Download Chapter 11 - Analysis of Financial Statements and Taxes

Chapter 11
Analysis of
Financial
Statements and
Taxes
© 2005 Thomson/South-Western
Financial Statements and Reports


Annual Report : A report issued annually by a
corporation to its stockholders , which contains basic
financial statements , as well as management’s
opinion of the past year’s operations and the firm’s
future prospects.
The annual report presents four basic financial
statements:
1. The Income Statement : summarizes the firm’s
revenues and expenses over an accounting period
,generally a quarter or a year.
2. The Balance Sheet : a statement of a firm’s
financial position at a specific point in time.
2
Financial Statements and Reports………cont.
3. Statement of Cash Flows : The cash receipts and the
cash disbursements ,as opposed to revenues and
expenses reported for the computation of net
income, generated by a firm during some specified
period.
4.Statement of Retained Earnings :a statement reporting
the change in the firm’s retained earnings as a
result of the income generated and retained during
the year.
The balance sheet figure for retained earnings is the
sum of the earnings retained for each year the firm
has been in business.
3
Unilate Textiles: Comparative Income Statements
Net Sales
Cos t of Goods Sold
$
1,500.0
(1,230.0)
$
1,435.0
(1,176.7)
Gros s Profit
Fixed Operating Expens es
Depreciation
270.0
(90.0)
(50.0)
258.3
(85.0)
(40.0)
EBIT
Interes t
130.0
(40.0)
133.3
(35.0)
90.0
(36.0)
98.3
(39.3)
EBT
Taxes (40%)
Net Income
Preferred Dividends
$
EAC
Common Dividends
Additions to Retained Earnings
54.0
-
$
54.0
(29.0)
$
25.0
59.0
59.0
(27.0)
$
32.0
4
Unilate Textiles: Comparative Balance Sheets
Cash & Marketable Securities
Accounts Receivable
Inventory
Total Current Assets
Gross Plant & Equipment
Less: Accumulated Deprec.
Net Plant & Equipment
Total Assets
$
$
$
15.0
180.0
270.0
465.0
680.0
(300.0)
$
$
$
$
380.0
845.0
$
40.0
160.0
200.0
400.0
$
$
350.0
750.0
600.0
(250.0)
5
Unilate Textiles: Liabilities and Equity
2005
Liabilities & Equity
Accounts Payable
Accruals
Notes Payable
Total Current Liabilities
Long-Term Bonds
Total Liabilities
Common Stock
Retained Earnings
Owner's Equity
$
$
$
$
Total Liabilites & Equity $
30.0
60.0
40.0
130.0
300.0
430.0
130.0
285.0
415.0
2004
$
$
15.0
55.0
35.0
105.0
255.0
360.0
130.0
260.0
390.0
845.0 $
750.0
$
$
6
Unilate Textiles: Statement of Retained Earnings
Balance of retained earnings Dec. 31, 2004
Add: 2005 Net Income
$260
54
Less: 2005 dividends to stockholders
( 29)
Balance of retained earnings Dec. 31, 2005
$285
7
Statement of Cash Flows (CFs)



The income statement provides an estimate of CFs
from normal operations.
To adjust the estimates of CFs obtained from the
income statement and to account for cash flows not
reflected in the income statement , we need to
examine the impact of changes in the balance sheet
accounts during the year in question.
Changes in the B/S accounts should be classified as
either a (source ) or a ( use) of cash .
8
Statement of Cash Flows (CFs)…..cont.

