II. Solutions to Study Questions, Problems, and Cases Chapter 1 1.1 The annual report is published primarily for shareholders, while the 10-K report is filed with the Securities and Exchange Commission and is used by regulators, analysts, and researchers. The financial statements and much of the financial data are identical in the two documents; but the 10-K report contains more detail (such as schedules showing management remuneration and transactions, a description of material litigation and governmental actions, and elaborations of many financial statement accounts) than the annual report; and the annual report presents additional public relations type material such as colored pictures, charts, graphs, and promotional information about the company. 1.2 The analyst should use the financial statements: the balance sheet, the income statement, the statement of stockholders' equity, and the statement of cash flows; the notes to the financial statements; supplementary information such as financial reporting by segments; the auditor's report; management's discussion and analysis of operating performance and financial condition; and the five-year summary of financial data. Use the public relations "fluff," such as colored pictures and descriptive material with caution. 1.3 A qualified report is issued when the overall financial statements are fairly presented "except for" items which the auditor discloses; an adverse opinion is issued when the financial statements have departures from GAAP so numerous that the statements are not presented fairly. A disclaimer of opinion is caused by a scope limitation resulting in the auditor being unable to evaluate and express an opinion on the fairness of the statements. An unqualified opinion with explanatory language is caused by a consistency departure due to a change in accounting principle, uncertainty caused by future events such as contract disputes and lawsuits, events which the auditor believes may present business risk and going concern problems. 1.4 The proxy statement is a document required by the SEC to solicit shareholder votes, since many shareholders do not attend shareholder meetings. The analyst can find important information in the proxy statement such as background information on the company's nominated directors, director and executive compensation, any proposed changes to those compensation plans and the audit and non-audit fees paid to the auditing firm. 1
1.5 Employee relations with management, employee morale and efficiency, the reputation of the firm with its customers and in its operating environment, the quality and effectiveness of management, provisions for management succession, potential exposure to regulatory changes, "bad publicity" in the media. 1.6 Depreciation is a process of cost allocation, which requires estimation of useful life, salvage value, and a choice among depreciation methods affecting the timing of expense recognition. 1.7 Expense and revenue recognition can be different for purposes of calculating taxable income and earnings reported in the financial statements. Thus, companies calculate taxable income taking advantage of every item that will reduce income; and the firm reports the highest possible income to shareholders. Two sets of books (at least!) are kept: one for the I.R.S. and one for the annual report. The financial analyst should be aware of the "deferred taxes" account, which reconciles differences between taxable and reported income. 1.8 (a)
Annual Depreciation Expense =
Asset cost Dep. period
Annual Depreciation Expense =
$450,000 15
= $30,000
(b)
Accum. Dep. at end of Yr. 1 = $30,000 Accum. Dep. at end of Yr. 2 = Dep. Yr. 1 + Dep. Yr. 2 = $60,000
(c)
Year 1 $450,000 30,000 $420,000
Historical Cost Accum. Dep. Fixed Assets (Net) (d)
(e)
Year 2 $450,000 60,000 $390,000
Dep. exp. for tax purposes Dep. expense reported in financial statements Amount by which dep. exp. for tax purposes exceeds dep. exp. for reporting purposes Amount by which taxable exp. exceeds reported exp. Tax rate Amount by which reported tax exp. exceeds actual taxes paid 2
= $45,000 = $30,000 = $15,000 = $15,000 = 0.3 = $ 4,500
1.9 (a)
1. Switch to straight line depreciation if not using. 2. Lengthen depreciation period for depreciable assets. (Items 1 and 2 would lower quality unless made to reflect economic reality.) 3. Sell assets for a gain. 4. Postpone loss recognition on inventory or investments. 5. Reduce advertising and marketing expenditures. 6. Reduce research and development expenditures. 7. Reduce repair and maintenance expenditures.
(b) To have a positive "real" impact on the firm's financial position, the company would have to increase revenue from a beneficial policy rather than a cosmetic change or to reduce costs in a manner that would not impair the long-term profitability of the firm. Examples: 1. Have a special end-of-year sale, offer discounts, offer rebates. 2. Invest in plant and equipment at end of year to get tax savings from depreciation. 3. Get employees involved in cost-cutting measures. 4. Sell assets, if for a profit, that the firm had already planned to sell at some point because of inefficiencies.
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1.10 Memorandum Date: To: From: Subject:
Current Date B.R. Neal, Director of Marketing Student's Name Contents of an Annual Report
The company's annual report presents financial information about the firm. This information package is published primarily for shareholders and the general public. The major components of an annual report are briefly described in this memo. 1) An annual report contains four financial statements: The balance sheet shows the financial condition (assets, liabilities, stockholders' equity) at end of year; the income or earnings statement presents the results of operations including revenues, expenses, net profit or loss, and net profit or loss per share for the year; the statement of stockholders' equity reconciles beginning and ending balances of accounts in the equity section of the balance sheet; and the statement of cash flows shows inflows and outflows of cash from operating, financing, and investing activities for the year. 2) Notes to the financial statements provide additional detail about particular items in the financial statements. 3) The auditor's report is prepared by an independent accounting firm and attests to the fairness of the information presented. 4) The five year summary shows key financial data including net sales, income/loss from continuing operations on a dollar and per share basis, assets, long term debt, and dividends per common share. 5) Quarterly stock prices record how the company's stock shares have performed over the past two years. 6) Management's Discussion and Analysis provides management's perspective on how the company is doing including favorable or unfavorable trends, and significant events or uncertainties. The remaining material in the annual report is included primarily to provide background information about the company and its management, and to make the document attractive and interesting to read. If staff members would like to learn more about any of the material in the company's annual report, the following book is highly recommended: Understanding Financial Statements by Fraser and Ormiston (Prentice Hall, 2004).
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1.11 (a) Earnings management refers to the practice of using accounting choices and techniques in such a way that earnings reports reflect what management wants the user to see, instead of the true financial performance of the company. (b) Managers are motivated to meet the earnings expectations of analysts on Wall Street. Companies not meeting these expectations have been punished with immediate stock price declines. This in turn negatively impacts the firm's total market capitalization and the value of stock options granted employees. (c) The following five techniques used by companies create illusions according to Levitt: 1. "Big Bath" restructuring charges – these charges are taken when a company reorganizes its businesses. Often companies overestimate the amount of the charges which then results in income being recorded at a later date to correct the error. These supposed one-time charges are usually received on Wall Street favorably since analysts tend to focus on future earnings. Author's example: An example of restructuring charges which led to confusion occurred over the ten-year period from 1986 to 1996, when AT&T took four major restructuring charges totaling over $14 billion— more than their reported earnings for that entire period. 2. Creative acquisition accounting – classifying part of the acquisition price when a merger occurs as "in-process" research and development. This item is then written off in the year of acquisition because there is a chance that the research will not result in increased earnings. If, in fact, earnings are increased later, the already written off expense will not negatively impact the earnings number. Author's example: In 1998, Compaq acquired Digital and immediately wrote off over $3 billion of "in-process" research and development. 3. Cookie jar reserves – overestimating liabilities for such items as sales returns, loan losses or warranty costs. This results in expenses being recorded in the year of the estimation, but allows a company to reverse these charges in a year when earnings are lower than desired. Author's example: The W.R. Grace and Co. used cookie jar reserves to stash away profits to be used in later years to mask declining earnings. The 5
former in-house audit chief blew the whistle on the firm in 1999, but the company had been abusing these reserves since the early 1990s. 4. Materiality – the concept that insignificant items need not be reported. Some companies abuse this concept by arguing that items are insignificant when in fact they are meaningful to users. Author's example: Years ago many firms offered to pay for retirees' medical costs not covered by Medicare. This was a relatively inexpensive benefit at the time. Severe healthcare inflation quickly made this benefit extremely costly to firms; however, companies used the materiality concept to claim that this liability need not be reported. When FASB forced companies to disclose what they had promised in medical benefits, many companies reported large losses. In 1991, IBM reported an accumulated cost of over $2 billion for postretirement benefits. 5. Revenue recognition – recording revenue before the transaction has actually occurred. Two examples of recognizing revenue erroneously were discussed in Chapter 1: Waste Management, Inc. and Xerox. (d)
Levitt proposes the following steps of action: 1. The SEC must implement rules regarding more detailed disclosures of changes in accounting assumptions. 2. The AICPA must clarify the rules to auditors of what is acceptable and what is unacceptable with regard to the illusory techniques described above. 3. The SEC must publish better guidance on the concept of materiality. 4. The SEC should consider guidance on the do's and don'ts of revenue recognition. 5. Private sector standard setters need to address areas where current rules are inadequate. FASB needs to promptly resolve current issues which will bring clarity to the definition of a liability. 6. The SEC will formally target companies for review that appear to manage earnings and will aggressively act on abuses of the financial reporting process. 7. The way audits are performed must be assessed. 8. Audit committees must be empowered and function as the ultimate guardian of investors. 6
9. Corporate management and Wall Street must embrace a cultural change. Companies should be rewarded for honesty, not for being clever enough to deceive users through financial reporting. (e) Levitt believes that audit staff are insufficiently trained and supervised. He also believes that audit committees in some firms are severely lacking in financial expertise. Remedies include the investigation and review of the auditing process and the development of recommendations intended to empower audit committees to perform their job correctly. 1.12 (a) Intel supplies the computing and communications industries with chips, boards, systems and software building blocks for computers, servers and networking and communication products. (b)
The analyst could learn the following by reading the letter to stockholders: • the significant negative financial impact (21% revenue decrease and 88% decline in net income) of the worldwide recession on Intel. • nearly two-thirds of Intel's sales were outside the Americas. • Intel is responding to the recession by looking to the future and is increasing capital investments and research and development, while also finding ways to increase productivity and cut costs.
(c) Intel received an unqualified audit opinion. The audit report states that the audit was conducted according to generally accepted auditing standards and the financial statements are in conformity with generally accepted accounting principles. (d)
The MD&A for Intel discusses the following items: 1. The company expects the key source of liquidity to be internal cash, cash from operating activities and short-term investments and trade assets. A relatively small amount of cash is generated externally from the sale of stock through employee plans. To date, Intel has not used other external sources of cash, but the company has the potential to borrow on sale securities already registered with the SEC in the total amount of $4.4 billion ($3.0 billion in commercial credit plus $1.4 billion in debt, equity, and other financing sources). 2. No material deficiencies of liquidity currently exist. 3. Intel plans to spend $5.5 billion in 2002 for capital expenditures. Specifics are not given with regard to what the funds will be spent on 7
or how the funds will be acquired. It is implied that funds will be internally generated and used to increase capacity for future products. 4. No anticipated changes in the mix and cost of financing resources are discussed. 5. The new FASB accounting rule for goodwill will cause amortization expense to decrease, thereby causing operating income to increase in 2002. 6. See 5 above. 7. Sales decreased 21% overall, caused by a combination of lower volume and lower prices. (e) Intel appears to be doing a good job positioning themselves for an economic recovery, when, and if, that occurs. The company is largely dependent on the worldwide computing industry. As a result, the main concerns are whether the economy will recover in the near future and whether Intel's customers will have also positioned themselves for a recovery.
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CASE 1.1 THE WALT DISNEY COMPANY 1. The audit committee report gives a good summary of the audit committee's responsibilities and the general topics that the committee reviewed and approved in the prior year; however, the report does not offer any information in depth. Items that a shareholder might want to know more about include • how the committee monitors the preparation of financial reports; • how the committee determines the independence of auditors; • highlights of the seven meetings in 2001; • what significant accounting issues were discussed. 2. The Walt Disney Company paid their external auditor a total of $51,610 million in 2001. Of this amount $8,660 million, or less than 17%, was attributed to audit fees. The remaining 83% of fees paid were for consulting services for financial information systems and process improvements ($36,179 million or 70% of total fees) and other audit-related fees and tax services ($6,771 million or 13% of total fees). It appears there may be two conflict-of-interest concerns. First, the audit firm appears to be directly involved in auditing a financial information system they have helped design. How can this be independent? Second, the consulting fees are much larger than the audit fees, creating a potential conflict in that there may be a pressure to render a clean audit opinion in order to retain the consulting revenues the audit firm is receiving. This information is valuable to the shareholder to assess the independence of the audit firm and to determine how much reliance should be put on the auditors' report. 3. Support of Proposal 1 could be defended using items from the "supporting statement" as well as examples of recent scandals of firms that brought the relationship of the audit firm to the company being audited into question. (Waste Management, Xerox and Enron are just three of many possible examples.) Opposition of Proposal 1 could be defended using the items the Board of Directors offers as well as examples of companies who have not been accused of questionable accounting practices but have used their audit firm for consulting services. Instructor's Note: Before the shareholders even voted on this proposal, it was announced that the Board of Directors had voluntarily decided to not use the same firm for both auditing and consulting services. 9
CASE 1.2 CYBERONICS, INC. 1. The Management Discussion and Analysis section provides important information that cannot be found anywhere else in the annual report. The section covers trends, events, and uncertainties in the areas of liquidity, capital resources, and operations. Information should include a discussion of: a. b. c. d. e. f. g.
internal and external sources of liquidity; any material deficiencies in liquidity and how they will be remedied; commitments for capital expenditures and expected sources of funding; anticipated changes in the mix and cost of financing resources; unusual or infrequent transactions which affect income from continuing operations; events which cause material changes in the relationship between costs and revenues; and a breakdown of sales increases into price and volume components.
2. The MD&A includes the following discussion of the seven items outlined in (1) above: a.
b.
c.
d.
External sources are used exclusively to finance the company and have mainly been public and private placements of securities. Cyberonics has also used debt in the form of capital leases. In 2001 the company raised $42.5 million from the sale of common stock in a private equity offering. The company believes that the money raised will last through April 30, 2003. After that time it is unclear if the firm will be able to generate internal or external funds. Many factors will determine if cash will become available, such as future FDA approvals for their products resulting in increased sales, the state of the U.S. capital markets and economy and the health care and medical device environment. Cyberonics has no firm commitments but anticipates spending $4.2 million to expand manufacturing capabilities and to enhance business infrastructure and facilities. It is implied that the funding for these capital expenditures will be from the $42.5 million raised through the common stock offering. No changes to the current mix and cost of financing resources were discussed. 10
e. f.
g.
There is no indication of unusual or infrequent transactions occurring in the future, however, in 2001 the company incurred nonrecurring charges of $6.5 million to fend off a take-over by Medtronic, Inc. It appears that there may be many items causing changes in the relationship between costs and revenues in the future. Revenues are dependent on future FDA approvals and Cyberonics does not anticipate approval before 2003, so revenues will most likely remain the same or decrease in 2002. On the other hand, as the company pursues its many clinical studies, costs will probably increase. Cost of sales are predicted to fluctuate, significant increases in selling and general and administrative expenses are expected, and based on the past several years, it is likely that research and development expenses will also increase. Since the company will probably not incur changes in 2002 such as the $6.5 million nonrecurring charges it had in 2001, this should help offset some of the other increased costs. As the company uses the cash raised from the common stock offering, interest income will decrease in the future. Currency exchange rates could cause gains or losses in the future. Overall, it appears that Cyberonics will have less revenues and more expenses in 2002. The sales increase of 15% for the ten-month period ended April 27, 2001 was due to a combination of volume and product mix.
