1 Chapter 2 Analysis of Financial Statements © 2007 Thomson/South-Western

2 Essentials of Chapter 2 What financial statements do corporations publish, and what information does each provide? How do investors utilize financial statements? What is ratio analysis and why are the results important to both managers and investors? What are some potential problems associated with financial statement analysis? What is the most important factor in financial statement analysis?

3 The Annual Report Verbal Section Usually a letter from the chairman Financial Statements The Income Statement The Balance Sheet Statement of Cash Flows Statement of Retained Earnings

4 Financial Statements The Balance Sheet The Income Statement Statement of Cash Flows Statement of Retained Earnings

5 The Balance Sheet Represents a picture taken on a specific date that shows a firm’s assets and how those assets are financed (debt or equity)

6 The Balance Sheet Cash & equivalents versus other assets All assets stated in dollars - only cash and equivalents represent money that can be spent Accounting alternatives – e.g., FIFO versus LIFO Breakdown of the common equity account Common stock at par, paid-in capital & retained earnings Book values often do not equal market values The time dimension A snapshot of the firm’s financial position during a specified period of time

7 Unilate Textiles: Dec. 31 Balance Sheets ($ millions, except per share data) Amount Percent of Total Assets Amount Percent of Total Assets Assets Cash and equivalents$ %$ % Accounts receivables Inventory Total current assets$ % b $ % b Net plant and equipment a Total assets$ %$ % Liabilities and Equity Accounts payable$ %$ % Accruals Notes payable Total current liabilities$ %$ % Long – term bonds Total liabilities (debt)$ %$ % Common stock (25,000,000 shares) Retained earnings Total common equity$ % Total liabilities and equity$ %$ % Book value per share = (Common equity)/Shares$16.60$15.60 Market value per share (stock price)$23.00$25.00

8 Unilate Textiles: Dec. 31 Balance Sheets ($ millions, except per share data) Additional information: Net working capital = Current assets – Current liabilities$335.0$295.0 Net worth = Total assets – Total liabilities Breakdown of net plant and equipment account: Gross plant and equipment$680.0$600.0 Less: Accumulated depreciation(300.0)250.0 Net plant and equipment$380.0$350.0

9 The Income Statement Presents the results of business operations during a specified period of time Summarizes the revenues generated and the expenses incurred

10 Unilate Textiles: Income Statements for Years Ending Dec. 31 ($ millions, except per shares data) Amount Percent of Total Sales Amount Percent of Total Sales Net sales$1, %$1, % Variable operating costs (82% of sales)(1,230.0)82.0(1,176.7)82.0 Gross profit$ $ Fixed operating costs except depreciation( 90.0)6.0( 85.0)5.9 Earnings before interest, taxes, depreciation, and amortization (EBITDA $ Depreciation( 50.0)3.3( 40.0)2.8 Net Operating income (NOI) = Earnings before interest and taxes (EBIT)$ Interest( 40.0)2.7( 35.0)2.4 Earnings before taxes (EBT)$ Taxes (40%)( 36.0)2.4( 39.3)2.7 Net income$ $ Preferred dividends0.0 Earnings available to common stockholders (EAC)$ Common dividends( 29.0)( 27.0) Addition to retained earnings$ Per share data (25,000,000 shares): Earnings per share = (Net income)/Shares$2.16$2.36 Dividends per share = (Common dividends)/Shares$1.16$1.08

11 Statement of Cash Flows Designed to show how the firm’s operations have affected its cash position Examines investment decisions (uses of cash) Examines financing decisions (sources of cash)

12 Unilate Textiles: Cash Sources and Uses, 2009 ($ million) Account Balances as of:Change 12/31/0912/31/08SourceUses Balance Sheet Effects (Adjustments) Cash and marketable securities$ 15.0$ 40.0$ 25.0 Accounts receivable $ 20.0 Inventory Gross plant and equipment Accounts payable Accruals Notes payable Long-term bonds Common stock (11,000,000 shares)130.0 Income Statement Information Net income$ 54.0 Add: depreciation 50.0 Gross cash flow from operations$ Dividend payment29.0 Totals$199.0

13 Unilate Textiles: Statement of Cash Flows for the Period Ending December 31, 2009 ($ million) Cash Flows from Operating Activities Net income$ 54.0 Additions (adjustments) to net income Depreciation50.0 Increase in accounts payable15.0 Increase in accruals5.0 Subtractions (adjustments) from net income Increase in accounts receivable(20.0) Increase in inventory(70.0) Net cash flow from operations$ 34.0 Cash Flows from Long-Term Investing Activities Acquisition of fixed assets$ (80.0) Cash Flows from Financing Activities Increase in notes payable$ 5.0 Increase in bonds45.0 Dividend payment(29.0) Net cash flow from financing$ 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

14 Statement of Retained Earnings Changes in the common equity accounts between balance sheet dates

15 Unilate Textiles: Statement of Retained Earnings for the Period Ending December 31, 2009 ($ million) Balance of retained earnings, December 31, 2008$260.0 Add: 2009 net income54.0 Less: 2009 dividends paid to stockholders (29.0) Balance of retained earnings, December 31, 2009$285.0

