CF-Chap 02-Analysis of Financial Statement

Chapter 2
Analysis of
Financial Statements and
Financial Planning and
Forecasting
1
© 2007 Thomson/South-Western
OUTLINE
2.1. The financial statements
2.2. The ratio analysis
2.3. The Dupont analysis
2.4. The uses and limitations of ratio analysis
2.5. Financial planning and forecasting
2
Essentials of Chapter 2
 What financial statements do corporations publish, and what
information does each provide?
 How do investors utilize financial statements?
 What is ratio analysis and why are the results important to
both managers and investors?
 What are some potential problems associated with financial
statement analysis?
 What is the most important factor in financial statement
analysis?
3
2.1. The financial statements
 The Annual Report
 Verbal Section
 Usually a letter from the chairman
 Financial Statements / Recording business activity /

Financial reports
 The Income Statement
 The Balance Sheet
 Statement of Cash Flows
 Statement of Retained Earnings
4
Financial Statements
 The Balance Sheet
 The Income Statement
 Statement of Cash Flows
 Statement of Retained Earnings
5
The Balance Sheet
 Represents a picture taken on a specific date that

shows a firm’s assets and how those assets are
financed (debt or equity)
Assets ≡ Liabilities + Stockholeder’s equity
6
The Balance Sheet
The Balance Sheet
 Assets
 Assets represent the firm’s investment are classified as

either short-term (current) or long-term
 Current asstes generally include items that will be

liquidated and thus converted into cash within one year
 Long-term, or fixed, assets include investment that

help generate cash flows over longer period
8
The Balance Sheet
 Debt
 Debt represents the loan the firm has outstanding, and it
generally is divided into 2 categories – short-term debt and
long-term debt
 Short – term debt (current liabilities) represent debt that is
due within 1 year – that is, these debts are paid off within 12
months. Current liabilities includes accounts payable
(amount owed to suppliers), accruals (amount owed to
employees and government) and notes payable (amount
owed to bank).
 Long-term debt includes the bonds and similar debt
instruments that the firm has issued that are paid off over a
period longer than 1 year
9
The Balance Sheet
 Equity
 Equity represents stockholders’ ownership, does not to be
“paid off”
 The common stock account shows the amount that
stockholders paid to company when the company issued
stock to raise funds.
 The retained earning account effectively represents the total
amount of income that the firm has saved and reinvested in
assets since the firm started business.
10
Unilate Textiles: Dec. 31 Balance Sheets ($
millions, except per share data)
2009 2008
Percent of Percent of
Amount Total Assets Amount Total
Assets
Assets
Cash and equivalents $ 15.0 1.8% $ 40.0 5.4%
Accounts receivables 180.0 21.3 160.0 21.3
Inventory 270.0 32.0 200.0 26.7
Total current assets $465.0 55.0%b $400.0 53.3%b
Net plant and equipmenta 380.0 45.0 350.0 46.7
Total assets $845.0 100.0% $750.0 100.0%
Liabilities and Equity
Accounts payable $ 30.0 3.6% $ 15.0 2.0%
Accruals 60.0 7.1 55.0 7.3
Notes payable 40.0 4.7 35.0 4.7
Total current liabilities $130.0 15.4% $105.0 14.0%
Long–term bonds 300.0 35.5 255.0 34.0
Total liabilities (debt) $430.0 50.9% $360.0 48.0%
Common stock (25,000,000 shares) 130.0 15.4 130.0 17.3
Retained earnings 285.0 33.7 260.0 34.7
Total common equity $415.0 49.1% 390.0 52.0
Total liabilities and equity $845.0 100.0% $750.0 100.0%
Book value per share = (Common equity)/Shares $16.60 $15.60

Market value per share (stock price) 11 $23.00 $25.00
Unilate Textiles: Dec. 31 Balance
Sheets ($ millions, except per share data)
Additional information: 2009 2008
Net working capital = Current assets – Current liabilities $335.0 $295.0
Net worth = Total assets – Total liabilities 415.0 390.0
Breakdown of net plant and equipment account:

