1. Chapter © 2008 McGraw-Hill Ryerson  Financial Statements, Cash Flow, and Taxes Prepared by Ernest Biktimirov, Brock University

2. 2-1 Chapter Outline 2.1The Balance Sheet 2.2The Income Statement 2.3Cash Flow 2.4Taxes

3. 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 2-2

4. 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 2-3

5. The Balance Sheet – Figure 2.1 2-4

6. Loonie Corporation Balance Sheet – Table 2.1 2-5

7. 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? 2-6

8. Example: Market vs. Book Values KINGSTON CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LTD$ 500 NFA 700 1,000Equity6001,100 $1,100$1,6001,1001,600 2-7

9. 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 2-8

10. Loonie Corporation Income Statement – Table 2.2 2-9

11. 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! 2-10

12. 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 2-11

13. 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 2-12

14. Example: Loonie Corporation OCF (I/S) = EBIT + depreciation – taxes = $547I/S Net Capital Spending (B/S and I/S) = Ending net fixed assets – Beginning net fixed assets + Depreciation = $130B/SI/S Changes in NWC (B/S) = Ending NWC – Beginning NWC = $330B/S Cash Flow from Assets = $547 – 130 – 330 = $87 CF to Creditors (B/S and I/S) = Interest paid – Net new borrowing = $24B/SI/S CF to Stockholders (B/S and I/S) = Dividends paid – Net new equity raised = $63B/SI/S Cash Flow from Assets = $24 + 63 = $87 2-13

15. Example: Balance Sheet and Income Statement 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 2-14

16. 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. 2-15

17. 2-16 2.4 Personal Tax Rates

18. $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 2-17

19. Example: Average vs. Marginal Tax 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) = $7,294.05 Total 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% 2-18

20. 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 2-19

21. Corporate Tax Rates FEDERAL ONTARIO COMBINED General Business 22.1% 14.00%36.1% Manufacturing and Processing 22.1 12.00 34.1 Small Business 13.1 5.50 18.6 (income up to $400,000) 2-20

22. 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 2-21

23. 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? 2-22

24. 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 2-23