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The case presents the student with financial ratios for eight pairs of unidentified companies
and asks them to mate the description of the company with the financial profile derived from the
ratios. The primary objective of this case is to introduce students to financial ratio analysis—in
particular, the range of ratios and the insights each one affords. This case presumes that students
have already been introduced to the definitions of various financial ratios through other readings
or lectures.
Discussion leadership of this case can be fairly straightforward. One could simply proceed
through the eight industries. There are, however, several teaching tactics that could enhance the
success of the learning experience:
Call on a different student to resolve the question in each industry. This case is an excellent
vehicle for bringing out the quiet or less confident student through a “cold call.” The task
is objective, so the student’s personal exposure is limited. If one asks the students to
choose the industry that they wish to address, the easier pairs (computers, retail, books
and music, and beer) tend to be dispatched first, while the harder pairs (health products,
paper, newspapers, and tools and hardware) will be dealt with later in the discussion. The
teacher might anticipate this by saving the “cold calls” until later in the class for students
suspected to be a little stronger than those that were called upon earlier. The result is good
pacing. The easier comparisons build upon the students’ confidence to tackle the harder
comparisons, and the harder comparisons lay the groundwork for closing comments by the
instructor.
Format the chalkboards in advance of class, writing the industry names as column
headings, with the company letters below them. During the class discussion, the instructor
can record the salient characteristics of the companies mentioned by the students in the
various columns. When the student exhausts the important observations, the instructor can
ask the student to identify the company in each pair.
Before asking students to cite the pertinent numbers, it may be useful to first ask them to
discuss the salient qualitative features of each company and the differences between the
pairs. Then ask them to describe what they would expect to see intuitively in the data
based on their prior observations. That approach tends to focus the discussion on the key
issues and discourages a mind-numbing recitation of the numbers. Indeed, one of the
important objectives of this case is to encourage students to focus on deriving practical
insights rather than on giving an “elevator analysis” (for example: this figure is up or that
figure is down). If the instructor is dealing with novices in finance, repeated
encouragement toward substantive conclusions may be necessary.
Maintain suspense. Students often ask for the correct answers as each industry is
discussed. By deferring the correct answers until the end, however, the instructor can use
the answers as a platform on which to give some general summary comments on the
nature of ratio analysis.
Manage your time carefully. The early (easy) industries can absorb more time than they
objectively require. The harder industry comparisons deserve more time because through
them, the students learn more about the limitations of ratio analysis. Moreover, since the
case raises many mechanical and substantive issues, it is worth leaving 15 minutes at the
end of class to survey the issues and get closure on them.
Case 6 The Financial Detective, 2005 49
Case Analysis
This case is primarily about the effects of managerial strategy on financial ratios, but it also
affords several insights about the effect of industry differences on financial ratios. For instance,
differences in asset intensity can produce dramatically different asset structures (for example,
compare the percentages of inventory and net property, plant, and equipment [PP&E] for paper
products with computers). The rate of technological change can manifest itself in several ways
including the reinvestment rate required to stay competitive (for example, compare dividend-
payout ratios for newspapers, and books and music). Industry structure is believed to affect the
profitability through the pricing power of the firm. The newspaper industry can be characterized
as locally oligopolistic (in some areas, however, monopolistic); the discount retail industry is
much more competitive in structure. The gross profit margins of the two industries differ
substantially.
The general insight for students must be that, in conducting the financial analysis of a firm,
one must understand the nature of the industry.
Table TN1 and Exhibit TN1 summarize the identities of the 16 firms. I usually withhold
the identities until the conclusion of the class period so that students will reason from the financial
data, rather than from other knowledge that they may have about those companies. Table TN1
also highlights the industry pairs that have proven to be relatively easier and harder 1 for the
students to sort out.
1 It might be possible to produce pairwise comparisons that were equally easy. The point of this exercise,
however, is to stimulate reflection on the uses and possible abuses of financial ratio analysis. The fact is that ratio
analysis of some companies will leave the analyst as puzzled as before—the instructor could emphasize that if this
happens, the analyst has not necessarily failed. Thoughtfully done, good ratio analysis should generate questions
for further analysis. Thus, puzzlement and closure are not necessarily the measures of effective analysis; reasoning
and inquiry are.
