Understanding Financial Statements, 10E by Aileen Ormiston, Lyn M. Fraser Solutions Manual

Type:

Solution Manual

Understanding Financial Resource: Statements Edition:

10th Edition

Author(s):

Aileen Ormiston Lyn M. Fraser

Solutions to Study Questions, Problems, and Cases Chapter 1 1.1

The types of questions that can be answered include the following:

• Would an investment generate attractive returns?

• What is the degree of risk inherent in the investment?

• Should existing investment holdings be liquidated?

• Will cash flows be sufficient to service interest and principal payments to support the firm’s borrowing needs?

• Does the company provide a good opportunity for employment, future advancement, and employee benefits?

• How well does this company compete in its operating environment?

• Is this firm a good prospect as a customer?

1.2 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.

1.3 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.

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1.4 The SEC has the legal authority to write accounting rules in the United States; however, they choose to delegate writing rules, for the most part, to the FASB. The SEC plays a supportive role and at times will encourage FASB to write particular rules or make changes to policies.

1.5 The annual report or Form 10-K includes the following four financial statements: 1. The balance sheet or statement of financial position shows the financial position—assets, liabilities, and stockholders’ equity—of the firm on a particular date, such as the end of a quarter or a year.

2. The income or earnings statement presents the results of operations— revenues, expenses, net profit or loss, and net profit or loss per share—for the accounting period.

3. The statement of stockholders’ equity reconciles the beginning and ending balances of all accounts that appear in the stockholders’ equity section of the balance sheet. Some firms prepare a statement of retained earnings, frequently combined with the income statement, which reconciles the beginning and ending balances of the retained earnings account. Companies choosing the latter format will generally present the statement of stockholders’ equity in a footnote disclosure.

4. The statement of cash flows provides information about the cash inflows and outflows from operating, financing, and investing activities during an accounting period.

1.6

The notes are, in fact, an integral part of the statements and must be read in order to understand the presentation on the face of each financial statement.

The notes to the financial statements provide a summary of the firm’s accounting policies, any changes in accounting policies during the reporting period, details about particular accounts, such as inventory, property, plant, and equipment, investments, debt and equity accounts, and information about items such as acquisitions, divestitures, pension and stock option plans, leases, legal proceedings, income taxes, contingencies, commitments, and segments,

1.7 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 2

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.

1.8 The Management Discussion and Analysis section is of potential interest to the analyst because it contains information that cannot be found in the financial data. The content of this section includes coverage of any favorable or unfavorable trends and significant events or uncertainties in the areas of liquidity, capital resources, and results of operations. In particular, the analyst can expect to find a discussion of the following: 1. The internal and external sources of liquidity 2. Any material deficiencies in liquidity and how they will be remedied 3. Commitments for capital expenditures, the purpose of such commitments, and expected sources of funding 4. Anticipated changes in the mix and cost of financing resources 5. Unusual or infrequent transactions that affect income from continuing operations 6. Events that cause material changes in the relationship between costs and revenues (such as future labor or materials price increases or inventory adjustments) 7. A breakdown of sales increases into price and volume components 1.9 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.

1.10 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.

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1.11 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, 20??).

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1.12 There is no solution presented as the information will be changing over time.

1.13 The SEC website contains information useful to the financial analyst including the following sections:* "About the SEC" explains the role of the SEC, outlines the laws, regulations, and rules of practice of the SEC, includes biographies of the SEC commissioners, lists upcoming events, offers a listing of all the forms available at the SEC, and includes the strategic plan, annual reports, budgets, and directories of the SEC. "Filings and Forms" includes the EDGAR database which allows analysts to access the SEC forms filed by publicly-held companies. A quick EDGAR tutorial is offered in this section as well as a description of SEC forms and how to request paper documents.

“Regulatory Actions” provides links to releases concerning SEC rulemaking activity.

"Staff Interpretations" provides guidance of the SEC staff members on various accounting and legal matters.

"Investor Information" allows the analyst to search for information, ask questions, file complaints, access research tools and calculators, and includes warnings and updates the SEC may desire to share with the public.

"SEC Newsroom" includes SEC press releases, speeches and testimony by senior SEC officials, special studies and reports and a daily summary of significant SEC actions.

"Litigation" provides information on SEC enforcement actions.

"Divisions & Offices" has links to each SEC division and office and includes an organization chart of the SEC. Each of the division links offers significant information related to each division's duties.

Other links provided on the SEC homepage include information for specific groups such as accountants, broker dealers, EDGAR filers and small business to name a few. *Information was obtained in May, 2011. Changes may have been made since that date.

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Case 1.1 (a) In 2010 Intel is the world's largest semiconductor chip maker based on revenue. The company also develops integrated digital technology, primarily integrated circuits, for industries such as computing and communications and hardware and software computing platforms. Other products include microprocessors, chipsets, motherboards, and wireless and wired connectivity products. (pg. 1 of Form 10-K) (b)

The analyst could learn the following by reading the letters from the CEO and the chairman: • Intel reported the best financial results ever in 2010, • Xeon and Itanium processors were introduced in 2010 that delivered higher performance for servers as well as better reliability and security features, • the Intel Atom processor family of products is allowing Intel to expand into new markets of computing devices, • new second generation “core” processors represent the largest increase in computing performance and capabilities over any previous generation, • since 2009 Intel has been shipping 32-nanometer process technology while the competition had not shipped any, • production of 22 nanometer process technology is scheduled to begin in 2011, • Intel acquired Infineon’s Wireless Solutions business and Texas Instruments’ cable modem product line to take advantage of connectivity growth opportunities, • in 2010 Intel announced plans to acquire McAfee, the world’s largest dedicated security technology company , in order to work toward better security in connected devices, • for the third consecutive year Intel was the largest purchaser of green power and earned certification and awards for sustainable construction as well as a philanthropy award for contributions to education, • dividends paid out continue to increase and the firm repurchases stock to increase stockholder value, • new factories are being built in Oregon and Arizona, • a new committee has been formed to monitor and ensure that Intel is in compliance with legal requirements globally and is operating at the highest level of integrity, and 6

• Intel is promoting education and access programs for women and underserved minorities, as well as increasing diversity in its own workforce. (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. Intel also received an unqualified opinion on the effectiveness of their internal controls over financial reporting. (pgs. 105-106 of Form 10-K) (d) The Management Discussion and Analysis for Intel discusses the following items: 1. The company expects the key source of liquidity to be cash from operating activities. In 2010, Intel generated over $16 billion of cash from operations. Cash is generated externally from the sale of stock through employee plans and the firm raised $587 million in proceeds in 2010. The company has the potential to borrow $3.0 billion under its commercial paper program. Intel borrowed $150 million in 2010 but this was repaid before year-end. In addition, Intel has the ability to offer an unspecified amount of debt, equity and other securities because it has an automatic shelf registration on file with the SEC. (pgs. 40-42 of Form 10-K) 2. No material deficiencies of liquidity currently exist. (pgs. 40-42 of Form 10-K) 3. Intel plans to spend approximately $9 billion plus or minus $300 million in 2011 for capital expenditures. The funds will be used for investments in 22 nanometer process technology. (pg. 39 of Form 10-K) It is implied that funding will come from cash from operations. (pg. 42 of Form 10-K) 4. No anticipated changes in the mix and cost of financing resources are discussed. (pgs. 39-42 of Form 10-K) 5. No unusual or infrequent transactions were found in 2010; however the Intel paid a large fine to the European Commission and settled a lawsuit with AMD in 2009. (pg. 34 of Form 10-K) 6. Intel's restructuring program to promote efficiency and reduce costs is expected to continue to positively impact the firm in 2011. (pg. 35 of Form 10-K) Intel is projecting higher revenues in 2011, but will also experience lower gross margins and higher expenses in most categories. On a percentage basis it appears that Intel may just maintain its current net profit margin. (pg. 39 of Form 10-K) 7

7. Sales increased 24% overall due to higher microprocessor and chipset unit sales, as well as higher microprocessor average selling prices. The PC Client Group revenues increased 21% primarily due to higher volume of notebook unit sales and, to a lesser extent, higher average selling prices for notebooks. One area that had significantly lower sales was the wireless connectivity product lines. The Data Center Group revenues increased 35% due primarily to volume, and, to a lesser extent, higher average selling prices. Revenues increased 27% in the Other Intel Architecture segment due to volume increases. (pgs. 31-33 of Form 10-K) (e) Intel appears to have a good strategy and is focusing on new growth opportunities. The firm has the financial resources to pursue their strategy. Some concerns may be potential competition and continued litigation.

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Case 1.2 (a) The 'Analysis ToolPak' add-in must be installed and active.

Enter data on this sheet before other financial statement information.

Clear

Company Name: Avnet Stock Ticker Symbol: U.S. Stock Exchange: Statement Year-end Dates: Financial Reports Rounded to : Supplemental Ratio Requirements:

AVT NYSE 12/31/2000 7/3/2010

Variable 6/27/2009

6/28/2008

2009

2008

Thousands 2010

Rent expense (in thousands): $

64,487 $

64,382 $

59,176

23.98 $

21.52 $

29.55

Dividends per share: End of year stock price (adjusted for splits ): $

Marketwatch.com URL for stock prices: http://marketwatch.co m/to o ls/ http://marketwatch.co m/to o ls/ http://marketwatch.co m/to o ls/ quo tes/histo rical.asp?date=07 quo tes/histo rical.asp?date=06 quo tes/histo rical.asp?date=06 %2F02%2F2010&symb=A VT& %2F26%2F2009&symb=A VT& %2F27%2F2008&symb=A VT& siteid=mktw siteid=mktw siteid=mktw Check Figures: Balance Sheet

Current Assets: $

6,630,168 $

5,144,252

Total Assets: $

7,782,382 $

6,273,516

Current Liabilities: $

3,439,615 $

2,455,860

Total Stockholders' Equity: $

3,009,117 $

2,760,857

Gross Profit: $

2,280,217 $

2,022,993 $

2,313,716

Operating Profit: $

635,600 $

(1,018,998) $

710,771

Net Profit: $

410,370 $

(1,129,712) $

489,578

Net Flows from Operations: $

(30,415) $

1,118,035 $

453,617

Net Flows from Investing Activity: $

(112,421) $

(397,685) $

(378,380)

Net Flows from Financing Activity: $

296,772 $

(405,241) $

(33,047)

Income Statement

Cash Flow

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(b) Each student’s response will differ depending on the news sources used and the date on which the student completes the assignment. Below is a sampling of news from articles in 2010-2011: Source: Online Product News, August 2010 "Avnet Express Launches Asia-Wide Ecommerce Site" Avnet is launching its first distributor website in Asia to offer a China payment capacity and rapid access to inventory held across Asia.

Source: Electronics Weekly, September 8, 2010 "Zammit: ‘No Major Risks’” Avnet’s European President, Patrick Zammit, discusses the German industrial economy which is showing good growth. He predicts a 30% growth rate in 2010.

Further he states that there is no inventory build-up at this time.

Source: Zacks Equity Research, May 19, 2011 "Avnet Flexes Distribution Muscle" Avnet will acquire IT distributor, Amosdec, headquartered in Paris. Avnet’s strategy has been to acquire smaller targets in markets where they want to expand their business. Avnet’s recent acquisitions of Bell Micro and Tallard have firmly established Avnet as a leading distributor in Latin America. (c) Item 1 in the Avnet Form 10-K for 2010 describes the business in which Avnet operates. The organizational structure of the firm is detailed including information about Avnet’s two operating groups, the economic regions in which the firm operates, and the products and solutions that Avnet provides to their customers. The firm’s strategy with regard to acquisitions is explained as well as the competition Avnet faces and the advantages they believe they have with regard to the competition.

Item 3 of the Form 10-K informs the reader of the legal proceedings in which Avnet is a party. Avnet has incurred liabilities related to environmental issues with regard to disposal of hazardous substances. The firm believes it has accrued its share of the costs for any environmental clean up in its financial statements.

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The auditor's report indicates that KPMG LLP has given Avnet unqualified opinions on their financial statements as well as their effectiveness in maintaining internal controls. *

*The auditor’s report is usually in Item 8; however, Avnet has moved this item to Item 15 and noted this under Item 8.

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Case 1.3 1.

Mattel, Inc. designs, manufactures, and markets a broad variety of toy products worldwide.

2. a. Balance sheet - pg. 54 b. Income statement - pg. 55 c. Statement of cash flows - pg. 56 d. Statement of stockholders' equity - pg. 57 e. Notes to the financial statements - pgs. 58-102 f. Management's discussion and analysis - pgs. 25-47 g. Summary of selected financial data - pg.24 h. Auditor's report - pg. 53 3. PricewaterhouseCoopers LLP 4. a. Assets - $5,417,733 b. Liabilities - $2,789,149 c. Stockholders' equity – $2,628,584 d. Net sales - $5,856,195 e. Net income - $684,863 f. Cash increased $164,126 g. Retained earnings - $2,720,645

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Case 1.4 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. e. f.

The principal source of liquidity for Apple is internal, cash generated by operating activities, as well as the current balances in cash, cash equivalents, and marketable securities. There is no mention in the MD&A of external sources of liquidity in the form of equity financing and Apple currently has no debt financing.

No material deficiencies of liquidity currently exist.

Apple plans to spend approximately $4 billion for capital expenditures, including product tooling and manufacturing process equipment, corporate facilities, and infrastructure. Apple has sufficient cash on hand ($51 billion) to cover these expenditures and has generated between $9 and $18 billion of cash from operating activities in each of the past three years.

No changes to the current mix and cost of financing resources were discussed. This is not surprising given the large amounts of cash Apple generates.

No unusual or infrequent transactions were discussed in the MD&A. If Apple continues to be successful in innovating new products that create high demand such as their iPhone and iPad products, the relationship between costs and revenues should be stable or could possibly result in higher revenues relative to costs. Competition or saturation of markets could result in higher costs relative to revenues, 13

g.

but at this point seems unlikely. Apple projects lower gross margin percentages in the future, but has been able to increase revenues faster than operating expenses other than cost of goods sold, therefore, it appears that Apple should be able to maintain the current relationship between costs and revenues.

Net sales increased 52% in 2010 after a 14% increase in 2009. The increase in sales was driven by an increase in the volume of sales of the iPhone and related products and services in both 2009 and 2010.

In addition the iPad was released in 2010. Mac unit sales increased in 2009 and 2010, however, selling prices declined. Sales volume increased for music related products and services both years as a result of growth of the iTunes App Store. Unit sales of iPods decreased in 2010 while net sales($) of iPods increased due to a shift in product mix toward iPod touch. In 2009, iPod net sales and unit sales decreased due to price reductions taken with the introduction of new iPods and a stronger U.S. dollar, offset partially by a higher mix of iPod touch sales.

3.

Apple explained changes in numbers and offered reasons for these changes. Some forward-looking information was offered in the discussion of expenses and capital expenditures, however, forwardlooking information related to future revenues would be helpful. The overall quality of the MD&A is good.

4.

Answers will vary based on individual students' reactions to the MD&A. An example of a possible response follows.

The prospects are excellent for Apple. The company focuses on innovation as evidenced by the increased spending on research and development. In addition, Apple is expanding its retail operations overseas to capture more markets. Demand for Apple products is currently high as evidenced by the large increase in sales in 2010. The firm generates significant amounts of cash and has no debt which has resulted in a solid financial structure.

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Chapter 2 2.1 The balance sheet shows the financial condition or financial position of a company on a particular date. The statement is a summary of what the firm owns (assets) and what the firm owes to outsiders (liabilities) and to internal owners (stockholders’ equity). By definition, the account balances on a balance sheet must balance; that is, the total of all assets must equal the sum of liabilities and stockholders’ equity. The balancing equation is expressed as: Assets = Liabilities + Stockholders’ equity 2.2

Each item on the balance sheet is expressed as a percentage of total assets.

2.3 The valuation of marketable securities on the balance sheet as well as other investments in debt and equity securities requires the separation of investment securities into three categories depending on the intent of the investment: 1. Held to maturity applies to those debt securities that the firm has the positive intent and ability to hold to maturity; these securities are reported at amortized cost. Debt securities are securities representing a creditor relationship, including U.S. Treasury securities, municipal securities, corporate bonds, convertible debt and commercial paper.

2. Trading securities are debt and equity securities that are held for resale in the short term, as opposed to being held to realize longer-term gains from capital appreciation. Equity securities represent an ownership interest in an entity, including common and preferred stock. These securities are reported at fair value with unrealized gains and losses included in earnings. Fair value is the price that would be received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date.

3. Securities available for sale are debt and equity securities that are not classified as one of the other two categories, either held to maturity or trading securities. Securities available for sale are reported at fair value with unrealized gains and losses included in comprehensive income. The cumulative net unrealized gains or losses are reported in the accumulated other comprehensive income section of stockholders’ equity.

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2.4 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.

2.5 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.

2.6 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.

2.7 The FIFO method of inventory valuation will produce an inventory valuation closest to current cost because the first goods purchased are assumed sold, therefore, the last goods are included in ending inventory and will be closest to current cost.

2.8 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.

2.9 Listing the account "Commitments and contingencies" on the balance sheet will draw attention to the fact that the firm has disclosures in the notes to the financial statements about contractual agreements and potential liabilities the firm has that may have a significant financial impact on the firm in the future.

2.10 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.

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2.11 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

2.12 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.

2.13 Net revenues Total accounts receivables Allowance for doubtful accounts

Change from 2011 to 2012 2.1% 2.5% (59.8%)

Allowance account as a percentage of receivables: Allowance for doubtful accounts Net Receivables + Allowance 2012 2011

$1,206 $93,233 + $1,206 $3,001 $89,135 + $3,001

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Percentage of Receivables 1.28% 3.26%

As revenues have increased at ABC, Inc., receivables have also increased. This is an expected pattern; however, it is unusual for the allowance account to decrease.

The allowance account as a percentage of total accounts receivables indicates that the management at ABC believes that a higher percentage of receivables will be collected compared to prior years as evidenced by the drop in the allowance/accounts receivables ratio from 3.26% to 1.28%. The analyst would want to explore the reason for this change. The valuation schedule indicates that actual write-offs for the firm are increasing each year. It is noteworthy that even though the actual write-offs are increasing, the dollar amount of the write-offs is significantly less than the estimated amount the firm has recorded as potential bad debt in the allowance account. If ABC expected significant customer defaults, this information should be disclosed in the notes to the financial statements. It is possible that the management at ABC unintentionally overestimated the allowance account in 2009 and 2011; however, it is also possible the firm is using the allowance account as a way to manipulate net income. By overestimating one year, the firm can correct the error in a later year by reducing the allowance account and causing an increase to net income. The credits (negative charges) to the bad debt expense account in 2010 and 2012 would result in higher net income in those years, while the charge to the bad debt expense account in 2011 would lower net income. The volatile pattern of charges when actual write-offs are trending upward is suspicious. In addition, if actual write-offs continue to increase in 2013, the current balance of $1,206 thousand may be inadequate.

