Friday, June 3, 2016

Accounting - Limited Brands, Inc Case Solution

Limited Brands, Inc.

Using the 2010 (year end Jan 2011) 10k for Limited answer the following questions.  Be sure to provide well written answers that are clearly supported.

1.                  What is the major reconciling item between NI and CFO?

2010 Depreciation and amortization = $394. This accounts for 82% of the difference between NI ($805) and CFO ($1,284).  Depreciation is still more than 50% of the difference for 2009 and 2008.  This non-cash add back is a common reconciling item on the indirect cash flow statement and is often a primary explanation for the difference between NI and CFO.

2.                  Calculate NI as a percentage of CFO – does it look stable over the 3 years?
(Millions)
2010
2009
2008
Net income
$805
$448
$216
Net cash provided by operating activities
$1,284
$1,174
$954
NI as % of CFO
62.7%
38.2%
22.6%

In comparison to 2010, NI as a percentage of CFO was relatively low in 2008 & 2009. The decrease in inventory for 2009 and the goodwill impairment in 2008 both skew this ratio downward.   Readers of financial statements concerned about flexibility in accounting – monitor the relation of NI and CFO for purposes of alerting to possible excess accounting flexibility being applied.  The assumption is that it is hard to create fake CFO.

3.                  From the balance sheet – calculate and show the changes in assets and liabilities appearing in the CFO section – do your numbers match the CFS?
(Millions except per share amounts)






ASSETS

 2010

2009 
Expected CFO adjustment
Actual
Difference
Accounts receivable
$232
$219
$-13
  $-11
   $-2
Inventories
$1,032
$1,037
$5
     $9
   $-4






LIABILITIES





Accounts Payable   Accrued Expenses   
$545
$765
$488
$693
$57
$72





Other CA
$163
160
$-3


  Total of above 3 items


$126
  $112
$14






Income Taxes Payable
$194
$141
$53
    $73
 $-20

Other Assets
Other LTL
$206
$761
$164
$731
$-42
$30


Total


$-12
     $51
$-63

There is a separate DIT reconciling item for deferred taxes (see top of CFO section) – one would combine DIT assets and liabilities on the balance sheet. (We will come back to tax accounting in a few weeks)
The CFS reconciling items reflect operating activities.  Balance sheet changes may occur for reasons other than operating activities, therefore the amounts may differ.  A frequent cause of differences is acquisition or disposition of businesses, which is reflected in the investing portion of the cash flow statement. In 2010, Limited Brands divested their remaining 25% ownership interest in Limited Stores.
4.                  Why are gains and losses reconciling items in CFO?

Gains and losses are usually a result of the difference between the cash received/paid and the Net Book Value (NBV) of the assets/liabilities acquired/settled.  The gain or loss is included in net income but has no operating cash consequence. The cash effects of the transactions will be shown in the investing sectionTherefore, we need to remove the effect of the gain or loss (as a reconciling item) when we start with net income and we are calculating CFO.

5.                  The primary investing activity appears to consistently be capital expenditures (CAPEX).  To what should we compare these numbers to evaluate their reasonableness?  Does the change in Sales or Net Income suggest a need for CAPEX?

Capital Expenditures should have two effects – 1) update the current Fixed Assets and replenish their productivity and 2) add more Fixed Assets which lead to increased sales – in the case of the Limited – more retail outlets.

As a first reasonableness check we can compare depreciation and CAPEX, as depreciation may be a crude measure of the aging of fixed assets, hence requiring updating or replacement.


2010
2009
2008
Depreciation & Amortization(CFS)
394
393
377
CAPEX (CFS)
274
202
479

Note 8 tells us that the Intangible amortization was $7 million, so most of the depreciation and amortization figure above relates to depreciation.  Clearly, in ‘08 CAPEX is larger than depreciation by a significant amount.  The ’09 and ‘10 figures are considerably smaller.  CAPEX is often lumpy – large investments occur infrequently.  This may explain the 2008 difference.

We should also look at the CAPEX/Sales ratio to evaluate the effect of CAPEX:

2010
2009
2008
Net sales
9,613
8,632
9,043
CAPEX
274
202
479
  - as % of Sales
2.9%
2.3%
5.3%

CAPEX as a percentage of Sales has declined dramatically over this time period. This might signal two things: 1) Limited is delaying updating stores in response to the recession and 2) prior Fixed Asset investments are now more productive in creating sales (in the case of new stores, one might expect a lag, the investment occurs, sales increase subsequently).

6.                  The financing activity was markedly different in 2010.  Discuss and explain why this might be the case.

The Limited began 2010 with a large balance of cash of $1.8 billion. Given that the company is in a mature stage and has minimal investing activities, this cash balance was used to make a huge dividend payout to shareholders, as well as a repurchase of common stock (which also results in a return of cash to shareholders). This large distribution resulted in a reduction in retained earnings since the cash dividend of $1,488 million exceeded 2010’s net income amount of $805 million. Notice also, that while the company made a large repayment of debt, it issued an additional amount of new debt in both 2009 and 2010 (albeit lesser than the amount of repayment so it is not entirely refinancing). These combined actions significantly increased the leverage of the firm.  Leverage can have a beneficial effect on return to shareholders (Return on Equity).

7.                  Given the CFO and Investing amounts – are you comfortable with the financing activity?  Explain.

Limited generated a steady amount of cash each year, and CFO greatly exceeds CFI as the company is relatively mature.  Regular dividends (prior to 2010) appear to require approximately $200 million.  Limited had sufficient free cash flow to repay the new debt they took out in 2009 and still have $1.1 billion in cash on hand after their significant distribution to investors. If results stay similar as they are in 2010, they should generate sufficient cash to repay their debt obligations.

8.                  Would you expect Limited to increase their dividend or continue to buy back common stock in the future?  Explain.

Dividends are an ongoing commitment, and investors react negatively to companies that cut their dividend.  Accordingly, companies are hesitant to increase a dividend unless they are confident that they will have the cash to pay a higher amount forever in the future.  In 2010 (per Footnote 19), Limited issued two special dividends of $1 per share in March and $3 per share in November. They also increased their regular quarterly dividend payout from $0.15 per share to $0.20 per share.  If management expects Limited’s excess free cash flows to persist, one might expect another dividend increase in the future.  Alternatively, they may prefer more stock buybacks or special dividends rather than committing to higher ongoing dividends.


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