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Outline of the Lecture
2.1 The Balance Sheet
2.2 The Income Statement
2.3 Cash Flow
2.4 Taxes
2.5 Capital Cost Allowance
2
2.1 The Balance Sheet
The balance sheet is asnapshotof the firm.
It summarizes what the firm owns (assets) and what it owes
(liabilities).
Assets minus liabilities belongs to owners. It is defined as
shareholders’ equity.
Assets− Liabilities ≡ Shareholders’ Equity.
3
2.1 The Balance Sheet
Assetsappear on the left-hand side of the balance sheet, and can
be of two types:
Current Assets: Assets that have a life of less than one year.
Cash, inventoryandaccounts receivableare examples of
current assets.
Fixed Assets: Assets that have a relatively long life. Fixed
assets can betangibleor intangible.
A building is a tangible asset.
A patent is an intangible asset.
4
2.1 The Balance Sheet
Liabilities appear on the right-hand side of the balance sheet,
and can also be of two types:
Current Liabilities: Liabilities that mature in less than one
year.Bank borrowingsandaccounts payableare examples
of current liabilities.
Long-Term Liabilities: Liabilities that mature in more than one
year.Long-term debtandemployee future benefitsare
examples of long-term liabilities.
5
2.1 The Balance Sheet
TheNet Working Capital(NWC) is the difference between
current assets and current liabilities.
A positive NWC means that the cash available over the next 12
months exceeds what will have to be paid over that period.
NWC is usually positive in healthy firms.
6
Assets Liabilities & Equity
Current assets
Fixed assets
6NWC
?
Currentliabilities
Long-termliabilities
Shareholders’Equity
7
Liquidity
Liquidity refers to the ease with which an asset can be converted
to cash.
Bank accounts, T-bills and similar assets are relatively liquid.
Inventory is less liquid: There is no guarantee the merchandise
will be sold.
Fixed assets are relatively illiquid.
Assets on the balance sheet are listed from the most liquid to the
least liquid.
8
Debt Versus Equity
Debtholders are the first claimants to the firm’s cash flows.
Shareholders are the residual claimants to the firm’s cash flows.
Were the firm liquidated today, the proceeds from the sale of
assets would first be used to repay debt and anything left would
be distributed among shareholders.
The use of debt in the firm’s capital structure is calledfinancial
leverage.
9
Sun-Rype Products LTD
Dec. 31, 2003, and Dec. 31, 2002, Balance Sheets ($000)
Assets Liabilities and Owners’ Equity
2003 2002 2003 2002
Cash & ST investments 8,595 1,894 Promissory notes 675 675Accounts receivable 10,259 10,183 Accounts payables 14,257 13,603Income taxes receivable 0 1,388 Income taxes payable 647 0Inventories 13,271 10,520 Current portion of LTD 504 30Prepaid expenses 416 372 Total current liabilities 16,083 14,308Future income tax benefit 288 401Total current assets 32,829 24,758 Long-term debt 153 389
Future income taxes 1,486 1,016Net fixed assets (NFA) 23,173 24,006 Total liabilities 17,722 15,713
Share capital & c. s. 18,797 18,688Retained earnings 19,483 14,363Total equity 38,280 33,051
Total assets 56,002 48,764 Total liabilities and equity 56,002 48,764
10
Market Value vs Book Value
Under theGenerally Accepted Accounting Principles, financial
statements show assets athistorical cost.
Assets are carried in the books at their purchase price, as this is
an objective, easily verifiable measure.
Market and book values may be close in the case of current
assets due to their short life.
In the case of fixed assets and equity, there may be substantial
differences between market and book values. Book values often
understate market values.
11
2.2 The Income Statement
Theincome statementmeasures the firm performance over some
period of time, generally a year.
The income shows what has happened between two balance
sheets.
The bottom line of the income statement is the net income or
earnings per share.
12
2.2 The Income Statement
Accounting principles are such that income is reported according
to an “accrual” rule, which provides a measure of current
operating performance.
Revenue and expense recognition are governed by thematching
principle, which states that operating performance can be
measured only if related revenues and expenses are accounted for
during the same period.
Hence accounting income and actual cash flow may be very
different.
13
Sun-Rype Products, LTD2003 Statement of Earnings and Retained Earnings ($000)
Net Sales 111,248Cost of sales 71,925Gross profit 39,323Selling, general, and administrative expenses 27,501Amortization 3,209Earnings before interest and taxes (EBIT) 8,613Interest expense 99Loss on capital dispositions 223Earnings before taxes (EBT) 8,291Taxes 3,171Net earnings 5,120
Retained earnings, beginning of year 14,363Retained earnings, end of year 19,483
Earnings per shareBasic 0.48Diluted 0.48
14
2.2 The Income Statement
Due to the matching principle, accounting income differs from
cash flow because the income statement containsnon-cash items.
