Financial Statements and Taxes RWJR, Chapter 2 September 2004
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 a snapshot of 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 Assets appear 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, inventory and accounts receivable are examples of current assets. Fixed Assets: Assets that have a relatively long life. Fixed assets can be tangible or 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 borrowings and accounts payable are examples of current liabilities. Long-Term Liabilities: Liabilities that mature in more than one year. Long-term debt and employee future benefits are examples of long-term liabilities. 5
2.1 The Balance Sheet The Net 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 Current liabilities NWC Long-term liabilities Fixed assets 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 called financial 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 675 675 Accounts receivable 10,259 10,183 Accounts payables 14,257 13,603 Income taxes receivable 0 1,388 Income taxes payable 647 0 Inventories 13,271 10,520 Current portion of LTD 504 30 Prepaid expenses 416 372 Total current liabilities 16,083 14,308 Future income tax benefit 288 401 Total current assets 32,829 24,758 Long-term debt 153 389 Future income taxes 1,486 1,016 Net fixed assets (NFA) 23,173 24,006 Total liabilities 17,722 15,713 Share capital & c. s. 18,797 18,688 Retained earnings 19,483 14,363 Total 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 the Generally Accepted Accounting Principles, financial statements show assets at historical 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 The income statement measures 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 the matching 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, LTD 2003 Statement of Earnings and Retained Earnings ($000) Net Sales 111,248 Cost of sales 71,925 Gross profit 39,323 Selling, general, and administrative expenses 27,501 Amortization 3,209 Earnings before interest and taxes (EBIT) 8,613 Interest expense 99 Loss on capital dispositions 223 Earnings before taxes (EBT) 8,291 Taxes 3,171 Net earnings 5,120 Retained earnings, beginning of year 14,363 Retained earnings, end of year 19,483 Earnings per share Basic 0.48 Diluted 0.48 14
2.2 The Income Statement Due to the matching principle, accounting income differs from cash flow because the income statement contains non-cash items. Amortization and loss on capital dispositions are 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 taxes accumulate 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 the future tax items on 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 called sources of cash. Activities that involve spending cash are called uses 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 1,388 Decrease in future income tax benefit 113 Decrease in net fixed assets 833 Increase in accounts payable 654 Increase in income taxes payable 647 Increase in long-term debt 238 Increase in future income taxes 470 Increase in share capital 109 Increase in retained earnings 5,120 Total 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, LTD 2003 Statement of Cash Flows Cash from operating activities Net earnings 5,120 Non-cash items: Amortization 3,209 Loss on capital dispositions 223 Deferred taxes 583 Other 267 Net cash from operations 9,420 Changes in non-cash working capital items (182) Net cash from operating activities 9,220 Cash from investing activities Net capital spending (2,599) Net cash from investing activities (2,599) Cash from financing activities Capital 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 The figure for changes in non-cash working capital items is obtained as follows: NCWC 03 = A/R 03 + IT/R 03 + Inv 03 + PPExp 03 (A/P 03 + IT/P 03 ) = 10,259 + 0 + 13,271 + 416 ( 14,257 + 647 ) = 9,042 NCWC 02 = A/R 02 + IT/R 02 + Inv 02 + PPExp 02 (A/P 02 + IT/P 02 ) and = 10,183 + 1,388 + 10,520 + 372 ( 13,603 + 0 ) = 8,860 NCWC = NCWC 03 NCWC 02 = 9,042 8,860 = 182. 26
The Statement of Cash Flows Net capital spending is calculated as follows: NFA 03 NFA 02 + Amort 03 + LCD 03 = 23,173 24,006 + 3,209 + 223 = 2,599. 27
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. 28
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. 29
