2-*Chapter Outline2.1The Balance Sheet2.2The Income Statement2.3Cash Flow2.4Taxes

1.*

Key Concepts and SkillsKnow the difference between book value and market valueKnow the difference between accounting net income and cash flowKnow how to determine a firms cash flow from its financial statementsUnderstand the difference between average and marginal tax rates, and tax treatment of dividends and capital gains

2-*

6.*

2.1 The Balance SheetThe balance sheet is a snapshot of the firms assets and liabilities at a given point in timeAssets are listed in order of liquidity

Ease of conversion to cashWithout significant loss of valueBalance Sheet Identity:

Assets = Liabilities + Stockholders Equity2-*

2.*Liquidity is a very important concept. Students tend to remember the convert to cash quickly component of liquidity, but often forget the part about without loss of value. Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesnt mean it is liquid. Also, point out that a firm can be TOO liquid. Excess cash holdings can lead to overall lower returns.

The Balance Sheet Figure 2.12-*

2.*The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct result of managements investment decisions. (Please emphasize that investment decisions are not limited to investments in financial assets.) Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of managements financing decisions. Remember that shareholders equity consists of several components and that total equity includes all of these components not just the common stock item. In particular, remind students that retained earnings belong to the shareholders.

Loonie Corporation Balance Sheet Table 2.12-*

2.* Table 2.1 gives an example of a simplified balance sheet. Many students make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are. Note that the information on this table is used to work an example on the calculation of cash flows later in the chapter. This example has links to the information in this table. The arrow in the left corner is used to return you to the example. Thus, you can easily move back and forth to have the students find the appropriate information to work the example. The same is true for the Loonie Corporation Income Statement.

Market vs. Book ValueThe 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?

2-*

2.*Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities and equity of the firm. Assets are listed at historical costs less accumulated depreciation this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the Total Assets line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth. Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities change in the market as well. This is especially true for longer-term liabilities. Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the markets estimation of the current value of ALL of the assets of the firm. The best estimate of the market value of the firms assets is market value of liabilities + market value of equity. Market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today.

Example: Market vs. Book Values2-*

KINGSTON CORPORATIONBalance SheetsMarket Value versus Book ValueBookMarketBookMarketAssetsLiabilities and Shareholders EquityNWC$ 400$ 600LTD$ 500$ 500NFA 700 1,000Equity6001,100$1,100$1,6001,1001,600

2.*Note that the market-to-book ratio, which compares the market value of equity to the book value of equity, is often used by analysts as a measure of valuation for a stock. It is generally a bad sign if a companys market-to-book ratio approaches 1.00 (meaning market value = book value) because of the GAAP employed in creating a balance sheet. It is definitely a bad sign if the ratio is less than 1.00. GAAP does provide for some assets to be marked-to-market, primarily those assets for which current market values are readily available due to trading in liquid markets. However, it does not generally apply to long-term assets, where market values and book values are likely to differ the most.

2.2 The Income StatementThe income statement is more like a video of the firms operations for a specified period of time.You generally report revenues first and then deduct any expenses for the periodMatching principle GAAP say to show revenue when it accrues and match the expenses required to generate the revenue

2-*

2.*Matching principle this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.

Loonie Corporation Income Statement Table 2.22-*

2.* Note that the information on this table is used to work an example on the calculation of cash flows later in the chapter. This example has links to the information in this table. The arrow in the left corner is used to return you to the example. Thus, you can easily move back and forth to have the students find the appropriate information to work the example. Remember that these are simplified income statements for illustrative purposes. COGS would include both the fixed costs and the variable costs needed to generate the revenues. Earnings before interest and taxes is often called operating income. Analysts often look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes. It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the Customs and Revenue Agency (CRA). In this instance, the life of the asset for depreciation purposes may be very different from the useful life of the asset.

Work the Web ExamplePublicly traded companies must file regular reports with Canadian securities regulatory authoritiesThese reports are usually filed electronically and can be searched at the SEDAR siteClick on the at sign, pick a company and see what you can find!

