Industry Identification through Ratio Analysis*

Industry Identification through Ratio Analysis* MERRIDEE BUJAKI, University of Ottawa SYLVAIN DUROCHER, University of Ottawa ABSTRACT 1

This case is designed to help students “see through the numbers”. Written initially for MBA students and senior analysts attending executive education sessions, it provides participants with (1) a common-size balance sheet and selected financial ratios for ten anonymous Canadian public companies, and (2) a list of ten diverse industry sectors. Participants are invited to reflect on the meanings of the different ratios provided in order to match the anonymous companies with their corresponding industry sector. Seeing through the numbers fosters the development of participants’ analytical skills, and group discussions contribute to the sharing of participants’ knowledge about the various industry segments involved.

Keywords Executive education; Industry classification; MBA; Ratio analysis DÉTERMINATION DU SECTEUR GRÂCE À L’ANALYSE INDICIAIRE RÉSUMÉ Le cas propose´ a pour but d’aider les e´tudiants a` « percer le sens des chiffres ». Re´dige´ au de´part pour les e´tudiants de programmes MBA et les analystes principaux assistant a` des seánces de formation des cadres, il fournit aux participants 1) un bilan en chiffres relatifs et certains ratios financiers se´lectionne´s pour dix socie´te´s canadiennes anonymes faisant appel public a` l’e´pargne et 2) une liste de dix diffe´rents secteurs d’activite´. Les participants sont invite´s a` re´flećhir au sens des diffe´rents ratios qui leur sont pre´sente´s afin d’associer les socie´te´s anonymes au secteur d’activite´ correspondant. Percer le sens des chiffres favorise le de´veloppement des compe´tences analytiques des participants, et les discussions de groupe contribuent au partage des connaissances que posse`dent les participants au sujet des divers secteurs d’activite´ en cause.

Mots clés : analyse indiciaire, classification sectorielle, formation des cadres, MBA The common-size balance sheets and a selection of financial ratios for ten anonymous Canadian public companies pertaining to their 2009 fiscal years are provided in Exhibit 1. These companies are listed as “A” to “J”. The financial information was * The authors would like to thank Industry Canada and the Centre for Executive Leadership of the Telfer School of Management of the University of Ottawa for the multiple opportunities offered for classroom testing of this case. They would also like to thank two anonymous reviewers and the editor for their helpful comments. 1. The format of this case is based on Drivers of Industry Financial Structure by Dwight B. Crane and Indra A. Reinbergs, published by Harvard Business School Publishing (HBS 9-201-039). Unlike the HBS case that used U.S. company data, this one is based on Canadian companies, uses more recent data and different industry segments, and provides a discussion of learning objectives, implementation guidance, and the results of classroom testing.

AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012) pages 315–322 © CAAA /ACPC doi:10.1111/1911-3838.12003

316

ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES

computed from the financial statements published on their respective websites or from the SEDAR database. Because ratio definitions can vary from one textbook to another or from one database to another, Exhibit 2 presents the precise definitions used in the present case. The companies for which financial information is provided in Exhibit 1 were selected from ten different industries. They pertain to the following industry classifications: 1. Airline 2. Bank 3. Developer and manager of commercial property 4. Electricity utility 5. Gold producer 6. Large retailer 7. Manufacturer of communications hardware 8. Oil producer 9. Professional services 10. Software developer Required Use the financial information provided for each company in Exhibit 1 and your personal knowledge of the industries listed above to match each company with its respective industry segment. Provide a brief rationale for your classifications. If needed, refer to the ratio definitions provided in Exhibit 2. CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE The traditional way to teach financial statement analysis to nonaccountants is to discuss the nature and meaning of each financial statement and its components, to present the relevance of horizontal (trend) analysis and vertical (common size) analysis, and to see how different categories of ratios reflect an enterprise’s profitability, operating activities, solvency, and leverage. Ratio analysis is also used to infer management strategies, for instance through the use of the du Pont model. The traditional teaching approach usually requires students to perform ratio analysis for a specific company, and to perform comparisons of different companies within the same industry and/or across industry sectors. The conventional

AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012)

0.8% 0.7% 1.7% 32.0% 66.0% 0.4% 1.6% 68.0% 100.0%

Accounts receivable

Inventory

Other current assets

Total current assets

Plant & equipment

Goodwill & intangibles

Other noncurrent assets

Total noncurrent assets

Total assets 6.6% 10.0% 4.9% 21.6% 30.0% 0.0% 8.6% 0.0%

Accounts payable

Unearned revenues

Other current liabilities

Total current liabilities

Long term debt

Asset retirement obligations

Other long term liabilities

Minority interest

Liabilities

28.8%

A

Cash & marketable securities

Assets

Common-size balance sheet

EXHIBIT 1 Financial information

0.0%

1.7%

0.0%

0.0%

23.8%

23.8%

17.8%

6.0%

100.0%

43.0%

9.4%

14.5%

19.2%

57.0%

4.7%

6.1%

27.4%

18.7%

B

0.0%

9.8%

0.0%

1.1%

40.4%

11.4%

0.0%

29.1%

100.0%

26.8%

7.6%

1.0%

18.2%

73.2%

3.2%

25.0%

3.9%

41.0%

C

0.7%

7.2%

2.0%

43.8%

15.3%

9.5%

0.0%

5.8%

100.0%

86.4%

23.4%

3.4%

59.6%

13.6%

2.1%

3.3%

7.8%

0.4%

D

4.6%

11.6%

0.0%

55.0%

5.3%

0.0%

0.0%

5.3%

100.0%

87.7%

0.0%

2.5%

85.2%

12.3%

1.5%

0.0%

9.5%

1.3%

E

0.0%

3.6%

4.6%

16.2%

21.6%

5.5%

0.0%

16.1%

100.0%

79.9%

4.9%

1.5%

73.6%

20.1%

4.1%

3.2%

9.8%

2.9%

G

0.0%

11.4%

0.0%

52.9%

38.9%

8.2%

5.9%

24.8%

100.0%

63.6%

1.9%

57.6%

4.1%

36.4%

2.5%

0.6%

13.9%

19.4%

H

0.1%

24.3%

0.0%

0.0%

70.6%

0.0%

0.0%

70.6%

100.0%

10.4%

9.3%

0.7%

0.5%

89.6%

0.0%

0.0%

53.6%

35.9%

I

0.0%

8.3%

0.0%

17.7%

25.3%

5.8%

4.6%

14.9%

100.0%

63.6%

6.5%

47.4%

9.6%

36.4%

4.1%

0.0%

31.1%

1.3%

J

(The table is continued on the next page.)

0.0%

11.6%

2.3%

16.8%

4.5%

0.8%

0.0%

3.7%

100.0%

85.8%

1.4%

0.0%

84.3%

14.2%

4.1%

4.1%

2.2%

3.9%

F

INDUSTRY IDENTIFICATION THROUGH RATIO ANALYSIS

317

AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012)

1.6% 39.8%

Other

Total shareholders’ equity

AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012) 0.99 0.65 0.03 0.07 1.52

Fixed asset turnover

Total asset turnover

Net income/assets (ROA)

Net income/equity (ROE)

Debt/equity

n.m. - not meaningful.

n.m.

Inventory turnover

Net income/sales (profit margin) 4

0.0% 4.3%

R&D/sales

Days of receivables

53.6%

Gross margin

Selected ratios

100.0%

20.0%

Retained earnings

Total liabilities and shareholders’ equity

0.0% 18.1%

Common shares

60.2%

A

Preferred shares

Shareholders’ Equity

Total liabilities

EXHIBIT 1 (Continued)

0.34

0.32

0.24

1.47

7.64

10.59

68

16.4%

6.5%

44.0%

100.0%

74.5%

2.1%

51.7%

20.7%

0.0%

25.5%

B

1.05

0.14

0.07

1.53

8.39

5.53

9

4.5%

0.0%

9.4%

100.0%

48.7%

0.2%

48.0%

0.5%

0.0%

51.3%

C

2.23

0.11

0.03

0.28

0.46

n.m.

