Financial Statement Analysis Notes
Financial Statement Analysis Notes
Financial Statement Analysis Notes
1.4 Identification of Company Strategies. The strategies of Home Depot and Lowes are
marked more by their similarities than by their differences. Both firms sell to the do-ityourself homeowner and the
professional builder, plumber, or electrician at
competitively low prices. Their in-store product offerings are similar, roughly evenly split
between building materials, electrical and plumbing supplies, hardware, paint, and floor
coverings. Their store sizes are approximately the same. Both use sales personnel with
expertise in a particular home improvement area to offer advice to customers. Both rely
on third-party credit cards for a large portion of their sales to customers. Home Depot
is slightly less than twice the size of Lowes in terms of number of stores. Home Depots
stores span the United States, whereas Lowes tends to locate in the eastern United
States. However, Lowes is expanding westward.
1.7 Effect of Industry Economics on Balance Sheet. Among the three firms, Intel
faces the greatest risk of technological change for its products. Although the
manufacture of semi-conductors is capital-intensive, Intel does not add financial risk to
its already high business risk. Thus, Firm B is Intel. The revenues of American
Airlines and Walt Disney change with changes in economic conditions, subjecting
them to cyclical risk and, thereby, reducing their use of long-term debt. Besides
producing movies and family entertainment, Disney operates theme parks, which the
firm does not include in property, plant, and equipment. This will reduce its
property, plant, and equipment to total assets percentage. American Airlines has few
assets other than its flight and ground support equipment. Thus, Firm A is Disney
and Firm C is American Airlines. It may seem strange that Disney has smaller
proportions of long-term debt in its capital structure compared to American Airlines.
One possible explanation is that the assets of American Airlines have a more ready
market in case a lender repossesses and sells them than does the more unique assets
of Disney. The more ready market reduces the borrowing cost. In this case,
however, the explanation lies in the fact that American Airlines has operated at a net
loss for several years and has negative shareholders equity. The result is a higher
ratio of long-term debt to assets for American Airlines than for Disney.
1.8 Effect of Business Strategy on Common-Size Income Statement. Firm A is
Dell and Firm B is Apple Computer. The clues appear next.
Cost of Goods Sold to Sales Percentages. One would expect Dell to have a
higher cost of goods sold to sales percentage because it adds less value, essentially
following an assembly strategy, and competes based on low prices. Apple
Computer can obtain a higher markup on its manufacturing costs because it creates
more unique products with a somewhat unique consumer following.
Selling and Administrative Expense to Sales Percentages. Both Dell and
assets and the most substantial borrowing in its capital structure. This balance
sheet structure is typical of the finance company, HSBC Finance. We ask students
why the capital markets allow a finance company to have such a high proportion of
borrowing in its capital structure. The answer is threefold: (1) Finance companies
have contractual rights to receive future cash flows from borrowers (the cash flow
tends to be highly predictable); (2) finance companies lend to many different
individuals, which diversifies their risk; and (3) borrowers often pledge collateral to
back up the loan, which provides the finance companies with an alternative for
collecting cash if borrowers default on their loans. Thus, the low risk in the asset
structure allows the firm to assume high risk on the financing side. We use this
opportunity to ask students how this firm can justify recognizing interest revenue
on its loans as the revenue accrues each period when it has an uncollectible loan
provision of 29.1 percent of revenues. Two points are noteworthy: (1) The
concern with uncollectibles is not with the size of the provision, but with how much
uncertainty there is in the amount of the provision (a high mean with a low standard
deviation is not a concern, but a high mean with a high standard deviation is a
concern) and (2) revenues represent interest revenues on loans, whereas the
provision for uncollectibles includes both unpaid principal and interest (thus, the
29.1 percent provision does not mean that the firm experiences defaults on 29.1
percent of its customers each year). Given that loans are nearly 700 percent of
revenues and the provision for uncollectible loans is 29 percent of revenues, it
implies a roughly 4 percent loan loss provision. The cash flow from operations to
capital expenditures ratio is high because of the low capital intensity of this firm.
