Reading 27: Analysis of Financial Statements: A Synthesis

net, discount, managing, selling, picking

Q25. Lawrence Berenz, CFA, is an analyst for Cannon Capital Management, a firm specializing in managing mid-cap value equity

portfolios for high net worth clients and institutions. Cannon follows a bottom up stock picking process and seeks to select

stocks for its portfolios that are selling at a 40% discount to intrinsic value.

Anne Douglas, CFA, a Senior Portfolio Manager with Cannon, has asked Berenz to analyze the stock of Brenda’s Bakery Supply. Brenda’s makes ovens, fryers, mixers, and other machines which are used in the process of making sweet foods and other confections. Recently, a diet craze in the United States has led consumers to seek low carbohydrate foods, which has cut down on the number of consumers going to bakeries, thus putting pressure on Brenda’s profitability. Douglas believes that the “low carb” craze will prove to be a short-lived fad, and that Brenda’s Bakery Supply offers compelling value at its current price.

Berenz begins his analysis by reviewing Brenda’s Bakery Supply’s financial statements for the last two years. Berenz believes that to properly analyze individual accounts, the balance sheet and income statement should be restated in order to more accurately portray the economic reality of the firm’s financial position. Berenz also disagrees with the practice of some analysts to assume that deferred taxes will not reverse in the future. Brenda’s Bakery Supply financial statements are shown in the exhibits below.

Before starting on the project, Douglas tells Berenz to focus on Brenda’s comprehensive income in order to reduce the volatility caused by nonrecurring items in net income and get a better idea of Brenda’s future earning power. Berenz states that he has reservations about the use of comprehensive income because U.S. GAAP does not require an adjustment for any minimum pension liabilities that may exist. Douglas then walks away saying she would like a report on his analysis before their 9:00 a.m. conference call the next morning.

Exhibit 1:

Brenda’s Bakery Supplies Consolidated Balance Sheets (in 000’s)
	2003	2004
Cash and Cash Equivalents	362	104
Accounts Receivable	494	600
Inventories	750	900
Total Current Assets	1,606	1,604
Net Fixed Assets	3,333	3,516
Goodwill	500	370
Prepaid Pension Cost	152	190
Total Assets	5,591	5,680

Current portion of long term debt	254	310
Accounts Payable	768	916
Total Current Liabilities	1,022	1,226
Deferred Taxes	194	272
Long Term Debt	1,944	2,380
Pension and Other Benefit Obligations	456	512
Total Liabilities	3,616	4,390
Common Stock	800	800
Retained Earnings	1,175	490
Total Equity	1,975	1,290
Total Liabilities and Equity	5,591	5,680

Exhibit 2: Footnotes to the Financial Statements

Brenda's reported an operating loss for 2004 and did not pay taxes. The tax rate in 2003 was 32% and the rate is assumed to be 32% going forward.
Brenda's incremental borrowing rate is 7%.
Inventory is valued at lower of cost or market based on the Last In First Out (LIFO) convention. The LIFO reserve was $240 for 2003 and $310 for 2004.
Brenda's currently has an 8 year, non-cancelable operating lease for machinery used to construct the heating elements in donut fryers. Annual lease expense reflected on the income statement is $50 per year. The interest rate implicit in the lease is 9%.
Brenda's has a defined-benefit pension plan. In recent years, stock market returns have been excellent. Due to the strong returns, plan assets exceed the projected benefit obligation (PBO) by $40.
Due to interest rate changes, the current market value of all outstanding long-term debt is $2,500,000.
25 years ago, a previous tenant at one of the facilities that Brenda's now owns dumped hazardous waste on the site. The Environmental Protection Agency (EPA) has designated this site for cleanup and Brenda's faces a highly certain environmental cleanup bill of $100.

In addition, Cannon Capital Management's chief economist has noted to Berenz that the consumer price index has been rising for several years, and it is expected to continue to rise over the foreseeable future at an annualized rate of 3.2%.

Which of the following adjustments should Berenz make to the balance sheet to reflect the proper value of inventory for 2004?

A) Decrease inventory by $70, decrease retained earnings by $22, and decrease deferred taxes by $48.

B) Increase inventory by $310, increase retained earnings by $310, and deferred taxes will be unchanged.

C) Increase inventory by $70, increase retained earnings by $48, and deferred taxes will be unchanged.

Q26. Which of the following adjustments should Berenz make to adjust for the status of Brenda’s pension plan for 2004?

A) Increase pension assets by $40, decrease pension liabilities by $512, decrease deferred taxes by $164, and increase equity by $230.

B) Increase pension assets by $40, decrease pension liabilities by $150, and increase equity by $27.

C) Decrease pension assets by $150, decrease pension liabilities by $512, and increase equity by $362.