Accounting Case Analysis

AMERICAN APPAREL CASE

Arcchit Mathur SMBA14079Shashank Kapoor SMBA14057Parineeta Singh SMBA14042Sumit Ahuja SMBA14065

AMERICAN APPAREL

Key Facts

On 3rd April 2014, the cash crunched American retailer, American Apparel, Inc needed to pay a huge amount of $13.4 million as interest and other debt repayments.

With the net loss of $106 million in 2013, the increase of approximately 400 percent as compared to a net loss of $37 million in 2012, the company has been sinking deep down in the losses. The company was not been able to deliver any profitability since 2009.

In the year 2013, the net sales of the company had increased marginally, still the company ended up with a bigger loss than ever before.

No wonder, the shares of the company had dived down from $17 to 0.56 cents during the same period, losing more than 80% of its share value (Refer to Exhibit 1).

The company’s controversial CEO Dov Charney had been able to sustain the business, with continued borrowing at an exorbitant rate (as high as 18 percent interest) and additional capital.

Last month, the company raised $28.5 million by selling more than 61 million shares at 50 cents each. Also renegotiated with the existing lenders. As a result, the company got some relief from the credit payments. Moving forward, what actions could save the company from drowning deep into the debt?

The CEO and founder Dov Charney recently stated, “We invested substantially in our infrastructure in 2012 and 2013, and almost all of these projects have been implemented. We expect 2014 to be a year where we return our full focus to exploiting the strength of our brand and delivering exceptional service to our retail and wholesale customers. We are committed to delivering a return on the investments we have made in our business.”

About The company

Based Los Angeles, California American Apparel is a vertically integrated manufacturer, distributor, and retailer of branded fashion apparel and accessories for men, women, children and babies.

As of February 28, 2014, the company had approximately 10,000 employees and operated 246 retail stores in 20 countries.

The company has business in the United States, Canada, Mexico, Brazil, United Kingdom, Ireland, Austria, Belgium, France, Germany, Italy, Netherlands, Spain, Sweden, Switzerland, Israel, Australia, Japan, South Korea, and China.

The company operates an e-commerce website with 12 different localized online stores in seven languages that serve customers from 30 countries worldwide.

The company has four operating segments: Wholesale, U.S. Retail, Canada, and International. “American Apparel ®” is a registered trademark of American Apparel (USA), LLC. U.S. Since 2006, the company is listed on the NYSE (New York stock Exchange).

The apparel manufacturing operations has spread out of 800,000 square foot facilities in the warehouse district of downtown Los Angeles, California.

Business Model

American Apparel's mission is to make great quality clothing without using cheap "sweatshop" labor and exploiting workers.

To seek profits through innovation not exploitation. By pursuing efficiencies in management and production, their aim was to demonstrate that the use of exploitative labor tactics is not only unnecessary but counterproductive.

Growth Strategy

The company is focused on growing by increasing the number of stores, building good online sales platform, bringing new merchandise for the users and creating strong Information systems to support the operations of the company.

The company has the Core Business Strengths of unique designs, advertising promotions and branding, quality products and broad appeal to consumers of various demographics.

About CEO & Founder

Dov Charney founded the garment business in 1998. The Ernst & Young named Dov Charney Entrepreneur of the Year in 2004. The Apparel Magazine, the Fashion Industry Guild and the Ad Specialty Industry all separately deemed him

"Man of the Year." Charney was included in the Los Angeles Times "100 Most Powerful People of Southern California" list and

Details Magazine inducted him to their "Power 50”. In the first annual Los Angeles Fashion Awards, Charney was recognized for Excellence in Marketing. In the year 2008, independent research report placed American Apparel as the Top Trendsetting Brand,

second only to Nike. In contrast to his achievements, he had been known for the use of sexually proactive advertisements for the

marketing of its products. Dov Charney has been associated with several controversial lawsuits, although none was proved in the court.

APPAREL INDUSTRY

The apparel industry was highly fragmented and highly volatile. The sales growth over the last five years had been eroded (-0.5% CAGR domestically and 1.4% CAGR

overall).

