Chapter 2: Financial Statements, Cash Flow, and Taxes Flashcards
Cash flow
we simply mean the difference between the number of dollars that come in and the number that go out
Statement of Financial Position (AKA Balance Sheet)
Financial statement showing a firm’s accounting value on a particular date.
Assets
What the firm owns!
Liabilities
What the firm owes!
Firm equity
The difference between a firms assets and liabilities
International financial reporting standards (IFRS)
Accounting standards to provide a common global language for business affairs so that company accounts are understandable and comparable across countries.
Generally Accepted Accounting Principles (GAAP)
A framework for a common set of principles, rules, and procedures of accounting.
Total value of the Firm to Investors (Figure 2.1)
- It’s current liabilities
- It’s Long-term debt
- Shareholder’s equity
Two types of fixed assets
1) Tangible fixed assets (like a truck, computer)
2) Intangible fixed assets (Like a trademark or patent)
Fixed asset
Has a relatively long life
Two types of assets:
1) Current assets
2) Fixed assets
Current asset has a life of less than ________, meaning the asset will convert into cash within _______ months
1 year
12 Months
Examples of a current asset
Inventory - as it is normally bought and sold within 1 year
Cash can be a current asset
Accounts receivable (money owed to the firm by its customers)
The firm’s liabilities are the first thing listed on the right-hand side of the ______________
statement of financial position (balance sheet)
Two types of liabilties
1) Current
2) Long-term
Current liabilities
have a life of less than one year (meaning they must be paid within the year) and are listed before long-term liabilities.
Accounts payable
money the firm owes to its suppliers
Example of current liability
Accounts payable
Long-term liability
A debt that is not due in the coming year
Example of long-term liability
A loan that the firm will pay off in five years
Terms for long-term creditors and long-term debt
Bond
Bondholders
Shareholder’s equity
By definition, the difference between the total value of the assets (current and fixed) and the total value of the liabilities (current and long term)
Assets =
Balance sheet equation
Statement of financial position identity
Liabilities + Shareholders’ equity
Net working capital
The difference between a firm’s current assets and its current liabilities
Net working capital is ___________ when current assets exceed current liabilities
positive
Based on the definitions of current assets and current liabilities, this means that the cash available over the next 12 months exceeds the cash that must be paid over that same period
In a healthy firm, __________ should be positive
Net working capital
The liabilities side of the statement of financial position primarily reflects
managerial decisions about capital structure and the use of short-term debt.
Three particularly important things to keep in mind when examining a statement of financial position are:
1) liquidity,
2) debt versus equity,
3) market value versus book value
1) liquidity,
refers to the speed and ease with which an asset can be converted to cash
What is liquid vs what isnt?
The common stock of a large publicly traded company is relatively liquid asset
A custom manufacturing facility is not very liquid
Any asset can be converted to cash quickly if we cut the price enough. A highly liquid asset is therefore one that can be quickly sold without significant ____________________
loss of value
illiquid asset
one that cannot be quickly converted to cash without a substantial price reduction.
Assets are normally listed on the statement of financial position in order of decreasing liquidity, meaning that the most liquid assets are listed _____
first
______ are relatively liquid and include cash and those assets that we expect to convert to cash over the next 12 months
Current assets
Inventory is probably the ____________ of the current assets, at least for many businesses.
least liquid
________ are, for the most part, relatively illiquid.
Fixed assets
Are trademarks liquid or naw?
They are rather illiquid
Cash holdings are the __________ of all investments, but they sometimes earn no return at all—they just sit there
most liquid
Shareholders’ equity value =
Assets - Liabilities
Shareholders’ equity is just the __________
residual portion
Financial leverage
The use of debt in a firm’s capital structure
The more debt a firm has (as a percentage of assets), the ________ is its degree of financial leverage
greater
__________ increases the potential reward to shareholders, but it also increases the potential for financial distress and business failure.
Financial leverage
Carrying value or the book value
The accounting value of a firm’s assets
IFRS allows companies to use the ___________ method; it also allows use of the __________ (fair value) method
historical cost
revaluation
When a company adopts the ____________, all items in a class of assets should be revalued simultaneously, and the revaluation should be performed with enough regularity to ensure that at the statement of financial position date the carrying amount is not materially different from the fair value amount
revaluation method
Market value
the price at which willing buyers and sellers trade the assets
A fundamental difference between Canadian GAAP and IFRS is that __________ accounting plays a more important role under IFRS
fair value
Impairment losses
The amount by which the carrying value of an asset or cash-generating unit exceeds its recoverable amount.
