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Statement Analysis, and Valuation
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in whole or in part.
Hewlett-Packard, on the other hand, outsources the manufacturing of many of
its computer components and therefore does not have as much property, plant, and
equipment. Thus, Firm (12) is Hewlett-Packard. We ask students why Hewlett-
Packard has such a small proportion of long-term debt in its capital structure.
Computer firms experience considerable technological risk related to the
introduction of new products by competitors. Products life cycles are short at
approximately one to two years. Hewlett-Packard does not want to add financial
risk to its already high business (asset side) risk. Also, computer firms have
relatively few assets (other than property, plant, and equipment) that can serve as
collateral for borrowing. Their most important resources, their technologies and
their people, do not show up on the balance sheet. The relatively low profit margin
evidences the increasingly commodity nature of most computer products and the
intense competition in the industry.
This leaves Firm (1) and Firm (5) as being Dupont and Procter & Gamble,
respectively. Firm (5) has a lower cost of sales to revenues percentage and a higher
selling and administrative expense to revenues percentage. It also has a higher
profit margin compared to Firm (1). Firm (5) is Procter & Gamble. The high profit
margin reflects the brand names of Procter & Gamble’s products. The high selling
and administrative expense percentage results from advertising and other
expenditures to stimulate demand and to maintain and enhance brand names. The
low cost of sales percentage reflects the relatively low cost of ingredients in most of
its products and the high selling prices it can charge. One final clue is that
investments in R&D are less critical for a consumer products company than for
firms in which technology development is important. Note that Procter & Gamble
shows a high percentage for intangibles, the result of goodwill and other intangibles
from companies it has acquired.
This leaves Firm (1) as Dupont. Its income statement percentages are similar to
those for Hewlett-Packard. It carries more debt than Hewlett-Packard does, related
to Dupont’s borrowing in order to finance its more capital-intensive operations.
We move next to Pacific Gas & Electric. Utilities are very capital-intensive and
carry high levels of debt. Firm (3) displays these characteristics. Note that
depreciation and amortization as a percentage of revenues is the highest for this
firm, reflective of its capital intensity. Also, its interest expense to revenues
percentage is the second highest among these firms, which one would expect from
the high levels of debt.
We move next to the two professional service firms, Kelly Services and
Omnicom Group. Neither firm will have a high proportion of property, plant, and
equipment. Thus, Firms (6), (7), and (9) are possibilities. Kelly Services should
have no inventories, and inventories for Omnicom Group should be small,
representing advertising work in process. This suggests that Firm (7) and Firm (9)
are the most likely candidates. One would expect the value added by employees of
Kelly (temporary help services) to be less than that of Omnicom (creative
advertising services). Thus, Firm (7) is Kelly and Firm (9) is Omnicom. Another
clue that Firm (7) is Kelly is that receivables relative to operating revenues indicate
a turnover of 6.4 (100.0%/15.7%) times per year and current liabilities relative to
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Statement Analysis, and Valuation
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operating expenses indicate a turnover of 8.0 (82.5%/10.3%) times per year. One
would expect faster turnovers for a temporary help business that pays its employees
more regularly for temporary work done. The corresponding turnovers for Firm (9)
are 2.3 (100.0%/43.2%) and 1.2 (87.4%/73.0%). The turnovers for Omnicom are
difficult to interpret because its operating revenues represent the commission and
fee earned on advertising work, whereas accounts receivable represent the full
amount (media time plus commission or fee) billed to clients and accounts payable
represent the full amount payable to various media. The higher percentages for
receivables and current liabilities for Firm (9) indicate the agency nature of
advertising firms. Firm (9) shows a relatively high proportion for intangibles,
consistent with recognizing goodwill in Omnicom’s acquisition of other marketing
services firms in recent years. The surprising result is that the cash flow from
operations to capital expenditures ratio for Kelly is so low. Given its low capital
intensity, one would expect a high ratio. The explanation relates to its very low
profitability, which leads to low cash flow from operations.
We move next to the fast-food restaurant, McDonald’s. The firm should have
inventories, but those inventories should turn over rapidly. The remaining firm with
the lowest inventory percentage is Firm (11), representing McDonald’s. Note that
the firm has a high proportion of its assets in property, plant, and equipment.
McDonald’s owns its company-operated restaurants and owns but leases other
restaurants to its franchisees. The relatively high profit margin percentage results
from McDonald’s dominance in its market and from its brand name.
