Analysis of Changes in Profitability and Growth: Cisco Systems, Inc. 1 By any stretch of the imagination, Cisco System s (CSCO) has been a strong growth company. A darling of the Internet boom of the late 1990s, it was one of the few technology companies tied to the Internet and telecommunications that prospered during that era. Its products - networking and communications equipment such as router and sw itching devices - built the infrastructure of the Internet. While most Internet and telecommunications firms str uggled and failed, their supplier, Cisco, capitalized on the new technology. At one poi nt in 2000, its market capitalization was over half a trillion dollars, the largest market capitaliza tion of any firm ever. Its stock price increased from $10 in 1995 to $80 in 2000, supported by sales growth from $2.0 billion in 1995 to $18.9 billion 2000. In early 2000, Ciscos P/E stood at 130 so investors saw plenty of room for more earnings growth. However, with the subsequent collapse of the technology bubble and the demise of telecommunications firm such as WorldCom, Qwes t, and AT&T, the anticipated growth failed to materialize. Indeed, in 2001 Cisco wrote down inventory by an astonish ing $2.3 billion (under the lower-of-cost-or-market rule), to reflect the dr op in demand for its products and the emergence of second-hand telecom equipment market. Exhibit 1 presents Ciscos income statements fo r the fiscal years 2000-2002 and balance sheets for 1999-2002. The exhibit also includes the cash flow from operations a nd cash investing sections of the cash flow statements. The 2000 sales of $18 .9 billion were up from $12.2 billion in 1999 and $8.5 billion in 1998, a tremendous gr owth record. But subsequent sales growth was not as impressive, as you can see, and led to declini ng earnings. Indeed, Cisc o posted a loss for 2001. Lower earnings on increasing shareholders equity clea rly implies that residual income is declining. By the end of 2002, Ciscos shares traded at $15, well down from the 2000 high of $80. Other information, most of the from the 10-K f ootnotes, that was useful in reformulating the financial statements is presented below. Note th at the cash flow statements from Exhibit 1 are particularly useful for identifying core income becau se some of the items in the reconciliation of net income to cash flow from operati ng activities involve unusual items.
Questions: 1. What adjustments are necessary to reformulate the income statements and balance sheets to properly separate financ ing from operations? 2. What adjustments are necessary to separate core operations from othe r sources of income? What items are identified as core in the Balance Sheet? 3. Calculate Core RNOA and decompose the ratio for Cisco for 2002 and 2001.
1. Long-term investments are comprised of the following: 2002 2001 2000 1999 Equity investments 567 1,529 6,225 877 Debt investments 8,233 8,817 7,463 6,155 8,800 10,346 13,688 7,032 All short-term investments ar e debt investments. Restri cted investments are debt investments. 2. $50 million of cash and equivalents is regarded as operating cash. 3. Interest and other income in the income statements is composed as follows. 2002 2001 2000 Interest income 895 967 577 Gain (loss) on investments (1,104) 163 531 (209) 1,130 1,108 The gain on investments applies mainly to debt and equity investments, but does include some derivative gains and losses and other small items. 4. The change in accumulated other comprehensiv e loss for all years was due almost entirely to unrealized gains and lo sses on debt investments. 5. Ciscos income tax rate (combined federal and state) is 36.8 percent.

Cisco Income Statements
					2002	2001	2000
Sales					18,915	22,293	18,928
Cost of sales, reported					6,902	11,221	6,746
Gross margin					12,013	11,072	12,182
R&D					3,448	3,922	2,704
Sales and marketing					4,264	5,296	3,946
General and administrative					618	778	633
Restructuring charges					---	1,170	---
Amortization of good will						690	154
Amortization of intagible assets					699	365	137
In-process R&D					65	855	1,373
total operating expenses					9,094	13,076	8,947
operating income from sales, before tax					2,919	(2,004)	3,235
Investment income					(209)	1,130	1,108
Income before tax					2,710	(874)	4,343
Taxes					817	140	1,675
Net income					1,893	(1,014)	2,668