Gross plant and equipment $680.0 $600.0
Less: Accumulated depreciation (300.0) 250.0
Net plant and equipment $380.0 $350.0
12
The Balance Sheet
 Cash & equivalents versus other assets
 All assets stated in dollars - only cash and
equivalents represent money that can be spent
 Accounting alternatives – e.g., FIFO versus LIFO
 Breakdown of the common equity account
 Common stock at par, paid-in capital & retained
earnings
 Book values often do not equal market values
 The time dimension
 A snapshot of the firm’s financial position during a
specified period of time
13
The Income Statement
 Presents the results of business operations during a

specified period of time
 Summarizes the revenues generated and the expenses
incurred
(?) Should identical firms report the same net income?
14
Unilate Textiles: Income Statements for Years
Ending Dec. 31 ($ millions, except per shares data)
2009 2008
Amount Percent of Amount Percent of
Total Sales Total Sales
Net sales $1,500.0 100.0% $1,435.0 100.0%
Variable operating costs (82% of sales) (1,230.0) 82.0 (1,176.7) 82.0
Gross profit $ 270.0 18.0 $ 258.3 18.0
Fixed operating costs except depreciation ( 90.0) 6.0 ( 85.0) 5.9
Earnings before interest, taxes, depreciation, and $ 180.0 12.0 173.3 12.1
amortization (EBITDA
Depreciation ( 50.0) 3.3 ( 40.0) 2.8
Net Operating income (NOI) =
Earnings before interest and taxes (EBIT) $ 130.0 8.8 133.3 9.3
Interest ( 40.0) 2.7 ( 35.0) 2.4
Earnings before taxes (EBT) $ 90.0 6.0 98.3 6.9
Taxes (40%) ( 36.0) 2.4 ( 39.3) 2.7
Net income $ 54.0 3.6 $ 59.0 4.1
Preferred dividends 0.0 0.0

Earnings available to common stockholders (EAC) $ 54.0 59.0
Common dividends ( 29.0) ( 27.0)
Addition to retained earnings $ 25.0 32.0
Per share data (25,000,000 shares):

Earnings per share = (Net income)/Shares $2.16 $2.36
Dividends per share = (Common dividends)/Shares 15 $1.16 $1.08
Statement of Cash Flows
Designed to show how the firm’s operations have

affected its cash position by examining the firm’s
investment decisions (uses of cash) and financing
decisions (sources of cash).
Is the firm generating the cash needed to purchase
additional fixed assets for growth?
Does it have excess cash flows that can be used to
repay debt or to invest in new products?
16
Statement of Cash Flows
 Examines investment decisions (uses of cash)
 Examines financing decisions (sources of cash)
17
18
Unilate Textiles: Cash Sources and Uses, 2009 ($ million)
Account Balances as of: Change
12/31/09 12/31/08 Source Uses
Balance Sheet Effects (Adjustments)
Cash and marketable securities $ 15.0 $ 40.0 $ 25.0

Accounts receivable 180.0 160.0 $ 20.0
Inventory 200.0 270.0 70.0
Gross plant and equipment 680.0 600.0 80.0
Accounts payable 30.0 15.0 15.0
Accruals 60.0 55.0 5.0
Notes payable 40.0 35.0 5.0
Long-term bonds 300.0 255.0 45.0
Common stock (11,000,000 shares) 130.0 130.0
Income Statement Information
Net income $ 54.0
Add: depreciation 50.0
Gross cash flow from operations $104.0 104.0
Dividend payment 29.0 29.0
Totals $199.0 $199.0

