© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Financial Statements, Taxes and Cash Flow

Chapter

Two

2.2 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

2.3 Chapter Outline

The Balance Sheet The Income Statement Cash Flow Taxes Capital Cost Allowance Summary and Conclusions

2.4 Balance Sheet

The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time

A “snapshot”

2.5 The Balance Sheet

Accounting Equation

Assets = Liabilities & Owners’ Equity

AssetsLiabilities & Equity

2.6 The Balance Sheet

2.7 Equity: Definition

The residual interest in the assets of the entity that remains after deducting liabilities

Equity = Assets - Liabilities

Net Assets

2.8 Asset Classification

In order of Liquidity (where liquidity is defined as the ability to convert to cash at or near face value, i.e. with no loss of value)

Current then Long-Term

Most Liquid

Least Liquid

2.9 Assets - Order of Classification

Current Assets Investments Property, Plant & Equipment Intangible Assets Other Assets

2.10 Definition-Current Asset

Cash and other assets that can reasonably be expected to be converted into cash or consumed within the current operating cycle or one year,

Whichever is longer

2.11 Current Operating Cycle

Time between acquisition of inventory and the conversion of the inventory back to cash

ReceivablesCas

h

Inventory

2.12 Typical Current Assets

Cash Short term investments Accounts and notes receivables Inventories Prepaid expenses

30-Daynote

receivableIBM

2.13 Liability Classifications

Current Liabilities Long-term Liabilities

2.14 Current Liabilities

Obligations expected to be eliminated through the use of existing current assets or by the creation of other current liabilities

Typically, debts that come due within one year

2.15 Typical current liabilities

Accounts Payable Notes Payable Accrued Expenses Deferred Revenues Current Maturities of Long-term Debt

2.16 Noncurrent Assets

Investments Property, Plant & Equipment Intangible Assets Other

5 yearBond

IBMPatent

2.17 Intangible Assets

An intangible asset Does not have a physical existence Is not a financial instrument Typically provides value over a long period of time

Reported at cost less accumulated amortization Intangibles with a limited life are amortized Intangibles with an indefinite life are not amortized but are subject to a

permanent impairment test on a periodic basis Examples:

Patents Trademarks Organization Costs Goodwill (amortization of Goodwill ended in Canada in 2001.

Companies now apply a “permanent impairment” test on a periodic basis.)

2.18 Long-Term Liabilities

Examples Bonds payable Leasehold obligations Deferred taxes

2.19 Net Working Capital

Current assets

Less: Current liabilities

Equals: Net Working capital

2.20 Net Working Capital and Liquidity

Net Working Capital 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 Caveat: tells us nothing about when the current assets will

be converted to cash nor when the current liabilities will require the payment of cash

Liquidity The 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

2.21 Market Vs. Book Value

Book Value - The value of the assets, liabilities and equity, as shown on the Balance Sheet

Market Value - The price at which the assets, liabilities or equity can actually be bought or sold.

2.22 Income Statement

The income statement is a flow concept – it measures the flow of revenues and expenses over some period of time.

Generally report revenues first and then deduct any expenses for the period

Matching principle – GAAP tells us to record revenue when it accrues and match the expenses required to generate the revenue

2.23 Canadian Enterprises Income Statement

See 2.14: Canadian Enterprises Example

2.24 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

We will look at how cash is generated from the firm’s assets and how it is paid to the holder’s of the firm’s securities (stocks & bonds)

2.25 Cash Flow From Assets

Cash Flow From Assets = Operating Cash Flow – Net Capital Spending – Increase in NWC

Cash Flow From Assets (CFFA) = Cash Flow to Bondholders + Cash Flow to Shareholders

Where: NWC = Net Working Capital Net Working Capital = Current Assets – Current Liabilities