Amortizationandloss on capital dispositionsare examples of
non-cash expenses.
There are other non-cash expenses that do not appear explicitely
on the income statement. For example, some of the taxes
reported on the income statement may not be paid in the current
period.Deferred taxesaccumulate in a long-term liability
account on the balance sheet.
15
2.2 The Income Statement
Amortization is a good example of the accrual concept of
income: Consider a $5,000 machine that will be used over five
years, at the end of which its value is expected to be zero. If
depreciation is straight-line, this machine loses $1,000 of its
value per year, seemingly the cost of using the machine as it
produces output.
16
2.2 The Income Statement
In the case of Sun-Rype, deferred taxes is the net change is all
thefuture tax itemson the balance sheets.
From 2002 to 2003, the current asset “future income tax benefit”
has decreases by 113, i.e. from 401 to 288, and the liability
“future income taxes” has increased by 470, i.e. from 1,016 to
1,486.
Deferred taxes in 2003 is then the net change in future taxes, i.e.(1,486−288
)−
(1,016−401
)= 583.
17
The Statement of Cash Flows
This is another financial statement companies must complete.
It provides a summary of inflows and outflows of cash over the
same period as the income statement.
This statement provides insight into the firm’s operating,
investing and financing cash flows and reconciles them with
changes in cash and marketable securities.
18
The Statement of Cash Flows
The statement of cash flow takes a closer look at the cash events
that occurred during the year.
To this end, sources and uses of cash need to be defined.
• Activities that bring cash to the firm are calledsources of
cash.
• Activities that involve spending cash are calleduses of cash.
19
The Statement of Cash Flows
Sources and Uses of Cash
An increase in a liability, (e.g. accounts payable) is a source of
cash.
A decrease in a liability is a use of cash.
An increase in an asset (e.g. inventory) is a use of cash.
A decrease in an asset is a source of cash.
20
The Statement of Cash Flows
For Sun-Rype in 2003, sources of cash are:
Sources of cash
Decrease in income taxes receivable 1,388Decrease in future income tax benefit 113Decrease in net fixed assets 833Increase in accounts payable 654Increase in income taxes payable 647Increase in long-term debt 238Increase in future income taxes 470Increase in share capital 109Increase in retained earnings 5,120Total sources of cash 9,572
21
The Statement of Cash Flows
For Sun-Rype in 2003, uses of cash are:
Uses of cash
Increase in accounts receivable 76
Increase in inventory 2,751
Increase in prepaid expenses 44
Total uses of cash 2,871
22
The Statement of Cash Flows
The net addition to cash is the difference between total sources of
cash and total uses of cash:
Total sources− Total uses = Net addition to cash
9,572 − 2,871 = 6,701.
We can verify that
Cash in 2003 − Cash in 2002 = Net addition to cash
8,595 − 1,894 = 6,701.
23
The Statement of Cash Flows
More formally, the statement of cash flows begins with net
income, then adds all non-cash expenses, changes in non-cash
working capital, capital spending and financing cash flows.
There is no standard format for the statement of cash flows.
Note that there are non-cash expenses that appear on the
statement of cash flow that are not explicitely shown on the
income statement.
24
Sun-Rype Products, LTD2003 Statement of Cash Flows
Cash from operating activitiesNet earnings 5,120Non-cash items:
Amortization 3,209Loss on capital dispositions 223Deferred taxes 583Other 267
Net cash from operations 9,420Changes in non-cash working capital items (182)
Net cash from operating activities 9,220
Cash from investing activitiesNet capital spending (2,599)
Net cash from investing activities (2,599)
Cash from financing activitiesCapital lease payment (29)Change in share capital 109
Net cash from financing activities 80
Net change in cash 6,701
25
The Statement of Cash Flows
Note the following:
• the item “other” in non-cash items in the section non-cash
operating activities is a non-cash expense that does not
explicitely appear on the income statement. This item is
clearly related to long-term debt which seems to involve
lease agreements.
• If one was to go “by the book” all the changes in long-term
debt would appear in the financing activities section.
26
The Statement of Cash Flows
For an outsider, the statement of cash flows would be as on the
following slide.
This is the statement of cash flows one would obtain by
following the textbook, i.e. without being able to exactly identify
all the operating non-cash expenses.