Firm (4) also is likely to be a financial services firm because it has a high
proportion of cash and marketable securities among its assets and a high proportion
of liabilities in its capital structure. This balance sheet structure is typical of the
insurance company, Allstate Insurance. Allstate receives cash from policyholders
each period as premium revenues. It pays out the cash to policyholders as they
make insurance claims. There is a lag between the receipt and disbursement of cash,
which for a property and casualty insurance company can span periods up to
several years. Allstate invests the cash in the interim to generate a return. The high
proportion of current liabilities represents Allstates estimate of the amount of
future claims arising from insurance coverage in force in the current and previous
periods. We ask students at this point to comment on the quality of earnings of an
insurance company. Our objective is to get students to see the extent of estimates
that go into recognizing claims expenses in a particular period. Claims made from
accidents or injuries during the current year related to insurance in force during that
year require relatively little estimation. However, policyholders may sustain a loss
during the current period but not file a claim immediately. Also, estimating the cost
of a claim may present difficulties if the claim amount is difficult to estimate (such
as with malpractice insurance) or if policyholders contest the amount Allstate is
willing to pay and the case goes through adjudication. Thus, the potential for low
quality earnings is present with insurance companies. We then point out that the
amount shown for other assets represents the unamortized portion of the cost of
writing a new policy (costs of investigating new policyholders to assess risk levels,
commissions paid to insurance agents for writing the new policy, and filing fees
with state insurance regulators). We ask why insurance companies do not write off
this amount in the year of initiating the policy. The explanation is one of matching.
Insurance companies recognize premium revenues over several future periods and
should match both policy initiation costs and claims costs against these revenues.
The cash flow from operations to capital expenditures ratio is high because of the
low capital intensity of this firm.
Four firms report R&D expenditures: Firm (1), Firm (2), Firm (5), and Firm
(12). Dupont, Hewlett-Packard, Merck, and Procter & Gamble will incur costs to
discover new technologies or to develop new products. By far, Firm (2) has the
highest R&D expense percentage and the highest profit margin. This firm is Merck.
Pharmaceutical companies must invest heavily in new drugs to remain competitive.
Also, the drug development process is lengthy, which increases R&D costs.
Pharmaceutical companies have patents on most of their drugs, providing such firms
with a degree of monopoly power. The demand for most pharmaceuticals is
relatively price inelastic because customers need the drugs and because the cost of
the drugs is often covered by insurance. The manufacturing process for
pharmaceuticals is capital-intensive, in part because of the need for precise
measurement of ingredients and in part because of the need for purity. Note that
Merck has a relatively high selling and administrative expense percentage. This high
percentage reflects the cost of maintaining a sales staff to market products to
physicians and hospitals and heavy advertising outlays to stimulate demand from
consumers.
Hewlett-Packard, on the other hand, outsources the manufacturing of many of
its computer components and therefore does not have as much property, plant, and
equipment. Thus, Firm (12) is Hewlett-Packard. We ask students why HewlettPackard has such a small proportion of long-term debt in its capital structure.
Computer firms experience considerable technological risk related to the
introduction of new products by competitors. Products life cycles are short at
approximately one to two years. Hewlett-Packard does not want to add financial
risk to its already high business (asset side) risk. Also, computer firms have
relatively few assets (other than property, plant, and equipment) that can serve as
collateral for borrowing. Their most important resources, their technologies and
their people, do not show up on the balance sheet. The relatively low profit margin
evidences the increasingly commodity nature of most computer products and the
intense competition in the industry.
This leaves Firm (1) and Firm (5) as being Dupont and Procter & Gamble,
respectively. Firm (5) has a lower cost of sales to revenues percentage and a higher
selling and administrative expense to revenues percentage. It also has a higher profit
margin compared to Firm (1). Firm (5) is Procter & Gamble. The high profit margin
reflects the brand names of Procter & Gambles products. The high selling and
inventories, but those inventories should turn over rapidly. The remaining firm with
the lowest inventory percentage is Firm (11), representing McDonalds. Note that
the firm has a high proportion of its assets in property, plant, and equipment.
McDonalds owns its company-operated restaurants and owns but leases other
restaurants to its franchisees. The relatively high profit margin percentage results
from McDonalds dominance in its market and from its brand name.
We are left with two unidentified firms in Exhibit 1.23, Firm (6) and Firm (8).
They are Best Buy and Abercrombie & Fitch, respectively. Both of these firms
have inventories. Firm (8) has a substantially lower cost of sales percentage, a
substantially higher selling and administrative percentage, and a higher profit margin
compared to Firm (6). Abercrombie & Fitch sells brand name clothing products
with a degree of fashion emphasis, whereas Best Buy sells electronic products with
near-commodity status at low prices. One would expect much greater gross profits
on sales of fashion apparel than on commodity-like electronic and appliance
products. However, the cost of retail store space for Best Buy should be less than
that of Abercrombie & Fitch because the latter firm tends to locate in malls. Thus,
Firm (6) is Best Buy and Firm (8) is Abercrombie & Fitch.