2.14 (a) Information to be used for all methods of inventory valuation: Beginning inventory Purchase Purchase Purchase Total

Units x Cost = Total 600 x $10 = $ 6,000 1,000 x 11 = 11,000 900 x 12 = 10,800 700 x 14 = 9,800 3,200 $37,600

Sales for the year = 1,900 units Ending inventory = 3,200 - 1,900 = 1,300 units Weighted average cost per unit: $37,600 = $11.75 3,200

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COGS = $11.75 x 1,900 units = $22,325 EI = $11.75 x 1,300 units = $15,275 Total goods available for sale = $37,600 FIFO COGS: 600@$10 = $ 6,000 1,000@$11 = $11,000 300@$12 = $ 3,600 1,900 units $20,600

EI: 600@$12 = $ 7,200 700@$14 = $ 9,800 1,300 units $17,000 Check answer: COGS +EI Total goods available

$20,600 17,000 $37,600

LIFO COGS: 700@$14 = $ 9,800 900@$12 = $10,800 300@$11 = $ 3,300 1,900 units $23,900

EI: 600@$10 = $ 6,000 700@$11 = $ 7,700 1,300 units = $13,700 Check answer: COGS +EI Total goods available

(b)

FIFO

(c)

LIFO

$23,900 $13,700 $37,600

(d) During inflationary periods, LIFO assumes the last goods purchased have been sold and the first goods purchased remain in ending inventory, therefore, 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 which assumes the first goods purchased have been sold and the last goods purchased remain in ending inventory results in a currently valued balance sheet inventory but an understated cost of goods sold expense and thus an overstatement of net income; average cost falls in between LIFO and FIFO. 19

2.15 (a) Information to be used for all methods of inventory valuation: Beginning inventory January 10 purchase April 25 purchase July 10 purchase October 15 purchase Total

Units x Cost = Total 10,000 x $3.00 = $ 30,000 4,000 x 3.50 = 14,000 10,000 x 4.00 = 40,000 6,000 x 4.50 = 27,000 8,000 x 5.00 = 40,000 38,000 $151,000

Sales for the year = 8,000 + 11,000 + 3,000 + 9,000 = 31,000 units Ending inventory = 38,000 - 31,000 = 7,000 units FIFO COGS: 10,000@$3.00 = $ 30,000 4,000@$3.50 = $ 14,000 10,000@$4.00 = $ 40,000 6,000@$4.50 = $ 27,000 1,000@$5.00 = $ 5,000 31,000 units $116,000

EI: 7,000@$5.00 = $35,000 Check answer: COGS +EI Total goods available

$116,000 35,000 $151,000

LIFO (periodic) COGS: 8,000@$5.00 = $ 40,000 6,000@$4.50 = $ 27,000 10,000@$4.00 = $ 40,000 4,000@$3.50 = $ 14,000 3,000@$3.00 = $ 9,000 31,000 units $130,000

EI: 7,000@$3.00 = $21,000 Check answer: COGS +EI Total goods available

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$130,000 21,000 $151,000

LIFO (perpetual) COGS: Jan. 1 - Mar.31 4,000@$3.50 = $14,000 4,000@$3.00 = $12,000 Apr. 1 - Jun. 30 10,000@$4.00 = $40,000 1,000@$3.00 = $ 3,000 Jul. 1 - Sept. 30 3,000@$4.50 = $13,500

EI: Mar. 31 6,000@$3.00 = $18,000 Jun. 30

Oct. 1 - Dec. 31 8,000@$5.00 = $40,000 1,000@$4.50 = $ 4,500

5,000@$3.00 = $15,000 Sept. 30 5,000@$3.00 = $15,000 3,000@$4.50 = $13,500 Dec. 31 5,000@$3.00 = $15,000 2,000@$4.50 = $ 9,000

Total COGS = $127,000

EI = $24,000

Check answer: COGS + EI = $127,000 + $24,000 = $151,000 Average Cost per unit: $151,000 = $3.97 38,000

COGS = $3.97 x 31,000 units = $123,070 EI = $151,000 - $123,070 = $ 27,930 (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 of net income; average cost falls in between LIFO and FIFO and is a good choice for companies with volatile inventories.

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2.16 (a) FIFO is probably used for the rest of Chemco's inventories. Companies using LIFO must disclose the value of those inventories as if FIFO had been used, which Chemco has done in this case. (b) Finished goods includes inventories that are complete and ready for sale.

Work in process is comprised of inventories currently in the manufacturing process, but not yet complete. Raw materials and supplies have not been put in the manufacturing process. The amount closest to current cost would be the FIFO inventory value. 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. The LIFO valuation reduction is a result of the impact of inflation on inventory values. Since the first goods purchased using LIFO remain in inventory, LIFO inventories would be valued at a lower amount than FIFO inventories during an inflationary period. Chemco's inventories are lower in 2012, ($447,866) than they would have been if reported using FIFO ($531,695).

2.17 (a) (b)

$60,000 = $12,000 per year 5

Year 1 Year 2

$60,000 x 2/5 = $24,000 ($60,000 - $24,000) x 2/5 = $14,400

2.18 Using the equation from Chapter 2, the calculations to determine dividends are as follows:

2008 2009 2010

Beginning retained earnings

+

700 890 1,045

+ + +

net income - dividends = 250 225 40 -

22

60 = 70 = 75 =

Ending retained earnings 890 1,045 1,010

2.19 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

23

$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

2.20 Liz, The reason that Tom thinks the debt structure of ShopWorld is risky and has calculated the debt ratio of the firm to be 76% has to do with the fact that ShopWorld is leasing a significant amount of fixed assets. When a firm chooses to lease property and equipment, the accounting rules require firms to record these leases as either an operating lease, a rental agreement, or a capital lease which is treated like purchasing the asset on credit. Capital leases cause the firm to record both an asset and a liability on the balance sheet, however, operating leases are merely disclosed in notes to the financial statements.

Since Tom realizes that ShopWorld is legally obligated to make payments on the operating leases for the duration of the lease, he has treated these amounts as an obligation or debt and added those amounts to the balance sheet numbers for debt. The amount that Tom added to the total liabilities on the balance sheet is the "Total future minimum lease payments" of $4,863 for the operating leases.

ShopWorld’s capital lease obligations are already included in the liabilities on the balance sheet.

Companies with debt of 76% are generally considered risky since this means the firm is financed with 76% debt and 24% from equity sources such as sales of stock or retained earnings. The higher the debt, the higher the chance of bankruptcy and the less chance the firm will be able to borrow more funds if needed.

Your friend, XXXXX 2.21 There is no solution presented here since a variety of companies may be used for this problem. Assigning specific companies will allow instructors to review answers in the class as a whole.

2.22 There is no solution presented here since a variety of industries may be used for this problem. Assigning specific industries will allow instructors to review answers in the class as a whole.

24

Case 2.1 (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, net Marketable equity securities Other long-term investments Goodwill Other long-term assets Total Assets

25

2007

2006

9% 18 8 5 6 2 2 50% 28% 2 5 7 8 100%

8% 10 9 4 6 2 1 40% 33% 1 8 8 10 100%

Liabilities: Current liabilities Short-term debt A/P Accrued compensation and benefits Accrued advertising Deferred income on shipments to distributor Other accrued liabilities Total current liabilities Long-term income tax payable Long-term debt Deferred tax liabilities Other long-term liabilities Total liabilities Stockholders' equity Common stock Accumulated. other comprehensive income Retained earnings Total stockholders' equity Total liabilities & stockholders' equity

2010

2009

--% 4 4 2 1 4 15% -3 1 2 21%

--% 4 5 1 1 3 14% -4 1 2 21%

26 1 52 79% 100%

28 1 50 79% 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 equity securities, long-term investments, goodwill, and an other assets account. The most significant assets to the company are cash and short-term investments, property, plant and equipment, long-term investments (including other long-term assets which include investments) 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 instruments, a break-down of the inventory account into raw materials, work in process and finished goods, detail of the property, plant and equipment account, the estimated useful lives of plant and equipment, goodwill, and other intangible assets.

26

The asset structure has changed. Current assets have increased 10% overall, while long-term assets have decreased by that amount. In particular, short-term investments more than doubled in dollar amount and increased from 10 to 18% of total assets. The changes in long-term assets consist of a 5% decline in the net property, plant and equipment account and a 5% decline in the other long-term investments accounts. The decline in the property, plant and equipment account is a result of the large increase in dollars in the short-term investment account as property, plant and equipment has actually increased in dollars. (c)

2010 2009

Allowance account as a percentage of accounts receivable: Allowance for doubtful accounts Net Receivables + Allowance

Percentage of Receivables

$28 $2,867 + $28

0.97%

$19 $2,273 + $19

Sales Total accounts receivable Allowance for doubtful accounts

0.83%

Change from 2009 to 2010 24.2% 26.3% 47.4%

As sales have increased both the accounts receivable and the allowance for doubtful accounts have also increased. This is a normal pattern. Looking at the valuation and qualifying accounts schedule in Intel's Form 10-K (page 111) it appears that Intel’s allowance account balance was more than adequate in 2008 and 2009. In 2010, Intel did not have any write-offs of bad debt yet increased the allowance account by $9 million. Intel may be anticipating customer defaults in 2011, but in 2008 and 2009, a recessionary period, Intel did a good job collecting on accounts receivable with minimal write-offs. It is also possible that Intel overestimated the account with the intention of later reducing it to improve the net income number.

It is noteworthy that Intel's two largest customers account for 38% of net revenues and 44% of accounts receivable in 2010. Should one of these customers default this would negatively impact Intel. In addition, if one of these customers takes their business elsewhere that would be highly detrimental to Intel's sales and ultimate profit. Intel believes that their two largest customers are low risk with regard to collection on their accounts based on historical experience. Since Dell and 27

Hewlett-Packard are Intel's two largest customers (page 8 of Form 10-K), this is probably a good assumption. (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 2009 and 2010, 21% of the capital structure is debt, while 79% 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 $327 million in the future (2011 and thereafter). The company has also committed to construct or purchase $4.6 billion of property, plant and equipment. Other commitments of $600 million include licenses, purchases of raw materials and non-contingent funding obligations. (Note 23 of Form 10-K) Contingencies are comprised of legal proceedings including significant challenges filed by AMD and others to the company’s competitive practices. The European Commission (EC) imposed a $1.447 billion fine on Intel in 2009 that Intel has paid; however, Intel has appealed the EC’s decision and the EC is expected to rule in 2012. Intel anticipates these challenges will continue for a number of years and may require substantial financial resources and management time to defend their position. (Note 29 of Form 10-K) (f) Deferred taxes are included under current assets, non-current assets and noncurrent liabilities. Share-based compensation is the most significant component of deferred taxes. (g) Intel has the following equity accounts: Preferred stock, Common stock, Accumulated other comprehensive income and Retained earnings.

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Case 2.2 Clear

Avnet

(AVT / NYSE)

Edit

Annual Consolidated Balance Sheet A m o unt s R o unde d t o : T ho us a nds

Results as of Jul 3, 2010 Jun 27, 2009 ASSETS Current Assets: Cash and cash equivalents Short-term investments

$

1,092,102

$

943,921

Total cash and short-term investments

1,092,102

943,921

Accounts receivable, net Inventories, net Current deferred taxes Other current assets

3,574,541 1,812,766

2,618,697 1,411,755

150,759

169,879

Total current assets

6,630,168

5,144,252

Property, plant, and equipment Less: accumulated depreciation

844,173 541,590

876,357 570,675

Net property, plant, and equipment

302,583

305,682

566,309

550,118

Long-term investments Goodwill, net Other intangibles, net Other deferred taxes Other assets $

Total assets

283,322 7,782,382

$

273,464 6,273,516

LIABILITIES Current Liabilities: Accounts payable Short-term debt Current portion of long-term debt Accrued liabilities Income taxes payable Other current liabilities

$

2,862,290 36,549

$

1,957,993 23,294

440,354 100,422

437,312 37,261

Total current liabilities

3,439,615

2,455,860

Long-term debt Deferred income taxes payable Other deferred liabilities Other liabilities

1,243,681

946,573

89,969

110,226

4,773,265

3,512,659

1,358,006 1,624,441 (692) 27,362

1,329,623 1,214,071 (931) 218,094

3,009,117

2,760,857

Total liabilities Minority interest STOCKHOLDERS' EQUITY Preferred stock Common stock, par value plus additional paid-in capital Retained earnings (accumulated deficit) Treasury stock Accumulated other comprehensive income (loss) Other stockholders' equity Total stockholders' equity Total liabilities and stockholders' equity

$

29

7,782,382

$

6,273,516

Avnet

(AVT / NYSE)

Annual Common Size Balance Sheet S um m a ry pe rc e nt a ge s in it a lic s

will no t f o o t due t o ro unding

Results as of Jul 3, 2010 Jun 27, 2009 ASSETS Current Assets: Cash and cash equivalents Short-term investments

14.0% 0.0%

15.0% 0.0%

Total cash and short-term investments

14.0%

15.0%

Accounts receivable, net Inventories, net Current deferred taxes Other current assets

45.9% 23.3% 0.0% 1.9%

41.7% 22.5% 0.0% 2.7%

Total current assets

85.2%

82.0%

Property, plant, and equipment Less: accumulated depreciation

10.8% 7.0%

14.0% 9.1%

Net property, plant, and equipment

3.9%

4.9%

Long-term investments Goodwill, net Other intangibles, net Other deferred taxes Other assets

0.0% 7.3% 0.0% 0.0% 3.6%

0.0% 8.8% 0.0% 0.0% 4.4%

100.0%

100.0%

36.8% 0.5% 0.0% 5.7% 1.3% 0.0%

31.2% 0.4% 0.0% 7.0% 0.6% 0.0%

Total current liabilities

44.2%

39.1%

Long-term debt Deferred income taxes payable Other deferred liabilities Other liabilities

16.0% 0.0% 0.0% 1.2%

15.1% 0.0% 0.0% 1.8%

Total liabilities

61.3%

56.0%

Minority interest

0.0%

0.0%

0.0% 17.4% 20.9% 0.0% 0.4% 0.0%

0.0% 21.2% 19.4% 0.0% 3.5% 0.0%

Total stockholders' equity

38.7%

44.0%

Total liabilities and stockholders' equity

100.0%

100.0%

Total assets LIABILITIES Current Liabilities: Accounts payable Short-term debt Current portion of long-term debt Accrued liabilities Income taxes payable Other current liabilities

STOCKHOLDERS' EQUITY Preferred stock Common stock, par value plus additional paid-in capital Retained earnings (accumulated deficit) Treasury stock Accumulated other comprehensive income (loss) Other stockholders' equity

30

(b) The overall structure of Avnet’s balance sheet is relatively stable from 2009 to 2010. All asset and liability accounts have increased in dollars with the exception of property, plant and equipment, prepaid and other current assets and other long-term liabilities. Due to the 24% growth in total assets some accounts have decreased as a percentage of total assets even though the account may have increased in dollars.

Current assets make up over 85% of total assets with accounts receivable and inventories being the most significant assets. Both of these accounts increased from 2009 to 2010 causing a 3.2% increase in current assets. This increase was offset by a decline in property, plant and equipment as well as a percentage decline in goodwill and other assets. Based on information in Note 5 of the Form 10-K, Avnet has disposed of buildings and equipment.

Current liabilities, in particular, accounts payable, are more significant than long-term liabilities. This is to be expected as Avnet should finance its current assets, including accounts receivable and inventories, with accounts payable.

Long-term debt is the most significant noncurrent liability. Both accounts payable and long-term debt have increased. Long-term debt should be used to finance longterm assets and it appears that Avnet has borrowed $300 million (see Note 7) in order to finance the acquisition of Bell Microproducts subsequent to the 2010 fiscal year (See Acquisitions under Item 1 of the Avnet Form 10-K).

Stockholders' equity has increased in dollars due to increases in retained earnings and paid-in capital accounts. The percentage decline of total stockholders’ equity is a result of the liabilities increasing at a faster rate than equity as well as the actual decline in accumulated other comprehensive income which has dropped by 3.1%. The increase in retained earnings is most likely the result of increased net income which is a positive sign.

Avnet’s balance sheet structure is appropriate for a distributor and no red flags are apparent from analyzing the balance sheet.

31

Case 2.3 1.

Logitech International S.A. Common Size Balance Sheet March 31, 2010 and 2009 ASSETS Current assets: Cash and cash equivalents Short-term investments Accounts receivable Inventories Other current assets Total current assets Property, plant and equipment Goodwill Other intangible assets Other assets Total assets LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable Accrued liabilities Total current liabilities Other liabilities Total liabilities Shareholders' Equity Shares, par value Additional paid-in capital Shares in treasury, at cost Retained earnings Accumulated other comprehensive loss Total shareholders' equity Total liabilities and shareholders' equity

32

2010

2009

20% -12 14 4 50% 6 34 6 4 100%

35% -15 16 4 70% 8 17 2 3 100%

16% 11 27% 10 37%

11% 9 20% 10 30%

2% 1 (24) 88 (4) 63% 100%

2% 3 (24) 94 (5) 70% 100%

2.

The asset structure of Logitech has changed significantly from 2009 to 2010.

Current assets have decreased from 70% to 50% of total assets with corresponding increases in long-term assets. The most significant current assets of the company are cash and cash equivalents, accounts receivable and inventories. Goodwill is the most significant long-term asset. Most of the decline is a result of the cash account decreasing, although accounts receivable and inventories have declined by 3% and 2%, respectively. It is probable that cash was used to acquire LifeSize and TV Compass. A significant amount of goodwill and intangible assets was recorded in 2010 as a result of the acquisitions explaining the shift in asset structure from short-term to long-term assets.

The debt structure changed, although less significantly than the asset structure. Current liabilities are 7% higher in 2010 relative to total assets compared to 2009. The increase in the accounts payable and accrued liabilities could be a result of having acquired two companies; however, this is inconsistent with the fact that accounts receivable and inventories decreased.

The equity structure has only changed because of the changes in the debt structure. The retained earnings account is significant at 88% of total assets in 2010. Even though the percentage of retained earnings relative to total assets decreased from 94% in 2009 to 88% in 2010 retained earnings increased in dollar amount.

3.

2010 2009

Allowance account as a percentage of accounts receivable: Allowance for doubtful accounts Net Receivables + Allowance

Percentage of Receivables

$5,870 $195,247 + $5,870

2.9%

$6,705 $213,929 + $6,705

Sales Total accounts receivable Allowance for doubtful accounts

Change from 2009 to 2010 (11.0%) (8.8%) (12.5%) 33

3.0%

Sales, accounts receivable and the allowance for doubtful accounts have all decreased in 2010, a normal pattern. The valuation schedule shows a completely different picture when looking at actual write-offs and charges to bad debt expense over the three year period from 2008 to 2010. Actual write-offs have decreased each year. In 2009 Logitech increased the allowance account by $5,102 thousand even though write-offs in 2009 were only $894 thousand. A slight reduction of the allowance account occurred in 2010. There are no disclosures in the excerpts that discuss why the firm believes there should have been such a large increase to the account. Possible explanations are that the firm may have unintentionally overestimated the allowance account based on projected customer defaults from the acquisitions in 2009 or could be intentionally manipulating the account. If Logitech credits the allowance account in the future to reduce the balance, this will result in higher net income in the year of the reduction.

