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Case 6-3 chapter 6 Financial Statement Analysis 10th k.r. subramanyam john j. wild On September 16, 20X8, Toys \"R\" Us [ToysRUs.Com], the world's largest toy seller, announced strategic initiatives to restructure its business. The total cost to implement these initiatives yielded a charge of $508 million, which exceeded operating earnings from the prior year. The $508 million charge consisted of costs to close and/or downsize stores, distribution centers, and administrative functions to streamline store formats, inventories and supply chains; and for changes in accounting estimates and provisions for legal settlements. These initiatives included the closing of 50 toy stores in the international division, predominantly in continental Europe, and 9 in the U.S. that did not meet the company's return on investment goals. It also closed 31 Kids \"R\"Us stores and converted 28 nearby U.S. toy stores into combination stores. Combination stores sell toys and apparel. These initiatives were expected to save more than $75 million in 20X9 and even more in subsequent years. At the time of the restructuring announcement, the company had 116,000 employees and 1,145 stores worldwide. Of the 1,145 stores, 697 are in the U.S. The company also ran 214 Kids \"R\" Us stores, 101 Babies \"R\" Us stores, and 2 KidsWorld stores. It hoped to reverse a trend of losing sales toWal-Mart and other discount retailers. Toys \"R\" Us had an 18.4% U.S. toy market share in 20X7, down from 18.9% in 20X6.WalMart's share and Target's share rose from 15.3% to 16.4%, and 6.4% to 7.1%, respectively, during that time. Toys \"R\" Us selected financial reports follow: Letter to Stockholders Toys \"R\" Us To Our Stockholders 20X8 was indeed a year of enormous challenge and change. We've spent the year intensively reviewing every aspect of our business and making some tough calls aimed at repositioning our worldwide business. Key elements of our strategic plan include a Total Solutions Strategy focused on our C-3 plan, which includes the reformatting and repositioning of our toy stores; development of a customer-driven culture; expanding product development; improving our customer value proposition; accelerating our supply chain management program; and expanding our channels of selling. In conjunction with these restructuring efforts, we have been proactively rebuilding and reshaping a stronger management team which will serve to build the foundation for repositioning your Company in the years ahead. We believe that the sum total of these efforts will serve as the springboard toward implementing our expanded vision for the future: to position Toys\"R\"Us as the worldwide authority on kids, families and fun. 20X8 Restructuring Benefits We ended 20X8 a much healthier and vibrant company. This was attributable to some tough strategic decisions that will shape the Company's future. We recorded restructuring and other charges of $508 million net of taxes, which caused the Company to incur a net loss in 20X8. The impact of making these tough calls will be evident in our future operations, growth, and financial performance. These charges are the result of an exhaustive review of all our operations in 20X8 from both a strategic and an Economic Value Added (EVA) perspective. These reviews prompted the following significant actions: The closing and/or downsizing of approximately 50 toy stores in the International arena, predominantly in continental Europe, and about 9 U.S. toy stores which do not meet the Company's strategic or financial objectives. This will free our management to focus on higher return opportunities; The conversion of 28 existing U.S. toy stores into \"combo\" stores, which will enable us to close 31 nearby Kids \"R\" Us stores. In addition to reducing operating costs and releasing working capital, this will allow us to enhance our productivity by further expanding kids' apparel into additional Toys\"R\"Us stores; The consolidation of several distribution centers and over half a dozen administrative offices. These actions will reduce administrative support functions in the U.S. and Europe, which will not only generate selling, general and administrative efficiencies, but \"flatten\" our organization and bring our management even closer to our stores and customers; The continuation of taking aggressive markdowns on clearance product to optimize inventory levels, accommodate new product offerings and accelerate our store reformatting. In conjunction with the initial stages of our supply chain re-engineering, we have already been 394 Financial Statement Analysis able to reduce same store inventories in all our divisions by over $560 million or 24% at year end 20X8, with roughly $480 million or 31% of this favorable swing coming from reduced inventory in the U.S. toy stores division alone. This brought us into the new year with heightened merchandise flexibility and increased \"open to buy\" as we begin the rollout of the initial phase of our store reformat program in 20X9. One of our other key priorities in 20X8 was to build a strong executive team, and we are well on our way towards assembling a truly outstanding management team. Since the beginning of 20X8, more than 50 percent of our officer team has either joined the company from the outside, or has been promoted or transferred to new assignments, bringing fresh perspectives and proven skills to our business. It is obvious our 20X8 sales and earnings were not what we wanted them to be. However, we've spent a year making tough calls and hard decisions, and we're now ready to move forward stronger and more focused than ever. Total Solutions Strategy Our restructuring program, in September 20X8, was the first step required to launch a winning strategy for Toys \"R\" Usa strategy which will realign our assets, organization and thinking based on customer-driven priorities in a more competitive