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 Solution Manual for Financial Reporting
Financial Statement Analysis and Valuation 9th
Edition by Wahlen
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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.

Buyer Power. Air courier services are a commodity. Firms in the industry offer
similar overnight or two-day deliveries. Firms also provide opportunities to track
shipments. Business customers can negotiate favorable shipping terms based on the
volume of shipments. Thus, buyer power among large corporate customers is high.

Supplier Power. The principal inputs are labor services, equipment, and
information systems. Except for pilots and some information-processing specialists,
the skill required to offer air courier services is relatively low. Therefore, competition
for jobs reduces supplier power. The principal items of equipment are airplanes,
trucks, and sorting equipment. The number of suppliers of this equipment is relatively
small, but the equipment offered is largely a commodity. Thus, equipment supplier
power is relatively low. Information systems are critical to scheduling, tracking, and
delivering parcels. Hiring individuals with the education and skills needed to design
and maintain this information system is not difficult because these skills and
education are not unique. Thus, supplier power is low.

Rivalry among Existing Firms. Seven air couriers now carry a 90% market share.
FedEx and UPS have the largest market shares and compete heavily. Smaller firms
compete more in particular geographical or customer markets. Thus, rivalry is
relatively high.

Threat of New Entrants. The cost of acquiring equipment, developing national

and international delivery networks, and overcoming entrenched firms in an
already-crowded market makes the threat of new entrants low.

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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Threat of Substitutes. The main threat to transportation of letter parcels is digital
transmission, and that threat is high. The threat of substitutes for transportation of
packages is low.

1.2 Economic Attributes Framework Applied to the Specialty Retailing Apparel

Industry.

Demand. Firms attempt to compete on design, colors, and other product attributes,
but apparel is largely a commodity. Demand is somewhat cyclical with economic

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Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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.

Dell. Dell’s products—computers, servers, and printers—are commodities. Dell tends

not to develop the technologies underlying these products. Instead, it purchases
the components from firms that develop the technologies (semiconductors and
computer software). Dell’s direct-to-customer marketing strategy is not unique, but
the extent to which Dell performs this strategy better than anyone else in the industry
gives it a competitive advantage. Its size, purchasing power, quality control, and
efficiency permit it to operate as a low-cost provider.

Southwest Airlines. Airline transportation is a commodity service in the sense that

seats on one airline cannot be differentiated from seats on another airline.
Southwest Airlines’ strategy is to be the lowest-cost provider of such services, thereby
differentiating itself on low prices.

Microsoft. The basic idea of a commodity product is that the product offerings of one
firm are so similar to those of other firms that customers can easily switch to
competitors’ products if price becomes an issue. The technological attributes of

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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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
are marked more by their similarities than by their differences. Both firms sell to the
do-it-yourself homeowner and the professional builder, plumber, or electrician at
competitively low prices. Their in-store product offerings are similar, roughly
evenly split between building materials, electrical and plumbing supplies, hardware,
paint, and floor coverings. Their store sizes are approximately the same. Both use
sales personnel with expertise in a particular home improvement area to offer
advice to customers. Both rely on third-party credit cards for a large portion of their
sales to customers. They are similar in size in terms of number of stores, which are
located primarily throughout North America.

1.5 Researching the FASB Website. The answer will change over time as the FASB
updates its activities. The purpose of the exercise is to familiarize students with the
FASB website and the kinds of information they can find there.

1.6 Researching the IASB Website. The answer will change over time as the IASB
updates its activities. The purpose of the exercise is to familiarize students with the
IASB website and the kinds of information they can find there.

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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

1.7 Effect of Industry Economics on Balance Sheets. Among the three firms, Intel
faces the greatest risk of technological change for its products. Although the
manufacture of semiconductors is capital-intensive, Intel does not add financial risk
to its already high business risk. Thus, Firm B is Intel. The revenues of American
Airlines and Walt Disney change with changes in economic conditions, subjecting
them to cyclical risk and, thereby, reducing their use of long-term debt. Besides
producing movies and family entertainment, Disney operates theme parks, which
the firm does not include in property, plant, and equipment. This will reduce its
property, plant, and equipment to total assets percentage. American Airlines has
few assets other than its flight and ground support equipment. Thus, Firm A is Disney
and Firm C is American Airlines. It may seem strange that Disney has smaller
proportions of long-term debt in its capital structure compared to American Airlines.
One possible explanation is that the assets of American Airlines have a ready market
in case a lender repossesses and sells them than do the more unique assets of Disney.
This reduces the borrowing cost. In this case, however, the explanation lies in the fact
that American Airlines has operated at a net loss for several years and has negative
shareholders’ equity. The result is a higher ratio of long-term debt to assets for
American Airlines than for Disney.

