Chapter 3

Analysis of Financial Statements

© 2005 Thomson/South-Western

Financial Statements and Reports

• The Income Statement

• The Balance Sheet

• Statement of Cash Flows

• Statement of Retained Earnings

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Unilate Textiles: Comparative Income Statements

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Net Sales 1,500.0$ 1,435.0$ Cost of Goods Sold (1,230.0) (1,176.7)

Gross Profit 270.0 258.3 Fixed Operating Expenses (90.0) (85.0) Depreciation (50.0) (40.0)

EBIT 130.0 133.3 Interest (40.0) (35.0)

EBT 90.0 98.3 Taxes (40%) (36.0) (39.3)

Net Income 54.0$ 59.0$ Preferred Dividends - -

EAC 54.0 59.0 Common Dividends (29.0) (27.0)

Additions to Retained Earnings 25.0$ 32.0$

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Cash & Marketable Securities 15.0$ 40.0$ Accounts Receivable 180.0 160.0 Inventory 270.0 200.0 Total Current Assets 465.0$ 400.0$ Gross Plant & Equipment 680.0$ 600.0$ Less: Accumulated Deprec. (300.0) (250.0) Net Plant & Equipment 380.0$ 350.0$ Total Assets 845.0$ 750.0$

Unilate Textiles: Assets

Unilate Textiles: Liabilities and Equity

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2012 2012Liabilities & EquityAccounts Payable 30.0$ 15.0$ Accruals 60.0 55.0 Notes Payable 40.0 35.0 Total Current Liabilities 130.0$ 105.0$ Long-Term Bonds 300.0 255.0 Total Liabilities 430.0$ 360.0$ Common Stock 130.0 130.0 Retained Earnings 285.0 260.0 Owner's Equity 415.0$ 390.0$

Total Liabilites & Equity 845.0$ 750.0$

Unilate Textiles: Statement of Retained Earnings

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Balance of retained earnings Dec. 31, 2004 $260

Add: 2005 Net Income 54

Less: 2005 dividends to stockholders ( 29)

Balance of retained earnings Dec. 31, 2005 $285

Unilate Textiles: Statement of Cash Flows 2012

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Cash Flows from Operating ActivitiesNet Income 54.0$

Adjustments to Net IncomeDepreciation 50.0Increase in Accounts Payable 15.0Increase in Accruals 5.0Increase in Accounts Recievable (20.0)Increase in Inventory (70.0)

Net Cash Flows from Operations 34.0$

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Unilate Textiles: Statement of Cash Flows Continued

Cash Flows from Long-Term InvestmentsAcquisition of Fixed Assets (80.0)$

Cash Flows from Financing ActivitiesIncrease in Notes Payable 5.0$ Increase in Bonds 45.0 Dividend Payment (29.0)

Net Cash Flow from Financing 21.0$

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Unilate Textiles: Statement of Cash Flows Continued

Cash Flows from Operations 34.0$ Cash Flows from Long-Term Investments (80.0) Cash Flows from Financing Activities 21.0

Net Change in Cash (25.0) Cash at the Beginning of the Year 40.0

Cash at the End of the Year 15.0$

Ratio Analysis

• Analysis of a firm’s ratios is generally the first step in financial analysis.

• Ratios are designed to show relationships between financial statement accounts within firms and between firms.

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What is the Purpose of Ratio Analysis?

• Give idea of how well the company is doing

• Standardize numbers; facilitate comparisons• Used to highlight weaknesses and strengths

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What Are the Five Major Categories of Ratios?What Questions Do They Answer?

• Liquidity: Can we make required payments in the current period?

• Asset mgt.: Right amount of assets vs. sales?• Debt mgt.: Right mix of debt and equity?• Profitability: Do sales prices exceed unit costs, and are

sales high enough as reflected in PM, ROE, and ROA?• Market values: Do investors like what they see as

reflected in P/E and M/B ratios?

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Industry Average Data

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RatioCurrent 4.1xQuick 2.1xInventory Turnover 7.4xDays Sales Outstanding (DSO) 32.1 daysFixed Asset Turnover 4.0xTotal Asset Turnover 2.1xDebt Ratio 45.0%TIE 6.5xFixed Charge Coverage 5.8xProfit Margin 4.7%ROA 12.6%ROE 17.2%Price/Earnings 13.0xMarket/Book 2.0x

What is Unilate’s Current Ratio?

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Current Ratio = Current AssetsCurrent Liabilities

$465.0$130.0

= = 3.6 times

Industry average = 4.1 times

What is Unilate’s Quick, or Acid Test, Ratio?

