JAMES WESTON: Hi.
Welcome back to Finance for Non-finance Professionals.
This week we've been talking about cash creation and cash flow,
and constructing our measure of free cash flows.
I want to talk very briefly about taxes.
Taxes are an important part of cash flows,
but we didn't spend that much time talking about it
in any of our previous lessons, and so I want to pause just for a minute
and speak a little bit about taxes.
Taxes are a real cash flow.
The money that goes out to the government, to the state,
to the municipality represent real dollar bills,
and so it's important to account for them.
We have accounted for them in all of our measures of free cash flow,
but I wanted to just talk briefly about taxes and tax planning.
Expenses are a shield of revenue from tax.
So when we think about it that way, we've got top line.
At the very top of our income statement we had revenue.
Everything that gets listed after that is really a tax shield.
Anything that I can take as an expense represents me
sort of shielding all of that revenue.
If I had no expenses, I would just pay taxes on all my revenue.
Anything that I can subtract off of revenue
before reporting a profit number lets me shield that money from taxes.
For example, interest expense on debt or a bank note is expensable before taxes.
I can take off interest expenses before I pay my taxes.
When we come around back to the cost of capital lesson in week four,
we'll talk about the importance of that from capital structure perspective,
why it makes debt financing cheaper.
Tax forecasting is really tricky, and in a full semester
course on financial statements analysis, you
would get into a lot more detail of it, but I just
want to talk very briefly about what we're sort
of assuming in our treatment of taxes.
We're assuming taxes get paid at whatever the firm's marginal rate is.
Now, if I was doing more complicated tax planning, low levels of profit
might be taxed at a low marginal rate and high levels of profit
might be taxed at a higher marginal rate,
and we're going to assume for all of our analysis
that there is sort of an average rate that the firm pays
on all of its profits.
We're going to assume that the firm can make use of all of its tax shields.
That's not always true.
Sometimes firms that have a loss in one division,
they can offset or put off taxes or put them over
here and worry about them later, in what we call tax loss or carry forwards.
We're going to ignore all that for the purposes of this.
You guys are non-finance professionals and I
don't want to get too deep into tax law and tax codes,
so we're going to give it a very sort of shallow treatment,
except to say that taxes represent real cash flows.
They're important.
We've incorporated them in our measure of free cash flows, which is completely
net of taxes.
So all of the taxes that we pay are baked into our measure
of net operating profit after tax, and all the tax
effects of asset sales, or capital expenditures,
we're assuming those measures are also net after tax.
I just want to mention that in this quick lesson
to make sure that we're on board with these are all of the tax accounting
has already been incorporated into our measure of free cash flow.
Our treatment on the taxes here is a little bit simplified,
and intentionally so.
So taxes represent a real cash flow.
Taxes can be difficult to forecast.
There's a whole area of tax accounting and planning
that we hire professional accountants to do for us.
They often drive financial decisions, like the fact that interest
expenses are tax deductible makes debt sometimes
a more attractive financing vehicle.
And the full scope of tax treatment is sort of beyond this short course,
but I wanted to talk about what our assumptions were about taxes,
and sort of reassure you that all of the tax net effects
are already baked into our measure of free cash flow.