financial statement analysis business ratios

Financial Statement Analysis: Business

Ratios

As stated in the introduction, financial statement analysis is a set of techniques to analyze the financial performance of a company, to assess its strengths and weaknesses, and to compare it to other firms in the same industry. This is important to both investors in the financial markets and managers in the firms.

Figure 1: Capital Markets

Three major decisions made by managers of a firm are the investment, financing and dividend decisions. These decisions are important for financial statement analysis because the major statements result from the firms decision. As a result, over time various measures have evolved to provide insight into and assess the performance of these decisions. An overview of these measures and their interrelationships is depicted in the following figure:

Financial Statement Analysis: Business RatiosMonday, 26 May 201411:05

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Figure 2: Financial Statement Analysis: A Conceptual FrameworkIn this chapter we will work through the above flow chart so that you acquire:

Conceptual skills required for understanding this flowchart,

Practical skills associated with what the metrics are and how they are constructed using current real world financial statements (including terminology, aggregation and critical accounting judgments)

Professional judgment skills including how to interpet and make decisions from information in the current 10-K filingsTo reinforce important concepts and measures we will reconcile each metric using the 2010 10-K filing of Procter and Gamble (PG) and demonstrate how you can immediately extend this to any current filing with the SECThe Valuation Tutor software for this Chapter is organized as follows:

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3.3 Fundamental Growth

The shareholders of a company are residual claimants. This means that they own what would be left after all other obligations of the company have been paid. The value of what they own is called the shareholders equity, calculated as the difference between the assets and the liabilities. This is what they would get if the company was liquidated; if the assets are worth less than the liabilities, they would get nothing. It also represents the net investment in the firm made by the shareholders. Shareholders equity comes from stock sold by the company and retained earnings. So growth in shareholders equity, which is what ultimately creates shareholder value, is fundamentally related to earnings (equivalently, net income) growth. Net income is the bottom line, and is what can be paid to shareholders or retained (reinvested) by the firm. So when you buy a stock, you buy a share of future earnings; if these are expected to grow quickly, you will be willing to pay more for the stock. How well the company performed on behalf of shareholders in generating the earnings is measured by the Return on Equity (ROE). ROE is the net income divided by the shareholders equity. Over time, shareholders equity grows if additional stock is issued or through retained earnings. The net income is the money earned from the investment made by shareholders, and so the ROE measures the return on this investment and therefore ROE is intimately related to growth. As a result, our starting point when introducing business ratios is the growth of shareholders equity.Consider a firm that does not pay dividends; in that case, shareholders


Consider a firm that does not pay dividends; in that case, shareholders equity would grow by the amount of the net income. A little notation makes this clear. Suppose the shareholders equity at time t is St, and it grows at rate g. Then,St+1 = St(1+g)If the firm earns Et and pays no dividends, St+1 = St + Et, soSt+Et=St(1+g) and solving for g, you get:g=Et/St = ROE.If the firm pays dividends D, we get St+1 = St + Et - Dt. Let PR be the payout ratio, the percentage of earnings that are paid, so Dt=Et*PR. Re-arranging and solving for g gives:g=Et(1-PR)/St = ROE*(1-PR) = ROE*RRRR is called the Retention Ratio, the percentage of earnings retained by the firm. The growth rate, g, is called the fundamental growth and shows how the growth of shareholders equity is related to earnings. Tutor Reconciliation: Proctor and Gamble (PG)Step 1: Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in earlier. Be sure to select the August 13, 2010 10-K from the dropdown. This is displayed at the bottom of the screen as follows:

We can reconcile Fundamental Growth by selecting the Consolidated Income Statement and Consolidated Balance Sheet as follows:

Step 2: Refer to the calculator part of the Valuation Tutor screen. This has computed fundamental growth from the following fields:


Net Income per Share = $4.47Shareholders Equity per share = $21.49Annual Dividend = $1.80Dividend Payout Ratio (DPR) = 0.366 (Derived in green 1.80/4.47)Retention Ratio (RR Derived) = 0.634 (RR = 1 DPR)Step 3: Click on Calculate:

You can observe above the additional derived fields are:Retention Ratio = 0.598Return on Equity = 0.208Growth Rate = 0.125That is Proctor and Gambles current fundamental or accounting growth is 12.5% annualized. In the Valuation tutor cases you will learn how to interpret this number but first:Step 4: Where did these numbers come from?Each of the numbers can be traced back to two primary financial statements (Income Statement and Balance Sheet):


For convenience we relate the numbers in the 10-K to a summary grid as depicted below and then refer to the line numbers in the summary grid. So for example from this you can see that the Net Income is $12,736 and so on.

3.4 DuPont Analysis

As we showed, fundamental growth for a firm equals Return on Equity (ROE) times the Retention Ratio (RR):Growth = ROE * RRThe DuPont model re-expresses the accounting return on equity (ROE) as the product of the Return on Assets (ROA) and Financial Leverage (measured by Total Assets/Shareholders Equity). ROE and ROA are two major ratios that are associated with the Financial Perspective of the balanced scorecard.The DuPont decomposition has an interesting history:Among the stocks that currently make up the Dow Jones Industrial Index the


Among the stocks that currently make up the Dow Jones Industrial Index the oldest is E. I. du Pont de Nemours And Company more commonly referred to simply as DuPont. DuPont was originally a gunpowder mill founded in July 1802 by Eleuthre Irne du Pont and today is one of the largest chemical companies in the world. DuPont was a pioneer with respect to management accounting systems, including devising the accounting ratio Return on Investment (ROI). Around 1912 their ROI approach was extended by one of their financial officers, Donaldson Brown, who decomposed the ROI calculation into a product of the sales turnover ratio and the profit margin ratio. In 1914 DuPont invested in General Motors (GM) to assist the struggling automobile company. In 1920, Pierre DuPont became chairman of GM, and during his tenure implemented a pioneering management accounting system that focused sharply on planning and control. By organizing resources around this system GM grew to be the largest automobile company in the world. In 1957 DuPont had to divest itself of General Motors because of the Clayton Antitrust Act. The DuPont decomposition became popular after its successful use at GM and DuPont.As a reminder, we note that ROE = Net Income/Shareholders Equity, and ROA = Net Income/Total Assets. ROE measures the rate at which shareholder wealth is increasing, while ROA measures the productivity of the assets in generating income, and therefore measures the efficiency of the investment decision.Formally, the DuPont formula is:ROE = (Net Income/Sales) * (Sales/Total Assets) * (Total Assets/Shareholders Equity)Each term in the decomposition has a specific meaning:Profit Margin Ratio = Net Income/SalesAsset Turnover Ratio or Asset Use Efficiency = Sales/Total AssetsFinancial Leverage Ratio= Total Assets/Shareholders EquityNote that the product of the first two terms is ROA. The third term is related

to the financing decision; a highly leveraged firm has low Shareholders Equity compared to Assets, while as before, the ROA results from the investment decision. In the DuPont formula, the effects of the investment decision are further decomposed into the product of operating efficiency as measured by the Profit Margin Ratio and asset utilization efficiency as measured by Asset Turnover Ratio. Tutor Reconciliation: Proctor and Gamble (PG)

Step 1: Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2. This was displayed at the bottom of the screen as follows:

We can reconcile the DuPont decomposition by selecting the Consolidated Income Statement and Consolidated Balance Sheet as follows:


Step 2: Refer to the calculator part of the Valuation Tutor screen. This has computed DuPont decomposition from the following per share fields:

Total Assets per Share = $45.075Sales per Share = $27.761Net Income per Share = $4.479Shareholders Equity = 21.4929Step 3: Click on Calculate for the DuPont decomposition:


You can observe above the additional derived fields are:Sales/Total Assets = 0.6159 = Assets Turnover Ratio or Asset EfficiencyNet Income/Sales = 0.1613 = Profit Margin RatioReturn on Assets = 0.0994 = Product of the Asset Turnover Ratio and Profit Margin Ratio.Total Assets/Total Equity = 2.0972 = Financial Leverage RatioReturn on Equity (ROE) = 0.2084So Proctor and Gambles has enhanced its ROA by exploiting financial leverage. Later in this chapter, you will learn how to interpret these numbers but first:Step 4: Where did these numbers come from?Each of the numbers can be traced back to two primary financial statements:

For convenience we relate the numbers in the 10-K to a summary grid as depicted below and then refer to the line numbers in the summary grid. So for example from this you can see that the Net Sales is $78,938 and the


for example from this you can see that the Net Sales is $78,938 and the Total Assets are $128,172 and so on.

3.5 Extended DuPont Analysis

The Extended DuPont provides an additional decomposition of the Profit Margin Ratio (Net Income/Sales) into two burden components, Tax and Interest, times the Operating Profit Margin. This is a positive refinement of the traditional DuPont Analysis to provide a refinement of the profit margin ratio into the operating profit margin ratio by taking out the effects arising from taxes and interest expense. As a result, it provides both management and the financial analyst with finer information about a company and its immediate competitors.Formally, the Extended DuPont formula is:ROE = (Net Income/EBT) * (EBT/EBIT) * (EBIT/Sales) * (Sales/Total Assets) * (Total Assets/Shareholders Equity)Each term in the decomposition has a specific meaning:Profit Margin Ratio =Net Income/Sales now decomposes into:Net Income/Earnings Before Taxes = Tax Burden RatioEarnings Before Taxes/Earnings Before Interest and Taxes = Interest Burden RatioEarnings Before Interest and Taxes/Sales = Operating Profit MarginAsset Turnover Ratio or Asset Use Efficiency = Sales/Total AssetsFinancial Leverage Ratio= Total Assets/Shareholders EquityNet Income is measured after taxes. So if taxes are zero the tax burden equals one and so the lower this number, the higher the tax burden. Similarly, if Interest Expense is zero then interest burden ratio equals one and therefore the higher the financial leverage, the lower is this number. The advantage of adjusting for taxes and interest is to gain better insight into the firms profit margin by focusing upon the operating profit margin.Note that the product of the first four terms is now ROA. This is driven by operations, financing and the management of taxes. A nice property of the Extended DuPont formula is that one can examine the breakdown of ROA from the perspective of major firm decisions --- investment, financing and tax decisions.The remainder of this decomposition is as before. That is, the fifth term is again related to the financing decision; a highly leveraged firm has low Shareholders Equity compared to Assets. Tutor Reconciliation: Proctor and Gamble (PG)


Tutor Reconciliation: Proctor and Gamble (PG)Practical Note: Analysts vary in terms of how they apply the Extended DuPont Analysis. The most common practical variation from the above definitions is to use the US GAAP definition of income from continuing operations. The International Financial Reporting Standards (IFRS) does not make the distinction between income from continuing operations and so this practical note only applies to US GAAP.The default numbers in Valuation Tutor screens have (CO) after them to indicate that this is in relation to Continuing Operations. The reconciliation provided in this section will illustrate this for Proctor and Gamble using continuing operations. Users of Valuation Tutor can apply either definition to the net income input field and if comparing across firms you should apply the same convention.Step 1: Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2. This was displayed at the bottom of the screen as follows:

We can reconcile the Extended DuPont by selecting the Consolidated Income Statement and Consolidated Balance Sheet as follows:

You can see from the above screen that the 10-K income statement for Proctor and Gamble breaks out income from continuing operations ($15,047) and taxes on income from continuing operations ($4,101) from total income from continuing operations after tax ($10,946) versus Proctor and Gambles Total Net Income after Tax ($12,736) which was used in the previous topic 3.4.Step 2: Refer to the calculator part of the Valuation Tutor screen. This has computed the Extended DuPont from the following per share fields:


Net Income (CO, Continuing Operations) = 3.756 per shareEBT (Earnings Before Taxes) = 5.3016 per shareEBIT (Earnings Before Interest and Taxes) = 5.6343 per shareSales per Share = 27.7609 per shareTotal Assets per Share = $45.0754 per shareShareholders Equity = 21.4929 per shareStep 3: Click on Calculate for the DuPont decomposition:

The additional derived fields are:Tax Burden (CO) = 0.7261Interest Burden = 0.9410Operating Margin = 0.2030 or 20.3%Asset Turnover = 0.6159Return on Assets (CO) = 0.0854.Financial Leverage Ratio = 2.0972 Return on Equity (ROE CO) = 0.1791That is Proctor and Gambles Operating Margin is refined to reveal the margin from continuing operations after adjusting for Tax and Interest burdens. Again in the next step we verify how these numbers have been estimated from the financial statements.Step 4: Where did these numbers come from?


Step 4: Where did these numbers come from?Each of the numbers can be traced back to two primary financial statements:

For convenience we again relate the numbers in the 10-K to the summary grid as depicted below and then refer to the line numbers in the summary grid. So for example you can see that the Net Earnings from Continuing Operations after tax is $10,946 and the Total Assets are $128,172 and so on.The full reconciliation can now be traced through as follows:

3.6 Profitability Ratios

These ratios provide immediate insight into how well management is running a business. They become especially meaningful in relation to competitors in the same industry. Two closely watched profitability ratios are:Gross Profit Margin = Gross Profit / Sales = (Sales COGS)/Sales


Gross Profit Margin = Gross Profit / Sales = (Sales COGS)/SalesOperating Profit Margin = EBIT / SalesGross Margin is the difference between a company's sales and cost of goods sold scaled by Sales. The higher the gross margin usually implies the higher priced its goods and or services are. For example, if two firms are operating at similar levels of cost efficiencies but one has a higher gross margin than the other this usually implies that the higher gross margin is either charging higher prices or dealing with non commoditized goods and services that carry a higher price tag

3.7 Working Capital Ratio

Working Capital is defined as Current Assets minus Current Liabilities net of financing and tax related activities. This leads to eliminating items such as short term debt and the current portion of long term debt as well as deferred tax assets/liabilities. The problem group is cash and marketable securities. The last group is usually split between the financing and investment decisions, but predominately is influenced by the financing decision. As a result, the usual simplifying assumption is to eliminate cash and marketable securities from working capital. With these eliminations it largely consists of: Accounts Receivable, Inventory and Accounts Payable. These major components lead to the three major turnover ratios. The numerator of these turnover ratios is usually defined relative to their closest driver. For example, Accounts Receivable is driven by Sales on Account and therefore Net Credit Sales is used in the numerator if available otherwise Sales. However, under historical cost accounting Inventory as measured on the balance sheet is more closely aligned with the Cost of Goods Sold (COGS) for an external analyst. Finally, Accounts Payable is driven by Purchases and so either Purchases if available or COGS is used in the numerator for this ratio. Formally, we can define them as follows:Accounts receivable turnover = Sales/Accounts ReceivablesInventory turnover = COGS/InventoryAccounts payable turnover = Purchases/Accounts payable or otherwise COGS/Accounts PayableIn addition, turnover ratios are often expressed in terms of number of days by dividing by the turnover ratio by 365:Number of days to Collect Accounts Receivable = 365/Accounts receivable


Number of days to Collect Accounts Receivable = 365/Accounts receivable turnover Number of days to Sell Inventory = 365/Inventory turnoverNumber of days to Pay Creditors =365/ Accounts payable turnoverFinally, the Cash Conversion cycle is then the aggregate number of days for collecting accounts receivable plus the number of days required to sell inventory minus the days to pay creditors.Cash Conversion Cycle = Number of Days to Sell Inventory + Number of days to collect accounts receivables Number of Days to Pay PayablesWhen comparing across firms in some industry the extension of liberal credit may be an important part of the firms business strategy. For example, for Wal-Mart to successfully implement their business model they have to excel along the Process dimension of a balanced scorecard. This is discussed further in the following example.As a final remark, note that when valuing a firm, changes in working capital may be a significant source of funds but this can only last for a limited period of time. Ultimately, change in working capital has to settle down, you should be careful to ensure that the change in working capital is not a significant source of funds in perpetuity!Tutor Reconciliation: Proctor and Gamble (PG)Our objective is to reconcile the following from the 10-K:

Step 1: Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.3. This is displayed at the bottom of the screen as follows:

The above items deal mainly with the income statement apart from the number of shares outstanding for expressing on a per share basis.


You can stretch across a little the column 1 as displayed above to make the labels more easily displayed and read. For Proctor and Gamble you can see the Cost of products sold ($37,919) as P&G describe it and Net Sales are $78,938.Similarly, total Inventories $6,384 and scrolling down reveals the working capital items on the Balance Sheet.Step 2: Click on Calculate and we can verify the input and derived fields for the following:

Total Asset Turnover = 0.6159Working Capital per Share (CA CL) = -1.9342 per shareWorking Capital Turnover (Sales/WC) = -14.3524 per shareInventory Turnover (COGS/Inventory) = 5.94Receivables Turnover = 14.80Payables Turnover = 2.55


Payables Turnover = 2.55Days to Sell Inventory = 61.45Days to Collect Receivables = 24.67Days to Pay Payables = 69.80Cash Conversion Cycle = 16.32In step 1 we extracted the relevant aggregate numbers from the 10-K and so the full reconciliation can now be traced through as follows. The first item below being Cash and cash equivalents $2,879.

