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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