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SolutionstoStudyQuestions,Problems,andCases

Chapter1
1.1 Theannualreportispublishedprimarilyforshareholders,whilethe10K
reportisfiledwiththeSecuritiesandExchangeCommissionandisusedby
regulators,analysts,andresearchers.Thefinancialstatementsandmuchofthe
financialdataareidenticalinthetwodocuments;butthe10Kreportcontainsmore
detail(suchasschedulesshowingmanagementremunerationandtransactions,a
descriptionofmateriallitigationandgovernmentalactions,andelaborationsof
manyfinancialstatementaccounts)thantheannualreport;andtheannualreport
presentsadditionalpublicrelationstypematerialsuchascoloredpictures,charts,
graphs,andpromotionalinformationaboutthecompany.
1.2 Theanalystshouldusethefinancialstatements:thebalancesheet,the
incomestatement,thestatementofstockholders'equity,andthestatementofcash
flows;thenotestothefinancialstatements;supplementaryinformationsuchas
financialreportingbysegments;theauditor'sreport;management'sdiscussionand
analysisofoperatingperformanceandfinancialcondition;andthefiveyear
summaryoffinancialdata.
Usethepublicrelations"fluff,"suchascoloredpicturesanddescriptivematerial
withcaution.
1.3 Aqualifiedreportisissuedwhentheoverallfinancialstatementsarefairly
presented"exceptfor"itemswhichtheauditordiscloses;anadverseopinionis
issuedwhenthefinancialstatementshavedeparturesfromGAAPsonumerousthat
thestatementsarenotpresentedfairly.Adisclaimerofopinioniscausedbya
scopelimitationresultingintheauditorbeingunabletoevaluateandexpressan
opiniononthefairnessofthestatements.Anunqualifiedopinionwithexplanatory
languageiscausedbyaconsistencydepartureduetoachangeinaccounting
principle,uncertaintycausedbyfutureeventssuchascontractdisputesand
lawsuits,eventswhichtheauditorbelievesmaypresentbusinessriskandgoing
concernproblems.
1.4 TheproxystatementisadocumentrequiredbytheSECtosolicit
shareholdervotes,sincemanyshareholdersdonotattendshareholdermeetings.
Theanalystcanfindimportantinformationintheproxystatementsuchas
1

backgroundinformationonthecompany'snominateddirectors,directorand
executivecompensation,anyproposedchangestothosecompensationplansand
theauditandnonauditfeespaidtotheauditingfirm.

1.5 Employeerelationswithmanagement,employeemoraleandefficiency,the
reputationofthefirmwithitscustomersandinitsoperatingenvironment,the
qualityandeffectivenessofmanagement,provisionsformanagementsuccession,
potentialexposuretoregulatorychanges,"badpublicity"inthemedia.
1.6 Depreciationisaprocessofcostallocation,whichrequiresestimationof
usefullife,salvagevalue,andachoiceamongdepreciationmethodsaffectingthe
timingofexpenserecognition.
1.7 Expenseandrevenuerecognitioncanbedifferentforpurposesofcalculating
taxableincomeandearningsreportedinthefinancialstatements.Thus,companies
calculatetaxableincometakingadvantageofeveryitemthatwillreduceincome;
andthefirmreportsthehighestpossibleincometoshareholders.Twosetsof
books(atleast!)arekept:onefortheIRSandonefortheannualreport.The
financialanalystshouldbeawareofthe"DeferredTaxes"account,which
reconcilesdifferencesbetweentaxableandreportedincome.
1.8
(a)

AnnualDepreciationExpense=

Assetcost
Dep.period

AnnualDepreciationExpense=

$450,000
15

=$30,000

(b) Accum.Dep.atendofYr.1=$30,000
Accum.Dep.atendofYr.2=Dep.Yr.1+Dep.Yr.2=$60,000
(c)
HistoricalCost
Accum.Dep.
FixedAssets(Net)
(d)

(e)

Year1
$450,000
30,000
$420,000

Year2
$450,000
60,000
$390,000

Dep.exp.fortaxpurposes
Dep.expensereportedinfinancialstatements
Amountbywhichdep.exp.fortaxpurposes
exceedsdep.exp.forreportingpurposes

=$45,000
=$30,000

Amountbywhichtaxableexp.exceedsreportedexp.
Taxrate

=$15,000
=0.3

=$15,000

Amountbywhichreportedtaxexp.exceedsactual
taxespaid

=$4,500

1.9
(a) 1.Switchtostraightlinedepreciationifnotusing.
2.Lengthendepreciationperiodfordepreciableassets.
(Items1and2wouldlowerqualityunlessmadetoreflecteconomicreality.)
3.Sellassetsforagain.
4.Postponelossrecognitiononinventoryorinvestments.
5.Reduceadvertisingandmarketingexpenditures.
6.Reduceresearchanddevelopmentexpenditures.
7.Reducerepairandmaintenanceexpenditures.

(b) Tohaveapositive"real"impactonthefirm'sfinancialposition,thecompany
wouldhavetoincreaserevenuefromabeneficialpolicyratherthanacosmetic
changeortoreducecostsinamannerthatwouldnotimpairthelongterm
profitabilityofthefirm.
Examples:
1.Haveaspecialendofyearsale,offerdiscounts,offerrebates.
2.Investinplantandequipmentatendofyeartogettaxsavings
fromdepreciation.
3.Getemployeesinvolvedincostcuttingmeasures.
4.Sellassets,ifforaprofit,thatthefirmhadalreadyplannedto
sellatsomepointbecauseofinefficiencies.

1.10
Date:
To:
From:
Subject:

Memorandum
CurrentDate
B.R.Neal,DirectorofMarketing
Student'sName
ContentsofanAnnualReport

Thecompany'sannualreportpresentsfinancialinformationaboutthefirm.
Thisinformationpackageispublishedprimarilyforshareholdersandthegeneral
public.Themajorcomponentsofanannualreportarebrieflydescribedinthis
memo.
1)Anannualreportcontainsfourfinancialstatements:Thebalancesheet
showsthefinancialcondition(assets,liabilities,stockholders'equity)atendof
year;theincomeorearningsstatementpresentstheresultsofoperationsincluding
revenues,expenses,netprofitorloss,andnetprofitorlosspersharefortheyear;
thestatementofstockholders'equityreconcilesbeginningandendingbalancesof
accountsintheequitysectionofthebalancesheet;andthestatementofcashflows
showsinflowsandoutflowsofcashfromoperating,financing,andinvesting
activitiesfortheyear.
2)Notestothefinancialstatementsprovideadditionaldetailaboutparticular
itemsinthefinancialstatements.3)Theauditor'sreportispreparedbyan
independentaccountingfirmandatteststothefairnessoftheinformation
presented.4)Thefiveyearsummaryshowskeyfinancialdataincludingnetsales,
income/lossfromcontinuingoperationsonadollarandpersharebasis,assets,
longtermdebt,anddividendspercommonshare.5)Quarterlystockpricesrecord
howthecompany'sstockshareshaveperformedoverthepasttwoyears.6)
Management'sDiscussionandAnalysisprovidesmanagement'sperspectiveonhow
thecompanyisdoingincludingfavorableorunfavorabletrends,andsignificant
eventsoruncertainties.
Theremainingmaterialintheannualreportisincludedprimarilytoprovide
backgroundinformationaboutthecompanyanditsmanagement,andtomakethe
documentattractiveandinterestingtoread.

Ifstaffmemberswouldliketolearnmoreaboutanyofthematerialinthe
company'sannualreport,thefollowingbookishighlyrecommended:
UnderstandingFinancialStatementsbyFraserandOrmiston(PrenticeHall,2007).

1.11

TheSarbanesOxleyActof2002

TheSarbanesOxleyActof2002wasenactedtoprotectinvestorsby
improvingtheaccuracyandreliabilityofcorporatedisclosuresmadepursuantto
thesecuritieslaws,andforotherpurposes.TheActiscomprisedofeleven"titles,"
eachwithmultiplesections.ThisActisinessenceanextensionoftheSecurities
ExchangeActof1934andis,therefore,enforcedbytheSecuritiesandExchange
Commission(SEC).Asummaryoftheeleventitlesfollows.
TitleIPublicCompanyAccountingOversightBoard(PCAOB)
EstablishesthePCAOBtooverseeandmonitortheauditofpubliccompaniesthat
aresubjecttothesecuritieslaws.TheBoardshallbeaprivate,nonprofit
organizationandwillregisterandinspectpublicaccountingfirmsthatconduct
audits,establishoradoptauditingrulesandstandards,conductinvestigations,
disciplinaryproceedingsandenforcecompliancewiththisAct,andsetandmanage
thebudgetoftheBoard.TheBoardwillbefundedbytheestablishmentofthe
"AnnualAccountingSupportFee."
TitleIIAuditorIndependence
Establishesrulestopreventconflictsofinterestbetweentheauditorandthefirm
beingaudited.Auditfirmsareprohibitedfromprovidingnonauditrelatedservices
whileactingasafirm'sauditor,suchasbookkeeping,informationsystemsdesign,
valuation,actuarial,internalaudit,orlegalservices.Inaddition,auditpartner
rotationisrequiredafteranauditpartnerhasperformedfiveyearsofauditservice
forafirm.
TitleIIICorporateResponsibility
Establishestherulesforthecompositionoftheauditcommitteeincludingthat
membersmustmeettheAct'sdefinitionofindependent.Theprincipalofficers,i.e.,
thechiefexecutiveofficerandchieffinancialofficer,mustsignthequarterlyand
annualreportsfiledwiththeSECtocertifytheaccuracyofthereports.Forfeiture
ofbonusesarerequiredshouldthereportsneedtoberestatedduetoamaterial
noncomplianceoftherules.Insidertradesbydirectorsandofficersduringpension
fundblackoutperiodsareprohibited.
TitleIVEnhancedFinancialDisclosures
Establishestherequirementforaninternalcontrolassessmenteachyearand
requiresmoreextensivedisclosuresinthefinancialstatementsforcorrecting
8

adjustmentsandoffbalancesheettransactions.Personalloanstoexecutivesare
prohibitedwiththeexceptionofcertaintypesofcredit.
TitleVAnalystConflictsofInterest
Establishesrulestoprotectanalystsfromconflictsofinterestsandencouragethe
objectivityandindependenceofsecuritiesanalystsinordertofostergreaterpublic
confidenceinanalysts'research.
TitleVICommissionResourcesandAuthority
AmendstheamountoffundingfortheSEC,aswellasamendmentstothe
qualificationsrequiredofbrokersanddealers.
TitleVIIStudiesandReports
Requiresthatavarietyofstudiesbeconductedandtheresultsreportedforsuch
itemsastheconsolidationofpublicaccountingfirms,creditratingagencies,
violatorsandviolationsofsecuritieslaws,enforcementactionsandinvestment
bankingfirms.
TitleVIIICorporateandCriminalFraudAccountability
Establishesregulationsandpenaltiesfordestructionofcorporateauditrecordsor
recordsinFederalinvestigationsandbankruptcy,protectionforwhistleblowers,
criminalpenaltiesfordefraudingshareholdersofpubliclytradedcompanies,and
amendsthestatuteoflimitationsforsecuritiesfraud.
TitleIXWhiteCollarCrimePenaltyEnhancements
Amendsandincreasesthepenaltiesforwhitecollarcriminals.
TitleXCorporateTaxReturns
Requiresthechiefexecutiveofficerofthecorporationtosignthefederalincome
taxreturn.
TitleXICorporateFraudAccountability
Amendsthefederalsentencingguidelines,increasescriminalpenaltiesandgives
theSECtemporaryfreezeauthorityandtheauthoritytoprohibitpersonsfrom
servingasofficersordirectors.

1.12
(a) Earningsmanagementreferstothepracticeofusingaccountingchoicesand
techniquesinsuchawaythatearningsreportsreflectwhatmanagementwantsthe
usertosee,insteadofthetruefinancialperformanceofthecompany.
(b) Managersaremotivatedtomeettheearningsexpectationsofanalystson
WallStreet.Companiesnotmeetingtheseexpectationshavebeenpunishedwith
immediatestockpricedeclines.Thisinturnnegativelyimpactsthefirm'stotal
marketcapitalizationandthevalueofstockoptionsgrantedemployees.
(c) Thefollowingfivetechniquesusedbycompaniescreateillusionsaccording
toLevitt:
1."BigBath"restructuringchargesthesechargesaretakenwhena
companyreorganizesitsbusinesses.Oftencompaniesoverestimatethe
amountofthechargeswhichthenresultsinincomebeingrecordedatalater
datetocorrecttheerror.Thesesupposedonetimechargesareusually
receivedonWallStreetfavorablysinceanalyststendtofocusonfuture
earnings.
Author'sexample:EastmanKodakCompanyhasrecordedrestructuring
chargeseveryyearsince1992andclaimsthesechargeswillendin2007.
2.Creativeacquisitionaccountingclassifyingpartoftheacquisitionprice
whenamergeroccursas"inprocess"researchanddevelopment.Thisitem
isthenwrittenoffintheyearofacquisitionbecausethereisachancethatthe
researchwillnotresultinincreasedearnings.If,infact,earningsare
increasedlater,thealreadywrittenoffexpensewillnotnegativelyimpactthe
earningsnumber.
Author'sexample:In2003,Johnson&Johnsonmadeacquisitionsfor$3.1
billionandimmediatelywroteoffjustunder$1billionof"inprocess"
researchanddevelopment.
3.Cookiejarreservesoverestimatingliabilitiesforsuchitemsassales
returns,loanlossesorwarrantycosts.Thisresultsinexpensesbeing
recordedintheyearoftheestimation,butallowsacompanytoreversethese
chargesinayearwhenearningsarelowerthandesired.
10

Author'sexample:TheW.R.GraceandCo.usedcookiejarreservestostash
awayprofitstobeusedinlateryearstomaskdecliningearnings.Theformer
inhouseauditchiefblewthewhistleonthefirmin1999,butthecompany
hadbeenabusingthesereservessincetheearly1990s.
4.Materialitytheconceptthatinsignificantitemsneednotbereported.
Somecompaniesabusethisconceptbyarguingthatitemsareinsignificant
wheninfacttheyaremeaningfultousers.
Author'sexample:Yearsagomanyfirmsofferedtopayforretirees'medical
costsnotcoveredbyMedicare.Thiswasarelativelyinexpensivebenefitat
thetime.Severehealthcareinflationquicklymadethisbenefitextremely
costlytofirms;however,companiesusedthematerialityconcepttoclaim
thatthisliabilityneednotbereported.WhenFASBforcedcompaniesto
disclosewhattheyhadpromisedinmedicalbenefits,manycompanies
reportedlargelosses.In1991,IBMreportedanaccumulatedcostofover$2
billionforpostretirementbenefits.
5.Revenuerecognitionrecordingrevenuebeforethetransactionhas
actuallyoccurred.
Sunbeamrecordedsalesofsummermerchandiselikeoutdoorgrillsinwinter
months,wellbeforetheproductwasshipped.Thecompanyultimatelyfiled
forbankruptcy.
(d)

Levittproposesthefollowingstepsofaction:
1.TheSECmustimplementrulesregardingmoredetaileddisclosuresof
changesinaccountingassumptions.
2.TheAICPAmustclarifytherulestoauditorsofwhatisacceptableand
whatisunacceptablewithregardtotheillusorytechniquesdescribedabove.
3.TheSECmustpublishbetterguidanceontheconceptofmateriality.
4.TheSECshouldconsiderguidanceonthedo'sanddon'tsofrevenue
recognition.
5.Privatesectorstandardsettersneedtoaddressareaswherecurrentrules
areinadequate.FASBneedstopromptlyresolvecurrentissueswhichwill
bringclaritytothedefinitionofaliability.

11

6.TheSECwillformallytargetcompaniesforreviewthatappeartomanage
earningsandwillaggressivelyactonabusesofthefinancialreporting
process.
7.Thewayauditsareperformedmustbeassessed.
8.Auditcommitteesmustbeempoweredandfunctionastheultimate
guardianofinvestors.
9.CorporatemanagementandWallStreetmustembraceaculturalchange.
Companiesshouldberewardedforhonesty,notforbeingcleverenoughto
deceiveusersthroughfinancialreporting.
(e) Levittbelievesthatauditstaffareinsufficientlytrainedandsupervised.He
alsobelievesthatauditcommitteesinsomefirmsareseverelylackinginfinancial
expertise.Remediesincludetheinvestigationandreviewoftheauditingprocess
andthedevelopmentofrecommendationsintendedtoempowerauditcommitteesto
performtheirjobcorrectly.

12

1.13
(a) Intelsuppliesthecomputingandcommunicationsindustrieswithchips,
boards,systemsandsoftwarebuildingblocksforcomputers,serversand
networkingandcommunicationproducts.
(b)

Theanalystcouldlearnthefollowingbyreadingthelettertostockholders:
growthin2004wasacrossawidespectrumofmarketsegments,
over75%ofIntel'ssaleswereoutsidetheAmericas,
theIntelbrandwasrankedfifthamongtheworld'smostvaluable
brandsaccordingtothe2004BusinessWeek/Interbrandranking,
Intelhashad18consecutiveyearsofprofitability,
afterseveralmisstepsbythecompanythatresultedincancellationor
delaysofproducts,thefirmappearstobeontrackagain,and
successionplanninghasbeenanimportantpartofIntel'sstrategy.

(c) Intelreceivedanunqualifiedauditopinion.Theauditreportstates
thattheauditwasconductedaccordingtogenerallyacceptedauditingstandardsand
thefinancialstatementsareinconformitywithgenerallyacceptedaccounting
principles.Intelalsoreceivedanunqualifiedopinionontheeffectivenessofits
internalcontrolsoverfinancialreporting.
(d)

TheMD&AforInteldiscussesthefollowingitems:
1.Thecompanyexpectsthekeysourceofliquiditytobeinternal
cash,cashfromoperatingactivitiesandshortterminvestmentsand
tradeassets.Arelativelysmallamountofcashisgeneratedexternally
fromthesaleofstockthroughemployeeplans.Todate,Intelhasnot
usedotherexternalsourcesofcash,butthecompanyhasthepotential
toborrowthroughthesaleofsecuritiesalreadyregisteredwiththe
SECinthetotalamountof$4.4billion($3.0billioninborrowings
plus$1.4billionindebt,equity,andotherfinancingsources).(pg.35)
2.Nomaterialdeficienciesofliquiditycurrentlyexist.(pg.35)
3.Intelplanstospendbetween$4.9and$5.3billionin2005for
capitalexpenditures,primarilyforinvestmentsin300mm,65
nanometerproductionequipment.SinceIntelhas$16.8billionof
liquidassetsitappearsthatcapitalexpenditureswillbecoveredwith
internallygeneratedfunds.(pg.35)
13

4.Noanticipatedchangesinthemixandcostoffinancingresources
arediscussed.(pg.35)
5.Nounusualorinfrequenttransactionswerefound.
6.ItappearsthatIntelwillcontinuetogrowitsrevenues,butthat
expenseswillgrowproportionatelywiththeexceptionoftheeffective
taxrate.Anincreaseintaxexpensecouldreduceoverallprofit.(pg.
41)
7.Salesincreased13.5%overall,causedbyhighervolume.(pgs.31
32)
(e) Intelappearstohavedoneagoodjobpositioningthemselvesforthe
economicrecovery.Thecompanyislargelydependentontheworldwide
computingindustryandasaresult,foreigncurrencyexchangerates,political
turmoilinforeigncountries,oradverseeconomicconditionsinthosecountries
couldnegativelyaffectIntel.Intelhas,however,beendiversifyingitsproductlines
andhascreatednewopportunitiesforgrowth.

14

1.14
(a)

15

(b) Eachstudentsresponsewilldifferdependingonthenewssourcesusedand
thedateonwhichthestudentcompletestheassignment.Belowisasamplingof
newsfromarticlesin2005:
Source:TheWallStreetJournal,April7,2005
"KodakReports2004Results;Restates2003"
Kodakfinallyreleasedits2004resultsaftermanydelays.Thecompanyadmitted
thattherewereweaknessesinitsinternalcontrolsandaccountingerrorshadbeen
foundintaxation,pensionsandrestructuringtransactions.Asaresultnetincome
numberswerelowerthanexpectedandthe2003resultshadtoberestated
downward.Therevenueandcashflownumberswereunaffected.
FitchRatingshasdowngradedKodak'sdebtratingsduetotheexpectednewdebt
thatKodakwilltakeonduetoacquisitions,decliningfilmsalesandthecompetitive
market.Kodakhasprojecteda30%declineinfilmsalesasthecompanyexpands
itsdigitalmarket.
Source:FinancialTimes,April25,2005
"Kodakstrugglestoadapttodigitalworld"
Kodak'sfirstquarterresultsweredisappointingandmakeitappearasthoughthe
companyisstrugglingtotransitionintothedigitalfield.S&PdowngradedKodak's
debttoajunkrating.Kodakhad$2.4billionofdebtinMarch.Theonlygood
newsisthatforthefirsttimeKodakovertookSonywiththemostmarketsharefor
digitalcamerasalesintheU.S.Kodakhas22%versusSony's19%.
Source:TheWallStreetJournal,April25,2005
"KodakShiftstoLossasRevenueSlips"
FirstquarterresultsindicatethatrevenueatKodakhasslipped3%andthefirm
reporteda$142millionloss.Kodakexplainedthatitdidnothaveenoughlowend
digitalcamerasinstock,silverandoilrelatedcostsrose,anditshealthcare
businesslostsalesduetodefectivescreensonscanners.
Kodak'sstrategycontinuestobetoreapprofitsfromfilmwhilefunding
acquisitionsanddevelopmentofdigitalproducts.Thecompanyexpects$1.7
billionofrestructuringoverthreeyearsasiteliminates15,000jobsandreducesits
facilitiesbyonethird.
16

Source:BusinessWeek,May23,2005
"ADigitalWarriorforKodak"
Kodak'sCEODanielCarpsuddenlyresignedandAntonioPerezwilltakeoverJune
1,2005,asCEO.ByearlyMaythestockpriceofKodakhadslumped30%from
its52weekhigh.ThemarkethasreactedfavorablytotheappointmentofPerezto
theCEOposition.HehasanimpressivebackgroundincludingbuildingHewlett
Packard'sprinterbusinessintoa$10billionmarket.Hespent25yearsatHewlett
Packard,buthismanagementstyleclashedwithCarlyFiorinaandheleftin2003to
becomeKodak'spresident.
(c) TheManagement'sLetterisupbeatandfocusesonlyonthepositivesthat
thecompanyhastooffer.Thecompanyisgoingthroughamajorrestructuring,
disposingofsomesegmentsandfocusingonthedigitalmarket.While
managementspeaksfavorablyofallsegmentstheydonotreallydiscusshow
competitivetheyarewithSony,Canon,Minoltaandothers.ItappearsthatKodak
mayhavesomeuniqueniches.Theretailphotokiosksarewellknownby
consumersandKodakalsospecializesindigitalimagingforthehealthcarefield,a
rapidlyexpandingarea.TheOutlooksectionofthelettergivesabulletedlistof
prioritieswhichisnice,butnotinformative.Managementdoesnotindicatehow
theywilldrivedigitalrevenuegrowth,meetearningsgoals,cutcosts,andmaintain
excellence.Whilemanagementrefersinfavorabletermstotheiremployees,there
mustbemanydisgruntledformeremployeesthathavebeendownsizedoutofthe
company,andonehastowonderaboutthecurrentmoraleoftheemployeesleft
behind.Outsidenewsonthefirminthefirstquarterof2005iscontrarytoallthat
managementsaidintheirlettertoshareholders.
Kodakreceivedanunqualifiedopinionwithexplanatorylanguagefromits
auditors,PricewaterhouseCoopersLLP,in2004.Theexplanatorynoterevealsthat
thefirmhadtorestate2003resultsduetoincometax,pensionandpostretirement
benefitplanmatters.TheauditorindicatesinitsreportthatKodakdidnotmaintain
effectiveinternalcontrolsoveritstax,pension,andpostretirementareas.Inthe
Management'sReportonInternalControlOverFinancialReporting,the
weaknessesaredescribedindetailandthenmanagementexplainswhattheyplanto
dotocorrecttheseproblems.Itispredictedthateffectivecontrolswillbeinplace
bythethirdquarterof2005.Sincemaintaininggoodinternalcontrolhasalways
17

beenarequirementofmanagement,andarequirementforauditorstoassess,one
hastoconsidertheimplicationssuggestednowthattheseitemsarebeingrevealed
asaresultoftheSarbanesOxleyActof2002.Forexample,howisitthata
companyaslargeasKodakthathasbeeninbusiness125years,doesnothave
employeeswithtaxaccountingexpertise?
Item1intheEastmanKodakForm10Kfor2004ismoreinformativethan
thelettertoshareholders,butstilllackinginsomeinformationthatwouldbe
helpfulinassessingthecompany.Unlikethelettertoshareholders,onecanlearn
abouttherestatementofthe2003numbers,keyrawmaterialsneeded(silver,for
example),theseasonalityofcertainsegmentswithinKodak,andthefactthatthe
firmisplanningtoreduceheadcountofemployeesby25%from2004to2006.But
nowhereintheextensivediscussionofmarketingandcompetitionarethenamesof
keycompetitorsrevealedorhowKodakstacksupagainstitscompetition.
Item3oftheForm10Kinformsthereaderofthelegalproceedingsinwhich
Kodakisaparty.Themostsignificantlegalproceedingsarethelawsuitsregarding
patentinfringementsfiledbyKodakagainstSony,aswellasthosefiledbySony
againstKodak.Asettlementwasreachedinanotherpatentinfringementlawsuitin
whichSunMicrosystemsagreedtopayKodak$92million.Finally,Kodakhas
settledandagreedtopay$140,000forenvironmentalviolations.
Item4oftheForm10Kliststhebiographiesoftheexecutiveofficers.Nine
oftheexecutiveshavebuilttheircareersatKodak.Italsoappearsthatthose
executiveshiredfromtheoutsidehavecomemainlyfromHewlettPackardand
GeneralElectric.Nothingunusualstandsoutfromreadingthebiographies.

