Introduction to Corporate Finance

2: Financial Statement and Cash Flow Analysis

2-4 COrPOr ATE TA XES

Taxation is one of the key measurement challenges facing financial decision-makers. In GPC’s income

statement (Table 2.2), we can see that the company’s taxes for 2016 totalled $599 million on pre-tax

income of $1,548 million – a significant cash outflow. The financial manager needs to understand the basics

of corporate taxation in order to estimate the after-tax benefits and costs required by proposed actions. Such

understanding also allows consultation with tax experts, such as a corporate tax counsellor or a tax consultant.

Here, we briefly review the most basic corporate tax concepts: the taxation of ordinary income, and

capital gains. Keep in mind that: (1) tax law is frequently revised; (2) companies are subject to tax rates

that differ from the personal tax rates applicable to non-corporate businesses such as sole proprietorships

and partnerships; and (3) tax rules differ from country to country.

2-4a OrDINArY COrPOrATE INCOME

Ordinary corporate income is income resulting from the sale of the company’s goods and services. This

income, or part of it, is usually taxed by governments in the countries which the company operates.

In Australia, the corporate income tax rate is 30%. The corporate income tax rate applies to both

resident and non-resident companies. A resident company is liable to corporate income tax on its

worldwide income and capital gains. A non-resident company is liable to corporate income tax on

its Australian-source income only, and on capital gains from the disposal of an asset that is taxable

LO2.6

ordinary corporate income

Income resulting from the sale

of the company’s goods and

services

10 Use the DuPont system to explain why a slower-than-average inventory turnover could cause a

company with an above-average net profit margin to have a below-average return on ordinary equity.

11 How can you reconcile investor expectations for a company with an above-average M/B ratio and a

below-average P/E ratio? Could the age of the company have any effect on this ratio comparison?

9 Assume that a company’s total assets and sales remain constant. Would an increase in each of the

following ratios be associated with a cash inflow or a cash outflow?

7 Which of the categories and individual ratios described in this chapter would be of greatest interest

to each of the following parties?

a Existing and prospective creditors (lenders)

b Existing and prospective shareholders

c The company’s management.

8 How could analysts use the availability of cash inflow and cash outflow data to improve the

accuracy of the liquidity and debt coverage ratios presented previously? What specific ratio

measures – using cash flow rather than financial statement data – would you calculate to assess the

company’s liquidity and debt coverage?

a Current ratio

b Inventory turnover

c Average collection period

d Average payment period

e Debt ratio

f Net profit margin.

CONCEPT REVIEW QUESTIONS 2-3