Positive Cash Flows Despite Losses & Capital Raising Focus Questions

part 1:

first, read these two case

s

Cash Flow Statements and Analysis

The Statement of Income and Cash Flows (pp. 15-23)

second, answer these

part 2:

first, read these two case

Signet Jewelers: Assessing Customer Financing Risk

Analyzing Financial Statements

second, answer these

Financial Accounting
V.G. Narayanan and Dennis Campbell, Co-Series Editors
+ INTERACTIVE ILLUSTRATIONS
Analyzing
Financial
Statements
V.G. NARAYANAN
HARVARD BUSINESS SCHOOL
SURAJ SRINIVASAN
HARVARD BUSINESS SCHOOL
5056
|
Published: April 11, 2017
Table of Contents
1 Introduction ……………………………………………………………………………………………………………….. 3
2 The Financial Analysis Framework …………………………………………………………………. 4
2.1 Understanding Return on Equity ……………………………………………………………………… 6
2.2 Profitability ………………………………………………………………………………………………………….. 8
2.3 Operating Efficiency ………………………………………………………………………………………….11
2.3.1 Return on Assets …………………………………………………………………………… 12
2.3.2 Digging Deeper into Asset Turnover ……………………………………………… 13
2.3.3 Inventory Turnover ………………………………………………………………………… 14
2.3.4 Accounts Receivable Turnover……………………………………………………………… 16
2.3.5 Accounts Payable Turnover ………………………………………………………………….. 18
2.3.6 Cash Conversion Cycle …………………………………………………………………. 20
2.3.7 Working Capital Turnover……………………………………………………………………… 22
2.4 Financial Leverage ………………………………………………………………………………….. 23
2.4.1 Interest Coverage Ratio ………………………………………………………………..27
2.4.2 Liquidity Ratios ……………………………………………………………………………………….. 28
3 Summary …………………………………………………………………………………………………………………… 30
4 Supplemental Reading ……………………………………………………………………………………………. 32
4.1 Key Ratios ………………………………………………………………………………………………………….. 32
5 Key Terms …………………………………………………………………………………………………………………. 34
6 Endnotes ……………………………………………………………………………………………………………………. 36
7 Index ……………………………………………………………………………………………………………… 37
This reading contains links to online interactive illustrations , denoted by the icon
above. To access these exercises, you will need a broadband Internet connection.
Verify that your browser meets the minimum technical requirements by visiting
http://hbsp.harvard.edu/tech-specs.
V.G. Narayanan, Thomas D. Casserly, Jr. Professor of Business Administration,
Harvard Business School, and Suraj Srinivasan, Philip J. Stomberg Professor of
Business Administration, Harvard Business School, developed this Core Reading
with the assistance of writer M. Penelope K. Rossano.
Copyright © 2017 Harvard Business School Publishing Corporation. All rights reserved.
5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS
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1 INTRODUCTION
T
he ability to analyze financial statements is essential for anyone trying to
understand a business and assess its performance. Managers can use
insights derived from financial analysis to inform their strategic decisions, and
outside stakeholders, such as debt and equity investors, can use the information
to evaluate a company’s performance. For example, managers might want to
assess an acquisition’s performance implications, a bank or supplier would need
to assess a client’s creditworthiness before granting a loan or extending credit,
and customers would like to understand a potential supplier’s long-term viability
before entering into a contract. In this reading, we will introduce financial
analysis tools that can be used to gain insights about a company’s business
model and financial performance. We will primarily use a ratio analysis method
called the DuPont framework. In this framework, one ratio tells us how efficiently
a company is utilizing its assets, while another ratio compares the company’s
cash to its upcoming liabilities to see if it will likely be able to pay its creditors.
Taken together, these ratios can be used to understand and assess the
company’s financial and operational performance.
Ratio analysis is useful in making comparisons across companies or in evaluating
a company’s performance over time. In the former case, financial analysis can be used
to assess the performance of managers across similar companies. In the latter case,
time-series analysis allows us to assess how well managers are executing the desired
strategy over time.
Throughout this reading, we will use the publicly available financial statements of
several retail companies to provide examples of various types of ratio analyses and
comparisons. They are Industria de Diseño Textil, S.A (Inditex Group), a Spanish
fast-fashion retailer; Prada S.p.A. (Prada), a luxury retail brand with Italian roots and
headquarters in Hong Kong; and three US-headquartered brands: The Gap, Inc.;
Nordstrom, Inc.; and Urban Outfitters, Inc.
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In 2015, Inditex was operating worldwide with over 6,600 stores 1 of fast-fashion
brand chains such as Zara, Pull & Bear, Stradivarius, and Massimo Dutti. It was
known in the retail world for being innovative in managing its supply chain and for
going very quickly from design to garment in about six weeks.
Founded in 1913 in Milan, by 2015 Prada was a luxury brand that produced and
sold high-quality leather goods, clothing, footwear, and accessories including eyewear
and fragrance for both men and women. It was operating internationally in more
than 70 countries at more than 600 directly operated stores at prestigious locations. 2
Prada executives carefully monitored both the creative and production processes to
guarantee excellent quality and exclusivity in its products. The company’s business
strategy combined its in-house design skill and industrial know-how to create
inventive, high-quality, trend-setting products.3
The Gap, Inc., was a global retailer offering apparel, accessories, and personal
products for men, women, and children under Gap, Banana Republic, Old Navy,
Athleta, and Intermix brands. In 2015, the company operated more than 3,700
company-owned and franchise locations. Its brand appeal was targeted at younger
customers.
In 2015, Urban Outfitters, Inc., operated under the Urban Outfitters, Anthropologie, Free People, Terrain, and BHLDN brands. 4 The company targeted a broad
range of culturally sophisticated customers: young adults aged 18–28 at Urban
Outfitter stores, women aged 28–45 at Anthropologie, and young, contemporary
women aged 25–30 at private label Free People.5
Nordstrom, Inc., founded in 1901 as a shoe store in Seattle, was committed to
providing superior customer service and delivering the best possible shopping
experience. In 2015, it was a leading fashion specialty retailer with an established ecommerce business. The company strived to maintain its reputation for its high level
of integrity, excellent customer service, and quality merchandise by offering an
extensive selection of high-quality, brand-name, private-label merchandise.6
2 THE FINANCIAL ANALYSIS
FRAMEWORK
Financial statement information comes from the three key statements: the income
statement, the balance sheet, and the statement of cash flows. The income statement
documents the company’s financial activity over a given accounting period, say, a
year. The balance sheet, on the other hand, reflects the company’s financial position,
assets, liabilities, and shareholder equity as of a particular date, say, the end of the
financial year. Like the income statement, the statement of cash flows also presents
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the firm’s cash flows over a given period, such as a year. In calculating ratios, it is
common to average the beginning and ending balance sheet amounts to measure the
average level of assets used during the period. We use this convention because income
statement items (e.g., revenues) are measured over the course of the year, so we
assume that the average balance sheet values have been used throughout the year to
generate a given level of revenues. However, some financial statement users may use
beginning-of-the-year amounts if appropriate, such as when the ratios will be used for
forecasting. Throughout this reading, we will use the average balance sheet amounts
when comparing income statement and balance sheets in any ratio. Certain ratios
may also be computed for shorter periods, such as quarters or months. For example,
to plan inventory levels, it is important to understand seasonal cycles, so inventory
ratios are often computed on a quarterly or monthly basis.
When conducting financial analysis, key questions an analyst typically asks relate
to the company’s performance. For example, how well has the company executed its
strategy? How well has it performed against its competitors? Does the performance
arise from superior operating capability or because of its financing mix? We will
begin our financial analysis of the company using two key metrics of performance:
return on equity (ROE) and return on assets (ROA). Both of these metrics allow an
analyst to assess how well a company has generated profits from the resources
deployed.
ROE measures overall business performance, specifically management’s ability to
generate profits for its shareholders. It is calculated by dividing net income by total
shareholders’ equity (SE).
ROA, also referred to as “return on investment,” is an indicator of the company’s
profitability relative to its assets or total capital employed in the firm (recall that assets
= liabilities + equity); it indicates how efficiently management uses the company’s
assets to generate earnings. ROA is calculated by dividing a company’s earnings by its
total assets.
As we will see later, breaking down each of these ratios into its underlying
components allows us to assess different aspects of a company’s performance relative
to comparable companies as well as to the firm’s past results.
The DuPont framework, commonly used for financial analysis, originated at the
DuPont Corporation in the 1920s. It decomposes ROE into subcomponents to
provide a deeper look at how the profit (or loss) was generated. Systematic analysis of
the ratios that make up the DuPont framework provide additional information about
how a company manages its business. Similar to peeling an onion, conducting
financial statement analysis that examines the most general ratios, then drills down to
its more granular components facilitates the analyst’s understanding of the
determinants of performance. For example, an analyst may ask whether a company’s
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performance is primarily driven by profit margins (how much profit the company
generates for its shareholders), asset turnover (how efficiently the company uses its
assets to generate return), or financial leverage (the level of debt the company
carries).
2.1 Understanding Return on Equity
Let’s start with the return on equity, which can be broken into three components:
• Profitability
• Operating efficiency
• Financial leverage
These values are derived by decomposing ROE into three parts:
ROE = net profit margin  asset turnover  financial leverage
That is,
sales
total assets
ROE = net income 

