Dr. Nancy Mangold, CSUH1 Financial Reporting and Financial Statement Analysis Dr. Nancy Mangold California State University, East Bay

Dr. Nancy Mangold, CSUH 1

Financial Reporting and Financial Statement Analysis

Dr. Nancy MangoldCalifornia State University, East Bay


Financial Statement Analysis - Purposes

Making an investment (common or preferred stocks)

Extending credit– short-term (bank loan to finance receivables or

inventories)– long-term (bank loan or public bond to finance

acquisition of property, plant, or equipment)



Assessing the operating performance and financial health of a supplier, customer, or competitor.

Valuing a firm in settings such as– the initial public offering of its common stock– as an acquisition candidate– in court-directed bankruptcy hearings or– in liquidation actions



Forming a judgment about damages sustained in a lawsuit

Forming an opinion on a client’s financial statements with respect to whether the client is a “going concern”

Assessing whether combinations in an industry might generate monopoly returns, thus prompting antitrust action by government regulators


Steps in Financial Statement Analysis

1.Identify

Economic Characteristics

2. Identify CompanyStrategies

3. Understand and

Cleanse the Financial

Statements

4.Analyze

Profitability and Risk

5. Value the Firm


Overview of Financial Statement Analysis

Identify the economic characteristics of the particular industry

Identify the strategies that a particular firm pursues to gain competitive advantage

Understand the financial statements of the particular firm and cleanse them of nonrecurring and unusual items


Overview of Financial Statement Analysis

Assess the profitability and risk of the firm using information in the financial statements

Value the particular firm


Identify the Industry Economic Characteristics

A large number of firms selling similar products

Grocery stores– Similar (non-differentiated) products– Low barriers to entry (retail space & access to

food product distributors)– Extensive competition– Low assets invested and high asset turnover



A smaller number of competitors selling unique products

Pharmaceutical companies– High entry barrier

» High R&D to create new drugs

» Lengthy government approval process to receive a patent for a new drug

» Exclusive rights to manufacture and sell the product for a long time



Pharmaceutical companies– Higher profit margins– Unique product liability risks– Risk of competitor develop superior drugs that

make one firm’s drug obsolete– Small debt financing



Technological change critical to a firm’s maintaining a competitive advantage

Computer software



Rapid growth in Industry sales Internet search services

– Yahoo, Excite, Lycos Internet service providers

– AOL– Earthlink

E-commerce – Amazon.com– eBay



Capital intensive industry Electric utility

– Large investments in property, plant & equipment– Monopoly in a particular area– Regulators set the rates– High profit margins to offset low asset turnover– High proportion of debt– Deregulation and market rates will reduce profit

margins.



Commercial Bank Assets

– Investment in short-term financial securities– Loans to businesses and consumers

Financing– Customer deposits– Short-term borrowing



Commercial Banks Small profit margins on interest rate

difference between lending and borrowing Fee based financial service more profitable

– Arranging mergers and acquisitions– Structuring financing packages for businesses– Guaranteeing financial commitments of

business customers


Tools for Studying Industry Economics

Value Chain Analysis Porter’s five forces classification An Economic attributes framework


Value Chain Analysis

A value chain for an industry involves the creation. Manufacture, and distribution of its products and services


Value ChainPharmaceutical Industry

Research to DiscoverDrugs

Approval of Drugs by

Government Regulators

Manufactyre ofDrugs

Creation of Demand for

DrugsDistribution to

Customers



Where value gets added in an industry? Value of drug discovery

– Prices paid to acquire firms with promising or newly discovered drugs

Value to test and obtain approval of new drugs– prices paid to clinical research firms to test and

to obtain approval of new drugs



Identify the strategic positioning of a particular firm within the industry

Traditionally in– Research discovery– Manufacturing– Demand Creation

Not in– Distribution to customers to pharmacies– Contract out drug testing and approval phase


