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
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.2
Chapter Outline
•
•
•
•
•
•
The Balance Sheet
The Income Statement
Cash Flow
Taxes
Capital Cost Allowance
Summary and Conclusions
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.3
The Balance Sheet
• Components
– Assets (Current & Long-Term)
– Liabilities (Current & Long-Term)
– Owners Equity
• Key concepts
– Liquidity
– Net Working Capital
• Current Assets minus Current
Liabilities
– Debt vs. Equity
– Market vs. Book Value
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.4
Balance Sheet - 2.1
• The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
• Assets are listed in order of liquidity
– Ease of conversion to cash
– Without significant loss of value
• Balance Sheet Identity
– Assets = Liabilities + Stockholders’ Equity
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.5
The Balance Sheet - Figure 2.1
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.6
Canadian Enterprises Balance Sheet – Table 2.1
See 2.14: Canadian Enterprises Example
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.7
Net Working Capital and Liquidity
• Net Working Capital
– Current Assets – Current Liabilities
– 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
• Liquidity
– 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
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.8
Debt v.s. Equity
• Generally, when a firm borrows it gives the bondholder first
claim on the firm’s cash flow and assets....equity holders
receive the residual value or whatever is left after the creditors
are paid.
• Thus, shareholders equity is the residual difference between
assets and liabilities.
• The use of debt financing is called financial leverage - debt
financing can magnify returns (gains and losses) to
shareholders or equity holders
– increases the potential return
– also increases the risk factor
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.9
Market Value vs Book Value
• Balance sheet values are book values
– GAAP requires assets to be shown at historical cost
– current asset book values can be very close to market value
– fixed assets can and often have major differences between historical
cost and market value
– GAAP Accounting principles of objectivity and
conservatism are the drivers behind historical cost.
• No argument about historical cost and because book is usually less
than mkt. - they are also conservative( if mkt values fall along way
below book - assets will be written down - good examples of this
are the write-downs of assets by the likes of Nortel, Cisco and
many other high tech. firms
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.10
Market Vs. Book Value
• The balance sheet provides the book value of
the assets, liabilities and equity.
• Market value is the price at which the assets,
liabilities or equity can actually be bought or
sold.
• Market value and book value are often very
different. Why?
• Which is more important to the decisionmaking process?
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.11
Example 2.2 - Quebec Corporation
NWC
NFA
QUEBEC CORPORATION
Balance Sheets
Market Value versus Book Value
Book Market
Book Market
Assets
Liabilities and
Shareholders’ Equity
$ 400 $ 600 LTD
$ 500 $ 500
700 1,000 SE
600 1,100
1,100 1,600
1,100 1,600
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.12
Income Statement - 2.2
• The income statement is more like a video of
the firm’s operations for a specified period of
time.
• You generally report revenues first and then
deduct any expenses for the period
• Matching principle – GAAP say to show
revenue when it accrues and match the
expenses required to generate the revenue
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.13
Canadian Enterprises Income Statement – Table 2.2
See 2.14: Canadian Enterprises Example
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.14
Work the Web Example
• Publicly traded companies must file regular
reports with the Ontario Securities
Commission
• These reports are usually filed electronically
and can be searched at the SEDAR site
• Click on the web surfer, pick a company and
see what you can find!
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.15
The Concept of Cash Flow - 2.3
• 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
utilizing assets and how it is paid to those that
finance the purchase of the assets
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.16
Cash Flow
• Key concept in the study of Corporate Finance
– liquidity is about turning assets into cash
– investment analysis and capital budgeting is about
discounted cash flows
– valuation of securities is about future discounted
cash flow at some rate of discount e.g bonds future interest payments and principle repayments
discounted back at a certain rate
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.17
Cash Flow
• Cash flows are essential to valuation
–
In Finance, one of the main concern is the timing of
cash flows. (another being the discount rate)
–
Since the income statement includes non-cash items, we
will have to adjust it to get information on cash flows
–
Balance sheet activity plays an important role in the
determination of the cash balance (e.g.)
• Collections on accounts receivable
• Borrowing on accounts payable
–
Work with reported financial statements to determine
historical cash flow.
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.18
Cash Flow
• Cash flow from an historical perspective calculated from financial statements - our
focus in this chapter
– how to calculate
• Projected cash flow - look at in later chapters
as we move into the question of valuation of
investments and securities
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.19
GAAP versus Cash Flow Time Line
Revenue
recognized
and
matched
expenses
Sale of goods
on credit
Time
Pay
Payroll
for
checks
raw goods issued
Pay
utilities
Cash flow Cash flow Cash flow
Collect
accounts
receivable
Cash flow
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.20
Cash Flow Summary
–The cash flow identity
Cash flow from assets =
Cash flow to creditors
(bondholders)
+ Cash flow to stockholders (owners)
–The balance sheet identity: Assets =
Liabilities + Equity
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.21
Cash Flow Summary (cont’d)
– II.Cash flow from assets
Cash flow from assets = Operating cash flow
– Net capital spending
– Additions to net working capital (NWC)
where
Operating cash flow =Earnings before interest and taxes (EBIT)
+ Depreciation – Taxes
Net capital spending = Ending net fixed assets –
Beginning net fixed assets
+ Depreciation
Change in NWC = Ending NWC – Beginning NWC
– III.