4.

The FIFO method is used to value inventory. Since the last goods purchased would still be in inventory, this method does reflect current cost of inventory on the balance sheet.

5.

Logitech operates in the high-tech industry which is generally a deflationary industry; therefore, the firm should realize tax savings as the first goods sold under FIFO would be the oldest and higher priced products resulting in lower net income.

6.

Logitech discusses the following commitments and contingencies in the notes to the financial statements (all amounts in millions): • • • •

Future minimum operating lease payments Purchase commitments Inventory purchase commitments Consulting, marketing and advertising commitments

$ 46.7 12.9 183.6 33.3

Logitech also has lawsuits, guarantees, indemnifications, letters of credit and potential performance-based payments as a result of an acquisition which may require payments in the future. The maximum possible payments for all these items are $106.4 million of which $7.9 million is currently outstanding.

The operating lease payments and commitments total $276.5 amounts to another 17% of obligations relative to total assets. This makes Logitech riskier than the balance sheet indicates.

34

7.

The change in retained earnings from 2009 to 2010 is $64,957 thousand which is the amount of net earnings for the year. This means that Logitech has not paid any dividends.

8.

Logitech has a large balance in their cash and cash equivalents account. It appears the firm is expanding through acquisitions. Currently the firm has no longterm debt and the retained earnings of the firm is significant and increasing.

9.

Investors and creditors would be concerned about the large amounts paid for goodwill related to acquisitions. Goodwill now makes up 34% of total assets, a significant, amount for an item that may be written off as impaired in the future if the acquisitions do not deliver above average earnings. The firm has acquired several firms in 2009 and 2010 which would imply that sales and earnings should rise; however, sales and earnings have declined 17% and 72%, respectively, from 2008 to 2010.

10. 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 further investigate the details of the acquisitions made by Logitech.

35

Case 2.4

1.

Walgreen Co. and Subsidiaries Common Size Balance Sheet

Assets Current Assets: Cash and cash equivalents Short-term investments Accounts receivable, net Inventories Other current assets Total Current Assets Non-Current Assets Property and equipment, at cost less accumulated depreciation and amortization Goodwill Other non-current assets Total Non-Current Assets Total Assets Liabilities and Shareholders’ Equity Current Liabilities Short-term borrowings Trade accounts payable Accrued expenses and other liabilities Income taxes Total Current Liabilities Non-Current Liabilities Long-term debt Deferred income taxes Other non-current liabilities Total Non-Current Liabilities Total Liabilities Shareholders' Equity Common stock Paid-in capital Employee stock loan receivable Retained earnings Accumulated other comprehensive (loss) income Treasury stock, at cost Total Shareholders' Equity Total Liabilities and Shareholders' Equity 36

August 31, 2010 2009 7% -9 28 1 45%

8% 2 10 27 1 48%

43 7 5 55% 100%

43 6 3 52% 100%

--% 17 11 -28%

--% 17 10 -27%

9% 1 7 17% 45%

9% 1% 6 16% 43%

--% 3 -64 -(12) 55% 100%

--% 3 (1) 61 -(6) 57% 100%

2.

Inventories are the most significant current asset and property and equipment is the most significant noncurrent asset. The proportion of inventories seems appropriate since the industry average relative to total assets, according to Exhibit 2.4 in the textbook, is 32.6% and Walgreen’s inventories are 28% of total assets. Walgreen’s property and equipment make up 43% of total assets while the industry average, according to Exhibit 2.5 in the textbook, is 12.4%.

3.

Walgreen uses the LIFO method of inventory valuation. The notes to the financial statements explain that inventories would have been recorded at a higher amount if the FIFO method of inventory had been used. This implies that inflation has occurred since under FIFO, the most recent purchases would be recorded on the balance sheet, and under LIFO, the first purchases would be recorded on the balance sheet.

4.

The majority of Walgreen’s liabilities is current and includes accounts payable and accrued expenses. Long-term debt is 9% of total assets. The dollar amount of total liabilities is $11,875 million, just under the amount of current assets. The level of risk appears to be low.

5.

Walgreen most likely paid dividends in the amount of $570 million calculated as follows: Beginning retained earnings + net income – dividends = Ending retained earnings $15,327 + $2,091 - dividends = $16,848 6.

Yes, Walgreen uses off-balance sheet financing in the form of operating leases As of August 31, 2010, total minimum lease payments totaled $36,790 million. This amount is larger than the total of Walgreen’s assets.

7.

Even though it appears from the balance sheet of Walgreen that the company may be creditworthy, reading the notes paints a much different picture. Off-balance sheet financing puts Walgreen at high risk. Operating leases are contractual obligations and, like debt, the firm must be able to make the lease payments or could be forced into bankruptcy. Without more information about the profitability of the firm and an assessment of how much cash they generate each year, the balance sheet and notes available suggest that Walgreen is a poor credit risk.

37

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 A common size income statement is created by dividing each of the line items on the income statement for a year by the net sales or net revenues amount for that same year.

3.3 Sales will increase or decrease if the amount of units sold increases or decreases or if the price at which the product or service is sold increases or decreases.

3.4 Gross profit margin can increase or decrease as a result of a change in sales prices, a change in cost of goods sold, or in the case of capital intensive industries, a change in volume. Increases (decreases) in sales prices, decreases (increases) in cost of goods sold and increases (decreases) in volume in capital intensive industries will lead to an increase in gross profit margin.

3.5 A decreasing gross profit margin could occur if the sales prices or volume in a capital intensive company decreased or the cost of goods sold increased.

Operating profit margin, while affected by the change in gross profit margin, is also affected by changes in operating expenses other than cost of goods sold.

Significant decreases in operating expenses such as general and administrative, marketing and selling or research and development, for example, could cause operating profit margin to increase despite a decrease in gross profit margin.

3.6 The beverage and athletic shoes industries are examples of industries that must advertise regularly or risk losing market share.

The pharmaceutical and high technology industries are examples of industries that must do extensive research and development to create new and innovative products.

38

3.7 Investment Income

Investment Account

(a) Cost method

$12,000*

$500,000

(b) Equity method

$30,000**

$518,000***

* $40,000 cash dividends x 30% ** $100,000 earnings x 30% *** $500,000 + $30,000 - $12,000 3.8

The four items included in comprehensive income include:

Foreign currency translation effects which are adjustments to the equity section of the balance sheet resulting from the translation of foreign financial statements.

Unrealized gains and losses on investments in debt and equity securities classified as available-for-sale are reported in comprehensive income.

Additional pension liabilities are reported as other comprehensive income when the accumulated benefit obligation is greater than the fair market value of plan assets less the balance in the accrued pension liability account or plus the balance in the deferred pension asset account.

Cash flow hedges (derivatives designated as hedging the exposure to variable cash flows of a forecasted transaction) are required to initially report any gain or loss from a change in the fair market value of the cash flow hedge in other comprehensive income and subsequently reclassify the amount into earnings when the forecasted transaction affects earnings.

3.9 The statement of stockholders' equity summarizes the changes in all of the equity accounts, including the retained earnings account.

39

3.10 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.

3.11 Sales growth Operating expense growth

Cost of goods sold Gross profit margin Operating profit margin Average tax rate Net profit margin

2012 to 2013

2011 to 2012

21.0% 22.2%

62.5% 63.6%

2013

2012

2011

78.8 % 21.2 11.9 42.9 6.8

76.9 % 23.1 13.8 42.6 7.9

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 2012-2013 relative to 2011-2012. 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 2011 and 2013.

40

41

3.12 Jackrabbit, 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) Gain on sale of equipment Equity losses Interest income Interest expense Pre-tax income Income tax expense Net income

$1,840,000 1,072,000 768,000 270,000 155,000 24,000 319,000 15,000 (9,000) 13,000 (16,000) 322,000 96,000 $226,000

3.13 Yarrick Company Common Size Income Statement (in percent) For the Years Ended December 31, 2013, 2012, and 2011 Net sales Cost of goods sold Gross profit margin Selling, gen. & admin.

Research & develop.

Operating profit margin Income tax expense Net profit margin

2013 100.0 58.2 41.8 17.7 16.0 8.1 3.0 5.1

2012 100.0 54.2 45.8 20.0 21.3 4.5 1.3 3.2

2011 100.0 53.7 46.3 29.1 40.3 (23.1) (8.2) (14.9)

Sales have increased 15.7 percent from 2011 to 2012 and 52.9 percent from 2012 to 2013 for Yarrick Company. This increase is the result of volume or price increases. The gross profit margin has declined each year. Yarrick has either lowered selling prices or costs of goods sold have risen and the company has not passed on those increases to their customers.

42

Operating profit margin has surprisingly increased despite the decline in gross profit margin. This has been achieved by significant reductions in selling, general, and administrative and research and development expenses in 2012. In dollars these expenses increased in 2013, but from a percentage standpoint decreased due to the large sales growth. The reduction in these expenses is concerning. To stay on the cutting edge of their industry it is important for Yarrick to spend enough in research and development. Cuts in this area may be detrimental to sales growth in the long-run. If advertising is being reduced or key productive, personnel are being laid off to achieve the cost reductions in selling, general and administrative expenses, this, too, can negatively impact the company's sales and profits. If Yarrick has been able to reduce costs through the elimination of waste, this would be a quality change.

Net profit has increased from a loss of $20 million to a profit of $12 million from 2011 to 2013 due to the above mentioned changes in operating expenses. Tax expense has not had a significant impact on the net profit of the firm.

3.14 (a) Gross profit margin: Tickets Concessions Total

2013 45.1% 91.2% 59.5%

2012 48.0% 90.0% 60.4%

2011 51.0% 88.3% 61.0%

(b) The overall gross profit margin of LA Theaters is declining. The cause of this decline is the result of tickets rather than concessions. If the cost of acquiring films is increasing, then ticket prices have not been raised proportionately, otherwise ticket prices have been reduced without a corresponding decrease in cost of films. Concessions gross profit margin is increasing each year which has mitigated the decline in overall gross profit margin. Concessions prices have been raised without corresponding increases in costs or the costs of concessions have been declining without a change in prices.

LA Theaters should focus on selling as many concessions as possible since the profit margin is quite high on these items. If ticket prices cannot be raised to compensate for increased costs, the management should be sure that the theaters are filled to capacity as volume increases in ticket revenues will result in higher gross profit margins. The cost of acquiring films is fixed, but does not change proportionately with the volume of ticket sales 43

3.15 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 2013 and 2012.

Sales also improved—by $100 million in 2012, but by only $50 million in 2013.

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 2011 and 2012 but reduced these expenditures to $50 million in 2013. Interest expense rose by $20 million in 2012 and 2013.

Analytical Paragraph Net income for Elf Corporation increased in 2012 and 2013, 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 2011 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 2013 has been achieved by reducing expenditures for advertising and marketing, which could help explain the slower sales growth in 2013 and could impair sales in the future.

3.16 Students answers will differ unless specific companies are assigned by the instructor.

3.17 There is no solution presented here since the list of technical projects on the FASB agenda is ever-changing.

44

Case 3.1 (a)

INTEL Common Size Income Statement

Sales Cost of Sales Gross Profit Research and development Marketing, general and administrative Restructuring and asset impairment Amortization of acquisition-related intangibles and costs Operating income Gains (losses) on equity investments, net Interest and other, net Income before taxes Provision for taxes Net Income Effective tax rate Growth rates Net revenues Operating costs Operating costs + COGS

2010 100.0% 34.7 65.3% 15.1 14.5 --

2009 100.0% 44.3 55.7% 16.3 22.6 0.6

2008 100.0% 44.5 55.5% 15.2 14.5 1.9

-35.7%

0.1 16.2%

-23.9%

0.8 0.3 36.8% 10.5 26.3%

(0.5) 0.5 16.2% 3.8 12.4%

(4.7) 1.3 20.5% 6.4 14.1%

28.6%

23.4%

31.1%

2009 - 2010 24.2% (6.8)% (4.7)%

45

2008- 2009 (6.5)% 16.5% 2.7%

Analysis of Income Statement Revenues for Intel increased in 2010 after a decline in 2009. Operating costs increased in 2009 causing a significant decline in operating profit; however, in 2010 operating costs decreased causing profitability to increase. The increase in revenues in 2010 was a result of both higher volume and higher average selling prices. The PC Client Group revenues increased 21% primarily due to higher volume of notebook unit sales and, to a lesser extent, higher average selling prices for notebooks. One area that had significantly lower sales was the wireless connectivity product lines. The Data Center Group revenues increased 35% due primarily to volume, and, to a lesser extent, higher average selling prices. Revenues increased 27% in the Other Intel Architecture segment due to volume increases. In 2009 the decrease in revenues resulted from lower selling prices while volume increased overall. (pgs. 31-33 of Form 10-K) The gross profit margin, stable in 2008 and 2009, increased significantly in 2010. The Management Discussion and Analysis (MDA) explains that the increase in gross profit margin was a result of higher revenues and to a lesser extent lower unit costs.

Higher revenues caused by volume increases result in higher gross profit margins when firms have fixed costs. As a manufacturer Intel would have significant fixed costs included in their cost of sales.

Operating profit decreased significantly from 2008 to 2009, as a result of the $1.447 billion fine paid to the European Commission and the $1.25 billion settlement paid to AMD in 2009. From 2009 to 2010 operating profit increased significantly as a result of the large increase in gross profit margin and the fact that no fines and settlements were paid in 2010 compared to 2009.

Research and development costs (R&D) increased in dollars despite a decline in percentage relative to net revenues in 2010. The increase in costs was due to higher profit-dependent compensation, an increase in employees and higher process development costs as Intel transitioned from 32 nanometer technology to the new generation 22 nanometer technology.

The European Commission fine and AMD settlement were recorded in marketing, general and administrative expenses in 2009 resulting in lower expenses in 2010.

Higher costs were incurred for advertising and profit-dependent compensation.

Operating profit margins have also increased as a result of the completion of restructuring programs implemented between 2006 and 2009. The firm is now realizing approximately $290 million of annual savings, a majority within cost of sales.

46

Intel has net overall gains from equity investments in 2010 although the amount is insignificant. Losses in investments in all three years were the result of impairment charges. Interest income and other, net, is a combination of gains on trading assets, exchange rate losses, interest expense and interest income. Interest income is the primary item included in this category and has declined significantly as a result of lower interest rates.

Intel's effective tax rate is relatively low compared to the statutory rate of 35 percent.

The firm has benefited from lower foreign tax rates (especially in 2009), settlements, and domestic manufacturing benefits. The higher rate in 2010 was because of higher profits in higher tax jurisdictions compared to 2009.

Net profits are healthy and increasing. If costs are managed well, profits should continue to 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 in dollars (not shares) over the threeyear period due to the proceeds from sales of common stock. Accumulated other comprehensive income has varied each year as a result of changes in pension liabilities and investment related items. The retained earnings account has increased overall in the three year period due to the large amount of net income in 2010. The increase in retained earnings was offset by charges for the repurchase and retirement of common stock and dividends every year.

According to the chairman of Intel the purpose of the repurchase of Intel’s common stock is to increase stockholder value. Since the company is retiring the stock it is definitely not for an investment. In fact, Intel’s stock price has increased from a low of $12.08 in 2009 to a high of $24.28 per share in 2010. Cash dividends have been increased each year to reward Intel's stockholders. This is a positive sign that the firm is doing well and as was seen on the balance sheet, Intel has enough cash to support the increased dividends.

47

Case 3.2

(a)

Avnet

Clear

(AVT / NYSE)

Edit

Annual Consolidated Income Statement A m o unt s R o unde d t o : T ho us a nds

( e xc e pt pe r s ha re a m o unt s )

Results for the Years Ending Jul 3, 2010 Jun 27, 2009 Jun 28, 2008 Net sales Less: Cost of goods sold

$ 19,160,172 16,879,955

$ 16,229,896 14,206,903

$ 17,952,707 15,638,991

Gross profit

2,280,217

2,022,993

2,313,716

Sales, general and administrative Research and development (R&D) Restructuring, impairment, and amortization Purchased in-process R&D Other operating expenses

1,619,198

1,531,522

1,564,003

25,419

1,510,469

38,942

Total operating expenses

1,644,617

3,041,991

1,602,945

Operating profit (loss)

635,600

(1,018,998)

710,771

Other income (expenses), net excluding interest expense

11,231

2,696

70,857

Earnings (loss) before interest and taxes

646,831

(1,016,302)

781,628

Interest expense

61,748

78,666

88,224

Earnings (loss) before taxes

585,083

(1,094,968)

693,404

Provision for (benefit from) income taxes

174,713

34,744

203,826

Earnings (loss) after taxes

410,370

(1,129,712)

489,578

Extraordinary items, net Discontinued operations, net Cumulative effect of changes in accounting principles, net Other after-tax income (loss), net Net profit (loss) Basic earnings per common share

48

$

410,370

$

(1,129,712) $

489,578

$

2.71

$

(7.49) $

3.26

Avnet

(AVT / NYSE)

Annual Common Size Income Statement S um m a ry pe rc e nt a ge s in it a lic s

will no t f o o t due t o ro unding

Results for the Years Ending Jul 3, 2010 Jun 27, 2009 Jun 28, 2008 Net sales Less: Cost of goods sold

100.0% 88.1%

100.0% 87.5%

100.0% 87.1%

11.9%

12.5%

12.9%

Sales, general and administrative Research and development (R&D) Restructuring, impairment, and amortization Purchased in-process R&D Other operating expenses

8.5% 0.0% 0.1% 0.0% 0.0%

9.4% 0.0% 9.3% 0.0% 0.0%

8.7% 0.0% 0.2% 0.0% 0.0%

Total operating expenses

8.6%

18.7%

8.9%

Operating profit (loss)

3.3%

(6.3%)

4.0%

Other income (expenses), net excluding interest expense

0.1%

0.0%

0.4%

Earnings (loss) before interest and taxes

3.4%

(6.3%)

4.4%

Interest expense

0.3%

0.5%

0.5%

Earnings (loss) before taxes

3.1%

(6.7%)

3.9%

Provision for (benefit from) income taxes

0.9%

0.2%

1.1%

Earnings (loss) after taxes

2.1%

(7.0%)

2.7%

Extraordinary items, net Discontinued operations, net Cumulative effect of changes in accounting principles, net Other after-tax income (loss), net

0.0% 0.0% 0.0% 0.0%

0.0% 0.0% 0.0% 0.0%

0.0% 0.0% 0.0% 0.0%

2.1%

(7.0%)

2.7%

29.9%

N/M

29.4%

Gross profit

Net profit (loss) Effective tax rate

(b) Avnet’s sales decreased 9.6% from 2008 to 2009, but then increased 18.05% in 2010. The global economic slowdown negatively impacted sales volume in 2009; however, in 2010 the technology markets recovered faster than expected resulting in increases to sales volume. Avnet was also able to increase sales volume because of acquisitions and the fact that 2010 was a 53 week fiscal year rather than the typical 52 week year.

Gross profit margin has declined over the three year period due to lower profit margins in other regions, particularly Asia, as compared to the Americas in 2010 and lower margins in Asia and the Americas in 2009 as compared to Europe, the Middle East and Africa region.