3. Cyberonics clearly explained changes in revenues and expenses as well as the sources of funding for the company. In addition, the company shared their expectations with regard to these items for the near future. 4. Answers will vary based on individual students' reactions to the risks involved in Cyberonics. Lack of FDA approval in the future could cause the worst case scenario -- bankruptcy. On the other hand, if Cyberonics can successfully develop treatments for depression, obesity, Alzheimer's or other disorders, the company's stock prices would increase significantly.
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Chapter 2 2.1 The estimation of the allowance for doubtful accounts affects both the valuation of accounts receivable on the balance sheet and the amount of bad debt expense recognized on the income statement. Changes in the allowance account relative to sales level and the amount of accounts receivable outstanding may be an indication that earnings quality is or is not being improved. For example, if a company expands sales by lowering its credit standards, then the allowance account should also be expanded if a quality earnings figure is to be reflected. 2.2 Inventories are a significant proportion of the asset structure for most firms (service firms are an exception). The inventory accounting method used will impact the valuation of inventories on the balance sheet and also the cost of goods sold expense on the income statement. If the valuation method is not realistic, the ending inventory and earnings figure will be distorted. 2.3 Although LIFO generates a larger cost of goods sold expense and lower earnings in a period of inflation, the tax benefits may outweigh the costs of reporting a lower earnings figure. Use of LIFO reduces a firm's taxable income and, thus, the firm saves in terms of actual cash, not just paper figures. 2.4 The straight-line method of depreciation spreads the expense evenly by periods, while the accelerated methods yield higher depreciation expense in the early years of an asset's life and lower expense in the later years. Use of an accelerated method for tax reporting tends to defer tax liabilities for firms which invest heavily in depreciable assets. For reporting purposes, straight-line depreciation will yield a higher earnings figure in the early years and will also distribute expense recognition smoothly. 2.5 The retained earnings account is the measurement of all undistributed earnings. The account does not represent cash in any way. A company can have positive retained earnings and have a zero cash balance. 2.6
A
B
C
Inventory Assets
28%
65%
43%
Net Fixed Assets Total Assets
40%
15%
11%
A is a manufacturer, B is a retailer and C is a wholesaler. 12
2.7 (a) January Total Inventory (Beg. Inv. + P)
Cost of Goods Sold
Ending Inventory (Tot. Inv. - COGS)
FIFO
$30,000 +$14,000 $44,000
8,000 x $3.00 $24,000
$44,000 - $24,000 $20,000
LIFO
$30,000 + $14,000 $44,000
4,000 x $3.50 + 4,000 x $3.00 $26,000
$44,000 - $26,000 $18,000
Ave. Cost
$30,000 + $14,000 $44,000
8,000 x ($44,000 ÷ 14,000) $25,120
$44,000 - $25,120 $18,880
Beginning Inventory: 10,000 units or $30,000 Purchases (P): 4,000 units x $3.50/unit = $14,000 Total Inventory (units): 14,000 units Sales (units): 8,000 units February Total Inventory (E. I. for Jan + P)
Cost of Goods Sold
Ending Inventory (Tot. Inv. - COGS)
$20,000 + $40,000 $60,000
2,000 x $3.00 4,000 x $3.50 + 5,000 x $4.00 $40,000
$60,000 - $40,000 $20,000
LIFO
$18,000 + $40,000 $58,000
10,000 x $4.00 + 1,000 x $3.00 $43,000
$58,000 - $43,000 $15,000
Ave. Cost
$18,880 + $40,000 $58,880
11,000 x ($58,880 ÷ 16,000) $40,480
$58,880 - $40,480 $18,400
FIFO
Purchases (P): 5,000 x $4.00 + 5,000 x $4.00 = $40,000 Total Inventory (units): 16,000 units Sales (units): 11,000 units 13
March Total Inventory (E.I. for Feb + P)
Cost of Goods Sold
Ending Inventory (Tot. Inv. - COGS)
$20,000 + $67,000 $87,000
5,000 x $4.00 6,000 x $4.50 + 1,000 x $5.00 $52,000
$87,000 - $52,000 $35,000
LIFO
$15,000 + $67,000 $82,000
8,000 x $5.00 + 4,000 x $4.50 $58,000
$82,000 - $58,000 $24,000
Ave. Cost
$18,400 + $67,000 $85,400
12,000 x ($85,400 ÷ 19,000) $54,000
$85,400 - $54,000 $31,400
FIFO
Purchases (P): 6,000 x $4.50 + 8,000 x $5.00 = $67,000 Total Inventory (units): 19,000 units Sales (units): 12,000 units Totals FIFO
LIFO
Average Cost*
$24,000 40,000 + 52,000 $116,000
$26,000 43,000 + 58,000 $127,000
$25,120 40,480 + 54,000 $119,600
Ending Inventory
$35,000
$24,000
$31,400
End. Inv. + COGS
$151,000
$151,000
$151,000
Total Cost of Goods Sold
*Average Cost may be calculated by combining all three months but answers must be adjusted, so that COGS + Ending Inventory = $151,000 (b) LIFO produces an understated inventory valuation on the balance sheet but a currently valued cost of goods sold on the income statement, matching current costs with current revenues; FIFO results in a currently valued balance sheet inventory but an understated cost of goods sold expense and thus an overstatement 14
of net income; average cost falls in between LIFO and FIFO and is a good choice for companies with volatile inventories. 2.8 $150,000 x 0.14 = $21,000 annual interest $21,000 = $1,750 monthly interest 12 $1,750 x 5 months = $8,750 accrued interest for 5 months (July 31 to December 31) 2.9 Revenue Expenses Earnings before Taxes Tax Expense (34%) Net Income
Tax Purposes $800,000 550,000 $250,000 85,000 $165,000
Reported Tax Expense Actual Taxes Paid Deferred Tax Liability
$108,800 (85,000) $23,800
Reporting Purposes $800,000 480,000 $320,000 108,800 $211,200
2.10 Treasury stock is shown as a reduction of shareholders' equity. (Most companies use the cost method rather than the par value method to account for treasury stock, so the cost of the treasury stock is deducted.) The number of shares acquired for treasury is deducted from the number of shares outstanding used to compute earnings per share; thus a firm can increase earnings per share by purchasing treasury stock. 2.11 Revenues Total Receivables Allowance for doubtful accounts
Change from 2000 to 2001 (9.59%) (38.50%) (79.11%)
15
Allowance account as a percentage of receivables:
2001 2000
Allowance for doubtful accounts Net Receivables + Allowance
Percentage of Receivables
$244 $20,183 + $244
1.19%
$1,168 $32,045 + $1,168
3.52%
As revenues have declined at Winnebago Industries, Inc., receivables have also declined. This is an expected pattern, however, it appears that the decline in the allowance account is more than one would expect. The downturn in the economy in 2001 could explain the decline in revenues, but generally it would be expected that the allowance for doubtful accounts would at least remain the same or even possibly increase relative to the receivables account if the economy worsens. The management at Winnebago believe that a higher percentage of receivables will be collected compared to prior years as evidenced by the drop in the allowance/receivables ratio from 3.52% to 1.19%. The analyst would want to explore the reason for this change. If no valid explanation can be found, it is possible that the account has been underestimated in order to increase earnings. 2.12 (a) LIFO is probably used for some or all of Maytag's inventories. Companies using LIFO must disclose the value of those inventories as if FIFO had been used, which Maytag has done in this case. (b) The amount closest to current cost would be the FIFO inventory value, $531,695. Under FIFO, the first goods purchased are assumed sold, so the last goods purchased would be included in the inventory valuation and would have been purchased at amounts closest to current costs.
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2.13 Chester Co. Balance Sheet at December 31, 20XX Assets Current Assets Cash Accounts receivable Inventory Prepaid expenses Total Current Assets Property, plant and equipment Less accumulated depreciation Property, plant and equipment, net Land held for sale Total Assets
$1,500 6,200 12,400 700 $20,800 34,000 (10,500) $23,500 9,200 $53,500
Liabilities and stockholders' equity Current liabilities Accounts payable Notes payable Accrued interest payable Current portion of long-term debt Total current liabilities Deferred taxes payable Bonds payable Total liabilities Stockholders' equity Common stock Additional paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity
17
$4,300 8,700 1,400 1,700 $16,100 1,600 14,500 $32,200 2,500 7,000 11,800 21,300 $53,500
2.14 There is no solution presented here for this exercise, but the authors would welcome students' responses. Some possibilities might include Exhibits 2.3 and 2.4 presented in bar or pie chart format; a diagram showing the cost flow assumptions used to value inventory; a pie chart displaying types of depreciation used for financial reporting; a drawing illustrating a distraught reader trying to understand accounting for deferred federal income taxes. 2.15 There is no solution presented here since a variety of companies may be used for this problem. Assigning a single corporation will allow instructors to review answers in the class as a whole. 2.16 (a)
INTEL Common Size Balance Sheet
Assets: Current Assets Cash and equivalents Short-term investments Trading assets A/R Inventories Deferred tax assets Other current assets Total current assets Property, plant and equipment Less: accumulated depreciation Property, plant and equipment, net Marketable strategic equity securities Other long-term investments Goodwill, net Acquisition-related intangibles, net Other assets Total Assets
18
2001
2000
18% 5 3 6 5 2 1 40% 77 (36) 41% -3 10 2 4 100%
6% 22 1 9 5 1 -44% 59 (28) 31% 4 4 10 2 5 100%
2001 Liabilities: Current liabilities Short-term debt A/P Accrued compensation and benefits Deferred income on shipments Accrued advertising Other accrued liabilities Income taxes payable Total current liabilities Long-term debt Deferred tax liabilities Total liabilities Stockholders' equity Common stock Acquisition-related unearned stock compensation Accumulated. other comprehensive income Retained earnings Total stockholders' equity Total liabilities & stockholders' equity
2000
1% 4 3 1 1 3 2 15% 2 2 19%
1% 5 4 1 2 3 2 18% 1 3 22%
20 --61 81% 100%
18 --60 78% 100%
(b) The current assets of Intel include cash, short-term investments, trading assets, accounts receivable, inventories, deferred tax assets and other current assets. Long-term assets are composed of property, plant and equipment, marketable strategic equity securities, long-term investments, goodwill, acquisition-related intangibles and an other assets account. The most significant assets to the company are cash and short-term investments, property, plant and equipment and goodwill. Trading assets and available-for-sale investments are reported at fair value. Nonmarketable equity securities are accounted for at historical cost, or, if Intel has significant influence over the investee the equity method is used. Inventories are valued using current average or FIFO. Straight-line depreciation is used for depreciating property, plant and equipment for financial reporting purposes. Other items learned from the notes about asset accounts include information about Intel's many investments, derivative financial statements, a break-down of the inventory account into raw materials, work in process and finished goods, the estimated useful lives of plant and equipment and goodwill and other acquisitionrelated intangibles. 19
The asset structure has shifted somewhat. Intel has reduced current assets (shortterm investments and accounts receivable) and invested more heavily in fixed assets. Marketable strategic equity securities and other long-term investments have also been reduced. (c)
2001 2000
Allowance account as a percentage of accounts receivable: Allowance for doubtful accounts Net Receivables + Allowance
Percentage of Receivables
$68 $2,607 + $68
2.54%
$84 $4,129 + $84
Sales Total Accounts Receivable Allowance for doubtful accounts
1.99%
Change from 2000 to 2001 (21.3%) (36.5%) (19.0%)
As sales have decreased so have accounts receivable and the allowance for doubtful accounts. Intel has been conservative in decreasing the allowance account as evidenced by the increase in percentage of estimated bad debts from 1.99% to 2.54%. This appears reasonable given the economic downturn that occurred in 2001. (d) Intel has the typical liabilities found on most companies' balance sheets: short-term debt, accounts payable, accrued liabilities, deferred income, income taxes payable, long-term debt and deferred tax liabilities. No one liability account is significant. In 2001, only 19% of the capital structure is debt, while 81% is equity. There have been no significant changes to the debt and equity structure. (e) Intel has commitments for operating leases and is committed to pay $610 million in the future (2002 and thereafter). The company has also committed to construct or purchase property, plant and equipment of approximately $1.9 billion. Contingencies include a lawsuit filed by Intergraph Corporation regarding patent rights, other various litigation proceedings and a potential liability for environmental clean-up. 20
(f) Deferred taxes are included under current assets and noncurrent liabilities. Depreciation is the most significant component of deferred taxes. (g) Intel has the following equity accounts: Preferred stock, Common stock, Acquisition-related unearned stock compensation, Accumulated other comprehensive income and Retained earnings.
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CASE 2.1 US AIRWAYS, INC. 1. US Airways, Inc. Common Size Balance Sheet December 31, ASSETS
2001
Current Assets Cash Cash equivalents Short-term investments Receivables, net Receivables from related parties, net Materials and supplies, net Deferred income taxes Prepaid expenses and other Total Current Assets Property and Equipment Flight equipment Ground property and equipment Less accumulated depreciation and amortization Purchase deposits for flight equipment Total Property and Equipment Other Assets Goodwill, net Pension assets Other intangibles, net Receivable from parent company Other assets, net Total Other Assets
22
-6% 6 4 2 2 -2 22
2000 -5% 9 4 1 3 5 2 29
91 15 (49) 57 -57
73 12 (33) 52 -52
7 5 4 1 4 21 100%
6 4 4 1 4 19 100%
LIABILITIES AND STOCKHOLDER'S EQUITY (DEFICIT) Current Liabilities Current maturities of long-term debt 2% Accounts payable 8 Traffic balances payable and unused tickets 10 Accrued aircraft rent 3 Accrued salaries, wages and vacation 5 Other accrued expenses 9 Total Current Liabilities 37 Noncurrent Liabilities Long-term debt, net of current maturities 44 Accrued aircraft rent 4 Deferred gains, net 7 Postretirement benefits other than pensions 19 Employee benefit liabilities and other 22 Total Noncurrent Liabilities 96 Commitments and Contingencies Stockholder's Equity (Deficit) Common stock, par value $1 per share, authorized, 1,000 shares, issued and outstanding 1,000shares -Paid-in capital 33 Retained earnings (deficit) (36 ) Receivable from parent company (28 ) Accumulated other comprehensive income (loss), net of income tax effect (2 ) Total Stockholder's Equity (Deficit) (33 ) 100 %
3% 6 10 4 3 5 31 30 2 7 15 20 74
-29 (9) (25) -(5) 100%
2. The asset structure of US Airways has shifted from current to noncurrent assets by 7 percentage points. Short-term investments and deferred taxes have decreased as equipment, goodwill and pension assets have increased as a percentage of total assets. Significant changes have occurred in the debt and equity structure of US Airways. Accounts payable and accrued expenses have caused current liabilities to increase. Long-term debt has grown an alarming 14% from 2000 to 2001. In addition, pensions and postretirement benefits have also increased. It appears that US Airways experienced a significant loss in 2001 as the retained earnings deficit increased by 27%. US Airways has more debt than total assets in both 2000 and 2001.
