Chapter
Two
Financial Statements, Taxes and
Cash Flow
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
2.1
Key Concepts and Skills
 Know the difference between book value and
market value
 Know the difference between accounting
income and cash flow
 Know the difference between average and
marginal tax rates
 Know how to determine a firm’s cash flow
from its financial statements
2.2
Chapter Outline






The Balance Sheet
The Income Statement
Cash Flow
Taxes
Capital Cost Allowance
Summary and Conclusions
2.3
Balance Sheet
 The balance sheet is a snapshot of the firm’s assets
and liabilities at a given point in time
A “snapshot”
2.4
The Balance Sheet
Assets
Liabilities
& Equity
Accounting Equation
Assets = Liabilities & Owners’ Equity
2.5
The Balance Sheet
2.6
Equity:
Definition
The residual interest in the assets of the
entity that remains after deducting
liabilities
Equity = Assets - Liabilities
Net Assets
2.7
Asset Classification
 In order of Liquidity (where liquidity is
defined as the ability to convert to cash at or
near face value, i.e. with no loss of value)
Most
Liquid
Least Liquid
Current then Long-Term
2.8
Assets - Order of Classification





Current Assets
Investments
Property, Plant & Equipment
Intangible Assets
Other Assets
2.9
Definition-Current Asset
 Cash and other assets that can reasonably be
expected to be converted into cash or
consumed
 within the current operating cycle
 or one year,
Whichever
is longer
2.10
Current Operating Cycle
 Time between acquisition of inventory and
the conversion of the inventory back to cash
Typical Current Assets
2.11





Cash
Short term investments
Accounts and notes receivables
Inventories
Prepaid expenses
IBM
30-Day
note
receivable
2.12
Liability Classifications
 Current Liabilities
 Long-term Liabilities
2.13
Current Liabilities
 Obligations expected to be eliminated through
the use of existing current assets or by the
creation of other current liabilities
 Typically, debts that come due within one year
2.14
Typical current liabilities





Accounts Payable
Notes Payable
Accrued Expenses
Deferred Revenues
Current Maturities of Long-term Debt
2.15
Noncurrent Assets




Investments
Property, Plant & Equipment
Intangible Assets
Other
IBM
5 year
Bond
Patent
2.16
Intangible Assets
 An intangible asset
 Does not have a physical existence
 Is not a financial instrument
 Typically provides value over a long period of time
 Reported at cost less accumulated amortization
 Intangibles with a limited life are amortized
 Intangibles with an indefinite life are not amortized but are subject to a
permanent impairment test on a periodic basis
 Examples:




Patents
Trademarks
Organization Costs
Goodwill (amortization of Goodwill ended in Canada in 2001.
Companies now apply a “permanent impairment” test on a periodic
basis.)
2.17
Long-Term Liabilities
 Examples
 Bonds payable
 Leasehold obligations
 Deferred taxes
2.18
Net Working Capital
Current assets
Less:
Current liabilities
Equals: Net Working capital
2.19
Net Working Capital and Liquidity
 Net Working Capital
 Positive when the cash that will be received over the next
12 months exceeds the cash that will be paid out
 Usually positive in a healthy firm
 Caveat: tells us nothing about when the current assets will
be converted to cash nor when the current liabilities will
require the payment of cash
 Liquidity
 The ability to convert to cash quickly without a significant
loss in value
 Liquid firms are less likely to experience financial distress
 However, liquid assets earn a lower return
 Tradeoff between liquid and illiquid assets
2.20
Market Vs. Book Value
 Book Value - The value of the assets, liabilities and
equity, as shown on the Balance Sheet
 Market Value - The price at which the assets,
liabilities or equity can actually be bought or sold.
2.21
Income Statement
 The income statement is a flow concept – it
measures the flow of revenues and expenses
over some period of time.
 Generally report revenues first and then deduct
any expenses for the period
 Matching principle – GAAP tells us to record
revenue when it accrues and match the
expenses required to generate the revenue
2.22
Canadian Enterprises Income Statement
See 2.14: Canadian Enterprises Example
2.23
The Concept of Cash Flow
 Cash flow is one of the most important pieces
of information that a financial manager can
derive from financial statements
 We will look at how cash is generated from the
firm’s assets and how it is paid to the holder’s
of the firm’s securities (stocks & bonds)
2.24
Cash Flow From Assets
 Cash Flow From Assets =
 Operating Cash Flow
 – Net Capital Spending
 – Increase in NWC
A
 Cash Flow From Assets (CFFA) =
 Cash Flow to Bondholders
 + Cash Flow to Shareholders
B
 Where: NWC = Net Working Capital
 Net Working Capital = Current Assets – Current Liabilities
2.25
Canadian Enterprises Income Statement
2.26
Canadian Enterprises Balance Sheet
2.27
Cash Flow Example: Canadian Enterprises
 Operating Cash Flow (OCF) =
 EBIT
 + Depreciation
 – Taxes
694
+ 65
- 250
= $509
 Net Capital Spending (NCS) =
 Ending net fixed assets
1,709
 – Beginning net fixed assets - 1,644
 + Depreciation
+ 65
= $130
 Increase in Net Working Capital =
 Ending NWC 1,403 – 389 = 1,014
 – Beginning NWC 1,112 – 428 = 684
= $330
2.28
Cash Flow Example: Canadian Enterprises
 Cash Flow From Assets (CFFA) =
 Operating Cash Flow $ 509
 – Net Capital Spending -130
 – Increase in NWC
-330
= $49
A
 CF to Creditors =
 Interest paid
 – Net new borrowing
$ 70
- 46
= $24
 CF to Shareholders =
 Dividends paid
 – Net new equity raised
 CFFA = 24 + 25 = $49
$ 65
- 40
= $25
B
2.29
Cash Flow Summary Table 2.4
2.30
Taxes - 2.4
 Taxes are the largest single expenditure made
by the average Canadian family
 In total, about 36.8% of Canada's GDP goes to
taxes (http://en.wikipedia.org/wiki/Taxation_in_Canada)
 A failure to understand how tax is calculated
can lead to the payment of more than tax than
necessary
 Marginal vs. average tax rates
 Marginal – the percentage paid on the next dollar
earned
 Average – Total tax paid / taxable income
2.31
Components of an Ideal Tax System
 Distribute the tax burden equitably
 Canada uses a “progressive” tax system, whereby
the amount of tax paid per dollar of income earned
rises with income
 A “regressive” tax system levies the same
percentage tax regardless of income
 The tax system should not affect the efficient
allocation of resources
 The tax system should be easy to administer
2.32
Federal Personal Tax Rates (2005)




