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

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

3. 3 Unilate Textiles: Comparative Income Statements

4. 4 Unilate Textiles: Comparative Balance Sheets

5. 5 Unilate Textiles: Liabilities and Equity

6. 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. 7 Unilate Textiles: Statement of Cash Flows 2005

8. 8 Unilate Textiles: Statement of Cash Flows Continued

9. 9

10. 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. 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. 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. 13 Industry Average Data

14. 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. 15 What is Unilate’s Quick, or Acid Test, Ratio? Industry average =2.1 times $465.0 - $270.0 $130.0 Quick Ratio = Current Assets- Inventories Current Liabilities == = 1.5 times $195.0 $130.0

16. 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. 17 What is Unilate’s Inventory Turnover Ratio? = $1,230.0 $270.0 = 4.66. times Industry average =7.4 times

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

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

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

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

22. 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. 23 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

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

25. 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. 26 Unilate’s Profitability Ratios-- Profit Margin, ROA, and ROE 4.7% Industry Average = $54.0 $1,500 0.036 = 3.6% ==

27. 27 Unilate’s ROA, and ROE 12.6% Industry Average = 17.2% Industry Average = $54.0 $845.0 = 0.064 = 6.4% = $54.0 $415.0 - 0 = 0.130 = 13.0% =

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

29. 29 Unilate’s Market Value Ratios Market/Book Ratio  $23.00 $16.00 1.4 times  2.0 times Industry Average =

30. 30 2001 2002 2003 2004 2005 18 17 16 15 14 13 12 11 10 Rate of Return on Common Equity Unilate Industry

31. 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. 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. 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. 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. 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. 36 The Federal Income Tax System  Individual Income Taxes  Corporate Income Taxes

37. 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. 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. 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. 40 Consult the tax rate schedules (Individual tax rates for 2004): Unmarried Taxpayer Taxable IncomeBase Tax Amt + Amount Over Base 0 – $ 7,150$0.00 + 10% 7,151 – 29,050715.00 +15% 29,051 – 70,3504,000.00 + 25% 70,351 – 146,75014,325.00 + 28% Above 319,10092,592.50 + 35% 146,751 – 319,10035,717.00 + 33% Average Rate Top of Bracket 10.0% 13.8% 20.4% 24.3% ~35.0% 29.0%

41. 41 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%.

42. 42 Corporate Income Taxes

43. 43 Corporate Tax Rates Taxable IncomeBase Tax + Amount Over Base 0 – $ 50,0000 + 15% 50,001 – 75,0007,500 + 25% 75,001 – 100,00013,750 + 34% 100,001 – 335,00022,250 + 39% Above 18,333,3336,416,667 + 35% 335,001 – 10,000,000113,900 + 34% 10,000,001 – 15,000,0003,400,000 + 35% 15,000,001 – 18,333,3335,150,000 + 38% Average Rate Top of Bracket 15.0% 18.3% 22.3% 34.0% 35.0% 34.0% 34.3% 35.0%

44. 44 Tax Liability = $22,250 + 0.39 ($108,000 - $100,000) = $ 25,370 Tax Liability = Base Tax Amount + 0.39 (taxable income - $100,000)

45. 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. 46 End of Chapter 11 Analysis of Financial Statements and Taxes