23
3. Investors and creditors would be concerned about both the potential profitability of US Airways and the ability of the firm to generate enough cash to pay the large amounts of debt that will ultimately come due. The most immediate concern is that the current assets of the company have declined and are far less than the current liabilities. How will US Airways be able to pay bills in the next year? Most resources are tied up in property, plant and equipment, items not easily saleable if cash is needed immediately. US Airways' total debt is 133% of total assets, therefore, investors and creditors should be concerned about potential bankruptcy of the firm. 4. Investors and creditors would want to look at all other financial statements, the notes to the financial statements, the management discussion and analysis, the auditor's report and stock price information. SEC documents, Form 10-K, Form 10-Q and Form 8-K reports, would be a good source of both financial and nonfinancial information. Financial information of competitors would be useful for comparison purposes. Nonfinancial information from newspapers and periodicals would also be useful. In particular, investors and creditors would want to determine the prospects of US Airways for the future by researching the following: • current trends in the airline industry; • security and terrorism issues affecting airlines; • possible funding from the Federal government.
24
CASE 2.2 Royal Appliance Mfg. Co. 1.
2001
2000
Accounts Receivable Total Assets
25.6%
30.4%
Inventories Total Assets
36.2%
32.8%
Account Receivable Net sales
8.4%
10.3%
Inventories Net sales
11.9%
11.1%
Accounts receivable relative to total assets and net sales have declined, while inventories have been increasing. It is possible that the downturn in the economy has caused this trend. Fewer customers or customers having financial problems could cause a decline in credit sales, leaving Royal with excess inventory. Another explanation could be that Royal tightened their credit policy, thereby causing fewer credit sales and more inventory left in stock. 2. Allowance account as a percentage of accounts receivable: 2001 7.7%
Allowance for doubtful accounts Net accounts receivable + allowance
2000 3.0%
Percent Changes Change from 2000 to 2001 4.9% (10.2%) 130.8%
Net sales Total accounts receivable Allowance for doubtful accounts
The trend in the percentage estimate of doubtful accounts relative to accounts receivable and the pattern of growth rates from sales, accounts receivable and the allowance for doubtful accounts is not normal. The decline in accounts receivable as sales are increasing would indicate a possible tightening of credit policy or 25
fewer customers buying on credit. Royal has significantly increased the expected amount of bad debts despite the decline in accounts receivable. Note 7 offers a reason for this unusual pattern. Royal's customers are generally mass market retailers. Some of these customers have been experiencing financial difficulties and some, such as Kmart, have filed for protection from creditors under bankruptcy laws. As a result, Royal's bad debt expenses have increased, which in turn, will lower profits and possibly cash collected. 3. Royal is a manufacturing company and therefore carries three types of inventories: component parts (raw materials), work in process and finished goods. Royal combines component parts and work in process in one inventory account. The company uses the FIFO method. FIFO includes the most recently acquired goods in ending inventory, therefore the amounts for inventories on the balance sheet do reflect current costs. 4. The answer to this question depends on the assumption made about the effect of inflation on Royal. If it is assumed that Royal operates in an inflationary environment, then the company has probably paid more in taxes, since the lower priced goods would be changed to cost of goods sold, increasing income and taxes. If it is assumed that Royal operates in a deflationary environment, then the company has probably realized tax savings, since cost of goods sold would include the higher priced goods, causing income and taxes to be lower. 5. Total property, plant and equipment is the most significant noncurrent asset category to Royal, accounting for 59.9% of total assets. The net property, plant and equipment accounts for 26.8% of total assets. The relative proportions of current and noncurrent asset seem reasonable for an appliance manufacturer. Plant and equipment is necessary for the manufacturing of appliances and compared to Exhibit 2.5 in the "Understanding Financial Statements" text book, 26.8% falls in the range given for a variety of manufacturers. Inventories, the most significant current asset for Royal, also falls in the range of inventories to total asset percentages listed in Exhibit 2.4 of the textbook. 6. Royal's current liabilities include accounts payable, accrued liabilities and current portions of capital lease obligations and notes payable. Noncurrent liabilities include a revolving credit agreement, capital lease obligations and deferred income taxes. Total liabilities relative to total assets have declined by about 5% from 2000 to 2001. This overall change was caused by several significant changes in liability 26
accounts. Relative to total assets, the revolving credit agreement declined by almost 11%, however current liabilities increased by 6%. In particular accounts payable, accrued salaries, benefits and payroll taxes and income taxes increased the most. 7. Yes, Royal has both commitments and contingencies. Commitments include operating leases with future minimum lease payments in the amount of $26, 640,000, commitments for future advertising and promotional expense of approximately $3,000,000 and other business commitments of approximately $4,300,000. Since operating leases are a form of off-balance-sheet financing, these are significant when looking at the debt structure of the company. Contingencies Royal has include lawsuits filed by Hoover and Bissell charging patent infringement by Royal, as well as a variety of other claims and litigation. in addition, Royal has filed patent infringement suits against Hoover and Bissell. Should Hoover and/or Bissell prevail on their claims, Royal could experience material adverse effects financially. No information is given to determine the probability of this occurrence. 8. Deferred income taxes appear in two classifications: current assets and noncurrent liabilities. Companies are required by GAAP to report one net current and one net noncurrent amount for deferred taxes based on when the temporary differences will reverse in the future. The two principal sources of timing differences for Royal are warranty and customer returns and basis difference in fixed and intangible assets, i.e., depreciation. The warranty and customer returns have caused an expense deduction for financial reporting purposes but not for tax purposes, causing Royal to pay more in taxes now and creating a deferred tax asset. Depreciation has created a deferred tax liability, because less tax has been paid due to a lower depreciation expense on the tax returns compared to higher depreciation expense for financial reporting purposes. 9.
Common shares + Additional paid-in-capital Number of shares issued $214,000 + $44,167,000 25,829,452 shares
= $1.72 per share
27
10.
Treasury shares, at cost $76,248,000 = Number of Treasury shares 12,365,700 shares
= $6.17 per share
The cost of treasury shares causes the shareholders' equity to be less for Royal. it would be helpful to have information on the reasons why the board of directors has embarked on a repurchase program. Is it merely to increase earnings per share, or does the board believe the stock is truly undervalued? Royal has a significant amount of debt, so the board has made a choice to use cash to repurchase stock instead of paying down debt. The future market value of Royal's stock will help answer the question if this was an appropriate investment decision by the board. Instructor's Note: The market value of Royal's common stock ranged from a low of $3.15 per share to a high of $6.61 per share in 2001. 11. Beginning retained earnings $61,165
+ +
Net income - Dividends = $9,324
-
28
$0
=
Ending retained earnings $70,489
Chapter 3 3.1 The multiple-step format provides several intermediate profit measures: gross profit, operating profit, and earnings before income taxes. The single-step format groups revenues together and then deducts all categories to arrive at net earnings. The multiple-step format is the most useful for analysis. 3.2 Depreciation, amortization, and depletion are all methods of allocating the costs of long-lived assets over their service lives. The difference among the three methods is the nature of the assets. Depreciation is used for tangible fixed assets such as buildings, machinery, and equipment. Amortization is used for intangible assets such as patents, copyrights, trademarks, licenses, franchises and capitalized leases. Depletion is used for natural resources such as oil and gas, minerals, and timberlands. 3.3 For a business firm to operate successfully it must spend a minimum amount on operating expenses to be competitive. Allowing operating expenses to grow faster than sales growth, however, may indicate a lack of control over expenses, waste or inefficiencies. Decreasing certain expenses such as advertising, research and development or repairs and maintenance may be detrimental to long-term sales growth. 3.4 The beverage and athletic shoes industries are examples of industries that must advertise regularly or risk losing market share (see example of Coca-Cola and Pepsi in Chapter 1). The pharmaceutical and high technology industries are examples of industries that must do extensive research and development to create new and innovative products. 3.5 The statement of stockholders' equity summarizes the changes in all of the equity accounts, including the retained earnings account. 3.6 The net income figure is based on accounting choices and estimates. The inventory valuation and depreciation methods chosen can vary significantly and impact differently on net income. Discretionary items such as advertising and repairs and maintenance can be manipulated to change the net income of a firm. Use of the equity method for investments may also distort net income. Nonrecurring and nonoperating items are included in net income. Net income also incorporates accounting changes and extraordinary items. Finally, net income does not equal cash flow. 29
3.7
2002 to 2003
2001 to 2002
21.0% 22.2%
62.5% 63.6%
Sales growth Operating expense growth
2002
2003 Cost of goods sold Gross profit margin Operating profit margin Average tax rate Net profit margin
78.8 % 21.2 11.9 42.9 6.8
76.9 % 23.1 13.8 42.6 7.9
2001 70.8 % 29.2 20.0 43.8 11.3
Sales growth over the three-year period is strong, but the rate of increase decreased 2002-2003 relative to 2001-2002. Sales growth could be the result of price increases, volume increases, or both. The reduction in the gross profit margin indicates problems with inventory cost controls, the pricing of products, or a combination of these factors. The decrease in the operating profit margin is partly a flow-through from the gross profit margin and the result of increasing operating expenses; operating expenses are increasing at a slightly faster rate than sales. Finally, the combination of problems with inventory management, pricing, and control of operating expenses has produced a deteriorating net profit margin. Tax expense has not been a contributing factor because the average tax rate decreased between 2001 and 2003. 3.8 Using the equation from Chapter 2, the calculations to determine dividends are as follows: Beginning retained earnings 1999 2000 2001
$ 760,115 1,026,288 1,171,364
+ + + +
net income - dividends = 328,528 200,967 47,736 -
30
62,355 = 55,891 = 55,079 =
Ending retained earnings 1,026,288 1,171,364 1,164,021
3.9 Investment Income
Investment Account
(a) Cost method
$12,500*
$500,000
(b) Equity method
$62,500**
$550,000***
* $50,000 cash dividends x 25% ** $250,000 earnings x 25% *** $500,000 + $62,500 - $12,500 3.10 Coyote Inc. Income Statement for the Year Net sales Cost of goods sold Gross profit Selling expenses General and administrative expenses Depreciation expense Operating profit Other Income (expense) Interest income Interest expense Pre-tax income Income tax expense Net income
$1,833,000 1,072,000 761,000 279,000 175,000 14,000 293,000 13,000 (16,000) 290,000 116,000 $174,000
3.11 Compare the following paragraphs, one more descriptive and the other more analytical. Have students assess their own writing as to the extent to which they have analyzed rather than described Elf Corporation's profit performance. Descriptive Paragraph Net income for Elf Corporation increased by $15 million in 2001 and 2000. Sales also improved—by $100 million in 2000, but by only $50 million in 2001. The gross profit margin remained constant over the three-year period at 50%, as did the average tax rate. Administrative expenses remained constant at $100 million. Elf Corporation expended $75 million for advertising and marketing in 1999 and 2000 but reduced these expenditures to $50 million in 2001. Interest expense rose by $20 million in 2000 and 2001. 31
Analytical Paragraph Net income for Elf Corporation increased in 2000 and 2001, but at a decreasing rate. Sales also improved both years, but at a decreasing rate. Elf Corporation maintained a 50% gross profit margin, reflecting the firm's ability to control the cost of products sold or to pass along price increases to customers. The increase in the rate of profit was impaired in 1995 by slower sales growth and by continued high interest expense. The rise in interest expense could be due to higher interest rates but probably is evidence of increased corporate borrowing, which could signal problems or be the result of expansion. The $50 million increase in operating profit in 2001 has been achieved by reducing expenditures for advertising and marketing, which could help explain the slower sales growth in 2001 and could impair sales in the future. 3.12 There is no solution presented here since the list of technical projects on the FASB agenda is ever-changing. 3.13 (a)
INTEL Common Size Income Statement
Sales Cost of Sales Gross Profit Research and development Marketing, general and administrative Amortization Purchased in-process research and development Operating income Gains (losses) on equity securities, net Interest and other, net Income before taxes Provision for taxes Net Income Effective tax rate
2001 100.0% 50.8 49.2 14.3 16.8 8.8
2000 100.0% 37.5 62.5 11.6 15.1 4.7
1999 100.0% 40.3 59.7 10.6 13.2 1.4
0.8 8.5
0.3 30.8
1.3 33.2
(1.8) 1.5 8.2 3.4 4.8%
11.1 2.9 44.8 13.6 31.2%
3.0 2.0 38.2 13.3 24.9%
40.9%
30.4%
34.9%
2000 - 2001 (21.3 %) 4.1 %
Growth rates Net revenues Total operating costs 32
1999 - 2000 14.8% 18.9%
Analysis of Income Statement Volatility exists with regard to revenues and expenses of Intel, as evidenced by the growth rates of revenues and operating costs from 1999 to 2001. From 1999 to 2000, operating expenses grew faster than revenues which negatively impacted operating profits. In 2001, revenue declined, however, expenses increased and therefore, had a significant negative impact on operating profit. While volatility is undesirable, it is expected in the high-tech industry. The Management’s Discussion and Analysis (MDA) states that the revenue decline in 2001 is due to lower volume and lower selling prices of microprocessors. In addition, revenues declined in all other product lines. The worldwide economic slowdown negatively impacted Intel, as well as most companies in the technology industry. The gross profit margin decreased significantly from 1999 to 2001. The MDA also explains why this occurred. Lower selling prices and high fixed costs are the main cause of the decline in gross profit. Positive changes in gross profit in 2000 compared to 1999 were the result of higher demand and higher prices for flash memory, as well as greater volume sales of microprocessors without an increase in fixed costs. Operating profit has declined each year, but the drop in 2001 was huge. All expenses with the exception of purchased research and development have increased each year. In raw dollars, research and development and marketing, general and administrative costs actually decreased; the percentage relative to sales is higher because of the large decline in sales. It is important for Intel to maintain research and development in order to gain a competitive edge in new product development. Intel was able to reduce dollars spent in research and development in 2001 by cutting travel-related expenses. Intel is also expanding through acquisitions to remain competitive in an ever-changing technology environment. Over the past three years Intel has acquired forty other companies and this has significantly increased amortization expense. (See notes to the financial statements.) Marketing, general and administrative costs increased due to the “Intel Inside” ad campaign, as well as profit-dependent bonus expenses and costs related to acquisitions. However, in 2001, Intel reduced spending on the ad campaign and bonuses. In 2000, Intel achieved abnormally high investment gains. These gains were most likely attributed to a booming economy and stock market in that year. The worldwide economic downturn in 2001 caused Intel to incur losses on investments. Interest income and other, net, increased in 2000, again due to favorable economic conditions and higher returns on investments. This number declined in 2001 as 33
interest rates cuts were made by the Federal Reserve Bank. The effective tax rate increased by over 10% in 2001 due to the nondeductibility of acquisition related items. Net profits were healthy in 1999 and 2000, but the bleak year of 2001 caused a significant decline in net profit of over 26%. While it is unlikely Intel will be able to achieve net profit margins of 20% and greater in the near future, it does appear that Intel is positioning themselves to achieve greater revenues. If costs are managed well, profits should trend upward. To continue to be successful, Intel must maintain good control of expenses, while continuing to develop cutting edge products. (b) The common stock account has increased over the three-year period due to the issuance of common stock and assumption of stock options in connection with acquisition and also because of sales of common stock through employee stock plans. Accumulated other comprehensive income increased significantly in 1999, but then declined dramatically in 2000. The cause of both changes was from unrealized gains and losses on available-for-sale investments. The retained earnings account increased overall during the three-year period but declined from 2000 to 2001. Increases were generated largely by net income and decreases to this account included the repurchase and retirement of common stock. It appears that the changes to the accumulated other comprehensive income account may reflect the booming economy in 1999 and then the economic downturn (especially of high technology companies) in 2000 and 2001. Net income was substantially lower in 2001 compared to prior years and the result was a decreasing retained earnings account. Intel is repurchasing and retiring common stock each year. Since the amounts repurchased (305 million shares) are close to the amounts sold (309 million shares) through employee stock plans, it is possible that Intel is trying to mitigate the dilutive effects of issuing stock on earnings per share.
