Income Statement

1、hbs case study 2: costco wholesale corporation financial statement analysis (a) lee hathaway mms 185: managerial finance professor veraldi september 27, 2007 it is important for stockholders to continuously re-evaluate their investments. although some investors do this more frequently and thoroughly

2、 than others, the majority of shareholders do so at least once each year. therefore, torres desire to update her analysis in order to determine whether costco was still operating efficiently makes perfect sense. after thorough examination, my analysis proves that costco remains one of the industrys

3、leading competitors and there seems to be no reason for torres to sell her shares as long as she wishes to retain holdings of a retail wholesale club in her portfolio. the common-size financial statements evaluating the period 1997-2001 (exhibit 9) reveal valuable information regarding costco. torre

4、s noticed that there were two revenue lines: net sale of goods and membership fees. she decided to use net sales of goods as the point of comparison and express other line items, including membership fees, as a percentage of net sales in order to allow for a clearer reflection of gross and operating

5、 margins. this format enabled her to analyze the profit and asset structures of costco over time. to begin, margarita torres common-size financial statements for costco demonstrate a rise in membership fees and other sources of revenue from 1.82% in 1997 to 1.93% in 2001. this is supported by costco

6、s trend to increase membership fees over time and also gain new members. for example fees cost $25 in 1986 and rose as high as $45 in 2002. but why were customers willing to pay a fee to shop at costco when they could go to discount stores for free? costco created value for the customer by only purc

7、hasing a handful of skus from its vendors, by selling goods at such a low per unit cost due to bulk packaging, by expanding its selection of name-brand products, by adding ancillary services, and by refusing to mark up products more than 14% over the distributors price. also, because of its target m

8、arket composed of wealthier clientele of small business owners and middle class shoppers, small increases in membership fees didnt seem to be heavily resisted. this may have been very different if margarita was analyzing membership fee increases at sams club who traditionally cater to a lower income

9、 customer. thus, the more savings costco passed on to its customers, the more it was able to increase its membership fee and the more members it attracted. moving onto operating expenses, merchandise costs experienced a slight decrease from 89.9% of net sales in 1997 to 89.63% in 2001. this signifie

10、s costcos ongoing attempt to provide customers with the lowest per unit cost possible and demonstrates the increase in purchasing power obtained through expansion. another interesting trend under the operating expenses section relates to the rise in sg&a (selling, general and administrative expenses

11、) from 8.74% of net sales in 1997 to 9.17% in 2001. examination of this figure as a percentage of sales gives some idea of managements efficiency of cash flow expenditure, showing that it is optimally keep under tight watch. the increase in this figure is most likely attributed to an increase in gen

12、eral and administrative expenses including salaries of non-sales personnel, rent, heat and lights due to store expansion rather than due to poor management. exhibit 4 demonstrates how costco grew from 274 stores in 1997 to 365 stores in 2001, an increase of 91 stores. in general, total operating exp

13、enses experienced a decrease from 2001 to 1997 due to costcos culture of cost-cutting. examples of cost-minimization methods include running stores in “no-frills” warehouses which reduced capital expenditures, loading goods with forklifts to minimize human labor, and utilizing cross-docking to reduc

14、e transportation costs and speed up inventory turnover. the next important piece of information regarding the profitable development of costco from 1997 to 2001 pertains to the increase in the firms operating income or ebit, the amount which remains after subtracting from sales all operating costs,

15、including depreciation and amortization, but before subtracting taxes and interest. as a percentage of net sales, costcos operating income rose from 2.70% in 1997 to 2.91% in 2001. this is a positive factor, meaning that the firm became more efficient. another interesting trend which demonstrates gr

16、owth is the rise in interest income and other expenses from 0.07% of sales in 1997 to 0.13% in 2001 on the income sheet. typically, this value fluctuates each year with the amount of cash a company keeps on hand. costcos increase suggests that the company either increased its amount of short-term de

17、posit investments held, switched its funds to money market funds, savings accounts, or cds with higher yielding interest rates, or their existing funds experienced a growth in interest rates. moving onto the income statement portion of the common-size financial statements, an increase in cash and eq

18、uivalents (3.20% of total assets in 1997 to 5.97% in 2001) and receivables (2.69% of total assets in 1997 to 3.22% in 2001) coupled with a decrease in inventory signify costcos improving efficiency over this five year period. it is important to mention two points. first, the decrease in inventory as

19、 a percentage of total assets from 30.8% in 1997 to 27.14% in 2001 signifies an increase in the turnover rate, perhaps due to improvements in its cross-docking system, food storage, and technology. second, cash and equivalents have increased because of investments costco made which could be converte