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
cost of goods sold to sales percentage because it adds less value, essentially following
an assembly strategy, and competes based on low prices. Apple Computer can
obtain a higher markup on its manufacturing costs because it creates more unique
products with a somewhat unique consumer following.

Selling and Administrative Expense to Sales Percentages. Both Dell and Apple
Computer engage in extensive promotion to market their products to consumers,
thereby increasing their selling expenses. One might expect Apple Computer to spend
more on marketing and advertising than Dell would spend. One also might expect
Dell, as a producer of commodities, to be more focused on controlling costs such as
administrative expenses. So it is interesting that Apple’s selling and administrative
expenses are considerably smaller than Dell’s.

Research and Development Expense to Sales Percentages. Apple Computer is

more of a technology innovator than Dell, thereby giving Apple Computer a higher
R&D (research and development) expense to sales percentage.

Net Income to Sales Percentages. These percentages are consistent with the
strategies of these firms. Compared to Dell, Apple Computer has a much higher profit
margin.

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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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
which the stores can obtain a higher markup on their acquisition cost. Discount
stores price low in an effort to gain volume. Thus, the cost of goods sold to sales
percentage of Macy’s should be lower than that of Dollar General. Department
stores engage in advertising and other promotions to stimulate demand. Also, their
cost for space is higher. These factors should increase their selling and
administrative expense to sales percentage. Dollar General maintains a high level of
debt, so interest expense (included in all other items) is much higher than it is for
Macy’s. One would expect that the department stores have a higher net income to
sales percentage.

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

various strategies for approaching this problem. One strategy begins with a
particular company, identifies unique financial characteristics (for example, hotel and
casino companies have a high proportion of property, plant, and equipment among
their assets), and then searches the common-size data in Text Exhibit 1.15 to identify
the company with that unique characteristic. Another approach begins with the
common-size data in Text Exhibit 1.15, identifies unusual financial statement
relations [for example, Firm (8) has a high proportion of receivables], and then
looks over the list of companies to identify the one most likely to have substantial
receivables among its assets. We follow both strategies here. 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 1.15, with
company names as column headings, are presented at the end of this solution in
Exhibit 1.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
services. In addition, receivables comprise a higher percentage for Firm (8) than for
Firm (1) [1,384% for Firm (8) versus 352% for Firm (1)], distinguishing Firm (8) as
Citigroup and Firm (1) as Goldman Sachs. Neither firm is fixed-asset-intensive,
reporting immaterial amounts of PP&E relative to revenues.
Firms (2), (5), and (7) have high percentages of property, plant, and equipment
and are clearly fixed-asset-intensive. These firms are Carnival Corporation (2),
Verizon Communications (5), and MGM Mirage (7). These firms are capital-asset-
intensive business models—operating cruise ships, telecommunications networks,
and hotel and casino chains, respectively. Firm (2) and Firm (7) have similar property,
plant, and equipment percentages and depreciation and amortization expense
percentages. Firm (5) has the highest depreciation and amortization expense
percentage, which implies a shorter depreciable life for its depreciable

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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