2-*

2.*

2.3 The Concept of Cash FlowCash flow is one of the most important pieces of information that a financial manager can derive from financial statementsThe statement of cash flows does not provide us with the same information that we are looking at hereWe will look at how cash is generated from utilizing assets and how it is paid to those that finance the purchase of the assets

2-*

2.*

Cash Flow from AssetsCash 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

2-*

2.*The first equation is how the cash flow from the firm is divided among the investors that financed the assets. The second equation is the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project.

Example: Loonie CorporationOCF (I/S) = EBIT + depreciation taxes = $547Net Capital Spending (B/S and I/S) = Ending net fixed assets Beginning net fixed assets + Depreciation = $130Changes in NWC (B/S) = Ending NWC Beginning NWC = $330Cash Flow from Assets = $547 130 330 = $87CF to Creditors (B/S and I/S) = Interest paid Net new borrowing = $24CF to Stockholders (B/S and I/S) = Dividends paid Net new equity raised = $63Cash Flow from Assets = $24 + 63 = $87

2-*

2.*Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on B/S that will take you to that slide. Another one exists on I/S. The arrows on the Balance Sheet and Income Statement slides will bring you back here. OCF = $694 + 65 212 = $547 Net Capital Spending = $1709 1644 + 65 = $130 Students often have a difficult time understanding why a cash outflow has a positive sign and a cash inflow has a negative sign. Emphasize that we are talking about SPENDING in the net capital spending formula and Investment in NWC. The formula for CFFA takes care of reducing cash flow when NCS is positive and increasing CF when it is negative. Ending NWC = $1,403 389 = $1,014 Beginning NWC = $1,112 428 = $684 Changes in NWC = $1,014 684 = $330 Net New Borrowing = Ending LT debt Beginning LT debt = $454 408 = $46 CF to creditors = $70 46 = $24 Net New Equity = $640 600 = $40 (Be sure to point out that here we want to determine the amount of equity raised in the capital markets, not retained earnings.) CF to stockholders = $103 40 = $63

Example: Balance Sheet and IncomeStatement InformationCurrent Accounts

2006: CA = $1,500; CL = $1,3002007: CA = $2,000; CL = $1,700Fixed Assets and Depreciation

2006: NFA = $3,000; 2007: NFA = $4,000Depreciation expense = $300LT Liabilities and Equity

2006: LTD = $2,200; Common Equity = $500; RE = $5002007: LTD = $2,800; Common Equity = $750; RE = $750Income Statement Information

EBIT = $ 2,700; Interest Expense = $200;Taxes = $1,000; Dividends = $1,2502-*

2.*Here is the additional information required to complete the income statement. You may want to give them this information and have them practice putting together a balance sheet and income statement. They should verify the $250 addition to retained earnings for 2007, and distinguish that from the retained earning balance at the end of 2007.Sales = $5,000; Costs = $2,000

Example: Cash FlowsOCF = $2,700 + 300 1,000 = $2,000NCS = $4,000 3,000 + 300 = $1,300Changes in NWC = ($2,000 1700) ($1,500 1,300) = $100CF from Assets = $2,000 1300 100 = $600CF to Creditors = $200 ($2,800 2,200) = -$400CF to Stockholders = $1,250 ($750 500) = $1,000CF from Assets = -$400 + 1,000 = $600The Cash Flow identity holds.

2-*

2.*Remind the students that changes in RE are not included because there is no cash flow associated with them. Net new equity consists of the purchase and sale of stock in the market. If the company had repurchased stock during the year, you would need to include the change in the Treasury stock account. An increase in Treasury Stock is a decrease in net new equity since it is a cash outflow from the firm to stockholders.

2-*2.4 Personal Tax Rates

This table shows federal and provincial tax rates for individuals in 2007. Point out to the students that taxes change every year.www: The latest federal and provincial tax rates can be found at the Canada Revenue Agency web site at www.cra-arc.gc.ca

$50,00014%Tax RatePersonal IncomeFederal marginal tax rate16%18%20%22%24%26%28%30%$100,000$150,000$200,000Federal average tax rateAverage vs. Marginal Tax Rates2-*

Marginal rates are higher than average rates, but the average rate will approach the highest marginal rate at the limit (for very high income levels).The marginal rate is the one to use for decision-making about investments and additional income. If the taxpayer earns a base salary of $50,000 and is considering an investment, then the federal marginal rate of 22% is key to evaluating the profitability of the investment. If instead the taxpayer earns a base salary above $80,000, then the 26% marginal rate applies.1.*

