Chapter Two

Financial Statements, Cash

Flows, Taxes, and the
Language of Finance
Principles of Managerial Finance
First Canadian Edition
Lawrence J. Gitman and Sean Hennessey
 Learning Goals
LG1 – Review characteristics, format, key
components, and relationships between
Income Statement, Balance Sheet,
Statement of Retained Earnings, and
Statement of Cash Flows.
LG2 – Analyze a firm’s cash flows; develop and
interpret the statement of cash flows.
 Learning Goals (continued)
LG3 – Introduce basics of corporate taxation in
Canada.
LG4 – Understand tax deductibility of
expenses, how they reduce actual, after-
tax costs to a profitable company.
LG5 – Discuss and illustrate Capital Cost
Allowance (CCA), the tax version of
amortization, and how CCA increases
cash flows.
 Learning Goals (continued)
LG6 – Review the information provided in a
publicly traded company’s annual report
to shareholders.
LG7 – Discuss some key concepts in finance
and review the language of finance.
 Four Principal Financial
Statements
Developed by the Canadian Institute of
Chartered Accountants:
1. Income Statement
2. Balance Sheet
3. Statement of Retained Earnings
4. Statement of Cash Flows
 Income Statement
• Provides financial summary of operating
results for a specified period.
• Main operating results consist of:
– Sales revenues, Cost of goods sold, Operating
expenses, Interest expenses, Taxes, and
Preferred share dividends.
 Income Statement (continued)
• Important sub-totals of these operating results
are:
– Gross margin.
– Operating earnings (EBIT).
– Earnings before taxes (EBT).
– Net Income after taxes (NIAT).
– Earnings available for common shareholders (EAC).
 Balance Sheet
• Presents summary of firm’s financial
position at a given point in time.
• Assets = Liabilities + Equity.
• In the short term, working capital
management focuses on current assets and
current liabilities.
 Balance Sheet (continued)
• Current Assets: • Current Liabilities:
– Cash, Marketable – Accounts payable,
securities, Accounts Line of credit,
receivable, Inventories Accruals
• Gross Fixed Assets: • Long-term debt
– Land & Buildings,
Machinery & • Shareholder’s equity:
equipment, Furniture, – Preferred shares,
Vehicles, Others Common shares,
• Less: Accumulated Retained earnings
amortization
 Statement of Retained Earnings

• Details changes in Retained Earnings from

the beginning to the end of the fiscal year.

Retained Earning Balance (start of year)

Plus: Net Income After Taxes
Less: Cash Dividends Paid
Retained Earning Balance (end of year)
 Statement of Cash Flows
• Provides summary of all inflows and
outflows of cash over the same period as the
Balance Sheet.
• Provides insights into the firm’s operating,
investment, and financing cash flows.
• Reconciles changes in cash and marketable
securities.
 The Firm’s Cash Flows
Operating Flows: Investment Flows:
• Payments: • Purchases & Sales:
– Accruals, Credit – Fixed assets, Business
purchases, Taxes, interests
Overhead expenses Financing Flows:
• Receipts: • Increases in Debt or
– Cash sales, Collection Equity
of credit sales, Tax
refunds • Reductions in Debt or
Equity
Figure 2.2 Cash Flows
 Inflows vs. Outflows
1. Decrease in any asset. 1. Increase in any asset.
2. Increase in any 2. Decrease in any
liability. liability.
3. Net income after 3. Net loss.
taxes.
4. Amortization and 4. Dividends paid.
other non-cash
expenses.
5. Repurchase or
5. Sale of shares.
retirement of shares.
Developing Cash Flow Statement
1. Cash and marketable securities (start of year).
2. Calculate net cash from operations.
3. Determine total changes in non-cash working
capital accounts.
4. Determine cash flows from investing activities.
5. Determine cash flows from financing activities.
6. Determine change in cash and marketable
securities (end of year).
 Taxation of Business Income
• Corporations can earn four types of income:
– Active Business Income
– Passive Income
– Intercorporate Dividends
– Capital Gains
• Types of Corporations for tax purposes:
– Non-Manufacturing
– Manufacturing or Processing
– Canadian-controlled private corporation (CCPC)
Deductions from Federal Tax Rate
• Federal Corporate Tax for general Non-
Manufacturing is 29.12%.
• Manufacturing and processing deduction
(Federal Tax of 22.12% of earnings).
• Small business deduction (Federal Tax of
13.12% on earnings up to $200,000).
• CCPC rate reduction (Federal Tax of
22.12% on earnings between $200,000 and
$300,000).
 Tax-Deductible Expenses
• There are two main categories of deductible
expenses for all types of Canadian
Corporation:
– Operating Expenses
– Interest Expenses
 CCA-Capital Cost Allowance
• Canadian Customs and Revenue Agency
(CCRA) requires companies to use their
schedule of Capital Cost Allowance (CCA)
as a means of amortizing expenses of
capital equipment for tax purposes.
• Like the concept of amortization, CCA is a
non-cash expense item that is deductible for
tax purposes.
 Company Annual Report
• Required for all publicly traded firms
• Letter to Shareholders
• Management’s Discussion and Analysis
• Financial Statements:
– Income statement, Balance Sheet, Statement of
retained earnings, Statement of cash flows
• Summary
 Language of Finance
• Basic accounting
• Financial forecasting
• Financial markets
• Cost of capital
• Capital budgeting