3.8 Liquidity Ratios


Liquidity ratios can be traced back to emergence of ratio analysis when banks started to demand financial statements in the latter 19th century. These ratios are designed to provide an indicator of a firms ability to repay its debts over the next twelve months. As a result, they are computed from the current assets and liabilities section of the balance sheet. Recall, the previous topic introduced working capital ratios. These ratios let a user assess how efficiently a firm is transforming its inventory into sales and how the firm is managing to collect its receivables and pay its payables. Liquidity ratios complement this working capital analysis by extending this to the analysis to assess whether a firm can meet its short run or current obligations.A further distinction can be made in the subsequent topic, between liquidity and solvency. Liquidity adopts a short run focus whereas solvency adopts a longer term focus. Solvency ratios assess whether a company is likely to be able to repay their debts in the longer run and thus whether they are a going concern. In the next section on financial leverage we introduce debt ratios that are relevant to assessing solvency.The primary liquidity ratios are the Current Ratio and its major liquidity refinements the Quick and the Cash Ratios. The Quick and Cash Ratios focus upon a firms ability to immediately repay its obligations. These are defined as follows:Current Ratio = Current Assets/Current LiabilitiesQuick Ratio = (Cash + Marketable Securities + Accounts Receivable)/Current LiabilitiesCash Ratio = (Cash + Marketable Securities)/Current LiabilitiesA major property of the Quick Ratio is that Inventory is excluded from Current Assets because this requires effort to convert into cash plus it may only be quickly convertible at a significant discount. Similarly, for Accounts Receivable but the discount is usually much smaller especially since the emergence of securitization. Securitization is the process of combining different companys accounts receivable and issuing securities against their cash flows that are sold to investors. Tutor Reconciliation: Proctor and Gamble (PG)Our objective is to reconcile the following from the 10-K:


Step 1: Bring up the Balance Sheet for Proctor and Gamble as described in section 3.2. For this example we will bring up two Balance Sheets instead of both the Balance Sheet and Income Statement. This is displayed at the bottom of the screen as follows:

For Proctor and Gamble you can see the Total Current Assets ($18,782) as P&G describe it and Accounts Receivable are $5,335.Similarly, total Inventories $6,384 and scrolling down reveals the working capital items on the Balance Sheet.Step 2: Click on Calculate and we can verify the input and derived fields for the following:


Current Ratio = 0.7735Quick Ratio = 0.3383Cash Ratio = 0.1186

3.9 Debt Ratios and Decomposing Financial

Leverage and Solvency

It is an open question whether the financing decision adds value to shareholders or not. We will make two observations here. First, we have already seen that increasing financial leverage has a positive impact upon ROE. This follows from the DuPont analysis where ROE was the product of ROA and Financial Leverage. However, it also increases risk and so equity investors will require a higher rate of return. If this higher rate of return exactly offsets the positive impact from financial leverage then it is all awash and the financing decision has no impact upon shareholder value. If the financing decision interacts with the investment decision, for example as per a financial institution then the financing decision matters. As a result, when analyzing the financing decision analysts are interested in assessing the risk of the firm and ultimately how this risk translates into changes in the cost of equity capital. We consider this issue formally in the Valuation part of this book. But first, we will analyze the financing decision and then relate it to growth forecasts for net income.Solvency versus Liquidity If a firms financial leverage becomes too high then questions arise regarding whether or not a firm is likely to be a going concern. Firms go bankrupt because they lack the cash (and or access to cash) to repay debt. Liquidity analysis adopts a short run focus and liquidity ratios are designed to assess a firms ability to meet their short term obligations. Solvency on the other hand adopts a longer term focus and Debt Ratios attempt to assess a companys ability to meet its long term obligations and thus whether it is a going concern. Recall from the DuPont decomposition that the Financial Leverage term is Assets/Shareholders Equity. Shareholders equity is defined from the basic accounting identity as: Total Assets Total Liabilities = Shareholders or Shareholders EquityDividing through by shareholders Equity and rearranging then the Financial Leverage term can be re-expressed as:Financial Leverage = Total Assets/Shareholders Equity = 1 + Total


Financial Leverage = Total Assets/Shareholders Equity = 1 + Total Liabilities/Shareholders Equity The last term is more commonly expressed relative to Total Assets as the Debt Ratio:Debt Ratio = Total Liabilities/Total AssetsThere are a number of variations to the Debt Ratio and the ones covered by the Valuation Tutor calculator are listed and defined below:Debt to Assets = (Long Term Debt + Debt Due within One Year) / Total AssetsDebt to Capital = (Long Term Debt + Debt Due within One Year) / Total EquityDebt to Equity =(Long Term Debt + Debt Due within One Year) / Shareholders EquityFinancial Leverage = Total Assets/Shareholders Equity = 1 + Total Liabilities/Shareholders EquityLong Term Debt Ratio = (Long Term Debt / Shareholders Equity)In addition, when interest expense is focused upon this also defines a coverage ratio:Interest Coverage = EBIT/EBTTutor Reconciliation: Proctor and Gamble (PG)Our objective is to reconcile the following from the 10-K:Step 1: Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2 as displayed above.

For Proctor and Gamble you will see that Debt Due within one year = $8,472 and the Long Term Debt ($21,360).Step 2: Click on Calculate and we can verify the input and derived fields for the following:


3.10 Degree of Operating Leverage and

Capacity

Degree of Operating Leverage (DOL)A firms operating leverage is defined as the percentage change in the firms operating earnings (EBIT less any non-operating income), that accompanies a percentage change in the contribution margin. That is, the operating income elasticity with respect to the contribution margin. This important number predicts for an analyst what the percentage change in operating earnings is given the percentage change in sales revenue. As a result, this number is important for predicting EBIT given the predicted growth in Sales Revenue. The consensus sales revenue forecast is readily available and the DOL provides an EBIT forecast given this consensus number.Formally, the definition of DOL is:


Formally, the definition of DOL is:Degree of Operating Leverage (DOL) = % Change in operating income / % Change in sales revenueEquivalently,Degree of Operating Leverage (DOL) = Contribution margin / EBITThis important measure reflects the fact that a change in Sales can lead to a more than proportional change in earnings from operations. In particular, the higher the degree of operating leverage the higher the predicted change. However, the relative size of the Degree of Operating Leverage is affected by how close the firm is to their break-even point. The closer the higher is the DOL.The above equivalence relationship is not immediately obvious. Understanding this requires reviewing the basics of cost volume profit (CVP) analysis first and then we will derive the above equivalence relationship. Cost Volume Profit AnalysisCost volume profit analysis studies the relationship among sales, variable costs and fixed costs. It assumes that linear costs provides a good description of real world cost behavior. From this assumption the accounting income statement can be restated in avariable costing format as follows starting from the traditional gross margin or absorption format::Absorption Costing:Sales Less COGSGross MarginLess Marketing and AdministrationNet Income from Operations (EBIT)A variable cost income statement highlights cost behavior (i.e., variable versus fixed costs) and contribution margin. This immediately ties in to a cost/volume/profit break even type of analysis:Variable CostingSalesLess Variable COGSLess Variable Marketing and Administration Contribution MarginLess Fixed OverheadLess Fixed Marketing and AdministrationNet Income from Operations (EBIT)The above format allows an analyst to immediately estimate the following important concepts:Contribution Margin (CM) = (Sales Revenue Total Variable Costs)Contribution Margin Ratio (CMR) = (Sales Revenue Total Variable Costs)/Sales RevenueSales Revenue*Contribution Margin Ratio = Contribution MarginThe usual immediate relationships to derive from cost volume profit analysis is to compute break even sales revenue and break even margins as follows:Break Even (B/E) Analysis ($Sales Revenue) = Total Fixed Costs/(Contribution Margin Ratio) Break Even (B/E) Margin = B/E $Sales Revenue/$Sales RevenueHowever, we are currently interested in deriving the equivalence relationship from the definition of DOL and the concept of contribution margin.Derivation of Equivalence Relationship for Degree of Operating Leverage (DOL)At the beginning of this topic we defined DOL and the equivalence relationship can be derived as follows:Degree of Operating Leverage (DOL) = % Change in operating income/% Change in sales revenueAssuming fixed costs remain unchanged and EBIT = Sales - Variable Costs -Fixed Costs, it follows:


Fixed Costs, it follows:%EBIT = (Sales - Variable Costs))/EBIT = CM / EBIT%Sales = Sales / SalesTaking the ratio of the above two equations and re-arranging:%EBIT /%Sales = Sales(CM/Sales) / EBIT = Sales*CMR / EBIT = CM / EBITThat is:Degree of Operating Leverage (DOL) = Contribution margin / EBITIn the next example we apply these relationships to the 10-K data:Tutor Reconciliation: Proctor and Gamble (PG)Our objective is to reconcile the following from the 10-K:

Step 1: Now bring up two Income Statements for Proctor and Gamble as described in section 3.2 as displayed below.

For Proctor and Gamble you can see that the Cost of products sold = $37,919 and the Selling, general and administration expense =$24,998. To recast the income statement from its full or absorption costing format to a direct or variable costing format we need to break up these costs into their fixed and variable components. For reconciliation purposes suppose we assume that 80% of the COGS are variable and 20% of the SA&G expenses


assume that 80% of the COGS are variable and 20% of the SA&G expenses are variable. These percentages can be subject to more refined analysis later but for now we are more concerned with mastering the operational details.Step 2: Click on Calculate and we can verify the input and derived fields for the following:

The above demonstrates the power of recasting the income statement in this manner. This lets you estimate the Degree of Operating Leverage but in addition it further lets you estimate Break Even points for Sales Revenue and implied Margin of Safety (i.e., Sales minus B/E Sales.Cost Behavior Assessment Remark: Observe above that the % Variable COGS, % Variable SG&A and % Variable Other are numbers inputted into the calculator. Where do these numbers come from? There are various approaches used by professionals in the field for assessing these numbers. Clearly, managers inside a firm have access to better information than financial analysts outside of the firm. However, financial analysts can still make reasonable assessments of the cost behavior. Interested readers are encouraged to work through questions 7-13 in the problem set at the end of this chapter. In particular, Question 9 provides the details for estimating cost behavior using regression analysis.Reconciling from the Income StatementThe reconciliation from the Income Statement is provided below.:


3.11 Degree of Financial Leverage and Degree

of Total Leverage

In this section we explored operating leverage which is sometimes referred to as first stage leverage and in the early topic on the DuPont decomposition we introduced the term financial leverage. The degree of financial leverage results from a second stage analysis of Earnings Before Taxes (EBT) and Earnings Before Interest and Taxes (EBIT). Alternatively, when viewed from the perspective of the Income Statement we can define the degree of Financial Leverage in terms of Net Income as follows:Degree of Financial Leverage = % Change in Net Income/% Change in EBIT

Degree of Total Leverage

This number relates a firms operating and financial leverage to its net income. This is a useful number for financial analysts to assess because it allows earnings forecasts to be made starting from Sales. However, first we consider the operational details including how to estimate this number from the financial statements. In relation to Sales Revenue the Degree of Total Leverage is defined as follows:Degree of Total Leverage = Degree of Operating Leverage * Degree of Financial LeverageDegree of Total Leverage = (% Change in EBIT / % Change in Sales) * (% Change in Net Income / % Change in EBIT)Degree of Total Leverage = % Change in Net Income / % Change in SalesOr rearranged this yields:% Change in Net Income = Degree of Total Leverage * % Change in SalesThat is, by starting with the problem of forecasting sales revenue then the Degree of Total Leverage can relate this forecast to an earnings forecast.We can further decompose the Degree of Total Leverage into the product of its two drivers, the Degree of Operating Leverage times the Degree of Financial Leverage. In this form it can be related directly to the Contribution Margin format of a Variable or Direct Income Statement as follows:Degree of Total Leverage = Degree of Operating Leverage * Degree of Financial LeverageDegree of Total Leverage = Contribution Margin/EBIT * EBIT/Net Income =


Degree of Total Leverage = Contribution Margin/EBIT * EBIT/Net Income = Contribution Margin/Net IncomeNext consider how this is computed from the financial statements.Tutor Reconciliation: Proctor and Gamble (PG)Our objective is to reconcile the following from the 10-K:

Step 1: Now bring up two Income Statements for Proctor and Gamble as described in section 3.2 as displayed below.

For Proctor and Gamble you can see that the Cost of products sold = $37,919 and the Selling, general and administration expense =$24,998. Plus now Interest Expense is $946.To recast the income statement from its full or absorption costing format to a direct or variable costing format we need to break up these costs into their fixed and variable components. For reconciliation purposes suppose we assume that 80% of the COGS are variable and 20% of the SA&G expenses are variable. These percentages can be subject to more refined analysis later but for now we are more concerned with mastering the operational details.Step 2: Click on Calculate and we can verify the input and derived fields for the following:


The above demonstrates the power of recasting the income statement in this manner. This lets you estimate the Degree of Financial Leverage as well as the Break Even points for Sales Revenue and implied Margin of Safety (i.e., Sales minus B/E Sales. The Degree of Total Leverage is the product of the Degree of Operating Leverage and the Degree of Financial leverage.The reconciliation from the Income Statement is provided below.

3.12 Earnings Season and the Importance of

Financial Statements to the Capital Markets

Todays stock markets are very sensitive to earnings season. This happens every quarter when the companies release their previous quarters earnings. The important numbers the market watches are, Sales Revenue


earnings. The important numbers the market watches are, Sales Revenue and Quarterly Earnings in relation to consensus forecasts. As discussed in the introduction to Valuation Tutor there are different models used to estimate what a stock is worth. The simplest is called the dividend model, covered in Chapter 6. This model takes the view that if you buy a stock, you are entitled to receive future dividends paid by the stock. From this perspective a stocks fair value equals the present value of the future dividends. Applying the above logic requires forecasting future dividends and also the rate(s) at which these will be discounted. Future dividends are paid from future earnings which in turn depend upon future sales revenue. As a result, stock prices depend upon both earnings and sales forecasts. Forecasting the future, however, is very difficult and in an influential old book by Burton Malkiel, A Random Walk Down Wall Street, he discussed implications for stock prices from the random walk hypothesis. This hypothesis applied to the stock market introduces the controversial idea that that one cannot consistently outperform market averages. Irrespective of ones view of this hypothesis it does serve to underscore the importance of beating the consensus forecast when observing changes in stock prices in relation to the release of additional financial statement information over time.

Chapter 4: Interpreting Business Ratios: Case

Studies

In the last chapter you learned how to construct business ratios and conduct activity analysis. In this chapter we show you how to use the ratios

in real world situations. We first use them to analyze the performance of Amazon.com over time. Then, we use them for a comparative analysis of

Wal-Mart and Target. In each case, you will see how the interpretation depends on the companys business model and strategy.

4.1 Amazon.com Stock Price History

To appreciate the importance of financial statements in understanding


To appreciate the importance of financial statements in understanding performance, consider the stock price history of Amazon.com.

The stock price was $2.40 on July 1, 1997, rose to $86.03 on April 1, 1999, and was at $89.06 in November of 1999, but then started to fall. In January

2000, it was $64.56. On February 1, 2001, it was at $10.19 and fell further to $5.97 by September of 2001. Then started a slow and fairly steady increase through 2008, and was followed by very strong gains though June 2011. On

June 1, 2011, the stock price was $191.63. Amazons performance in the first decade of the 21st century has been impressive, especially considering

that the stock market (as measured by the S&P 500 Index) lost 7.67% between January 2000 and June 2011. The price history also shows that

Amazon lost over 90% of its shareholder value in 2000-2001and then recovered very strongly.

So what happened?

We will analyze Amazons performance in two ways. First, we will look at the business ratios over time. Then, we will look at how Amazon changed its

business strategy and how this was reflected in both the ratios and the stock price.

4.2 DuPont Analysis of Amazon.com

In the last chapter, we started with concept of fundamental or accounting growth which is defined as:

Fundamental Growth = ROE * Retention Ratio

ROE is Net Income/Shareholders Equity and the Retention Ratio is 1 Dividend Payout Ratio. Since Amazon paid no dividends,

the retention ratio is one, and therefore we will restrict our attention to the Amazons ROE.

As background, we will refer to an article in a Fortune Magazine dated December 18, 2000 by Katrina Brooker. The article describes Amazons

focus on growth (GBF or Get Big Fast) and an obsession with customer satisfaction. It will be useful to keep this in mind as we take you through the analysis. A much more detailed account of the early history of Amazon.com is in the book Amazon.Com: Get Big Fast by Robert Spector (April 2000).

It contains fascinating details about the growth of the company and the evolution of its strategy over time, particularly at the end of the 1990s.


to the Amazons ROE.

The DuPont decomposition of ROE is:

ROE = Net Income/Sales * Sales/Total Assets * Total Assets/Shareholders Equity

This decomposition rewrites ROE as the product of three terms, Profit Margin Ratio, Asset Turnover Ratio and Financial Leverage

respectively.

The following table shows the DuPont decomposition for Amazon.com over its recent history. We will look at some of the

sub-components below.