34
CASE 3.1 THE WALT DISNEY COMPANY 1. The format of the income statements is neither a multiple-step, nor a singlestep format. Virtually all operating expenses are lumped together in one account, making it difficult to assess particular areas of strength or weakness of the Walt Disney Company (Disney). It is impossible to calculate gross profit margin, a ratio that is especially helpful to the investor or creditor. Operating profit margin can be calculated, but the analyst would need to decide which items to include in this calculation. A better presentation would include cost of sales, gross profit and operating profit. It would also be helpful for Disney to break out key operating expenses such as advertising and other selling and general and administrative costs. 2. One way to evaluate the income statement would be to reorder the line items and prepare a common size income statement such as the following:
35
The Walt Disney Company Common Size Income Statement Year Ended September 30, (in percent) 2001 100.00 85.76 3.04 5.75
Revenues Cost and expenses Amortization of intangible assets Restructuring and impairment charges Operating profit Gain on sale of businesses Net interest expense and other Equity in the income of investees Income before income taxes, minority interests and the cumulative effect of accounting changes: Income taxes Minority interests Income before the cumulative effect of accounting changes Cumulative effect of accounting changes: Film accounting Derivative accounting Net (loss) income Effective tax rate Revenue growth Operating expense growth *
2000 100.00 85.22 4.85 0.36
1999 100.00 85.40 1.95 0.73
5.45 0.09 (1.65) 1.19
9.57 1.92 (1.95) 0.82
11.92 1.47 (2.61) (0.54)
5.08 4.19 0.41
10.36 6.32 0.42
10.24 4.32 0.38
0.48
3.62
5.54
(0.90) (0.20) (0.62)
--3.62
--5.54
82.54%
61.00%
42.20%
2000-2001 (0.59% ) 3.94%
1999-2000 8.37% 11.26%
*includes cost and expenses, amortization and restructuring and impairment charges Disney's revenues grew from 1999 to 2000 but then declined in 2001. Since the year-end for the company is September 30, most likely the negative effects on revenue from the terrorist attack on September 11, 2001 will not show up until the 2002 financial reports. Of even more concern is that regardless of revenue growth or decline, operating expenses are growing faster than revenues in all years. 36
Costs and expenses overall are stable at around 85%, however, more detail is needed to assess the efficiency of Disney with respect to such items as advertising or general and administrative expenses. Operating profit declines each year, probably due to acquisitions and the corresponding amortization charges, as well as the enormous restructuring and impairment charge in 2001. Disney has made some poor investment decisions in the Internet area and is paying the price in 2001. The write-offs related to the GO.com portal business closure and other investments in the Internet area should be a one-time charge. Income before income taxes, minority interests and special items have followed the same overall trend of operating profit, although in 2000, Disney increased this figure slightly, due to an increase on gains on sale of business combined with lower interest expense and other items. On a positive note, it appears that the equity income is increasing and can be attributed to Disney's investment in Euro Disney. Of course, it is now unknown what the effects of terrorist attacks might have on this investment. Disney's exceedingly high effective tax-rate is explained by the lack of deductibility of amortization expense every year. In 2000 and 2001 Disney also had items related to dispositions and the impairment of intangible assets that caused the tax rate to be large. Cumulative effects of accounting changes negatively impacted net profit margin in 2001. Since these items should be one-time charges, 2002 should not be affected. Net profit margin has been on a downward trend for the same reasons prior earnings figures have declined. Even though the one-time charges will disappear for future years, the impact of the economic downturn and possible future terrorist attacks may continue to put downward pressure on Disney's revenues and earnings in the future. 3. The information in Note 15 is useful in assessing future operations of Disney. Investors and creditors could further evaluate the prospects of the purchase of Fox Family Worldwide by analyzing Fox’s prior financial statements and researching the company. Interesting information revealed in Note 15 is that Disney paid $5.2 billion for what appears to be $1.1 billion of assets. Without further information, one can only guess that almost 80% of the purchase price may be goodwill. Obviously the programming commitments mentioned in the note have some value, however, given the economic downturn and recent past history of 37
Disney's investment choices, more information is needed to determine if the purchase price paid was more than the value Disney will receive. The Pro Forma Results of Operations are not particularly useful. Their main purpose appears to be for Disney to show users of their financial statements positive net income numbers in a poor year. The GAAP-based income statements reflect the prior poor decisions of management, useful information for any user. A more helpful Pro Forma Results of Operations would have been one under the assumption that Fox Family Worldwide had been a part of Disney in 2001.
38
CASE 3.2 MICRON TECHNOLOGY, INC. 1. (a)
Micron Technology, Inc. Common Size Income Statement (Percent) 2001 2000 1999 Net sales 100.0 100.0 100.0 COGS 97.2 48.9 75.6 Gross margin 2.8 51.1 24.4 Selling, general and administrative 13.3 6.9 10.8 Research and development 12.4 6.7 12.4 (0.1) 2.0 Other operating expense (income) 1.9 Operating income (loss) (24.8 37.6 (0.8) ) Interest income 3.4 1.8 3.2 Interest expense (0.4) (1.5) (5.0) Gain (loss) on issuance of subsidiary stock (0.1) 0.0 0.1 0.2 0.0 Other non-operating income (expense) (2.5) Income (loss) before taxes and minority interests (24.4 38.1 (2.5) ) Income tax (provision) benefit 11.3 (13.1 1.0 ) Minority interests in net income (0.2) (0.7) (0.8) Income (loss) from continuing operations (13.3 24.3 (2.3) ) Loss on discontinued PC operations, net of taxes and minority interest: Loss from operations of PC business (0.9) (0.7) (0.4) 0.0 0.0 Loss on disposal of PC Operations (1.7) Net loss from discontinued PC Operations (2.6) (0.7) (0.4) (2.7) Net income (loss) (15.9 23.6 ) (b) Sales growth Operating cost growth* *Includes Cost of goods sold. Effective tax rate
1999-2000 147.1% 53.0%
2000-2001 (38.1% ) 23.7% 2000 34.2%
2001 46.5% 39
1999 39.0%
2. Volatility in the high technology industry is evident when looking at the past three years of income statement information for Micron Technology. While Micron realized significant sales growth from 1999 to 2000, operating costs did not increase proportionately and the Company realized substantial earnings growth. However, from 2000 to 2001 sales growth declined significantly while operating costs increased at a hefty rate. Sales growth in 2000 was driven by volume increases. Product shipments increased 50% from 2000 to 2001 but this did not translate into higher sales due to the huge decline in selling prices. According to the management discussion and analysis (MDA), average selling prices declined by 60% to 85% probably due to competitive pressures and a weak economy. The gross profit margin reflects the above-mentioned items. From 1999 to 2000 the large increase in gross profit was most likely due to decreases in manufacturing costs since average selling prices only increased 3% according to the MDA. From 2000 to 2001, the 60% to 85% drop in selling prices caused gross profit margin to decline from 51.1% to 2.8%. Operating profit is dismal with the exception of the year 2000. The percentage figures are skewed each year due to the large increases and decreases in the sales numbers. In raw dollars, selling, general and administrative and research and development costs have increased every year. Given the increase in volume in all years, this is not surprising. Unfortunately the small gross profit generated in 2001 could not possibly cover the necessary operating expenses other than cost of goods sold at Micron. The end result has been a substantial decline in operating profit margin from a positive 36.6% to a negative 24.8%. Net profit margin has followed the same trend as operating profit margin for the same reasons. However, the substantial losses in 2001 have generated positive tax benefits for Micron, resulting in a higher net profit margin relative to operating profit margin. In addition, it is noteworthy that interest expense has dropped each year. One reason for this is the conversion of notes into common stock as mentioned in the notes. Micron has disposed of its PC business. This one-time loss will hopefully be beneficial in the future since these operations had been generating losses every year. Micron will need to further reduce manufacturing costs and/or raise prices if the Company is to be successful. No company can continue to exist long-term with results such as Micron experienced in fiscal year 2001.
40
Chapter 4 4.1
4.3
(a) (b) (c) (d) (e) (f)
I F F I F F
(g) (h) (i) (j) (k) (l)
F I I F I F
4.2
(a) (b) (c) (d) (e) (f)
O O F C or I O O
(g) (h) (i) (j) (k) (l)
I F F O O C
Luna Enterprises Statement of Cash Flows for Year Ending December 31, 20X9 Cash flow from operating activities Net income Non-cash operating items: Depreciation
$1,050 100 1,150
Cash provided (used) by current assets and liabilities: Accounts receivable Inventory Accounts payable Accrued wages payable Net cash provided by operating activities
(550) 300 300 (100) 1,100
Cash flows from investing activities Purchase of plant and equipment Sale of long-term investments Net cash used for investing activities
(600) 250 (350)
Cash flows from financing activities Decrease in bonds payable Payment of dividends Net cash used by financing activities
(300) (200) (500)
Increase in cash
250
41
4.4 (a) Cash flow from operating activities Net income Depreciation Deferred taxes Accounts receivable Inventory Accounts payable Cash provided (used) by operations
Firm A
Firm B
$ 75,000 10,000 3,000 (40,000) (40,000) (20,000) ($ 12,000)
$ 75,000 30,000 18,000 (5,000) 10,000 (5,000) $ 123,000
Cash flow from investing activities Purchase of plant, property and equipment
($ 20,000)
($ 70,000)
Cash flow from financing activities Short-term debt Long-term debt Dividends paid Net cash flow from financing activities
$ 17,000 20,000 (5,000) $ 32,000
Change in cash
$
(b) Inflows Operating activities Short-term debt Long-term debt Outflows Operating activities Purchase of PP&E Reduction of long-term debt Dividends paid Change in cash
Firm A $ 0 17,000 20,000 37,000 12,000 20,000 0 5,000 37,000 0
0
$
2,000 (10,000) (35,000) ($ 43,000) $ 10,000
% 0 46 54 100
Firm B $ 123,000 2,000 0 125,000
% 98 2 0 100
32 54 0 14 100
0 70,000 10,000 35,000 115,000
0 61 9 30 100
10,000
Both firms reported net income of $75,000, but, in reality, they had an entirely different operating performance, because Firm B had a strong positive operating cash flow, and Firm A had to borrow to finance operations, the purchase of capital assets, and the payment of dividends. Firm B was able to reduce debt while 42
expanding capital assets and paying dividends. This problem illustrates the importance of cash flow as a performance measure. 4.5
Little Bit, Inc. Statement of Cash Flows for Year Ended 12-31-X9
Cash flow from operating activities Net income Non-cash expenses included in net income: Depreciation Deferred income taxes Cash provided by (used for) current assets and liabilities Accounts receivable Inventory Prepaid rent Accounts payable Accrued salaries payable Nonoperating items included in net income: Gain on sale of building Net cash used by operating activities
($
Cash flows from investing activities Purchase of plant and equipment* Sale of building Purchase of land Net cash used by investing activities
(150,000) 55,000 (15,000) ($ 110,000)
$
40,000 60,000 10,000 (65,000) (70,000) (7,000) 25,000 (9,000)
Cash flows from financing activities Additions to short-term debt Additions to long-term debt** Reductions of long-term debt Sale of common stock Dividends paid*** Net cash provided by financing activities
(5,000) 21,000)
118,000 40,000 (20,000) 20,000 (22,000) 136,000
Increase in cash
$
43
5,000
*Beginning Property and Equipment - Building sold + Acquisitions Ending Property and Equipment
$450,000 100,000 150,000 $500,000
**Beginning long-term debt + Additions - Reductions Ending long-term debt
$190,000 40,000 20,000 $210,000
***Beginning Retained Earnings + Net income - Dividends Ending Retained Earnings
$157,000 40,000 22,000 $175,000
Analysis Inflows Sale of equipment Short-term debt Long-term debt Sale of common stock Total
$ 55,000 118,000 40,000 20,000 233,000
% 24 51 17 8 100
Outflows Operating activities Purchase of property and equipment Purchase of land Reduction of long-term debt Dividends paid Total
21,000 150,000 15,000 20,000 22,000 228,000
9 66 7 8 10 100
Little Bit, Inc. failed to generate cash from operating activities due primarily to growth in inventories and receivables. The firm appears to be expanding, as evidenced also by the increase in capital assets. The expansion is being supported primarily by debt (long-term and shortterm debt combined contributed 68% of total cash). It would appear that Little Bit is using short-term debt in part for the acquisition of plant and equipment. Ordinarily, this would not be a good matching of debt
44
maturity, with the assets being financed, but it could be justified if short- term interest rates are lower than long-term rates and/or if credit is readily available to Little Bit. It is essential that Little Bit generate cash flow in the future to lessen the need for short-term debt, perhaps by controlling the growth of inventories and receivables. 4.6 (a) Cash provided by operations in 20X8 is considerably less than net income. The major reason is the $288.2 million increase in accounts receivable. Inventory also increased substantially ($159.4 million) but the growth in inventory was comparable to what the firm experienced in 20X7. Additions to plant and equipment were about the same in 20X8 as 20X7, so the increase in receivables appears out of line with overall expansion. Techno may be loosening credit to customers in order to stimulate sales and income (note increase in net income between 20X7 and 20X8), but the result of the receivables management is a sharp reduction in operating cash flow. If the firm continues to build receivables at the same pace, Techno will likely experience negative operating cash flow in 20X9. (b) Inflows Operations Investment activities Short-term borrowings Add. to long-term borrowings Outflows Add. to plant and equipment Investment activities Purchase of treasury stock Dividends Repay long-term borrowings Change in cash
