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Chapter 2

Chapter 2. Analysis of Financial Statements. Learning Outcomes Chapter 2. Describe the basic financial information that is produced by corporations and explain how the firm’s stakeholders use such information.

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Chapter 2

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  1. Chapter 2 Analysis of Financial Statements

  2. Learning Outcomes Chapter 2 • Describe the basic financial information that is produced by corporations and explain how the firm’s stakeholders use such information. • Describe the financial statements that corporations publish and the information that each statement provides. • Describe how ratio analysis should be completed and why the results of such an analysis are important to both managers and shareholders. • Discuss potential problems (caveats) associated with financial statement analysis.

  3. The Annual Report • Discussion of Operations • 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)

  8. Unilate Textiles: Dec. 31 Balance Sheets ($ millions, except per share data)

  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 share data)

  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, 2010 ($ million)

  13. Unilate Textiles: Statement of Cash Flows for the Period Ending December 31, 2010 ($ million)

  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, 2010 ($ million)

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

  22. Current Assets- Inventories Current Liabilities Quick Ratio = $195.0 $130.0 $465.0 - $270.0 $130.0 = = = 1.5 times Industry average = 2.1 times Unilate’s Quick (Acid Test) Ratio

  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. Cost of goods sold Inventory turnover = Inventory $1,230.0 = 4.6 . 6 times = $270.0 Industry average = 7.4 times Unilate’s Inventory Turnover Ratio

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

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

  28. Sales Total assets turnover = Total assets $1,500.0 = 1.8 times = $845.0 Industry Average 2.1 times = 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 $430.0 = 0.509 = 50.9% = $845.0 Industry Average = 42.0% Unilate’s Debt Ratio

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

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

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

  34. Net Profit Profit margin = Sales $54.0 $1,500 = = 0.036 = 3.6% Industry Average = 4.9% Unilate’s Profit Margin Ratio

  35. Net income ROA = Total assets = 0.064 = 6.4% $54.0 $845.0 = Industry Average = 10.3% Unilate’s Return on Total Assets

  36. Net income ROE = Common equity = $54.0 $415.0 - 0 = 0.130 = 13.0% Industry Average = 17.7% Unilate’s Return on Common Equity

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

  38. Price per share Price/Earnings Ratio = Earnings per share $23.00 10.6 times = = $2.16 Industry Average = 15.0 times Unilate’s Price/Earnings Ratio

  39. Market price per share Market/Book Ratio = Book value per share 1.4 times $23.00 $16.00 = = Industry Average = 2.5 times Unilate’s Market/Book Ratio

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

  41. Rate of Return on Common Equity (ROE)

  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

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