Gap, Inc. Financial Analysis

Introduction and Overview

Financial Statements Included in the Annual Report

Consolidated Statements of Cash Flow

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Major Competitors of the GAP, Inc. American Eagle Outfitters, Inc. , J. Crew Group, Inc. , and the TJX Companies, Inc. can be shown as the major competitors for the GAP, Inc. Based on the data given in annual reports of the companies, gross margin % for GAP, Inc. is 36%, while American Eagle Outfitters has 36%, J. Grew Group, Inc. as 40%, and TJX has 32% gross margin. Stock price on November 2, 2012 is $35. 11 for the GAP, Inc. , while it is $21. 05 for American Eagle Outfitters, Inc. , $43. 55 for J. Crew Group, Inc. , and $41. 52 for the TJX Companies, Inc. Debt-to-equity ratio is the total debt divided by total shareholder’s equity and this ratio is a measure of company solvency and its ability to meet its short- and long term obligations. For the major competitors of the GAP, Inc. this ratio calculated as below: Auditing Firm of the GAP, Inc.

Deloitte & Touche LLP have audited the accompanying consolidated balance sheets of the GAP, Inc. and the other financial statements which are the consolidated statements of income, stockholder’s equity, and cash flows for three years in the period ended in January 28, 2012. They have also consulted the Company’s internal control over financial reporting as of January 28, 2012. Deloitte & Touche LLP indicated that consolidated financial statements, which are given in the annual report, present fairly the financial position of The GAP, Inc. nd subsidiaries as of January 28, 2012 in conformity with accounting principles generally accepted in the United States of America. Also, in their opinion, the company maintained effective internal control over financial reporting as of 28 January, 2012 based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Financial Accounting Analysis

The Inventory Method

The company used the weighted-average method while reviewing inventory to compile the financial statements.

When using the weighted average method, the cost of goods available for sale is divided by the number of units available for sale, which yields the weighted-average cost per unit and to estimate ending inventory cost number of units in the ending inventory is multiplied by the weighted average cost per unit.

The Depreciation Method and Estimated Useful Lives of the Depreciable Assets Over the estimated useful lives of the related assets, the straight line method is used while computing depreciation to compile financial statements. The estimated useful life of depreciable assets is shown as below: 3.

Goodwill and Intangible Assets The company reviews not only intangible assets for impairment, but also the carrying amount of goodwill annually. The goodwill and other indefinite-lived intangible assets, including trade name, are recorded in other long-term assets in the consolidated balance sheet of company as shown in Note 3: 4.

The class of Stocks and Number of Shares As you can see in the consolidated balance sheet, the company has common stock with authorized 2. 3 billion shares; issued 1. 106 billion shares for all periods presented; outstanding 485 million and 588 million shares for periods presented.

The company is authorized to issue 60 million shares of Class B common stock, which is convertible into shares of common stock on a share-for-share basis and no Class B shares have been issued as of January 28, 2012. The Company is also authorized to issue 30 million shares of one or more series of preferred stock, which has a par value of $0. 05 per share and no preferred share has been issued as of January 28, 2012. 5. Treasury Stock and Number of Shares Treasury Stock held by the company has 621 and 518 shares for the periods presented in the consolidated balance sheet as January 28, 2012 and January 29, 2011. . Dividends paid by the Company The company declared and paid dividends during the period reviewed as shown in the consolidated statements of income and it is $0. 45 in fiscal year 2011, $0. 40 in fiscal year 2010, and $0. 34 in fiscal year 2009 per share. The price per share of the common stock The price per share of the common stock as of the most recent fiscal year-end date, which is January 28, 2012, is $18. 69. On the other hand, the price per share on November 3, 2012, which is the day we can see the close price before the report date, is $35. 11.

Generated Cash

The company generated $1. 363 billion net cash by operating activities during fiscal year 2011. The amount of generated cash generated during fiscal year 2011 decreased $381 million comparing the amount generated during fiscal year 2010. Also, net cash provided by operating activities during fiscal year 2010 decreased $184 million compared with fiscal year 2009. The cash outflows for investing activities of the company are primarily for capital expenditures and purchases of investments, whereas cash inflows are primarily provided from maturities of short-term investments.