Table 1: Amazons DuPont decomposition history

Note that in 2000 2002 Amazon had a positive ROE but both the numerator and the denominator were negative. This is obviously

is not a good sign but does reinforce the loss of over 90% of shareholder value in 2000-2001. The trend however reflected

steady improvement which was a good sign, also reflected in the stock price.

Amazons financial statements allow additional information to be extracted. For example, observe that Amazons Total Assets

increased significantly from 1998 to 1999. To understand why requires digging further into Amazons 10-K report for information

provided in addition to the major financial statements.

You can use Valuation Tutor to access the historical 10-K for Amazon. Select Amazon as the stock to analyze, and in the

Information Browser at the bottom, click on 10-K and then scroll down to find the 2000 10-K (filed in March of 2001):

Amazons 2000 10-K filing covers the period of time ending December 31, 1999 and is usually released in the first quarter of

the year.

Item 1 of the 2000 10-K reveals:

WAREHOUSING, INVENTORY, FULFILLMENT AND


WAREHOUSING, INVENTORY, FULFILLMENT AND DISTRIBUTION

We significantly expanded our US distribution infrastructure in 1999 with the addition of new distribution facilities in Fernley,

Nevada; Coffeyville, Kansas; Campbellsville, Kentucky; Lexington, Kentucky; McDonough, Georgia; and Grand Forks, North Dakota. We also opened two new international distribution centers, one in the UK and one in Germany. On an aggregate basis, these eight

new distribution centers comprised approximately four million square feet of warehouse space. The geographic coverage of these distribution centers and their capacity have dramatically

improved our fulfillment capabilities and will allow us to continue to increase our volume. The new distribution centers also give us

more control over the distribution process and facilitate our ability to deliver merchandise to customers on a reliable and timely basis.

We now have a total of 10 distribution centers, including our facilities in Seattle, Washington, and New Castle, Delaware.

In Item 1 they further observe that:

OUR SIGNIFICANT AMOUNT OF INDEBTEDNESS COULD AFFECT OUR BUSINESS

We have significant indebtedness. As of December 31, 1999, we had indebtedness under senior discount notes, convertible

subordinated notes, capitalized lease obligations and other asset financing totaling approximately $1.48 billion. With the sale of our

Premium Adjustable Convertible Securities(TM), also known as PEACS, in February 2000, we incurred additional debt of

approximately $681 million. We may incur substantial additional debt in the future. :

That is, Amazons investment decision had a significant impact upon its financial statements. In particular, the expansion of

assets and debt combined with a significant jump in negative income led to Amazons stockholders equity turning negative by

2000.

Armed with this background information we can return to the DuPont decomposition for Amazon and how it changed over time.

Applying DuPont Decomposition to Amazon

The DuPont decomposition lets you track three important ratios:

Profitability

Asset Utilization

Financial Leverage

Each of these three items is key to understanding Amazons performance, especially in light of the significant warehousing

investments made in 1999 that were funded by debt incurred in 1999 and 2000.

Profitability

First, consider profitability. From 1995 to 2000, there was a dot com bubble where shares of internet companies rose to very

high levels. Many of these companies did not generate any profits, and Amazon.com was no exception to this, as described in a

colorful manner in the Fortune Magazine article, as follows:

(FORTUNE Magazine) A year ago, getting Jeff Bezos to talk about making money was a bit like getting Bill Clinton to define

sex. Last fall, when asked when he thought Amazon.com would turn a profit, he hemmed, hawed, and mumbled something about


turn a profit, he hemmed, hawed, and mumbled something about not "missing out on the big opportunities of the Internet." Pressed further, he gave this murky response: "Look at USA Today; it took

11 years to become profitable."

Beautiful Dreamer, Katrina Brooker, Fortune Magazine Dec 18, 2000.

It turned out that Bezos was correct as the following profit margin trends show. In the chart below you can see that the profit margin fluctuated wildly in the early years and then ultimately settled down

into a more normal range. Table 1 reveals how negative net income was. However, by 2002 Amazons profit margin is

signaling a significant change. It ultimately stabilized in the latter the latter part of the decade.

Amazons profit margin behavior suggests that the 1999 asset expansion ultimately proved to be worthwhile for Amazons

shareholders.

Asset Turnover

The second major term in the DuPont decomposition asks: how efficiently assets are being utilized in the company. The Asset

Turnover ratio is calculated by dividing Sales Revenue by Total Assets. This ratio provides insight into how efficiently assets are

being utilized to generate sales revenue.

The chart reveals a positive trend over the early years. That is, Amazon appears to be learning to utilize its assets more efficiently


Amazon appears to be learning to utilize its assets more efficiently during the first decade of the 21st century. This graph strongly

reinforces Amazons decision to expand its warehousing capability in 1999 as this proved to be important for supporting the growth in

sales exhibited by Amazon (see Table 1). In addition, the combination of the positive asset utilization trends with the positive

trends in profit margins provided even stronger reinforcement of the investment decision made in 1999 and it was not until the

economic crisis of 2008/2009 that any real change in trends occurred.

However, the investment decision did add a considerable amount of debt to Amazons Balance Sheet and so the third major

component of the DuPont decomposition provides insight into how this is reflected in the financial statements.

Financial Leverage

Finally, ROE is the product of ROA and Financial Leverage and financial leverage reflects Amazons debt policy. Financial

Leverage only makes sense for firms that have positive shareholders equity and so the blanks parts in the graph below correspond to the times Amazon had a negative shareholders

equity.

1998 1999 2000

Recall that Amazon introduced some significant debt when it invested in its own warehouses. For example, Amazons 2000 10-

K reveals that from 1998 to 1999 Amazons debt increased significantly:

Long-term Debt 348,140 1,466,338 2,127,464

The increasing debt, combined with increasing losses, drove Amazons shareholder equity to be negative. It took until 2005

before Amazon recorded a positive shareholders equity and the graph depicts a significant improving trend in financial leverage as

Amazon was building up retained earnings and paying down its debt.

4.3 Application of Working Capital Ratios to

Amazon.com

In the previous chapter, we defined the major working capital ratios:

Accounts receivable turnover = Sales/Accounts Receivables


Accounts receivable turnover = Sales/Accounts Receivables

Inventory turnover = COGS/Inventory

Accounts payable turnover = Purchases/Accounts payable or otherwise COGS/Accounts Payable

In addition, turnover ratios are often expressed in terms of number of days by dividing 365 by the turnover ratio:

Number of days to Collect Accounts Receivable = 365/Accounts receivable turnover

Number of days to Sell Inventory = 365/Inventory turnover

Number of days to Pay Creditors =365/ Accounts payable turnover

Finally, the Cash Conversion cycle is the sum of the first two, the aggregate number of days for collecting accounts receivable and the number of days required to sell

inventory.

Now, recall that it was 1999 when Amazon expanded into its own warehouses. This was the year where the GBF strategy started to take effect but had a negative impact

in the. This was reflected in Amazons inventory management ratios as follows:

COGS increased sharply in 1999 along with Sales. However, the cost of this was the sharp decline in inventory turnover and increase in days to sell inventory; the days to

sell inventory almost tripled to 59.69 from 22.61. The impact of the old economy managers is evident in 2000 where the days to sell inventory were almost halved and by 2001 were equal to 1998 levels but with a 600% increase in sales. In other words,

the GBF strategy was back in balance with at least 1998 ratio levels.

Amazons other working capital ratios are as follows:

You can see that Amazon increased the days to paying its payables especially in


You can see that Amazon increased the days to paying its payables especially in 1999 when it increased to 125.27 days; this recovered to the 1998 levels by 2000.

Similarly, on the collection front Amazons 1999 numbers increased sharply. Overall, it can be seen that Amazons working capital strategy is to attain favorable creditor

terms but collect their payables relatively quickly.

Overall, Amazons GBF and expansion in 1999 led to a significant deterioration in their working capital management which was subsequently rectified by their

managers

.4 The Value Chain and Amazon.com

You have seen how the performance of the company changed over time, as reflected in the ratios and in the stock price. The DuPont analysis revealed some of the

problems that Amazon faced and illustrates that Amazons management dealt with these problems and ultimately overcame them, so that by 2003, the Net Income became positive and by 2005, Shareholders Equity became positive. However,

although these numbers reflect what happened we would also like to get insight into what they to change their strategy to overcome the issues they faced in 1999 and

2000.

Business Model and Business Strategy

Recall from the Introduction that what a company does to create shareholder value is called the business model. One way of representing what a company does is in

terms of Porters Value Chain. A value chain describes the sequence of primary activities implied by a firms business model that add value to shareholders. This sequence of value-adding activities converts inputs into the products or services

described in the firms business model. Figure 1, depicts a traditional generic Value Chain:


Figure 1: Traditional Value Chain

This chain also has a set of support activities. These support activities were Procurement, Technology, Human Resources and Firm Infrastructure in Porters

original presentation.

