Chapter 11

Analysis of Financial Statements and Taxes

© 2005 Thomson/South-Western

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Financial Statements and Reports

The Income Statement

The Balance Sheet

Statement of Cash Flows

Statement of Retained Earnings

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Unilate Textiles: Comparative Income Statements Net Sales 1,500.0$ 1,435.0$

Cost of Goods Sold (1,230.0) (1,176.7)

Gross Profit 270.0 258.3 Fixed Operating Expenses (90.0) (85.0) Depreciation (50.0) (40.0)

EBIT 130.0 133.3 Interest (40.0) (35.0)

EBT 90.0 98.3 Taxes (40%) (36.0) (39.3)

Net Income 54.0$ 59.0$ Preferred Dividends - -

EAC 54.0 59.0 Common Dividends (29.0) (27.0)

Additions to Retained Earnings 25.0$ 32.0$

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Unilate Textiles: Comparative Balance Sheets

Cash & Marketable Securities 15.0$ 40.0$ Accounts Receivable 180.0 160.0 Inventory 270.0 200.0 Total Current Assets 465.0$ 400.0$ Gross Plant & Equipment 680.0$ 600.0$ Less: Accumulated Deprec. (300.0) (250.0) Net Plant & Equipment 380.0$ 350.0$ Total Assets 845.0$ 750.0$

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Unilate Textiles: Liabilities and Equity

2005 2004Liabilities & EquityAccounts 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$ Common 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$

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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

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Unilate Textiles: Statement of Cash Flows 2005

Cash Flows from Operating ActivitiesNet Income 54.0$

Adjustments to Net IncomeDepreciation 50.0Increase in Accounts Payable 15.0Increase in Accruals 5.0Increase in Accounts Receivable (20.0)Increase in Inventory (70.0)

Net Cash Flows from Operations 34.0$

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Unilate Textiles: Statement of Cash Flows Continued

Cash Flows from Long-Term InvestmentsAcquisition of Fixed Assets (80.0)$

Cash Flows from Financing ActivitiesIncrease in Notes Payable 5.0$ Increase in Bonds 45.0 Dividend Payment (29.0)

Net Cash Flow from Financing 21.0$

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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 Cash (25.0) Cash at the Beginning of the Year 40.0

Cash at the End of the Year 15.0$

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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.

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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

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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?

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Industry Average DataRatioCurrent 4.1xQuick 2.1xInventory Turnover 7.4xDays Sales Outstanding (DSO) 32.1 daysFixed Asset Turnover 4.0xTotal Asset Turnover 2.1xDebt Ratio 45.0%TIE 6.5xFixed Charge Coverage 5.8xProfit Margin 4.7%ROA 12.6%ROE 17.2%Price/Earnings 13.0xMarket/Book 2.0x

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What is Unilate’sCurrent Ratio?

Current Ratio = Current AssetsCurrent Liabilities

$465.0$130.0

= = 3.6 times

Industry average = 4.1 times

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What is Unilate’sQuick, or Acid Test, Ratio?

Industry average = 2.1 times

$465.0 - $270.0$130.0

Quick Ratio = Current Assets- InventoriesCurrent Liabilities

= = = 1.5 times$195.0$130.0

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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.

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What is Unilate’s Inventory Turnover Ratio?

Industry average = 7.4 times

=$1,230.0$270.0

= 4.66. times

Inventory turnover =Cost of good sold

Inventories

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Comments on Unilate’s Inventory Turnover

Compares poorly with industry

May be holding excess inventories

May be holding old/obsolete inventory

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What is Unilate’s Days Sales Outstanding Ratio?

Industry average = 32.1 days

days 43.2$4.167

$180.0

360

$1,500.0

$180.0

360*Sales Annual

sReceivable

SalesDaily

sReceivableDSO

Note: Use Annual CREDIT sales, if available

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What is Unilate’s Fixed Assets Turnover Ratio?

Fixed assets turnover =Sales

Net fixed assets

=$1,500.0$380.0

= 3.9 times

= 4.0 timesIndustry Average

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What is Unilate’s Total Assets Turnover Ratios?

Total asse ts turnover =Sales

Total asse ts

=$1,500.0$845.0 = 1.8 times

= 2.1 timesIndustry Average

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Unilate’s Fixed Assets Turnover and Total Assets Turnover

Total asset turnover is below industry average.

