Fin355 Chapter 2 Answers

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Chapter 2 Textbook Solutions
QUESTIONS
3. Why is EBIT an important line item in the income statement? What does EBIT show us? ANSWER Earnings before interest and taxes (EBIT) is the lowest line on the income statement that isn't affected by the firm's method of financing (the relative amounts of debt and equity used). It is important because it allows an evaluation of physical business operations separate from the influence of financing decisions. It is therefore often called operating income. 4. What is meant by liquidity in financial statements?

ANSWER In financial statements liquidity implies the ease with which assets can be converted into cash without substantial loss. With respect to liabilities it is related to the immediacy with which they require cash.

5. What are the common misstatements of balance sheet figures and why do they present a problem? ANSWER Receivables are often overstated in that they contain uncollectible accounts. Inventories are overstated when items are carried at values that exceed what they're actually worth. Less frequently, payables omit legitimate liabilities of the company. Such misstatements represent a firm as being worth more than it actually is. That deceives investors and others interested in dealing with the company. 6. Do the definitions of current assets and current liabilities suggest a quick way of looking at the firm's ability to meet its financial obligations (pay its bills) over the near term? (Hint: Think in terms of ratios.)

ANSWER Current assets represent things that are expected to become cash within a year (inflows), while current liabilities require cash within a year (outflows). Being able to pay the bills means the inflows have to exceed the outflows in the short run. This suggests forming the ratio of current assets to current liabilities (called the current ratio). If that ratio exceeds 1.0, the firm should be able to pay its bills in the next year.

7. How are capital and working capital different?
ANSWER Capital refers to the money used to start businesses and acquire long-lived assets. Working capital refers to the money used to support day to day operations. We can therefore think of the two as differing with respect to time. Capital is long term and working capital is short term. 8. What is leverage and how does it work? What is the main concern about using it? ANSWER Leverage refers to using borrowed (someone else's) money to support a business rather than the owner's own equity. Leverage can enhance financial results if the business earns more with the borrowed money than the interest cost of borrowing it. In that case leverage multiplies good financial results into better ones. The concern about using borrowed money is that interest has to be paid whether results are good or not. When a business earns less using borrowed money than the cost of borrowing it, leverage multiplies poor results into very poor results.

9. Define the term tax base and discuss common bases. What government units tax on each? What are these taxes commonly called?
ANSWER A tax base is the item or activity on which a tax is levied. The common bases are income, wealth, and consumption. Income taxes simply require the payment of a percentage of income to the

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Chapter 2

government in every period, usually a year. Income is taxed by the federal government, most states, and a few cities (e.g. New York City). A wealth tax charges the owner of property a percentage of its value each year. The most common wealth tax is levied on real estate by cities and counties. A consumption tax charges users a percentage of the cost of products they consume. The most common consumption tax is a sales tax usually levied by states, counties, and cities. The federal government's consumption taxes are called excise taxes.

10. What is the total effective tax rate?
ANSWER The total effective tax rate is the combination of state and federal income tax rates. It is less than the sum of the...
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