49

As market conditions worsened in late 2008 and accelerated in 2009, Avnet took action to reduce costs as sales demand declined. Even though the dollar amount of selling, general, and administrative expenses decreased in 2009, the percentage of these expenses relative to sales increased. The cost reduction initiative was effective and in 2010 selling, general, and administrative expenses increased in dollars as sales increased, but as a percentage of sales decreased.

Avnet generated a positive operating profit margin in 2008 and 2010. The operating loss in 2009 was a result of the restructuring, integration and impairment charges.

The global economic downturn resulted in impairment charges for goodwill and intangible assets in several operating units. Restructuring charges were related to the cost reduction initiative previously mentioned and included severance packages for personnel reductions and the write-down of fixed assets. Integration charges resulted from the acquisitions. The charges for these items in 2008 and 2010 were much smaller than the amounts charged in 2009. Operating profit has rebounded in 2010 but is still not at the level reached in 2008 because of the decline in gross profit margin.

Other income is insignificant and is largely comprised of the effects of foreign currency changes and gains on sales of assets. Interest expense declined all years due to lower average debt, lower interest rates, the extinguishment of debt and the effects of adopting an accounting standard.

Avnet’s typical effective tax rate appears to be between 29% and 30%, which is lower than the 35% statutory tax rate. This is mainly a result of lower taxes in foreign markets and tax audit settlements. In 2009 Avnet had a positive tax expense, rather than a benefit due to the non-deductibility of the impairment charges.

Net profit margin has followed the pattern of operating profit margin. After an especially poor year in 2009, Avnet has begun to recover and improve profit margins.

To increase profit margins in the future Avnet will need to increase prices in regions that have lower profit margins. Due to competition this may not be possible. If the most recent acquisitions prove to be successful, this may be beneficial to the overall success of Avnet as they capture more market share resulting in better control over prices and margins.

50

Case 3.3 (a)

Taser International, Inc. Common Size Income Statement

Sales Cost of Sales Gross Profit Sales, general and administrative Research and development Income (loss) from operations Interest and other income, net Income (loss) before taxes Provision for taxes Net Income

2010 100.0% 47.8 52.2% 45.0 13.1 (5.9)% -(5.9)% (0.8) (5.1)%

2009 100.0% 39.2 60.8% 41.7 19.2 (0.1)% 0.2 0.1% 0.1 -0-%

2008 100.0% 38.6 61.4% 41.9 13.9 5.6% 1.9 7.5% 3.6 3.9%

Effective tax rate

14.3%

101.2%

47.6%

Growth rates Net revenues Operating costs + COGS

2009 - 2010 (16.6)% (11.8)%

2008- 2009 12.3% 19.1%

Analysis of Income Statement Revenues in 2009 increased due to more product orders in the international market and the Federal market while in 2010 the decrease in revenues was driven by volume decreases in these areas. Sales also declined in 2010 because of adverse economic conditions as domestic law enforcement agencies dealt with budget constraints.

Even though revenues increased in 2009, operating costs increased faster causing an operating loss. In 2010 the operating loss grew larger as revenues decreased, but operating costs did not decrease proportionately.

Gross profit margin declined over the three year period with a significant decrease in 2010. It is possible that selling prices declined or cost of goods sold increased. A more plausible reason would be that gross profit margins are lower due to the volume decreases. Taser is a manufacturer and would likely have significant fixed costs.

51

Selling, general and administrative expenses increased in dollars from 2008 to 2009, but not as a percent of revenues. The opposite occurred in 2010 when these expenses decreased in dollars but rose as a percentage of revenues. It appears that Taser put cost controls in place in 2010 to minimize the negative impact of the economy on their profits. With the exception of depreciation and the other operating expenses, all selling, general and administrative expenses were reduced.

Research and development expenses were volatile over the three years, increasing significantly in 2009 and then decreasing by about the same amount in 2010. This is explained in the management’s discussion and analysis as being a result of development costs coming to fruition for two new products. These costs are now being recorded in cost of goods sold in 2010.

Interest and other income dropped by a large amount from 2008 to 2010. Given the economic conditions and the drop in interest rates, it is not surprising this has occurred. More surprising is the extreme differences in effective tax rates from year to year. Based on the large rates in 2008 and 2009 when Taser produced a positive income before taxes, and the low rate in 2010 when Taser operated at a loss, it would seem that Taser incurs expenses that are not tax deductible.

Net profit for Taser is dismal, dropping from a positive net income in 2008 to a loss in 2010. Taser’s future is highly dependent on the economic recovery. For revenues to increase, the Federal government and local governments will need to have solved their budget issues. Personal sales of Taser’s products will also depend on the economy as individuals will need to have discretionary income to purchase the company’s products.

52

Case 3.4 (a)

Zebra Technologies Corporation Common Size Income Statement

Net sales of tangible products Revenue from services and software Total net sales Cost of sales of tangible products Cost of services and software Total cost of Sales Gross Profit Selling and marketing Research and development General and administrative Amortization of intangible assets Litigation settlement Exit, restructuring and integration costs Asset impairment charges Total operating expenses Operating income (loss) Investment income Foreign exchange gain (loss) Other, net Income (loss) before taxes Income taxes Net Income (loss) Effective tax rate Growth rates Net revenues Operating costs Operating costs + COGS Gross profit margin: Products Services and software Total

2010 89.4% 10.6 100.0% 47.5 4.3 51.8 48.2% 12.8 10.7 8.3 1.0 (0.1)

2009 87.2% 12.8 100.0% 50.0 5.1 55.1 44.9% 12.8 10.7 10.1 1.3 --

2008 89.2% 10.8 100.0% 46.3 4.6 50.9 49.1% 12.9 9.8 8.4 1.9 (0.5)

0.5 -33.2 15.0% 0.2 -(0.2) 15.1% 4.5 10.6%

1.5 (0.1) 36.3 8.6% 0.4 -(0.2) 8.8% 2.9 5.9%

2.1 16.1 50.7 (1.6)% 0.1 0.4 (0.1) (1.2)% 2.7 (3.9)%

29.8%

33.2%

(222.5)%

2009 - 2010 19.1% 8.6% 10.6% 2010 46.8% 59.7% 48.2%

2009 42.7% 59.9% 44.9% 53

2008- 2009 (17.7)% (41.0)% (25.9)% 2008 48.1% 57.0% 49.1%

Analysis of Income Statement The majority of Zebra Technologies Corporation’s (Zebra) revenues are from tangible products as opposed to services and software. Revenues decreased from 2008 to 2009, but recovered somewhat in 2010. Revenues may have decreased due to a reduction of selling prices or volume; however, given the poor economy in 2009 the decline in revenue is more likely a result of a decline in volume. Even though revenues declined in 2009, operating costs declined at a faster rate and Zebra was able to turn an operating loss into a profit. In 2010 revenues increased while operating costs increased at a slower rate, allowing for a significant increase in operating profit.

Gross profit margin has declined and increased in the same manner as revenues from 2008 to 2010. Services and software gross profit margins are higher than the margins for tangible products, but since they make up a minority of total revenues, the overall profit margin is less than that for services and software. The downward trend in gross profit margin in 2009 may be a result of declining selling prices, increased cost of sales or the result of a declining volume of sales, assuming fixed costs are significant in the cost of sales structure. In 2010, the increase in gross profit margin may be a result of increasing selling prices, decreasing cost of sales or increasing volume of sales.

Operating expenses have decreased all three years resulting in an increasing operating profit margin. Zebra has been able to reduce the dollar amount of selling and marketing, general and administrative, amortization of intangible assets, litigation, exit, restructuring and integration costs and asset impairment charges over the three year period. The most significant reduction is the asset impairment charges which occurred only in 2008 when Zebra determined that identified intangible assets were impaired as a result of the economy.

Total other income has declined mainly due to foreign exchange losses in 2009 and 2010 compared to foreign exchange gains in 2008. Effective tax rates are slightly lower than the statutory tax rate of 35% in 2009 and 2010 as a result of lower foreign tax rates and tax exempt interest income. The unusual tax rate in 2008 is a result of the non-deductibility of the asset impairment charges which resulted in Zebra having a positive tax expense despite an operating loss.

Net profit has trended upward from 2008, when it was a loss, to 2010 when the firm had a 10.6% net profit margin. With the asset impairment charges behind 54

them and the economy recovering, Zebra should be able to maintain or increase profits in the future.

55

Chapter 4 4.1 The statement of cash flows is a useful document because it is the only financial statement where the analyst can learn about cash generation in the firm. A positive net income figure on the income statement is ultimately insignificant unless a company can translate its earnings into cash.

4.2 Cash includes cash and highly liquid short-term marketable securities, called cash equivalents.

Operating activities include delivering or producing goods for sale and providing services and the cash effects of transactions and other events that enter into the determination of net income.

Investing activities include acquiring and selling securities that are not cash equivalents, productive assets that are expected to benefit the firm for long periods of time and lending money and collecting on loans.

Financing activities include borrowing from creditors and repaying the principal of debt and obtaining resources from owners and providing them with a return on investment.

4.3 The direct method shows cash collections from customers, interest and dividends collected, other operating cash receipts, cash paid to suppliers and employees, interest paid, taxes paid, and other operating cash payments. The indirect method starts with net income and adjusts for deferrals; accruals; noncash items, such as depreciation and amortization; and nonoperating items, such as gains and losses on asset sales. The direct and indirect methods yield identical figures for net cash flow from operating activities because the underlying accounting concepts are the same.

4.4 The cash flow statement helps investors, creditors and other users determine the following about a firm: • Its ability to generate cash flows in the future • Its capacity to meet obligations for cash • Its future external financing needs • Its success in productively managing investing activities • Its effectiveness in implementing financing and investing strategies

56

4.5

(a) I (b) F (c) F (d) I (e) F (f) F

(g) F (h) I (i) I (j) F (k) I (l) F

4.6

(a) O (b) O (c) F (d) C or I (e) O (f) O

(g) O (h) F (i) F (j) O (k) O (l) C

4.7

(a) L (b) H (c) H (d) L (e) L

(f) H (g) L (h) L (i) H (j) H

4.8

(a) Outflow, F (b) Inflow, I (c) Outflow, F (d) Inflow, F (e) Outflow, I

(f) Outflow, F (g) Outflow, I (h) Inflow, F (i) Inflow, I (j) Outflow, I

57

4.9 (a) Beginning retained earnings $3,600

+

+

$1,050

(b)

Net income - Dividends = -

$200

=

Ending retained earnings

$4,450

Dragoon Enterprises Statement of Cash Flows For Year Ending December 31, 2012 Cash flow from operating activities Net income Non-cash operating items: Depreciation Cash provided (used) by current assets and liabilities: Accounts receivable Inventory Accounts payable Accrued wages payable Interest payable Income taxes payable Net cash provided by operating activities Cash flows from investing activities Purchase of plant and equipment Sale of long-term investments Net cash used for investing activities Cash flows from financing activities Decrease in bonds payable Increase in common stock Increase in paid-in capital Payment of dividends Net cash used by financing activities Increase in cash

$1,050 100 (550) 110 300 (100) (50) 150 1,010 (700) 140 (560) (300) 70 330 (200) (100) 350

58

4.10 (a)

Net income - Change in retained earnings = Dividends

Firm A Firm B

$75,000 $75,000

-

$70,000 $40,000

= =

$ 5,000 $35,000

(b) 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

$

2,000 (10,000) (35,000) ($ 43,000)

Change in cash

$

$ 10,000

(c) 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 59

0

% 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 expanding capital assets and paying dividends. This problem illustrates the importance of cash flow as a performance measure.

4.11

Little Bit, Inc. Statement of Cash Flows For Year Ended December 31, 2012

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 expenses Accounts payable Accrued liabilities Net cash used by operating activities Cash flows from investing activities Purchase of plant and equipment Purchase of long-term investments Net cash used by investing activities Cash flows from financing activities Additions to long-term debt Sale of common stock Net cash provided by financing activities Increase in cash

$ 5,500 18,000 500 (6,500) (8,500) (4,000) 2,000 (16,000) ($ 9,000 ) (6,000) (1,000) ($ 7,000 ) 17,000 15,000 $ 32,000 $ 16,000

60

Analysis Inflows Long-term debt Sale of common stock Total

$ 17,000 15,000 32,000

% 53 47 100

Outflows Operating activities Purchase of property and equipment Purchase of long-term investments Total

9,000 6,000 1,000 16,000

56 38 6 100

Little Bit, Inc. failed to generate cash from operating activities due primarily to growth in inventories, receivables and prepaid expenses, combined with the payment of accrued liabilities. The firm may be expanding as evidenced by the increase in capital assets.

The expansion is being supported primarily by long-term debt and the sale of common stock. It would appear that Little Bit is using long-term debt only for the acquisition of plant and equipment, but also to cover the negative cash flow from operations. This is generally not good to match long-term debt maturities with the financing of current assets.

It is essential that Little Bit generate cash flow in the future to lessen the need for debt, perhaps by controlling the growth of inventories and receivables.

61

4.12 (a) Cash provided by operations in 2012 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 2011. Additions to plant and equipment were about the same in 2012 as 2011, 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 2011 and 2012), 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 2013. (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

2009 $ % 24,525 8.2 14,408 4.8 125,248 41.8 135,249 45.2 299,430 100.0

2008 $ % 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 2011 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 investments. A sharply reduced cash flow from operations in 2012 (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 62

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 2012.

4.13 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 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.

4.14 There is no solution presented here as the students will be choosing a variety of companies.

63

4.15 (a) Advantages of large cash balances are that: • companies can survive economic recessions; • cash is available for future investment opportunities; • cash is available to reward shareholders with dividends; and • cash is available for acquisitions. (b) Disadvantages of large cash balances are that: • cash may be earning little or no return; • holding cash may indicate the firm is no longer finding growth opportunities; • firms may lose investors who think there is no company strategy to put cash to work; and • economic recoveries occur more slowly if firms are unwilling to invest in new growth and hire new employees. (c) Students answers will vary depending on information located at the time they do research. In 2011, firms with the largest cash and liquid balances were: Microsoft, Apple, Cisco, Google, and Johnson & Johnson.

64

Case 4.1

Intel Statement of Cash Flows Summary Analysis (dollars in millions)

Inflows: Operations Maturities and sales of available-for-sale investments Maturities and sales of trading assets Return of equity method investments Proceeds from divestitures Other investing activities Increase in short-term debt Proceeds from government grants Excess tax benefit from sharebased payment arrangements Issuance of long-term debt Proceeds from sales of shares Total Inflows Outflows: Additions to PPE Acquisitions, net of cash Purchase of available-for-sale investments Purchases of trading assets Origination of loans receivable Investments in non-marketable equity instruments Decrease in short-term debt Repayment of debt Repurchase of common stock Payments of dividends Total Outflows Change in cash

2010 $ % 16,692 42

2009 $ % 11,170 46

2008 $ % 10,926 49

13,133

33

7,756

32

7,993

36

8,846

22

2,543

10

1,766

8

199 0 218 23

1 0 1 0

449 0 89 0

2 0 0 0

316 85 34 0

1 0 0 0

79

0

0

0

182

1

65 0 0 0 587 1 39,842 100

9 0 1,980 8 400 2 24,396 100

30 0 0 0 1,105 5 22,437 100

5,207 218

14 1

4,515 853

19 4

5,197 16

20 0

17,675 8,944 498

46 23 1

8,655 4,186 343

37 18 1

6,479 2,676 0

25 10 0

393 1 0 0 157 0 1,736 5 3,503 9 38,331 100 1,511 65

250 1 87 0 0 0 1,762 7 3,108 13 23,759 100 637

1,691 6 40 0 0 0 7,195 27 3,100 12 26,394 100 (3,957)

Intel generates much cash from operations (CFO). CFO is larger than net income in all three years. This is mainly due to depreciation, a non-cash expense. Other non-cash items that caused CFO to be higher than net income include share-based compensation, restructuring and asset impairment charges, amortization of intangibles, and gains on investments. When analyzing the changes in assets and liabilities, no concerns arise. The increase in accounts receivable in 2010 has been driven by increases in fourth quarter sales which will most likely be collected in the first quarter of 2011. The increase in inventories in 2010 is the result of stocking new products. Accounts payable changes are driven by timing of payments. (See Management Discussion & Analysis (MDA), pg. 41.)

The relatively low and decreasing percentage of cash flow from operations is explained by the purchases and ultimate maturities of investments. In all three years between 90% and 98% of cash has been generated from operations or maturities of investments. Investments have most likely been purchased from cash that was originally generated from operations.

Although neither short-term nor long-term debt has been used significantly to generate cash, Intel did borrow long-term in 2009 to finance the purchase of the firm's common stock. (See pg. 41 of MDA.) Cash has been generated from the sale of stock to employees and in 2008 the contribution was 5% of total inflows.

The majority of cash is used to purchase available-for-sale investments and trading assets and the dollar amounts spent have more than doubled from 2008 to 2010.

Intel continues to invest yearly in new property, plant and equipment which is an expected expenditure for this type of firm since Intel should be updating and replacing plant and equipment as new products are developed.

The repurchase of common stock was a significant use of cash in 2008 which declined in 2009 and 2010. It appears that the repurchase of stock may have resulted in higher values for Intel’s stockholders, as the common stock price per share has increased. Payment of dividends has been consistent each year and the dividend per share has increased. Because Intel has the cash available, these items are a good use of their excess cash.

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.

Case 4.2 (a) Begins on next page.