20、d into cash immediately rather than through borrowing. thus, costco has positively increased the liquidity of its assets and increased its inventory turnover over this five year period. torres common-size financial statements also show the changing composition of costcos financing structure over tim

21、e. the fact that interest expense consistently fell over the five year span from -0.35% of net sales in 1997 to -0.09% in 2001 demonstrates costcos ability to reduce its overall amount of debt during these years. exhibit nines balance sheet portion supports this reduction, documenting an increase in

22、 total current liabilities from 35.86% of total assets in 1997 to 40.76% in 2001 and an increase in accounts payable from 25.46% of assets in 1997 to 27.03% in 2001. this signifies that the companys debts or obligations due within one year increased, further corresponding with the fact that short-te

23、rm borrowing increased from 0.46% of assets in 1997 to 1.93% in 2001. with an increase in short-term borrowing it is logical to expect to see a decrease in long-term borrowing. the income statement proves that this is indeed the case, documenting a decrease in long-term debt from 16.74% of sales in

24、1997 to 8.52% in 2001. this relates back to the decrease in costcos interest expense on the income statement, representing the companys decision to switch to short-term and away from long-term methods. furthermore, the decrease in long-term debt helped account for a decrease in total liabilities fro

25、m 53.32% of total assets in 1997 to 50.46% in 2001. in addition to this information, the current liabilities portion also documents an increase in retained earnings from 33.56% of total assets in 1997 to 38.94% in 2001. this increase means costco gained more money, perhaps due to their ability to de

26、crease debt, to reinvest into future business ventures with potential growth such as capital investment, research, or development. torres turned next to a sustainable growth model to evaluate costco over the same period, which decomposes into four steps: profitability and earnings retention, leverag

27、e, turnover and margins, pretax income and tax effect. analysis of the growth model provides information about the causes of change responsible for costcos growth. from torres sustainable growth model it is apparent that for five straight years costco maintained an earnings retention ratio of 100%.

28、this is a result of the costcos decision not to pay dividends, instead choosing to reinvest net income back into the company. investor dissatisfaction may result from the complete absence of dividends, especially if the return on their shares becomes mediocre or unsatisfactory. the return on equity

29、(roe) percentages may also disappoint investors due to their downward trend since 1997. however, investors should not be dismayed by the fall of roe from 18.6% in 1998 to 14.2% in 2001. consistent reinvestment into the company occurred in the form of new store construction and efficient modification

30、s of old stores during these years. such capital investments take time to generate profits and for management evaluate whether aggressive expansion was beneficial or detrimental to the companys health. additionally, investors shouldnt be disappointed even though costcos roe in 2001 is lower than in

31、1997 because it still remains a large positive figure. as long as costco continues to demonstrate its capability of effective and successful reinvestment through techniques such as firm expansion and capital improvement then investors will likely remain satisfied with their investment and stock pric

32、e will continue to rise in the future. the roe component was broken down even further into the return to assets ratio (roa) and the financial leverage ratio to allow torres to better understand how leverage influenced costcos return on equity. the analysis documents a decreasing trend for both roa,

33、8.4% in 1997 to 7.0% in 2001, and financial leverage, 2.22 in 1997 to 2.04 in 2001. as previously stated when analyzing the meaning behind the roe component of the profitability and earnings retention analysis, although it is easy to jump to the conclusion that insufficient management and decreased

34、efficiency are responsible for these downward trends, it would be unwise to do so. with the addition of so many new stores to the corporation, it is unfair to assume that from inception they are as capable as old stores of achieving the same level of high performance, especially since it takes a whi

35、le to gain new members for whom the savings outweigh the cost of the required annual membership fee. although it appears that growth has been achieved too quickly and too ambitiously, signs of improvements in company efficiency both in the common-size statements and in the company overview forecast

36、a bright future for the expansionary efforts of costco for both the company and for investors. in order to discuss turnover and margins it is necessary to break down costcos roa into asset turnover and net income margin. used to measure how much profit was generated per dollar of sales, costcos net

37、income margin increased slightly to 1.73% in 2001 from 1.43% in 1997, but decreased from the values of 1998-2000. although this could be one of the reasons behind the drop in roa the data doesnt seem compelling enough to be the sole reason behind the decrease since costco usually generates little pr

38、ofit from each sale since it limits markup. the consistent decrease in asset turnover from 4.43 to 4.03, meaning fewer dollars in sales were made for each dollar in assets, seems more explanatory and probably occurred because costco expanded its asset base so furiously in such a short period of time

39、 that sales struggled to keep up. this demonstrates that new store openings definitely impacted the ratios and caused them to decrease. however, it is highly likely that in the future these ratios will increase, perhaps reaching higher figures than in 1997. the fourth step of decomposing the net inc

