Learning Objectives

After reading this chapter, you should be able to:

13-1. Explain the issues involved in researching 13-3. Employ the strategic audit as a method
a case situation of organizing and analyzing case
13-2. Analyze financial statements using information
ratio analysis, common-size statements,
­Z-values and economic measures

Finding the Problems in the Friendly Skies

United Airlines agreed to merge with Continental Airlines in 2010 and
the passenger nightmare began. Rather than merge each of the big
systems (Reservations, Websites & Frequent Flyer Programs) over time,
they merged all three on the same day. The entire operation came to a
­standstill as the system lost track of pilots and assigned flights to pilots
who were retired or deceased. A litany of problems plagued the airline for
the next five years as a series of senior leadership teams tried to figure out
how to fix the business. From 2012 to 2015 United was at or close to the bottom
of most airline performance metrics i­ncluding delays, cancel­lations, bumped passengers,
complaints filed, and lost bags. In 2015 it was ranked last among the non-discount airlines by J.D. Power &
Associates in their customer satisfaction survey.
The stunning number of poor business decisions just exasperated the situation:

1. The new CEO of the airline spent thousands of hours and over a year to pick the coffee for the organization

2. The company moved to a chute system of boarding that encouraged passengers to get in their chutes long
before the plane even landed

3. The new uniforms were cheap and did not hold up to repeated cleanings.

A new CEO took over in late 2014 and the company got to work systematically examining what it would take to
bring the organization back. The company began surveying customers collecting 8,000 surveys a day and they
sent “customer experience” teams to fully evaluate the current situation.
Looking both internally and externally the company found a large number of both small and large items
that needed to be corrected and got to work. Easier issues included matching the other major carriers method
for boarding planes, quickly selecting a far better type of coffee, and establishing a group to re-vamp the uni-
forms. Bigger issues were addressed including settling all the union-related issues (the company agreed to a

379

M13B_WHEE5488_15_GE_C13.indd 379 6/21/17 7:01 AM

 380 PART 5    Introduction to Case Analysis

moratorium on outsourcing some jobs until 2017), revamping the travel patterns of planes
to minimize weather disruptions, and changing the baggage handling procedures.
Analyzing and systematically repairing the company appeared to be working by early
2016. Rates for mishandled bags, missed connections, and on-time performance were
improving dramatically.
This type of in-depth, investigative analysis is a key part of analyzing strategy cases.
This chapter provides various analytical techniques and suggestions for conducting this
kind of case analysis.
SOURCES: D. Bennett, “The United Way,” Bloomberg BusinessWeek, January 18–24, 2016,
pp. 50–55; http://www.jdpower.com/sites/default/files/2015057%20NA%20Airline_%20(FINAL).pdf;
B. Mutzabaugh, “Era of airline merger mania comes to a close with last US Airways flight,” USA
Today, October 16, 2015 (http://www.usatoday.com/story/travel/flights/todayinthesky/2015/10/15
/airline-mergers-american-delta-united-southwest/73972928/).

The Case Method

The analysis and discussion of case problems has been the most popular method of
teaching strategy and policy for many years. Furthermore, most of the big consulting
13-1. Explain the issues companies use case analysis as their primary means of selecting candidates for on-site
involved in research- interviews. The case method offers the opportunity to move from a narrow, specialized
ing a case situation
view that emphasizes functional techniques to a broader, less precise analysis of the
overall corporation. Cases present actual business situations and enable you to examine
both successful and unsuccessful corporations. In case analysis, you might be asked to
critically analyze a situation in which a manager had to make a decision of long-term
corporate importance. This approach gives you a feel for what it is like to face making
and implementing strategic decisions.

Researching the Case Situation

You should not restrict yourself only to the information and timing of when the case
was written unless your instructor states otherwise. You should, if possible, undertake
13-2. Analyze financial outside research about the environmental setting. Check the decision date of each case
statements using ratio (typically the latest date mentioned in the case) to find out when the situation occurred
analysis, common-size
statements, Z-values
and then screen the business periodicals for that time period. An understanding of
and economic the economy during that period will help you avoid making a serious error in your
measures ­analysis—for example, suggesting a sale of stock when the stock market is at an a­ ll-time
low or taking on more debt when the prime interest rate is over 15%. Information about
the industry will provide insights into its competitive activities. Important Note: Don’t
go beyond the decision date of the case in your research unless directed to do so by your
instructor.
Use industry information services such as Compustat, Compact Disclosure (for
older cases), and a wide variety of information sources available on the Internet.
Hoover’s online corporate directory (www.hoovers.com) and the U.S. Securities and
Exchange Commission’s EDGAR database (www.sec.gov) provide access to corporate
annual reports and 10-K forms. Most companies post their annual reports along with

