Financial Statements,
Cash Flows and Taxes
1
Outline
• The Balance Sheet
• The Income Statement
• Net Working Capital
• Financial Cash Flow
• Personal and Corporate Taxes
• Summary and Conclusions
2
The Balance Sheet
• An accountant’s snapshot of the firm’s accounting
value as of a particular date.
• The Balance Sheet Identity is:
Assets = Liabilities + Stockholder’s Equity
3
ABC Inc. Balance Sheet
as of Dec 31 ($ in thousands)
Assets
Current Assets
Cash
Accounts Receivables
Inventory
Total
Fixed Assets
Net Plant & Equipment
Total Assets
2021
2022
$45
260
320
$625
$50
310
385
$745
$985
$1610
$1100
$1845
4
Balance Sheet (Continued)
• The assets are listed in order by the length of
time it normally would take a firm with
ongoing operations to convert them into cash.
• Clearly, cash is much more liquid than
property, plant and equipment.
5
Balance Sheet (Continued)
Liabilities and Equity
Current Liabilities
Accounts Payables
Notes Payable
Total
Long term debt
Shareholders Equity
Common stock
Retained Earnings
Total
Total Liabilities & Equity
2021
2022
$210
110
$320
$205
$260
175
$435
$225
290
795
$1085
$1610
290
895
$1185
$1845
Liability order reflects time to maturity
6
Balance Sheet Analysis
•
When analyzing a balance sheet, the
financial manager should be aware of three
concerns:
1. Liquidity
2. Debt versus equity
3. Market Value versus Book value
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Liquidity
• Refers to the ease and speed with which
assets can be converted to cash.
• Current assets are the most liquid.
• Some fixed assets are intangible.
• The more liquid a firm’s assets, the less likely
the firm is to experience problems meeting
short-term obligations.
• Liquid assets frequently have lower rates of
return than fixed assets.
8
Debt versus Equity
• Generally, when a firm borrows it gives the
bondholders first claim on the firm’s cash flow.
• Thus shareholder’s equity is the residual
difference between assets and liabilities.
9
Debt Vs. Equity Example
Original
Sales
$1000
COGS
-700
Depreciation
-50
EBIT
250
Interest
-50
Taxable Income
200
Taxes @ 40%
-80
Net Income
120
Number of Shares 1000
EPS
0.12
Expansion Project Requiring $1000 investment
Issued 500 common
Issued $1000 in
Shares @ $2 each
Bonds @10%
1500
$1200
$1500 $1200
-1000
-1000
-1000
-1000
-100
-100
-100
-100
400
100
400
100
-50
-50
-150
-150
350
50
250
-50
-140
-20
-100
20
210
30
150
-30
1500
1500
1000
1000
0.14
0.02
0.15
-0.03
10
Market Value versus Cost (Book Value)
• The accounting value of a firm’s assets is
frequently referred to as the carrying value or
book value.
• Market value is a completely different
concept. It is the price at which willing buyers
and sellers trade the assets.
11
The Income Statement
• The income statement measures performance
over a specific period of time.
• The accounting definition of income is
Revenue – Expenses = Income
12
ABC Inc. Income Statement for year ending 2022 ($ in
thousands)
Net Sales
Cost of Goods Sold
Depreciation
Earnings Before Interest & Taxes
Interest
Taxable Income
Taxes
Net Income
$710
480
30
$200
20
180
53
$127
Dividends
Additions to Retained Earnings
27
$100
13
Income Statement Analysis
•
There are three things to keep in mind when
analyzing an income statement:
1. International Financial Reporting Standards
(IFRS)
2. Non Cash Items
3. Time and Costs
14
International Financial Reporting Standards
1. IFRS
• The matching principle of IFRS dictates that
revenues be matched with expenses. Thus,
income is reported when it is earned, even
though no cash flow may have occurred.
• Income is reported when it is earned or accrued.
(For example, when goods are sold for credit,
sales and profits are reported).
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Income Statement Analysis
2. Non Cash Items
• These are expenses that do not affect cash flow
directly.
• Depreciation is the most apparent. No firm ever
writes a cheque for “depreciation.”
• Another noncash item is deferred taxes, which
does not represent a cash flow.
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Income Statement Analysis
3. Time and Costs
• In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can
vary such inputs as labour and raw materials.
• In the long run, all inputs of production (and hence
costs) are variable.