The industry inventory levels or stock levels had been steadily increasing over the last five years, The international sales had grown by a CAGR of 11.3% over the same period. The CAGR for total sales (combining international and domestic sales) over this period was about 1.6%. In the apparel industry, the American Apparel’ was facing stiff competition from the Gap, Urban Outfitters,

American eagle, and Express. Some of these competitors had better financial power to reduced cost due to an outsourcing model.

Past Present and Future

Year 2008

Till 2008, the aggressive expansion of the company, the explicit use of sex proactive advertising and very good quality products, paid well in terms of the profitability of the company.

The company created a very strong brand recognition, and its products have been able to appeal the young with its trend-setting designs and Charney’s unique fashion sense.

In 2008, the company’s CEO was named "Retailer of the Year" at the 15th Annual Michael Awards for the Fashion Industry,

The company grew from 147 stores in 2006 to 260 stores in 2008, while expanding on both domestic, as well as international stores. The sales increased by whooping 40 percent as compared to the previous year. The rapid expansion of the stores and retail centers had put the company into the one of the fastest growing company in the retail sector.

Year 2009 till 2012

The success story continued until 2009 Due to the immigration issues, the company was required to terminate 2000 American Apparel workers from

its factory, some of its workers were more than a decade old, leading to the company’s inability to complete orders on time and meet the demand. As a result, the production was badly hit and resulted in stock-outs.

The operating profit decreased from $ 36 million to $3 million, a massive decrease of 92% in year 2009. The company’s net profit drastically fell from $ 14 million in 2008 to $1 million in 2009, a humongous downfall of 93%.

The global recession made the recovery all the more difficult. For the first, time the company’s sales declined from $558 million to $532 million, a downfall of 5%. The operating income fell from $24 million to a negative $50 million, a significant drop in the profitability by exorbitant 300%. The huge loans and the interest payments further intensified the loss, resulting into a net loss of $86 million as compared to the last year loss of $36 million, an increase of 140% as compared to 93% increase last year.

Shattered by the losses and lack of liquidity, the money situation worsened by the first quarter of 2011, and the company stated that it might file a protection against bankruptcy under section 11. Desperate for funds, the CEO Dov was able to bring the investors .However, the loans taken by the company were excessively costly.

Due to the significant efforts, the net loss restrained to $39 million in 2011 as compared to $87 million last year.

In year 2012, the company undertook efforts to upgrade the production forecasting and allocation system, which would enhance the Logistic, demand planning solution. On the other hand, it continued building the stores. The total net loss decreased from $39 million to $37 million in the year 2012. The sales also started building up. The net sales of the company increased from $547 million to 617 million in 2012.

Year 2013 The worst of all the years 2013

The company implemented two important strategic initiatives - inventory management and the new distribution center.

The company also completed its RFID (Radio-frequency identification) system and implementation of oracle, ATG web commerce application, for its e-commerce platform.

The cost of goods sold increased from $289 million to $ 313 million, crushing both net and gross margins. The net loss increased to mammoth $106 million, with the sales grown at a marginal three percentage, from $617 million to $633 million.

Already pressurized by the rocket high interest rates and debt repayments, the company has cash of only eight million on 31 Dec. The increased cost axed the cash from operations by whopping $36 million into negative cash from operations of $12 million

Year 2014 and Ahead

2014 the net sales had decreased to $137.1 million, due to drop off both comparable store as well as wholesales net sales.

The gross profit reduced to $72.0 million in the first quarter as compared to last year’s first quarter results. In the first quarter annual report of 2014, the company reassured the investors of its commitment to reduce

the cost by bringing down the manufacturing as well as administrative costs. This year the company had also put halt on excessive capital expenditure and would be more focused to

remove the inefficiencies associated with the production process while, building up the productivity for a profitable future.

