Hello, I'm Professor Brian Bushee, welcome back. This video kicks off a three video sequence where we're gonna use ratio analysis to study the case of a growth company and see what we can learn about the sources of their competitive advantages and disadvantages. I can't wait, let's get started. Let's start with some background on Plainview technology. So Plainview manufactures iris scanning equipment for biometric identification. In 2009, Plainview lost its largest customer, a defense contractor. Which accounted for half of it's business. The customer transferred it's business to a foreign competitor which had lower labor costs. Plainview management responded by increasing automation. They also built new plants in California and South Carolina to be closer to their customers. Plainview expanded into new industries, health care, financial institutions, nuclear power. They switch from high volume standard products to smaller batch, customized products. In 2010, Plainview adopted new 6G technology, which provides better manufacturing results at a lower manufacturing cost. The company's experienced explosive growth after surviving its crisis, and is now picked up a greater following by analysts and investors. A new analyst has just a few hours to prepare before participating on a conference call with Plainview Technology management, the only information they have are the financial statements and ratios, based on the ratios, what seems to be the secret to the company's turnaround, and what questions would you ask management during the call? Before we take a look at the ratios, I always think it's a good idea to start with the financial statements. Take a look at the balance sheet, the income statement and cash flow statement to see if there's any trends that jump out at us or seem unusual. Then we can keep those in the back of our mind as we go through the ratios. So here's the asset side of the balance sheet for Plainview. I'm gonna put up the pause sign, and recommend that you pause the video. Take a minute or so to look over the balance sheet and see if there's anything that jumps out at you. And then resume the video and we'll talk about what you're seeing. >> It certainly appears this PP&E has grown substantially. >> There also is a huge jump in inventory in accounts receivable after 2009. >> Yes, but the whole company has gotten bigger. Look at total assets. Do you have a point that you are trying to make? >> Yes, Dave, I do have a point. My point is that the balance sheet is a good starting point to try to look at what's going on in the company. Eric noted that there were big increases in accounts and inventory. Elizabeth noted that there were big increases in PP&E. We probably wanna understand those. But you're right that if the company's growing so much as a whole, it's hard to interpret the balance sheet. And so later on, we'll look at techniques that will take out the effects of this growth, and let us know whether line items on the balance sheet are going faster or slower than other line items. Here is the liabilities and stockholders' equity side of the balance sheet. So please, again, pause the video, take a look and see what you find. >> Well I would say that long term debt and paid in capital have grown tremendously. >> Hey, I wanted to go first this time. Accounts payable has grown similar to inventory and accounts receivable. But current liabilities are actually down in 2011. >> But you are going to pop in and tell us again that the whole company is growing, and we can't learn anything until we remove the effects of growth and yada, yada, yada. >> Yes, that's what I was going to say. That it's hard to draw too many conclusions from this part of the balance sheet without taking out the effects of growth. But there are a few things that sort of leap out as we look through this. So for instance, current liabilities went down even though the company grew substantially. So there are some things that you can occasionally learn by looking at the balance sheet as a starting point. Next we're gonna look at the income statement. Here are the last three years of income for Plainview. Please pause the video and see what trends leap out at you. >> Well, it looks like- >> It looks like sales, gross profit, operating income and net income are all growing stupendously. >> And yes, we will have to remove the effects of growth to understand this better, which we'll do later in the video. Next, we have the statement of cash flows. We're gonna start with the operating section that shows you cash flows from operating activities. Please pause the video and take a look. >> Ladies first. Even though net income has been growing steadily, cash from operations is, for lack of a better term, quite squirrelly. >> Squirrelly? Is that some strange jargon for volatile? Look at those big negatives for inventory and accounts receivable. >> Yes, those negatives match the growth we saw on the balance sheet. Now I think we are getting somewhere. >> We are getting somewhere. We see a lot of volatility in cash flows. And it looks like a lot of it is driven by accounts receivable and inventory, which we saw big movements on, on the balance sheet. We are getting somewhere. Here are the investing and financing sections of the statement of cash flows along with the supplemental disclosures of cash interest paid and cash taxes paid. So again, pause the video and take a look. >> Although at capital expenditures, proceeds from borrowing and common stock issued mirror the growth in PP&E, debt and equity on the balance sheet. >> Yes, this part of this statements shows us the company's growing substantially through capital expenditures. We don't see any acquisitions listed here so it's all internal cap x, which makes since because from the case we know that they built two new factories. And they're financing this growth with both debt and equity, so we see a lot of cash flow from debt issuances, and we see some cash flow from a couple of equity issuances, so they're financing themselves with both debt and equity. Now that we've taken a look at all the financial statements, I want to talk about something called common size financial statements. As we've talked about, it's hard to spot trends in the financial statements when there's tremendous growth. Basically, the growth in assets and growth in sales drive trends in all of the other line items. What we really want to know is, are certain line items growing more or less than would be expected given the overall growth in assets or sales? So we're gonna come up with a common size balance sheet where we'll express all numbers as a percent of total assets, which will remove the effect of the growth of assets. We'll come up with a common size income statement, where we'll express all numbers as a percent of sales, thereby taking out the growth in sales. The cash flow statement is typically not common sized. It's not as susceptible to growth. And it's not clear what we would divide by to common size it. So it's only