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FINANCIALIANALYSIS AND PLANNING

NTRODUCTION

CHAPTER 2

REVIEW OF ACCOUNTING
CHAPTER 3

FINANCIAL ANALYSIS
CHAPTER 4

FINANCIAL FORECASTING
CHAPTER 5

OPERATING AND FINANCIAL LEVERAGE

Understanding and utilizing financial statements for the analysis of the firms performance, for
comprehending the dynamics revealed within the balance sheet, and for forecasting the future
financial situation of the firm are key skills required of the financial manager.

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Review of Accounting
LEARNING OBJECTIVES
1 Demonstrate a reasonable 4 Explain the importance of 6 Identify the different forms of
ability to prepare the three cash flows as identified in the investment income and the
basic financial statements. statement of cash flows. different taxes payable on this
income.
2 Examine the limitations of the 5 Outline the effect of corporate
income statement as a mea- tax considerations on aftertax 7 Explain the concept of tax
sure of a firms profitability. cash flow. savings.
3 Examine the limitations of the
balance sheet as a measure of
a firms financial position.

The language of finance flows logically from
accounting. To be adequately prepared to study
the concepts of finance, it is necessary to com-
prehend the material drawn from the account-
ing area. Although our focus in finance is
decision making that seeks to produce value
today from future expected cash flows, it is
important to understand where a firm has been
and where it is at the present time. Financial
statements help us to understand this.
Much of the early frustration suffered by
students who have difficulty with finance can
be overcome if such concepts as retained earn-
ings, shareholders equity, amortization, and
historical/replacement cost accounting are
brought into focus.
This chapter examines the three basic types
of financial statementsthe income statement,
the balance sheet, and the statement of cash
flowswith particular attention paid to the in-
terrelationships among these three measurement
devices. The requirements and the suggestions
for the format of these statements are detailed in
the handbook of the Canadian Institute of Char-
tered Accountants (CICA). The CICA Handbook
sets the requirements for the financial statements
prepared by chartered accountants.
From these statements we may be able to
estimate the future direction of the firm and bet-
ter understand the basis of value. Furthermore,
we can examine the differences between cash
flow and income. As special preparation for the
financial manager, we also briefly examine
income tax considerations affecting financial
decisions.

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CHAPTER 2 Review of Accounting 23

INCOME STATEMENT
The income statement
Measures the profitability of a firm over a time period (month, year)
Assists financial decision making and analysis, utilizing past patterns for predicting the
timing, uncertainty, and amount of future earnings and cash flows
The income statement as presented in Table 21 for the Kramer Corporation is presented in a
stair-step fashion so that we can examine the profit or loss after each major type of expense item.

TABLE 21
Income statement
KRAMER CORPORATION
Income Statement
For the Year Ended December 31, 2009

1. Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000
2. Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000
3. Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
4. Selling and administrative expense . . . . . . . . . . . . . . . . 220,000
5. Amortization expense. . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
6. Operating profit (EBIT)* . . . . . . . . . . . . . . . . . . . . . . . . 230,000
7. Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
8. Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . 210,000
9. Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99,500
10. Earnings after taxes (EAT) . . . . . . . . . . . . . . . . . . . . . . . $ 110,500
11. Preferred stock dividends . . . . . . . . . . . . . . . . . . . . . . . 10,500
12. Earnings available to common shareholders . . . . . . . . . 100,000
13. Shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
14. Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.00
*Earnings before interest and taxes.

Gross profit: Sales (revenues) less cost of goods sold (direct costs related to sales). May
contain some fixed costs but exclude overheads.
Contribution margin (not presented here): Sales less variable costs.
After subtracting selling and administrative expense and amortization1 (or fixed costs from
contribution margin) we determine
Operating profit (earnings before interest and taxes): A measure of how efficient
management is in generating revenues and controlling expenses.
Amortization can be a significant expense derived from the capital assets devel-
oped by the firm and identified on the balance sheet. A high gross profit margin (25
to 50 percent) can be eroded to a low operating profit because of heavy expenses in-
curred in marketing the product and managing the company.
Earnings (net income or loss): Operating profit is adjusted for revenues and expenses
not related to operational matters. Interest reflecting the financing policies of the firm
or its leverage, as explored in Chapter 5 and taxes reflecting government are of partic-
ular note.

1
Amortization was not treated as part of cost of goods sold in this instance, but rather as a separate expense. Depend-
ing on the circumstances, all or part of amortization may be treated as cost of goods sold. Amortization as recom-
mended in the CICA Handbook, Section 3060.33 recognizes the declining value of a capital asset over its life.
Depreciation or depletion are other acceptable terms for amortization.

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F I N A N C E I N A C T I O N

Where Did Those Earnings Go?

Nortel Networks in 2007 recorded the following in the equity por-
tion of its balance sheet (in billions of U.S. dollars): Q
1 How did Nortel get a negative position in retained
earnings?

Contributed capital $39.0 www.nortel.com

Retained earnings (deficit) <36.3> Symbol: NT
Equity 2.7

In mid-2008 the market value of its equity had dropped to

$3 billion from $350 billion in 2000, when its book value was
about $29 billion. In 2009 Nortel sought bankruptcy protection.

Earnings are not the same as the cash flow because of accrual accounting and the
matching principle of revenues to expenses. Earnings represent a longer-run view of
the firm, while the cash flow statement which complements the income statement fo-
cuses on the firms survival in the short term.

Return on Capital
We should note the return on capital to the three primary sources provided by investors:
Bondholders $20,000 in interest (item 7)
Preferred shareholders $10,500 in dividends (item 11)
Common shareholders $100,000 of earnings available (item 12)

Earnings (or income) can be paid to shareholders (preferred and common) as dividends
or retained in the firm for reinvestment on behalf of the common shareholders. The rein-
vested funds, identified on the balance sheet, theoretically belong to the common sharehold-
ers, but do not represent cash. These funds will be invested in accounts receivable,
inventories, capital, or other assets, and hopefully provide future earnings and dividends
appropriate to the risk assumed.
A short supplement to the income statement, a statement of retained earnings (Table 22),
usually indicates the disposition of earnings.2 A dividend of $50,000 for common sharehold-
ers has been declared in our example.

TABLE 22
Statement of
retained earnings Statement of Retained Earnings
For the Year Ended December 31, 2009

Retained earnings, balance, January 1, 2009 . . . . . . . . . . . . $250,000

Add: Earnings available to common shareholders, 2009 100,000
Deduct: Cash dividends declared in 2009 . . . . . . . . . . 50,000
Retained earnings, balance, December 31, 2009 . . . . . . . . $300,000

Valuation Basics from the Income Statement

The goal of the firm was identified in Chapter 1 as the maximization of shareholder value.
This value is easy to measure immediately, based on todays market share price. However,

2
The statement may also indicate any adjustments to previously reported incomes as well as any restriction on cash
dividends.

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CHAPTER 2 Review of Accounting 25

shareholders, investors, and analysts will be interested in attempting to forecast future value.
Over time these future values will determine shareholders return on their capital.
Shareholders claim on earnings is a fundamental measure of value. Common sharehold-
ers are sensitive to the number of shares outstanding, with more shares resulting in lower earn-
ings available to each shareholder. Therefore to gauge shareholder returns we compute
earnings per share.

Earnings available to common shareholders

Earnings per share (e.p.s.) (21)
Number of shares outstanding

As indicated in item 14 of Table 21,

$100,000
e.p.s. $1
100,000 shares

A corollary to this is that before any new shares are issued, the financial manager must be
sure that the capital raised by issuing the new shares will eventually generate sufficient earn-
ings to avoid reducing earnings per share. The past trends and forecasts of earnings per share
is a closely watched financial ratio. Market share prices react immediately to announced earn-
ings particularly if they are different from the consensus of investors.
Shareholders will also be interested in what percentage of earnings is paid out immediately
as dividends and this is referred to as the payout ratio.

Dividend per share

Payout ratio (22)
Earnings per share

With $50,000 paid out by Kramer to 100,000 shareholders, or dividends per share of $0.50,

$0.50
Payout ratio 0.50 or 50%
$1

Growth in earnings is important for the survival of small businesses requiring increasing
amounts of capital. Small businesses are often forced to rely on reinvested earnings to fund ex-
pansion as their access to the capital market and banking system is restricted. If these sources
of external capital are prepared to lend or invest in the small firm they will carefully study the
progress made by the firm in earnings growth. Furthermore any valuation of the firms shares,
which are not publicly traded, will focus on earnings.
Shareholders interest in earnings per share will influence the price they are prepared to
pay for shares of the firm. A relationship between earnings per share and current market value
is the price-earnings ratio (P/E ratio).

Market share price

P/E ratio (23)
Earnings per share

If the market value per share for Kramer Corporation were $12, the price-earnings ratio
would be

$12
P/E ratio 12
$1

The price-earnings ratio (P/E ratio) of a firm is influenced by

Earnings and sales growth
Risk (business performance and debt-equity structure)
Dividend payment policy
Quality of management
Many other factors

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26 PART 2 Financial Analysis and Planning

This ratio allows comparison of the relative market value of many companies on the basis of
$1 of earnings per share. Firms expected to provide greater than average future returns often
have P/E ratios higher than the market average P/E ratio. As investors expectations for future
returns change, a companys P/E ratio, as indicated in Table 23, can shift substantially.

TABLE 23
Price-earnings ratios for
selected companies P/E Ratio
Dec. Sept. Sept. Mar.
Corporation Industry 1981 1992 2001 2008

AbitibiBowater (ABH) Forest products 3.7 n.a. 9.3 n.a.

BCE (BCE) Telecommunications 7.8 11.2 24.8 7.2
Bank of Montreal (BMO) Banking 3.9 8.8 11.0 11.2
Loblaw (L) Grocery chain 6.2 18.5 27.8 25.1
MolsonCoors (TAP.A) Brewery 9.1 13.5 21.3 17.7
Open Text (OTC) Tech. software n.a. n.a. 43.5 50.0
EnCana (ECA) Petroleum 10.3 143.4 7.0 13.6
TSX Composite* Index 8.6 110.2 81.9 17.7
*No P/E ratios are reported on negative earnings. The TSX Composite Index is the exception due to huge
losses at Nortel and JDS.