Example: Average vs. MarginalTax RatesThe taxable income of Stephanie Fenton, an Ontario resident, is $88,000. Calculate Stephanies (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) = $17,489.15Provincial: .0605($35,488) + .0915($70,976 35,488) +.1116($88,000 $70,976) = $7,294.05Total tax: $17,489.15 + $ 7,294.05 = $24,783.20b) Average tax rate = $24,783.20 /88,000 = 28.16%c) Marginal tax rate = .26 + .1116 = .3716 = 37.16%2-*

Personal Taxes on Investment IncomeInterest 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 investors marginal rate

2-*

2.*

Corporate Tax Rates FEDERAL ONTARIO COMBINED

General Business 22.1% 14.00%36.1%

Manufacturing andProcessing 22.1 12.00 34.1

Small Business 13.1 5.50 18.6(income up to $400,000)2-*

This table shows the corporate tax rates for 20071.*

Corporate TaxationDividends 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 taxableLoss carry-backLoss carry-forward2-*

2.*Point out to the students that corporations cannot claim a capital loss on assets that were depreciated

Quick QuizWhat 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 firms 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?

2-*

2.*

SummaryThe balance sheet shows the firms accounting value on a particular date.The income statement summarizes a firms 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

2-*

2.*

8.*

1.*

6.*

2.*Liquidity is a very important concept. Students tend to remember the convert to cash quickly component of liquidity, but often forget the part about without loss of value. Remind them that we can convert anything to cash quickly if we are willing to lower the price enough, but that doesnt mean it is liquid. Also, point out that a firm can be TOO liquid. Excess cash holdings can lead to overall lower returns. 2.*The left-hand side lists the assets of the firm. Current assets are listed first because they are the most liquid. Fixed assets can include both tangible and intangible assets, and they are listed at the bottom because they generally are not very liquid. These are direct result of managements investment decisions. (Please emphasize that investment decisions are not limited to investments in financial assets.) Note that the balance sheet does not list some very valuable assets, such as the people who work for the firm. The liabilities and equity (or ownership) components of the firm are listed on the right-hand side. This indicates how the assets are paid for. Since the balance sheet has to balance, total equity = total assets total liabilities. The portion of equity that can most easily fluctuate to create this balance is retained earnings. The right-hand side of the balance sheet is a direct result of managements financing decisions. Remember that shareholders equity consists of several components and that total equity includes all of these components not just the common stock item. In particular, remind students that retained earnings belong to the shareholders.2.* Table 2.1 gives an example of a simplified balance sheet. Many students make it through business school without ever seeing an actual balance sheet, particularly those who are not majoring in finance or accounting. This is a good place to talk about some of the specific types of items that show up on a balance sheet and remind the students what accounts receivable, accounts payable, notes payable, etc. are. Note that the information on this table is used to work an example on the calculation of cash flows later in the chapter. This example has links to the information in this table. The arrow in the left corner is used to return you to the example. Thus, you can easily move back and forth to have the students find the appropriate information to work the example. The same is true for the Loonie Corporation Income Statement.2.*Current assets and liabilities generally have book values and market values that are very close. This is not necessarily the case with the other assets, liabilities and equity of the firm. Assets are listed at historical costs less accumulated depreciation this may bear little resemblance to what they could actually be sold for today. The balance sheet also does not include the value of many important assets, such as human capital. Consequently, the Total Assets line on the balance sheet is generally not a very good estimate of what the assets of the firm are actually worth. Liabilities are listed at face value. When interest rates change or the risk of the firm changes, the value of those liabilities change in the market as well. This is especially true for longer-term liabilities. Equity is the ownership interest in the firm. The market value of equity (stock price times number of shares) depends on the future growth prospects of the firm and on the markets estimation of the current value of ALL of the assets of the firm. The best estimate of the market value of the firms assets is market value of liabilities + market value of equity. Market values are generally more important for the decision making process because they are more reflective of the cash flows that would occur today.2.*Note that the market-to-book ratio, which compares the market value of equity to the book value of equity, is often used by analysts as a measure of valuation for a stock. It is generally a bad sign if a companys market-to-book ratio approaches 1.00 (meaning market value = book value) because of the GAAP employed in creating a balance sheet. It is definitely a bad sign if the ratio is less than 1.00. GAAP does provide for some assets to be marked-to-market, primarily those assets for which current market values are readily available due to trading in liquid markets. However, it does not generally apply to long-term assets, where market values and book values are likely to differ the most.2.*Matching principle this principle leads to non-cash deductions like depreciation. This is why net income is NOT a measure of the cash flow during the period.2.* Note that the information on this table is used to work an example on the calculation of cash flows later in the chapter. This example has links to the information in this table. The arrow in the left corner is used to return you to the example. Thus, you can easily move back and forth to have the students find the appropriate information to work the example. Remember that these are simplified income statements for illustrative purposes. COGS would include both the fixed costs and the variable costs needed to generate the revenues. Earnings before interest and taxes is often called operating income. Analysts often look at EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of the operating cash flow of the firm. It is not true in the strictest sense because taxes are an operating cash flow as well, but it does provide a reasonable estimate for analysis purposes. It is important to point out that depreciation expense is often figured two different ways, depending on the purpose of the financial statement. If we are computing the taxes that we will owe, we use the depreciation schedule provided by the Customs and Revenue Agency (CRA). In this instance, the life of the asset for depreciation purposes may be very different from the useful life of the asset. 2.*