assets compared to Firm (2) and Firm (7). Due to technological obsolescence, the
depreciable assets of Verizon likely have a shorter life than the casinos and hotels
of MGM or the ships of Carnival. Thus, Firm (5) is Verizon. Note that Verizon does
not amortize its wireless licenses, meaning amortization of these licenses will not
explain the higher depreciation and amortization expense to revenues percentage for
Firm (5). The percentage of accumulated depreciation to the cost of property, plant,
and equipment also is much higher for Firm (5) than for Firm (2) or Firm (7), a
consequence of Firm (5)’s higher depreciation and amortization expense. Another
distinguishing characteristic of Firm (5) is that it has a lower cost of sales
percentage than does Firm (2) or Firm (7). Verizon’s services are more capital-
intensive, not labor-intensive, compared to those of Carnival and MGM, which lowers
Verizon’s operating expense line. Also, Carnival and MGM sell meals as part of
their services, including the cost in cost of sales. Of the three firms, Firm (5) has the
highest selling and administrative expense to revenues percentage.
Telecommunication services are more competitive than luxury entertainment, which
increases marketing expenses and lowers revenues for Verizon.
To distinguish Firm (2) (Carnival) from Firm (7) (MGM Mirage), recognize that
Firm (7) finances more heavily with long-term debt, consistent with hotel and
casino properties supporting higher leverage than cruise ships. Firm (7)’s higher
proportion of long-term debt might suggest that compared to ships, hotels and casinos
serve as better collateral for loans. Another possibility is that MGM simply chose to
use debt more extensively than did Carnival. Firm (7) has a higher selling and
administrative expense percentage and thereby a lower net income percentage.
Distinguishing these two firms is a close call. The land-based services of MGM are
probably more competitive because of the direct competition located nearby and the
low switching costs for customers. Once customers commit to a cruise, their 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 high profit
margins; high proportions of cash and marketable securities; low proportions of
property, plant, and equipment; and low long-term debt. All are consistent with
technology-based firms. These firms differ on their R&D percentages, with Firm (12)
having the lowest percentage. Both Johnson & Johnson and Cisco invest in R&D
to create new products, whereas eBay invests in technology to support the
offering of its online services. The clue suggests that eBay is Firm (12). In addition,
Firm (12) differs from Firm (6) and Firm (3) in that it has no inventory, consistent
with eBay’s business model of being a market- making intermediary rather than a
producer. Firm (12) also differs from Firm (6) and Firm (3) in the amount of
intangibles. Intangibles dominate the balance sheet of Firm (12). The problem
indicates that eBay has grown its network of online services largely by acquiring
other firms, which increases goodwill and other intangibles. Thus, Firm (12) is eBay.

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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 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
Cisco. A few subtle differences between the percentages for these two firms are as
follows: As a high-tech company, Cisco requires more R&D than Johnson & Johnson
does, which generates revenues from branded over-the-counter consumer health
products, which do not require as much R&D investment. This suggests that Johnson
& Johnson is Firm (3) and Cisco is Firm (6). In the same vein, Cisco will turn over
inventory faster than Johnson & Johnson will, which is revealed in Cisco’s
having a lower inventory percentage compared to Johnson & Johnson.
This leaves four firms: Firms (4), (9), (10), and (11). The four remaining firms are
Kellogg’s, Amazon.com, Molson Coors, and Yum! Brands, respectively.
Amazon.com is likely the least fixed-asset-intensive of the firms. It must invest in
information systems but does not need manufacturing or retailing assets, as the
other three do. In addition, Amazon will require the highest levels of R&D among the
four firms. This suggests that Firm (9) is Amazon.com. Firm (9) also has 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 to revenues
percentages for Amazon.com and eBay [Firm (12)]. Amazon.com includes the full
selling price of goods sold in its revenues whenever it takes product risk and
the cost of the product sold in the cost of sales. On the other hand, eBay does not
assume product risk, so its revenue includes only customer posting and transaction
fees and advertising fees. Its cost of sales percentage is quite low because it includes
primarily compensation of personnel maintaining its auction sites.
This leaves Firm (4), Firm (10), and Firm (11). Firm (11) has the smallest
inventories percentage, consistent with a restaurant selling perishable foods. The
cost of sales percentage for Firm (11) is the highest of these three remaining firms.
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
does Firm (4). Molson Coors has made significant investments in acquisitions of other
beer companies in recent years, which increased its goodwill. Kellogg’s has a smaller
yet still significant goodwill percentage, consistent with Kellogg’s’ strategy of
acquiring other branded foods companies and recognizing goodwill. Firm (10) is
Molson Coors and Firm (4) is Kellogg’s.

1-8
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 Statement Analysis, and Valuation
Overview of Financial Reporting, Financial
Chapter 1
Exhibit 1.A—(Problem 1.10)
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Goldman Carnival MGM Amazon Molson Yum!