Value Chain Beverage Industry

Creation ofBeverageProduct

Manufacture ofConcentrate

Mixing of Concentrate,

Water, Sweetenerto Produce

Beverage or Syrup

Containerizing Beverage or Syrup in Bottles, Cans or

other Container

Distribution to Retail Outlets


Value Chain Beverage Industry

Coke engages in– New Product Development– Manufacture of Concentrate (secret ingredients and

formula) Contract out bottling operation

– 15% subsidiaries– 40% independent bottlers– 45% noncontrolled affiliates– Bottlers ship beverages to retail stores


Business strategy analysis is an important starting point for the analysis of financial statements

It allows the analyst to probe the economics of the firm at a qualitative level

It allows the identification of the firm’s profit drivers and key risks

Business Strategy Analysis



Enabling the analyst to assess the sustainability of the firm’s performance and make realistic forecasts of future performance



Useful in guiding financial analysis Cross-sectional analysis

– expect firms with cost leadership strategy to have lower gross margins and higher asset turnover than firms that follow differentiated strategies



Useful in guiding financial analysis Time-series analysis

– closely monitor any increases in expense ratios and asset turnover ratios for low cost firms.

– monitor any decreases in investments critical to differentiation for firms that follow differentiation strategy.


Industry Analysis

In analyzing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in which the firm is competing.

The profitability of various industries differs systematically.


Industry Analysis

ROE - 1971-1990 All US Mfg. Companies 12.6% Food & kindred prod. ind. 15.2% Paper & allied prod. ind. 12.5% Iron & Steel ind. 3.9%


Industry Analysis

Industry structure influences profitability of firms in an industry

Average profitability of an industry is influenced by five forces.


Porter’s Five Forces Classification

Degree of actual and potential competition– Rivalry among existing firms– Threat of New Entrants– Threat of Substitute Products

Bargaining power in input and output mkts– Bargaining power of buyers– Bargaining power of suppliers


Industry Structure and Profitability

Degree of Actual and Potential Competition

Industry Profitability

Bargaining Power of Buyers

Rivalry Among Existing firms

Threat of New Entrants

Threat ofSubstitute Products

Bargaining Power in Input and Output Markets

Bargaining Power of Suppliers



Rivalry Among

Existing Firms

Industry Growth

Concentration

Differentiation

Switching Costs

Scale/Learning economies

Fixed-Variable costs

Excess Capacity

Exit Barrier

Threat of

New Entrants

Scale Economies

First mover Advantage

Distribution Access

Relationships

Legal Barriers

Threat of

Substitute Products

Relative price and performance

Buyers’ willingness to switch


Bargaining Power in Input and Output Markets

Bargaining Power

of Buyers

Switching costs

Differentiation

Importance of product for cost and quality

Number of buyers

Volume per buyer

Bargaining Power

of Suppliers

Switching costs

Differentiation

Importance of product for cost and quality

Number of suppliers

Volume per supplier



Profits in an industry are a function of the max price that customers are willing to pay for the industry’s product or service

One of the key determinants of price is the degree of competition among suppliers of the same or similar products



Perfect Competition– Price = marginal cost– few opportunities for super-normal profits

Monopoly– earn monopoly profits

Most Industry in between perfect competition and monopoly


3 Competitive Forces in an Industry

Rivalry between existing firms Threat of entry of new firms Threat of substitute products or services


Competitive Force 1:Rivalry among Existing Firms

In some industries, firms compete aggressively, pushing price close to marginal cost

In other industries, they find ways to coordinate their pricing, or compete on non-price dimensions (innovation, brand image)

Several factors determine the intensity of competition between existing players in an industry


Industry Growth Rate

If an industry is growing very rapidly, existing firms need not grab market share from each other to grow

In stagnant industries, the only way existing firms can grow is by taking share away from the other players– price wars


Concentration and Balance of Competitors

The number of firms in an industry and their relative sizes determine the degree of concentration in an industry

The degree of concentration influences the extent to which the firms in an industry can coordinate their pricing and other competitive moves