Unilate might have excess inventories and receivables.

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Calculate the Debt Ratio

Debt Ratio = Total debt Total assets

= +

=

$130.0. $300.0.$845.0

45.0%

= $430.0$845.0

=0.509 = 50.9%

Industry Average

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Calculate the Times-Interest-Earned Ratio

TIE = EBIT Interest charges

3.3 times$40.0

$130.0==

Industry Average = 6.5 times

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Calculate theFixed Charge Coverage Ratio

All three previous ratios reflect use of debt, but focus on different aspects.

rateTax 1

payment fund Sinkingpayments

LeasechargesInterest

payments LeaseEBITFCC

2.2

3.63$

0.140$

0.10$0.400.41

$8.0$

$10.0$130.0

Industry Average = 5.8x

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

4.7%Industry Average =

Profit margin = Net income

Sales

$54.0$1,500

0.036 = 3.6%==

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Unilate’s ROA, and ROE

12.6%Industry Average =

17.2%Industry Average =

$54.0$845.0

= 0.064 = 6.4%

=

ROA = Net income

Total assets

$54.0$415.0

- 0 = 0.130 = 13.0%=

ROENet income

=Common equity

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Unilate’s Market Value Ratios Price/Earnings Ratio

10.6 times $2.16$23.00

Price / earnings ratio =Price per share

Earnings per share

13.0 timesIndustry Average =

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Unilate’s Market Value Ratios Market/Book Ratio

Market / Book ratio = Market price per share

Book value per share

$23.00$16.00

1.4 times

2.0 timesIndustry Average =

30 2001 2002 2003 2004 2005

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Rate of Return on Common Equity

UnilateUnilate

IndustryIndustry

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Summary of Ratio Analysis:The DuPont Equation

ROA = Net Profit Margin X Total Assets TurnoverNet Income

Sales

Sales Total Assets

X=

$54.0$1,500.0

X=$1,500.0$845.0

= 3.6% X 1.8 = 6.4%

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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)

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What are Some PotentialProblems and Limitations ofFinancial Ratio Analysis?

Comparison with industry averages is difficult if the firm operates many different divisions.

“Average” performance not necessarily good.

Inflation distorts balance sheets.

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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.

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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

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The Federal Income Tax System

Individual Income Taxes

Corporate Income Taxes

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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

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What is your Tax Liability?

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.

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First, calculate your taxable income:

What is Your Tax Liability?

Salary $40,000

Dividends 2,100

Personal Exemption (3,100)

Deductions (6,000)

Taxable Income $33,000

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Consult the tax rate schedules(Individual tax rates for 2004):Unmarried Taxpayer

Taxable Income Base Tax Amt + Amount Over Base

0 – $ 7,150 $0.00 + 10%

7,151 – 29,050 715.00 +15%

29,051 – 70,350 4,000.00 + 25%

70,351 – 146,750 14,325.00 + 28%

Above 319,100 92,592.50 + 35%146,751 – 319,100 35,717.00 + 33%

Average RateTop of Bracket

10.0%

13.8%

20.4%

24.3%

~35.0% 29.0%

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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%.

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Corporate Income Taxes

Income $100,000

Taxable dividend income 3,000

Interest income 5,000

Taxable Income $108,000

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Corporate Tax Rates

Taxable Income Base Tax + Amount Over Base

0 – $ 50,000 0 + 15%

50,001 – 75,000 7,500 + 25%

75,001 – 100,000 13,750 + 34%

100,001 – 335,000 22,250 + 39%

Above 18,333,333 6,416,667 + 35%

335,001 – 10,000,000 113,900 + 34%

10,000,001 – 15,000,000 3,400,000 + 35%

15,000,001 – 18,333,333 5,150,000 + 38%

Average RateTop of Bracket

15.0%

18.3%

22.3%

34.0%

35.0%

34.0%

34.3%

35.0%

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Tax Liability = $22,250 + 0.39 ($108,000 - $100,000) = $ 25,370

Tax Liability = Base Tax Amount + 0.39 (taxable income - $100,000)

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Point:

The calculation of individual and corporate tax rates (marginal and average) use the same basic method.

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Before Next Class

1.Review Chapter 11 materials

2.Do Chapter 11 homework

3.Prepare for Final Exam