Price-earnings ratios consolidate a great deal of information about a company and yet can
be confusing. When a firms earnings are dropping rapidly, perhaps even approaching zero, the
decline in its share price may be more gradual. This process can give rise to the appearance of
an increasing P/E ratio under adversity. This happens occasionally in cyclical industries such
as Canadas resource-based companies.
In 1992 many shares were trading at high P/E ratios due to depressed earnings. Through
the 1990s P/E ratios were high by historical standards due to very low interest rates and good
economic growth prospects. EnCana was at a ratio well above 100 in 1992, a reflection of the
poor earnings in the petroleum industry. As earnings improved, P/E ratios became more rea-
EnCana sonable, and by 2001 with record earnings in the oil patch EnCanas P/E ratio had dropped
www.encana.com considerably on expectations of subdued growth due to expected declines in oil and gas prices.
Open Text Corporation
www.opentext.com Open Text, a company in the high-tech business, trades at a large P/E ratio on the basis of fu-
ture expected earnings not its current meagre earnings.
Shareholders may place a higher value on income received from dividends, as compared
to future expected earnings that may result from reinvested earnings. Therefore dividends of-
ten form the basis of the valuation of the firms performance. The yield in immediate returns
via dividends is the dividend yield.

Dividends per share

Dividend yield (24)
Market share price

For Kramer Corporation this is,

$0.50
Dividend yield 0.0417 or 4.17%
$12

Limitations of the Income Statement

A financial analyst examines the income statement with knowledge of how earnings or prof-
its are defined. While the accountant records past events, the financial analyst builds models
and suggests values based on the future. Like the economist, the analyst views past events as
somewhat irrelevant for valuation purposes. It is the timing of cash flows in the future that is

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F I N A N C E I N A C T I O N

Apparently Earnings Are Flexible

As we entered this decade, many expressed concern with the
quality of earnings reported by publicly traded companies. This
has lead to new reporting and regulatory standards. In efforts to
meet earnings targets, accountants and managers had resorted to
stretching accounting standards beyond their reasonable limits.
Earnings can be managed or manipulated because profes-
sional accounting bodies allow latitude. Accruals, such as allowance
for doubtful accounts or warranty expenses, and write-downs of
assets (inventories and capital) are by their nature discretionary.
Margins can also be managed, by classification of overhead as a
cost of goods rather than administrative expenses. Management
has this discretion due to its experience and the need to make esti-
mates of many of the revenues and expenses that will flow through
the firm.
There is pressure on companies to meet earnings targets, and
share prices often decline when targets are not met. Auditors that
audit the statements rely to a significant extent on company man-
agement. The securities commission in each province has the
power to force public companies to clarify or reissue financial
statements. Under Hot Topics at the OSC website, current con-
cerns in accounting practice are identified.
During this past decade, senior managers at several companies
have been dismissed because of alleged manipulation of the com-
panys financial statements. In the footnotes to financial statements,
under significant accounting policies, there is a statement that
the firm makes estimates and assumptions that affect . . . the
reported amounts of revenues and expenses during the reporting
period. Sometimes this practice leads to misleading financial
statements and regulatory investigations.
Several theories have been suggested about the factors contribut-
ing to the management or manipulation of reported earnings:
Bonuses (Compensation is tied to reported earnings.)
Political considerations (High reported earnings attract soci-
etal attention.)
Smoothing (Less volatile earnings are viewed favourably by
the market.)
Debt covenants (Debt contracts are often based on book
value calculations.)
Big bath (New CEOs will look better in the future if assets
are written down as they take over, avoiding future amorti-
zation charges.)
Q
1 Identify and judge the validity of estimates made by
TELUS in reporting income.
Q
2 What is the mandate of the Ontario Securities
Commission?
http://about.telus.com/investors/en
Symbol: T
www.osc.gov.on.ca

relevant for valuation. The accountant imposes a specific time period on the income state-
ment, requiring accruals that dont necessarily reflect the timing of cash flows or changes in
a corporations value. The accountant and economist, or financial analyst, would likely have
different numbers to reflect a companys profits.
The economist defines income as the change in real worth that occurs between the begin-
ning and the end of a specified time period. To the economist, an increase in the value of a
firms land as a result of a new airport being built on an adjacent property is an increase in the
real worth of the firm. It therefore represents income. Similarly, the elimination of a competi-
tor might also increase the firms real worth and, therefore, result in income in an economic
sense. The accountant does not ordinarily employ such a broad definition of income.
Accounting values are established primarily by actual transactions, and income that is
gained or lost during a given period is a function of verifiable transactions. While the poten-
tial sales price of a companys property may go from $10 million to $20 million as a result of
new developments in the area, its shareholders may perceive only a much smaller gain from
operations, as reported in the accounting statements.
Also, as will be pointed out in Chapter 3, there is some flexibility in the reporting of trans-
actions. This means similar events may result in differing measurements of income at the end
of the period. The choices accountants make in accounting policies and methods used for
value determination should be clearly indicated in the notes to financial statements. The in-
tent of this section is not to criticize the accounting profession, for it is certainly among the
best-organized, best-trained, and best-paid professions, but to alert students to the fact that
some judgment is involved in financial reporting. Therefore, consumers of financial statements
must also be prepared to exercise judgment, look at the footnotes, and sometimes read be-
tween the lines. Because finance focuses on cash flows and their timing, one must be careful
not to equate income and cash flow.

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28 PART 2 Financial Analysis and Planning

BALANCE SHEET
The balance sheet indicates the firms
Holdings (what the firm owns)
Obligations (financing as liabilities or equity [ownership interest])
Measure of its worth at a point in time
A balance sheet for the Kramer Corporation as presented in Table 24 allows us to exam-
ine the firms ability to accept opportunities and to deal with difficulties. It is a cumulative
chronicle of all the companys transactions since its inception. In contrast, the income state-
ment measures results only over a short, quantifiable period. Good income statement results
usually produce healthy balance sheets. Generally, balance sheet items are stated on an
original-cost basis rather than at present worth.

TABLE 24
Balance sheet
KRAMER CORPORATION
Balance Sheet (Statement of Financial Position)
December 31, 2009

Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000
Marketable securities . . . . . . . . . . . . . . . . . . . . . . 10,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . $ 220,000
Less: Allowance for bad debts . . . . . . . . . . . . . 20,000 200,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . 450,000
Other assets:
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Capital assets:
Plant and equipment, original cost . . . . . . . . . . . $1,100,000
Less: Accumulated amortization . . . . . . . . . . . 600,000
Net plant and equipment . . . . . . . . . . . . . . . . . . 500,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Liabilities and Shareholders Equity

Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000
Notes payable (bank indebtedness) . . . . . . . . . . . 100,000
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Total current liabilities . . . . . . . . . . . . . . . . . . . 210,000
Long-term liabilities:
Bonds payable, 2020 . . . . . . . . . . . . . . . . . . . . . 90,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 300,000
Shareholders equity:
Preferred stock, 500 shares . . . . . . . . . . . . . . . . . 50,000
Common stock, 100,000 shares . . . . . . . . . . . . . 350,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 300,000
Total shareholders equity . . . . . . . . . . . . . . . . 700,000
Total liabilities and shareholders equity . . . . . . . . . $1,000,000

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CHAPTER 2 Review of Accounting 29

Interpretation of Balance Sheet Items

Asset accounts are listed in order of liquidity. Liquidity is a measure of how quickly an asset can
be converted to cash. Current assets are items that may be converted to cash within one year (or
the normal operating cycle of the firm). This is an important consideration, as significant in-
creases can quickly tie up cash resources. The financial manager must monitor these resources
carefully and plan to finance any increases. Capital demands will be explored in Chapter 6 to 8.
Marketable securities are temporary investments of excess cash (lower of cost or current
market value).
Accounts receivable include an allowance for bad debts (based on historical evidence) to
suggest their anticipated collection value.
Inventory may be in the form of raw material, goods in process, or finished goods.
Prepaid expenses represent future expenses that have already been paid (insurance pre-
miums, rent).
Investments, unlike marketable securities, are a longer-term commitment of funds, includ-
ing stocks, bonds, or investments in other corporations (often for acquisition).
Plant and equipment is identified as original cost minus accumulated amortization. Accumu-
lated amortization is not to be confused with the amortization expense item of the income state-
ment in Table 21. It is the sum of all past and present amortization charges on currently
owned assets, whereas amortization expense is the current years charge.
Obligations of the Kramer Corporation that finance assets are represented by $300,000 in
debt and $700,000 of shareholders equity. Current liabilities are short-term obligations due
within one year.
Accounts payable represent amounts owed on open account to suppliers.
Notes payable are generally short-term signed obligations to the banker or other
creditors.
Accrued expense is an obligation incurred but payment has not yet occurred.
(additional wages for services provided and owed workers)
Shareholders equity represents the total contribution and ownership interest of preferred
and common shareholders. The preferred stock investment position is $50,000, on the basis of
500 shares. In the case of common stock, 100,000 shares have been issued for $350,000.3 We can
assume that the 100,000 shares were originally sold at $3.50 each. Finally, $300,000 in retained
earnings from the statement of retained earnings (Table 22) represents the firms cumulative
earnings since inception minus dividends and any other adjustments.

Valuation Basics from the Balance Sheet

Shareholders equity minus the preferred stock component represents the net worth or book
value of the firm. If you take everything that the firm owns and subtract the debt and pre-
ferred stock outstanding, the remainder belongs to the common shareholder and represents
net worth.4 In the case of the Kramer Corporation, we show:

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . 300,000
Shareholders equity . . . . . . . . . . . . . . . . . . . 700,000
Preferred stock outstanding . . . . . . . . . . . . . 50,000
Net worth assigned to common . . . . . . . . . . $ 650,000
Common shares outstanding . . . . . . . . . . . . 100,000
Net worth, or book value, per share . . . . . . . $ 6.50

3
In most current Canadian circumstances, new common stock and preferred stock is issued on a no-par-value basis.
However, some corporate balance sheets still reflect the historical split between the par value of shares on issue and
the premium, termed contributed surplus, paid by investors above that par value.
4
An additional discussion of preferred stock is presented in Chapter 17. Preferred stock represents neither a debt claim
nor an ownership interest in the firm. It is a hybrid, or intermediate, security.

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30 PART 2 Financial Analysis and Planning

The original investment in the firm by shareholders was $350,000 and $300,000 of earn-
ings have since been reinvested in the firm. Together these totals also represent the net worth
of $650,000.
Because the concept of net worth (book value) is based on historical asset costs (Assets
Liabilities Preferred stock), net worth may bear little relationship to value currently put on
shareholders equity by investors or the marketplace via share price. This will occur because
the assets held by the firm have increased in value but this increased value is not yet recog-
nized by the financial statements. Analysts often calculate the relationship between market
value per share and historical book value per share.