Cash flow to creditors
Cash flow to creditors = Interest paid – Net new borrowing
– IV. Cash flow to stockholders
Cash flow to stockholders = Dividends paid – Net new equity raised
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.22
Cash Flow From Assets
• Cash Flow From Assets (CFFA) = Cash Flow
to Bondholders + Cash Flow to Shareholders
• Cash Flow From Assets = Operating Cash
Flow – Net Capital Spending – Changes in
NWC
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.23
Example: Canadian Enterprises
• OCF (I/S) = EBIT + depreciation – taxes = $509
• NCS (B/S and I/S) = ending net fixed assets –
beginning net fixed assets + depreciation = $130
• Changes in NWC (B/S) = ending NWC –
beginning NWC = $330
• CFFA = 509 – 130 – 330 = $49
• CF to Creditors (B/S and I/S) = interest paid – net
new borrowing = $24
• CF to Stockholders (B/S and I/S) = dividends paid
– net new equity raised = $25
• CFFA = 24 + 25 = $49
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.24
Cash Flow Summary Table 2.4
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.25
Example: Balance Sheet and Income
Statement Information
• Current Accounts
– 1998: CA = 1500; CL = 1300
– 1999: CA = 2000; CL = 1700
• Fixed Assets and Depreciation
– 1998: NFA = 3000; 1999: NFA = 4000
– Depreciation expense = 300
• LT Liabilities and Equity
– 1998: LTD = 2200; Common Equity = 500; RE = 500
– 1999: LTD = 2800; Common Equity = 750; RE = 750
• Income Statement Information
– EBIT = 2700; Interest Expense = 200; Taxes = 1000; Dividends
= 1250
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.26
Example: Cash Flows
• OCF = 2700 + 300 – 1000 = 2000
• NCS = 4000 – 3000 + 300 = 1300
• Changes in NWC = (2000 – 1700) – (1500 –
1300) = 100
• CF From Assets = 2000 – 1300 – 100 = 600
• CF to Bondholders = 200 – (2800 – 2200) =
-400
• CF to Shareholders = 1250 – (750 – 500) =
1000
• CF From Assets = -400 + 1000 = 600
• The CF identity holds.
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.27
Taxes - key concepts
• Earnings and cash flow are on an after tax basis - taxes
represent real costs and cash requirements for firms
• Taxes can be a major factor in investment decisions including
mergers and acquisitions.
– Tax ‘pools’ of the acquired company can be used in the new entity to
shelter income - the value of these pools to the acquiring company
needs to be established
• Financial management considerations - corporate taxation is a
complex and specialized field.....good communication between
tax experts and other financial staff is important as the after tax
impact of business decisions needs to be established.
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.28
Taxes - 2.4
• The one thing we can rely on with taxes is that
they are always changing
• Marginal vs. average tax rates
– Marginal – the percentage paid on the next dollar
earned
– Average – the tax bill / taxable income
• Other taxes
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.29
Taxes
Key issues:
–
–
–
–
–
–
What is an average tax rate?
What is a marginal tax rate?
Why do we pay attention to marginal tax rates?
What are corporate tax rates?
What are individual tax rates?
How does the difference between corporate and individual
tax rates affect corporate finance?
• How do tax rates relate to the goal of
corporate finance?
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.30
Individual Tax Rates
FEDERAL
Taxable Income $
Tax Rate
0- 332183
16%
32183-64368
22%
64368-104648
104648- UP
26%
29%
Provincial
generally applied as a % of the Basic Federal
Tax - exception Alberta
Alberta - 10%
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.31
T2.7 Marginal versus Average Tax Rates
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.32
Taxes on Investment Income
• taxes on dividends/interest and capital gains
• dividends
– two clear goals • Partial elimination of double taxation with corporations paying
dividends from after tax income and full taxation in the hands
of shareholders -> dividend tax credit
• this tax shelter applies to dividends paid by Canadian
Corporations thus encouraging Canadian investors to invest in
Canadian firms
• Capital Gains
– rates are at 50% of the gain now being taxed - down from 75%
– tax deferral from only realized gains being taxed results in lower
‘effective tax’
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.33
Taxable Income
• taxable income is different from net income
– net income needs to conform to GAAP
– taxable income is calculated according to tax rules
established by the various taxing authorities
– e.g. book depreciation vs capital cost allowance
• book depreciation attempting to match revenues earned from
the use of a tangible depreciable asset with the costs associated
with the asset
• capital cost allowance - allowable deductions associated with
various types of assets - patchwork of tax rules that often have
stemmed from government budget and economic development
objectives.
– Income is taxed differently across various industries
with the ‘rules’ continually changing
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.34
Capital Cost Allowance
• Key concepts and terms:
– Depreciation for tax purposes
– Classes of assets
– Asset purchases and sales
• net acquisitions are used if multiple purchases
• one half year rule applies to net acquisitions
• sale - the balance in the pool is reduced by the lesser of sale
price or original cost
– Termination of asset pool
• terminal loss occurs when there is remaining UCC after the
last asset disposal - this amount is fully tax deductible
• recaptured CCA occurs with a negative UCC after the last
asset disposal - this amount is fully taxable
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.35
Some CCA Classes – Table 2.8
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.36
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?
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.37
CCA Example – Solution
Beginning
Fixed
Assets
CCA
Ending
Fixed
Assets
2004
50000
(100,000 x 50%)
10,000
(50,000 x 20%)
40000
(50,000 - 10,000)
2005
90,000
(40,000 + 50,000)
18,000
(90,000 x 20%)
72,000
(90,000 - 18,000)
Year
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.38
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?
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.
2.39
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.
Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved.