had an inter-
est expense of $70,000 and a tax rate of 21 percent. (Assume that interest is fully
deductible.)
a. What is the company’s net income for 2019?
b. What is its operating cash flow?
c. Explain your results in (a) and (b).
18. Accounting Values versus Cash Flows In Problem 17, suppose Rainbow Umbrella Corp.
paid out $34,000 in cash dividends. Is this possible? If spending on net fixed assets and
net working capital was zero, and if no new stock was issued during the year, what was
the change in the firm’s long-term debt account?
19. Calculating Cash Flows Cusic Industries had the following operating results for 2019:
sales = $24,360; cost of goods sold = $17,600; depreciation expense = $3,400; interest
expense = $860; dividends paid = $790. At the beginning of the year, net fixed assets
38  ■■■  PART I Overview

were $18,650, current assets were $5,560, and current liabilities were $3,040. At the end
of the year, net fixed assets were $21,180, current assets were $6,410, and current liabil-
ities were $3,445. The tax rate was 21 percent.
a. What is net income for 2019?
b. What is the operating cash flow for 2019?
c. What is the cash flow from assets for 2019? Is this possible? Explain.
d. If no new debt was issued during the year, what is the cash flow to creditors? What
is the cash flow to stockholders? Explain and interpret the positive and negative signs
of your answers in (a) through (d).
20. Calculating Cash Flows Consider the following abbreviated financial statements for
Weston Enterprises:

WESTON ENTERPRISES WESTON ENTERPRISES

Partial Balance Sheets 2019 Income Statement
Assets Liabilities and Owners’ Equity Sales $17,688
2018 2019 2018 2019 Costs 7,1 1 8
Depreciation 1,478
Current assets $1,157 $ 1,411 Current liabilities $ 481 $ 534 Interest paid 392
Net fixed assets 5,261 6,125 Long-term debt 2,856 3,256

a. What is owners’ equity for 2018 and 2019?

b. What is the change in net working capital for 2019?
c. In 2019, Weston Enterprises purchased $2,820 in new fixed assets. How much in fixed
assets did Weston Enterprises sell? What is the cash flow from assets for the year?
The tax rate is 22 percent.
d. During 2019, Weston Enterprises raised $545 in new long-term debt. How much long-
term debt must Weston Enterprises have paid off during the year? What is the cash
flow to creditors?
Use the following information for Ingersoll, Inc., for Problems 21 and 22. Assume the tax rate
is 21 percent.

2018 2019
Sales $ 8,462 $ 9,082
Depreciation 1,2 15 1,216
Cost of goods sold 2,9 12 3,305
Other expenses 690 577
Interest 567 652
Cash 4,438 5,620
Accounts receivable 4,874 6,6 1 7
Short-term notes payable 858 806
Long-term debt 14,537 17,334
Net fixed assets 37, 2 1 1 39,049
Accounts payable 4,661 4,520
Inventory 10,444 10,733
Dividends 1,032 1,1 35

21. Financial Statements Draw up an income statement and balance sheet for this company
for 2018 and 2019.
22. Calculating Cash Flow For 2019, calculate the cash flow from assets, cash flow to cred-
itors, and cash flow to stockholders.
 CHAPTER 2 Financial Statements and Cash Flow  ■■■  39

CHALLENGE 23. Cash Flows You are researching Time Manufacturing and have found the following
(Questions 23–24) accounting statement of cash flows for the most recent year. You also know that the
company paid $81 million in current taxes and had an interest expense of $38 million.
Use the accounting statement of cash flows to construct the financial statement of cash
flows.

TIME MANUFACTURING
Statement of Cash Flows
($ in millions)

Operations
Net income $ 187
Depreciation 74
Deferred taxes 11
Changes in assets and liabilities
Accounts receivable −12
Inventories 15
Accounts payable 11
Accrued expenses −6
Other 2
Total cash flow from operations $282
Investing activities
Acquisition of fixed assets −$   194
Sale of fixed assets 19
Total cash flow from investing activities −$ 175
Financing activities
Retirement of long-term debt −$ 145
Proceeds from long-term debt sales 110
Dividends −67
Repurchase of stock −32
Proceeds from new stock issue 39
Total cash flow from financing activities −$ 95
Change in cash (on balance sheet) $ 12

24. Net Fixed Assets and Depreciation On the balance sheet, the net fixed assets (NFA)
account is equal to the gross fixed assets (FA) account, which records the acquisition cost
of fixed assets, minus the accumulated depreciation (AD) account, which records the total
depreciation taken by the firm against its fixed assets. Using the fact that NFA = FA
− AD, show that the expression given in the chapter for net capital spending, NFAend
− NFAbeg + D (where D is the depreciation expense during the year), is equivalent to
FAend − FAbeg.

Excel Master It! Problem

Excel Using Excel to find the marginal tax rate can be accomplished using the VLOOKUP function.
Master However, calculating the total tax bill is a little more difficult. Below we have shown a copy
coverage online
of the IRS tax table for an individual for 2018 (the income thresholds are indexed to inflation
and change through time):
40  ■■■  PART I Overview

If taxable
income is But not
over -- over -- The tax is:
$ 0 $ 9,525 10% of the amount over $0
9,525 38,700 $952.50 plus 12% of the amount over $9,525
38,700 82,500 $4,453.50 plus 22% of the amount over $38,700
82,500 157,500 $14,089.50 plus 24% of the amount over $82,500
157,500 200,000 $32,089.50 plus 32% of the amount over $157,500
200,000 500,000 $45,689.50 plus 35% of the amount over $200,000
500,000 $150,689.50 plus 37% of the amount over $500,000

In reading this table, the marginal tax rate for taxable income less than $9,525 is 10 percent.
If the taxable income is between $9,525 and $38,700, the tax bill is $952.50 plus the marginal
taxes. The marginal taxes are calculated as the taxable income minus $9,525 times the marginal
tax rate of 12 percent.
Below, we have the tax table for a married couple filing jointly:
If taxable income But Tax rate
is over -- less than --
$ 0 $ 19,050 10%
19,050 77,400 12
77,400 165,000 22
165,000 315,000 24
315,000 400,000 32
400,000 600,000 35
600,000 37

a. Create a tax table in Excel for a married couple similar to the individual tax table
shown above. Your spreadsheet should then calculate the marginal tax rate, the average
tax rate, and the tax bill for any level of taxable income input by a user.
b. For a taxable income of $265,000, what is the marginal tax rate?
c. For a taxable income of $265,000, what is the total tax bill?
d. For a taxable income of $265,000, what is the average tax rate?

Mini Case CASH FLOWS AT WARF COMPUTERS, INC.

Warf Computers, Inc., was founded 15 years ago by Nick Warf, a computer programmer. The small
initial investment to start the company was made by Nick and his friends. Over the years, this same
group has supplied the limited additional investment needed by the company in the form of both
equity and short- and long-term debt. Recently the company has developed a virtual keyboard (VK).
The VK uses sophisticated artificial intelligence algorithms that allow the user to speak naturally
and have the computer input the text, correct spelling and grammatical errors, and format the
document according to preset user guidelines. The VK even suggests alternative phrasing and
sentence structure, and it provides detailed stylistic diagnostics. Based on a proprietary, very
advanced software/hardware hybrid technology, the system is a full generation beyond what is cur-
rently on the market. To introduce the VK, the company will require significant outside investment.
Nick has made the decision to seek this outside financing in the form of new equity
investments and bank loans. Naturally, new investors and the banks will require a detailed
financial analysis. Your employer, Angus Jones & Partners, LLC, has asked you to examine
the financial statements provided by Nick. Here are the balance sheets for the two most recent
years and the most recent income statement:
 CHAPTER 2 Financial Statements and Cash Flow  ■■■  41

WARF COMPUTERS
Balance Sheets ($ in thousands)

2018 2019 2018 2019

Current assets Current liabilities
Cash and equivalents $ 469 $ 542 Accounts payable $ 582 $ 623
Accounts receivable 802 859 Accrued expenses 481 296
Inventories 795 769    Total current
Other 94    110     liabilities $ 1,063 $ 919
   Total current assets $ 2,160 $2,280 Long-term liabilities
Fixed assets Deferred taxes $ 191 $ 257
Property, plant, and Long-term debt 1,379 1,415
  equipment $ 3,815 $4,978    Total long-term
Less accumulated     liabilities $ 1,570 $ 1,672
  depreciation 1,310 1,608 Stockholders’ equity
Net property, plant, and Preferred stock $ 25 $    25
equipment $2,505 $3,370 Common stock 151 155
Intangible assets and Capital surplus 934 949
others    851    953 Accumulated retained 1,924 3,112
   Total fixed assets $3,356 $4,322   earnings
   Less treasury stock 151    230
   Total equity $2,883 $ 4,011
Total liabilities and
$ 5,516 $6,602 shareholders’ equity $ 5,516 $6,602
Total assets

WARF COMPUTERS
Income Statement ($ in thousands)

Sales $9,068
Cost of goods sold 5,347
Selling, general, and administrative expense 848
Depreciation    298
Operating income $ 2,575
Other income     90
EBIT $2,665
Interest expense 164
Pretax income $ 2,501
Taxes 625
Current: $559
Deferred: $66     
Net income $ 1,876
Dividends $ 688
Retained earnings $ 1,188

Nick also has provided the following information: During the year the company raised $274,000
in new long-term debt and retired $238,000 in long-term debt. The company also sold $19,000
in new stock and repurchased $79,000 in stock. The company purchased $1,778,000 in fixed
assets and sold $514,000 in fixed assets.
Angus has asked you to prepare the financial statement of cash flows and the accounting
statement of cash flows. He also has asked you to answer the following questions:
1. How would you describe Warf Computers’s cash flows?
2. Which cash flow statement more accurately describes the cash flows at the company?
3. In light of your previous answers, comment on Nick’s expansion plans.