18

CASE1.1
THEWALTDISNEYCOMPANY
1.
Therangeofnumbersthatcouldbeconsideredastotalcompensationwould
probablyrangefromaminimumoftheamountslistedinthe"Summary
CompensationTable"toamaximumthatwouldincludeallthebenefitsoutlinedin
thenotesattachedtothetable.Inmanyfirmsemployeesaregivenasummary
sheetoutliningtheircompensationanditincludesnotjustsalaryandbonus,but
alsothebenefitsthatthefirmchoosestopayforthatemployee.Usingtheabove
rationalearangefromminimumtomaximumiscalculatedbelowforMichael
Eisner:
Year

2004

2003

2002

2001

Compensationfromtable $8,312,373$7,318,431$6,092,894$1,004,020
Securitysystems
18,663 28,483
16,422
Securityservices
716,335
808,965
480,951
NewYorkapartment
120,000

120,000

120,000

Totalcompensation
$9,167,371$8,275,879$6,709,907$1,004,020
Note:Itappearsthatthebenefitsfor2001maynothavebeenrevealedinthenotes
astheywereinthelaterproxystatements.
2.
Thehourlysalaryrangefromminimumtomaximumbasedontheanswerto
part1wouldbeasfollows:
2004
2003
2002
2001
3.

$2,078.09$2,291.84
$1,829.61$2,068.97
$1,523.22$1,677.48
$251.00

Thepayincreasesbasedontheminimumandmaximumnumberswouldbe:
20032004
20022003
20012002

Minimum
13.6%
20.1%
506.9%

Maximum
10.8%
23.3%

19

4.
ThehighpayratesthatCEOsreceivecanbeattributedtothelonghoursthat
mustbeworked,theextensiveknowledgeandexpertisetheindividualmusthave,a
lackofjobsecurity,andthefactthatthereisalimitedsupplyofqualifiedpeople
forthisposition.Inaddition,since2002andtheenactmentoftheSarbanesOxley
Act,theCEOistakingonmoreliabilityduetohavingtocertifytheaccuracyofthe
financialstatements.
5.

Ashareholderwouldhaveearnedthefollowingreturns:
20032004
12.3%($9181)/$81
20022003
35.0%($8160)/$60
20012002 (17.8%)
($6073)/$73

Theaveragereturnoverthethreeyearperiodwouldhavebeen24.7%.
($9173)/$73
6.
Since2002,thepercentagepayincreasethatMichaelEisnerreceivedisin
linewiththerateofreturnthatshareholdersreceived.Giventhecomplexitiesof
thejob,thelonghoursrequired,thelackofjobsecurityandthenecessary
knowledgeandexpertiseneededforthejob,theCEOshouldbepaidhandsomely.
Ontheotherhand,the506.9%payincreaseseemsoutoflineespeciallysince
shareholdersreceivedanegativereturnfrom2001to2002.Despitethearguments
forthehighpay,thereareonly24hoursinadayandonemustquestionifanyone
isworththousandsofdollarsperhour.Consideringthedifferentialbetweenthe
lowestpaidworkers(probablyminimumwage)andtheCEO,thehighratethat
MichaelEisnerreceivesseemstobebasedongreed,notvalue.
7.

Studentswillmostlikelyhavevaryingopinions.

20

CASE1.2
ULTIMATEELECTRONICS,INC.
1.
TheManagementDiscussionandAnalysissectionprovidesimportant
informationthatcannotbefoundanywhereelseintheannualreport.Thesection
coverstrends,events,anduncertaintiesintheareasofliquidity,capitalresources,
andoperations.Informationshouldincludeadiscussionof:
a.
b.
c.
d.
e.
f.
g.

internalandexternalsourcesofliquidity;
anymaterialdeficienciesinliquidityandhowtheywillberemedied;
commitmentsforcapitalexpendituresandexpectedsourcesof
funding;
anticipatedchangesinthemixandcostoffinancingresources;
unusualorinfrequenttransactionswhichaffectincomefrom
continuingoperations;
eventswhichcausematerialchangesintherelationshipbetweencosts
andrevenues;and
abreakdownofsalesincreasesintopriceandvolumecomponents.

2.
TheMD&Aincludesthefollowingdiscussionofthesevenitemsoutlinedin
(1)above:
a.

b.

c.

Managementstatesthathistoricallythefirmhasusedbothinternaland
externalsourcestofundthecompany;however,in2004,thecompany
used,ratherthangeneratedcashfromoperationsandappearstobe
relyingonborrowings,anexternalsourceoffunding,tosupport
operations.
Managementbelievesthatcashfromoperationsandtherevolvingline
ofcreditwillbesufficienttofundoperationsthrough2005.The
futureplansofthecompanyaretospendlessonexpansionandfocus
oncurrentproblemswiththehopeofgeneratingcashfromoperations.
Ifthecompanyissuccessful,thenthereisnodeficiency,butifthey
areunsuccessfulthenitappearstheyhavenoplantoremedythe
possibledeficiency.
UltimateElectronics,Inc.,anticipatesspending$12milliontoresolve
issueswithitsmanagementinformationsystem,instoreprojectstied
tomerchandisinginitiatives,therelocationofastore,remodelsof
existingstoresandtheopeningofonenewstorein2005.Funding
sourceswillbecashfromoperationsorthelineofcredit.
21

d.
e.
f.

g.

Nochangestothecurrentmixandcostoffinancingresourceswere
discussed;however,giventhefirm'spooroperatingresults,itappears
likelythatthefirmmayneedtotakeonmoredebt.
Thereisnoindicationofunusualorinfrequenttransactionsoccurring
inthefuture.
Whethertherearechangesintherelationshipbetweencostsand
revenuesishighlydependentonhoweffectivemanagementisin
implementingitsplanfor2005.Ifthefirmcanreducecostsandfocus
oncurrentstores,ratherthanspendingonexpansion,itispossiblethat
revenuescouldgrowfasterthanoverallcosts.Ontheotherhand,the
companyneedsanewapproachtoadvertisingtoincreasesalesand
thiscouldincreasecosts,whilenotincreasingrevenuesandprofits.
Basedontheinformationgivenitisdifficulttoknowforsurewhat
mightreallyhappen.
Thesalesincreaseof1%fortheyearendedJanuary31,2004,wasdue
tohighervolumeduetotheopeningofnewstores.Thesalesincrease
wasnegativelyimpactedbyadecreaseincomparablestoresalesof
9%fortheyear.

3.

UltimateElectronics,Inc.,explainedthoroughlytheproblemsand
challengesthecompanyisfacing.Managementofferedtheirplanto
remedythissituationandwhilethereportwasoptimistic,itwasalso
honest.

4.

Answerswillvarybasedonindividualstudents'reactionstothe
challengesthefirmfacesandwhethertheythinkmanagementcan
overcometheseobstacles.

Note:UltimateElectronics,Inc.,filedforbankruptcyin2005.Aprivateinvestor
boughtthecompanyandpaidoffthedebt.Someofthepoorperforming
storeswereclosed,whileotherlocationsremainedintact.

22

Chapter2
2.1 Theestimationoftheallowancefordoubtfulaccountsaffectsboththe
valuationofaccountsreceivableonthebalancesheetandtheamountofbaddebt
expenserecognizedontheincomestatement.ChangesintheAllowanceaccount
relativetosaleslevelandtheamountofaccountsreceivableoutstandingmaybean
indicationthatearningsqualityisorisnotbeingimproved.Forexample,ifa
companyexpandssalesbyloweringitscreditstandards,thentheAllowance
accountshouldalsobeexpandedifaqualityearningsfigureistobereflected.
2.2 Inventoriesareasignificantproportionoftheassetstructureformostfirms
(servicefirmsareanexception).Theinventoryaccountingmethodusedwill
impactthevaluationofinventoriesonthebalancesheetandalsothecostofgoods
soldexpenseontheincomestatement.Ifthevaluationmethodisnotrealistic,the
endinginventoryandearningsfigurewillbedistorted.
2.3 AlthoughLIFOgeneratesalargercostofgoodssoldexpenseandlower
earningsinaperiodofinflation,thetaxbenefitsmayoutweighthecostsof
reportingalowerearningsfigure.UseofLIFOreducesafirm'staxableincome
and,thus,thefirmsavesintermsofactualcash,notjustpaperfigures.
2.4 Thestraightlinemethodofdepreciationspreadstheexpenseevenlyby
periods,whiletheacceleratedmethodsyieldhigherdepreciationexpenseinthe
earlyyearsofanasset'slifeandlowerexpenseinthelateryears.Useofan
acceleratedmethodfortaxreportingtendstodefertaxliabilitiesforfirmswhich
investheavilyindepreciableassets.Forreportingpurposes,straightline
depreciationwillyieldahigherearningsfigureintheearlyyearsandwillalso
distributeexpenserecognitionsmoothly.
2.5 TheRetainedEarningsaccountisthemeasurementofallundistributed
earnings.Theaccountdoesnotrepresentcashinanyway.Acompanycanhave
positiveretainedearningsandhaveazerocashbalance.
Inventory
Assets

28%

65%

43%

NetFixedAssets

40%

15%

11%

2.6

23

TotalAssets
Aisamanufacturer,Bisaretailer,andCisawholesaler.

24

2.7(a)Informationtobeusedforallmethodsofinventoryvaluation:
Beginninginventory
January10purchase
April25purchase
July10purchase
October15purchase
Total

UnitsxCost=Total
10,000 x$3.00=$30,000
4,000x3.50=14,000
10,000x4.00=40,000
6,000x4.50=27,000
8,000x5.00=40,000
38,000
$151,000

Salesfortheyear=8,000+11,000+3,000+9,000=31,000units
Endinginventory=38,00031,000=7,000units
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
31,000units$116,000

EI:

7,000@$5.00=$35,000

Checkanswer:COGS
+EI
Totalgoodsavailable

$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
31,000units $130,000

EI:

7,000@$3.00=$21,000

Checkanswer:COGS
+EI
Totalgoodsavailable

LIFO(perpetual)
COGS:
Jan.1Mar.31
4,000@$3.50=$14,000
4,000@$3.00=$12,000

EI:
Mar.31
6,000@$3.00=$18,000
25

$130,000
21,000
$151,000

Apr.1Jun.30
10,000@$4.00=$40,000
1,000@$3.00=$3,000
Jul.1Sept.30
3,000@$4.50=$13,500

Jun.30

Oct.1Dec.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

TotalCOGS=$127,000

EI=$24,000

Checkanswer:COGS+EI=$127,000+$24,000=$151,000
AverageCostperunit:
$151,000
$3.97
38,000

COGS=$3.97x31,000units=$123,070
EI =$151,000$123,070=$27,930
(b) LIFOproducesanunderstatedinventoryvaluationonthebalancesheetbuta
currentlyvaluedcostofgoodssoldontheincomestatement,matchingcurrentcosts
withcurrentrevenues;FIFOresultsinacurrentlyvaluedbalancesheetinventory
butanunderstatedcostofgoodssoldexpenseandthusanoverstatementofnet
income;averagecostfallsinbetweenLIFOandFIFOandisagoodchoicefor
companieswithvolatileinventories.

2.8
$150,000x0.14=$21,000annualinterest
$21,000
=$1,750monthlyinterest
12
$1,750x5months=$8,750accruedinterestfor5months(July31to
December31)
26

2.9
Revenue
Expenses
EarningsbeforeTaxes
TaxExpense(34%)
NetIncome

TaxPurposes
$800,000
550,000
$250,000
85,000
$165,000

ReportedTaxExpense
ActualTaxesPaid
DeferredTaxLiability

$108,800
(85,000)
$23,800

ReportingPurposes
$800,000
480,000
$320,000
108,800
$211,200

2.10 Treasurystockisshownasareductionofshareholders'equity.(Most
companiesusethecostmethodratherthantheparvaluemethodtoaccountfor
treasurystock,sothecostofthetreasurystockisdeducted.)Thenumberofshares
acquiredfortreasuryisdeductedfromthenumberofsharesoutstandingusedto
computeearningspershare;thusafirmcanincreaseearningspershareby
purchasingtreasurystock.

27

2.11

Changefrom
2003to2004
27.9%
16.0%
(12.8%)

Revenues
TotalReceivables
Allowancefordoubtfulaccounts

Changefrom
2002to2003
17.3%
17.3%
(21.7%)

Allowanceaccountasapercentageofreceivables:
Allowancefordoubtfulaccounts
Netreceivables+Allowance
2004
2003
2002

$41
$1,696+$41
$47
$1,451+$47
$60
$1,217+$60

Percentageof
Receivables
2.36%
3.14%
4.70%

AsrevenueshaveincreasedatTexasInstruments,receivableshavealsoincreased,
butnotasmuchasrevenues.Thisisanexpectedpattern;however,itisunusualfor
theallowanceaccounttodecrease.TheAllowanceaccountasapercentageoftotal
receivablesindicatesthatthemanagementatTexasInstrumentsbelievesthata
higherpercentageofreceivableswillbecollectedcomparedtoprioryearsas
evidencedbythedropintheallowance/receivablesratiofrom4.70%to2.36%.
Theanalystwouldwanttoexplorethereasonforthischange.ItispossibleTexas
Instrumentshadrecordedhigherbaddebtsduringtheeconomicdownturninyears
priorto2002,butcustomersdidnotdefaultasexpected.Thefirmcouldthenbe
correctingtheprioroverestimation.Ifnovalidexplanationcanbefound,itis
possiblethattheaccounthadbeenunderestimatedinprioryearsinordertolater
increaseearnings.

28

2.12
(a) FIFOisprobablyusedfortherestofKennametal'sinventories.Companies
usingLIFOmustdisclosethevalueofthoseinventoriesasifFIFOhadbeenused,
whichKennametalhasdoneinthiscase.
(b) Finishedgoodsreferstothoseinventoriesthatarecompleteandreadyfor
sale.Workinprocessandpowderblendsareinventoriescurrentlyinthe
manufacturingprocess,butnotyetcomplete.Rawmaterialsandsupplieshavenot
beenputinthemanufacturingprocess.Theamountclosesttocurrentcostwould
betheFIFOinventoryvalue.UnderFIFO,thefirstgoodspurchasedareassumed
sold,sothelastgoodspurchasedwouldbeincludedintheinventoryvaluationand
wouldhavebeenpurchasedatamountsclosesttocurrentcosts.TheLIFO
valuationreductionisaresultoftheimpactofinflationoninventoryvalues.Since
thefirstgoodspurchasedusingLIFOremainininventory,LIFOinventorieswould
bevaluedataloweramountthanFIFOinventoriesduringaninflationaryperiod.
Kennametal'sinventoriesarelowerin2004,($388,077)thantheywouldhavebeen
ifreportedusingFIFO($412,448).
2.13
(a) Targetwouldrecordtheassetsleasedunderproperty,plantandequipment,
netofanydepreciationoramortizationrecordedtodate.Thecapitallease
obligationwouldberecordedincurrentandnoncurrentliabilities.Thecurrent
portionwouldbethe$3milliondueintheupcomingyearandthelongtermportion
couldbe$88million.Interest,depreciationandamortizationexpensewouldbe
recordedontheincomestatement.
(b) Rentexpenseof$240millionin2004,and$150millionin2003and2002,
wouldbeincludedwithinoperatingexpensesonTarget'sincomestatement.A
referenceto"Commitments"wouldbeincludedintheliabilitysectionofTarget's
balancesheet.
(c) Operatingleasesareaformofoffbalancesheetfinancing.Theamounts
owedforoperatingleasesshouldbelookedatasfuturedebtwhenanalyzinga
firm'sfinancialstatements.Inthiscase,Targethasoveralloperatinglease
obligationsof$3,049million.Iftheanalystaddsthisamounttoallotherdebt,
Targethasfutureliabilitiesof$22,313millionor69%oftotalassets.Without
considerationoftheoperatingleasesitappearsthatTarget'sratioofdebttoassetsis
only60%.
29

2.14

ChesterCo.
BalanceSheetatDecember31,20XX

Assets
CurrentAssets
Cash
Accountsreceivable
Inventory
Prepaidexpenses
TotalCurrentAssets
Property,plantandequipment
Lessaccumulateddepreciation
Property,plantandequipment,net
Landheldforsale
TotalAssets

$1,500
6,200
12,400
700
$20,800
34,000
(10,500)

Liabilitiesandstockholders'equity
Currentliabilities
Accountspayable
Notespayable
Accruedinterestpayable
Currentportionoflongtermdebt
Totalcurrentliabilities
Deferredtaxespayable
Bondspayable
Totalliabilities
Stockholders'equity
Commonstock
Additionalpaidincapital
Retainedearnings
Totalstockholders'equity
Totalliabilitiesandstockholders'equity

30

$23,500
9,200
$53,500

$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

2.15 Thereisnosolutionpresentedhereforthisexercise,buttheauthorswould
welcomestudents'responses.SomepossibilitiesmightincludeExhibits2.3and2.4
presentedinbarorpiechartformat;adiagramshowingthecostflowassumptions
usedtovalueinventory;apiechartdisplayingtypesofdepreciationusedfor
financialreporting;adrawingillustratingadistraughtreadertryingtounderstand
accountingfordeferredfederalincometaxes.
2.16 Thereisnosolutionpresentedheresinceavarietyofcompaniesmaybeused
forthisproblem.Assigningspecificcompanieswillallowinstructorstoreview
answersintheclassasawhole.
2.17 Thereisnosolutionpresentedheresinceavarietyofindustriesmaybeused
forthisproblem.Assigningspecificindustrieswillallowinstructorstoreview
answersintheclassasawhole.
2.18
(a)

INTEL
CommonSizeBalanceSheet
2004

Assets:
CurrentAssets
Cashandequivalents
Shortterminvestments
Tradingassets
A/R
Inventories
Deferredtaxassets

17 %
12
7
6
5
2

Othercurrentassets

Totalcurrentassets
Property,plantandequipment,net
Marketablestrategicequitysecurities
Otherlongterminvestments
Goodwill,net
Otherassets

50 %
33 %
1
5
8
3
31

2003

17 %
12
6
6
5

1
49 %
35 %
1
4
8
3

TotalAssets

100 %

32

100 %

Liabilities:
Currentliabilities
Shorttermdebt
A/P
Accruedcompensationandbenefits
Accruedadvertising
Deferredincomeonshipments
Otheraccruedliabilities
Incometaxespayable
Totalcurrentliabilities
Longtermdebt
Deferredtaxliabilities
Totalliabilities
Stockholders'equity
Commonstock
Acquisitionrelatedunearnedstockcompensation
Accumulated.othercomprehensiveincome
Retainedearnings
Totalstockholders'equity
Totalliabilities&stockholders'equity

2004

2003

1%
4
4
2
1
3
2
17 %
1
2
20 %

%
4
3
2
1
3
2
15 %
2
3
20 %

13

67
80 %
100 %

14

66
80 %
100 %

(b) ThecurrentassetsofIntelincludecash,shortterminvestments,trading
assets,accountsreceivable,inventories,deferredtaxassetsandothercurrentassets.
Longtermassetsarecomposedofproperty,plantandequipment,marketable
strategicequitysecurities,longterminvestments,goodwill,andanotherassets
account.Themostsignificantassetstothecompanyarecashandshortterm
investments,property,plantandequipmentandgoodwill.
Tradingassetsandavailableforsaleinvestmentsarereportedatfairvalue.Non
marketableequitysecuritiesareaccountedforathistoricalcost,or,ifIntelhas
significantinfluenceovertheinvesteetheequitymethodisused.Inventoriesare
valuedusingcurrentaverageorFIFO.Straightlinedepreciationisusedfor
depreciatingproperty,plantandequipmentforfinancialreportingpurposes.
Otheritemslearnedfromthenotesaboutassetaccountsincludeinformationabout
Intel'smanyinvestments,derivativefinancialinstruments,abreakdownofthe
inventoryaccountintorawmaterials,workinprocessandfinishedgoods,detailof
theproperty,plantandequipmentaccount,theestimatedusefullivesofplantand
equipment,goodwill,andotherintangibleassets.
33

Theassetstructureisstable.Theonlypercentagechangesinassetsarethe2%
declineinnetproperty,plantandequipmentduetoaccumulateddepreciationanda
1%increaseintradingassetsandlongterminvestments.Liabilitiesandequity,
overallhaveremainedat20%and80%,respectively.
(c)

2004
2003

Allowanceaccountasapercentageofaccountsreceivable:
Allowancefordoubtfulaccounts
NetReceivables+Allowance

Percentageof
Receivables

$43
$2,999+$43

1.41%

$55
$2,960+$55

Sales
TotalAccountsReceivable
Allowancefordoubtfulaccounts

1.82%

Changefrom
2003to2004
13.5%
0.9%
(21.8%)