Market value MV Market value per share

(25)
Book value BV Book value per share

For the Kramer Corporation with a market value of $12,

MV $12
1.85 times
BV $6.50

In examining this ratio we have to ask ourselves why market value has moved away from
book value and is this justified. A higher ratio suggests that the assets have achieved synergies
beyond their original cost and are expected to generate increasing returns by way of cash flows
in the future. A lower ratio may suggest the opposite. The Kramer ratio appears reasonable.
In Table 25 we look at disparities between market value and book value for a number of
publicly traded companies as identified by the ratio in the last column. Besides asset valua-
tion, a number of other factors may explain the wide differences, including industry outlook,
growth prospects, quality of management, and risk-return expectations. Open Text is a tech-
nology company with a lot of human capital, which doesnt show up on the balance sheet,
and it is a firm with good growth potential. EnCana has a high valuation from high oil and
gas prices. AbitibiBowater, in the pulp and paper business with huge investment in tangible
capital assets, has been subject to unrelenting competition and poor growth prospects.

TABLE 25
Comparison of market
value to book value per Ratio of
share, July 2008 Market Value Book Value Market Value
Corporation per Share per Share to Book Value

AbitibiBowater (ABH) $ 8.21 $28.10 0.29

BCE (BCE) 38.68 21.43 1.80
Bank of Montreal (BMO) 45.96 29.71 1.55
Loblaw (L) 30.47 20.10 1.52
MolsonCoors (TAP.A) 56.42 39.55 1.43
Open Text (OTC) 30.26 12.45 2.43
EnCana (ECA) 76.81 26.47 2.90
Source: Company financial reports, TSX website, www.tsx.com.

Limitations of the Balance Sheet

The values on the balance sheet are often subject to interpretation or revaluation.
Values are stated on a historical or original cost basis, not market values (some assets
may be worth considerably more than their original cost or may require many times
the original cost for replacement).
Accounting policy choice, which should be disclosed in the financial notes, will influ-
ence the recorded values.

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Meeting the Targets!

Biovail Corporation is a Canadian pharmaceutical company. Be-
tween 2001 and 2004, according to the Ontario Securities Com-
mission (OSC) and the Securities and Exchange Commission (SEC)
Q
1 How has Biovails share price performed since early
2008 when this issue was raised?

of the United States, it manipulated its financial statements. It was

suggested that Biovail
Used outdated and misleading exchange rates in its valuation
Q
2 What are Biovails comments on these events and
charges?

Recorded phony sales at the end of financial quarters www.biovail.com

Moved research and development expenses off its balance
Symbol: BVF
sheet to the pharmaceutical technologies division
Overstated the impact of a truck accident and product loss
The overall impact was misleading to investors. Biovail settled out
www.sec.gov/litigation/litreleases/2008/lr20506.htm
of court, paying a fine.

Contingent liabilities omitted from the balance sheet, or items such as intangibles that
are included, may have a hard-to-determine influence on economic value. Contingent
liabilities should be disclosed in footnotes on the balance sheet, alerting us to their
possible impact.
The accounting profession has grappled with the valuation problem for decades, and there
have been moves toward more market-based orientation for financial statements. In the 1980s
the profession recommended the use of the current cost (or replacement cost) method, in
which assets were revalued at their current costs; this method has been abandoned.
There has also been evidence that the financial statements adjusted to more fully reflect
current values do not impact significantly on the valuation perspective of investors. Investors
quickly reflect the value changes of companys assets or liabilities by raising or lowering mar-
ket share prices. Investors required only sufficient information from statements on which to
base their valuations, but whether it is historically or current valuebased does not seem to
matter. Efficient markets, as discussed in Chapter 14, appear to be indifferent to how financial
information is displayed.

STATEMENT OF CASH FLOWS

International
Accounting Standards
Board www.iasb.org
Financial Accounting
Standards Board
www.fasb.org
In evaluating investment opportunities finance considers cash flows and their timing of ut-
most importance. Accrual accounting attempts to match revenues and expenses over time
through the income statement and the subsequent impact on the balance sheet at a point in
time, even if the related cash flows occur at quite different times. Therefore these two state-
ments do not provide adequate information on the amount and timing of cash flowing into
and out of the business.
A third financial statement is required to translate income statement and balance sheet
data into cash flow information. The statement of cash flows identifies the sources and uses
of the firms cash between a beginning and ending balance sheet. International Accounting
Standards that are initiating the global standardization of accounting information have brought
the CICA Handbook in Canada and FASB in the United States together on this statement.
The statement of cash flow statement reports changes in cash and cash equivalents (rather
than working capital) resulting from the activities of the firm during a given period. For many
internal and external users of a firms financial information, cash flow information is critical.
The cash flow statement allows an analyst to identify
Cash flow generated from the firms assets
Financial obligations (interest and dividends)
Commitment to new assets

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32 PART 2 Financial Analysis and Planning

Cash equivalents are highly liquid investments (usually with maturities of less than three
months) less any bank overdrafts. They should have little risk of change in value, because they
are held to meet short-term commitments. Equity investments are therefore excluded. The
firm should disclose its policy distinguishing between cash equivalents and investments and if
their use is restricted due to bank requirements or by foreign currency exchange controls.
Movements between cash and cash equivalents are not reported, nor are financing and invest-
ing activities that do not use cash or equivalents, such as buying a business for shares or by
assuming debts.
The statement of cash flows can highlight
The relative buildup in short-term and long-term assets
The means of financing used to support any growth in the firms asset base
The appropriateness and the future implications of the financing used
Historical cash flows are often useful in estimating future cash flows. Financial forecast-
ing, discussed in Chapter 4, projects cash flow statements for future operating periods. A cor-
poration that has $1 million in accrual-based accounting profits can determine whether it can
actually afford to pay a cash dividend to shareholders, buy new equipment, or undertake new
projects.
The cash flow statements for the small business are particularly important, as cash flow is
more relevant to the firms short-term survival than its reported income. One is likely to be
concerned about the quality, timing, and amount of earnings, and hence the firms ability to
acquire assets and meet its obligations. In the very competitive corporate environment of to-
day exacting cash flow analysis is essential for a firms survival.

Developing an Actual Statement

We use the information previously provided for the Kramer Corporation to illustrate how the
statement of cash flows is developed.
But first, lets identify the three primary sections of the statement of cash flows. These sec-
tions are:
1. Operating activities
2. Investing activities
3. Financing activities
After each of these sections is completed, the results are added together to compute the
net increase or decrease in cash and cash equivalents for the corporation. An example of the
process is shown in Figure 21. Lets begin with cash flows from operating activities.

Determining Cash Flows from Operating Activities

Basically, we are going to translate income from operations from an accrual to a cash basis. There
are two ways to accomplish this objective. First, the firm may use a direct method, in which
every item on the income statement is adjusted from accrual accounting to cash accounting.
This is a tedious process that requires the adjustment of all sales to cash sales, all purchases ad-
justed to cash purchases, and so on. A June 1998 statement in the CICA Handbook encourages
the use of the direct method. This may be a method that appeals to smaller firms that have
their financial information on an easily accessible cash basis.
However, a more popular method that is favoured by larger firms is the indirect method, in
which net income represents the starting point and then adjustments are made to convert net
income to cash flows from operations.5 This is the method we will use here. This method

5
The indirect method is similar to procedures used to construct the old sources and uses of funds statement.

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CHAPTER 2 Review of Accounting 33

Figure 21
Illustration of concepts
(1)
behind the statement of Cash inflows Cash outflows
cash flows Generation of Cash flows from Expenditure of funds
funds in normal operating activities in normal operations
operations

(2)
Sale of plant Purchase of plant
and equipment Cash flows from and equipment
Liquidation of investing activities Long-term investment
long-term
investment

(3)
Sale of bonds, Retirement or
common stock, Cash flows from repurchase of
preferred stock, financing activities bonds, common stock,
and other preferred stock, and
securities other securities
Payment of cash
(4) dividends

Add items 1, 2, and

3 together to arrive
at net increase
(decrease) in cash

provides more information on the dynamics of cash flow. Regardless of whether the direct or
indirect method is used, the same final answer is derived.
We follow these procedures to compute cash flows from operating activities using the in-
direct method.6
Start with net income.
Recognize that noncash deductions in computing net income should be added back
to net income to increase the cash balance. These include such items as amortization,
deferred income taxes, restructuring charges, and foreign exchange losses. This pro-
duces cash flow from operations.
Next identify changes in noncash working capital.
Recognize that increases in current assets are a use of funds and reduce the cash balance
(indirectly)as an example, the firm spends more funds on inventory.
Recognize that decreases in current assets are a source of funds and increase the cash
balance (indirectly)that is, the firm reduces funds tied up in inventory.
Recognize that increases in current liabilities are a source of funds and increase the cash
balance (indirectly)that is, the firm gets more funds from creditors.
Recognize that decreases in current liabilities are a use of funds and decrease the cash
balance (indirectly)that is, the firm pays off creditors.
These steps are illustrated in Figure 22.
We follow these procedures for the Kramer Corporation, drawing primarily on material
from Table 21 (the previously presented income statement) and from Table 26 (which
shows balance sheet data for the most recent two years). A quick look at the changes in as-
sets on the balance sheets from one year to the next tells us of increased demands for cash
resources.

6
In addition to the items mentioned, we may need to recognize the gains or losses on the sale of operating and non-
operating assets. We exclude these for ease of analysis.

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34 PART 2 Financial Analysis and Planning

Figure 22
Steps in computing
cash provided by
Net income
operating activities
using the indirect
method

Amortization and other

noncash items

Increase in
current assets

Decrease in
current assets

Increase in
current liabilities

Decrease in
current liabilities

equals

Cash provided by (used

in) operating activities

The analysis is presented in Table 27. We begin with net income (earnings after taxes) of
$110,500 and add back amortization of $50,000. We then show that increases in current assets
(accounts receivable and inventory) reduce funds and that decreases in current assets (prepaid
expenses) increase funds. Also, we show increases in current liabilities (accounts payable) as an
addition to funds and decreases in current liabilities (accrued expenses) as a reduction of
funds.
We see in Table 27 that the firm generated $150,500 in cash flows from operating activi-
ties. This figure is $40,000 larger than the net income figure reported to shareholders
($150,500 $110,500). You can also envision that a firm with little amortization and a mas-
sive buildup of inventory might show lower cash flow than reported net income. Once cash
flows from operating activities are determined, management has a better feel for what can be
allocated to investing or financing needs such as paying cash dividends.