20X8 $ % 24,525 8.2 14,408 4.8 125,248 41.8 45.2 135,249 299,430 100.0
20X7 $ % 177,387 78.1 0 0 45,067 19.9 4,610 2.0 227,064 100.0
94,176 0 45,854 49,290 0 189,320
93,136 21.2 34,771 7.9 39,267 8.9 22,523 5.1 250,564 56.9 440,361 100.0
110,110
49.8 0 24.2 26.0 0 100.0
(213,197)
In 20X7 Techno generated most of its cash (78%) internally through operations. About 20% came from short-term borrowings, apparently to finance working capital. As the result of a strong operating cash flow and a large cash account balance ($291 million) Techno was able to expand plant and equipment while reducing by $250.5 million its long-term borrowings and to add long-term 45
investments. A sharply reduced cash flow from operations in 20X8 (see discussion in "a" above) resulted in the need for heavy long-term and short-term borrowings to support growth in receivables, inventory, and plant and equipment. The apparent use of some long-term borrowing for working capital needs could be a problem in the future. Techno also more than doubled its payment of dividends in spite of the decrease in operating cash flow. Given, however, that Techno ended the year with a cash balance of $188.2 million, the firm does not appear to have any immediate liquidity problems. The analyst would want to explore the cause of the buildup in receivables in 20X8. 4.7
Summary analysis of Motorola Inc. statement of cash flows:
Inflows (in millions of dollars) Operations Proceeds from dispositions of investments and business Proceeds from dispositions of property, plant and equipment Sales of short-term investments Net proceeds from issuance of commercial paper and short-term borrowings Net proceeds from issuance of debt Issuance of preferred stock Issuance of common stock Effect of exchange rate changes Total Inflows Outflows (in millions of dollars) Operations Acquisitions and investments, net Capital expenditures Purchases of short-term investments Repayment of commercial paper and shortterm borrowings Repayment of debt Payment of dividends Effect of exchange rate changes Total Outflows Net increase (decrease) in cash and cash equivalents
46
2001 1,976
2000 0
1999 2,140
4,063
1,433
2,556
14 233
174 345
468 0
0 4,167 0 362 148 10,963
3,884 1,190 0 383 0 7,409
0 501 484 544 0 6,693
0 512 1,321 0
1,164 1,912 4,131 0
0 632 2,856 496
5,688 305 356 0 8,182
0 5 333 100 7,645
403 47 291 33 4,758
2,781
(236)
1,935
Inflows (in percent of total) Operations Proceeds from dispositions of investments and business Proceeds from dispositions of property, plant and equipment Sales of short-term investments Net proceeds from issuance of commercial paper and short-term borrowings Net proceeds from issuance of debt Issuance of preferred stock Issuance of common stock Effect of exchange rate changes Total Inflows Outflows (in percent of total) Operations Acquisitions and investments, net Capital expenditures Purchases of short-term investments Repayment of commercial paper and shortterm borrowings Repayment of debt Payment of dividends Effect of exchange rate changes Total Outflows
2001 18.0
2000 0.0
1999 32.0
37.1
19.3
38.2
0.1 2.1
2.3 4.7
7.0 0.0
0.0 38.0 0.0 3.3 1.4 100.0
52.4 16.1 0.0 5.2 0.0 100.0
0.0 7.5 7.2 8.1 0.0 100.0
0.0 6.3 16.1 0.0
15.2 25.0 54.0 0.0
0.0 13.3 60.0 10.4
69.5 3.7 4.4 0.0 100.0
0.0 0.1 4.4 1.3 100.0
8.5 1.0 6.1 0.7 100.0
Analysis of cash flow from operating activities: Cash flow from operations (CFO) has been erratic over the three-year period from 1999 to 2001 for Motorola. In addition, CFO has not corresponded to changes in net earnings. The company generated more CFO than net earnings in 1999 but then had negative CFO in 2000 despite an increase in net earnings. Motorola generated a net loss in 2001 but was once again able to generate positive CFO in that year. An investigation into the causes of this erratic behavior is warranted. In all three years Motorola added back non-cash charges that included depreciation, amortization and reorganization expenses. These items cause CFO to be higher than net earnings. In 2000 the negative CFO was caused by the large increases in accounts receivable and inventories and payment of current liabilities. In addition, the net earnings in 1999 and 2000 occurred because of gains on sales of investments. Without these gains, Motorola would have generated net losses. In 2001 the company decreased accounts receivable and inventories significantly 47
and paid off a large amount of accounts payable and other current liabilities. The enormous reorganization charge is the reason the company was still able to generate cash, however, these expenses will have to be paid in the future. Without the other financial statements and notes it is difficult to assess with certainty what Motorola’s strategy is for the future, however, it appears that the company is experiencing difficulty in generating positive operating earnings and is, therefore, reorganizing and disposing of segments of the business. Looking at the other cash inflows and outflows will be helpful in further assessing the situation. Analysis of cash inflows: Since Motorola generated 32% or less of CFO each year, the company had to find alternative sources of financing. Disposing of businesses was a key source each year. If the company was eliminating segments operating at losses, then this will probably benefit the firm in the future. On the other hand, if Motorola is selling profitable segments out of a need for cash, this will be detrimental in the future unless new businesses are developed or acquired to generate revenue and cash. Over 68% of Motorola’s cash came from borrowed funds in 2000, the year of negative CFO. Of concern is the heavy reliance on short-term borrowings, which need to be repaid in one year. As a result the company had to reborrow, long-term, in 2001. Analysis of Cash Outflows: In 1999 and 2000, Motorola used the majority of cash for acquisitions, investments and capital expenditures. Hopefully this means the company has chosen to replace dispositions of business segments with more profitable alternatives. In 2001, less was spent in these areas as the firm repaid a significant amount of commercial paper and short-term borrowings. To be successful in the future, Motorola needs to be able to focus on core operations that generate profits. Reorganizations should not continue year after year, and this is a red flag raised in the statement of cash flows. In addition, selling off parts of a business year after year to acquire cash will not continue indefinitely nor is it an appropriate way to survive. Future financial information should be evaluated carefully. 4.8 What follows is a sample article. The article should include the following key points: 1) cash flow from operations is different from net income; 2) a brief explanation of why the two measurements differ; and 3) cash is what is needed to 48
stay afloat. A good basis for the article is the example of the "Nocash Corporation" in Chapter 4. Your business may be on its way to bankruptcy even though you are showing a healthy profit. Net income, the bottom line of the income statement, is not the same thing as cash flow from operations. As any business owner knows, it is cash that the firm needs to pay its employees, bankers, and suppliers. Net income is an accounting measurement that doesn't actually show cash coming in from the company's business operations. For example, the company's sales may be growing due to the extension of credit to an increasing number of customers who aren't going to pay their bills. Sales are counted in net income, but the cash may not come in at all. The company may be building inventory that will eventually have to be sold at a loss or not sold at all—that problem affects cash flow but isn't showing up on the income statement yet. If suppliers hear about all these problems, they may quit selling goods to the company on credit, so some of the cash outflow that has been in essence delayed (for accounting purposes in calculating net income) will have to be paid out immediately. To get through this patch, the company may have to borrow to cover the cash shortage, which will require future cash for debt service. If the company doesn't turn things around, the problems will compound, leading to potential disaster. The key to avoiding all of this is to keep a close eye on cash flow from operations as well as net income because that is what the bankers and the suppliers and investors are going to be watching. 4.9 There is no solution presented here as the students will be choosing a variety of internet companies.
49
4.10
Intel Statement of Cash Flows $ 8,654
2001 % 35
$ 12,827
2000 % 41
$ 12,134
1999 % 58
Inflows: Operations Sales and maturity of investment Increase in short-term debt Increase in long-term debt Sale of ESOP Put warrants Total Inflows
15,398 61 23 0 306 1 762 3 0 0 25,143 100
17,124 55 138 1 77 0 797 3 0 0 30,963 100
7,987 38 69 0 118 1 543 3 20 0 20,871 100
Outflows: Increase of property, plant and equipment Acquisitions, net Purchase of investments Other, investing Decrease in short-term debt Decrease in long-term debt Repurchase of stock Cash dividends Total Outflows
7,309 36 883 4 7,141 36 260 1 0 0 10 0 4,008 20 3 538 20,149 100
6,674 21 2,317 7 17,188 54 980 3 0 0 46 0 4,007 13 470 2 31,682 100
3,403 18 2,979 16 7,055 37 799 4 0 0 0 0 4,612 24 366 1 19,214 100
Change in cash
4,994
(719)
1,657
Intel generates much cash from operations (CFO). CFO is larger than net income in all three years. This is mainly due to depreciation and amortization (non-cash expenses). Also in 2001 the decrease in accounts receivable also contributed significantly to the larger CFO relative to net income. The low percentage of cash flow from operations is explained by the purchases and ultimate maturities of investments. In all three years, 96% of cash has been generated from operations or maturities of investments. Neither short-term nor long-term debt has been used significantly to generate cash. Some cash has been generated from the sale of stock to employees. The largest use of cash is to purchase available-for-sale investments. Intel has generated so much cash throughout its history that the company has extra cash to invest until it is needed for acquisitions and capital expenditures. 50
The company continues to invest yearly in new property, plant and equipment which is an expected expenditure for this type of firm. It is good that Intel is increasing dollars in this area despite the economic downturn. They are positioning themselves well for when the economy recovers. Intel has also begun acquiring other technology companies to expand into related markets and this is another use of cash. Another use of cash is for the repurchase and retirement of common stock. While this may benefit stockholders in the form of capital appreciation of their stock, one must consider whether this is the best use of excess cash for the company. In addition, Intel has increased the dollar and percentage of cash dividends paid each of the past three years. Intel’s cash position is solid. The company generates good cash flow from operations and as a result should be able to meet future financing needs easily.
51
CASE 4.1 HASBRO, INC. 1.
Inflows: CFO Other investing activities Borrowings > 3 months Short-term borrowings Stock option/warrant transactions Total Inflows
Hasbro Statement of Cash Flows 2000
%
1999
%
1998
%
162,556
14.0
391,512
33.8
126,587
14.4
82,863 912,979 0
7.1 78.7 0.0
30,793 460,333 226,103
2.7 39.7 19.5
16,986 407,377 271,895
1.9 46.2 30.9
0.2 2,523 1,160,921 100.0
Outflows: Additions to PPE Investments/acquisitions Repayments of borrowings > 3 months Repayments of shortterm borrowings Purchase of common stock Dividends Exchange rate changes Total Outflows
367,548 28.0 42,494 3.2 0.5 7,049 1,313,965 100.0
Change in cash
(153,044)
50,358 4.3 1,159,099 100.0
58,493 6.6 881,338 100.0
125,055 138,518
9.5 10.6
107,468 352,417
10.2 33.3
141,950 667,736
13.3 62.7
291,779
22.2
308,128
29.2
24,925
2.3
341,522
26.0
0
0.0
0
0.0
237,532 22.5 178,917 16.8 45,526 4.3 42,277 4.0 5,617 .5 9,570 0.9 1,056,688 100.0 1,065,375 100.0 102,411
(184,037)
Hasbro's earnings have declined over the past three years and the company is now operating at a loss. Despite this downward trend the company has been able to generate cash from operations (CFO). Increases in accounts receivables, inventories and prepaid expenses in 1998 caused CFO to be far less than net earnings. Substantially more CFO than earnings was generated in 1999 due to the large increase in amortization caused by acquisitions and the large increase in current liabilities. CFO was impressive in 2000 despite the net loss. This was due to the significant decreases in accounts receivables and inventories. In addition, Hasbro was able to pay down a large amount of accounts payable and current liabilities. 52
Of concern is the large amount of cash inflows derived from borrowing each year. Short and long-term borrowings have contributed 77.1%, 59.2% and 78.7% of cash inflows in 1998, 1999 and 2000 respectively, while CFO contributed most of the balance. CFO has been large enough over the three year period to cover capital expenditures and dividends, but not enough to cover investment and acquisition activity, debt repayments and the purchase of common stock. It appears that Hasbro made a poor decision in its investment in Hasbro Interactive and Games.com. These investments have probably been partly responsible for not only the decline in earnings, but the increase in debt. The disposition of these operations should help improve financial results in the future. Of greater concern is the use of scarce cash for repurchase of common stock with borrowed funds. The repurchases of common stock in at least 1998 and 1999, and maybe 2000, were probably made when stock prices were fairly high. Given the recent economic downturn it is unlikely there is a financial benefit in the near future of this investment. 2. Hasbro is successful in generating positive CFO and has so far been able to make payments on debt. The disposition of a losing operation should help the company produce higher earnings and cash in the future. Therefore, it appears that Hasbro would be a credit worthy company. 3.
Balance sheet information that would be useful includes: • the proportion of short-term versus long-term debt, • detail of types of debt outstanding (from notes), and • amounts of debt due in the next five years (from notes).