Valuation Tutor Note: In the above screen both the value-adding and support activities have been depicted. This requires checking all plot checkboxes and then

checking the subset of Primary Activities beside.

Business Strategy

Porter then continued to define business strategy relative to the set of activities in a value chain. Business strategy describes how the firm operates within its competitive

environment in an attempt to gain a competitive advantage. From a value chain perspective, a firms strategy can be classified into the following categories:

The business performs different activities from rivals or,



The business performs similar activities in different ways

The business chooses not to perform certain activities

The Valuation tutor software lets you represent the results of your business strategy analysis using a relative weighting system.

Example: Suppose the key parts of the business strategy revolve around sales and marketing and then customer service. Here the weighting assigned to Sales and

Marketing may be 100% and Customer may be 75%. Suppose further the remaining activities are weighted at 30%. In this case the value chain subsegments reflect the

various weights based upon the analysis of strategy.

Application to Amazon.com

The value chain perspective allows us to build up an understanding of the change in Amazons business strategy from the 10-K. Let us start with the 2000 10-K, filed in

March of 2001. The business strategy is summarized as:

Amazon.com seeks to be the world's most customer-centric company where customers can find and discover anything they may want to buy online. We intend to

continue to optimize our Internet platform to expand the range of products and services offered to our customers and partners. This platform consists of strong

global brand recognition, a large and growing customer base, innovative technology, extensive and sophisticated fulfillment capabilities (consisting of fulfillment and

customer service) and significant e-commerce expertise. We believe that this platform allows us to launch new e-commerce businesses quickly, with a high quality of

customer experience, economical incremental cost and good prospects for success. We also believe that this platform's flexibility allows us to expand the range of

products and services offered to our customers through relationships with strategic partners on terms that are attractive to our customers, our strategic partners and us.

The filing goes on to list the expansion of the company along different dimensions and the marketing and sales customer service efforts.

Three points emerge from this: first, Amazon has chosen to both perform similar activities to its rivals but in different ways. At the time, most of its competitors were traditional bricks and mortar stores, i.e. companies with physical stores. Amazon chose instead to be a virtual store, allowing Amazon in principle to offer customers anything they want. Second, they want to be the worlds most customer-centric company, and so their focus is on the Customer Service part of the value chain.

Third, you can see the emphasis on growing large, in terms of the range of products offered by Amazon itself and also growth in launching new companies and partnering


offered by Amazon itself and also growth in launching new companies and partnering with existing companies.

In terms of the value chain, you can see that most of the focus is on Marketing & Sales and Customer Service.

Amazon placed very little weight on Inbound Logistics and Operations. In the same filing, under Results of Operations, they mention a current-year focus on balancing

revenue growth with operating efficiency. This is an indication that the first three parts of the value chain were being paid less attention than the last two. We will

describe what this re-balancing was in a moment, but it is interesting that by 2003, operational efficiency took a much more prominent role in the Part 1 of the 10-K filing. In the 2003 10-K (reflecting information up to December 2002), the stated strategy is:

nWe seek to offer Earths Biggest Selection and to be Earths most customer-centric company, where customers can find and discover anything they may want to buy. We endeavor to offer our customers the lowest possible prices. Through our Merchants@

and Amazon Marketplace programs, we enable businesses and individuals to sell virtually anything to Amazon.coms millions of customersOur business strategy is to offer our customers low prices, convenience, and a wide selection of merchandise.

We endeavor to offer our customers the lowest prices possible. We strive to improve our operating efficiencies and to leverage our fixed costs so that we can

afford to pass along these savings to our customers in the form of lower prices. We also enable third-party sellers to offer products on our site, in many instances

alongside our product selection, and set their own retail prices

Here you see the mention of operational efficiencies and low prices. The remainder of the Part 1 of the 10-K is similar to the previous years and you can access it easily

from Valuation Tutor. This means that by this time, the company was more firmly focused on the first parts of the value chain: logistics and operations, efforts that had

started in 2000. The 2011 filing is very similar to the 2003 filing: We strive to offer our customers the lowest prices possible through low everyday product pricing and

free shipping offers, including through membership in Amazon Prime, and to improve our operating efficiencies so that we can continue to lower prices for our customers.

We also provide easy-to-use functionality, fast and reliable fulfillment, and timely customer service.

Now the activities such as operational efficiency, low pricing procurement, sales and marketing with Amazon prime receives greater emphasis. Their customer centric

focus still implies most weight provided to the customer.

The result is greater balance among the activities.


The result is greater balance among the activities.

The above took a few years to implement and the story is described next.

Greater Focus on Human Resource Management

So what did they do in 2000 to pay more attention to operational efficiency? The answer to this question is revealed in the 10-K statement which indirectly revealed

that major changes were being implemented. Consider the following exhibit referred to in Amazons 2000 10-K. This contained an unusual set of disclosures on sequential

days:

10.9+ Offer Letter of Employment to Joseph Galli, Jr. dated June 23, 1999, as amended and restated September 30, 1999 filed with the Company's Annual Report

on Form 10-K on March 29, 2000).

This immediately resulted in three additional hires:


10.10+ Offer Letter of Employment to Warren C. Jenson dated September 4, 1999, as amended and restated September 30, 1999 filed with the Company's Annual

Report on Form 10-K on March 29, 2000).

10.11+ Offer Letter of Employment to Jeff Wilke, dated September 2, 1999 filed with the Company's Annual Report on Form 10-K on March 29, 2000).

10.12+ Offer Letter of Employment to Richard Dalzell, dated August 13, 1997 filed with the Company's Annual Report on Form 10-K on March 29, 2000).

Note that the first of these hires was made in 1999. The three people hired by Amazon were interesting in a number of ways. They all had old-economy

backgrounds, meaning that that they had not worked for an internet based company, but rather in traditional manufacturing companies. Joseph Galli served with The

Black and Decker Corporation from 1980 to June 1999; Warren C. Jensen had served as an Executive Vice President and Chief Financial Officer for Delta Air Lines

and earlier General Electric, Inc.; Jeff Wilke served with AlliedSignal. Finally, an earlier Amazon hire, Rick Dalzell, was also included in these filings. Rick Dalzell had

previously come to Amazon from Wal-Mart Stores Inc.

These hires delegated decision making powers managers who would focus upon controlling costs and improving operational efficiency. As described in the book by Spector, real fiscal and operational discipline began with the hiring of Joe Galli as

chief operations officer, and his assembling of old economy veterans from the likes of Delta Airlines, NBC, AlliedSignal, and MCI. Budgets were formalized. Every

division became accountable for expenditures. Executives had to write operating plans that outlined specific financial deadlines and had to reach specific sales goals

and margins. Amazon employees were taught about profit-and-loss statements, balance sheets, and cash-flow analysis.

It is not easy for a corporation or a CEO to bring about such changes as revealed in the Fortune Magazine article dated December 18, 2000 by Katrina Brooker. Here she describes the problems that arose from a sole focus upon GBF and customer service:

GBF also wreaked havoc in the warehouses. Last year the company spent an estimated $200 million building seven distribution centers around the country--from

Nevada to Kentucky. The idea is that if these three million square feet of warehouse space are run efficiently, Amazon will be able sell to as many customers as, say, Wal-

Mart at a fraction of the cost. But when Jeff Wilke, Amazon's new operations chief, got a look at them for the first time last fall he was stunned: They were a mess. There

were defective products on the shelves and mystery shipments arriving that no one remembered ordering. Once a truckload of kitchen knives showed up--no one knew where it came from or where it was supposed to go. It just sat there. "We kept it all--

we just kept it," says Wilke, shaking his head. "We put it on the shelf and said, 'I don't know. What matters is the customer.' " By the end of 1999 it seemed that GBF was

still in the saddle: While sales were up 169%, to $1.6 billion, net losses had risen from $125 million in 1998 to $720 million.

This again emphasizes that Amazon.Com was so focused upon the last two links on the value chain (Marketing & Sales, Customer Service) and not sufficiently on the rest

of the chain.

As noted earlier Amazon realized this and took steps to rectify this problem. The article continues to describe this as follows:

But the truth was that behind the scenes Bezos was working to ensure that Amazon got its spending under control. His key move, in fact, had occurred in June when he

reached into the old economy to hire Joe Galli, a 19-year Black & Decker vet.

