**Activity: Short & Long term**
**Inventory turnover is an important aspect for any retailer to consider
is. Over the past three years Gap Inc’s 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 “Average Days in Inventory” 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.**

**Liquidity**
**A simple analysis of Gap’s 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,
Gap’s 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 Gap’s 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.**

**Solvency**
**Gap’s 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.**

**Profitability**
**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 Gap’s 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 Gap’s 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 Gap’s 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 Gap’s 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.’s
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
Gap’s growth during 1999 to be extremely high, 55.2%. We also calculated
Gap’s growth using 2000 numbers and found it to be more realistic--31.3%.
Perhaps Gap’s greatest problem arises from its extremely large and fast
growth. Gap’s 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
“support roughly [a] 25% annual profit growth between fiscal 2001 and mid-decade.
This information will prove useful in calculating the intrinsic value of
Gap’s 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 Gap’s 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%.
Gap’s 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 Gap’s stock.**
**However, some large assumptions were made in the calculations of
the intrinsic values of Gap’s 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 Gap’s stock, despite company’s
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.**

**Terminology:**

**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 InvestorWords.com**
**http://www.investorwords.com**