Assaleshaveincreasedaccountsreceivablehasremainedalmostthesameandthe
allowancefordoubtfulaccountshasdecreased.Thisisanabnormalpattern.One
wouldexpectaccountsreceivabletoincreasemore,butthefactthatithasnotis
goodsincethismeansIntelhascollectedmorereceivablesincash.Itwouldbe
normalfortheAllowanceaccounttoremainstable,butanassumptionhasbeen
madeatIntelthatmorereceivableswillbecollectedcomparedtoprioryears.
Giventheupturnintheeconomyin2004,thismaybeareasonableassumption.
LookingatthevaluationandqualifyingaccountsscheduleinIntel'sForm10K
(page85)itappearsthatInteloverestimatedtheAllowanceaccountbyquiteabit
priorto2002.Actualwriteoffsrangebetween$16and$21millioneachyear,yet
theAllowanceaccountwas$68millionin2002.Theeffectnowofrecordingless
baddebtexpensecausesnetincometobehigherthanitwouldbeotherwise.Itis
possiblethatIntelpurposelyoverestimatedthebaddebtexpenseduringthe
economicdownturnwhenthemarketswerealreadyexpectingpoorprofitnumbers.
ItisnoteworthythatIntel'sthreelargestcustomersaccountfor45%ofaccounts
receivable.Shouldoneofthesecustomersdefaultthiswouldnegativelyimpact
Intel.Inaddition,shouldoneofthesecustomerschoosetotakeitsbusiness
34

elsewhere,thatwouldbehighlydetrimentaltoIntel'ssalesandultimateprofits.
Intelbelievesthatitsthreelargestcustomersarelowriskwithregardtocollection
ontheiraccountsbasedonhistoricalexperience.SinceDellandHewlettPackard
areIntel'stwolargestcustomers(page11ofForm10K),thisisprobablyagood
assumption.
(d) Intelhasthetypicalliabilitiesfoundonmostcompanies'balancesheets:
shorttermdebt,accountspayable,accruedliabilities,deferredincome,income
taxespayable,longtermdebtanddeferredtaxliabilities.Nooneliabilityaccount
issignificant.In2003and2004,only20%ofthecapitalstructureisdebt,while
80%isequity.Therehavebeennosignificantchangestothedebtandequity
structure.
(e) Intelhascommitmentsforoperatingleasesandiscommittedtopay$563
millioninthefuture(2005andthereafter).Thecompanyhasalsocommittedto
constructorpurchaseproperty,plantandequipmentofapproximately$2.8billion.
Othercommitmentsincludinglicensesandnoncontingentfundingobligationstotal
$687million.
Contingenciesincludetaxmattersandlegalproceedings.Inteliscurrentlytryingto
resolveadisputewiththeInternalRevenueService(IRS).Itispossiblethatnet
incomewouldbenegativelyimpactedshouldtheIRSprevailinthedispute.For
taxyears1999and2000Intelcouldpotentiallyowe$600million,plusinterest.
IntelhasbeeninvolvedforyearsinpatentinfringementlawsuitswithIntergraph
Corporation.Intelhassettledthesecasesandrecordeda$162millionchargeto
costofsalesin2004.Another$63millionrepresentingthevalueofintellectual
propertywillamortizedovertheassets'remaininglives.
UnresolvedlawsuitstodateincludeasuitbroughtbyMicroUnity,Inc.,forpatent
infringementandafalseadvertisingclaiminIllinoisamongstothers.The
outcomesoftheselawsuitscouldnegativelyimpactIntel'snetincomeinfuture
years.Intelhasalsobeeninvolvedinanenvironmentalcleanup,butthishasbeen
largelyresolvedandnomaterialadverseimpactisexpected.
(f)
Deferredtaxesareincludedundercurrentassetsandnoncurrentliabilities.
Depreciationisthemostsignificantcomponentofdeferredtaxes.
(g) Intelhasthefollowingequityaccounts:Preferredstock,Commonstock,
Acquisitionrelatedunearnedstockcompensation,Accumulatedother
comprehensiveincomeandRetainedearnings.
35

36

2.19

Eastman Kodak

(EK / NYSE)

Annual Consolidated Balance Sheet


Amounts Rounded to : Millions

Results as of December 31
2004
ASSETS
Current Assets:
Cash and cash equivalents
Short-term investments

Total cash and short-term investments

1,255

2003

1,250

1,255

1,250

Accounts receivable, net


Inventories, net
Current deferred taxes
Other current assets

2,544
1,158
556
135

2,327
1,078
596
201

Total current assets

5,648

5,452

12,694
8,182

13,176
8,125

4,512

5,051

513
1,446
478
521
1,619

446
1,349
294
439
1,815

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
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

14,737

868
69
400
3,028
625

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

37

832
489
457
2,798
643
36

4,990

5,255

1,852
67

2,302
89

4,017

Total liabilities

14,846

3,955

10,926

11,601

1,828
7,922
(5,844)
(90)
(5)

1,828
7,515
(5,852)
(238)
(8)

3,811

3,245

14,737

14,846

Eastman Kodak

(EK / NYSE)

Annual Common Size Balance Sheet


Summary percentages in italics will not foot due to rounding

ASSETS
Current Assets:
Cash and cash equivalents
Short-term investments

Results as of December
31
2004
2003

8.5%
0.0%

8.4%
0.0%

8.5%

8.4%

Accounts receivable, net


Inventories, net
Current deferred taxes
Other current assets

17.3%
7.9%
3.8%
0.9%

15.7%
7.3%
4.0%
1.4%

Total current assets

38.3%

36.7%

86.1%
55.5%

88.8%
54.7%

30.6%

34.0%

3.5%
9.8%
3.2%
3.5%
11.0%

3.0%
9.1%
2.0%
3.0%
12.2%

100.0%

100.0%

5.9%
0.5%
2.7%
20.5%
4.2%
0.0%

5.6%
3.3%
3.1%
18.8%
4.3%
0.2%

33.9%

35.4%

12.6%
0.5%
0.0%
27.3%

15.5%
0.6%
0.0%
26.6%

74.1%

78.1%

0.0%
12.4%
53.8%
-39.7%
-0.6%
0.0%

0.0%
12.3%
50.6%
-39.4%
-1.6%
-0.1%

25.9%

21.9%

100.0%

100.0%

Total cash and short-term investments

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
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
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

38

(b) EastmanKodak'sbalancesheetisstablefrom2003to2004,withonlyminor
changesintheaccounts.ThemostsignificantcurrentassetaccountsareAccounts
ReceivableandCash.TheReceivablesaccounthasincreased1.6%.Property,
PlantandEquipmentisthelargestassetKodakhasandthisaccountisdecreasingin
bothdollarsandpercentage.Kodakalsohasasignificantamountofgoodwilland
11%ofassetsareclassifiedas"other"whichincludesmainlyprepaidpensioncosts.
Overallcurrentliabilitieshavedecreasedasaresultofreductionsinshort
termdebtandcurrentportionsoflongtermdebt.Accruedliabilitiesarethemost
significantcurrentliabilityandhaveincreasedfrom2003to2004.Totalliabilities
havedecreasednotonlybecauseoftheabovementionedchanges,butalsobecause
longtermdebthasalsodecreased.
Stockholders'equityhasalsoincreasedmainlybecauseoftheincreasein
retainedearnings.Kodakhasbeenabletoreduceitsoveralldebtsothatitnow
makesup74.1%oftotalassetsin2004insteadof78.1%asitwasin2003.The
capitalstructureisriskyduetothelargeamountsofdebtsoitisgoodKodakis
tryingtoreduceit.

39

CASE2.1
1.

LUCENTTECHNOLOGIES
CommonSizeBalanceSheet
September30
ASSETS

CurrentAssets
Cashandcashequivalents
Marketablesecurities
Receivables
Inventories
Othercurrentassets
TotalCurrentAssets
Marketablesecurities
Property,plantandequipment,net
Prepaidpensioncosts
Goodwillandotheracquiredintangibles,net
Otherassets
TotalAssets
LIABILITIESANDSHAREOWNERS'DEFICIT
CurrentLiabilities
Accountspayable
Payrollandbenefitrelatedliabilities
Debtmaturingwithinoneyear
Othercurrentliabilities
TotalCurrentLiabilities
NoncurrentLiabilities
Postretirementandpostemploymentbenefitliabilities
Pensionliabilities
Longtermdebt
Liabilitytosubsidiarytrustissuingpref.securities
Otherliabilities
TotalLiabilities
8.00%redeemableconvertiblepreferredstock

40

2004
20%
5
8
5
11
49%
4
8
32
2
5
100%

2003
24%
4
9
4
8
49%

10
30
1
10
100%

5%
7

14
26%

7%
7
2
15
31%

29
11
29
7
7
109%

29
16
28
7
10
121%
5

Shareowners'Deficit
Commonstock
Additionalpaidincapital
Accumulateddeficit
Accumulatedothercomprehensiveloss
TotalShareowners'Deficit
Totalliabilities,redeemableconvertiblepreferred
stockandshareowners'deficit

136
(123)
(22)
(9)%

140
(143)
(23)
(26)%

100%

100%

2.
TheindividualpercentagesofassetsforLucentTechnologieshaveshifted
withincurrentandnoncurrentassets,butcurrentassetsremainedstableat49%of
totalassets.Themostsignificantcurrentasset,cashhasdeclined,butmarketable
securitiesandothercurrentassetshaveincreased.Thecompany'smostsignificant
assetisprepaidpensioncostswhichincreased2%from2003to2004,with
property,plantandequipmentdecreasinganequalamount.Inaddition,other
assetsdecreasedandlongtermmarketablesecuritiesincreased.
ChangeshaveoccurredinthedebtandequitystructureofLucentTechnologies.
Accountspayableanddebtmaturingwithinoneyearhavedecreased,causing
currentliabilitiestoalsodecrease.Pensionsandothernoncurrentliabilitieshave
alsodecreased.Despitethedecreaseindebt,LucentTechnologieshasmoredebt
thantotalassetsinboth2003and2004.ItappearsthatLucentwasprofitablein
2004sincetheaccumulateddeficitbecamelessnegative.Lucenthasanextremely
riskydebtstructure.
3.
Investorsandcreditorswouldbeconcernedabouttheabilityofthefirmto
generateenoughcashtopaythelargeamountsofdebtthatwillultimatelycome
due.Mostresourcesaretiedupinprepaidpensioncosts,itemsnotsaleableifcash
isneededimmediately.LucentTechnologies'totaldebtis109%oftotalassets,
therefore,investorsandcreditorsshouldbeconcernedaboutpotentialbankruptcy
ofthefirm.
4.
Investorsandcreditorswouldwanttolookatallotherfinancialstatements,
thenotestothefinancialstatements,themanagementdiscussionandanalysis,the
auditor'sreportandstockpriceinformation.SECdocuments,Form10K,Form
10QandForm8Kreportswouldbeagoodsourceofbothfinancialand
nonfinancialinformation.Financialinformationofcompetitorswouldbeusefulfor
comparisonpurposes.Nonfinancialinformationfromnewspapersandperiodicals
41

wouldalsobeuseful.Inparticular,investorsandcreditorswouldwantto
determinetheprospectsofLucentTechnologiesforthefuturebyresearchingthe
telecommunicationsindustry.

42

1.

CASE2.2
1800CONTACTS,INC.
CommonSizeBalanceSheet
January3andJanuary1
ASSETS

2004

CurrentAssets
Cash
Accountsreceivable,net
Otherreceivables
Inventories,net
Prepaidincometaxes
Deferredincometaxes
Othercurrentassets
TotalCurrentAssets
Property,plantandequipment
Office,computerandotherequipment
Manufacturingequipment
Manufacturingfacility
Leaseholdimprovements
Less:Accumulateddepreciationandamortization
Netproperty,plantandequipment
Otherassets
Deferredincometaxes
Goodwill
Definitelivedintangibles,net
Other
TotalOtherAssets
TotalAssets

43

2005

1%
1
1
28
1
1
1
34%

3%
3
2
20

1
2
31%

9
4
8
2
23%
(8)
15%

7
11
7
4
29%
(10)
19%

1
39
10
1
51%
100%

1
31
16
2
50%
100%

LIABILITIESANDSTOCKHOLDERS'EQUITY
CurrentLiabilities
Currentportionoflongtermdebt
Currentportionofcapitalleaseobligations
Acquisitionpayable
Incometaxespayable
Accountspayable
Accruedliabilities
Unearnedrevenue
TotalCurrentLiabilities
LongtermLiabilities
Lineofcredit
Longtermdebt,netofcurrentportion
Capitalleaseobligations,netoflongtermportion
Deferredincometaxliabilities
Unearnedrevenue,netofcurrentportion
Otherlongtermliabilities
TotalLongtermLiabilities
TotalLiabilities
Stockholders'Equity
Commonstock
Additionalpaidincapital
Retainedearnings
Accumulatedothercomprehensiveincome(loss)
TotalStockholders'Equity
TotalLiabilitiesandStockholders'Equity

4%

10
5

19%

2%

1
9
7
3
22%

17

17%
36%

13
7

1
2
1
24%
46%

49
15

64%
100%

42
11

54%
100%

2.
Inventoryisthemostsignificantcurrentassetandalsomakesup20%oftotal
assets.
3.
Untilthemostrecentyear,2004,(endedJanuary1,2005)accounts
receivablewasaninsignificantaccountto1800Contactssincemostcustomers
prepayfortheircontactlenspurchases.TheacquisitionofClearLab,a
manufacturerofcontactlenses,hascausedtheAccountsReceivableaccountto
increaseandasaresult,anallowancefordoubtfulaccountsappearstohavebeen
establishedforthefirsttimein2004.Asaresult,limitedanalysiscanbecompleted
asthereisonlyoneyearofdata.
44

Allowanceaccountasapercentageofaccountsreceivable:
Allowancefordoubtfulaccounts
Netaccountsreceivable+allowance

2004
0.8%

2003
0.0%

PercentChanges
Netsales
Totalaccountsreceivable
Allowancefordoubtfulaccounts

Changefrom
2003to2004
13.0 %
239.5 %
Cannotcalculate

ThenewlyestablishedAllowanceaccountcannotbeproperlyanalyzed.The
estimatedamountof0.8%maybeadequategiventhatU.S.retailsalesarecollected
incashpriortodeliveryofproductandinternationalsales,whichappeartohave
generatedtheaccountsreceivable,areonly3.4%oftotalsales.Oncethereisa
longerhistory,moreanalysiscanbecompleted.Lookingattheincreasesinsales
andaccountsreceivableisnotallthatvaluableeither,sincetheaccountsreceivable
wassuchasmallnumberin2003,thegrowthincreditsaleshascausedthe
percentageincreasetobeunusuallylarge.
4.
1800Contactsisbotharetailerandamanufacturingcompanyandtherefore
carriesfourtypesofinventories:purchasedcontactlenses,rawmaterials,workin
processandfinishedgoods.ThecompanyusestheFIFOmethod.FIFOincludes
themostrecentlyacquiredgoodsinendinginventory,thereforetheamountsfor
inventoriesonthebalancesheetdoreflectcurrentcosts.
5.
Theanswertothisquestiondependsontheassumptionmadeabouttheeffect
ofinflationon1800Contacts.Ifitisassumedthatthecompanyoperatesinan
inflationaryenvironment,thenthecompanyhasprobablypaidmoreintaxes,since
thelowerpricedgoodswouldbechargedtocostofgoodssold,increasingincome
andtaxes.Ifitisassumedthat1800Contactsoperatesinadeflationary
environment,thenthecompanyhasprobablyrealizedtaxsavings,sincecostof
goodssoldwouldincludethehigherpricedgoods,causingincomeandtaxestobe
lower.
45

6.
Goodwill,definitelivedintangibleassets,andproperty,plantandequipment
arethemostsignificantnoncurrentassetcategoriesto1800Contacts,accounting
for66%oftotalassets.
Therelativeproportionsofcurrentandnoncurrentassetsseemreasonablefora
companythatbothmanufacturesandsellscontactlensesasaretailer.Plantand
equipmentisnecessaryforthemanufacturingprocessandinventoriesareimportant
tobothmanufacturersandretailers.Comparedtotherangeofinventoriesandnet
fixedassetsrelativetototalassetpercentageslistedinExhibits2.4and2.5ofthe
textbook,thenumbersdonotseemunusual.Thegoodwillandintangibleassets
seemhigh;however,1800Contactshasexpandedthroughacquisitionsandthe
companyisrelativelynewwhichaccountsforthelargepercentagesinthesetwo
accounts.Thedefinitelivedintangibleassetswillultimatelybeamortizedtozero,
resultinginashiftintheassetstructure.
7.
Accountspayableandaccruedliabilitiesarethemostsignificantcurrent
liabilities.Significantnoncurrentliabilitiesincludealineofcreditandlongterm
debt.Tofundinventoriesanddailyoperationsrequiresbothaccountspayableand
accruedliabilities,soitmakessensethatthesetwoaccountsarethemost
significantcurrentaccounts.Usingalongtermlineofcreditandlongtermdebtto
fundmanufacturingoperationsandacquisitionsalsoisappropriate.
8.
Theassetstructureof1800Contactshassomechanges.Inventorieshave
changedthemost,declining8%from2003to2004.Thisistheresultofa
decreaseddollaramountofinventories,aswellasincreasesinotheraccountssuch
asaccountsandotherreceivables,manufacturingequipment,leasehold
improvements,andintangibleassets.
Theliabilityandequitystructurehashadasignificantchangeasdebtincreased
overallby10%andequitydecreasedbythesameamount.Withtheexceptionsof
thecurrentportionsofdebtandtheacquisitionpayable,allcurrentliabilities
increased.Alllongtermliabilitiesalsoincreasedwiththeexceptionoflongterm
debt,however,thedeclineinlongtermdebtappearstobemerelyashiftfrom
contractualnotestothelineofcredit.Theequitydeclineismainlyaresultofthe
increaseddebt;butretainedearningsdiddeclineindollaramount.Thiscouldbe
theresultofeitherlossesordividends.
9.

Yes,1800Contactshascommitmentsasoutlinedbelow(inthousands):
46

Operatingleases
$10,340
Advertising
14,600
Purchaseofinventory
322
Purchaseofequipment
1,600
Telecommunicationsservice
665
Guaranteedfee
500
Sincethesecommitmentsareaformofoffbalancesheetfinancing,theyare
significantwhenlookingatthedebtstructureofthecompany.Addingthetotal
commitmentsof$28,027tothetotaldebtofthecompanyincreasesobligationstoa
totalof$78,508.
Note:Thepercentageofdebtwasnotrecalculatedsincesomeofthecommitments
wouldalsoaddamountstotheassetsideofthebalancesheet.Tocalculaterevised
percentagesrequiresamorethoroughanalysisofthesecommitments.
10.
Beginningretained
earnings
$12,834

Net
income

($616)

47

Dividend =
s
$0

Endingretained
earnings
$12,218

Chapter3
3.1 Themultiplestepformatprovidesseveralintermediateprofitmeasures:
grossprofit,operatingprofit,andearningsbeforeincometaxes.Thesinglestep
formatgroupsrevenuestogetherandthendeductsallcategoriestoarriveatnet
earnings.Themultiplestepformatisthemostusefulforanalysis.
3.2 Depreciation,amortization,anddepletionareallmethodsofallocatingthe
costsoflonglivedassetsovertheirservicelives.Thedifferenceamongthethree
methodsisthenatureoftheassets.Depreciationisusedfortangiblefixedassets
suchasbuildings,machinery,andequipment.Amortizationisusedforintangible
assetssuchaspatents,copyrights,trademarks,licenses,franchisesandcapitalized
leases.Depletionisusedfornaturalresourcessuchasoilandgas,minerals,and
timberlands.
3.3 Forabusinessfirmtooperatesuccessfullyitmustspendaminimumamount
onoperatingexpensestobecompetitive.Allowingoperatingexpensestogrow
fasterthansalesgrowth,however,mayindicatealackofcontroloverexpenses,
wasteorinefficiencies.Decreasingcertainexpensessuchasadvertising,research
anddevelopmentorrepairsandmaintenancemaybedetrimentaltolongtermsales
growth.
3.4 Thebeverageandathleticshoesindustriesareexamplesofindustriesthat
mustadvertiseregularlyorrisklosingmarketshare(seeexampleofCocaColaand
PepsiinChapter1).
Thepharmaceuticalandhightechnologyindustriesareexamplesofindustriesthat
mustdoextensiveresearchanddevelopmenttocreatenewandinnovativeproducts.
3.5 Thestatementofstockholders'equitysummarizesthechangesinallofthe
equityaccounts,includingtheRetainedEarningsaccount.
3.6 Thenetincomefigureisbasedonaccountingchoicesandestimates.The
inventoryvaluationanddepreciationmethodschosencanvarysignificantlyand
impactdifferentlyonnetincome.Discretionaryitemssuchasadvertisingand
repairsandmaintenancecanbemanipulatedtochangethenetincomeofafirm.
Useoftheequitymethodforinvestmentsmayalsodistortnetincome.
Nonrecurringandnonoperatingitemsareincludedinnetincome.Netincomealso
48

incorporatesaccountingchangesandextraordinaryitems.Finally,netincomedoes
notequalcashflow.

49

3.7

2006to2007

2005to2006

21.0%
22.2%

62.5%
63.6%

Salesgrowth
Operatingexpensegrowth

2007
Costofgoodssold
Grossprofitmargin
Operatingprofitmargin
Averagetaxrate
Netprofitmargin

78.8 %
21.2
11.9
42.9
6.8

2006

2005

76.9 %
23.1
13.8
42.6
7.9

70.8 %
29.2
20.0
43.8
11.3

Salesgrowthoverthethreeyearperiodisstrong,buttherateofincreasedecreased
20062007relativeto20052006.Salesgrowthcouldbetheresultofprice
increases,volumeincreases,orboth.Thereductioninthegrossprofitmargin
indicatesproblemswithinventorycostcontrols,thepricingofproducts,ora
combinationofthesefactors.Thedecreaseintheoperatingprofitmarginispartlya
flowthroughfromthegrossprofitmarginandtheresultofincreasingoperating
expenses;operatingexpensesareincreasingataslightlyfasterratethansales.
Finally,thecombinationofproblemswithinventorymanagement,pricing,and
controlofoperatingexpenseshasproducedadeterioratingnetprofitmargin.Tax
expensehasnotbeenacontributingfactorbecausetheaveragetaxratedecreased
between2005and2007.
3.8 UsingtheequationfromChapter2,thecalculationstodeterminedividends
areasfollows:
Beginning
retainedearnings
2007
2008
2009

760
1,026
1,171

netincome

+
+
+

330
200
48

50

dividend
Endingretained
=
earnings
s
64 =
55 =
55 =

1,026
1,171
1,164

3.9

InvestmentIncome

InvestmentAccount

(a)Costmethod

$12,500 *

$500,000

(b)Equitymethod

$62,500 **

$550,000 ***

*$50,000cashdividendsx25%
**$250,000earningsx25%
***$500,000+$62,500$12,500
3.10

CoyoteInc.
IncomeStatementfortheYear
Netsales
Costofgoodssold
Grossprofit
Sellingexpenses
Generalandadministrativeexpenses
Depreciationexpense
Operatingprofit
Otherincome(expense)
Interestincome
Interestexpense
Pretaxincome
Incometaxexpense
Netincome

51

$1,833,000
1,072,000
761,000
279,000
175,000
14,000
293,000
13,000
(16,000)
290,000
116,000
$174,000

3.11

YarrickCompany
CommonSizeIncomeStatement(inpercent)
FortheYearsEndedDecember31,2007,2006,and2005

Netsales
Costofgoodssold
Grossprofitmargin
Selling,gen.&admin.
Research&develop.
Operatingprofitmargin
Incometaxexpense
Netprofitmargin

2007
100.0
58.2
41.8
17.7
16.0
8.1
3.0
5.1

2006
100.0
54.2
45.8
20.0
21.3
4.5
1.3
3.2

2005
100.0
53.7
46.3
29.1
40.3
(23.1)
(8.2)
(14.9)

Saleshaveincreased15.7%from2005to2006and52.9%from2006to
2007forYarrickCompany.Thisincreaseistheresultofvolumeorpriceincreases.
Thegrossprofitmarginhasdeclinedeachyear.Yarrickhaseitherloweredselling
pricesorcostsofgoodssoldhaverisenandthecompanyhasnotpassedonthose
increasestoitscustomers.
Operatingprofitmarginhassurprisinglyincreaseddespitethedeclineingross
profitmargin.Thishasbeenachievedbysignificantreductionsinselling,general,
andadministrativeandresearchanddevelopmentexpensesin2006.Indollars
theseexpensesincreasedin2007,butfromapercentagestandpointdecreaseddue
tothelargesalesgrowth.Thereductionintheseexpensesisconcerning.Tostay
onthecuttingedgeofitsindustryitisimportantforYarricktospendenoughin
researchanddevelopment.Cutsinthisareamaybedetrimentaltosalesgrowthin
thelongrun.Ifadvertisingisbeingreducedorkeyproductivepersonnelarebeing
laidofftoachievethecostreductionsinselling,generalandadministrative
expenses,this,too,cannegativelyimpactthecompany'ssalesandprofits.If
Yarrickhasbeenabletoreducecoststhroughtheeliminationofwaste,thiswould
beaqualitychange.
Netprofithasincreasedfromalossof$20toaprofitof$12from2005to2007due
totheabovementionedchangesinoperatingexpenses.Taxexpensehasnothada
significantimpactonthenetprofitofthefirm.
52

3.12 Comparethefollowingparagraphs,onemoredescriptiveandtheothermore
analytical.Havestudentsassesstheirownwritingastotheextenttowhichthey
haveanalyzedratherthandescribedElfCorporation'sprofitperformance.
DescriptiveParagraph
NetincomeforElfCorporationincreasedby$15millionin2007and2006.
Salesalsoimprovedby$100millionin2000,butbyonly$50millionin2007.
Thegrossprofitmarginremainedconstantoverthethreeyearperiodat50%,asdid
theaveragetaxrate.Administrativeexpensesremainedconstantat$100million.
ElfCorporationexpended$75millionforadvertisingandmarketingin2005and
2006butreducedtheseexpendituresto$50millionin2007.Interestexpenserose
by$20millionin2006and2007.
AnalyticalParagraph
NetincomeforElfCorporationincreasedin2006and2007,butata
decreasingrate.Salesalsoimprovedbothyears,butatadecreasingrate.Elf
Corporationmaintaineda50%grossprofitmargin,reflectingthefirm'sabilityto
controlthecostofproductssoldortopassalongpriceincreasestocustomers.The
increaseintherateofprofitwasimpairedin2005byslowersalesgrowthandby
continuedhighinterestexpense.Theriseininterestexpensecouldbeduetohigher
interestratesbutprobablyisevidenceofincreasedcorporateborrowing,which
couldsignalproblemsorbetheresultofexpansion.The$50millionincreasein
operatingprofitin2007hasbeenachievedbyreducingexpendituresforadvertising
andmarketing,whichcouldhelpexplaintheslowersalesgrowthin2007andcould
impairsalesinthefuture.
3.13 Studentsanswerswilldifferunlessspecificcompaniesareassignedbythe
instructor.
3.14 Thereisnosolutionpresentedheresincethelistoftechnicalprojectsonthe
FASBagendaiseverchanging.