Determining Cash Flows from Investing Activities

The second section in the statement of cash flows relates to long-term investment activities in
other issuers securities or, more importantly, in plant and equipment. Increasing investments
represent a use of funds, and decreasing investments represent a source of funds.
Examining Table 26 for the Kramer Corporation, we show the cash flow information in
Table 28.

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CHAPTER 2 Review of Accounting 35

TABLE 26
Comparative balance
sheets KRAMER CORPORATION
Comparative Balance Sheets
Dec. 31 Dec. 31
2009 2008

Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 $ 30,000
Marketable securities . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000
Accounts receivable (net) . . . . . . . . . . . . . . . . . . 200,000 170,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000 160,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 30,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . 450,000 400,000
Investments (long-term) . . . . . . . . . . . . . . . . . . . . . . 50,000 20,000
Plant and equipment . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000 1,000,000
Less: Accumulated amortization . . . . . . . . . . . . . 600,000 550,000
Net plant and equipment . . . . . . . . . . . . . . . . . . . . 500,000 450,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 $ 870,000

Liabilities and Shareholders Equity

Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 $ 45,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . 30,000 35,000
Total current liabilities . . . . . . . . . . . . . . . . . . . 210,000 180,000
Long-term liabilities:
Bonds payable, 2020 . . . . . . . . . . . . . . . . . . . . . 90,000 40,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 220,000
Shareholders equity:
Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 50,000
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 350,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . 300,000 250,000
Total shareholders equity . . . . . . . . . . . . . . . . 700,000 650,000
Total liabilities and shareholders equity . . . . . . . . . $1,000,000 $870,000

Determining Cash Flows from Financing Activities

In the third section of the statement of cash flows, we show the effects of financing activities
on the corporation. Financing activities apply to the sale or retirement of bonds, common
stock, preferred stock, and other corporate securities. Also, the payment of cash dividends is
considered a financing activity. The sale of the firms securities represents a source of funds, and
the retirement or repurchase of such securities represents a use of funds.
Using the data from Tables 21, 22, and 26, the financing activities of the Kramer
Corporation are shown in Table 29.

Combining the Three Sections of the Statement

We now combine the three sections of the statement of cash flows. This statement of cash
flows reveals information not readily available from the other two statements.

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36 PART 2 Financial Analysis and Planning

TABLE 27
Cash flows from
operating activities Operating Activities

Net income (earnings after taxes) (Table 21) $110,500

Add items not requiring an outlay of cash:
Amortization (Table 21) . . . . . . . . . . . . . . . . . . 50,000 50,000
Cash flow from operations . . . . . . . . . . . . . . . . . . . 160,500
Changes in noncash working capital:
Increase in accounts receivable (Table 26) . . . . (30,000)
Increase in inventory (Table 26) . . . . . . . . . . . . (20,000)
Decrease in prepaid expenses (Table 26) . . . . . 10,000
Increase in accounts payable (Table 26) . . . . . . 35,000
Decrease in accrued expenses (Table 26) . . . . . (5,000)
Net change in noncash working capital. . . . . . . . . (10,000)
Cash provided by (used in) operating activities $150,500

TABLE 28
Cash flows from
investing activities Investing Activities

Increase in investments (long-term securities) (Table 26) ($ 30,000)

Increase in plant and equipment (Table 26) . . . . . (100,000)
Cash used in investing activities . . . . . . . . . . . . . . ($130,000)

TABLE 29
Cash flows from
financing activities Financing Activities

Increase in bonds payable (Table 26) . . . . . . . . . . $ 50,000

Preferred stock dividends paid (Table 21). . . . . . . (10,500)
Common stock dividends paid (Table 22) . . . . . . (50,000)
Cash used in financing activities . . . . . . . . . . . . . . ($ 10,500)

As it reveals the patterns of cash flows in the firm, the information from this statement
is valuable information to bankers, creditors, and investors who focus on dividends. These
groups are particularly concerned with the liquidity of the firm and its ability to generate
cash flow. Highly profitable firms have been known to go bankrupt because of the firms in-
ability to generate the cash needed to meet its obligations. The statement of cash flows also
reveals information on the firms management of, and requirements for, financing and
investment.
We see in Table 210 that Kramer Corporation created excess funds from operating activ-
ities that were utilized heavily in investing activities and somewhat in financing activities. As
a result, there is a $10,000 increase in the cash balance, and this can also be reconciled with
the increase in the cash balance of $10,000 from $30,000 to $40,000, as indicated in Table 26.
Cash demands and funding are examined by way of
Chapters 6 to 8: Working capital (current assets and liabilities) from operating
activities

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CHAPTER 2 Review of Accounting 37

TABLE 210
Statement of cash flows
KRAMER CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2009

Operating Activities
Net income (earnings after taxes) . . . . . . . . . . $110,500
Add items not requiring an outlay of cash:
Amortization . . . . . . . . . . . . . . . . . . . . . . . . 50,000 50,000
Cash flow from operations . . . . . . . . . . . . . . . 160,500
Changes in noncash working capital:
Increase in accounts receivable . . . . . . . . . . (30,000)
Increase in inventory . . . . . . . . . . . . . . . . . . (20,000)
Decrease in prepaid expenses . . . . . . . . . . . 10,000
Increase in accounts payable . . . . . . . . . . . . 35,000
Decrease in accrued expenses . . . . . . . . . . . (5,000)
Net change in noncash working capital . . . . . (10,000)
Cash provided by (used in) operating activities $150,500
Investing Activities
Increase in investments (long-term securities) . (30,000)
Increase in plant and equipment . . . . . . . . . . . (100,000)
Cash used in investing activities . . . . . . . . . . . ($130,000)
Financing Activities
Increase in bonds payable . . . . . . . . . . . . . . . . 50,000
Preferred stock dividends paid . . . . . . . . . . . . (10,500)
Common stock dividends paid . . . . . . . . . . . . (50,000)
Cash used in financing activities . . . . . . . . . . . ($ 10,500)
Net increase (decrease) in cash*
during the year . . . . . . . . . . . . . . . . . . . . . . $ 10,000
Cash, beginning of year* . . . . . . . . . . . . . . . . . 30,000
Cash, end of year* . . . . . . . . . . . . . . . . . . . . . $ 40,000
*This would include cash equivalents if there were any.

Chapter 12: Capital budgeting from investing activities

Chapter 16 to 18: Capital structure needs (bonds, preferreds, common shares) from
financing activities
One might also further analyze how the buildups in various accounts were financed. For
example, if there is a substantial increase in inventory or accounts receivable, is there an asso-
ciated buildup in accounts payable and short-term bank loans? If not, the firm may have to
use long-term financing to carry part of the short-term needs. An even more important ques-
tion might be: How are increases in long-term assets being financed? Most desirably, there
should be adequate long-term financing and profits to carry these needs. If not, then short-
term funds (trade credit and bank loans) may be utilized to carry long-term needs. This is a po-
tentially high-risk situation, in that short-term sources of funds may dry up while long-term
needs continue to demand funding. In the problems at the back of this chapter, you will have
an opportunity to further consider these points.

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F I N A N C E I N A C T I O N

Earnings and Cash Flow: The Difference at Teck

Teck is one of the worlds largest producers of copper, zinc, and
lead concentrates, with interests from Canadas high arctic to Chile
in South America. As an integrated natural resource company, its
activities include mineral exploration, mining, smelting, and refin-
ing. Sales in 2007 reached $6.4 billion with net earnings of $1.7
billion. Tecks net earnings are sensitive to change in commodity
prices and the U.S. dollar. A US$ 1 cent change in the per pound
copper price will change net earnings by $11 million; a US$ 1 cent
change in the Canadian dollar will change net earnings by
$26 million.
To remain competitive in these world markets, Teck must con-
tinually reinvest in modern equipment. These capital investments
are funded by borrowing in the capital markets and also from funds
ditures remained strong. An important observation is the significant
difference between cash flow from operations and earnings. The
most significant contributor to the difference is amortization (or de-
preciation) charges, which, of course, are related to previous and
current capital expenditures. It was this cash flow that partially
funded the capital investments. In finance our focus is primarily on
cash flow.
Q
1 Is Teck continuing this substantial investment?
Update the table.
Q
2 Where is all that cash flow going?

generated from Tecks operations. The table here shows that al- www.teck.com
though earnings were volatile over a recent period, capital expen- Symbol: TCK.B

Cash Flow Capital

Earnings from Operations Expenditures
2007 $1,681 $2,001 $571
2006 2,395 2,606 391
2005 1,345 1,647 326
2004 594 1,116 216
2003 149 338 162
2002 30 201 187
2001 (21) 418 346
2000 85 239 211
Note: Figures in millions, available with the latest financial statements.

Simplification of Table 210 can occur by eliminating the Changes in noncash working
capital and using the consolidated line Net change in working capital. This simplification
loses some of the dynamics of the changes within various accounts.
The direct method would be similar to Table 210 with an adjustment to operating activ-
ities recording receipts and payments for operational expenses, although the Cash provided
by operating activities would be the same.

AMORTIZATION AND CASH FLOW

One of the most confusing items for finance students is whether amortization is a source of funds
to the corporation. In Table 27, we added amortization to net income in determining the cash
flow from operations. The reason we added back amortization was not because amortization was
a source of new funds, but rather because we had subtracted this noncash deduction in arriving at
net income and have to add it back to determine the actual cash flow effect of operations.
Amortization represents an attempt to allocate the initial cost of an asset over its useful
life. In essence, we attempt to match the annual expense of plant and equipment ownership
against the revenues being produced. Nevertheless, the charging of amortization is purely an
accounting entry and does not directly involve the movement of funds. To go from account-
ing flows to cash flows in Table 27, we restored the noncash deduction of $50,000 for amor-
tization that was subtracted in Table 21, the income statement.