Although the adoption of IFRS in 2011 allowed Canadian companies to improve comparability worldwide with companies from more than ______ IFRS-adopted countries, it reduced Canadian companies’ comparability with ________.
130
U.S. companies
Statement of Comprehensive Income (Income Statement)
Financial statement summarizing a firm’s performance over a period of time
Under IFRS, a company has the flexibility to present either a single statement of comprehensive income or separate it into two statements:
the income statement presenting revenues and expenses, and the other comprehensive income statement presenting unrealized gains and losses
Income statement equation
Revenues - Expenses = Income
Net income is often expressed on a per-share basis and called ____________________
earnings per share (EPS).
Are taxes reported on the income statement?
No sir, on a separate statement
When looking at the statement of comprehensive income, the financial manager needs to keep three things in mind:
1) IFRS,
2) cash versus non-cash items,
3) and time and costs.
Revenue is recognized on the statement of ___________ when it is probable that any future economic benefit associated with the item of revenue will flow to the firm and the amount of revenue can be reliably measured, not when cash inflow occurred
comprehensive income
Thus, income is reported when it is earned or accrued, even though no cash flow has necessarily occurred.
For example, when goods are sold for credit, sales and profits are reported.
A primary reason that accounting income differs from cash flow is that a statement of comprehensive income contains _________
non-cash items
Non-cash items
Expenses charged against revenues that do not directly affect cash flow, such as depreciation.
What is the most important non-cash item?
Depreciation!!!
Two parts of the future
1) The short run
2) The long run
In the _________, all business costs are _______. Given sufficient time, assets can be sold, debts can be paid, and so on.
long run
variable
Accountants tend to classify costs as either _______ costs or _______ costs.
product
period
Product costs
include things such as raw materials, direct labour expense, and manufacturing overhead
______________________ are reported on the statement of comprehensive income as _______________________, but they include both fixed and variable costs
Product costs
Costs of goods sold (COGS)
Period costs
Costs that are incurred during a particular time period and are reported as selling, general, and administrative expenses.
Cash flows from assets =
Cash flow identity
Cash flow to bondholders (or creditors) + Cash flows to shareholders (or owners)
Cash flow identity explained
The cash flow from the firms assets is equal to the cash flow paid to suppliers of capital to the firm
Cash Flow from Assets
The total of cash flow to bondholders and cash flow to shareholders, consisting of operating cash flow, capital spending, and additions to net working capital.
Cash Flow from Assets contains 3 components, what are they?
1) Operating cash flow
2) Capital spending
3) Additions to net working capital
Operating cash flow
refers to the cash flow that results from the firm’s day-to-day activities of producing and selling
It should usually be positive; a firm is in trouble if operating cash flow is negative for a long time because the firm is not generating enough cash to pay operating costs
Capital spending
refers to the net spending on fixed assets (purchases of fixed assets less sales of fixed assets)
Additions to net working capital
the amount spent on net working capital
It is measured as the change in net working capital over the period being examined and represents the net increase in current assets over current liabilities
OPERATING CASH FLOW definition
Cash generated from a firm’s normal business activities.
How to calculate operating cash flow equation
EBIT + Depreciation - Taxes = Operating cash flows
Revenue - Costs
**Important: do not include depreciation or interest!! - it is not a cash outflow, and interest is a financing
expense
Include taxes
EBIT
Earnings before interest and taxes
How to calculate Net capital spending equation
Ending fixed assets - beginning fixed assets + depreciation = net investment in fixed assets
is just money spent on fixed assets less money received from the sale of fixed assets
Could net capital spending be negative?
Yes - This would happen if the firm sold more assets than it purchased
NWC
Net working capital
Ending NWC - Beginning NWC = Change in NWC
Net working capital equation
Cash flow from assets equation
Operating cash flow - Net capital spending - Changes in NWC = Cash flow from assets
Free cash flow
Another name for cash flow from assets.
Cash that the firm is free to distribute to creditors and shareholders because it is not needed for working capital or fixed asset investment
Cash Flow to Creditors
A firm’s interest payments to creditors less net new borrowings.
Cash flow to Shareholders
Dividends paid out by a firm less net new equity raised.