sales
total assets
equity
Which simplifies to,
ROE =
net income
sales


total assets
sales
=
total assets
equity
net income
equity
Interactive Illustration 1 demonstrates in a graphical format how the three
components of ROE link together. Change the numerical values of net income, sales,
assets, and equity, and observe their effects on the ROE “block,” as well as on the
simplified income statement and balance sheet.
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INTERACTIVE ILLUSTRATION 1
DuPont Framework
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHtruh
Managers can use the financial analysis framework to evaluate the sources of
favorable or unfavorable performance in each of these three areas, which helps them
take actions to increase the company’s overall ROE. In this reading, to demonstrate
how each of the underlying factors contributes to a company’s ROE, we will calculate
each ratio for Prada and then provide the ratios for the other companies described in
the introduction. Prada’s financial statement numbers are given in Exhibit 1. All
financial numbers are in millions of euros.
Note that we average the beginning and ending balances of shareholders’ equity for
the period in which net income is earned for our analysis. To illustrate, we will plug in
the values from Exhibit 1, as follows:
Prada’s average shareholders’ equity (SE) in 2015
=
( beginning SE + ending SE )
2
( €2,688 + €3,001)
=
2
= €2,845
ROE for Prada in 2015 =
€451
= 15.8%
€2,845
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Similarly, we calculate ROE for the other retailers for fiscal year 2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
ROE
41.8%
25.4%
31.9%
15.8%
15.4%
Note that the ROEs for Prada and Urban Outfitters differ by less than half a
percentage point. Gap is highly profitable, with ROE of 41.8%. Further analysis of the
drivers of ROE will inform us about how these companies manage their business.
2.2 Profitability
The first component of the ROE decomposition is profitability, the profit margin that
the company achieves from each dollar of sales after all expenses have been accounted
for:
Net profit margin =
net income
sales
Using the values from Exhibit 1, we find:
Net profit margin for Prada in 2015 =
€451
= 12.7%
€3,552
Similarly, we calculate the net profit margin for the other retailers for fiscal year 2015
as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Net Profit Margin
7.7%
13.8%
5.3%
12.7%
7.0%
The net profit margin for Urban Outfitters, 7%, and Prada, almost 13%, indicates
that Prada would earn about twice Urban Outfitters’ profit for every dollar of sales
after accounting for all costs. This margin structure fits their business models. Prada
is a luxury brand that sells high-end specialty products, while Urban Outfitters’
products appeal to more cost-conscious customers. Gap, whose net profit margin of
7.7% is similar to that of Urban Outfitters, also has a similar customer profile. Urban
Outfitters and Gap are both low-cost providers, whereas Prada’s more differentiated
model operates at the higher end of the customer spectrum. Companies with a low-
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cost model tend to sell larger quantities at lower margins, while companies with a
differentiated strategy tend to have higher profit margins but sell lower volumes.
Recall that the ROE for both Urban Outfitters and Prada is approximately 15%. We
will discuss later what may account for this similarity in ROE despite the big
difference in the two companies’ net profit margin.
A big advantage of the DuPont decomposition framework is that it lets us dig
deeper into the components of ROE (“peeling the onion” analogy again), in this case,
net income margin. For example, some investors may be interested in the gross profit
margin, which represents the amount of profit that is left to cover other expenses
after only the cost of goods sold is subtracted from revenues. This means that gross
profit margin measures profit before operating expenses as a percent of sales. It is
calculated by dividing the net revenue minus cost of goods sold, by sales.
Gross profit margin =
gross profit
sales
Using the data from Exhibit 1, we get the following:
Gross profit margin for Prada in 2015 =
€2,551
€3,552
= 71.8%
Similarly, we calculate gross profit margin for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Gross Profit Margin
38.3%
58.3%
36.9%
71.8%
35.4%
As discussed earlier, Prada is a luxury brand; a gross margin at 72% is consistent
with the higher price of its products. Urban Outfitters, on the other hand, is targeting
a customer group of younger adults, so the lower gross margin of 35% will facilitate a
more affordable price to their customers.
Examining a company’s expense structure can also help you better understand its
performance. One common performance metric for a retail company is how efficient
its selling, general, and administrative expenses (SG&A) are. SG&A margin is defined
as the amount of SG&A expenses incurred by a company for every dollar of revenues
earned. SG&A expenses are one component of operating expenses.
SG&A margin =
selling, general, and administrative (SG&A) expenses
sales
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which, using the data in Exhibit 1, gives us the following:
Prada’s SG&A margin in 2015 =
€1,716
€3,552
= 48.3%
Similarly, we calculate SG&A margin for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
SG&A Margin
25.7%
35.6%
27.2%
48.3%
24.4%
Since SG&A includes expense items such as advertising and selling expenses, it is
appropriate for Prada to have a higher expense level than Urban Outfitters and Gap
given Prada’s higher-end advertising and likely greater selling expenses for its luxury
brand compared to the fast-fashion retailers.
Review how these common profitability measurements are derived from the
income statement in Interactive Illustration 2. Select one of the four metrics at the
top of the graphic, and explore how those metrics would be affected by different
performance scenarios (e.g., more annual revenue, reduced costs, etc).
INTERACTIVE ILLUSTRATION 2
Profitability Ratios a
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2pHtruh
a
For simplicity, this representation limits the range of possible values. For example, COGS, and
operating expenses could both be larger than revenue, leading to a net loss.
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2.3 Operating Efficiency
In addition to questions about profitability, analysts also often ask how efficiently a
company is using its assets. The next component of the ROE decomposition, asset
turnover, helps answer this question. Asset turnover tells us the extent of sales
generated by a dollar (or euro in our example) of assets. The amount of sales
generated by a unit of assets depends on the strategy the company uses to generate
sales or deliver a service. This efficiency measure also depends on the technology the
company is using. For instance, a retailer with greater percentage of online sales—
ones where fixed assets are not needed to deliver revenues—will have a greater asset
turnover than a purely brick-and-mortar retailer.
sales
Asset turnover =
average total assets
Applying this to our Prada example gives us the following:
Prada’s average total assets in 2015
=
=
( beginning total assets + ending total assets )
2
( €3,888 + €4,739 )
2
= €4,314
Prada’s asset turnover in 2015 =
€3,552
€4,314
= 0.8
Similarly, we calculate asset turnover for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Asset Turnover
2.1
1.2
1.5
0.8
1.6
It is worthwhile to repeat why we have used average total assets rather than the
beginning or ending value of assets in the denominator. A company records its sales
at every point throughout the year using assets in place. Assets in place may change
during the year depending on the company’s investments. Averaging the start- and
end-of-year assets provides a basis for comparison when looking at assets that
support the level of sales achieved over the year.
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Urban Outfitters’ asset turnover is twice that of Prada’s, meaning the fast-fashion
retailer sells twice as much per unit of assets as the more luxury-oriented brand. This
is likely because Prada has to make larger investments for a given level of sales. Prada
stores need to be located in more upscale areas and have more fashionable interiors
than Urban Outfitters does. The value of inventory in a Prada store is also likely to be
greater than that in an Urban Outfitters store. The difference in business models is
apparent in the ratios: Prada, with its higher-end luxury brands, generates greater
profit per unit of revenue than Urban Outfitters, but sells lower volume for the assets
in place. Recall that the net profit margin for Prada was about twice that of Urban
Outfitters, meaning that Urban Outfitters makes lower profit per unit of revenue but
sells twice as much as Prada does per unit of assets that it uses. These two factors net
each other out when we compare the two companies’ profitability per unit of asset
utilized. This brings us to our next concept, return on assets.
2.3.1 Return on Assets
Return on assets (ROA) measures profits as a proportion of total resources used or
financed by the firm. It is calculated by dividing net income by average total assets.
ROA is the product of the first two terms of the DuPont decomposition:
net profit margin × asset turnover.
ROA =
net income
average total assets
Using our example, we find the following:
Prada’s ROA in 2015 =
€451
= 10.4%
€4,314
Similarly, we calculate ROA for the other retailers for fiscal year 2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
ROA
16.2%
17.2%
8.1%
10.4%
11.3%
As discussed earlier, while Prada and Urban Outfitters have distinctly different net
profit margins and asset turnover ratios consistent with their differing market
positions and business strategies, when we consider ROA, the two effects almost
cancel each other out. Note here that Nordstrom’s ROA is 8.1%, which is somewhat
lower than Prada’s 10.4%. Despite the lower ROA, Nordstrom’s ROE in the ROE
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table in Section 2.1 is much higher, 31.9%, compared to Prada’s 15.8%. We will return
to this apparent puzzle later when we discuss leverage.
A firm’s total assets are financed by a mixture of debt and equity. Net income (the
numerator in the ROA formula) includes interest expense, which is the financing cost
of debt. If the analyst wishes to ignore the firm’s financing mix, he or she would
eliminate the financing impact on net income, which would determine a pure return
on investment before financing costs. ROA is often calculated by dividing after-tax
net income before interest expense by average total assets.
2.3.2 Digging Deeper into Asset Turnover
Companies need a mix of assets to drive their business performance. For example,
retail companies need stores (long-term assets) as well as shorter-term assets such as
inventories. By examining whether asset turnover efficiency is driven by short-term
or long-term assets, an analyst can learn about how well managers are undertaking
long-term investments versus how well they are handling the business’s day-to-day
operational activities.
sales
Long-term asset turnover =
average long-term assets
Here are the long-term asset turnover numbers for our retail examples:
Prada’s average long-term (LT) assets in 2015
=
=
(beginning LT assets + ending LT assets)
(€2, 427 + €2, 839)
= €2,633
2
2
Prada’s LT asset turnover in 2015 =
€3,552
= 1.3
€2,633
Similarly, we calculate LT asset turnover for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
LT Asset Turnover
4.8
2.4
3.7
1.3
2.9
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As with the total asset turnover ratios, Urban Outfitters uses its LT assets more
efficiently than Prada does. Gap appears to be the most efficient in utilizing its longterm assets to produce sales revenues.
Let’s turn to short-term operations. A company needs working capital to manage
its day-to-day operations. Working capital is composed of receivables plus inventory
less the amount the company owes to its vendors, such as accounts payable.
Companies need smaller amounts of working capital if they can collect more quickly
from their customers (lower receivables), hold lower levels of inventory for a given
level of sales (faster inventory turnover), and receive greater financing from their
vendors (greater accounts payable). Let’s examine each of these in turn.
2.3.3 Inventory Turnover
Inventory turnover, calculated as cost of goods sold divided by the average inventory
for the period, measures how often the inventory is sold during a given time period. It
is useful in understanding how efficiently a business manages its inventory levels. Just
as holding more assets for a given level of sales does, holding more inventory for a
given level of sales decreases efficiency. Although businesses may prefer to hold lower
inventory levels, the trade-off is to avoid running out of products available for
customers. Inventory levels also depend on product characteristics (e.g., perishable
products versus packaged goods), stocking efficiency, variation in product demand,
and so forth. As when we calculate asset turnover, we use the average inventory
balance rather than the ending balance. This is especially relevant for a firm that is