• Financial accountants do not distinguish between
variable costs and fixed costs. Instead, accounting
costs usually fit into a classification that
distinguishes product costs from period costs.
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Net Working Capital
Net Working Capital = Current Assets – Current Liabilities
• NWC is +ve when current assets are greater
than current liabilities.
• A firm can invest in NWC. This is called
change in NWC.
• The change in NWC is usually +ve in a
growing firm.
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ABC Inc. Current Assets and Current Liabilities
as of Dec 31 ($ in thousands)
Current Assets
Cash
Accounts Receivables
Inventory
Total
2021
$45
260
320
$625
2022
$50
310
385
$745
Current Liabilities
2021
2022
Accounts Payables
$210
$260
Notes Payable
110
175
Total
$320
$435
Here we see NWC increased from 625-320 = $305 in 2021 to 745-435
=310 in 2022. This increase of $5 is an investment of the firm.
19
Financial Cash Flow
• In finance, the most important item that can
be extracted from financial statements is the
actual cash flow of the firm.
• Since there is no magic in finance, it must be
the case that the cash received from the firm’s
assets must equal the cash flows to the firm’s
creditors and stockholders.
CF(A) = CF(B) + CF(S)
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Cash Flow Summary
1. Cash Flow from Assets =
Cash Flow to Creditors + Cash Flow to Stockholders
This is based upon the balance sheet identity:
Assets = Liabilities + Equity
2. Cash Flow from Assets =
Operating Cash Flow
- Net Capital Spending
- Additions to NWC
Where
Operating Cash Flow =
Net Capital Spending =
EBIT + Depreciation – Taxes
Ending Net Fixed Assets
- Beginning NFA
+ Depreciation
Change in NWC = Ending NWC – Beginning NWC
3. Cash Flow to Creditors = Interest Paid – Net New Borrowing
4. Cash Flow to Stockholders = Dividends paid – Net New Equity Raised
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ABC Inc Cash Flow from Assets ($ in thousands)
Cash Flow from Assets:
Operating Cash Flow:
EBIT
+ Depreciation
- Taxes
=OCF
Change in Net Working Capital:
Ending NWC
- Beginning NWC
=Change in NWC
Net Capital Spending:
Ending Net Fixed Assets
-Beginning Net Fixed Assets
+Depreciation
=Net Capital Spending
1100
-985
30
$145
Cash Flow from Assets
$27
$200
30
53
$177
$310
-305
$5
22
ABC Inc Cash Flow from Assets ($ in thousands)
Total Cash Flow to Creditors and Stockholders:
Cash Flow to Creditors:
Interest Paid
-Net New Borrowing
Cash Flow to Creditors
$20
-20
0
Cash Flow to Stockholders:
Dividends Paid
-Net New Equity Raised
Cash Flow to Stockholders
$27
0
$27
Cash Flow to Creditors and Stockholders
$27
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CORPORATE AND PERSONAL
TAXES
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Federal & Ontario Personal Tax Rates,
Brackets, and Surtaxes for 2021
Jurisdiction
Federal
Bracket ($s)
$49,020 or less
$49,021 - 98,040
$98,041 - 151,978
$151,979 – 216,511
Over $216,511
Tax Rate
15%
$7,353 + 20.5% on next $49,020
$17,402.1 + 26% on next $53,938
$31,425.98 + 29% on the next 64,533
$50,140.55 + 33% on income over $216,511
Ontario
$45,142 or less
$45,143 – 90,287
$90,288 – 150,000
$150,001 – 220,000
Over $220,000
5.05%
2,279.67 + 9.15% on next $45,145
$6,410.44 + 11.16% on next $59,713
$13,074.41 + 12.16% on next $70,000
$21,586.41 + 13.16% on income over $220,000
No Surtax at Federal level.
Ontario Income Tax < $4,875
Ontario Income Tax $4,875 – 6,237
Ontario Income Tax above $6,237
surtax =$0
surtax = 20%
surtax = $272.60 + 56% of Ontario Income Tax above $6,237
Dividend Gross up is 38%. Dividend tax credit is 20.73% at the federal level and 13.8% at the Ontario
level of the actual dividend
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Taxation of Investment Income
• interest income taxed like employment income.
