Identify the Industry Economic Characteristics
The economic characteristics and competitive dynamics of an industry play a key role in influencing the strategies firms in the industry employ, their profitability and risk factors, and therefore the types of financial statement relations you should expect to observe. Consider, for example, the financial statement data for firms in four different industries shown in Exhibit 1.3. This exhibit expresses all items on the balance sheets and income statements as percentages of revenue. Consider how the economic characteristics of these industries affect their financial statements.
Grocery Store Chain
The products of a particular grocery store chain are difficult to differentiate from similar products of other grocery store chains, a trait that characterizes such products as commodities. In addition, low barriers to entry exist in the grocery store industry; an entrant needs primarily retail space and access to food products distributors. Thus, extensive competition and nondifferentiated products result in a relatively low net income to sales, or profit margin, percentage (3.5% in this case). Grocery stores, however, need relatively few assets to generate sales (34.2 cents in assets for each dollar of sales). The assets are described as turning over 2.9 times (100.0%/34.2%) per year. (Each dollar invested in assets generated, on average, $2.90 of revenues.) Each time the assets of this grocery store chain generate one dollar of revenue, it generates a profit of 3.5 cents. Thus, during a one-year period, the grocery store earns 10.15 cents (3.5% 3 2.9) for each dollar invested in assets.
The economic characteristics and competitive dynamics of an industry play a key role in influencing the strategies firms in the industry employ, their profitability and risk factors, and therefore the types of financial statement relations you should expect to observe. Consider, for example, the financial statement data for firms in four different industries shown in Exhibit 1.3. This exhibit expresses all items on the balance sheets and income statements as percentages of revenue. Consider how the economic characteristics of these industries affect their financial statements.
Grocery Store Chain
The products of a particular grocery store chain are difficult to differentiate from similar products of other grocery store chains, a trait that characterizes such products as commodities. In addition, low barriers to entry exist in the grocery store industry; an entrant needs primarily retail space and access to food products distributors. Thus, extensive competition and nondifferentiated products result in a relatively low net income to sales, or profit margin, percentage (3.5% in this case). Grocery stores, however, need relatively few assets to generate sales (34.2 cents in assets for each dollar of sales). The assets are described as turning over 2.9 times (100.0%/34.2%) per year. (Each dollar invested in assets generated, on average, $2.90 of revenues.) Each time the assets of this grocery store chain generate one dollar of revenue, it generates a profit of 3.5 cents. Thus, during a one-year period, the grocery store earns 10.15 cents (3.5% 3 2.9) for each dollar invested in assets.
Pharmaceutical Company
The barriers to entry in the pharmaceutical industry are much higher than for grocery stores. Pharmaceutical firms must invest considerable amounts in research and development to create new drugs. The research and development process is lengthy with highly uncertain outcomes. Very few projects result in successful development of new drugs. Once new drugs have been developed, they must then undergo a lengthy government testing and approval process. If the drugs are approved, firms receive patents that give them exclusive rights to manufacture and sell the drugs for an extended period. These high entry barriers permit pharmaceutical firms to realize much higher profit margins on approved patent-protected products compared to the profit margins of grocery stores. Exhibit 1.3 indicates that the pharmaceutical firm generated a profit margin of 12.1%, more than three times that reported by the grocery store chain. Pharmaceutical firms, however, face product liability risks as well as the risk that competitors will develop superior drugs that make a particular firm’s drug offerings obsolete. Because of these business risks, pharmaceutical firms tend to take on relatively small amounts of debt financing as compared to firms in industries such as electric utilities and commercial banks.
Electric Utility
The principal assets of an electric utility are its capital-intensive generating plants. Thus, property, plant, and equipment dominate the balance sheet. Because of the large investments required by such assets, electric utility firms generally demanded a monopoly position in a particular locale, and until recent years, usually obtained it. Government regulators permitted this monopoly position but set the rates that utilities charged customers for electric services. Thus, electric utilities have traditionally realized relatively high profit margins (10.5% in this case) to offset their relatively low total asset turnovers (0.495 ¼ 100.0%/202.0% in this case). The monopoly position and regulatory protection reduced the risk of financial failure and permitted electric utilities to invest large amounts of capital in long-lived assets and take on relatively high proportions of debt in their capital structures. The economic characteristics of electric utilities have changed dramatically in recent years with gradual elimination of monopoly positions and the introduction of competition that affects rates, reducing profit margins considerably.
