The Case of the Unidentified Industries - 2006

SOM 640 Financial Analysis and Decisions Dr. Mila Getmansky Sherman

Jianing Gao Grant Gigee Bill Killough-Hill Parvathy Sadanandan

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1. Match companies from 14 different industries to corresponding financial data. Be very thorough how and why you obtain your answers. Make sure to clearly write up your assumptions and back them up with specific references, your personal knowledge of these industries, and any other relevant information. When possible, compare industries using more than one financial ratio.

In The Case of the Unidentified Industries, our group used a number of means to discern the identities of the fourteen listed unknown entities. We found that it was important to keep in mind the year that the case was written because business conditions have changed and companies are at a different place in their development. Publicly available financial filings were helpful in some instances as well as our combined general knowledge of industries and the process of elimination.

In this section we will present our determinations of which companies matched with what financial data. In order to be concise, we will list the companies by letter as presented in the spreadsheet and discuss the items most relevant in making the determination.

A. This is the online book seller. Most significant here were the relatively low inventory for a retail business and high inventory turnover. We felt that this pointed to the online nature of the business. Also related to being an online business is the low plant and equipment. We were also able to research the 2006 10-K for Amazon.com, a large and well-known online book seller (http://phx.corporate-ir.net/phoenix.zhtml?c=97664&p=irol-sec&control_selectgroup=Annual %20Filings) and found that the high percentage of cash in the balance sheet as well as the high

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long-term debt percentage is both reflected accurately. We surmised that the debt may have been due to the company using leverage to grow during that stage of their enterprise. B. This is the bookstore chain. This determination was indicated by the high inventory coupled with the high plant and equipment both of which would be present in a retail chain with many stores filled with books. The inventory here turns over slower than at Amazon and their profit per revenue is lower due to their increased costs of overhead. C. This is the online PC vendor. The case indicates that more than half of sales are to business customers. This would translate into the relatively high accounts receivable number as businesses would be invoiced and pay on account. The case also states that most manufacturing is outsourced which would explain the low numbers for inventory and plant and equipment and very high inventory turnover. They would not need to own factories and inventory would pass through quickly because it was already sold. D. This is the pharmaceutical manufacturer. This decision was reached with some process of elimination but there are financial that are also indicative. It has a high percentage of assets represented in other assets which could be patents on drugs. The receivables collection period is also relatively high reflection the non-retail nature of this business. Comparing the profit per revenue to the profit per net worth, we might surmise that the companys profits were strong a high profit/revenue and its stock price was high comparably low profit/net worth. E. This is the advertising agency. Here the unique nature of billings and percentage

commission of media buys causes some unusual financial information to be reported. We could see that the accounts receivable were roughly equal to the accounts payable and both are somewhat high, reflecting the pass-through nature of billing for media buys. Plant and equipment is low because the business operates an office but most tellingly there is no inventory

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conclusively marking this as a service business. F. This is the software developer. Here again there are few definitive financials but by

elimination and the combination of factors we can get a good picture. This business has a very low inventory percentage indicating its emphasis on service as well as very low plant and equipment reflecting the operations location in an office with computers. Their receivables collection period is long indicating that they most likely sell to other businesses and they are one of the most profitable of the fourteen, which we would expect from a software company. G. This is the HMO. First we can see that this is a service business due to the lack of inventory and low plant and equipment. Next, the accounts receivable is very high reflecting the complex billing in the medical industry especially billing to the government through Medicaid or Medicare. The revenue per assets is high reflecting the volume of money changing hands in medicine but the profit ratios are relatively low due to the narrow margins for HMOs. H. This is the restaurant chain. Here the most distinguishing factors are the rapid inventory turnover due to the perishable nature of the product and the low receivables collection time due to the customers typically paying by cash or credit card. We also notice a high plant and equipment due to the amount of locations and equipment necessary for a restaurant chain. I. This is the retail grocery chain. On the asset side of the balance sheet we see high numbers

for inventory and plant and equipment reflecting the necessity of keeping large stores well stocked. In liabilities the moderately high accounts payable reflect having many suppliers. We also notice a quick receivables collection period reflecting the retail business and high revenue to assets but low profit to revenue indicating the high volume and low margin nature of the grocery business.

