; CHAPTER 2 Financial Statements_ Cash Flow_ and Taxes
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CHAPTER 2 Financial Statements_ Cash Flow_ and Taxes


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									CHAPTER 11
Financial Statements, Cash Flow,
and Ratio Analysis

    Balance sheet
    Income statement
    Statement of cash flows
    Ratio Analysis

The Annual Report
   Balance sheet – provides a snapshot of a
    firm’s financial position at one point in time.
   Income statement – summarizes a firm’s
    revenues and expenses over a given period of
   Statement of retained earnings – shows how
    much of the firm’s earnings were retained,
    rather than paid out as dividends.
   Statement of cash flows – reports the impact
    of a firm’s activities on cash flows over a
    given period of time.
Balance Sheet: Assets
               2005      2004
Cash            $ 15.0     $40.0
A/R              180.0     160.0
Inventories      270.0     200.0
  Total CA     $ 465.0     400.0
Gross FA         680.0     600.0
Less: Dep.     (300.0)   (250.0)
  Net FA         380.0     350.0
Total Assets    $845.0    $750.0
   Balance sheet:
   Liabilities and Equity
                            2005     2004
Accts payable                $30.0     15.0
Notes payable                 40.0     35.0
Accruals                      60.0     55.0
  Total Current Liabilities $130.0   $105.0
Long-term debt               300.0    255.0
Total Liabilities           $430.0   $360.0
Common stock                 130.0    130.0
Retained earnings            285.0    260.0
  Total Equity              $415.0   $390.0
Total Liabilities & Equity $845.0     750.0 2-4
Income statement
                     2005      2004
Sales             $1500.0     $1435.0
COGS             (1,230.0)   (1,176.7)
Other expenses      (90.0)      (85.5)
  EBITDA             180.0       173.3
Depr. & Amort.      (50.0)      (40.0)
  EBIT             $130.0        133.3
Interest Exp.       (40.0)      (35.0)
EBT                  $90.0       $98.3
Taxes (40%)         (36.0)      (39.3)
Net income          $ 54.0       $59.0
Common Dividends    (29.0)      (27.0)
Other data
                   2005     2004
Shares outstanding    25       25
EPS                $2.16    $2.36
DPS                $1.16    $1.08
Stock price       $23.00   $23.00

Statement of Retained Earnings

Balance of retained
 earnings, 12/31/04          $260
     Add: Net income, 2005      54
     Less: Dividends paid     (29)
Balance of retained
 earnings, 12/31/05          $285

How to make cash-flow statement
    There are   3 parts in the statement.
1.   Cash flow   from operating activities
2.   Cash flow   from financing activities
3.   Cash flow   from investment activities

       Guidelines for cash flow
       from operating activities
1.   Start with the net income after interest and taxes before
     distribution of dividends.
2.   Add back depreciation.
3.   Among the items of current assets compare between
     the figures of last year and the current year. if there is an
     increase, then deduct the amount as it refers to the use of
     cash. If there is a decrease, then add the amount as it is a
     source of cash.
4.   Among the items of current liabilities, if there is an
     increase, then add as it refers to a source of cash. If there
     is a decrease, then deduct as it is a use of cash.
5.   Ignore: (a) cash amount of current assets and (b) notes
     payable of current liabilities.                           2-9
      More tips for cash-flow statement
   For investment activities, use the gross amount
    rather than net amount. Increase is assets is a use
    of cash, so deduct the amount. Decrease in assets
    is a source of cash, so add the amount.
   For financing activities, increase in debt or
    stock means procurement in cash, so add the
    amount. Decrease in debt or stock means
    repayment, so deduct the amount. Distribution of
    dividends is a a use, so deduct the amount. Notes
    payable should be included and treated like any
    other long term debt.
 Statement of Cash Flows (2005)
Net income                         $54.0
Add back depreciation               50.0
Subtract (Uses of cash):
  Increase in A/R                  (20.0)
  Increase in inventories          (70.0)
Add (Sources of cash):
  Increase in A/P                   15.0
  Increase in accruals               5.0
Net cash provided by operations.   $34.0

   Statement of Cash Flows (2005)
a. Net cash provided by operation         $34.0
b. Cash Flow from Investment             (80.0)
   Increase in notes payable         5.0
   Increase in long-term debt       45.0
   Payment of cash dividend         (29.0)
Net cash from financing                    21.0
NET CHANGE IN CASH                       (25.0)
Plus: Cash at beginning of year            40.0
Cash at end of year                       $15.0