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CHAPTER 2 Review of Accounting 39

TABLE 211
Comparison of
accounting and Year 1
cash flows
(1) Accounting Flows (2) Cash Flows
Earnings before amortization and taxes (EBAT) . $1,000 $1,000
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 100
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . 900 900
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 400
Earnings after taxes (EAT) . . . . . . . . . . . . . . . . . . $ 500 500
Purchase of equipment . . . . . . . . . . . . . . . . . . . 500
Amortization charged without cash outlay . . . . 100
Cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100

Year 2

Earnings before amortization and taxes (EBAT) . $1,000 $1,000

Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 100
Earnings before taxes . . . . . . . . . . . . . . . . . . . . . 900 900
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 400
Earnings after taxes (EAT) . . . . . . . . . . . . . . . . . . $ 500 500
Amortization charged without cash outlay . . . . 100
Cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600

Let us examine a very simple case involving amortization. Assume we purchase a machine
for $500 with a five-year life and we pay for it in cash. Our amortization schedule calls for
equal amortization of $100 per year for five years. Assume further that our firm has $1,000 in
earnings before amortization and taxes and the tax obligation is $400. Note the difference be-
tween accounting flows and cash flows for the first two years in Table 211.
Since we took $500 out of cash flow originally (column 2), we do not wish to take it out
again. Thus, we add back $100 in amortization each year to wash out the subtraction in the
income statement.

FREE CASH FLOW

A term that has received increasingly greater attention is free cash flow (FCF). This is actually
a by-product of the previously discussed statement of cash flows. Free cash flow is equal to:
Cash flow from operating activities
Minus: Capital expenditures (required to maintain the productive capacity of the
firm)
Minus: Dividends (needed to maintain the necessary payout on common stock and
to cover any preferred stock obligation)
The concept of free cash flow forces the stock analyst or banker not only to consider how
much cash is generated from operating activities, but also to subtract out the necessary capital
expenditures on plant and equipment to maintain normal activities. Similarly, dividend
payments to shareholders must be subtracted out, as these dividends must generally be paid to
keep shareholders satisfied.
The balance, free cash flow, is then available for special financial activities. In the last
decade, special financing activities have often been synonymous with leveraged buyouts, in

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40 PART 2 Financial Analysis and Planning

which a firm borrows money to buy its stock and take itself private with the hope of restruc-
turing its balance sheet and perhaps going public again in a few years at a higher price than it
paid. Leveraged buyouts are discussed more fully in Chapter 15. The analyst or banker nor-
mally looks at free cash flow to determine whether there are sufficient excess funds to pay back
the loan associated with the leveraged buyout.

INCOME TAX CONSIDERATIONS

From income the firm is usually required to pay income taxes, reducing available cash flows.
Therefore virtually every financial decision is influenced by federal and provincial income tax
considerations. We briefly examine tax rates and in a general way note how they will influence
corporate financial decisions by reducing income and cash flows. The primary orientation is
toward the principles governing corporate tax decisions, though many of the same principles
apply to a sole proprietorship or partnership.
We also examine personal tax considerations to identify how various investment returns
are taxed differently under the Income Tax Act. This is of interest from a corporate point of
view, because investors prefer the investment returns that receive the most favourable tax treat-
ment. Although the capital markets generally express yields or rate of return on a before-tax
basis, the astute investor is usually focused on the aftertax yield or return.
Later chapters, especially Chapter 12, refer to the specific nature of income tax effects.
There tax-allowable amortization (known as capital cost allowance) is explored in detail and re-
lated to the capital budgeting decision. The Income Tax Act sets rules by which capital expen-
diture (capital cost allowance) can be deducted from income over several years, and these
usually differ from how the firm amortizes a capital expenditure for accounting purposes. For
cash flow effects we are concerned only with what is permissible under the Act.
Given the complexity and ever-changing nature of the Canadian tax environment, an in-
dividual is well advised to get current advice from a tax expert in cases where tax implications
may be important.
It is the incremental changes in the firm that come under analysis. When a firm under-
takes an investment it wants to know the rate of tax that will be applied to the income gen-
erated. An investor will also want to know how much the tax bite will be on any returns
they receive from an investment. Therefore, as investment analysts we are concerned with
the marginal tax rate, which is the rate of tax on the last dollar of cash flow or income
earned.

Corporate Tax Rates

Corporate federal and provincial tax rates are continually changing, both in accordance with
governments need for revenue and their policies for promoting certain industries. In this sec-
tion we use rates for 2009, knowing these may be changed in subsequent budgets by the gov-
Canada Revenue ernment of the day. Recently the general trend in tax rates has been slightly downward.
Agency
www.cra-arc.gc.ca
The federal corporate tax rate attempts to be in line with competing international jurisdic-
tions. This federal rate is reduced to allow the provinces to levy their own taxes on corporate
income. Table 212 outlines the tax rates after combining the federal and provincial rates.
Small business and manufacturing income are generally accorded reduced tax rates. Corpora-
tions should also be aware that some provinces have tax holidays (usually for CCPCs and des-
ignated industries), capital taxes on large corporations and payroll taxes. These we will leave to
a tax course.
The general working definition of a small business in Canada is a firm that employs less
than 100 persons, but small market share and ownership concentration also serve to define a
small business. For tax purposes, the first $400,000 of active business income earned per year
by a Canadian-controlled private corporation (CCPC) gets a 16 percent deduction of federal

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CHAPTER 2 Review of Accounting 41

TABLE 212
Combined federal and
provincial corporate (CCPC)
income tax rates, 2009 Manufacturing Active Small Canadian-
and Processing Business Controlled Active
Income Income Business Income
<$400,000

British Columbia . . . . . . . 30.0% 30.0% 14.5%

Alberta . . . . . . . . . . . . . . 29.0 29.0 14.0
Saskatchewan . . . . . . . . . 29.0 31.0 15.5
Manitoba . . . . . . . . . . . . 32.0 32.0 13.0
Ontario . . . . . . . . . . . . . . 31.0 33.0 16.5
Quebec . . . . . . . . . . . . . 30.9 30.9 19.0
New Brunswick . . . . . . . 32.0 32.0 16.0
Nova Scotia . . . . . . . . . . 35.0 35.0 16.0
Prince Edward Island . . . 35.0 35.0 13.38
Newfoundland . . . . . . . . 24.0 33.0 16.0
Yukon . . . . . . . . . . . . . . . 21.5 34.0 15.0/13.5
Northwest Territories . . . . 30.5 30.5 15.0
Nunavut . . . . . . . . . . . . . 31.0 31.0 15.0

tax payable. These reductions aim to encourage small businesses. Active income is interpreted
to exclude personal services corporations and specified investment businesses. Manufacturing
and processing industries in some provinces receive a reduced rate. A small manufacturing
business is taxed federally at the same rate as other small businesses. These considerations are
included in the marginal tax rates of Table 212.

Effective Tax Rate Examples

Let us look at three examples of calculating tax payable for a business year ending December
31, 2009. Active business income is determined by reducing income by allowable expenses,
including capital cost allowance.

1. Nonmanufacturing company Canadian-controlled private

corporation operating in Ontario:
Active business income . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Combined federal and provincial tax rate 16.5%
Total tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,500
2. Manufacturing company Canadian-controlled private
corporation operating in Nova Scotia:
Active business income . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Combined federal and provincial tax rate 16%
Total tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000
3. Manufacturing company foreign-controlled operating
in British Columbia:
Active business income . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Combined federal and provincial tax rate 30%
Total tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

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42 PART 2 Financial Analysis and Planning

Personal Taxes
Individuals, as of 2008, are taxed by the federal government at rates of 15, 22, 26, and 29 per-
cent of taxable income. These rates are applied progressively as higher amounts of taxable in-
come are reported by the individual. Provincial tax payable, as of 2008, is also calculated on
taxable income (which is sometimes defined differently) with the percentage varying across
provinces and territories. Furthermore, various surtaxes are payable in some provinces on
higher income. For investment purposes, the taxpayer makes decisions on the basis of the mar-
ginal tax rate, the tax that will be paid on the last dollar of income received. It is aftertax in-
come that counts.
The Income Tax Act distinguishes between income received as interest (bonds), divi-
dends (shares), or capital gains (increase in an investments value) and taxes each at different
rates. This is of interest to corporations, as it may be a minor influence on the way they raise
monies from investors. Investors will prefer one form of income over another, all other things
being equal. Table 213 shows the top marginal tax rates in each province on incomes in ex-
cess of $123,000 and the rate on incomes in a midrange for each type of investment income.

TABLE 213
Combined federal and
provincial personal Interest Dividends Capital Gains
income tax rates, 2008 Top Top Top

British Columbia 43.70% 29.98% 18.47% 4.40% 21.85% 14.99%

Alberta 39.00 32.00 16.00 5.85 19.50 16.00
Saskatchewan 44.00 35.00 20.35 7.30 22.00 17.50
Manitoba 46.40 34.75 23.83 6.94 23.20 17.38
Ontario 46.41 31.15 23.96 7.52 23.20 15.58
Quebec 48.22 38.37 29.69 15.42 24.11 19.19
New Brunswick 46.95 37.48 23.18 9.45 23.48 18.74
Nova Scotia 48.25 36.95 28.35 13.25 24.13 18.48
Prince Edward Island 47.37 35.80 24.44 9.19 23.69 17.90
Newfoundland 45.00 35.30 28.11 14.04 22.50 17.65
Yukon 42.40 31.68 17.23 4.40 21.20 15.84
Northwest Territories 43.05 30.60 18.25 4.40 21.53 15.30
Nunavut 40.50 29.00 22.24 5.56 20.25 14.50
Note: The second rate is applied to marginal income between $37,885 and $59,180.

Dividends for income tax purposes are increased or grossed up and have a tax credit avail-
able as an attempt to overcome double taxation. This occurs because the individual pays both
personal tax and corporate tax as a shareholder. Capital gains are tax-free on personal residences.
Only 50 percent of a capital gain is taxable. The special treatment of capital gains is an attempt
to encourage capital formation. With this cursory look at personal taxation, the student should
be aware that different forms of income received from the corporation are taxed differently.
The tax rates of Table 213 should be considered marginal tax rates as they apply to the
last dollar of investment income received. As has been noted, the investor is concerned with
the aftertax yield on an investment. This is determined by the formula

Investment yield (1 Tax rate)

Cost of a Tax-Deductible Expense

The businessperson often states that a tax-deductible item, such as interest on business loans,
travel expenditures, or salaries, costs substantially less than the amount expended, on an after-
tax basis. To investigate how this process works, let us examine the tax statements of two

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CHAPTER 2 Review of Accounting 43

corporationsthe first pays $100,000 in interest, and the second has no interest expense. An
average tax rate of 40 percent is used for each computation.