66

Clear

Avnet

(AVT / NYSE)

Edit

Annual Consolidated Statement of Cash Flows A m o unt s R o unde d t o : T ho us a nds

Results for the Years Ending Jul 3, 2010 Jun 27, 2009 Jun 28, 2008 Cash flows from operating activities: Income (loss) from continuing operations $ Adjustments to reconcile to net cash provided by operating activities: Depreciation and amortization Stock-based compensation Restructuring and impairment charges Increase (decrease) in provision for deferred income taxes (Gain) loss on sales of investments, acquisitions, and securities (Gain) loss on sales of property, plant, and equipment Other non-cash items, net Changes in assets and liabilities: (Increase) decrease in receivables (Increase) decrease in inventories (Increase) decrease in other current assets Increase (decrease) in accounts payable, accrued liabilities, and income taxes payable Increase (decrease) in deferred liabilities Other assets and liabilities, net

410,370

$

(1,129,712) $

489,578 58,845 25,389

46,424 (8,751)

65,781 18,269 1,411,127 (92,787) (14,318)

101,100 (49,903)

15,385

38,414

24,192

(1,070,302) (459,917)

709,908 483,453

46,100 36,453

947,370

(372,100)

(278,137)

(30,415)

1,118,035

453,617

(66,888) 12,015

(110,219) 13,157

(89,657) 12,061

(69,333) 11,785

(314,941) 14,318

(369,385) 68,601

(112,421)

(397,685)

(378,380)

296,469 (4,535)

(406,805)

(41,928)

60,643 28,363

Net cash provided by (used in ) operating activities Cash flows from investing activities: Purchases of property, plant, and equipment Sales of property, plant, and equipment Purchases of marketable securities and short-term investments Sales of marketable securities and short-term investments Acquisitions, net of cash acquired Other investing activities, net Net cash provided by (used in) investing activities Cash flows from financing activities: Short-term borrowings, net Proceeds from long-term borrowings Payment of long-term borrowings Proceeds from sales of common stock Repurchase of common stock / treasury stock Dividends to shareholders Other financing activities, net

4,838

1,564

8,881

Net cash provided by (used in) financing activities

296,772

(405,241)

(33,047)

Net cash provided by (used for) discontinued operations Effect of exchange rate changes on cash, net

(5,755)

(11,637)

40,909

Net increase (decrease) in cash and equivalents for period Cash and equivalents, beginning of period

148,181 943,921

303,472 640,449

83,099 557,350

Cash and equivalents, end of period

$

Supplemental disclosures of cash flow information: Cash paid during the year for: Interest Income taxes (refunded)

1,092,102

60,556 92,565

67

$

943,921

66,895 126,010

$

640,449

71,549 170,764

Avnet

(AVT / NYSE)

Annual Summary Analysis Statement of Cash Flows S um m a ry pe rc e nt a ge s in it a lic s

do no t f o o t due t o ro unding dif f e re nc e s

Jul 3, 2010 Inflows Proceeds from operating activities Sales of property, plant, and equipment Sales of marketable securities and short-term investments Divestiture of acquisitions, net of cash acquired Proceeds from other investing activities, net Proceeds from short-term borrowings, net Proceeds from long-term borrowings Proceeds from sales of common stock Proceeds from other financing activities, net Proceeds from discontinued operations Gains from effect of exchange rate changes on cash, net Total Inflows Outflows Losses from operating activities Purchases of property, plant, and equipment Purchases of marketable securities and short-term investments Acquisitions, net of cash acquired Losses from other investing activities, net Payment of short-term borrowings, net Payment of long-term borrowings Repurchase of common stock / treasury stock Payment of dividends to shareholders Payment of other financing activities, net Losses from discontinued operations Losses from effect of exchange rate changes on cash, net Total Outflows Net increase (decrease) in cash and cash equivalents

%

$ 12,015 11,785 296,469 4,838 $

3.7

3.6 91.2 1.5

325,107

100.0

30,415 66,888 69,333 4,535 5,755

17.2 37.8

$

176,926

100.0

$

148,181

$

Results for the Years Ending Jun 27, 2009 % Jun 28, 2008 $ $ 1,118,035 97.5 453,617 13,157 1.1 12,061 14,318 1.3 68,601 1,564 0.1 8,881 40,909 $

1,147,074

100.0

$

2.6

3.2

584,069

77.7 2.1

11.7

1.5 7.0 100.0

$ 110,219 314,941 406,805 11,637

39.2

$

%

$

843,602

$

303,472

89,657 369,385 41,928 -

13.1 37.3

48.2

1.4 100.0

$

500,970

$

83,099

17.9 73.7

8.4

100.0

(b) Avnet generated positive cash flow from operating activities (CFO) in 2008 and 2009, but used CFO in 2010. The pattern of CFO is inconsistent with the net income pattern which showed profits in 2008 and 2010, but a large loss in 2009.

Further it is undesirable for a firm to generate less CFO relative to net income as Avnet has done in 2008 and 2010. The reasons for the inconsistencies are explained below.

The reason CFO is slightly lower than net income in 2008 is because of the payment of accrued expenses, increases in inventories and the gain on sale of assets, a non-cash item. The increase in inventories was most likely the result of the economic downturn. In 2009 Avnet generated a large amount of CFO, a year when the firm had a significant loss. Several items contributed to the positive CFO including the noncash impairment charges, and large reductions in receivables and inventories, while still paying down accounts payable. The negative CFO in 2010, a year when Avnet had a positive profit, was mainly the result of the huge increase in receivables and inventories. Sales increases in the fourth quarter should be collected in fiscal 2011, reducing receivables and generating positive CFO in the first quarter. The increase in inventories may also be a result of acquisitions and, if this is the case, the amount of inventories should adjust as all acquisitions are integrated with Avnet’s current divisions. It is noteworthy that Avnet used 68

accounts payable in 2010 to support the increases in receivables and inventories and will have to repay these amounts in 2011. This will cause a reduction in CFO in 2011 relative to net income.

The majority of cash inflows in 2008 and 2009 were from CFO which is desirable.

In 2009, 97.5% of cash inflows were a result of CFO. Investing activities and gains from exchange rate changes contributed nearly 19% of cash inflows in 2008 with nearly 78% coming from CFO. In 2010 Avnet did not generate CFO. Over 91% of cash inflows came from an increase in long-term debt. These funds were most likely used for upcoming acquisitions which occurred subsequent to fiscal 2010.

The key use of cash in 2008 was for acquisitions with some cash used to repay long-term debt and purchase property, plant, and equipment. In 2009 a significant amount of long-term debt was repaid and the firm continued to make acquisitions comparable in amount to 2008. Avnet also purchased property, plant, and equipment. With negative CFO in 2010, Avnet reduced the amount spent on acquisitions and property, plant and equipment. All cash outflows are appropriate uses of cash for this firm.

Assuming that Avnet is successful in integrating acquisitions and producing high sales and positive profits, CFO should improve in 2011.

69

Case 4.3 1.

Gerber Scientific, Inc. Statement of Cash Flows Summary Analysis For the Years Ended April 30, (dollars in thousands)

Inflows: Cash from operations Proceeds from sale of available for sale investments Proceeds from sale of net assets Debt proceeds Common stock activities Effect of exchange rate Total Inflows Outflows: Capital expenditures Purchases of available for sale investments Business acquisitions Investments in intangible assets Debt repayments Debt issuance costs Common stock activities Other financing activities Effect of exchange rate Total Outflows Change in cash

2010

%

2009

%

2008

%

25,096

20

9,774

8

10,205

3

464

0

705

1

751

0

13,709 11 89,525 69 0 0 333 0 129,127 100.0

2,622 2 110,686 88 898 1 0 0 124,685 100.0

345 0 321,862 96 1,373 0 1,413 1 335,949 100.0

4,489

4

8,187

6

8,589

3

308 3,473

0 3

457 34,273

0 27

753 4,650

0 2

1,368 117,176 494 486

1 92 0 0

828 80,271 1,174 0

1 63 1 0

868 314,256 993 0

0 95 0 0

341 0 0 0 128,135 100.0 992

0 0 3,074 2 128,264 100.0 (3,579)

70

0 0 0 0 330109 100.0 5,840

2.

Gerber Scientific (Gerber) has generated positive cash from operating activities (CFO) all three years and in 2009 and 2010 CFO was greater than the reported net income. In 2008 CFO was lower than net income as a result of increasing accounts receivable, increasing inventories and decreasing accounts payable and accrued liabilities. CFO was higher all three years relative to net income as a result of non-cash items such as depreciation and stock-based compensation. Accounts receivable and inventories decreased in both 2009 and 2010 which is a positive sign that the firm is selling inventory and collecting on accounts receivable. The high collections of accounts receivable in 2009 correspond with the large payments on accounts payable and accrued liabilities that year. An analysis of the income statement is needed to explain why there is a net loss in 2010 as CFO is positive.

Gerber does not generate enough CFO to cover expenses and cash needs above and beyond operating activities. The majority of cash is from debt proceeds each year, although the dollar amount has decreased. The only other significant source of cash is from the sale of assets in 2010.

Debt repayments are the primary use of cash every year. It is good that Gerber is able to repay debt and it is a positive sign that the amount of debt needed each year is on a downward trend. In 2009 Gerber made significant acquisitions which could possibly explain the net loss in 2010 if the acquired firm was not doing well.

The amount Gerber has spent on property, plant and equipment has dropped by half in 2010 compared to 2008 and 2009. It is important for firms to replace plant and equipment as needed. Perhaps Gerber did not need to make as many capital expenditures in 2010 as a result of the acquisitions in 2009. The sale of net assets in 2010 may be a result of downsizing operations which could also explain the decline in capital expenditures.

Gerber has a positive cash balance and does pay back debt each year. To strengthen the firm’s cash position it needs to continue to pay down debt and generate more cash from operations as opposed to borrowing each year to pay back debt.

3.

Gerber is successful in generating positive CFO and has so far been able to make payments on debt. Their creditworthiness is average.

4.

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), 71

amount of debt due in the next five years (from notes), and minimum future payments for operating leases and other commitments (from notes).

72

Case 4.4 1.

Agilysys, Inc. Statement of Cash Flows Summary Analysis For the Years Ended March 31, (dollars in thousands)

Inflows: Cash from operations Proceeds from Primary Fund Proceeds from borrowings on life insurance Proceeds from investment Proceeds from marketable securities Floor plan financing Proceeds from credit facility Issuance of common shares Excess tax benefit Effect of exchange rate Operating cash flowsdiscontinued operations Total Inflows Outflows: Cash from operations Claim on Primary Fund Investments in life insurance policies Investments in marketable securities Acquisition of business Purchase of PPE Floor plan financing Principal payment-credit facility

2010

%

2009

%

2008

%

103,924

82

0

0

0

0

4,772

4

0

0

0

0

12,500

10

0

0

844

3

0

0

9,513

14

4,770

15

61 0

0 0

81 59,607

0 85

6,088 14,552

19 47

5,077

4

0

0

0

0

89 9 695

0 0 0

0 0 911

0 0 1

1,447 213 1,314

5 1 4

0 0 127,127 100.0

94 0 70,206 100.0

1,995 6 31,223 100.0

0 0

0 0

80407 5,268

77 5

159,240 0

28 0

1,712

2

5,996

6

7,623

1

45 0 13,306 74,468

0 0 14 76

4 2,381 7,056 0

0 2 7 0

52 236,210 8,775 0

0 42 2 0

5,077

5

0

0

0

0

73

Debt financing costs Purchase of treasury shares Principal payment-longterm obligation Dividends paid Operating cash flowsdiscontinued operations Total Outflows

1,578

2

0

0

0

0

0

0

0

0

149,999

27

216 1,360

0 1

67 2,718

0 3

197 3,407

0 0

74 0 97,836 100.0

0 0 103,897 100.0

0 0 565,503 100.0

Change in cash

29,291

(33,691)

(534,280)

2.

Agilysys, Inc. has volatile cash flow from operating activities (CFO) over the three years from 2008 to 2010. The firm experienced a net loss from continuing operations in 2009, but generated profits in 2008 and 2010. The pattern for CFO does not match the pattern of net income. CFO was negative in 2008 and 2009 and positive in 2010. The causes of the differences between net income and CFO are discussed below.

In 2008 the primary reasons for the negative cash flow, despite a positive net income, were the large payments for income taxes payable and accounts payable as well as the reduction of accrued liabilities. This implies that Agilysys generated significant taxable income in 2007.

In 2009 the negative CFO is expected since the firm operated at a loss. It is noteworthy that the negative CFO is less than the loss. In fact, the firm would have had a positive CFO except, that once again there were significant payments for accounts payable and accrued liabilities. Asset impairment charges, a non-cash item, are the reason that CFO is much better than the net loss. Agilysys, may have acquired businesses in the past that have not generated above-average earnings, causing the firm to write-off goodwill and other intangible and tangible assets associated with that business. The decline in amortization in 2010 supports this theory.

In 2010 CFO is much larger than the net income as a result of the decline in accounts receivable and inventories while accounts payable increased. For all three years Agilysys collected on accounts receivable which caused CFO to be higher. In 2008 and 2009 the firm was increasing inventories, but in 2010 sold inventories in an amount greater than the prior two years’ increases. As discussed in Note 8 from the Form 10-K of Agilysys, the firm terminated a financing agreement with IBM and decided to finance working 74

capital needs through their accounts payable. The pattern of decreasing accounts payable in 2008 and 2009 with a subsequent increase in 2010 is consistent with the change in financing arrangements.

Agilysys has not generated cash from operations in 2008 or 2009, but in 2010, CFO provided 82 % of total cash inflows. The primary source of excess cash has been from borrowing, with the IBM Floor Plan providing most of the financing in 2008 and 2009. In 2008 the firm did generate 34% of funds from investments with smaller amounts coming from issuance of common stock, effects of exchange rates and cash from discontinued operations.

Cash outflows vary each year. In 2008 Agilysys used a significant amount of cash to acquire another business, repurchase treasury stock and support operations. Given the economic recession, this strategy may not have been the best choice. It is possible that the impairment charges in 2009 could be related to the acquisition in 2008. In 2009 most cash outflows were the result of the negative CFO. In 2010 the majority of cash outflows were used to repay the IBM Floor Plan. In all three years the firm did continue to invest in property, plant and equipment, and the amount nearly doubled in 2010 which may be a result of the economic recovery. It is noteworthy that the dollars paid for dividends have decreased over the three year period. Some of this decrease is probably the result of the repurchase of common stock, but could also be the result of the firm decreasing the dividends paid per share.

Agilysys had over $604 million of cash on hand at the beginning of 2008.

Due to their acquisition strategy, repurchase of treasury stock and the repayment of debt, the firm burned through most of their excess cash, ending 2010 with just over $65 million. This is not surprising as many firms experienced difficulties in 2007 through 2009 during the recession. It is positive that Agilysys has been able to survive these difficult years, has paid down debt and is now generating positive CFO. 3.

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 volatility of CFO for Agilysys cannot be observed by looking at only the income statement or the balance sheet. The reasons for 75

this volatility can be determined fairly quickly by looking at the statement of cash flows.

76

Chapter 5 5.1 The credit analyst is concerned with the ability of the borrower to repay interest and principal on loans. Questions raised in a credit analysis would focus on the borrowing cause, the firm's capital structure, and the source of the debt repayment. The investment analyst attempts to estimate the future earnings stream in order to attach a value to the securities being considered. Questions raised in an investment analysis would focus on the company's performance record, future expectations and the firm's competitive position, risk in the capital structure and the expected returns.

5.2 Financial ratios can serve as screening devices, indicate areas of potential strength or weakness, and reveal matters that need further investigation. But financial ratios do not provide answers in and of themselves, and they are not predictive. Financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis. It should also be noted that there is no one definitive set of key financial ratios, there is no uniform definition for all ratios, and there is no standard that should be met for each ratio. Finally, there are no “rules of thumb” that apply to the interpretation of financial ratios. Each situation should be evaluated within the context of the particular firm, industry, and economic environment.

5.3 Liquidity ratios measure a firm’s ability to meet cash needs as they arise. Activity ratios measure the liquidity of specific assets and the efficiency of managing assets. Leverage ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges. Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity. Market ratios measure returns to stockholders and the value the marketplace puts on a company’s stock.

5.4 The Du Pont System helps the analyst see how the firm's decisions and activities over the course of an accounting period interact to produce an overall return to the firm's shareholders. By reviewing the relationships of a series of financial ratios, the analyst can identify strengths and weaknesses as well as trace potential causes of any problems in the overall financial condition and performance of the firm.

77

The ratios which are looked at include the return on investment (profit generated from the overall investment in assets) which is a product of the net profit margin (profit generated from sales) and the total asset turnover (the firm’s ability to produce sales from its assets). Extending the analysis the return on equity (overall return to shareholders, the firm’s owners) is derived from the product of return on investment and financial leverage (proportion of debt in the capital structure). Using this system, the analyst can evaluate changes in the firm’s condition and performance, whether they are indicative of improvement or deterioration or some combination. The evaluation can then focus on specific areas contributing to the changes.

5.5 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 %

Times Interest Earned

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 %

Quick Ratio Average Collection Period

78

Net Profit Margin

76,800 1,500,000

5.1 %

Return on Total Assets

76,800 1,145,000

6.7 %

Return on Equity

76,800 28.4 % 270,000 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.

Although the high debt ratio improves the return on equity, it also increases risk. The increased use of financial leverage has more than offset the decrease in profitability:

79

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

5.6 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.

5.7 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

80

(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.

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!

5.8 (a) XYZ is more liquid than ABC. XYZ’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.

ABC’s liquidity ratios are all below one. It appears that ABC must find external funding in the short-term to be able to pay current liabilities. XYZ generated more than 2.5 times the cash from operations in compared to ABC.

81

Total asset turnover is the same for both firms with ABC showing better inventory efficiency than XYZ, but XYZ is managing accounts receivable and fixed assets better than ABC. ABC is highly leveraged compared to XYZ. 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 XYZ, which means the firm has no trouble covering capital expenditures, debt repayment and dividends with cash from operations. ABC is only covering $0.43 on every dollar of these same items with cash generated from their operations.

ABC generates higher operating and net profits than XYZ, and therefore has higher return on assets and equity ratios. The return on equity ratio is extremely high due to the fact that ABC uses a significant amount of debt (76%) and is generating sufficient returns to cover the cost of the debt.

XYZ, while not as profitable, is translating their profits into cash much better than ABC. (b) Stock Price EPS

ABC $41 $4.59

XYZ $35 $1.19

PE Ratio

8.9

29.4

The PE ratio indicates the value being placed by the stock market on a company’s earnings. A higher value is being placed on XYZ compared to the value placed on ABC. Investors may be placing a higher value on XYZ, because they understand the importance of cash flow from operations and view it as a better measure than accrual-based profits.

5.9 (a) (b) (c) (d) (e) (f) (g) (h) (i)

Current D N I D D N I I N

Quick N N I D N N I I N 82

Net Wk. Capital N N I D D N I I N

Debt I N D N I N I D D

(j) (k) (l)

N D I

D D N

N N N

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.

5.10 (a)

Debt

Equity

Debt Ratio*

40+10 90+10

= 50%

40 90+10

= 40%

Times Interest Earned*

18 4.8+1.5

= 2.86 x

18 4.8

= 3.75x

Operating Profit Interest Expense Earnings before tax Income tax exp.

(40%) Net Income Shares Outstanding Earnings per share

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

7,020 50,000

Return on Equity Return on Assets (adjusted)

18,000,000 6,300,000 11,700,000

= 14.04%

7,020+6,300(1-0.4) = 10.80 100,000

Financial Leverage Index

14.04 10.80

*Numbers are in millions

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= 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

(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 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.

5.11 At first glance, it appears that Wal-Mart has poor short-term liquidity.

The current, quick and cash flow liquidity ratios are all below 1.0. This means the firm does not have as many current assets or liquid items to cover current liabilities. The quick ratio is especially low due to the large amount of inventories Wal-Mart must have to stock its stores. The cash flow liquidity ratio is decreasing as a result of cash flow from operations decreasing from 2009 to 2010.

The cash conversion cycle, however, offers a much better picture of the firm.

The average collection period is insignificant at 5 days which makes sense.

Wal-Mart takes bank credit cards such as MasterCard and Visa and is, therefore, not at risk if customers default on bank credit cards. Days inventory held has increased by two days but at 42 days does not seem too large for a giant retailer. The days payable outstanding has also increased two days but at 39 days Wal-Mart pays suppliers in a timely manner. The cash conversion cycle has increased one day to eight days in 2010 which is a relatively short conversion period. The fact that Wal-Mart is able to convert sales into cash so quickly may explain why they are successful with a current ratio below one. Further evidence that Wal-Mart does not have liquidity problems is the positive cash flow from operations number which is over $23 billion both years.

