Financing Activities Analysis of The Gap, Inc. and Nordstrom, Inc. Financial Statement Analysis April 24, 2013 Introduction The Gap, Inc. and Nordstrom, Inc. are retail companies with similar aspirations, yet different business strategies. Both strive to be top competitors in the retail industry and have generated and maintained a steady customer demand for their products and services. Their journeys to competitiveness in this industry have been based on very different strategies, however. This report is an analysis of the companies’ financing activities in relation to management reporting versus user decisions regarding risk.
Analysis of each company’s long-term debt obligations and shareholder’s equity provides a deeper understanding of financial position, and the question of whether the information given by preparers is quality information for users can be answered. Backgrounds and Strategies Gap, Inc. was founded in 1969 by Doris Fisher and her husband Don and operates as an apparel retail company with product lines for men, women, children and babies under the Gap, Old Navy, Banana Republic, Piperlime, Athleta and Intermix brands.
The Gap’s newest mission is to “be the world’s favorite for American style” (Gap 10-K, 2013). It operates via two segments, Stores and Direct, and has franchise agreements in Australia, Asia, Latin America, Eastern Europe, Africa and the Middle East. It also sells third party designs and brands through Piperlime, Intermix and certain Gap stores. The company currently has around 3,100 stores and 300 franchised stores in 90 countries, and seems to be continuing its strategic intent to increase its global reach (Yahoo! Finance, 2013). Nordstrom, Inc. s a much older company, founded in 1901 as a retail shoe business in Seattle and later incorporated in 1946. Nordstrom has over the years become one of the “leading fashion specialty retailers based in the US” (Nordstrom 10-K, 2013). Nordstrom operates through two segments, Retail and Credit, with the Retail segment offering selections of private label and brand named apparel, cosmetics, shoes and accessories for men, women and children. It operates 242 department stores in 31 States, and competes directly with Macys, Bloomingdales, Dillard’s, Saks Fifth Ave and Neiman Marcus.
Nordstrom operates its Credit Segment through a federal savings bank called Nordstrom fsb that supplies two Nordstrom VISA credit cards, a private label credit card and a debit card that all feature a loyalty program for shoppers (Yahoo! Finance, 2013). While The Gap is focused on a global strategy, Nordstrom appears to be focused on growing its segments in the US only. Exhibit 1 shows key statistics for both companies. The Gap is a much larger company with greater reach than Nordstrom. The Gap appears to have higher margin and turnover ratios with lower leverage than Nordstrom.
Nordstrom, however, has experienced sharper growth in the last year with a return on equity that is similar to The Gap’s. Overall, they have very different capital structures and revenue streams that generate similar returns on equity. Leverage Initial analysis of the financial statements shows Nordstrom to be leveraged more significantly than The Gap. Leverage is a measure of risk, which can magnify both gains and losses, and the higher a firm is leveraged, the more debt it is using to finance business operations.
Exhibit 2 shows a comparison of the companies’ long-term debt to equity ratios (leverage) before and after assumptive modifications. Interestingly, after taking into account off-balance sheet financing activities like operating leases, which according to GAAP rules do not need to be included on the balance sheet, and considering the implications of accumulated other comprehensive income (AOCI) and treasury stock activities, it appears that The Gap becomes the slightly more leveraged firm. Both companies also appear to be significantly more leveraged in reality compared to what management has depicted in financial statements.
Analysis of Long Term Debt and Shareholder’s Equity Both companies operate a majority of their stores and facilities through operating leases, with Nordstrom carrying some small capital leases as well. Exhibit 3 shows each company’s annual lease payment schedules with payment amounts per year with present value (PV) amounts for determining an overall modification to long-term debt (LTD) for each company. 2012 LTD for each company was taken from balance sheets and is assumed to consist of only term loans.
Both companies have other long-term liabilities, but the details of those obligations are not as clearly defined for either company as straight term loans, therefore they are omitted from this analysis to better compare the companies. The interest rates used to determine the PV of lease payments were the most current term loan interest rates given in the 10-Ks for each company. The Gap appears to have significant lease obligations and the PV of those payments for the next several years added a large amount of off-balance sheet debt to their LTD.
Nordstrom’s lease obligations added to its LTD as well. The effect of adding operating lease obligations to LTD made The Gap’s debt increase dramatically to almost $2 billion more than Nordstrom’s LTD. Analysis and modification of both LTD and shareholder’s equity is needed for a clear identification of leverage. Exhibit 4 shows the major contributing factors to each company’s shareholder’s equity: common stock, additional paid-in capital, retained earnings, treasury stock, dividends and additional other comprehensive income (AOCI).
Identifying the nature of each of these factors as either cash or noncash providers of equity gives an estimation of the quality of earnings. Noncash transactions are unrealized and therefore can be assumed to be earnings of lesser quality and omitted from shareholder’s equity balances. Exhibit 4 shows both companies’ balances in each of these accounts and which accounts had the greatest impact on the change in shareholder’s equity over the past year. The major contributing factors to retained earnings for both companies were net income, cash dividends and treasury stock purchases made in cash, so these accounts were determined to be cash.
AOCI on the other hand consisted of gains and losses in derivative financial instruments and foreign currency translations for The Gap, and post-retirement obligations for Nordstrom; all noncash and therefore omitted from the balances on shareholder’s equity. The Gap’s AOCI balance was a positive number indicating a gain, so this amount was subtracted from the original shareholder’s equity, while Nordstrom’s AOCI balance was a loss so this was added back into equity. Company Comparisons and Conclusion Referring back to Exhibit 2, the overall modifications to LTD and hareholder’s equity for both companies give very different pictures of leverage. The Gap at first glance appeared to have a much smaller risk factor than Nordstrom, but after taking into account its very large operating lease obligations and AOCI, it’s actually slightly more leveraged overall than Nordstrom. It would seem that The Gap is not utilizing its debt to its full potential to generate shareholder wealth when compared to Nordstrom because Nordstrom experienced a greater increase in revenues over the last year with less leverage.
The Gap has significantly more operations around the world than Nordstrom however; so one could argue that for the amount of debt and the revenue potential they do have they are less risky than Nordstrom. The quality of information given in financial statements has different implications for different parties. On the preparer’s side, GAAP rules govern where, what and how financial information is disclosed and this can significantly alter how financing activities of a company are portrayed.
In these specific cases, it has shown to alter the measure of leverage enough so that these companies appear to be significantly less leveraged than they actually are. This is not to say that the preparers of these documents are intentionally manipulative. Accounting rules under GAAP allow for operating lease agreements to not be disclosed within the balance sheet and for the noncash items in AOCI to be included into shareholder’s equity. It becomes the user’s responsibility to dig into the notes of the financial statements to glean a better picture.
Both companies adhere to GAAP accounting principles and policies and disclose their policies clearly in their financial statements; therefore this analysis does not condemn either company. References GPS Profile | Gap, Inc. (The) Common Stock Stock – Yahoo! Finance. (2013, March). Retrieved April 2013, from http://finance. yahoo. com/q/pr? s=GPS+Profile JWN Profile | Nordstrom, Inc. Common Stock Stock – Yahoo! Finance. (2013, March). Retrieved April 2013, from http://finance. yahoo. com/q/pr? s=JWN+Profile