II.

FINANCIAL STATEMENTS, CASH FLOW AND TAXES

MATHBUSFIN
Learning Outcomes
• 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.

Financial Statement Analysis

• Involves evaluation of a firm’s financial position to identify its current strength and
weaknesses and to suggest actions that the firm might pursue to take advantage those
strength and correct any weaknesses to accomplish its goal of wealth maximization.
(Financial statement analysis is the process of reviewing and analyzing a company's
financial statements to make better economic decisions to earn income in future. These
statements include the income statement, balance sheet, statement of cash flows,
notes to accounts and a statement of changes in equity.)
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
(A company’s yearly report to shareholders, documenting its activities and finances in
the previous financial report.)
Financial Statements
• The Balance Sheet
• The Income Statement
• Statement of Cash Flows
• Statement of Retained Earnings

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
– Capital or Equity
– Stockholders’ Equity

(Balance Sheet - a statement of the assets, liabilities, and capital of a business or

other organization at a particular point in time, detailing the balance of income
and expenditure over the preceding period.
Assets – property owned by a person or company, regarded as having value and
available to meet debts, commitments, or legacies.
Liabilities – a thing for which someone is responsible, especially a debt or
financial obligation.
Stockholders Equity – is the total amount of capital given to a company by its
shareholders in exchange for stock, plus any donated capital or retained
earnings.
Capital or Equity - can refer to funds raised to support a particular business or
project. And can also represent the accumulated wealth of a business,
represented by its assets less liabilities.)
• 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
Unilate Textiles: Dec. 31 Balance Sheets

$ millions, except per-share data

 Additional information: 2012 2011

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

The Income Statement

• Presents the results of business operations during a specified period of time
• Summarizes the revenues generated and the expenses incurred
– Revenues
– Gains
– Expenses
– Losses
– Net Income
(The income statement is also referred to as the profit and loss statement, P&L,
statement of income, and the statement of operations. The income statement reports
the revenues, gains, expenses, losses, net income and other totals for the period of time
shown in the heading of the statement.)
Unilate Textiles: Income Statements for Years Ending Dec. 31

$ millions, except per-share data

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)
(In financial accounting, a cash flow statement, also known as statement of cash flows,
is a financial statement that shows how changes in balance sheet accounts and income
affect cash and cash equivalents, and breaks the analysis down to operating, investing,
and financing activities.)
Unilate Textiles: Cash Sources and Uses, 2012($ million)

Unilate Textiles: Statement of Cash Flows for the Period Ending December 31, 2012 ($ million)
Statement of Retained Earnings
• Changes in the common equity accounts between balance sheet dates
(The statement of retained earnings (retained earnings statement) is a financial
statement that outlines the changes in retained earnings for a company over a specified
period.)
Unilate Textiles: Statement of Retained Earnings for the Period Ending December 31, 2012
($ million)

Balance of retained earnings, December 31, 2011 $260.0

Add: 2011 net income 54.0

Less: 2011 dividends paid to stockholders (29.0)

Balance of retained earnings, December 31, 2012 $285.0

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)]
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
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
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
Liquidity Ratios
• Current ratio
• Quick (Acid test) ratio
 (Liquidity Ratios – ratios that show the relationship of a firm’s cash and other current
assets to its current liabilities; they provide an indication of the firm’s ability to meet its
current obligation)
Unilate’s Current Ratio

Current Assets
Current Ratio =
Current Liabilities

= $465.0
= 3.6 times
$130.0

Industry average = 4.1 times

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

Unilate’s Liquidity Position

• Liquidity ratios suggest that Unilate’s liquidity position is fairly poor

Asset Management Ratios

• Inventory Turnover Ratio
• Days Sales Outstanding (DSO)
• Fixed Assets Turnover Ratio
• Total Assets Turnover Ratio
Unilate’s Turnover Ratio Inventory

Unilate’s Days Sales Outstanding Ratio

Unilate’s Fixed Assets Turnover Ratio

Unilate’s Total Assets Turnover Ratio

Debt Management Ratios
• Debt Ratio
• Times-Interest-Earned Ratio
• Fixed Charge Coverage Ratio

Unilate’s Debt Ratio

Unilate’s Times-Interest-Earned Ratio

Unilate’s Fixed-charge Coverage Ratio

Profitability Ratios

 Net Profit Margin

 Return on total assets
 Return on common equity
Unilate’s Profit Margin Ratio

Unilate’s Return on Total Assets

Unilate’s Return on Common Equity

Market Value Ratios

• Price/Earnings Ratio
• Market/Book Ratio

Unilate’s Price/Earnings Ratio

Unilate’s Market/Book Ratio

Summary of Ratio Analysis (The DuPont Analysis)

Rate of Return on Common Equity (ROE)

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)

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

PROBLEM 2-1
• WHAT KIND OF FINANCIAL INFORMATION IS A PUBLICLY TRADED
REQUIRED TO PROVIDE TO ITS STOCKHOLDERS? WHICH
FINANCIAL STATEMENT DO YOU THINK PROVIDES THE BEST
INFORMATION FOR INVESTORS?

• DIFFERENTIATE (COMPARE) AMONG THE INFORMATION THAT IS

PROVIDED IN EACH OF THE FINANCIAL STATEMENT: (1) BALANCE
SHEET (2) INCOME STATEMENT AND (3) STATEMENT OF CASH
FLOWS.