Concentration and Balance of Competitors

One dominant firm in an industry– IBM mainframe computer ind. in 1970s

– it can set and enforces the rules of competition

Two or three equal-sized players– Coke and Pepsi in US soft-drink industry

– can implicitly cooperate with each other to avoid destructive price competition

Industry Fragmented – Severe price competition


Degree of Differentiation and Switching Costs

The extent of competition depends on the extent to which firms in an industry can differentiate their products and services

If the products in an industry are very similar, customers are ready to switch from one competitor to another purely on the basis of price


Degree of Differentiation and Switching Costs

Switching costs determine customers’ propensity to move from one product to another

When switching costs are low, there is a greater incentive for firms in an industry to engage in price competition


Scale /Learning Economies and the Ratio of Fixed to Var. Costs

If there is a steep learning curve or there are other types of scale economies in an industry, size becomes an important factor for firms in the industry

In such situations, there are incentives to engage in aggressive competition for market share


Scale /Learning Economies and the Ratio of Fixed to Var. Costs

If the ratio of fixed to variable costs is high, firms have an incentive to reduce prices to utilize installed capacity– Airline industry, price wars are common


Excess Capacity and Exit Barrier

If capacity in an industry is larger than customer demand, there is a strong incentive for firms to cut prices to fill capacity.

Excess capacity will be more problem if there are significant barriers for firms to exit the industry

Exit barriers are high when the assets are specialized, or if there are regulations which make exit costly.


Competitive Force 2: Threat of New Entrants

The potential of earning abnormal profits will attract new entrants to an industry.

The very threat of new firms entering an industry potentially constrains the pricing of existing firms within it.

The ease with which new firms can enter an industry is a key determinant of its profitability.


Competitive Force 2: Threat of New Entrants

Several factors determine the height of barriers to entry in an industry– Economies of scale– First mover advantage– Access to channels of distribution and

relationships– Legal barrier


Economies of Scale

When there are large economies of scale, new entrants face the choice of having– either to invest in a large capacity which night

not be utilized right away, – or to enter with less than the optimum capacity

New entrants will at least initially suffer from a cost disadvantage in competing with existing firms


Economies of Scale

Economies of scale might arise from large investments in– research and development

» Pharmaceutical or Jet engine industries

– brand advertising» Soft-drink industry

– physical plant and equipment» Telecommunications industry


First Mover Advantage

Early entrants in an industry may deter future entrants if there are first mover advantages

First mover might be able to – set industry standards

– enter into exclusive arrangements with suppliers of cheap raw materials

– acquire scarce government licenses to operate in regulated industries


First Mover Advantage

If there are learning economies, early firms will have an absolute cost advantage over new entrants.

First mover advantages are also likely to be large when there are significant switching costs for customers once they start using existing products. (DOS, Windows)


Access to Channels of Distribution and Relationships

Powerful barriers to entry Limited capacity in the existing distribution

channels High costs of developing new channels



Examples Formidable barriers for a new entrant into

the domestic auto industry– difficulty of developing a dealer network

New consumer goods manufacturer– difficult to obtain supermarket shelf space for

their products



Existing relationships between firms and customers in an industry make it difficult for new firms to enter an industry– Auditing– Investment banking– Advertising


Legal Barriers

Patents and copyrights in research-intensive industries limit entry

Licensing regulations limit entry into – medical services– broadcasting – telecommunications


Competitive Force 3:Threat of Substitute Products

Substitutes for travel over short distance– Airlines and car rental services

Substitutes as packaging in the beverage industry– plastic bottles and metal cans

New technology changes usage of product– Energy conserving technology reduce

consumption of electricity and fossil fuels


Competitive Force 3: Threat of Substitute Products

The threat of substitutes depends on– the relative price and performance of the

competing products or services– on customers’ willingness to substitute


Competitive Force 3:Threat of Substitute Products

Customers’ willingness to switch A critical factor in making this competitive

dynamic work– tap water and bottled water (price premium)– designer label clothing (price premium),

customers place a value on the image offered by designer labels.