53
CASE 4.2 AMAZON.COM, INC. 1. Summary of analysis of amazon.com, Inc. statement of cash flows: Inflows (in thousands of dollars) Sales and maturities of marketable securities Proceeds from exercise of stock options Proceeds from issuance of common stock Proceeds from long-term debt Effect of exchange rates Total Inflows Outflows (in thousands of dollars) Operations Purchases of marketable securities Purchases of fixed assets Investments in equity method investees Repayment of long-term debt Financing costs Effect of exchange rates Total Outflows Net increase (decrease) in cash and cash equivalents Inflows (in percent of total) Sales and maturities of marketable securities Proceeds from exercise of stock options Proceeds from issuance of common stock Proceeds from long-term debt Total Inflows Outflows (in percent of total) Operations Purchases of marketable securities Purchases of fixed assets Investments in equity method investees Repayment of long-term debt Financing costs Effect of exchange rates Total Outflows
54
2001 370,377 16,625 99,831 10,000 0 496,833
2000 545,724 44,697 0 681,499 0 1,271,920
1999 2,064,101 64,469 0 1,263,639 489 3,392,698
119,782 567,152 50,321 6,198 19,575 0 15,958 778,986
130,442 184,455 134,758 62,533 16,927 16,122 37,557 582,794
90,875 2,359,398 287,055 369,607 188,886 35,151 0 3,330,972
(282,153)
689,126
61,726
2001 74.5 3.4 20.1 2.0 100.0
2000 42.9 3.5 0.0 53.6 100.0
1999 60.8 1.9 0.0 37.3 100.0
15.4 72.8 6.5 0.8 2.5 0.0 2.0 100.0
22.4 31.7 23.1 10.7 2.9 2.8 6.4 100.0
2.7 70.8 8.6 11.1 5.7 1.1 0.0 100.0
Amazon.com (Amazon) has been unsuccessful generating cash from operations (CFO) in all three years presented in the statement of cash flows. The main reason is that the company has operated at a loss all years. CFO is actually much better than the net losses, even though the number is negative. One cause of the difference between the net loss and CFO is the large amount of amortization expense, a non-cash item, that Amazon records each year. Two noteworthy items in 1999 are the build-up of inventories and the increased use of accounts payable. The company was successful in 2000 and 2001 in decreasing inventories and that helped generate cash. By 2001, Amazon also began paying down their accounts payable. All three years the firm has recorded losses from their equity investments. While this does not negatively impact CFO, it is an indication that the company may have made some poor investment choices. Significant noncash restructuring charges also added to CFO in 2000 and 2001. Perhaps the restructuring has helped the company gain better control of inventories and is the reason that the net loss in 2001 is not as great as the 2000 loss. Amazon had over $2 billion of cash tied up in marketable securities in 1999, however, this amount has been significantly decreased in the two subsequent years. The firm has had to use this cash to sustain operations. Other than the cash from sales of marketable securities, Amazon has had to borrow significantly to fund operations. In 2001 the company also sold common stock to obtain cash.. Amazon has used cash to purchase marketable securities but as mentioned previously, these funds have dwindled due to the negative CFO each year. In 1999 the company made large investments in both fixed assets and equity-method investees. Each year after 1999 less has been spent in these two areas. The firm has paid back a small amount of debt, however, compared to the amounts borrowed, Amazon will most likely have enormous repayments to make in the future. To survive in the future Amazon must begin generating profits which would most likely translate into positive cash flow. With looming debt repayments, the excess cash in marketable securities will disappear quickly if the firm does not begin generating positive CFO. 2. The statement of cash flows is extremely useful in making credit decisions. Although the statement of cash flows is prepared from the balance sheet and income statement, it presents information in a way that reveals how the firm is generating cash and how the cash is being used, over a period of time. The statement of cash flows reveals that Amazon has not 55
been able to generate cash from operations even though sales are increasing; and it helps pinpoint the reasons for positive or negative cash flows. The statement of cash flows also shows why the firm has had to borrow heavily and provides a clear picture of how the debt is being used. Overall, the statement of cash flows has helped identify the serious problems Amazon is experiencing. Since cash is the source of debt repayment, the information contained in the statement of cash flows is an essential tool in assessing a firm's credit worthiness. 3.
Amazon has increased sales 68% from 1999 to 2000 and 13% from 2000 to 2001. If the firm can continue to increase sales without increasing costs, then it would certainly be possible to generate positive CFO in 2002. Jeff Bezos claims that the company has fixed costs that will not continue to increase. Based on the changes from 2000 to 2001 this seems to be validated. Sales increased 13%, yet the loss decreased by 60%. Several other factors must be considered, however, such as the economic downturn and the terrorist attack and the effect these two items may have on 2002 sales.
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Chapter 5 5.1 Current Ratio
725,000 475,000
1.53 times
400,000 475,000
0.84 times
275,000 1,500,000/365
67 days
Inventory Turnover
1,200,000 325,000
3.69 times
Fixed Asset Turnover
1,500,000 420,000
3.57 times
Total Asset Turnover
1,500,000 1,145,000
1.31 times
Debt Ratio
875,000 1,145,000
76.4 %
200,000 72,000
2.78 times
Gross Profit Margin
300,000 1,500,000
20.0 %
Operating Profit Margin
200,000 1,500,000
13.3 %
Net Profit Margin
76,800 1,500,000
5.1 %
Return on Total Assets
76,800 1,145,000
6.7 %
76,800 270,000
28.4 %
Quick Ratio Average Collection Period
Times Interest Earned
Return on Equity
57
The current position is deteriorating, as measured by the current and quick ratios, and is below the industry average. The average collection period has increased and is slightly longer than the industry average, indicating potential weakness in credit and/or collection policies. The inventory turnover has slowed and is well below competitors' levels. Eleanor's Computers is apparently overstocked with inventory due to inventory management problems and/or sluggish sales. Capital asset efficiency is in good shape, as evidenced by an improving and above average fixed asset turnover. The efficient management of fixed assets approximately offsets the poor inventory turnover, and the total asset turnover is only slightly weaker than the industry. The inventory has apparently been financed with debt, resulting in an increasing debt ratio, which is well above industry standards. A combination of too much debt and low profit is producing difficulty in covering interest payments, shown by times interest earned. The gross profit margin has slipped due either to lack of cost controls for products sold, the need to sell products at discounts, or both. The operating profit margin, however, reflects good control of operating expense. The overall return, as measured by the net profit margin, has fallen because of the combination of cost/pricing policies and high interest charges. The return on investment, which has declined and is below the industry average, reflects decreasing profitability and the overstocking of inventory. Return on equity is above the industry average and is trending upward. The increased use of financial leverage has more than offset the decrease in profitability: Net Profit Margin
x
Total Asset Turnover
=
Return on Investment
5.12
x
1.31
=
6.71
Return on Investment (Assets/Equity)
x
Financial Leverage
=
Return on Equity
6.71
x
4.24
=
28.44
58
Although the high debt ratio improves the return on equity, it also increases risk. 5.2 Luna's current ratio has increased and is above the industry average, the average collection period has shortened and is less than the industry average, and the inventory turnover ratio has improved; the ratios indicate that Luna has no obvious problems with liquidity or the management of inventory and receivables. Both the total asset turnover and fixed asset turnover ratios have declined, however, and are below the industry. Problems with asset utilization are apparently caused by the management of capital assets. Luna's expansion of capital assets has been more rapid than sales growth, given the declining ratio; the firm may be underutilizing its plant and equipment or may not yet be benefiting from asset growth. Luna's debt ratio is stable and below the industry, while interest coverage is above industry; the declining fixed charge coverage implies that lease payments for Luna are excessive. The decreasing net profit margin is apparently attributable to escalating operating costs rather than cost of goods sold, and the operating expenses are traceable to costs associated with the capital asset expansion and lease payments. These problems have adversely affected the overall returns. 5.3 Gross profit margin Operating profit margin Net profit margin Current ratio Quick ratio
(a) FIFO
(b) LIFO
53.33 % 33.33 % 19.93 % 1.61 0.77
25.83 % 5.83 % 2.06 % 1.10 0.77
(c) The ratios calculated using FIFO give the appearance that Rare Metals, Inc. is doing well, while the ratios calculated using LIFO give the opposite effect. Based on the cost of goods sold (COGS) and ending inventory amounts, prices of the metal have been increasing. The first goods purchased, which are the lower priced items, are included in COGS under FIFO. Using LIFO, however, a better match is made with current cost and revenues and a more realistic picture of profitability is illustrated. The company will most likely have to replace goods sold at the higher price in the future. The difference in profit margins has resulted from a “paper” profit recorded under the FIFO method.
59
Ending inventory is undervalued when LIFO is used during inflation. The FIFO valuation is a better reflection of the current market price of Rare Metals, Inc.’s inventory. As a result the current ratio of 1.61 is a more accurate representation than 1.10. The quick ratios are identical because inventory has been eliminated from the calculation, and inventory is the only difference in the numbers being compared. (d) Yes, cash flow from operating activities will differ due to the difference in taxes paid. Assuming that the inventory method is the only cause of differences in amounts on the income statement, the amount of tax expense is greater when FIFO rather than LIFO is used. Although tax expense may not be identical to cash paid for taxes, if in this case it is assumed that taxable income and earnings before taxes are the same, Rare Metals Inc. would have paid $289 million more in taxes if they chose the FIFO method instead of the LIFO method. While profit margins would be higher using FIFO, cash flow from operations would be higher using LIFO. It is important to note that it is cash, not profit or earnings, that must be used to pay the bills! 5.4 (a) Canon is more liquid than Eastman Kodak (Kodak). Canon’s current and quick ratios are both above one and the cash-flow liquidity ratio is close to one, indicating the company should be able to pay current liabilities as they come due. Kodak’s liquidity ratios are all below one. It appears that Kodak must find external funding in the short-term to be able to pay current liabilities. Canon generated more than 2.5 times the cash from operations in 2000 compared to Kodak. Total asset turnover is the same for both firms with Kodak showing better inventory efficiency than Canon, but Canon is managing accounts receivable and fixed assets better than Kodak. Kodak is highly leveraged compared to Canon. This is not surprising given the differences seen in the liquidity area between the two firms. The cash flow adequacy ratio is over one for Canon, which means the firm has no trouble covering capital expenditures, debt repayment and dividends with cash from operations. Kodak is only covering $0.40 on every dollar of these same items with cash generated from their operations. Kodak generates higher operating and net profits than Canon, and therefore has higher return on assets and equity ratios. The return on equity ratio is extremely high due to the fact that Kodak uses a significant amount of debt 60
(76%) and is generating sufficient returns to cover the cost of the debt. Canon, while not as profitable, is translating their profits into cash much better than Kodak. (b) Stock Price EPS PE Ratio
Kodak $39 $4.62
Canon $34 $1.16
8.4
29.3
The PE ratio indicates the value being placed by the stock market on a company’s earnings. A higher value is being placed on Canon compared to the value placed on Kodak. Investors may be placing a higher value on Canon, because they understand the importance of cash flow from operations and view it as a better measure than accrual-based profits. 5.5 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)
Current D N I D D N I I N N D I
Quick N N I D N N I I N D D N
Net Wk. Capital N N I D D N I I N N N N
Debt I N D N I N I D D N I D
The instructor might want to discuss why a firm would make a specific transaction at the end of the period to affect certain ratios. For example, consider item (l). If the objective is to increase the current ratio and decrease the debt ratio, perhaps to meet requirements in a loan covenant, the firm could pay cash to a supplier to reduce payables at the end of the accounting period.
61
5.6 (a)
Debt
Equity
Debt Ratio*
40+10 90+10
= 50%
Times Interest Earned*
18 4.8+1.5
= 2.86 x
Operating Profit Interest Expense Earnings before tax Income tax exp. (40%) Net Income Shares Outstanding Earnings per share
Return on Assets (adjusted)
18 4.8
= 3.75x
18,000,000 4,800,000 13,200,000
4,680,000
5,280,000
7,020,000 800,000 $8.78
7,920,000 1,000,000 $7.92 = 14.04%
7,020+6,300(1-0.4) = 10.80 100,000
Financial Leverage Index
= 40%
18,000,000 6,300,000 11,700,000
7,020 50,000
Return on Equity
40 90+10
14.04 10.80
= 1.3
7,920 60,000
= 13.20%
7,920+4,800(1-0.4) = 10.80 100,000 13.20 10.80
= 1.2
*Numbers are in millions (b) Use of debt would increase the debt ratios from 44% to 50%, while equity financing would reduce the debt ratio to 40%. Interest coverage would decline from 3.1 times to 2.86 times if debt is employed; times interest earned would increase to 3.75 times with stock financing. Earnings per share would be higher with the debt financing. The financial leverage index is greater than 1, indicating the successful use of financial leverage under either alternative, but is higher with debt financing. The Board would want to consider each of these ratios and other factors as well. The additional risk resulting from adding debt would likely exert downward pressure on the price to earning ratio and thus could result in a decreased share price. The Board would want to review the reasonableness of the projection for operating profit, including the stability and predictability of the firm's earnings stream in the past. Other factors would 62
include the marketability of stock relative to the current and future availability of credit; interest rate expectations; the effect of each alternative on the cost of capital; and the amount and timing of planned future expansions. 5.7 Short-term liquidity at Charter Communications, Inc. is poor and has deteriorated from 2000 to 2001. The company’s current assets are less than one-third of current liabilities. In 2000 the cash flow liquidity ratio was good at 0.92 but has dropped to 0.38 in 2001. This drop is most likely the result of the drop in cash flow operations from 2000 to 2001. The average collection period has increased slightly but is at an acceptable level. The firm is using accounts payable extensively to finance operations as evidenced by the length of time they take to pay bills, 154 days on average in 2000 and 129 days in 2001. The decline in days payable outstanding could be caused by a tightening of credit by Charter’s suppliers. Based on the information from the statement of cash flows, the company is generating significant losses but is able to generate cash from operations due to depreciation and amortization expenses, which are noncash charges. The company (and industry) is capital intensive as can be seen by the large amounts of depreciation and amortization and the low asset turnover rates. The firm is efficient with regard to accounts receivable, but total asset turnover is 0.16, the same as the fixed asset turnover ratio. To continue to be successful, the firm needs to generate a higher level of sales without a proportional increase in expenses. This would then result in higher fixed and total asset turnover and better cash flow generation. 5.8 Hasbro’s capital structure is more risky in 2000 compared to 1999. The firm has increased debt from 57.9% to 65.3% of assets. The long-term debt to total capitalization ratio indicates that much of the debt added to the firm’s capital structure is long-term. As a result of increased debt and lack of profitability in 2000, the company can no longer cover interest and lease expenses with profits; however, cash generated from operations is still enough to cover the actual cash payments in 2000 for interest and leases. Profitability is deteriorating at Hasbro. The gross profit margin has declined 4.1% indicating that either costs are increasing or selling prices are being lowered. Hasbro needs to control costs better or pass increased costs onto customers to improve the gross profit margin. Operating and net profit in 1999 have turned to losses in 2000. Further investigation of the cause of these losses is warranted. Due to the financial leverage used in the firm, the effect on return on equity has been magnified in both 1999 (positively) and 63
in 2000 (negatively). As stated previously, despite the accrual-based losses the firm has incurred, Hasbro still generates positive cash from operations. Cash flow margin and cash return on assets have declined from the 1999 levels but are still positive. Hasbro’s long-term solvency is adequate. The increased use of debt is probably a result of the underlying causes of the profit deterioration. 5.9 Writers of the 2004 annual report will probably want to emphasize rebounding in 2004 from an abnormal year in 2003. They will want to point out reasons for the improvement in 2004, showing how the company is building for continued success. The "Summary of Analysis" section at the end of Chapter 5 provides an overview of the positive aspects of R.E.C., Inc.'s performance and outlook. The annual report will focus on strengths: sales growth, well-managed expansion, increased profit, positive cash flow, effective cost controls, improvement in receivables and inventory management, overall favorable outlook for economy, industry and geographic location. There will be some need to explain the identified problems, such as the negative cash flow in 2003 and how the firm has recovered, which is actually a major plus. 5.10 There is no solution presented for this exercise due to the vast amount of information which can be found on this topic. Having students share what they have learned from their searches can lead to interesting discussions.