Dov Charney, CEO of American Apparel indicated: "We are encouraged by our first quarter performance with our achieved results ahead of our 2014 business plan. The results of our cost control efforts are being seen in all areas of the business, and we are now fully focused on measures to improve top line performance." Showing the way forward, he said, “Its (American Apparel) 247 stores could be 20% more productive with the right tweaks; the online business could double, wholesale could grow by 20% to 30%.”

Recent Happenings

On 25th March 2014, in order to comply with the terms and conditions of debt renegotiation, the company raised more shares capital. CEO Johannes Minho Roth, of FiveT, a Zurich-based firm invested an enormous sum, by purchasing $26 million of the shares and become the second largest outside shareholder, after CEO Dov Charney.

Roth believed that the company is grossly undervalued. Roth on his investment in American apparel stated, “We cannot believe how cheap it is,” Roth said. Especially since, “it’s a lot further in the restructuring process than people think.” “He’s a visionary,” “Dov wants to make it his life goal to make American Apparel into a successful company. I have a very positive view on him.”

Although the raising of funds gave some time to the company and enabled to pay off the debt, the danger of default had just subsided and not gone away with the next big interest payment due in April 2014.

On April 14, 2014, the debt-ridden company had one more blow. Based on an internal enquiry, the board accused and dismissed CEO Dov Charney of “willful misconduct,” based on the sex assaults and sexual harassment cases. The board clarified that the firing was based on the personal misconduct than the professional one. The firing came at a time when the company is suffocating under the debt burden. An interest payment of $14 million had to be paid, by the end of April 2014. The analyst were viewing this event as the last nail in the coffin. Would the Dov charley’s exit from the company trigger the default that the company has been avoiding for long? What were the performance areas that dragged the company down in the debt? Has the American apparel lost it appeal, and the CEO Dov Charney lost his charm? (Please refer to the excel sheets for hints)

RATIO ANALYSIS AND FINDINGS

Activity Ratio- Profit depends on rate of turnover and the net margin. Activity Ratios, also termed as

Performance ratios or Turnover ratios, judge how well the facilities at the disposal of the enterprise are being utilized.

In other words, these ratios measure the effectiveness with which a concern uses resources at its disposal. Activity

ratios are used to measure the relative efficiency of a firm based on its use of its assets, leverage or other such balance

sheet items. These ratios are important in determining whether a company's management is doing a good enough job

of generating revenues, cash, etc. from its resources. They comprise of Debtor’s turnover ratio and Asset turnover

ratio.

Years-> 2013 2012 2011 2010 2009

ACTIVITY RATIOS

Inventory Turnover 3.69 3.43 3.01 3.34 3.86Receivables Turnover 29.04 28.12 29.09 31.73 33.51

Working Capital Turnover 10.92 8.22 12.19 8.61 5.47

Total Asset Turnover 1.92 1.89 1.68 1.63 1.69

Findings:

Inventory Turnover is slightly higher(3.69) as compared to previous years i.e. in 2011-2013 averge was 3.55

as compared to last year’s 3.43.

Receivables Turnover is also on a higher level as compared to previous year’s by 0.92 but as compared to 2009-11 its

low.

Working Capital Turnover has raised 2.7 compared from previous year.

Total Asset Turnover rosen a little from 1.89 to 1.92

Coverage Ratio- A measure of a company's ability to meet its financial obligations. In broad terms, the higher

the coverage ratio, the better the ability of the enterprise to fulfill its obligations to its lenders. The trend of coverage

ratios over time is also studied by analysts and investors to ascertain the change in a company's financial position.

Common coverage ratios include the interest coverage ratio, debt service coverage ratio and the asset coverage ratio.

Years-> 2013 2012 2011 2010 2009

COVERAGE RATIOS

Cash Coverage Ratio (0.32) 0.57 0.07 (1.36) 2.00Interest Coverage Ratio (0.75) 0.02 (0.70) (2.11) 1.08

Findings:

Cash Coverage Ratio has declined from 0.57 to (0.32) and has turned negative.

Interest Coverage Ratio has declined from 0.02 to (0.75) and also had turned negative.

