Chapter Two Financial Statements, Cash Flows, Taxes, and the Language of Finance

1. Chapter TwoFinancial Statements, Cash Flows, Taxes, and the Language of Finance Principles of Corporate Finance Canadian Edition Lawrence J. Gitman and Sean Hennessey

2. Learning Goals LG1 – Review characteristics, format, key components, and relationships between Income Statement, Balance Sheet, Statement of Retained Earnings, and Statement of Cash Flows. LG2 – Analyze a firm’s cash flows; develop and interpret the statement of cash flows.

3. Learning Goals (continued) LG3 – Introduce basics of corporate taxation in Canada. LG4 – Understand tax deductibility of expenses, how they reduce actual, after-tax costs to a profitable company. LG5 – Discuss and illustrate Capital Cost Allowance (CCA), the tax version of amortization, and how CCA increases cash flows.

4. Learning Goals (continued) LG6 – Review the information provided in a publicly traded company’s annual report to shareholders. LG7 – Discuss some key concepts in finance and review the language of finance.

5. Four Principal Financial Statements Developed by the Canadian Institute of Chartered Accountants: • Income Statement • Balance Sheet • Statement of Retained Earnings • Statement of Cash Flows

6. Income Statement • Provides financial summary of operating results for a specified period. • Main operating results consist of: • Sales revenues, Cost of goods sold, Operating expenses, Interest expenses, Taxes, and Preferred share dividends.

7. Income Statement (continued) • Important sub-totals of these operating results are: • Gross margin. • Operating earnings (EBIT). • Earnings before taxes (EBT). • Net Income after taxes (NIAT). • Earnings available for common shareholders (EAC).

8. Balance Sheet • Presents summary of firm’s financial position at a given point in time. • Assets = Liabilities + Equity. • In the short term, working capital management focuses on current assets and current liabilities.

9. Current Assets: Cash, Marketable securities, Accounts receivable, Inventories Gross Fixed Assets: Land & Buildings, Machinery & equipment, Furniture, Vehicles, Others Less: Accumulated amortization Current Liabilities: Accounts payable, Line of credit, Accruals Long-term debt Shareholder’s equity: Preferred shares, Common shares, Retained earnings Balance Sheet (continued)

10. Statement of Retained Earnings • Details changes in Retained Earnings from the beginning to the end of the fiscal year. Retained Earning Balance (start of year) Plus: Net Income After Taxes Less: Cash Dividends Paid Retained Earning Balance (end of year)

11. Statement of Cash Flows • Provides summary of all inflows and outflows of cash over the same period as the Balance Sheet. • Provides insights into the firm’s operating, investment, and financing cash flows. • Reconciles changes in cash and marketable securities.

12. Operating Flows: Payments: Accruals, Credit purchases, Taxes, Overhead expenses Receipts: Cash sales, Collection of credit sales, Tax refunds Investment Flows: Purchases & Sales: Fixed assets, Business interests Financing Flows: Increases in Debt or Equity Reductions in Debt or Equity The Firm’s Cash Flows

13. Figure 2.2 Cash Flows

14. Decrease in any asset. Increase in any liability. Net income after taxes. Amortization and other non-cash expenses. Sale of shares. Increase in any asset. Decrease in any liability. Net loss. Dividends paid. Repurchase or retirement of shares. Inflows vs. Outflows

15. Developing Cash Flow Statement • Cash and marketable securities (start of year). • Calculate net cash from operations. • Determine total changes in non-cash working capital accounts. • Determine cash flows from investing activities. • Determine cash flows from financing activities. • Determine change in cash and marketable securities (end of year).

16. Taxation of Business Income • Corporations can earn four types of income: • Active Business Income • Passive Income • Intercorporate Dividends • Capital Gains • Types of Corporations for tax purposes: • Non-Manufacturing • Manufacturing or Processing • Canadian-controlled private corporation (CCPC)

17. Deductions from Federal Tax Rate • Federal Corporate Tax for general Non-Manufacturing is 29.12%. • Manufacturing and processing deduction (Federal Tax of 22.12% of earnings). • Small business deduction (Federal Tax of 13.12% on earnings up to $200,000). • CCPC rate reduction (Federal Tax of 22.12% on earnings between $200,000 and $300,000).

18. Tax-Deductible Expenses • There are two main categories of deductible expenses for all types of Canadian Corporation: • Operating Expenses • Interest Expenses

19. CCA-Capital Cost Allowance • Canadian Customs and Revenue Agency (CCRA) requires companies to use their schedule of Capital Cost Allowance (CCA) as a means of amortizing expenses of capital equipment for tax purposes. • Like the concept of amortization, CCA is a non-cash expense item that is deductible for tax purposes.

20. Company Annual Report • Required for all publicly traded firms • Letter to Shareholders • Management’s Discussion and Analysis • Financial Statements: • Income statement, Balance Sheet, Statement of retained earnings, Statement of cash flows • Summary

21. Language of Finance • Basic accounting • Financial forecasting • Financial markets • Cost of capital • Capital budgeting