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J.

This is the department store chain with its own brand credit card. This business fits the

profile of a retail business except for its 41 day receivables collection period. We see high inventory, plant and equipment and accounts payable with a slower turnover than the grocery store and the lengthy collection number reflects the store credit card, which would be billed and paid off in most cases over time. K. This is the retail drug chain. Again we are looking at numbers reflecting a retail business with high inventory, plant and equipment and accounts payable. This business also reflects the high volume low margin ratios with high revenue to assets and low profit to revenue. The distinction here is the higher accounts receivable which likely reflects billing insurance and government programs for prescription medication. L. This is the electric and gas utility. From the case we know that the utility gains 72% of its

revenue from electricity and the remaining 28% from natural gas sales. This explains having an inventory which a purely electric utility would not. Beyond that, the distinguishing features here are the large plant and equipment number due to a large infrastructure and a 40 day receivable collection period due to the process of billing customers. M. This is the airline. First we can see that there are no inventories, telling us that this is a service business. Secondly, there is a high plant and equipment number because the business owns very expensive airplanes. Accounts receivable are low because most customers pay with cash or credit card and the return on equity is the lowest at .082, reflecting the low profits in the highly competitive airline industry. N. Lastly we have the commercial bank. There is no inventory again, indicating a service. Ninety percent of these businesses assets are in accounts receivable reflecting loans made by the bank and most notably, the collection period for these receivables is more than eleven years.

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Next we will address the specific questions related to the case. 2. For the advertising agency, about half of total revenue is derived from commissions that equal 15% of media purchases for clients. What are the implications for accounts receivable? Accounts receivable for the advertising agency are inflated relative to the companys revenue due to the pass-through nature of billing in this industry. While the agency will bill and record as receivable all of the money for media purchases on behalf of a client, they will only retain 15% of this amount as revenue causing the receivables number to look large. (The advertising agency has a larger percentage account receivable in their total assets. The case shows the total assets consist of 37% of account receivable. Advertising agency bills the total of their charge of media purchase to the account receivable to clients. After they receive the money back from the clients they pay the bill from the media buys and keeps 15% of it as their commission. Thus both account receivable and account payable amounts are large. The collection period is also long since the advertising agency will put the due date of the bill to their customer on the advertisement show day but will book account receivable after the agency gets the sales agreement with the client 1 year or 2 years ago.)

3. What is the main difference (in financial statements) between service and non-service firms? Please, explain. The main difference between service and non-service industries as represented in their respective financial statements is the presence or absence of inventory. Service industries will have no inventory while others will have some of their assets in inventory. Service businesses will also typically have lower plant and equipment assets proportionately however there are exceptions to

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this such as an airline. (Service industry might have a higher salary expense since their revenue come mostly from employees services. They have no inventory on the balance sheet, since service firms do not produce products. PP&E can be very low or very high, it depends on the individual industry. For example, accounting firms will not have much PP&\E. However, service firms that provide transportation might have a very higher PP&E on their balance sheet, for instance, airline companies. Asset turnover ratio can be very high or low. As in the above example, accounting firms will have very high asset turnover and airline companies will have a lower asset turnover.)

4. What are the benefits and costs associated with a high inventory turnover (relative to the industry average)? A high inventory turnover relative to other businesses in the same industry reflects the efficient use of capital, not tying it up in materials or finished goods and thereby freeing it up to be invested in other revenue-producing assets. This would tend to create a competitive advantage in either scale or breadth for the more efficient company. Inventory turnover =cost of goods sold/ inventory at start of year. If the company keeps the cost of goods per unit and inventory as the same level of other similar size companies in the same industry, a higher inventory turnover means the company sells their products faster than other companies and bring in more revenue than other companies. It also indicates that the company has a better control over their raw materials and finished goods; they do not over purchase raw materials. This can benefit their cash flow so they can use the money to invest in other things to bring more revenue to the company, instead of tie on the raw materials in the warehouse.