19
Unilate Textiles: Statement of Cash Flows
for the Period Ending December 31, 2009 ($ million)
Cash Flows from Operating Activities
Net income $ 54.0
Additions (adjustments) to net income
Depreciation 50.0
Increase in accounts payable 15.0
Increase in accruals 5.0
Subtractions (adjustments) from net income
Increase in accounts receivable (20.0)
Increase in inventory (70.0)
Net cash flow from operations $ 34.0
Cash Flows from Long-Term Investing Activities
Acquisition of fixed assets $ (80.0)
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 $ 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
20
Statement of Retained Earnings
Changes in the common equity accounts between

balance sheet dates
21
Unilate Textiles: Statement of Retained Earnings for
the Period Ending December 31, 2009 ($ million)
Balance of retained earnings, December 31, 2008 $260.0
Add: 2009 net income 54.0
Less: 2009 dividends paid to stockholders (29.0)
Balance of retained earnings, December 31, 2009 $285.0
22
2.2. The ratio analysis
2.2.1. How do investors use financial statements?
 Working (operating) capital
 The term working capital generally refers to a firm’s
current assets
 Much of funding for these short-term assets is
provided from “loans” (suppliers, employees, the
government)
 Investors are interested in a firm’s operating capital
for 2 reasons:
1. Short-term financing arrangements must be paid off
in the short-term.
2. Short-term investments generally earn a lower return
than long-term investments.
24
2.2.1. How do investors use
financial statements?
 Working (operating) capital
 Net working capital
 Net operating capital

Unilate Textiles: Dec. 31 Balance Sheets ($
millions, except per share data)
2009 2008
Percent of Percent of
Amount Total Assets Amount Total
Assets
Assets
Cash and equivalents $ 15.0 1.8% $ 40.0 5.4%
Accounts receivables 180.0 21.3 160.0 21.3
Inventory 270.0 32.0 200.0 26.7
Total current assets $465.0 55.0%b $400.0 53.3%b
Net plant and equipmenta 380.0 45.0 350.0 46.7
Total assets $845.0 100.0% $750.0 100.0%
Liabilities and Equity
Accounts payable $ 30.0 3.6% $ 15.0 2.0%
Accruals 60.0 7.1 55.0 7.3
Notes payable 40.0 4.7 35.0 4.7
Total current liabilities $130.0 15.4% $105.0 14.0%
Long–term bonds 300.0 35.5 255.0 34.0
Total liabilities (debt) $430.0 50.9% $360.0 48.0%
Common stock (25,000,000 shares) 130.0 15.4 130.0 17.3
Retained earnings 285.0 33.7 260.0 34.7
Total common equity $415.0 49.1% 390.0 52.0
Total liabilities and equity $845.0 100.0% $750.0 100.0%
Book value per share = (Common equity)/Shares $16.60 $15.60

Market value per share (stock price) 26 $23.00 $25.00
 Operating cash flows represents the cash flow that the
firm would have available for investing in assets if it has
no debt
Unilate Textiles: Income Statements for Years
Ending Dec. 31 ($ millions, except per shares data)
2009 2008
Amount Percent of Amount Percent of
Total Sales Total Sales
Net sales $1,500.0 100.0% $1,435.0 100.0%
Variable operating costs (82% of sales) (1,230.0) 82.0 (1,176.7) 82.0
Gross profit $ 270.0 18.0 $ 258.3 18.0
Fixed operating costs except depreciation ( 90.0) 6.0 ( 85.0) 5.9
Earnings before interest, taxes, depreciation, and $ 180.0 12.0 173.3 12.1
amortization (EBITDA
Depreciation ( 50.0) 3.3 ( 40.0) 2.8
Net Operating income (NOI) =
Earnings before interest and taxes (EBIT) $ 130.0 8.8 133.3 9.3
Interest ( 40.0) 2.7 ( 35.0) 2.4
Earnings before taxes (EBT) $ 90.0 6.0 98.3 6.9
Taxes (40%) ( 36.0) 2.4 ( 39.3) 2.7
Net income $ 54.0 3.6 $ 59.0 4.1
Preferred dividends 0.0 0.0

Earnings available to common stockholders (EAC) $ 54.0 59.0
Common dividends ( 29.0) ( 27.0)
Addition to retained earnings $ 25.0 32.0
Per share data (25,000,000 shares):