Relative Bargaining Power in Input and Output Market

On the input side, firms enter into transactions with suppliers of – Labor, raw materials and components– Finances

On the output side, firms either – Sell directly to the final customers or– Enter into contracts with intermediaries in the

distribution chain


Relative Bargaining Power in Input and Output Market

The relative economic power of the two sides is important to the overall profitability of the industry firms


Competitive Force 4: Bargaining Power of Buyers

Two factors Price sensitivity

– determines the extent to which buyers care to bargain on price

Relative bargaining power– determines the extent to which they will

succeed in forcing the price down


Price Sensitivity

Buyers are more price sensitive when the product is– undifferentiated and– there are few switching costs– the importance of the product to their cost

structure


Price Sensitivity

When the product represents a large fraction of the buyers’ cost– Buyer is likely to expend the resources to shop

for a lower cost alternative. If the product is a small fraction of the

buyers’ cost– Buyer may not expend resources to search for

lower cost alternatives


Price Sensitivity

The importance of the product to the buyers’ product quality also determines whether or not price becomes the most important determinant of the buying decision


Relative Bargaining Power

Relative bargaining power in a transaction depends ultimately on the cost to each party of not doing business with the other party


Relative Bargaining Power The buyers’ bargaining power is determined by

– the number of buyers relative to the number of suppliers

– volume of purchases by a single buyer

– number of alternative products available to the buyer

– buyers’ costs of switching from one product to another

– threat of backward integration by the buyers



Automobile industry Car manufacturers have considerable power

over component manufacturers– large buyers– several alternative suppliers to choose from– switching costs are relatively low



PC industry Computer makers have low bargaining

power relative to the operating system software producers because of high switching costs


Competitive Force 5: Bargaining Power of Suppliers

Suppliers are powerful when – there are only a few companies– there are few substitutes available to their

customers



In the soft-drink industry– Coke and Pepsi very powerful relative to the

bottlers– metal can suppliers not powerful because

» intense competition among can producers

» threat of substitution of cans by plastic bottles



Suppliers also have a lot of power over buyers when the suppliers’ product or service is critical to buyers’ business– Airline pilots in the airline industry



Suppliers also tend to be powerful when they pose a credible threat of forward integration– IBM powerful relative mainframe computer

leasing companies because of IBM’s unique position as a mainframe supplier


The Industry Analysis:The PC Industry

The PC industry began in 1981 when IBM announced its PC with Intel’s microprocessor and Microsoft’s DOS operating system

In 1997 US had an installed base of 100 million personal computers

In 1997 shipments were 30 million units, up 21% from 1996



Despite this spectacular growth, the PC industry in 1993 was characterized by low profitability

IBM, Compaq and Dell reported poor performance in the early 1990s and were forced to undergo internal restructuring


Competition in the PC IndustryReasons

the industry was highly fragmented – many firms producing virtually identical

products– Top 5 vendors controlling 60% market share– Competition intense, leading to routine price

cuts on a monthly basis



Component costs accounted for more than 60% of total hardware costs of a personal computer

Volume purchases of components reduced these costs

intense competition for market share among competing manufacturers



Products produced by different firms in the industry were virtually identical and

There were few opportunities to differentiate the products

Brand name and service customers value in the early years

Less important as PC buyers became more informed about the technology



Switching costs across different brands of PCs were relatively low

Vast majority of the PCs used Intel microprocessors and Microsoft Windows operating systems



Access to distribution was not a significant barrier– Dell Computers distributed through direct mail

in 1980s and introduced Internet-based sales in the mid 1990s

– Computer superstores, CompUSA, willing to carry several brands



Virtually all the components needed to produce a personal computer were available for purchase

There were very few barriers to entering the industry– Michael Dell in early 1980s assembled PCs in

his Univ. of Texas dormitory room



Apple’s Macintosh computers offered significant competition as a substitute product.