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The fixed and total asset turnover ratios are declining slightly. A possible reason for the decline could be that Wal-Mart is expanding and opening new stores and increased revenues have not yet caught up to the increase in fixed assets and inventories that would be needed for an expansion. Wal-Mart’s increasing revenues and good conversion cycle are positive signs that WalMart operates efficiently. Short-term liquidity appears to be under control despite the low current, quick and cash flow liquidity ratios.

5.12 AMC has a risky capital structure. In 2010 the firm had 79.2% debt, most of which was long-term. Debt has increased significantly from 2009.

The interest (accrual-based and cash-based) and fixed charge coverage ratios are low, but have improved from 2009 to 2010. An increase in operating and net profit appears to have contributed to an increase in cash flow from operations. Cash flow adequacy which was 1.2 in 2009 has dropped to 0.3 in 2010, indicating that AMC can no longer cover capital expenditures, debt repayments and dividends with cash generated from operations. The change in this ratio needs to be investigated to determine if the increase in debt has been caused by an expansion which also increased capital expenditures. If so, then in subsequent years the cash flow adequacy ratio should improve, assuming the expansion leads to higher cash flow. In addition, it would be important to know if AMC is paying dividends and if they have increased.

With such a risky capital structure it would be unwise for the firm to use cash for dividends before paying down debt.

The overall profitability of AMC is improving. The gross profit margin has declined slightly due to higher costs or a decrease in prices. It is unlikely that AMC would reduce ticket prices as historically prices have increased. It is more likely that AMC has had higher costs that could not be passed on to customers in the form of higher prices. The poor economy from 2007 through 2009 would have caused customers to eliminate luxury items from their budgets and this would have included attending movie theaters.

Operating profit, a loss in 2009, is now positive in 2010. AMC has been able to increase revenues without a corresponding increase in operating expenses.

Net profit has benefited from the increase in operating profit. Given the large increase in debt, it would be expected that net profit may have decreased as a result of increased interest expense. This did not happen which could be a result of a decrease in interest rates and/or an increase in other miscellaneous income. Return on assets and return on equity were negative in 2009 but are now positive for the reasons already mentioned. Return on equity is significantly larger than return on assets due to the high leverage of AMC. The cash return on assets has improved over the past year which is positive.

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AMC needs to continue its strategy that has resulted in higher revenues, profits and cash flows; however, the firm must monitor its capital structure and work toward reduction of debt. The risky capital structure is of concern with regard to the long-term solvency of the firm.

5.13 Writers of the 2013 annual report will probably want to emphasize rebounding in 2013 from an abnormal year in 2012. They will want to point out reasons for the improvement in 2013, 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 Sage 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 2012 and how the firm has recovered, which is actually a major plus.

5.14 There is no solution presented for this problem since students will choose different industries. Having students share what they have learned from their research can lead to interesting discussions.

5.15 There is no solution presented for this problem since students will choose different industries. Having students share what they have learned from their research can lead to interesting discussions.

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Case 5.1 (a) and (b) Short-term liquidity Current ratio Quick ratio Cash flow liquidity ratio* Average collection period Days inventory held Days payable outstanding Cash conversion 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

2008

Ind. Avg.*

2010

2009

3.39 2.99 4.13 24 days 91 days 56 days 59 days

2.79 2.40 3.31 24 days 69 days 45 days 48 days

51 days 74 days 48 days 77 days

15.22 4.03 6.61 2.44 .69

15.45 5.30 8.27 2.04 .66

7.2 4.9 7.7 11.7 1.2

21.77%

21.45%

45.2%

2.1 1.5

4.03% 4.68% 0.28 0.27 0.9 1.28 1.27 N/M 5711 times 1119 times 1.8 times N/M 3029 times 2490 times 127 times 48 times 61 times 1.88 times 1.45 times 1.31 times 65.31% 35.73% 26.28% 38.26% 18.14% 23.19% 26.42%

*includes trading assets **includes short-term debt

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55.69% 16.26% 12.44% 31.80% 8.23% 10.48% 21.04%

55.46% 23.82% 14.08% 29.07%

30.0% (0.3)%

Market measures Earnings per share Closing price PE ratio Based on closing price Dividend payout rate Dividend yield Based on closing price

2010

2009

2008

$2.06 $20.84

$0.79 $20.33

$0.93 $14.18

10.12 30.58%

25.73 70.89%

15.25

3.02%

2.75%

Ind. Avg.

* Industry average is from The Risk Management Association, Annual Statement Studies, 2010; 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, market measures and quality of financial reporting issues. 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 the increases in all current assets but especially the increase in short-term investments. Current liabilities have increased but not at a rate proportionate to the increases in current assets. The current and quick ratios in 2010 are above the industry average. The cash-flow liquidity ratio increased as well due to the increases in liquid assets and increasing cash from operations. 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 35% of total assets and, therefore, Intel should not have problems paying debt as it comes due.

This company has no problem generating cash from operations as evidenced by the statement of cash flows.

Accounts receivable increased as a result of higher fourth quarter sales in 2010. The collection period is stable and well below the industry average.

One concern is that two customers account for 44% of accounts receivable and 38% of sales. A default by either customer would be detrimental to the company. The two customers are Dell and Hewlett-Packard so the risk of default is probably small.

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As sales have increased both the accounts receivable and the allowance for doubtful accounts have also increased. This is a normal pattern. Looking at the valuation and qualifying accounts schedule in Intel's Form 10-K (page 111) it appears that Intel’s allowance account balance was more than adequate in 2008 and 2009. In 2010, Intel did not have any write-offs of bad debt yet increased the allowance account by $9 million. Intel may be anticipating customer defaults in 2011, but in 2008 and 2009, a recessionary period, Intel did a good job collecting on accounts receivable with minimal write-offs. It is also possible that Intel has overestimated the account with the intention of later reducing it to improve the net income number.

Days inventory held has increased significantly and is now above the industry average. This is a concern because of the rapid obsolescence of products in the high technology industry. According to the management discussion and analysis (MDA) the increase in inventories was a result of higher microprocessor inventories due to ramping new products.

Days payable outstanding has increased by 11 days indicating Intel is paying suppliers slower. While this number is still acceptable, it should be watched in the future. It is possible that Intel, due to its excellent short-term liquidity, is better able than its competitors to obtain more favorable credit terms from its suppliers.

The cash conversion cycle has increased by 11 days due to the large increase in days inventory that was somewhat offset by the increase in days payable outstanding. Due to Intel’s excellent collection period and the fact that they pay suppliers more slowly, the firm has a cash conversion cycle that is still better than the industry.

Overall the short-term liquidity of Intel is excellent. The firm has more cash and short-term investments than their total liabilities and will not have a problem paying bills in the future.

Operating Efficiency As discussed under short-term liquidity, Intel’s inventory turnover is worse in 2010 compared to 2009 and the firm is taking longer to pay accounts payable.

The fixed and total asset turnover ratios for Intel are low compared to the competition. Intel invests heavily in fixed assets to increase capacity, while keeping inventory levels low, a strategy opposite their competition. The 89

fixed asset turnover is somewhat improved due to sales increasing while net property, plant and equipment was relatively stable. The total asset turnover showed slight improvement. This was a result of the improvement in fixed asset turnover that was largely offset by the much poorer inventory.

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. Liabilities make up approximately 21 percent of total assets, making Intel's capital structure low risk.

Intel is generating profits and a large amount of cash from operations, allowing the company to cover interest and lease payments easily. Cash flow adequacy is over one meaning Intel generates a lot of excess cash each year even after paying debt, buying plant and equipment and paying dividends.

The financial leverage index indicates Intel is using debt successfully in both 2010 and 2009. Should Intel need to borrow in the future, the large equity cushion will allow them to obtain financing readily.

Profitability Revenues for Intel increased in 2010 after a decline in 2009. Operating costs increased in 2009 causing a significant decline in operating profit; however, in 2010 operating costs decreased causing profitability to increase. The increase in revenues in 2010 was a result of both higher volume and higher average selling prices. The PC Client Group revenues increased 21% primarily due to higher volume of notebook unit sales and, to a lesser extent, higher average selling prices for notebooks. One area that had significantly lower sales was the wireless connectivity product lines. The Data Center Group revenues increased 35% due primarily to volume, and, to a lesser extent, higher average selling prices. Revenues increased 27% in the Other Intel Architecture segment due to volume increases. In 2009 the decrease in revenues resulted from lower selling prices while volume increased overall.

The gross profit margin, stable in 2008 and 2009, increased significantly in 2010 and is now more than double the industry average. The MDA explains that the increase in gross profit margin was a result of higher revenues and, to a lesser extent, lower unit costs. Higher revenues caused by volume increases result in higher gross profit margins when firms have fixed costs.

As a manufacturer Intel would have significant fixed costs included in their cost of sales.

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Operating profit decreased significantly from 2008 to 2009, as a result of the $1.447 billion fine paid to the European Commission and the $1.25 billion settlement paid to AMD in 2009. From 2009 to 2010 operating profit increased significantly as a result of the large increase in gross profit margin and the fact that no fines and settlements were paid in 2010 compared to 2009. The industry average for operating profit is negative while Intel has a healthy 35.73% profit margin.

Research and development costs (R&D) increased in dollars despite a decline in percentage relative to net revenues in 2010. The increase in costs was due to higher profit-dependent compensation, an increase in employees and higher process development costs as Intel transitioned from 32 nanometer technology to the new generation 22 nanometer technology.

The European Commission fine and AMD settlement were recorded in marketing, general and administrative expenses in 2009 resulting in lower expenses in 2010. Higher costs were incurred for advertising and profitdependent compensation.

Operating profit margins have also increased as a result of the completion of restructuring programs implemented between 2006 and 2009. The firm is now realizing approximately $290 million of annual savings, a majority within cost of sales.

Intel has net overall gains from equity investments in 2010 although the amount is insignificant. Losses in investments in all three years were the result of impairment charges. Interest income and other, net, is a combination of gains on trading assets, exchange rate losses, interest expense and interest income. Interest income is the primary item included in this category and has declined significantly as a result of lower interest rates.

Intel's effective tax rate is relatively low compared to the statutory rate of 35 percent. The firm has benefited from lower foreign tax rates (especially in 2009), settlements, and domestic manufacturing benefits. The higher rate in 2010 was because of higher profits in higher tax jurisdictions compared to 2009.

Net profits are healthy and increasing. The return on assets (both accrualbased and cash-based) and return on equity have improved in 2010 as a result of the increasing profits without a proportional increase in assets and equity. If costs are managed well and Intel continues to develop cutting edge 91

products, profits should continue to trend upward or at the very least remain stable.

Market Measures Earnings per share decreased in 2009, but increased 160% in 2010 compared to 2009. Intel reported its best financial results ever in 2010 yet the market did not reward Intel for their superior performance. In fact, the PE ratio dropped from 25.73 to 10.12 as a result of virtually no change in the closing price relative to the huge increase in earnings per share.

The dividend yield of approximately 3% offers a good return for investors at a time when CD rates are much less. Intel has chosen to increase their dividends every year while also repurchasing their common stock.

Quality of Financial Reporting Intel has disclosed key information as required in their annual report and Form 10-K. Overall, the quality of financial reporting is good.

Strengths Strong cash flow from operations Solid short-term liquidity Better fixed asset management Low debt levels Increasing sales, profits, and dividends Weaknesses Reliance on two customers Riskiness and competitiveness of high technology industry High inventory days held Investment potential Intel’s financial performance is excellent especially when one considers the recent economic recession. Revenues, profits and cash flows for Intel increased significantly in 2010, yet the firm has not yet been rewarded for their ability to manage their finances so well. The PE ratio is unusually low and suggests that now would be a good time to invest in the company.

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.

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Case 5.2

Avnet

(AVT / NYSE)

Show Formulas

Summary of Financial Statement Ratios

Jul 3, 2010

Liquidity Ratios: Current ratio Quick ratio Cash flow liquidity

Results for the Years Ending Jun 27, 2009

Jun 28, 2008

1.93 times 1.40 times 0.31 times

2.09 times 1.52 times 0.84 times

Average collection period Days inventory held Days payable outstanding Cash conversion cycle

69.00 days 40.00 days 62.00 days 47 days

59.00 days 37.00 days 51.00 days 45 days

Activity Ratios: Accounts receivable turnover Inventory turnover Payables turnover Fixed asset turnover Total asset turnover

5.36 times 9.31 times 5.90 times 63.32 times 2.46 times

6.20 times 10.06 times 7.26 times 53.09 times 2.59 times

Leverage Ratios: Debt ratio Long-term debt to total capitalization Debt to equity Financial leverage (FL) Times interest earned Cash interest coverage Fixed charge coverage Cash flow adequacy

61.33 % 29.24 % 1.59 times 2.59 times 10.29 times 2.03 times 5.55 times (0.43) times

55.99 % 25.53 % 1.27 times 2.27 times (12.95) times 19.60 times (6.67) times 2.16 times

8.06 times 9.73 times 5.22 times 3.45 times

11.90 % 3.32 % 2.14 % (0.16) %

12.46 % (6.28) % (6.96) % 6.89 %

12.89 % 3.96 % 2.73 % 2.53 %

5.27 %

(18.01) %

13.64 % (0.39) %

(40.92) % 17.82 %

Profitability Ratios: Gross profit margin Operating profit margin Net profit margin Cash flow margin Return on assets (ROA) or Return on investment (ROI) Return on equity (ROE) Cash return on assets

Market Ratios: Earnings per share Price-to-earnings Dividend payout Dividend yield

$

2.71 8.85 0 0.00 0 0.00 0

$

(7.49) 0.00 N/M 0.00 0 0.00 0

NOTES: If a ratio's numerator and/or denominator equals zero, no ratio is displayed.

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$

3.26 9.06 0 0.00 0 0.00 0

Analysis of Avnet - 2010 Avnet, a leading distributor of electronic components, enterprise computer and storage products and embedded subsystems, appears to be on the road to recovery in 2010, after a volatile three year period. The recent downturn in the economy presented challenges for many firms, including Avnet, with 2009 being a particularly difficult year. A discussion of the financial wellbeing of Avnet follows, as well as recommendations for investors and creditors.

Short-term liquidity Avnet's short-term liquidity is slightly worse in 2010 compared to 2009. The current and quick ratios have both declined as a result of current liabilities rising faster than current assets. The cash flow liquidity ratio decreased significantly in 2010 as cash from operating activities (CFO) was negative.

Avnet generated a large amount of CFO in 2009 due to large reductions in accounts receivable and inventories; however, in 2010, both accounts receivables and inventories increased significantly causing the negative CFO. The economic recovery in 2010 resulted in higher sales and therefore, higher balances in accounts receivable which should be collected in the first quarter of 2011. Inventories probably increased as both a result of increased demand and acquisitions that Avnet has completed.

The average collection period has increased ten days and is fairly long at 69 days. This should be monitored. Inventory days held increased three days but is an acceptable amount at 40 days. Avnet is taking 11 days longer in 2010 as compared to 2009 to pay suppliers. At 62 days this could be a problem if the firm is not paying bills on time. The cash conversion cycle is good at 47 days and is relatively stable as the increase in average collection period was offset by the longer days payable.

Both sales and accounts receivable increased in 2010, but the allowance for doubtful accounts decreased, an abnormal pattern. For all three years presented, the amount of write-offs shown in the valuation schedule for Avnet is less than half of the estimated balance in the allowance for doubtful accounts. It appears that the allowance account was overstated at the beginning of 2008, so the declining balance is not a concern. It is not clear if the balance was overstated intentionally to manipulate the het income in later years, or if Avnet anticipated more significant write-offs in a recessionary period.

94

Based on the positive CFO in both 2008 and 2009 and the increasing cash balance, despite the negative CFO in 2010, Avnet does not have any immediate liquidity concerns. As mentioned above, the firm should try to improve its collection period and ensure that suppliers are being paid on time.

Operating efficiency The accounts receivable, inventory and accounts payable turnovers were discussed under short-term liquidity. Fixed asset turnover has increased which is good. This is a result of a reduction in fixed assets while simultaneously increasing sales. Based on the note detailing property, plant and equipment, Avnet was able to reduce their investment in buildings and furniture, machinery and equipment, but according to the Management Discussion and Analysis, these reductions may be the result of write-downs of fixed asset values. Total asset turnover declined slightly as total assets, especially accounts receivable and inventories, increased faster than sales.

Even though fixed asset turnover increased by ten times, fixed assets (3.9% of total assets) are not as significant to the firm’s business as accounts receivable and inventories which make up 69.2% of total assets.

Capital structure and long-term solvency Avnet's debt structure is somewhat risky. The firm has over 61% of debt relative to total assets in 2010, compared to 56% in 2009. Most of Avnet’s debt is short-term in the form of accounts payable and accrued liabilities.

This makes sense as the majority of Avnet’s assets are also short-term.

Long-term debt has increased in 2010 as the firm borrowed funds to finance the acquisition of Bell Microproducts subsequent to the fiscal 2010 year.

The above-mentioned percentages will change as Bell Microproducts’ financial statements are combined with Avnet’s current statements. While Avnet also has operating lease commitments, given the large cash balance Avnet carries and the improved economic conditions in 2010, the capital structure seems appropriate.

The times interest earned and fixed charge coverage ratios improved from negative amounts in 2009 to positive amounts in 2010 because Avnet generated losses in 2009, but not in 2010. Cash interest coverage declined significantly due to the negative CFO in 2010 (discussed under short-term liquidity section).

Cash flow adequacy was excellent in 2008 and 2009, but with CFO negative in 2010, this ratio is also negative. Avnet uses cash for appropriate items 95

such as repayment of debt, purchase of property, plant, and equipment, and acquisitions to expand their overall business. In fact, Avnet’s strategy for growth is to target companies in smaller markets where they do not currently have a presence. Avnet has acquired many firms in foreign markets.

Profitability Avnet’s sales decreased 9.6% from 2008 to 2009, but then increased 18.05% in 2010. The global economic slowdown negatively impacted sales volume in 2009; however, in 2010 the technology markets recovered faster than expected resulting in increases to sales volume. Avnet was also able to increase sales volume because of acquisitions and the fact that 2010 was a 53 week fiscal year rather than the typical 52 week year.

Gross profit margin has declined over the three year period due to lower profit margins in other regions, particularly Asia, as compared to the Americas in 2010 and lower margins in Asia and the Americas in 2009 as compared to Europe, the Middle East and Africa region.

As market conditions worsened in late 2008 and accelerated in 2009, Avnet took action to reduce costs as sales demand declined. Even though the dollar amount of selling, general, and administrative expenses decreased in 2009, the percentage of these expenses relative to sales increased. The cost reduction initiative was effective and in 2010 selling, general, and administrative expenses increased in dollars as sales increased, but as a percentage of sales decreased.

Avnet generated a positive operating profit margin in 2008 and 2010. The operating loss in 2009 was a result of the restructuring, integration and impairment charges. The global economic downturn resulted in impairment charges for goodwill and intangible assets in several operating units.