64
5.11 (a) and (b) Short-term liquidity Current ratio Quick ratio Cash flow liquidity ratio Average collection period Days inventory held Days payable outstanding Net trade cycle Operating efficiency Accounts receivable turnover Inventory turnover Accounts payable turnover Fixed asset turnover Total asset turnover Leverage Debt ratio Long-term debt to total capitalization Debt to equity Financial leverage index Times interest earned Cash interest coverage Fixed charge coverage Cash flow adequacy Profitability Gross profit margin Operating profit margin Net profit margin Cash flow margin Return on total assets Return on equity Cash return on assets
Ind. Avg.*
2001
2000
2.68 2.34 2.89 36 days 61 days 48 days 49 days
2.45 2.19 3.04 45 days 65 days 69 days 41 days
59 days 87 days 35 days 111 days
10.18 6.00 7.62 1.46 0.60
8.17 5.64 5.30 2.25 0.70
6.2 4.2 10.5 4.5 1.3
19.29%
22.16%
47.1%
2.85% 1.86% 0.24 0.28 1.21 1.28 40 times 297 times 187 times 397 times 10 times 67 times 1.10 times 1.78 times 49.18% 8.50% 4.86% 32.61% 2.91% 3.60% 19.49%
65
62.49% 30.82% 31.24% 38.03% 21.97% 28.23% 26.75%
1999
2.3 1.3
0.8 271 times 6.2 times 377 times 92 times 3.22 times 59.73% 33.23% 24.89% 41.29%
29.3% 5.8%
Market measures Earnings per share PE ratio High (4th quarter) Low (4th quarter) Dividend payout rate Dividend yield High (annual) Low (annual)
2001
2000
$0.19
$1.57
182.16 102.84 42.11%
29.74 19.15 4.46%
.21% .41%
.09% .23%
1999
Ind. Avg.
* Industry average is from Robert Morris Associates, Annual Statement Studies, 2001; SIC #3674 (c) As requested, an evaluation of Intel has been completed. The following report includes an evaluation of short-term liquidity, capital structure and longterm solvency, operating efficiency and profitability, and market measures. Strengths and weaknesses are identified and the investment potential and creditworthiness of the firm are assessed. Short-term Liquidity Intel's short-term liquidity is impressive. The current and quick ratios are both increasing due to current liabilities decreasing faster than current assets. The cash-flow liquidity ratio declined slightly due to the drop in cash from operations (CFO). CFO declined mainly due to the decrease in sales and net income. Intel has a significant amount of cash and short-term investments and therefore, should not have problems paying debt as it comes due. In fact, cash and short-term investments are greater than the total liabilities of Intel. This company has no problem generating cash from operations as evidenced by the statement of cash flows. Accounts receivable has decreased significantly as a percentage of total assets. The collection period has improved by nine days and is well below the industry average. One concern is that five customers account for 41% of accounts receivable and a default by any one would be significant to the company. Days inventory held has declined and is below the industry average. It is noteworthy that Intel has only 5% of total assets tied up in inventories. This is good because of the rapid obsolescence of products in the high technology industry. 66
Days payable outstanding has decreased indicating Intel is paying suppliers faster, however, Intel takes longer to pay than the competition. The net trade cycle has increased eight days. The improved collection period and days inventory held has been offset in 2001 by the quicker payment of accounts payable. Overall the short-term liquidity of Intel is excellent. Compared to the industry Intel operates within, their ratios and account balances are better than their competitors. Intel has higher amounts of cash and investments than the competition. Operating Efficiency As discussed under short-term liquidity, Intel has improved the turnover of accounts receivable and inventory and is also paying accounts payable quicker. The fixed and total asset turnover ratios for Intel are low compared to the competition. The decline in both turnover ratios has been caused by an increase in fixed assets combined with a decrease in net sales. While this is generally an alarming sign, research of Intel's strategies indicates that Intel is positioning itself for when the economy turns around. In the end, Intel's investments during tough times may pay off handsomely later. Capital structure and long-term solvency Intel has little debt, especially when compared to their competition. Most of the company's debt is short-term and all debt can be covered with the current levels of cash and short-term investments. Total liabilities have decreased from 2000 to 2001 caused by decreases in accounts payable, accrued liabilities, deferred income, income taxes payable and deferred tax liabilities. Intel is still generating profit and a large amount of cash from operations, allowing the company to cover interest and lease payments. The large decline in the coverage ratios can be attributed to the huge drop in profits experienced in 2001, however, cash generated from operations has not declined proportionately. The financial leverage index indicates Intel is using debt successfully in both 2000 and 2001. Should Intel need to borrow in the future, the large equity cushion will allow them to obtain financing readily.
67
Profitability Volatility exists with regard to revenues and expenses of Intel, as evidenced by the growth rates of revenues and operating costs from 1999 to 2001. From 1999 to 2000, operating expenses grew faster than revenues which negatively impacted operating profits. In 2001, revenue declined, however, expenses increased and therefore, had a significant negative impact on operating profit. While volatility is undesirable, it is expected in the hightech industry. The Management’s Discussion and Analysis (MDA) states that the revenue decline in 2001 is due to lower volume and lower selling prices of microprocessors. In addition, revenues declined in all other product lines. The worldwide economic slowdown negatively impacted Intel, as well as most companies in the technology industry. The gross profit margin decreased significantly from 1999 to 2001. The MDA also explains why this occurred. Lower selling prices and high fixed costs are the main cause of the decline in gross profit. Positive changes in gross profit in 2000 compared to 1999 were the result of higher demand and higher prices for flash memory, as well as greater volume sales of microprocessors without an increase in fixed costs. Operating profit has declined each year, but the drop in 2001 was huge. All expenses with the exception of purchased research and development have increased each year. In raw dollars, research and development and marketing, general and administrative costs actually decreased; the percentage relative to sales is higher because of the large decline in sales. It is important for Intel to maintain research and development in order to gain a competitive edge in new product development. Intel was able to reduce dollars spent in research and development in 2001 by cutting travel-related expenses. Intel is also expanding through acquisitions to remain competitive in an ever-changing technology environment. Over the past three years Intel has acquired forty other companies and this has significantly increased amortization expense. (See notes to the financial statements.) Marketing, general and administrative costs increased due to the “Intel Inside” ad campaign, as well as profit-dependent bonus expenses and costs related to acquisitions. However, in 2001, Intel reduced spending on the ad campaign and bonuses. In 2000, Intel achieved abnormally high investment gains. These gains were most likely attributed to a booming economy and stock market in that year. The worldwide economic downturn in 2001 caused Intel to incur losses on investments. 68
Interest income and other, net, increased in 2000, again due to favorable economic conditions and higher returns on investments. This number declined in 2001 as interest rates cuts were made by the Federal Reserve Bank. The effective tax rate increased by over 10% in 2001 due to the nondeductibility of acquisition related items. Net profits were healthy in 1999 and 2000, but the bleak year of 2001 caused a significant decline in net profit of over 26%. The decline in profits has negatively affected the return on assets and return on equity; however, cash return on assets has not dropped as much as the accrual-based ratios because Intel is still generating good cash flow. While it is unlikely Intel will be able to achieve net profit margins of 20% and greater in the near future, it does appear that Intel is positioning themselves to achieve greater revenues. If costs are managed well, profits should trend upward. To continue to be successful, Intel must maintain good control of expenses, while continuing to develop cutting edge products. Market Measures EPS has declined significantly due to the drop in sales and reduction in profits. The PE ratio is high in 2001 because the stock price has not dropped proportionately to the drop in earnings. The marketplace still places a high value on Intel. The dividend yield would indicate that investors will have their greatest return in stock appreciation as opposed to dividends. Intel has chosen to gradually increase dividends each year despite the volatility of earnings. Strengths Strong cash flow from operations Solid short-term liquidity Low debt levels Better receivables and inventory management Investing for the future Weaknesses Decreasing revenues Decreasing profits Volatility of industry
69
Investment potential Intel's stock prices have dropped due to the overall economic downturn. Whether revenues and profits improve will be highly dependent on the economy and the competition. Intel has positioned itself for an economic turnaround, therefore, now may be the time to purchase the stock. Creditworthiness Intel's solid short-term and long-term solvency combined with strong cash flow from operations and a low debt ratio make this company a good credit risk.
70
CASE 5.1 APPLE COMPUTERS, INC. 1.
Common Size Balance Sheets (in percent) ASSETS:
Current assets: Cash and cash equivalents Short-term investments Accounts receivable, less allowances Inventories Deferred tax assets Other current assets Total current assets Property, plant and equipment Non-current debt and equity investments Other assets Total assets
71
Ind. Avg.*
2001
2000
38.4 33.6
17.5 41.7
14.2
7.7 0.2 2.8 2.7 85.4 9.4
14.0 0.5 2.4 3.7 79.8 6.2
29.2 19.5
2.1 3.1 100.0
11.5 2.5 100.0
62.8 16.6
2001
2000
13.3 11.9 25.2 5.3 4.4 34.9
17.0 11.4 28.4 4.4 6.8 39.6
--
1.1
28.1
22.1
(0.2) 37.5
0.0 33.6
(0.3 ) 65.1
3.6 60.4
Ind. Avg.
LIABILITIES AND STOCKHOLDERS' EQUITY: Current Liabilities: Accounts payable Accrued expenses Total current liabilities Long-term debt Deferred tax liabilities Total liabilities
18.3 41.1 16.6 0.4 63.5
Commitments and contingencies Shareholders' equity Series A nonvoting convertible preferred stock, no par value; 150,000 shares authorized, none and 75,750 issued and outstanding, respectively Common stock, no par value; 900,000,000 shares authorized; 350,921,661 and 335,676,889 shares issued and outstanding, respectively Acquisition-related deferred stock compensation Retained earnings Accumulated other comprehensive income (loss) Total shareholders' equity Total liabilities and shareholders' equity
72
100.0
100.0
36.5
Common Size Income Statement (in percent)
2001
Net sales 100.0 Cost of Sales 77.0 Gross margin 23.0 Operating expenses: Research and development 8.0 Selling, general and administrative 21.2 Special charges: Executive bonus -Restructuring costs -In-process research and development 0.2 Total operating expenses 29.4 Operating income (loss) (6.4) Gains on non-current investment, net 1.6 Unrealized loss on convertible securities (0.2) Interest and other income, net 4.0 Total interest and other income, net 5.4 Income (loss) before provision for income taxes (1.0) Provision for (benefit from) income taxes (0.3) Income (loss) before accounting change (0.7) Cumulative effect of accounting changes, net of income taxes 0.2 Net income (loss) (0.5) Effective tax rate Sales growth Operating expense growth
2000
1999
100.0 72.9 27.1
100.0 72.3 27.7
4.8
5.1
14.6
16.2
1.1 0.1
-0.5
-20.6 6.5
-21.8 5.9
4.6
3.7
-2.5 7.1
-1.4 5.1
13.6
11.0
3.8
1.2
9.8
9.8
-9.8
-9.8
28.0
11.1
28.8 2000-2001 (32.82%) (3.95%)
73
Ind. Avg.* 33.7
29.7 4.0
1999-2000 30.14% 22.96%
Summary Analysis of Statement of Cash Flows (all dollar values in millions) Inflows: Cash from Operations Proceeds from maturities of short-term investments Proceeds from sales of shortterm investments Proceeds from sale of property, plant and equipment Proceeds from sales of equity investments Other Proceeds from issuance of common stock Total Inflows Outflows: Purchase of short-term investments Purchase of long-term investments Purchase of property, plant and equipment Other Repurchase of common stock Total Outflows Increase (decrease) in cash and cash equivalents
2001 % 3.3
2000 $ % 868 18.6
1999 $ % 822 18.9
4,811 85.1
3,075 65.9
3,108 71.6
$ 185
278
4.9
256
5.5
47
1.1
--
--
11
0.2
23
0.5
340 --
6.0 --
372 --
8.0 --
245 8
5.7 0.2
42 0.7 5,656 100.0
85 1.8 4,667 100.0
86 2.0 4,339 100.0
4,268 94.1
4,267 88.9
4,236 94.3
1
--
232
4.8
112
2.5
232 5.1 36 0.8 --4,537 100.0
142 3.0 45 0.9 116 2.4 4,802 100.0
71 1.6 --75 1.6 4,494 100.0
1,119
(135)
(155)
74
Financial Ratios 2001 2000 Short-term liquidity Current ratio 3.39 2.81 Quick ratio 3.38 2.79 Cash flow liquidity ratio 2.98 2.53 Average collection period 32 days 44 days Days inventory held 1 day 2 days Days payable outstanding 71 days 73 days Net trade cycle (38 days) (27 days) Operating efficiency Accounts receivable turnover 11.51 8.38 Inventory turnover 375.27 176.27 Accounts payable turnover 5.15 5.03 Fixed asset turnover 9.51 19.05 Total asset turnover 0.89 1.17 Capital structure and long-term solvency Debt to total assets 34.89% 39.63% Long-term debt to total 7.48% 6.81% capitalization Debt to equity 0.54 0.66 Financial leverage index ** 1.62 Times interest earned (21.50) 24.86 Cash interest coverage 12.35 46.75 Fixed charge coverage (2.58) 6.61 Cash flow adequacy 0.80 6.11 Profitability Gross profit margin 23.0% 27.1% Operating profit margin (6.4%) 6.5% Net profit margin (0.5%) 9.8% Cash flow margin 3.4% 10.9% Return on assets (0.4%) 11.6% Return on equity (0.6%) 19.1% Cash return on assets 3.1% 12.8% Market Measures Earnings per share ($0.07) $2.42
1999 Ind Avg* 1.5 0.9 62 days 60 days 48 days 74 days 5.9 6.1 7.5 8.3 1.4 63.5% 2.9 7.64 15.74 4.63 11.58
2.9
27.7% 5.9% 9.8% 13.4%
33.7% 4.0%
* Industry average is from Robert Morris Associates, Annual Statement Studies, 2001; SIC #3571 ** Since earnings are a loss financial leverage index is below 1
75
Short-term liquidity Apple Computers' short-term liquidity position is excellent. The firm has 72% of total assets in cash, cash equivalents and short-term investments. Cash and cash equivalents are greater than the total liabilities of Apple. All ratios are better than the industry average. As sales have dropped, accounts receivable have declined as well. This has caused Apple to continue to generate cash from operations, in spite of a loss in 2001. The allowance account has also declined but not as much as receivables. Apple estimates bad debt of just under 10% in 2001, an increase of over 3% from 2000. Based on the notes, actual bad debt changes have not been this high, however, one customer does account for 9.4% of net receivables, and this could be the cause of the large estimate for bad debts. The average collection period has improved 12 days. The days inventory held is an extremely low number. While low days are desirable, one must wonder if Apple is losing sales due to understocking inventory. The company utilizes accounts payable well by delaying payment until they have sold inventory and collected the cash. The high days payable outstanding is the reason Apple has a negative net trade cycle. If suppliers tighten credit, Apple should be able to pay on these accounts with no problem. Operating efficiency Apple has improved receivables and inventory turnovers. Fixed assets turnover, on the other hand, has dropped by nearly half. This is a result of the 30% decline in sales combined with a 35% increase in property, plant and equipment. This ratio is still above the industry average, but Apple needs to work on increasing sales to continue to be efficient. The total asset turnover has declined and is below the industry average. This is a result of the less efficient use of fixed assets, as well as the large amount of funds in cash, cash equivalents and short-term investments that are not currently being used to generate cash.
