Financial Statements, Taxes and Cash Flow

1. Chapter Two Financial Statements, Taxes and Cash Flow

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

3. Chapter Outline • The Balance Sheet • The Income Statement • Cash Flow • Taxes • Capital Cost Allowance • Summary and Conclusions

4. Balance Sheet • The balance sheet is a snapshot of the firm’s assets and liabilities at a given point in time A “snapshot”

5. Liabilities & Equity Assets The Balance Sheet Accounting Equation Assets = Liabilities & Owners’Equity

6. The Balance Sheet

7. Equity = Assets - Liabilities Net Assets Equity: Definition The residual interest in the assets of the entity that remains after deducting liabilities

8. Most Liquid Least Liquid 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

9. Assets - Order of Classification • Current Assets • Investments • Property, Plant & Equipment • Intangible Assets • Other Assets

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

11. Cash Receivables Inventory Current Operating Cycle • Time between acquisition of inventory and the conversion of the inventory back to cash

12. 30-Day note receivable IBM Typical Current Assets • Cash • Short term investments • Accounts and notes receivables • Inventories • Prepaid expenses

13. Liability Classifications • Current Liabilities • Long-term Liabilities

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

15. Typical current liabilities • Accounts Payable • Notes Payable • Accrued Expenses • Deferred Revenues • Current Maturities of Long-term Debt

16. 5 year Bond Patent IBM Noncurrent Assets • Investments • Property, Plant & Equipment • Intangible Assets • Other

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.)

18. Long-Term Liabilities • Examples • Bonds payable • Leasehold obligations • Deferred taxes

19. Net Working Capital Current assets Less: Current liabilities Equals: Net Working capital

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

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.

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

23. Canadian Enterprises Income Statement See 2.14: Canadian Enterprises Example

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)

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

26. Canadian Enterprises Income Statement

27. Canadian Enterprises Balance Sheet

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

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 A B

30. Cash Flow Summary Table 2.4

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

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

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

34. Federal Marginal Tax Rates – 2005 Tax Year Marginal Tax Rate 29% 26% 22% 16% $ of Taxable Income $0 $35,395 $71,190 $115,739

35. Top Marginal Tax Rates: 2005 Salary & Interest Capital Gains Dividends Federal 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 Scotia 48.25 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

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

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

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.

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).

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

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

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?

43. CCA Example – Solution

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

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

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

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?

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.