Chapter 2
Financial Statements, Taxes, and Cash Flow
Financial Statements
Balance Sheet
The balance sheet is a statement of the firm’s financial position, listing all assets
(in order of liquidity), liabilities, and equities of a firm at a specific point in time.
Total Assets = Total Liabilities + Stockholders’ Equity
Assets
Cash and Marketable Securities
Accounts Receivable
Inventories
Total Current Assets
Machinery and Equipment
Buildings
Land
Depreciation
Net Plant and Equipment
Total Assets
Liabilities and Equity
Accounts Payable
Notes Payable
Accruals
Total Current Liabilities
Long-term Bonds
Total Debt
Preferred Stock
Common Stock
Retained Earnings
Total Common Equity
Total Liabilities and Equity
Net Working Capital
-
Current Assets – Current Liabilities (NWC = CA – CL)
Positive when the cash that will be received over the next 12 months exceeds the
cash that will be paid out.
NWC is usually positive in a healthy firm.
Liquidity
-
Ability to convert cash quickly without a significant loss in value.
Liquid firms are less likely to experience financial distress because they have an
increased ability to meet short-term obligations.
However, liquid assets earn a lower return.
Canadian Enterprise Balance Sheet
Market Value vs. Book Value
-
The balance sheet provides the book value of the assets, liabilities, and equity.
These values are based on historical cost.
Market value is the price at which the assets, liabilities, or equity can actually be
bought or sold.
The difference between market and book values is usually higher for fixed assets
than for current assets.
For financial decisions, the value of an asset, the value of a firm, or the value of
the firm’s common stock depends on market value.
QUEBEC CORPORATION
Balance Sheets
Market Value versus Book Value
Book
Market
$ 400
NFA
700
1,100
Market
Liabilities and Shareholders’ Equity
Assets
NWC
Book
$ 600 LTD
$ 500
$ 500
600
1,100
1,100
1,600
1,000 SE
1,600
Income Statement
The income statement lists all income and expense items for a particular period of time.
Net Sales
- Cost of Goods Sold
- Depreciation
Operating Income (EBIT)
- Interest
Taxable Income, Earnings Before Taxes (EBT)
- Taxes
Net Income
Net Income = Dividends + Addition to Retained Earnings
Per share data:
Common stock price
Earnings per share (EPS)
Dividends per share (DPS)
Book value per share (BVPS)
Canadian Enterprises Income Statement
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.
Example: Canadian Enterprises
Operating Cash Flow = EBIT + depreciation – taxes
= 694 + 65 -250 = $509
Net capital spending = Ending NFA – Beginning NFA + depreciation
= 1709 – 1644 + 65 = $130
Changes in NWC = Ending NWC - Beginning NWC
= (1403 – 389) – (1112 – 428) = 1014 – 684 = $330
Cash Flow from Assets = 509 – 130 -330 = $49
Cash Flow to Creditors = Interest paid – Net new borrowing
= 70 – (454 – 408) = 70 – 46 = $24
Cash Flow to Stockholders = Dividends paid – Net new equity raised
= 65 – (640 – 600) = 65 – 40 = $25
Cash Flow from Assets = 24 + 25 = $49
Taxes
-
The one thing that we can rely on with taxes is that they are always changing.
Marginal tax rate = the percentage paid on the next dollar earned.
Average tax rate = total tax bill / taxable income
Individual tax rates
These rates apply to income from employment (wages and salary) and from
unincorporated businesses.
Example
You live in Quebec and have a taxable income of $75,000. Find your total tax bill, your
average tax rates, and your marginal tax rate.
