978-1337614689 Chapter 1 Part 1

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CHAPTER 1

OVERVIEW OF FINANCIAL REPORTING, FINANCIAL

STATEMENT ANALYSIS, AND VALUATION

Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases

1.1 Porter’s Five Forces Applied to the Air Courier Industry.

1.2 Economic Attributes Framework Applied to the Specialty Retailing Apparel

Industry.

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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conditions; customers tend to delay purchases or trade down during economic

downturns. Demand is seasonal within the year. Demand grows at the growth rate

in population, which suggests that apparel retailing is a relatively mature market. To

the extent that retailers can generate customer loyalty, demand is not highly price-

sensitive. However, given the similarity of product offerings across firms, firms

cannot price their goods too much out of line with those of their competitors.

Supply. In most markets, there are many firms selling similar apparel. The barriers

to entry are not particularly high because an apparel line and retail space are the

most important ingredients.

Manufacturing. The manufacturing process is labor-intensive. The manufacturing

process is relatively simple, and firms source their apparel from Asia, which has

low wages.

Marketing. Because of the large number of suppliers selling similar products,

apparel-retail firms must stimulate demand with attractive store layouts, colorful

product offerings, and various sales promotions.

Investing and Financing. Firms must finance inventory, usually with a

combination of supplier and bank financing. The risk of inventory obsolescence is

somewhat high if the product offerings in a particular season do not sell. Firms tend

to rent retail space in shopping malls, so they need to engage in extensive long-term

borrowing.

1.3 Identification of Commodity Businesses.

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computer software are duplicated relatively easily, a commodity attribute. However,

Microsoft’s size permits it to invest in new technology development and keep it on

the leading edge of new technologies. Microsoft also has a huge advantage in terms

of installed base, meaning that most customers almost have to purchase its software

to be able to use application programs and to communicate with other computer

users. Thus, its products are inherently commodities, but Microsoft is able to

overcome some of the disadvantages of commodity status.

Johnson & Johnson. Johnson & Johnson operates in three business segments:

consumer health care, pharmaceuticals, and medical equipment. It derives the

majority of its revenue and profits from the latter two industries. Patents protect the

products of these two industries, which give the firm a degree of market power.

Until another firm creates a new product that dominates the patented product of

Johnson & Johnson, its product is not a commodity. However, rapid technological

change makes most products obsolete before the end of the patent’s life. Johnson &

Johnson’s products probably have fewer commodity attributes than the other three

firms in this exercise.

One of the purposes of this exercise is to illustrate that firms can pursue product

differentiation strategies and low-cost leadership strategies and, if performed well,

can gain “most admired status.”

1.4 Identification of Company Strategies. The strategies of Home Depot and Lowe’s

1.5 Researching the FASB Website. The answer will change over time as the FASB

1.6 Researching the IASB Website. The answer will change over time as the IASB

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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1.7 Effect of Industry Economics on Balance Sheets. Among the three firms, Intel

1.8 Effect of Business Strategy on Common-Size Income Statements. Firm A is Dell

and Firm B is Apple Computer. The clues appear next.

Cost of Goods Sold to Sales Percentages. One would expect Dell to have a higher

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1.9 Effect of Business Strategy on Common-Size Income Statements. Firm A is

Dollar General and Firm B is Macy’s. Department stores sell branded products, for

1.10 Effect of Industry Characteristics on Financial Statement Relations. There are

various strategies for approaching this problem. One strategy begins with a

The two financial services firms will have balance sheets dominated by cash,

securities, and loans receivable. Firms (8) and (1) meet this description. Cash and

securities present 2,256% for Firm (1), typical of a securities firm, suggesting that it

is Goldman Sachs. Firm (8) also has a high percentage of cash and securities

(2,198%), consistent with Citigroup’s involvement in a wide range of financial

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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assets compared to Firm (2) and Firm (7). Due to technological obsolescence, the

lowers Verizon’s operating expense line. Also, Carnival and MGM sell meals as

Telecommunication services are more competitive than luxury entertainment, which

increases marketing expenses and lowers revenues for Verizon.

switching costs are higher. Thus, one would expect MGM to have higher marketing

costs and a lower net income to revenues percentage. This reasoning suggests that

Firm (7) is MGM and Firm (2) is Carnival.

Three firms have R&D expenses: Firms (3), (6), and (12). These firms are

Johnson & Johnson, Cisco Systems, and eBay, respectively. All three firms have

Chapter 1

Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

It is difficult to distinguish Firm (3) as Johnson & Johnson and Firm (6) as

information systems but does not need manufacturing or retailing assets, as the

highest cost of sales percentage of the four firms, consistent with Amazon.com’s

low value added for its online services. It is interesting to compare the cost of sales

The extent of competition in the restaurant business is likely higher than that for the

branded food products of Molson Coors and Kellogg’s, consistent with lower value

added (higher cost of sales percentage) for Firm (11). Thus, Firm (11) is Yum!

Brands.