27
Sun-Rype Products, LTD2003 Statement of Cash Flows (Textbook Method)
Cash from operating activitiesNet earnings 5,120Non-cash items:
Amortization 3,209Loss on capital dispositions 223Deferred taxes 583
Net cash from operations 9,135Changes in non-cash working capital items (182)
Net cash from operating activities 8,953
Cash from investing activitiesNet capital spending (2,599)
Net cash from investing activities (2,599)
Cash from financing activitiesChange in promissory notes 0Change in LTD 238Change in share capital 109
Net cash from financing activities 347
Net change in cash 6,701
28
2.3 Cash Flow
Cash flowis one of the most important piece of information that
can be obtained from financial statements.
Cash flow is the most reliable measure of a borrower’s ability to
repay its debts.
In what follows, we calculatecash flow from asset, which may
also be calledfree cash flow. Note that there are different
definitions of free cash flow.
29
2.3 Cash Flow
From the balance sheet, we know that
Assets= Liabilities + Stockholders’ equity,
and thus
Cash flow from assets= Cash flow to bondholders
+ Cash flow to shareholders.
30
2.3 Cash Flow
Cash flow from assets (CF(A))has three components:
Operating cash flow (OCF): Cash flow resulting from
day-to-day activities.
Additions to net working capital (∆NWC): Net change in
short-term assets.
Net Capital spending (NCS): Net purchases of fixed assets.
31
2.3 Cash Flow
Operating cash flowrepresentscash revenuesminuscash costs,
which excludes, among others, amortization and deferred taxes.
In our cash flow calculation, interest expense is considered a
financing expenseand thus will appear in the cash flow to
bondholders.
Note that the way we use financing expense contrasts with the
accounting definition of operating cash flow (interest expense is
not mentioned on the statement of cash flows).
32
2.3 Cash Flow
As we have seen earlier, there are non-cash expenses that can be
seen on the statement of cash flows but not on the income
statement.
It is therefore more precise to calculate OCF using the statement
of cash flows than the income statement.
In what follows, we will calculate CF(A) using two methods:
The textbook method and a more general method.
33
Cash Flow from Assets: Textbook Method
In order to follow the textbook method using Sun-Rype’s
financial statements, we will rearrange Sun-Rype’s balance sheet.
We will lump all future income taxes items in one “net future
income taxes” item and promissory notes and all long-term debt
items together.
34
Sun-Rype Products LTD
Dec. 31, 2003, and Dec. 31, 2002, Balance Sheets ($000), Rearranged
Assets Liabilities and Owners’ Equity
2003 2002 2003 2002
Cash & ST investments 8,595 1,894 Accounts payables 14,257 13,603Accounts receivable 10,259 10,183 Income taxes payable 647 0Income taxes receivable 0 1,388 Total current liabilities 14,904 13,603Inventories 13,271 10,520Prepaid expenses 416 372 LTD and PN 1,332 1,094Total current assets 32,541 24,357 Net future income taxes 1,198 615
Total liabilities 17,434 15,312Net fixed assets (NFA) 23,173 24,006
Share capital & c. s. 18,797 18,688Retained earnings 19,483 14,363Total equity 38,280 33,051
Total assets 55,714 48,363 Total liabilities and equity 55,714 48,363
35
Cash Flow from Assets: Textbook Method
Using the textbook method, OCF is calculated as follows:
OCF = EBIT + Amortization− Taxes.
For Sun-Rype in 2003, this gives
8,613 + 3,209− 3,171 = 8,651.
36
Cash Flow from Assets: Textbook Method
We know that Sun-Rype did not pay 3,171 in taxes in 2003 since
some taxes have been deferred. The actual taxes paid by
Sun-Rype in 2003, referred to ascurrent taxes, are
Current Taxes = Taxes− Deferred Taxes
= 3,171− 583
= 2,588.
37
Cash Flow from Assets: Textbook Method
In the textbook, all taxes are current and thus their definition of
OCF is in fact equivalent to
OCF = EBIT + Amortization− Current Taxes,
which gives
OCF = 8,613 + 3,209− 2,588 = 9,234
for Sun-Rype in 2003.
38
Cash Flow from Assets: Textbook Method
Similarly, OCF can be calculated as follows:
OCF = Net Income+ Amortization + Interest Expense
+ Loss on Cap. Disp.+ Deferred Taxes
which gives
5,120 + 3,209 + 99 + 223 + 583 = 9,234
for Sun-Rype in 2003.