103

12.0%

0.0%

23.7%

100.0%

31.0%

3.5%

11.1%

20.8%

2.6%

69.0%

D

3.26

0.07

0.02

0.13

0.15

n.m.

266

11.8%

0.0%

55.3%

100.0%

23.5%

0.3%

5.6%

16.1%

1.5%

76.5%

E

0.54

0.03

0.02

0.15

0.18

1.76

53

13.5%

0.0%

52.1%

100.0%

64.8%

3.7%

5.1%

56.0%

0.0%

35.2%

F

0.85

0.17

0.09

1.22

1.66

28.16

29

7.4%

0.0%

25.8%

100.0%

54.0%

7.6%

53.0%

8.6%

0.0%

46.0%

G

32.02

0.44

0.01

1.03

25.43

56.09

49

1.4%

16.6%

67.3%

100.0%

3.2%

1.6%

22.1%

20.5%

0.0%

103.2%

H

19.04

0.14

0.01

0.05

10.57

n.m.

3878

14.2%

0.0%

50.7%

100.0%

5.0%

0.8%

4.0%

1.0%

0.7%

95.0%

I

1.05

0.17

0.08

1.11

11.48

n.m.

102

7.4%

0.0%

56.3%

100.0%

48.7%

4.6%

32.4%

20.9%

0.0%

51.3%

J

318 ACCOUNTING PERSPECTIVES / PERSPECTIVES COMPTABLES


319

EXHIBIT 2 Ratio definitionsa Ratio

Calculation

Interpretation

Gross margin

(Sales – cost of goods sold)/sales

A measure of the amount of each sales dollar that is available to cover operating expenses and generate profit.

R&D/sales

R&D/sales

Level of investment in research and development relative to sales.

Profit margin

Net income/sales

Net income resulting from each dollar of sales; an indicator of profitability.

Days of receivables

Accounts receivable/ average day’s sales

Average age of the accounts receivable; an indicator of the efficiency of the firm’s collection policies relative to its credit terms.

Inventory turnover

Cost of goods sold/ inventories

Number of times per year that the value of inventory is replaced; an indicator of the efficiency of the firm’s inventory management practices.

Fixed asset turnover

Sales/plant & equipment

The efficiency with which fixed assets are used to generate sales.

Total asset turnover

Sales/total assets

The efficiency with which assets are used to generate sales.

Return on assets

Net income/assets

How much profit is generated for each dollar invested in assets; an indicator of success in generating profit for each dollar of assets.

Return on equity

Net income/total owners’ equity

Rate of return on that portion of the assets provided by the owners.

Debt/ equity

Total liabilities/ total owners’ equity

Proportion of debt in capital structure; reflects the risk caused by the interest and principal requirements of debt.

Notes: a

The definitions provided in this table are classical ones used in financial analysis textbooks (see, e. g., Marshall, McManus, and Viele, 2011). Some ratios may be computed slightly differently for firms in specific industry segments. The balance sheet numbers considered in the ratio computations in this table are those as at 2009 year-end.

approach thus involves a “single company ⇒ population”2 oriented teaching strategy. Thinking the other way around involves a reflection on how different industry sectors, given their respective characteristics, would retrospectively affect financial statement figures and financial ratios. This involves a “population ⇒ single company” oriented teaching strategy. This approach involves a higher degree of 2. The term “population” is used to represent the large number of companies that compose an industry segment. However, the authors recognize that it may be difficult to make inferences and draw conclusions on populations. AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012)