Merck
Pacific
Gas &
Electric
3
Allstate
4
P&G
5
Best Buy
6
Kelly
Services
7
A&F
8
Omnicom
Group
9
HSBC
Finance
10
McDonald's
11
HP
12
11.6%
23.0%
9.2%
362.6%
6.0%
1.1%
1.6%
14.7%
8.3%
27.3%
8.8%
11.6%
18.2%
17.8%
48.4%
9.6%
25.0%
2.9%
47.7%
0.0%
8.9%
8.7%
4.1%
10.6%
15.7%
0.0%
2.7%
10.5%
43.2%
5.0%
697.5%
0.0%
4.0%
0.5%
16.8%
5.3%
87.8%
101.2%
272.3%
10.3%
46.4%
15.4%
6.9%
66.1%
13.1%
3.2%
132.4%
18.3%
52.8%
35.0%
50.9%
50.3%
92.8%
179.5%
6.7%
3.6%
21.8%
24.6%
6.1%
9.3%
3.7%
3.1%
26.6%
39.5%
7.7%
5.4%
1.3%
1.9%
46.3%
86.1%
8.5%
9.8%
15.2%
15.8%
8.2%
58.4%
0.0%
60.5%
2.8%
120.7%
112.8%
9.5%
6.0%
4.1%
2.6%
4.7%
0.0%
12.9%
55.7%
12.0%
40.9%
26.7%
9.5%
12.2%
34.7%
22.0%
113.7%
197.9%
277.1%
537.5%
170.6%
35.2%
27.8%
80.5%
129.6%
794.3%
121.0%
100.2%
30.5%
24.0%
60.0%
16.5%
51.2%
70.1%
391.7%
19.4%
39.1%
26.1%
18.7%
2.5%
10.3%
0.9%
12.7%
2.8%
73.0%
22.9%
122.1%
565.5%
10.8%
43.3%
37.5%
12.2%
36.9%
22.4%
42.7%
78.7%
88.9%
66.9%
51.3%
75.1%
25.5%
79.8%
3.6%
10.3%
2.7%
13.9%
12.8%
52.1%
7.4%
26.4%
20.2%
86.5%
10.0%
56.9%
15.1%
35.4%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
-75.6%
-23.4%
-60.7%
-91.6%
-49.2%
-75.6%
-82.5%
-33.3%
-87.4%
-29.1%
-63.3%
-76.4%
-4.5%
-6.8%
-12.6%
-0.9%
-3.9%
-1.8%
-0.8%
-5.1%
-1.8%
-1.7%
-5.1%
-4.2%
-6.8%
-4.4%
-24.1%
-20.1%
0.0%
0.0%
-10.7%
0.0%
-23.9%
-2.6%
-18.2%
0.0%
-15.3%
0.0%
-49.4%
0.0%
0.0%
0.0%
-25.0%
0.0%
-4.9%
0.0%
-6.0%
-2.5%
-1.2%
-1.2%
-1.1%
-8.4%
-4.8%
-3.3%
21.0%
-6.9%
-1.7%
-5.1%
-0.2%
-1.5%
0.0%
-0.5%
0.3%
-5.0%
-0.6%
-4.1%
-32.7%
-3.7%
-2.2%
-7.8%
-0.6%
-1.5%
0.0%
6.3%
16.7%
32.7%
-10.6%
8.1%
4.2%
15.2%
0.7%
14.3%
-0.5%
2.2%
-0.1%
0.8%
0.0%
7.4%
1.2%
7.5%
-3.3%
4.5%
1.7%
18.3%
-2.1%
6.7%
1.4
1.6
1.3
6.6
1.6
5.1
0.8
18.7
4.6
100.9
2.8
3.6
1.13 Value Chain Analysis and Financial Statement Relationships. There are
various approaches to this problem. One approach begins with a particular
company, identifies unique financial characteristics (for example, profit margin
potential), and then searches the common-size financial data to identify the
company with that unique characteristic.
