Chapter 2

Analysis of
Financial
Statements
 Financial Statements
and Reports
Annual Report: A report issued annually by a
corporation to its stockholders, which contains
basic financial statements, as well as
managements opinion of the past years
operations and the firms future prospects.

The Income Statement:

The Balance Sheet
Statement of Cash Flows
Statement of Retained Earnings 2
 Unilate Textiles: Comparative

Net Sales
Income$ Statements
1,500.0 $ 1,435.0
Cos t of Goods Sold (1,230.0) (1,176.7)
Gros s Profit 270.0 258.3
Fixed Operating Expens es (90.0) (85.0)
Depreciation (50.0) (40.0)
EBIT 130.0 133.3
Interes t (40.0) (35.0)
EBT 90.0 98.3
Taxes (40%) (36.0) (39.3)
Net Incom e $ 54.0 $ 59.0
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Preferred Dividends - -
kh m o a v a

EAC 54.0 59.0

rs
st co ngs

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to rni
oc m

Com m on Dividends (29.0) (27.0)

Ea

Additions to Retained Earnings $ 25.0 $ 32.0

3
 Unilate Textiles: Comparative

Balance Sheets
Cas h & Marketable Securities $ 15.0 $ 40.0
Accounts Receivable 180.0 160.0
Inventory 270.0 200.0
Total Current As s ets $ 465.0 $ 400.0
Gros s Plant & Equipm ent $ 680.0 $ 600.0
Les s : Accum ulated Deprec. (300.0) (250.0)
Net Plant & Equipm ent $ 380.0 $ 350.0
Total As s ets $ 845.0 $ 750.0

4
 Unilate Textiles:
Liabilities and Equity
2005 2004
Liabilities & Equity
Accounts 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
Com m on 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
5
 Unilate Textiles: Statement
of Retained Earnings

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

6
 Unilate Textiles: Statement
of Cash Flows 2005

Cash Flows from Operating Activities

Net Incom e $ 54.0
Adjustments to Net Income
Depreciation 50.0
Increas e in Accounts Payable 15.0
Increas e in Accruals 5.0
Increas e in Accounts Receivable (20.0)
Increas e in Inventory (70.0)
Net Cash Flows from Operations $ 34.0
7
 Unilate Textiles: Statement
of Cash Flows Continued

Cash Flows from Long-Term Investments

Acquis ition of Fixed As s ets $ (80.0)
Cash Flows from Financing Activities
Increas e in Notes Payable $ 5.0
Increas e in Bonds 45.0
Dividend Paym ent (29.0)
Net Cas h Flow from Financing $ 21.0

8
 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 Cas h (25.0)
Cas h at the Beginning of the Year 40.0
Cas h at the End of the Year $ 15.0

9
 Ratio Analysis

Analysis of a firms ratios is generally the first

step in financial analysis.

Ratios are designed to show relationships

between financial statement accounts within
firms and between firms.

10
 What is the Purpose
of Ratio Analysis?
Give an idea of how well the company is
doing
Standardize numbers to facilitate
comparisons
Highlight weaknesses and strengths

11
 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? 12
 Industry Average Data
Ratio
Current 4.1x
Quick 2.1x
Inventory Turnover 7.4x
Days Sales Outs tanding (DSO) 32.1 days
Fixed As s et Turnover 4.0x
Total As s et Turnover 2.1x
Debt Ratio 45.0%
TIE 6.5x
Fixed Charge Coverage 5.8x
Profit Margin 4.7%
ROA 12.6%
ROE 17.2%
Price/Earnings 13.0x
Market/Book 2.0x 13
 What is Unilates Current
Ratio?

Current Ratio = Current Assets

Current Liabilities

= $465.0 = 3.6 times

$130.0

Industry average = 4.1 times

14
 What is Unilates
Quick, or Acid Test, Ratio?

Current Assets- Inventories

Quick Ratio =
Current Liabilities

= $465.0 - $270.0 = $195.0 = 1.5 times

$130.0 $130.0

Industry average = 2.1 times

15
 Liquidity ratios
Indicate for each action whether the current ratio, the
quick ratio and the cash ratio will increase (I), decrease
(D) or not change (NC). Assume net working capital is
positive.
Current Quick Cash
1. Short-term debt is paid ______ ______ _____
2. Long-term debt is paid ______ ______ _____
3. Inventory is sold on credit at a profit ______ ______ _____
4. Inventory is sold for cash at cost ______ ______ _____
5. A customer pays their bill ______ ______ _____
6. Inventory is purchased on accounts
payable ______ ______ _____
7. Inventory is purchased for cash
8. Cash is received from long-term loan ______ ______ _____
16
 Liquidity ratios

Current Quick Cash

1. Short-term debt is paid I I I
2. Long-term debt is paid D D D
3. Inventory is sold on credit at a profit I I NC
4. Inventory is sold for cash at cost NC I I
5. A customer pays their bill NC NC I
6. Inventory is purchased on accounts
payable D D D
7. Inventory is purchased for cash NC D D
8. Cash is received from long-term loan I I I

17
 Unilates Liquidity Position

Ratios is slightly below industry average.