53

3.15
(a)

INTEL
CommonSizeIncomeStatement
2004
100.0 %
42.3
57.7 %
14.0

Sales
CostofSales
GrossProfit
Researchanddevelopment
Marketing,generaland
administrative
Impairmentofgoodwill
Amortizationandimpair.of
acquisitionrelatedintangibles
Purchasedinprocessresearchand
development
Operatingincome
Lossesonequitysecurities,net
Interestandother,net
Incomebeforetaxes
Provisionfortaxes
NetIncome
Effectivetaxrate

14.2
2.0

16.2

0.5

1.0

2.1

29.6
(
0.8
30.4
8.5
21.9

25.0
(0.9
0.6
24.7
6.0
18.7

16.4
(1.4
0.7
15.7
4.1
11.6

%
)
%
%

20032004
13.5 %
0.6 %

54

2002
100.0 %
50.2
49.8 %
15.1

13.6

27.8 %

Growthrates
Netrevenues
Totaloperatingcosts

2003
100.0 %
43.3
56.7 %
14.5

%
)
%
%

24.2 %

%
)
%
%

25.9 %

20022003
12.6 %
7.0 %

Analysis of Income Statement


Revenues for Intel have been increasing at a steady rate over the three-year period from
2002 to 2004. Operating expenses have not increased proportionately with the revenue
increases, resulting in increased profitability for the company. Revenue increases are
mainly a result of increased volume of sales.
The gross profit margin has increased significantly over the three-year period. The
Management Discussion and Analysis (MDA) explains why this occurred. Intel was
able to lower costs in the Architecture Business, while at the same time increasing
sales. The Intel Communications Group negatively impacted the gross profit margin
due to the write-down of inventory due to lower replacement costs as well as higher
unit costs for flash memory products.
Operating profit has increased each year, a result of the gross profit improvements as
well as changes in other operating expenses. On a percentage basis, operating
expenses have declined relative to sales as a result of solid sales growth without a
corresponding increase in costs. Research and development dollars have increased
each year and this is a good sign since it is important for Intel to continually develop
new and innovative products. Marketing, general and administrative expenses declined
in dollars in 2003, but have increased in 2004. Intel did not reduce advertising dollars,
but rather was able to cut costs in 2003 as a result of reduced headcount as they
refocused on core strategic areas. In 2003 Intel recorded what appears to be a one-time
impairment charge for goodwill related to the Wireless Communications and Computing
Group. This division has not performed as well as expected.
In all three years Intel incurred losses on their equity securities. Its losses are most
likely attributed to a weak economy and stock market over the past three years. The
good news is that the losses were much less in 2004 compared to 2003 and 2002.
Interest income and other, net, increased in 2004, due to higher investment balances
and higher interest rates.
Intel's effective tax rate is relatively low compared to the statutory rate of 35%. The
firm appears to be benefiting from tax losses due to divestitures and export sales
benefits.
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.

55

(b) TheCommonStockaccounthasdecreasedoverthethreeyearperiodduetothe
repurchaseandretirementofcommonstock.NowheredoesIntelexplainwhytheyare
repurchasingsomuchofitsownstock.Sincethecompanyisretiringthestock,itis
definitelynotforaninvestmentandthequantityofsharesrepurchasedismuchgreater
thanitsneedsforemployeestockprograms.ThemostlikelyexplanationisthatIntel
istryingtoincreasetheearningspersharenumberinordertoincreasetheshareprice
ofitsstock.
Accumulatedothercomprehensiveincomehasincreasedfrom2002to2004.The
causeofthechangeismainlyfromunrealizedgainsoninvestments.
TheRetainedEarningsaccountincreasedallthreeyearsduetoprofitsgenerated.Intel
doubleditsdividendin2004aswell.

56

3.16 (a)

57

58

(b) EastmanKodak(Kodak)hasgeneratedsalesgrowthatanincreasingrateeach
year,butitisnotallthatimpressive.WorseisthatKodak'soperatingcostsgrewat
15.3%whensalesonlygrew2.9%from2002to2003.Costswerebettercontrolledin
2004,butnotenoughtocovertheincreasethatoccurredincostofgoodssold,
thereforeleadingtoanoperatingloss.Salesgrowthismainlyaresultofacquisitions
andtheeffectofforeignexchangerates.Infact,Kodak'slargestsegment,Digital&
FilmImagingSystems,experienceda1%decreaseinsales.
Grossprofitmarginisdecliningsignificantlyeveryyearandisnowbelow30%.This
istheresultofpricedeclinesintraditionalfilmproducts.Kodakhasnotbeenableto
replaceitshighmarginfilmproductswithcomparablemargindigitalproducts.One
positiveareaistheincreaseingrossprofitmarginintheGraphicCommunications
segment,aresultofacquisitionsin2004.
59

Kodakgeneratedanoperatinglossin2004.Operatingprofitmarginin2003decreased
asaresultofthedeclininggrossprofitmargincombinedwithanincreaseinselling,
generalandadministrative(SGA)expensesandrestructuringcosts.In2004,Kodak
reducedSGAexpenses,butresearchanddevelopment(R&D)andrestructuringcosts
increased.SGAexpensesincreasedslightlyin2003duetoassetimpairmentsand
legalsettlements,buttheseitemsdeclinedin2004.Employeepositionswere
eliminatedin2004andadvertisingwasreduced.AsKodakmovesintothedigitalarea
itseemsthatmore,ratherthanless,fundingshouldbeusedtoadvertisenewproducts.
R&Dhasbeenincreasedeachyearwhichisusuallyagoodsignthatafirmistryingto
innovate;however,carefulreadingoftheManagementDiscussionandAnalysis
(MDA)revealsthatsomeoftheincreaseisaresultofwritingoffpurchasedinprocess
R&Dinprioryearscomparedtothemostrecentyear.Mostcompaniesrecordthis
itemasaseparatelineontheirincomestatements,butKodakhashiddenthis
information.
RestructuringcostshaveincreasedeachyearasKodaktriestotransitionfromfilmto
digitalproducts.Thecompanyislayingofflargenumbersofemployeesandselling
offplantandequipment.TheinformationKodakoffersinitsMDAregarding
restructuringcostsfocusesmoreonthedownsizingofthefirmwithoutmuchsaid
abouthowtheyintendtomovesuccessfullyintothedigitalarea.
Netprofitmarginispositiveallyears,despitethe2004operatingloss.Theother
incomein2004isaresultoflegalsettlementsinKodak'sfavor,aonetime,
nonrecurringitem.Interestexpensehasdeclinedandthenincreasedoverthethree
yearsasinterestratesdeclinedandthenincreased.Thetaxbenefitsin2004and2003,
andthelow14.9%taxratein2002arearesultofearningsinlowertaxedjurisdictions
outsideoftheUnitedStatescombinedwithlossesincurredinhighertaxed
jurisdictions.Finally,Kodakhasbenefitedfromaonetimegainfromdiscontinued
operations.
Kodakhasmanychallengestoovercome.Itsstrategysofar,hasnotbeenbeneficialin
termsofprofitability.

60

CASE3.1
DILLARD'S,INC.
1.
Theformatoftheincomestatementisasinglestepformat.Allrevenues
havebeencombinedandallexpenseshavebeencombined,withoutregardto
whethertheitemisoperatingornonoperating.Thisformatdoesnotallowthe
analysttoassessthecoreoperationsofthefirmseparatefromtheinvestingand
financingactivitiesofthefirm.Byusingamultiplestepformat,theanalystcan
assessthecoreoperationsandalsoidentifystrengthsandweaknessesofthe
companybyanalyzingtheintermediateprofitnumbersgrossprofit,operating
profitandincomebeforetaxes,aswellasnetprofit.
2.
Dillard's,Inc.*
CommonSizeIncomeStatement
(Percent)
2004 2003 2002
NetSales
100.0 100.0 100.0
Costofsales
66.6 68.0 66.4
Grossprofit
33.4 32.0 33.6
Advertising,selling,administrativeandgeneral
27.9 27.6 27.3
Depreciationandamortization
4.0
3.8
3.8
Rentals
0.7
0.9
0.9
Assetimpairmentandstoreclosingcharges
0.3
0.6
0.7
Operatingprofit
0.5
(0.9)
0.9
Servicecharges,InterestandOtherincome
3.8
3.5
4.1
Interestanddebtexpense
(1.8) (2.4) (2.4)
Incomebeforeincometaxes
2.5
0.2
2.6
Incometaxes
0.9
0.1
0.9
Incomebeforecumulativeeffectofaccountingchange
1.6
0.1
1.7
Cumulativeeffectofaccountingchange,netoftaxbenefit
of$0

(6.7)
NetIncome(Loss)
1.6
0.1
(5.0)
(b)
Salesgrowth
Operatingcostgrowth*
*IncludesCostofgoodssold.

20032004
(0.9%)
(2.3%)
2004

20022003
(3.9%)
(2.2%)
2003

61

2002

Effectivetaxrate

36.2%

41.6%

35.4%

*AlthoughDillard'sfiscalyearendisJanuary29,2005,January31,2004,andFebruary1,2003,thefiscalyearsarereferredtoas2004,2003,and
2002,respectively.

3.
Dillard'ssalesandoperatingcostgrowthhavedeclinedinboth2003and
2004,butnotproportionately.Dillard'swasbetterabletocontrolcostsin2004
comparedto2003.Itappearsthatthecompanyhasmadepositiveprogressin
increasingsalesintheCosmetics,Shoes,Accessories,andLingeriedivisions,but
stillhasmuchworktodotodeterminewhysalesaredeclininginallotherareas.

Grossprofitmargindeclinedin2003andincreasedin2004.Boththedeclineand
theincreasearearesultofhigher,thenlowermarkdownactivity.Dillard'sneedsto
purchaseinventoriesindemandthatdonotneedtobemarkeddownanditappears
thatperhapstheyhaverecognizedthisin2004.
Otheroperatingexpensesarestablewiththeexceptionofassetimpairmentswhich
aredecliningeachyear.Depreciationhasincreased,whilerentalshavedecreased,
perhapsbecauseDillard'sisusingmoreownedassetsorcapitalleases,comparedto
operatingleases.Theassetimpairmentchargesarerelatedmainlytostoreclosings,
sooncethestoresareformallyclosedthesechargesshoulddecline.
Incomebeforetaxesdeclinedin2003,butincreasedin2004.Otherincomewas
lowerin2003,butincreasedin2004.Inaddition,interestexpensehasdeclinedin
2004.EitherDillard'shaslessdebtorinterestrateshavedropped.Sinceinterest
rateswererisingin2004,itismorelikelythatdebthasbeenpaiddown.
Theincometaxrateseemsreasonablein2002and2004,butissomewhathighin
2003.Thisisaresultofnotbeingabletodeductthewriteoffofgoodwill.
Netincomefollowedthesamepatternasoperatingprofitandincomebeforetaxes,
exceptin2002.Anetlosswasincurredin2002asaresultofthecumulativeeffect
ofanaccountingchange.Thechangewastorecordimpairmentchargesasaresult
ofimplementingtheFASBruleNo.142.
Dillard'soperatesinthehighlycompetitiveretailenvironmentandneedstoreassess
itsproductlinesinmostdivisions.Thecompanydoesnotappeartobecompeting
well,butseemstohaverecognizedthisin2004andismakingadjustmentsthat
haveimprovedprofitability.

62

1.
(a)

CASE3.2
APPLIEDMATERIALS,INC.

AppliedMaterials,Inc.
CommonSizeIncomeStatement
(Percent)
2004 2003 2002
Netsales
100.0 100.0 100.0
COGS
53.8 64.2 59.4
Grossmargin
46.2 35.8 40.6
Researchanddevelopmentandengineering
12.4 20.5 20.8
Marketingandselling
4.9
7.3
7.6
Generalandadministrative
4.5
6.7
6.4
Restructuring,assetimpairmentsandothercharges
2.1
8.3
1.7
Litigationsettlements,net
0.3

Income/(loss)fromoperations
22.0
(7.0)
4.1
Interestexpense
(0.7) (1.0) (1.0)
Interestincome
1.5
3.3
3.6
Income/(loss)beforetaxes
22.8
(4.7)
6.7
Provisionfor/(benefitfrom)incometaxes
6.0
(1.4)
1.4
Netincome/(loss)
16.8
(3.3)
5.3
(b)
Salesgrowth
Operatingcostgrowth*
*IncludesCostofgoodssold.
(c)
Effectivetaxrate

20032004
79.0%
30.4%
2004
26.1%

20022003
(11.6%)
(1.3%)
2003
29.5%

63

2002
21.0%

2.
Volatilityinthehightechnologyindustryisevidentwhenlookingatthepast
threeyearsofincomestatementinformationforAppliedMaterials.Appliedhada
salesdeclinefrom2002to2003,butoperatingcostsdidnotdecrease
proportionatelyandthecompanyoperatedataloss.However,from2003to2004
salesgrowthincreasedsignificantlywhileoperatingcostsincreasedatlessthanhalf
thesalesgrowthrate.
Thegrossprofitmarginreflectstheextremevolatilityinthehightechnology
industry.From2002to2003thedecreaseingrossprofitcouldbearesultoflower
sellingpricesorhighercostofgoodssold;however,inthisindustry,manyofthe
costsareprobablyfixedsuchasequipmentandbuildingsusedtomakethe
products.Thedeclinewasmorelikelyduetodecreasesinsalesandtheinability
forthecompanytoreduceoverheadcostsproportionately.Theoppositehas
occurredin2004.
Operatingprofitfollowsthesamepatternasgrossprofit,decreasingin2003,but
reboundingsignificantlyin2004.Thepercentagefiguresareskewedin2004due
tothelargeincreasesinthesalesnumbers.Inrawdollars,researchand
developmentandengineering,marketingandselling,andgeneraland
administrativecostshaveincreasedin2004,butthepercentagesonthecommon
sizeincomestatementhavedecreased.In2003,Appliedtriedtomakeadjustments
forthesevereeconomicdownturnbydownsizing,andthecostofthisrestructuring
isthereasonfortheoperatinglossthatyear.Sincethisshouldbeaonetime,
nonrecurringevent,aportionofthechargeshouldbeignoredwhencomparingone
yeartothenext.Anotheronetimeeventoccurredin2004whenAppliedsettled
litigationproceedings.
Netprofitmarginhasfollowedthesametrendasoperatingprofitmarginforthe
samereasons.However,thelossin2003generatedpositivetaxbenefitsfor
Applied,resultinginahighernetprofitmarginrelativetooperatingprofitmargin.
Interestexpensehasbeenstableeachyear;however,interestincomehasdeclined.
Thiscouldbeduetoloweramountsinvestedoradeclineininterestrates,butsince
Appliedspentmoreonrealignmentactivitiesin2003,andrevenueshaddeclined,it
isprobablyaresultofloweramountsinvested.
Appliedappearstohavemadegooddecisionsinrealigningitsoperationsduringthe
economicdownturnandnowthattheindustryandeconomyarebeginningtoturn
around,Appliedisreapingthebenefits.
64

65

Chapter4
4.1

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

I
F
F
I
F
F

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

F
I
I
F
I
F

4.2

4.3(a)
Beginningretained
earnings

Net
income

$3,600

$1,050

(b)

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

O
O
F
CorI
O
O

Dividend =
s
$200

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

I
F
F
O
O
C

Endingretained
earnings
$4,450

LunaEnterprises
StatementofCashFlows
ForYearEndingDecember31,2009
Cashflowfromoperatingactivities
Netincome
Noncashoperatingitems:
Depreciation
Cashprovided(used)bycurrentassetsandliabilities:
Accountsreceivable
Inventory
Accountspayable
Accruedwagespayable
Netcashprovidedbyoperatingactivities
Cashflowsfrominvestingactivities
Purchaseofplantandequipment
Saleoflongterminvestments
Netcashusedforinvestingactivities
Cashflowsfromfinancingactivities
Decreaseinbondspayable
Paymentofdividends
Netcashusedbyfinancingactivities
66

$1,050
100
(550 )
300
300
(100 )
1,100
(600 )
250
(350 )
(300 )
(200 )
(500 )

Increaseincash

250

4.4(a)

NetincomeChangeinretainedearnings=Dividends

FirmA
FirmB

$75,000
$75,000

$70,000
$40,000

=$5,000
=$35,000

(b)
Cashflowfromoperatingactivities
Netincome

FirmA
$ 75,00
0
10,00
0
3,000
(40,0
00
(40,0
00
(20,0
00
($ 12,00
0

Depreciation
Deferredtaxes
Accountsreceivable
Inventory
Accountspayable
Cashprovided(used)byoperations
Cashflowfrominvestingactivities
Purchaseofplant,propertyandequipment
Cashflowfromfinancingactivities
Shorttermdebt

FirmB
$ 75,000
30,000
)

18,000
(5,000 )

10,000

(5,000 )

($ 20,00 )
0
$ 17,00
0
20,00
0
(5,00 )
0
$ 32,00
0

Longtermdebt
Dividendspaid
Netcashflowfromfinancingactivities
Changeincash

$
67

$ 123,00
0
($ 70,000 )

2,000

(10,00 )
0
(35,00 )
0
($ 43,000 )
$ 10,000

(c)
Inflows
Operatingactivities
Shorttermdebt
Longtermdebt
Outflows
Operatingactivities
PurchaseofPP&E
Reductionoflongtermdebt
Dividendspaid
Changeincash

FirmA
$
0
17,000
20,000
37,000
12,000
20,000
0
5,000
37,000

%
0
46
54
100

FirmB
$
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

Bothfirmsreportednetincomeof$75,000,but,inreality,theyhadanentirely
differentoperatingperformance,becauseFirmBhadastrongpositiveoperating
cashflow,andFirmAhadtoborrowtofinanceoperations,thepurchaseofcapital
assets,andthepaymentofdividends.FirmBwasabletoreducedebtwhile
expandingcapitalassetsandpayingdividends.Thisproblemillustratesthe
importanceofcashflowasaperformancemeasure.
4.5

LittleBit,Inc.
StatementofCashFlows
ForYearEndedDecember31,2009

Cashflowfromoperatingactivities
Netincome
Noncashexpensesincludedinnetincome:
Depreciation
Deferredincometaxes
Cashprovidedby(usedfor)currentassetsandliabilities
Accountsreceivable
Inventory
Prepaidexpenses
Accountspayable
Accruedsalariespayable
68

$
5,500
18,000
500
(6,500
(8,500
(4,000
2,000
(16,000

)
)
)
)

Netcashusedbyoperatingactivities

( $
9,000

Cashflowsfrominvestingactivities
Purchaseofplantandequipment
Purchaseoflongterminvestments
Netcashusedbyinvestingactivities

(6,000 )
(1,000 )
( $
)
7,000

Cashflowsfromfinancingactivities
Additionstolongtermdebt
Saleofcommonstock
Netcashprovidedbyfinancingactivities

Increaseincash

17,000
15,000
$
32,000
$
16,000

69

Analysis
Inflows
Longtermdebt
Saleofcommonstock
Total

$
17,000
15,000
32,000

%
53
47
100

Outflows
Operatingactivities
Purchaseofpropertyandequipment
Purchaseoflongterminvestments
Total

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

56
38
6
100

LittleBit,Inc.,failedtogeneratecashfromoperatingactivitiesdueprimarilyto
growthininventories,receivablesandprepaidexpenses,combinedwiththe
paymentofaccruedliabilities.Thefirmmaybeexpandingasevidencedbythe
increaseincapitalassets.
Theexpansionisbeingsupportedprimarilybylongtermdebtandthesaleof
commonstock.ItwouldappearthatLittleBitisusinglongtermdebtnotonlyfor
theacquisitionofplantandequipment,butalsotocoverthenegativecashflow
fromoperations.Thisisgenerallynotgoodtomatchlongtermdebtmaturities
withthefinancingofcurrentassets.
ItisessentialthatLittleBitgeneratecashflowinthefuturetolessentheneedfor
debt,perhapsbycontrollingthegrowthofinventoriesandreceivables.
4.6
(a) Cashprovidedbyoperationsin2008isconsiderablylessthannetincome.
Themajorreasonisthe$288.2millionincreaseinaccountsreceivable.Inventory
alsoincreasedsubstantially($159.4million)butthegrowthininventorywas
comparabletowhatthefirmexperiencedin2007.Additionstoplantand
equipmentwereaboutthesamein2008as2007,sotheincreaseinreceivables
appearsoutoflinewithoverallexpansion.Technomaybelooseningcreditto
customersinordertostimulatesalesandincome(noteincreaseinnetincome
between2007and2008),buttheresultofthereceivablesmanagementisasharp
reductioninoperatingcashflow.Ifthefirmcontinuestobuildreceivablesatthe
samepace,Technowilllikelyexperiencenegativeoperatingcashflowin2009.
70

(b)
Inflows
Operations
Investmentactivities
Shorttermborrowings
Add.tolongtermborrowings
Outflows
Add.toplantandequipment
Investmentactivities
Purchaseoftreasurystock
Dividends
Repaylongtermborrowings

Changeincash

2008
$
%
24,525
8.2
14,408
4.8
125,248
41.8
135,249
45.2
299,430 100.0

2007
$
%
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
34,771
39,267
22,523
250,564
440,361

110,110

49.8
0
24.2
26.0
0
100.0

21.2
7.9
8.9
5.1
56.9
100.0

(213,197)