growing quickly, as the level of inventory may have increased significantly during the
year.
Inventory turnover =
cost of goods sold (COGS)
average inventory
Interactive Illustration 3 is a demonstration of inventory turnover in action. Start
the animation of items moving through a warehouse facility over the course of two
years of business operations. Reset the illustration and replay it with different
assumptions about the firm’s average inventory and annual COGS. The effect of
these parameters are reflected in the “Days Inventory” and “Inventory Turnover”
outputs at the bottom.
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INTERACTIVE ILLUSTRATION 3 Inventory Turnover and Days in Inventory
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2I9pGVd
Applying the data from Exhibit 1 gives us the following:
Prada’s average inventory in 2015
=
(beginning inventory + ending inventory )
(€450 + €655)
=
2
= €552
2
Prada’s inventory turnover in 2015 =
€1,001
€552
= 1.8
Similarly, we calculate inventory turnover for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Inventory Turnover
5.3
4.3
5.1
1.8
6.4
As a fast fashion business, it is no surprise that Urban Outfitters turns over its
inventory faster (6.4 times a year) than Prada’s luxury products (1.8 times). Urban
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Outfitters is also somewhat more efficient in handling its inventory when compared
to the other fast fashion business, Gap, whose inventory turnover is 5.3.
Another metric for measuring inventory use is the days inventory held, the average
number of days the inventory is held before it is sold, as opposed to the inventory
turnover, which measures how many times the inventory turned over during the
period. It is calculated dividing the COGS by 365 days, then dividing the average
inventory by this number.
average inventory
Days inventory held =
cost of goods sold 365 days
or:
365
Days inventory held =
inventory turnover
Applying the data for our Prada example yields the following:
365
Prada’s days inventory held in 2015 =
€1,001 €552
= 201
Similarly, we calculate days inventory held for the other retailers for fiscal year 2015
as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Days Inventory Held
69
86
72
201
57
Again it makes sense that Urban Outfitters turns its inventory faster than Prada
because the average number of days that Urban Outfitters holds its inventory is
substantially shorter—57 days versus Prada’s 201 days.
2.3.4 Accounts Receivable Turnover
Accounts receivable (AR) turnover measures a company’s efficiency in collecting
receivables from its customers. Companies often provide credit to their customers as
a way to increase sales. However, this practice comes at the risk of having some
customers be unable to pay when the bill comes due. The accounts receivable
turnover is calculated by dividing sales revenues by the average accounts receivable
(AR) balance. While AR turnover depends on the company’s credit practices, a
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declining AR turnover indicates a weaker ability to collect cash from customers,
which could indicate a business weakness. For example, it could mean that the
company’s customers are having trouble paying what they owe.
sales
Accounts receivable turnover =
average accounts receivable
Prada’s average accounts receivable (AR) in 2015
=
( beginning AR + ending AR )
(€308 + €346)
=
2
= €327
2
Prada’s accounts receivable turnover in 2015 =
€3,552
€327
= 10.9
Similarly, we calculate the AR turnover for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Accounts
Receivable Turnover
44.6
54.3
6.0
10.9
52.9
A related metric is days sales outstanding (DSO), also referred to as the average
collection period or days sales in receivables. It measures the average number of days
it takes for a business to collect payment from a customer. Say the firm’s credit policy
is to allow payment within 30 days. If, for example, the DSO is 40 days, it may
indicate that there is a payment problem. The DSO is calculated by dividing the
average accounts receivable by the sales per day, that is, sales divided by 365.
Days sales outstanding =
average accounts receivable
sales 365 days
or
Days sales outstanding =
365 days
accounts receivable turnover
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Using the data from Exhibit 1, we find the following:
Prada’s days sales outstanding in 2015 =
365
€3,552 €327
= 34
Similarly, we calculate DSO for the other retailers for fiscal year 2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Days Sales
Outstanding
8
7
61
34
7
Retailers such as the ones in our examples typically do not offer credit to their
customers, therefore they do not incur high levels of receivables. Gap, Inditex, and
Urban Outfitters’ low level of DSO generally results from the companies’ vendors of
miscellaneous goods (e.g., furniture and fixtures) and sundry services. Therefore,
Nordstrom’s DSO of about two months and Prada’s of about one month deserve
some attention. It turns out that Nordstrom has a credit card operation that offers
Nordstrom-branded cards to its customers, which retains the receivables on its
balance sheet. This accounts for Nordstrom’s lower receivable turnover ratio and
higher DSO. Prada, on the other hand, sells not only through its own stores but also
through franchises. Therefore, the franchises owe Prada for the products it sells to
them for sale to the end customer, as well as possible royalty fees.
2.3.5 Accounts Payable Turnover
The accounts payable (AP) turnover measures how long it takes a company to pay its
vendors, including suppliers of inventory, services, or other noninventory items.
Recall that payables are the flip side of receivables, that is, payables occur when the
vendor allows the company credit in paying for goods or services rendered. Accounts
payable turnover is calculated as total purchases divided by the average accounts
payable. (An alternate definition substitutes cost of goods sold for purchases).
Accounts payable turnover =
purchases
average accounts payable
Applying this ratio to our Prada example gives us the following:
Prada’s purchases in 2015 = COGS + ending inventory − beginning inventory
=€1,001+ €655 − €450 = €1,206
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Prada’s average accounts payable (AP) in 2015
=
(beginning AP + ending AP)
2
€349
+
€437
(
)
=
2
= €393
Prada’s accounts payable turnover in 2015 =
€1,206
€393
= 3.1
Similarly, we calculate accounts payable turnover for the other retailers for fiscal year
2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Accounts Payable
Turnover
8.4
3.2
6.6
3.1
15.0
As with inventory and receivables, it is useful to think of accounts payable turnover
in terms of the number of days it takes the company to pay its accounts payable, or
days payable outstanding (DPO). This ratio is calculated by dividing the average
accounts payable by the average daily purchases (that is, total purchases divided by
365).
Days payable outstanding =
average accounts payable
purchases 365 days
Alternatively,
Days payable outstanding =
365 days
accounts payable turnover
Applying the data from Exhibit 1 gives us the following:
Prada’s days payable outstanding in 2015 =
365
€1,206 €393
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= 119
19
Similarly, we calculate DPO for the other retailers for fiscal year 2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Days Payable
Outstanding
44
115
56
119
24
The difference between Urban Outfitters’ days payable outstanding of 24 days
versus Prada’s 119 days indicates that Urban Outfitters pays its vendors much faster
than Prada does. To evaluate the efficiency implication of these different days payable
outstanding ratios, we would need to compare the historical numbers as well as the
credit terms. Credit from suppliers serves as a form of short-term financing that can
be beneficial if it is cheaper than bank credit or other sources of financing. However,
an increasing trend in days payable outstanding can suggest that the company has
liquidity problems, making it unable to pay its suppliers on time.
2.3.6 Cash Conversion Cycle
The length of time between when a company must pay its suppliers for inventory
until it collects cash from its customers is called the cash conversion cycle. It is the
sum of days inventory held plus days sales outstanding less days payable outstanding.
A negative cash conversion cycle typically indicates that the business purchased goods
from a supplier on credit and can sell the inventory and collect cash from the
customer even before the supplier requires payment to be made.
Cash conversion cycle = days inventory + days sales outstanding − days payable outstanding
The pertinent events that affect the cash conversion cycle—payment (for an item)
to a supplier, the item (or a product that includes that item) is sold, and the
customer’s payment for that sale is received—are displayed on a timeline in
Interactive Illustration 4. Use the sliders to change the timing of these events, to
push the cash conversion cycle to be long, short, or negative.
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INTERACTIVE ILLUSTRATION 4
Cash Conversion Cycle
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2ujeHXe
Using the data for Prada in Exhibit 1, we find the following:
Prada’s cash conversion cycle in 2015 = 201 + 34 −119 = 116
Similarly, we calculate the cash conversion cycle for the other retailers for fiscal year
2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Cash Conversion
Cycle
33
(22)
77
116
39
Urban Outfitters’ cash conversion cycle of 39 days means the company must
finance 39 days’ worth of sales, compared to Prada’s 116 days. Inditex, on the other
hand, has a negative cash conversion cycle of 22 days; the company can sell its goods
before paying its suppliers, which means it does not need to invest in financing its
inventory. This is because Inditex takes longer to pay its suppliers (days payable
outstanding = 115 days), not because of its receivables days outstanding (days sales
outstanding = 7) or the number of days it holds inventory (days inventory held = 86).
Prada, in comparison, holds its inventory longer and, as a result, has more cash tied
up in its business operations.
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2.3.7 Working Capital Turnover
Closely related to cash conversion is the concept of working capital, defined as
current assets less current liabilities. Working capital turnover is calculated by
dividing net sales by the result of average current assets minus average current
liabilities.
sales
Working capital turnover =
average working capital
where
Working capital = current assets −current liabilities
For Prada, this result is as follows:
Prada’s average current assets in 2015
=
=
( beginning current assets + ending current assets )
2
( €1, 461+ €1,900 )
2
= €1,681
Prada’s average current liabilities in 2015
=
=
( beginning current liabilities + ending current liabilities )
2
( €707 + €1,115 )
2
= €911
Prada’s working capital turnover in 2015 =
€3,552
(€1,681− €911)
= 4.6
Similarly, we calculate the working capital turnover for the other retailers for fiscal
year 2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Working Capital
Turnover
8.1
5.4
5.3
4.6
5.9
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Working capital turnover measures the efficiency with which a company manages
its working capital to generate sales. Gap with a working capital turnover of 8.1 is the
most effective of the retailers listed.
Calculations for common efficiency measures are visualized in Interactive
Illustration 5. Select a metric from the top row to see what items are drawn from the
income statement and balance sheet to calculate that ratio.
INTERACTIVE ILLUSTRATION 5 Efficiency Ratios
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2uo8MQH
2.4 Financial Leverage
Having examined the drivers of profitability and operating efficiency, we next assess
how capital structure affects a company’s performance. This leads to the last
component of the DuPont decomposition framework, financial leverage. In the
DuPont decomposition formula, the last term is also referred to as the equity
multiplier and is calculated by dividing average total assets by average shareholder’s
equity.
Managers can successfully use financial leverage to improve a company’s
performance if the return on borrowed funds is greater than the interest cost of those
borrowed funds on an after-tax basis because interest cost is tax-deductible. The
benefit of borrowing is that managers can operate from a larger asset base than the
amount that would be financed only from shareholders’ equity. For example, if a firm
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23
receives a $100 equity investment and has no debt, it can use that $100 to buy assets
that generate revenues. If the firm borrows an additional $100 as debt, it can use the
extra capital to purchase more revenue-generating assets. This would result in greater
profits for shareholders as long as the business generates a higher return on its assets
than what it must pay to service the debt. Interactive Illustration 6 shows how
leverage affects companies’ EPS and ROE.
INTERACTIVE ILLUSTRATION 6
Leverage Ratios
Scan this QR code, click the image, or use this link to access the interactive illustration: bit.ly/hbsp2GiuO8Y
