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Financial Statements, Cash Flow, and Taxes

2. Financial Statements, Cash Flow, and Taxes. Prepared by Ernest Biktimirov, Brock University. 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

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Financial Statements, Cash Flow, and Taxes

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  1. 2 Financial Statements, Cash Flow, and Taxes Prepared by Ernest Biktimirov, Brock University

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

  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

  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

  5. The Balance Sheet – Figure 2.1

  6. Loonie Corporation Balance Sheet – Table 2.1

  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?

  8. Example: Market vs. Book Values

  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

  10. Loonie Corporation Income Statement – Table 2.2

  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!

  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

  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

  14. 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

  15. 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

  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.

  17. 2.4 Personal Tax Rates

  18. Average vs. Marginal Tax Rates Tax Rate Federal marginal tax rate 30% 28% Federal average tax rate 26% 24% 22% 20% 18% 16% Personal Income 14% $150,000 $100,000 $50,000 $200,000

  19. 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) = $7,294.05 • 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%

  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

  21. Corporate Tax Rates FEDERALONTARIOCOMBINED 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)

  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

  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?

  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

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