M13B_WHEE5488_15_GE_C13.indd 380 6/21/17 7:01 AM

 CH A PTER 13    Suggestions for Case Analysis 381

all filings on the investor page of their company website. This background will give you
an appreciation for the situation as it was experienced by the participants in the case.
Use a search engine such as Google or Bing to find additional information about the
industry and the company.
A company’s annual report and SEC 10-K form from the year of the case can be
very helpful. According to the Yankelovich Partners survey firm, 8 out of 10 portfolio
managers and 75% of security analysts use annual reports when making decisions.1
They contain not only the usual income statements and balance sheets, but also cash
flow statements and notes to the financial statements indicating why certain actions
were taken. On 10-K forms you will find detailed information not usually available in
an annual report. SEC 10-Q forms include quarterly financial reports. SEC 14-A forms
include detailed information on members of a company’s board of directors and proxy
statements for annual meetings. Some resources available for research into the economy
and a corporation’s industry are suggested in Appendix 13.A.
A caveat: Before obtaining additional information about the company profiled in a
particular case, ask your instructor if doing so is appropriate for your class assignment.
Your strategy instructor may want you to stay within the confines of the case informa-
tion provided in the book. In this case, it is usually acceptable to at least learn more
about the societal environment at the time of the case.

Financial Analysis: A Place to Begin

Once you have read a case, a good place to begin your analysis is with the financial
statements. Ratio analysis is the calculation of ratios from data in these statements. It is
13-3. Employ the done to identify possible financial issues. A review of key financial ratios can help you
strategic audit as a assess a company’s overall situation and pinpoint some problem areas. Ratios are useful
method of organizing
regardless of firm size and enable you to compare a company’s ratios with industry aver-
and analyzing case
information ages. Table 13–1 lists some of the most important financial ratios, which are (1) liquidity
ratios, (2) profitability ratios, (3) activity ratios, and (4) leverage ratios.

Analyzing Financial Statements

In your analysis, do not simply make an exhibit that includes all the ratios (unless
your instructor requires you to do so), but select and discuss only those ratios that
have an impact on the issues you are addressing about that company. For instance,
accounts receivable and inventory provide a source of funds. If receivables and inven-
tories are double the industry average, reducing them will provide needed cash. In
this situation, the case report should include not only sources of funds but also the
number of dollars freed for use. Compare these ratios with industry averages to
discover whether the company is out of line with others in the industry. Annual and
quarterly industry ratios can be found in the library or on the Internet. (See the
resources for case research in Appendix 13.A.) In the years to come, expect to see
financial entries for the trading of CERs (Certified Emissions Reductions). This is
the amount of money a company earns from reducing carbon emissions and selling
them on the open market.
A typical financial analysis of a firm would include a study of the operating state-
ments for five or so years, including a trend analysis of sales, profits, earnings per share,
debt-to-equity ratio, return on investment, and so on, plus a ratio study comparing the

M13B_WHEE5488_15_GE_C13.indd 381 6/21/17 7:01 AM

 382 PART 5    Introduction to Case Analysis

TABLE 13–1 Financial Ratio Analysis

How
Formula Expressed Meaning
1. Liquidity Ratios
Current ratio Current assets Decimal A short-term indicator of the
Current liabilities ­company’s ability to pay its short-term
liabilities from short-term assets; how
much of current assets are available to
cover each dollar of current liabilities.
Quick (acid test) Current assets − Inventory Decimal Measures the company’s ability to
ratio Current liabilities pay off its short-term obligations from
­current assets, excluding inventories.
Inventory to net Inventory Decimal A measure of inventory balance;
working capital Current assets − Current ­ easures the extent to which the
m
liabilities ­cushion of excess current assets over
current liabilities may be threatened by
unfavorable changes in inventory.
Cash ratio Cash + Cash equivalents Decimal Measures the extent to which the
Current liabilities ­company’s capital is in cash or cash
equivalents; shows how much of the
current obligations can be paid from
cash or near-cash assets.

2. Profitability Ratios
Net profit margin Net profit after taxes Percentage Shows how much after-tax profits are
Net sales generated by each dollar of sales.