Right off the bat, chief operating officer Galli played hardball. He hired a slew of new managers, all with old-economy backgrounds: Delta, NBC, AlliedSignal, MCI. He pushed Amazon to start structuring itself like, well, an old-economy company. He

forced it to set up a formal budget. He established an approval process for expenses. For example, all major purchases--computers, distribution machines--required signoff by top management (i.e., Galli). He hired Wilke to apply the Six Sigma methods to the distribution centers. He also presided over the company's first major layoffs, when he


distribution centers. He also presided over the company's first major layoffs, when he let 2% of the work force go in January.

Galli was not a popular guy. Accustomed to Bezos' freewheeling leadership, employees found Galli heavy-handed. He was stifling innovation, they complained, hurting Amazon's close-knit culture. "It was cruel the way he laid those people off,"

sniffs one former exec, who left in part because of Galli. The COO became notorious last fall when he took away the employees' free Tylenol and aspirin. It was a small perk, but for many employees Galli's move was a symbol of everything they hated

about him. The outcry was so fierce that the company restored the perk within a week. "That was, frankly, just a mistake that Joe made. Like, oops, you know, people

do really spend a lot of time at their computers," recalls David Risher, general manager of Amazon's U.S. virtual stores. Galli, who left in July to become CEO of VerticalNet, insists his moves were for the good of the company. "Some steps are

less popular than others, because anytime you become more disciplined, you have to change your behavior," he says.

While Galli got the blame, Bezos was the man behind the orders. In fact, when asked about Galli, Bezos makes the chain of command clear: "The senior management

team was very much in step, and we knew exactly what we wanted to do." And in the days since Galli's departure, Bezos has not let up. Gone are the days of "Get big

fast." Bezos' new motto is "Make some great cash, baby." Instead of looking for ways to grow sales, employees look for ways to save money. "So, if its a tradeoff--two

weeks to do a project for $200 or three weeks for $100--18 months ago we would take the two-week, $200 approach," says LeBlang. "Today I do it in three weeks for

$100." Now every division must carefully account for what it spends. Each meets weekly to go over its numbers. Executives must also write operating plans that outline

specific financial deadlines and target precise sales goals and margins. "Now we have discipline," says Brian Birtwistle, product manager of the online software store. "You map out everything--what marketing you'll do for the year; what initiatives you'll launch; what you have to do to make those numbers realistic." Sounds like Business

101, and indeed it is. To learn the basics of P&Ls, balance sheets, and cash flow analysis, Amazon employees now take Finance 101 courses offered at the Seattle

headquarters. When they've completed that, they take Finance 102.

The last part of the article is very interesting: it points out that since operational efficiency is measured by the tools of financial statement analysis (such as margins),

management must understand how the firms activities affect the financial statements. Beyond managers, outside analysts also use the same tools for analyzing a

company. For example, in 2000, analysts such as Ravi Surya of Lehman Brothers argued that Amazon lost money on every sale. According to book by Spector: Suria

stated that Amazon lost money on every sale, if you included costs for marketing, product development, warehousing, and fulfillmentin addition to the usual fees paid to wholesalers and distributors. Furthermore, Suria argued, all of those Amazon-built

warehouses, which were chock-full of merchandise, had severely slowed down the pace of moving goods in and out. Therefore, in his opinion, Amazon.com had become

essentially a traditional retailer (insult!)and an inefficient one at thatand that the company was woefully lacking from an operational aspect. Amazons shares fell

20% on the day Surias report was released.

Spector goes on to report that In October 2000, Amazon.com showed Wall Street that it was changing its profligate ways. Analysts were pleasantly surprised when the

company reported a third-quarter loss of 25 cents a share, which was well below their estimate of 33 cents a share. Operating losses as a percentage of sales dropped

from 22 percent to 11 percent. Gross margins were a company record 26 percent, up from 20 percent the previous year.

4.5 The Balanced Scorecard and Amazon.com

The Balanced Scorecard approach (Arthur Schneiderman (1987), Kaplan and Norton (1992)) can be used within a firm as a method for communicating business strategy.

It is a methodology that lets senior management communicate and implement


Describing business strategy requires multiple dimensions because of the varying emphasis given to different activities in the value chain

There needs to exist some balance among these dimensions when an organization implements its business model via its strategy.

Understanding major firm decisions in terms of these multiple dimensions and their balance is necessary for conducting meaningful financial statement

analysis.

It is a methodology that lets senior management communicate and implementbusiness strategy at all levels of the organization. When an analyst outside the firm

conducts financial statement analysis, the Balanced Scorecard provides a framework for gaining a better understanding of the firms business strategy. Some important

underlying themes to this approach are:

Specifically, the Balanced Scorecard views the firms business strategy from four perspectives:

Application to Amazon.com

In the 1990s and up to the time of hiring Galli, Amazons business strategy was unbalanced from a balanced scorecard perspective. In particular Amazon was over-

emphasizing the Customer and Learning and Growth to the detriment of the Financial and Process dimensions.

The Financial perspective requires looking at measures that are relevant to the valuation of the company by shareholders. These include items like return on equity, return on assets, and stock price. For Amazon the ROE was deteriorating from 1998

to 1999 and was not a meaningful measure in 2000 because both the numerator (Net Income) and denominator (Shareholders Equity) were negative by 2000. As a result,

the DuPont decomposition of ROA (Return on Assets) provides a meaningful measure. In particular, the drivers of ROA (Profit Margin Ratio and Asset Turnover

Ratio) were very unstable under the GBF and Customer Obsession strategy no matter what it costs strategy that was implemented in 1999. However, these ratios started to stabilize after traditional cost constraints were imposed via old economy

techniques such as implementing a traditional master budget cycle at Amazon.

The Process perspective refers to the internal activities performed by a firm. This includes identifying activities for which it is important for the firm to excel and captures

what in financial statement analysis is referred to as business efficiency. The most relevant item here to Amazon around 1998-2000 was the inventory ratios, such

inventory turnover and days to sales inventory given Amazons warehousing


inventory turnover and days to sales inventory given Amazons warehousing expansion plans that were implemented in 1999. From 1998 to 1999 the days to sell inventory increased from 22.61 days to 59.69 days a whopping 264% increase in the

time inventory stayed with Amazon. With the amount of capital tied up in inventory and warehouses it is not surprising that at this time Amazons related working capital ratios were also out of balance with days to pay payable increasing from 86.85 to to

125.27 days or just over 4-months on average to pay their creditors in 1999. The impact from imposing cost constraints upon their business strategy was almost

immediate. In 2000 efficiency picked up and the days to sell inventory were almost halved to 30.26 days and days to pay payables were reduced to 84.13 which was

around 1998 levels.

The Learning and Growth perspectives refer to employee and informational activities requiring innovation and continual improvement. For Amazon some relevant

ratios are that Sales growth did decline from 1999 to 2000 (from 269% in 1999 to 168% in 2000) but 168% is still consistent with a strategy of GBF. In addition, the

DuPont decomposition revealed that asset turnover was increasing which was a positive trend in the light of Amazon undertaking a significant expansion into

warehousing. As a result, employees of Amazon had to go down the learning curve along this dimension. The positive trend in asset turnover provides evidence in

support of this dimension.

Finally, the Customer perspective requires the identification of performance metrics that measure the companys success in meeting customers expectations viewed

from the customer or outsiders perspective. Direct information on these is available in the supporting notes to the financial statements as well as other parts of the 10-K. For example, measures of customer service, customer ratings, customer loyalty or

retention. For Amazon the word customer is used often in its 10-K. Further, in the supporting notes to their 1999 financials Amazon reveal the following metrics:

Amazon disclosed the following in their 2000 10-K footnotes to the statements. This description contains some performance metrics for the Customers perspective:

Growth in net sales in 1999 and 1998 reflects a significant increase in units sold due to the growth of our customer base, repeat purchases from existing customers,

increased international sales, and the introduction of new product offerings. These new product offerings include music and DVD/video in June and November of 1998, respectively, toys and electronics in July 1999 and home improvement, software and

video games in November 1999. We increased our issuance of promotional gift certificates to customers in 1999 to promote new product lines, however, which partially offset such growth in net sales. The Company had approximately 16.9

million, 6.2 million and 1.5 million cumulative customer accounts as of December 31, 1999, 1998 and 1997, respectively. The percentage of orders by repeat customers

increased from 64% in the fourth quarter of 1998 to 73% in the fourth quarter of 1999. The increase in net sales in 1998 was also partially due to the launch of the UK and

German focused Web sites in October 1998.

