CHAPTER 11 Financial Statements, Cash Flow, and Ratio Analysis

1. CHAPTER 11Financial Statements, Cash Flow, and Ratio Analysis Balance sheet Income statement Statement of cash flows Ratio Analysis

2. 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 time. • 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.

3. 2005 $ 15.0 180.0 270.0 $ 465.0 680.0 (300.0) 380.0 $845.0 2004 $40.0 160.0 200.0 400.0 600.0 (250.0) 350.0 $750.0 Balance Sheet: Assets Cash A/R Inventories Total CA Gross FA Less: Dep. Net FA Total Assets

4. 2005 $30.0 40.0 60.0 $130.0 300.0 $430.0 130.0 285.0 $415.0 $845.0 2004 15.0 35.0 55.0 $105.0 255.0 $360.0 130.0 260.0 $390.0 750.0 Balance sheet: Liabilities and Equity Accts payable Notes payable Accruals Total Current Liabilities Long-term debt Total Liabilities Common stock Retained earnings Total Equity Total Liabilities & Equity

5. Income statement 2005 $1500.0 (1,230.0) (90.0) 180.0 (50.0) $130.0 (40.0) $90.0 (36.0) $ 54.0 (29.0) 2004 $1435.0 (1,176.7) (85.5) 173.3 (40.0) 133.3 (35.0) $98.3 (39.3) $59.0 (27.0) Sales COGS Other expenses EBITDA Depr. & Amort. EBIT Interest Exp. EBT Taxes (40%) Net income Common Dividends

6. 2005 25 $2.16 $1.16 $23.00 2004 25 $2.36 $1.08 $23.00 Other data Shares outstanding EPS DPS Stock price

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

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

9. Guidelines for cash flow from operating activities • Start with the net income after interest and taxes before distribution of dividends. • Add back depreciation. • 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. • 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. • Ignore: (a) cash amount of current assets and (b) notes payable of current liabilities.

10. 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.

11. Statement of Cash Flows (2005) $54.0 50.0 (20.0) (70.0) 15.0 5.0 $34.0 CASH FLOW FROM OPERATIONS: Net income Add back depreciation Subtract (Uses of cash): Increase in A/R Increase in inventories Add (Sources of cash): Increase in A/P Increase in accruals Net cash provided by operations.

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

13. 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 well • Long term debt issued to pay cash dividends

14. Methods of Ratio analysis • Bench mark analysis • Time series analysis • Cross section analysis

15. What are the five major categories of ratios, and what questions do they answer? • Liquidity: Can we make required payments? • Asset management: right amount of assets vs. sales? • Debt management: 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 value: Do investors like what they see as reflected in P/E and M/B ratios?

16. Liquidity Ratioa. Current Ratio for 2005. Current ratio = Current assets / Current liabilities = $465 / $130 = 3.6 Industry average: 4.1

17. Comments on current ratio • 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.

18. 1. Liquidity Ratiob. 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.

19. 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.

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

21. 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.

22. 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 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.

23. 2. Asset Management Ratio:c. Fixed asset turnover ratiod. 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

24. 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.

25. 2. Overall comments on asset management • 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%].

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

27. 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.

28. 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.

29. 3. Overall comments on Debt management • 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.

30. 4. Profitability Ratios (DuPont Analysis) a. Profit Margin on Sales =Net income/sales x b. Total Asset Turnover=Sales /Total Asset = c. Return on Assets (ROA) = Net Income/Total Assets x d. Financial Leverage=Total Assets/Common Equity = e. Return on Equity (ROE) =Net income (available to common stockholders)/Common Equity

31. Profitability Ratios

32. Overall comments on Profit performances • 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.

33. 5. Market value ratio • a. Price/ Earnings Ratio =Market price per share/EPS EPS=Net income available to common stockholders/No. of common shares outstanding. So, EPS=$54/25=$2.16

34. 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.

35. 5. Market value ratio (Contd.) • b. Market/Book value ratio • Book value=Common equity/No. of shares outstanding =$415/25=$16.60 • 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

36. 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 down.

37. 5. Overall comments on market performances • 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 seriously.