Hello, I'm Professor Brian Bushee.

Welcome back.
This video kicks off a three video
sequence where we're going to use
racial 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 its business.
The customer transferred its business
to a foreign competitor which had lower
labor costs.
Plainview managers 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,
healthcare,
financial institutions, nuclear power.
They switched 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 companies experienced explosive
growth after surviving its crisis.
And has 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 of the company's turn around?
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 minds as we go through the ratios.
So here's the assets side of

the balance sheet for Plainview.

I'm going to 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 that
PPND has grown substantially.
>> There also is a huge jump in inventory
and 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 receivable and inventory.
Elizabeth noted that there
were big increases in PP&E.
We probably want to understand those.
But you're right that if
I company is 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 growing 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 going to 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 going to 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 squirrely.
>> Squirrely?
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 lending, the capital
expenditures, proceeds from borrowing, and
common stock issued mirrored
the growth in PP&D, debt, and
inequity on the balance sheet.
>> Yes.
This part of the statement shows
us the company's growing substantially
through capital expenditures.
We don't see any acquisitions listed
here so it's all internal capex.

Which makes sense because from the case

we know 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 their 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 going to come up with a common
side balance sheet where we'll express
all numbers as a percentage
of total assets,
which will remove the effect
of the growth at assets.
We'll come up with a common sized
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 sized balance sheet for
plain view.
Specifically the asset side.
So why don't you pause and take a look.
>> Even though PP and T was growing so
much this makes it look
like it is shrinking.
It is really inventory that
is growing splendously.
>> 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 affects on cash flow.
So we're going to want to pay close
attention to what's going on with
inventory as we go through
the rest of these videos.

Here is the liability and

stockholder's 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 liability, since stock equals 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 common 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 the 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 he picked up the key thing
here which is there is 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 going to look at this more
as we go through the videos.
Finally we have the DuPont analysis.
Here is the return on equity for
Plainview, and then it's broken down into
all of its 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 the slide and
see what kind of conclusions you draw.
I'm going to 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 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 if we return on assets, we see that
it increased from 7% to almost 10%,
which means that every dollar in
assets is now generating about $0.10
of that income for Plainview compared
to only seven cents 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 of sales now generates
almost $0.07 of net income.
Instead of $0.05.
What's $0.02?
Well if you multiply it times
a hundred million in sales it adds up
pretty quickly.
Now if we look at asset turnover,
it briefly went up and
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 is no clear upward
trend in asset turn over.
So it looks like the sole secret
to Plainview success with the ROE
is that sales have become more
profitable over this period.
>> You said last video that ROE

equals ROA times financial average.

In 2011, 9.68 times 2.28 is 22.1,
not 16.4, just another in
a long line of your mistakes.
>> This actually isn't a mistake.
It's a simplification.
So if you remember from last video the
return and return in equity is net income.
But the return and
return on assets is the lever 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 have to add 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 adopt
the new 6G technology?
Maybe every company in the industry hopped
back to profitability as a result of
the new technology
>> Excellent point, Elizabeth.
What we talked about in the 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 its increase in ROE.
It didn't take on more data,
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,
Plainview's return on sales grew
dramatically over this period,
whereas its asset turnover was flat,
much like the competitors.
So, the secret to Plainview's success
is that their sales became much more
profitable between 2009 and 2011.
>> Okay, but how were they ale 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 ration analysis for
Planview technology.
See you then.
>> See you next video.