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
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2.2
Chapter Outline
•
•
•
•
•
The Balance Sheet
The Income Statement
Cash Flow
Taxes
Summary and Conclusions
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2.3
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
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2.4
Balance Sheet
Assets
Liabilities and Equity
Cash and Marketable Securities
Accounts Receivable
Inventories
Total Current Assets
Accounts Payable
Notes Payable
Accruals
Total Current Liabilities
Machinery and Equipment
Buildings
Land
- Depreciation
Total Fixed Assets
Total Assets
Long-term Debt
Total Debt
Preferred Stock
Common Stock
Retained Earnings
Total Common Equity
Total Liabilities and Equity
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2.5
The Balance Sheet - Figure 2.1
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2.6
Net Working Capital and Liquidity
• 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
– 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
because they have an increased ability to meet short-term
obligations
– However, liquid assets earn a lower return
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2.7
Canadian Enterprises Balance Sheet – Table 2.1
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2.8
Market 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.
• Market value and book value are often different.
Is the difference higher for current assets or
fixed assets? Why?
• Which is more important to the decision-making
process?
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2.9
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
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2.10
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 (EBT)
- Taxes
Net Income
• Net Income = Dividends + Addition to Retained Earnings
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2.11
Income Statement - 2.2
• Per share data:
- Common stock price
- Earnings per share (EPS)
- Dividends per share (DPS)
- Book value per share (BVPS)
• 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
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2.12
Canadian Enterprises Income Statement – Table 2.2
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2.13
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
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2.14
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
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2.15
Example: Canadian Enterprises
• OCF = EBIT + depreciation – taxes
• NCS = ending net fixed assets – beginning net
fixed assets + depreciation
• Changes in NWC = ending NWC – beginning
NWC
• CFFA = ?
• CF to Creditors = interest paid – net new
borrowing
• CF to Stockholders = dividends paid – net new
equity raised
• CFFA = ?
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2.16
Cash Flow Summary Table 2.4
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2.17
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
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2.18
Example: Cash Flows
•
•
•
•
•
•
•
OCF =
NCS =
Changes in NWC =
CF From Assets =
CF to Bondholders =
CF to Shareholders =
CF From Assets =
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2.19
Taxes - 2.4
• The one thing we can rely on with taxes is that
they are always changing
• Marginal vs. average tax rates
– Marginal tax rate– the percentage paid on the next
dollar earned
– Average tax rate– the tax bill / taxable income
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2.20
Individual Taxes
• 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
Quebec
Taxable income
Tax Rate
Taxable Income
Tax Rate
$ 0 – 31,677
17.0%
$ 0 – 26,700
16.0%
31,678 – 63,354
22.0%
26,701 – 53,405
20.0%
63,355 – 103,000
26.0%
53,406 and over
24.0%
103,001 and over
29.0%
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2.21
Individual Taxes
• Federal tax =
• Provincial tax =
• Total tax bill = Federal tax + Provincial tax =
• Average tax rate = Total tax / Taxable income
• Marginal tax rate = Federal rate + Provincial
rate
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2.22
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.
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2.23
Example (Dividends)
• 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
Provincial tax at 11.6%
Less dividend tax credit
Provincial tax payable
Total tax
• Therefore, the tax rate on dividends
=
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2.24
Example (Dividends)
• 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)]
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2.25
Taxes on Investment Income
• Interest
$5,000 in interest income would be taxed as
follows:
Federal tax + Provincial tax =
• Therefore, the effective tax rate on interest in
Ontario =
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2.26
Taxes on Investment Income
• 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
• Therefore, the effective tax rate on capital gains in Ontario
• 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.
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2.27
Corporate Taxes
• 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.
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2.28
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.
• Taxes
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