Comment about the financial
condition from the CF statement
   The net change in cash flow is negative.
    This indicates that during the year the firm
    has more cash outflow than inflow. The cash
    position of the firm has deteriorated
    compared to the last year.
   Huge inventories piled up that consumed
    cash as well as the accounting profit
   Increase in fixed assets consumed cash as
   Long term debt issued to pay cash dividends
Methods of Ratio analysis
   Bench mark analysis
   Time series analysis
   Cross section analysis

What are the five major categories of
ratios, and what questions do they
   Liquidity: Can we make required payments?
   Asset management: right amount of assets
    vs. sales?
   Debt management: Right mix of debt and
   Profitability: Do sales prices exceed unit
    costs, and are sales high enough as
    reflected in PM, ROE, and ROA?
   Market value: Do investors like what they
    see as reflected in P/E and M/B ratios?

  1. Liquidity Ratio
     a. Current Ratio for 2005.

Current ratio  = Current assets / Current
            = $465 / $130
            = 3.6
Industry average: 4.1

       Comments on current ratio
                     2005       2004       Ind.
                      3.6        3.8       4.1

   The firm has a liquidity which is more than the benchmark
    of 2. However, it is less than the industry average, as well
    as that of last year. It seems like liquidity position has
    become weaker of the firm. Of course, it is still well above
    the bench mark. On the other hand, the firm is able to
    allocate more funds for investment now which might be a
    good sign.
 1. Liquidity Ratio
 b. Quick ratio for 2005.
                    Current assets - inventories
Quick ratio2005 =
                   Current liabilities
                =$195 / $130 =1.5x
Quick ratio2004 =1.9
Industry average=2.1
Comment: Although the ratio is better than the
norm of 1 but it is much lower than the industry
average. Compared to the last year it is worse as
well. The firm needs to improve that.

    1. Overall comments on liquidity
   Although the bench mark analysis suggests
    that the firm is conveniently placed but both
    time series and cross section analysis indicate
    that liquidity performances are poor. The firm
    needs to increase its cash balance which has
    drastically gone down in the current year. A
    reason for low liquidity is that the sales has
    increased only around 4% in the current year
    which must be responsible for poor cash
    balance and poor accounts receivables.

2. Asset Management Ratio:
a. Inventory turnover
Inv. turnover    = Sales / Inventories
                 = $1230 / $270
                 = 4.6x

                2005   2004   Ind.
                4.6x   5.9x   7.4x

Comments on
Inventory Turnover
   Unilate’s inventory is sold out and
    restocked, or “turned over”, 4.6 times
    per year, which is considerably lower
    than the industry average of 7.4
    times. It might be holding excessive
    stock of inventory which indeed is
    unproductive. It might have old
    inventory piled up that suggests poor
    inventory management.
  2. Asset Management Ratio:
  b. Days Sales Outstanding (DSO):
  Average number of days required for collection of sales

   DSO    = Receivables / Average sales per day
          = Receivables / (Sales/365)
          = $180 / ($1,500/360)= 43.2 days

                      2005         2004        Ind.
      DSO             43.2         40.7        32.0

Unilete collects sales too slowly compared to the
industry, and the collection performance is getting
worse day-by-day. it has a poor credit policy.
2. Asset Management Ratio:
c. Fixed asset turnover ratio
d. Total asset turnover ratios
FA turnover    = Sales / Net fixed assets
               = $1,500 / $380 = 3.9x
               Industry average= 4.0x
TA turnover    = Sales / Total assets
               = $1,500 / $845 = 1.8x
               Industry average= 2.1x

              2005      2004        Ind.
 FA TO        3.9x      4.1x       4.0x
 TA TO        1.8x      1.9x       2.0x     2-23
Comment on Fixed Assets turnover
and total asset turnover ratio
   Compared to the industry, the fixed
    assets turnover ratio is alright but the
    total asset turnover ratio is weak. The
    reason might be the poor inventory
    management of the firm.

    2. Overall comments on asset
   Poor performances in all the asset management
    ratios are due to poor sales promotion.
    Considering the DSO, the firm can not relax the
    credit terms, so to reduce the sales price and/or
    aggressive market campaign may be a good
    option to promote sales. To improve the DSO,
    the firm should be more punctual in its
    collection of credit sales. Cash discount can be
    increased. The reason for poor asset
    management ratio is the inefficient inventory
    management. Abnormal increase in inventory in
    the current year [35%] does not match with
    sales promotion [4%].                         2-25
    3. Debt Management Ratio

  a. Debt Ratio=Total Debt/Total Assets
  b. Times interest earned=EBIT/Interest charges

                 2005        2004        Ind.

