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PA R T Introduction to Case Analysis 5 CHAPTER 12 suggestions for Case Analysis Howard Schilit, founder of the Center for Financial Research & Analysis (CFRA), works with a staff of 15 analysts to screen financial databases and analyze public financial filings of 3,600 companies, looking for inconsistencies and aggressive accounting methods. Schilit calls this search for hidden weaknesses in a company’s performance forensic accounting. “I’m like an investigative reporter,” explains Schilit. “I’m interested in finding companies where the conventional wisdom is that they’re very healthy, but if you dig a bit deeper, you find the emperor is not wearing the clothes you thought.”1 He advises anyone interested in analyzing a company to look deeply into its financial statements. For example, when the CFRA noticed that Kraft Foods made $122 million in acquisitions in 2002, but claimed $539 million as “goodwill” assets related to the purchases, it concluded that Kraft was padding its earnings with one-time gains. According to Schilit, unusually high goodwill gains related to recent acquisitions is a red flag that suggests an underlying problem. Schilit proposes a short checklist of items to examine for red flags: 쏋 Cash flow from operations should exceed net income: If cash flow from operations drops below net income, it could mean that the company is propping up its earnings by selling assets, borrowing cash, or shuffling numbers. Says Schilit, “You could have spotted the problems at Enron by just doing this.”2 쏋 Accounts receivable should not grow faster than sales: A firm facing slowing sales can make itself look better by inflating accounts receivable with expected future sales and by making sales to customers who are not credit worthy. “It’s like mailing a contract to a dead person and then counting it as a sale,” says Schilit.3 쏋 Gross margins should not fluctuate over time: A change of more than 2% in either direction from year to year is worth a closer look. It could mean that the company is using other revenue, such as sales of assets or write-offs to boost profits. Sunbeam reported an increase of 10% in gross margins just before it was investigated by the SEC. 쏋 Examine carefully information about top management and the board: When Schilit learned that the chairman of Checkers Restaurants had put his two young sons on the board, he warned investors of nepotism. Two years later, Checkers’ huge debt caused its stock to fall 85% and all three family members were forced out of the company. Learning Objectives After reading this chapter, you should be able to: 쏋 쏋 Research the case situation as needed Analyze financial statements by using ratios and common-size statements 쏋 쏋 Use the strategic audit as a method of organizing and analyzing case information Footnotes are important: When companies change their accounting assumptions to make the statements more attractive, they often bury their rationale in the footnotes. Schilit dislikes companies that extend the depreciable life of their assets. “There’s only one reason to do that—to add a penny or two to earnings—and it makes me very mistrustful of management.”4 Schilit makes his living analyzing companies and selling his reports to investors. Annual reports and financial statements provide a lot of information about a company’s health, but it’s hard to find problem areas when management is massaging the numbers to make the company appear more attractive than it is. That’s why Michelle Leder created her Web site, www.footnoted.org. She likes to highlight “the things that companies bury in their routine SEC filings.”5 This type of in-depth, investigative analysis is a key part of analyzing strategy cases. This chapter provides various analytical techniques and suggestions for conducting this kind of case analysis. 12.1 The Case Method The analysis and discussion of case problems has been the most popular method of teaching strategy and policy for many years. The case method provides the opportunity to move from a narrow, specialized view that emphasizes functional techniques to a broader, less precise analysis of the overall corporation. Cases present actual business situations and enable you to examine both successful and unsuccessful corporations. In case analysis, you might be asked to critically analyze a situation in which a manager had to make a decision of long-term corporate importance. This approach gives you a feel for what it is like to face making and implementing strategic decisions. 