The flip side of leverage is that the company becomes committed to meeting
interest payments, whereas dividend payment to equity holders is discretionary.
Borrowing can thus create a risk of financial distress when the firm’s performance is
depressed. If the business were to suffer a loss, the debt amplifies the loss’s effect on
equity holders. Therefore, companies should avoid very high levels of debt financing.
Analysts use the extent of financial leverage to assess the leverage’s benefit as well as
to measure distress risk.
Using the ROE decomposition formula provided earlier, we can measure the
impact of all non-equity financing—or any kind of debt—on the firm’s ROE. If all the
assets are financed by equity, the multiplier is 1. As debt increases, the equity
multiplier also increases.
Equity multiplier =
average total assets
average equity
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24
Using the data in Exhibit 1, we calculate the following:
Prada’s average total assets in 2015
=
=
( beginning total assets + ending total assets )
( €3,888 + €4,739 )
2
2
= €4,314
Prada’s average shareholders’ equity (SE) in 2015
=
( beginning SE + ending SE )
2
( €2,688 + €3,001)
=
2
= €2,845
Prada’s equity multiplier in 2015 =
€4,314
= 1.5
€2,845
Similarly, we calculate the equity multiplier for the other retailers for fiscal year 2015
as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Equity Multiplier
2.6
1.5
3.9
1.5
1.4
Urban Outfitters and Prada’s equity multipliers are quite similar—1.4 and 1.5,
respectively—indicating that the two companies have similar capital structure
strategies. However, Nordstrom has a high equity multiplier of 3.9. Recall that
Nordstrom’s ROE was 31.9%, significantly higher than Prada’s 15.8%, despite
Nordstrom’s lower ROA (8.1%) compared to Prada’s (10.4%). The answer lies in the
significantly higher level of leverage as indicated by Nordstrom’s equity multiplier,
which is more than double Prada’s. Can Prada improve its returns to shareholder
equity (ROE) by taking on more debt? Prada’s managers must grapple with this
question. The answer would depend on the extent of financial risk they wish to take
on. Alternately, should Nordstrom’s shareholders be concerned that the company has
very high debt levels? They would need to consider whether Nordstrom’s business
operations can support these high debt levels without causing the firm to slip into
financial distress.
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Another commonly used measure of leverage is the debt-to-equity ratio, which is
calculated as the ratio of average total liability divided by average shareholder’s
equity.
Leverage ratio =
average total liabilities
average shareholders’ equity
Using the data in Exhibit 1, we find the following:
Prada’s average total liabilties in 2015
=
( beginning total liabilities + ending total liabilities )
=
( €1,187 + €1,721)
2
2
= €1, 454
Prada’s average shareholders’ equity (SE) in 2015
=
( beginning SE + ending SE )
2
( €2,688 + €3,001)
=
2
= €2,845
Prada’s leverage ratio in 2015 =
€1, 454
= 0.5
€2,845
Similarly, we calculate the leverage ratio for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Leverage Ratio
1.6
0.5
2.9
0.5
0.4
Not surprisingly, Nordstrom’s leverage ratio, at 2.9, is significantly higher than
Prada’s at 0.5. We can peel the onion further and compare the different retailers in
terms of long-term debt versus short-term liabilities.
Long-term leverage ratio =
average long-term liabilities
average equity
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26
Prada’s average long-term (LT) liabilties in 2015
=
(beginning LT liabilities + ending LT liabilities)
2
(€480 + €606)
=
= €543
2
Prada’s average shareholders’ equity (SE) in 2015
=
( beginning SE + ending SE )
2
( €2,688 + €3,001)
=
2
= €2,845
Prada’s long-term leverage ratio in 2015 =
€543
= 0.2
€2,845
Similarly, we calculate the LT leverage ratio for the other retailers for fiscal year 2015
as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Long-Term
Leverage Ratio
0.8
0.1
1.8
0.2
0.1
These ratios indicate that Nordstrom has significantly greater long-term debt
compared to its equity than the other retailers in our sample do.
2.4.1 Interest Coverage Ratio
As discussed earlier, one possible result of higher leverage is the risk that the company
may not be able to meet its debt payment obligations. Many debt providers, such as
banks, protect themselves from their creditors’ default by requiring the companies to
follow certain restrictions (or covenants) defined by the ratios that measure the extent
of financing risk. The interest coverage ratio is used to gauge whether a business can
make the interest payments on its outstanding debt. The ratio is measured as earnings
before interest and taxes (EBIT) divided by interest expense.
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EBIT
Interest coverage ratio =
interest expense
which for Prada would be as follows:
Prada’s interest coverage ratio in 2015 =
€702
€13
= 54
Similarly, we calculate the interest coverage ratio for the other retailers for fiscal year
2015 as follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Interest Coverage
Ratio
28
N/A
11
54
N/A
Interest coverage ratio is useful for assessing the firm’s long-term solvency by
examining its ability to cover interest expense on debt, typically long-term debt.
Nordstrom, with an interest coverage ratio of 11, has the lowest ability to meet its
debt obligations within this sample of retailers. Although it is difficult to assess the
extent of distress risk from this ratio alone, it is clear that Prada, with a ratio of 54,
and Gap at 28, have a greater amount of earnings to cover interest expense. Because
Urban Outfitters and Inditex did not incur much interest expense in 2015, their
interest coverage ratios are less meaningful.
2.4.2 Liquidity Ratios
Analysts, especially those concerned with assessing a company’s short-term liquidity
(for example, a credit analyst in a bank), use measures such as the current ratio to
determine if funds provided by current assets would be sufficient to meet demand
from current liabilities.
The current ratio is calculated as current assets divided by current liabilities.
Current assets include cash as well as assets such as inventory and accounts receivable
that are likely to convert to cash in the short term. Current liabilities include accounts
payable, wages payable, and other items that will require cash payout in the short
term. The higher the current ratio, the easier it is for the business to meet its
approaching liabilities. However, if the current ratio is too high, it might indicate that
the business is not managing its working capital efficiently.
Current ratio =
current assets
current liabilities
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For Prada, the current ratio is as follows:
Prada’s current ratio in 2015 =
€1,900
€1,115
= 1.7
Similarly, we calculate current ratio for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Current Ratio
1.9
1.9
1.9
1.7
2.3
Overall, all the retailers’ current ratios hover around similar levels. Banks and other
short-term lenders often impose requirements for the current ratio level and that of
other, similar liquidity ratios in a given industry. It is also helpful to compare current
with historical levels of the ratio to determine whether there are any reasons for
concern or whether this metric should be differentiated across similar companies.
The quick ratio, or acid test ratio, is similar to the current ratio except only highly
liquid current assets are considered available for paying current liabilities. This ratio
measures a firm’s ability to meet current obligations even if its inventory cannot be
sold immediately. It is calculated by considering cash, marketable securities, and
accounts receivable, but not inventory, which is relatively less liquid; businesses in
distress may have trouble turning their inventory into cash.
Quick ratio =
( cash and marketable securities + accounts receivable )
current liabilities
Applying the data from Exhibit 1, we get the following:
Prada’s quick ratio in 2015 =
€715 + €346
= 1.0
€1,115
Similarly, we calculate the quick ratio for the other retailers for fiscal year 2015 as
follows:
FY 2015
Gap
Inditex
Nordstrom
Prada
Urban Outfitters
Quick Ratio
0.8
1.3
1.1
1.0
0.9
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The retailers in our sample generally appear to be quite comfortable in meeting
their current liabilities from highly liquid current assets though Gap and Urban
Outfitters are a little less so than the other companies.
3 SUMMARY
The financial analysis framework provides a methodology for assessing and digging
deeper into the drivers of a company’s performance. Analysts and others can use
financial ratios to compare the company’s performance to its peers or to its own
historical performance. Managers can then use the insights to improve the way the
business operates, by improving either its profit margins, its asset utilization, or its
capital structure. In this reading, we have used the DuPont decomposition framework
to provide a basic structure for ratio analysis. There are many additional ratios not
covered here, and you may find somewhat different definitions from what we have
used here.
In order to conduct insightful financial analysis, you must develop a deep
understanding of the business economics of a company and its industry to select the
appropriate ratios to measure and then to interpret them correctly. As seen in our
retail examples, it is also important to probe deeper to understand the causes of
differences in the ratios’ measures. A good analyst typically uses a portfolio of ratios
to understand the overall picture of a company and the drivers of its performance.
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EXHIBIT 1 Prada Group’s Balance Sheet and Income Statement
Prada Group: Consolidated statement of financial position
(amounts in millions of Euros)
January 31, 2015
January 31, 2014
715
346
655
184
1,900
582
308
450
121
1,461
1,474
943
422
2,839
1,230
901
296
2,427
4,739
3,888
267
437
411
1,115
67
349
291
707
255
42
309
606
1,721
208
42
230
480
1,187
256
2,163
131
451
256
1,853
(49)
628
3,001
17
2,688
13
4,739
3,888
Assets
Current assets
Cash and marketable securities
Trade receivables, net
Inventory, net
Other current assets
Total current assets
Non-current assets
Property, plant, and equipment
Intangible assets
Other non-current assets
Total non-current assets
Total assets
Liabilities and shareholders’ equity
Current liabilities
Bank overdrafts and short-term loans
Trade payable
Other current liabilities
Total current liabilities
Non-current liabilities
Long-term financial payables
Deferred tax liabilities
Other non-current liabilities
Total non-current liabilities
Total liabilities
Share capital
Share capital
Other reserves
Translation reserves
Net income for the year
Total shareholders’ equity
Non-controlling interests
Total liabilities and shareholders ’ equity
Consolidated income statement
(amounts in millions of Euros)
Net revenue
Cost of goods sold
Gross margin
Selling, general and administrative costs
Product design and development costs
Operating expenses
Earnings before interest and taxes
Net interest expenses
Other income/(expenses)
Income before taxes
Taxation
Net income for the year
Net income—non-controlling interests
Net income—shareholders
Basic and diluted earnings per share in euros per share
For the twelve months ended
January 31, 2015
3,552
(1,001)
2,551
1,716
133
1,849
702
(13)
(21)
668
(209)
459
8
451
0.176
January 31, 2014
3,587
(939)
2,648
1,580
129
1,709
939
(9)
(8)
922
(285)
637
10
627
0.245
Source: Extracted from Prada Annual Report for the year ended January 31, 2015.
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4 SUPPLEMENTAL READING
4.1 Key Ratios
purchases
Accounts payable turnover =
average accounts payable
sales
Accounts receivable turnover =
average accounts receivable
sales
Asset turnover =
average total assets
Cash conversion cycle = days inventory + days sales outstanding − days payable outstanding
Cost of goods sold = beginning inventory + purchases − ending inventory
Credit purchases = cost of goods sold + ending inventory − beginning inventory
Current ratio =
current assets
current liabilities
average inventory
Days inventory held =
cost of goods sold 365 days
365
Days inventory held =
inventory turnover
Days payable outstanding =
average accounts payable
purchases 365 days
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365 days
Days payable outstanding =
accounts payable turnover
Days sales outstanding =
average accounts receivable
sales 365 days
365 days
Days sales outstanding =
accounts receivable turnover
Equity multiplier =
average total assets
average equity
Gross profit margin =
gross profit
sales
EBIT
Interest coverage ratio =
interest expense
Inventory turnover =
Leverage ratio =
cost of goods sold (COGS)
average inventory
average total liabilities
average shareholders’ equity
sales
Long-term asset turnover =
average long-term assets
Long-term leverage ratio =
Net profit margin =
average long-term liabilities
average equity
net income
sales
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Quick ratio =
ROA =
( cash and marketable securities + accounts receivable )
current liabilities
net income
average total assets
sales
total assets net income
ROE = net income 

