Hello, I'm Professor Brian Bushee.Welcome back.This video kicks off a three videosequence where we're going to useracial analysis to study the case ofa growth company, and see what wecan learn about the sources of theircompetitive advantages and disadvantages.I can't wait, let's get started.Let's start with some backgroundon Plainview Technology.So, Plainview manufactures iris scanningequipment for biometric identification.In 2009,Plainview lost its largest customer,a defense contractor which accounted forhalf of its business.The customer transferred its businessto a foreign competitor which had lowerlabor costs.Plainview managers respondedby increasing automation.They also built newplants in California andSouth Carolina to becloser to their customers.Plainview expanded into new industries,healthcare,financial institutions, nuclear power.They switched from high volume standardproducts to smaller batch customizedproducts.In 2010,Plainview adopted new 6G technology,which provides better manufacturingresults at a lower manufacturing cost.The companies experienced explosivegrowth after surviving its crisis.And has now picked up a greaterfollowing by analysts and investors.A new analyst has just a few hoursto prepare before participating ona conference call withPlainview Technology management.The only information they haveare the financial statements and ratios.Based on the ratios, what seems to bethe secret of the company's turn around?And what questions would youask management during the call?Before we take a look at the ratios Ialways think it's a good idea to startwith the financial statements.Take a look at the balance sheet, theincome statement, and cash flow statementto see if there's any trends thatjump out at us or seem unusual.Then we can keep those in the back ofour minds as we go through the ratios.So here's the assets side ofthe balance sheet for Plainview.I'm going to put up the pause sign andrecommend that you pause the video.Take a minute or soto look over the balance sheet andsee if there's anything that jumps outat you and then resume the video andwe'll talk about what you're seeing.>> It certainly appears thatPPND has grown substantially.>> There also is a huge jump in inventoryand accounts receivable after 2009.>> Yes, butthe whole company has gotten bigger.Look at total assets.Do you have a point thatyou are trying to make?>> Yes Dave, I do have a point.My point is that the balance sheetis a good starting point to try tolook at what's going on in the company.Eric noted that there were big increasesin accounts receivable and inventory.Elizabeth noted that therewere big increases in PP&E.We probably want to understand those.But you're right that ifI company is growing somuch as a whole,It's hard to interpret the balance sheet.And so later on we'll look at techniquesthat will take out the effects of thisgrowth and let us know whether line itemson the balance sheet are growing faster orslower than other line items.Here is the liabilities and stockholders'equity side of the balance sheet,so please again pause the video.Take a look, and see what you find.>> Well,I would say that long term debt, andpaid in capital have grown tremendously.>> Hey I wanted to go first this time.Accounts payable has grown similar toinventory and accounts receivable.But current liabilitiesare actually down in 2011.>> But, you are going to pop in and tellus again that the whole company is growingand we can't learn anything untilwe remove the effects of growth.And yada, yada, yada.>> Yes, that's what I was going to say.That it's hard to draw toomany conclusions from thispart of the balance sheet withouttaking out the effects of growth.But there are a few things that sortof leap out as we look through this.So for instance current liabilitieswent down even though the company grewsubstantially.So there are some things that youcan occasionally learn by looking atthe balance sheet as a starting point.Next we're going to lookat the income statement.Here are the last three yearsof income for Plainview.Please pause the video andsee what trends leap out at you.>> Well, it looks like->> It looks like sales.Gross profit, operating income, andnet income are all growing stupendously.>> And yes, we will have to removethe effects of growth to understand thisbetter, which we'll do later in the video.Next we have the statement of cash flows.We're going to start with the operatingsection that shows you cash flows fromoperating activities,please pause the video and take a look.>> Ladies first.Even though net income hasbeen growing steadily,cash from operations is, forlack of a better term, quite squirrely.>> Squirrely?Is that some strange jargon for volatile?Look at those big negatives forinventory and accounts receivable.>> Yes, those negatives matchthe growth we saw on the balance sheet.Now I think we are getting somewhere.>> We are getting somewhere.We see a lot of volatility in cash flows,andit looks like a lot of it is drivenby accounts receivable and inventory,which we saw big movementson on the balance sheet.We are getting somewhere.Here are the investing and financingsections of the statement of cash flows,along with the supplemental disclosures ofcash interest paid and cash taxes paid.So, again, pause the video andtake a look.>> Although lending, the capitalexpenditures, proceeds from borrowing, andcommon stock issued mirroredthe growth in PP&D, debt, andinequity on the balance sheet.>> Yes.This part of the statement showsus the company's growing substantiallythrough capital expenditures.We don't see any acquisitions listedhere so it's all internal capex.Which makes sense because from the casewe know they built two new factories.And they're financing this growthwith both debt and equity, sowe see a lot of cash flowfrom debt issuances, andwe see some cash flow froma couple of equity issuances.So they're financing themselveswith both debt and equity.Now that we've taken a look atall their financial statements,I want to talk about something calledcommon size financial statements.As we've talked about,it's hard to spot trends in the financialstatements when there's tremendous growth.Basically, the growth in assets andgrowth in sales drive trends inall of the other line items.What we really want to know is,are certain line items growing more orless than would be expected giventhe overall growth in assets or sales.So we're going to come up with a commonside balance sheet where we'll expressall numbers as a percentageof total assets,which will remove the effectof the growth at assets.We'll come up with a common sizedincome statement, where we'll expressall numbers as a percent of salesthereby taking out the growth in sales.The cash flow statement istypically not common sized.It's not as susceptible to growth.And it's not clear what we woulddivide by to common size it.So it's only the balance sheet andthe income statement thatare typically common sized.Here's the common sized balance sheet forplain view.Specifically the asset side.So why don't you pause and take a look.