We are left with two unidentified firms in Text Exhibit 1.23, Firm (6) and Firm
(8). They are Best Buy and Abercrombie & Fitch, respectively. Both of these firms
have inventories. Firm (8) has a substantially lower cost of sales percentage, a
substantially higher selling and administrative percentage, and a higher profit
margin compared to Firm (6). Abercrombie & Fitch sells brand name clothing
products with a degree of fashion emphasis, whereas Best Buy sells electronic
products with near-commodity status at low prices. One would expect much greater
gross profits on sales of fashion apparel than on commodity-like electronic and
appliance products. However, the cost of retail store space for Best Buy should be
less than that of Abercrombie & Fitch because the latter firm tends to locate in
malls. Thus, Firm (6) is Best Buy and Firm (8) is Abercrombie & Fitch.
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Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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Exhibit 1.C—(Problem 1.11) (Text Exhibit 1.23)
E.I.du
Pontde
NemoursMerck
Pacific
Gas&
ElectricAllstateP&G
Best
Buy
Kelly
ServicesA&F
Omnicom
Group
HSBC
FinanceMcDonald’sHP
123456789101112
BALANCESHEET
Cash&marketablesecurities11.6%23.0%9.2%362.6%6.0%1.1%1.6%14.7%8.3%27.3%8.8%11.6%
Receivables18.248.425.047.78.94.115.72.743.2697.54.016.8
Inventories17.89.62.9—8.710.6—10.55.0—0.55.3
Property,plant,andequipment,atcost87.8101.2272.310.346.415.46.966.113.13.2132.418.3
Accumulateddepreciation(52.8) (50.9) (92.8) (6.7)(21.8) (6.1)(3.7)(26.6) (7.7) (1.3) (46.3) (8.5)
Property,plant,andequipment,net35.050.3179.53.624.69.33.139.55.41.986.19.8
Intangibles15.28.2—2.8112.86.02.6—55.740.99.534.7
Otherassets 15.8 58.4 60.5120.7 9.5 4.1 4.712.9 12.0 26.7 12.2 22.0
Totalassets113.7%197.9%277.1%537.5%170.6%35.2%27.8%80.5%129.6%794.3%121.0%100.2%
Currentliabilities30.5%60.0%51.2%391.7%39.1%18.7%10.3%12.7%73.0%122.1%10.8%37.5%
Long‐termdebt24.016.570.119.426.12.50.92.822.9565.543.312.2
Otherlong‐termliabilities36.942.788.951.325.53.62.712.87.420.210.015.1
Shareholders’equity 22.4 78.7 66.9 75.179.810.313.952.126.4 86.556.9 35.4
TotalLiabilitiesandShareholders’
Equity113.7%197.9%277.1%537.5%170.6%35.2%27.8%80.5%129.6%794.3%121.0%100.2%
INCOMESTATEMENT
Operatingrevenues100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%100.0%
Costofsales(excludingdepreciation)or
operatingexpenses(75.6)(23.4)(60.7)(91.6)(49.2)(75.6)(82.5)(33.3)(87.4)(29.1)(63.3)(76.4)
Depreciationandamortization(4.5)(6.8)(12.6)(0.9)(3.9)(1.8)(0.8)(5.1)(1.8)(1.7)(5.1)(4.2)
Sellingandadministrative(6.8)(24.1)—(10.7)(23.9)(18.2)(15.3)(49.4)—(25.0)(4.9)(6.0)
Researchanddevelopment(4.4)(20.1)——(2.6)——————(2.5)
Interest(expense)/income(1.2)(1.1)(4.8)21.0(1.7)(0.2)—0.3(0.6)(32.7)(2.2)(0.6)
Incometaxes(1.2)(8.4)(3.3)(6.9)(5.1)(1.5)(0.5)(5.0)(4.1)(3.7)(7.8)(1.5)
Allotheritems,net —16.7(10.6) 4.2 0.7(0.5)(0.1) — 1.2(3.3) 1.7(2.1)
Netincome6.3%32.7% 8.1%15.2%14.3%2.2% 0.8% 7.4%7.5% 4.5%18.3% 6.7%
Cashflowfromoperations/capital
expenditures1.65.10.818.74.61.41.61.36.6100.92.83.6
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
1.12 Effect of Industry Characteristics on Financial Statement Relations: Global
Perspective. There are various approaches to this problem. One approach begins
with a particular company, identifies unique financial characteristics (for example,
steel companies have a high proportion of property, plant, and equipment among
their assets), and then searches the common-size financial data to identify the
company with that unique characteristic.