marketplace. In the \"R\" Us brand, we have one of the best-known brand names in the world: our challenge is to more effectively develop this strong customer franchise potential. Today's retail marketplace demands stores that are exciting, easy to shop and customer-friendly. While our selection is still superior to our competitors, that alone is not compelling enough to rebuild market share and brand loyalty. We must become more focused on developing greater everyday customer value in terms of price, service, and the total shopping experience. Management's Discussion and Analysis Results of Operations and Financial Condition During 20X8 the Company announced strategic initiatives to reposition its worldwide business and other charges including the customer-focused reformatting of its toy stores into the new C-3 format, as well as the restructuring of its International operations which resulted in a charge of $353 million ($279 million net of tax benefits, or $1.05 per share). The strategic initiatives resulted in a restructuring charge of $294 million. The other charges of $59 million primarily consist of changes in accounting estimates and provisions for legal settlements. The Company is closing and/or downsizing underperforming stores and consolidating distribution centers and administrative offices. As a result, approximately 2,600 employees will be terminated worldwide. Stores expected to be closed had aggregate store sales and net operating losses of approximately $322 million and $5 million, respectively, for the year ended January 30, 20X9. The write-down of property, plant, and equipment relating to the above mentioned closures and downsizings were based on both internal and independent appraisals. Unused reserves at January 30, 20X9, should be utilized in 20X9, with the exception of long-term lease commitments, which will be utilized in 20X9 and thereafter. Details on the components of the charges are described in the Notes to the Consolidated Financial Statements and are as follows: Description Charge Utilized Reserve Balance Closings/downsizings: Lease commitments ........................................... $ 81 $ $ 81 Severance and other closing costs ..................... 29 4 25 Write-down of property, plant & equipment ........ 155 155 Other .................................................................. 29 5 24 Total restructuring .................................................. $294 $164 $130 Changes in accounting estimates and Provisions for legal settlements ......................... $ 59 $ 20 $ 39 Chapter Six | Analyzing Operating Activities 395 In 20X8 the Company also announced markdowns and other charges of $345 million ($229 million net of tax benefits, or $.86 per share). Of this charge, $253 million relates to markdowns required to clear excess inventory from stores. These markdowns should enable the Company to achieve its optimal inventory assortment and streamline systems so that it can proceed with the C-3 conversions on an accelerated basis. The Company's objective with its new C-3 concept is to provide customers with a better shopping experience leading to increased sales and higher inventory turns. In addition, the Company recorded $29 million in markdowns related to the store closings discussed previously. The Company also recorded charges to cost of sales of $63 million related to inventory system refinements and changes in accounting estimates. Unused reserves at January 30, 20X9, are expected to be utilized in 20X9. Details of the markdowns and other charges are as follows: Description Charge Utilized Reserve Balance Markdowns Clear excess inventory ................................ $253 $179 $ 74 Store closings ............................................. 29 2 27 Change in accounting estimates & other ........ 63 57 6 Total cost of sales ........................................... $345 $238 $107 The strategic initiatives, markdowns, and other charges described above are expected to improve the Company's free cash flow and increase operating earnings. CONSOLIDATED STATEMENTS OF EARNINGS Toys \"R\" Us, Inc., and Subsidiaries Year Ended January 30, January 31, February 1, (In millions except per share data) 20X9 20X8 20X7 Net sales ........................................................... $11,170 $11,038 $9,932 Cost of sales...................................................... 8,191 7,710 6,892 Gross profit ................................................... 2,979 3,328 3,040 Selling, advertising, general, and administrative expenses ............................... 2,443 2,231 2,020 Depreciation, amortization, and asset write-offs 255 253 206 Restructuring and other charges....................... 294 60 Total operating expenses............................... 2,992 2,484 2,286 Operating income (loss)................................ (13) 844 754 Interest expense ................................................ 102 85 98 Interest and other income.................................. (9) (13) (17) Interest expense, net..................................... 93 72 81 Earnings (loss) before income taxes.................. (106) 772 673 Income taxes ..................................................... 26 282 246 Net earnings (loss) ..................................................... $ (132) $ 490 $ 427 Basic earnings (loss) per share......................... $ (0.50) $ 1.72 $ 1.56 396 Financial Statement Analysis CONSOLIDATED BALANCE SHEETS Toys \"R\" Us, Inc., and Subsidiaries January 30, January 31, (In millions) 20X9 20X8 Assets Current assets Cash and cash equivalents ...................................... $ 410 $ 214 Accounts and other receivables................................ 204 175 Merchandise inventories........................................... 1,902 2,464 Prepaid expenses and other current assets .............. 81 51 Total current assets ............................................. 