Work stations produced by Sun, DEC, and other vendors were potential substitutes at the higher end of the PC market.


The Power of Suppliers and Buyers

Suppliers and buyers had significant power over firms in the industry

Key hardware and software components for PCs were controlled by firms with virtual monopoly

Intel - microprocessor production Microsoft - DOS and Windows op. systems



Buyers gained more power during the ten years from 1983 to 1993

Corporate buyers (a significant portion of the customer base) were highly price sensitive since the expenditure on PCs represented a significant cost to their operations



As customers became knowledgeable about PC technology, they were less influenced by brand name in their purchase decision

Buyers increasingly viewed PCs as commodities and used price as the most important consideration in their buying decision



Intense rivalry and low barriers to entry in the personal computer industry, there was severe price competition among different manufacturers

There was tremendous pressure on firms to spend large sums of money to – introduce new products rapidly– maintain high quality– provide excellent customer support



These factors led to a low profit potential in the industry

The power of suppliers and buyers reduced the profit potential further

PC industry represented a technologically dynamic industry, its profit potential was poor.



Few indications of change in the basic structure of the personal computer industry, there was little likelihood of viable competition emerging to challenge the domination of Microsoft and Intel in the input markets

The profitability of the PC industry may not improve significantly any time in the future


Competitive Strategy Analysis



The profitability of a firm is influenced not only by its industry structure but also by the strategic choices it makes in position itself in the industry

There are two main competitive strategies– Cost leadership– Differentiation


Cost LeadershipSupply same product or service at a lower cost

Economies of scale and scope

Efficient production

Simpler product designs

Lower input costs

Low cost distribution

Little R& D or Brand advertising

Tight cost control system

DifferentiationSupply a unique product or service at a cost lower than the price premium customers will pay

Superior product quality

Superior product variety

Superior customer service

More flexible delivery

Investment in brand image

Investment in R&D

Control system focus on creativity and innovation

Competitive Advantage

Match between firm’s core competencies and key success factors to execute strategy

Match between firm’s value chain and activities required to execute strategy

Sustainability of competitive advantage



Sources of Competitive Advantage

Cost Leadership Differentiation


Competitive Strategy 1:Cost Leadership

enables a firm to supply the same product or service offered by its competitors at a lower cost

When the product or service is a commodity, cost leadership might be the only way to achieve superior performance


Ways to Achieve Cost Leadership

Economies of scale and scope Economies of learning Efficient production Simpler product design Lower input costs low cost distribution Little R & D Little brand advertising Tight cost control systems Efficient organizational processes


Cost Leader Focus on tight cost control make investment in efficient scale plants Focus on product designs Reduce manufacturing costs Minimize overhead costs Make little investment in risky R & D Avoid serving marginal customers Have organizational structures focus on cost

control


Cost Leaders

Able to earn above-average profitability by merely charging the same price as its rivals

The cost leader can force its competitors to– cut prices and accept lower returns or– exit the industry


Differentiation

Providing a product or service that is distinct in some important respect valued by the customer

Nordstrom- exceptionally high customer service

Filene’s Basement Stores - discount retailer competing purely on a low cost basis


Differentiation

Seeks to be unique in its industry along some dimension that is highly valued by customers

Supply a unique product or service at a cost lower than the price premium customers will pay


Differentiation

To be successful– Needs to identify one or more attributes of a

product or service that customers value– Position itself to meet the chosen customer

need in a unique manner– achieve differentiation at a cost that is lower

than the price the customer is willing to pay for the differentiated product or service


Drivers of Differentiation

Superior product quality Superior product variety Superior customer service Bundled services Delivery timing


Differentiation requires

Investment in R & D Investment in brand image Investment in product appearance Investment in reputation Investment in engineering skills Investment in marketing capabilities Organizational structure to foster creativity and

innovation


Choice between Cost Leadership and Differentiation

Firms target differentiation still need to focus on costs, so the differentiation can be achieved at an acceptable cost

Cost leaders cannot compete unless they achieve at least a minimum level on key dimensions on which competitors might differentiate, such as quality and service


Achieving & Sustaining Competitive Advantage

To evaluate whether a firm will achieve its competitive advantage, Ask

What are the key success factors and risks associated with the firm’s chosen competitive strategy?