Gross profit Sales − Cost of goods sold Percentage Indicates the total margin available to
margin Net sales cover other expenses beyond cost of
goods sold and still yield a profit.
Return on invest- Net profit after taxes Percentage Measures the rate of return on the total
ment (ROI) Total assets assets utilized in the company; a measure
of management’s efficiency, it shows the
return on all the assets under its control,
regardless of source of financing.
Return on equity Net profit after taxes Percentage Measures the rate of return on the
(ROE) Shareholders’ equity book value of shareholders’ total
investment in the company.
Earnings per Net profit after taxes − Dollars per Shows the after-tax earnings generated
share (EPS) ­Preferred stock dividends share for each share of common stock.
Average number of common
shares
3. Activity Ratios
Inventory turnover Net sales Decimal Measures the number of times that
Inventory average inventory of finished goods was
turned over or sold during a period of
time, usually a year.
Days of inventory Inventory Days Measures the number of one day’s
Cost of goods sold + 365 worth of inventory that a company has
on hand at any given time.

M13B_WHEE5488_15_GE_C13.indd 382 6/21/17 7:01 AM

 CH A PTER 13    Suggestions for Case Analysis 383

TABLE 13–1 Financial Ratio Analysis, (continued)

How
Formula Expressed Meaning
Net working Net sales Decimal Measures how effectively the net work-
­capital turnover Net working capital ing capital is used to generate sales.

Asset turnover Sales Decimal Measures the utilization of all the com-
Total assets pany’s assets; measures how many sales
are generated by each dollar of assets.
Fixed asset Sales Decimal Measures the utilization of the c­ ompany’s
turnover Fixed assets fixed assets (i.e., plant and equipment);
measures how many sales are generated
by each dollar of fixed assets.
Average collec- Accounts receivable Days Indicates the average length of time
tion period Sales for year + 365 in days that a company must wait to
­collect a sale after making it; may be
compared to the credit terms offered by
the company to its customers.
Accounts receiv- Annual credit sales Decimal Indicates the number of times that
able turnover Accounts receivable accounts receivable are cycled during
the period (usually a year).
Accounts payable Accounts payable Days Indicates the average length of time in
period Purchase for year ÷ 365 days that the company takes to pay its
credit purchases.
Days of cash Cash Days Indicates the number of days of cash on
Net sales for year ÷ 365 hand, at present sales levels.

4. Leverage Ratios
Debt-to-asset ratio Total debt Percentage Measures the extent to which borrowed
Total assets funds have been used to finance the
company’s assets.
Debt-to-equity Total debt Percentage Measures the funds provided by
ratio Shareholders’ equity creditors versus the funds provided by
owners.
Long-term debt to Long-term debt Percentage Measures the long-term component of
capital structure Shareholders’ equity capital structure.

Times interest Profit before taxes + Interest Decimal Indicates the ability of the company to
earned charges meet its annual interest costs.
Interest charges
Coverage of fixed Profit before taxes + Interest Decimal A measure of the company’s ability to
charges charges + Lease charges meet all of its fixed-charge obligations.
Interest charges + Lease
obligations
Current liabilities Current liabilities Percentage Measures the short-term financing
to equity Shareholders’ equity ­portion versus that provided by owners.

continued

M13B_WHEE5488_15_GE_C13.indd 383 6/21/17 7:01 AM

 384 PART 5    Introduction to Case Analysis

TABLE 13–1 Financial Ratio Analysis, (continued)

How
Formula Expressed Meaning
5. Other Ratios
Price/earnings ratio Market price per share Decimal Shows the current market’s evaluation
Earnings per share of a stock, based on its earnings; shows
how much the investor is willing to pay
for each dollar of earnings.
Divided payout Annual dividends per share Percentage Indicates the percentage of profit that
ratio Annual earnings per share is paid out as dividends.

Dividend yield on Annual dividends per share Percentage Indicates the dividend rate of return to
common stock Current market price per share common shareholders at the current
market price.

NOTE: In using ratios for analysis, calculate ratios for the corporation and compare them to the average and quartile ratios for the
­particular industry. Refer to Standard & Poor’s and Robert Morris Associates for average industry data. Special thanks to Dr. Moustafa
H. Abdelsamad, former dean, Business School, Texas A&M University—Corpus Christi, Corpus Christi, Texas, for his definitions of
these ratios.