Liquidity Ratio- Liquidity ratios measure the short-term solvency, i.e., the firm’s ability to pay its current dues.

They comprise of Current Ratio and Liquid ratio.

Years 2013 2012 2011 2010 2009

LIQUIDITY RATIOS

Current Ratio 1.33 1.39 1.61 1.01 2.87Quick Ratio 0.18 0.22 0.22 0.11 0.40

Cash Ratio 0.05 0.08 0.07 0.04 0.14

Findings:

Current Ratio is slightly down from 1.39 to 1.33 and also its lower then 2009-2011 average of 1.90

Quick Ratio is a bit lower then last year’s 0.22 i.e. 0.18.

Cash Ratio is also down to 0.05

Solvency Ratio - A key metric used to measure an enterprise’s ability to meet its debt and other obligations. The

solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities.

The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.

The measure is usually calculated as follows:

Years 2013 2012 2011 2010 2009

SOLVENCY RATIOS

Total Debt To Total Asset Ratio 1.23 0.93 0.85 0.77 0.52Long Term Debt To Equity Ratio -3.22 6.54 2.77 0.52 0.67

Total Debt To Equity Ratio -5.31 13.86 5.75 3.37 1.08

Findings:

Total Debt to Total Asset Ratio has shown improvement, there is a rise of 0.30 i.e. from 0.93 to 1.23.

Long Term Debt to Equity Ratio has gone down drastically from 6.54 to -3.22 showing a decrease of 9.34.

Total Debt To Equity Ratio dipped from 13.86 to -5.31 and has turned negative.

Cash Performance Ratio- It focus on the cash being generated in terms of how much is being generated and the safety net that it provides to the company. These ratios can give users another look at the financial health and performance of a company.

Years 2013 2012 2011 2010 2009

CASH PERFORMANC

ERATIOS

Cash Return To Revenue -0.02 0.04 0.00 -0.06 0.08Cash Return On Assets -0.04 0.07 0.01 -0.10 0.14Cash Return On Equity NMF NMF 0.05 -0.43 0.29

Cash Return To Net Income NMF -0.63 -0.06 0.38 0.65

Findings:

Cash Return to Revenue is down from 0.04 to -0.02 and has turned negative which shows negative return of cash on revenue.

Cash Return on Assets has also turned negative from -0.04 to 0.07 which means cash return is not good enough on assets. Cash Return on Equity is also down. Cash Return to Net Income is continuously down since past 3 years.

Profitability Ratio- It is a measurement that help to determine the ability of a company to generate earnings in comparison to its costs and expenses over a certain time period. A compny having higher profitability ratio then its competitors is considered of doing well in business.

Years 2013 2012 2011 2010 2009

PROFITABILITY RATIOS

Net Profit Margin -17% -6% -7% -16% 0%Gross Profit Margin 51% 53% 54% 53% 57%

Return On Assets -9% 0% -7% -15% 7%Return On Equity NMF -169% -82% -115% 1%

Findings:

Net Profit Margin is negative since 4 years from 2010-2013 and is -17% in 2013 which shows declining profits.

Gross Profit Margin is also in diminishing trend. Return on Assets has also turned negative again after 2012 to 9%. Return on Equity is continuously down since past 3 years which means investors are not getting

positive return on their investments.

CASH FLOW STATEMENT

A cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing and financing activities.

Cash flow from operating activities

An accounting item indicating the money a company brings in from ongoing, regular business activities,

such as manufacturing and selling goods or providing a service. Cash flow from operating activities does not

include long-term capital or investment costs. It does include earnings before interest and taxes plus

depreciation minus taxes.

Analysis- Cash flow from operating activities for 2009-2013

By analyzing the cash flow from operating activities, there has been a negative trend in maintaining

operating cash flow. In 2009, 2011 and 2012 there was a positive net cash flow and negative in 2010 and

2013, which shows a very high fluctuating trend.