Sachs Corp J&J Kellogg’s Verizon Cisco Mirage Citigroup .com Coors Brands eBay
1 2 3 4 5 6 7 8 9 10 11 12
BALANCE SHEET
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%
Receivables 352.8 2.8 15.2 8.9 12.0 8.8 4.2 1,384.8 4.0 13.3 2.0 5.1
Inventories — 2.4 7.9 7.0 2.1 3.0 1.5 — 8.9 4.0 1.3 —
Property, plant, and equipment, at cost — 286.8 43.0 55.4 221.5 33.8 278.8 — 7.8 41.4 61.1 32.9
Accumulated depreciation — (59.8) (20.4) (32.5) (132.6) (22.6) (52.8) — (2.6) (14.1) (28.3) (18.9)
Property, plant, and equipment, net —% 227.0% 22.5% 22.9% 88.9% 11.2% 226.0% —% 5.3% 27.3% 32.9% 14.0%
Intangibles — 36.5 43.4 39.8 75.2 40.5 6.0 101.9 5.0 109.4 8.3 90.9
Other assets 57.3 7.2 24.0 4.8 19.0 28.3 81.0 208.5 7.2 59.7 11.4 33.3
Total assets 2,666.2% 280.0% 133.2% 85.4% 207.9% 188.6% 322.9% 3,893.3% 56.4% 218.2% 57.9% 182.6%

Current liabilities 2,080.8% 37.8% 32.7% 27.7% 26.6% 37.8% 41.7% 2,878.4% 30.0% 20.7% 15.3% 43.4%
Long‐term debt 390.9 69.1 12.7 31.7 48.2 28.5 172.2 596.1 0.4 38.4 31.6 —
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%
1-8

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%
Cost of sales (excluding depreciation) or
operating expenses (54.6) (61.6) (29.0) (58.1) (40.1) (36.1) (56.0) (73.4) (85.8) (59.5) (75.1) (26.1)
Depreciation and amortization (2.0) (9.9) (4.4) (2.9) (15.0) (1.5) (10.8) (5.0) (1.5) (5.7) (4.9) (2.8)
Selling and administrative (1.4) (12.1) (29.3) (23.7) (27.6) (27.6) (19.3) (5.1) (2.6) (27.9) (7.6) (33.7)
Research and development (1.6) — (12.2) — — (14.6) — (7.7) (5.1) — — (8.5)
Interest (expense)/income 9.5 (2.8) (0.1) (2.5) (1.9) 1.0 (8.5) 78.4 — (1.8) (2.0) 1.3
Income taxes (14.3) (0.1) (6.2) (3.8) (3.4) (4.3) (2.6) (16.0) (1.0) (2.2) (2.8) (4.7)
All other items, net (8.0) 0.1 1.6 — (5.5) — 2.3 (28.8) (0.3) 5.2 0.4 —
Net income 27.6% 13.6% 20.3% 9.0% 6.6% 17.0% 5.3% 42.3% 3.7% 8.0% 8.0% 25.5%

Cash flow from operations/capital

expenditures n.m. 1.0 4.9 2.7 1.5 9.8 1.0 n.m. 8.8 1.8 1.6 5.1
1.11 Effect of Industry Characteristics on Financial Statement Relations. There are
various strategies for approaching this problem. One strategy begins with a
particular company, identifies unique financial characteristics (for example, electric
utilities have a high proportion of property, plant, and equipment among their
assets), and then searches the common-size data in Text Exhibit 1.16 to identify the
company with that unique characteristic. Another approach begins with the
common-size data in Text Exhibit 1.16, identifies unusual financial statement
relations [for example, Firm (10) has a high proportion of receivables], and then looks
over the list of companies to identify the one most likely to have substantial
receivables among its assets. We follow both strategies here. 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 1.16, with
company names as column headings, are presented at the end of this solution in
Exhibit 1.B.
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 have
contractual rights to receive future cash flows from borrowers (the cash flow tends to
be highly predictable); (2) finance companies lend to many different individuals,
which diversifies their risk; and (3) borrowers often pledge collateral to back up the
loan, which provides the finance companies with an alternative for collecting cash if
borrowers default on their loans. Thus, the low risk in the asset structure allows the
firm to assume high risk on the financing side. We use this opportunity to ask students
how this firm can justify recognizing interest revenue on its loans as the revenue
accrues each period when it has an uncollectible loan provision of 29.1% of revenues.
Two points are noteworthy: (1) The concern with uncollectibles is not with the size
of the provision, but with how much uncertainty 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) revenues represent interest revenues on
loans, whereas the provision for 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 year). Given that loans are nearly 700% of revenues
and the provision for uncollectible loans is 29% of revenues, it implies a roughly 4%
loan loss provision. The cash flow from operations to capital expenditures ratio is
high because of the low capital intensity of this firm.
Firm (4) also is likely to be a financial services firm because it has a high
proportion of cash and marketable securities among its assets and a high proportion
of liabilities in its capital structure. This balance sheet structure is typical of the
insurance company, Allstate Insurance. Allstate receives cash from policyholders
each period as premium revenues. It pays out the cash to policyholders as they
make insurance claims. There is a lag between the receipt and disbursement of cash,

