 # Chapter 3 Analysis of Financial Statements

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Chapter 3 Analysis of Financial Statements

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

Unilate Textiles: Comparative Income Statements

Unilate Textiles: Assets

Unilate Textiles: Liabilities and Equity

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

Unilate Textiles: Statement of Cash Flows 2012

Unilate Textiles: Statement of Cash Flows Continued

Unilate Textiles: Statement of Cash Flows Continued

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.

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

What Are the Five Major Categories of Ratios
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?

Industry Average Data

What is Unilate’s Current Ratio?
Current Assets Current Liabilities \$465.0 \$130.0 = 3.6 times Industry average = 4.1 times

What is Unilate’s Quick, or Acid Test, Ratio?
\$ \$270.0 \$130.0 Quick Ratio = Current Assets- Inventories Current Liabilities = = 1.5 times \$195.0 Industry average = 2.1 times

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.

What is Unilate’s Inventory Turnover Ratio?
= \$1,230.0 \$270.0 4.6 6 . times Industry average = 7.4 times

Compares poorly with industry May be holding excess inventories May be holding old/obsolete inventory.

What is Unilate’s Days Sales Outstanding Ratio?
Industry average = 32.1 days

What is Unilate’s Fixed Assets Turnover Ratio?
= \$1,500.0 \$380.0 3.9 times = 4.0 times Industry Average

What is Unilate’s Total Assets Turnover Ratios?
= \$1,500.0 \$845.0 1.8 times = 2.1 times Industry Average

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

Calculate the Debt Ratio
Debt Ratio = Total debt Total assets = + \$130.0 . \$300.0 \$845.0 45.0% \$430.0 0.509 = 50.9% Industry Average

Calculate the Times-Interest-Earned Ratio
TIE = EBIT Interest charges 3.3 times \$40.0 \$130.0 = Industry Average = 6.5 times

Calculate the Fixed Charge Coverage Ratio
Industry Average = 5.8x All three previous ratios reflect use of debt, but focus on different aspects.

Unilate’s Profitability Ratios-- Profit Margin, ROA, and ROE
\$54.0 \$1,500 0.036 = 3.6% = 4.7% Industry Average =

Unilate’s ROA, and ROE \$54.0 \$845.0 = 0.064 = 6.4% = 12.6%
= = 6.4% = 12.6% Industry Average = \$54.0 \$415.0 - 0 = = 13.0% = 17.2% Industry Average =

Unilate’s Market Value Ratios Price/Earnings Ratio
10.6 times \$2.16 \$23.00 = 13.0 times Industry Average =

Unilate’s Market Value Ratios Market/Book Ratio
= \$23.00 \$16.00 1.4 times 2.0 times Industry Average =

Rate of Return on Common Equity
18 17 16 15 14 13 12 11 10 Industry Unilate

Summary of Ratio Analysis: The DuPont Equation
ROA = Net Profit Margin X Total Assets Turnover Net Income Sales Total Assets X = \$54.0 \$1,500.0 \$845.0 = % X = 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)

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.

What are Some Potential Problems and Limitations of Financial Ratio Analysis?
Seasonal factors can distort ratios. “Window dressing” techniques can make statements and ratios look better. Different operating and accounting practices distort comparisons.

What are Some Potential Problems and Limitations of Financial 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