The reason of this negativity in net cash flow from operating activities is the negative balance of account

receivables; reason being the clients who has taken services from the company has not paid for it till now.

There is a negative net cash flow in 2013, which is mainly due to increase in deferred taxes payments in

comparison to last 4 years.

Cash flow from Investing Activities-

An item on the cash flow statement that reports the aggregate change in a company's cash position resulting

from any gains (or losses) from investments in the financial markets and operating subsidiaries, and changes

resulting from amounts spent on investments in capital assets such as plant and equipment.

Analysis- Cash flow from investing activities for 2009-2013

By analyzing the cash flow from investing activities, it’s been noticed that there has been a continuous

negative cash flow. Main reason behind this negative cash flow from investment is the continuous increase

in capital expenditures by purchasing of fixed assets. In past 5 years company was having a low liquidity

ratio and low cash reserves still the management is investing heavy amount of cash in buying fixed assets

and increasing long-term debts. Since past 5 years they have invested 20890, 15700, 11070, 21610 and

27050 because which they maintaining negative cash flow of (20890), (15660), (10760), (24850) and

(25150).

Cash flow from Financing Activities-

A category in a company’s cash flow statement that accounts for external activities that allow a firm to raise

capital and repay investors, such as issuing cash dividends, adding or changing loans or issuing more stock.

Cash flow from financing activities shows investors the company’s financial strength. A company that

frequently turns to new debt or equity for cash, for example, could have problems if the capital markets

become less liquid.

Analysis- Cash flow from financing activities for 2009-2013

By analyzing the cash flow from financing activities, there has been a fluctuating trend in maintaining the

cash flowing from all the financing activities. There has been increase in the bowings of the company, which

has resulted in increased long-term debts. This is the reason behind the unstable financial position of the

company. There is no negative trend in cash flow from financing activities but the borrowings are constantly

rising.

Operating activities Investing activities Financing activities

$(40,000)

$(30,000)

$(20,000)

$(10,000)

$-

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

(12,723)

(25,147)

34,228

23,589

(24,853)

4,214 2,305 (10,759)

12,582

(32,370)

(15,662)

48,172 45,203

(20,889)(25,471)

Cash flow from different Activities

2009 2010 2011 2012 2013

Net (decrease) increase in cash

$(5,000)

$(4,000)

$(3,000)

$(2,000)

$(1,000)

$-

$1,000

$2,000

$3,000

$4,000

Net Increase/Decrease in Cash

2013 2012 2011 2010 2009

Consolidated Balance Sheet Analysis

American Apparel, Inc. and Subsidiaries

Consolidated Balance Sheets

December 31,

(Amounts and shares in thousands, except per share amounts) 2013 2012 2011 2010 2009

ASSETS

CURRENT ASSETS

Cash $8,676 $12,853 $10,293 $7,656 $9,046

Trade accounts receivable, net of allowances of $2,229 and

$2,085 at December 31, 2013 and 2012, respectively 20,701 22,962 20,939 16,688 16,907

Restricted cash - 3,733

Prepaid expenses and other current assets 15,636 9,589 7,631 9,401 9,994

Inventories, net 1,69,378 1,74,229 1,85,764 1,78,052 1,41,235

Income taxes receivable and prepaid income taxes 306 530 5,955 4,114 4,494

Deferred income taxes, net of valuation allowance 599 494 148 626 4,627

Total current assets 2,15,296 2,24,390 2,30,730 2,16,537 1,86,303

Property and Equipment, net 69,303 67,778 67,438 85,400 1,03,310

Deffered taxes 2,426 1,261 1,529 1,695 12,033

Other Assets, net 46,727 34,783 25,024 24,318 25,933

TOTAL ASSETS $3,33,752 $3,28,212 $3,24,721 $3,27,950 $3,27,579

From the above we can conclude:

Cash has decreased from 12,853 to 8,676 in the year 2013. Trade Receivables came down to 20,701 in 2013 from 22,962. Cash restricted was 3,733 in the year 2012. Prepaid Expenses increased from 9,589 to 15,636 in 2013. In 2013, Inventories fell from 174229 to 169378. Income Taxes receivables and prepaid income taxes fell from 530 to 306 in 2012. Deferred Income taxes increased to 599. TOTAL CURRENT ASSETS declined to 215296 from 224390 in the year 2013. Property and Equipment increased to 69,303 Deferred taxes increased to 2426 Other assets increased to 46727 Thereby, increasing TOTAL ASSETS by 5540 in the year 2013.