Sun-Rype Products, LTD 2003 Statement of Cash Flows (Textbook Method) Cash from operating activities Net earnings 5,120 Non-cash items: Amortization 3,209 Loss on capital dispositions 223 Deferred taxes 583 Net cash from operations 9,135 Changes in non-cash working capital items (182) Net cash from operating activities 8,953 Cash from investing activities Net capital spending (2,599) Net cash from investing activities (2,599) Cash from financing activities Change in promissory notes 0 Change in LTD 238 Change in share capital 109 Net cash from financing activities 347 Net change in cash 6,701 30
2.3 Cash Flow Cash flow is 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 calculate cash flow from asset, which may also be called free cash flow. Note that there are different definitions of free cash flow. 31
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. 32
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. 33
2.3 Cash Flow Operating cash flow represents cash revenues minus cash costs, which excludes, among others, amortization and deferred taxes. In our cash flow calculation, interest expense is considered a financing expense and 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). 34
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. 35
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. 36
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 13,603 Accounts receivable 10,259 10,183 Income taxes payable 647 0 Income taxes receivable 0 1,388 Total current liabilities 14,904 13,603 Inventories 13,271 10,520 Prepaid expenses 416 372 LTD and PN 1,332 1,094 Total current assets 32,541 24,357 Net future income taxes 1,198 615 Total liabilities 17,434 15,312 Net fixed assets (NFA) 23,173 24,006 Share capital & c. s. 18,797 18,688 Retained earnings 19,483 14,363 Total equity 38,280 33,051 Total assets 55,714 48,363 Total liabilities and equity 55,714 48,363 37
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. 38
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 as current taxes, are Current Taxes = Taxes Deferred Taxes = 3,171 583 = 2, 588. 39
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. 40
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. 41
Cash Flow from Assets: Textbook Method NWC, in the textbook, is calculated as follows: NWC = NWC end NWC beg. For Sun-Rype in 2003, this gives 32,541 14,904 ( 24,357 13,603 ) = 6,883. 42
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. 43
Cash Flow from Assets: Textbook Method NCS, in the textbook, is calculated as follows: NFA end NFA beg + 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. 44
Cash Flow from Assets: Textbook Method That is, NCS for Sun-Rype is calculated as follows: NCS = NFA end NFA beg + Amortization + Loss on Cap. Disp., which gives NCS = 23,173 24,006 + 3,209 + 223 = 2,599. 45
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. 46
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). 47
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. 48
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. 49
Cash Flow from Assets: Textbook Method We can see that CF(A) = CF(B) + CF(S) = ( 139) + ( 109) = 248. 50
Cash Flow from Assets: A More General Method We have seen that the statement of cash flows lists some non-cash expenses that do not explicitely appear on the income statement. In the case of Sun-Rype, these non-cash expenses are related to long-term debt. Regarding NWC and NCS, we cannot do better than what we have done above. We can nevertheless improve our definition of OCF. 51
Cash Flow from Assets: A More General Method That is, OCF = EBIT + Depreciation Other cash, operating expenses OCF = Net income + Non-cash, non-operating expenses From the statement of cash flows we can compute OCF as follows: OCF = Net Cash from Operations + Interest Expense 52
Cash Flow from Assets: A More General Method Net cash from operations is the line before the changes in non-cash working capital items. This definition of OCF gives us OCF = 9,420 + 99 = 9,519 for Sun-Rype in 2003. 53
Sun-Rype Products, LTD 2003 Statement of Cash Flows Cash from operating activities Net earnings 5,120 Non-cash items: Amortization 3,209 Loss on capital dispositions 223 Deferred taxes 583 Other 267 Net cash from operations 9,420 Changes in non-cash working capital items (182) Net cash from operating activities 9,220 Cash from investing activities Net capital spending (2,599) Net cash from investing activities (2,599) Cash from financing activities Capital 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 More General Method Using this method, Sun-Rype s CF(A) in 2003 is given by CF(A) = 9,519 6,883 2,599 = 37. 55