Earnings per share = (Net income)/Shares $2.16 $2.36
Dividends per share = (Common dividends)/Shares 28 $1.16 $1.08
 Free cash flow: measures the cash flow that the firm is
free to pay to investors (bondholders and stockholders)
after considering the cash investments that are needed to
continue operations
 Economic value added (EVA): earnings from actions
taken by a company must be sufficient to compensate the
suppliers of funds – both bondholders and stockholders.
 EVA measure gives an estimate of the true economic
profit that is generated by a firm.
30
2.2. Financial Statement (Ratio Analysis)
 Ratios are accounting numbers translated into
relative values
 Ratios are designed to show relationships between
financial statement accounts within firms and
between firms
31
The Purpose of Ratio Analysis
 Gives an idea of how well the company is doing
 Standardizes numbers; facilitates comparisons
 Used to highlight weaknesses and strengths
32
2.2.2. Financial Statement (Ratio Analysis)
 Five Major Categories of Ratios

 Liquidity: is the firm able to meet its current
obligations
 Asset management: is the firm effectively
managing its assets
 Debt management: does the firm have the right
mix of debt and equity
 Profitability: the combined effects of liquidity,
asset and debt management
 Market values: relates the firm’s stock price to its
earnings and the book value
33 per share
 Liquidity Ratios
 Current ratio
 Quick (Acid test) ratio
34
Liquidity Ratios:
Current Ratio
Current Assets
Current Ratio =
Current Liabilities
= $465.0 = 3.6 times

$130.0
Industry average = 4.1 times
35
Liquidity Ratios:
Quick (Acid Test) Ratio
Quick Ratio = Current Assets- Inventories

Current Liabilities
= $465.0 - $270.0 = $195.0 = 1.5 times

$130.0 $130.0
36
→ Conclusion about Unilate’s Liquidity Position:
Liquidity ratios suggest that Unilate’s liquidity position
is fairly poor
37
 Asset Management Ratios
 Inventory Turnover Ratio
 Days Sales Outstanding (DSO)
 Fixed Assets Turnover Ratio
 Total Assets Turnover Ratio
38
Asset Management Ratios:
Inventory Turnover Ratio
Cost of goods sold

Inventory turnover =
Inventory
$1,230.0
= = 4.6
. 6 times
$270.0
39
Asset Management Ratios
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
40
Fixed Assets Turnover Ratio
Sales
Fixed assets turnover =
Net fixed assets
$1,500.0
= = 3.9 times
$380.0
Industry Average = 4.0 times
41
Total Assets Turnover Ratio
Sales
Total assets turnover =
Total assets
$1,500.0
= = 1.8 times
$845.0
42
 Debt Management Ratios
 Debt Ratio
 Times-Interest-Earned Ratio
 Fixed Charge Coverage Ratio
43
Debt Management Ratios
Debt Ratio
Debt Ratio = Total liabilities

Total assets
= $430.0 = 0.509 = 50.9%

$845.0
Industry Average = 42.0%
44
Times-Interest-Earned Ratio
TIE = EBIT
Interest charges
$130.0
= = 3.3 times
$40.0
45
Fixed 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 
 $8.0  $63.3
$40.0  $10.0   
 1  0.4 
46
 Profitability Ratios
 Net Profit Margin
 Return on Total Assets
 Return on Common Equity
47
Profitability Ratios
Profit Margin Ratio
Net income
Profit margin =
Sales
$54.0
= = 0.036 = 3.6%
$1,500
48
Return on Total Assets
Net income
ROA =
Total assets
$54.0 = 0.064 = 6.4%
=
$845.0
49
Return on Common Equity
Net income
ROE =
Common equity
= $54.0 - 0 = 0.130 = 13.0%
$415.0
50
 Market Value Ratios
 Price/Earnings Ratio
 Market/Book Ratio
51
Market Value Ratios
Price/Earnings Ratio
Price per share
Price/Earnings Ratio =
Earnings per share
$23.00
= = 10.6 times
$2.16
52
Market Value Ratios
Market/Book Ratio
Market price per share