Consolidated Balance Sheet Analysis

December 31,

(Amounts and shares in thousands, except per share amounts) 2013 2012 2011 2010

CURRENT LIABILITIES

Accounts Payable $91,291 $82,109 $80,240 $70,792

Short-Term Debt / Current Portion of Long-Term Debt $45,751 $62,259 $51,556 $139,038

Other Current Liabilities $24,947 $17,241 $11,554 $4,321

Total Current Liabilities $161,989 $161,609 $143,350 $214,151

Long-Term Debt $218,921 $112,856 $98,868 $986

Other Liabilities $11,485 $10,695 $12,046 $12,605

Deferred Liability Charges $18,761 $20,968 $22,327 $25,184

Misc. Stocks $0 $0 $0 $0

Minority Interest $0 $0 $0 $0

Total Liabilities $411,156 $306,128 $276,591 $252,926

Stock Holders Equity

Common Stocks $11 $11 $11 $8

Capital Surplus $185,472 $177,081 $166,486 $153,881

Retained Earnings ($256,424) ($150,126) ($112,854) ($73,540)

Treasury Stock ($2,157) ($2,157) ($2,157) ($2,157)

Other Equity ($4,306) ($2,725) ($3,356) ($3,168)

Total Equity ($77,404) $22,084 $48,130 $75,024

Total Liabilities & Equity $333,752 $328,212 $324,721 $327,950

From above we can conclude:

Current Liabilities increased to 161989 in 2013 from 214151 in 2010. And, TOTAL LIABILITIES reached till 411156 in 2013. Much higher than TOTAL LIABILITIES in 2010 i.e.

252926. TOTAL EQUITY declined over the years and got negative in the year 2013 i.e. (77,404) Thereby, increasing TOTAL LIABILITIES AND EQUITY by 5540 in the year 2013.

CONCLUSION :

Liquidity Measure 2013 2012 2011 2010 2009Current Ratio 1.3290779 1.388474652 1.609557028 1.011141671 2.871501233

The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm’s current assets to its current liabilities. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses.

Here, Current Ratio has been declining since 2009 and reached till 1.3290779 in the year 2013 i.e. below 1.5.

Liquidity Measure 2013 2012 2011 2010 2009Total Debt to Total Assets 1.231920708 0.932714221 0.851780452 0.77123342 0.51968532

The debt to total assets ratio is an indicator of financial leverage. It tells you the percentage of total assets that were financed by creditors, liabilities, debt. The debt to total assets ratio is calculated by dividing a corporation's total liabilities by its total assets.

Here, TOTAL DEBT TO TOTAL ASSETS is 1.231920708, which means company’s debts are much higher than the company’s total assets.

Liquidity Measure 2013 2012 2011 2010 2009Debt to Equity Ratio -5.311818511 13.86198153 5.74674839 3.37126786 1.08196846

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

Here, DEBT TO EQUITY RATIO is negative, which means total liabilities of a company exceed its total equity.

Liquidity Measure 2013 2012 2011 2010 2009Interest coverage -0.745685486 0.023147814 -0.70229444 -2.10731727 1.07902063

A ratio used to define how easily a company could pay interest on outstanding debt. It is calculated by dividing a company’s earnings before interest and tax (EBIT) of one period by the company’s interest expenses of the same period.

Here, INTEREST COVERAGE is negative indicating that company’s interest expenses are much higher than the company’s earnings before interest and tax.

Therefore, from the above, we can conclude, that the company’s financial position is not strong and hence it is difficult to survive in the industry.