TAXABLE INCOME
$
0 - 35,595
$35,595 - 71,190
$ 71,190 - 115,739
Over $ 115,739
TAX RATE
16%
$ 5,695 + 22% on next $35,595
$13,526 + 26% on next $44,549
$25,109 + 29% on remainder
 Alberta Provincial tax is levied at a rate of 10% of federal
taxable income
 Other provinces levy provincial income taxes as a percentage
of federal income tax payable
2.33
Federal Marginal Tax Rates – 2005 Tax Year
Marginal
Tax Rate
29%
26%
22%
16%
$0
$35,395
$71,190
$115,739
$ of Taxable
Income
2.34
Top Marginal Tax Rates: 2005
Salary &
Interest Capital Gains
Federal
29.0%
14.50%
B.C.
43.7%
21.85%
Alberta
39.0%
19.5%
Saskatchewan
44.0%
22.0%
Manitoba
46.4%
23.2%
Ontario
46.41
23.20%
Quebec
48.22
24.11%
New Brunswick 46.84
23.42%
Nova Scotia
48.25
24.13%
PEI
47.37
23.69%
Newfoundland 48.64
24.32%
Dividends
19.58%
31.58%
24.08%
28.33%
35.08%
31.33%
32.81%
37.26%
33.06%
31.96%
37.32%
Note: The rate is the combined federal + provincial tax, including surtaxes
when they exist
2.35
Corporate Tax Rates: 2005
Non-CCPC
CCPC
Small Bus < $300,000
Active Business Income
Investment Income
Federal
Alberta
22.1%
11.5%
13.1%
22.1%
35.8%
3%
11.5%
11.5%
Source: www.kpmg.ca
CCPC – Canadian controlled private corporation
2.36
Capital Gains
 A capital gain is equal to Sale Price – Purchase Price
 One half of the capital gain must be brought into income (50%
inclusion rate), where it is taxed at your full marginal rate
 For tax purposes, capital gains are first offset against any
capital losses for the same year
 If capital losses exceed capital gains for the year, the net
capital losses may be carried back three (3) years to offset
taxable capital gains in those years
 Any remaining capital losses can be carried forward
indefinitely to offset future capital gains
2.37
Dividends
 Dividends are subject to preferential tax rules
 On Nov 23, 2005, Minister of Finance Ralph Goodale
announced that the taxation of dividends in Canada will be
changed for the 2006 tax year to slow the conversion of firms
into Income Trusts
 For the 2005 tax year, all dividends are first grossed up by
multiplying the actual dividend by 1.25 (The grossed up
dividend is referred to as the taxable dividend)
 You then claim a tax credit equal to 13.3333% of the taxable
dividend
 For the 2006 tax year & beyond, dividends from large public
companies will have a gross-up of 45% and a dividend tax
credit of 19%.
 The intent of the gross up and tax credit rules are to eliminate
some of the double taxation that occurs when dividends are
taxed at the personal level.
2.38
Dividend: Example
 You have just received a dividend of $100
from a Canadian corporation. How do you
report this on your 2005 tax return?
 Step #1: Multiply the actual dividend by 1.25.
The result of $125 is the taxable dividend
 Multiply the taxable dividend by .133333.
The result ($16.66) is the federal tax credit
(this reduces your federal personal tax
otherwise payable by $16.66).
2.39
Capital Cost Allowance (CCA): One Asset
 CCA is depreciation for tax purposes
 CCA is deducted before taxes and acts as a tax
shield
 A tax shield is the amount we would have paid in
tax, had we not bought the asset
 Every capital asset is assigned to a specific
asset class by the government
 Every asset class is given a depreciation
method and rate
 Half-year Rule – In the first year, only half of
the asset’s cost can be used for CCA purposes
2.40
Some CCA Classes
Class
1
3
6
7
8
9
10
12
16
17
22
Rate
4%
5%
10%
15%
20%
25%
30%
100%
40%
8%
50%
Description
Buildings purchased after 1987
Buildings purchased between 1978 & 1987
