Financial Statement Analysis for Gap, Inc.
(Gap, Old Navy, The Banana Republic)

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For the financial statement analysis, three years of statements were calculated; 1999, 1998, and 1997.  In addition, although the fiscal year 2000 statements were released only on April 5th, the relevant ratios have been calculated and are included in the analysis.  The ratios have been analyzed to establish trends and the trend analyses have been classified under the following sections: Activity Short & Long terms, Liquidity, Solvency, and Profitability.  Unless specifically noted, all references to ďGapĒ include all three divisions: The Gap, Old Navy, and The Banana Republic.

Activity: Short & Long term
Inventory turnover is an important aspect for any retailer to consider is.  Over the past three years Gap Incís inventory turnover has decreased.  During 1997 it was 6.13, in 1998 it was 7.27, in 1999 it was 5.38, and in 2000 it was 5.11.  It also appears that cost of goods sold as a percentage of sales has declined over the past four years.  Analysis of ďAverage Days in InventoryĒ indicates that Gap has become less efficient in managing its inventory, as this has fluctuated from 59.54 days (1997) to 50.21 (1998) to 67.85 (1999) and to 71.43 days in 2000.  While they have clearly become less efficient, recent articles point to improvement in their methods.  Last year (2000) appears to have been a bad year for Gap Inc. when expectations for the winter holiday season failed to materialize.  A relatively positive change has occurred with respect to the cash cycle as the payables turnover has decreased somewhat: 16.93 (1997), 16.45 (1998), 15.62 (1999); 14.60 (2000).  This simply means that Gap is taking a little more time in paying off its suppliers--which is not necessarily a bad thing for Gap--but possibly discouraging to both current and future suppliers. (Days: 21.56 (1997), 22.19 (1998), 23.37 (1999), 25 (2000))
Unlike the short term ratios, Gap appears to be improving its efficiency in the long term because total asset turnover has been increasing from 2.18 in 1997 to 2.48 to 2.54 and then to 2.24 in 2000.  There has been an upward trend in total asset turnover even though the 2000 ratio is lower.  However, total asset turnover could be increasing simply from total assets decreasing due to depreciation.  Turnovers, inventory turnover especially, should begin to improve within 2001.  According to the February 16th Value Line, Gap is better utilizing a new distribution system and is in an improved retail environment which should improve sales and such turnovers.

A simple analysis of Gapís financial statements reveals that the corporation is becoming less liquid.  Its current ratio has been decreasing: 1.85 in 1997, 1.21, 1.25 to 0.95 in 2000.  This means that the company has fewer assets to cover the debt it has acquired.  Additionally, Gapís quick ratio has also been decreasing from 1.11 in 1997 to 0.53 to 0.42 and to 0.27 in 2000.  A less pronounced decline is exhibited in Gapís cash flow to current liability ratio as well: 0.85 to 0.89 to 0.84 to 0.46 at the end of 2000.  Overall, Gap is becoming less liquid--a bad sign to potential lenders.

Gapís debt to asset ratio has increased slightly over the past four years from 0.53 in 1997 to 0.60 to 0.57 and to 0.58 in 2000.  A more dramatic change has emerged in times interest earned.  In 1997, Gap had an extremely large TIE ratio of 286.14 due primarily due to net interest income rather than expense.  However the TIE ratio has declined to 97.88 in 1998, to 57.21 in 1999, and to 22.98 in 2000.

With respect to profitability, it appears that Gap has become more profitable over the three years 1997, 1998, and 1999.  However, consulting recent articles and the Value Line sheet on Gap reveals that 2000 was less profitable than the prior three years. Profitability is often considered to be of the utmost importance regardless of the investor and Gapís trend shows improvements in profitability which may overshadow the other declines.  Gross profit margin increased in the years 1997-1999 from 0.382 to 0.413 to 0.418.  It dropped to 0.371 in 2000 but is beginning to rise again.  Return on Assets also increased in the years 1997 to 1999 from 0.179 to 0.226 to 0.246.  It dropped to 0.144 in 2000 but it too is rising or will begin to rise.  Return on Equity has a similar trend: 0.328 to 0.522 to 0.592 at the end of 1999--quite a substantial increase.  This was followed by a fall to 0.340 during 2000, but as is the case with the other ratios, Gap is recovering and improving.  The ROE increase that had previously taken place leads us to believe that Gap has been making better use of its financial leverage.  Gap has also slightly increased its tax burden ratio although its interest burden has decreased slightly, meaning that it may be paying out more in interest expense than in the past.  The final profit ratio worth noting is Gapís profit margin, EBIT/Sales.  This ratio has increased over 1997, 1998, and 1999 from 0.131 to 0.147 to 0.156; however it dropped to 0.10 in 2000.  This means that Gap was earning more per dollar of sales before interest and taxes.  As was the case with the other profitability ratios, Gap fell during 2000 but it is beginning to recover.