Firm (10) has a significantly higher intangibles to revenues percentage than

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Exhibit 1.A—(Problem 1.10)

Goldman

Sachs

Carnival

Corp

J&J Kellogg’s Verizon

Cisco

MGM

Mirage

Citigroup

Amazon

.com

Molson

Coors

Yum!

Brands eBay

1 2

34 56

7

89

10

11 12

BALANCE SHEE

T

Cash & marketable securities 2,256.1% 4.1% 20.1% 2.0% 10.6% 96.9% 4.1% 2,198.0% 26.0% 4.5% 1.9% 39.3%

Other long‐term liabilities 92.6 5.6 21.1 14.6 90.2 15.3 53.8 171.3 4.4 33.9 12.0 9.4

Shareholders’ equity 101.9 167.5 66.7 11.3 42.8 107.0 55.1 247.5 21.4 125.3 (1.0) 129.8

Total Liabilities and Shareholders’

Equity 2666.2% 280.0% 133.2% 85.4% 207.9% 188.6% 322.9% 3893.3% 56.4% 218.2% 57.9% 182.6%

INCOME STATEMENT

Operating revenues 100.0% 100.0%

100.0%

100.0% 100.0%

100.0%

100.0% 100.0% 100.0% 100.0% 100.0%

100.0%

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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1.11 Effect of Industry Characteristics on Financial Statement Relations. There are

various strategies for approaching this problem. One strategy begins with a

assets), and then searches the common-size data in Text Exhibit 1.16 to identify the

Firm (10) stands out because it has the highest proportion of receivables among

its assets and the most substantial borrowing in its capital structure. This balance

sheet structure is typical of the finance company, HSBC Finance. We ask students

why the capital markets allow a finance company to have such a high proportion of

borrowing in its capital structure. The answer is threefold: (1) Finance companies

there is in the amount of the provision (a high mean with a low standard deviation is

not a concern, but a high mean with a high standard deviation is a concern) and (2)

uncollectibles includes both unpaid principal and interest (thus, the 29.1% provision

does not mean that the firm experiences defaults on 29.1% of its customers each

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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which for a property and casualty insurance company can span periods up to several

(12). 3M, Hewlett-Packard, Merck, and Procter & Gamble will incur costs to

discover new technologies or to develop new products. By far, Firm (2) has the

highest R&D expense percentage and the highest profit margin. This firm is Merck.

Pharmaceutical companies must invest heavily in new drugs to remain competitive.

Also, the drug development process is lengthy, which increases R&D costs.

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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approximately one to two years. Hewlett-Packard does not want to add financial

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. 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

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

are 2.3 (100.0%/43.2%) and 1.2 (87.4%/73.0%). The turnovers for Omnicom are

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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amount (media time plus commission or fee) billed to clients and accounts payable

(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

Overview of Financial Reporting, Financial

Exhibit 1.B—(Problem 1.11)

3M

Merck

Pacific

Gas &

Electric

Allstate

P&G

Best

Buy

Kelly

Services

A&F

Omnicom

Group

HSBC

Finance

McDonald’s

HP

1 23456 7 8 9 10 11 12

BALANCE SHEE

T

Cash & marketable securities 6.7% 23.0% 9.2% 362.6% 6.0% 1.1% 1.6% 14.7% 8.3% 27.3% 8.8% 11.6%

INCOME STATEMENT

Operating revenues 100.0% 100.0% 100.0%

100.0%

100.0% 100.0%

100.0%

100.0% 100.0% 100.0% 100.0%

Cost of sales (excluding depreciation) or

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Overview of Financial Reporting, Financial

Statement Analysis, and Valuation

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1.12 Effect of Industry Characteristics on Financial Statement Relations: A Global

Perspective. There are various approaches to this problem. One approach begins

with a particular company, identifies unique financial characteristics (for example,

their assets), and then searches the common-size financial data to identify the

in Exhibit 1.C.

The high proportions of cash, marketable securities, and receivables for Firm (1)

suggest that it is BNP Paribas, the French multinational bank, insurance, and

financial services company. On the banking side, BNP Paribas recognizes interest

revenue from loans each year and must match against this revenue the cost of any

“Operating Expenses.” 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 BNP

not be known until borrowers default, and the actual cost of claims will not be

(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

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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, Oracle, Roche Holding, and Nestlé, respectively.

Roche Holding and Oracle 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 (7) and (9). Both firms have low cost of sales percentages, but

Firm (9) has a higher cost of sales percentage than Firm (7), suggesting that Firm

(9) is Roche Holdings because pharmaceutical products are generally more

expensive to produce than are cloud-based computing applications and networking

products includes primarily the cost of the chemical raw materials, which machines

combine into various drugs. Pharmaceutical firms must price their products

(12) is Toyota Motor and Firm (3) is Nestlé. However, Toyota Motor has

implemented just-in-time inventory systems, which speed its inventory turnover.

Nestlé tends to manufacture chocolates to meet seasonal demands and therefore

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Statement Analysis, and Valuation

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intercorporate investments. Japanese companies tend to operate in groups, called

to deliver products and services: steel manufacturing (Nippon Steel),

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.

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

Accor and the retail chains Marks & Spencer and Carrefour. Clearly, Firm (5) is not

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.