Financial Statements, Taxes and Cash Flow Faculty of Business Administration Lakehead University Spring 2003 May 5, 2003 2.1 The Balance Sheet 2.2 The Income Statement 2.3 Cash Flow 2.4 Taxes 2.5 Capital Cost Allowance Outline of the Lecture 1
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. 2 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. These can be tangible or intangible. A building is a tangible asset. A patent is an intangible asset. 3
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 borrowing 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. 4 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 the same period. NWC is usually positive in healthy firms. 5
Assets Liabilities & Equity Current assets Current liabilities NWC Long-term liabilities Fixed assets Shareholders Equity 6 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. 7
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. 8 Assets Instruments du Rhône, Inc. 2002 and 2001 Balance Sheets (in millions of $) Liabilities and Owners Equity 2002 2001 2002 2001 Current assets Current liabilities Cash 140 107 Accounts payables 213 197 Accounts receivable 294 270 Notes payable 50 53 Inventory 269 280 Accrued expenses 223 205 Other 58 50 Total current liabilities 486 455 Total current assets 761 707 Long-term liabilities Long-term assets Deferred taxes 117 104 PP&E 1,423 1,274 Long-term debt 471 458 Accum. depreciation (550) (460) Total LT liabilities 588 562 Net PP&E 873 814 Intangible assets 245 221 Stockholders equity Net L-T assets 1,118 1,035 Preferred stock 39 39 Common stock 376 339 Accum. retained earnings 390 347 Total equity 805 725 Total 1,879 1,742 Total 1,879 1,742 9
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. 10 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. Revenue is recognized at the time of sale, i.e. when the asset accounts receivable increases rather than as cash is collected. 11
2.2 The Income Statement Accounting income represents a selective recognition of both current period actual cash flows and changes in asset values. Reported income under this method (the accrual concept) provides a measure of current operating performance, which is not solely based on cash flows. 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. 12 Instruments du Rhône, Inc. 2002 Income Statement (in millions of $) Total operating revenue 2,262 Cost of goods sold (1,655) Selling, general, and administrative expenses (327) Depreciation (90) Operating income 190 Other income 29 Earnings before interest and taxes (EBIT) 219 Interest expense (49) Pretax income 170 Taxes (84) Current: $71 Deferred: $13 Net income 86 Retained earnings: $43 Dividends: $43 13
2.2 The Income Statement Another reason as to why accounting income differs from cash flow is that the income statement contains non-cash items. In the present example, depreciation and deferred taxes are non-cash items, as they don t involve any cash outflow. Depreciation 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. 14 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 the present chapter, we are interested in calculating cash flow from asset, which may also be called free cash flow. There are different definitions of free cash flow, which implies that there are different measures of cash flow. This is not the statement of cash flows, which we will see in Chapter 3. 15
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. 16 2.3 Cash Flow Cash flow from assets involves three components: Operating cash flow: cash flow resulting from the day-to-day activities. Capital spending: purchases of fixed assets minus sales of fixed assets. Additions to net working capital: net amount spent on short-term assets. 17
Operating Cash Flow Operating cash flow is revenues minus cash costs, which means that depreciation and deferred taxes will be excluded. This calculation will also exclude interest expense, as this is a financing expense and will appear in the cash flow to bondholders. Note that the exclusion of financing expense contrasts with the accounting definition of operating cash flow. 18 Operating Cash Flow Operating cash flow (OCF) can be calculated from the top of the bottom of the income statement: Top: Bottom: OCF = EBIT + Depreciation Current taxes OCF = Net income + Depreciation + Deferred taxes + Interest expense More generally, OCF = EBIT + Depreciation Other cash, operating expenses OCF = Net income + Non-cash, non-operating expenses 19
Operating Cash Flow: An example For Instruments du Rhône, this gives us, for 2002, OCF = EBIT + Depreciation Other cash, operating expenses = 219 + 90 71 = 238, or, similarly, OCF = Net income + Non-cash, non-operating expenses = 86 + 13 + 49 + 90 = 238. 20 Net Capital Spending Net capital spending (NCS) is calculated as NCS = Ending net fixed assets Beginning net fixed assets + Depreciation Note the addition of depreciation, without which NCS would be understated. Note also that we are using net fixed assets in this equation. 21