Market/Book Ratio =
Book value per share
= $23.00 = 1.4 times
$16.00
53
Summary of Ratio Analysis:
The DuPont Analysis
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%
54
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)
55
Potential Problems and Limitations of
Financial Ratio Analysis
 Comparison with industry averages is difficult if the firm
operates many different divisions
 Inflation distorts balance sheets
 Seasonal factors can distort ratios
 “Window dressing” can make ratios look better.
 Different operating and accounting practices distort
comparisons
 Sometimes hard to tell if a ratio is “good” or “bad”
 Difficult to tell whether company is, on balance, in
strong or weak position
56
Chapter 2 Essentials
 What financial statements do corporations publish?

 Balance sheet, income statement, statement of
cash flows, and statement of retained earnings
 How do investors utilize financial statements?
 Debtholders estimate future cash flows to
determine whether the debt contracts will be
honored
 Stockholders estimate future cash flows to
determine the value of the firm’s common stock.
57
Chapter 2 Essentials
 What is ratio analysis and why are the results

important to both managers and investors?
 Ratio analysis is used to evaluate a firm’s current
financial position and the direction this position is
expected to take in the future.
 What is the most important factor in financial
statement analysis?
 To form general impressions about a firm’s
financial position, judgment must be used when
interpreting financial ratios
58

CF-Chap 02-Analysis of Financial Statement

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CF-Chap 02-Analysis of Financial Statement

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Chapter 2

2.1. The financial statements

2.2. The ratio analysis

2.3. The Dupont analysis

2.4. The uses and limitations of ratio analysis

2.5. Financial planning and forecasting

 Financial Statements / Recording business activity /

 The Balance Sheet

 Statement of Cash Flows

 Statement of Retained Earnings

 The Balance Sheet

 The Income Statement

 Statement of Cash Flows

 Statement of Retained Earnings

 Represents a picture taken on a specific date that

Assets ≡ Liabilities + Stockholeder’s equity

 Assets represent the firm’s investment are classified as

 Current asstes generally include items that will be

 Long-term, or fixed, assets include investment that

Book value per share = (Common equity)/Shares $16.60 $15.60

Breakdown of net plant and equipment account:

 Presents the results of business operations during a

Preferred dividends 0.0 0.0

Per share data (25,000,000 shares):

Designed to show how the firm’s operations have

 Examines investment decisions (uses of cash)

 Examines financing decisions (sources of cash)

Account Balances as of: Change

12/31/09 12/31/08 Source Uses

Balance Sheet Effects (Adjustments)

Cash and marketable securities $ 15.0 $ 40.0 $ 25.0

Income Statement Information

Net income $ 54.0

Add: depreciation 50.0

Gross cash flow from operations $104.0 104.0

Dividend payment 29.0 29.0

Totals $199.0 $199.0

Changes in the common equity accounts between

Balance of retained earnings, December 31, 2008 $260.0

Add: 2009 net income 54.0

Less: 2009 dividends paid to stockholders (29.0)

Balance of retained earnings, December 31, 2009 $285.0

 Net operating capital

Book value per share = (Common equity)/Shares $16.60 $15.60

Preferred dividends 0.0 0.0

Per share data (25,000,000 shares):

 Gives an idea of how well the company is doing

 Standardizes numbers; facilitates comparisons

 Used to highlight weaknesses and strengths

 Five Major Categories of Ratios

 Quick (Acid test) ratio

= $465.0 = 3.6 times

Quick Ratio = Current Assets- Inventories

= $465.0 - $270.0 = $195.0 = 1.5 times

Industry average = 2.1 times

 Asset Management Ratios

 Inventory Turnover Ratio

 Days Sales Outstanding (DSO)

 Fixed Assets Turnover Ratio

 Total Assets Turnover Ratio

Cost of goods sold

Industry average = 7.4 times

Industry average = 32.1 days