Financial Statements Part II

MD&A Can Shed Light On Your Investment

Financial Statements and Management's Discussion & Analysis

When reviewing financial statements, it is often important to read the management discussion and analysis (MD&A) section in order to fully and accurately interpret a company’s financial position. MD&A discusses the company’s various aspects of operations, often including revenue, investments, and liabilities. In addition to discussing both past and present business operations, MD&A will often include forward looking statements which talk about future developments and goals. This article addresses management’s assessment of the financial condition of Bake-O Donuts, Inc. in comparison to Financial Statements Part I. In addition, this article discusses management’s concerns, outlined in Bake-O Donuts' 2003 Annual Report, and recommends a course of action addressing these concerns.

Look for Signs, Don't Believe Everything You Read

Management’s Assessment

The assessment in Financial Statements Paper Part I concluded that Bake-O Donuts’ experienced significant growth between 1999 and 2003. In 1999 Bake-O Donuts reported total revenue of $439 million, whereas in 2003, $1.1 billion in revenue was reported. This is a five year increase of 61 percent or $661 million. Also noted in Financial Statements Part I is Bake-O Donuts’ rise in earnings per share between 1999 and 2003. In 1999 Bake-O Donuts’ reported earnings per share at $0.58 per share, and in 2003 earnings per share had risen to $1.66 per share, a 65 percent or $1.08 increase per share. This assessment of Bake-O Donuts’ financial situation led to the conclusion that the company is financially sound in accordance with the income statement.

At first glance, Bake-O Donuts’ 2003 balance sheet reports a working capital deficit of $38,977, which for most, is a sign of a company’s inability to remain profitable. This isn’t the case for Bake-O Donuts’, as noted in the MD&A.

According to MD&A in regards to Bake-O Donuts’ financial position, and explanation is given which helps to explain why Bake-O Donuts is reported a negative working capital. As explained, Bake-O Donuts’ completed a series of small acquisitions that included separate acquisitions of several well-known individual upscale Dallas, Texas donut shops; a small donut chain in Colorado Springs, Colorado called Ronny’s Donut Hole and another donut shop located in San Antonio, Texas.

In addition, Bake-O Donuts’ MD&A notes the 2002 acquisitions of fifteen breakfast restaurants, primarily located in Cleveland and areas of Louisiana, in connection with what is known as the Donut Acquisition; the purchase of 27 donut shops, primarily located on the East and West Coasts of the United States; and 27 Texas-based breakfast restaurants.

The above mentioned acquisitions are intended to add and compliment the existing Bake-O Donuts’ chain of restaurants. The acquisitions are not intended to act as real estate investments.

As mentioned in Financial Statements Paper Part I, much of the capital used to finance the above mentioned acquisitions was derived from paid in capital from the sale of senior notes. Net cash provided by operating activities is reported to be $122 million, $46 million of which came from net income. Net cash used in investing activities is reported to be just under $190 million, $163 million was spent on property and equipment additions, and $27 million on business acquisitions, net of cash acquired. Bake-O Donuts’ net cash provided by financing activities is $90 million. This figure is the total of over $8 million in purchases of common stock for treasury, $49 million in payments under credit line, and $148 million in borrowings on senior notes. The bottom line of Bake-O Donuts’ cash and cash equivalents at end of year is just over $35 million. This is impressive numbers for would-be investors.

If Management Gives Reason for Concern, Pay Attention

Management’s Concerns

In the MD&A comparison of year ended December 31, 2003 and year ended December 31, 2002, several concerns have been raised, including increased cost of revenues, location labor expenses, operating expenses, general and administrative expenses, and the significant increase in impairment charges in fiscal 2003.

Year-over-year cost of revenues increased 24.7 percent or $63 million. As a percentage of revenues, cost of revenues in 2003 increased 0.3 percent over 2002 numbers. Location labor expenses increased $64 million, a 24.7 percent increase year-over-year. Other operating expenses also increase year-over-year by 21.2 percent or $47.2 million. This expense as a percentage of revenues decreased 0.5 percent to 24.4 percent in 2003. General and administrative expenses increased by $8.3 million, 19.2 percent from 2002. According to management’s notes, this is due to increased travel expenses needed to support operations.

“The significant increases in impairment charges in fiscal 2003, resulted from 2003 sales declines in these restaurants, additional further deterioration in the specific restaurant’s profitability, perceived 2003 deterioration of the market area and/or specific location, and management’s 2003 downward revised outlook for further opportunity and/or improvement of forecasted sales and profitability trends for such specific property. Assets that were impaired are primarily leasehold improvements and to a lesser extent equipment”.

An area that Bake-O Donuts should be more aware of is increasing its liquidity and capital resources. In 2003, Bake-O Donuts increased its borrowing capacity to $350 million, suggesting that the company may be stretching itself thin. While Bake-O Donuts intends to continue its expansion efforts, management must be weary of the potential for economic decline, which may cause a loss of revenue, a loss in real estate values, and further increases in impairment charges.

In Closing...

When comparing Financial Statements Paper Part I to management’s discussion and analysis of Landry’s 2003 financial statements, the two reports show similar results. Concerns raised in Financial Statement Paper Part I in relation to working capital are addressed by management. In the management’s discussion it is noted that acquisitions made up much of Bake-O Donuts' expenses for 2002 and 2003. Furthermore, it is noted that funding for Bake-O Donuts expansion and acquisitions is mainly derived from the sale of long-term senior notes. In addition to the Financial Statements Paper Part I and management’s discussion and analysis of Bake-O Donuts' 2003 financial statements, management’s concerns regarding expenses are addressed. Expenses increase year-over-year in 2003, much of which is caused by a significant increase in impairment charges from sales declines. A key area that Bake-O Donuts' management should be more aware of is the potential for significant loss due to poor economic conditions. With Bake-O Donuts increasing their liquidity, they are potentially spreading their assets too thin, which may lead to the closure of locations.

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