76
Capital structure and long-term solvency Apple is much less risky than the competition, having approximately 35% debt in its capital structure, with only 7.5% of that long-term debt. Prior to 2001, the firm used debt successfully and had excellent coverage ratios. The net loss generated in 2001 has caused the negative times interest earned and fixed charge coverage ratios, however, this has not prevented Apple from generating the necessary cash to cover the actual interest and lease payments. Even with the poor year, Apple was able to cover 80% of capital expenditures with cash from operations. In years prior to 2001 the firm has generated more cash than needed for capital expenditures, allowing for excess cash to be invested. Long-term solvency, like short-term liquidity is good. Profitability Profitability has been negatively impacted in 2001 due to the large decline in sales, without a corresponding decrease in operating expenses. The nature of the computer industry is volatile, and successful firms will be those that can adjust rapidly to these volatile conditions. Gross profit margin is lower at Apple compared to the industry, and, in addition, this percentage dropped 4.7% over the three-year period presented. Without the management discussion and analysis one can only guess at the cause of this decline. Given the extreme competition in this industry, it is likely that Apple had to lower selling prices rather than costs increasing. Operating profit margin increased from 1999 to 2000 due to higher sales without proportional increases in operating expenses. From 2000 to 2001, however, the large drop in sales has caused an operating loss. It is good to see that Apple has increased research and development despite the decline in sales since innovative products may be the key to future profitability. If sales can be increased in the future, it appears that Apple should be able to reduce the percentage amount of selling, general and administrative expenses. One area that should be monitored is advertising expense. In 2001 the company chose to reduce advertising expenses, but it is important that this discretionary item not be cut so much that future sales are harmed. An item not included on the income statement is stock-based compensation. If this amount had been expensed, earnings would be significantly lower as indicated in Note 9 of the financial statements. It is important that investors and creditors review the compensation plan information in the proxy material to determine possible future impacts on profitability. 77
Net profit margin was 9.8% in 2000 and 1999 but is negative in 2001, though not as low as operating profit margin. Gains on long-term investments and interest income have mitigated the negative impact of lower sales and the operating loss in 2001. How Apple does in the future will depend not only on the economy and industry within which they operate, but also how well Apple can adjust expenses to changes in sales. Distinguishing their products through new innovations is a strategy that could contribute to future profits, which appears to be a strategy of Apple since they have increased research and development. Market Measures The earnings per share numbers are indicative of the volatile industry Apple operates within. Market data was not provided to calculate PE ratios. 2. Strengths Solid short-term liquidity and long-term solvency Cash flow from operations is positive Efficient management of current assets and liabilities Low debt ratios Investments in research and development
Weaknesses Volatile industry Highly competitive industry Declining sales and profit margins Operating at a loss in 2001 Declining fixed asset turnover and total asset turnover
3. The following factors may cause historical trends to be unreliable as a prediction of the future. • Global and national economic conditions could impact sales significantly. • Terrorist attacks in the future could adversely affect the company. • Significant innovations of competitors could negatively impact Apple. • Volatility in the industry could impact Apple's suppliers and in turn hurt Apple. • Accounting scandals have negatively impacted stock prices of all companies. • Apple's significant short and long-term investments are affected by the economic, political and investing environment.
78
CASE 5.2 ZILA, INC. 1.
Common Size Balance Sheets
(in percent)
2001
2000
Ind Avg*
2.2 13.6 23.2 2.9 41.9 12.9 6.7 16.8 16.6 -5.1 100.0
7.2 12.7 17.0 3.5 40.4 12.1 7.2 16.4 16.0 3.8 4.1 100.0
7.7 36.7 30.5 1.8 76.5 9.9
ASSETS Current assets: Cash Trade receivables Inventories-net Prepaid expenses and other Total current assets Property and equipment, net Purchased technology rights, net Goodwill, net Trademarks and other intangibles, net Cash held by trustee Other assets Total assets
LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable 7.0 8.5 Accrued liabilities 4.4 4.6 Short-term borrowings 8.0 0.1 1.0 Current portion of long-term debt 1.1 Total current liabilities 20.5 14.2 5.9 Long-term debt 5.4 20.1 Total liabilities 25.9 Shareholders' equity Preferred stock 0.6 -Common stock 0.1 -Capital in excess of par 104.4 102.2 Accumulated other comprehensive income 0.2 0.1 Accumulated deficit (30.5) (21.9) (0.5 ) Less: Treasury stock (0.7 ) 79.9 Total shareholders' equity 74.1 Total liabilities and shareholders' equity 100.0 100.0
79
9.9 3.7
27.4 11.9 1.3 51.4 9.3 65.3
34.7
Common Size Income Statement (in percent)
2001
2000
1999
Net revenues Cost of products sold Gross profit Selling, general and administrative Research and development Depreciation/amortization Operating income (loss) Interest income Interest expense Other income (expense) Gain on sale of assets Income (loss) before taxes Income tax benefits (expense) Net income (loss)
100.0 56.2 43.8
100.0 51.6 48.4
100.0 48.2 51.8
Effective tax rate Sales growth Operating expense growth
43.2 4.1 4.8 (8.3) 0.4 (0.8) (0.3) -(9.0)
41.8 2.1 4.5 (0.0) 0.5 (0.3) (0.2) 6.0 6.0
44.7 5.6 5.0 (3.5) 0.4 (0.5) --(3.6)
0.4 (8.6)
(2.3 ) 3.7
0.8 (2.8)
(5.0)
37.5
(23.3)
2000-2001 (5.0%) 2.3%
80
Ind. Avg.* 100.0 69.4 30.6 25.3 5.2
3.8
1999-2000 8.8% 5.2%
Summary Analysis of Statement of Cash Flows (all dollar values in thousands)* Inflows: Cash from Operations Sale of assets Short-term borrowings Issuance of common stock Long-term debt Cash released by trustee Total Inflows
2001 $ % --1,031 9.8 6,109 57.9 476 4.5 --27.8 2,928 10,544 100.0
2000 $ 1,135 7,750 -224 -1,907 11,016
% 10.3 70.4 -2.0 -17.3 100.0
1999 $ % ----29 0.3 259 2.7 9,209 97.0 --9,498 100.0
Outflows: Cash from operations Property, plant and equipment Acquisition Purchase of intangibles Repayment of short-term debt Treasury stock purchase Cash held by trustee Repayment of long-term debt Total Outflows
8,684 60.1 2,598 18.0 1,849 12.8 834 5.8 --125 0.8 --2.5 361 14,451 100.0
--5,198 46.3 --159 1.4 21 0.2 410 3.6 --5,441 48.5 11,229 100.0
792 8.8 1,763 19.7 --686 7.7 ----4,835 53.9 893 9.9 8,968 100.0
Increase (decrease) in cash and cash equivalents
(3,907)
*Numbers may not add due to rounding.
81
(212)
530
Financial Ratios Short-term liquidity Current ratio Quick ratio Cash flow liquidity ratio Average collection period Days inventory held Days payable outstanding Net trade cycle CFO
2001
2000
2.04 0.91 (0.45) 52 days 157 days 47 days 162 days
2.84 1.64 0.61 47 days 121 days 61 days 107 days
(8,684)
1,135
Growth Rates from 2000 to 2001 Sales Accounts receivable Allowance for doubtful accounts
1999
Ind Avg* 1.5 0.9 50 days 67 days 43 days 74 days
(5.0%) 5.2% (9.8%) 2001
Operating efficiency Accounts receivable turnover 7.08 Inventory turnover 2.33 Accounts payable turnover 7.77 Fixed asset turnover 7.49 Total asset turnover 0.96 Capital structure and long-term solvency Debt ratio 25.91% Long-term debt to total 6.82% capitalization Debt to equity 0.35 Financial leverage index ** Times interest earned (10.26) Cash interest coverage (15.89) Fixed charge coverage (5.27) Cash flow adequacy (2.93)
82
2000
1999
Ind. Avg.
7.84 3.03 6.06 8.22 1.00
7.3 5.5 8.5 37.2 2.6
20.07% 6.82%
65.3%
0.25 1.20 0.10 8.31 0.66 0.11
3.2 (6.27) (2.45) (2.90) (0.30)
3.4
Profitability Gross profit margin Operating profit margin Net profit margin Cash flow margin Return on total assets Return on equity Cash return on assets Market Measures Earnings per share PE ratio High (4th quarter) Low (4th quarter)
43.8% (8.3%) (8.6%) (11.78%) (8.23%) (11.13%) (11.34%)
48.4% (0.0%) 3.7% 1.46% 3.77% 4.72% 1.46%
($0.15) (20) (14)
$0.07 71 45
51.8% (3.5%) (2.8%) (1.11%)
30.6% 5.2%
* Industry average is from Robert Morris Associates, Annual Statement Studies, 2001; SIC #5047 ** Since earnings are a loss financial leverage index is below 1 Short-term liquidity Zila's short-term liquidity is deteriorating. All ratios have become worse from 2000 to 2001, however, the current and quick ratios are above the industry average. The decline in these two ratios has been caused mainly by the significant increase in short-term borrowings. An important piece of information regarding the short-term borrowings is revealed in the notes to the financial statements. These borrowings at Bank One were paid off in August, 2001 when Zila borrowed from Congress Financial Corporation. The new borrowings consist of a $12 million line of credit, double the prior amount from Bank One. This has most likely caused the current and quick ratio to decline further since the year-end 2001. It should be further noted that Zila had violated covenants of the Bank One loans. The cash flow liquidity ratio is negative in 2001 as a result of negative cash from operations. The cause of the negative cash flow is a result of the net loss in 2001 combined with a reduction of accounts payable and a significant increase in inventories. Cash from operations was positive in only 2000, but this was caused by the significant use of accounts payable in that year. The average collection period has grown by 5 days from 2000 to 2001 and is now higher than the industry average. In addition an analysis of the accounts receivable account creates more questions than answers. Sales have declined from 2000 to 2001, yet accounts receivable have increased, indicating possibly more lenient collection policies. One would expect the allowance for doubtful accounts to rise also, but instead this account has 83
decreased. While there may be legitimate reasons for this decline, such as prior over estimation of this account, one has to consider the possibility of manipulation to increase net earnings. Days inventory held has increased by 36 days and is 90 days longer than the industry. The increase in inventory in 2001 is explained by the large purchase of inventory connected to Zila entering the saw palmetto business line of products in 2001. If the firm is successful in this particular product line, inventory balances should decline in the future. Days payable outstanding has decreased from 61 to 47 days and is almost in line with the industry average. The net trade cycle was negatively impacted in 2001 by the higher collection period and days inventory held, as well as the faster payment of accounts payable. Zila needs to manage their current assets better in order to achieve better cash from operations. Operating efficiency Zila is not as efficient as their competitors as evidenced by the turnover ratios. In addition to the poor management of accounts receivable and inventory, the company has low and declining fixed and total asset turnovers. The decline in sales coupled with increasing capital expenditures has added to the efficiency problem in the company. Sales declined significantly in the vitamin/food supplement industry according to the president of the firm. Capital structure and long-term solvency Zila, surprisingly, does not have as risky a capital structure as their competition. The leverage ratios indicate the firm finances approximately 26% of assets with debt and only 7% is long-term. The challenges Zila is facing are not with the amount of debt in the company's capital structure but rather the lack of profitability and generation of cash from operations. The year 2000 is the only year that Zila has positive cash from operations and a net profit, resulting in positive coverage ratios. Even 2000, however, Zila had a low cash flow adequacy ratio of 0.11. The company needs to focus on increasing revenues and decreasing expenses, discussed in the next section. Profitability Net revenues increased from 1999 to 2000 without a corresponding increase in expenses, resulting in Zila generating a profit. Revenues declined from 2000 to 2001, while expenses increased, negatively impacting the profitability of 2001. Although gross profit margin is higher than the industry average, the trend is downward over the three-year period, dropping 84
8%. Either costs of products are rising, or the company is discounting selling prices. This area is one that needs to be addressed, as the firm should be trying to pass on costs to customers. Zila's selling, general and administrative (SGA) costs are high. From 1999 to 2000 the company appeared to control these costs better, however, they have increased again in 2001. With the drop in gross profit margin and the large SGA expense, the firm has not generated operating profit in three years. Research and development expenses have been volatile over the three-year period. Further investigation is warranted. The Oratest project is a good use of these funds, but the lower percentage of R&D in 2000 is questionable given the industry Zila operates within. Net profit margins are also negative in 1999 and 2001. The positive amount in 2000 is a result of a one-time gain on the sale of assets. Without considering this gain, Zila did not generate net profit in 2000. Adding further to the losses in 2001 is the increase in interest expense caused by the increased short-term borrowings. The return on assets, return on equity and cash return on assets reflect the problems of operating efficiency, lack of profits and lack of cash from operations. The future success of Zila appears to be closely tied to the success of the Oratest project and their entrance into the saw palmetto line of business. The firm needs to address how to reduce costs while increasing revenues. Market measures In 2000, the market placed a high value on the company, but stock prices have dropped, most likely due to the uncertainty of FDA approval and the poor operating results. 2. • • • •
Reasons for investment in Zila common stock Potential success of Oratest, pending FDA approval Stock price is currently low Capital structure is not as risky as competition Entrance into saw palmetto product line could help firm achieve profitability
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Reasons against investment in Zila common stock • Risky business due to possible FDA rejections • Poor profitability caused by high SGA expenses • Negative cash from operations • Risk of having high inventory levels • Questionable patterns of sales, accounts receivable and allowance for doubtful accounts • High net trade cycle • Inconsistent funding of R&D • Doubled short-term borrowings at new financial institution after year-end • Violation of bank covenants at Bank One 3.
Reasons for loaning Zila additional funds • Current amounts of debt are low relative to assets and equity • Potential for success of Oratest project could generate significant cash and profits • Higher interest rate could be charged due to higher risk
Reasons against loaning Zila additional funds • Doubled short-term borrowings after year-end • Violation of loan covenants at prior bank • Negative cash from operations • Lack of profitability • FDA rejection of Oratest would further hurt profits and cash of company
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