A

B

2.26 Canadian Enterprises Income Statement

2.27 Canadian Enterprises Balance Sheet

2.28 Cash Flow Example: Canadian Enterprises

Operating Cash Flow (OCF) = EBIT 694 + Depreciation + 65 – Taxes - 250

= $509 Net Capital Spending (NCS) =

Ending net fixed assets 1,709 – Beginning net fixed assets - 1,644 + Depreciation + 65

= $130 Increase in Net Working Capital =

Ending NWC 1,403 – 389 = 1,014 – Beginning NWC 1,112 – 428 = 684

= $330

2.29 Cash Flow Example: Canadian Enterprises Cash Flow From Assets (CFFA) =

Operating Cash Flow $ 509 – Net Capital Spending -130 – Increase in NWC -330

= $49 CF to Creditors =

Interest paid $ 70 – Net new borrowing - 46

= $24 CF to Shareholders =

Dividends paid $ 65 – Net new equity raised - 40

= $25 CFFA = 24 + 25 = $49

B

A

2.30 Cash Flow Summary Table 2.4

2.31 Taxes - 2.4

Taxes are the largest single expenditure made by the average Canadian family

In total, about 36.8% of Canada's GDP goes to taxes (http://en.wikipedia.org/wiki/Taxation_in_Canada)

A failure to understand how tax is calculated can lead to the payment of more than tax than necessary

Marginal vs. average tax rates Marginal – the percentage paid on the next dollar

earned Average – Total tax paid / taxable income

2.32 Components of an Ideal Tax System

Distribute the tax burden equitably Canada uses a “progressive” tax system, whereby

the amount of tax paid per dollar of income earned rises with income

A “regressive” tax system levies the same percentage tax regardless of income

The tax system should not affect the efficient allocation of resources

The tax system should be easy to administer

2.33 Federal Personal Tax Rates (2005)

TAXABLE INCOME TAX RATE $ 0 - 35,595 16% $35,595 - 71,190 $ 5,695 + 22% on next $35,595 $ 71,190 - 115,739 $13,526 + 26% on next $44,549 Over $ 115,739 $25,109 + 29% on remainder

Alberta Provincial tax is levied at a rate of 10% of federal taxable income

Other provinces levy provincial income taxes as a percentage of federal income tax payable

2.34 Federal Marginal Tax Rates – 2005 Tax Year

Marginal Tax Rate

$ of Taxable Income

$35,395 $71,190 $115,739

16%

22%

26%

29%

$0

2.35 Top Marginal Tax Rates: 2005

Salary &

Interest Capital Gains DividendsFederal 29.0% 14.50% 19.58%B.C. 43.7% 21.85% 31.58%Alberta 39.0% 19.5% 24.08%Saskatchewan 44.0% 22.0% 28.33%Manitoba 46.4% 23.2% 35.08%Ontario 46.41 23.20% 31.33%Quebec 48.22 24.11% 32.81%New Brunswick 46.84 23.42% 37.26%Nova Scotia48.25 24.13% 33.06%PEI 47.37 23.69% 31.96%Newfoundland 48.64 24.32% 37.32%

Note: The rate is the combined federal + provincial tax, including surtaxes when they exist

2.36 Corporate Tax Rates: 2005

Federal Alberta

Non-CCPC 22.1% 11.5%

CCPC

Small Bus < $300,000 13.1% 3%

Active Business Income 22.1% 11.5%

Investment Income 35.8% 11.5%Source: www.kpmg.ca

CCPC – Canadian controlled private corporation

2.37 Capital Gains

A capital gain is equal to Sale Price – Purchase Price One half of the capital gain must be brought into income (50%

inclusion rate), where it is taxed at your full marginal rate For tax purposes, capital gains are first offset against any

capital losses for the same year If capital losses exceed capital gains for the year, the net

capital losses may be carried back three (3) years to offset taxable capital gains in those years

Any remaining capital losses can be carried forward indefinitely to offset future capital gains

2.38 Dividends

Dividends are subject to preferential tax rules On Nov 23, 2005, Minister of Finance Ralph Goodale

announced that the taxation of dividends in Canada will be changed for the 2006 tax year to slow the conversion of firms into Income Trusts

For the 2005 tax year, all dividends are first grossed up by multiplying the actual dividend by 1.25 (The grossed up dividend is referred to as the taxable dividend)

You then claim a tax credit equal to 13.3333% of the taxable dividend

For the 2006 tax year & beyond, dividends from large public companies will have a gross-up of 45% and a dividend tax credit of 19%.

