Financial Statements, Cash Flows, and

Taxes

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 Financial Statements

When obtaining loans, raising share capital, buying/selling

parts or all of a business, it would be optimal if the financial
manager could obtain market values for all of the firm’s
assets;
Perfect information is difficult to find.
We rely on financial statements as our information source.
– Based on accounting methods (GAAP, then IFRS)
We need to convert historical accounting data into projected
future cash flows.

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 The Balance Sheet

The balance sheet is a snapshot of the firm (the financial

“picture”) at a point in time.
Assets (what the firm owns) equals Liabilities (what the firm
owes) plus Shareholders’ Equity (the residual claim) :
A = L + OE.
– Make-up of a firm’s assets reflects the line of business the
company is in.
• NWC policy, capital allocation policy
– Capital structure reflects managerial decisions on how to
finance assets.

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 The Balance Sheet

Ross, Westerfield, Jordan, and Roberts, “Fundamentals of Corporate Finance”, McGraw-Hill, 2013
 The Balance Sheet

Liquidity
– Liquidity refers to the speed and ease with which an asset can be converted to cash.
Debt vs. Equity
– To the extent a firm borrows money, it usually gives debt holders (creditors) first
claim to the firm’s cash flow.
Market Value vs. Book Value
– Why aren’t these equal?

An increase in an asset account or a decrease in a liability or equity account is a use of

cash.
Likewise, a decrease in an asset account or an increase in a liability or equity account is
a source of cash.

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 Income Statement

Basic idea
Revenue – Expenses = Income

Time period

Monthly, quarterly, or annually

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 The Income Statement

The income statement measures profitability over a period of

time.
Sales Revenue less COGS = Gross Profit
less Operating Expenses = EBIT
less Interest Expense = EBT
less Taxes = Net Income
less Dividends = addition to Retained Earnings

Net income is often expressed on a per-share basis (EPS).

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 The Income Statement

International Financial Reporting Standards (IFRS):

Revenue Recognition Principle
• revenue is recognized when the earning process is virtually complete and
the value of the exchange of goods or services is known or can be reliably
determined.
Matching Principle
• the costs associated with producing revenues are matched to and expensed
with the revenues they helped earn.

Concept of Accrual Accounting.

Principles ignore the timing of ACTUAL cash flows to and from the firm.

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 International Financial Reporting Standards
(IFRS)

IFRS allows companies to use the historical cost method

Also allows use of the revaluation (fair value) method

– All items in an asset class should be revalued simultaneously
– Revaluation should be performed with enough regularity to ensure that
the carrying amount is not materially different from the fair value

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 Financial statements example

Refer to “Abby’s Retail” in the in-class Excel file

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 The Cash Flow Statement

Measures the increase or decrease in cash and

cash equivalents

Sources and Uses of Cash

Activities that bring in cash
Activities that involve disbursing cash
Can trace changes in the balance sheet to see how the firm
obtained its cash and how the firm disbursed its cash

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 Cash Flow Analysis

From the financial statements, an analyst can calculate cash

flows from assets and cash flows to investors (creditors and
share-holders) where:
CF from assets = CF to shareholders
+ CF to creditors
This is called the Cash Flow Identity

These cash flows can be used to value the firm and to value
shareholders’ equity.

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 Cash Flow Analysis

Cash Flow from Assets (three categories):

1. Operating Cash Flow
• cash flows from the firm’s day-to-day activities of producing and
selling.

• Operating Cash Flow (OCF or CFO)

• = EBIT + depreciation – taxes
• Depreciation - Non-cash expense/add back.
• Taxes - Cost of doing business/subtract off.
• Interest - Financing expense/not included.

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 Cash Flow Analysis

2. Capital Spending
• Net capital spending is the difference between what was spent
on fixed assets and what was received from the sale of fixed
assets.
• Ending fixed assets (net) – Beginning fixed assets (net) +
Depreciation = Net Capital Spending, also called “Net change
in fixed assets”
• (Net investment)

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 Cash Flow Analysis

3. Net Working Capital (NWC)

• NWC is the difference between current assets and current
liabilities.
• Ending NWC – Beginning NWC = Net Change in NWC.

Cash flow from assets = Cash flow from operations

- Net change in fixed assets
- Net change in NWC

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 Cash Flow Analysis

Cash Flow to Creditors/Bondholders:

Cash flow to creditors
= Interest paid – Net new LT debt

Cash Flow to Shareholders:

Cash flow to shareholders
= Dividends paid – Net new equity

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Cash Flow Analysis Summary

Ross, Westerfield, Jordan, and Roberts, “Fundamentals of Corporate Finance”, McGraw-Hill, 2013
 Taxes

In finance, we are concerned with after-tax cash flows.

The size of the tax bill is determined through tax laws and regulations in the
annual budgets of the federal government (administered through the CRA)
and provincial governments.

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 Taxes

Average tax rate – tax bill divided by taxable income.

Marginal tax rate – the extra tax you would pay if you earned one more dollar.
Progressive tax rates – higher incomes are taxed at higher rates – federal and SK
governments.
Flat tax rate – there is only one rate applied to all income.
In finance, marginal tax rates are relevant to decision making.
*Note: tax rates given in this presentation are FOR EXAMPLE ONLY. For current rates, visit the CRA website &
download the appropriate form*

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 Individual Tax Rates

Taxes on Investment Income

1. Dividends
Corporations pay dividends with after-tax income.
– **Remember: this cash is either paid out as a dividend to the shareholders or held in Retained
Earnings**
Dividends paid to other corporations are tax exempt; dividends paid to individuals are
taxed twice.
The dividend tax credit reduces the impact of double taxation.

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 Individual Tax Rates

2. Capital Gains
Capital gains arise when an investment increases in value above its purchase price.
For capital gains, taxes apply at 50% of the applicable marginal tax rate.
Individuals pay taxes on capital gains only when stock is sold.
Note: There is a realized lifetime capital gains exemption for small business owners,
farmers, and fishers.

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 Carry-backs and Carry-forwards

If capital losses exceed capital gains, the net capital loss may be carried
back to previous years’ returns, and can be carried forward too.

Operating losses can be carried back, and forward too, with some
limitations.

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 Federal & Provincial tax rates, 2020

http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html#provincial
– Viewed

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Individual Tax
Rates:
Saskatchewan

https://www.taxtips.ca/taxrates/sk.htm

Go to http://www.cra-arc.gc.ca/ for the CRA tax

forms.
 Capital Cost Allowance (CCA)

CCA is depreciation for tax purposes in Canada.

– Deducted (similarly to an expense) to determine taxable income.
– CCA class determines the maximum CCA rate.
– Generally follows the declining balance method.
– The CCA for each year is computed by multiplying the asset’s undepreciated capital
cost (UCC) by the appropriate CCA rate.
– Half year rule (year 1)

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 Some CCA Classes

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Ross, Westerfield, Jordan, and Roberts, “Fundamentals of Corporate Finance”

 CCA Schedule example

Refer to CCA tab in the in-class Excel file.

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