Chapter 2 Notes: Financial Statements, Cash Flow, and Taxes

2.1 Statement of Financial Position

  • The statement of financial position (SFP) is a snapshot of the firm’s assets and liabilities at a given point in time.
  • Assets are listed in order of liquidity:
    • Ease of conversion to cash
    • Without significant loss of value
  • Statement of Financial Position Identity:
    Assets=Liabilities+Stockholders’ Equity\text{Assets} = \text{Liabilities} + \text{Stockholders' Equity}
  • Net Working Capital (NWC): NWC=Current Assets−Current Liabilities\text{NWC} = \text{Current Assets} - \text{Current Liabilities}
    • Positive when the cash that will be received over the next 12 months exceeds the cash that will be paid out.
    • Usually positive in a healthy firm.
  • Liquidity: the ability to convert to cash quickly without a significant loss in value.
    • Liquid firms are less likely to experience financial distress but liquid assets typically earn lower returns.
    • Tradeoff between liquid and illiquid assets.
  • Value versus Cost:
    • The SFP shows book value (historical cost) of assets, liabilities, and equity.
    • Market value is the price at which assets/liabilities/equity can actually be bought or sold.
    • Market value and book value often differ; this matters for decision-making.
  • IFRS considerations (2.1):
    • IFRS allows historical cost accounting.
    • IFRS also allows revaluation (fair value) in asset classes, but all items in an asset class should be revalued simultaneously.
    • Revaluation should be performed with enough regularity to keep carrying amount close to fair value.

2.1 (continued) Example references

  • Canadian Tire – Statements of Financial Position (2018 & 2019) illustrate SFP structure in practice.

2.2 Statement of Comprehensive Income

  • The statement of comprehensive income is like a video of the firm’s operations over a period.
  • Revenues are reported first, followed by deducting expenses for the period.
  • Matching principle:
    • IFRS requires revenue to be shown when it accrues and to match the expenses required to generate that revenue.

2.2 (additional) Example materials

  • Table 2.2: Canadian Tire Corp. Ltd. 2019 Income Statement (illustrative)
  • Work the Web Example (2.2):
    • Publicly traded companies file regular reports with securities regulators (e.g., Ontario Securities Commission).
    • Reports can be searched on sites like SEDAR.

2.3 Cash Flow

  • Cash flow is a critical piece of information for financial managers: how cash is generated from assets and paid to financiers.

2.3 Cash Flow From Assets (CFFA)

  • Core identity:
    CF<em>From Assets=CF</em>to creditors+CFto shareholders\text{CF}<em>{\text{From Assets}} = \text{CF}</em>{\text{to creditors}} + \text{CF}_{\text{to shareholders}}
  • CFFA can also be expressed as:
    CFFrom Assets=Operating Cash Flow−Net Capital Spending−ΔNWC\text{CF}_{\text{From Assets}} = \text{Operating Cash Flow} - \text{Net Capital Spending} - \Delta \text{NWC}
  • Definitions:
    • Operating Cash Flow (OCF):
      OCF=EBIT+Depreciation−Taxes\text{OCF} = \text{EBIT} + \text{Depreciation} - \text{Taxes}
    • Net Capital Spending (NCS):
      NCS=Ending Net Fixed Assets−Beginning Net Fixed Assets+Depreciation\text{NCS} = \text{Ending Net Fixed Assets} - \text{Beginning Net Fixed Assets} + \text{Depreciation}
    • Changes in Net Working Capital (ΔNWC):
      ΔNWC=Ending NWC−Beginning NWC\Delta \text{NWC} = \text{Ending NWC} - \text{Beginning NWC}
  • Cash flow to financiers:
    • CF to Bondholders (creditors):
      CFto creditors=Interest Paid−Net New Borrowing\text{CF}_{\text{to creditors}} = \text{Interest Paid} - \text{Net New Borrowing}
    • CF to Shareholders (owners):
      CFto shareholders=Dividends Paid−Net New Equity Raised\text{CF}_{\text{to shareholders}} = \text{Dividends Paid} - \text{Net New Equity Raised}
  • Cash Flow Identity (example form): CF<em>From Assets=CF</em>to creditors+CFto shareholders\text{CF}<em>{\text{From Assets}} = \text{CF}</em>{\text{to creditors}} + \text{CF}_{\text{to shareholders}}
    • Example from slides:
    • CFO, NCS, and ΔNWC calculations lead to a positive CF From Assets, which then split into CF to bondholders and CF to shareholders.