In2007Technogeneratedmostofitscash(78%)internallythroughoperations.
About20%camefromshorttermborrowings,apparentlytofinanceworking
capital.Astheresultofastrongoperatingcashflowandalargecashaccount
balance($291million)Technowasabletoexpandplantandequipmentwhile
reducingby$250.5millionitslongtermborrowingsandtoaddlongterm
investments.Asharplyreducedcashflowfromoperationsin2008(seediscussion
in"a"above)resultedintheneedforheavylongtermandshorttermborrowingsto
supportgrowthinreceivables,inventory,andplantandequipment.Theapparent
useofsomelongtermborrowingforworkingcapitalneedscouldbeaproblemin
thefuture.Technoalsomorethandoubleditspaymentofdividendsinspiteofthe
decreaseinoperatingcashflow.Given,however,thatTechnoendedtheyearwith
acashbalanceof$188.2million,thefirmdoesnotappeartohaveanyimmediate
liquidityproblems.Theanalystwouldwanttoexplorethecauseofthebuildupin
receivablesin2008.
4.7 Whatfollowsisasamplearticle.Thearticleshouldincludethefollowing
keypoints:1)cashflowfromoperationsisdifferentfromnetincome;2)abrief
explanationofwhythetwomeasurementsdiffer;and3)cashiswhatisneededto
71

stayafloat.Agoodbasisforthearticleistheexampleofthe"NocashCorporation"
inChapter4.
Yourbusinessmaybeonitswaytobankruptcyeventhoughyouareshowinga
healthyprofit.Netincome,thebottomlineoftheincomestatement,isnotthe
samethingascashflowfromoperations.Asanybusinessownerknows,itiscash
thatthefirmneedstopayitsemployees,bankers,andsuppliers.
Netincomeisanaccountingmeasurementthatdoesn'tactuallyshowcashcoming
infromthecompany'sbusinessoperations.Forexample,thecompany'ssalesmay
begrowingduetotheextensionofcredittoanincreasingnumberofcustomers
whoaren'tgoingtopaytheirbills.Salesarecountedinnetincome,butthecash
maynotcomeinatall.Thecompanymaybebuildinginventorythatwill
eventuallyhavetobesoldatalossornotsoldatallthatproblemaffectscash
flowbutisn'tshowingupontheincomestatementyet.Ifsuppliershearaboutall
theseproblems,theymayquitsellinggoodstothecompanyoncredit,sosomeof
thecashoutflowthathasbeeninessencedelayed(foraccountingpurposesin
calculatingnetincome)willhavetobepaidoutimmediately.
Togetthroughthispatch,thecompanymayhavetoborrowtocoverthecash
shortage,whichwillrequirefuturecashfordebtservice.Ifthecompanydoesn't
turnthingsaround,theproblemswillcompound,leadingtopotentialdisaster.
Thekeytoavoidingallofthisistokeepacloseeyeoncashflowfromoperations
aswellasnetincomebecausethatiswhatthebankersandthesuppliersand
investorsaregoingtobewatching.
4.8 Thereisnosolutionpresentedhereasthestudentswillbechoosingavariety
ofcompanies.
4.9 Thenetincomefor1800Contactswasaprofitof$9,864in2001,but
declinedtolossesof$4,004and$1,438for2002and2003.(Allnumbersarein
thousands.)Cashusedorprovidedfromoperatingactivitieswasanegative$6,817
in2001,butincreasedtopositive$9,508and$18,644in2002and2003.Thekey
reasonforthisabnormaltrendisthelargeincreaseininventoryin2001and
subsequentreductionsininventoryin2002and2003.
ReadingtheManagement'sDiscussionandAnalysisandItem1of1800Contacts'
Form10Kexplainsthereasonsforthechangeininventories.PriortoNovember
2003,mostsuppliersofcontactlensesrefusedtoselltodirectmarketers.1800
72

Contactsstockpiledinventoryasaresult,butnolongerneededtodothisafter
Congresspassedlegislationforcingsuppliersofcontactstoworkwithdirect
marketers.
Thenetlossesarearesultofhigherlegalexpensesduetosignificantlobbying
efforts.Thecompanyalsomadeanacquisitionofamanufacturerofcontactlenses
whichincreasedoperatingexpensesandwriteoffsofpurchasedinprocessresearch
anddevelopment.
Itappearsthattheitemscausingtheabnormaltrendwilldisappearinfutureyears.

73

4.10

Intel
StatementofCashFlowsSummaryAnalysis

Inflows:
Operations
Maturitiesandsalesof
availableforsaleinvestments
Increaseinshorttermdebt
Increaseinlongtermdebt
Proceedsfromsalesofshares
TotalInflows
Outflows:
AdditionstoPPE
Acquisitions,netofcash
Purchaseofavailableforsale
investments
Other,investing
Decreaseinshorttermdebt
Repaymentsandretirementof
debt
Repurchaseandretirementof
commonstock
Paymentsofdividends

2004
$
13,119
15,633
24
0
894

%
44

29,670

53
0
0
3
10
0

3,843
53

2003
$
11,515

20,970

40
0
0
5
10
0

15,499

36
0
1
4
10
0

13
0

3,656
61

18
0

4,703
57

29
0

16,618
151
0

57
1
0

11,662
199
152

57
1
1

6,309
330
101

40
2
1

31

137

18

7,516
1,022

26
3
10
0

4,012
524

20
2
10
0

4,014
533

25
3
10
0

TotalOutflows

29,234

Changeincash

436

74

8,488
0
0
967

%
55

2002
$
%
9,129 59

20,403
567

5,634
0
55
681

16,065
(566)

Intelgeneratesmuchcashfromoperations(CFO).CFOislargerthannetincome
inallthreeyears.Thisismainlyduetodepreciationandamortization(noncash
expenses).Accountsreceivable,inventoriesandaccountspayableareincreasing
butnotatalarmingamounts.
Thelowpercentageofcashflowfromoperationsisexplainedbythepurchasesand
ultimatematuritiesofinvestments.Inallthreeyearsatleast95%ofcashhasbeen
generatedfromoperationsormaturitiesofinvestments.Neithershorttermnor
longtermdebthasbeenusedsignificantlytogeneratecash.Somecashhasbeen
generatedfromthesaleofstocktoemployees.
Thelargestuseofcashistopurchaseavailableforsaleinvestments.Intelhas
generatedsomuchcashthroughoutitshistorythatthecompanyhasextracashto
investuntilitisneededforacquisitionsandcapitalexpenditures.
Thecompanycontinuestoinvestyearlyinnewproperty,plantandequipment
whichisanexpectedexpenditureforthistypeoffirm.ItisgoodthatIntelis
spendingdollarsinthisarea.
Anotheruseofcashisfortherepurchaseandretirementofcommonstock.While
thismaybenefitstockholdersintheformofcapitalappreciationoftheirstock,one
mustconsiderwhetherthisisthebestuseofexcesscashforthecompany.Intel
increaseditsrepurchasesofcommonstocksignificantlyin2004,butalsodoubled
theamountofcashdividendspaidtoshareholders.
Intelscashpositionissolid.Thecompanygeneratesgoodcashflowfrom
operationsandasaresultshouldbeabletomeetfuturefinancingneedseasily.

75

4.11(a)

76

77

(b) Kodakgeneratesgoodcashflowfromoperatingactivities(CFO),although
thedollaramounthasdecreasedfrom2002to2004.CFOislargerthannetincome
eachyearduetothenoncashchargesofdepreciationandamortization.
Othersignificantsourcesofcashflowvaryfromyeartoyear.In2002and2003,
longtermdebtwastheotherkeysourceofcash.Proceedsfromlongtermdebt
providedcashinflowsin2004,butnotasmuchasinprioryears.Inadditionthe
firmgeneratedcashfromdiscontinuedoperations.Asmallamountofcashhas
beengeneratedfromsellingshortterminvestments.
Kodakusesbetween45and49%ofcashoutflowstorepayshorttermandlong
termdebteachyear.Cashisalsousedtopurchasenewproperty,plantand
equipmentandacquireothercompanies.Thisisanexpectedandappropriateuseof
thefirm'sfunds.Treasurystockwaspurchasedin2002,butKodakhasnot
continuedrepurchasingstockinlateryears.Thisisprobablyagoodstrategysince
payingdownthelargeamountsofdebtthecompanyhasoutstandingshouldbea
priority.Kodakhasalsoreducedtheamountofdividendspaidtoshareholders
everyyear.ThistooisappropriatebasedonKodak'sriskydebtstructureandthe
currentrestructuringtotransitionintothedigitalarea.Thecompanystillhasa
limitedamountofcashtoinvestinmarketablesecurities.
Inthefuture,Kodakshouldbeabletocontinuetogeneratecashandpayoffdebt
whileexpandingintothedigitalarea.

78

CASE4.1
PETMEDEXPRESS,INC.
1.

PetMedExpress,Inc.
StatementofCashFlowsSummaryAnalysis
FortheYearsEndedMarch31
2004

2003

2002

36

970,301

62

476,024

18

15,000

1 2,016,921

75

64

580,836

0
100.
0

0
1,566,137

741,740

92

744,596

56

555,645

365,000

28

141,214

11

68,443

68,442

247,209

11

0
100.
0

0
1,319,252

0 1,566,833
100.
0 2,369,687

66
100.
0

246,885

328,585

Inflows:
Cashfromoperations
1,105,595
Netproceedsfromthe
saleofpropertyand
equipment
0
Proceedsfromthe
exerciseofstockoptions
andwarrants
1,999,345
Borrowingsfromloan
obligations
0
TotalInflows
3,104,940
Outflows:
Purchasesofproperty
andequipment
Purchasesofintangible
asset
Paymentsonthelineof
credit
Paymentsonloan
obligation
Paymentsoncapital
leaseobligation
Paymentsonmortgage
payable
TotalOutflows
Changeincash

810,183
2,294,757

79

37

0
205,327
100.
0 2,698,272

7
100.
0

23

PetMedExpresshasgeneratedanincreasingdollaramountofcashfrom
operations(CFO)from2002to2004,butCFOhasbeensignificantlysmallerthan
thenetincomethefirmhasproducedeachyear.Twonoteworthyreasonsforthis
aretheconstantlyincreasingAccountsReceivablesandInventoryaccounts.
PetMedExpresshasalsousedlargeamountsofaccountspayabletosupportthe
increaseinaccountsreceivableandinventory.Thefirmdidpayoffaccrued
liabilitiesin2002and2003.Thispatternisgenerallyseenincompaniesunableto
manageitsworkingcapitalwell,orinfirmsthatareneworexpanding.Mostlikely
PetMedExpressfallsintothelattercategoryaspetcarecombinedwithInternet
operationsisanewindustry.Thelargeincreasesinnetincomesupportthistheory.
PetMedExpresshasgeneratedothercashinflowsfromsalesofpropertyand
equipmentandborrowingsin2002,andfromproceedsfromtheexerciseofstock
optionsandwarrantsin2003and2004.Theamountofcashgeneratedfromthe
saleofpropertyandequipmentin2002issurprisingforaneworexpanding
company;however,itispossiblethefirmchosetosellitsfixedassetsinorderto
payoffitsmortgage(seecashoutflows)andisnowusingoperatingleasesinstead.
Thiscouldalsoexplainwhythefirmnolongerhascapitalleaseobligationsafter
2002.
Thefirmhasspentmostofitsexcesscashonpurchasingpropertyandequipment.
In2003and2004,PetMedExpresshasbeenpayingofftheloantakenoutin2002,
withoutborrowingmore.Thisisapositivesignthatthecompanyisdoingwell.
ThetrendisupwardforbothnetincomeandCFO.OncePetMedExpressisableto
decrease,ratherthanincreaseaccountsreceivablesandinventories,CFOshould
growtoalargeramountthanthenetincomeofthefirm.PetMedExpressappears
tobedoingwell.
2. PetMedExpressissuccessfulingeneratingpositiveCFOandhassofarbeen
abletomakepaymentsondebt.Unlessthecompanyhasanunusuallylarge
amountofoperatingleasesandothercommitments,itappearstheywouldbea
goodcreditrisk.
3.

Balancesheetinformationthatwouldbeusefulincludes:
theproportionofshorttermversuslongtermdebt,
detailoftypesofdebtoutstanding(fromnotes),
amountsofdebtdueinthenextfiveyears(fromnotes),and
80

operatingleaseandothercommitmentsthefirmmayhave(from
notes).

81

1.

CASE4.2
CANDELACORPORATION
CandelaCorporation
StatementofCashFlowsSummaryAnalysis
FortheYearsEndedJuly3,2004,June28,2003,andJune29,2002
200
4

Inflows:
Cashfromoperations
Proceedsfromissuanceofcommonstock
Netborrowingsonlineofcredit
Effectofexchangeratechanges
TotalInflows

2003

2002

1,13
2
19
4,70
7
78
0
0
172
3
6,01 100.
1
0

11,65
5

65

4,620
26
0
0
1,552
9
17,82 100.
7
0

394
50
890

Outflows:
Cashusedinoperations
0
0
Purchasesofproperty,plantandequipment 685 100
Repurchasesoftreasurystock
0
0
Principalpaymentsoflongtermdebt
0
0
Netrepaymentsonlineofcredit
0
0
TotalOutflows
100.
685
0
Changeincash

5,32
6

30
4
66
100
1,334
.0

0
1,227
0
3,330
1,114

0 7,071 52
22 1,058
8
0 5,215 38
59
370
2
19
0
0
100.
100
5,671
0 13,714
.0
12,15
6

(12,38
0)

CandelaCorporationhasvolatilecashflowfromoperatingactivities(CFO)
overthethreeyearsfrom2002to2004.Thefirmexperiencedanetlossin2002,
buthassincerecordednetprofitsin2003and2004.CFOwasnegativeandmuch
worsethanthenetlossin2002.In2003,CFOwaspositiveandgreaterthannet
income,butin2004,CFOtookaplunge,thoughstillpositive,wasmuchlessthan
netincome.

70

AccountsreceivablegreweachyearandthishasreducedCFOespeciallyin2002
and2004.Withtheexceptionof2003inventorieshavebeenincreasing,also
causingareductioninCFO.Theincreasesinaccountsreceivableandinventories
couldbeduetoanexpansionorpoormanagementofassets.Thefirmhasreduced
accountspayableallyearsdespitethecurrentassetincreases.In2003,theincome
TaxPayableaccountincreasedcausingCFOtobeover$4millionhigherthanit
otherwisewouldhavebeen,buttheimpactin2004wasareductioninthisaccount
causingCFOtobeless.OthernegativeimpactstoCFOin2004includedincreases
toothercurrentassetaccountsandthetaxeffectsofstockoptionsbeingexercised.
Candelahasgeneratedcashfromtheissuanceofcommonstockallthreeyears;
however,thissourceofcashshouldnotbereliedonforfuturecashinflows.The
firmneedstofocusonincreasingCFO.Otherthanuseofalineofcreditin2002,
thefirmhasnotusedshorttermorlongtermdebt.SinceCandelaoperates
globally,foreignexchangerateeffectshavepositivelyimpactedthecashflowsof
thefirm.
Candela'sonlyinvestmentsarepurchasesofproperty,plantandequipment,butthe
dollaramountofinvestmentdeclinedsignificantlyin2004.Sincethefirm
discontinuedoperations,thiscouldbethereasonforfewercapitalexpenditures.
Noothercashwasusedin2004,butthefirmdidrepurchaseasignificantamountof
treasurystockin2002,andmadepaymentsonlongtermdebtandthelineofcredit
in2003.Itisgoodthefirmhasmadepaymentsondebtwithoutborrowingmore.
Furtherinvestigationisneededtodetermineiftherepurchaseofcommonstockwas
agooduseofthecompany'sfunds.
Candeladoesnotappeartohaveanyliquidityproblems,butcouldworkonbeing
moreefficientincollectingitsaccountsreceivable.Thebuildupofinventoriesin
2004shouldalsobeinvestigatedfurther.
2.
Thestatementofcashflowsisextremelyusefulinmakingcreditdecisions.
Althoughthestatementofcashflowsispreparedfromthebalancesheetand
incomestatement,itpresentsinformationinawaythatrevealshowthefirmis
generatingcashandhowthecashisbeingused,overaperiodoftime.The
volatilityofCFOforCandelacannotbeobservedbylookingatonlytheincome
statementorthebalancesheet.Thereasonsforthisvolatilitycanbedetermined
fairlyquicklybylookingatthestatementofcashflows.
71

72

Chapter5
5.1

Sixitemsshouldbeconsideredwhenassessingtheareaofrevenue:
prematurerevenuerecognition,
useofthegrossversusthenetbasisofrecordingrevenue,
vendorfinancing,
chargestotheallowancefordoubtfulaccounts,
priceversusvolumechanges,and
realversusnominalgrowthofsales.

5.2 Dependingonwhichinventoryvaluationmethodafirmuses,determinesthe
valueofcostofgoodssoldontheincomestatementandendinginventorybalances
onthebalancesheet.Ifthereisinflationordeflationoftheproductsbeingvalued,
thencostofgoodssoldandendinginventoryusingFIFOorLIFOwillbehigheror
lowerdependingonthedirectionofpricechanges.Thisinturnwillimpact
whethernetincomeishigherorlower.
IfafirmusestheLIFOmethodofinventoryvaluationduringinflationarytimes,it
ispossibletorecordpaperprofitsifmoreinventoryissoldthanispurchasedor
manufactured.Understandingtheinventoryvaluationmethodswillallowtheuser
offinancialstatementstounderstandwhatchangesinthesenumbersarerealversus
whichchangeshaveoccurredonlyonpaperasaresultofthechoiceofaparticular
method.
5.3 Whilewritingdownanasset'svalueresultsinlowernetincomeintheperiod
ofthewritedown,relativetothenextaccountingperiod,netincomewillbehigher.
Companiesthatpurposelywritedownassets,orwritedownmorethanisnecessary,
maybetryingtoshowpositiveearningsgrowthinthefollowingaccountingperiod
inhopesofimpressinginvestors.
5.4 Restructuringchargescouldbeeitheranoperatingoranonoperating
expense,dependingonthecircumstances.Iftherestructuringchargeistrulyaone
timeitemthatisnotexpectedtorecur,thenitcouldbeviewedasnonoperating.
Firmswhorecordrestructuringchargesoftenaremorethanlikelyrecordingitems
thatareordinaryoperatingexpensesinthecourseoftheirbusiness.

73

5.5 Purchasingtreasurystockforinvestmentpurposeswouldbeappropriatefor
firmsthatbelievethemarkethasundervaluedtheirstockprice.Somefirmsalso
purchasetheirowncommonstockinordertoreissueitforemployeestock
programs.Thisisappropriateforpreventingthedilutionofthestockpricefor
currentinvestors.Itwouldbeapoordecisiontopurchasetreasurystockforthe
solepurposeoftryingtoboostearningspershare,especiallyifthefirmdoesnot
haveenoughcashtocoverdailyoperatingneedsandlongtermneedssuchas
purchasingproperty,plantandequipmentandrepayingdebt.
5.6 Ratherthanviewingthisasaonetimeevent,analystsshouldconsiderthe
implicationsofsuchacharge.WorldComwasnotanewcompany,andtherefore,
thefirmshouldhavebeenabletostatisticallyestimatebaddebtwithafairamount
ofaccuracy.Theonetimechargeinsuchalargeamountshouldbearedflagthat
eitherthefirm'saccountingdepartmentisnotcompetent,orthatthereisthe
possibilityofmanipulationofthereserveaccount,AllowanceforDoubtful
Accounts.
5.7 Thegrossprofitmargincouldincreaseasaresultofsellingpriceincreasesor
decreasesinthecostsofobtaininginventories.Athirdreasoncouldbeduetohigh
fixedcostsinthefirmwhichdonotincreaseordecreasewithdemand,suchas
depreciationofplantandequipment.Witha20%salesgrowthrate,excess
capacitycouldbeusedwithoutacorrespondingincreaseincostofgoodssold.
Thesewouldallbeplausiblereasonsforthehighergrossprofitmargin.
Ifafirmhadwrittendownasignificantamountofinventoryintheprioryear,the
followingyeartherewouldnotbeacorrespondingwritedownofinventory,and
grossprofitmarginwouldlookhigherrelativetotheprioryear'snumber.This
wouldbeaqualityissuethattheanalystwouldwanttotakeintoconsideration
whenanalyzingafirm'sfinancialstatements.
5.8 Salariesandwagesaregenerallynotconsideredtobediscretionaryexpenses;
however,payinghighersalariesthanisthenormcouldbeconsideredaspartly
discretionary.ItappearsthatCostcoischoosingtopayhighersalariesandoffer
betterbenefitstoitsemployeesthanWalMart.Bydoingthis,Costcoappearstobe
operatingmoreefficientlyandeffectivelythanWalMart.Employeeturnoveris
quiteabitloweratCostco,andsalespersquarefoot,profitsperemployee,and
operatingincomegrowtharebetteratCostco.

74

5.9 Studentswillhaveavarietyofanswerstothisquestion,butanexampleofa
possibleresponsefollows:
Conflictsofinterestcanarisebetweenwhatmanagementwantsinvestorsand
creditorstoseeandtheeconomicrealityoftransactionsevenwhentheaccounting
rulesarefollowed.Forexample,firmsmaylegallyrecordleasesasoperating
leases,wherebyinformationabouttheobligationsarerevealedonlyinthenotes,
insteadofdirectlyonthebalancesheet.Bynegotiatingleaseagreementsthatmeet
thecriteriaforoperatingleasesasprescribedbytheFASB,managementcanmake
suretheobligationisnotshownasaliability,similartoacapitallease.
Thetimingofrevenuesandexpensescanbeplannedsothattherecordingofthe
itemoccursinoneyearasopposedtoanotheryear.Inayearinwhichnetincome
islowerthanexpected,managementcouldchoosetosellassetsinordertoreport
gainsonsale.Whilethereisnothingwrongwithcompletingthesalestransaction
perse,theintentofsellingtheassetwhenitcanmaskanotherwisepooryear
wouldbeconsideredpoorqualityoffinancialreporting.
5.10 Thereisnoresponsepresentedhereasavarietyoffirmscouldbechosen.
5.11 SincetheSEChomepagechangesasupdatesaremade,studentsmayfind
differentitemsavailableeachsemester.
5.12 ThequalityoffinancialreportingforIntelisgood.Intelhasexplaineditems
wellinitsmanagementdiscussionandanalysisandthenotestothefinancial
statements.OnequestionableareathatwasdiscussedinChapter2iswhetherthe
allowancefordoubtfulaccountsmayhavebeenoverestimatedinyearspriorto
2004.Inteldoesuseoffbalancesheetfinancingandhasafewpotentialliabilities,
buttheseitemsarediscussedastheyshouldbe,andgivenIntel'ssolidfinancial
position,thefirmhasnoreasontopurposelytrytohideinformation.
5.13 (a)I. Sales
1.
Prematurerevenuerecognition
AccordingtoNote1,"SignificantAccountingPoliciesandRestatements,"Kodak
recordsrevenuecorrectly.
2.