• Dividends from Canadian companies are grossed
up by 44% (taxable dividend); then a dividend tax
credit (DTC) is deducted from tax payable — this
messy mechanism reduces double taxation:
–
–
–
–
–
Taxable dividend (TD) = 1.44 × Dividend
Include TD in taxable income
Federal DTC = 0.1797 × TD
Provincial DTC = Prov. credit % × TD
Deduct DTC from federal and provincial tax.
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Capital Gains Taxation
• Capital gain is the profit from sale of an
investment.
• Taxable capital gain is the portion included in
taxable income.
• Inclusion rate 50%.
• Net allowable capital losses can only be
written off against taxable capital gains.
• Tax-free: gain on principal residence; first
$500K of family farms, small businesses.
27
Marginal Tax Rates
• Marginal or incremental income/cost is the
basis for financial decisions.
• Marginal tax rate is the rate that applies to the
marginal, or incremental income — the “next
$”.
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Investment Income Tax Treatment for an Ontario
Resident with a taxable income of $220,000
• Interest Tax Treatment
Interest
Federal Tax @ 33%
Provincial Tax @ 13.16%
Surtax @ 56% of the Provincial Tax
Total Tax
$1000.00
330.00
131.60
73.70
$535.30
Capital Gain
Taxable Capital Gain
Federal Tax at 33%
Provincial Tax @ 13.16%
Surtax @ 56% of the Provincial Tax
Total Tax
$1000.00
500.00
165.00
65.80
36.85
$267.65
• Capital Gain Tax Treatment
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Investment Income Tax Treatment for an Ontario
Resident with a taxable income of $220,000
(continued)
• Dividend Tax Treatment
Dividends
Gross Up at 38%
Grossed Up Dividends
$1000.00
380.00
$1380.00
Federal Tax @ 33% on Grossed Up Dividend
Less Dividend Tax Credit @ 20.73% of Actual Dividend
Federal Tax Payable
Provincial Tax @ 13.16%
Surtax @ 56% of the Provincial Tax
Less Dividend Tax Credit @ 13.8% of Actual Dividend
Provincial Tax including Surtax
Total Tax
455.40
207.30
248.10
181.61
101.70
138.00
145.31
$393.41
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Corporate Tax Rates in Canada
Federal
Ontario
Combined
15%
11.5%
26.5%
All small corporations 9%
with a taxable income
up to $500,000
3.2%
12.2%
Basic corporation
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Carry-back and Carry-forward
• Net capital loss can be carried back up to 3
years and forward indefinitely to reduce
prior or future taxes on capital gains
• Net operating loss can be carried back and
forward up to 3 and 20 years respectively
since 2006
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Capital Cost Allowance (CCA)
• CCA is the depreciation for tax purposes.
• CCA is deducted before taxes and acts as a tax
shield.
• Every capital assets is assigned to a specific asset
class by the government.
• Every asset class is given a depreciation method
and rate.
• The CCA rate is the rate that is applied to the
undepreciated capital cost (UCC) of an asset class.
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Common Capital Cost Allowance
Classes
Class Rate
1 4%
8 20%
10 30%
Assets
Buildings acquired after 1987
Furniture, photocopiers
Vans, trucks, tractors, and
equipment
22 50%
Pollution control equipment
43 30%
Manufacturing Equipment
45 45%
Computers
13 Straight line Leasehold improvements
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UCC and CCA
• UCC: Undepreciated capital cost
(undepreciated book value of assets)
• UCC(at the end of the year)=UCC (at the
beginning of the year) – CCA
• Initial UCC = Cost of Asset at Purchase
• Half-year Rule – In the first year of the
acquisition, CCA will be claimed only on half of
the net acquisition value of the asset
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CCA and CCA Tax Shield
Example: Van was purchased for $30,000. Tax rate is 40%.
UCC of
CCA at
Year Pool
Addition
30%
T(CCA)
1
$0
$30,000
$4,500
$1,800
2
25,500
0
7,650
3,060
3
17,850
0
5,355
2,142
4
12,495
0
3,748
1,499
5
8,747
0
2,624
1,050
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Summary and Conclusions
• Financial statements provide important
information regarding the value of the firm.
• A financial manager should be able to determine
cash flow from the financial statements of the
firm.
• Knowing how to determine cash flow helps the
financial manager make better decisions.
• Since taxes affect cash flows, we learned how
corporations are taxed.
• Not all investment incomes are taxed the same.
We learned how different types of investment
incomes are taxed at the personal level.
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