Question

Cisco Income Statements 2002 2001 2000 Sales 18,915 22,293 18,928 Cost of sales, reported 6,902 11,221 6,746 Gross margin 12,013 11,072 12,182 R&D 3,448 3,922 2,704 Sales and marketing 4,264 5,296 3,946 General and administrative 618 778 633 Restructuring charges --- 1,170 --- Amortization of good will 690 154 Amortization of intagible assets 699 365 137 In-process R&D 65 855 1,373 total operating expenses 9,094 13,076 8,947 operating income from sales, before tax 2,919 -   (2,004) -   3,235 Investment income (209) 1,130 1,108 Income before tax 2,710 (874) 4,343 Taxes 817 140 1,675 Net income 1,893 -   (1,014) -   2,668

Cisco Balance Sheets Assets 2002 2001 2000 1999 Current Assets: Working Cash 9,484 4,873 4,234 913 Short-term investments 3,172 2,034 1,291 1,189 Accounts Receivable 1,105 1466 2299 1250 Inventories 880 1684 1232 658 Deferred tax assets 2,030 1809 1091 580 Lease receivables 239 405 -   -   Prepaid expenses 523 564 963 171 total current assets 17,433 12,835 11,110 4,761 investments 8,800 10,346 13,688 7,032 restricted investments 1,264 1,286 1,080 Property and equipment 4,102 2,591 1,426 825 Goodwill 3,565 3,189 2,937 157 Lease receivables 39 253 527 500 Purchased intangibles 797 1,470 1,150 303 Other assets 3,059 3,290 746 235 Total assets 37,795 35,238 32,870 14,893 Liabilities Current Accounts payable 470 644 739 374 Income tax payable 579 241 233 630 Accrued compensation 1,365 1,058 1,317 679 Deferred revenue 3,892 3,214 1,386 724 Other accrued liabilities 2,496 2,553 2,653 631 Restructuring liabilities 322 386 --- --- 9,124 8,096 6,328 3,038 Minority interest 15 22 45 44 Common shareholders' equity 28,656 27,120 26,497 11,811