2,597 2,904 Property and equipment Real estate, net ........................................................ 2,354 2,435 Other, net.................................................................. 1,872 1,777 Total property and equipment .............................. 4,226 4,212 Goodwill, net............................................................. 347 356 Other assets ............................................................. 729 491 $7,899 $7,963 Liabilities Current liabilities Short-term borrowings.............................................. $ 156 $ 134 Accounts payable ..................................................... 1,415 1,280 Accrued expenses and other current liabilities ......... 696 680 Income taxes payable ............................................... 224 231 Total current liabilities......................................... 2,491 2,325 Long-term debt......................................................... 1,222 851 Deferred Income taxes .............................................. 333 219 Other liabilities......................................................... 229 140 Stockholders' equity Common stock.......................................................... 30 30 Additional paid-in capital ........................................ 459 467 Retained earnings .................................................... 4,478 4,610 Foreign currency translation adjustments ................ (100) (122) Treasury shares, at cost............................................ (1,243) (557) Total stockholders' equity..................................... 3,624 4,428 $7,899 $7,963 Chapter Six | Analyzing Operating Activities 397 Financial Statement Footnote Restructuring and Other Charges On September 16, 20X8, the Company announced strategic initiatives to reposition its worldwide business. The cost to implement these initiatives, as well as other charges resulted in a total charge of $333 ($266 net of tax benefits, or $1.00 per share). The Company determined that the strategic initiatives required a restructuring charge of $294 to close and/or downsize stores, distribution centers, and administrative functions. This worldwide plan includes the closing of 50 toy stores in the International division, predominantly in continental Europe, and 9 in the United States that do not meet the Company's return on investment objectives. The Company will also close 31 Kids \"R\"Us stores and convert 28 nearby U.S. toy stores into combination stores in the new C-3 format discussed below. Combination stores include toys and an apparel selling space of approximately 5,000 square feet. Other charges consist primarily of changes in accounting estimates and provisions for legal settlements of $39 recorded in selling, general, and administrative expenses. Of the total restructuring and other charges, $149 relates to domestic operations and $184 relates to International operations. Remaining reserves of $149 should be utilized in 20X9, with the exception of long-term lease commitments, which will be utilized in 20X9 and thereafter. Also on September 16, 20X8, the Company announced mark-downs and other charges to cost of sales of $345 ($229 net of tax benefits, or $.86 per share). The Company has designed a new store format called C-3. The Company plans to convert approximately 200 U.S. toy stores to the new C-3 format in 20X9. Of this charge, $253 related to markdowns required to clear excess inventory from its stores so the Company can proceed with its new C-3 store format on an accelerated basis. Another component of the charge was inventory markdowns of $29 related to the closing and/or downsizing of stores discussed above. The Company also recorded charges to cost of sales of $63 related to inventory system refinements and changes in accounting estimates. Of these charges, $288 relate to domestic operations and $57 relate to International operations. Remaining reserves of $107 are expected to be utilized in 20X9. Additionally, in the fourth quarter of 20X8, the Company recorded a charge of $20 ($13 net of tax benefits, or $.05 per share), related to the resolution of third party claims asserted from allegations made by the Federal Trade Commission. This charge was in addition to a $15 charge relating to the same matter, included in the charges mentioned above. At January 30, 20X9, the Company had approximately $45 of liabilities remaining for its restructuring program announced in 20X5 primarily relating to long-term lease obligations. The Company believes that reserves are adequate to complete the restructuring and other programs described previously. On July 12, 20X6, an arbitrator rendered an award against the Company in connection with a dispute involving rights under a license agreement for toy store operations in the Middle East. Accordingly, the Company recorded a provision of $60 during 20X6 ($38 net of tax benefits, or $.14 cents per share), representing all costs in connection with this matter. Required: Refer to the Toys \"R\" Us financial information to answer the following questions. 1. What is the total amount that Toys \"R\" Us spent for its restructuring plan? Analyze the breakdown of charges and identify where the charge is reported in the income statement. 2. Recast the income statement without the restructuring charge and analyze operating performance for 20X9 by comparing with 20X8 performance. 3. Identify the major elements of its restructuring strategy and their economic effects. What will be the effect on future income and how are the savings expected to arise? 4. Discuss how the restructuring liability could be used by Toys \"R\" Us as a vehicle for earnings management. In your opinion is Toys \"R\" Us managing earnings through this charge? 5. Describe how an analyst would recast the balance sheet and income statement of Toys \"R\" Us to reflect the restructuring costs as an investment to create future cost savings. 6. How can the relative success of these restructuring activities be measured