365 366 PART 5 12.2 Introduction to Case Analysis Researching the Case Situation You should not restrict yourself only to the information written in the case unless your instructor states otherwise. You should, if possible, undertake outside research about the environmental setting. Check the decision date of each case (typically the latest date mentioned in the case) to find out when the situation occurred and then screen the business periodicals for that time period. An understanding of the economy during that period will help you avoid making a serious error in your analysis, for example, suggesting a sale of stock when the stock market is at an all-time low or taking on more debt when the prime interest rate is over 15%. Information about the industry will provide insights into its competitive activities. Important Note: Don’t go beyond the decision date of the case in your research unless directed to do so by your instructor. Use computerized company and industry information services such as Compustat, Compact Disclosure, and CD/International, available on CD-ROM or online at the library. On the Internet, Hoover’s OnLine Corporate Directory (www.hoovers.com) and the Security Exchange Commission’s Edgar database (www.sec.gov) provide access to corporate annual reports and 10-K forms. This background will give you an appreciation for the situation as it was experienced by the participants in the case. Use a search engine such as Google to find additional information about the industry and the company. A company’s annual report and SEC 10-K form from the year of the case can be very helpful. According to the Yankelovich Partners survey firm, 8 out of 10 portfolio managers and 75% of security analysts use annual reports when making decisions.6 They contain not only the usual income statements and balance sheets, but also cash flow statements and notes to the financial statements indicating why certain actions were taken. 10-K forms include detailed information not usually available in an annual report. SEC 10-Q forms include quarterly financial reports. SEC 14-A forms include detailed information on members of a company’s board of directors and proxy statements for annual meetings. Some resources available for research into the economy and a corporation’s industry are suggested in Appendix 12.A. A caveat: Before obtaining additional information about the company profiled in a particular case, ask your instructor if doing so is appropriate for your class assignment. Your strategy instructor may want you to stay within the confines of the case information provided in the book. In this case, it is usually acceptable to at least learn more about the societal environment at the time of the case. 12.3 Financial Analysis: A Place to Begin Once you have read a case, a good place to begin your analysis is with the financial statements. Ratio analysis is the calculation of ratios from data in these statements. It is done to identify possible financial strengths or weaknesses. Thus it is a valuable part of SWOT analysis. A review of key financial ratios can help you assess a company’s overall situation and pinpoint some problem areas. Ratios are useful regardless of firm size and enable you to compare a company’s ratios with industry averages. Table 12–1 lists some of the most important financial ratios, which are (1) liquidity ratios, (2) profitability ratios, (3) activity ratios, and (4) leverage ratios. CHAPTER 12 TABLE 12–1 Suggestions for Case Analysis 367 Financial Ratio Analysis How Expressed Formula 1. Liquidity Ratios Current ratio Quick (acid test) ratio Inventory to net working capital Cash ratio Current assets Current liabilities Decimal Current assets  Inventory Current liabilities Decimal Inventory Decimal Current assets  Current liabilities Cash  Cash equivalents Current liabilities Meaning A short-term indicator of the company’s ability to pay its short-term liabilities from short-term assets; how much of current assets are available to cover each dollar of current liabilities. Measures the company’s ability to pay off its short-term obligations from current assets, excluding inventories. A measure of inventory balance; measures the extent to which the cushion of excess current assets over current liabilities may be threatened by unfavorable changes in inventory. Decimal Measures the extent to which the company’s capital is in cash or cash equivalents; shows how much of the current obligations can be paid from cash or near-cash assets. Net profit after taxes Net sales Percentage Shows how much after-tax profits are generated by each dollar of sales. Sales  Cost of goods sold Net sales Percentage Indicates the total margin available to cover other expenses beyond cost of goods sold and still yield a profit. Return on investment (ROI) Net profit after taxes Total assets Percentage Measures the rate of return on the total assets utilized in the company; a measure of management’s efficiency, it shows the return on all the assets under its control, regardless of source of financing. Return on equity (ROE) Net profit after taxes Shareholders’ equity Percentage Measures the rate of return on the book value of shareholders’ total investment in the company. Dollars per share Shows the after-tax earnings generated for each share of common stock. Decimal Measures the number of times that average inventory of finished goods was turned over or sold during a period of time, usually a year. Days Measures the number of one day’s worth of inventory that a company has on hand at any given time. 2. Profitability Ratios Net profit margin Gross profit margin Earnings per share (EPS) 3. Activity Ratios Inventory turnover Days of inventory Net profit after taxes – Preferred stock dividends Average number of common shares Net sales Inventory Inventory Cost of goods sold  365 continued 368 PART 5 TABLE 12–1 Introduction to Case Analysis Financial Ratio Analysis , (continued) How Expressed Formula Meaning Net sales Net working capital Decimal Measures how effectively the net working capital is used to generate sales. Asset turnover