1-9
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Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

which for a property and casualty insurance company can span periods up to several
years. Allstate invests the cash in the interim to generate a return. The high proportion
of current liabilities represents Allstate’s estimate of the amount of future claims
arising from insurance coverage in force in the current and previous periods. We ask
students at this point to comment on the quality of earnings of an insurance company.
Our objective is to get students to see the extent of estimates that go into recognizing
claims expenses in a particular period. Claims made from accidents or injuries during
the current year related to insurance in force during that year require relatively little
estimation. However, policyholders may sustain a loss during the current period but
not file a claim immediately. Also, estimating the cost of a claim may present
difficulties if the claim amount is difficult to estimate (such as with malpractice
insurance) or if policyholders contest the amount Allstate is willing to pay and the
case goes through adjudication. Thus, the potential for low- quality earnings is present
with insurance companies. We then point out that the amount shown for other assets
represents the unamortized portion of the cost of writing a new policy (costs of
investigating new policyholders to assess risk levels, commissions paid to insurance
agents for writing the new policy, and filing fees with state insurance regulators).
We ask why insurance companies do not write off this amount in the year of initiating
the policy. The explanation is one of matching. Insurance companies recognize
premium revenues over several future periods and should match both policy initiation
costs and claims costs against these revenues. The cash flow from operations to capital
expenditures ratio is high because of the low capital intensity of this firm.
Four firms report R&D expenditures: Firm (1), Firm (2), Firm (5), and Firm
(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. Pharmaceutical
companies have patents on most of their drugs, providing such firms with a
degree of monopoly power. The demand for most pharmaceuticals is relatively price
inelastic because customers need the drugs and because the cost of the drugs is often
covered by insurance. The manufacturing process for pharmaceuticals is capital-
intensive, in part because of the need for precise measurement of ingredients and in
part because of the need for purity. Note that Merck has a relatively high selling
and administrative expense percentage. This high percentage reflects the cost of
maintaining a sales staff to market products to physicians and hospitals and heavy
advertising outlays to stimulate demand from consumers.
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. Product life cycles are short at

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 Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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 3M and Procter & Gamble,
respectively. Firm (5) has a higher cost of sales to revenues percentage and a higher
selling and administrative expense to revenues percentage. It also has a high profit
margin. 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. 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 very high percentage for intangibles, the result of goodwill and other
intangibles from companies it has acquired.
This leaves Firm (1) as 3M. Its income statement percentages are similar to
those for Procter & Gamble. However, 3M invests more heavily in R&D than Procter
& Gamble because a greater proportion of its products are industrial or healthcare-
related. 3M also has been less aggressive than Procter & Gamble in making
acquisitions, so intangible assets are less significant on the balance sheet.
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 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

1-11
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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 1.16, 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.

1-12
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Exhibit 1.B—(Problem 1.11)
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Pacific
Gas & Best Kelly Omnicom HSBC
3M Merck Electric Allstate P&G Buy Services A&F Group Finance McDonald's HP

1 2 3 4 5 6 7 8 9 10 11 12
BALANCE SHEET

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%
Receivables 13.7 48.4 25.0 47.7 8.9 4.1 15.7 2.7 43.2 697.5 4.0 16.8
Inventories 11.6 9.6 2.9 — 8.7 10.6 — 10.5 5.0 — 0.5 5.3
Property, plant, and equipment, at cost 76.3 101.2 272.3 10.3 46.4 15.4 6.9 66.1 13.1 3.2 132.4 18.3
Accumulated depreciation (48.2) (50.9) (92.8) (6.7) (21.8) (6.1) (3.7) (26.6) (7.7) (1.3) (46.3) (8.5)