Cash flow to creditors equation
AKA
cash flow to bondholders equation
Interest paid - Net new borrowing = Cash flow to creditors
Cash flow to shareholders equation
Dividends paid - Net new equity = cash flow to shareholders
This account tells us how many shares the company has sold
Total cash flow of the firm
includes capital spending and additions to net working capital
This will frequently be negative
Net income is not _______
Cash flow
The size of the tax bill is determined through tax laws and regulations in the annual budgets of the_________ (administered by Canada Revenue Agency (CRA)) and ____________
federal government
provincial governments
According to economic theory, an ideal tax system has three features
1) it should distribute the tax burden equitably, with each taxpayer shouldering a “fair share.”
2) the tax system should not change the efficient allocation of resources by markets
3) the system should be easy to administer.
Investment income is also taxable
Interest income is taxed at the same rates as employment income, but special provisions reduce the taxes payable on dividends and capital gains
Individual income tax rates—2017
- 06% Up to $38,898
- 70% 38,899–77,797
- 50% 77,798–89,320
- 29% 89,301–108,460
- 70% 108,461 and over
Average tax rate
Total taxes paid divided by total taxable income.
Other words: the percentage of your income that goes to pay taxes
Marginal tax rate
Amount of tax payable on the next dollar earned.
Flat rate tax
The same tax rate for all incomes
The treatment of dividends in Canada is at least a partial exception because there are two clear goals
1) First, corporations pay dividends from after-tax income so tax laws shelter dividends from full tax in the hands of shareholders
2) Second, the dividend tax credit applies only to dividends paid by Canadian corporations
Dividend tax credit
Tax formula that reduces the effective tax rate on dividends.
TABLE 2.6
Combined Top Marginal Tax Rates for Individuals—2018
BC Numbers:
- 80% - Interest and Regular income
- 90% - Capital Gains
- 20% - Eligible Dividends
- 73% - Non-eligible Dividends
Capital gains
The increase in value of an investment over its purchase price
Realized capital gains
The increase in value of an investment, when converted to cash
___________, like individuals, are subject to taxes levied by the federal and provincial governments.
Canadian corporations
In general, a taxable firm must earn _____________________ in additional EBIT for each extra dollar of dividends
1/(1 − Tax rate)
Dividends on common shares received from other Canadian corporations qualify for a ___% exemption and are received tax free
100
_____ does not have a tiered capital gains tax system.
Canada
When a firm disposes of an asset for more than it paid originally, the difference is a ________
Capital gain
At the time of writing, capital gains received by corporations are taxed at_______% of the marginal tax rate.
50
loss carry-back
Using a year’s capital losses to offset capital gains of previous years.
loss carry-forward
Using a year’s capital losses to offset capital gains of future years.
Non-capital losses can be carried back _______
three years
Capital cost allowance (CCA)
Depreciation for tax purposes, not necessarily the same as depreciation under IFRS; depreciation method under Canadian tax law allowing for the accelerated write-off of property under various classifications.
_________ calculation begins by assigning every capital asset to a particular class
CCA
_________ assets like leasehold improvements follow straight-line depreciation for CCA
Intangible
For all other assets, CCA follows the declining _______________.
balance method
How to calculate CCA (equation?)
Undepreciated capital cost (UCC) x Appropriate rate
Accelerated Cost Recovery System (ACRS)
System used in the USA - Canada’s version is the capital cost allowance (CCA)
Half-year rule
CRA’s requirement to figure CCA on only one-half of an asset’s installed cost for its first year of use.
Adjusted cost of disposal
When an asset is sold, the UCC in its asset class (or pool) is reduced by what is realized on the asset or by its original cost, whichever is less
Net acquisitions
Total installed cost of capital acquisitions minus adjusted cost of any disposals within an asset pool.
How to calculate net acquisitions costs (equatio)
From the total installed cost of all acquisitions, we subtract the adjusted cost of disposal of all assets in the pool
The result is net acquisitions for the asset class
If net acquisitions are positive, we apply the half-year rule and calculate CCA as we did earlier. If net acquisitions is negative, there is no adjustment for the half-year rule.
Terminal loss
The difference between UCC and adjusted cost of disposal when the UCC is greater.
Recaptured depreciation
The taxable difference between adjusted cost of disposal and UCC when UCC is smaller.
The goal of financial management is to maximize the __________ of the stock, not its ________
market value
book value