Another approach begins with the common-size data, identifies unusual financial
statement relationships (for example, R&D intensity), and then looks over the list
of companies to identify the one most likely to have that unusual financial
statement relationship. This teaching note employs both approaches. All of the
data are scaled by total revenues (except for the final data item, which is cash flow
from operations over capital expenditures); so throughout this discussion when we
refer to a percentage, it is a percentage of revenues. The data from Exhibit 1.25 in
the text, with company names as column headings, are presented at the end of this
solution in Exhibit 1.E.
Four Firms (1), (3), (4), and (7) incur R&D expenditures, and three do not.
Wyeth, Amgen, Mylan, and Johnson & Johnson engage in research to develop new
products. Thus, they represent these four numbered firms in some combination.
One would expect the firms enjoying patent protection (Wyeth and Amgen) to have
the highest profit margins (that is, net income divided by sales). This would suggest
that Firm (1) is neither Wyeth nor Amgen. Also, Firm (1) has the highest cost of
goods sold percentage of the four companies and its R&D percentage is the lowest,
which are inconsistent with this being Wyeth or Amgen. Products with patent
protection should have the lowest cost of goods sold percentages (resulting from
high markups on cost to arrive at selling prices). Thus, following another line of
logic, the need to continually discover new drugs should lead Wyeth and Amgen to
have the highest R&D percentages, which would be Firm (3) or Firm (4), as
discussed below.
With this being the case, the other two firmsFirm (1) and Firm (7)are
Mylan and Johnson & Johnson in some combination. The brand recognition of
Johnson & Johnsons products should give it a high profit margin. Price
competition among generic firms should give Mylan a lower profit margin. This
reasoning would suggest that Johnson & Johnson is Firm (7) and Mylan is Firm (1).
Firm (7) also has higher selling and administrative expenses versus Firm (1),
consistent with Johnson & Johnson. The low profit margin of Mylan is the result
of major ethical drug firms now competing aggressively in the generic market.
This leaves Firms (3) and (4) as Wyeth and Amgen in some order. The
biotechnology industry is significantly less mature than the ethical drug industry.
Few biotechnology drugs have received FDA approval, and research to develop new
drugs is intensive. Given the few biotechnology drugs available in the market,
Amgens profit margin as well as its R&D expense percentage should be higher than
those of Wyeth. Thus, Firm (3) is Amgen and Firm (4) is Wyeth. Wyeths higher
selling and administrative expense percentage results from its need to maintain a
sales force. The biotechnology products of Amgen are fewer in number and at this
point are essentially pulled through the distribution process by customer demand.
Thus, it has less need for a sales force.
We are now left with Covance, Cardinal Health, and Walgreens and Firms (2),
(5), and (6). Covance will have very low inventories, whereas Cardinal Health
(wholesaler) and Walgreens (retailer) will have larger inventories. Thus, Firm (5) is
Covance. This firm will need property, plant, and equipment to conduct the testing
of new drugs. Of the remaining two firms, Cardinal Health and Walgreens,
Walgreens will likely have a higher proportion of assets in property, plant, and
equipment for retail space. Cardinal Health needs only warehousing facilities for its
drug wholesaling activities. Thus, Firm (6) is Walgreens and Firm (2) is Cardinal
Health. Advertising expenditures by Walgreens drive up its selling and
administrative expense percentage relative to that of Cardinal Health. Walgreens
accepts cash and third-party credit cards for sales; therefore, it will have less
receivables than Cardinal Health, which sells to businesses on credit. Also notice
that Cardinal Health, as a wholesaler, has a very high cost of sales percentage
relative to Walgreens and all other firms in this set.
It is interesting to note that the highest profit margins in the pharmaceutical
industry occur with the upstream activities (discovery of new drugs) instead of the
downstream activities (wholesaling and retailing). It also is interesting that the
profit margin of Covance lies between the high profit margins of the creators of new
drugs and the low profit margins of those firms involved in distribution. Covance
must possess some technical expertise in order to offer drug-testing services, thus
providing the rationale for a higher profit margin than those achieved by the
wholesalers and retailers. The higher profit margin for Walgreens over Cardinal
Health is probably attributable to brand name recognition and the large number of
retail stores nationwide. The wholesaling function of Cardinal is low value added.
The pharmaceutical benefit management services are somewhat differentiable but
quickly copied by competitors.
