ACC 326 Week 5 Analysis of Financial Statements Example

Sales Up, Returns Down: Horizontal, Vertical, Ratio and DuPont Analysis of Two Years at a Composite Regional Sporting Goods Retailer

[Student Name]

University of Phoenix

ACC/326: Managerial Accounting

Week 5 Assignment

[Instructor Name]

[Date]

The retailer and all figures are composites written for a model paper; analytical methods and research findings come from the sources listed.

A composite sporting goods retailer operates 38 stores across four states, selling footwear, apparel, team equipment and outdoor gear. It opened four new stores last year, financed partly with a new term loan. Its owners are pleased that sales grew 7%, but return on equity fell, and the company's bank has asked for an explanation before renewing a credit line. Growth in sales is only good news if the money tied up to produce it earns a return. This paper analyzes the retailer's two most recent years to explain what happened.

Horizontal Analysis

Sales rose from $196.0 million to $210.0 million, an increase of 7.1%. Cost of goods sold rose faster, 8.8%, from $127.4 million to $138.6 million, so gross profit grew only 4.1%, to $71.4 million. Operating expenses rose 7.1%, to $58.8 million, in line with sales, as new stores added rent and staff. Operating income fell 8.0%, from $13.7 million to $12.6 million. Interest expense rose from $1.6 million to $2.1 million because of the new loan, and net income fell 13.2%, from $9.1 million to $7.9 million.

Vertical Analysis

As a share of sales, gross margin fell from 35.0% to 34.0%. Management's notes attribute this to heavier markdowns on outdoor gear after a warm winter. Operating margin fell from 7.0% to 6.0% and net margin from 4.6% to 3.8%. On the balance sheet, inventory rose from 40.4% of total assets to 43.0%.

Liquidity

Current assets of $64.0 million against current liabilities of $36.0 million give a current ratio of 1.78, almost unchanged from 1.77. But the quick ratio, which excludes inventory, fell from 0.35 to 0.26, because cash declined from $8.1 million to $6.2 million while inventory rose from $43.6 million to $52.4 million. For a retailer, a low quick ratio is normal, but the decline means the company depends more on selling its stock, and on its credit line, to pay suppliers.

Efficiency

Inventory turnover, cost of goods sold divided by average inventory of $48.0 million, was 2.9 times, or about 126 days of stock on hand, down from 3.1 times the year before. Inventory grew 20% while sales grew 7%. Some growth was needed to stock new stores, but store count rose about 12%, so inventory outpaced even that. Asset turnover, sales divided by average total assets of $115.0 million, was 1.83, down from 1.88.

Solvency

Total liabilities rose from $55.0 million to $66.0 million, and the ratio of liabilities to equity rose from 1.04 to 1.18. Operating income now covers interest 6.0 times, down from 8.6 times. These levels remain comfortable, and Beaver (1966) found that ratios predictive of failure, especially cash flow to debt, deteriorate well before distress, not at levels like these. The trend, however, is in the wrong direction.

Profitability and DuPont Analysis

Return on average equity fell from about 17.7% to 14.5%. The DuPont breakdown shows why. Net margin fell from 4.64% to 3.76%. Asset turnover fell from 1.88 to 1.83. The equity multiplier, average assets divided by average equity, rose from 2.02 to 2.11. Multiplying the three parts gives 14.5% for the current year.

Most of the decline came from margin. The equity multiplier actually rose and partly offset the fall, which means the company borrowed more but earned less on each dollar of sales. Soliman (2008) found that the DuPont components carry information investors use beyond total return, and Fairfield and Yohn (2001) showed that changes in asset turnover help forecast future profitability. The retailer's falling turnover is therefore a warning, not just a description of last year.

Cash Flow

The statement of cash flows confirms the pattern. Cash from operations fell from $14.2 million to $9.6 million, even though net income fell by only $1.2 million, because $8.8 million more was tied up in inventory. Capital spending on the four new stores was $11.5 million, so the company spent more on stores than its operations produced and made up the gap with the new $6.0 million term loan and a draw on its cash balance. Free cash flow, operating cash flow less capital spending, turned negative, at about minus $1.9 million, after being positive the year before. A retailer can run negative free cash flow during an expansion, but only for a limited time, and the bank will want to know when the new stores are expected to become cash positive.

Comparing the Store Groups

Management's segment note shows that the 34 established stores increased comparable sales 3.2%, a reasonable result in a year with a warm winter, while the four new stores produced $9.8 million in their partial first year. Sales per square foot at the new stores were about 70% of the chain average, which is typical of a first year but means their inventory is turning much more slowly. Part of the drop in turnover will therefore reverse as those stores mature, and part reflects outdoor gear that simply did not sell.

Questions for Management

The analysis raises specific questions. How much of the inventory increase is seasonal gear that will require further markdowns? Are the four new stores on track to reach the sales per square foot of the older stores? What is the plan to bring inventory days back toward 115? Will the company slow expansion until margins recover? The bank will want answers before renewing the line.

Limits of the Analysis

Ratios depend on accounting choices. The retailer uses FIFO, which, with rising prices, reports higher inventory and profit than LIFO would. One-time costs of opening stores are included in operating expenses and may not recur. Two years is a short period, and industry benchmarks would strengthen the comparison. Weygandt et al. (2021) caution that ratios should be read alongside the notes and management's discussion, not in place of them.

Conclusion

The retailer's sales grew, but markdowns lowered margins, inventory grew much faster than sales and new debt raised the equity multiplier. Return on equity fell mainly because the company earned less on each dollar of sales and needed more assets to produce each dollar. The company is not in financial difficulty, but it should reduce inventory and prove that its new stores can earn their keep before expanding further.

References

Beaver, W. H. (1966). Financial ratios as predictors of failure. Journal of Accounting Research, 4, 71-111. https://doi.org/10.2307/2490171

Fairfield, P. M., & Yohn, T. L. (2001). Using asset turnover and profit margin to forecast changes in profitability. Review of Accounting Studies, 6(4), 371-385. https://doi.org/10.1023/A:1012430513430

Soliman, M. T. (2008). The use of DuPont analysis by market participants. The Accounting Review, 83(3), 823-853. https://doi.org/10.2308/accr.2008.83.3.823

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2021). Accounting principles (14th ed.). Wiley.