Commercial Bank
Through their borrowing and lending activities, commercial banks serve as intermediaries in the supply and demand for financial capital. The principal assets of commercial banks are investments in financial securities and loans to businesses and consumers. The principal financing for commercial banks comes from customers’ deposits and short-term borrowings. Because customers can generally withdraw deposits at any time, commercial banks invest in securities that they can quickly convert into cash if necessary. Because money is a commodity, one would expect a commercial bank to realize a small profit margin on the revenue it earns from lending (interest revenue) over the price it pays for its borrowed funds (interest expense). The profit margins on lending are indeed relatively small. In contrast, the 13.0% margin for the commercial bank shown in Exhibit 1.3 reflects the much higher profit margins it generates from offering fee-based financial services such as structuring financing packages for businesses, guaranteeing financial commitments of business customers, and arranging mergers and acquisitions. Note that the assets of this commercial bank turn over just 0.09 (100.0%/ 1,136.1%) times per year, reflecting the net effect of interest revenues and fees from investments and loans of 6–8% per year, which requires a large investment in financial assets.
The barriers to entry in the pharmaceutical industry are much higher than for grocery stores. Pharmaceutical firms must invest considerable amounts in research and development to create new drugs. The research and development process is lengthy with highly uncertain outcomes. Very few projects result in successful development of new drugs. Once new drugs have been developed, they must then undergo a lengthy government testing and approval process. If the drugs are approved, firms receive patents that give them exclusive rights to manufacture and sell the drugs for an extended period. These high entry barriers permit pharmaceutical firms to realize much higher profit margins on approved patent-protected products compared to the profit margins of grocery stores. Exhibit 1.3 indicates that the pharmaceutical firm generated a profit margin of 12.1%, more than three times that reported by the grocery store chain. Pharmaceutical firms, however, face product liability risks as well as the risk that competitors will develop superior drugs that make a particular firm’s drug offerings obsolete. Because of these business risks, pharmaceutical firms tend to take on relatively small amounts of debt financing as compared to firms in industries such as electric utilities and commercial banks.
Electric Utility
The principal assets of an electric utility are its capital-intensive generating plants. Thus, property, plant, and equipment dominate the balance sheet. Because of the large investments required by such assets, electric utility firms generally demanded a monopoly position in a particular locale, and until recent years, usually obtained it. Government regulators permitted this monopoly position but set the rates that utilities charged customers for electric services. Thus, electric utilities have traditionally realized relatively high profit margins (10.5% in this case) to offset their relatively low total asset turnovers (0.495 ¼ 100.0%/202.0% in this case). The monopoly position and regulatory protection reduced the risk of financial failure and permitted electric utilities to invest large amounts of capital in long-lived assets and take on relatively high proportions of debt in their capital structures. The economic characteristics of electric utilities have changed dramatically in recent years with gradual elimination of monopoly positions and the introduction of competition that affects rates, reducing profit margins considerably.
Commercial Bank
Through their borrowing and lending activities, commercial banks serve as intermediaries in the supply and demand for financial capital. The principal assets of commercial banks are investments in financial securities and loans to businesses and consumers. The principal financing for commercial banks comes from customers’ deposits and short-term borrowings. Because customers can generally withdraw deposits at any time, commercial banks invest in securities that they can quickly convert into cash if necessary. Because money is a commodity, one would expect a commercial bank to realize a small profit margin on the revenue it earns from lending (interest revenue) over the price it pays for its borrowed funds (interest expense). The profit margins on lending are indeed relatively small. In contrast, the 13.0% margin for the commercial bank shown in Exhibit 1.3 reflects the much higher profit margins it generates from offering fee-based financial services such as structuring financing packages for businesses, guaranteeing financial commitments of business customers, and arranging mergers and acquisitions. Note that the assets of this commercial bank turn over just 0.09 (100.0%/ 1,136.1%) times per year, reflecting the net effect of interest revenues and fees from investments and loans of 6–8% per year, which requires a large investment in financial assets.
No comments:
Post a Comment