>> Even though PP and T was growing somuch this makes it looklike it is shrinking.It is really inventory thatis growing splendously.>> Yes, Elizabeth, nice catch.It is inventory whose growth is out ofwhack compared to the rest of the company.And we saw earlier that inventoryhad negative affects on cash flow.So we're going to want to pay closeattention to what's going on withinventory as we go throughthe rest of these videos.Here is the liability andstockholder's equity side of the commonsize balance sheet, so again,pause take a look and see what you see.>> These numbers look much more,as Elizabeth would say, squirrely.The biggest trend is the increasein liabilities relative to equity.>> Yes Eric.The big conclusion we would drawhere is that the numbers seem tobe squirrely on the liability andstockholders equity side.There doesn't seem to bea lot of clear trends.The numbers are bouncing up and down.The only trend that really emerges istotal equity has gone down as a percentof liability, since stock equals equityover time, which means the company isrelying more on debt financing and otherliabilities, and less on equity financing.>> Andhere is the common size income statement,where everything hasbeen divided by sales.Please pause and take a look.>> Gross profit percentagehas gotten bigger.But isn't this a video on the ratios?When are we going tostart looking at ratios?>> Well Dave these technically are ratios.We're dividing numbers by sales.And any time you divide one numberby another number it's a ratio.But he picked up the key thinghere which is there is a clearincreasing trend in the grossprofit margin ratio.And that increase in gross marginhas driven the increase inoperating income ratio,and the net income ratio.We're going to look at this moreas we go through the videos.Finally we have the DuPont analysis.Here is the return on equity forPlainview, and then it's broken down intoall of its components with the definitionsat the bottom of the slide.Why don't you pause the video for a minuteor two, take a look at the slide andsee what kind of conclusions you draw.I'm going to go ahead andpop in here and analyze this one.For return on equity, we see a large andincreasing trend in ROEover the three year period.It started at 11%, which meant that forevery dollar of equity,the company generated $0.11 of net income,and now it's 16%.So for every dollar of equity, the companygenerates $0.16 of net income, soeach dollar of equity is generatingan extra nickel of net income,which is a pretty big increaseover a three year period.Now, let's look at the two drivers of ROE,return on assets and financial leverage,to see if Plainview's increase in ROE isdue to better operating performance orto taking on more debt.So if we return on assets, we see thatit increased from 7% to almost 10%,which means that every dollar inassets is now generating about $0.10of that income for Plainview comparedto only seven cents a couple years ago.So, clearly, there's been an improvementin operating performance.If we look at financial leverage,it's been fairly flat over this period,around 2.3.So, for every dollar of equity,Plainview has $2.30 of assets,which means they're taking on about $1.30of debt and that really hasn't changed.So, it seems like the increase in ROE isprimarily driven by the improvement inreturn on assets.Now let's look at the two drivers ofreturn on assets, return on sales, andasset turnover.We see another increasingtrend in return on saleswhich means that Plainview sales havebecome more profitable over this period.ROS has gone from 5% to almost 7%, soeach dollar of sales now generatesalmost $0.07 of net income.Instead of $0.05.What's $0.02?Well if you multiply it timesa hundred million in sales it adds uppretty quickly.Now if we look at asset turnover,it briefly went up andthen came back down to around 1.45,which means that forevery dollar of assets Plainviewgenerates about $1.45 in sales butthere is no clear upwardtrend in asset turn over.So it looks like the sole secretto Plainview success with the ROEis that sales have become moreprofitable over this period.>> You said last video that ROEequals ROA times financial average.In 2011, 9.68 times 2.28 is 22.1,not 16.4, just another ina long line of your mistakes.>> This actually isn't a mistake.It's a simplification.So if you remember from last video thereturn and return in equity is net income.But the return andreturn on assets is the lever net income.Which is net income plusafter-tax interest expense.Because the returns are different,it won't multiply together.To get it to multiply together cleanly,you have to add third factor, ora correction factor, which would be netincome divided by after-tax net income.If you multiply that thirdfactor times ROA andfinancial leverage, then you will get ROE.>> Didn't Plainview adoptthe new 6G technology?Maybe every company in the industry hoppedback to profitability as a result ofthe new technology>> Excellent point, Elizabeth.What we talked about in the earlier videois that we need to do cross-sectionalcomparisons.So what I'll do next is compare Plainviewto three of their closest competitors.If you look at the industry,it looks like Plainview ishaving much more success thantheir other three competitors.They're the only company that hadan increase in ROE over this time period.Their ROA was also up, whereas twoof their competitors were down andone was up and then down.They're the only company that hadan increase in return on sales,the other three companieswere either down orflat and there doesn't seem to be muchdifference in terms of asset turnover.So to wrap up, what we learnedfrom the DuPont analysis is thatthe big increases in ROE forPlainview were unique for the industry.Plainview was clearly doing somethingthat the rest of the industry was notable to do.Plainview's improved ROA wasthe source of its increase in ROE.It didn't take on more data,it didn't lever up because financialleverage was largely unchanged.Instead, the ultimate source ofthe ROE increase was improvement inprofit margin or return on sales.In contrast to the competitors,Plainview's return on sales grewdramatically over this period,whereas its asset turnover was flat,much like the competitors.So, the secret to Plainview's successis that their sales became much moreprofitable between 2009 and 2011.>> Okay, but how were they ale tomake their sales more profitable?Can ratio analysis tell us that?>> Well, I do have a fewmore ratios up my sleeve andwe can take a look atthose in the next video.Yes, let's wrap up here.And I'll see you next video,when we continue the ration analysis forPlanview technology.See you then.>> See you next video.