Does the firm currently have the resources and capabilities to deal with the key success factors and risks?



Has the firm made irreversible commitments to bridge the gap between its current capabilities and the requirements to achieve its competitive advantages



Has the firm structured its activities– R&D

– design

– manufacturing

– marketing

– distribution

– customer service

in a way consistent with its competitive strategy?



Is the company’s competitive advantage sustainable?

Are there any barriers that make imitation of the firm’s strategy difficult?



Are there any potential changes in the firm’s industry structure that might dissipate the firm’s competitive advantage– new technology– foreign competition– changes in regulation– changes in customer requirements

Is the company flexible enough to address these changes?


Competitive Strategy AnalysisDell Computer

Michael Dell assembled IBM in 1984 and sell directly to end users at a significantly lower price than competitors

Now– Fourth largest computer maker

– 18 billion in revenue

– 1.5 billion in net income

– 51% growth in sales and 78% growth in net income


DellLow Cost Competitive Strategy

Direct selling to customers, saves on retail markups– As computer become standardized on the

Windows-Intel platform, the value of distribution through retailers decline

– Began selling through Internet in 1996– By 1999 generate several million dollars of

sales per pay through Internet


Dell-Low-Cost Competitive Strategy

Made-to-Order Manufacturing– Developed flexible manufacturing system that allowed

the company to assemble and ship computers very quickly, usually five days of receiving the order

– Avoid large inventories of parts and assembled computers

– Low inventories allowed Dell to save working capital costs

– Reduced costly write-offs of obsolete inventories



Third-party services– Low cost approaches to after-sales service

» Telephone based service

» Third-party maintenance service

– Several hundred technical support representatives accessible to the customers by phone any time of the day

– Using a comprehensive electronic maintenance system, the service representatives could diagnose and help the customer to resolve problems in the majority of cases



Third-party services– When on-site maintenance is required, Dell

used 3rd party maintenance contracts with office equipment companies such as Xerox.

– Dell avoid investing in an expensive field service network without compromising on service qulaity



Low Accounts Receivable– Reduce its accounts receivable days to an

industry minimum by encouraging its customers to pay by credit card at the time of the purchase or through electronic payment immediately after the purchase



Focused investment in R&D– Recognized most of the basic innovations in the

personal computer industry were led by the component suppliers and software producers

– Dell’s innovations were primarkly in creating a low-cost, high-velocity organization that can respond quickly to these changes

– By focusing its R&D innovations, Dell was able to minimize these costs and get high return on its investments



As a result of the above strategy Dell achieved a significant cost advantage over its competitors in the personal computer industry

This advantage resulted in a consistent pattern of rapid growth increasing market share and very high profitability in an industry that is characterized by – rapid technological changes– significant supplier – buyer power and intense competition



Dell’s strategy involved activities that are highly interrelated and involved continuous organizational innovations, Dell’s business model was difficult to replicate, making Dell’s competitive advantage sustainable

No competitor today has been able to replicate Dell’s business model

The extraordinarily high earnings and book value multiples is likely to be sustained


Economic Attributes Framework

Useful in studying the economic characteristics of a business because it ties in with items reported in the financial statements


Economic Attributes FrameworkDemand

Customers highly sensitive to price (autos) Customers insensitive to price (soft drink) Is demand growing rapidly (internet service) Industry relatively mature (grocery stores) Does demand move with the economic cycle

(construction of new homes and offices)


Economic Attributes FrameworkDemand

Is demand insensitive to business cycles (food products and medical care)

Does demand vary with the seasons of a year (toys or ski equipment)

Is demand relatively stable throughout the year (office supplies)


Economic Attributes FrameworkSupply

Are there many suppliers offering similar products?