Inventories are the least liquid of Unilates
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.
18
 What is Unilates
Inventory Turnover Ratio?

Cost of good sold

Inventory turnover =
Inventories
$1,230.0
= = 4.6
.6 times
$270.0

Industry average = 7.4 times

19
 Comments on Unilates
Inventory Turnover

Compares poorly with industry

May be holding excess inventories
May be holding old/obsolete inventory

20
 What is Unilates Days
Sales Outstanding Ratio?
Receivable s Receivable s
DSO
Daily Sales Annual Sales *
360

$180.0 $180.0
43.2 days
$1,500.0 $4.167
360

Industry average = 32.1 days
Note: Use Annual CREDIT sales, if available 21
 What is Unilates Fixed
Assets Turnover Ratio?

Sales
Fixed assets turnover =
Net fixed assets
$1,500.0
= = 3.9 times
$380.0

Industry Average = 4.0 times

22
 What is Unilates Total
Assets Turnover Ratios?

Sales
Total assets turnover =
Total assets
$1,500.0
= = 1.8 times
$845.0

Industry Average = 2.1 times

23
 Unilates Fixed Assets
Turnover and Total Assets
Turnover
Total asset turnover is below industry
average.
Unilate might have excess inventories
and receivables.

24
 Calculate the Debt Ratio

Debt Ratio = Total debt

Total assets

= $130.0 . = $430.0 = 0.509 = 50.9%

. + $300.0
$845.0 $845.0

Industry Average = 45.0%

25
 Calculate the Times-
Interest-Earned Ratio

TIE = EBIT
Interest charges

$130.0
= = 3.3 times
$40.0
Industry Average = 6.5 times

26
 Calculate the Fixed
Charge Coverage Ratio
EBIT Lease payments
FCC
Interest Lease Sinking fund payment
charges payments 1 Tax rate

$130.0 $10.0 $140.0
2 .2
$8.0 $63.3
$40.0 $10.0
1 0.4
Industry Average = 5.8x
All three previous ratios reflect use of debt, but focus on
different aspects. 27
 Unilates Profitability Ratios-
Profit Margin, ROA, and ROE

Net income
Profit margin =
Sales

$54.0
= = 0.036 = 3.6%
$1,500

Industry Average = 4.7%

28
 Unilates ROA, and ROE
Net income
ROA =
Total assets
$54.0 = 0.064 = 6.4%
=
$845.0
Industry Average = 12.6%
Net income
ROE =
Common equity
= $54.0 - 0 = 0.130 = 13.0%
$415.0
Industry Average = 17.2% 29
 Unilates Market Value Ratios
Price/Earnings Ratio

Price per share

Price / earnings ratio =
Earnings per share

$23.00
10.6 times
$2.16

Industry Average = 13.0 times

30
 Unilates Market Value
Ratios Market/Book Ratio

Market price per share

Market / Book ratio =
Book value per share
$23.00
1.4 times
$16.00
Industry Average =2.0 times
31
 Rate of Return on
Common Equity
18
Industry
17
16
15
14
13
12 Unilate
11
10
2001 2002 2003 2004 2005 32
 Summary of Ratio Analysis:
The DuPont Equation
ROA = Net Profit Margin X Total Assets Turnover
Net Income Sales
= X
Sales Total Assets
$54.0 $1,500.0
= X
$1,500.0 $845.0

= 3.6% X 1.8 = 6.4%

33
 DuPont Equation
Provides Overview

Firms profitability (measured by ROA)

Firms expense control (measured by profit

margin)

Firms asset utilization (measured by total

asset turnover)
34
 What are Some Potential
Problems and Limitations
of Financial Ratio Analysis?

Comparison with industry averages is

difficult if the firm operates many
different divisions.
Average performance not necessarily
good.
Inflation distorts balance sheets.
35
 More Problems and
Limitations of Ratio Analysis
Seasonal factors can distort ratios.
Window dressing techniques can
make statements and ratios look
better.
Different operating and accounting
practices distort comparisons.

36
 Still More Problems and
Limitations of Ratio Analysis
Sometimes hard to tell whether a ratio
is good or bad
Difficult to tell whether company is, on
balance, in strong or weak position

37
Thank You

38