=
sales
total assets
equity
equity
SG&A margin =
selling, general, and administrative (SG&A) expenses
sales
Working capital = current assets − current liabilities
sales
Working capital turnover =
average working capital
5 KEY TERMS
accounts payable (AP) turnover Measures how long it takes a company to pay
its vendors, including suppliers of inventory, services, or other noninventory items.
accounts receivable (AR) turnover Measures a company’s efficiency in
collecting receivables from its customers.
asset turnover Measures how efficiently the company uses its assets to generate
return.
average collection period Measures the average number of days it takes for a
business to collect payment from a customer. Also called days sales outstanding
(DSO).
balance sheet A financial statement that provides a snapshot of the company’s
resources and the claims on those resources at a specific point in time.
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cash conversion cycle The length of time between when a company must pay its
suppliers for inventory until it collects cash from its customers.
current ratio Measures the sufficiency of a firm’s funds, provided by current assets,
to meet demand from current liabilities.
days inventory held The average number of days the inventory is held before it is
sold.
days payable outstanding (DPO) The number of days it takes the company to
pay its accounts payable.
DuPont framework A ratio analysis method, originated by the DuPont
Corporation in the 1920s, which decomposes ROE into subcomponents to provide a
deeper look at how profit (or loss) was generated.
equity multiplier The measure of the impact of debt on a firm’s ROE.
financial leverage The degree to which a company uses fixed-cost financing such
as bank loans, bonds, and preferred stock. The more debt and preferred stock
financing a company uses, the higher its financial leverage.
gross profit margin The amount of profit that is left to cover other expenses after
only the cost of goods sold is subtracted from revenues.
income statement A financial statement that shows an entity’s operating
performance over a given period of time.
interest coverage ratio Gauges whether a business can make the interest
payments on its outstanding debt.
inventory turnover Measures how often the inventory is sold during a given time
period.
profitability In the DuPont framework, the profit margin that the company
achieves from each dollar of sales after all expenses have been accounted for.
quick ratio Measures a firm’s ability to meet current obligations even if its
inventory cannot be sold immediately.
ratio analysis The use of simple calculations as financial analysis tools, which can
be used to gain insights about a company’s business model and financial
performance.
return on assets (ROA) An indicator of the company’s profitability relative to its
assets or total capital employed in the firm.
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return on equity (ROE) A measure of a business’s profitability in relation to its
shareholder equity. It is found by dividing net income by the book value of the equity.
selling, general, and administrative (SG&A) margin The amount of SG&A
expenses incurred by a company for every dollar of revenues earned.
shareholders’ equity A measure of a business’s profitability that is found by
subtracting liabilities from the company’s assets. It consists of contributed capital
(stock) and retained earnings.
statement of cash flows A financial statement showing cash sources and uses by a
company over an accounting cycle.
working capital The liquid capital used in day-to-day business operations.
working capital turnover Measures the efficiency with which a company manages
its working capital to generate sales.
6 ENDNOTES
1 Inditex, Annual Report 2014 (A Coruña, Spain: Inditex, 2015) p. 193.
2 Prada Group, Annual Report 2014 (Milan, Italy, 2015), p. 5.
3 Prada Group, Annual Report 2014 (Milan, Italy, 2015), p. 17.
4 Urban Outfitters, Inc. SEC Form 10-K, January 31, 2015 (Philadelphia, PA), p. 1.
5 Urban Outfitters, Inc. SEC Form 10-K, January 31, 2015 (Philadelphia, PA), pp. 2–3.
6 Nordstrom, Inc., SEC Form 10-K, January 31, 2015 (Seattle, WA), p. 4.
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7 INDEX
accounts payable (AP) turnover, 18, 19,
32, 34
accounts receivable (AR) turnover, 16,
17, 32, 34
asset turnover, 11, 12, 32, 34
assets, in return on equity calculation, 6,
7
average collection period, 17, 34
balance sheet, 4, 34
cash conversion cycle, 20, 21, 32, 35
cost of goods sold, 32
credit purchase, 32
current ratio, 28, 29, 32, 35
days inventory held, 16, 32, 35
days payable outstanding (DPO), 19, 20,
21, 32, 33, 35
days sales outstanding (DSO), 17, 18, 20,
21, 32, 33, 35
DuPont framework, 3, 5, 7, 35
efficiency ratios, 23
equity multiplier, 23, 24, 25, 33, 35
equity, in return on equity calculation,
6, 7
financial analysis, 3, 5, 7
financial leverage, 6, 35
Gap, 3, 4, 8, 9, 10, 11, 12, 13, 14, 15, 16,
17, 18, 19, 20, 21, 22, 23, 25, 26, 27, 28,
29, 30
gross profit margin, 9, 33, 35
income statement, 4, 35
Inditex, 3, 4, 8, 9, 10, 11, 12, 13, 15, 16,
17, 18, 19, 20, 21, 22, 25, 26, 27, 28, 29
interest coverage ratio, 27, 28, 33, 35
interest expense, 13
inventory turnover, 14, 15, 33, 35
leverage, 35
leverage ratio, 26, 33
liquidity ratios, 28
long-term asset turnover, 13, 33
long-term leverage ratio, 26, 27, 33
net income, 6, 7, 12, 13
net profit margin, 8, 33
Nordstrom, 3, 4, 8, 9, 10, 11, 12, 13, 15,
16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28,
29
operating efficiency, 6, 11
performance, analysis of, 3, 5, 7, 9, 10
performance, financial leverage and, 23,
24, 30
performance, mix of assets driving, 13
Prada, 3, 4, 7, 8, 9, 10, 11, 12, 13, 14, 15,
16, 17, 18, 19, 20, 21, 22, 25, 26, 27, 28,
29, 31
profit margins, 6
profitability, 6, 8, 35
profitability ratios, 10
quick ratio, 29, 34, 35
ratio analysis, 3, 35
ratios, periods used in calculating, 5
return on assets (ROA), 5, 12, 13, 34, 36
return on equity (ROE), 5, 6, 7, 8, 34, 36
sales, in return on equity calculation, 6,
7
selling, general, and administrative
(SG&A) margin, 9, 10, 34, 36
shareholders’ equity (SE), 5, 7, 23, 25,
26, 27, 31, 33, 36
statement of cash flows, 4, 36
Urban Outfitters, 3, 4, 8, 9, 10, 11, 12,
13, 14, 15, 16, 17, 18, 19, 20, 21, 22, 25,
26, 27, 28, 29, 30
working capital, 14, 22, 34, 36
working capital turnover, 22, 34, 36
5056 | Core Reading: ANALYZING FINANCIAL STATEMENTS
37
9 – 117 – 038
R E V : J A N U A R Y 2 2, 2 0 1 9
G E RA RD O P É RE Z C A V A Z O S
S U R AJ S R I N I V AS AN
M O NI C A BA R A LD I
Signet Jewelers: Assessing Customer Financing
Risk
“I think they’re heading for a cliff,” said Marc Cohodes referring to his latest short-sell target, Signet
Jewelers (Signet).1 Cohodes had made a long career as a canny short seller, with successful shorts on
companies from pinball manufacturers to speech-recognition software companies to subprime
lenders.2 In early 2016, he had set his sights on Signet, the parent company of jewelry brands such as
Kay, Zales, and Jared. Cohodes believed that Signet had become addicted to boosting sales through a
risky customer credit program and had a product portfolio consisting of low-quality jewelry—
”trinkets,” as he called them.3 According to Cohodes, Signet was also masking the quality of its credit
program through a practice called recency accounting, which allowed them to downplay the number
of customers who were delinquent on repayment.
Signet pushed back, with CEO Mark Light decrying the “targeted attack” of Cohodes and other
short sellers and affirming that its in-house customer financing program, which the company
considered a major competitive advantage, followed “strict risk tolerance standards.”4,5 The company
also announced strategic moves, including the potential sale of its credit portfolio and an investment
by a private equity firm. Investors and analysts appeared to buy Signet’s argument: its stock price had
stabilized by February 2017, buoyed by bullish arguments for Signet’s growth prospects and
competitive advantages in a fragmented jewelry industry. 6,7
Cohodes was undeterred. He said, “Their credit book, to me, is beyond toxic. So you have a toxic
business, a toxic combination, and I don’t know their way out. I do not know their way out.”8
Signet Jewelers
Company History
Signet, initially known as Ratner Group, was founded in the U.K. in 1949 and rapidly expanded
through a series of acquisitions in the 1980s and early 1990s.9 The company rebranded as Signet in 1993
and grew throughout the 2000s both organically and through acquisitions. In 2008, the company
Professors Gerardo Pérez Cavazos and Suraj Srinivasan and Case Researcher Monica Baraldi (Case Research & Writing Group) prepared this case
with the assistance of Teaching Fellow Iris Leung and Research Associate Quinn Pitcher. It was reviewed and approved before publication by Marc
Cohodes. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed
solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or
ineffective management.
Copyright © 2017, 2018, 2019 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized,
photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
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redomiciled in Bermuda, keeping its headquarters in Akron, Ohio. In May 2014, Signet acquired Zale
Corporation, a large competitor that owned Zales jewelry stores, for $1.4 billion. 10 By 2016, Signet was
the world’s largest retail jeweler, focusing on the mid-market segment of the sector. The company had
a 13-14% share of the $41 billion U.S. mid-market jewelry segment. No other competitor had more than
a 1% share of the segment.11 (See Exhibit 1 for Signet’s stock price data.)
Brand Strategy
In 2016, Signet employed around 30,000 people and operated in 3,625 in-mall and off-mall stores
and kiosks in the US, Canada, and the UK. Signet’s goal was to be the leader in the mid-market jewelry
segment wherever it operated. Mid-market jewelry purchases generally ranged from $100-$10,000.
Bridal jewelry was crucial to Signet, owing to the large and stable market for jewelry pieces such as
engagement rings (see Exhibit 2 on Signet’s merchandise and segment mix and Exhibit 3 for Signet’s
financial statements). For Signet’s three main American brands, Kay, Jared, and Zales, engagement
rings between $1,000-5,000 comprised 65%, 78%, and 45% of their total stock of engagement rings,
respectively. 12,13,14 Signet leveraged its large size to buy many of its goods directly from international
vendors, a cost advantage not available to the myriad of small players in the jewelry sector.15
Signet used a multi-brand strategy to capture a greater share of the mid-market jewelry sector. The
company operated its Kay and Jared stores under the umbrella of Sterling Jewelers. Kay was the largest
specialty retail jewelry store brand in the U.S. based on sales. Jared operated stores at free-standing
sites across the U.S. Zales operated predominantly in shopping malls, emphasizing diamond jewelry
to shoppers who sought jewelry from recognizable designers and brands. Amongst its international