The amount of net cash used for investing activities is $454 million during the fiscal year 2011, $429 million during the fiscal year 2010 and $537 million during the fiscal year 2009, while maturities of short-term investments are $150 million, $600 million, and $125 million in fiscal year 2011, 2010 and 2009. The cash outflows from financial activities are primarily repurchases of the company’s common stock and dividend payments, while cash inflows are primarily proceeds from the issuance of long-term debt.

Proceeds from issuance of long-term debt are $1. 646 billion for fiscal year 2011 and net cash used for financing activities is $602 million. 9. Ratio Analysis for the Company The current ratio is the one of the measures of company equity and it indicates the relationship between current assets and current liabilities. For the company, current ratio is calculated as below: The return on sales ratio measures the company’s profitability and it indicates the relationship between net income and sales. For the company, return on sales ratio is shown below:

The debt-to-equity ratio is a measure of the company’s solvency and it measures the relative proportions of financing from debt and financing from shareholders. It is calculated for the company as seen below: The return on investment ratio shows the return generated per dollar of total investment and it is calculated for the company as seen below: The return on owner’s equity ratio measures the return generated per dollar of owner’s equity and for the company the return on owner’s equity ratio is: The gross margin ratio measures the gross profit of the company’s products and for the company it is calculated as shown below:

The inventory turnover measures the speed at which company sells its inventory. This measure is important to ensure that inventory delivered customers in a timely manner so that cash can be received by the company. Net profit margin measures also company’s profitability and it is mostly used for internal comparison. It is also an indicator of a company's pricing strategies and how well it controls costs. Profit margin for the company is: The asset turnover ratio calculates the total revenue for every dollar of assets a company owns and it is calculated for the company as seen below:

The quick ratio is measure of a company’s ability to meet its current obligations like the current ratio and it is more reliable measurement of liquidity because it considers only assets that are quickly converted to cash as quick assets. The quick ratio for the company is: The price-to-earnings (P/E) ratio of a share is the market price of the share divided by the annual earnings per share. a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. Based on the price per share on January 28, 2012, the price-to-earnings ratio for the GAP, Inc. s: 10. 11.

Segments reported by the company The GAP, Inc. dentified its operating segments based on the way to manage and evaluate the business activities and based on this way the company has two reportable segments: Stores and direct. The stores reportable segment has results of the retail stores for Gap, Old Navy, and Banana Republic which are brands of the GAP, Inc. while the direct reportable segment includes the results for the brands of the company, both domestic and international.

Managerial Accounting Analysis

Return on Investment for Stores and Direct Segments As it is mentioned before, return on investment is calculated as net income divided by average total assets company has.

While calculating return on investment each segment for the company, which are stores and direct, we need net income for these different segments and also average total assets as given financial information by reportable segments in the annual report. The operating income, depreciation and amortization expenses, purchases of property and equipment for each segment, and the effective tax rate, which is given as 39. 2% for fiscal year 2011, are used to calculate the net income for each segment. The return on investment, which is net income divided by segment assets, for the stores reportable segment is 0. 37, while it is 0. 22 for direct reportable segment. It means that the company earned $3. 7 for every $100 investment for the reportable stores segment and $22 for every $100 investment for the direct reportable segment. Calculations for the return on investment ratio are shown in the table below: 2. Residual Income Residual income (RI) is a managerial accounting measurement used to assess and compare the relative success of business units. The basic formula for calculating residual income is to multiply operating assets by the minimum required rate of return, and then subtract this value from operating income.

For the stores and direct reportable segments, the residual income is: Assuming that 70% of the expenses are fixed: a. Contribution Margin Contribution margin is the total sales less total variable costs at a given level of activity. For the GAP, Inc. total sales amount is $14. 549 billion during the fiscal year 2011 as seen in the consolidated statements of income, while total variable cost is $2. 782 billion, which is 30% of cost of goods sold and occupancy expenses. Based on this data, contribution margin in fiscal year 2011 is:

Contribution Margin Ratio

The contribution margin ratio is the contribution margin per unit divided by selling price per unit or contribution margin divided by total sales. The contribution margin ratio of the company is 0. 8088 or 80. 88% in fiscal year 2011, as you can see the calculation below: Break-even in Sales Dollars The break-even point in dollars can be calculated by using contribution margin ratio approach. The basic formula with this approach is fixed cost divided by contribution margin ratio for the break-even in sales dollars. The fixed cost for the company is $6. 92 billion ($9,275 * 70%) and the break-even point in dollars: : .

