Financial Education

U. S. GAAP considers inventory cost at the time it was placed in inventory, whereas International Accounting Standards base the cost on the order in which the products are sold. When possible, international standards prefer that the specific identification method be used.

When it is not practical to track inventory costs on a unit basis, international standards permit either the first-in, first-out (FIFO) method or the weighted average cost method. Lifo is not permitted, as it is under U.S. standards. Fortunately, U.S. standards require companies using LIFO to report the FIFO inventory value, and thus it is generally possible to adjust the U.S. financial statements for comparability with firms that do not use LIFO.

Both standards require inventory to be stated at the lower of cost or market value, and inventory that has declined in value must be written down. Under U.S. standards these writedowns cannot be reversed even if the inventory subsequently rises in value. International standards do permit reversal of inventory writedowns.

Accounting-based income statements are prepared to reflect the earnings available to owners. As such, they deduct the cost of debt (interest expense). Dividends and opportunity costs for equity holders are not deducted. The concept of residual income is that a certain level of earnings is necessary merely to cover the cost of providing equity capital. Only earnings above this level (the residual) actually increase the value of the investment.

For example, consider a company with a book value of $1 million and earnings of $50,000. There are positive earnings, but are they sufficient for investors? If the required return on a similar equity investment is 10%, then earnings would have to be at least $100,000 to justify the risk. Otherwise the investor should find an alternative investment that can satisfy the return requirement.

Residual income, then, is the difference between accounting net income and the required income as calculated by multiplying book value per share by the required return on equity.

In a clean surplus environment, the change in net pension asset or liability would flow through the income statement as a pension expense. However, both U.S. GAAP and International Accounting Standards allow for a number of smoothing mechanisms when reporting pension expense. Still, the change in liabilities is a good place to start the discussion.

The pension obligation can change for a number of reasons:

1. The employee’s service during the period, which increases the future liability
2. Interest expense on the prior liability
3. Changes in the terms of the plan
4. Changes in actuarial assumptions

Furthermore, the assets in the plan can increase or decrease in value due to contributions, benefits paid and market fluctuations.

Current accounting rules require service and interest costs to be recognized immediately, while the other items can be amortized over a number of years. Furthermore, the rules allow for the return on plan assets to be estimated (the expected return) rather than used directly. All differences between the expected and actual values are also amortized.

Since there are smoothing mechanisms, the reported pension expense will not always reflect the change in the plan’s economic status and investors may wish to use the related disclosures to create a more accurate picture of the financial situation.

International Accounting Standard 19 (IAS 19) allows certain gains and losses due to changes in the pension plan or market returns to b smoothed over several years rather than recognized at once. As a result, the balance sheet generally does not reflect the full net asset or liability. Prior to the adoption of SFAS 158 US rules were similar. In some cases, such as after the Internet bubble burst, many plans were being shown on balance sheets as having net assets (due to past market returns being smoothed in) when the actual funded status was a net liability.

As an example of the effect smoothing can have, consider note 35 to the consolidated financial statements of Lloyds TSB Group PLC 20-F filing:

The present value of funded obligations is the amount Lloyds would have to pay today in order to satisfy its future pension obligations (assuming the actuarial assumptions involved are correct.) This amount changed relatively little between 2005 and 2006 – an increase of 58 million or less than one third of one percent.

The fair value of scheme assets is the amount Lloyds has in the fund to cover the future obligations. This amount increased by 1.25 billion, or nearly 9%.

Below that is the difference between the two amounts, or the funded status. In each of the two years, Lloyds had less in the fund than would be needed to satisfy the future obligation. In other words, the plan is underfunded. However, the small rise in liabilities compared to assets significantly reduced the funding gap in 2006.

The next line shows how much of the net liability has not yet been recognized due to permissible accounting smoothing. In 2005 there were 485 million of unrecognized losses. In 2006 this shifted to an unrecognized 263 million gain.

So, in 2005 Lloyds had an unfunded position (economic value) of 3.3 billion. Some of this was not recognized on the balance sheet, however, which showed the liability as being just $2.8 billion – 485 million less than the economic liability.

In 2006, the unfunded position had fallen dramatically to just 2.1 billion. However, the smoothing was now ignoring some gains and the balance sheet liability was shown as being 2.4 billion – 263 million more than the economic liability.

Investors might want to replace the balance sheet figures with the economic status in order to get a more current picture of the true assets and liabilities. This would also be useful when comparing the balance sheets of a firm that uses IAS with one that reports under U.S. GAAP. Since passage of SFAS 158, U.S. firms are now recording the full economic liability (net funded status) on the balance sheet.

Clean surplus accounting means that all changes in shareholder equity that do not result from transactions with shareholders (such as dividends, share repurchases or share offerings) are reflected in the income statement. Residual income valuation models such as EVA(R) assume that there is a clean surplus.