Cisco Balance Sheets
Assets			2002	2001	2000	1999
Current Assets:
	Working Cash		9,484	4,873	4,234	913
	Short-term investments		3,172	2,034	1,291	1,189
	Accounts Receivable		1,105	1466	2299	1250
	Inventories		880	1684	1232	658
	Deferred tax assets		2,030	1809	1091	580
	Lease receivables		239	405	-	-
	Prepaid expenses		523	564	963	171
total current assets			17,433	12,835	11,110	4,761
	investments		8,800	10,346	13,688	7,032
	restricted investments			1,264	1,286	1,080
	Property and equipment		4,102	2,591	1,426	825
	Goodwill		3,565	3,189	2,937	157
	Lease receivables		39	253	527	500
	Purchased intangibles		797	1,470	1,150	303
	Other assets		3,059	3,290	746	235
Total assets			37,795	35,238	32,870	14,893
Liabilities
Current
	Accounts payable		470	644	739	374
	Income tax payable		579	241	233	630
	Accrued compensation		1,365	1,058	1,317	679
	Deferred revenue		3,892	3,214	1,386	724
	Other accrued liabilities		2,496	2,553	2,653	631
	Restructuring liabilities		322	386	---	---
			9,124	8,096	6,328	3,038
Minority interest			15	22	45	44
Common shareholders' equity			28,656	27,120	26,497	11,811

Cash Flow
Years Ended	July 27, 2002		July 28, 2001		July 29, 2000
Cash flows from operating activities:
Net income (loss)		$1,893.00		($1,014.00)		$2,668.00
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization		1,957		2,236		863
Provision for doubtful accounts		91		268		40
Provision for inventory		149		2,775		339
Deferred income taxes		($573.00)		($924.00)		($782.00)
Tax benefits from employee stock option plans		61		1,397		2,495
Adjustment to conform fiscal year ends of pooled acquisitions		-		-		($18.00)
In-process research and development		53		739		1,279
Net (gains) losses on investments and provision for losses		1,127		43		($92.00)
Restructuring costs and other special charges		-		501		-
Change in operating assets and liabilities:
Accounts receivable		270		569		($1,043.00)
Inventories		673		($1,644.00)		($887.00)
Prepaid expenses and other current assets		($28.00)		($25.00)		($249.00)
Accounts payable		($174.00)		($105.00)		286
Income taxes payable		389		($434.00)		($365.00)
Accrued compensation		307		($256.00)		576
Deferred revenue		678		1,629		662
Other accrued liabilities		($222.00)		251		369
Restructuring liabilities		($64.00)		386		-
Net cash provided by operating activities		6,587		6,392		6,141
Cash flows from investing activities:
Purchases of short-term investments		($5,473.00)		($4,594.00)		($2,473.00)
Proceeds from sales and maturities of short-term investments		5,868		4,370		2,481
Purchases of investments		($15,760.00)		($18,306.00)		($14,778.00)
Proceeds from sales and maturities of investments		15,317		15,579		13,240
Purchases of restricted investments		($291.00)		($941.00)		($458.00)
Proceeds from sales and maturities of restricted investments		1,471		1,082		206
Acquisition of property and equipment		($2,641.00)		($2,271.00)		($1,086.00)
Purchases of technology licenses		-		($4.00)		($444.00)
Acquisition of businesses, net of cash and cash equivalents		16		($13.00)		24
Change in lease receivables, net		380		457		($535.00)
Purchases of investments in privately held companies		($58.00)		($1,161.00)		($130.00)
Lease deposits		320		($320.00)		-
Purchase of minority interest of Cisco Systems, K.K. (Japan)		($115.00)		($365.00)		-
Other		159		($516.00)		($424.00)
Net cash used in investing activities		($807.00)		($7,003.00)		($4,377.00)
Cash flows from financing activities:
Issuance of common stock		655		1,262		1,564
Repurchase of common stock		($1,854.00)		-		-
Other		30		($12.00)		($7.00)
Net cash (used in) provided by financing activities		($1,169.00)		1,250		1,557
Net increase in cash and cash equivalents		4,611		639		3,321
Cash and cash equivalents, beginning of fiscal year		4,873		4,234		913
Cash and cash equivalents, end of fiscal year		$9,484.00		$4,873.00		$4,234.00