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Industry average = 2.1 times

$465.0 - $270.0$130.0

Quick Ratio = Current Assets- InventoriesCurrent Liabilities

= = = 1.5 times$195.0$130.0

Unilate’s Liquidity Position• Ratios is slightly below industry average.• Inventories are the least liquid of Unilate’s assets

and they are the assets that suffer losses in the event of a forced sale.

• The quick ratio shows that, if receivables are collected in full, Unilate can payoff its current liabilities without having to liquidate its inventory.

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What is Unilate’s Inventory Turnover Ratio?

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=$1,230.0$270.0

= 4.66. times

Inventory turnover =Cost of good sold

Inventories

Industry average = 7.4 times

Comments on Unilate’s Inventory Turnover• Compares poorly with industry

• May be holding excess inventories

• May be holding old/obsolete inventory.

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What is Unilate’s Days Sales Outstanding Ratio?

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Industry average = 32.1 days

days 43.2$4.167

$180.0

360

$1,500.0

$180.0

360

Sales Annual

sReceivable

SalesDaily

sReceivableDSO

What is Unilate’s Fixed Assets Turnover Ratio?

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Fixed assets turnover =Sales

Net fixed assets

=$1,500.0$380.0

= 3.9 times

= 4.0 timesIndustry Average

What is Unilate’s Total Assets Turnover Ratios?

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Total asse ts turnover =Sales

Total asse ts

=$1,500.0$845.0 = 1.8 times

= 2.1 timesIndustry Average

Unilate’s Fixed Assets Turnover and Total Assets Turnover

• Total asset turnover is below industry average.

• Unilate might have excess inventories and receivables.

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Calculate the Debt Ratio

Debt Ratio = Total debt Total assets

= +

=

$130.0. $300.0.$845.0

45.0%

= $430.0$845.0

=0.509 = 50.9%

Industry Average

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Calculate the Times-Interest-Earned Ratio

TIE = EBIT Interest charges

3.3 times$40.0

$130.0==

Industry Average = 6.5 times

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Calculate theFixed Charge Coverage Ratio

All three previous ratios reflect use of debt, but focus on different aspects.

rateTax 1

payment fund Sinkingpayments

LeasechargesInterest

payments LeaseEBITFCC

2.2

3.63$

0.140$

0.10$0.400.41

$8.0$

$10.0$130.0

Industry Average = 5.8x

Unilate’s Profitability Ratios--Profit Margin, ROA, and ROE

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4.7%Industry Average =

Profit margin = Net income

Sales

$54.0$1,500

0.036 = 3.6%==

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Unilate’s ROA, and ROE

12.6%Industry Average =

17.2%Industry Average =

$54.0$845.0

= 0.064 = 6.4%

=

ROA = Net income

Total assets

$54.0$415.0

- 0 = 0.130 = 13.0%=

ROENet income

=Common equity

Unilate’s Market Value Ratios Price/Earnings Ratio

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10.6 times $2.16$23.00

Price / earnings ratio =Price per share

Earnings per share

13.0 timesIndustry Average =

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Unilate’s Market Value Ratios Market/Book Ratio

Market / Book ratio = Market price per share

Book value per share

$23.00$16.00

1.4 times

2.0 timesIndustry Average =

Rate of Return on Common Equity

30 2001 2002 2003 2004 2005

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17

16

15

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13

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UnilateUnilate

IndustryIndustry

Summary of Ratio Analysis:The DuPont Equation

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ROA = Net Profit Margin X Total Assets TurnoverNet Income

Sales

Sales Total Assets

X=

$54.0$1,500.0

X=$1,500.0$845.0

= 3.6% X 1.8 = 6.4%

DuPont Equation Provides Overview• Firm’s profitability (measured by ROA)

• Firm’s expense control (measured by profit margin)

• Firm’s asset utilization (measured by total asset turnover)

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What are Some PotentialProblems and Limitations ofFinancial Ratio Analysis?

• Comparison with industry averages is difficult if the firm operates many different divisions.

• “Average” performance not necessarily good.

• Inflation distorts balance sheets.

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What are Some PotentialProblems and Limitations ofFinancial Ratio Analysis?

• Seasonal factors can distort ratios.• “Window dressing” techniques can make

statements and ratios look better.• Different operating and accounting

practices distort comparisons.

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What are Some PotentialProblems and Limitations ofFinancial Ratio Analysis?

• Sometimes hard to tell if a ratio is “good” or “bad”

• Difficult to tell whether company is, on balance, in strong or weak position

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