Grossvs.netbasis
75

ThisitemdoesnotaffectKodak.
3.
Vendorfinancing
InformationonvendorfinancingisgiveninNotes1and12.InNote1,under
"Revenue"itisexplainedthatKodakrecordsrevenuefromcustomerfinancing
arrangements.InNote12,itisrevealedthatKodakhasamaximumguarantee
amountforcustomerfinancingof$128million,with$71millioncurrently
outstanding.
4.
Allowancefordoubtfulaccounts
Thefollowingisananalysisoftherelationshipamongsales,accountsreceivable
andtheallowancefordoubtfulaccountsforKodak.
(inmillions)
Sales
Accountsreceivable,gross
Less:Allowancefordoubtfulaccounts
Accountsreceivable,net

2004
$13,517
2,671
(127)
$2,544

2003
$12,909
2,439
(112)
$2,327

%change
4.7
9.5
13.4

Therelationshipbetweensales,accountsreceivableandtheallowancefordoubtful
accountsisnormal.Asthepercentageofsaleshasincreased,accountsreceivable
andtheallowanceaccounthavealsoincreased.Thepercentageoftheallowance
accountrelativetototalaccountsreceivableseemsreasonableat4.8%and4.6%,
respectively,for2004and2003.Amountsactuallywrittenoffareslightlylessthan
thebaddebtexpensechargedeachyear,exceptin2003,when$70millionwas
writtenoffandonly$45millionwasrecordedasbaddebtexpense.Thiscouldbe
theresultofacorrectionofanoverestimationinprioryears.
5
Pricevs.volumechanges
Salesincreasedalmost4.7%from2003to2004.Theoverallincreasewasaresult
ofacombinationoffactorsaffectingthefoursegmentswithinKodak.TheDigital
&FilmImagingSystemssegmentsalesdecreased1%duetopricingissues.The
Healthsegmentsalesincreased10%duetovolumeandacquisitionincreasesand
theeffectofforeignexchangerates,butalsoincludedsomepricedeclines.
CommercialImagingsalesincreasedduetoexchangeratesasvolumedecreased.
GraphicCommunicationssalesincreased109%duetoacquisitions.
6.

Realvs.nominalgrowth
76

Sales(inmillions)
Asreported(nominal)
Adjusted(real)
UsingbaseperiodCPI(19821984=100)

2004
$13,517
13,517

2003
$12,909
13,152

%change
4.7
2.8

(2004CPI/2003CPI) x 2003sales = Adjustedsales


(184.3/180.9)
x
12,909
=
13,152
Adjustingforinflationindicatesthatsalesincreasedlessthanthenominalincrease
insales.
II.

CostofGoodsSold

7.
Costflowassumptionforinventory
KodakusesLIFOformostU.S.inventoriesandFIFOfortheremainderofits
inventories.LIFOproduceshigherqualityearnings,butFIFOproducesan
inventoryvalueonthebalancesheetclosesttocurrentcost.
8.
BaseLIFOlayerliquidation
LIFOliquidationsin2004and2003reducedcostofgoodssoldand,therefore,
increasedprofitsby$69millionand$45million,respectively.Thepoorwording
inthenotescouldcausethereadertomissthatprofitswereincreasedonpaper
only.
9.
Fulfillmentcosts
ThisitemdoesnotaffectKodak.
10. Lossrecognitiononwritedownofinventories
AccordingtoNote3,Kodakwrotedowninventoriesin2004and2003,of$100
millionand$75million,respectively.Theuserneedstoadjustearningsforfuture
comparisonpurposes.

77

III.

OperatingExpense

11. Discretionaryexpenses
Kodakhasthefollowingdiscretionaryexpenses:
(inmillions)
Advertisingexpense(fromNote1)
Researchanddevelopment

2004
$513
854

2003
$596
776

2002
$630
757

Kodakhasdecreasedadvertisingexpenseseveryyear.Thereisnoquality
explanationprovidedinthemanagementdiscussionandanalysisforthedeclinein
advertisingexceptthatthe$83millionreductionin2004wasintheDigital&Film
ImagingSystemssegment.Ifthereductionwasinthefilmareaonlythisis
probablyagoodplacetocutcosts,butifadvertisingisnotbeingmaintainedor
increasingfordigitalproducts,thiscouldnegativelyimpactfuturesales.
Researchanddevelopment(R&D)increasedeachyear.Accordingtomanagement
theincreaseisaresultofincreasedspendinginthedigitalareaaswellas
acquisitionrelated,whiletraditionalR&Dinfilmhasbeenreduced.TheHealth
andGraphicCommunicationssegmentsaretheonlyareasthatappeartohave
increasedR&Dspending.ManagementonlydiscussesthedecreasesinR&Dinthe
traditionalareafortheDigital&FilmImagingSystemssegment,notanyincreases
relatedtothedigitalproducts.ThenumbersforR&Dcannotbereconciledfrom
thesegmentdiscussiontotheoverallnumbers.Thisispoorqualityoffinancial
reporting.
12. Depreciation
Kodakusesthestraightlinemethodofdepreciationwhichisgenerallyoflower
quality.Inaddition,thefirmuseslivesupto20yearsformachineryand
equipment.Manyfirmsdepreciateequipmentnomorethan8or10years,so20
yearsseemstobeanunusuallylonglife.
13. Assetimpairment
Kodakreportednoassetimpairmentsin2004.
14. "Bigbath"orrestructuringcharges
AccordingtoNote16,Kodakisrestructuringitsbusinesstomoveintothedigital
area.Itappearsthatthefirmiscommittedatleastthrough2006tocontinuethe
78

eliminationofemployeepositionsaswellasbuildingsandequipment.According
toChapter1,Kodakhasbeen"restructuring"since1992.Whileallofthe
eliminationsarediscussedatlength,nowhereisitexplainedhowKodakplanstobe
successfulinthedigitalarea.Thisispoorqualityofreportingoranindicationthat
managementdoesnothaveasolidplanforthefuture.
15. Reserves
Inadditiontotheallowancefordoubtfulaccountsandtherestructuringcharges
discussedpreviously,Kodakhasreservesforwarrantycostsandenvironmental
remediationcostsof$62millionand$153million,respectively,atDecember31,
2004and2003.(SeeNotes11and12.)
16. Inprocessresearchanddevelopment
Acquisitionsin2004and2003resultedina$15millionand$10millionchargefor
inprocessR&D.Thisamounthasnotbeenreportedseparately,butaspartofthe
R&Dexpenseoverall.Thisispoorqualityoffinancialreporting.
17. Pensionaccountinginterestrateassumption
Kodakrecordednetpensionexpenseof$3millionand$98millionforU.S.and
nonU.S.pensionplansin2004.Kodak'sU.S.pensionplansarecurrently
overfundedby$5million,butthenonU.S.pensionplansareunderfundedby$777
million.Kodakhasmaintainedanassumedlongtermrateofreturnonplanassets
of9.0%.Sincetheactualreturnsonplanassetshavebeenhigherthantheexpected
returns,theassumedrateisreasonable.OfconcernistheunderfundednonU.S.
pensionplanscombinedwiththelargeamountsaccruedforotherpostretirement
benefitsof$3,270million.
IV.

NonoperatingRevenueandExpense

18. Gains(losses)fromsaleofassets
Gainsfromsalesofassetswererecordedin2004,2003,and2002,intheamounts
of$15,$13,and$24million,respectively,accordingtoNote14.
19. Interestincome
Kodakdoesnotspecifyamountsforinterestincome.Thecompanyhasanaccount
titled"otherincome(charges)"thatincludesinvestmentincomeandintereston

79

pastdueaccountsreceivableandfinancerevenueonsales.Theamountsinthese
accountsarestablefromyeartoyear.(SeeNote14.)

80

20. Equityincome
Equityincomeisincludedinthe"otherincome(charges)"category.Equitylosses
wererecordedin2002and2003,butequityincomeof$30millionwasrecordedin
2004.
21. Incometaxes
Kodak'seffectivetaxratehasbeenvolatile(benefitsof186%and82%in2004and
2003andarateof15%in2002)duelargelytotheeffectsofforeigntaxratesthat
differfromU.S.taxrates.

Netdeferredtaxassetsareshownforboth2004and2003.Pensionsand
postretirementbenefitshavecausedthelargestamountofdeferredtaxassets.
22. Unusualitems
Kodakdoesnothavethiscategoryonitsincomestatement.
23. Discontinuedoperations
Kodakhasdiscontinuedoperationsallthreeyearsfrom2002to2004andreported
earnings,netoftaxes.Note22andthepresentationofthisinformationontheface
oftheincomestatementareconfusingastheamountscannotbereconciledbetween
thetwo.Thisispoorqualityoffinancialreporting.
24.

Accountingchanges

25. Extraordinaryitems
Kodakdoesnothavetheseitems.
V.

Otherissues

26. Materialchangesinnumberofsharesoutstanding
Thenumberofcommonsharesoutstandingdeclinedfrom2002to2003duetothe
repurchaseof7,354,316sharesoftreasurystockandtheissuanceof2,357,794
sharestoemployees.Theresultofthesetransactionswouldbeanincreasetothe
2002earningspersharenumber.SinceKodakhasalargeamountofdebt,thelarge
purchaseofcommonstockinamountsgreaterthanneededforemployeestock
optionplansisquestionable.

81

27.

Operatingearnings,a.k.a.coreearnings,proformaearningsor
EBITDA
Kodakdoesnotpresentoperatingearningsnumbersotherthanthoserequiredby
GAAP.
QualityofFinancialReportingTheBalanceSheet
Kodakhasincluded"CommitmentsandContingencies"(Note11)onthefaceofits
balancesheet,butalsohasguaranteesthatshouldbeconsideredwhenassessingthe
potentialobligationsofthefirm.TheseitemsarediscussedinNote12.According
toNotes11and12,Kodakhascommitmentsandpotentialobligationstotaling
$2,052millionnotreporteddirectlyonthebalancesheet.Theseitemsareas
follows(inmillions):
Operationalcommitments$859
Qualex$113
Lettersofcredit/suretybonds$227
Operatingleases$515
Leasebacks$40
Guarantees$298
QualityofFinancialReportingTheStatementofCashFlows
Therearenoapparentproblemsofqualityoffinancialreportingrevealedonthe
statementofcashflows.
(b) Avarietyofanswersispossibledependingontheoverallobjectivein
adjustingnetearnings.Thefollowingisoneofmanypossiblesolutions:
(inmillions)
Netearningsasreportedin2004
Adjustments
b.deductbaseLIFOlayerliquidation
c.addbacklossrecognizedonwrite
downofinventories
h.deductgainfromsaleofassets
j.deductequityincome
m.deductgainfromdiscontinued
operations

82

$556
(69 )
100
(15 )
(30 )
(475 )
$67

83

Case51

NortelNetworksCorporation

1.
NortelNetworksCorporationhasariskycapitalstructure.Debt
makesup73%oftotalassetswithoverhalfofthetotaldebtlongterm.The
firmdoesnothaveretainedearnings,butratheranaccumulateddeficitthat
increasedfrom2003to2004.
2.
Nortelhasalargenumberofcommitmentsandguaranteesthatmake
itscapitalstructureevenmorerisky.Manyoftheguaranteesthatare
disclosedcannotbeestimatedinregardtomaximumpotentialliability.
Whilesomeofthedisclosuresrelatetoitemsthathavebeenaccruedonthe
balancesheet,manyitemsareonlyrevealedinthenotes.Alistofthese
itemsfollows:
Note12Guarantees
Itemsa,eandfincludepotentialliabilitiesthathavenotbeenestimated,nor
isthereamaximumpotentialliabilitythatisknown.Theseliabilitiesinclude
retainedliabilitiesrelatedtosalesofbusinessesordiscontinuedoperations
suchastax,environmental,litigationandemploymentmatters.Nortelhas
alsoindemnifiedbanksandcreditorsagainstlossesandcostsrelatedtothe
useofloanproceeds.Indemnificationagreementsalsoexisttocounterparties
incertaininvestmentbankingagreements,theadministrationofcapitaltrust
accounts,employeebenefitplans,indenturesforpublicdebtandassetsale
agreements.
Itemsc,dandeincludemaximumamountsthatcouldbepotentialliabilities,
buttheseamountsarenotincludedonthebalancesheet.Theyareasfollows
(inmillions):
a.
b.
c.

Leaseagreementswithcertainlessors
$48
Guaranteeddebtofcustomers

7
Securitizedreceivablessubjecttorepurchase 266

Note13Commitments
Norteliscommittedtopayforcertainitemsinthefuture,butagainthese
itemsarenotincludeddirectlyonthebalancesheet.Alistoftheseitems
follows(inmillions):
81

a.
b.
c.
d.
e.
f.
g.

Bid,performancerelatedandotherbonds
Venturecapitalfinancing
Purchasecommitments
Operatingleases
Outsourcingcontracts
Specialcharges
Reductionforsubleaseincome

$430
16
1,254
821
463
499
(153)

Thepotentialguaranteesandcommitmentstotalto$3,651million.Adding
thistotheamountofdebtalreadyonthebalancesheetmeansNortelhas
possibleobligationsgreaterthan94%ofthetotalassetsofthefirm.
AccordingtoNortel,$751millionoftheseitemswillprobablyneverhaveto
bepaid,butthereisalwayssomeuncertainty.Manyofthecommitments,
however,areitemsthatwillhavetobepaidinthefuture.
3.
Nortelhasofferedextensivedisclosuresrelatedtoguaranteesand
commitmentssooverallthequalityoffinancialreportingisgood.Havinga
summarytableoutliningitemsthatmustbepaidversusitemsunlikelytobe
paidwouldbeusefultofinancialstatementusers.

82

Case52

FindWhat.com,Inc.

TheChecklistforEarningsQualityincludessixitemstoconsiderunderPart
I,Sales.Thefirstfiveitemsarelookedatusingtheinformationfor
FindWhat.com,Inc.
1.
Prematurerevenuerecognition
Accordingtothedisclosuresonrevenues,FindWhat.comrecordsrevenueat
thecorrectpointofrecognition.Despitethedisclosures,thereissome
concerninthisareaduetothefactthatthefirm'sinternalcontrolsrelatedto
revenuerecognitionwerefoundtobedeficient.Moreinformationaboutthis
deficiencyandthetypesofadjustmentsthatweremadewouldbeuseful
informationtothereaderofthefinancialstatements.Thequalityof
informationpresentedispoor.
2.
Grossvs.netbasis
SomeofFindWhat.com'srevenuesarerecordedgross,whileotherrevenues
arerecordednet.Helpfulinformationthatwouldhaveimprovedthequality
ofthisdisclosurewouldbeabreakdownoftotalrevenuesrecordedgross
versusnet.
3.
Vendorfinancing
FindWhat.comdoesnotindicatethattheyhaveanyvendorfinancing
agreements.
4.
Allowancefordoubtfulaccounts
Thefollowingcalculationsshouldbemadetoanalyzetherelationship
amongsales,accountsreceivableandtheallowancefordoubtfulaccounts:
Allowanceaccountasapercentageofaccountsreceivable(dollarsin
thousands):

2004

Allowancefordoubtfulaccounts
Netreceivables+Allowance

percentageof
Receivables

$3,095
$26,117+$3,095

10.59%

83

2003

$223
$5,051+$223

4.23%

Changefrom
2003to2004
134.8%
453.9%
1287.9%

Sales
TotalAccountsReceivable
Allowancefordoubtfulaccounts

FindWhat.comisanewcompanythathashadmajoracquisitionsin2004
thatincreasedallnumbersbylargeamounts.Thepatternofincreasesamong
thesales,accountsreceivableandallowanceaccountsisnormal.Thefirm
hasestimatedthattheyexpecttohaveamuchgreaterpercentageofbad
debtsinthefutureasevidencedbytheincreaseinthepercentageofthe
allowanceaccountfrom4.23%to10.59%.Thedisclosuresinthisarea
explainthatthelargeincreaseisaresultofthemergerwithEspotting.
Espottinghasmorebillablecustomersand,therefore,thepotentialformore
baddebtsthanthekeycustomersofFindWhat.comwhoprepayforits
services.LookingattheValuationandQualifyingAccountsscheduleit
appearsthatFindWhat.comhasbeenconservativeinitsestimates.Actual
writeoffshavebeenhalfoftheamountchargedasbaddebtexpensein2002
and2003andevenlessthanhalfin2004.Withoutabetterhistoryofthebad
debtexpensefromthecompaniesacquiredin2004,itishardtobecertainif
FindWhat.comhasoverestimatedthisreserveaccount.
Thedisclosuresofferedaregoodinthatthecompanyhasspelledout
calculationsthattheyhaveconsideredsuchastherelationshipofbaddebtto
revenues.Inaddition,a"whatif"scenariohasbeendetailedexplainingthe
impactonnetincomeifthefirmhaseitherunderestimatedoroverestimated
theallowanceaccount.
5.
Pricevs.volumechanges
Thelargeincreaseinrevenuesismainlyaresultofvolumeincreasesdueto
theacquisitionsin2004,butFindWhat.com'soriginalbusinessesalso
experiencedvolumeincreases.

84

Chapter6
6.1
CurrentRatio

725,000
475,000

1.53times

400,000
475,000

0.84times

275,000
1,500,000/365

67days

InventoryTurnover

1,200,000
325,000

3.69times

FixedAssetTurnover

1,500,000
420,000

3.57times

TotalAssetTurnover

1,500,000
1,145,000

1.31times

DebtRatio

875,000
1,145,000

76.4%

200,000
72,000

2.78times

GrossProfitMargin

300,000
1,500,000

20.0%

OperatingProfitMargin

200,000
1,500,000

13.3%

NetProfitMargin

76,800
1,500,000

5.1%

ReturnonTotalAssets

76,800
1,145,000

6.7%

QuickRatio
AverageCollectionPeriod

TimesInterestEarned

85

ReturnonEquity

76,800
28.4%
270,000
Thecurrentpositionisdeteriorating,asmeasuredbythecurrentandquick
ratios,andisbelowtheindustryaverage.Theaveragecollectionperiodhas
increasedandisslightlylongerthantheindustryaverage,indicatingpotential
weaknessincreditand/orcollectionpolicies.Theinventoryturnoverhas
slowedandiswellbelowcompetitors'levels.Eleanor'sComputersis
apparentlyoverstockedwithinventoryduetoinventorymanagement
problemsand/orsluggishsales.
Capitalassetefficiencyisingoodshape,asevidencedbyanimprovingand
aboveaveragefixedassetturnover.Theefficientmanagementoffixedassets
approximatelyoffsetsthepoorinventoryturnover,andthetotalasset
turnoverisonlyslightlyweakerthantheindustry.
Theinventoryhasapparentlybeenfinancedwithdebt,resultinginan
increasingdebtratio,whichiswellaboveindustrystandards.Acombination
oftoomuchdebtandlowprofitisproducingdifficultyincoveringinterest
payments,shownbytimesinterestearned.
Thegrossprofitmarginhasslippedduetolackofcostcontrolsforproducts
sold,theneedtosellproductsatdiscounts,orboth.Theoperatingprofit
margin,however,reflectsgoodcontrolofoperatingexpense.Theoverall
return,asmeasuredbythenetprofitmargin,hasfallenbecauseofthe
combinationofcost/pricingpoliciesandhighinterestcharges.
Thereturnoninvestment,whichhasdeclinedandisbelowtheindustry
average,reflectsdecreasingprofitabilityandtheoverstockingofinventory.
Returnonequityisabovetheindustryaverageandistrendingupward.
Althoughthehighdebtratioimprovesthereturnonequity,italsoincreases
risk.Theincreaseduseoffinancialleveragehasmorethanoffsetthe
decreaseinprofitability:
NetProfit
Margin

TotalAsset
Turnover

Returnon
Investment

5.12

1.31

6.71

Returnon

Financial

Returnon

86

Investment
(Assets/Equity)
6.71

Leverage
x

4.24

Equity
=

28.44

6.2 Luna'scurrentratiohasincreasedandisabovetheindustryaverage,
theaveragecollectionperiodhasshortenedandislessthantheindustry
average,andtheinventoryturnoverratiohasimproved;theratiosindicate
thatLunahasnoobviousproblemswithliquidityorthemanagementof
inventoryandreceivables.Boththetotalassetturnoverandfixedasset
turnoverratioshavedeclined,however,andarebelowtheindustry.
Problemswithassetutilizationareapparentlycausedbythemanagementof
capitalassets.Luna'sexpansionofcapitalassetshasbeenmorerapidthan
salesgrowth,giventhedecliningratio;thefirmmaybeunderutilizingits
plantandequipmentormaynotyetbebenefitingfromassetgrowth.Luna's
debtratioisstableandbelowtheindustry,whileinterestcoverageisabove
industry;thedecliningfixedchargecoverageimpliesthatleasepaymentsfor
Lunaareexcessive.Thedecreasingnetprofitmarginisapparently
attributabletoescalatingoperatingcostsratherthancostofgoodssold,and
theoperatingexpensesaretraceabletocostsassociatedwiththecapitalasset
expansionandleasepayments.Theseproblemshaveadverselyaffectedthe
overallreturns.
6.3
Grossprofitmargin
Operatingprofitmargin
Netprofitmargin
Currentratio
Quickratio

(a)FIFO

(b)LIFO

53
.3
33
.3
19
.9
1.
6
0.
7

25
.8
5.
8
2.
0
1.
1
0.
7

3 %
3 %
3 %
1
7

3 %
3 %
6 %
0
7

(c) TheratioscalculatedusingFIFOgivetheappearancethatRare
Metals,Inc.,isdoingwell,whiletheratioscalculatedusingLIFOgivethe
87

oppositeeffect.Basedonthecostofgoodssold(COGS)andending
inventoryamounts,pricesofthemetalhavebeenincreasing.Thefirstgoods
purchased,whicharethelowerpriceditems,areincludedinCOGSunder
FIFO.UsingLIFO,however,abettermatchismadewithcurrentcostand
revenuesandamorerealisticpictureofprofitabilityisillustrated.The
companywillmostlikelyhavetoreplacegoodssoldatthehigherpricein
thefuture.Thedifferenceinprofitmarginshasresultedfromapaper
profitrecordedundertheFIFOmethod.
EndinginventoryisundervaluedwhenLIFOisusedduringinflation.The
FIFOvaluationisabetterreflectionofthecurrentmarketpriceofRare
Metals,Inc.sinventory.Asaresultthecurrentratioof1.61isamore
accuraterepresentationthan1.10.Thequickratiosareidenticalbecause
inventoryhasbeeneliminatedfromthecalculation,andinventoryistheonly
differenceinthenumbersbeingcompared.
(d) Yes,cashflowfromoperatingactivitieswilldifferduetothe
differenceintaxespaid.Assumingthattheinventorymethodistheonly
causeofdifferencesinamountsontheincomestatement,theamountoftax
expenseisgreaterwhenFIFOratherthanLIFOisused.Althoughtax
expensemaynotbeidenticaltocashpaidfortaxes,ifinthiscaseitis
assumedthattaxableincomeandearningsbeforetaxesarethesame,Rare
Metals,Inc.,wouldhavepaid$289millionmoreintaxesiftheychosethe
FIFOmethodinsteadoftheLIFOmethod.Whileprofitmarginswouldbe
higherusingFIFO,cashflowfromoperationswouldbehigherusingLIFO.
Itisimportanttonotethatitiscash,notprofitorearnings,thatmustbeused
topaythebills!
6.4
(a) CanonismoreliquidthanEastmanKodak(Kodak).Canonscurrent
andquickratiosarebothaboveoneandthecashflowliquidityratioisclose
toone,indicatingthecompanyshouldbeabletopaycurrentliabilitiesas
theycomedue.Kodaksliquidityratiosareallbelowone.Itappearsthat
Kodakmustfindexternalfundingintheshorttermtobeabletopaycurrent
liabilities.Canongeneratedmorethan2.5timesthecashfromoperationsin
2000comparedtoKodak.