brands, Signet owned market leaders H. Samuel and Ernest Jones in the U.K. and Peoples in Canada.
Accordingly, Signet’s operations were organized into five business segments: Sterling Jewelers, U.K.
Jewelry, Zale Jewelry, Piercing Pagoda, and Others.16
Customer Finance
Customers at Kay and Jared had the opportunity to access a financing program provided directly
by Signet .1 7 Zales stores did not offer the finance program, although they did offer third-party
financing through a Zales-branded credit card and planned to adopt the credit program over time.
Signet maintained that its financing program was integral to maintaining its competitive advantage
and that no other competitor had the scale and systems necessary to manage an in-house financing
program.18 Financing programs required infrastructure to approve loans, service existing loans, and
collect in instances where full repayment was not received. Such infrastructure was not cheap: based
on the scale of Signet operations, equity research analysts estimated that the SG&A expenses associated
with retail financing businesses could total up to 30% of interest income.19
The financing program allowed Signet to reach middle income customers that didn’t have the
financial ability to purchase a piece of jewelry outright . This was a boon to bridal jewelry sales, as 75%
of these sales in the Sterling division utilized financing.20 In its 2016 annual report, Signet stated,
Our in-house consumer financing program provides Signet with a competitive
advantage through the enabling of incremental profitable sales that would not occur
without a consumer financing program. Several factors inherent in the U.S. jewelry
business support the circumstances through which Signet is uniquely positioned to
generate profitable incremental business through its consumer financing program. These
factors include a high average transaction value; a significant population of customers
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seeking to finance merchandise primarily in the bridal category; and the minimum scale
necessary to administer credit programs efficiently.21
Signet claimed that the “lifetime value” of a customer obtained through the financing program was
“estimated to be 3.5 times that” of customers not obtained through the program.Higher average value
for in-house financed transactions and high demand for financing in the bridal category drove this
additional value. Customer financing also provided the opportunity to generate new revenues from
finance charges and fees. On average, Signet’s receivable portfolio turned over every nine months. At
the end of January 2016 and 2015, 52.7% and 50.5% of balances due, respectively, were from customers
who had enrolled in the financing program more than 12 months prior to their most recent purchase. 22
(See Exhibit 4 on Signet’s customers financing statistics.)
Credit applications originating at Signet’s retail locations were automatically approved or denied
by a statistical model designed by Signet’s Risk Management team. The algorithm, which took the
approval decision out of the hands of commissions-based salespeople, considered credit bureau
information, income, employment, address verification, and debt levels. 23 Signet also relied on the Fair
Isaac Corporation (FICO) score, a credit risk metric that was widely used in the consumer finance
industry to assess credit worthiness.24 Signet reported that, from 2014 to 2016, the balance-weighted
FICO score for customers utilizing financing was consistently around 660.25 In 2015, individuals
earning less than 50% of median family income (MFI) in the United States had an average credit score
of 664, compared to 775 for individuals with an income greater than 120% of MFI. 26 Overall, the average
FICO score for adult Americans in 2015 was approximately 695.27
Grant’s Interest Rate Observer, a leading publication covering debt markets, found that the
weighted FICO score of Signet customers was “marginally higher than the 640 threshold of
subprime.”28 Individuals with subprime credit scores generally received worse financing terms,
generally in the form of higher interest rates.29 Credit card issuers such as JPMorgan Chase and
Citigroup typically offered interest rates that ranged from 14% for good and excellent borrowers to
25% for borrowers with average or subprime credit quality.30
Signet reported the performance of its accounts receivable portfolio using the recency accounting
method, which required that customers paid at least 75% of their due amounts to remain curren t (see
Exhibit 5 for Signet’s recency accounting practices). This contrasted with the more conservative
“contractual method”, which required customers to pay 100% of the periodical obligation by the
negotiated deadline to keep a loan current .31 (See Exhibit 6 for opinions on the use of recency and
contractual accounting).
Jewelry Industry
In 2016, sales in the U.S. jewelry sector reached $61.8 billion. Diamonds accounted for 36% of sales,
although their share of total sales was falling due to lower demand and lower prices. Sector sales grew
13.5% from 2011 to 2016. Sales were categorized into two groups: costume jewelry and fine jewelry.
Costume jewelry was generally inexpensive and made with imitation gems, making up 83% of sales
volume but only 17% of sales value. In 2016, the average price of costume jewelry was approximately
$13, fine jewelry was $311, and luxury jewelry was $1,520.32
The average US household spent $612 per year on fine jewelry and watches. Household income was
a major driver of jewelry purchasing behavior: households with annual income of over $150,000 spent
an average of approximately $2,000 on jewelry per year. Individuals aged 25-34 years and 55-64 years
spent a greater amount than average on jewelry. For the 25-34 age group, marriage-related purchases
3
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Signet Jewelers: Assessing Customer Financing Risk
were the main driver, while earning power drove the trend for the 55-64 age group. The 25-34 age
group spent an average of $786 on jewelry per household.33
Consumers seeking to buy jewelry had several choices, from specialty retail jewelers like Signet and
Tiffany & Co. (Tiffany), large all-purpose retailers such as Wal-Mart and Costco, department stores
such as Macy’s and J.C. Penney, online from Blue Nile, and TV retailers like QVC. Specialty jewelry
retailers made up 39% of sales. Online retailing was growing, accounting for a 16% of sales by 2016,
facilitated by improved technology and stronger consumer confidence in ecommerce.34
The retail jewelry industry was highly fragmented and competitive, with around 21,000 retailers at
the end of 2014.35 Mergers and bankruptcies were common occurrences.36 Sector specialists reported
that over 200 jewelry retailers in the U.S. closed their operations in the third quarter of 2015 alone.
Specialty jewelers such as Signet, Blue Nile, and Tiffany competed on brand reputation, customer
service and product innovation, with competition for engagement jewelry being especially intense .37
Blue Nile
In 1999, Blue Nile became the first company to sell diamonds online and soon became the world
largest online retailer of diamonds and fine jewelry.38 In 2015, the company achieved net sales of $480
million and employed over 350 people. The company’s goal was to “be nothing less than the
preeminent destination for diamond engagement rings and fine jewelry both online and off.” It
advertised competitive prices and maintained low inventory since diamonds were purchased on a “just
in time” basis following customers’ orders.
Blue Nile aimed to maintain lower overhead than
traditional jewelers and pass the savings on to the customer.39 Blue Nile was an online-only retailer
until 2015, when it began testing a display case of bridal jewelry in two Nordstrom stores. 40 Shortly
after, Blue Nile opened its first display-only stores, called “Webrooms,” soon expanding to four
different U.S. states.41 In the “Webrooms” customers could see and touch precious stones, and receive
guidance from Blue Nile consultants. However, all transactions were still completed online.
Blue Nile did not extend credit to customers, but issued a private label credit card through a
sponsoring bank. The card did not have an annual fee and awarded special access to cardholder-only
offers and promotions. On Blue Nile’s balance sheet, trade accounts receivable were composed
primarily of amounts due from financial institutions related to credit card sales.
Tiffany & Co.
Tiffany, founded in 1837, was a global specialty retailer headquartered in New York City. The
company was the clear leader of a fragmented luxury jewelry sector, capturing a 14.2% market share
compared to 5.8% for the next-closest competitor, Cartier.42 Tiffany focused on maintaining its leading
position in the luxury market, projecting a brand image associated with “high-quality gemstone
jewelry, particularly diamond jewelry; sophisticated style and romance; excellent customer service; an
elegant store and online environment; upscale store locations; “classic” product positioning; and
distinctive and high-quality packaging materials (most significantly, the TIFFANY & CO. blue box).” 43
Tiffany maintained a flagship store on Fifth Avenue in New York City, which served as an attraction
for international tourists and serious buyers alike.
Tiffany managed four product segments: fashion jewelry, engagement jewelry and wedding bands,
statement jewelry, and non-jewelry accessories such as leather goods, timepieces, china, crystal, and
fragrances. 44 The company operated 124 Tiffany & Co. stores in the Americas, 81 stores in Asia-Pacific,
56 stores in Japan, 41 stores in Europe, and five stores in the United Arab Emirates.45 The company also
sold merchandise through an ecommerce website.
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Tiffany offered a “Tiffany Select Financing” program on engagement rings and watches starting at
$1,000 and all other purchases starting at $2,500. 46 The receivables associated with Tiffany’s credit
program amounted to $71.9 million and $75.2 million in fiscal years 2016 and 2015, respectively. Tiffany
reported that 97% of those receivables were current, and its allowance for estimated losses was $1.1
million on January 31, 2017 (see Exhibits 7a-7c for Blue Nile and Tiffany financials).
Luxury diamond jewelry was Tiffany’s main revenue source, with input purchased globally and
manufactured mainly in America.47 In 2015, engagement jewelry and wedding bands made up 29% of
Tiffany’s global sales, with an average price of $3,300. 48 Tiffany’s had an impressive legacy of jewelry
design, dating back to the 19th century. The company’s website touted its legacy of design leadership,
claiming to have in 1886 “introduced the engagement ring as we know it today. Previously, diamond
rings were set in bezels. But Mr. Tiffany’s ring was designed to highlight brilliant-cut diamonds by
lifting the stone off the band into the light.” 49 In addition, throughout the company’s history, various