Another approach begins with the common-size data, identifies unusual
financial statement relationships [for example, Firm (12) has a high proportion of
cash, marketable securities, and receivables among its assets], and then looks over
the list of companies to identify the one most likely to have that unusual financial
statement relationship. This teaching note employs both approaches. All of the data
are scaled by total revenues (except for the final data item, which is cash flow from
operations over capital expenditures); so throughout this discussion when we refer
to a “percentage,” it is a percentage of revenues. The data from Text Exhibit 1.24 in
the text, with company names as column headings, are presented at the end of this
solution in Exhibit 1.D.
The high proportions of cash, marketable securities, and receivables for Firm
(1) suggest that it is Fortis, the Dutch insurance and banking company. Insurance
companies receive cash from premiums each year and invest the funds in various
investment vehicles until the money is needed to pay insurance claims. They
recognize premium revenue from the cash received and investment income from
investments each year. They must match against this revenue an appropriate portion
of the expected cost of insurance claims from policies in force during the year.
Fortis includes this amount in Text Exhibit 1.24 on the line labeled “Operating
Expenses.” Operating revenues also include interest revenue on loans made. One
might ask why Fortis has such a high proportion of financing in the form of current
liabilities. This balance sheet category includes the estimated cost of claims not yet
paid from insurance in force. It also includes deposits by customers in its banks.
One also might ask what types of quality of earnings issues arise for a company
such as Fortis. One issue relates to the measurement of insurance claims expense
each period. The ultimate cost of claims will not be known with certainty until
customers make claims and settlement is made. Prior to that time, Fortis must
estimate what that cost will be. The need to make such estimates creates the
opportunity to manage earnings and lowers the quality of earnings. Another issue
relates to estimated uncollectible loans. Fortis recognizes interest revenue from
loans each year and must match against this revenue the cost of any loans that will
not be repaid. The need to make such estimates also provides management with an
opportunity to manage earnings and, therefore, lowers the quality of earnings.
Firm (6) stands out because it is the only other firm [besides Fortis, Firm (1)]
with zero inventory. Firm (6) also has an unusually high proportion of assets in
receivables and in current liabilities. The pattern is typical for a professional service
firm, such as an advertising agency, which creates and sells advertising copy for
clients (for which it has a receivable) and purchasing time and space from various
media to display it (for which it has a current liability). Additional evidence that
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Statement Analysis, and Valuation
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in whole or in part.
Firm (6) is Interpublic Group is the high percentage for intangibles, representing
goodwill from acquisitions.
Four firms have R&D expenses: Firms (3), (7), (9), and (12). These are Toyota
Motor, Sun Microsystems, Roche Holding, and Nestlé, respectively.
Roche Holding and Sun Microsystems are more technology-oriented and,
therefore, likely to have higher percentages of R&D compared to Toyota and
Nestlé. This suggests that they are Firms (9) and (7) in some combination. Firm (9)
has a lower cost of sales percentage than Firm (7), suggesting that Firm (9) is
Roche Holdings, because patented pharmaceutical products generally sell at much
higher markups and generate higher profit margins than more competitively priced
computer networking equipment sold by Sun Microsystems. It is interesting to
observe the relatively small cost of goods sold to sales percentage for Roche. The
manufacturing cost of pharmaceutical products includes primarily the cost of the
chemical raw materials, which machines combine into various drugs.
Pharmaceutical firms must price their products significantly above manufacturing
costs to recoup their investments in R&D. The inventories of Firm (9) turn over
more slowly at 2.3 times per year (28.5/12.2) than those of Firm (7) at 10.9 times
per year (53.5/4.9). The inventory turnover of Roche is consistent with the making
of fewer production runs on each pharmaceutical product to gain production
efficiencies. Firm (9) also is more capital-intensive compared to Firm (7). This
suggests that Firm (7) is Sun Microsystems and Firm (9) is Roche Holdings. Sun
uses only 11.6 cents in fixed assets for each dollar of sales generated. These ratios
are consistent with Sun’s strategy of outsourcing most of its manufacturing
operations. The manufacture of pharmaceuticals is highly automated, consistent
with the slower fixed asset turnover of Roche. Also note that Sun has very little
long-term debt in its capital structure. Computer products have short product life
cycles. Lenders are reluctant to lend for a long period because of the concern for
technological obsolescence. Computer companies that outsource their production
also have few assets that can serve as collateral for long-term borrowing.
This leaves Firms (3) and (12) as Nestlé and Toyota Motor in some
combination. Firm (3) has a larger amount of receivables relative to sales than Firm
(12) does, consistent with Toyota Motor providing financing for its customers’
purchases of automobiles. Nestlé will have receivables from wholesalers and
distributors of its food products, but not to the extent of the multi-year financing of
automobiles. The inventory turnover of Firm (12) is 6.0 times a year (51.3%/8.5%),
whereas the inventory turnover of Firm (3) is 11.0 times a year (76.2%/6.9%). At
first, one might expect a food processor to have a much higher inventory turnover
than an automobile manufacturer, suggesting that Firm (12) is Toyota Motor and
Firm (3) is Nestlé. However, Toyota Motor has implemented just-in-time inventory
systems, which speeds its inventory turnover. Nestlé tends to manufacture
chocolates to meet seasonal demands and therefore carries inventory somewhat
longer than one might expect. Firm (12) has a much higher percentage of selling
and administrative expense to sales than Firm (3) does. Both of these firms
advertise their products heavily. It is difficult to know why one would have a
substantially different percentage than the other. The profit margin of Firm (12) is
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Statement Analysis, and Valuation
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in whole or in part.
substantially higher than that of Firm (3). The auto industry is more competitive
than at least the chocolate side of the food industry. However, other food products
encounter extensive competition. Firm (3) has a high proportion of intercorporate
investments. Japanese companies tend to operate in groups, called kieretsu. The
members of the group make investments in the securities of other firms in the
group. This would suggest that Firm (3) is Toyota Motor. Another characteristic of
Japanese companies is a heavier use of debt in their capital structures. One of the
members of these Japanese corporate groups is typically a bank, which lends to
group members as needed. With this more-or-less assured source of funds, Japanese
firms tend to take on more debt. Although the ratios give somewhat confusing
signals, Firm (12) is Nestlé and Firm (3) is Toyota Motor.
Firms (2), (4), (5), (8), and (10) are fixed asset-intensive, with net fixed assets
exceeding 50% of revenues, but it is difficult to clearly distinguish between them.
Among the industries represented, at least six rely extensively on fixed assets to
deliver products and services: steel manufacturing (Sumitomo Metal),
telecommunications (Deutche Telekom), hotel chains (Accor), electric utilities
(E.ON), retail store chains (Marks & Spencer and Carrefour), and auto
manufacturing (Toyota). We have already identified Toyota, so we need to
distinguish only between the other five.
Of those five firms, Firms (2), (4), and (8) have made the largest investments in
gross fixed assets, all of which exceed 100% of revenues. Electric utilities, steel
manufacturers, and telecommunication firms most heavily utilize fixed assets in the
delivery of their products and services. Within these three industries, steel
manufacturers will likely have the most significant inventories; so Firm (2) is
Sumitomo Metal. Firm (8) carries a higher proportion of long-term debt and is
depreciating its assets more slowly than Firm (4) is. Electricity-generating plants
are likely to support more leverage and are likely to have longer useful lives
compared to the more technology-based fixed assets needed for distribution of
telecommunication services. This would suggest that Firm (4) is Deutsche Telekom
and Firm (8) is E.ON. The difference in the accounts receivable turnovers is
somewhat surprising. It is not clear why the accounts receivable turnover for
Deutsche Telekom is significantly faster than that of its German counterpart E.ON.
The remaining firms are (5), (10), and (11), and they represent the hotel group
Accor and the retail chains Marks & Spencer and Carrefour. Clearly, Firm (5) is not
a retailer because it has very little inventory, which indicates it is Accor, the hotel
group.
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Statement Analysis, and Valuation
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in whole or in part.
Comparing Firm (10) and Firm (11), Firm (11) is distinguished by its high cost
of goods sold percentage and small profit margin percentage. This pattern suggests
commodity products with low value added. This characterizes a supermarket/
grocery business. Firm (11) is Carrefour. Its combination of a rapid receivables
turnover of 15.2 times per year (100/6.6) and rapid inventory turnover of 10.0 times
per year (77.9/7.8) also are consistent with a grocery business. The remaining firm
is Firm (10), which is Marks & Spencer, the department store chain. Compared to
Firm (11), which is Carrefour, Firm (10) has a lower cost of sales percentage but a
higher selling and administrative expense percentage and higher profit margins,
consistent with it being a department store chain rather than a grocery chain.
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Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
Exhibit 1.D—(Problem 1.12) (Text Exhibit 1.24)
Fortis
Sumitomo
Metal
Toyota
Motor
Deutsche
Telekom Accor
Inter‐
public
Group
SunMicro‐
systemsE.ON
Roche
Holding
Marks&
SpencerCarrefourNestlé
123456789101112
BALANCESHEET
Cash&marketablesecurities313.7% 2.2% 21.8% 4.9% 16.2% 32.7%19.5% 17.9% 43.4% 4.7% 6.0% 6.5%
Receivables412.98.448.812.017.069.621.838.820.46.96.612.2
Inventories—27.76.92.11.3—4.95.812.25.97.88.5
Property,plant,andequipment,atcost6.6186.966.2195.392.823.235.2134.762.982.634.542.0
Accumulateddepreciation (2.8)(125.4)(36.5)(127.9)(36.9)(15.2)(23.6)(76.0)(24.9)(29.3)(17.7)(22.8)
Property,plant,andequipment,net3.8% 61.4% 29.7% 67.4% 55.9% 8.1%11.6% 58.7% 38.0% 53.3% 16.8% 19.2%
Intangibles2.4——87.531.646.327.226.532.34.414.134.1
Otherassets 66.2 33.216.225.925.517.518.428.512.7 4.9 7.716.1
Totalassets829.8%133.0%123.5%199.7%147.5%174.1%103.3%176.2%158.8%80.1%59.0%96.6%
Currentliabilities120.3% 18.3% 45.4% 40.3% 70.2% 98.8%40.8% 40.6% 25.3% 25.5% 32.2% 30.2%
Long‐termdebt630.840.922.88.824.925.79.121.36.223.410.85.8
Otherlong‐termliabilities55.624.710.180.76.314.213.143.515.08.13.610.7
Shareholders’equity23.149.045.169.946.035.640.370.8112.423.212.450.0
TotalLiabilitiesandShareholders’Equity829.8%133.0%123.5%199.7%147.5%174.1%103.3%176.2%158.8%80.1%59.0%96.6%
INCOMESTATEMENT
Operatingrevenues100.0% 100.0% 100.0% 100.0% 100.0% 100.0%100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Costofsales(excludingdepreciation)or
operatingexpenses(18.7)(80.3)(76.2)(56.1)(70.4)(62.4)(53.5)(64.5)(28.5)(62.8)(77.9)(51.3)
Depreciationandamortization(0.6)(6.0)(5.7)(17.8)(5.8)(2.5)(3.4)(5.1)(3.5)(4.5)(2.1)(2.4)
Sellingandadministrative(4.8)(1.4)(5.9)(15.9)—(26.4)(25.1)(22.7)(20.5)(24.7)(16.3)(30.2)
Researchanddevelopment——(3.6)———(13.4)—(18.5)——(1.8)
Interest(expense)/income(69.7)(0.3)0.5(4.0)(1.1)(1.7)1.2(1.4)0.5(1.8)(0.6)(1.0)
Incometaxes(1.1)(5.1)(3.5)(2.3)(3.5)(2.2)(1.5)(0.1)(6.9)(2.2)(0.8)(3.4)
Allotheritems,net (0.4) — 0.9(0.1)(11.3)(0.5) 0.2 1.1 0.1 1.6 0.1 7.6
Netincome4.7%6.8% 6.5% 3.8% 7.9% 4.2% 4.5% 7.3% 22.6% 5.6% 2.3% 17.3%
Cashflowfromoperations/capitalexpenditures(5.5)1.1 2.1 2.3 2.0 6.3 3.0 1.7 4.0 2.7 1.8 2.2
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
1-19
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in whole or in part.
1.13 Value Chain Analysis and Financial Statement Relations. There are various
approaches to this problem. One approach begins with a particular company,
identifies unique financial characteristics (for example, profit margin potential), and
then searches the common-size financial data to identify the company with that
unique characteristic.
