Financial Accounting a Ratio Analysis

Financial Accounting

A ratio analysis can help to gain understanding of a company's financial position. Ratios regarding profitability and liquidity provide a quick snapshot of the company's performance and allow for easier translation of financial performance over multiple time periods. To analyze the financial situation of the Gap Inc., four ratios will be analyzed -- the net income percentage, the return on equity, working capital and the current ratio. The first two are profitability ratios and the latter two are liquidity ratios. Together, they will paint a picture of the company's financial health by illustrating the degree to which the Gap converts its revenues into profits and by indicating the company's ability to meet its short-term debt obligations.

The net income percentage is defined as net income divided to total revenue. For the Gap in 2008 the net income was $967 million and the total revenue was $14,526 million. This gives the company a net income percentage of 6.65%. This compares to the 2007 net income percentage of 5.28% and the 2006 figure of 4.88%. The net income percentage reflects how well a company translates the revenues it earns to profits. The bottom line figure, the net income, is distributed to shareholders or kept as retained earnings. At the Gap, the past three years have seen a trend of improved translation of revenues into profits. The 6.65% net income percentage is a solid number for a retailer, given the industry average net income percentage is just 3.8% (MSN Moneycentral, 2009).

The return on equity is defined as net income divided by average stockholder's equity. The latter is generally taken as the mean of the beginning and ending equity levels for the firm. The net income was $967 million in 2008 for the Gap. The beginning stockholder's equity was $4.274 billion and the ending equity was $4.387 billion. This gives an average equity for 2008 of $4.3305 billion. As a result, the return on equity for 2008 is 22.32%. This is a strong ROE figure, given that the industry average is just 13.8% (MSN Moneycentral, 2009). It is consistent with the Gap's five-year average ROE as well, which is 20.2% (MSN Moneycentral, 2009). What this figure shows is that for every dollar of equity capital, the Gap makes 22.32 cents. The ROE should be taken in context with the firm's capital structure. In this case, Gap is not highly leveraged at a debt ratio of just 42%, so the company not only has a strong equity base but is able to translate that equity into strong returns for its shareholders.

Taken together, the net income percentage and return on equity can be used to evaluate the company's profitability. The Gap Inc. has, based on the above calculations, been a profitable company for the past several years. It is converting an increasing amount of its revenue into profit and returns a healthy amount of profit to its shareholders. In both measures, the firm outperforms its industry average, which indicates that the Gap has a number of strengths that it is using to best the competition. Overall, the Gap is a consistently and strongly profitable company.

Working capital is a liquidity measure, defined as the current assets less the current liabilities. For the Gap Inc. In 2008, the current assets were $4,005 million and the current liabilities were $2,158 million. This gives the company a working capital of $1,847 million. The working capital reflects the firm's ability to pay its short-term debt obligations, in dollar terms. Current assets are typically those that are either cash or can be quickly converted to cash in order to meet debt obligations. For 2008, the Gap's working capital indicates that it can easily meet its short-term debt obligations with its current assets. Drilling down specifically to cash or near-cash current assets we can see that the Gap has a substantial cash holding of $1,715 million, which should be easily sufficient, even if they have difficult converting their other current assets (mostly inventory) into cash.

The second liquidity measure is the current ratio. This is defined as the current assets divided by the current liabilities. The current assets are $4,005 million and the current liabilities are $2,158 million. This gives the Gap a current ratio of 1.855. This figure indicates that the Gap has strong liquidity. The industry average current ratio is 2.5 (MSN Moneycentral, 2009), so the Gap has less capacity to meet its current obligations than many of its peers. However, in the retail industry most firms have a large portion of their current assets tied up in inventory, which distorts the current ratio figures higher. The Gap's figure of 1.855 is strong and indicates that the company will have little difficulty in meeting its upcoming obligations.

Overall, the liquidity measures provide an indication of the company's short-term health. Low amounts of working capital or a poor current ratio can indicate that the firm is in short-term distress. The figures for the Gap in 2008 do not indicate a firm in financial distress. Rather, they indicate that the company will have little difficulty in meeting its upcoming financial obligations. The company has strong working capital figure and a high current ratio. The latter is especially important in light of the fact that the company has a strong cash holding and will not need to rely on liquidated inventory in order to meet its obligations.

The liquidity and profitability ratios tell us that the Gap Inc. is a company in good financial health. It has the current assets needed to meet its debt obligations. In addition, the company does a better-than-average job of converting its revenues into profit and equity. The Gap's solid financial ratios paint a picture of a company in good financial health at the beginning of 2009.

Notes to the Balance Sheet

For Gap Inc.'s 2008 Form 10-K, the notes to the financial statements are outlined in two different ways. The first is Note 1 (p.41), which is the summary of significant accounting policies, many of which directly impact the balance sheet. Note 2 is "Additional Financial Statement Information" (p.47), under which a couple of balance sheet items are explained in more detail.

The first note to the balance sheet (p.41) discusses the policies regarding the treatment of cash and cash equivalents. It states that amounts in transit from banks or credit card companies are recorded on the balance sheet under cash and cash equivalents. This is because the remittances typically take around two days to complete. Thus, while these monies are not presently in the company's account, they will be imminently. Other policies include that short-term investments less than 91 days in maturity are considered cash equivalents and any long-term investment with a maturity in the next 91 days are given the same treatment.

The second note to the balance sheet regards merchandise inventory (p.42). The company practices the weighted-average cost method of recording inventory. They make particular note of the fact that prior to 2006 they used the FIFO method. The Gap uses the lower of cost or market to record its inventories, creating a reserve fund for current merchandise inventory that is expected to be liquidated below cost.