Class exercise 1_solution

MSc F&A
Common-size statements
Class exercise solution

Requirement i)
Company Industry
1 Chemicals and pharmaceuticals
2 Aerospace
3 Computer science
4 Department stores
5 Consumer foods
6 Electric utility
7 Newspaper publishing
8 Consumer finance
9 Airline

Requirement ii)
The airline, consumer finance, and electric utility industries are service industries. They
are characterized by the absence of cost of goods sold and inventories. Companies 6, 8,
and 9 have the lowest ratios (COS/sales and inventories/total assets). Newspaper
publishing may also be considered a service industry; we will return to this later.

Company 8 is the consumer finance company. It has a high level of debt balanced by a
high level of receivables and investments (loans and securities). Much of its debt is
short-term, reflecting the short maturities of its loans. It has almost no fixed assets. The
ratio of interest expense to revenues is the highest for this company.

Both the electric utility and airline firms would have high fixed assets; utilities generally
have higher assets (lower asset turnover), are more profitable, and have higher debt
and interest expense. Airlines, on the other hand, have high current liabilities for trade
payables (payments to suppliers) and for advance ticket sales (other current liabilities).
We conclude that company 6 is the electric utility and company 9 is the airline.

Companies 1, 2, and 3 have high R&D expense, consistent with the aerospace,
chemicals and drugs, and computer software industries. Aerospace would have the
highest inventory (low inventory turnover). Customer prepayments under long term
contracts result in lower receivables and large customer advances (other current
liabilities). Therefore, company 2 is the aerospace firm.
Distinguishing company 1 from company 3 is difficult. Computer software and drugs are
both characterized by high R & D. The inclusion of chemicals, however, should lower
the intensiveness of R&D, suggesting that company 3 is the computer software firm.
Computer software, lacking manufacturing, is less capital intensive than chemicals and
drugs and the latter is generally more profitable. Further, the chemical industry (being
older) should have "older" plant (greater proportion depreciated). Company 1 is,
therefore, the chemical and drugs firm and company 3 is in the computer software
industry.

Companies 4, 5, and 7 remain. Company 4 has high inventories and COS, the highest
receivables relative to assets, and high asset turnover, all of which suggest a retailer. It
has no R&D, high advertising expense, and low pre-tax profit margins. Company 4 is
the department store firm.

Company 5 has high net property relative to assets, and the highest ratio of advertising
to revenues. Company 5 must be the consumer foods company.

Company 7 is the newspaper publisher. It has very low inventory but high cost of goods
sold; inventory is primarily newsprint while cost of goods sold includes the high cost of
reporting and production. Company 7 has the highest intangibles (newspapers
purchased) and very high pre-tax profit margins (most newspapers have only indirect
competition).

Summary
This exercise was intended to show that industries have balance sheet and income
statement characteristics that set them apart from others. These characteristics are
often used to compare firms within an industry (e.g. advertising as a percentage of sales
for consumer goods firms). Summarized data should be used with caution, however.
Different firms (even in the same industry) classify identical items differently. Thus the
analyst should examine original financial statements to achieve better comparability.
Differences among firms may be due to operational or classification differences. When
management is available to answer questions, these differences are often useful
starting points for obtaining a better understanding of the firm.