Cash Flow from Assets: Conclusion Operating cash flow is 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 negative total cash flow is 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
2.4 Taxes Benjamin Franklin once said: Certainty? In this world nothing is certain but death and taxes. Even though firms and individuals are certain to pay taxes, a good understanding of how different sources of cash are taxed can help save significant amounts of money. This is called tax planning. 57
Individual Income Tax Rates Federal tax rates in 2002: Taxable income Tax Rate From 0 to 31,677 16% From 31,677 to 63,354 22% From 63,354 to 103,000 26% Above 103,000 29% 58
Individual Income Tax Rates Ontario tax rates in 2002: Taxable income Tax Rate From 0 to 31,893 6.05% From 31,893 to 63,786 9.15% Above 63,786 11.16% 59
Taxes on Investment Income Interest Income: Taxed like personal income. Dividends: Dividend tax credits (Federal: 13.33% of 125% of dividend; Ontario: 5.13% of 125% of dividend). Capital Gains: Capital gains from Canadian companies are taxed at 50% of the owner s marginal tax rate. 60
Taxes on Investment Income Let t f denote the individual s federal marginal tax rate, let t p denote the individual s provincial tax rate (Ontatio), and let m denote the individual s investment income. If m is an interest payment, the individual ends up with (1 t f t p ) m. If m is a dividend, the individual ends up with m [ (t f 0.1333) + (t p 0.0513) ] 1.25m. 61
Taxes on Investment Income If m is a capital gain, the individual ends up with ( 1 t ) f +t p m. 2 62
Taxes on Investment Income: An Example Investment Income of $100, Net of Taxes Source of Income Tax Bracket (t f,t p ) Interest Capital Gain Dividend (16%, 6.05%) $77.95 $88.98 $95.51 (22%, 9.15%) $68.85 $84.43 $84.14 (26%, 11.16%) $62.84 $81.42 $76.63 (29%, 11.16%) $59.84 $79.92 $72.88 63
Corporate Tax Rates Corporate tax rates result from the competition among countries and provinces to attract companies. Since the establishment of a company is a long-term investment, it is important to know the trend in corporate taxes. When an assset is sold for more than what the firm paid for, the difference is taxed as a capital gain. Capital losses may be carried back (3 years) and forward (indefinitely) to reduce capital gains in other years. 64
2.5 Capital Cost Allowance Capital cost allowance (CCA) is depreciation for tax purposes in Canada. CCA provides a tax shield for 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) 65
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. 66
2.5 Capital Cost Allowance Let V denote the asset cost at the time of its purchase, and let c denote the CCA rate for this asset class (assume this is not straight-line depreciation). CCA depreciation in the first year, denoted D 1, is D 1 = c V 2, and the undepreciated capital cost (UCC) after one year is UCC 1 = V D 1 = V cv 2 = (1 c)v 2 + V 2. 67
2.5 Capital Cost Allowance CCA depreciation in the second year is D 2 = c UCC 1 and the undepreciated capital cost after two years is UCC 2 = UCC 1 D 2 = (1 c)ucc 1 = (1 c) 2V 2 + (1 c)v 2. 68
2.5 Capital Cost Allowance Similarly, in the third year is D 3 = c UCC 2 and thus UCC 3 = UCC 2 D 3 = (1 c)ucc 2 = (1 c) 3V 2 + (1 c)2v 2. 69
2.5 Capital Cost Allowance We can generalize this expression for all t 2, i.e. D t = c UCC t 1 and UCC t = (1 c) t V 2 + (1 c)t 1V 2. 70
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. 71
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 UCC 1 = 1,800,000 225,000 = $1,575,000 72
2.5 Capital Cost Allowance: An Example The CCA depreciation in the second year is 25% 1,575,000 = $393,750, and thus UCC 2 = 1,575,000 393,750 = $1,181,250. 73
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 74
Asset Purchases and Sales Suppose an asset is sold at time T for $S. Two things may happen: S > UCC T : If S > UCC 0, the difference S UCC 0 is taxed as capital gain, and the difference UCC 0 UCC T is substracted from the asset pool (assuming the asset pool is continued). S UCC T : In this case, the difference UCC T S is added to the asset pool and depreciates until the asset pool is terminated (possibly forever). 75
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, if S > UCC, then the difference (S UCC) is added to the income and CCA is recaptured. 76