Chapter 3 Analysis of Financial Statements and Taxes © 2005 Thomson/South-Western

2 Financial Statements and Reports  The Income Statement  The Balance Sheet  Statement of Cash Flows  Statement of Retained Earnings

3 Unilate Textiles: Comparative Income Statements

4 Unilate Textiles: Comparative Balance Sheets

5 Unilate Textiles: Liabilities and Equity

6 Unilate Textiles: Statement of Retained Earnings Balance of retained earnings Dec. 31, 2004$260 Add: 2005 Net Income54 Less: 2005 dividends to stockholders ( 29) Balance of retained earnings Dec. 31, 2005$285

7 Unilate Textiles: Statement of Cash Flows 2005

8 Unilate Textiles: Statement of Cash Flows Continued

9

10 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.

11 What is the Purpose of Ratio Analysis?  Give idea of how well the company is doing  Standardize numbers; facilitate comparisons  Used to highlight weaknesses and strengths

12 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?

13 Industry Average Data

14 What is Unilate’s Current Ratio? Current Ratio = Current Assets Current Liabilities $465.0 $130.0 == 3.6 times Industry average =4.1 times

15 What is Unilate’s Quick, or Acid Test, Ratio? Industry average =2.1 times $ $270.0 $130.0 Quick Ratio = Current Assets- Inventories Current Liabilities == = 1.5 times $195.0 $130.0

16 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.

17 What is Unilate’s Inventory Turnover Ratio? = $1,230.0 $270.0 = times Industry average =7.4 times

18 Comments on Unilate’s Inventory Turnover  Compares poorly with industry  May be holding excess inventories  May be holding old/obsolete inventory.

19 What is Unilate’s Days Sales Outstanding Ratio? Industry average =32.1 days

20 What is Unilate’s Fixed Assets Turnover Ratio? = $1,500.0 $380.0 = 3.9 times = 4.0 times Industry Average

21 What is Unilate’s Total Assets Turnover Ratios? = $1,500.0 $845.0 = 1.8 times = 2.1 times Industry Average

22 Unilate’s Fixed Assets Turnover and Total Assets Turnover  Total asset turnover is below industry average.  Unilate might have excess inventories and receivables.

23 Calculate the Debt Ratio Debt Ratio = Total debt Total assets = + = $130.0.$ $ % = $430.0 $845.0 = = 50.9% Industry Average

24 Calculate the Times-Interest-Earned Ratio TIE = EBIT Interest charges 3.3 times $40.0 $130.0 = = Industry Average =6.5 times

25 Calculate the Fixed Charge Coverage Ratio All three previous ratios reflect use of debt, but focus on different aspects. Industry Average = 5.8x

26 Unilate’s Profitability Ratios-- Profit Margin, ROA, and ROE 4.7% Industry Average = $54.0 $1, = 3.6% ==

27 Unilate’s ROA, and ROE 12.6% Industry Average = 17.2% Industry Average = $54.0 $845.0 = = 6.4% = $54.0 $ = = 13.0% =

28 Unilate’s Market Value Ratios Price/Earnings Ratio 10.6 times $2.16 $23.00  13.0 times Industry Average =

29 Unilate’s Market Value Ratios Market/Book Ratio  $23.00 $ times  2.0 times Industry Average =

Rate of Return on Common Equity Unilate Industry

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

32 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)

33 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.

34 What are Some Potential Problems and Limitations of Financial Ratio Analysis?  Seasonal factors can distort ratios.  “Window dressing” techniques can make statements and ratios look better.  Different operating and accounting practices distort comparisons.

35 What are Some Potential Problems and Limitations of Financial Ratio Analysis?  Sometimes hard to tell if a ratio is “good” or “bad”  Difficult to tell whether company is, on balance, in strong or weak position

36 The Federal Income Tax System  Individual Income Taxes  Corporate Income Taxes

37 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

38 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.

39 First, calculate your taxable income: What is Your Tax Liability? Salary$40,000 Dividends2,100 Personal Exemption (3,100) Deductions(6,000) Taxable Income$33,000

40 Consult the tax rate schedules (Individual tax rates for 2004): Unmarried Taxpayer Taxable IncomeBase Tax Amt + Amount Over Base 0 – $ 7,150$ % 7,151 – 29, % 29,051 – 70,3504, % 70,351 – 146,75014, % Above 319,10092, % 146,751 – 319,10035, % Average Rate Top of Bracket 10.0% 13.8% 20.4% 24.3% ~35.0% 29.0%

41 Tax Liability = Base tax amount + tax rate (taxable income - $29,050) Tax Liability = $4, ($33,000 - $29,050) = $4, 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%.

42 Corporate Income Taxes

43 Corporate Tax Rates Taxable IncomeBase Tax + Amount Over Base 0 – $ 50, % 50,001 – 75,0007, % 75,001 – 100,00013, % 100,001 – 335,00022, % Above 18,333,3336,416, % 335,001 – 10,000,000113, % 10,000,001 – 15,000,0003,400, % 15,000,001 – 18,333,3335,150, % Average Rate Top of Bracket 15.0% 18.3% 22.3% 34.0% 35.0% 34.0% 34.3% 35.0%

44 Tax Liability = $22, ($108,000 - $100,000) = $ 25,370 Tax Liability = Base Tax Amount (taxable income - $100,000)

45 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

46 End of Chapter 11 Analysis of Financial Statements and Taxes