Sources and uses of Cash : The Rules :
Sources of cash
-Increase in a liability or
equity account ( borrowing
Funds or selling stock)
-Decrease in an asset account.
( selling inventory or collecting
receivables)
Uses of cash
- Decrease in a liability or
Equity account ( paying off
a loan or buying back a a stock )
- increase in an asset account.
( Buying fixed assets or buying
more inventory)
9
Statement of Cash Flows (CFs)…..cont
Balance sheet accounts’ changes can be
classified as resulting from :
1.Operations .
2.Long- term investments .
3. Financing activities.
10
Statement of Cash Flows (CFs)…..cont
I. Operating CFs are those associated with the
production and sale of goods and services.
- Net income + depreciation is the primary
operating CF,but changes in accounts payable
,accounts receivable ,inventories and accruals are
also classified as operating CFs.( they are directly
affected by the firm’s day-to-day operations)
II. Investment CFs arise from the purchase or sale of
plant ,property and equipment.
III. Financing Cash Inflows result from issuing debt
or common stock and the financing outflow occur
when the firm pays dividends or repays debt.
11
Unilate Textiles: Statement of Cash Flows 2005
Cash Flows from Operating Activities
Net Income
$
Adjustments to Net Income
Depreciation
Increase in Accounts Payable
Increase in Accruals
Increase in Accounts Recievable
Increase in Inventory
Net Cash Flows from Operations
54.0
50.0
15.0
5.0
(20.0)
(70.0)
$
34.0
12
Unilate Textiles: Statement of Cash Flows…. Cont.
Cash Flows from Long-Term Investments
Acquisition of Fixed Assets
Cash Flows from Financing Activities
Increase in Notes Payable
$ 5.0
Increase in Bonds
45.0
Dividend Payment
(29.0)
Net Cash Flow from Financing
$ (80.0)
$
21.0
13
Unilate Textiles: Statement of Cash Flows …Cont.
Cash Flows from Operations
Cash Flows from Long-Term Investments
Cash Flows from Financing Activities
$
Net Change in Cash
Cash at the Beginning of the Year
Cash at the End of the Year
34.0
(80.0)
21.0
(25.0)
40.0
$
15.0
14
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.
15
What is the Purpose of Ratio Analysis ?



Gives an idea of how well the company
is doing .
Standardize numbers; facilitate
comparisons…!
Used to highlight weaknesses and
strengths.
16
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?
17
Industry Average Data
Ratio
Current
Quick
Inventory Turnover
Days Sales Outs tanding (DSO)
Fixed As s et Turnover
Total As s et Turnover
Debt Ratio
TIE
Fixed Charge Coverage
Profit Margin
ROA
ROE
Price/Earnings
Market/Book
4.1x
2.1x
7.4x
32.1 days
4.0x
2.1x
45.0%
6.5x
5.8x
4.7%
12.6%
17.2%
13.0x
2.0x
18
What is Unilate’sCurrent Ratio?
Current Ratio =
=
Current Assets
Current Liabilities
$465.0
$130.0
= 3.6 times
Industry average = 4.1 times
19
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
20
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.
21
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
22
Comments on Unilate’s Inventory Turnover

Compares poorly with industry

May be holding excess inventories

May be holding old/obsolete inventory.
23
What is Unilate’s Days Sales Outstanding Ratio?
Receivable s
Receivable s
DSO 

Daily Sales
 Annual Sales 


360


$180.0
$180.0


 43.2 days
 $1,500.0  $4.167
 360 


Industry average = 32.1 days
24
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
25
What is Unilate’s Total Assets Turnover Ratios?
Sales
Total assets turnove r =
Total assets
$1,500.0
=
$845.0
= 1.8 times
Industry Average = 2.1 times
26
Unilate’s Fixed Assets Turnover and Total Assets
Turnover


Total asset turnover is below industry
average.
Unilate might have excess inventories and
receivables.
27
Calculate the Debt Ratio
Debt Ratio = Total debt
Total assets
. + $300.0
. = $430.0 = 0.509 = 50.9%
= $130.0
$845.0
$845.0
Industry Average = 45.0%
28
Calculate the Times-Interest-Earned Ratio
TIE =
EBIT
Interest charges
$130.0
= 3.3 times
=
$40.0
Industry Average = 6.5 times
29
Calculate theFixed 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 
$63.3
 $8.0 
$40.0  $10.0  