Federal Tax Rates
Taxable income
Tax Rate
$ 0 – 31,677
17.0%
31,678 – 63,354
22.0%
63,355 – 103,000
26.0%
103,001 and over
29.0%
Quebec
Taxable Income
$ 0 – 26,700
26,701 – 53,405
53,406 and over
Tax Rate
16.0%
20.0%
24.0%
Federal tax = (($31,677 x 17%) + [($63,354 - 31,677) x 22%] + [($75,000 – 63,354) x
26%] = $5,385.09 + $6,968.94 + $3,027.96 = $15,381.99
Provincial tax = ($26,700 x 16%) + [($53,405 – 26,700) x 20%] + [($75,000 – 53,405) x
24%] = $4,272 + $5,341 + $5,182.8 = $14,795.8
Total tax bill = Federal tax + Provincial tax = $15,381.99 + $14,795.8 = $30,177.79
Average tax rate = Total tax / Taxable income = $30,177.79 / $75,000 = 40.02%
Marginal tax rate = Federal rate + Provincial rate = 26% + 24% = 50%
Taxes on Investment Income
Dividends
-
There is a tax shelter for dividend income. This reduces the problem of double
taxation of dividends.
Actual dividends are “grossed up” by 25% and the federal tax is calculated on this
figure.
A dividend tax credit of 13 1/3 % of the actual dividend is subtracted from the
federal tax to get the net federal tax payable.
The provincial tax is then added.
Example
How will the dividend income for an Ontario resident who earned $5,000 in dividends in
2003 be taxed? His regular income was $150,000 and the Ontario dividend tax credit is
5.13%.
Actual dividends
Gross up to 25%
Grossed up dividends
Federal tax at 29%
Less dividend tax credit
Federal tax payable
$5,000
1,250
(5,000 x 0.25)
$6, 250
1,812.5 (6,250 x 0.29)
(833.13) (0.13333 x $6,250)
$979.37
Provincial tax at 11.6%
Less dividend tax credit
Provincial tax payable
725
(320.63)
$404.37
Total tax
$1,383.74
(6,250 x 0.116)
(6,250 x 0.0513)
(979.37 + 404.37)
Therefore, the tax rate on dividends = ($1,383.74 / $5,000) = 27.67%
OR
The effective tax rate on dividend in Ontario can also be computed using the following
formula:
1.25 [(Federal tax rate – 0.1333) + (Provincial tax rate – 0.0513)]
1.25 [(0.29 – 0.1333) + (0.116 – 0.0513)] = 27.67%
Interest
$5,000 in interest income would be taxed as follows:
Federal tax + Provincial tax = ($5,000 x 29%) + ($5,000 x 11.16%)
= $1,450 + $558 = $2,008
Therefore, the effective tax rate on interest in Ontario = $2,008 / $5,000 = 40.16%
Capital gains
-
Capital gains occur when the selling price of an asset exceeds its original price.
Taxes on capital gains are currently 50% of the applicable marginal rate.
An Ontario resident with capital gains of $5,000 would pay
Capital gains
Taxable capital gains (50%)
Federal tax at 29%
Provincial tax at 11.16%
Total tax
$5,000
2,500
725
279
$1,004
Therefore, the effective tax rate on capital gains in Ontario = $1,004 / $5,000 = 20.08%
As a result, income from capital gains is more attractive than either interest or dividend
income because individuals pay taxes on realized capital gains only when the asset sale
actually takes place.
Corporate taxes
-
-
Canadian corporations must pay taxes to both federal and provincial governments.
Although corporate tax rates appear to be lower than individual tax rates,
corporate income is subject to double taxation because individuals must pay
personal tax income on any dividends received.
Since interest is a tax deductible expense for corporations, debt financing has a
tax advantage over equity financing.
Interest received by a corporation from another Canadian corporation is fully
taxable while dividends are tax exempt.
Capital gains received by corporations are taxed at 50% of the marginal rate.
-
Capital losses occur when the selling price of an asset is lower than its original
cost. If capital losses exceed capital gains, the net capital loss may be carried back
to reduce capital gains in the three prior years.
Capital Cash Allowance (CCA)
-
CCA is depreciation for tax purposes.
CCA is deducted before taxes and acts as a tax shield.
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.
Some CCA Classes
Example
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?
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