Another approach begins with the common-size data, identifies unusual
financial statement relationships (for example, R&D intensity), and then looks over
the list of companies to identify the one most likely to have that unusual financial
statement relationship. This teaching note employs both approaches. All of the data
are scaled by total revenues (except for the final data item, which is cash flow from
operations over capital expenditures); so throughout this discussion when we refer
to a “percentage,” it is a percentage of revenues. The data from Text Exhibit 1.25 in
the text, with company names as column headings, are presented at the end of this
solution in Exhibit 1.E.
Four Firms (1), (3), (4), and (7) incur R&D expenditures, and three do not.
Wyeth, Amgen, Mylan, and Johnson & Johnson engage in research to develop new
products. Thus, they represent these four numbered firms in some combination. One
would expect the firms enjoying patent protection (Wyeth and Amgen) to have the
highest profit margins (that is, net income divided by sales). This would suggest
that Firm (1) is neither Wyeth nor Amgen. Also, Firm (1) has the highest cost of
goods sold percentage of the four companies and its R&D percentage is the lowest,
which are inconsistent with this being Wyeth or Amgen. Products with patent
protection should have the lowest cost of goods sold percentages (resulting from
high markups on cost to arrive at selling prices). Thus, following another line of
logic, the need to continually discover new drugs should lead Wyeth and Amgen to
have the highest R&D percentages, which would be Firm (3) or Firm (4), as
discussed below.
With this being the case, the other two firms—Firm (1) and Firm (7)—are
Mylan and Johnson & Johnson in some combination. The brand recognition of
Johnson & Johnson’s products should give it a high profit margin. Price
competition among generic firms should give Mylan a lower profit margin. This
reasoning would suggest that Johnson & Johnson is Firm (7) and Mylan is Firm (1).
Firm (7) also has higher selling and administrative expenses versus Firm (1),
consistent with Johnson & Johnson. The low profit margin of Mylan is the result of
major ethical drug firms now competing aggressively in the generic market.
This leaves Firms (3) and (4) as Wyeth and Amgen in some order. The
biotechnology industry is significantly less mature than the ethical drug industry.
Few biotechnology drugs have received FDA approval, and research to develop
new drugs is intensive. Given the few biotechnology drugs available in the market,
Amgen’s profit margin as well as its R&D expense percentage should be higher
than those of Wyeth. Thus, Firm (3) is Amgen and Firm (4) is Wyeth. Wyeth’s
higher selling and administrative expense percentage results from its need to
maintain a sales force. The biotechnology products of Amgen are fewer in number
and at this point are essentially pulled through the distribution process by customer
demand. Thus, it has less need for a sales force.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
We are now left with Covance, Cardinal Health, and Walgreens and Firms (2),
(5), and (6). Covance will have very low inventories, whereas Cardinal Health
(wholesaler) and Walgreens (retailer) will have larger inventories. Thus, Firm (5) is
Covance. This firm will need property, plant, and equipment to conduct the testing
of new drugs. Of the remaining two firms, Cardinal Health and Walgreens,
Walgreens will likely have a higher proportion of assets in property, plant, and
equipment for retail space. Cardinal Health needs only warehousing facilities for its
drug wholesaling activities. Thus, Firm (6) is Walgreens and Firm (2) is Cardinal
Health. Advertising expenditures by Walgreens drive up its selling and
administrative expense percentage relative to that of Cardinal Health. Walgreens
accepts cash and third-party credit cards for sales; therefore, it will have less
receivables than Cardinal Health, which sells to businesses on credit. Also notice
that Cardinal Health, as a wholesaler, has a very high cost of sales percentage
relative to Walgreens and all other firms in this set.
It is interesting to note that the highest profit margins in the pharmaceutical
industry occur with the upstream activities (discovery of new drugs) instead of the
downstream activities (wholesaling and retailing). It also is interesting that the
profit margin of Covance lies between the high profit margins of the creators of
new drugs and the low profit margins of those firms involved in distribution.
Covance must possess some technical expertise in order to offer drug-testing
services, thus providing the rationale for a higher profit margin than those achieved
by the wholesalers and retailers. The higher profit margin for Walgreens over
Cardinal Health is probably attributable to brand name recognition and the large
number of retail stores nationwide. The wholesaling function of Cardinal is low
value added. The pharmaceutical benefit management services are somewhat
differentiable but quickly copied by competitors.