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    Lecture 2 - Answer Part 1

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    1. Liquidity measures how quickly an asset can be converted to cash without loss of value. Firms face a tradeoff between high liquidity, which provides a safety factor for meeting short-term obligations, and low liquidity, which allows funds to be invested for higher returns. 2. Accounting income statements may not accurately reflect actual cash flows because revenues and expenses are recorded when earned or incurred, not necessarily when cash is received or paid. 3. A company's cash flow from assets could be negative if it is rapidly expanding and making large capital expenditures, rather than reflecting poor performance.

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    Lecture 2 - Answer Part 1

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    1. Liquidity measures how quickly an asset can be converted to cash without loss of value. Firms face a tradeoff between high liquidity, which provides a safety factor for meeting short-term obligations, and low liquidity, which allows funds to be invested for higher returns. 2. Accounting income statements may not accurately reflect actual cash flows because revenues and expenses are recorded when earned or incurred, not necessarily when cash is received or paid. 3. A company's cash flow from assets could be negative if it is rapidly expanding and making large capital expenditures, rather than reflecting poor performance.

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    1. Liquidity measures how quickly an asset can be converted to cash without loss of value. Firms face a tradeoff between high liquidity, which provides a safety factor for meeting short-term obligations, and low liquidity, which allows funds to be invested for higher returns. 2. Accounting income statements may not accurately reflect actual cash flows because revenues and expenses are recorded when earned or incurred, not necessarily when cash is received or paid. 3. A company's cash flow from assets could be negative if it is rapidly expanding and making large capital expenditures, rather than reflecting poor performance.

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    185 views3 pages

    Lecture 2 - Answer Part 1

    Uploaded by

    Thắng Thông
    1. Liquidity measures how quickly an asset can be converted to cash without loss of value. Firms face a tradeoff between high liquidity, which provides a safety factor for meeting short-term obligations, and low liquidity, which allows funds to be invested for higher returns. 2. Accounting income statements may not accurately reflect actual cash flows because revenues and expenses are recorded when earned or incurred, not necessarily when cash is received or paid. 3. A company's cash flow from assets could be negative if it is rapidly expanding and making large capital expenditures, rather than reflecting poor performance.

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    of 3

    CHAPTER 2

    CONCEPT REVIEW AD CRITICAL THINKING QUESTIONS

    1. Liquidity [LO1] What does liquidity measure? Explain the trade-off a firm faces
    between high liquidity and low liquidity levels.

    Answer

    Liquidity measures how quickly and easily an asset can be converted to cash
    without significant loss in value. It’s desirable for firms to have high liquidity so that
    they have a large factor of safety in meeting short-term creditor demands. However,
    since liquidity also has an opportunity cost associated with it—namely that higher
    returns can generally be found by investing the cash into productive assets—low
    liquidity levels are also desirable to the firm. It’s up to the firm’s financial
    management staff to find a reasonable compromise between these opposing needs.

    2. Accounting and Cash Flows [LO2] Why might the revenue and cost figures shown on
    a standard income statement not be representative of the actual cash inflows and
    outflows that occurred during a period?

    Answer
    The recognition and matching principles in financial accounting call for revenues,
    and the costs associated with producing those revenues, to be “booked” when the
    revenue process is essentially complete, not necessarily when the cash is collected
    or bills are paid. Note that this way is not necessarily correct; it’s the way accountants
    have chosen to do it.

    6. Cash Flow from Assets [LO4] Suppose a company’s cash flow from assets is negative
    for a particular period. Is this necessarily a good sign or a bad sign?

    Answer
    For a successful company that is rapidly expanding, for example, capital outlays will
    be large, possibly leading to negative cash flow from assets. In general, what matters
    is whether the money is spent wisely, not whether cash flow from assets is positive
    or negative.

    7. Operating Cash Flow [LO4] Suppose a company’s operating cash flow has been
    negative for several years running. Is this necessarily a good sign or a bad sign?

    Answer
    It’s probably not a good sign for an established company, but it would be fairly
    ordinary for a start-up, so it depends.

    8. Net Working Capital and Capital Spending [LO4] Could a company’s change in NWC
    be negative in a given year? ( Hint: Yes.) Explain how this might come about. What
    about net capital spending?

    Answer
    For example, if a company were to become more efficient in inventory management,
    the amount of inventory needed would decline. The same might be true if it becomes
    better at collecting its receivables. In general, anything that leads to a decline in
    ending NWC relative to beginning would have this effect. Negative net capital
    spending would mean more long-lived assets were liquidated than purchased.

    QUESTION AND PROBLEM

    1. Building a Balance Sheet [LO1] Penguin Pucks, Inc., has current assets of $4,800, net
    fixed assets of $27,500, current liabilities of $4,200, and long-term debt of $10,500.
    What is the value of the shareholders’ equity account for this firm? How much is net
    working capital?

    SOLUTION

    To find owner’s equity, we must construct a balance sheet as follows:

    Balance Sheet
    CA $4,800 CL $4,200
    NFA 27,500 LTD 10,500
    OE ??
    TA $32,300 TL & OE $32,300

    We know that total liabilities and owner’s equity (TL & OE) must equal total assets
    of $32,300. We also know that TL & OE is equal to current liabilities plus long-term
    debt plus owner’s equity, so owner’s equity is:

    OE = $32,300 – 10,500 – 4,200 = $17,600

    NWC = CA – CL = $4,800 – 4,200 = $600

    2. Building an Income Statement [LO1] Papa Roach Exterminators, Inc., has sales of
    $734,000, costs of $315,000, depreciation expense of $48,000, interest expense of
    $35,000, and a tax rate of 35 percent. What is the net income for this firm?

    SOLUTION
    The income statement for the company is:

    Income Statement
    Sales $734,000
    Costs 315,000
    Depreciation 48,000
    EBIT $371,000
    Interest 35,000
    EBT $336,000
    Taxes(35%) 117,600
    Net income $218,400
    3. Dividends and Retained Earnings [LO1] Suppose the firm in Problem 2 paid out
    $85,000 in cash dividends. What is the addition to retained earnings?

    SOLUTION
    One equation for net income is:

    Net income = Dividends + Addition to retained earnings

    Rearranging, we get:

    Addition to retained earnings = Net income – Dividends


    = $218,400 – 85,000 = $133,400

    9. Calculating Net Capital Spending [LO4] Earnhardt Driving School’s 2010 balance
    sheet showed net fixed assets of $2.8 million, and the 2011 balance sheet showed net
    fixed assets of $3.6 million. The company’s 2011 income statement showed a
    depreciation expense of $345,000. What was net capital spending for 2011?

    SOLUTION
    Net capital spending = NFAend – NFAbeg + Depreciation
    Net capital spending = $3,600,000 – 2,800,000 + 345,000
    Net capital spending = $1,145,000

    11. Cash Flow to Creditors [LO4] The 2010 balance sheet of Maria’s Tennis Shop, Inc.,
    showed long-term debt of $2.3 million, and the 2011 balance sheet showed long-
    term debt of $2.55 million. The 2011 income statement showed an interest
    expense of $190,000. What was the firm’s cash flow to creditors during 2011?

    SOLUTION
    Cash flow to creditors = Interest paid – Net new borrowing
    Cash flow to creditors = Interest paid – (LTDend – LTDbeg)
    Cash flow to creditors = $190,000 – ($2,550,000 – 2,300,000)
    Cash flow to creditors = –$60,000

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