Corporation A Corporation B
Earnings before interest and taxes . . . . . . . . . . . . $400,000 $400,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 0
Earnings before taxes (taxable income) . . . . . . . . . 300,000 400,000
Taxes (40%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 160,000
Earnings aftertaxes . . . . . . . . . . . . . . . . . . . . . . . . $180,000 $240,000
Difference in earnings after taxes$60,000

Although Corporation A paid $100,000 more in interest than Corporation B, its earn-
ings aftertaxes are only $60,000 less than those of Corporation B. Thus, we say the $100,000
in interest costs the firm only $60,000 in aftertax earnings. The aftertax cost of a tax-de-
ductible expense can be computed as the actual expense times one minus the tax rate. In this
case, we show $100,000 (1 Tax rate), or $100,000 0.60 $60,000. The reasoning in this
instance is that the $100,000 is deducted from earnings before determining taxable income,
thus saving us $40,000 in taxes and costing only $60,000 on a net basis. The tax savings or
tax shield is computed by multiplying the expense times the tax rate: ($100,000 0.40
$40,000).
Because a dividend on common stock is not tax-deductible, we say it cost us 100 percent
of the amount paid. From a purely corporate cash flow viewpoint, the firm would be indiffer-
ent between paying $100,000 in interest and $60,000 in dividends.

Amortization (Capital Cost Allowance) as a Tax Shield

Amortization often leads to confusion. It is often the major noncash expense of the income
statement, and yet our focus in finance is on actual cash flows. Confusion also arises because,
in Canada, amortization that is allowable for tax purposes is referred to as capital cost allowance.
We explore capital cost allowance in more depth in Chapter 12.
Corporations often produce a different income statement for tax purposes, the major
difference being the amortization charge. Let us examine a situation in which the accounting
amortization charge and the capital cost allowance are the same. We will examine Corpora-
tions A and B again, this time with an eye toward amortization rather than interest. Corpora-
tion A charges off $100,000 in amortization (capital cost allowance), while Corporation B
charges off none.

Corporation A Corporation B
Earnings before interest and taxes . . . . . . . . . . . . $400,000 $400,000
Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 0
Earnings before taxes (taxable income) . . . . . . . . . 300,000 400,000
Taxes (40%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 160,000
Earnings after taxes . . . . . . . . . . . . . . . . . . . . . . . $180,000 $240,000
Amortization charged without cash outlay . . . . 100,000 0
Cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 $240,000
Difference$40,000

We compute earnings after taxes and then add back amortization to get cash flow. The dif-
ference between $280,000 and $240,000 indicates that Corporation A enjoys $40,000 more in
cash flow. The reason is that amortization allowable for tax purposes shielded $100,000 from

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F I N A N C E I N A C T I O N

Tax Rules
In the 2007 federal budget the government announced significant
corporate tax rate changes to make Canada a very competitive tax
regime. These changes were expected to have an impact the deci-
sion making of corporations.
The federal tax rate was scheduled to reduce to 15 percent from
19.5 percent in 2008. With Provincial tax rates included this would
bring the rate down to 25 to 31 percent depending on the province.
Internationally corporate tax rates in early 2008 ranged from Japan
at 41 percent, to France at 33 percent, the United Kingdom at 28
percent, and Ireland at 12.5 percent. These differences can have a
significant impact on capital formation in these countries.
In the 2004 budget income trusts (except resource royalty and
rolled into the trust. This freed the firm to pursue other projects with
new capital, but with a decrease in their capital asset foundation.
The government was concerned that with the popularity of
trusts there could be a sharp drop in taxes collected. Additionally
there was concern that trusts didnt produce new business activity,
only the recycling of old businesses.
Q
1
Can you think of tax rules or rates that affect your
decision making?
Q
2 How has the CREIT trust done since 2004?

real estate investment trusts, such as CREIT) were hard-hit. Income www.fin.gc.ca
trusts were developed to provide high yields for investors with
favourable tax treatment. The other reason was for corporations to
www.creit.ca
spin off older, developed assets, such as oil and gas properties, that Symbol: ref.un.creit
were producing heavy cash flows and receive cash for the assets

taxation in Corporation A and saved $40,000 in taxes, which eventually showed up in cash
flow. Though amortization is not a new source of funds, capital cost allowance (CCA) does
provide tax shield benefits that can be measured as CCA times the tax rate, or in this case
$100,000 0.40 $40,000. A more comprehensive discussion of amortizations effect on
cash flow is presented in Chapter 12 as part of the long-term capital budgeting decision.

SUMMARY

1. The financial manager must be thoroughly familiar with the language of accounting in order to
administer the financial affairs of the firm and to prepare an income statement, balance sheet, and
statement of cash flows.
2. The income statement provides a measure of the firms profitability over a specified time period.
Earnings per share represent residual income available to the common shareholder that may either
be paid out in the form of dividends or reinvested to generate future profits and dividends. A
limitation of the income statement is that it reports income and expenses primarily on a transaction
basis and thus may not recognize certain important economic changes as they occur.
3. The balance sheet is a snapshot of the financial position of the firm at a point in time, with the share-
holders equity section purporting to represent ownership interest. Because the balance sheet is pre-
sented on a historical cost basis, it may not represent the true value of the firm.
4. The cash flow statement, usually called the statement of cash flows, reflects the flows of cash between
reporting dates. Through this statement we get a rough picture of operating cash flows and the nature
of the firms investment and financing activities.
5. The corporate tax structure and the tax implications of interest, location, type of business, and
amortization affect finance decisions. The aftertax cost and cash flow implications of these items are
important throughout the text and are examined in more detail as warranted.
6. The aftertax cash flow to the individual varies depending on whether investment income is in the
form of interest, dividends, or capital gain. (Highest to lowest marginal tax rate.)
7. A tax savings is the reduction of taxes otherwise payable as a result of an allowable deduction of an
expense from taxable income.

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CHAPTER 2 Review of Accounting 45

REVIEW OF FORMULAS

Earnings available to common shareholders

1. Earnings per share (e.p.s.) (21)
Number of shares outstanding

Dividend per share

2. Payout ratio (22)
Earnings per share

Market share price

3. P/E ratio (23)
Earnings per share

Dividends per share

4. Dividend yield (24)
Market share price

Market value MV Market value per share

5. (25)
Book value BV Book value per share

LIST OF TERMS

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CICA Handbook 22 shareholders equity 29
income statement 23 net worth, or book value 29
gross profit 23 market value per share 30
contribution margin 23 historical book value per share 30
operating profit (earnings before interest and historical or original cost basis 30
taxes) 23 current cost (replacement cost)
earnings (net income or loss) 23 method 31
earnings per share 25 statement of cash flows 31
payout ratio 25 cash flow 31
price-earnings ratio (P/E ratio) 25 free cash flow (FCF) 39
dividend yield 26 aftertax yield 40
balance sheet 28 marginal tax rate 40
liquidity 29 tax savings or tax shield 43

DISCUSSION QUESTIONS

1. Discuss some financial variables that affect the price-earnings ratio.

2. What is the difference between book value per share of common stock and market value per share?
Why does this disparity occur?
3. Explain how amortization generates actual cash flows for the company.
4. What is the difference between accumulated amortization and amortization expense? How are they
related?
5. Comment on why inflation may restrict the usefulness of the balance sheet as normally presented.
6. Explain why the statement of cash flows provides useful information that goes beyond income state-
ment and balance sheet data.
7. What are the three primary sections of the statement of cash flows? In which section would the pay-
ment of a cash dividend be shown?

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46 PART 2 Financial Analysis and Planning

8. How can we use a statement of cash flows to analyze how a firms assets were financed?
9. What is free cash flow? Why is it important to leveraged buyouts?
10. Why is interest expense said to cost the firm substantially less than the actual expense, whereas divi-
dends cost it 100 percent of the outlay?

INTERNET RESOURCES AND QUESTIONS

For current individual and corporate tax rates: www.kpmg.ca/tax

www.pwcglobal.com/ca (search tax facts)
The International Accounting Standards Board: www.iasb.org
The Canadian Institute of Chartered Accountants: www.cica.ca
Canada Revenue Agency: www.cra-arc.gc.ca

1. What is the CICA and what does it do?

2. The CICA identifies current trends in accounting and reporting? What are some of the emerging is-
sues in accounting?
3. What is the International Accounting Standards Board (IASB) and what are its objectives?
4. IAS financial statements (IFRS) are accepted by many countries around the world. Are these state-
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ments accepted in Canada?

PROBLEMS

1. Given the following information, prepare, in good form, an income statement for Dental Drilling
Company. Use a corporate tax rate of 22 percent to calculate taxes.

Selling and administrative expense . . . . $50,000

Amortization expense . . . . . . . . . . . . . 80,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Interest expense . . . . . . . . . . . . . . . . . . 30,000
Cost of goods sold . . . . . . . . . . . . . . . . 150,000

2. Prepare in good form an income statement for 4U Cards Ltd. Take your calculations all the way
down to computing earnings per share.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000
Shares outstanding . . . . . . . . . . . . . . . 100,000
Cost of goods sold . . . . . . . . . . . . . . . 300,000
Interest expense . . . . . . . . . . . . . . . . . 20,000
Selling and administrative expense . . . 40,000
Amortization expense . . . . . . . . . . . . . 30,000
Preferred stock dividends . . . . . . . . . . 80,000
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . 110,000

3. Frantic Fast Foods had earnings after taxes of $390,000 in the year 2008 with 300,000 shares outstand-
ing. On January 1, 2009, the firm issued 25,000 new shares. Because of the proceeds from these new
shares and other operating improvements, earnings after taxes increased by 20 percent.
a. Compute earnings per share of the year 2008.
b. Compute earnings per share of the year 2009.