88

TotalassetturnoveristhesameforbothfirmswithKodakshowingbetter
inventoryefficiencythanCanon,butCanonismanagingaccountsreceivable
andfixedassetsbetterthanKodak.
KodakishighlyleveragedcomparedtoCanon.Thisisnotsurprisinggiven
thedifferencesseenintheliquidityareabetweenthetwofirms.Thecash
flowadequacyratioisoveroneforCanon,whichmeansthefirmhasno
troublecoveringcapitalexpenditures,debtrepaymentanddividendswith
cashfromoperations.Kodakisonlycovering$0.40oneverydollarofthese
sameitemswithcashgeneratedfromitsoperations.
KodakgenerateshigheroperatingandnetprofitsthanCanon,andtherefore
hashigherreturnonassetsandequityratios.Thereturnonequityratiois
extremelyhighduetothefactthatKodakusesasignificantamountofdebt
(76%)andisgeneratingsufficientreturnstocoverthecostofthedebt.
Canon,whilenotasprofitable,istranslatingitsprofitsintocashmuchbetter
thanKodak.
(b)
StockPrice
EPS
PERatio

Kodak
$39
$4.62

Canon
$34
$1.16

8.4

29.3

ThePEratioindicatesthevaluebeingplacedbythestockmarketona
companysearnings.AhighervalueisbeingplacedonCanoncomparedto
thevalueplacedonKodak.Investorsmaybeplacingahighervalueon
Canonbecausetheyunderstandtheimportanceofcashflowfromoperations
andviewitasabettermeasurethanaccrualbasedprofits.
6.5
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)

Current
D
N
I
D
D
N
I
I

Quick
N
N
I
D
N
N
I
I
89

NetWk.Capital
N
N
I
D
D
N
I
I

Debt
I
N
D
N
I
N
I
D

(i)
(j)
(k)
(l)

N
N
D
I

N
D
D
N

N
N
N
N

D
N
I
D

Theinstructormightwanttodiscusswhyafirmwouldmakeaspecific
transactionattheendoftheperiodtoaffectcertainratios.Forexample,
consideritem(l).Iftheobjectiveistoincreasethecurrentratioanddecrease
thedebtratio,perhapstomeetrequirementsinaloancovenant,thefirm
couldpaycashtoasuppliertoreducepayablesattheendoftheaccounting
period.

90

6.6
(a)

Debt

Equity

DebtRatio*

40+10
90+10

=50%

TimesInterest
Earned*

18
4.8+1.5

=2.86x

OperatingProfit
InterestExpense
Earningsbeforetax
Incometaxexp.(40%)
NetIncome
SharesOutstanding
EarningsPerShare

18,000,000
6,300,000

11,700,000
4,680,000

7,020,000
800,000
$8.78

ReturnonEquity

7,020
50,000

ReturnonAssets
(adjusted)

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

FinancialLeverage
Index

14.04
10.80

40
90+10

=40%

18
4.8

=3.75x

18,000,000
4,800,000

13,200,000
5,280,000

7,920,000
1,000,000
$7.92
=
14.04%

7,920
60,000

=
13.20%

=10.80

7,920+4,800(1
0.4)
100,000

=10.80

=1.3

13.20
10.80

=1.2

*Numbersareinmillions
(b) Useofdebtwouldincreasethedebtratiosfrom44%to50%,while
equityfinancingwouldreducethedebtratioto40%.Interestcoverage
woulddeclinefrom3.1timesto2.86timesifdebtisemployed;timesinterest
earnedwouldincreaseto3.75timeswithstockfinancing.Earningspershare
wouldbehigherwiththedebtfinancing.Thefinancialleverageindexis
greaterthan1,indicatingthesuccessfuluseoffinancialleverageundereither
alternative,butishigherwithdebtfinancing.
TheBoardwouldwanttoconsidereachoftheseratiosandotherfactorsas
well.Theadditionalriskresultingfromaddingdebtwouldlikelyexert
91

downwardpressureonthepricetoearningratioandthuscouldresultina
decreasedshareprice.TheBoardwouldwanttoreviewthereasonableness
oftheprojectionforoperatingprofit,includingthestabilityandpredictability
ofthefirm'searningsstreaminthepast.Otherfactorswouldincludethe
marketabilityofstockrelativetothecurrentandfutureavailabilityofcredit;
interestrateexpectations;theeffectofeachalternativeonthecostofcapital;
andtheamountandtimingofplannedfutureexpansions.
6.7 ShorttermliquidityatAmazon.comisgoodandimprovingfrom2003
to2004.Thecurrentandquickratiosarebothaboveonetoone,asisthe
cashflowliquidityratio.Thefirm'saccountsreceivablecollectionperiod
hasincreasedbytwodaysbutisstillaverylow11days.Daysinventory
heldhasalsoincreasedbysixdaysandisnowat33days.Amazon.comis
takingfourdayslongertopaytheiraccountspayable.Aslongas
Amazon.comispayingitssuppliersinatimelymanner,the79dayspayable
outstandingisallowingthefirmtocollectitscashfromcustomersbeforeit
paysitssuppliers.Thisisgoodcashmanagementandcausesthenegative
cashconversioncycle.
Fixedassetturnoverhasimprovedwhichmeansthelevelofsalesgrowthis
morethananyincreasesinfixedassets.Despitetheincreaseinfixedasset
turnover,totalassetturnoverhasdeclined.Ifthemagnitudeofaccounts
receivableandinventoriesisgreaterthanfixedassets,thedeclineintotal
assetturnovercanbeexplainedbythedeclineinaccountsreceivableand
inventoryturnovers.ItisalsopossiblethatAmazon.comhaslargeamounts
ofcash,investmentsandgoodwillwhichcouldcausethetotalassetturnover
tobelower.
OverallAmazon.comhasgoodliquidityandoperatingefficiency.
6.8 AMChasariskycapitalstructurewithover80%debt,mostofwhich
islongterm.Theinterest(accrualbasedandcashbased)andfixedcharge
coverageratiosarelow,buthaveimprovedfrom2003to2004.Thiswas
probablyaresultoftheincreaseinoperatingprofits,whichmayhave
resultedinanincreaseincashflowfromoperations.Cashflowadequacy
hasdeclined.Sincetheothercashflowratioshaveincreased,capital
expenditures,debtrepaymentsordividendspaidhaveincreased.
TheprofitabilityofAMCisimprovingbutnetprofitmarginisnegative.
92

Grossandoperatingprofitmarginshavebothimprovedduetobettercost
controloranincreaseinprices.Thereasonwhyoperatingprofitsare
positiveandnetprofitsarenegativeisprobablyduetothelargeamountof
debtand,therefore,higherinterestexpense.Theaccrualbasedreturnratios
arenegativeasaresultofthenetlosses,butcashgeneratedfromoperations
mustbeimprovingbasedonthecashflowmarginandthecashreturnon
assets.
AMCneedstoworkonreducingdebtandinterestexpenseinorderto
improveprofitability.Longtermsolvencyatthispointisnotaconcern,but
thecapitalstructureisriskyandmustbewatched.
6.9 Writersofthe2004annualreportwillprobablywanttoemphasize
reboundingin2004fromanabnormalyearin2003.Theywillwanttopoint
outreasonsfortheimprovementin2004,showinghowthecompanyis
buildingforcontinuedsuccess.The"SummaryofAnalysis"sectionatthe
endofChapter5providesanoverviewofthepositiveaspectsofR.E.C.,
Inc.'sperformanceandoutlook.Theannualreportwillfocusonstrengths:
salesgrowth,wellmanagedexpansion,increasedprofit,positivecashflow,
effectivecostcontrols,improvementinreceivablesandinventory
management,overallfavorableoutlookforeconomy,industryand
geographiclocation.Therewillbesomeneedtoexplaintheidentified
problems,suchasthenegativecashflowin2003andhowthefirmhas
recovered,whichisactuallyamajorplus.
6.10 Thereisnosolutionpresentedforthisproblemsincestudentswill
choosedifferentindustries.Havingstudentssharewhattheyhavelearned
fromtheirresearchcanleadtointerestingdiscussions.
6.11 Thereisnosolutionpresentedforthisproblemsincestudentswill
choosedifferentindustries.Havingstudentssharewhattheyhavelearned
fromtheirresearchcanleadtointerestingdiscussions.

93

6.12
(a)and(b)
Shorttermliquidity
Currentratio
Quickratio
Cashflowliquidityratio
Averagecollectionperiod
Daysinventoryheld
Dayspayableoutstanding
Cashconversioncycle
Operatingefficiency
Accountsreceivableturnover
Inventoryturnover
Accountspayableturnover
Fixedassetturnover
Totalassetturnover
Leverage
Debtratio
Longtermdebttototal
capitalization
Debttoequity
Financialleverageindex
Timesinterestearned
Cashinterestcoverage
Fixedchargecoverage
Cashflowadequacy
Profitability
Grossprofitmargin
Operatingprofitmargin
Netprofitmargin
Cashflowmargin
Returnontotalassets
Returnonequity
Cashreturnonassets

2003

3.00
2.68
3.78
32days
67days
49days
50days

3.33
2.96
4.02
36days
71days
47days
60days

51days
74days
40days
85days

11.41
5.52
7.44
2.17
0.71

10.18
5.18
7.86
1.81
0.64

7.2
4.9
9.2
5.9
1.0

19.87%

19.72%

45.3%

1.79%
2.41%
0.25
0.25
1.24
1.24
203times 122times
299times 223times
55times 37times
2.68
2.58
times
times
57.72%
29.61%
21.97%
38.35%
15.61%
19.48%
27.25%

94

56.71%
24.99%
18.72%
38.20%
11.97%
14.91%
24.43%

2002

Ind.
Avg.*

2004

1.8
1.1

0.9
52times 2.8times
147times
19times
1.89times

49.76%
16.37%
11.65%
34.11%

29.0%
2.8%

Marketmeasures
Earningspershare
PEratio
High(4thquarter)
Low(4thquarter)
Dividendpayoutrate
Dividendyield
High(annual)
Low(annual)

2004

2003

2002

$1.17

$0.86

$0.47

21.20
16.82
13.68%

39.67
32.00
9.30%

.47%
.81%

.23%
.53%

Ind.
Avg.

*IndustryaverageisfromTheRiskManagementAssociation,Annual
StatementStudies,20042005;SIC#3674
(c) Asrequested,anevaluationofIntelhasbeencompleted.Thefollowing
reportincludesanevaluationofshorttermliquidity,capitalstructureandlongterm
solvency,operatingefficiencyandprofitability,marketmeasuresandqualityof
financialreportingissues.Strengthsandweaknessesareidentifiedandthe
investmentpotentialandcreditworthinessofthefirmareassessed.

ShorttermLiquidity
Intel'sshorttermliquidityisimpressive.Thecurrentandquickratiosare
bothdecreasingduetocurrentliabilitiesincreasingfasterthancurrentassets.
Thecashflowliquidityratiodeclinedduetotheincreasingcurrentliabilities.
Cashfromoperationsisincreasingeveryyearduetoincreasesinnetincome.
Intelhasasignificantamountofcashandshortterminvestmentsand,
therefore,shouldnothaveproblemspayingdebtasitcomesdue.Infact,
cashandshortterminvestmentsaregreaterthanthetotalliabilitiesofIntel.
Thiscompanyhasnoproblemgeneratingcashfromoperationsasevidenced
bythestatementofcashflows.
Accountsreceivableisstable.Thecollectionperiodhasimprovedbyfour
daysandiswellbelowtheindustryaverage.Oneconcernisthatthree
customersaccountfor43%ofaccountsreceivableandadefaultbyanyone
wouldbesignificanttothecompany.
Daysinventoryheldhasdeclinedandisbelowtheindustryaverage.Itis
noteworthythatIntelhasonly5%oftotalassetstiedupininventories.This
95

isgoodbecauseoftherapidobsolescenceofproductsinthehightechnology
industry.
DayspayableoutstandinghasincreasedindicatingIntelispayingsuppliers
slower;however,Inteltakeslongertopaythanthecompetition.Thecash
conversioncyclehasdecreasedtendays.Theimprovedcollectionperiod
anddaysinventoryisheldcombinedwiththeslowerpaymentofaccounts
payableisthereasonforthedecline.
OveralltheshorttermliquidityofIntelisexcellent.Comparedtothe
industryInteloperateswithin,itsratiosandaccountbalancesarebetterthan
theircompetitors.Intelhashigheramountsofcashandinvestmentsthanthe
competition.
OperatingEfficiency
Asdiscussedundershorttermliquidity,Intelhasimprovedtheturnoverof
accountsreceivableandinventoryandisalsopayingaccountspayable
slower.
ThefixedandtotalassetturnoverratiosforIntelarelowcomparedtothe
competition.Intelinvestsheavilyinfixedassetstoincreasecapacity,while
keepinginventorylevelslow,astrategyoppositeitscompetition.The
increaseinbothturnoverratioshasbeencausedbyanincreaseinsales
withoutacomparableincreaseinassets.
CapitalStructureandLongtermSolvency
Intelhaslittledebt,especiallywhencomparedtoitscompetition.Mostof
thecompany'sdebtisshorttermandalldebtcanbecoveredwiththecurrent
levelsofcashandshortterminvestments.Liabilitiesmakeuplessthan20%
oftotalassets,makingIntel'scapitalstructurelowrisk.
Intelisgeneratingprofitsandalargeamountofcashfromoperations,
allowingthecompanytocoverinterestandleasepaymentseasily.Cashflow
adequacyiswelloverone,meaningIntelgeneratesalotofexcesscasheach
year.ThefinancialleverageindexindicatesIntelisusingdebtsuccessfully
inboth2004and2003.ShouldIntelneedtoborrowinthefuture,thelarge
equitycushionwillallowthemtoobtainfinancingreadily.
Profitability
96

Revenues for Intel have been increasing at a steady rate over the three-year
period from 2002 to 2004. Operating expenses have not increased
proportionately with the revenue increases, resulting in increased profitability
for the company. Revenue increases are mainly a result of increased volume
of sales.
The gross profit margin has increased significantly over the three-year period.
The Management Discussion and Analysis explains why this occurred. Intel
was able to lower costs in the Architecture Business, while at the same time
increasing sales. The Intel Communications Group negatively impacted the
gross profit margin due to the write-down of inventory due to lower
replacement costs as well as higher unit costs for flash memory products.
Operating profit has increased each year, a result of the gross profit
improvements as well as changes in other operating expenses. On a
percentage basis, operating expenses have declined relative to sales as a
result of solid sales growth without a corresponding increase in costs.
Research and development dollars have increased each year, and this is a
good sign since it is important for Intel to continually develop new and
innovative products. Marketing, general and administrative expenses
declined in dollars in 2003, but have increased in 2004. Intel did not reduce
advertising dollars, but rather was able to cut costs in 2003 as a result of
reduced headcount as they refocused on core strategic areas. In 2003 Intel
recorded what appears to be a one-time impairment charge for goodwill
related to the Wireless Communications and Computing Group. This division
has not performed as well as expected.
In all three years Intel incurred losses on its equity securities. These losses
are most likely attributed to a weak economy and stock market over the past
three years. The good news is that the losses were much less in 2004
compared to 2003 and 2002.
Interest income and other, net, increased in 2004, due to higher investment
balances and higher interest rates.
Intel's effective tax rate is relatively low compared to the statutory rate of
35%. The firm appears to be benefiting from tax losses due to divestitures
and export sales benefits.
Net profits are healthy and increasing. If costs are managed well, profits
should continue to trend upward. To continue to be successful, Intel must
97

maintain good control of expenses, while continuing to develop cutting edge


products.

MarketMeasures
Earningspersharehasincreasedassalesandprofitshaverisen.ThePEratio
ishighin2003,buthasdroppedin2004.Themarketplaceisnotplacingas
highavalueonIntel.Thiscouldbeduetotheriskinessofthehigh
technologyindustry,asIntel'sfinancialstatusisexcellent.Thedividend
yieldwouldindicatethatinvestorswillhavetheirgreatestreturninstock
appreciationasopposedtodividends.Intelhaschosentodoubleits
dividendsin2004aswellasrepurchaseasignificantamountofcommon
stock.
QualityofFinancialReporting
Intelhasdisclosedkeyinformationasrequiredintheirannualreportand
Form10K.TheonlyquestionableitemiswhetherIntelinprioryearshad
overstateditsallowancefordoubtfulaccounts,areserveaccountthatcanbe
manipulated.Thisaccountappearsappropriatein2004.Overall,thequality
offinancialreportingisgood.
Strengths
Strongcashflowfromoperations
Solidshorttermliquidity
Lowdebtlevels
Betterreceivablesandinventorymanagement
Increasingprofits
Increasingcashfromoperations
Weaknesses
Relianceonthreecustomers
Riskinessofhightechnologyindustry
Investmentpotential
Intel'sstockpriceshavedroppedduetotheoveralleconomicdownturn.
SincerevenuesandprofitsareincreasingIntel'sstockmaybeagoodvalueat
thistime.
98

Creditworthiness
Intel'ssolidshorttermandlongtermsolvencycombinedwithstrongcash
flowfromoperationsandalowdebtratiomakethiscompanyagoodcredit
risk.

6.13

Eastman Kodak

(EK / NYSE)

Summary of Financial Statement Ratios

2004

Liquidity Ratios:
Current ratio
Quick ratio
Cash flow liquidity

1.13
0.90
0.48

Average collection period


Days inventory held
Days payable outstanding
Net trade cycle
Activity Ratios:
Accounts receivable turnover
Inventory turnover
Payables turnover
Fixed asset turnover
Total asset turnover
Leverage Ratios:
Debt ratio
Long-term debt to total
capitalization
Debt to equity
Times interest earned
Cash interest coverage
Fixed charge coverage
Cash flow adequacy

69
45
34
80

Results for the Years Ending December 31


2003
2002

times
times
times
days
days
days
days

1.04
0.83
0.54
66
46
35
77

times
times
times
days
days
days
days

5.31
8.25
11.00
3.00
0.92

times
times
times
times
times

5.55
8.10
10.50
2.56
0.87

times
times
times
times
times

74.14

78.14

32.70
2.87
-0.52
8.21
0.22
0.84

%
times
times
times
times
times

41.50
3.58
2.05
12.92
1.51
1.15

%
times
times
times
times
times

99

6.75
14.70
4.02
0.97

times
times
times
times

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

29.36
-0.64
4.11
8.48

%
%
%
%

32.34
2.34
1.96
12.14

%
%
%
%

3.77

1.70

14.59
7.78

%
%

7.80
10.56

%
%

0
%
%

$
0.66
38.89
174.24
4.48

36.07
9.31
6.14
17.28

%
%
%
%

$
2.61
13.43
68.97
5.14

0
%
%

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

$
0.28
115.18
178.57
1.55

0
%
%

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

AnalysisofEastmanKodak2004
EastmanKodak(Kodak)iscurrentlyfacingmanychallengesasthecompany
triestomoveoutofitstraditionalareaofbusiness,film,andintothedigital
areaandhightechnologyindustry.Thefirmhasbeenrestructuringsince
1992andisstillintheprocessofeliminatingjobsandfacilities.Therecent
changeinmanagementtoaCEOthathasextensiveexperiencefrom
HewlettPackardmaybepositiveforthefirm.Thecompetitioninthe
technologyindustryisprobablyfargreaterthanKodakhaseverexperienced
inthefilmindustry.Inrecentyearsthefirmhasnothadimpressivefinancial
results.AdiscussionofthefinancialwellbeingofKodakfollows,aswellas
recommendationsforinvestorsandcreditors.
ShorttermLiquidity
Kodak'sshorttermliquidityisstable.Thecurrentandquickratiosseem
adequateandhaveimprovedslightlyfrom2003to2004.Thisisaresultof
100

anincreaseinaccountsreceivable,whileshorttermdebtandthecurrent
portionoflongtermdebthavefallen.Thecashflowliquidityratiois
decreasingslightlyduetothedropincashfromoperations(CFO)whichis
fasterthanthedropinthecurrentliabilities.
Theaveragecollectionperiodhasincreasedthreedaysandisnowafairly
long69days.Thisshouldbemonitored.Inventorydaysheldandthedays
payableoutstandingarestable.Thecashconversioncycleishigherbythree
daysduetothecollectionperiod.Kodakpaysitssuppliersquickerthanthey
collectfromitscustomers.ItwouldbeinKodak'sbestinteresttoreviewthis
areaandtrytominimizethecashconversioncycle,bycollectingreceivables
quickerandperhapspayingsuppliersslower.
ThedecreasingCFOismainlytheresultofdecreasingprofits,soKodak
needstoincreaseprofitsinordertoincreasecashflow.
OperatingEfficiency
Theaccountsreceivable,inventoryandpayablesturnoverswerediscussed
undershorttermliquidity.Fixedandtotalassetturnovershaveincreased,
whichisgood.Thisisaresultofslightlyincreasingsalescombinedwiththe
largerreductioninfixedassetsduetodownsizing.Ofconcerniswhether
Kodakhascuttoomanyemployeesandfacilities.
CapitalStructure
Kodak'sdebtstructureisrisky,butimproving.Thefirmnowhas74%debt
in2004,comparedto78%debtin2003.Longtermdebthasdeclinedthe
most,from41.5%to32.7%.
Timesinterestearnedandfixedchargecoverageareonadownwardtrend
duetothedropinoperatingprofitseachyear.In2004,Kodakgeneratedan
operatingloss.Interestexpensedroppedin2003,butincreasedagainin
2004,despitethedeclineinoveralldebt.Thiswasaresultofincreased
interestratesasthecompanyreplacedcommercialpaperdebtwithSenior
Notes.Cashinterestcoverageisstillhealthy,butdecliningduetothedrop
inCFOasdiscussedearlier.
Cashflowadequacywasaboveonein2003,butbelowonein2004and
2002.Kodakhasmadeafewchangestoimprovethisratiosuchascutting
dividendsandstoppingtherepurchaseprogramforcommonstock.Thefirm
101

muststillfigureouthowtoimproveprofitabilityinordertomakefurther
improvementsinthisratio.
Profitability
Kodakhasgeneratedsalesgrowthatanincreasingrateeachyear,butitisnot
allthatimpressive.WorseisthatKodak'soperatingcostsgrewat15.3%
whensalesonlygrew2.9%from2002to2003.Costswerebettercontrolled
in2004,butnotenoughtocovertheincreasethatoccurredincostofgoods
sold,thereforeleadingtoanoperatingloss.Salesgrowthismainlyaresult
ofacquisitionsandtheeffectofforeignexchangerates.Infact,Kodak's
largestsegment,Digital&FilmImagingSystems,experienceda1%
decreaseinsales.
Grossprofitmarginisdecliningsignificantlyeveryyearandisnowbelow
30%.Thisistheresultofpricedeclinesintraditionalfilmproducts.Kodak
hasnotbeenabletoreplaceitshighmarginfilmproductswithcomparable
margindigitalproducts.Onepositiveareaistheincreaseingrossprofit
marginintheGraphicCommunicationssegment,aresultofacquisitionsin
2004.
Kodakgeneratedanoperatinglossin2004.Operatingprofitmarginin2003
decreasedasaresultofthedeclininggrossprofitmargincombinedwithan
increaseinselling,generalandadministrative(SGA)expensesand
restructuringcosts.In2004,KodakreducedSGAexpenses,butresearchand
development(R&D)andrestructuringcostsincreased.SGAexpenses
increasedslightlyin2003duetoassetimpairmentsandlegalsettlements,but
theseitemsdeclinedin2004.Employeepositionswereeliminatedin2004
andadvertisingwasreduced.AsKodakmovesintothedigitalareaitseems
thatmore,ratherthanless,fundingshouldbeusedtoadvertisenewproducts.
R&Dhasbeenincreasedeachyear,whichisusuallyagoodsignthatafirm
istryingtoinnovate;however,carefulreadingoftheManagement
DiscussionandAnalysis(MDA)revealsthatsomeoftheincreaseisaresult
ofwritingoffpurchasedinprocessR&Dinprioryearscomparedtothe
morerecentyear.Mostcompaniesrecordthisitemasaseparatelineontheir
incomestatements,butKodakhashiddenthisinformation.
RestructuringcostshaveincreasedeachyearasKodaktriestotransition
fromfilmtodigitalproducts.Thecompanyislayingofflargenumbersof
102

employeesandsellingoffplantandequipment.TheinformationKodak
offersinitsMDAregardingrestructuringcostsfocusesmoreonthe
downsizingofthefirmwithoutmuchsaidabouthowtheyintendtomove
successfullyintothedigitalarea.
Netprofitmarginispositiveallyears,despitethe2004operatingloss.The
otherincomein2004isaresultoflegalsettlementsinKodak'sfavor,aone
time,nonrecurringitem.Interestexpensehasdeclinedandthenincreased
overthethreeyearsasinterestratesdeclinedandthenincreased.Thetax
benefitsin2004and2003,andthelow14.9%taxratein2002,arearesultof
earningsinlowertaxedjurisdictionsoutsideoftheUnitedStatescombined
withlossesincurredinhighertaxedjurisdictions.Finally,Kodakhas
benefitedfromaonetimegainfromdiscontinuedoperations.
Kodakhasmanychallengestoovercome.Itsstrategysofar,hasnotbeen
beneficialintermsofprofitability.
MarketMeasures
Duetothedecreasingprofits,earningspersharehasalsodecreased.The
pricetoearningsratiohasskyrocketedasinvestorshavebidupthestock
pricedespitethedroppingprofits.Investorsmaybelievethatthecompany
canturnarounditspoorprofitabilityinthenearfuture.Dividendsare
decreasing.Thepayoutratioismisleadingasaresultofthemuchlower
earningspershare.
QualityofFinancialReporting
ThefollowingexamplesillustratewhyKodak'spresentationisnotalways
clear,andtherefore,ofpoorquality:
(a)ThebaseLIFOlayerliquidationcausedpaperprofits,buttheexplanation
inthenotesdiscussesthereductionincostofgoodssold.
(b)Thefirmhaswrittenoffhugeamountsofinventoryandthiswillimpact
comparabilitybetweenprofitnumbersyeartoyear.
(c)MixinginprocessR&DwiththerecurringamountsofR&Dis
misleading.
(d)BetterexplanationsofthechangesinadvertisingandR&Dbysegment
wouldimprovethequalityoffinancialreporting.
(e)Depreciationofequipmentinhightechnologyfirmsisusuallybasedon
shortlives,yetKodakhasequipmentlivesofupto20years.
103

(f)Taking15yearstorestructureseemsexcessiveandindicativeofalackof
asolidtransitionplan.
(g)Discontinuedoperationsinformationisnotdisclosedwellbetween
earningsandpossiblegainsfromdispositions.ThenumbersinNote22do
notreconcilewiththeincomestatementamounts.
(h)In2002,Kodakrepurchasedmoretreasurystockthanneededfor
employeestockplans.
(i)Amorecomparable2004earningsnumber,adjustedforonetime,
nonrecurringitems,is$67millioncomparedtothereported$556million,an
88%decrease.
Strengths
Stableshorttermliquidity
Fixedassetturnoverincreasing
Longtermdebtdecreasing
Transitionfromfilmtodigitalarea
Newmanagement

Weaknesses
Averagecollectionperiod
increasing
Riskydebtstructure
Poorcoverageratios
DecliningCFO
Decliningprofitmargins
Constantrestructuring
Highlycompetitiveindustry

104

InvestmentPotential
Kodak'sstockpricehasbeenimprovingin2004.Investingnowdependson
whetheronebelievescurrentmanagementcaneffectivelymoveKodakinto
thedigitalareasuccessfully.After12yearsofrestructuringthefirmisstill
struggling,butismakingsomepositivechangestoitsfinancialposition.
Profitabilityispoorandthisiskeytoturningthefirmaround.Increasing
profitabilitywouldleadtoincreasedCFOandthefirmcouldpaydowndebt
toamoreacceptablelevel.InvestinginKodakintheshorttermisnot
recommended.Thereispotentialstockpricegrowthinthelongterm,
however,ifthenewmanagementsucceeds.Thisstockisnotforriskaverse
investors.
Creditworthiness
Kodak'salreadyhighdebtratiocombinedwithitsoffbalancesheet
commitmentsdoesnotmakeitagoodcreditrisk.Kodakneedstoincrease
profitsandCFObeforetakingonmoredebt.