16 What Information Do Investors Use from Financial Statements Net working capital = NWC = Current assets - Current liabilities Operating cash flow = NOI (1-Tax rate) + Depreciation and amortization expense = Net operating profit after taxes + Depreciation and amortization expense Free cash flow = FCF = operating cash flow - Investments = Operating cash flow - (  in fixed assets +  NOWC) Economic Value Added =EVA = NOI (1 - Tax rate) - [(Invested capital) X (After-tax cost of capital as a percent)]

17 Financial Statement (Ratio) Analysis Ratios are accounting numbers translated into relative values Ratios are designed to show relationships between financial statement accounts within firms and between firms

18 The Purpose of Ratio Analysis Gives an idea of how well the company is doing Standardizes numbers; facilitates comparisons Used to highlight weaknesses and strengths

19 Five Major Categories of Ratios Liquidity: is the firm able to meet its current obligations Asset management: is the firm effectively managing its assets Debt management: does the firm have the right mix of debt and equity Profitability: the combined effects of liquidity, asset and debt management Market values: relates the firm’s stock price to its earnings and the book value per share

20 Liquidity Ratios Current ratio Quick (Acid test) ratio

21 Unilate’s Current Ratio Current Ratio = Current Assets Current Liabilities $465.0 $130.0 == 3.6 times Industry average =4.1 times

22 Unilate’s Quick (Acid Test) Ratio Industry average =2.1 times $ $270.0 $130.0 Quick Ratio = Current Assets- Inventories Current Liabilities == = 1.5 times $195.0 $130.0

23 Unilate’s Liquidity Position Liquidity ratios suggest that Unilate’s liquidity position is fairly poor

24 Asset Management Ratios Inventory Turnover Ratio Days Sales Outstanding (DSO) Fixed Assets Turnover Ratio Total Assets Turnover Ratio

25 = $1,230.0 $270.0 = times Inventoryturnover= Cost of goods sold Inventory Industry average =7.4 times Unilate’s Inventory Turnover Ratio

26 Industry average =32.1 days Unilate’s Days Sales Outstanding Ratio

27 Fixed assets turnover= Sales Net fixedassets = $1,500.0 $380.0 = 3.9 times = 4.0 times Industry Average Unilate’s Fixed Assets Turnover Ratio

28 Total assets turnover = Sales Total assets = $1,500.0 $845.0 = 1.8 times = 2.1 times Industry Average Unilate’s Total Assets Turnover Ratio

29 Debt Management Ratios Debt Ratio Times-Interest-Earned Ratio Fixed Charge Coverage Ratio

30 Debt Ratio = Total liabilities Total assets =42.0% = $430.0 $845.0 = = 50.9% Industry Average Unilate’s Debt Ratio

31 TIE = EBIT Interest charges 3.3 times $40.0 $130.0 = = Industry Average =6.5 times Unilate’s Times-Interest-Earned Ratio

32 Industry Average = 5.8 times Unilate’s Fixed Charge Coverage Ratio

33 Profitability Ratios Net Profit Margin Return on Total Assets Return on Common Equity

34 4.9% Industry Average = Profit margin= Net income Sales $54.0 $1, = 3.6% == Unilate’s Profit Margin Ratio

% Industry Average = $54.0 $845.0 = = 6.4% = ROA= Net income Total assets Unilate’s Return on Total Assets

% Industry Average = $54.0 $ = = 13.0% = ROE Net income = Common equity Unilate’s Return on Common Equity

37 Market Value Ratios Price/Earnings Ratio Market/Book Ratio

times $2.16 $23.00 == Price/Earnings Ratio= Price pershare Earnings per share 15.0 times Industry Average = Unilate’s Price/Earnings Ratio

39 Market/Book Ratio = Market price per share Book value per share = $23.00 $ times = 2.5 times Industry Average = Unilate’s Market/Book Ratio

40 ROA = Net Profit Margin X Total Assets Turnover Net Income Sales Total Assets X = $54.0 $1,500.0 X = $845.0 = 3.6% X 1.8 = 6.4% Summary of Ratio Analysis: The DuPont Analysis

41 Rate of Return on Common Equity (ROE), Unilate Industry

42 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)

43 Potential Problems and Limitations of Financial Ratio Analysis Comparison with industry averages is difficult if the firm operates many different divisions Inflation distorts balance sheets Seasonal factors can distort ratios “Window dressing” can make ratios look better. Different operating and accounting practices distort comparisons Sometimes hard to tell if a ratio is “good” or “bad” Difficult to tell whether company is, on balance, in strong or weak position

44 Chapter 2 Essentials What financial statements do corporations publish? Balance sheet, income statement, statement of cash flows, and statement of retained earnings How do investors utilize financial statements? Debtholders estimate future cash flows to determine whether the debt contracts will be honored Stockholders estimate future cash flows to determine the value of the firm’s common stock.

45 Chapter 2 Essentials What is ratio analysis and why are the results important to both managers and investors? Ratio analysis is used to evaluate a firm’s current financial position and the direction this position is expected to take in the future. What is the most important factor in financial statement analysis? To form general impressions about a firm’s financial position, judgment must be used when interpreting financial ratios