Chapter 2
Analysis of Financial
Statements
1
Learning Outcomes
Chapter 2
Describe the basic financial information that is produced by
corporations and explain how the firm’s stakeholders use such
information.
Describe the financial statements that corporations publish and
the information that each statement provides.
Describe how ratio analysis should be completed and why the
results of such an analysis are important to both managers and
shareholders.
Discuss potential problems (caveats) associated with financial
statement analysis.
2
The Annual Report
Discussion of Operations
 Usually a letter from the chairman
Financial Statements
 The Income Statement
 The Balance Sheet
 Statement of Cash Flows
 Statement of Retained Earnings
3
Financial Statements
The Balance Sheet
The Income Statement
Statement of Cash Flows
Statement of Retained Earnings
4
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)
5
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
6
Unilate Textiles: Dec. 31 Balance Sheets
($ millions, except per share data)
7
Unilate Textiles: Dec. 31 Balance Sheets
($ millions, except per share data)
2010
2009
$335.0
$295.0
415.0
390.0
Gross plant and equipment
$680.0
$600.0
Less: Accumulated depreciation
(300.0)
250.0
$380.0
$350.0
Additional information:
Net working capital = Current assets – Current liabilities
Net worth = Total assets – Total liabilities
Breakdown of net plant and equipment account:
Net plant and equipment
8
The Income Statement
Presents the results of business operations
during a specified period of time
Summarizes the revenues generated and the
expenses incurred
9
Unilate Textiles: Income Statements for Years Ending Dec. 31
($ millions, except per share data)
10
Statement of Cash Flows
Designed to show how the firm’s operations
have affected its cash position
Examines investment decisions
(uses of cash)
Examines financing decisions
(sources of cash)
11
Unilate Textiles: Cash Sources and Uses, 2010
($ million)
12
Unilate Textiles: Statement of Cash Flows for the
Period Ending December 31, 2010 ($ million)
13
Statement of Retained Earnings
Changes in the common equity accounts
between balance sheet dates
14
Unilate Textiles: Statement of Retained
Earnings for the Period Ending December 31,
2010 ($ million)
Balance of retained earnings, December 31, 2010
Add: 2010 net income
$260.0
54.0
Less: 2010 dividends paid to stockholders
(29.0)
Balance of retained earnings, December 31, 2010
$285.0
15
What Information Do Investors Use from
Financial Statements
Net working capital
 = NWC = Current assets - Current liabilities
Operating cash flow
 = NOI (1-Tax rate) + Depreciation and amortization expense
 = Net operating profit after taxes + Depreciation and amortization
expense
Free cash flow
 = FCF = operating cash flow - Investments
 = Operating cash flow - (in fixed assets + NOWC)
Economic Value Added
 =EVA = NOI (1 - Tax rate) - [(Invested capital) X (After-tax cost of
capital as a percent)]
16
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
17
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
18
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 per share
19
Liquidity Ratios
Current ratio
Quick (Acid test) ratio
20
Unilate’s Current Ratio
Current Ratio =
Current Assets
Current Liabilities
$465.0 =
$130.0
3.6 times
Industry average =
4.1 times
=
21
Unilate’s Quick (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
22
Unilate’s Liquidity Position
Liquidity ratios suggest that Unilate’s liquidity
position is fairly poor
23
Asset Management Ratios
Inventory Turnover Ratio
Days Sales Outstanding (DSO)
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
24
Unilate’s Inventory Turnover Ratio
Cost of goods sold
Inventory turnover =
Inventory
$1,230.0
.6 times
= 4.6
=
$270.0
Industry average = 7.4 times
25
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
26
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
27
Unilate’s Total Assets Turnover Ratio
Total assets turnover
Sales
=
Total assets
$1,500.0
=
$845.0
= 1.8 times
Industry Average = 2.1 times
28
Debt Management Ratios
Debt Ratio
Times-Interest-Earned Ratio
Fixed Charge Coverage Ratio
29
Unilate’s Debt Ratio
Debt Ratio = Total liabilities
Total assets
= $430.0 = 0.509 = 50.9%
$845.0
Industry Average = 42.0%
30
Unilate’s Times-Interest-Earned Ratio
TIE =
EBIT
Interest charges
$130.0
= 3.3 times
=
$40.0
Industry Average = 6.5 times
31
Unilate’s 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 times
 $8.0  $63.3
$40.0  $10.0  

 1 0.4 
Industry Average = 5.8 times
32
Profitability Ratios
Net Profit Margin
Return on Total Assets
Return on Common Equity
33
Unilate’s Profit Margin Ratio
Profit margin
Net Profit
=
Sales
$54.0
=
= 0.036 = 3.6%
$1,500
Industry Average = 4.9%
34
Unilate’s Return on Total Assets
Net income
ROA =
Total assets
=
$54.0
$845.0
= 0.064 = 6.4%
Industry Average = 10.3%
35
Unilate’s Return on Common Equity
Net income
ROE =
Common equity
= $54.0 - 0 = 0.130 = 13.0%
$415.0
Industry Average = 17.7%
36
Market Value Ratios
Price/Earnings Ratio
Market/Book Ratio
37
Unilate’s Price/Earnings Ratio
Price/Earnings Ratio
Price per share
=
Earnings per share
$23.00
=
= 10.6 times
$2.16
Industry Average = 15.0 times
38
Unilate’s Market/Book Ratio
$23.00
$16.00
=
Market/Book Ratio
Market price per share
=
Book value per share
1.4 times
=
Industry Average = 2.5 times
39
Summary of Ratio Analysis:
The DuPont Analysis
ROA = Net Profit Margin X Total Assets Turnover
Sales
Net Income
X
=
Total Assets
Sales
=
$54.0
$1,500.0
X
$1,500.0
$845.0
=
3.6%
X
1.8
= 6.4%
40
Rate of Return on Common Equity
(ROE)
41
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)
42
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
43