Cash Flow Years Ended July 27, 2002 July 28, 2001 July 29, 2000 Cash flows from operating activities: Net income (loss) $1,893.00 ($1,014.00) $2,668.00 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation and amortization 1,957 2,236 863 Provision for doubtful accounts 91 268 40 Provision for inventory 149 2,775 339 Deferred income taxes ($573.00) ($924.00) ($782.00) Tax benefits from employee stock option plans 61 1,397 2,495 Adjustment to conform fiscal year ends of pooled acquisitions - - ($18.00) In-process research and development 53 739 1,279 Net (gains) losses on investments and provision for losses 1,127 43 ($92.00) Restructuring costs and other special charges - 501 - Change in operating assets and liabilities: Accounts receivable 270 569 ($1,043.00) Inventories 673 ($1,644.00) ($887.00) Prepaid expenses and other current assets ($28.00) ($25.00) ($249.00) Accounts payable ($174.00) ($105.00) 286 Income taxes payable 389 ($434.00) ($365.00) Accrued compensation 307 ($256.00) 576 Deferred revenue 678 1,629 662 Other accrued liabilities ($222.00) 251 369 Restructuring liabilities ($64.00) 386 - Net cash provided by operating activities 6,587 6,392 6,141 Cash flows from investing activities: Purchases of short-term investments ($5,473.00) ($4,594.00) ($2,473.00) Proceeds from sales and maturities of short-term investments 5,868 4,370 2,481 Purchases of investments ($15,760.00) ($18,306.00) ($14,778.00) Proceeds from sales and maturities of investments 15,317 15,579 13,240 Purchases of restricted investments ($291.00) ($941.00) ($458.00) Proceeds from sales and maturities of restricted investments 1,471 1,082 206 Acquisition of property and equipment ($2,641.00) ($2,271.00) ($1,086.00) Purchases of technology licenses - ($4.00) ($444.00) Acquisition of businesses, net of cash and cash equivalents 16 ($13.00) 24 Change in lease receivables, net 380 457 ($535.00) Purchases of investments in privately held companies ($58.00) ($1,161.00) ($130.00) Lease deposits 320 ($320.00) - Purchase of minority interest of Cisco Systems, K.K. (Japan) ($115.00) ($365.00) - Other 159 ($516.00) ($424.00) Net cash used in investing activities ($807.00) ($7,003.00) ($4,377.00) Cash flows from financing activities: Issuance of common stock 655 1,262 1,564 Repurchase of common stock ($1,854.00) - - Other 30 ($12.00) ($7.00) Net cash (used in) provided by financing activities ($1,169.00) 1,250 1,557 Net increase in cash and cash equivalents 4,611 639 3,321 Cash and cash equivalents, beginning of fiscal year 4,873 4,234 913 Cash and cash equivalents, end of fiscal year $9,484.00 $4,873.00 $4,234.00 Analysis of Changes in Profitability and Growth: Cisco Systems, Inc. 1 By any stretch of the imagination, Cisco System s (CSCO) has been a strong growth company. A darling of the Internet boom of the late 1990s, it was one of the few technology companies tied to the Internet and telecommunications that prospered during that era. Its products - networking and communications equipment such as router and sw itching devices - built the infrastructure of the Internet. While most Internet and telecommunications firms str uggled and failed, their supplier, Cisco, capitalized on the new technology. At one poi nt in 2000, its market capitalization was over half a trillion dollars, the largest market capitaliza tion of any firm ever. Its stock price increased from $10 in 1995 to $80 in 2000, supported by sales growth from $2.0 billion in 1995 to $18.9 billion 2000. In early 2000, Cisco’s P/E stood at 130 so investors saw plenty of room for more earnings growth. However, with the subsequent collapse of the technology bubble and the demise of telecommunications firm such as WorldCom, Qwes t, and AT&T, the anticipated growth failed to materialize. Indeed, in 2001 Cisco wrote down inventory by an astonish ing $2.3 billion (under the lower-of-cost-or-market rule), to reflect the dr op in demand for its products and the emergence of second-hand telecom equipment market. Exhibit 1 presents Cisco’s income statements fo r the fiscal years 2000-2002 and balance sheets for 1999-2002. The exhibit also includes the cash flow from operations a nd cash investing sections of the cash flow statements. The 2000 sales of $18 .9 billion were up from $12.2 billion in 1999 and $8.5 billion in 1998, a tremendous gr owth record. But subsequent sales growth was not as impressive, as you can see, and led to declini ng earnings. Indeed, Cisc o posted a loss for 2001. Lower earnings on increasing shareholders’ equity clea rly implies that residual income is declining. By the end of 2002, Cisco’s shares traded at $15, well down from the 2000 high of $80. Other information, most of the from the 10-K f ootnotes, that was useful in reformulating the financial statements is presented below. Note th at the cash flow statements from Exhibit 1 are particularly useful for identifying core income becau se some of the items in the reconciliation of net income to cash flow from operati ng activities involve unusual items. Questions: 1. What adjustments are necessary to reformulate the income statements and balance sheets to properly separate financ ing from operations? 2. What adjustments are necessary to separate core operations from othe r sources of income? What items are identified as core in the Balance Sheet? 3. Calculate Core RNOA and decompose the ratio for Cisco for 2002 and 2001.

Answer 1

1. In order to reformulate the income statements and balance sheets to properly separate financing from operations, we need to perform normalization. The concept of normalization involves adjusting revenues or those expeses that are non-recurring so that only the conventional transactions of a company are reflected on the financial statements.Several business operations that are not normal make it to the financial statements, consequently hurting the earnings of the company. Hence, normalization is performed to get rid of any such anomalies and be intact with the right historical information. This facilitates comparison with other companies as well as effective forecasting.

Normalization adjustments:

a.Owner’s Expenses and Salary:

Sometimes, the owner tends to pay his own expenses through the accounts of the company. Such expenditures may include internet costs, using vehicle for travelling,fue for the vehicle, etc. These costs reduce the net revenue of the company. When the company shuts down, these expenses must be added back to the earnings.

b.Rental Income:

A company may decide to pay rent that is above or below the market rate, where the company premises are owned by the company or a holding company. Normalization of financial statements can be done by adjusting the rental expense at the current market value. Also, where the company earns a rental income from its properties and does not constitute a part of the company operations, this income should be eliminated from the financial statements. Also, any loans affiliated to properties should not find their place in the balance sheet.

2. Cash is the most important item on the balance sheet. Since balance sheet measures day-to-day operations, it is important to measure the liquidity of the company to meet the short-term debt and obligations. For that purpose, the cash in hand helps in fulfilling the short-term needs of the company.

3. RNOA- Return on Net Operating Assets

RNOA = net income/ total assets

For 2002, RNOA= 1893/37795 =0.05 =5%

For 2001, RNOA=(1014)/35238 = 0.028= 2.8%

In 2001, the net income was negative. Hence, 2002 gives a somewhat fair value for RNOA