1

0.4


Industry Average = 5.8x
All three previous ratios reflect use of debt, but focus on
different aspects.
30
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%
31
Unilate’s ROA, and ROE
Net income
ROA =
Total assets
$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%
32
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
33
Unilate’s Market Value Ratios Market/Book Ratio
Market price per share
Market / Book ratio =
Book value per share

$23.00
$16.00
1.4 times

Industry Average = 2.0 times
34
Rate of Return on
Common Equity
18
Industry
17
16
15
14
13
Unilate
12
11
10
2001
2002
2003
2004
2005
35
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%
36
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)
37
What are Some Potential Problems and Limitations of
Financial Ratio Analysis?
1. Comparison with industry averages is
difficult if the firm operates many different
divisions in different industries.
2. “Average” performance not necessarily
good. It is best to focus on the industry
leaders' ratios.
3. Inflation distorts balance sheets. If recorded
values are historical,they could be
substantially different from true values.
38
Potential Problems and Limitations…..cont
4. Seasonal factors can distort ratios (e.g. Inventory
turnover ratio could be substantially different if
B/S figure used for inventory is the one just
before vs. the one just after a particular season)
5. “Window dressing” techniques can make
statements and ratios look better.e.g. borrowing
just before the B/S date,holing the proceeds as
cash ,could improve current and quick ratios.
6. Different operating and accounting practices distort
comparisons.e.g inventory and depreciation
methods can affect B/S and make comparison
among firms difficult.
39
Potential Problems and Limitations…..cont.
7. Sometimes it is difficult( hard )to tell if a ratio is
“good” or “bad”.e.g a high current ratio might
indicate strong liquidity position which is
“good” or excessive cash which is “bad”.
8. Difficult to tell whether company is, on balance,
in strong or weak position. A firm might have
some ratios that look “good" and others that
look “bad”
40
The Federal
Income Tax System

Individual Income Taxes

Corporate Income Taxes
41
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
42
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?
43
What is Your Tax Liability?
First, calculate your taxable income:
Salary
Dividends
$40,000
2,100
Personal Exemption
(3,100)
Deductions
(6,000)
Taxable Income
$33,000
44
Consult the tax rate schedules
(Individual tax rates for 2004):
Unmarried Taxpayer
+ Amount
Average Rate
Taxable Income
0 – $ 7,150
7,151 – 29,050
29,051 – 70,350
70,351 – 146,750
146,751 – 319,100
Above 319,100
Base Tax Amt
$0.00
715.00
4,000.00
14,325.00
35,717.00
92,592.50
Over Base
+ 10%
+15%
+ 25%
+ 28%
+ 33%
+ 35%
Top of Bracket
10.0%
13.8%
20.4%
24.3%
29.0%
~35.0%
45
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%.
46
Corporate Income Taxes
Income
$100,000
Taxable dividend income
3,000
Interest income
5,000
Taxable Income
$108,000
47
Corporate Tax Rates
Taxable Income
Base Tax
+ Amount
Over Base
Average Rate
Top of Bracket
0 – $ 50,000
50,001 –
75,000
75,001 –
100,000
100,001 –
335,000
335,001 – 10,000,000
10,000,001 – 15,000,000
15,000,001 – 18,333,333
0
7,500
13,750
22,250
113,900
3,400,000
5,150,000
+ 15%
+ 25%
+ 34%
+ 39%
+ 34%
+ 35%
+ 38%
15.0%
18.3%
22.3%
34.0%
34.0%
34.3%
35.0%
Above 18,333,333
6,416,667
+ 35%
35.0%
48
Tax Liability = Base Tax
Amount + 0.39 (taxable income
- $100,000)
Tax Liability = $22,250 +
0.39 ($108,000 - $100,000)
= $ 25,370
49
Corporate Tax Codes Differ from
Individual Tax Codes:








Interest and dividend income received
Interest and dividends paid by a corporation
Corporate capital gains
Corporate loss carryback and carryover
Accumulated earnings tax
Consolidated corporate tax returns
Taxation of small business S corporations
Depreciation
50