39
Cash Flow from Assets: Textbook Method
∆NWC, in the textbook, is calculated as follows:
∆NWC = NWCend − NWCbeg.
For Sun-Rype in 2003, this gives
32,541−14,904−(
24,357−13,603)
= 6,883.
40
Cash Flow from Assets: Textbook Method
Note that∆NWC is given by the net change in cash minus the
changes in non-cash working capital items from the statement of
cash flows. That is,
∆NWC = 6,701− (−182) = 6,883.
41
Cash Flow from Assets: Textbook Method
NCS, in the textbook, is calculated as follows:
NFAend − NFAbeg + Amortization.
Using Sun-Rype as an example, we need to take the loss on
capital dispositions into account in the NCS calculation since we
used it in the OCF calculation.
42
Cash Flow from Assets: Textbook Method
That is, NCS for Sun-Rype is calculated as follows:
NCS = NFAend− NFAbeg + Amortization+ Loss on Cap. Disp.,
which gives
NCS = 23,173− 24,006 + 3,209 + 223 = 2,599.
43
Cash Flow from Assets: Textbook Method
The overall cash flow from assets for Sun-Rype in 2003 is then
CF(A) = OCF− ∆NWC − NCS
= 9,234− 6,883− 2,599
= −248.
44
Cash Flow from Assets: Textbook Method
Let
CF(B) = Cash Flow to Bondholders
CF(S) = Cash Flow to Shareholders
and thus
CF(A) = CF(B) + CF(S).
45
Cash Flow from Assets: Textbook Method
Cash flow to bondholders is given by
CF(B) = Interest expense− Net new borrowing,
since new borrowing represents a cash flow from creditors to the
firm. For Sun-Rype in 2003, we have
CF(B) = 99 − (1,332−1,094) = −139.
46
Cash Flow from Assets: Textbook Method
Cash flow to shareholders, on the other hand, is given by
CF(S) = Dividends− Net new stock issue,
since the issue of new shares represents a cash flow from
shareholders to the firm. For Sun-Rype in 2003, we have
CF(S) = 0 − (18,797−18,688) = −109.
47
Cash Flow from Assets: Textbook Method
We can see that
CF(A) = CF(B) + CF(S) = (−139) + (−109) = −248.
48
Cash Flow from Assets: A Different Method (optional)
We have seen that the statement of cash flows lists some non-cash
expenses that do not explicitely appear on the income statement.
Also, the changes in non-cash working capital items that appear
on the statement of cash flows may differ from what can be
calculated from the balance sheet.
49
Cash Flow from Assets: A Different Method (optional)
Let us first have a look atcash flow from operations (CFO).
CFO considers all operating cash flows, including changes in
non-cash working capital.
50
Sun-Rype Products, LTD2003 Statement of Cash Flows
Cash from operating activitiesNet earnings 5,120Non-cash items:
Amortization 3,209Loss on capital dispositions 223Deferred taxes 583Other 267
Net cash from operations 9,420Changes in non-cash working capital items (182)
Net cash from operating activities 9,220
Cash from investing activitiesNet capital spending (2,599)
Net cash from investing activities (2,599)
Cash from financing activitiesCapital lease payment (29)Change in share capital 109
Net cash from financing activities 80
Net change in cash 6,701
51
Cash Flow from Assets: A Different Method (optional)
CFO considers interest as an operating expense, we consider it as
a financing expense. We must therefore add back interest to CFO
in order to measure cash flow.
Note, however, that interest expense saves the company taxes
since interest is a tax-deductible expense.
To have a better feeling of the company’s ability to generate cash,
it then makes sense to add back theafter-tax interest expense.
52
Cash Flow from Assets: A Different Method (optional)
Net capital spending can also be found on the statement of cash
flows.
That is, we can usecash flow from investing activities (CFI)to
measure the firm’s net capital spending.
To finish, we also need to consider the change in cash. Whatever
is added to the firm’s cash account is not distributed to investors
and is thus condidered an outflow.
53
Sun-Rype Products, LTD2003 Statement of Cash Flows
Cash from operating activitiesNet earnings 5,120Non-cash items:
Amortization 3,209Loss on capital dispositions 223Deferred taxes 583Other 267
Net cash from operations 9,420Changes in non-cash working capital items (182)
Net cash from operating activities 9,220
Cash from investing activitiesNet capital spending (2,599)
Net cash from investing activities (2,599)
Cash from financing activitiesCapital lease payment (29)Change in share capital 109
Net cash from financing activities 80
Net change in cash 6,701
54
Cash Flow from Assets: A Different Method (optional)
With all these values, we can compute the firm’sfree cash flow
(FCF):
FCF = CFO + (1− t)Interest− CFI − ∆Cash
For Sun-Rype in 2003, this gives:
FCF = 9,220 +(
1− 3,1718,291
)×99− 2,599− 6,701 = −19
55
Cash Flow from Assets: Conclusion
Operating cash flowis a crucial indicator of a firm’s capacity to
generate return to its stakeholders. A firm with a negative
operating cash flow does generate enough revenue to cover
operating costs.