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abstraction for students, essentially seeing through the numbers. It also involves the use of adapted teaching material, which is an objective of the present case. The choice of industry sectors included in the case was driven by two selection criteria. First, a sufficient number of Canadian companies had to exist in the sector. Second, the sector’s activities had to be not so specialized that we could not expect our class participants to be able to infer them. Case Learning Objectives The general objective of this case is to enhance participants’ analytical skills, in particular their financial analysis skills. The case requires a higher level of abstraction than the usual “single company ⇒ population” approach. Indeed, it requires students to imagine the activities involved in specific industry segments and their respective unique characteristics and figure out how these activities and characteristics would be reflected in a company’s financial statements and financial ratios, given the period under study (i.e., 2009). Additional specific objectives include enhancing participants’ knowledge of the content of financial statements and the computation of financial ratios, increasing their ability to compare industry segments, and stimulating the sharing of knowledge, learning from peers and group discussion. Implementation Guidance This case is targeted at senior undergraduate students, graduate students, or executives who possess a basic knowledge of financial statements and ratio analysis. For example, it is well-suited for MBA or executive MBA accounting courses or executive education. The case is designed to be discussed in small groups of four to six members with diverse industry backgrounds. The professor or facilitator circulates from one group to another to stimulate discussion, provide insights to deepen the analysis and answer specific questions in relation to prerequisite knowledge. The group discussion of about 30 to 40 minutes is then followed by a plenary class discussion of another 20 to 30 minutes to compare the classifications adopted by each group, discuss the rationales supporting these classifications, provide the participants with the names of the ten companies involved (and thus the appropriate classification), and finally obtain feedback from participants about the merits of the activity. CLASSROOM TESTING This case was used ten times by the authors in 2010 and 2011. It was developed for the specific needs of an executive MBA accounting course offered in a Canadian university and for the specific requirements of executive training sessions mainly involving Industry Canada senior analysts. More recently, the case was used in several MBA classes as well. Each time, the use followed the implementaAP Vol. 11 No. 4 — PC vol. 11, no 4 (2012)


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tion guidance stated above. The average time required to complete the activity was 60 minutes. The verbal feedback obtained from participants revealed that they found the case to be of appropriate level of difficulty (i.e., not too complex and not too easy). About 90 percent of the groups involved were able to perform an appropriate matching. The plenary discussions about the matches were fruitful for identifying the different rationales supporting the classification of a company under a specific industry segment. All groups did not necessarily invoke exactly the same reasons for their classification. Also of particular relevance were the discussions about the mismatches, in the sense that the groups had to explain why the financial statement and ratio figures led them to think that the mismatched enterprise belonged to a specific industry segment. The other groups were then able to provide their own rationales. Ideas could then be debated, which contributed to a deeper understanding of the meanings of key ratios and financial information, and of the similarities and differences across industry segments. As group members held different backgrounds, the group discussions were fruitful in sharing knowledge about the diverse industries involved, in confronting interpretations of financial ratios, and in imagining the types of accounts likely to be included in financial statement information. Participants considered having groups made up of individuals with a variety of backgrounds to be an important aspect of the case. It is also worth noting that while circulating among groups, professors were frequently asked to explain the meaning of asset retirement obligations, minority interests, and unearned revenues appearing on the common-size balance sheets. One instance of the use of this case highlighted the importance of participants having sufficient basic knowledge of financial statements and financial ratios. During one particular executive training session, some participants who were not sufficiently familiar with these concepts were quite lost in their respective group deliberations, and found the case to be beyond their capabilities. In evaluating the case, many individuals commented on how much they enjoyed the challenge of the exercise, which some described as an “intellectual puzzle”. Other individuals commented on how the exercise gave them confidence that through their previous life experiences they had acquired considerable background information relevant to understanding financial statements and financial statement analysis. TEACHING NOTES Teaching notes for instructional cases are not published in the journal but are made available to full CAAA member subscribers in a password-protected area of the CAAA website. If you are a full member of the CAAA with a subscription to Accounting Perspectives and wish to obtain a copy of the Teaching Notes, please go to http:// www.caaa.ca/AccountingPerspectivesAP/JournalIssues/CasesTNSM to log in and access the notes. AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012)

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REFERENCES Crane, D. B., and I. A. Reinbergs. 2000. Drivers of industry financial structure. Boston: Harvard Business School Publishing. Marshall, D. H., W. W. McManus, and D. F. Viele. 2011. Accounting: What the numbers mean. New York: McGraw-Hill/Irwin.

AP Vol. 11 No. 4 — PC vol. 11, no 4 (2012)

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Industry Identification through Ratio Analysis*

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