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CHAPTER 2 Review of Accounting 47

4. Bettis Bus Company had earnings after taxes of $600,000 in the year 2008 with 300,000 shares of
stock outstanding. On January 1, 2009, the firm issued 40,000 new shares. Because of the
proceeds from these new shares and other operating improvements, earnings after taxes increased
by 25 percent.
a. Compute earnings per share for the year 2008?
b. Compute earnings per share for the year 2009?
5. Brad Gravel Pitt Company has sales of $327,000 and cost of goods sold of $135,000.
a. What is the gross profit margin?
b. If the average firm in the gravel industry has a gross profit margin of 52 percent how is this firm
doing?
6. The Censored Book Company sold 1,200 finance textbooks to Arctic College for $60 each in 2009.
These books cost $42 to produce. In addition, Censored Books spent $2,000 (selling expense) to per-
suade the college to buy its books. Censored Books borrowed $30,000 on January 1, 2009, on which
it paid 10 percent interest. Both interest and principal were paid on December 31, 2009. Censored
Books tax rate is 30 percent. Amortization expense for the year was $4,000. Did Censored Books
make a profit in 2009? Verify your answer with an income statement presented in good form.
7. Lemon Auto Wholesalers had sales of $700,000 in 2009, and cost of goods sold represented 70 per-
cent of sales. Selling and administrative expenses were 12 percent of sales. Amortization expense was
$10,000, and interest expense for the year was $8,000. The firms tax rate is 30 percent.
a. Compute earnings after taxes.
b. Assume the firm hires Ms. Fender, an efficiency expert, as a consultant. She suggests that by in-

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creasing selling and administrative expenses to 14 percent of sales, sales can be increased to
$750,000. The extra sales effort will also reduce cost of goods sold to 66 percent of sales (there
will be a larger makeup in prices as a result of more aggressive selling). Amortization expense
will remain at $10,000. However, more automobiles will have to be carried in inventory to
satisfy customers, and interest expense will go up to $15,000. The firms tax rate will remain at
30 percent. Compute revised earnings after taxes based on Ms. Fenders suggestions for Lemon
Auto Wholesalers. Will her ideas increase or decrease profitability?
8. Arrange the following income statement items so they are in the proper order of an income
statement:

Taxes Earnings after taxes

Shares outstanding
Gross profit
Interest expense
Amortization expense
Preferred stock dividends
Sales
Earnings available to common shareholders
Cost of goods sold
Earnings per share
Earnings before taxes
Selling and administrative expense
Operating profit

9. Dog River Company has an operating profit of $200,000. Interest expense for the year was $10,000;
preferred dividends paid were $18,750; and common dividends paid were $30,000. The tax was
$61,250. The Dog River Company has 20,000 shares of common stock outstanding.
a. Calculate the earnings per share and the common dividends per share for the Dog River
Company.
b. What is the payout ratio?
c. What was the increase in retained earnings for the year?
d. If Dog Rivers share price is $26.40 what is its price-earnings ratio (P/E)?
10. Johnson Alarm Systems had $800,000 of retained earnings on December 31, 2009. The company
paid dividends of $60,000 in 2009 and had retained earnings of $640,000 on December 31, 2008.
a. How much did Johnson earn during 2009?
b. What would earnings per share be if 50,000 shares of common stock are outstanding?
c. What is the payout ratio?
d. If Johnsons share price is $13.20 what is its price-earnings ratio (P/E)?

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48 PART 2 Financial Analysis and Planning

11. Okra Snack Delights, Inc. has an operating profit of $210,000. Interest expense for the year was
$30,000, preferred dividends paid were $24,700, and common dividends paid were $36,000. The tax
was $59,300. The firm has 16,000 shares of common stock outstanding.
a. Compute earnings per share and common dividends per share.
b. What is the increase in retained earnings for the year?
12. Classify the following balance sheet items as current or noncurrent:

Common stock Investments

Accounts payable Marketable securities
Preferred stock Accounts receivable
Prepaid expenses Plant and equipment
Bonds payable Accrued wages payable
Inventory Retained earnings

13. Arrange the following items in proper balance sheet presentation:

Accumulated amortization . . . . . . . . . . . . . . . . . . . . . . . $300,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,000
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000
Plant and equipmentoriginal cost . . . . . . . . . . . . . . . . 680,000
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Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000

Allowance for bad debts . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Common stock, 100,000 shares outstanding . . . . . . . . . . 188,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,000
Preferred stock, 1,000 shares outstanding . . . . . . . . . . . . 50,000
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000

14. Landers Nursery and Garden Stores has current assets of $220,000 and capital assets of $170,000.
Current liabilities are $80,000 and long term liabilities are $140,000. There is $40,000 in preferred
stock outstanding and the firm has issued 25,000 shares of common stock. Compute book value (net
worth) per share.
15. The Holtzman Corporation has assets of $400,000, current liabilities of $50,000, and long-term lia-
bilities of $100,000. There is $40,000 in preferred stock outstanding; 20,000 shares of common stock
have been issued.
a. Compute book value (net worth) per share.
b. If there is $22,000 in earnings available to common shareholders and Holtzmans stock has a
P/E ratio of 15 times earnings per share, what is the current price of the stock?
c. What is the ratio of market value per share to book value per share?
16. Bradley Gypsum Company has assets of $1.9 million, current liabilities of $700,000, and long-term
liabilities of $580,000. There is $170,000 in preferred stock outstanding; 30,000 shares of common
stock have been issued.
a. Compute book value (net worth) per share.
b. If there is $42,000 in earnings available to common shareholders and Bradleys stock has a P/E
of 15 times earnings per share, what is the current price of the stock?
c. What is the ratio of market value per share to book value per share?
17. In the previous problem what is the P/E ratio if the firm sells at two times book value per share?
18. Fill in the blank spaces with categories 1 through 7:
1. Balance sheet (BS)
2. Income statement (IS)
3. Current assets (CA)

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CHAPTER 2 Review of Accounting 49

4. Capital assets (Cap A)

5. Current liabilities (CL)
6. Long-term liabilities (LL)
7. Shareholders equity (SE)

Indicate Whether
Item Is on Balance If on Balance
Sheet (BS) or Sheet, Designate
Income Statement (IS) Which Category Item
Retained earnings
Income tax expense
Accounts receivable
Common stock
Bonds payable, maturity 2019
Notes payable (six months)
Net income
Selling and administrative expenses
Inventories
Accrued expenses
Cash
Plant and equipment
Sales

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Operating expenses
Marketable securities
Accounts payable
Interest expense
Income tax payable
19. Identify whether each of the following items increases or decreases cash flow:

Increase in inventory Dividend payment

Decrease in prepaid expenses Increase in short-term notes payable
Decrease in accounts receivable Amortization expense
Increase in cash Decrease in accounts payable
Decrease in inventory Increase in long-term investments

20. The Rogers Corporation has a gross profit of $880,000 and $360,000 in amortization expense. The
Evans Corporation has $880,000 in gross profit, with $60,000 in amortization expense. Selling and
administrative expense is $120,000 for each company. Given that the tax rate is 40 percent, compute
the cash flow for both companies. Explain the difference in cash flow between the two firms.
21. The following information is provided for the Solitude Corporation.
a. Prepare a statement of cash flows for Solitude.
b. Identify the major accounts contributing to the change in cash position, from the three differ-
ent components of the cash flow statement.

Balance Sheets
December 31, December 31,
2009 2008
Assets
Cash ...................... $ 77,490 $ 29,520
Accounts receivable . . . . . . . . . . . . . 59,040 66,420
Inventory . . . . . . . . . . . . . . . . . . . . . 154,980 132,840
Equipment . . . . . . . . . . . . . . . . . . . . 136,530 110,700
Less: Accumulated amortization . . 33,210 22,140
Net equipment . . . . . . . . . . . . . . . . . 103,320 88,560
Total assets . . . . . . . . . . . . . . . . . . . . $394,830 $317,340

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50 PART 2 Financial Analysis and Planning

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . $ 62,730 $ 36,900
Taxes payable . . . . . . . . . . . . . . . . . 7,380 14,760
Common stock . . . . . . . . . . . . . . . . . 243,540 221,400
Retained earnings . . . . . . . . . . . . . . 81,180 44,280
Total liabilities and equity . . . . . . . . $394,830 $317,340
During 2009, the following occurred:
1. Net income was $73,800.
2. Equipment was purchased for cash, and no equipment was sold.
3. Shares were sold for cash.
4. Dividends were declared and paid.
22. Prepare a statement of cash flows for the Waif Corporation.
Balance Sheets
December 31, December 31,
2009 2008
Assets
Cash ...................... $ 54,500 $ 17,400
Accounts receivable . . . . . . . . . . . . . 64,800 52,200
Inventory . . . . . . . . . . . . . . . . . . . . . 142,200 149,300
Land ...................... 60,000 87,000
Plant and equipment . . . . . . . . . . . . 206,000 158,000
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Less: Accumulated amortization . . 55,000 33,000

Net plant and equipment . . . . . . . . . 151,000 125,000
Total assets . . . . . . . . . . . . . . . . . . . . $472,500 $430,900

Liabilities and Equity

Accounts payable . . . . . . . . . . . . . . $ 27,000 $ 37,000
Bonds payable . . . . . . . . . . . . . . . . . 118,000 158,000
Common stock . . . . . . . . . . . . . . . . . 170,000 130,000
Retained earnings . . . . . . . . . . . . . . 157,500 105,900
Total liabilities and shareholders equity $472,500 $430,900
During 2009, the following occurred:
1. Net income was $91,000.
2. Bonds were retired by issuing new common stock.
3. No equipment was sold.
4. Cash dividends were paid.
23. Prepare a statement of cash flows for the Crosby Corporation.
CROSBY CORPORATION
Income Statement
Year ended December 31, 2009
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,200,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000
Gross profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000
Selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . 420,000
Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Earnings before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240,000
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Earnings after taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000

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CHAPTER 2 Review of Accounting 51

Preferred stock dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Earnings available to common shareholders . . . . . . . . . . . . . . . $ 150,000
Shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.25

Statement of Retained Earnings

For the year ended December 31, 2009
Retained earnings, balance, January 1, 2009 . . . . . . . . . . . . . . . . . . . . . $ 500,000
Add: Earnings available to common shareholders, 2009 . . . . . . . . . . . 150,000
Deduct: Cash dividends declared and paid in 2009 . . . . . . . . . . . . . . 50,000
Retained earnings, balance, December 31, 2009 . . . . . . . . . . . . . . . . . . $ 600,000