A negativetotal cash flowis not alarming when the firm is
growing. It should nevertheless be positive at some point in time
otherwise the return from investing in the firm cannot be positive.
56
2.5 Capital Cost Allowance
Capital cost allowance(CCA) is depreciation for tax purposes in
Canada. CCA provides atax shieldfor Canadian corporations.
To calculate the CCA for an asset, we must know its asset class,
which determines the rate to be used. (e.g. 4% for buildings
acquired after 1987, 30% for vans and trucks)
57
2.5 Capital Cost Allowance
The half-year rule: Only one half of an asset value can be
depreciated for tax purposes in the first year. This ensures that
the tax shield is applied on assets that have actually been used
during the year.
58
2.5 Capital Cost Allowance
Let V denote the asset cost at the time of its purchase, and letc
denote the CCA rate for this asset class (assume this is not
straight-line depreciation).
CCA depreciation in the first year, denotedD1, is
D1 = c×V2
,
and the undepreciated capital cost (UCC) after one year is
UCC1 = V − D1 = V − cV2
= (1−c)V2
+V2
.
59
2.5 Capital Cost Allowance
CCA depreciation in the second year is
D2 = c×UCC1
and the undepreciated capital cost after two years is
UCC2 = UCC1 − D2
= (1−c)UCC1
= (1−c)2V2
+ (1−c)V2
.
60
2.5 Capital Cost Allowance
Similarly, in the third year is
D3 = c×UCC2
and thus
UCC3 = UCC2 − D3
= (1−c)UCC2
= (1−c)3V2
+ (1−c)2V2
.
61
2.5 Capital Cost Allowance
We can generalize this expression for allt ≥ 2, i.e.
Dt = c×UCCt−1
and
UCCt = (1−c)t V2
+ (1−c)t−1V2
.
62
2.5 Capital Cost Allowance: An Example
Mississauga Manufacturing Ltd. just invested in some new
processing machinery to take advantage of more favourable CCA
rates in a new federal budget. The machinery qualifies for 25
percent CCA rate and has an installed cost of $1,800,000.
Calculate the CCA and UCC for the first five years.
63
2.5 Capital Cost Allowance: An Example
Answer: In the first year, the CCA rate can only be applied on
half the instalment cost, which is $900,000. This means a CCA
depreciation of
25%×900,000 = $225,000
in the first year, and thus
UCC1 = 1,800,000− 225,000 = $1,575,000
64
2.5 Capital Cost Allowance: An Example
The CCA depreciation in the second year is
25%×1,575,000 = $393,750,
and thus
UCC2 = 1,575,000− 393,750 = $1,181,250.
65
2.5 Capital Cost Allowance: An Example
For the first five years, we have
Year Beginning UCC CCA Ending UCC
1 $1,800,000.00 $225,000.00 $1,575,000.00
2 1,575,000.00 393,750.00 1,181,250.00
3 1,181,250.00 295,312.50 885,937.50
4 885,937.50 221,484.38 664,453.12
5 664,453.12 116,113.28 498,339.84
66
Asset Purchases and Sales
Suppose an asset is sold at timeT for $S. Two things may
happen:
S> UCCT : If S> UCC0, the differenceS−UCC0 is taxed as
capital gain, and the differenceUCC0−UCCT is substracted
from the asset pool (assuming the asset pool is continued).
S≤UCCT : In this case, the differenceUCCT −S is added to the
asset pool and depreciates until the asset pool is terminated
(possibly forever).
67
Asset Purchases and Sales
In reality, this procedure will be applied on net acquisitions of
assets. That is, what is added to or subtracted from the asset pool
depends on the net proceeds from asset sales and purchases.
When an asset pool is terminated (the last asset in it has just been
sold), then the difference between UCC and the sale proceeds are
either added to or subtracted from the income. If the sales price
is below UCC, the terminal loss (UCC−S) is subtracted from the
income. On the other hand, ifS> UCC, then the difference
(S−UCC) is added to the income and CCA is recaptured.
68
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