Chapter 3

Analysis of
Financial
Statements
and Taxes

© 2005 Thomson/South-Western
 Financial Statements
and Reports
The Income Statement

The Balance Sheet

Statement of Cash Flows

Statement of Retained Earnings

2
 Unilate Textiles: Comparative
Income Statements
Ne t S a le s $ 1,500.0 $ 1,435.0
Cos t of Goods S old (1,230.0) (1,176.7)
Gros s P rofit 270.0 258.3
Fixe d Ope ra ting Expe ns e s (90.0) (85.0)
De pre cia tion (50.0) (40.0)
EBIT 130.0 133.3
Inte re s t (40.0) (35.0)
EBT 90.0 98.3
Ta xe s (40%) (36.0) (39.3)
Ne t Incom e $ 54.0 $ 59.0
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P re fe rre d Divide nds - -

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EAC 54.0 59.0

st co ngs

de
to rni
oc m

Com m on Divide nds (29.0) (27.0)

Ea

Additions to Re ta ine d Ea rnings $ 25.0 $ 32.0

3
 Unilate Textiles: Comparative
Balance Sheets
Ca s h & Ma rke ta ble S e curitie s $ 15.0 $ 40.0
Accounts Re ce iva ble 180.0 160.0
Inve ntory 270.0 200.0
Tota l Curre nt As s e ts $ 465.0 $ 400.0
Gros s P la nt & Equipm e nt $ 680.0 $ 600.0
Le s s : Accum ula te d De pre c. (300.0) (250.0)
Ne t P la nt & Equipm e nt $ 380.0 $ 350.0
Tota l As s e ts $ 845.0 $ 750.0

4
 Unilate Textiles:
Liabilities and Equity
2005 2004
Liabilitie s & Equity
Accounts P a ya ble $ 30.0 $ 15.0
Accrua ls 60.0 55.0
Note s P a ya ble 40.0 35.0
Tota l Curre nt Lia bilitie s $ 130.0 $ 105.0
Long-Te rm Bonds 300.0 255.0
Tota l Lia bilitie s $ 430.0 $ 360.0
Com m on S tock 130.0 130.0
Re ta ine d Ea rnings 285.0 260.0
Owne r's Equity $ 415.0 $ 390.0
Tota l Lia bilite s & 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
Cas h Flow s from Ope rating Ac tivitie s
Ne t Incom e $ 54.0
Adjus tme nts to Ne t Inc ome
De pre cia tion 50.0
Incre a s e in Accounts P a ya ble 15.0
Incre a s e in Accrua ls 5.0
Incre a s e in Accounts Re ce iva ble (20.0)
Incre a s e in Inve ntory (70.0)
Ne t Cas h Flow s from Ope rations $ 34.0
7
 Unilate Textiles: Statement
of Cash Flows Continued
Cas h Flow s from Long-Te rm Inve s tme nts
Acquis ition of Fixe d As s e ts $ (80.0)
Cas h Flow s from Financ ing Ac tivitie s
Incre a s e in Note s P a ya ble $ 5.0
Incre a s e in Bonds 45.0
Divide nd P a ym e nt (29.0)
Ne t Ca s h Flow from Fina ncing $ 21.0

8
 Unilate Textiles: Statement
of Cash Flows Continued
Cas h Flow s from Ope rations $ 34.0
Cas h Flow s from Long-Te rm Inve s tme nts (80.0)
Cas h Flow s from Financ ing Ac tivitie s 21.0
Ne t Cha nge in Ca s h (25.0)
Ca s h a t the Be ginning of the Ye a r 40.0
Ca s h a t the End of the Ye a r $ 15.0

9
 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.

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
Curre nt 4.1x
Quick 2.1x
Inve ntory Turnove r 7.4x
Da ys S a le s Outs ta nding (DS O) 32.1 da ys
Fixe d As s e t Turnove r 4.0x
Tota l As s e t Turnove r 2.1x
De bt Ra tio 45.0%
TIE 6.5x
Fixe d Cha rge Cove ra ge 5.8x
P rofit Ma rgin 4.7%
ROA 12.6%
ROE 17.2%
P rice /Ea rnings 13.0x
Ma rke t/Book 2.0x 13
 What is Unilate’s
Current Ratio?

Current Ratio = Current Assets

Current Liabilities

= $465.0 = 3.6 times

$130.0
Industry average = 4.1 times

14
 What is Unilate’s
Quick, or Acid Test, Ratio?
Quick Ratio = Current Assets- Inventories
Current Liabilities

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

$130.0 $130.0
Industry average = 2.1 times

15
 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.
16
 What is Unilate’s
Inventory Turnover Ratio?