Amazons 2000 10-K was a little less forthcoming on the customer dimension although they reinforced their strategy in many parts of the 10-K. For example:

U.S. Books, Music and DVD/Video Segment. The U.S. Books, Music and DVD/video segment had net sales of $1.7 billion, $1.3 billion and $588 million in 2000, 1999 and 1998, respectively. During 2000, we continued to enhance our book, music, DVD and

video stores by expanding selection, making it easier to find items, and generally improving the customer experience. In 2000, our Book store had the largest pre-order in our history. Over 410,000 copies of "Harry Potter and the Goblet of Fire" were pre-

ordered on our sites worldwide. We joined with Federal Express to provide complementary upgrades to the first 250,000 customers who ordered to ensure

delivery on the day of release. In addition, we launched an e-Books store, offering e-books in Microsoft Reader format for PCs and laptops, as well as downloadable e-

audiobooks from our strategic partner, Audible, Inc.

In summary, in 1999 Amazon pursued GBF and Customer obsession without


In summary, in 1999 Amazon pursued GBF and Customer obsession without imposing cost constraints on their strategy. As a result when viewed from a Growth

and Customer perspective Amazon looked great. On the other hand when viewed from their Financial and Process perspectives Amazon did not look so good awful.

So the implementation of their strategy was not in balance. However, with the steps taken in 2000, significant improvements were made in relation to both the Financial

and Process dimensions. Ultimately, Amazons stock price reflected these steps.

Amazon has chosen to both perform similar activities to its rivals but in different ways. At the time, most of its competitors were traditional bricks and mortar stores.

Choosing to be a virtual store on the World Wide Web allowed Amazon in principle to offer the Earths Biggest Selection. Conceptually this illustrates why Porters

original description of a value chain was extended to embrace the world of electronic commerce by Rayport and Sviokla (1994). They observed that the traditional value

chain model treated information processing as a supporting element of the value-adding process and not as a source of value itself. However, the information

generated by customer-centric entities is a source of value for customer centric businesses such as Amazon and Netflix. This activity is driven by databases and

predictive algorithms designed to make it easier for customers to find reliable product and service ratings.

In this development Rayport and Sviokla view the value chain as a pair of chains the traditional physical chain operating in the physical world of marketplace and a

virtual (or synthetic) chain that operates in the new information world referred to as marketspace. This categorization provides a better description of the business model

for technology firms such as Amazon, versus a traditional bricks and mortar firms such as Wal-Mart and Barnes and Noble who choose to extend their businesses to

have a presence in both spaces.

More recently Amazon has added to its revenue streams by offering e-commerce services to sellers and developers some of whom compete directly against

Amazon.com. This item reflects another interesting extension of Porters original static framework to a dynamic and more chainlike in terms of linking back to itself,

value chain.

Dynamic Value Chains and Amazon

The difference between a static and dynamic value chains is that in a dynamic chain different entities assume different positions on the chain depending upon things like

the time of day and a customers location. For example Amazon and third party suppliers compete with each other on Amazons own platform. The dynamic

dimension of Amazons value chain is communicated in Item 1 of Amazons 2010 10-K. Here they report two additional parts of their business model:

Sellers

We offer programs that enable sellers to sell their products on our websites and their own branded websites and to fulfill orders through us. We are not the seller of record

in these transactions, but instead earn fixed fees, revenue share fees, per-unit activity fees, or some combination thereof.

Developers

We serve developers through Amazon Web Services, which provides access to technology infrastructure that developers can use to enable virtually any type of

business.

That is, seller services and order-fulfillment part of Amazons business essentially competes with Amazons own sales and procurement teams. Similarly, the Web Services division enables other businesses to compete with Amazon and others.

These are examples of Amazon embracing a dynamic value chain in their business model.

Dynamic Value Chains and Risk

The risk facing entities in todays dynamic value chains is that a company can suddenly drop out of the chain. This was a problem that Borders bookstores faced

when competing against Amazon and Barnes and Noble. Ironically, they were still


when competing against Amazon and Barnes and Noble. Ironically, they were still the second largest bricks and mortar bookstore when they lost their position in the

chain. This led to the recent bankruptcy court events for Borders:.

July 22, 2011 a federal bankruptcy judge approved the Borders Groups plan to liquidate. Borders at its height in 2003 operated 1,249 bookstores and 399 at the

time of bankruptcy.

Both internal and external factors are blamed for Borders demise. Clearly, online retailing and electronic book readers were major factors. For example, Borders

waited several years before it rolled out its version of an e-reader called Kobo. The other major bricks-and-mortar competitor, Barnes and Noble, were much more

proactive in their response to the successes of Amazons Kindle. Barnes and Noble developed its e-reader, the Nook which today is competing successfully against the

Kindle.

Borders also failed to adapt to a dynamic external environment and badly timed their expansion. They expanded excessively around the same time period when Amazon

was generating significant performance gains from re-inventing the implementation of their business model. In addition, the world was rapidly embracing digital for books,

music and movies around this time. Borders ill-timed expansion resulted in relatively flat sales along with rising costs. The following table from a 2008 10-K reflects these

problems.

4.6 SWOT Analysis

The above Borders story underscores the importance of continually performing a SWOT analysis. SWOT stands for: Strengths, Weaknesses, Opportunities and

Threats classified into two dimensions, internal and external. The internal assessments are the Strengths (Internal comparative advantages) and

Weaknesses (internal disadvantages relative to competitors). The external assessments are the Opportunities (external opportunities for generating additional

sales and earnings) and Threats (external disadvantages relative to competitors and potential competitors).

Applied to Borders a SWOT analysis would increasingly flag significant Weaknesses and Threats with little bright news along the dimensions Strengths and Opportunities.

For example, for Borders Weaknesses are clearly their rapidly deteriorating profit margins combined with flat sales after their expansion phase. This is evident starting

from 2006 (see above 2008 10-K s data which covers 2003 to 2007). Threats were


from 2006 (see above 2008 10-K s data which covers 2003 to 2007). Threats were also growing significantly from Internet book sales, growth in e-books and the shift to digital music and movie downloads. The only potential Strength over this time period for Borders was the strong growth exhibited in International sales. Finally, the major

potential Opportunity for Borders turned into an opportunity lost. This was the growth in the e-book market which Borders completely missed. Instead they

allocated significant resources to expanding bricks and mortar and ran up costs at a time when they faced significant Threats from e-commerce

4.7 Summary of Amazon.com

As you have learned item 1A of the 10-K usually provides a clear statement of a firms business model. We have seen that for the case of Amazon that the modern concept

of a dynamic value chain, embracing both physical and virtual links, is required to accurately describe its business model. Amazons business strategy can now be

described relative to this chain in the way described earlier. That is, recall the concept of a business model can be classified as follows:


The business performs similar activities in different ways

The business chooses not to perform certain activities

The first two of these apply to Amazons strategy. First, the embracing of virtual activities and the inclusion of dynamic links on the chain are examples performing

different activities from rivals. That is, initially Amazons rivals were Barnes and Noble and Borders and by choosing a web storefront compared to a bricks and

mortar storefront Amazons business strategy was to perform similar activities in different ways. The range of goods were then extended to the lofty objective for

offering Earths Biggest Selection and so Amazons rivals ultimately became the Wal-Marts, K-Marts, Targets and other retailing chains as opposed to the Barnes and

Nobles and Borders..

A second major pillar of Amazons strategy was to be Earths most customer centric . This was feasible with a web based model with real time database access to each of the primary links on the value chain. Customers could receive immediate support both in terms of fulfillment related questions, product information/ratings

issues and even product suggestions. If Amazon was successful at offering earths largest selection of products then amazon could draw to the attention of its customers

products that they never previously knew existed.

Combined in this way Amazons business strategy was largely built upon the objective of Get Big Fast (GBF) using a value chain that was internally linked so that

it was difficult for a competitor to attack any specific link. This strategy created large amounts of shareholder value for Amazon in the 1990s as the stock price chart below

reveals.


However, you can observe from the above that after an initial phase of phenomenal price appreciation problems started to emerge for Amazon as revealed from

Amazons Return on Equity which was becoming increasingly negative (1998 ROE = -.90, 1999 ROE = -2.70).

4.8 Wal-Mart and Target: Strategic Differences

In the case of Amazon, we saw how getting strategy into balance had a major impact upon stock price performance. We now examine the impact of different strategies on ratios and stock prices by comparing Wal-Mart and Target. Our objective is to apply

Financial Statement Analysis to identify the relative strengths and weaknesses of these companies (which are immediate competitors).

The tools we will use in this case study were introduced in Chapter 3. An overview of how we will analyze the companies is shown in Figure 1:

Figure 1: Summary of Business Ratio Analysis

We will start with the stock price performance of Wal-Mart and Target. Then, we will


We will start with the stock price performance of Wal-Mart and Target. Then, we will become acquainted with the business model and business strategy. After that, we

will compare them along three di

financial statement analysis business ratios

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