2.3 Example (CFFA) – Walk-through

  • Given data (illustrative):
    • Current Accounts: CA 2020 = $1{,}500; CL 2020 = $1{,}300; CA 2021 = $2{,}000; CL 2021 = $1{,}700
    • Fixed assets and depreciation: NFA 2020 = $3{,}000; NFA 2021 = $4{,}000; Depreciation expense = $300
    • LT Liabilities and Equity: LTD 2020 = $2{,}200; Common Equity 2020 = $500; Retained Earnings (RE) 2020 = $500; LTD 2021 = $2{,}800; Common Equity 2021 = $750; RE 2021 = $750
    • Statement of Comprehensive Income: EBIT = $2{,}700; Interest Expense = $200; Taxes = $1{,}000; Dividends = $1{,}250
  • Calculations:
    • OCF = $2{,}700 + $300 - $1{,}000 = $2{,}000
    • NCS = Ending NFA - Beginning NFA + Depreciation = $4{,}000 - $3{,}000 + $300 = $1{,}300
    • ΔNWC = (Ending NWC) - (Beginning NWC) = (Ending CA - Ending CL) - (Beginning CA - Beginning CL) = ( $2{,}000 - $1{,}700 ) - ( $1{,}500 - $1{,}300 ) = $300 - $200 = $100
    • CF From Assets = $2{,}000 - $1{,}300 - $100 = $600
  • Cash flows to financiers:
    • CF to Bondholders = $200 - ( $2{,}800 - $2{,}200 ) = $200 - $600 = -$400
    • CF to Shareholders = $1{,}250 - ( $750 - $500 ) = $1{,}250 - $250 = $1{,}000
  • Cash flow identity holds: $600 = -$400 + $1{,}000$

2.4 Taxes

  • Key tax concepts:
    • Individual vs. corporate taxes
    • Marginal vs. average tax rates:
    • Marginal: the percentage paid on the next dollar earned
    • Average: tax bill ÷ taxable income
  • Taxes on investments:
    • Dividend tax credit (for Canadian residents) reduces the effective tax rate on dividends from Canadian corporations; a tax-incentive mechanism for investing in equities.
    • Capital gains tax is charged on the investment’s increase in value over its purchase price.
  • Capital Cost Allowance (CCA):
    • Depreciation for tax purposes in Canada; deducted before taxes, acting as a tax shield.
    • Assets are assigned to asset classes; each class has a depreciation method and rate.
    • Accelerated Investment Rule: in the first year, one-and-a-half times the prescribed rate can be used for CCA purposes.
  • Table 2.8 (Common CCA classes) – illustrative examples:
    • Class 1: Buildings acquired after 1987 — rate: 4% (example from table)
    • Other common classes include asset types such as equipment, vehicles, and intangible assets; exact rates are listed in Table 2.8.
  • Important note on half-year rule: only half-year of CCA is generally allowed in the year of acquisition (part of the standard CCA framework).
  • Asset classes and rates (examples you’ll see in exercises):
    • Example: Class 8 (often used for computer hardware, some equipment, etc.) with CCA rate commonly cited as 20%
    • Example: Class 43 (machinery) with a CCA rate of 30%

2.4 Taxes – Examples

  • Example: ABC Corporation purchases $100,000 of photocopiers in 2020; asset class 8; CCA rate = 20%
    • 2020: Beginning fixed assets = $100,000; CCA = $30,000; Ending fixed assets = $70,000
    • 2021: Beginning fixed assets = $70,000; CCA = $14,000; Ending fixed assets = $56,000
  • Example: Kool Drinks Corporation purchases $300,000 of bottling machinery in 2019; asset class 43; CCA rate = 30%
    • 2019: Beginning UCC = $300,000; CCA = $135,000; Ending UCC = $165,000
    • 2020: Beginning UCC = $165,000; CCA = $49,500; Ending UCC = $115,500
    • 2021: Beginning UCC = $115,500; CCA = $34,650; Ending UCC = $80,850
  • Tax outcomes for asset sale scenarios (contingent on sale price):
    • If sold for $150,000 (versus original cost $300,000): no capital gain; there is a CCA recapture of $69,150.
    • If sold for $75,000: there is a terminal loss of $5,850 (given the UCC and adjusted cost figures).

2.5 Summary and Conclusions

  • The statement of financial position shows the firm’s accounting value on a date.
  • The statement of comprehensive income summarizes performance over a period.
  • Cash flow measures the difference between inflows and outflows of cash, and cash flows are measured after tax.
  • CCA is depreciation for tax purposes in Canada (note the half-year rule).
  • Key questions to guide decision-making include:
    • What is the difference between book value and market value, and which should be used for decision making?
    • What is the difference between accounting income and cash flow, and which is relevant for decisions?
    • What is the difference between average and marginal tax rates, and which should be used in decisions?
    • How are a firm’s cash flows determined, and where are the requisite equations and data found?
    • What is CCA, how is it calculated, and what are its implications for after-tax cash flow?

2.6 Quick Quiz (summary prompts)

  • What is the difference between book value and market value, and which should we use for decision making?
  • What is the difference between accounting income and cash flow, and which do we need for decisions?
  • What is the difference between average and marginal tax rates, and which should be used in financial decisions?
  • How do we determine a firm’s cash flows? What are the equations and where do we find the information?
  • What is CCA? How is it calculated? What is the half-year rule?

2.7 Practical connections and implications

  • The cash flow framework (OCF, NCS, ΔNWC) links accounting statements to real cash movement, enabling evaluation of investment decisions and capital structure.
  • The distinction between book value and market value influences project appraisal, financing choices, and valuation exercises.
  • Tax considerations (dividends, capital gains, CCA, terminal losses, recapture) materially affect after-tax cash flows and investment profitability.
  • IFRS differences (historical cost vs. revaluation) can affect reported asset values and the signaling of firm health to investors.
  • Understanding asset classes and depreciation rules helps forecast after-tax cash flows and assess tax shields from investments.