Cardinal
Health
Amgen
Wyeth
Covance
Walgreens
J&J
12.5%
22.7%
20.7%
34.2%
13.5%
20.7%
109.3%
16.8%
202.6%
1.9%
5.7%
7.2%
3.9%
2.0%
1.9%
6.1%
2.5%
25.2%
63.7%
13.8%
13.8%
66.6%
27.4%
39.2%
95.5%
16.9%
242.9%
63.7%
16.0%
13.1%
73.9%
24.9%
49.0%
20.5%
30.5%
192.8%
12.1%
18.7%
3.7%
74.2%
27.1%
47.1%
5.8%
8.5%
96.0%
4.1%
3.9%
10.7%
22.6%
5.5%
17.1%
2.3%
1.6%
39.7%
20.1%
15.2%
7.9%
43.0%
20.4%
22.5%
43.4%
24.0%
133.2%
Current liabilities
Long-term debt
Other long-term liabilities
Shareholders' equity
30.1%
100.5%
19.4%
52.6%
11.5%
3.3%
1.7%
8.8%
32.6%
61.2%
13.3%
135.9%
30.0%
47.4%
31.5%
84.0%
25.2%
0.0%
5.4%
65.4%
10.7%
3.7%
2.6%
22.7%
32.7%
12.7%
21.1%
66.7%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
100.0%
-59.7%
-8.3%
-12.2%
-6.2%
-6.9%
-2.7%
0.1%
4.1%
-94.4%
-0.4%
-3.1%
0.0%
-0.2%
-0.5%
0.0%
1.3%
-15.3%
-7.2%
-20.1%
-20.2%
0.2%
-7.0%
-2.5%
28.0%
-27.4%
-4.1%
-25.9%
-14.8%
-0.1%
-8.4%
-0.1%
19.3%
-62.5%
-3.9%
-13.7%
0.0%
0.4%
-4.3%
-5.3%
10.5%
-72.2%
-1.5%
-21.1%
0.0%
-0.1%
-1.8%
0.0%
3.2%
-29.0%
-4.4%
-29.3%
-12.2%
-0.1%
-6.2%
1.6%
20.3%
2.3
3.0
8.9
4.4
4.0
2.2
4.9
Objectives
A.
Review the purpose, format, terminology, and accounting principles
underlying the balance sheet, income statement, and statement of cash flows.
B.
II.
Income Statement
a. For wholesale and retail customers, Nike apparently recognizes revenues from the
sale of products at the time of sale. The criteria for revenue recognition are (1)
substantial completion of the revenue-generating process by delivering products or
services and (2) receipt of cash or a receivable whose cash-equivalent value a firm
can measure with reasonable accuracy. The sale of products to retailers constitutes
substantial performance unless Nike is required to take back unsold items. There is
no indication that returns are substantial; furthermore, Nike recognizes a reduction
for return sales at the time of sales. The Futures ordering program likely
matches products to specific customer needs. Nike carries substantial accounts
receivable from its customers. The allowance for uncollectible accounts had a
balance equal to 3.7 percent of gross accounts receivable [$110.8/($2,883.9 +
$110.8)] at the end of 2009 and 2.7 percent [$78.4/($2,795.3 + $78.4)] at the end
of 2008. Thus, Nikes revenue recognition appears appropriate.
b. The notes indicate that Nike uses FIFO for domestic and international inventories.
Firms are free to select their inventory cost-flow assumption from the set deemed
acceptable by standard-setting bodies. These bodies do not provide a set of criteria
that firms must apply to determine which inventory cost-flow assumption is
appropriate. The FASB permits firms in the United States to use FIFO, LIFO,
weighted average, and several other methods. Nike probably uses FIFO because
the physical flow of its inventory is FIFO. Also, Nike saves record-keeping costs
by using FIFO for reporting to foreign governments and to its shareholders in the
United States.
c. Nike does not conduct any of its manufacturing. Thus, depreciation expense
relates to buildings and equipment used in selling and administrative activities.
Nikes income statement classifies expenses by their function instead of their
nature. Thus, Nike includes depreciation expense in selling and administrative
expenses.
d. The notes indicate that in 2009, income tax expense was $469.8 million, whereas
the current amount of income taxes payable was $763.9 million, which means that
Nike paid $294.1 million in tax that increased deferred tax assets or reduced
deferred tax liabilities. Firms recognize deferred taxes for temporary differences
between taxable income and income for financial reporting. The taxable income of
Nike for 2009 is greater than its income before taxes for financial reporting. This
probably occurred because Nike recognized revenues for financial reporting in 2009
that it will recognize in later years for tax reporting and because it recognized
restructuring and impairment charges during 2009 financial reporting that it will not
be able to deduct from taxable income until later years. The basis for measuring the
amount of income tax expense is the amount of revenues and expenses recognized
during the year for financial reporting. The basis for measuring income tax payable
is the amount of revenues and expenses recognized during the year for tax
reporting. Because these amounts are usually different, firms are required to
recognize deferred tax assets and deferred tax liabilities on their balance sheets.