2.*

2.*The first equation is how the cash flow from the firm is divided among the investors that financed the assets. The second equation is the cash flow that the firm receives from its assets. This is an important equation to remember. We will come back to it and use it again when we do our capital budgeting analysis. We want to base our decisions on the timing and risk of the cash flows we expect to receive from a project.2.*Use the information from the balance sheet and income statement presented previously to work through this example. There is a hyperlink on B/S that will take you to that slide. Another one exists on I/S. The arrows on the Balance Sheet and Income Statement slides will bring you back here. OCF = $694 + 65 212 = $547 Net Capital Spending = $1709 1644 + 65 = $130 Students often have a difficult time understanding why a cash outflow has a positive sign and a cash inflow has a negative sign. Emphasize that we are talking about SPENDING in the net capital spending formula and Investment in NWC. The formula for CFFA takes care of reducing cash flow when NCS is positive and increasing CF when it is negative. Ending NWC = $1,403 389 = $1,014 Beginning NWC = $1,112 428 = $684 Changes in NWC = $1,014 684 = $330 Net New Borrowing = Ending LT debt Beginning LT debt = $454 408 = $46 CF to creditors = $70 46 = $24 Net New Equity = $640 600 = $40 (Be sure to point out that here we want to determine the amount of equity raised in the capital markets, not retained earnings.) CF to stockholders = $103 40 = $63 2.*Here is the additional information required to complete the income statement. You may want to give them this information and have them practice putting together a balance sheet and income statement. They should verify the $250 addition to retained earnings for 2007, and distinguish that from the retained earning balance at the end of 2007.Sales = $5,000; Costs = $2,0002.*Remind the students that changes in RE are not included because there is no cash flow associated with them. Net new equity consists of the purchase and sale of stock in the market. If the company had repurchased stock during the year, you would need to include the change in the Treasury stock account. An increase in Treasury Stock is a decrease in net new equity since it is a cash outflow from the firm to stockholders.This table shows federal and provincial tax rates for individuals in 2007. Point out to the students that taxes change every year.www: The latest federal and provincial tax rates can be found at the Canada Revenue Agency web site at www.cra-arc.gc.ca Marginal rates are higher than average rates, but the average rate will approach the highest marginal rate at the limit (for very high income levels).The marginal rate is the one to use for decision-making about investments and additional income. If the taxpayer earns a base salary of $50,000 and is considering an investment, then the federal marginal rate of 22% is key to evaluating the profitability of the investment. If instead the taxpayer earns a base salary above $80,000, then the 26% marginal rate applies.1.*2.*

This table shows the corporate tax rates for 20071.*2.*Point out to the students that corporations cannot claim a capital loss on assets that were depreciated2.*

2.*