The intent of the gross up and tax credit rules are to eliminate some of the double taxation that occurs when dividends are taxed at the personal level.

2.39 Dividend: Example

You have just received a dividend of $100 from a Canadian corporation. How do you report this on your 2005 tax return?

Step #1: Multiply the actual dividend by 1.25. The result of $125 is the taxable dividend

Multiply the taxable dividend by .133333. The result ($16.66) is the federal tax credit (this reduces your federal personal tax otherwise payable by $16.66).

2.40 Capital Cost Allowance (CCA): One Asset

CCA is depreciation for tax purposes CCA is deducted before taxes and acts as a tax

shield A tax shield is the amount we would have paid in

tax, had we not bought the asset 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

2.41 Some CCA Classes

Class Rate Description

1 4% Buildings purchased after 1987

3 5% Buildings purchased between 1978 & 1987

6 10% Fences, greenhouses, some types of buildings

7 15% Canoes, rowboats, boats & their motors

8 20% Property not included elsewhere

9 25% Aircraft

10 30% Cars, trucks, tractors, computer hardware

12 100% China, cutlery, computer software

16 40% Taxis

17 8% Roads, parking lots, sidewalks

22 50% Most power-operated, movable equipment bought before 1988 & used for excavating, moving, placing or compact earth, rock,

concrete or asphalt

2.42 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?

2.43 CCA Example – Solution

Year

Undepreciated Capital Cost

(Start of Year) CCA

Undepreciated Capital Cost

(End of Year)

2004 $100,000$10,000

(100,000 x 20% x 50%)

$90,000(100,000 - 10,000)

2005$90,000 $18,000

(90,000 x 20%)$72,000

(90,000 - 18,000)

2.44 Selling an Asset When the Pool Remains

When an asset is sold, the UCC of the asset class or pool is reduced by the lesser of sale price or original cost

Example: We purchase a van for $30,000. Five years later we sell it for $7,500.

The sale price (adjusted cost of disposal) is $7,500 and the UCC in Class 10 is reduced by this amount

Assume that, after five years, the remaining UCC for the van was $6,123.

Since the sale price exceeded the UCC, future CCA deductions will be reduced

If the sale price was less then the UCC, the difference will be captured in the form of higher CCA deductions in future years

The adjusted cost of disposal

2.45 Terminating the Asset Pool

An asset pool is terminated when the last asset in the asset class is sold The adjusted cost of disposal is first deducted from the remaining UCC If the adjusted cost of disposal is less then the remaining UCC, the

difference is called a terminal loss. This becomes a tax deduction of the year

If the adjusted cost of disposal is more than the remaining UCC, the difference is called recapture. This is treated like fully taxable income for the period (since we paid too little tax in the past)

If the sale price exceeds the purchase price, then: The adjusted cost of disposal is set equal to the purchase price The difference between the adjusted cost of disposal (the purchase price) and

the remaining UCC is called recapture, which is brought into income and taxed at your full marginal rate

The difference between the sale price and the purchase price is taxed as a capital gain

2.46 Example: Buying & Selling an Antique Car

You purchase a classic car for $50,000 (which is the only asset in class 10)

After five years, you sell the car for $75,000 The UCC after five years is 6,123 Recapture = $50,000 – 6,123 = $43,877 Capital gain = $75,000 – 50,000 = $25,000

2.47 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?

2.48 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.