Governmental laws dictate the manner of measuring taxable income. As long as
firms apply these laws correctly in measuring their taxable income each year and
pay the required taxes, they have no additional obligation to governmental entities
at this time. The presence of a deferred tax asset or a deferred tax liability on the
balance sheet is not an indication that governmental bodies have permitted firms to
delay paying taxes. Rather, it indicates the desire of standard-setters to match
income tax expense with income before taxes for financial reporting.
Balance Sheet
e. The allowance for uncollectible accounts arises because Nike recognizes revenue
earlier than the time it collects cash. Because Nike is not likely to collect 100
percent of the amount reported as sales revenue, it must recognize an expense for
estimated uncollectible accounts and reduce gross accounts receivable to the
amount it expects to collect in cash. Nike increases the balance in the allowance
account for estimated uncollectible accounts arising from sales each year. It reduces
the balance in the allowance account for actual customers accounts deemed
i. The FASB concluded that firms should report changes in assets and liabilities that
do not immediately affect net income and retained earningsbut may affect them
in the futureas a separate component of shareholders equity in the account
Accumulated Other Comprehensive Income. In 2009, Nikes other
comprehensive income relates to foreign currency translation losses ($335.3
million) and net unrealized gains on cash flow and net investment hedges ($451.4
million).
Statement of Cash Flows
j. Under U.S. GAAP and IFRS, firms must use the accrual basis of accounting when
measuring net income. Firms usually recognize revenue at the time of sale of goods
and services, not necessarily when they receive cash from customers. Regardless
of when they expend cash, firms attempt to match expenses with associated
revenues. The accrual basis gives a better indication of a firms operating
performance than the cash basis does because of the matching of inputs and
outputs. The statement of cash flows reports the amount of cash received from
customers net of amounts paid to suppliers of goods and services.
k. Depreciation expense reduces net income but does not require a cash expenditure in
the year of the expense recognition. The cash effect occurred in the year a firm
acquired the property, plant, and equipment; the firm classified the cash outflow as
an investing activity in the statement of cash flows at that time. The addition adds
back to net income the amount subtracted in calculating earnings for the year.
l. Part d. in the text says that Nike paid more income taxes during 2009 than it
recognized as income tax expense. Net income on the first line of the statement of
cash flows reflects a subtraction for income tax expense, whereas an additional
portion was paid in cash in 2009. The additional amount paid in cash but not yet
expensed is subtracted from net income in calculating cash from operations.
m. Net income on the first line of the statement of cash flows includes revenues
recognized each year. Nike does not necessarily collect cash each year in an
amount exactly equal to revenues. It may collect cash during 2009 from sales
made in prior years, and it may not collect cash on some sales made in 2009 until
later years.
The subtraction for the increase in accounts receivable means that
Nike received less cash than it recognized as sales revenue.
n. Net income on the first line of the statement of cash flows includes a subtraction
for the cost of goods sold during each year. Nike will likely purchase a different
amount of inventory than it sells. An increase in inventories means that Nike
purchased more than it sold. Thus, the cash outflow for purchases potentially
exceeds cost of goods sold and requires a subtraction from net income for the
additional cash required. Whether additional cash was in fact required in any year
depends on the change in accounts payable, discussed next.
o. Accounts payable reflects amounts owed to suppliers for inventory items
purchased. Purchases of inventory items increase this liability, and cash payments
reduce it. The adjustment for inventory in Part n. converted cost of goods sold to
purchases. The adjustment for accounts payable converts purchases to cash
payments to suppliers. An increase in accounts payable means that Nike
purchased more than its cash expenditure for purchases. Thus, the adjustments for
the change in inventories and the change in accounts payable convert cost of goods
sold included in net income to cash payments to suppliers for inventory items.
