Effect of Industry Characteristics on Financial Statement Relationships.
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 to identify the company with that unique characteristic. Another approach begins with the common-size data, identifies unusual financial statement relationships (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. Firm (10) has a high proportion of receivables among its assets and substantial borrowing in its capital structure. This balance sheet structure is typical of the finance company, HSBC Finance. Why do 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 cash flows in the future 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. How can this firm justify recognizing interest revenue on its loans as it accrues each period when it has an uncollectible loan provision of 27.1 percent 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 27.1 percent provision does not mean that the firm experiences defaults on 27.1 percent of its customers each year. The percentage for depreciation and amortization includes the amortization of the cost of establishing loans. HSBC Finance capitalizes these costs (included in Other Assets) and amortizes them over the term of the loan. The cash flow from operations to capital expenditures ratio is high because of the low capital intensity of this firm. Firm (12) 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, 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. 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 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. 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, filing fees with state insurance regulators). Why do insurance companies do not write this amount off 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 research and development (R&D) expenditures, Firm (4), Firm (5), Firm (6), and Firm (9). Dupont, Hewlett-Packard, Merck and Procter & Gamble will all incur costs to discover new technologies or develop new products. Firm (9) has the highest R&D expense to revenues percentage, the most fixed assets per dollar of sales, and the highest profit margin. This firm is Merck. Pharmaceutical companies must invest heavily in new drugs to remain competitive. The drug development process is also 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 also relatively price inelastic, both 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 expenses to revenues percentage. This high percentage reflects both 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 many of its computer components and will therefore not have as much property, plant and equipment. Thus, Firm (4) is Hewlett-Packard. Why does Hewlett-Packard have 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. Products life cycles are short, 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 (5) and Firm (6) as being Dupont and Procter & Gamble in some combination. Firm (5) has a lower cost of sales to revenues percentage and a higher selling and administrative expense to revenues percentage. It also has a higher profit margin than Firm (6). 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. The low cost of sales percentage reflects the relatively low cost of ingredients in most of its products and the high selling prices it can charge. One final clue is that investments in R&D are less critical for a consumer products company than for firms where technology development is important. Note that Procter & Gamble shows a high percentage for intangibles, the result of goodwill and other intangibles from companies it has acquired.
This leaves Firm (6) as Dupont. Its income statement percentages are similar to those for Hewlett-Packard. It carries more debt than Hewlett-Packard, related to Dupont’s borrowing to finance its more capital-intensive operations. We move next to Pacific Gas & Electric. Utilities are very capital intensive and carry high levels of debt. Firm (11) displays these characteristics. Note that depreciation and amortization as a percentage of revenues is the highest for this firm, reflective of its capital intensity. Its interest expense to revenues percentage is also the second highest among these firms, which one would expect from the high levels of debt.
We move next to the two service firms, Kelly Services and Omnicom Group. Neither firm will have a high proportion of property, plant and equipment. Thus, Firms (1), (2), and (8) 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 (1) and Firm (8) are the most likely candidates. One would expect the value added by employees of Kelly (temporary help services) would be less than that of Omnicom (creative advertising services). Thus, Firm (1) is Kelly and Firm (8) is Omnicom. Another clue that Firm (1) is Kelly is that receivables relative to operating revenues indicate a turnover of 6.8 (=100.0%/14.6%) times per year and current liabilities relative to operating expenses indicate a turnover of 8.7 (= 84.0%/9.7%) times per year. The corresponding turnovers for Firm (8) are 2.0 (= 100.0%/50.4%) and .8 (= 70.2%/89.7%). One would expect faster turnovers for a temporary help business that pays its employees more regularly for temporary work done. One would expect even higher turnovers for Kelly Services than those above for Firm (1). 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 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 (8) indicate the agency nature of advertising firms. Firm (8) shows a relatively high proportion for intangibles, consistent with recognizing goodwill in the acquisition of other marketing services firms by Omnicom in recent years. Neither firm has much longterm debt, consistent with the low collateral value of its assets (primarily employees). The surprising result is that the cash flow from operations to capital expenditures ratio for Kelly is so low. Given its low capital intensive, 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, McDonalds. The firm should have inventories but its inventories should turn over rapidly. The remaining firm with the lowest inventory percentage is Firm (7), representing McDonalds. Note that the firm has a high proportion of its assets in property, plant and equipment. McDonalds owns its company-operated restaurants and owns but leases other restaurants to its franchisees. The relatively high profit margin percentage results from McDonalds dominance in its market and its brand name.
We are left with two unidentified firms in Exhibit 1.16, Firm (2) and Firm (3) and they are Abercrombie & Fitch and Best Buy in some combination. Both of these firms have inventories. Firm (3) has substantially more property, plant and equipment per dollar of sales and a much higher profit margin than Firm (2). 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 the cost of store space for Best Buy to be less than that of Abercrombie & Fitch, since the latter firm tends to locate in malls. Thus, Firm (2) is Best Buy and Firm (3) is Abercrombie & Fitch.