50 Case 6 The Financial Detective, 2005
LEVEL OF
IDENTITIES OF PAIRS OF COMPANIES CHALLENGE
Turning to the pairs of comparisons, we seek to impress upon the students the impact that
different business strategies will have on the financial ratios of the companies.
Gross margin: Company B’s gross margin is more than 12% higher than company A’s,
which reflects the higher input costs for company A’s medical diagnostics and devices product
segment, as well as the higher prices that company B can charge on ethical prescription
pharmaceuticals.
Case 6 The Financial Detective, 2005 51
Inventory turnover: Company A turns over its inventories far more quickly than company
B. Company A markets its consumer products to retailers, which have high-turnover orientations,
while company B sells almost exclusively to institutions and pharmacies, which may take longer to
exhaust their supplies.
Net profit margin: Many of company A’s products are branded consumer products that
command a price premium. Company B’s patented products also command a price premium.
Company B’s premium is higher than company A’s, reflecting the benefits of patent protection on
prescription pharmaceuticals, and the additional returns needed to support company B’s large
research and development (R&D) efforts.
Net fixed assets: Company C shows a relatively high level of property, plant, and
equipment (PP&E), which is consistent with its status as a major brewery. Company D has much
lower net fixed assets since much of N’s brewing operation is outsourced. Company C’s higher
fixed assets are also due to its other holdings such as theme parks.
Gross profit versus net profit: Company D has higher gross profit, consistent with the
premium pricing of its specialty brews versus the mass-marketing approach that was taken by
company C. Conversely, company C’s net profit margin is almost three times greater than
company D’s. This may reflect the economies of scale that company C can achieve through its
large size, relative to company D.
Current ratio: Company D’s current assets to current liabilities ratio is three times greater
than company C’s, whose current ratio is less than one, illustrating a careful financial approach.
Debt to assets and equity: Again, the relatively low level of debt may demonstrate the
company’s commitment to financially conservative policies. (An alternative explanation is that, as
a younger firm, company D has had less access to debt financing than would a more mature
company.)
Inventory turnover: Consistent with company C’s mass-market approach, C’s inventory
turnover is significantly higher than D’s turnover.
52 Case 6 The Financial Detective, 2005
Asset turnover: Due to the relatively low level of assets required (because of outsourcing),
company D’s asset turnover is much higher. C’s lower turnover is consistent with a firm that owns
its manufacturing facilities as well as asset-intensive theme parks.
Case 6 The Financial Detective, 2005 53
Cash and short-term investments percentage: The computer and software industry is
notoriously volatile. Company F, led by its charismatic founder, has recently emerged from a
particularly turbulent period, which could have resulted in the firm’s demise. Therefore, company
F’s extremely large holdings of cash and cash equivalents may represent the company’s efforts to
insure itself against any future difficulties.
Gross profit versus net profit: Company F has higher gross profit, consistent with the
premium pricing of its highly differentiated product designs versus the commodity-product
approach of company E. Conversely, company E’s net profit margin is almost twice as large as
company F’s, which reflects company E’s low-cost focus.
SG&A percentage: Company E has a lower SG&A percentage, consistent with its low-
cost mail-order strategy. Company E’s higher SG&A reflects the costs associated with its unique
retail store concept.
Receivables turnover: Company F has a higher receivables turnover, reflecting the fast
payments made by consumers in the form of credit card purchases.
Fixed asset turnover: Company E’s turnover is more than twice as large as F’s. This might
reflect E’s strategy as an assembler of components that have been manufactured by its suppliers.
Books and music: companies G and H
54 Case 6 The Financial Detective, 2005
Company G is Amazon.com: the on-line retailer of books and music, plus a variety of
other consumer goods. Company H is Barnes & Noble, Inc., the largest bookseller in the
United States, with more then 800 brick-and-mortar bookstores. The key differences between
those two firms primarily derive from one being an established, traditional retailer and the other
being a relatively new, on-line business.
Cash and short-term-equivalents percentage: Company G has more than half of its assets
in cash and cash equivalents, which may reflect the firm’s readiness for implementing its
acquisition strategy. (Alternatively, this conservative position may illustrate the carefulness that is
required in the volatile on-line retail business.)
Net fixed assets percentage: Company G, an on-line retailer, needs far fewer fixed assets
than company H, the bricks-and-mortar bookseller, to sell its merchandise. Company G’s
percentage of net fixed assets is, therefore, significantly higher.
Long-term-debt percentage: More than half of company G’s percentage of total liabilities
& equity is comprised of long-term debt. This may be because company G, unable to raise capital
in a post dot-com bust environment, sought financing through the debt market to fund its
acquisitions.
Beta: Company G’s beta is more than three times higher than company H’s, which
illustrates the relatively higher risk of company G, which only recently began to post positive net
income.
Inventory turnover: Given its ability to keep relatively low inventories, it is not surprising
that company G would also be able to manage a high turnover ratio. Since company H must
maintain high stocks of merchandise, it has a correspondingly lower inventory turn.
Net profit margin: Company H has a lower net profit margin than company G, which
reflects company H’s regular discount strategy.
Case 6 The Financial Detective, 2005 55
SG&A expense percentage: Company I’s selling, general, and administrative expense are
higher than company J’s, which may reflect the higher costs associated with being a large
company. (Note how those higher SG&A costs flow through the income statement, such that
company J’s net profit margin is ultimately higher than I’s.)
Company K is the Black and Decker Corporation, which manufactures and markets a
broad range of power tools, primarily for consumer use. Company L is Snap-on Inc., also a
manufacturer of tools and other hardware, but the company is known for its high quality
merchandise and for its direct sales to professional mechanics and commercial technicians.
Gross profit percentage: Company K sells lower-priced products intended for the
consumer market, whereas company L markets higher margin precision tools for the commercial
customer. As such, company L’s gross profit percentage is measurably higher than K’s.
SG&A expense percentage: Company L has a higher level of selling, general, and
administrative expenses, which corresponds to the costs associated with maintaining its large
direct sales force. (This flows through the income statement, leading to a lower net profit margin
and a lower return on equity for company L versus company K).
Dividend payout ratio: Company L’s payout ratio is more than four-and-a-half times
greater than K’s, which may suggest its need to maintain a high rate of reinvestment to remain
competitive.
56 Case 6 The Financial Detective, 2005
Case 6 The Financial Detective, 2005 57
Receivables turnover: Company M has a higher receivables turnover, due to its lower use
of credit sales.
Net fixed assets: As a largely centralized operation, company P has a significantly higher
level of net fixed assets than company O; in addition, this reflects company O’s recent investment
in a large corporate headquarters.
Cost-of-goods-sold percentage: Company P’s level of cost of goods sold is lower than
company O’s, which may suggest that as a larger centralized company, company P may be in a
better position to negotiate for volume discounts on inputs, such as newsprint.
SG&A expense percentage: Although the case states that firm O is decentralized
(suggesting, for instance, duplicative editorial and business functions at its many small
newspapers), the SG&A percentage is slightly lower for this firm. One possible explanation is that
high prices may be masking a relatively high SG&A expense. A way to determine this would be to
examine performance ratios such as subscriptions or advertising revenue per employee
58 Case 6 The Financial Detective, 2005
(unfortunately, the case does not present these data). This is a learning point for the student: how
ratio analysis begets more questions and analysis.
Net profit margin: Company O’s net profit margin is higher, which may reflect the “local
monopolies,” or at least less intense competition outside of the major metropolitan newspaper
markets.
After surveying the industries and revealing the identities of the firms, a useful closing for
the instructor is to summarize the determinants of the big differences between firms in the same
industries:
Product mix
Asset mix
Financial policy
It is important for students to observe that all those elements are based largely on
decisions that managers make, as opposed to luck or the dictates of the environment. To grasp the
relationship between managerial choice and financial performance is to lay the groundwork for
understanding the rich range of alternatives at management’s disposal for achieving financial
goals.
At the end of class, the instructor can also make a number of observations about the art of
ratio analysis. For instance:
Ratio analysis is only as good as the financial statements that underlie it. In particular, one
needs to understand the accounting policies that generated the statements. The various
treatments of goodwill, lease obligations, and equity interests in subsidiaries appear in the
discussions. In addition, the absence of data can frustrate ratio analysis.
Frameworks such as the DuPont system of ratios and categories of ratios (activity,
profitability, liquidity, and leverage) are useful organizing schemes for an analysis.
Naïve ratio analysis can absorb considerable time, as one seeks to find a pattern (any
pattern) in the blizzard of numbers. Effort is economized by thinking first about the
underlying business that generated the ratios.
Exhibit TN1
58
THE FINANCIAL DETECTIVE, 2005
Case Exhibit 1, with the Names of the Companies Revealed