Chapter

© 2008 McGraw-Hill Ryerson

Financial Statements, Cash Flow, and Taxes

Prepared by Ernest Biktimirov, Brock University

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Chapter Outline

2.1 The Balance Sheet

2.2 The Income Statement

2.3 Cash Flow

2.4 Taxes

Key Concepts and Skills

• Know the difference between book value and market value

• Know the difference between accounting net income and cash flow

• Know how to determine a firm’s cash flow from its financial statements

• Understand the difference between average and marginal tax rates, and tax treatment of dividends and capital gains

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2.1 The Balance Sheet

• 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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The Balance Sheet – Figure 2.1

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Loonie Corporation Balance Sheet – Table 2.1

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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 decision-making process?

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Example: Market vs. Book Values

KINGSTON CORPORATION

Balance Sheets

Market Value versus Book Value

Book Market Book Market

Assets Liabilities and Shareholders’ Equity

NWC $ 400 $ 600 LTD $ 500 $ 500

NFA 700 1,000 Equity 600 1,100

$1,100 $1,600 1,100 1,600

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2.2 The Income Statement

• 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

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Loonie Corporation Income Statement – Table 2.2

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Work the Web Example

• Publicly traded companies must file regular reports with Canadian securities regulatory authorities

• These reports are usually filed electronically and can be searched at the SEDAR site

• Click on the “at sign,” pick a company and see what you can find!

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2.3 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

• The statement of cash flows does not provide us with the same information that we are looking at here

• 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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Cash Flow from Assets

• Cash Flow from Assets = Cash Flow to Creditors + Cash Flow to Stockholders

• Cash Flow from Assets = Operating Cash Flow – Net Capital Spending – Change in Net Working Capital

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Example: Loonie Corporation

• OCF (I/S) = EBIT + depreciation – taxes = $547• Net Capital Spending (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

• Cash Flow from Assets = $547 – 130 – 330 = $87• 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 = $63• Cash Flow from Assets = $24 + 63 = $87

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Example: Balance Sheet and IncomeStatement Information

• Current Accounts• 2006: CA = $1,500; CL = $1,300• 2007: CA = $2,000; CL = $1,700

• Fixed Assets and Depreciation• 2006: NFA = $3,000; 2007: NFA = $4,000• Depreciation expense = $300

• LT Liabilities and Equity• 2006: LTD = $2,200; Common Equity = $500; RE = $500• 2007: LTD = $2,800; Common Equity = $750; RE = $750

• Income Statement Information• EBIT = $ 2,700; Interest Expense = $200;• Taxes = $1,000; Dividends = $1,250

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Example: Cash Flows

• OCF = $2,700 + 300 – 1,000 = $2,000• NCS = $4,000 – 3,000 + 300 = $1,300• Changes in NWC = ($2,000 – 1700) – ($1,500 –

1,300) = $100• CF from Assets = $2,000 – 1300 – 100 = $600• CF to Creditors = $200 – ($2,800 – 2,200) = -$400• CF to Stockholders = $1,250 – ($750 – 500)

= $1,000• CF from Assets = -$400 + 1,000 = $600• The Cash Flow identity holds.

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2.4 Personal Tax Rates

$50,000

14%

Tax Rate

Personal Income

Federal marginal tax rate

16%

18%

20%

22%

24%

26%

28%

30%

$100,000 $150,000 $200,000

Federal average tax rate

Average vs. Marginal Tax Rates

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Example: Average vs. MarginalTax Rates

• The taxable income of Stephanie Fenton, an Ontario resident, is $88,000. Calculate Stephanie’s (a) dollar tax liability, (b) average tax rate, and (c) marginal tax rate.

a) Dollar tax liability:

Federal: .15($37,178) + .22($74,357 – 37,178) + .26($88,000 – 74,357) = $17,489.15

Provincial: .0605($35,488) + .0915($70,976 – 35,488) +.1116($88,000 – $70,976) = $7,294.05Total tax: $17,489.15 + $ 7,294.05 = $24,783.20

b) Average tax rate = $24,783.20 /88,000 = 28.16%c) Marginal tax rate = .26 + .1116 = .3716 = 37.16% 2-19

Personal Taxes on Investment Income

• Interest income is taxed at the same rates as ordinary income

• Dividends earned on shares of Canadian companies are effectively taxed at a lower rate than interest income because of the dividend tax credit

• Only half of the capital gain is taxed at the investor’s marginal rate

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Corporate Tax Rates

FEDERAL ONTARIO COMBINED

General Business 22.1% 14.00% 36.1%

Manufacturing andProcessing 22.1 12.00 34.1

Small Business 13.1 5.50 18.6(income up to $400,000)

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Corporate Taxation

• Dividends on shares of other Canadian corporations are not taxed at all!

• Capital Gains (Losses) – Increase (Decrease) in the value of an investment over its purchase price • Only 50% of capital gain is taxable• Loss carry-back• Loss carry-forward

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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?

• How do we determine a firm’s cash flows? What are the equations and where do we find the information?

• What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

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Summary

• 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.

• Normally the marginal tax rate is relevant for financial decision making.

• Interest, dividends, and capital gains are taxed differently at the personal and corporate levels

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