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5. Which firms are more likely to have higher inventory turnover? Online businesses are more likely to have higher inventory turnover because they operate lean, on high volumes. This is followed by grocery stores, restaurants, and utilities .

6. For the online direct factory to customer personal computer vendor (i.e., Dell), most of manufacturing is outsourced. What are the implications of this for the inventory and inventory turnout? The implications are low inventory and high turns. Their inventory model is JIT (just-in-time), drop-ship for special items.

7. For the online direct factory to customer personal computer vendor (i.e., Dell), more than half of sales are to business customers. What are the implications for the receivables collection period? The receivable collection period is higher; business- to- business transactions are typically 30-45 days.

8. The department store has its own brand charge card, what does it mean for the receivable collection period? The department store acts as a creditor so the receivable collection period will be at least 30 days because people usually dont pay charge cards for 30 days or longer.

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9. Under which conditions will the electric and gas utility company be classified as a service provider? If the company made revenue only from electricity sales, it would be classified as a service provider, because they dont store anything and thus the inventory would be zero. But here, 72% of the companys revenue is from electricity sales and 28% of its revenue is from natural gas sales. Since natural gas has to be stored, the inventory for this company will not be zero and the company cannot be classified as a service provider.

10. Which industries are likely to have shorter receivable collection periods? Retail firms are likely to have shorter receivable collection periods (less than 30 days). Examples are bookstore chain, online bookseller, retail drug chain, retail grocery chain, family restaurant business. The exception would be a department store with its own brand charge card.

11. Which industries are more likely to have a higher PP&E percentage? In this case, the largest group of industries with high PP&E percentages is the traditional retail businesses. Grocers, drugstores, bookstores and restaurants all have significant assets in buildings and equipment. The other two businesses in the case with high percentages in PP&E are the airline, which needs to own many planes to provide its service and the utility which must operate a generation facility containing large capital investments.

12. Compare retail bookstore to the online bookseller. What are the differences (in terms of strategy, marketing, financial statements, and ratios)? The retail bookstore as compared to the online version counts on its physical locations and in-

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store marketing to sell books to customers who prefer to browse and examine the merchandise and will pay a higher price. Online, however, customers can count on low prices and delivered convenience. On financial statements we can see the obviously higher plant and equipment of the traditional bookstore along with higher inventories and slower turnover. Lastly it is clear that the online bookseller is more profitable by all measures - as compared to revenue, assets or net worth. Book store has a higher PP&E, rental, utility, employees cost, inventory cost. Marketing: book store sell books at higher rate to people like to shopping physically in stores, customer also can end up buying books they did not plan before after visiting a book store, people are not comfortable with internet, kids and older people. Online selling: compete price to people want to get discount and know what exactly book they want. For example, students.

13. Talk about how and why the highest profitability firms (A, C, F, and H) achieved such status. The two online businesses, A and C, generate high profits through the efficiency of low PP&E, low inventories and rapid inventory turnover. The combination of these factors generates a great deal of revenue with a minimum of assets. The software developer in F seems to be generating profit based on knowledge and other intangibles. They have low PP&E and inventory with the primary revenue-generating asset represented by other assets - likely containing copyrights or other intellectual property. The restaurant chain in H is doing very well keeping inventory low and turning it quickly. Their revenue to assets ratio as compared to the profit to revenue would suggest that they are

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generating a great deal of volume so that while margins are not very high, they are still relatively profitable.

14. For your group, which was the hardest comparison, i.e., you were debating between two companies and how to assign them (for example in class, we were vigorously debating between advertising and HMO companies). The choice between a retail drug chain and a bookstore chain posed problems because both showed moderate-to-high inventory, PP&E, and accounts payable, as one would expect of retail stores. However, on the basis of receivables collection period, we were able to distinguish the twothe bookstores being only a week while the drug chain, depending on insurance payments, is over two weeks. In addition, the bookstores inventory is slightly higher, reflecting the nonperishable nature of its goods.

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References:

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