,Solution manual for Financial Reporting, Financial
Statement Analysis and Valuation, 10th Edition
James M. Wahlen
Notes
1- The file is chapter after chapter.
2- We have shown you 10 pages.
3- The file contains all Appendix and Excel
sheet if it exists.
4- We have all what you need, we make
update at every time. There are many
new editions waiting you.
5- If you think you purchased the wrong file
You can contact us at every time, we can
replace it with true one.
Our email:
, 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.
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
1-1
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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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, 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.
1-3
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,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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, 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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,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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, 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.
1-7
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, Statement Analysis, and Valuation
Overview of Financial Reporting, Financial
Chapter 1
Exhibit 1.A—(Problem 1.10)
© 2023 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% 33.2% 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’
1-8
Equity 2666.2% 280.0
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%
Cost of sales (excluding depreciation) or (61.6)
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)
(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)
(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)
(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)
(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
0.1 1.6 — (5.5) — 2.3 (28.8) (0.3) 5.2 0.4 —
Net income 27.6% 13.6% 20.3%
13.6% 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
1.0 4.9 2.7 1.5 9.8 1.0 n.m. 8.8 1.8 1.6 5.1
Statement Analysis and Valuation, 10th Edition
James M. Wahlen
Notes
1- The file is chapter after chapter.
2- We have shown you 10 pages.
3- The file contains all Appendix and Excel
sheet if it exists.
4- We have all what you need, we make
update at every time. There are many
new editions waiting you.
5- If you think you purchased the wrong file
You can contact us at every time, we can
replace it with true one.
Our email:
, 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.
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
1-1
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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
1-2
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, 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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,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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, 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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,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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, 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.
1-7
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, Statement Analysis, and Valuation
Overview of Financial Reporting, Financial
Chapter 1
Exhibit 1.A—(Problem 1.10)
© 2023 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% 33.2% 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’
1-8
Equity 2666.2% 280.0
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%
Cost of sales (excluding depreciation) or (61.6)
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)
(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)
(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)
(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)
(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
0.1 1.6 — (5.5) — 2.3 (28.8) (0.3) 5.2 0.4 —
Net income 27.6% 13.6% 20.3%
13.6% 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
1.0 4.9 2.7 1.5 9.8 1.0 n.m. 8.8 1.8 1.6 5.1