 Debt Ratio      50.9%       48%         45%
Times interest
                 3.3 x       3.8x        6.5x

Debt Management Ratio
   The debt ratio is significantly higher
    than the industry. Compared to the
    previous year it is increasing as well.
    This is alarming as interest charges are
    compulsory obligation. In future this
    may result in a constraint to raise debt.
    It might be rationalized by an increased
    EPS by means of high debt financing.
Debt Management Ratio
   Times interest earned ratio is worse
    than the industry, as well as, that of
    last year. Unilete is covering its interest
    charges by a low margin of safety. This
    affects the potentiality of raising further
    debt in future.

3. Overall comments on Debt
   Poor debt ratio and TIE ratio indicate
    that the firm is highly a levered one.
    This may affect the cost of debt in
    future. The firm has raised debt capital
    to pay dividend, which is not a good
    sign. Whether the firm was capable of
    utilizing the advantage of debt financing
    depends on profitability.
    4. Profitability Ratios
    (DuPont Analysis)
a. Profit Margin on Sales =Net income/sales
b. Total Asset Turnover=Sales /Total Asset
c. Return on Assets (ROA) = Net Income/Total
d. Financial Leverage=Total Assets/Common Equity
e. Return on Equity (ROE) =Net income (available to
   common stockholders)/Common Equity
  Profitability Ratios
                   2005         2004       Ind.

                 (54/1500)    (59/1435)
Profit Margin                              4.7%
                   3.6%         4.1%

                 (1500/845)   (1435/750)
Asset Turnover                               2
                    1.77x        1.9x
                  (54/845)     (59/750)
ROA                                        9.5%
                    6.4%        7.87%
Financial        (845/415)    (750/390)
Leverage            2.04         1.92
ROE                             15.1%      17.2%
       Overall comments on Profit
   Comment on Profitability Ratios: All the profitability ratios
    are poorer than those of industry. Deterioration is also
    noticeable compared to those of previous year. Both
    Asset Turnover and Return on Assets ratios are
    significantly lower for the firm in 2005 than the previous
    year, as well as, than the industry averages. On the other
    hand, Financial Leverage is higher than the industry. This
    confirms the earlier observation of excess of fixed assets
    and inventories, and debt. The firm should devote to
    inventory and asset management. The apparent benefit
    of leverage in terms of tax exemption is not evidential in
    profit promotion. Operating activities of the firm suffered
    from poor liquidity position, poor asset management, and
    above average debt.
   5. Market value ratio
    a. Price/ Earnings Ratio =Market price
     EPS=Net income available to common
         stockholders/No. of common shares
         outstanding. So, EPS=$54/25=$2.16
2005               2004                Industry
$23/$2.16=10.6x $23/$2.36=9.7x        13.0x

         5. Market value ratio (Contd.)
         Comment on P:E Ratio
   P/E ratio is higher for firms with high growth potentials as well
    as for riskier firms. P/E of the firm has increased from the
    previous year. Either growth rate might have increased or risk
    has increased. Following table shows that growth rate
    (ROE*Retention rate) has gone down compared to the previous
    year. So, the firm must have increased risk perhaps due to high
    leverage than industry average. Of course the increased P:E
    ratio indicates that the firm gained more trust of investors.

                    ROE            Retention     Growth rate
     2004           13%            (54-29)/54    6%
     2005           13%            (54-29)/54    6%
      5. Market value ratio (Contd.)
    b. Market/Book value ratio
    Book value=Common equity/No. of shares outstanding
    M/B value ratio=Market price per share/Book value per
                share=$23/$16.6 =1.4x
    Previous year: BV=$390/25=15.6
    Previous year M/B=$23/$15.6=1.7x
    Industry average=2.0x
    2005                2004                   Industry
    1.4 x               1.7x                   2.0
       5. Market value ratio (Contd.)
   Comment: The market value per share is 1.4
    times the book value per share of the firm in
    the current year. This is remarkably lower
    than the industry average of 2 times. In the
    previous year the same ratio was 1.7 times for
    the firm. It demonstrates that not only the
    firm performs poorer than the industry but
    also the trust of investors in the firm goes
     5. Overall comments on market
   One of the most important ratios to evaluate the
    performances of the firm is the price-earnings
    ratio. The ratio is still less than the industry
    although it has increased in the current year
    compared to the previous year. The
    improvement may indicate that the firm is
    gaining some trust of investors. Since the
    market price of share is the same as of the
    previous year, the share price may not be
    dependable as it may suffer from “thin trading
    problem”. In that case the P/E ratio, as well as
    the market value ratio should not be taken


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