Dirty surplus accounting occurs when some items – most notably foreign currency translation adjustments and certain pension liability adjustments – are adjusted from shareholder equity without passing through the income statement. In order to adjust the income statement to reflect a clean surplus, an investor can replace “net income” with “total comprehensive income.”

Global Payments is a leading payment processing and consumer money transfer company. The risk factors section of their 10-K notes the following:

We are exposed to foreign currency risks because of our significant card processing operations in Canada, the Czech Republic, and those in the Asia-Pacific region, as well as our significant electronic money transfer operations in the U.S. and Europe.

We have significant operations in Canada which are denominated in Canadian dollars. In addition, we have significant operations in the Asia-Pacific region, the Czech Republic and Spain. We are subject to the risk that currency exchange rates between these regions and the United States will fluctuate, potentially resulting in a loss of some of our revenue and earnings when such amounts are exchanged into U.S. dollars.

We also have significant money transfer operations in the U.S. and Europe which subject us to foreign currency exchange risks as our customers deposit funds in the local currencies of the originating countries where our branches are located, and we typically deliver funds denominated in the home country currencies to each of our settlement locations.

Global Payments’ revenue and net income for the three years ending May 31, 2007 are summarized below.

However, turning to the statement of shareholder equity we see that there were significant other components of “total comprehensive income.”

The most significant adjustment is the foreign currency translation adjustment, which results from the net assets of foreign subsidiaries being translated into dollars at current exchange rates. Since the amount is positive in all periods, if the subsidiaries have positive net assets the amount reflects strengthening foreign currencies (a weaker dollar.) The adjustment does not flow through the income statement unless the gains or losses are realized. However, it does reflect the underlying economic position and investors may also want to adjust the statements for better comparison to firms that translate foreign operations using the temporal method.

All one needs to do is replace net income with total comprehensive income.

Since the currency adjustments were positive in all three years, profit margin based on comprehensive income were higher in all three years. Had foreign currencies weakened against the dollar, margins would have been reduced. In addition, the profit margins were much more volatile when based on comprehensive income – rising 440 basis points in 2006 rather than 200, then falling by 290 basis points in 2007 rather than 30.

Furthermore, net income growth patterns are markedly different from the growth in comprehensive income. Net income grew at double digit rates in both 2006 and 2007. Comprehensive income, however, rose faster in 2006 and actually declined in 2007.

When foreign operations are translated using the all-current method, all income statement items are translated at the ending exchange rate. Since a single exchange rate is being used, all income statement ratios (such as profit margins) will be the same when translated as they were in the subsidiary’s currency. Retained earnings, however, may be affected by any dividends, which are translated at the rate in effect at the time the dividend was paid.

The parent company will show higher revenue and profits when the foreign currency strengthens, and lower revenue and profit when the foreign currency weakens. If the foreign subsidiary’s margins differ significantly from the parent company’s overall profitability, changes in the foreign currency will impact the profit margins reported by the parent since the translated percentage of sales and profits will differ.

Consider a US company with a Japanese subsidiary. The chart below translates the Japanese unit’s results into the parent company income statement under the assumption of stable, rising and falling currencies.

Now consider the impact on the parent’s consolidated income statement. In the example below, the non-Japanese operations of the U.S. company are summarized in the left column, and the other columns add in the Japanese results. The U.S. operations are less profitable than those in Japan, and the fluctuations in the yen impact not just the total dollar revenue and sales but the consolidated profit margins as well.

Investors noticing a rising or falling profit margin would want to understand whether it was stemming merely from changes in currency or whether it was an underlying business trend.

When foreign subsidiary results are translated into parent currency using the temporal method, any changes in the net monetary assets and liabilities flow through the income statement as a gain or loss. It can be important to consider this gain or loss when comparing the results to other companies, especially when those companies have different capital structures or use the all-current method.

The amount and direction of any reported gain or loss will depend upon the direction of currency movement and on whether the subsidiary’s financial position is one of net monetary assets or net monetary liabilities.  In the case of a strengthening foreign currency, a gain will be reported when there are net monetary assets and a loss when there are net monetary liabilities. For a weakening foreign currency, there will be a loss on a net monetary asset position and a gain on a net monetary liability position.

Convertible bonds can be exchanged for shares at the option of the bondholder, who clearly will do so only when it is more beneficial than holding the bonds for redemption at face value. Since the bonds can be converted into equity, they retain characteristics of both types of securities.

An investor considering buying shares in a company should evaluate whether converting the bonds into equity would significantly increase the number of shares outstanding, which would impact earnings per share. Investors in both debt and equity securities would want to consider the possible impact on the company’s financial condition, such as is illustrated by the debt/equity ratio.

If the conversion price of the bond is significantly higher than the market price of equity securities, conversion is unlikely. The bonds would be more appropriately treated as debt.