Restructuring charges were related to the cost reduction initiative previously mentioned and included severance packages for personnel reductions and the write-down of fixed assets. Integration charges resulted from the acquisitions. The charges for these items in 2008 and 2010 were much smaller than the amounts charged in 2009. Operating profit has rebounded in 2010 but is still not at the level reached in 2008 because of the decline in gross profit margin.

Other income is insignificant and is largely comprised of the effects of foreign currency changes and gains on sales of assets. Interest expense 96

declined all years due to lower average debt, lower interest rates, the extinguishment of debt and the effects of adopting an accounting standard.

Avnet’s typical effective tax rate appears to be between 29% and 30%, which is lower than the 35% statutory tax rate. This is mainly a result of lower taxes in foreign markets and tax audit settlements. In 2009 Avnet had a positive tax expense, rather than a benefit due to the non-deductibility of the impairment charges.

Net profit margin has followed the pattern of operating profit margin. After an especially poor year in 2009, Avnet has begun to recover and improve profit margins. The return on assets and equity amounts are greatly improved as Avnet has become profitable again in 2010. The cash return on assets is negative due to negative CFO. To increase profit margins in the future Avnet will need to increase prices in regions that have lower profit margins. Due to competition this may not be possible. If the most recent acquisitions prove to be successful, this may be beneficial to the overall success of Avnet as they capture more market share resulting in better control over prices and margins.

Market Measures Earnings per share has improved to a positive number in 2010, but is still below the 2008 amount. The PE ratio reflects this fact as it is less in 2010 than it was in 2008, indicating that the market has not yet placed as high a value on the company as it did in 2008. Stock prices have climbed slightly relative to 2009.

The firm chooses not to pay dividends. This is a good choice given their acquisition strategy. Firms that need to borrow to finance expansion should be using their cash resources for investment in growth opportunities and to repay debt, before paying dividends.

Strengths Acquisition strategy Fixed asset turnover increasing Increased demand and sales of products Improving profit margins

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Weaknesses Long average collection period Long days payable outstanding Debt structure somewhat risky Impairments of assets Competitive industry Negative economic conditions Investment Potential Avnet's stock price has not recovered to 2008 levels so now may be a good time for investment in the firm’s common stock. The firm has effectively reduced operating expenses and returned to profitability in 2010.

Management has a good acquisition strategy to expand the business. There is potential stock price growth if Avnet is able to acquire viable companies that can be successfully integrated.

Creditworthiness Avnet has a high debt ratio, but over half of the debt is short-term in the form of accounts payable and accrued liabilities. The firm has significant cash on hand and has a successful record of repaying debt. With the improvement in the economy, higher demand for Avnet’s products, and expansion through acquisitions, Avnet should be considered a creditworthy company.

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Case 5.3

1.

99

100

101

102

103

104

105

106

Short-term liquidity Spartech’s current ratio increased slightly as a result of increases in accounts receivable and inventories, while current liabilities decreased, in particular, current maturities of long-term debt. The quick ratio is stable and above one to one. The cash flow liquidity ratio was below one in 2009 and dropped by almost half in 2010. This is a result of a large decrease in both cash from operations (CFO) and the cash balance. CFO has been positive all three years, but has declined each year from 2008 to 2010. The decline in 2009 was largely a result of paying accounts payable, while the decline in CFO in 2010 compared to 2009 was a result of a net loss, decreasing deferred income taxes, and increasing accounts receivable and inventories. The net loss was a result of asset impairments and restructuring charges, most likely caused by the recent economic recession. Sales increased in 2010, a positive sign that may have resulted in the increasing receivables. The cash balance declined sharply as Spartech used cash to purchase property, plant and equipment and pay down debt in amounts greater than the CFO generated.

The cash conversion cycle has improved by five days due to the firm taking five days longer to pay suppliers. The average collection period improved by three days while the inventory days held grew by three days. All three components of the cash conversion cycle are acceptable amounts and at 29 days, the cycle is relatively short.

Sales, accounts receivable and the allowance for doubtful accounts all increased which is a normal pattern. The allowance account has increased faster than accounts receivable as Spartech has estimated more bad debts in the future. Based on the valuation schedule the increase is expected as actual write-offs increased in 2009. In 2010, the firm had an issue with one customer which also contributed to the higher estimate. It appears that a note receivable was created for this customer and a separate allowance for doubtful accounts was added as well.

The short-term liquidity for Spartech is adequate, but the firm needs to rebuild its cash balance. The pattern of decline in CFO cannot continue if the firm is to maintain adequate liquidity.

Operating efficiency The discussion in the prior section of the cash conversion cycle explained the reasons for the changes in the accounts receivable, inventory and accounts payable turnover ratios. The fixed and total asset turnover ratios have increased as a result of sales increasing while fixed and total assets both decreased. The firm sold its Wheels and Profiles Divisions in 2009 in addition to closing other facilities. It appears that the divisions sold may have been unprofitable so the divestiture of 107

these businesses should help improve Spartech’s financial condition. Spartech has also recognized significant impairments of assets, especially goodwill and intangible assets. This is not a positive sign as it implies that the firm may have overpaid for businesses that did not deliver profits as expected; however, since many firms suffered this same fate as a result of the economy, this is not a surprise.

Capital structure and long-term solvency The capital structure of Spartech is risky. Long-term debt has decreased in dollars, but increased in percentage relative to total assets in 2010. The firm also has offbalance sheet items consisting of operating leases and commitments to purchase raw materials. The drop in total assets is a result of the decreasing cash balance, decreasing fixed assets due to sales of businesses and decreases to goodwill and intangible assets due to impairments. The retained earnings account has declined significantly as a result of net losses. Lenders have added restrictions in loan covenants as a condition to lend to Spartech which is of concern.

Spartech is facing potential liabilities in legal proceedings related to environmental damages caused by the firm. While Spartech is unable to estimate the amount of potential liability, this adds further risk to the company’s capital structure.

The firm’s financial leverage index is above one indicating that Spartech uses its debt successfully. The coverage ratios, both accrual and cash-based, have all declined. The accrual-based ratios are now negative as a result of the net loss in 2010. Cash interest coverage is still positive, but decreasing. The cash flow adequacy ratio, above one in 2008 is dropping rapidly each year and is now below one. The decreasing CFO combined with increasing amounts spent on capital expenditures and debt repayments is responsible for the decline in this ratio.

Spartech needs to improve its cash flow and pay down debt to improve its balance sheet.

Profitability Profitability is poor for Spartech. Sales declined in 2009 and then increased in 2010 while operating expenses decreased at a faster rate than sales in 2009 and increased at faster rate in 2010. The key item responsible for the movement in opposite directions is the large charges for impairments in 2008 and 2010 that resulted in Spartech having net losses in those years. The net profit in 2009 was less than one percent.

Sales changes were a result of both volume and price changes. Reduced demand for products during the recession occurred in 2009 and in 2010 volume increased 108

as the economy recovered. Increases in raw material costs also contributed to the sales increase in 2010 as Spartech passed on price increases to customers.

Gross profit margin decreased from 2009 to 2010 as a result of inefficiencies caused by disruptions from plant consolidations, equipment line moves, organizational changes, and not passing on increased raw material costs to customers in a timely manner. In 2009 Spartech did a better job passing on price increases and working more efficiently.

Selling, general, and administrative expenses increased all three years as a percentage of sales; however, the dollar amount of these expenses decreased in 2009. Several items caused higher expenses in 2010 including high bad debt expense due to one customer, severance costs associated with the departure of the president and chief executive officer, higher professional fees related to resolving contingencies and the reinstatement of temporary compensation reductions that occurred in 2009.

Spartech would have had a small operating profit in all years had it not been for the large impairment and restructuring charges in 2008 and 2010. These charges are indicative of poor decisions in prior acquisitions and also a result of the steep downturn in the economy.

Interest expense decreased in 2010 and is most likely a result of the reduction in debt combined with lower interest rates. The large tax rate in 2009 may be a result of Spartech being unable to deduct expenses such as impairment charges.

Net profit margin has followed the same pattern as operating profit margin.

Cash flow margin and cash return on assets have both decreased due to the decreasing CFO which was previously discussed. The return on assets and return on equity ratios reflect the net losses that occurred in 2010. The return on equity is far worse than the return on assets ratio due to the risk associated with a highly leveraged capital structure.

Spartech needs to continue reducing costs where possible and increase sales and CFO. More cash is needed to reduce the debt level. Assuming the poor decisions that led to asset impairments are behind them, the firm should return to profitability in 2011. As the economic recovery continues this should allow Spartech to increase sales and ultimately profits and CFO.

109

Market Measures The positive earnings per share in 2009 appears to have been rewarded by the capital markets as Spartech’s stock price and PE ratio increased. The company no longer pays dividends which is appropriate since paying down debt should be a higher priority.

2. Reasons to invest Short-term liquidity is adequate Good cash conversion cycle Increasing sales Change in management Increasing fixed and total asset turnover Economic recovery beginning

Reasons not to invest Risky capital structure Declining CFO Economic conditions Poor profitability Impairment charges Environmental litigation

3. Reasons to lend Short-term liquidity is adequate Good cash conversion cycle Increasing sales Financial leverage index indicates successful use of debt History of repaying debt Positive CFO

Reasons not to lend Risky capital structure Declining CFO Poor profitability Impairment charges Environmental litigation Restrictions in current lenders’ loan covenants

110

Case 5.4 1.

The 'Analysis ToolPak' add-in must be installed and active.

Enter data on this sheet before other financial statement information.

Clear

Company Name: Applied Materials Stock Ticker Symbol:

AMAT

U.S. Stock Exchange:

NASDAQ 12/31/2000 10/31/2010

Statement Year-end Dates: Financial Reports Rounded to :

Variable 10/25/2009

10/26/2008

2009

2008

Thousands

Supplemental Ratio Requirements:

2010

Rent expense (in thousands): $

52,000 $

64,000 $

68,000

Dividends per share: $

0.27 $

0.24 $

0.24

End of year stock price (adjusted for splits ): $

12.35 $

12.95 $

11.40

Marketwatch.com URL for stock prices: http://marketwatch.co m/to o ls/ http://marketwatch.co m/to o ls/ http://marketwatch.co m/to o ls/ quo tes/histo rical.asp?date=10 quo tes/histo rical.asp?date=10 quo tes/histo rical.asp?date=10 %2F29%2F2010&symb=A M A T %2F23%2F2009&symb=A M A %2F24%2F2008&symb=A M A &siteid=mktw T&siteid=mktw T&siteid=mktw

Check Figures: Balance Sheet

Income Statement

Cash Flow

Current Assets: $

6,765,315 $

5,688,947

Total Assets: $

10,943,345 $

9,574,243

Current Liabilities: $

2,887,876 $

1,939,457

Total Stockholders' Equity: $

7,536,113 $

7,094,608

Gross Profit: $

3,715,002 $

1,430,805 $

3,442,828

Operating Profit: $

1,383,708 $

(393,616) $

1,355,431

Net Profit: $

937,866 $

(305,327) $

960,746

Net Flows from Operations: $

1,722,853 $

332,665 $

1,710,468

Net Flows from Investing Activity: $

(861,612) $

112,689 $

(75,986)

Net Flows from Financing Activity: $

(576,131) $

(281,339) $

(1,426,037)

No enterable fields exist below this point

111

Clear

Applied Materials

(AMAT / NASDAQ)

Edit

Annual Consolidated Balance Sheet A m o unt s R o unde d t o : T ho us a nds

Results as of Oct 31, 2010 Oct 25, 2009 ASSETS Current Assets: Cash and cash equivalents Short-term investments

$

1,857,664 726,918

$

1,576,381 638,349

Total cash and short-term investments

2,584,582

2,214,730

Accounts receivable, net Inventories, net Current deferred taxes Other current assets

1,831,006 1,547,378 512,944 289,405

1,041,495 1,627,457 356,336 448,929

Total current assets

6,765,315

5,688,947

2,868,788 1,905,784

2,906,957 1,816,524

963,004

1,090,433

1,307,283 1,336,426 286,821 284,496

1,052,165 1,170,932 306,416 265,350

Property, plant, and equipment Less: accumulated depreciation Net property, plant, and equipment Long-term investments Goodwill, net Other intangibles, net Other deferred taxes Other assets Total assets

$ 10,943,345

$

$

$

9,574,243 Yes

LIABILITIES Current Liabilities: Accounts payable Short-term debt Current portion of long-term debt Accrued liabilities Income taxes payable Other current liabilities Total current liabilities Long-term debt Deferred income taxes payable Other deferred liabilities Other liabilities Total liabilities

657,971

477,148

1,258 1,107,995 273,421 847,231

1,240 584,354 12,435 864,280

2,887,876

1,939,457

204,271

200,654

315,085

339,524

3,407,232

2,479,635

5,419,878 11,510,843 (9,396,274) 1,666

5,208,846 10,934,004 (9,046,562) (1,680)

7,536,113

7,094,608

Minority interest STOCKHOLDERS' EQUITY Preferred stock Common stock, par value plus additional paid-in capital Retained earnings (accumulated deficit) Treasury stock Accumulated other comprehensive income (loss) Other stockholders' equity Total stockholders' equity Total liabilities and stockholders' equity

$ 10,943,345

No enterable fields exist below this point

112

$

9,574,243

Applied Materials

(AMAT / NASDAQ)

Annual Common Size Balance Sheet S um m a ry pe rc e nt a ge s in it a lic s

will no t f o o t due t o ro unding

Results as of Oct 31, 2010 Oct 25, 2009 ASSETS Current Assets: Cash and cash equivalents Short-term investments

17.0% 6.6%

16.5% 6.7%

Total cash and short-term investments

23.6%

23.1%

Accounts receivable, net Inventories, net Current deferred taxes Other current assets

16.7% 14.1% 4.7% 2.6%

10.9% 17.0% 3.7% 4.7%

Total current assets

61.8%

59.4%

26.2% 17.4%

30.4% 19.0%

Net property, plant, and equipment

8.8%

11.4%

Long-term investments Goodwill, net Other intangibles, net Other deferred taxes Other assets

11.9% 12.2% 2.6% 2.6% 0.0%

11.0% 12.2% 3.2% 2.8% 0.0%

100.0%

100.0%

6.0% 0.0% 0.0% 10.1% 2.5% 7.7%

5.0% 0.0% 0.0% 6.1% 0.1% 9.0%

26.4%

20.3%

1.9% 0.0% 0.0% 2.9%

2.1% 0.0% 0.0% 3.5%

Total liabilities

31.1%

25.9%

Minority interest

0.0%

0.0%

0.0% 49.5% 105.2% (85.9%) 0.0% 0.0%

0.0% 54.4% 114.2% (94.5%) 0.0% 0.0%

Total stockholders' equity

68.9%

74.1%

Total liabilities and stockholders' equity

100.0%

100.0%

Property, plant, and equipment Less: accumulated depreciation

Total assets LIABILITIES Current Liabilities: Accounts payable Short-term debt Current portion of long-term debt Accrued liabilities Income taxes payable Other current liabilities Total current liabilities Long-term debt Deferred income taxes payable Other deferred liabilities Other liabilities

STOCKHOLDERS' EQUITY Preferred stock Common stock, par value plus additional paid-in capital Retained earnings (accumulated deficit) Treasury stock Accumulated other comprehensive income (loss) Other stockholders' equity

113

Clear

Applied Materials

(AMAT / NASDAQ)

Edit

Annual Consolidated Income Statement A m o unt s R o unde d t o : T ho us a nds

( e xc e pt pe r s ha re a m o unt s )

Results for the Years Ending Oct 31, 2010 Oct 25, 2009 Oct 26, 2008 Net sales Less: Cost of goods sold

$

Gross profit

9,548,667 5,833,665

$

5,013,607 3,582,802

$

8,129,240 Yes 4,686,412

3,715,002

1,430,805

3,442,828

Sales, general and administrative Research and development (R&D) Restructuring, impairment, and amortization Purchased in-process R&D Other operating expenses

941,848 1,143,521 245,925

734,518 934,115 155,788

965,164 1,104,122 39,948

Total operating expenses

2,331,294

1,824,421

2,087,397

Operating profit (loss)

1,383,708

(393,616)

1,355,431

24,765

(70,883)

73,793

1,408,473

(464,499)

1,429,224

21,507

21,304

20,506

(21,837)

Other income (expenses), net excluding interest expense Earnings (loss) before interest and taxes Interest expense Earnings (loss) before taxes

1,386,966

(485,803)

1,408,718

Provision for (benefit from) income taxes

449,100

(180,476)

447,972

Earnings (loss) after taxes

937,866

(305,327)

960,746

Extraordinary items, net Discontinued operations, net Cumulative effect of changes in accounting principles, net Other after-tax income (loss), net Net profit (loss) Basic earnings per common share

$

937,866

$

(305,327) $

960,746

$

0.70

$

(0.23) $

0.71

Enter following data only if Multiple Source information is available

114

Applied Materials

(AMAT / NASDAQ)

Annual Common Size Income Statement S um m a ry pe rc e nt a ge s in it a lic s

will no t f o o t due t o ro unding

Results for the Years Ending Oct 31, 2010 Oct 25, 2009 Oct 26, 2008 Net sales Less: Cost of goods sold

100.0% 61.1%

100.0% 71.5%

100.0% 57.6%

38.9%

28.5%

42.4%

Sales, general and administrative Research and development (R&D) Restructuring, impairment, and amortization Purchased in-process R&D Other operating expenses

9.9% 12.0% 2.6% 0.0% 0.0%

14.7% 18.6% 3.1% 0.0% 0.0%

11.9% 13.6% 0.5% 0.0% (0.3%)

Total operating expenses

24.4%

36.4%

25.7%

Operating profit (loss)

14.5%

(7.9%)

16.7%

Other income (expenses), net excluding interest expense

0.3%

(1.4%)

0.9%

Earnings (loss) before interest and taxes

14.8%

(9.3%)

17.6%

Gross profit

Interest expense

0.2%

0.4%

0.3%

14.5%

(9.7%)

17.3%

Provision for (benefit from) income taxes

4.7%

(3.6%)

5.5%

Earnings (loss) after taxes

9.8%

(6.1%)

11.8%

Extraordinary items, net Discontinued operations, net Cumulative effect of changes in accounting principles, net Other after-tax income (loss), net

0.0% 0.0% 0.0% 0.0%

0.0% 0.0% 0.0% 0.0%

0.0% 0.0% 0.0% 0.0%

9.8%

(6.1%)

11.8%

32.4%

N/M

31.8%

Earnings (loss) before taxes

Net profit (loss) Effective tax rate

115

Clear

Applied Materials

(AMAT / NASDAQ)

Edit

Annual Consolidated Statement of Cash Flows A m o unt s R o unde d t o : T ho us a nds

Results for the Years Ending Oct 31, 2010 Oct 25, 2009 Oct 26, 2008 Cash flows from operating activities: Income (loss) from continuing operations $ Adjustments to reconcile to net cash provided by operating activities: Depreciation and amortization Stock-based compensation Restructuring and impairment charges Increase (decrease) in provision for deferred income taxes (Gain) loss on sales of investments, acquisitions, and securities (Gain) loss on sales of property, plant, and equipment Other non-cash items, net Changes in assets and liabilities: (Increase) decrease in receivables (Increase) decrease in inventories (Increase) decrease in other current assets Increase (decrease) in accounts payable, accrued liabilities, and income taxes payable Increase (decrease) in deferred liabilities Other assets and liabilities, net Net cash provided by (used in ) operating activities Cash flows from investing activities: Purchases of property, plant, and equipment Sales of property, plant, and equipment Purchases of marketable securities and short-term investments Sales of marketable securities and short-term investments Acquisitions, net of cash acquired Other investing activities, net Net cash provided by (used in) investing activities