Supplemental Material - Investment Decision for the Company

There are different criteria to assess the overall performance of companies. We have discussed various perspectives to make a comprehensive evaluation for the GAP, Inc. in the previous parts of the report. While discussing nature of the investment decision, the data given before is used to explain the performance of the company for investors. Investors invest money in company’s stock expecting a return in their investment in the form of dividends or appreciation in the price of stock.

From this perspective, we should evaluate the price of stock for the company and the dividends paid. As it is mentioned before, the price per share of the common stock was $18. 69 on January 28, 2012, while it is $35. 11 on November 2, 2012. The price to equity ratio is 22, assuming that the earnings per share will be the same for November 2, 2012 within fiscal year 2011, while it was only 12 on January 28, 2012. Comparing the previous data, it is possible to say that investors can expect higher earnings growth in the future, but it would not be useful for investors to use only this ratio as a basis of investment.

Major competitors should also be assessed from the industry analysis perspective to decide to invest company. To compare the company performance with the major competitors, we calculated gross margin ratio and debt-to-equity ratio before. These measurements are very important to assess the situation of the company in industry. Although J. Crew Group, Inc. is basically higher gross margin relatively to its competitors, the GAP, Inc. has also high gross margin which is the same with another American Eagle Outfitters, Inc. and higher than TJX Companies, Inc. The GAP, Inc. ’s debt-to-equity ratio is 1. 69, while it is 0. 38 for AEO, 2. 4 for JCG and 1. 83 for TJX. It means that the GAP, Inc. had $1. 69 of debt for every $1. 00 of shareholder’s equity. From this perspective, American Eagle Outfitters has lower debt for every $1. 00 of shareholders’ equity, while other competitors have more debt relatively to the GAP, Inc. We can say that debt-to-equity ratio for our company is acceptable among the companies in industry. For the evaluation of the companies based on financial statements, the analysts usually use a combination of three methods of analysis which are horizontal analysis, vertical analysis and ratio analysis as we made in the previous parts of the report.

Horizontal analysis examines the changes in one financial statement item over time, while vertical analysis shows each item on a financial statement as a percentage of one particular item on the statement. Investors use the vertical analysis to evaluate the composition of the company’s financial position and earnings. As we can see in the vertical analysis, the company’s percentage of net income for fiscal year 2011 is 5. 73 while it is 8. 21 for fiscal year 2010. Investors should take this into account and compare these values with the competitors’ values to see that the situation of industry between these years.

On the other hand, we can see that cash as a percentage of total assets for fiscal year 2011 is 25. 40 while it is 22. 09 for fiscal year 2010. This gives us some insight into the cash management system of the company. From the horizontal analysis perspective, the GAP, Inc. had a 30. 81 change negatively in net income, while it had 20. 76 percent increase in cash and a 5. 05 increase in total assets. We can see that decreasing amount of income is the result of mostly increasing cost of goods sold and occupancy expenses. So, investors should take this into account and compare it with the company’s another competitors in the industry.

Finally, ratio analysis is used to judge the company’s efficiency in using its current assets and liabilities. It is really important to see whether company is profitable or liquid for investors to decide invest on the company. Based on the current and quick ratio, we can say that company’s liquidity is enough to pay its liabilities. We measured company’s profitability by using gross margin, return on sales, return on assets, asset turnover and returns on owner’s equity and profit margin and see that company is profitable to invest and since it has almost 12% return on investment which shows us it makes sense to invest on the GAP, Inc.

Investment decision is quite difficult for investors since they should asses the company from many different perspectives, we can say that the GAP, Inc. is one of the leading companies in the industry and it has a good return on investment. The changes between fiscal year 2011 and fiscal year 2010 should be taken into account by comparing with competitors and previous fiscal years. In general investors could see that the price per share of the common stock has increasing value for the company and it is profitable to invest. So, I would invest in this company, since I believe that it has a good return for investors.

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