Fences, greenhouses, some types of buildings
Canoes, rowboats, boats & their motors
Property not included elsewhere
Aircraft
Cars, trucks, tractors, computer hardware
China, cutlery, computer software
Taxis
Roads, parking lots, sidewalks
Most power-operated, movable equipment bought before 1988 &
used for excavating, moving, placing or compact earth, rock,
concrete or asphalt
2.41
Example: CCA Calculation
 ABC Corporation purchased $100,000 worth
of photocopiers in 2004. Photocopiers fall
under asset class 8 with a CCA rate of 20%.
How much CCA will be claimed in 2004 and
2005?
2.42
CCA Example – Solution
Year
2004
2005
Undepreciated
Capital Cost
(Start of Year)
$100,000
$90,000
CCA
Undepreciated
Capital Cost
(End of Year)
$10,000
(100,000 x 20%
x 50%)
$90,000
(100,000 - 10,000)
$18,000
(90,000 x 20%)
$72,000
(90,000 - 18,000)
2.43
Selling an Asset When the Pool Remains
 When an asset is sold, the UCC of the asset class or pool is
reduced by the lesser of
 sale price or
 original cost
The adjusted cost of disposal
 Example: We purchase a van for $30,000. Five years later we
sell it for $7,500.
 The sale price (adjusted cost of disposal) is $7,500 and the
UCC in Class 10 is reduced by this amount
 Assume that, after five years, the remaining UCC for the van
was $6,123.
 Since the sale price exceeded the UCC, future CCA
deductions will be reduced
 If the sale price was less then the UCC, the difference will be
captured in the form of higher CCA deductions in future years
2.44
Terminating the Asset Pool
 An asset pool is terminated when the last asset in the asset class is sold
 The adjusted cost of disposal is first deducted from the remaining UCC
 If the adjusted cost of disposal is less then the remaining UCC, the
difference is called a terminal loss. This becomes a tax deduction of the
year
 If the adjusted cost of disposal is more than the remaining UCC, the
difference is called recapture. This is treated like fully taxable income for
the period (since we paid too little tax in the past)
 If the sale price exceeds the purchase price, then:
 The adjusted cost of disposal is set equal to the purchase price
 The difference between the adjusted cost of disposal (the purchase price) and
the remaining UCC is called recapture, which is brought into income and taxed
at your full marginal rate
 The difference between the sale price and the purchase price is taxed as a
capital gain
2.45
Example: Buying & Selling an Antique Car
 You purchase a classic car for $50,000 (which is the
only asset in class 10)
 After five years, you sell the car for $75,000
 The UCC after five years is 6,123
 Recapture = $50,000 – 6,123 = $43,877
 Capital gain = $75,000 – 50,000 = $25,000
2.46
Quick Quiz
 What is the difference between book value and
market value? Which should we use for decision
making purposes?
 What is the difference between accounting income
and cash flow? Which do we need to use when
making decisions?
 What is the difference between average and marginal
tax rates? Which should we use when making
financial decisions?
 How do we determine a firm’s cash flows? What are
the equations and where do we find the information?
 What is CCA? How is it calculated?
2.47
Summary 2.6
 The balance sheet shows the firm’s accounting value
on a particular date.
 The income statement summarizes a firm’s
performance over a period of time.
 Cash flow is the difference between the dollars
coming into the firm and the dollars that go out.
 Cash flows are measured after-tax.
 CCA is depreciation for tax purposes in Canada.
Remember the half-year rule.