105

CASE6.1
ACTIONPERFORMANCECOMPANIES,INC.
1.

106

107

108

109

110

111

112

113

ShorttermLiquidity
ActionPerformanceCompanies,Inc.'s(Action)current,quickandcashflow
liquidityratiosarealldecreasing.Thelargedeclineinprofitin2004resulted
inanequallylargedeclineincashfromoperations(CFO)andthecash
accountbalancedeclinedover$36millionfrom2003to2004.Accounts
receivableandprepaidroyaltiesalsodeclinedcausingtotalcurrentassetsto
declineover7%.Accountspayableandaccruedexpensesdecreased,butnot
atthesamerateasthecurrentassetaccounts.
Thecashconversioncyclehasincreased16dayseventhoughthecompany
improvedtheaveragecollectionperiod15days.Inventoryisbeingheld19
dayslongerin2004comparedto2003.Aportionoftheinventoryincrease
isattributedtotheFunlineacquisitionandthefactthatFunlineneedshigher
amountsofinventorytoservicethemassmerchantretailers.Dayspayable
outstandingdecreased12daysmeaningthefirmispayingitssuppliers
quicker.Actionneedstofindwaystoreduceinventorylevelsinorderto
improveCFOandthecashconversioncycle.
Despitethedecreaseinsalesandaccountsreceivable,theallowancefor
doubtfulaccountshasincreasedsignificantly.Calculationstoanalyzethese
accountsareasfollows:

2004
2003

Allowancefordoubtfulaccounts
Netreceivables+Allowance

percentageof
Receivables

$9,367
$51,769+$9,367

15.3%

$3,634
$69,890+$3,634

4.9%

Changefrom
2003to2004
(6.8%)
(16.8%)
157.8%

Sales
TotalAccountsReceivable
Allowancefordoubtfulaccounts
114

TheValuationandQualifyingAccountsschedulesupportsalower
percentagethanthe15.3%thatActionisexpectingtobeuncollectible.
Writeoffstodatehavenotbeenaslargeastheamountchargedtobaddebt
expense;however,ActiondoesofferapossibleexplanationinitsForm10K.
OnethirdofthewholesaledistributorsthatActionsellstoarehaving
financialdifficultiesincludingpayingonreceivablesdueAction.
Overalltheshorttermliquidityisadequate,butonadownwardtrend.The
inventorylevelsanddeclinesinCFOshouldbemonitored.
OperatingEfficiency
Thediscussioninthepriorsectionofthecashconversioncycleexplainedthe
reasonsforthechangesintheaccountsreceivable,inventoryandaccounts
payableturnoverratios.Thefixedassetturnoverratiohasdecreasedasa
resultofthedecreaseinsalesin2004combinedwithincreasesinproperty,
plantandequipment.Thedecreasesinboththefixedassetandinventory
turnovershaveresultedinanoveralldecreasetototalassetturnover.The
downwardtrendofsalesisofconcern.
CapitalStructureandLongtermSolvency
ThecapitalstructureofAction,onthesurface,doesnotappearrisky.
Besidesthereductionincurrentliabilitiesdiscussedintheshortterm
liquiditysection,thefirmredeemedconvertiblenotesinfiscalyear2004,
causinglongtermdebttodropsignificantly.Asaresult,infutureyearsless
cashshouldbeneededforrepaymentsofdebt.Deferredincometaxeshave
increasedsignificantlysoitispossiblethatmorecashwillbeneededinthe
futurefortaxpurposes.Thereis,however,moreriskinthiscompany.Items
notincludedonthebalancesheet,butstillrequiringoutlaysofcash,include
royaltyguarantees,personalserviceagreement,purchaseobligations,and
operatingleasepayments.Theseitemstotal$170,992thousand.Addingthis
amounttothetotalliabilitiesonthebalancesheetresultsinfuture
obligationsrepresenting74%oftotalassets.
Thecoverageratios,bothaccrualandcashbased,havealldeclinedduetothe
decreaseinprofitsandCFO.ThisisthekeychallengethatActionfaces
determininghowtoreversethedownwardtrendinsales,profitsandCFO.A
questionablestrategyofActionisthechoicetonotonlypaydividends,butto
increasethemeveryyeardespitethedecreasesinprofitsandCFO.When
115

consideringbothonbalancesheetandoffbalancesheetobligations,Action
hasariskycapitalstructure.

Profitability
TheprofitabilityofActionispoor.Allprofitmarginshavedecreasedfrom
2002to2004.ThesalesdecreasesarearesultofaweakNASCARcollector
marketandlowerordersfromwholesaledistributorsthatareexperiencing
theirownfinancialhardships.TheNASCARcollectiondiecastmarket
sufferedfromproductionproblemsthatnegativelyimpactedsales.The
acquisitionofFunline,however,increasedsalestomassmerchantretailersin
2004,afterthisareasuffereddeclinesin2003asaresultofAction'slargest
customersnotorderinginventoryinthesecondhalfoftheyear.Trackwide
salesarenegativelyimpactedduetoweatherconditionsandweak
economies.
Grossprofitmarginhasdecreasedbyover10%from2002to2004.This
couldbetheresultoflowersellingpricesorhighercostofgoodssold.
Giventheproductionproblemsthefirmhasexperienced,itismoreprobable
thatcostshaveincreasedandareresponsibleforthelowergrossprofit.
Allotheroperatingexpenseshaveincreasedeachyeareventhoughsales
havedeclined.Thisisanegativepatternandonewhichthecompanyneeds
toaddressiftheyhaveanyhopeofimprovingthedecliningoperatingprofit
marginnumbers.
Netprofitmarginhasfollowedthesamepatternasgrossandoperatingprofit
margin.Avarietyofitemshavebothincreasedanddecreasedthebottom
linenumber.Interestexpenseisdecreasingasaresultofthereductionof
longtermdebt.ForeignexchangegainshavebenefitedActioneachyear,
althoughthiscouldchangeinthefuture.Actionhashadapositiveimpact
fromajointventure,buttheeffectivetaxrateisalarge66%duetohigher
foreigntaxes.
Actionmustfindawaytobettercontrolcostofgoodssoldandoperating
expenses.Inaddition,thefirmneedstoreversethedownwardtrendofsales
116

toreversethedownwardtrendofreturnonassets,returnonequityandcash
returnonassets.AllreturnsaredecliningasprofitsandCFOdeclineinthe
firm.
MarketMeasures
Action'sstockpricehasdroppedfromahighin2002of$50.27persharetoa
lowof$8.37persharein2004.Thepricetoearningsratioindicatesthatthe
pricehasnotdroppedcomparablytothedeclineinearningspershare.Itis
possiblethenthatthesharepricemaycontinuetodropmore.Asmentioned
earlier,thedividendpolicyseemsoutoflinegiventhedismalfinancial
performanceofthefirmoverthepastthreeyears.
2. Strengths
Weaknesses
Averagecollectionperiodhasimproved Inventorieshaveincreased
Operatingefficiencyispoor
Cashflowfromoperationsisstill
Decliningsales,profitsand
positive
CFO
Longtermdebthasbeenreduced
Poorcoverageratios
Riskycapitalstructuredueto
manycommitments
3.
Theinvestmentpotentialispoor.Action'sfinancialpositionisheaded
inthewrongdirection.Thecompanyhasincreasinginventoriesassales
decline.Theindustryisuniqueanddependsonthelevelofinterestpeople
haveincarracing.Costsarenotbeingcontrolledwellandthefirmhas
manyoffbalancesheetcommitments.Becauseofthedecreasingsalesand
profits,CFOhasbeennegativelyimpacted.Thestockpricehasnotfallen
comparablytothedeclineinearningspershare,soitcouldcontinuetodrop.
Investmentisnotrecommendedatthistime.
Thecreditworthinessofthefirmisalsopoor.AlthoughCFOisstilla
positivenumber,ifsales,profits,and,therefore,CFO,continuetodecline,
thefirmwillhaveeverdecreasingamountsofcash.Whilethedebtonthe
balancesheetisreasonable,thefirmhastoomanyoffbalancesheet
commitmentsand,therefore,hasariskydebtstructure.Itisnot
recommendedthatmoreloansbegiventothiscompany.

117

CASE6.2
TASERINTERNATIONAL,INC.
1.

118

119

120

121

122

123

124

125

ShorttermLiquidity
TaserInternational,Inc.(Taser)hasexcellentshorttermliquidity.Theamountson
thecommonsizebalancesheetareskewedasaresultofthelargeincreaseinassets
from2003to2004.Forexample,cashandshortterminvestmentshavemorethan
doubled,butinpercentagetermstheamountdroppedfrom50.5%to29.2%.The
increaseincashandshortterminvestmentsisaresultofbothcashfromoperations
(CFO)andproceedsfromtheexerciseofstockoptionsandwarrants.Exceptfor
theIncomeTaxReceivableaccount,allothercurrentassetaccountshaveincreased
indollars.Thecurrentassetdeferredincometaxeshasincreasedasignificant
amount.Currentliabilitiesalsoincreasedindollaramounts,butdeclinedin
percentageterms;however,currentliabilitiesroseslightlyfastercomparedto
currentassets.Thisresultedinasmalldeclineinthecurrentandquickratios,but
thesetworatiosarequitehigh.Thecashflowliquidityratioisalsoveryhighandit
hasincreasedasaresultoftheincreaseinCFO.
Theaveragecollectionperiodhasdecreasedby35daysfrom2003to2004.Thisis
anexcellentimprovementespeciallywhenconsideringthatsalesincreased177%.
Accountsreceivableintotalincreasedonly58%andtheallowancefordoubtful
accountsincreased300%.Oneconcernisthattwodistributorsaccountfor37%of
theaccountsreceivablebalance.Thedefaultbyoneofthesedistributorscould
negativelyimpactthecompany.
Daysinventoryheldhasdecreasedby10days,butisstillrelativelyhighat112
days.Thiscouldbeexplainedbythelargedemandforthecompany'sproductsas
evidencedbythegrowthrateofsales.
Dayspayableoutstandinghasincreasedfrom134to144days.Whilethishelps
improvethecashconversioncycle,takingthislongtopaysuppliersmaynot
alwaysbeagoodthing.Taserneedstomakesuretheyarepayingitsbillsontime
soasnottoloseanycriticalsuppliers.Thecombinationofimprovingtheturnover
ofaccountsreceivableandinventoryandtakinglongertopaysuppliershasresulted
inagoodcashconversioncycleof14days.
OperatingEfficiency
Theoperatingefficiencyofaccountsreceivable,inventoryandaccountspayable
wasdiscussedintheshorttermliquiditysection.Fixedassetturnoverandtotal
assetturnoverhavedeclinedasaresultoflargeincreasesinlongtermassetsata
fasterratethantheincreaseinsales.Property,plantandequipmentishigherasa
resultoftheconstructionofanewbuildingandpurchaseoffurnitureandcomputer
126

equipment.Whilethishascausedthedropinfixedassetturnover,overtimethis
ratioshouldimproveifTasercontinuestoincreasesales.Totalassetturnoverhas
beenimpactedbyfixedassetturnoverandalsothelargeincreasesindeferred
incometaxesandshorttermandlongterminvestments.
CapitalStructureandLongtermSolvency
Taserdoesnothaveariskycapitalstructure.Thefirmhaspaidoffalllongterm
debtanditappearsthatthenewbuildingwillreplaceleaseobligations.Thedebt
ratioisbelow9%andiscomprisedmainlyofaccountspayable,accruedliabilities,
anddeferredrevenueordinaryoperatingaccounts.Coverageratiosareexcellent
andcashflowadequacyisaboveoneinboth2003and2004.
Profitability
Aspreviouslymentioned,Taserhadaphenomenalsalesincreasein2004of177%.
Commonsizeincomestatementamountsareskewedasaresult.Grossprofit
marginhasincreasedby5.2%.Thisisduetoincreasedsellingprices,lowercosts
oralargeamountoffixedcosts.Withoutthemanagementdiscussionandanalysis,
itisdifficulttoguesswhichitemaboveistheactualreason.
Operatingexpensesasapercentageofsaleshavealsodecreased,resultingina
14.1%increaseinoperatingprofit.Therearemostlikelyfixedcostsinthe
operatingexpensesthathavenotincreasedinproportiontosales.Itisgoodthat
Taserhaschosentoincreaseadvertising,trainingandeducation,andresearchand
developmentexpensestofurtherpromoteitsproducts.
Netprofitmarginsarealsoincreasing,butnotasmuchasoperatingprofitdueto
theprovisionforincometaxes.Sincethefirmwasprofitable,theydidincurtax
expense,butitisatexpectedtaxratesof38.9%and39.5%in2004and2003,
respectively.Beneficialtothenetprofitmarginhasbeentheincreaseininterest
income,aresultofthelargeincreasesinshorttermandlongterminvestments,
combinedwiththedecreaseininterestexpense,asthefirmhasreduceddebt.
Cashflowmarginhasincreasedalmost27%asaresultoftheincreaseinCFO.All
oftheabovementionedincreasestoprofitandcashhaveresultedinhealthyreturn
amountsrelativetoassetsandequity.Despitetheexcellentcashandprofitability
picture,thereareconcernsthattheinvestorandcreditorwouldhave.Thefirmhas
comeunderincreasingscrutinyrelatedtothesafetyofitsproducts.Manylawsuits
havebeenfiled,andifTaserisunabletosuccessfullydefenditself,demandforits
productscoulddropasfastasithasrisen.InthiscaseCFOandprofitscouldbe
127

negativelyimpacted.Investorsandcreditorsmayalsobeconcernedaboutthe
errorsintheaccountingareathatresultedintherestatementandtheerroronthe
statementofcashflowswhichindicatespoorqualityoffinancialreporting.
MarketMeasures
Inboth2003and2004,themarkethasplacedahighvalueonthecompany.Thisis
notunexpectedgiventheexcellentoverallfinancialpositionofthefirm.
2.

3.

ReasonsforinvestmentinTasercommonstock
Excellentshorttermandlongtermliquidity
Capitalstructureisnotrisky
CFOandprofitsarepositiveandincreasing

ReasonsagainstinvestmentinTasercommonstock
Stockpriceisalreadyhighrelativetoearningspershare
Riskofhavinghighinventorylevels
Riskfromlawsuits
Restatementandaccountingerrors

ReasonsforloaningTaseradditionalfunds
Nocurrentlongtermdebt
Debtratioisbelow9%
Shorttermandlongtermliquidityareexcellent
CFOandprofitsarepositiveandincreasing

ReasonsagainstloaningTaseradditionalfunds
Dayspayableoutstandingishigh
UnsuccessfuldefenseoflawsuitscouldnegativelyimpactCFO
Restatementandaccountingerrors

128

Appendix6A
6A.1
Table6A1ContributionbySegmenttoRevenue(Percentages)
2004
2003
71.6
Digital&FilmImagingSystems
67.96
4
18.8
Health
19.87
3
CommercialImaging
5.94
6.13
GraphicCommunications
5.36
2.68
AllOther(notareportablesegment)
.87
.72
100.0
100.
TotalRevenues
0
00
Table6A2ContributionbySegmenttoOperatingProfit(Loss)
(Percentages)
2004
2003
45.5
Digital&FilmImagingSystems
70.73
6
52.1
Health
53.05
4
11.9
CommercialImaging
15.49
4
(17.0
GraphicCommunications
7 ) (1.21 )
(22.2
AllOther(notareportablesegment)
0 ) (8.43 )
100.0
100.
TotalOperatingProfit(Loss)
0
00

2002
71.7
4
18.1
2
6.30
3.20
.64
100.
00

2002
58.6
8
32.8
0
8.98
1.60
(2.0
6 )
100.
00

Table6A3Earnings(Loss)BeforeIncomeTaxes/NetSales(Percentages)
2004
2003
2002
Digital&FilmImagingSystems
6.31
4.50
8.56
19.5
18.9
Health
16.20
8
5
CommercialImaging
15.82
13.7
14.9
129

GraphicCommunications

(19.34 )
(154.2
4 )

AllOther(notareportablesegment)

8
(3.18 )
(82.8
0 )

2
5.22
(33.
75 )

Table6A4CapitalExpendituresbySegment(Percentages)
2004
2003
75.8
Digital&FilmImagingSystems
66.74
6
16.3
Health
16.30
0
CommercialImaging
4.57
4.83
GraphicCommunications
6.30
1.81
AllOther(notareportablesegment)
6.09
1.20
100.0
100.
TotalCapitalExpenditures
0
00

2002
71.4
5
14.1
9
8.06
5.60
.70
100.
00

Table6A5ReturnonInvestmentbySegment(Percentages)
2004
2003
Digital&FilmImagingSystems
6.98
4.68
Health
16.43
18.32
CommercialImaging
21.45
16.62
GraphicCommunications
(11.70 ) (1.84 )
(189.5
(1100
AllOther(notareportablesegment)
8 )
.0 )

2002
8.76
21.43
17.23
3.47
(41.5
4 )

Table6A6RankingofSegmentsin2004(Percentages)
%of Contributio
Operating
Total
nto
Profit
Segment
Operating
Margin
Assets
Profit
Digital&FilmImaging
64.71
70.73
6.31
Health
20.61
53.05
16.20
GraphicCommunications
9.32
(17.07 )
(19.34 )
CommercialImaging
4.61
15.49
15.82
AllOther(notareportable
.75
(22.20 ) (154.24 )
130

Returnon
Invest
ment
6.98
16.43
(11.70 )
21.45
(189.58 )

segment)
AnalysisofSegments
Referringfirsttothegeographicinformationprovided,themajorityofKodak's
salesareoutsidetheUnitedStates.Salesareincreasingslightlyoverseas,relative
toU.S.sales.
TheDigital&FilmImagingSystems(D&FIS)andHealthsegmentsarethetwo
largestrevenueproducersforKodak.D&FIShascontributedlesstorevenueeach
year,whileHealthhascontributedmore.TheCommercialImagingcontributionto
revenuehasdeclinedoverthethreeyearperiod.GraphicCommunicationshas
generatedmorerevenueinthepastthreeyears.
Asonewouldexpect,in2004theD&FISandHealthsegmentscontributedthe
mosttooperatingprofit.CommercialImagingalsocontributedpositivelyto
operatingprofit,butGraphicsCommunicationsgeneratedoperatinglosses.Health
andCommercialImaginghavecontributedmoretooperatingprofitinboth2004
and2003,whileD&FIScontributedlessin2003comparedto2002and2004.No
clearpatternexistsfortheoperatingprofitmarginsinthreeofthefoursegments.
HealthhasthehighestoperatingprofitmarginwithCommercialImagingclose
behind.D&FISgeneratesapositiveoperatingprofitmarginwhileGraphic
Communicationsdoesnot.Operatingprofitmarginshavedeclinedin2003and
increasedin2004inD&FISandCommercialImaging.Health'soperatingprofit
marginincreasedin2003anddeclinedin2004.GraphicCommunicationshasa
decreasingoperatingprofitmarginfrom2002to2004.
Thetrendsinthecapitalexpendituresareexpected.Over50%ofcapital
expenditureseachyearareusedintheD&FISsegment,butin2004,theamount
droppedcomparedtoprioryears.ThisisalsoexpectedsinceKodak'sfilmareais
becomingobsolete.Healthreceivesthesecondlargestamountoffundingfor
capitalexpenditures.GraphicCommunicationsisreceivingmorefundingin2004
comparedto2003,whilelessisspenteachyearintheCommercialImaging
segment.
InterestinglythereturnoninvestmentisthebestandincreasingforCommercial
Imaging.Healthhasagoodreturnoninvestmentbutitisdecreasingeachyearas
thesegmentacquiresmoreassets.D&FIS'sreturnoninvestmenthasdeclinedin
2003andincreasedin2004.GraphicCommunicationsisgeneratingnegative
returnoninvestmentin2004and2003.Basedonthemanagement'sdiscussionand
131

analysisoperatingexpenseswerehighin2004asaresultofsignificantacquisition
activityinthisarea.Kodaknowneedstofocusonachievingprofitabilityinthis
segment.TheHealthsegment'sreturnoninvestmentshouldbemonitoredaswell
inordertostopthedownwardtrend.Finally,theD&FISsegmentisinastateof
transitionfromfilmtodigitalproductsandisnotdoingaswellasitdid
traditionally.KodakwillneedtoputforththeappropriatefundingforR&Dand
advertising,whilemaintainingcostcontroltomoveforwardsuccessfullyinthis
segment.

132

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