organizations had commissioned Tiffany’s to create custom designs, such as the Lombardi Trophy for
the NFL and the Great Seal of the United States, which appears on the one-dollar bill.50
Cohodes Takes Aim at Signet
Cohodes’ Thesis
Marc Cohodes began his finance career in 1982 at Northern Trust in Chicago after completing his
undergraduate education at Babson College. In 1985, he joined David Rocker (MBA ‘69) at his new
fund, Rocker Partners, and helped it grow from $20 million in assets to $700 million by 2000.51 By then,
Cohodes had risen to general partner, specializing in short-selling.a He was described as a man “who
knew every trick company executives used to make their operations look better than they actually
were. [Cohodes] prides himself on being able to spot trouble.” 52 In 2003, Cohodes gained national
attention when he engaged in a long-term short-selling campaign against NovaStar Financial, a
subprime lender that eventually sought Chapter 11 bankruptcy protection.53
Cohodes outlined his reasoning for short-selling Signet. First, according to Cohodes,
They [Signet] don’t really sell jewelry. You can’t appraise this stuff. If you go to Blue
Nile, Tiffany, or the HBS jewelry store, and they sell you a ring with a 2-carat diamond
with G-color, VS1-clarity, you can get it appraised and insured. You are buying an asset.
It’s real. You may overpay, but it’s worth something. You can appraise it, you can sell it.
You buy a Zales, Kay, Jared’s piece of jewelry, it’s not worth anything. It’s not real. I mean,
it’s real, but it’s so marked up, there’s no jewel or gem value to what you’re buying.54
Cohodes believed that Signet was boosting sales by offering customers credit because of the low
quality of the jewelry. He believed that 60-65% of the company’s business came from lending to
customers and the sale of warranty-like Extended Service Plans (ESPs).55 Cohodes said:
A while ago, this guy [an activist investor] showed up and encouraged Signet to use
credit to boost sales. Once you use credit to boost sales, it’s like being on drugs. It’s very
a Short-selling was a bet placed on a stock that, according to the short-seller’s research and belief, was overvalued. To short-sell
a stock, investors borrowed a stock from someone who owned it, then sold it. If the short seller made the right prediction, the
stock fell in value and the short seller bought the stock on the open market to return what they had borrowed. If the repurchase
price was lower because the stock dropped, the short seller made a profit. If the price rose, the short-seller would need more
money to “cover” the same number of shares and the short-seller would lose money. Jeffrey B. Little and Lucien Rhodes,
Understanding Wall Street, New York: McGraw-Hill, 2004, p. 94.
5
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Signet Jewelers: Assessing Customer Financing Risk
hard to get off. And that’s where they are. Even if they try to sell their credit book: Who
wants it? And how much of a haircut will they demand in order to buy it? And it’s kind
of like, ok, is the credit book worth 80 cents on the dollar, 60 cents on the dollar? Whatever
it is, it’s not worth 100. At the end of the day the credit is no good. I come for you and say
you owe me money, I want the ring back, and the guy says go fish, we broke up and she
took the ring. You can repo a car that has title. You can repo a house that has title. How
do you have credit or anything against some ring, necklace, earrings, or whatever?56
The media picked up on the concerns that Cohodes and other investors had with Signet’s business
model. On February 15, 2016, Bloomberg News ran an article titled “Is Signet a diamond empire or
finance company?” The article detailed how an aggressive credit policy had helped Signet become one
of the largest jewelry companies in the U.S. but cautioned, “behind its sparkly empire lie consumer
loans that bankers might consider subprime debt.”57 Analysts estimated that 35% of Signet’s
receivables were owed by subprime borrowers. They estimated that if Signet was to sell its credit book
it would have to take a 25% to 30% discount on its subprime receivables, while the discount on prime
receivables would be no greater than 5%. 58
Use of Recency Accounting
Cohodes was particularly concerned with Signet’s accounting of its receivables portfolio through
the “recency” method.59 With recency accounting, the customer might only need to pay a portion of
the amount due in a period for the account to remain current. As a result, the amount of delinquent
loans was understated relative to the more widely used approach, the contractual method.60 For
Cohodes, recency accounting masked the true condition of Signet’s credit portfolio:
No retailer uses recency accounting anymore. No one uses it. The question is, why do
they use it and what would it look like if they account for it like other companies? And
the credit trends are not going their way and that’s in a boom economy. So frankly, I don’t
know how they can get out of this thing. I think they’re heading for a cliff. The cliff is, ‘we
can’t sell the credit book, we can’t really extend more credit and our business is very credit
dependent.’ It’s kind of like they’re going to have to go off of heroin cold turkey which is
going to affect their sales and earnings. Then the stock falls and debt becomes an issue.61
One analyst noted that, “the percentage of non-performing loans as a percentage of Signet’s
receivable balance has remained constant: at 3.8% in 2015; 3.7% in 2014; 3.6% in 2013; 3.7% in 2012” and
that it was rare to see such limited movement in non-performing loans, suggesting that the trend may
indicate the use of the recency method to produce stable numbers.62
In June 2016, Grant’s Interest Rate Observer reported on Signet, based on Cohodes research. The
Grant’s report announced that “in-store credit facilitated no fewer than 61.7% of sales in the quarter
ended April 30 [2016]” increasing from 52.6% in fiscal year 2007. The report also noted Cohodes
research on bankruptcy filings that named Signet as a creditor. Through March of 2016, 3,274
individuals submitting for personal bankruptcy named Signet as a creditor, up from 2,663 in the fourth
quarter of 2015 and 1,903 in the first quarter of 2015.63 Following the report, Signet stock fell 6.58%, to
close at $92.23 on June 2, 2016.64
Extended Service Plans
There were additional concerns regarding Signet’s sales of extended service plans (ESPs). The ESPs
functioned like a warranty and allowed consumers to access special services, such as the possibility of
having a ring resized for life. ESP sales had grown in significance as a percentage of total sales from
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2014 to 2016.65 Most rings in Signet’s stores were sized 7 for women and 10 for men, requiring resizing
upfront for most customers. Signet sales representatives would pitch the ESP to these customers since
it was only slightly more expensive than the resizing alone. Grant’s Interest Rate Observer noted that
ESPs were responsible for $348 million in revenue, equal to 3.5% of total revenue, in the fiscal year
ending January 30, 2016.66 Signet did not disclose the profit margin on these plans, but Grant’s believed
that they were a material portion of operating earnings.67
Cohodes was more colorful in his characterization of the ESP program: “Why you need an extended
warranty on jewelry is beyond me. That’s the dumbest thing I’ve ever seen. Oh, it includes ‘free ring
sizing.’ Come on now.”68
Two Recent Scandals
Compounding the criticisms of Cohodes and other short-sellers was a run of bad news for Signet.
In February 2016, an arbiter ruled that a group of current and former employees could pursue their
claims that Signet had discriminated against women under the Equal Pay Act. Several female workers
had filed a lawsuit in 2008 alleging that Signet had paid them less and promoted them less often than
their male counterparts.69 The arbiter’s decision came two years after other female employees accused
CEO Mark Light and other top executives of bias and harassment. 70 In February 2017, the Washington
Post reported that “roughly 250 women and men who worked at Sterling allege that female employees
at the company throughout the 1990s and 2000s were routinely sexually harassed.”71 This news led to
a one-day stock price decline of 12.75%.72 Cohodes reacted to the scandal stating: “I’m not surprised.
When I invest, I always look for bad management because bad people make for great shorts. They
never disappoint. They not only mess up once, they do it over and over again.”
In May 2016, BuzzFeed, an internet media outlet, identified a group of Kay Jewelers customers that
complained about receiving defective jewels after sending them in for repairs. 73 More than 300
customers lodged complaints against Signet with the Consumer Financial Protection Bureau,
lamenting that the diamonds did not sparkle as much, had imperfections, and even had different serial
numbers.74 Analysts reported that customers were taking to Kay’s Facebook page to register
complaints, focusing on “increased dissatisfaction among shoppers beginning in April […] reaching an
average of 5.5 complaints per day.”75 Most complaints were about replaced gems, but branched out to
other products, services, lost items, and bad repairs.76
Signet Responds
Recency Accounting
In March of 2016, Signet began to respond to concerns about its credit portfolio and recency
accounting. CFO Michele Santana responded to criticisms, saying that “we [Signet] have provided and
operated in-house credit for 30 years and it gives us a number of competitive advantages,” especially
when it came to bridal sales. She continued: “due to our scale, we are able to administer our credit
program very efficiently and effectively,” and that it was “designed for rapid repayment that
minimizes risk and enables the customer to make additional jewelry purchases using their credit
facility.” 77
During the 2016 first quarter conference call in May 2016, Santana responded to questions about the
use of recency accounting:
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Signet Jewelers: Assessing Customer Financing Risk
At the end of the day, regardless of recency or contractual, whatever method you’re
on, the financial results are going to yield the same answer. The provision will be the
same, our bad debt expense will be the same, but to that point, the reason why we use our
recency is, one, we have done it since the beginning of time and it really has worked well
for us over the years with the type of lending that we do. Jewelry lending is that emotional
It gives the customer some
connection and it does optimize our collections for us…
flexibility based on the disciplined criteria that we had outlined of our recency ageing,
what a customer has to remit to stay current. It leaves that customer in good standing if
they are having maybe a challenging month where they can’t remit a full payment, and
that psychology and that flexibility of working with that customer puts that customer
first…78