the balance sheet and the income statement that are typically common sized. Here's the common size balance sheet for Plainview, specifically the asset side. So why don't you pause and take a look? >> Even though PP&E was growing so much, this makes it looks like it is shrinking. It is really inventory that is growing splendiferously. >> Yes Elizabeth, nice catch. It is inventory whose growth is out of whack compared to the rest of the company. And we saw earlier that inventory had negative effects on cash flow. So we're gonna wanna pay close attention to what's going on with inventory as we go through the rest of these videos. Here is the liability and stockholders' equity side of the common size balance sheet. So again, pause, take a look and see what you see. >> These numbers look much more, as Elizabeth would say, squirrely. The biggest trend is the increase in liabilities relative to equity. >> Yes, Eric, the big conclusion we would draw here is that the numbers seem to be squirrely on the liability and stockholders equity side. There doesn't seem to be a lot of clear trends. The numbers are bouncing up and down. The only trend that really emerges is total equity has gone down as a percent of liabilities and stockholders' equity over time. Which means the company is relying more on debt financing and other liabilities and less on equity financing. And here is the comma size income statement where everything has been divided by sales. Please pause and take a look. >> Gross profit percentage has gotten bigger but isn't this a video on ratios? When are we going to start looking at ratios? >> Well Dave, these technically are ratios. We're dividing numbers by sales and any time you divide one number by another number it's a ratio. But you picked up the key thing here which is there's a clear increasing trend in the gross profit margin ratio, and that increase in gross margin has driven the increase in operating income ratio and the net income ratio. We're gonna look at this more as we go through the videos. Finally we have DuPont Analysis. Here is the return on equity for Plainview. And then it's broken down into all of it's components with the definitions at the bottom of the slide. Why don't you pause the video for a minute or two, take a look at this slide and see what kind of conclusions you draw. I'm gonna go ahead and pop in here and analyze this one. For return on equity we see a large and increasing trend in ROE over the three year period. It started at 11%, which meant that for every dollar of equity the company generated $0.11 of net income. And now it's 16% so for every dollar of equity the company generates $0.16 of net income. So each of dollar of equity is generating an extra nickel of net income which is a pretty big increase over a three year period. Now let's look at the two drivers of ROE, return on assets and financial leverage to see if Plainview's increase in ROE is due to better operating performance or to taking on more debt. So for return on assets we see that increase from 7% to almost 10% which means that every dollar in assets is now generating about $0.10 of net income for Plainview compared to only $0.07 a couple years ago. So clearly there's been an improvement in operating performance. If we look at financial leverage, it's been fairly flat over this period, around 2.3. So for every dollar of equity, Plainview has $2.30 of assets, which means they're taking on about $1.30 of debt, and that really hasn't changed. So it seems like the increase in ROE is primarily driven by the improvement in return on assets. Now let's look at the two drivers of return on assets. Return on sales and asset turnover. We see another increasing trend in return on sales which means that Plainview sales have become more profitable over this period. ROS has gone from 5% to almost 7% so each dollar sales now generates almost $0.07 of net income instead of $0.05. What's $0.02? Well if you multiply it times 100 million in sales, it adds up pretty quickly. Now if we look at asset turnover, it briefly went up but then came back down to around 1.45, which means that for every dollar of assets Plainview generates about $1.45 in sales. But there's no clear upward trend in asset turnover, so it looks like the sole secret to Plainview success with their ROE is that there sales have become more profitable over this period. >> You said last video that ROE equals ROA times financial language. In 2011, 9.68 times 2.28 is 22.1, not 16.4. Just another in a long line of your mistakes. >> This one actually isn't a mistake, it's a simplification. So if you remember from last video, the return in return on equity is net income, but the return in return on assets is delivered net income. Which is net income plus after-tax interest expense. Because the returns are different, it won't multiply together. To get it to multiply together cleanly you'd have to add a third factor, or a correction factor, which would be net income divided by after-tax net income. If you multiply that third factor times ROA and financial leverage, then you will get ROE. >> Didn't Plainview adopted new 6G technology? Maybe every company in the industry had better profitability as a result of the new technology. >> Excellent point Elizabeth, what we talked about in an earlier video is that we need to do cross sectional comparisons. So what I'll do next is compare Plainview to three of their closest competitors. If you look at the industry, it looks like Plainview is having much more success than their other three competitors. They're the only company that had an increase in ROE over this time period. Their ROA was also up, whereas two of their competitors were down and one was up and then down. They're the only company that had an increase in return on sales. The other three companies were either down or flat and there doesn't seem to be much difference in terms of asset turnover. So to wrap up what we learned from the DuPont analysis is that the big increases in ROE for Plainview were unique for the industry. Plainview was clearly doing something that the rest of the industry was not able to do. Plainview's improved ROA was the source of it's increase in ROE. It didn't take on more debt, it didn't lever up because financial leverage was largely unchanged. Instead, the ultimate source of the ROE increase was improvement in profit margin or return on sales. In contrast to the competitors, Plainviews' return on sales grew dramatically over this period, whereas his asset turnover was flat much like the competitor's. So the secret to Plainview's success is that their sales became much more profitable between 2009 and 2011. >> Okay, but how were they able to make their sales more profitable? Can ratio analysis tell us that? >> Well, I do have a few more ratios up my sleeve, and we can take a look at those in the next video. Yes, let's wrap up here. And I'll see you next video, when we continue the ratio analysis for Plainview Technology. See you then. >> See you next video.