Are there few suppliers offering unique products?

Are there high barriers to entry? Are there low barriers to entry?


Economic Attributes FrameworkManufacturing

Is the manufacturing process Capital intensive? (electric utility) Labor intensive? (advertising, professional

services) Combination of the two (auto

manufacturing or airline transportation)


Economic Attributes FrameworkManufacturing

Is the manufacturing process Complex with low tolerance for error (high

tech, heart pacemakers) Simple with ranges of acceptable-quality

products (nonmechanized toys?)


Economic Attributes FrameworkMarketing

Is the product promoted To other businesses

– sales staff play a key role To consumers

– advertising, coupons are principal promotion mechanisms


Economic Attributes FrameworkMarketing

Does demand pull products through distribution channels?

Do firms have to create demand continually?


Economic Attributes FrameworkFinancing

Are the assets of firms in the industry relatively short term

– commercial banks relatively long term

– Electric utilities



Relatively little risk in the assets of firms in the industry– Firms can carry high proportions of debt

financing High risks in the assets resulting from

– Short product life cycles– product liability concerns– Firms have low debt and high equity financing



Is the industry relatively profitable and mature?– Generating more cash flow from operations

than is needed for acquisitions of property, plant, and equipment?

Is the industry growing rapidly and in need of external financing?

Example of Soft Drink Industry


Framework for Strategy Analysis

Nature of Product or Service Degree of Integration within Value Chain Degree of Geographical Diversification Degree of Industry Diversification


Coke

Compete broadly in the beverage industry Products

– soft drinks– fruit juices– tonic waters– sport drinks

Differentiated product through– Brand recognition– Domination of distribution channels


Degree of Integration within Value Chain

Vertical integration strategy– participating in all phases of the value chain– or select only certain phases within the chain



Manufacturing– Conduct all manufacturing operations itself

(steel manufacturing)– Outsource all manufacturing (athletic shoes)– Outsource the manufacturing of components

but conduct the assembly operation in house (auto, computer hardware)



Distribution– Maintain control over the distribution function

» Wendy’s - owns most of its restaurants

– Outsource distribution» (McDonalds - independent franchisees

» Computer hardware firms use indirect sellers - value added resellers and systems

integrators


CokeDegree of Integration with Value Chain

Engages in– New product development– Manufacture its concentrate– Promotes its products

Outsource– Bottling– Distribution


Coke Degree of Integration with Value Chain

Perceives its value-added activities are– Secret formula that makes up the concentrate– Promoting its product for brand name and brand

loyalty Outsource bottling operation

– Not value enhancing– Capital intensive– Requires LT debt financing– Coke appears less risking with less debt


Coke Degree of Integration with Value Chain

Seller power over its bottlers– maintain significant portion of profit margin

Bottlers accept smaller margin for monopoly power in a particular area and strong demand for Coke products.


Degree of Geographical Diversification

Target domestic market? Integrate horizontally across many

countries?– Create opportunity for growth– exposes to risks from

» exchange rate changes

» political uncertainties

» additional competitors


Coke -Geographical Diversification

North America– 6.6% growth rate

Outside North America– 67% revenues– 79% operating income – 7.2% growth rate

Central Europe, Middle East and Far East– 54% revenues– 58% operating income


Degree of Industry Diversification

Operate in a single industry? Diversify across multiple industries?

– Moderate the product, cyclical, regulatory, and other risks that it encounters when operating in a single industry

– Need to understand and manage multiple and different businesses effectively


CokeDegree of Industry Diversification

Operates exclusively in the beverage industry Product line includes

– Orange juice (Minute Maid)– fruit juices (Hi-C)– Iced tea (Nestea)– sports drinks

Principal products - soft drink– Coke, Barq’s Root Beer, Sprite, Fanta)

Documents

Dr. Nancy Mangold, CSUH1 Financial Reporting and Financial Statement Analysis Dr. Nancy Mangold California State University, East Bay