Comparative Balance Sheets

December 31, December 31,
2009 2008
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . $ 100,000 $ 70,000
Accounts receivable (net) . . . . . . . 350,000 300,000
Inventory . . . . . . . . . . . . . . . . . . . 430,000 410,000
Prepaid expenses . . . . . . . . . . . . . 30,000 50,000

www.mcgrawhill.ca/olc/block
Total current assets . . . . . . . . . . 910,000 830,000
Investments (long-term securities) . 70,000 80,000
Plant and equipment . . . . . . . . . . 2,400,000 2,000,000
Less: Accumulated amortization 1,150,000 1,000,000
Net plant and equipment . . . . . . . 1,250,000 1,000,000
Total assets . . . . . . . . . . . . . . . . . . . . $2,230,000 $1,910,000

Liabilities and Shareholders Equity

Current liabilities:
Accounts payable . . . . . . . . . . . . . $ 440,000 $ 250,000
Notes payable . . . . . . . . . . . . . . . 400,000 400,000
Accrued expenses . . . . . . . . . . . . 50,000 70,000
Total current liabilities . . . . . . . 890,000 720,000
Long-term liabilities:
Bonds payable, 2018 . . . . . . . . . . 120,000 70,000
Total liabilities . . . . . . . . . . . . . 1,010,000 790,000
Shareholders equity:
Preferred stock . . . . . . . . . . . . . . . 90,000 90,000
Common stock . . . . . . . . . . . . . . . 530,000 530,000
Retained earnings . . . . . . . . . . . . . 600,000 500,000
Total shareholders equity . . . . . 1,220,000 1,120,000
Total liabilities and shareholders equity $2,230,000 $1,910,000

The following questions apply to the Crosby Corporation, as presented in the previous problem.
24. Describe the general relationship between net income and net cash flows from operating activities for
the firm.
25. Has the buildup in plant and equipment been financed in a satisfactory manner? Briefly discuss.
26. Compute the book value per common share for 2008 and 2009 for the Crosby Corporation.
27. If the market value of a share of common stock is 2.4 times book value for 2009, what is the firms
P/E ratio for 2009?

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52 PART 2 Financial Analysis and Planning

28. Prepare a statement of cash flows for the Winfield Corporation for 2009.

WINFIELD CORPORATION
Balance Sheets
December 31, December 31,
2009 2008
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . $ 1,750 $ 1,400
Accounts receivable . . . . . . . . . . . . 7,875 5,425
Inventory . . . . . . . . . . . . . . . . . . . . . 33,250 28,000
Prepaid expenses . . . . . . . . . . . . . . 1,225 1,050
Total current assets . . . . . . . . . . . 44,100 35,875
Investments (long-term) . . . . . . . . . . 17,500 21,000
Capital assets:
Land . . . . . . . . . . . . . . . . . . . . . . . 15,750 7,000
Buildings . . . . . . . . . . . . . . . . . . . . . 100,000 100,000
Less: Accumulated amortization . . 61,500 58,000
Net buildings . . . . . . . . . . . . . . . . . . . 38,500 42,000
Equipment . . . . . . . . . . . . . . . . . . . . 36,750 28,000
Less: Accumulated amortization . . 10,500 7,000
Net equipment . . . . . . . . . . . . . . . . . . 26,250 21,000
www.mcgrawhill.ca/olc/block

Total assets . . . . . . . . . . . . . . . . . . . . . $142,100 $126,875

Liabilities and Shareholders Equity

Current liabilities:
Accounts payable . . . . . . . . . . . . . . $ 15,750 $ 17,500
Notes payable . . . . . . . . . . . . . . . . . 8,750 6,125
Accrued expenses . . . . . . . . . . . . . . 9,275 7,350
Interest payable . . . . . . . . . . . . . . . . 1,225 1,400
Total current liabilities . . . . . . . . . 35,000 32,375
Long-term liabilities:
Bonds payable, 2019 . . . . . . . . . . 43,750 38,500
Total liabilities . . . . . . . . . . . . . . . 78,750 70,875
Shareholders equity:
Common stock . . . . . . . . . . . . . . . . 24,500 24,500
Retained earnings . . . . . . . . . . . . . . 38,850 31,500
Total shareholders equity . . . . . . 63,350 56,000
Total liabilities and shareholders equity $142,100 $126,875

WINFIELD CORPORATION
Income Statement
Year ended December 31, 2009
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $210,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,500
Gross profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122,500
Selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . 95,900
Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,100
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500

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CHAPTER 2 Review of Accounting 53

Other income and losses:

Gain on sale of investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,250
Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,575
Loss on sale of equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050
Net other income and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,775
Earnings before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,375
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,375
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,000
During 2009, the following occurred:
a. From the long-term investments, a dividend of $1,575 was received. Shares originally costing
$3,500 were sold for $8,750 from the investment account.
b. Land was purchased for $8,750. Purchase was completed with a note payable of $8,750, with in-
terest and principal due in 12 months.
c. New equipment was purchased for $15,750 cash. Old equipment originally costing $7,000 with
accumulated amortization of $3,500 was sold for $2,450.
d. Notes payable at $6,125 were paid.
e. Bonds were sold at par for $5,250.
f. A dividend of $6,650 was paid.
g. The 2009 amortization expense was $3,500 for buildings and $7,000 for equipment.
29. For December 31, 2008, the balance sheet of the Dominion Pines Corporation is as follows:

www.mcgrawhill.ca/olc/block
Balance Sheet
Current Assets Liabilities
Cash . . . . . . . . . . . . . . $ 15,000 Accounts payable . . . . . . . . . . $ 20,000
Accounts receivable . . 22,500 Notes payable . . . . . . . . . . . . 30,000
Inventory . . . . . . . . . . 37,500 Bonds payable . . . . . . . . . . . . 75,000
Prepaid expenses . . . . 18,000

Capital Assets Shareholders Equity

Plant and equipment . . $375,000 Common stock . . . . . . . . . . . . $150,000
Less: Accumulated Retained earnings . . . . . . . . . . 118,000
amortization . . . . 75,000
Net plant and equipment 300,000 Total liabilities and
Total assets . . . . . . . . . $393,000 shareholders equity . . . . . . $393,000

Sales for 2009 were $330,000, with cost of goods sold being 60 percent of sales. Amortization expense
was 10 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the
bonds payable was 12 percent, while interest on the notes payable was 10 percent. These are based on
December 31, 2008, balances. Selling and administrative expenses were $33,000, and the tax rate aver-
aged 20 percent. During 2009, the cash balance and prepaid expense balance were unchanged. Ac-
counts receivable and inventory each increased by 20 percent, and accounts payable increased by 30
percent. A new machine was purchased on December 31, 2009, at a cost of $60,000. A cash dividend
of $6,100 was paid to common shareholders at the end of 2009. Also, notes payable increased by
$10,000 and bonds payable decreased by $15,000. The common stock account did not change.
a. Prepare an income statement for 2009.
b. Prepare a balance sheet as of December 31, 2009.
c. Prepare a statement of cash flows for the year ending December 31, 2009.
30. Bobbies Coffee Beans Ltd., located in downtown Kelowna, B.C., has the following taxable income
for 2008 and 2009.

2008 . . . . . . . . . . . . . $ 52,000
2009 . . . . . . . . . . . . . 124,000

a. Compute the total tax obligation for Bobbies Coffee Beans each year.
b. Compute the average tax rate for each year.

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54 PART 2 Financial Analysis and Planning

31. Coastal Pipeline Corp. anticipates cash flows from operating activities of $8 million in 2010. It will
need to spend $1.5 million on capital investments in order to remain competitive within the indus-
try. Common share dividends are projected at $0.6 million and preferred dividends at $0.25 million.
a. What is the firms projected free cash flow for the year 2010?
b. What does the concept of free cash flow represent?
32. Given the following information, prepare, in good form, an income statement for the Luba Corpora-
tion. Use the corporate tax rates in Chapter 2 to calculate taxes. Luba is a manufacturer in Manitoba.

Selling and administrative expense . . . . . . . . . . . . . . . $ 77,000

Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . 66,000
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 226,000

33. For Luba Corporation, what is the tax savings due to amortization expense?
34. R. E. Forms Ltd. had taxable income of $75,000 from an active business in 2009. Calculate its tax
payable if it operates in Alberta as compared to operating in Ontario.
35. J. B. Wands has $14,000 to invest. He lives in Saskatchewan and has other income of $40,000 for the year.
A current bond issue is paying 6 percent, while a popular share issue offers a 5 percent dividend return.
a. Calculate the better return on an aftertax basis. What is the aftertax yield?
b. What other factors should be considered?
www.mcgrawhill.ca/olc/block

36. Billie Fruit lives in the Yukon and her income fluctuates from year to year ranging from over
$100,000 to about $39,000. She has two investments of $20,000 each in shares and both achieving a
return of 7 percent, one by dividend and the other by capital gain.
a. Calculate the better return on an aftertax basis if this is a high-income year. What is the after-
tax yield?
b. Calculate the better return on an aftertax basis if this is a low income year. What is the aftertax
yield?
37. Banff Corporation has determined that its average bondholder has a marginal tax rate of 39 percent.
Banff s corporate tax rate is 40 percent. A current bond issue would require a 7 percent yield. Con-
sidering the tax savings to the firm and the taxes to be paid by the individual bondholder, what are
the overall tax consequences of this issue from the governments perspective?

S&P PROBLEMS

1. Earnings and dividends per share: Using the latest annual income statement (under Excel Analyt-
ics) of Abitibi Consolidated Inc. (ABY), TransCanada Corporation (TRP) and Canwest Global Com-
munications (CWG), determine earnings and dividends per common share. Using the latest share
price (www.tsx.ca) determine the price earnings ratio of each firm. Suggest reasons for the differences
in the P/E ratios for the firms.
2. Market value to book value: Using the latest annual balance sheet (under Excel Analytics) of Inco
Ltd. (N) and Telus Corporation (TU), calculate equity book value per share. Determine the market
value to book value ratio using the latest share price (www.tsx.ca). Suggest reasons for the difference.
3. Cash flow: Identify the major accounts contributing to the change in cash position, from the three
different components of the latest annual statement of cash flows (under Excel Analytics) for Inco
Ltd. (N) and Extendicare Inc. (EXE.A). Are operations generating enough cash flow to fund capital
expenditures?
4. Marginal and average tax rates: Using the latest annual income statement (under Excel Analytics)
from Big Rock Brewery (BEERF) and Falconbridge Ltd. (8824B), calculate the average tax rate (in-
come taxes paid divided by pretax income) for the past two years. Compare this to the marginal tax
rates identified in Table 212. Why would there be a difference?