Question

BALANCE SHEET

Which of the following actions are most likely to directly increase cash as shown on a firm’s balance sheet? Select the appropriate assumptions that underlie your answer.

1. It issues $6 million of new common stock.

2. It buys new plant and equipment at a cost of $3 million.

3. It reports a large loss for the year.

4. It increases the dividends paid on its common stock.

1. Statements (b) and (d) will increase the amount of cash on a company's balance sheet. Statement (a) will decrease cash through the sale of common stock. Selling stock uses cash from financing activities. On one hand, Statement (c) would decrease cash; however, it is also possible that Statement (c) would increase cash, if the firm receives a tax refund for taxes paid in a prior year.

2. Statements (b) and (d) will increase the amount of cash on a company's balance sheet. Statement (a) will increase cash through the sale of common stock. Selling stock provides cash through financing activities. On one hand, Statement (c) would decrease cash; however, it is also possible that Statement (c) would increase cash, if the firm receives a tax refund for taxes paid in a prior year.

3. Statements (b) and (d) will decrease the amount of cash on a company's balance sheet. Statement (a) will increase cash through the sale of common stock. Selling stock provides cash through financing activities. On one hand, Statement (c) would decrease cash; however, it is also possible that Statement (c) would increase cash, if the firm receives a tax refund for taxes paid in a prior year.

4. Statements (b) and (d) will decrease the amount of cash on a company's balance sheet. Statement (a) will decrease cash through the sale of common stock. Selling stock uses cash from financing activities. On one hand, Statement (c) would decrease cash; however, it is also possible that Statement (c) would increase cash, if the firm receives a tax refund for taxes paid in a prior year.

5. Statements (b) and (d) will decrease the amount of cash on a company's balance sheet. Statement (a) will increase cash through the sale of common stock. Selling stock provides cash through financing activities. Statement (c) would neither increase or decrease cash for taxes paid in a prior year.

Answer 1

Observations:

1. It issues $6 million of new common stock. àIncreases cash balances as it involves issuing Common Stock (Ordinary Shares) and receiving Cash.
2. It buys new plant and equipment at a cost of $3 million. à Decreases cash balance as it involves paying cash for buying Plant and Equipment.
3. It reports a large loss for the year. à Loss is derived from Income Statement. It means less income but more expenses. Assuming all income and expenses are cash items, this results in less cash in Balance Sheet.

However, if Income before depreciation is positive, that means there is increase in cash balance in Balance Sheet, as depreciation is a non-cash item. This detail is providing just to share the knowledge, however since this part is not considered in all the options that was provided in the question, this part can be ignored while answering by presuming that the Loss for the year is all related with cash income and cash expenses.

4. It increases the dividends paid on its common stock. à Increase in dividend meaning more dividend payment resulting in less cash.

Considering the above, the appropriate answer is:

3. Statements (b) and (d) will decrease the amount of cash on a company's balance sheet. Statement (a) will increase cash through the sale of common stock. Selling stock provides cash through financing activities. Statement (c) would neither increase or decrease cash for taxes paid in a prior year.

The other options provided in the question are incorrect for the below reasons:

Option 1 mentions Statement (b) and (d) will increase cash which is incorrect based on the above observations.

Option 2 mentions Statements (b) and (d) will increase the amount of cash which is incorrect based on the above observations.

Option 4 mentions Statement (a) will decrease cash through the sale of common stock which is incorrect based on the above observations.

Option 3 mentions “ however, it is also possible that Statement (c) would increase cash, if the firm receives a tax refund for taxes paid in a prior year.” – It is not always true of receiving tax refund (cash) in the current year or a loss making year just because taxes were paid in the prior year. Tax refund will be refund only in cases if excess taxes is paid than required in the prior year.