Our opinion after analyzing Gapís financial statements, (that is if 2000 is set aside as an anomaly) is that it is indeed becoming more profitable although it may be less liquid, solvent, and efficient (short term).  We believe that the declines in liquidity, solvency, and short term efficiency may simply be fluctuations due to restructurings and/or expansions.  Part of Gapís inefficiencies and short-comings may likely be attributed to its recently less successful company, The Banana Republic.  This store has been less successful in attracting customers as Gap Inc.ís other two companies--The Gap and Old Navy.  Another worthwhile consideration is that Gap may improve in the areas of liquidity, solvency, and efficiency over the next year now that the company has wisely scaled back its plans for store opening to those better aligned with sustainable growth.
Furthermore, we have found Gap, Inc. to have an extremely high growth rate.  An important part of deciding whether or not to buy such a stock is in the valuation of its stock price.  We have calculated Gapís growth during 1999 to be extremely high, 55.2%.  We also calculated Gapís growth using 2000 numbers and found it to be more realistic--31.3%.  Perhaps Gapís greatest problem arises from its extremely large and fast growth.  Gapís CAPM rate, however, appears to be only 17.83% which makes calculation of its intrinsic value extremely difficult because most of the dividend discount models do not work when growth is greater than the CAPM rate.  The events of 2000 modify this problem because ROE has dropped and Gap has stated that it will slow down growth.  Fortunately, Value Line reported in its February 16, 2001, sheet for Gap that it expects it will be able to ďsupport roughly [a] 25% annual profit growth between fiscal 2001 and mid-decade.  This information will prove useful in calculating the intrinsic value of Gapís stock which will be compared to its current stock price in order to decide whether or not to buy the stock.
Gap pays relatively little in dividends, $0.09, and so the Dividend Discount Model does not really apply.  Therefore the cash flow method will be used, assuming a cash flow from operations over the year 2000 to be about $1.3 billion.  Growth will be assumed to continue at 25% until the end of 2005 when it will drop.  We have calculated three different scenarios of what the growth could drop to: 5% if growth declines substantially, 10% if growth declines moderately, and 15% if growth declines to a lesser degree.  For a company such as Gap Inc. we believe 10% to be fairly likely and a good estimate given Gapís past growth and performance.  The intrinsic values we have calculated given 25% growth continuing until the end of 2005 are: $14.53 at 5%, $18.46 at 10%, and $36.44 at 15%.  Gapís stock price closed today at $23.80 and when compared to the 10% future constant growth rate intrinsic value of $18.46 it is likely most investors would not want to buy Gapís stock.
However, some large assumptions were made in the calculations of the intrinsic values of Gapís stock.  First we assume that growth would suddenly drop off from 25% to 10% at the end of 2005 but the company may actually continue to grow at 25% for several more years increasing the intrinsic value of the stock.  Also, if Gap can grow at a constant rate of 15% indefinitely, the intrinsic value based on operating cash flows would be $36.44.  Therefore, the stock would be undervalued and a good investment.  There are other inherent factors that decrease the accuracy of our calculations, thus reducing the quality of our judgment.  On February 16th, the Value Line information sheet for Gap, Inc., with a (then) recent stock price of $29.56, gave the company a timeliness rating of 3.  The stock price has dropped since then and perhaps Gap is currently a better investment.  Intrinsic value calculations aside, we believe that Gap is still a good investment with substantial future growth and Value Line seems to agree.  The February 16th sheet shows that the price range for Gap by 2005 will likely fall between $45 and $65.
Two additional positive aspects of Gapís stock, despite companyís relatively poorly showing during 2000, are that its earnings per share continue to increase in addition to its book value per share.  In conclusion, Gap, Inc. appears to have good growth potential.  It is now getting back on the right track and will likely continue to do well; making it a worthwhile investment, especially within this decade.

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Activity- Short & Long Term: These are ratios that involve everyday activities such as with inventories.
                   Generally short term is considered less than 3 years. Long term is considered 3 or more years.
    Relevant terms: Inventory turnover, Average Days in Inventory, Total Asset Turnover, Payables Turnover

Turnover: "For a company, the ratio of annual sales to inventory; or equivalently, the fraction of a year that an
                   average item remains in inventory. Low turnover is a sign of inefficiency, since inventory usually has a
                   rate of return of zero. here also called inventory turnover."
    Relevant terms: Accounts Receivable Turnover, Asset Turnover, Capital Turnover

Liquidity: "The ability of an asset to be converted into cash quickly and without any price discount."
    Relevant terms: Current Ratio, Quick Ratio, Current Liability Ratio

Solvency: Refers to the ability of a company "to pay all debt obligations as they become due."
    Relevant terms: Debt To Asset Ratio, Times Interest Earned (TIE) Ratio

Profitability: "The ability to earn a profit."
    Relevant terms: Profit Margin, Return On Assets, Return On Equity, Return On Sales (ROS)

Capital Asset Pricing Model (CAPM): "An economic model for valuing stocks by relating risk and expected return.
                Based on the idea that investors demand additional expected return (called the risk premium) if asked to accept additional risk."
    Relevant terms: CAPM rate

Definitions are taken from