The accrued liabilities accounts reflect amounts owed to suppliers of various
services. Purchases of these services increase these liabilities, and cash payments
reduce them. Net income on the first line of the statement of cash flows includes
an expense for the cost of these services consumed during the year. An increase in
the liability for these items means that the cash expenditure during the year was
less than the amount recognized as an expense. The addition to net income
indicates that the cash outflow was less than the expense. Cash flow from
operations did not decrease by the full amount of the expense.
p. The FASB requires firms to report the proceeds from selling property, plant, and
equipment or divesting a subsidiary as an investing activity. Their rationale for
this classification is two-fold: (1) Selling such noncurrent assets is not the primary
operating activity of most companies, and (2) cash expenditures to purchase these
assets appear as investing activities. If a firm sells such assets at a gain or loss, it
must subtract the gain from net income or add back the loss to net income when
computing cash flow from operations. This subtraction or addition nets the effect
of the gain or loss to zero in the operating section of the statement of cash flows
and shows the full cash proceeds as an investing activity. Therefore, Nike
subtracted $60.6 million for the gain from the divestiture of the Bauer subsidiary in
2008 from operating activities, and added proceeds of $246.0 million as an
investing activity.
q. The FASB requires firms to report changes in short-term bank borrowing as a
financing activity. Their rationale for not including such borrowing as an operating
activity, which is the classification of changes in other current liabilities, is that a
firm does not generate operating cash flows by borrowing from banks. Operating
cash flows come from selling goods and services to customers. On the other hand,
changes in other current liabilities relate directly to purchases of goods and services
used in operations, justifying their inclusion in the operating section of the
statement of cash flows.
Relations between Financial Statement Items (Amounts in Millions):
r. Sales Revenue ................................................................................
$ 19,176.1
Increase in Accounts Receivable*..................................................
(238.0)
Cash Collected from Customers....................................................
$ 18,938.1
*Amount taken from the Consolidated Statement of Cash Flows.
s. Cost of Goods Sold .......................................................................
Decrease in Inventories*................................................................
Cost of Inventories Purchased.......................................................
Decrease in Accounts Payable**...................................................
Cash Paid for Purchases of Inventory...........................................
$ 10,571.7
(32.2)
$ 10,539.5
255.7
$ 10,795.2
4,103.0
423.7
(271,0)
$ 4 ,255.7
2,211.9
335.0
(248.9)
2,298.0
u. Retained Earnings:
Balance, May 31, 2008..................................................................
Net Income in fiscal 2009..............................................................
Dividends in fiscal 2009 ................................................................
Stock Repurchases in fiscal 2009 ..................................................
Other Adjustments (Plug) .............................................................
Balance, May 31, 2009..................................................................
5,073.3
1,486.7
(466.7)
(632.7)
(9.2)
5,451.4
y. Nike outsources its manufacturing and most of the retailing of its products. Thus, the
principal
fixed assets are corporate headquarters, research facilities, warehouses, and transportation equipment.
One might think of Nike as serving essentially a wholesaling function along with product
development and promotion.
z. Nike has few fixed assets to serve as collateral for borrowing. Also, Nike generates more than
sufficient cash flow from operations to finance the small amount of investments in fixed assets.
Thus, Nike does not need significant notes payable or long-term debt financing.
aa. As discussed in Part y., Nike outsources the production of its products to manufacturers located in
Asia. The property, plant and equipment needs of Nike are minimal, and probably represent
warehouses and distribution facilities. As such, one might expect minimal increases or even decreases
in property, plant and equipment each year. Also, compared to property, plant, and equipment,
total assets are growing faster, causing the percentages to decline relative to total assets.
bb. In each year, Nike reported a significant addback for depreciation. Although depreciation is not a
source of cash, it is deducted as an expense on the income statement to arrive at net income. For
firms that have depreciation charges, cash flows from operations are typically greater than net
income because net income includes this expense, whereas it is excluded (added back) as a cash
flow from operations.
cc. Cash flow from operations exceeded expenditures on property, plant, and equipment each year, so
Nike did not need to rely on external financing for its capital expenditures. Indeed, Nike uses
excess cash flows each year to pay dividends and repurchases common shares.
dd. The repurchases of common stock substantially exceeded the issue of new stock under stock option
plans and other stock issues in all three years. Thus, Nike is not repurchasing shares to maintain a
level number of shares outstanding to avoid dilution.
Nike likely had excess cash and believed
that its stock price was undervalued. Such stock repurchases often result in an increase in the market
price of the stock.
ee. In fact, Nike increased its dividend payout rate (dividends as a percentage of net income) during this
three-year period. The total amount of dividends paid out each year increased relative to net income.
Nike may be using dividend payout together with common share repurchases to signal its ability to
generate cash flows that can be distributed to shareholders, which should cause the share price to
increase.