Net Capital Spending Similarly, net capital spending could be calculated as follows: NCS = Ending fixed assets Beginning fixed assets. Note that the asset values used here are not net of depreciation and thus we don t need to add depreciation back. 22 Net Capital Spending: An example For Instruments du Rhône, net fixed assets (NFA) are defined as net long-term assets, and fixed assets (FA) are the sum of PP&E and intangible assets. Net capital spending for 2002 is then NCS = End. NFA Beg. NFA + Depreciation or, similarly, = 1,118 1,035 + 90 = 173 NCS = End. FA Beg. FA = (1,423 + 245) (1,274 + 221) = 173. 23
Additions to Net Working Capital Operating cash flow is calculated from the income statement and thus includes transactions for which cash has not been collected yet. Additions to net working capital solves this problem by looking at the accounts that have yet to be received (accounts receivable). Additions to net working capital also tells us how much of the inventory has been paid in cash ( inventory accounts payable), whether the firm has repaid some of its short-term debt, etc.. 24 Additions to Net Working Capital: An example For Instruments du Rhône, NWC in 2001 was 707 455 = 252, and NWC in 2002 was 761 486 = 275, for a change of NWC = 275 252 = 23 in NWC in 2002. 25
Cash Flow from Assets Cash flow from assets, CF(A), can then be calculated as follows: CF(A) = OCF NCS NWC. Note that an increase in NWC means a net purchase of short-term assets, which implies less cash to distribute to bondholders and shareholders, and thus this amount has to be subtracted from OCF. The same reasoning applies to NCS. 26 Cash Flow from Assets: An example For Instruments du Rhône, this means CF(A) = OCF NCS NWC = 238 173 23 = 42. That is, a net amount of $42 million has been distributed to bondholders and shareholders through interest payments, dividend payments, stock repurchases and debt repayments. 27
Cash Flow to Bondholders Cash flow to bondholders, CF(B), is given by CF(B) = Interest expense Net new borrowing, since new borrowing represents a cash flow from creditors to the firm. For Instuments du Rhône, this is CF(B) = 49 (471 458) = 36. 28 Cash Flow to Shareholders Cash flow to shareholders, CF(S), 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 Instuments du Rhône, this is CF(S) = 43 [ 39 + 376 (39 + 339) ] = 6. 29
Instruments du Rhône s Cash Flow In 2002, Instruments du Rhône s assets have generated a total cash flow of $42 million. $36 million have been distributed to bondholders. $6 million have been distributed to shareholders. This is consistent with the equation mentioned earlier, i.e. CF(A) }{{} 42 = CF(B) }{{} 36 + CF(S). }{{} 6 30 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. 31
Benjamin Franklin once said: 2.4 Taxes 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. 32 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% 33
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% 34 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 1/2 of individual s marginal tax rate. 35
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. If m is a capital gain, the individual ends up with ( 1 t ) f +t p m. 2 36 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 37
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. 38 2.5 Capital Cost Allowance Capital cost allowance (CCA) is depreciation for tax purposes in Canada. It provides a tax shield for firms. To calculate the CCA for an asset, we must first know its asset class, which determines the rate to be used. (e.g. 4% for buildings acquired after 1987, 30% for vans and trucks) The half-year rule: Only one half of an asset value can be depreciated for tax purposes in the first year. This measure exists to discourage firms from acquiring assets for tax purposes. This ensures that the tax shield is applied on assets that have actually been used during the year. 39
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. 40 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. 41
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. 42 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. 43
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. 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 in the first year, and thus 25% 900,000 = $225,000 UCC 1 = 1,800,000 225,000 = $1,575,000 44 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. 45
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 46 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). 47
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. 48