40、ome margin into pretax return on sales and the tax effect demonstrates that changes in the net margin were not driven by the costco managements ability to influence its tax rate. this is due to the fact that the tax rate remains a constant 40% throughout the time period. thus, the tax effect stayed

41、stable at 60%. by utilizing benchmarking ratios in the third step in her ratio analysis, torres was able to see costcos ability to stay competitive against main competitors in operational efficiency. however, there were also areas which the company lingered behind other wholesale clubs like bjs. bef

42、ore beginning the ratio analysis evaluation, it is important to consider that sams club is included in the overall data and balance sheets for wal-mart. therefore, it is difficult to isolate differences of mark-up, membership fees, profitability, and inventory turnover between the wholesale club, sa

43、ms club, and the discount store, wal-mart. also, although sears is viewed as a competitor it truly falls into the department store category competing primarily with federated department stores which owns macys and bloomingdales. thus, in the majority of these ratio analyses, costco competes primaril

44、y with bjs. first torres looked at gross margin to get a better sense for how costco compared to main competitors in operational efficiency. in 2001, costcos gross margin of 10.4% is much lower than sears of 26.6% and wal-marts of 21.5%. only bjs has a lower gross margin of 9.2%. therefore, in 2001,

45、 costco remained very competitive by providing goods to customers at a very low mark-up and at a lower per unit cost. it would be interesting to view the gross margin of sams club separated from wal-mart to understand how the wholesale club competed individually. operating margin, reflecting how muc

46、h profit a retailer generated from selling its items after paying all operating expenses, also describes the operational efficiency of costco compared to its competitors. because torres included membership fees in revenues for both costco and bjs, it is logical to compare these two companies first.

47、bjs operating margin of 4.41% is higher than costcos of 2.85% in 2001. in fact all the other competitors have higher operating margins, with wal-mart recording the highest of 5.94% although this could be inflated because membership fees of sams club were not included. although the fact that costcos

48、operating margin is the lowest of all four companies, it is important to remember that although this ratio gives analysts an idea of how much a company makes on each dollar of sales, it is important to look at the change in operating margin over time rather than just a single year. perhaps this is a

49、 down year for costcos operating margin because the firm paid off a lot of debt or financed the creation of more new stores than usual. thus, it is important to look at other ratios to evaluate costcos competitiveness against other leading firms in the industry. despite the disappointing value of op

50、erating margin compared to competitors, costco remains very competitive in terms of its net margin in 2001 of 1.73%. wal-mart has the highest ratio of 3.26%, but as mentioned earlier, this is skewed by the fact that the figure includes way more than the sams club wholesale clubs. most importantly, c

51、ostco has a higher net margin than bjs 1.56%, meaning that the company proved to be more effective at converting revenue into actual profit. this demonstrates that in 2001 costco remained very competitive in terms of operational efficiency and cost control. having past net margins would have been he

52、lpful in determining whether costco improved or began falling short. torres also calculated the firms current ratios in order to reflect their short-term liquidity. costco proved to be very competitive in this category with a current ratio of 0.94, a figure very close to the optimal 1.0. although ra

53、tios greater than 1 tend to indicate that short-term assets were sufficient to service short-term liabilities, costco seems to be following the idea that too high of a current ratio signifies an inefficient use of capital. both wal-mart and sears appear to be trying to prove their security by having

54、 high current ratios of 2.70 and 2.32 respectively, while bjs follows the same model of costco with a current ratio of 1.20. thus, bjs appears to be the most competitive with costco, operating very efficiently by maintaining enough short-term assets to service short-term liabilities without ineffici

55、ently using capital. again it would be interesting to see costcos current ratio with that of its competitors over the past five years to gain a better idea of whether the firm has become more or less competitive. moving onto inventory turnover, costco appears to dominate the other companies in terms

56、 of its operational efficiency in this category. boasting the highest ratio of 11.7, the only competitor close to costco is bjs with an inventory turnover ratio of 8.9. this describes numerically the fact that costcos inventory remains in the store for a very short amount of time before sale, meanin

57、g that the firm knows and understands its customers preferences and efficiently manages its cross-docking system. thus, unlike sears with a ratio of 5.0, costco ties up very little money in unsold inventory and has greater flexibility to adjust their product mix more frequently putting them at a com

58、petitive advantage. the last important ratios relate to each companys ability to receive collections from customers and to pay suppliers in a timely manner. costco ties with wal-mart for the lowest average receivables period, meaning that they both are extremely efficient at obtaining funds from cus

59、tomers on average in three days. bjs is extremely close with four days after purchase, while sears needs to reconsider the firms financing options, on average receiving money for purchases 287 days later. besides being able to gather customer money efficiently, it appears that costco is efficient at paying bills. with an average payable period of 33 days, it takes costco a little over a mon