Property, plant, and equipment, net 28.1 50.3 179.5 3.6 24.6 9.3 3.1 39.5 5.4 1.9 86.1 9.8
Intangibles 39.1 8.2 — 2.8 112.8 6.0 2.6 — 55.7 40.9 9.5 34.7
Other assets 4.1 58.4 60.5 120.7 9.5 4.1 4.7 12.9 12.0 26.7 12.2 22.0
Total assets 108.1% 197.9% 277.1% 537.5% 170.6% 35.2% 27.8% 80.5% 129.6% 794.3% 121.0% 100.2%

Current liabilities 23.5% 60.0% 51.2% 391.7% 39.1% 18.7% 10.3% 12.7% 73.0% 122.1% 10.8% 37.5%
Long‐term debt 28.9 16.5 70.1 19.4 26.1 2.5 0.9 2.8 22.9 565.5 43.3 12.2
1-13

Other long‐term liabilities 16.8 42.7 88.9 51.3 25.5 3.6 2.7 12.8 7.4 20.2 10.0 15.1
Shareholders' equity 38.8 78.7 66.9 75.1 79.8 10.3 13.9 52.1 26.4 86.5 56.9 35.4

Overview of Financial Reporting, Financial

Total Liabilities and Shareholders' Equity 108.1% 197.9% 277.1% 537.5% 170.6% 35.2% 27.8% 80.5% 129.6% 794.3% 121.0% 100.2%
INCOME STATEMENT

Statement Analysis, and Valuation

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%
Cost of sales (excluding depreciation) or
operating expenses (46.1) (23.4) (60.7) (91.6) (49.2) (75.6) (82.5) (33.3) (87.4) (29.1) (63.3) (76.4)
Depreciation and amortization (4.7) (6.8) (12.6) (0.9) (3.9) (1.8) (0.8) (5.1) (1.8) (1.7) (5.1) (4.2)
Selling and administrative (20.4) (24.1) — (10.7) (23.9) (18.2) (15.3) (49.4) — (25.0) (4.9) (6.0)
Research and development (5.8) (20.1) — — (2.6) — — — — — — (2.5)
Interest (expense)/income (0.4) (1.1) (4.8) 21.0 (1.7) (0.2) — 0.3 (0.6) (32.7) (2.2) (0.6)
Income taxes (6.5) (8.4) (3.3) (6.9) (5.1) (1.5) (0.5) (5.0) (4.1) (3.7) (7.8) (1.5)
All other items, net (0.0) 16.7 (10.6) 4.2 0.7 (0.5) (0.1) — 1.2 (3.3) 1.7 (2.1)

Chapter 1
Net income 16.1% 32.7% 8.1% 15.2% 14.3% 2.2% 0.8% 7.4% 7.5% 4.5% 18.3% 6.7%
Cash flow from operations/capital

expenditures 4.3 5.1 0.8 18.7 4.6 1.4 1.6 1.3 6.6 100.9 2.8 3.6
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, 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 1.17, with
company names as column headings, are presented at the end of this solution 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 loans that
will not be repaid. Operating revenues include interest revenue on loans made. BNP
Paribas also has a high proportion of financing in the form of current liabilities. This
balance sheet category includes the deposits from banking customers, as well as
estimated cost of claims not yet paid from insurance in force. 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. BNP Paribas
includes this amount in Text Exhibit 1.17 on the line labeled “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 Paribas. One issue relates
to the measurement of bad debts expenses on loans as well as insurance claims
expense each period. The ultimate cost of credit losses will not be known until
borrowers default, and the actual cost of claims will not be known with certainty
until customers make claims and settlement is made. Prior to that time, BNP Paribas
must estimate what the costs of these risks will be. The need to make such estimates
creates the opportunity to manage earnings and lowers the quality of earnings.
Firm (6) stands out because it is the only other firm [besides BNP Paribas, 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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© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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 solutions
sold by Oracle. 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
29.7 times per year (17.8%/0.6%). 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 Oracle and Firm (9) is Roche Holdings. Oracle uses
only 10.8 cents in fixed assets for each dollar of sales generated. These ratios are
consistent with Oracle’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 Oracle has a large
proportion of long-term debt in its capital structure, but at the same time has huge
holdings of cash and marketable securities. This is consistent with some other large,
successful tech companies (for example, Apple and Microsoft). 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 multiyear 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 speed 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 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

1-15
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

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 (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.
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
Nippon Steel. 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. 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.