If the conversion price of the bond is significantly lower than the market price of the stock, conversion is likely and it may be appropriate to reclassify the debt as equity using either the book or market value of the debt.

If the conversion price of the bond is near the market price of the stock, the bond retains many qualities of both debt and equity securities. It may be useful to treat it as both debt and equity, and to compare the impacts of various scenarios.

The balance sheet typically includes all debt maturing in more than 12 months as a single line item. However, additional disclosures can be found throughout the firm’s financial reports. As an example, we examine the recently filed Gerber Scientific 10K.

LIQUIDITY AND CAPITAL RESOURCES

The Company’s primary ongoing cash requirements, both in the short and long-term, will be to fund operating and capital expenditures, product development, acquisitions, expansion in China, pension plan funding and debt service. The primary sources of liquidity are internally generated cash flows from operations and available borrowings under the Company’s credit facility. These sources of liquidity are subject to all of the risks of the Company’s business and could be adversely affected by, among other factors, a decrease in demand for the Company’s products, charges that may be required because of changes in market conditions or other costs of doing business, delayed product introductions, or adverse changes to the Company’s availability of funds.

The Company believes that its cash on hand, cash flows from operations and borrowings expected to be available under the Company’s revolving credit facility will enable the Company to meet its ongoing cash requirements. As of April 30, 2007, the Company had $20.5 million available for borrowing under its revolving credit facility based on its borrowing base.

The following table shows information about the Company’s capitalization as of the dates indicated:

Cash Flows

The following table summarizes the Company’s consolidated cash flows by major activity.

Cash Flows from Operating Activities – The $24.4 million decrease in cash flows from operations in fiscal 2007, as compared with fiscal 2006, was primarily driven by increased accounts receivable and inventory as well as lower accounts payable. The increase in accounts receivable was primarily related to elevated sales volume during the Company’s fourth quarter as compared with the same period in fiscal 2006. As revenue continues to increase, the Company expects that its accounts receivable balances will similarly increase.

Analysis: Considering that data, an investor would be pleased by the reduction in debt and improved solvency ratios, but concerned by the steep drop in cash from operations. It would be prudent to monitor the receivables, in particular, to confirm management’s explanation that the rise was due to timing (in which case they should decline relative to sales as the receivables are collected) or due to collection problems (in which case they would not.)

Long-term Debt - The Company’s primary source of debt is a $50.0 million asset-based revolving line of credit with a group of banking institutions, which matures in 2008. The Company also has a term loan that is payable in monthly installments through 2010 and $6.0 million of industrial development bonds that mature in 2014.

The Company was in compliance with its financial covenants as of April 30, 2007. The Company’s future compliance with its covenants will depend primarily on its success in growing the business and generating operating cash flows. Future compliance with the financial covenants may be adversely affected by various economic, financial and industry factors. Noncompliance with the covenants would constitute an event of default under the credit facility, allowing the lenders to accelerate repayment of any outstanding borrowings. In the event of potential failure by the Company to continue to be in compliance with any covenants, the Company would seek to negotiate amendments to the applicable covenants or obtain compliance waivers from its lenders.

The Company entered into a third amendment to its credit facility with Citizens Bank of Massachusetts and Sovereign Bank (the “Third Amendment”) during May 2007. The Third Amendment provides for a line of credit available in the form of term loans with a maximum aggregate amount of $10.0 million for permitted acquisitions. Principal amounts outstanding under the Third Amendment are payable in 30 equal installments. The Third Amendment provides that borrowings accrue interest, payable monthly, at an annual rate equal to the specified London Interbank Offer Rate (”LIBOR”) plus 175 basis points or the designated prime rate at the Company’s option. In addition, a fee of 25 basis points is incurred on the difference between $10.0 million and the average daily principal amount outstanding under the Third Amendment. Term loan borrowings may be made through October 31, 2008 so long as the aggregate principal amount of outstanding term loans does not exceed $10.0 million.

OFF-BALANCE SHEET ARRANGEMENTS

The Company’s participation in financing arrangements to assist customers in obtaining leases with third parties constitute the only off-balance sheet arrangements as defined in Item 303(a)(4) of the SEC’s Regulation S-K. The Company has agreements with major financial services institutions to assist purchasers of its equipment. These leases typically have terms ranging from three to five years. As of April 30, 2007, the amount of lease receivables financed under these agreements between the external financial services institutions and the lessees was $16.8 million. The Company’s net exposure related to recourse provisions under these agreements was approximately $5.6 million.  The equipment sold generally collateralizes the lease receivables.  In the event of default by the lessee, the Company has liability to the financial services institution under recourse provisions once the institution repossesses the equipment from the lessee and returns it to the Company. The Company then can resell the equipment, the proceeds of which are expected to substantially cover a majority of the liability to the financial services institution. As of April 30, 2007 and 2006, the Company recorded undiscounted accruals for the expected losses under recourse provisions of $0.4 million and $0.6 million, respectively.