Sales Total assets Decimal Measures the utilization of all the company’s assets; measures how many sales are generated by each dollar of assets. Fixed asset turnover Sales Fixed assets Decimal Measures the utilization of the company’s fixed assets (i.e., plant and equipment); measures how many sales are generated by each dollar of fixed assets. Net working capital turnover Average collection period Accounts receivable Sales for year  365 Days Indicates the average length of time in days that a company must wait to collect a sale after making it; may be compared to the credit terms offered by the company to its customers. Accounts receivable turnover Annual credit sales Accounts receivable Decimal Indicates the number of times that accounts receivable are cycled during the period (usually a year). Accounts payable period Accounts payable Purchases for year  365 Days Indicates the average length of time in days that the company takes to pay its credit purchases. Days of cash Cash Net sales for year  365 Days Indicates the number of days of cash on hand, at present sales levels. Percentage Measures the extent to which borrowed funds have been used to finance the company’s assets. 4. Leverage Ratios Debt to asset ratio Total debt Total assets Debt to equity ratio Total debt Shareholders’ equity Percentage Measures the funds provided by creditors versus the funds provided by owners. Long-term debt to capital structure Long-term debt Shareholders’ equity Profit before taxes  Interest charges Interest charges Percentage Measures the long-term component of capital structure. Decimal Indicates the ability of the company to meet its annual interest costs. Coverage of fixed charges Profit before taxes  Interest charges  Lease charges Interest charges  Lease obligations Decimal A measure of the company’s ability to meet all of its fixed-charge obligations. Current liabilities to equity Current liabilities Shareholders’ equity Percentage Measures the short-term financing portion versus that provided by owners. Times interest earned CHAPTER 12 TABLE 12–1 Suggestions for Case Analysis 369 Financial Ratio Analysis, (continued) Formula Market price per share Earnings per share 5. Other Ratios Price/earnings ratio Divided payout ratio Dividend yield on common stock How Expressed Meaning Decimal Shows the current market’s evaluation of a stock, based on its earnings; shows how much the investor is willing to pay for each dollar of earnings. Annual dividends per share Annual earnings per share Percentage Indicates the percentage of profit that is paid out as dividends. Annual dividends per share Current market price per share Percentage Indicates the dividend rate of return to common shareholders at the current market price. NOTE: In using ratios for analysis, calculate ratios for the corporation and compare them to the average and quartile ratios for the particular industry. Refer to Standard & Poor’s and Robert Morris Associates for average industry data. Special thanks to Dr. Moustafa H. Abdelsamad, Dean, Business School, Texas A&M University—Corpus Christi, Corpus Christi, Texas, for his definitions of these ratios. ANALYZING FINANCIAL STATEMENTS In your analysis, do not simply make an exhibit that includes all the ratios (unless your instructor requires you to do so), but select and discuss only those ratios that have an impact on the company’s problems. For instance, accounts receivable and inventory may provide a source of funds. If receivables and inventories are double the industry average, reducing them may provide needed cash. In this situation, the case report should include not only sources of funds but also the number of dollars freed for use. Compare these ratios with industry averages to discover whether the company is out of line with others in the industry. Annual and quarterly industry ratios can be found in the library or on the Internet. (See the resources for case research in Appendix 12.A.) In the years to come, expect to see financial entries for the trading of CERs (Certified Emissions Reductions). This is the amount of money a company earns from reducing carbon emissions and selling them on the open market. To learn how carbon trading is likely to affect corporations, see the Environmental Sustainability Issue. A typical financial analysis of a firm would include a study of the operating statements for five or so years, including a trend analysis of sales, profits, earnings per share, debt-to-equity ratio, return on investment, and so on, plus a ratio study comparing the firm under study with industry standards. As a minimum, undertake the following five steps in basic financial analysis. 1. Scrutinize historical income statements and balance sheets: These two basic statements provide most of the data needed for analysis. Statements of cash flow may also be useful. 2. Compare historical statements over time if a series of statements is available. 3. Calculate changes that occur in individual categories from year to year, as well as the cumulative total change. 4. Determine the change as a percentage as well as an absolute amount. 