Cost of good sold

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

Industry average = 7.4 times

17
 Comments on Unilate’s
Inventory Turnover

Compares poorly with industry

May be holding excess inventories

May be holding old/obsolete inventory

18
 What is Unilate’s Days
Sales Outstanding Ratio?
Receivables Receivables
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 19
 What is Unilate’s Fixed
Assets Turnover Ratio?
Sales
Fixed assets turnover =
Net fixed assets
$1,500.0
= = 3.9 times
$380.0

Industry Average = 4.0 times

20
 What is Unilate’s Total
Assets Turnover Ratios?
Sales
Total asse ts turnover =
Total asse ts
$1,500.0
= = 1.8 times
$845.0

Industry Average = 2.1 times

21
 Unilate’s Fixed Assets
Turnover and Total Assets
Turnover

Total asset turnover is below industry

average.
Unilate might have excess inventories
and receivables.

22
 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%

23
 Calculate the
Times-Interest-Earned Ratio
TIE = EBIT
Interest charges

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

24
 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. 25
 Unilate’s Profitability Ratios--
Profit Margin, ROA, and ROE

Net income
Profit margin =
Sales

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

Industry Average = 4.7%

26
 Unilate’s ROA, and ROE
Net income
ROA =
Total asse ts
$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% 27
 Unilate’s 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

28
 Unilate’s 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
29
 Rate of Return on
Common Equity
18
Industry
17
16
15
14
13
12 Unilate
11
10
2001 2002 2003 2004 2005 30
 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%

31
 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)
32
 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.
33
 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.
34
 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

35
 The Federal
Income Tax System

Individual Income Taxes

Corporate Income Taxes

36
 Individual Income Taxes

 Taxable Income: Gross income minus

exemptions and allowable deductions as set
forth in the tax code

 Marginal Tax Rate: the tax on the last unit

of income

 Average Tax Rates: taxes paid divided by

taxable income 37
 Individual Income Taxes

Your salary is $40,000.

You received $2,100 in dividends.
You are single.
 Your personal exemption is $3,100.
 Your itemized deductions are $6,000.

What is your Tax Liability?

38
 What is Your Tax Liability?
First, calculate your taxable income:
Salary $40,000
Dividends 2,100
Personal Exemption (3,100)
Deductions (6,000)
Taxable Income $33,000 39
 Consult the tax rate schedules
(Individual tax rates for 2004):
Unmarried Taxpayer
+ Amount Average Rate
Taxable Income Base Tax Amt Over Base Top of Bracket
0 – $ 7,150 $0.00 + 10% 10.0%
7,151 – 29,050 715.00 +15% 13.8%
29,051 – 70,350 4,000.00 + 25% 20.4%
70,351 – 146,750 14,325.00 + 28% 24.3%
146,751 – 319,100 35,717.00 + 33% 29.0%
Above 319,100 92,592.50 + 35% ~35.0%

40
 Tax Liability = Base tax amount +
tax rate (taxable income - $29,050)

Tax Liability = $4,000 +

0.25($33,000 - $29,050) = $4,987.50
Marginal Tax Rate is the tax rate applied to the
last unit of income = 25.0%.

Average Tax Rate =

Total tax liability / total taxable income
= $4,987.50/$33,000 = 15.1%. 41
 Corporate Income Taxes

Income $100,000
Taxable dividend income 3,000
Interest income 5,000
Taxable Income $108,000

42
 Corporate Tax Rates
+ Amount Average Rate
Taxable Income Base Tax Over Base Top of Bracket
0 – $ 50,000 0 + 15% 15.0%
50,001 – 75,000 7,500 + 25% 18.3%
75,001 – 100,000 13,750 + 34% 22.3%
100,001 – 335,000 22,250 + 39% 34.0%
335,001 – 10,000,000 113,900 + 34% 34.0%
10,000,001 – 15,000,000 3,400,000 + 35% 34.3%
15,000,001 – 18,333,333 5,150,000 + 38% 35.0%
Above 18,333,333 6,416,667 + 35% 35.0%
43
Tax Liability = Base Tax Amount +
0.39 (taxable income - $100,000)

Tax Liability = $22,250 +

0.39 ($108,000 - $100,000)
= $ 25,370

44
Point:

The calculation of individual and

corporate tax rates (marginal and
average) use the same basic method.

45
 Before Next Class

1.Review Chapter 11
materials
2.Do Chapter 11
homework
3.Prepare for Final Exam
46