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3.1 The Balance Sheet

The financial statement that shows the value of the firms assets and liabilities at a particular time. It shows the firms:
- Current Assets (Most liquid forms of assets) - Fixed Assets (Assets of an investment nature) - Current Liabilities (Short term and current portion of long term debts) - Long Term Liabilities (Long term borrowings) - Shareholders Equity (Difference between total assets and total liabilities)
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An Example of the Balance Sheet

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The Balance Sheet

Current Assets These are the most liquid assets These could be:
Cash and Marketable Securities Accounts Receivable Inventories Other Current Assets

Non-Current Assets Long-term assets which are unlikely to be turned into cash soon These could be: Net Fixed Assets Intangible Assets Other Assets
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The Balance Sheet

Net Fixed Assets
Long lived assets such as buildings, plant, equipment etc. - Also called fixed assets. - Shown on the Balance Sheet at their original cost net of accumulated depreciation.

Intangible Assets
Long lived assets such as brand names, patents, copyrights, manpower etc. These assets have no physical reality, and are thus called intangible assets.

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The Balance Sheet

Liabilities
Liabilities represent money owed by the firm to its creditors. These could be: Current Liabilities Long Term Debt Other Long-Term Liabilities

Current liabilities are short term obligations which are likely to be paid off rapidly. Example: Bank debt and accounts payable. Long term liabilities represent debts that come due after the end of the year. Example: Long-term debt
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The Balance Sheet

Shareholders Equity
What is left over after all of firms obligations (liabilities) have been paid off belongs to the shareholders, and is called shareholders equity. This can be:
Capital Retained earnings

Capital represents amounts raised from the sale of the companys shares to investors. Retained earnings represents earnings which the management has retained and reinvested in the firm.
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Book Value vs. Market Value

Book Value and Market Value Book value is determined by GAAP Shown at historical cost adjusted for depreciation Market value is the price at which the firm can resell an asset Typically, market value book value

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3.2 The Income Statement

The financial statement that shows the revenues, expenses and net income of a firm over a period of time.
It shows the firms: Sales of their products Operating expenses O ti Financing expenses Taxes paid Net earnings.

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An Example of the Income Statement

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3.3 The Statement of Cash Flows

This is the financial statement that shows the firms cash receipts and cash payments over a period of time.
Three broad categories of cash flows are covered - Operating activities
- Investing activities - Financing activities

Note that the Income Statement shows the firms accounting profits not its cash flows

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The Statement of Cash Flows

Profit vs. Cash Flows
Profits subtract depreciation (a non-cash expense) Profits ignore cash expenditures on new capital (the expense is capitalized) Profits record income and expenses at the time of sales, not when the cash exchanges actually occur Profits do not consider changes in working capital
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An Example of the Statement of Cash Flows

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3.4 Cash Flow from Assets, Financing Flow and Free Cash Flow
A firms cash flow from assets is the cash it generates through its operating activities, net of its investments in working capital and fixed assets.
CF from assets = CF used in financing + Change in cash in the bank bank.

- Another term for cash flow from assets is Free Cash Flow. This is because the cash flow from assets is the cash available to pay out to the bond and shareholders.

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3.5 Accounting Practice and Accounting Malpractice.

Although the depth of coverage of the GAAP is quite vast, accountants still have significant leeway to color up the financial statements. - Allowance for bad debts - Revenue recognition During the years 2000 to 2004, there were quite a few detections of such unholy practices by firms that led to big scandals and corporate failures.
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Accounting Practice and Accounting Malpractice

The US congress passed the Sarbanes-Oxley Act in 2002 to ensure that a firms reports represent their actual financial conditions accurately. Differences in international accounting standards create problems in comparing foreign companies. International Accounting Standards (IAS) is gaining grounds to becoming an international set of rules that is similar to GAAP.
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3.6 Taxes
Corporate Taxes
Corporate tax = Federal tax + Provincial tax The federal tax rate is 16.5% 11% for small businesses. Provincial taxes vary across the country In O I Ontario, a small b i i ll business pays 4 % provincial tax that makes 4.5% i i l h k their total taxes 15.5%. Interest paid by a corporation is a tax deductible expense.

Note that dividends are not.

Thus, interest payments increase the amount of money available to creditors and shareholders.
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Taxes

FIRM A $21 $79

FIRM B $35 $65

Distribution of EBIT: Governments share + (Creditors Share + Shareholders Share) Firm A = $21 + ($40 + $39) = $21 + $79 = $100 Firm B = $35 + ($0 + $65) = $35 + 65 = $100
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Taxes
Marginal Tax Rate - tax paid on each extra dollar of income. Average Tax Rate - total tax bill divided by total income. For individual taxpayers, federal and provincial taxes are calculated separately. Taxes for individuals are progressive. Dividends are effectively taxed at a lower rate than interest income.
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Taxes
Personal Taxes
Interest income is taxed as ordinary income at the appropriate marginal tax rate. Dividends are eligible for a dividend tax credit.

Gross-up dividend by 44%, then take a dividend tax credit of 17.9739% of grossed-up dividend.

50% of capital gains are included in taxable income.

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