5. Adjust for inflation if that was a significant factor. Examination of this information may reveal developing trends. Compare trends in one category with trends in related categories. For example, an increase in sales of 15% over three years may appear to be satisfactory until you note an increase of 20% in the cost of goods sold 370 PART 5 Introduction to Case Analysis ENVIRONMENTAL sustainability issue IMPACT OF CARBON TRADING Do you know about carbon trading, emissions allowances, cap-and-trade, or CERs? These are terms you can expect to hear a lot more in the years to come. The concept of carbon trading is something that will soon be affecting the balance sheets and income statements of all corporations, especially those with international operations. It is one way to account for environmental sustainability initiatives. The Kyoto Protocol established an emissions trading program that assigned annual limits on greenhouse gases emitted by facilities within each country’s boundaries. The countries signing the pact, including Canada, Japan, and the European Union, were then able to trade emission surpluses and deficits with each other. In addition, individual countries or companies could invest in projects in developing nations that would reduce emissions and use those reductions to meet their own targets. In 2005 the European Union initiated a trading system allowing individual facilities to sell credit allowances they had earned for reducing greenhouse gas emissions. It created a tradable commodity, the Certified Emissions Reduction (CER), which gave a facility the right to emit one metric ton of carbon dioxide annually. The CER was created by another facility that reduced its carbon dioxide emissions. (Reducing or trapping one metric ton of methane from entering the atmosphere was worth 21 CERs due to methane’s greater impact on global warming.) By 2006, a CER traded on the European market for around 25 euros with trading volume totaling one million CERs per day. Barclays, Citibank, Credit Suisse, HSBC, Lehman Brothers, and Morgan Stanley soon opened trading desks for CERs at London’s Canary Wharf, the global center for carbon trading. By 2007, European and Asian traders bought and sold approximately $60 billion worth of emission CERs. Carbon trading has created an opportunity for new and established companies. For example, Mission Point Capital Partners is one of more than 50 private equity and hedge funds specializing in carbon finance and clean energy. Mission Point created a joint venture in 2008 with GE and AES to develop large volumes of emissions credits. These would be sold to U.S. companies like Yahoo! and News Corp that wanted to become carbon neutral by offsetting their carbon emissions. Assuming that the U.S. federal government would soon establish a cap-and-trade market for emissions, the joint venture partners expected to produce 10 million tons of emission credits by 2010. According to Kevin Walsh, managing director of GE Energy Financial Services, “We think this is going to be an enormous market.” SOURCE: A. White, “Environment: The Greening of the Balance Sheet,” Harvard Business Review (March 2006), pp. 27–28; M. Gunther, “Carbon Finance Comes of Age,” Fortune (April 28, 2008), pp. 124–132. during the same period. The outcome of this comparison might suggest that further investigation into the manufacturing process is necessary. If a company is reporting strong net income growth but negative cash flow, this would suggest that the company is relying on something other than operations for earnings growth. Is it selling off assets or cutting R&D? If accounts receivable are growing faster than sales revenues, the company is not getting paid for the products or services it is counting as sold. Is the company dumping product on its distributors at the end of the year to boost its reported annual sales? If so, expect the distributors to return the unordered product the next month, thus drastically cutting the next year’s reported sales. Other “tricks of the trade” need to be examined. Until June 2000, firms growing through acquisition were allowed to account for the cost of the purchased company, through the pooling of both companies’ stock. This approach was used in 40% of the value of mergers between 1997 and 1999. The pooling method enabled the acquiring company to disregard the premium it paid for the other firm (the amount above the fair market value of the purchased company often called “good will”). Thus, when PepsiCo agreed to purchase Quaker Oats for $13.4 billion in PepsiCo stock, the $13.4 billion was not found on PepsiCo’s balance sheet. As of June 2000, merging firms must use the “purchase” accounting rules in which the true purchase price is reflected in the financial statements.7 CHAPTER 12 GLOBAL Suggestions for Case Analysis 371 issue FINANCIAL STATEMENTS OF MULTINATIONAL CORPORATIONS: NOT ALWAYS WHAT THEY SEEM A multinational corporation follows the accounting rules for its home country. As a result, its financial statements may be somewhat difficult to understand or to use for comparisons with competitors from other countries. For example, British firms such as British Petroleum use the term turnover rather than sales revenue. In the case of AB Electrolux of Sweden, a footnote to an an- nual report indicates that the consolidated accounts have been prepared in accordance with Swedish accounting standards, which differ in certain significant respects from U.S. generally accepted accounting principles (U.S. GAAP). For one year, net income