1-16
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Exhibit 1.C—(Problem 1.12)
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Inter-
Nippon Toyota Deutsche public Roche Marks &
BNP Steel Motor Telekom Accor Group Oracle E.ON Holding Spencer Carrefour Nestlé
1 2 3 4 5 6 7 8 9 10 11 12
BALANCE SHEET
Cash & marketable securities 2,649.8% 15.8% 21.8% 4.9% 16.2% 32.7% 151.5% 17.9% 43.4% 4.7% 6.0% 6.5%
Receivables 1,754.2 11.9 48.8 12.0 17.0 69.6 14.5 38.8 20.4 6.9 6.6 12.2
Inventories — 22.4 6.9 2.1 1.3 — 0.6 5.8 12.2 5.9 7.8 8.5
Property, plant, and equipment, at cost 83.7 172.5 66.2 195.3 92.8 23.2 21.9 134.7 62.9 82.6 34.5 42.0
Accumulated depreciation (31.5) (126.2) (36.5) (127.9) (36.9) (15.2) (11.1) (76.0) (24.9) (29.3) (17.7) (22.8)
Property, plant, and equipment, net 52.5% 46.3% 29.7% 67.4% 55.9% 8.1% 10.8% 58.7% 38.0% 53.3% 16.8% 19.2%
Intangibles 32.4 1.8 — 87.5 31.6 46.3 13.3 26.5 32.3 4.4 14.1 34.1
Other assets 330.4 29.5 16.2 25.9 25.5 17.5 18.7 28.5 12.7 4.9 7.7 16.1
Total assets 4,819.1% 127.6% 123.5% 199.7% 147.5% 174.1% 302.8% 176.2% 158.8% 80.1% 59.0% 96.6%

Current liabilities 3,445.8% 30.1% 45.4% 40.3% 70.2% 98.8% 46.4% 40.6% 25.3% 25.5% 32.2% 30.2%
Long‐term debt 425.3 27.7 22.8 8.8 24.9 25.7 105.6 21.3 6.2 23.4 10.8 5.8
Other long‐term liabilities 706.2 34.2 10.1 80.7 6.3 14.2 21.8 43.5 15.0 8.1 3.6 10.7
1-17

Shareholders' equity 241.8 63.2 45.1 69.9 46.0 35.6 129.0 70.8 112.4 23.2 12.4 50.0
Total Liabilities and Shareholders' Equity 4,819.1% 127.6% 123.5% 199.7% 147.5% 174.1% 302.8% 176.2% 158.8% 80.1% 59.0% 96.6%

Overview of Financial Reporting, Financial

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%
Cost of sales (excluding depreciation) or

Statement Analysis, and Valuation

operating expenses (20.0) (80.0) (76.2) (56.1) (70.4) (62.4) (17.8) (64.5) (28.5) (62.8) (77.9) (51.3)
Depreciation and amortization (4.0) (5.6) (5.7) (17.8) (5.8) (2.5) (6.8) (5.1) (3.5) (4.5) (2.1) (2.4)
Selling and administrative (5.0) (8.2) (5.9) (15.9) — (26.4) (24.4) (22.7) (20.5) (24.7) (16.3) (30.2)
Research and development — — (3.6) — — — (15.6) — (18.5) — — (1.8)
Interest (expense)/income (45.5) (0.4) 0.5 (4.0) (1.1) (1.7) (3.1) (1.4) 0.5 (1.8) (0.6) (1.0)
Income taxes (8.1) (2.6) (3.5) (2.3) (3.5) (2.2) (6.9) (0.1) (6.9) (2.2) (0.8) (3.4)
All other items, net (1.0) (0.3) 0.9 (0.1) (11.3) (0.5) (1.3) 1.1 0.1 1.6 0.1 7.6
Net income 16.2% 3.8% 6.5% 3.8% 7.9% 4.2% 24.0% 7.3% 22.6% 5.6% 2.3% 17.3%

Cash flow from operations/capital expenditures 4.2 1.9 2.1 2.3 2.0 6.3 7.2 1.7 4.0 2.7 1.8 2.2

Chapter 1
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 1.18,
with company names as column headings, are presented at the end of this solution
in Exhibit 1.D.
Four firms, 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.

1-18
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Chapter 1
Overview of Financial Reporting, Financial
Statement Analysis, and Valuation

We are now left with Covance, Cardinal Health, and Walgreens as 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.

1-19
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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