The Pacific Sunwear of California - Financial Analysis

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Pac Sun’s acid test ratio has had similar trends to its current ratio. The acid test ratio decreased from 2011 to 2012 (1 to 0.57) and continued this trend from 2012 to 2013 (.57 to .41). Inventories have shown a cyclical pattern over the past three years but seems to have less of an effect since the acid test trends stay consistent with the current ratio. Interestingly enough, Aeropostale’s inventories also acted in a cyclical manner however, opposite to the direction in which Pac Sun’s moved. Ultimately, its acid test also showed the same downward trend from 2011 to 2013 (1.44 to 0.85) as its current ratio.

Due to PSUN’s decreasing cash account and operating loss from 2011 to 2013 , its cash flow liquidity ratio decreased by nearly 49% (0.47 to 0.23). Increasing the current liabilities only added fuel to the fire and helped contribute to a rapid drop in the three year time period. Once again, Aero followed Pac Sun in a decreasing trend as its cash flow liquidity dropped from 2011 to 2013 by 62% (1.16 to .44). Decreasing operating income and cash coupled with increasing current liabilities played a significant role in the decreasing trend of this ratio.

B. Analysis of Financial Leverage

Pac Sun’s financial leverage ratios present a bad outlook for the company. The debt ratio has been climbing steadily over the three year period (Figure B.1). On December 7, 2011, the Company obtained a $60 million term loan funded by an affiliate of Golden Gate Capital. Interest was at a rate of 5.5% per annum to be paid in cash, due and payable quarterly in arrears, and 7.5% per annum, due and payable-in-kind (“PIK”) annually in arrears. The high leverage put Pac Sun at high risk, as it may have a hard time repaying such large debt with a negative income year over year. On the other hand, shareholders’ equity has been shrinking over the period as accumulated deficit grew: the company need the capital to make up for it disappointing losses.

Operating profit is negative. Pac Sun has failed to identify and respond appropriately to changing consumer preferences and fashion trends in a timely manner. Significant competition from vertically-integrated, brand-based, and online retailers could have a material adverse effect on Pac Sun. In addition, product costs from manufacturing partners may increase, which could result in significant margin erosion. With the rise of digital channels, teens no longer rely on the mall to socialize. If this trend continues, it is bad news for Aeropostale, as well as Pac Sun, as their entire business was based mostly on young customers who hang out at the mall. What is worse, the malls see the rise of teen retail's next killer: fast fashion. Zara, H&M, and Forever 21 have much shorter lead times than traditional teen retailers. The impact on cash flow shows that the accumulated deficit in retained earning in 2014 was more than 5 million dollars. As a consequence, long term debt is disproportionately large compared to equity (Figure B.2). The huge cash outflow also shows up in disappearing cash in current assets over the period.

SG&A expenses have been decreasing over the three year period, at the same time when revenue went up. Operating loss decreased over 2012-2014. In fiscal 2012, the Company recorded $8 million of interest expense, including approximately $5 million of accrued PIK interest, related to the Term Loan. This figure increased by only another million in fiscal year 2013. The rate of decreasing expenses is greater than the increasing rate of interest expense, which helped bring the TIE ratio from a disappointing -16.1 to -1.5. As seen in Figure B.3, Pac Sun did better than Aeropostale since the later’s operating profit drop to a disappointing negative figure in 2014.

C. Operating Efficiency

Pac Sun’s operating efficiency seems to be increasing over the past three years. In regards to the majority of the activity ratios, they are improving their turnover times. When looking further into the accounts, we noticed that the company had made some major changes. Although Pac Sun showed low performance in regards to cash flows, it has seemed to be fine-tuning its accounts with cost-cutting measures.

We must take into consideration each company’s type of business. They operate on a cash-basis for sales with a business-to-consumer model. The only exception to the cash-basis is with regards to gift cards, which is minuscule, and therefore disregarded in the analysis. As a result, accounts receivables for these two retail companies are zero, which in turn made accounts receivable turnover ratios of zero for the end of 2014, 2013 and 2012.

The inventory turnover ratio and accounts payable turnover results from Pac Sun show that they have increased their efficiency in regards to inventory management and payback respectively. When looking further into the management discussion and analysis, or MD & A, we learned that the company explained that it has actually lowered its cost of goods sold as a measure of percentage of sales. They have also lowered their inventories while Aeropostale has been increasing their inventories. Increased expansion is a leading reason for this increase with Aeropostale. In 2011 Pac Sun’s COGS was 78% of net sales in comparison with 75% in 2012 and 2013. Their MD & A suggested that they are cutting costs by ordering inventories more efficiently and following a more improved Just In Time inventory system. Timing for both retailers is key to improving profits, however, Aeropostale’s COGS has actually gone up as a percentage of sales. This can be seen from their international expansion as they have been heavily involved with operations in Mexico. Since they are ordering more frequently with different styles for other countries, the ordering costs have actually increased. There are 54 stores currently operating in Mexico alone with a total of 96 stores outside the U.S. In order for Aeropostale to keep costs low they will need to improve their inventory management system as Pac Sun has been doing. From these results we can explain why Pac Sun’s inventory turnover ratio has steadily gone up while Aeropostale’s ratio has decreased as a percentage of sales. The results of COGS along with Aeropostale’s recent expansion and Pac Sun’s recent consolidation have contributed to inverse outcomes with Aeropostale’s and Pac Sun’s accounts payable turnover ratios.

Changes in methods of asset management have also resulted in increased asset turnover ratios for Pac Sun. Their store operating leases are mentioned in the MD & A as one of the largest expenses. They’ve lowered plant, property, and equipment by cutting costs to plant maintenance and renovation