Santana assured analysts that Signet’s financial results would be the same regardless of the kind of
accounting practice they used and that the range of customer FICO scores was “broadly in the same
range as what we saw in [2015] Q4.”79
Credit Portfolio Review
Signet announced in its May 2016 conference call that its board of directors had authorized
management to conduct a strategic evaluation of the company’s credit portfolio. Goldman Sachs had
been engaged as the company’s financial advisor in this process.80 CEO Light said,
We will consider a full range of options as we evaluate our in-house and outsourced
credit programs. These options include but are not limited to optimizing credit offerings,
optimizing allocated debt and equity capitalization of the credit portfolio including
potential incremental securitization; bringing all credit function in-house over the long
term; insourcing some credit functions and outsourcing others, and outsourcing all credit
functions. This evaluation is a top priority and as we move through this we will remain
focused on executing our operational plans and driving profitable growth in our
business.81
Signet announced its second quarter fiscal year 2016 results in August 2016. Light provided an
update on the sale of the credit portfolio, stating that they were moving “as quickly and prudently as
possible” on the issue. He assured investors that, if the credit portfolio remained on Signet’s books,
they would likely “increase leverage against it and use the proceeds on growth initiatives, buybacks
and/or dividends.” Light also noted that Signet would “likely revamp and expand our reporting and
disclosure of credit profitability, contractual aging, and other metrics.” 82 Throughout, Light defended
Signet’s business model, saying “much like other companies that sell valuable things like cars and
computers, we at Signet sell products, we finance them and we insure them. It’s a complete end-to-end
solution that our customers embrace and makes great business sense for us.”83
Leonard Green & Partners Investment and Second Quarter Results
Signet’s 2016 second quarter results showed a decrease in total sales of 2.6%, compared to a 4.2%
increase in the same quarter in the prior year. Light admitted that “Signet sales and earnings were
disappointing in the second quarter, giving no sign yet of a rebounding trend.” Yet he remained
optimistic: “To sum up, we had a challenging quarter but we know why and we have sound plans to
address it. We possess numerous competitive advantages and expect to strengthen our leading position
and gain profitable market share.”84
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During the earnings call, Light announced that the private equity firm Leonard Green & Partners
had agreed to invest $625 million in convertible preferred Signet shares, representing 8% of Signet
common stock. Signet intended to use most of the proceeds in a share buyback scheme.85 Signet
believed that Leonard Green & Partners would bring retail experience to the board, and added
Jonathan Sokoloff of the firm to its board. Light said: “We wanted a long-term investor. A firm doing
due diligence and getting under the covers validates our business model that Wall Street as a whole
isn’t getting.”86 Cohodes saw the investment in a different light:
Why wouldn’t you invest in the convertible preferred? They get a 5% dividend and
are protected in the downside. Let’s say the company hits the trees, they’re first in line.
First in the capital structure. All that is, is kind of a high juice loan. You do that deal all
day long. What do they care? The stock could go to zero, and if the company is really in
trouble, they’re first in line. They’re more than happy to step up.
Response to Recent Scandals
Responding to the BuzzFeed report on alleged gem swaps and jewelry quality, Signet issued a press
release in June 2016, stating:
“Signet Jewelers’ entire team culture is directed toward ensuring that we earn and
maintain customer trust. […] This commitment to customer care has allowed Signet to
satisfy many millions of customers, year after year. […] In our design and service centers,
we manage more than 4,000,000 service and repair transactions each year, and over 99%
are completed without negative customer feedback. Of those generating negative
customer feedback, many are related to either repairs taking longer than expected due to
our high standards, or shipping delays, which we work diligently to address in
cooperation with our shipping partners. In addition, we strongly object to recent
allegations on social media, republished and grossly amplified, that our team members
systematically mishandle customers’ jewelry repairs or engage in “diamond swapping.”
Incidents of misconduct, which are exceedingly rare, are dealt with swiftly and
appropriately.
Light added: “The trust of our customers is not something we take lightly. It has been an honor to
help our customers […] for almost 100 years, and dedication to superior customer service and quality
control is integral to who we are and how we conduct business. Our guests are our most precious
commodity, and we are committed to maintaining their trust.”87 Signet announced in August that it
would be testing an in-store system to “highlight the unique marks of everybody’s diamond.” Light
maintained that Signet had “a great process in place” when it came to the careful repair and return of
jewelry, but said that the new systems would create “even more transparency” and would be a “huge
competitive advantage” for Signet over time.88
In response to the company’s ongoing gender discrimination scandal, Signet issued a public
response:
The fact is, many of the allegations were brought to Sterling’s attention for the first
time during the current litigation, and some appear to date back more than 25 years. The
company has processes in place for receiving and investigating such allegations, and we
wish that anyone who had a workplace concern back then used those processes, so that
we could have investigated their concerns and responded appropriately.89
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Signet Jewelers: Assessing Customer Financing Risk
Light also took aim at the short-sellers, claiming Signet was the victim of a “targeted attack by short
sellers, who led an orchestrated campaign to amplify the controversy.”90
Changes in ESP Accounting91
In May 2016, Signet changed its revenue recognition practices relating to ESPs. Prior to this date,
“the Sterling Jewelers division deferred and recognized revenue of its ESPs over a period of 14 years,
with approximately 45% of the revenue recognized in the first two years.” With the change in revenue
recognition, “the Sterling Jewelers division deferred and recognized revenue over 17 years for all
ESPs.” It also started including the upfront resizing costs as part of the ESPs’ claim costs, changing its
accounting policies to recognize “approximately 57% [of] revenue within the first two years for ESPs
sold on or after May 2, 2015.” Signet claimed the move was intended to bring ESP revenue recognition
for the Sterling division in line with practices in the Zale division.
2016 Results
Signet published its 2016 results on March 9, 2017 and used its earnings call to directly address some
of the concerns of Cohodes and the other short-sellers while reaffirming its strength in mid-market
jewelry. CEO Mark Light commented
Over the last seven years, post-recession, Signet U.S. total sales have grown at 12%
compounded annual growth rate. […] Signet has consistently outperformed the jewelry
industry. Given the fragmented industry, we believe we have many years of profitable
growth and market share gains ahead of us.92
However, short-selling and the attendant public criticisms of Signet had shaken investor
confidence. The stock had fallen from a peak of $151 on October 30, 2015 to $70 on March 9th, 2017.93
Sell-Side Analyst Reaction
Prior to Cohodes’ involvement, analyst sentiment was predominantly bullish heading into 2016.
The bullish tone was kicked off by the well-known analyst Abby Joseph Cohen, president of the Global
Markets Institute at Goldman Sachs, who picked Signet as one of her stocks to watch at Barron’s 2016
Investment Roundtable in January 2016 when the stock was trading at $126.93. Cohen said that “The
company has had some issues: It was sued for gender discrimination. But Signet is held in high esteem
by customers, and has a good distribution network.”94
Other analysts did not share Cohodes’s concerns about Signet’s credit portfolio. Analysts at Wells
Fargo’s Equity Research believed the risk was overstated, noting on June 23, 2016 that 65% of all
transactions across all of Signet’s businesses had been made without credit since mid-2015. The analysts
were also unconcerned with the use of recency accounting, reporting that Signet’s percentage of nonperforming loans peaked at 5% during the 2008-2009 credit crisis, compared to 4% at the time of the
report, and that the company had nonetheless emerged from the recession “relatively healthy.” Finally,
the analysts noted that the number of credit accounts per Kay/Jared store had been roughly steady
over five years, which they took as evidence that Signet had not “been moving down the credit chain
to a broader set of customers.”95
Deutsche Bank Market Research remained positive on Signet and gave it a “buy” rating in its
August 2016 report. They believed that Signet’s business had been hurt by the BuzzFeed report and
the attacks on its credit portfolio by short-sellers, but did not believe that these issues would do any
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Signet Jewelers: Assessing Customer Financing Risk
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more than cause some short-term volatility. Deutsche Bank’s analysts encouraged Signet to look past
the scandals of the past couple of months and to instead focus on the strength of its product line going
into the 2016 holiday season. Additionally, they believed that any downside associated with the sale of
Signet’s credit book would be offset by management’s stated commitment to creating shareholder
value through the sale of the book.96
Other analysts were more bearish and offered caveats. J.P. Morgan Equity Research downgraded
Signet to “neutral,” stating that it believed that Signet could achieve earnings growth in the low double
digits over the next couple of years despite concerns about the macro environment.97 Analysts were
also predicting that Signet would forego potential revenue if the sale of its $1.7 billion credit portfolio
was successful. Wells Fargo anticipated a potential sale price of $1.5 billion and a profit-sharing
arrangement.98 However, $600 million of the proceeds would have to be used to repay a securitization
backed by accounts receivables. In addition, they also forecasted $800-850 million in lost revenues due
to the lost control of the credit operation. Ultimately, according to the Wells Fargo analysts, in selling
the credit business, Signet would put at risk a financial to…

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