1. © 2003 The McGraw-Hill Companies, Inc. All rights reserved. Financial Statements, Taxes and Cash Flow Chapter Two

2. 2.1 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

3. 2.2 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Chapter Outline The Balance Sheet The Income Statement Cash Flow Taxes Summary and Conclusions

4. 2.3 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

5. 2.4 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Balance Sheet Assets Liabilities and Equity Cash and Marketable Securities Accounts Payable Accounts Receivable Notes Payable Inventories Accruals Total Current Assets Total Current Liabilities Long-term Debt Machinery and Equipment Total Debt Buildings Preferred Stock Land Common Stock - Depreciation Retained Earnings Total Fixed Assets Total Common Equity Total Assets Total Liabilities and Equity

6. 2.5 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. The Balance Sheet - Figure 2.1

7. 2.6 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

8. 2.7 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Canadian Enterprises Balance Sheet – Table 2.1

9. 2.8 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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?

10. 2.9 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example 2.2 - Quebec Corporation QUEBEC CORPORATION Balance Sheets Market Value versus Book Value BookMarketBookMarket AssetsLiabilities and Shareholders’ Equity NWC$ 400$ 600LTD$ 500 NFA 700 1,000SE6001,100 1,6001,1001,600

11. 2.10 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

12. 2.11 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

13. 2.12 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Canadian Enterprises Income Statement – Table 2.2

14. 2.13 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

15. 2.14 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

16. 2.15 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 = ?

17. 2.16 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Cash Flow Summary Table 2.4

18. 2.17 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

19. 2.18 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. Example: Cash Flows OCF = NCS = Changes in NWC = CF From Assets = CF to Bondholders = CF to Shareholders = CF From Assets =

20. 2.19 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

21. 2.20 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 RatesQuebec Taxable incomeTax RateTaxable IncomeTax Rate $ 0 – 31,67717.0%$ 0 – 26,70016.0% 31,678 – 63,35422.0%26,701 – 53,40520.0% 63,355 – 103,00026.0%53,406 and over24.0% 103,001 and over29.0%

22. 2.21 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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

23. 2.22 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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.

24. 2.23 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 =

25. 2.24 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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)]

26. 2.25 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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 =

27. 2.26 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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.

28. 2.27 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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.

29. 2.28 Copyright © 2005 McGraw-Hill Ryerson Limited. All rights reserved. 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