Chapter 2 Flashcards
Financial statements
• In the best of all worlds, the financial manager has full market value information about all of the firm’s assets; however, this rarely (if ever) happens.
• We rely on financial statements as our source for this information. Loading…
• We need to convert historical accounting data into projected future cash flows.
The balance sheet
The balance sheet is a snapshot of the firm’s assets and liabilities (the financial “picture”) at a given point in time.
• Assets (what the firm owns) equals Liabilities (what the firm owes) plus Shareholders’ Equity (the residual claim) A = L + OE.
The balance sheet - order
Current assets
- Assets go in order of liquidity
Ex/ cash - accounts receivable
fixed assets (listed in order of permanancy)
1. Tangiable fixed assets: smth you can touch
2. Intangible fixed assets: can’t touch
Current liabilities
Long term debt
Shareholders equity
Net Working Capital
Difference between current assets and current liabilities
●Current Assets – Current Liabilities
●Net working capital : Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out (cash inflow > cash outflow)
●Usually positive in a healthy firm
Liquidity
– Liquidity refers to the speed and ease with which an asset can be converted to cash.
– Ability to convert to cash quickly without a significant loss in value
– Liquid firms are less likely to experience financial distress
– However, liquid assets earn a lower return
– Tradeoff between liquid and illiquid assets
Value VS cost
- The statement of financial position 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.
Debt vs Equity
Debt is a financial obligation
– To the extent a firm borrows money, it usually gives debt holders (creditors) first claim to the firm’s cash flow.
– Financial leverage
Market value vs Book value
Book value represents a company’s net worth based on its assets and liabilities recorded on the balance sheet, reflecting historical costs. Market value, on the other hand, is what investors are willing to pay for the company, driven by stock price, future growth potential, and market sentiment. They differ because market value considers factors like future earnings, intangible assets, and investor perception, while book value is grounded in past financial data.
International financial reporting standards
• IFRS allows companies to use the historical cost method
• Also allows use of the revaluation (fair value) method (so you know the true value of your assets/liabilities)
– 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
Statement of comprehensive income
• Formerly called Income Statement- more like a video of the firm’s operations for a specified period of time
• Basic idea
Revenue – Expenses = Income
• Matching principle – IFRS say to show revenue when it accrues and match the expenses required to generate the revenue
• Time period
Monthly, quarterly, or annually
Statement of comprehensive income - what does it measure and what are components of it
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).
Statement of comprehensive income - international financial reporting standards
• You generally report revenues first and then deduct any expenses for the period
• Matching principle – IFRS say to show revenue when it accrues and match the expenses required to generate the revenue
• Non-cash items: depreciation
• Time and costs: Long term vs short term; fixed cost vs. variable costs
The cash flow statement - what does it measure and why do we use it
Measures the increase or decrease in cash and cash equivalents
• Cash flow is one of the most important pieces of information that a financial manager can derive from financial statements
• 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
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
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 (CFFA) = Cash flow to bondholders + Cash flow to shareholders
Cash Flow From Assets = (Operating cash flow - Net capital spending) - Changes in NWC (ΔNWC)
Cash flow from assets - categories
Operating cash flow, capital spending & additions to NWC
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.
(use I/S)
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.
Net Capital Spending (B/S and I/S) = ending net fixed assets – beginning net fixed assets + depreciation
Net working capital
Firms also invest in CA
NWC is the difference between current assets and current liabilities.
Changes in NWC (B/S) = ending NWC – beginning NWC
The total CFFA is therefore:
Cash flow from assets = sash flow from operations - net cash flow from assets - net change in NWC
Cash flow analysis
Cash Flow to Creditors/Bondholders:
A firm’s interest payment to creditors less net new borrowings CF to Creditors (B/S and I/S) = interest paid – net new borrowing
Cash Flow to Shareholders: Cash flow to shareholders
= Dividends paid – Net new equity
Always check if the cash flow identity holds (using the B/S and I/S in the powerpoint) CFFA = CF to creditors + CF to S/H
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.
• Individual vs. corporate taxes
• Marginal vs. average tax rates
– Marginal: the percentage paid on the next dollar earned
– Average: the percentage of your income that goes to pay taxes (tax bill/taxable
income)
• In finance, marginal tax rates are relevant to decision making.
Taxes - individual vs corporate taxes
Individual tax rate: federal + provincial tax rates
The corporate tax rate is the percentage of a company’s profits that it must pay to the government in taxes. It applies to the earnings after expenses have been deducted but before dividends are distributed to shareholders. This rate can vary by country, region, and industry.
Taxes - marginal vs average tax rates
Marginal: The percentage paid on the next dollar earned. Example: if taxable income is >50,197 but up to 100,392, the marginal tax is 20.50%.
Average: The percentage of your income that goes to pay taxes. Average tax = Total tax bill ÷ Total taxable income
Taxes on investments
When an investor holds stocks, they are subject to two types of taxes:
Dividend tax credit: A tax formula that reduces the effective tax rate on dividends.
Capital gains tax: Tax is paid on the investment’s increase in value over its purchase price
Taxes on investment income - 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.
Taxes on investment income - 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.
Carry backs and carry forwards
• Capital gains received by corporations are taxed at 50% of the marginal tax rate
• If capital losses exceed capital gains, the net capital loss may be carried back up to three years and forward indefinitely.
• For operating losses, the carry-back period is three years and the carry-forward period is seven years.
- dependant on assets
Capital cost allowance
• CCA is depreciation for tax purposes in Canada.
CCA is deducted before taxes and acts as a tax shield.
Every capital asset is assigned to a specific asset class by the government.
Every asset class is given a deprecation method and rate.
Accelerated investment rule
In the first year, one-and-a-half
times the prescribed rate can be used for CCA purpose (e.g., Taxi cabs).
One and a half year rule
(i.e., accelerated investment incentive
in which CCA amount is 1.50 times the prescribed rate in year 1).
For example, beginning UCC is $800,000 and CCA rate is 20%. CCA
in year one is: $800,000 x 1.5(.20) = $240,000
Note: One and a half-year rule always applies when equipment(s) are replaced
CCA - additional concepts
•Usually firms have multiple machines (i.e., more than one photocopier)
in an asset class.
•When an asset is sold, the asset class is reduced by the realized value of the asset, or by its original cost, whichever is less.
Closing an asset class
When the last asset in an asset class is sold, the asset class is terminated. This can result in a terminal loss or recaptured CCA.
➢ Terminal Loss: The difference between the UCC and the adjusted cost when the UCC is greater.
➢ Recaptured CCA: The taxable difference between the adjusted cost and the UCC (under depreciated cost) when the UCC is smaller.
➢ CCA Recapture/terminal loss = Lower of selling price and the original cost (sales price of an assets) – Ending UCC