of 4,830m SEK (Swedish kronor) approximated 5,655m SEK according to U.S. GAAP. Total assets for the same period were 84,183m SEK according to Swedish principle, but 86,658m according to U.S. GAAP. The analysis of a multinational corporation’s financial statements can get very complicated, especially if its headquarters is in another country that uses different accounting standards. See the Global Issue for why financial analysis can get tricky at times. COMMON-SIZE STATEMENTS Common-size statements are income statements and balance sheets in which the dollar figures have been converted into percentages. These statements are used to identify trends in each of the categories, such as cost of goods sold as a percentage of sales (sales is the denominator). For the income statement, net sales represent 100%: calculate the percentage for each category so that the categories sum to the net sales percentage (100%). For the balance sheet, give the total assets a value of 100% and calculate other asset and liability categories as percentages of the total assets with total assets as the denominator. (Individual asset and liability items, such as accounts receivable and accounts payable, can also be calculated as a percentage of net sales.) When you convert statements to this form, it is relatively easy to note the percentage that each category represents of the total. Look for trends in specific items, such as cost of goods sold, when compared to the company’s historical figures. To get a proper picture, however, you need to make comparisons with industry data, if available, to see whether fluctuations are merely reflecting industry-wide trends. If a firm’s trends are generally in line with those of the rest of the industry, problems are less likely than if the firm’s trends are worse than industry averages. If ratios are not available for the industry, calculate the ratios for the industry’s best and worst firms and compare them to the firm you are analyzing. Common-size statements are especially helpful in developing scenarios and pro forma statements because they provide a series of historical relationships (for example, cost of goods sold to sales, interest to sales, and inventories as a percentage of assets) from which you can estimate the future with your scenario assumptions for each year. Z-VALUE AND INDEX OF SUSTAINABLE GROWTH If the corporation being studied appears to be in poor financial condition, use Altman’s Z-Value Bankruptcy Formula to calculate its likelihood of going bankrupt. The Z-value formula 372 PART 5 Introduction to Case Analysis combines five ratios by weighting them according to their importance to a corporation’s financial strength. The formula is: Z  1.2x1  1.4x2  3.3x3  0.6x4  1.0x5 where: x1 x2 x3 x4 x5  Working capital/Total assets (%)  Retained earnings/Total assets (%)  Earnings before interest and taxes/Total assets (%)  Market value of equity/Total liabilities (%)  Sales/Total assets (number of times) A score below 1.81 indicates significant credit problems, whereas a score above 3.0 indicates a healthy firm. Scores between 1.81 and 3.0 indicate question marks.8 The Altman Z model has achieved a remarkable 94% accuracy in predicting corporate bankruptcies. Its accuracy is excellent in the two years before financial distress, but diminishes as the lead time increases.9 The index of sustainable growth is useful to learn whether a company embarking on a growth strategy will need to take on debt to fund this growth. The index indicates how much of the growth rate of sales can be sustained by internally generated funds. The formula is: g* = 3P11 - D211 + L24 3T - P11 - D211 + L24 where: P D L T  (Net profit before tax/Net sales)100  Target dividends/Profit after tax  Total liabilities/Net worth  (Total assets/Net sales)100 If the planned growth rate calls for a growth rate higher than its g*, external capital will be needed to fund the growth unless management is able to find efficiencies, decrease dividends, increase the debt-equity ratio, or reduce assets through renting or leasing arrangements.10 USEFUL ECONOMIC MEASURES If you are analyzing a company over many years, you may want to adjust sales and net income for inflation to arrive at “true” financial performance in constant dollars. Constant dollars are dollars adjusted for inflation to make them comparable over various years. One way to adjust for inflation in the United States is to use the Consumer Price Index (CPI), as given in Table 12–2. Dividing sales and net income by the CPI factor for that year will change the figures to 1982–1984 U.S. constant dollars (when the CPI was 1.0). Adjusting for inflation is especially important for companies operating in the emerging economies, like China and Russia, where inflation in 2008 rose to 6.6%, the highest in 10 years. In that same year, Zimbabwe’s inflation rate was the highest in the world at 2.2 million%!11 Another helpful analytical aid provided in Table 12–2 is the prime interest rate, the rate of interest banks charge on their lowest-risk loans. For better assessments of strategic decisions, it can be useful to note the level of the prime interest rate at the time of the case. A decision to borrow money to build a new plant would have been a good one in 2003 at 4.1% but less practical in 2007 when the average rate was 8.1%.