Financial statements cash flow and taxes
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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

2

Financial Statements, Cash Flow, and Taxes

Prepared by Ernest Biktimirov, Brock University


Chapter outline

Chapter Outline

2.1The Balance Sheet

2.2The Income Statement

2.3Cash Flow

2.4Taxes


Key concepts and skills

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


2 1 the balance sheet

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


The balance sheet figure 2 1

The Balance Sheet – Figure 2.1


Loonie corporation balance sheet table 2 1

Loonie Corporation Balance Sheet – Table 2.1


Market vs book value

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?


Example market vs book values

Example: Market vs. Book Values


2 2 the income statement

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


Loonie corporation income statement table 2 2

Loonie Corporation Income Statement – Table 2.2


Work the web example

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!


2 3 the concept of cash flow

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


Cash flow from assets

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


Example loonie corporation

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


Example balance sheet and income statement information

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


Example cash flows

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.


2 4 personal tax rates

2.4 Personal Tax Rates


Financial statements cash flow and taxes

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


Example average vs marginal tax rates

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%


Personal taxes on investment income

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


Corporate tax rates

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)


Corporate taxation

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


Quick quiz

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?


Summary

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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