937,866

$

(305,327) $

960,746

304,515 126,070 258,590 (186,057) 20,473 20,034 17,000

291,203 147,160 240,268 18,863 45,214 24,017 62,539

320,051 178,943 39,948 (58,259) 39,919 6,826 (5,035)

(766,937) 144,626 179,313

586,993 359,560 35,585

421,834 (638,256) (31,358)

730,958

(889,134)

(126,310)

(63,598)

(284,276)

601,419

1,722,853

332,665

1,710,468

(169,081)

(248,427)

(287,906) 42,210 (5,534,475)

(1,777,736)

(956,249)

1,407,804 (322,599)

1,317,365

5,939,509 (235,324)

(861,612)

112,689

(75,986)

(6,441) 128,832 (350,000) (348,522)

(750) 61,824 (22,906) (319,507)

(2,117) 393,978 (1,499,984) (325,405) 7,491

(576,131)

(281,339)

(1,426,037)

Cash flows from financing activities: Short-term borrowings, net Proceeds from long-term borrowings Payment of long-term borrowings Proceeds from sales of common stock Repurchase of common stock / treasury stock Dividends to shareholders Other financing activities, net Net cash provided by (used in) financing activities Net cash provided by (used for) discontinued operations Effect of exchange rate changes on cash, net Net increase (decrease) in cash and equivalents for period Cash and equivalents, beginning of period Cash and equivalents, end of period

$

Supplemental disclosures of cash flow information: Cash paid during the year for: Interest Income taxes (refunded)

(3,827)

742

457

281,283 1,576,381

164,757 1,411,624

208,902 1,202,722

1,857,664

14,485 187,484

No enterable fields exist below this point

116

$

1,576,381

14,372 134,240

$

1,411,624

14,580 368,459

Applied Materials

(AMAT / NASDAQ)

Annual Summary Analysis Statement of Cash Flows S um m a ry pe rc e nt a ge s in it a lic s

do no t f o o t due t o ro unding dif f e re nc e s

1,722,853 1,407,804 128,832 -

Results for the Years Ending Oct 25, 2009 % $ $ 52.9 332,665 19.4 43.2 1,317,365 76.9 3.9 61,824 3.6 742 0.1

3,259,489

100.0

Oct 31, 2010 Inflows Proceeds from operating activities Sales of property, plant, and equipment Sales of marketable securities and short-term investments Divestiture of acquisitions, net of cash acquired Proceeds from other investing activities, net Proceeds from short-term borrowings, net Proceeds from long-term borrowings Proceeds from sales of common stock Proceeds from other financing activities, net Proceeds from discontinued operations Gains from effect of exchange rate changes on cash, net

%

$

Total Inflows

$

Outflows Losses from operating activities Purchases of property, plant, and equipment Purchases of marketable securities and short-term investments Acquisitions, net of cash acquired Losses from other investing activities, net Payment of short-term borrowings, net Payment of long-term borrowings Repurchase of common stock / treasury stock Payment of dividends to shareholders Payment of other financing activities, net Losses from discontinued operations Losses from effect of exchange rate changes on cash, net Total Outflows Net increase (decrease) in cash and cash equivalents

$

$

1,712,596

100.0

$ 169,081 1,777,736 322,599 6,441 350,000 348,522 3,827

$

2,978,206

$

281,283

Applied Materials

0.2 11.8 11.7

0.1 100.0

%

1,710,468 42,210 5,939,509 393,978 7,491 457

21.1 0.5 73.4

8,094,113

100.0

$

4.9 0.1 -

$ 248,427 956,249 750 22,906 319,507 -

5.7 59.7 10.8

Oct 26, 2008

$

1,547,839

$

164,757

287,906 5,534,475 235,324 2,117 1,499,984 325,405 -

16.1 61.8

1.5 20.6

100.0

$

7,885,211

$

208,902

3.7 70.2 3.0

19.0 4.1

100.0

(AMAT / NASDAQ)

Additional Ratio Analysis Growth Rate Comparisons Between 2010 vs. 2009 2009 vs. 2008 Selected Income Statement Growth Rates: Sales growth rate Gross profit growth rate Operating expenses growth rate Operating profit growth rate Net profit growth rate

90.46 159.64 27.78 451.54 407.17

% % % % %

(38.33) % (58.44) % (12.60) % (129.04) % (131.78) %

Accounts Receivable Analysis Sales growth rate Gross accounts receivable growth rate Accounts receivable allowance growth rate

90.46 % 71.80 % 9.85 %

(38.33) %

Allowance as a % of gross accounts receivable

Results for the Years Ending Oct 31, 2010 Oct 25, 2009 3.88 % 6.07 %

NOTES: "N/M" indicates a calculated rate is not meaningful for analysis

117

Applied Materials

(AMAT / NASDAQ)

Show Formulas

Summary of Financial Statement Ratios Results for the Years Ending Oct 25, 2009

Oct 31, 2010

Liquidity Ratios: Current ratio Quick ratio Cash flow liquidity

Oct 26, 2008

2.34 times 1.81 times 1.49 times

2.93 times 2.09 times 1.31 times

Average collection period Days inventory held Days payable outstanding Cash conversion cycle

70.00 days 97.00 days 42.00 days 125 days

76.00 days 166.00 days 49.00 days 193 days

Activity Ratios: Accounts receivable turnover Inventory turnover Payables turnover Fixed asset turnover Total asset turnover

5.21 times 3.77 times 8.87 times 9.92 times 0.87 times

4.81 times 2.20 times 7.51 times 4.60 times 0.52 times

31.14 % 2.64 % 0.45 times 1.45 times 64.34 times 132.88 times 19.53 times 3.29 times

25.90 % 2.75 % 0.35 times 1.35 times (18.48) times 33.49 times (3.86) times 0.58 times

66.10 times 143.59 times 16.08 times 2.78 times

38.91 % 14.49 % 9.82 % 18.04 %

28.54 % (7.85) % (6.09) % 6.64 %

42.35 % 16.67 % 11.82 % 21.04 %

8.57 %

(3.19) %

12.44 % 15.74 %

(4.30) % 3.47 %

Leverage Ratios: Debt ratio Long-term debt to total capitalization Debt to equity Financial leverage (FL) Times interest earned Cash interest coverage Fixed charge coverage Cash flow adequacy

Profitability Ratios: Gross profit margin Operating profit margin Net profit margin Cash flow margin Return on assets (ROA) or Return on investment (ROI) Return on equity (ROE) Cash return on assets

Market Ratios: Earnings per share Price-to-earnings Dividend payout Dividend yield

$

0.70 17.64 0 38.57 % 2.19 %

$

(0.23) 0.00 N/M (104.35) % 1.85 %

NOTES: If a ratio's numerator and/or denominator equals zero, no ratio is displayed.

"N/M" indicates a calculated ratio is not meaningful for analysis

118

$

0.71 16.06 0 33.80 % 2.11 %

Short-term liquidity Applied Materials’ (Applied) short-term liquidity is good even though the current and quick ratios are decreasing. Current assets and current liabilities both increased from 2009 to 2010; however, current liabilities increased at a faster rate. Account receivable increased significantly while inventories decreased. This is a positive sign and most likely the result of the 90% growth in sales in 2010. Accounts payable and accrued liabilities also increased significantly to support the growth in accounts receivable and possibly to replace inventories sold in 2010. Despite the decrease in the current and quick ratios, both are relatively high. The cash flow liquidity ratio increased and is well above one, another indication of good shortterm liquidity. This ratio increased due to the large increase in cash flow from operations (CFO). The substantial increase in CFO in 2010 compared to 2009 was the result of a good net income number compared to a net loss in 2009, significant non-cash items such as depreciation, amortization, stock-based compensation, restructuring and impairment charges, and a large increase in accounts payable and accrued liabilities. Also adding to the positive CFO were decreases in inventories and other current assets. The increase in current liabilities was largely offset by the increase in accounts receivable or CFO would have been even higher. Applied generated good CFO all years including 2009 when the firm operated at a loss. The pattern of changes in the working capital accounts, accounts receivable, inventories and accounts payable and accrued liabilities, is what one would expect—the current asset changes generally offset the current liability changes.

The average collection period decreased six days but is still fairly long at 70 days.

Days inventory held was extremely high at 166 days in 2009 and it is good that Applied has improved this ratio to 97 days. Applied is paying their suppliers seven days sooner in 2010 compared to 2009. The decreases in collection period and days inventory held have resulted in a much more favorable cash conversion cycle in 2010. Further improvement in the collection period and days inventory held is warranted as Applied pays their suppliers quicker than they receive funds from their customers.

Sales and accounts receivable increased significantly from 2009 to 2010 after large decreases in 2009. These changes are a result of the steep economic downturn in 2009 followed by the beginning of a recovery in the technology industry in the latter part of 2009, and continuing in 2010. The allowance for doubtful accounts did not increase proportionately. The charges and write-offs reported in the valuation schedule are volatile. In 2009 Applied increased the estimate for bad debts by over $62 million even though the current year’s write-offs were only half a million dollars. Write-offs in 2010 were only $7.5 million leaving a large balance in the account. Given the recession, it is possible Applied anticipated customer 119

defaults which did not occur. It is also possible that the firm has overstated the allowance account to manipulate net income. In later years, if Applied reduces the account balance, net income will be increased.

Applied has good short-term liquidity, but could have even better liquidity if credit terms were tightened for their customers and inventory was turned over quicker.

The firm generates good CFO and also has a significant investment in marketable securities. Applied should not have issues in the short-term funding their operations.

Operating efficiency The operating efficiency of accounts receivable, inventory and accounts payable was discussed in the short-term liquidity section. Fixed and total asset turnover increased significantly as a result of the 90% increase in sales. Fixed asset turnover was also positively impacted by the decline in property, plant and equipment.

Capital structure and long-term solvency Applied does not have a risky capital structure. The firm has insignificant longterm debt and an acceptable amount of operating lease obligations. Even though times interest earned and fixed charge coverage were negative in 2009, the firm had more than enough cash to pay for interest expense and lease obligations. The cash interest coverage ratio was over 33 times in 2009 and increased to over 132 times in 2010 as a result of the substantial CFO applied generates each year.

Cash flow adequacy was excellent in 2008 and 2010. The ratio declined in 2009 as a result of lower CFO due to the net loss incurred that year combined with a large amount of cash used to pay current liabilities. Applied has relatively small amounts needed for debt repayments, but does consistently invest in capital expenditures and rewards stockholders with consistent dividends. Even in 2009 when CFO only covered 58% of these items, Applied was still able to increase the cash balance as a result of selling marketable securities. In fact, over 95% of cash inflows each year are a combination of CFO and the cash returns earned on short-term investments.

Applied has positioned itself well to survive downturns in the economy and the volatile high technology industry.

Profitability Applied’s profitability was negatively impacted in 2009 as sales declined 38.3% and operating expenses only declined 12.6%; however, in 2010 the firm’s profitability rebounded with a 90.5% increase in sales and an increase in operating expenses of only 27.8%. As a manufacturer, Applied has many fixed costs that do 120

not change proportionately with changes in sales. The sales changes in both years were largely driven by changes in demand for Applied’s products as the economy worsened and then improved.

Gross profit margin dropped significantly in 2009 and then improved in 2010, but not to 2008 levels. While it is possible that the changes in gross profit margin were a result of decreases in selling prices or increases in cost of goods sold in 2009 (and vice versa for 2010), it is more probable that the changes were a result of the fixed cost structure of the firm.

Operating profit margins followed the same pattern as gross profit margin. Because of the large sales growth in 2010 and the large decline in sales in 2009, the operating expense percentages relative to sales are mathematically skewed. Even though the dollar amounts for selling, general and administrative expenses and research and development decreased in dollars in 2009, the percentages increased.

The opposite occurred in 2010. Applied incurred restructuring and impairment charges in 2009 and 2010 that put downward pressure on operating profit margins those years. Assuming these items occurred as the firm adjusted to a volatile economic environment, improvements in profitability should be seen in the future.

Selling, general and administrative expenses have not returned to 2008 levels even though sales in 2010 were greater than in 2008, implying that the firm may now be more cost efficient. Applied has chosen to invest more dollars in research and development which is a good strategy to ensure they are producing innovative products.

Net profit margin has followed the same pattern as operating profit margin. Interest expense is minimal and stable. The provision for taxes has decreased and increased, consistent with the profit changes discussed above. Applied has an effective tax rate just under the federal statutory rate which could be the result of lower foreign tax rates.

Applied had a particularly poor year in 2009, but this is expected given the economic recession. The return on assets and equity, have improved in 2010. Cash flow margin and cash return on assets have increased and are higher than the accrual-based ratios which means Applied turns their profits into cash. The firm is well-positioned to improve profitability and continue to generate good CFO. Market measures Earnings per share has returned to 2008 levels in 2010 and the PE ratio is consistent for those years. In the current economic environment, the dividend payout and yield are consistent and offer a fair return to stockholders. Applied used 121

a significant amount of cash in 2008 to repurchase their common stock. There was slight improvement in the closing stock price in 2009 compared to 2008 which could be a result of the repurchase. A smaller amount of funds were used in 2010 to repurchase stock, but the market has not yet reacted with higher demand for Applied’s stock.

2.

Table 5A.1 Contribution by Segment to Revenue (Percentages) 2010 2009 2008 Silicon Systems Group 55.55 39.10 49.27 Applied Global Services 19.53 27.86 28.65 Display 9.41 10.00 12.00 Energy and Environmental Solutions 15.51 23.04 10.08 Total revenue 100.00 100.00 100.00 Note the change in trends over the three-year period. The Silicon Systems Group continues to be the largest revenue producer, but in 2009 this segment contributed less to revenue than in 2008 while the Energy and Environmental Solutions Group contributed much more to revenue in 2009. The Applied Global Services and Display segments have declining contributions to revenues each year.

Table 5A.2 Contribution by Segment to Operating Profit (Percentages) 2010 2009 2008 Silicon Systems Group 93.17 151.04 65.78 Applied Global Services 16.61 86.61 29.17 Display 13.17 38.53 16.08 Energy and Environmental Solutions (22.95) (176.18) (11.03) Total operating profit 100.00 100.00 100.00 The Silicon Systems Group has consistently contributed the most to operating profit. The Applied Global Services and Display segments have contributed positively to operating profit, but the dollar amounts declined over the three year period in both groups. The Energy and Environmental Solutions segment has generated operating losses each year and the dollar amount is increasing each year as well.

Table 5A.3 Operating Profit Margin by Segment (Percentages) 2010 2009 2008 Silicon Systems Group 35.68 10.25 30.70 Applied Global Services 18.09 8.25 23.40 Display 29.75 10.21 30.81 Energy and Environmental Solutions (31.48) (20.28) (25.16) 122

Despite the economic downturn in 2009, the Silicon Systems Group, Applied Global Services and Display segments continued to deliver positive operating profit margin. Since this year appears to be an aberration the percentages will be compared from 2008 to 2010. The Silicon Systems Group is the only segment that has improved operating profit margin from 2008 to 2010. The Applied Global Services segment is more than five percent below the 2008 profit margin. The Display segment s only one percentage point less than what it was in 2008. The Energy and Environmental Solutions segment has not only generated operating losses, but is much worse in 2010 compared to 2008.

Table 5A.4 Capital Expenditures by Segment (Percentages) 2010 2009 2008 Silicon Systems Group 42.84 22.30 61.37 Applied Global Services 6.06 14.40 19.65 Display 5.04 13.89 11.45 Energy and Environmental Solutions 46.06 49.41 7.53 Total capital expenditures 100.00 100.00 100.00 Applied has chosen to invest more heavily in Energy and Environmental Solutions while reducing investments in the Applied Global Services and Display segments. The firm continues to invest in the Silicon Systems Group, but the amounts are volatile year to year. Investment in this segment is a good strategy as it produces the largest revenue and operating profits for the firm.

The Energy and Environmental Solutions segment appears to be a newer segment focusing on areas that are not yet profitable. This segment was probably harmed in 2009 as a result of the poor economy and has not been able to recover as of 2010. It is not clear if the lower spending in the Applied Global Services and Display segments is the cause of the lower revenue and operating profit contributions or if there has just been a shift in demand for these products and services.

Table 5A.5 Return on Investment by Segment (Percentages) 2010 2009 2008 Silicon Systems Group 81.67 16.81 69.33 Applied Global Services 26.25 11.04 41.73 Display 63.86 11.52 45.63 Energy and Environmental Solutions (33.26) (12.64) (9.94) The Silicon Systems Group and Display segments have generated the greatest return on investment and excluding 2009, these two segments have 123

improved the return from 2008 to 2010. The Applied Global Services segment delivers good return on investment even though the percentage has decreased from 2008 to 2010. The Energy and Environmental Solutions segment has produced negative returns all years and in 2010 the return was much worse than prior years. Applied needs to monitor and assess this segment to determine if the amount of dollars spent for capital expenditures will begin to generate positive returns in the future.

Table 5A.6 Ranking of Segments in 2010 Percentage Percent Operating of Total Contribution Profit Return on Segment to Operating Margin Investment Assets Profit Silicon Systems Group 42.73 93.17 35.68 81.67 Energy and Environmental Solutions 25.85 (22.95) (31.48) (33.26) Applied Global Services 23.70 16.61 18.09 26.25 Display 7.72 13.17 29.75 63.86 The Silicon Systems Group is Applied’s largest and most profitable segment. The firm is entering new markets and spending significant amounts in the Energy and Environmental Solutions segment. To date, the investment in this segment has not paid off and has, in fact, deteriorated with regard to profitability and return on investment. With the economy recovering in 2010, perhaps this segment will begin to improve. The Applied Global Services and Display segments are profitable for Applied and should not be neglected as they both deliver impressive returns on investment.

3.

Strengths Good short-term liquidity Positive CFO Improved collection period and days inventory held Improved cash conversion cycle Low debt and ability to cover fixed charges and debt repayments Sales growth Increasing profit margins Increased spending on research and development Consistent dividends Three of four segments perform well 124

Weaknesses Cash conversion cycle still high Overstated bad debt expense Poor year in 2009 Restructuring and impairments Energy and Environmental Solutions segment unprofitable Risky industry 4.

The stock price of Applied has declined in 2010 compared to 2009 despite the large sales growth and increasing profit margins achieved. The market may be penalizing the firm for its continued spending in the Energy and Environmental Solutions segment without producing positive returns. Applied has good short and long-term solvency and should be entering new and innovative markets. As long as the firm properly monitors the results in this segment, now may be a good time to invest in the firm while the stock price is low.

Applied generates excellent cash flows each year and has significant liquid balances in cash and short-term investments. The firm has very little long-term debt and is, therefore, a creditworthy company.

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