CONTRACTUAL CASH OBLIGATIONS AND COMMITMENTS

As of April 30, 2007, the Company had the following contractual cash obligations and commercial commitments (including restructuring related commitments):

Analysis: Investors should watch for the credit line expiration date and any signs that it might not be renewed (it most likely will be.) If not there could be difficulties repaying it, particularly if the cash from operations remains depressed.  The company also has significant other contractual financial commitments due during that time.

Note 8.  Borrowings

The Company’s outstanding debt is comprised of the following:

All of the Company’s outstanding debt was at variable interest rates as of April 30, 2007. As the underlying interest rates are believed to represent market rates, the carrying amounts are considered to approximate fair value.

Credit Facility - The Company has a credit facility (the “Credit Facility”) with Citizens Bank of Massachusetts, the Export-Import Bank of the United States (”Ex-Im”) and Sovereign Bank. The Credit Facility consists of a $50.0 million asset-based revolving line of credit (the “Revolver”) that includes a $13.0 million working capital loan guarantee from Ex-Im. The Credit Facility also includes a $1.2 million term loan (the “Term Loan”) and a $6.5 million standby letter of credit. The Revolver matures on October 31, 2008. The Term Loan requires 60 equal monthly principal payments that began in December 2005 and matures in November 2010. Weighted average interest rates of the Company’s primary credit facility, inclusive of deferred debt issue costs amortized, were 9.5 percent in the fiscal year ended April 30, 2007, 11.0 percent in the fiscal year ended April 30, 2006 and 13.5 percent in the fiscal year ended April 30, 2005.

The Credit Facility obligations are collateralized by selected assets of the Company in the United States and its subsidiaries in the United Kingdom and Canada, including inventory, accounts receivable, and real estate and leasehold improvements. The Credit Facility obligations are also collateralized by the capital stock of certain subsidiaries of the Company.

Under the Revolver, the Company can terminate its commitment at any time, subject to a prepayment fee. If the Company were to terminate its commitment by October 31, 2007, the fee would be 2.0 percent of the outstanding balance, and if it were to terminate its commitment between November 1, 2007 and October 31, 2008, the fee would be 1.0 percent of the outstanding balance. The Company may permanently reduce the Revolver commitment by up to $10.0 million without any prepayment fee.

Revolver borrowings are subject to a borrowing base formula based upon eligible accounts receivable and eligible inventory. The Company must maintain a minimum availability of $1.0 million. Interest on obligations under the Revolver is charged, at the option of the Company, at the London Interbank Offered Rate (”LIBOR”) plus 1.75 percent, or at the lender’s prime rate. As of April 30, 2007, the Company had $20.5 million available for borrowing on the Revolver based on its borrowing base.

The Company is required to pay an annual commitment fee on a monthly basis of 0.25 percent of the daily difference between the total commitment amount of the Revolver and the aggregate outstanding principal amount of the loans under the Revolver.

Interest on obligations under the Term Loan is charged, at the option of the Company, at LIBOR plus 2.0 percent, or at the lender’s prime rate.

The Company is required to maintain certain financial covenants, including leverage and debt service coverage ratios. The agreement also includes limitations on additional indebtedness and liens, investments, legal entity restructurings, changes in control and restrictions on dividend payments. The Company was in compliance with all of the covenants under its financing arrangements as of April 30, 2007.

In May 2007, the Company amended its Credit Facility to include term loans for acquisitions. See Note 19.

Industrial Development Bonds - The Company has outstanding $6.0 million of Variable Rate Demand Industrial Development Bonds (”Industrial Development Bonds”). The interest rate is adjusted to market rates on a weekly basis. During the fiscal years ended April 30, 2007 and 2006, the weighted average interest rate was 3.6 percent and 2.7 percent, respectively. The Industrial Development Bonds are collateralized by certain property, plant and equipment and mature in 2014.

The demand feature of the Industrial Development Bonds is supported by a letter of credit from a major United States commercial bank. The letter of credit, which expires in September 2007, automatically renews on an annual basis through an evergreen clause and carries a fee of 1.75 percent of the face amount. Advances under the letter of credit become a note payable on demand at the bank’s prime interest rate. The bank providing the letter of credit has a mortgage and security interest in certain property. There were no outstanding amounts under this letter of credit as of April 30, 2007 or 2006.

Short-term Lines of Credit - The Company had short-term bank lines of credit with several international banks of approximately $4.8 million as of April 30, 2007.

Analysis:  This final section did not present any additional issues. Overall, Gerber Scientific has been reducing its debt load dramatically and will likely extend its credit facilities before they expire. Investors will want to closely monitor cash from operations, and particularly accounts receivable, to either confirm management’s evaluation or for signs that something less benign is the cause.