Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
1-21
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in whole or in part.
Exhibit 1.E—(Problem 1.13) (Text Exhibit 1.25)
Mylan
Laboratories
Cardinal
HealthAmgenWyethCovanceWalgreensJ&J
1234567
BALANCESHEET
Cash&marketablesecurities12.5%1.9%63.7%63.7%12.1%4.1%20.1%
Receivables22.75.713.816.018.73.915.2
Inventories20.77.213.813.13.710.77.9
Property,plant,andequipment,atcost34.23.966.673.974.222.643.0
Accumulateddepreciation(13.5)(2.0)(27.4)(24.9)(27.1)(5.5)(20.4)
Property,plant,andequipment,net20.71.939.249.047.117.122.5
Intangibles109.36.195.520.55.82.343.4
Otherassets16.82.516.9 30.5 8.5 1.624.0
Totalassets202.6%25.2%242.9%192.8%96.0%39.7%133.2%
Currentliabilities30.1%11.5%32.6%30.0%25.2%10.7%32.7%
Long‐termdebt100.53.361.247.4—3.712.7
Otherlong‐termliabilities19.41.713.331.55.42.621.1
Shareholders’equity 52.6 8.8135.9 84.065.422.7 66.7
TotalLiabilitiesandShareholders’Equity202.6%25.2%242.9%192.8%96.0%39.7%133.2%
INCOMESTATEMENT
OperatingRevenues100.0%100.0%100.0%100.0%100.0%100.0%100.0%
Costofsales(excludingdepreciation)oroperatingexpenses(59.7)(94.4)(15.3)(27.4)(62.5)(72.2)(29.0)
Depreciationandamortization(8.3)(0.4)(7.2)(4.1)(3.9)(1.5)(4.4)
Sellingandadministrative(12.2)(3.1)(20.1)(25.9)(13.7)(21.1)(29.3)
Researchanddevelopment(6.2)—(20.2)(14.8)——(12.2)
Interest(expense)/income(6.9)(0.2)0.2(0.1)0.4(0.1)(0.1)
Incometaxes(2.7)(0.5)(7.0)(8.4)(4.3)(1.8)(6.2)
Allotheritems,net 0.1 — (2.5) (0.1) (5.3) — 1.6
Netincome4.1% 1.3%28.0% 19.3%10.5% 3.2%20.3%
Cashflowfromoperations/capitalexpenditures2.33.08.94.44.02.24.9
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
1-22
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in whole or in part.
Integrative Case 1.1: Starbucks
I. Objectives
A. Identify the economics characteristics of the specialty coffee retail industry
and Starbucks’ strategy for competing in this industry as background for the
integrative case on Starbucks used throughout the book.
B. Review the purpose, format, terminology, and accounting principles
underlying the balance sheet, income statement, and statement of cash
flows.
C. Introduce common-size and percentage-change income statements and
balance sheets and the insights such statements provide.
D. Establish an understanding of Starbucks’ business so that it can be used as a
case throughout a course to illustrate all of the steps of the six-step analysis
and valuation framework. Our experience suggests that Starbucks works
well because it is a company that nearly all students easily understand and
find interesting.
II. Teaching Strategy—We have taught this case with two approaches. If an
opportunity exists to distribute the case prior to the first class, we give students the
solutions to the questions involving the balance sheet, income statement, statement
of cash flows, and relations between financial statements. We ask them to review
these parts on their own and to prepare solutions to the questions under the
sections labeled “Industry and Strategy Analysis” and “Interpreting Financial
Statement Relationships.” We devote the first class to discussing these two
sections of the case. If we cannot distribute the case ahead of time, we devote
approximately three hours of class time to discuss the entire case. Alternatively,
you can choose to emphasize particular questions based on the amount of time
available and refer students to the solution for the remaining parts.
Note to Instructors:
Starbucks is a good company to use for classroom discussion and demonstration of
the techniques throughout this book. Students generally relate easily and readily to
Starbucks because they are familiar with Starbucks’ coffee shops and products. As
a company and a set of financial statements, Starbucks is a good setting for
illustrating the techniques of analysis, accounting quality assessment, forecasting,
and valuation because the business model is straightforward and not complex. This
case relies on fiscal 2012 data; so in following years, you can easily bring students
up to date by distributing more recent financial statements and numbers and types
of stores open. These data are readily available from Starbucks’ website or from
the SEC.
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Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
Industry and Strategy Analysis
a. Porter’s five forces applied to the specialty coffee retail industry:
1. Buyer Power: Buyer power for specialty coffees is less than that for
commodity coffees because consumers view specialty coffees as higher quality
and more unique. These characteristics of specialty coffees increase
consumers’ willingness to pay more for such coffees and make them less price-
sensitive. Combining the specialty coffee with a pleasant café or coffee shop
setting (the “Starbucks Experience”) in which consumers purchase and enjoy
the coffee decreases consumers’ price sensitivity still further. Thus, buyer
power appears to be relatively low.
2. Supplier Power: Suppliers of the high-quality Arabica coffee beans used in
specialty coffees have a bit more power over their customers because of their
customers’ need for such coffee beans. Commodity coffee beans are not an
attractive alternative for such customers. However, specialty coffee beans are
produced by suppliers around the world. Worldwide sourcing means that there
are many suppliers of similar specialty coffee beans, which give purchasers
such as Starbucks an ability to switch suppliers to gain an advantage. Specialty
coffee beans are even traded on commodity market exchanges. Moreover,
cooperative or collusive association of green coffee bean growers that controls
the supply or the price of beans exists. Thus, supplier power is low.
3. Rivalry among Existing Firms: There are many direct competitors in the
specialty coffee retail industry. The competitors span a wide range of sizes and
business approaches, including large-scale fast-food chains (for example,
McDonald’s), doughnut chains (for example, Tim Hortons, Dunkin Donuts,
and Krispy Kreme), coffee shop chains (for example, Panera Bread, Caribou
Coffee, and Peet’s Coffee & Tea), and local coffee shops and cafes. The issue
for Starbucks is whether the “Starbucks Experience” sufficiently differentiates
the firm from competitors whose specialty coffees might be of equal quality.
Rivalry among firms appears to be high.
4. Threat of New Entrants: No barriers to entry exist. Opening coffee shops
requires very little capital, technology, or expertise. In addition to new coffee
shop chains springing up, established retail food chains have the ability to add
specialty coffees to their menus, as McDonald’s is doing aggressively with the
McCafé initiative. In addition, it is now common for gas station chains to offer
specialty coffee kiosks in their convenience shops. Starbucks’ primary
competitive advantage, relative to new entrants, is the advantage of an
established brand name. It also has a scale advantage because it has saturated
the United States with retail stores and is growing its business in other
countries (further evidence of the lack of barriers to entry). Thus, the threat of
new entrants appears to be high.
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Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
5. Threat of Substitutes: There are numerous beverage substitutes to specialty
coffees, which make the threat of substitutes high. Substitute beverages span a
wide range, including soft drinks (Coca-Cola and PepsiCo), teas, waters,
juices, sports drinks, beer, and wine. However, there are fewer substitutes for
the “Starbucks Experience,” which is a competitive advantage relative to the
threat of substitutes. Nevertheless, the threat of substitutes appears to be high.
b. Starbucks combines the sale of specialty coffees and other high-quality beverages
with friendly and competent service in a unique setting in which customers can
enjoy the beverages. This combination has allowed the firm to create the
“Starbucks Experience,” which differentiates it from direct competitors. Its market
saturation in the United States has permitted the firm to establish a brand name,
which it is now exporting to other countries. Its use of licensing arrangements has
fostered the rapid growth. Starbucks is now leveraging its brand name by selling
coffee beans and ground coffees through grocery stores, warehouse clubs, and food
distributors. It also is leveraging its brand name by forming partnerships with other
established brand name firms to sell various high-quality beverages. Starbucks
appears to be aggressively pursuing multiple avenues to maintain its growth,
discourage new entrants, and leverage its brand name.
Balance Sheet
c. Cash includes cash on hand and in checking accounts. Cash equivalents include
amounts that a firm can easily convert into cash. Cash equivalents usually have a
maturity date of less than three months at the time of purchase so that changes in
interest rates have an insignificant effect on their market value. Cash equivalents
might include investments in U.S. Treasury bills, commercial paper, and money
market funds.
d. Securities that a firm intends to sell within one year of the balance sheet date
appear in Short-Term Investments. Securities that a firm expects to hold for more
than one year appear in the noncurrent asset Long-Term Investments. You can use
this question to introduce the concepts of trading, available-for-sale, and held-to-
maturity security categories, but be aware that this discussion usually requires
some time to explain how and why accounting differs for each category. You can
defer such discussion to later in the course, particularly when discussing investing
activities (Chapter 8).
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Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
e. The accounts receivable arise because Starbucks recognizes revenue earlier than
the time it collects cash. It is useful to query students on which specific lines of
Starbucks’ business create accounts receivable. They will quickly realize that the
majority of receivables do not arise from company-operated retail store revenues,
the vast majority of which are in cash (or cash equivalent credit card sales). The
receivables arise primarily from Starbucks specialty business, which includes
revenues from licensees and revenues from sales to foodservice accounts and
distributions to grocery stores. Because Starbucks is not likely to collect 100% of
the amount reported as receivables, it must recognize an expense for estimated
uncollectible accounts and reduce gross accounts receivable to the amount it
expects to collect in cash. Starbucks reports the balance in the allowance for
uncollectible accounts as a subtraction from gross accounts receivable on the
balance sheet. Starbucks increases the balance in the allowance account for
estimated uncollectible accounts arising from credit sales each year. It reduces the
balance in the allowance account for actual customers’ accounts deemed
uncollectible.
f. The Accumulated Depreciation accounts reports the cumulative depreciation
recognized since the firm acquired depreciable assets that appear on the balance
sheet. Depreciation Expense reports only the amount of depreciation recognized
for a particular accounting period.
g. Deferred tax assets arise when a temporary difference between net income and
taxable income provides a future tax benefit to the firm. This occurs (1) when a
firm recognizes revenue earlier of tax reporting than for financial reporting
(subsequent recognition of the revenue for financial reporting will not give rise to
a tax payment) or (2) when a firm recognizes expenses earlier for financial
reporting than for tax reporting (subsequent recognition of the expense for tax
reporting will reduce income tax payments). Deferred tax liabilities arise when a
temporary difference will require a firm to make a tax payment in the future. This
occurs (1) when a firm recognizes revenue earlier for financial reporting than for
tax reporting (subsequent recognition of the revenue for tax reporting will require
the firm to pay taxes) or (2) when a firm recognizes an expense earlier for tax
reporting than for financial reporting (subsequent recognition of the expense for
financial reporting does not give rise to a tax deduction, thereby increasing taxable
income and taxes payable). Note that the classification of deferred taxes on the
balance sheet for a particular revenue or expense depends on (1) the likelihood of
temporary differences giving rise to a deferred tax asset or a deferred tax liability
and (2) the timing of the likely reversal of the temporary difference (less than one
year or longer than one year).
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
h. U.S. GAAP require firms to report marketable securities and investments in
securities at market value at the end of each accounting period. In some
circumstances, U.S. GAAP also requires firms to translate the assets and liabilities
of their foreign subsidiaries and branches into U.S. dollars using the current
exchange rate. Changes in the valuations of assets and liabilities from these
accounting principles give rise to unrealized gains and losses that firms will not
realize until they convert the assets into cash or settle their liabilities with cash.
The ultimate realized gain or loss depends on the market prices of securities and
the exchange rate at the time of sale or settlement. U.S. GAAP does not permit
firms to include the unrealized gains or losses in net income; instead, the firm must
include them in accumulated other comprehensive income. At the time of sale or
settlement, the amount of the gains or losses becomes established and realized. At
that time, the firm includes the realized gain or loss in net income. The specific
determinants of comprehensive income are covered in greater detail in Chapter 2
and Chapter 8.
Income Statement
i. Revenues from company-owned stores represent the revenues from sale of coffee
beverages, food, and other products in the retail stores that Starbucks owns and
manages. Revenues from licensing represent various fees that Starbucks receives
from retail stores that it does not own or manage. Starbucks likely receives a
royalty based on revenues of these stores. It also likely receives revenues for
inventory and products sold to the licensees and for various services provided.
Revenues from foodservice represent amounts received from the sale of products
to grocery stores, warehouse clubs, and food service distributors. Note that
Starbucks’ income from its partnerships and joint ventures with PepsiCo and
Unilever and others appears as “Income from Equity Investees,” which we discuss
in Solution k below.
j. Cost of sales likely includes the cost of the raw materials, such as coffee beans,
teas, dairy products, sugar, paper products, and similar items that make up
Starbucks’ products. Occupancy costs include rent, property taxes, insurance,
utilities, and maintenance costs of its company-owned stores. Store operating
expenses include compensation of its employees working in the company-owned
stores, as well as advertising and other marketing expenses.
k. As indicated in Solution i, the Income of Equity Investees represents Starbucks’
share of the earnings of partnerships with PepsiCo and Unilever. In addition,
Starbucks is involved in numerous joint ventures to own and operate Starbucks’
stores in countries outside the United States. Note that Income from Equity
Investees represents Starbucks’ share of the bottom line of the income statements
of the partnerships, not the top line (that is, the partnerships’ revenue). Starbucks
reports its investments in these partnerships under “Equity and Other Investments”
in the noncurrent assets section of the balance sheet.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
Statement of Cash Flows
l. Firms use the accrual basis of accounting in measuring net income. Firms usually
recognize revenue at the time of sale of goods and services, not necessarily when
they receive cash from customers. Firms attempt to match expenses with the time
periods during which they consume economic resources, regardless of when they
expend cash. The accrual basis gives a better indication of a firm’s operating
performance than the cash basis because of the matching of inputs and outputs.
Cash flows from operating activities in the statement of cash flows reports the
amount of cash received from customers net of amounts paid to suppliers of goods
and services.
m. Depreciation and amortization expenses reduce net income but do not require cash
expenditures in the year of their recognition. (The cash effect occurred in the year
a firm acquired the depreciable or amortizable asset; the firm classified the cash
outflow as an investing activity in the statement of cash flows at that time.) The
addition adds back to net income the amount subtracted in calculating earnings for
the year, in effect zeroing out its effect on cash flow from operations.
n. Net income on the first line of the statement of cash flows includes a subtraction
for the cost of sales during each year. Starbucks likely purchases a different
amount of inventory than it uses or sells. An increase in inventories means that
Starbucks purchased more than it used or sold. Thus, the cash outflow for
purchases potentially exceeds cost of sales and requires a subtraction from net
income for the additional cash required. Whether additional cash was in fact
required in any year depends on the change in accounts payable, discussed next.
o. Accounts payable reflects amounts owed to suppliers for inventory items
purchased. Purchases of inventory items increase this liability, and cash payments
reduce it. The adjustment for inventory in Solution n converts cost of sales to
purchases. The adjustment for accounts payable converts purchases to cash
payments to suppliers. A decrease in accounts payable means that Starbucks’ cash
payments to suppliers during the year exceeded the amounts purchased. Thus, the
adjustments for the change in inventories and the change in accounts payable
convert cost of sales included in net income to cash payments to suppliers of
inventory items.
p. The FASB requires firms to report most changes in investment securities as an
investing activity, not an operating activity. The rationale is that firms derive
operating cash flows by selling goods or services to customers, not from selling
marketable securities.
q. The FASB requires firms to report changes in short-term borrowing as a financing
activity, not an operating activity. The rationale is that firms derive operating cash
flows by selling goods or services to customers, not by borrowing cash.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
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in whole or in part.
Relations between Financial Statements
r. Retained Earnings, October 2, 2011 ……………………………………………. $ 4,297
Net Income for Fiscal 2012 ……………………………………………………….. 1,384
Cash Dividends ………………………………………………………………………… (513)
Stock Repurchases in Fiscal 2012 (Plug) …………………………………….. (122)
Retained Earnings, September 30, 2012 ……………………………………… $ 5,046
The fact that net income does not fully explain the change in retained earnings
means that Starbucks distributed capital to common shareholders. Starbucks has a
recent history paying dividends, but not of repurchasing stock. The dividends are
shown on the statement of cash flows, as is the repurchase of common stock
($549). Starbucks allocates common stock repurchases to paid-in capital and
retained earnings, so we plug the remaining difference in retained earnings to stock
repurchases. As it turns out, the statement of equity (not provided) actually
indicates cash dividends of $544 and stock repurchases of $593, split among
additional paid-in capital ($502) and retained earnings ($91). The differences
between these figures and those included above are due to differences between
dividends declared ($544) versus cash actually paid and shown on the statement of
cash flows ($513), indicating that Starbucks must have dividends payable included
in liabilities at year end.
s. Property, Plant and Equipment, October 1, 2011 ………………………….. $ 6,163
Plus Acquisition of Property, Plant and Equipment during 2012
(See Statement of Cash Flows) ……………………………………………. 856
Less Acquisition Cost of Property, Plant and Equipment Sold or
Retired during 2012 (Plug) …………………………………………………. (116)
Property, Plant and Equipment, September 30, 2012 …………………….. $ 6,903
Accumulated Depreciation, October 1, 2011 ……………………………….. $ 3,808
Plus Depreciation Expense during 2012 (See Statement of Cash
Flows) ……………………………………………………………………………… 550
Less Accumulated Depreciation on Property, Plant and Equipment
Sold or Retired during 2012 (Plug) ………………………………………. (114)
Accumulated Depreciation, September 30, 2012 ………………………….. $ 4,244
Starbucks does not report separately the cost of the property, plant, and equipment
sold or retired, nor the amount of accumulated depreciation on the property, plant,
and equipment sold, so we must deduce and plug these amounts. For simplicity,
the problem instructs students to assume that the total $550 million is depreciation
expense. Starbucks reports in Note 8 that Amortization Expense in 2008 amounted
to only $4.5 million, so depreciation expense is actually $545.5.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation
1-29
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in whole or in part.
Interpreting Financial Statement Relations
t. The difficulty with interpreting common-size percentages is that the amounts for a
particular account are not independent of the amounts for all other accounts. Note
in Text Exhibit 1.29 that cash and cash equivalents increased 3.5% in fiscal 2012,
while total assets increased by 11.7% during the same year. Many other assets
increased at faster rates, thereby causing the common-size percentages for cash
and cash equivalents to decline.
u. Between fiscal 2009 and 2012, current liabilities increased from $1,581 million to
$2,210 million, while noncurrent liabilities declined from $939 million to $895
million. Total shareholders’ equity increased significantly between these years,
largely due to the large profits recognized (which more than offset the large
dividends paid). The decline in short-term and long-term debt as a percentage of
total assets is due to the modest increase in total liabilities being outpaced by
higher growth rates for equity (and assets).
v. The proportion of revenue from company-operated stores declined from 83.7% to
79.2%, and the proportion of revenues from both licensing and foodservice
increased (although the dollar amounts of revenue from company-operated retail
and foodservice increased.) Starbucks has licensed more new stores than it has
opened new company-operated stores in recent years in an effort to expand
quickly, leading to an increase in the common-size percentage of revenues for
licensing.
w. The main contributing factors for the increase in the net income to revenues
percentage (the net profit margin) are decreases in operating expenses, especially
cost of sales and store operating expenses (slightly offset by increases in general
and administrative expenses). The costs for these items include variable and fixed
elements. (Costs that are somewhat fixed over the short-run include occupancy
costs such as rent expense and store operating costs such as wages and salaries.)
As Starbucks has grown its revenues, these costs have seemingly increased at
slower rates, resulting in a declining expense percentage for these two expense
items. This is consistent with the revenue growth coming from licensing, as noted
in the percentage change columns, and such revenue streams are less likely to be
associated with increases in fixed costs.