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

© 2004 Pearson Education Canada Inc.

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Chapter TwoFinancial Statements, Cash

Flows, Taxes, and the Language of Finance

Principles of Managerial Finance

First Canadian Edition

Lawrence J. Gitman and Sean Hennessey


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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.


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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.


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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.


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Four Principal Financial Statements

Developed by the Canadian Institute of Chartered Accountants:

1. Income Statement

2. Balance Sheet

3. Statement of Retained Earnings

4. Statement of Cash Flows


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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.


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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).


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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.


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Balance Sheet (continued)• 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


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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)


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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.


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The Firm’s Cash Flows

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


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Figure 2.2 Cash Flows


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Inflows vs. Outflows

1. Decrease in any asset.2. Increase in any

liability.3. Net income after

taxes.4. Amortization and

other non-cash expenses.

5. Sale of shares.

1. Increase in any asset.2. Decrease in any

liability.3. Net loss.

4. Dividends paid.

5. Repurchase or retirement of shares.


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Developing Cash Flow Statement

1. Cash and marketable securities (start of year).

2. Calculate net cash from operations.

3. Determine total changes in non-cash working capital accounts.

4. Determine cash flows from investing activities.

5. Determine cash flows from financing activities.

6. Determine change in cash and marketable securities (end of year).


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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)


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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).


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Tax-Deductible Expenses

• There are two main categories of deductible expenses for all types of Canadian Corporation:– Operating Expenses– Interest Expenses


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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.


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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


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Language of Finance

• Basic accounting

• Financial forecasting

• Financial markets

• Cost of capital

• Capital budgeting