firm under study with industry standards. As a minimum, undertake the following five
steps in basic financial analysis.
1. Examine historical income statements and balance sheets: These two basic statements
provide most of the data needed for analysis. Statements of cash flow may also be useful.
2. Compare historical statements over time if a series of statements is available.
3. Calculate changes that occur in individual categories from year to year, as well as
the cumulative total change.
4. Determine the change as a percentage as well as an absolute amount.
5. Adjust for inflation if that was a significant factor.
Examination of this information may reveal developing trends. Compare trends
in one category with trends in related categories. For example, an increase in sales of
15% over three years may appear to be satisfactory until you note an increase of 20%
in the cost of goods sold during the same period. The outcome of this comparison
might suggest that further investigation into the manufacturing process is necessary.
If a company is reporting strong net income growth but negative cash flow, this would
suggest that the company is relying on something other than operations for earnings
growth. Is it selling off assets or cutting R&D? If accounts receivable are growing faster
than sales revenues, the company is not getting paid for the products or services it is
counting as sold. Is the company dumping product on its distributors at the end of the
year to boost its reported annual sales? If so, expect the distributors to return the unor-
dered product the next month, thus drastically cutting the next year’s reported sales.
Other “tricks of the trade” need to be examined. Until June 2000, firms growing
through acquisition were allowed to account for the cost of the purchased company
through the pooling of both companies’ stock. This approach was used in 40% of the value
of mergers between 1997 and 1999. The pooling method enabled the acquiring company
to disregard the premium it paid for the other firm (the amount above the fair market
value of the purchased company often called “good will”). Thus, when PepsiCo agreed to
purchase Quaker Oats for $13.4 billion in PepsiCo stock, the $13.4 billion was not found

M13B_WHEE5488_15_GE_C13.indd 384 6/21/17 7:01 AM

 CH A PTER 13    Suggestions for Case Analysis 385

on PepsiCo’s balance sheet. As of June 2000, merging firms must use the “purchase”
accounting rules in which the true purchase price is reflected in the financial statements.2
The analysis of a multinational corporation’s financial statements can get very
­complicated, especially if its headquarters is in another country that uses different
accounting standards.

Common-Size Statements
Common-size statements are income statements and balance sheets in which the dollar
figures have been converted into percentages. These statements are used to identify
trends in each of the categories, such as cost of goods sold as a percentage of sales (sales
is the denominator). For the income statement, net sales represent 100%: calculate
the percentage for each category so that the categories sum to the net sales percent-
age (100%). For the balance sheet, give the total assets a value of 100% and calculate
other asset and liability categories as percentages of the total assets with total assets as
the denominator. (Individual asset and liability items, such as accounts receivable and
accounts payable, can also be calculated as a percentage of net sales.)
When you convert statements to this form, it is relatively easy to note the percent-
age that each category represents of the total. Look for trends in specific items, such as
cost of goods sold, when compared to the company’s historical figures. To get a proper
picture, however, you need to make comparisons with industry data, if available, to see
whether fluctuations are merely reflecting industry wide trends. If a firm’s trends are
generally in line with those of the rest of the industry, problems are less likely than if
the firm’s trends are worse than industry averages. If ratios are not available for the
industry, calculate the ratios for the industry’s best and worst firms and compare them
to the firm you are analyzing. Common-size statements are especially helpful in devel-
oping scenarios and pro forma statements because they provide a series of historical
relationships (for example, cost of goods sold to sales, interest to sales, and inventories
as a percentage of assets) from which you can estimate the future with your scenario
assumptions for each year.

Z-Value and the Index of Sustainable Growth

If the corporation being studied appears to be in poor financial condition, use Altman’s
Z-Value Bankruptcy Formula to calculate its likelihood of going bankrupt. The Z-value
formula combines five ratios by weighting them according to their importance to a
corporation’s financial strength. The formula is:
Z = 1.2x1 + 1.4x2 + 3.3x3 + 0.6x4 + 1.0x5
where:
x1 = Working capital/Total assets (%)
x2 = Retained earnings/Total assets (%)
x3 = Earnings before interest and taxes/Total assets (%)
x4 = Market value of equity/Total liabilities (%)
x5 = Sales/Total assets (number of times)
A score below 1.81 indicates significant credit problems, whereas a score above 3.0 indi-
cates a healthy firm. Scores between 1.81 and 3.0 indicate question marks.3 The Altman
Z model has achieved a remarkable 94% accuracy in predicting corporate bankruptcies.
Its accuracy is excellent in the two years before financial distress, but diminishes as the

M13B_WHEE5488_15_GE_C13.indd 385 6/21/17 7:01 AM

 386 PART 5    Introduction to Case Analysis

lead time increases. It has also been found to be the strongest predictor of bankruptcy
and it and the current ratio are great tools to assess the financial health of organizations.4
The index of sustainable growth is useful to learn whether a company embarking
on a growth strategy will need to take on debt to fund this growth. The index indicates
how much of the growth rate of sales can be sustained by internally generated funds.
The formula is:
[P(1 - D)(1 + L)]
g* =
[T - P(1 - D)(1 + L)]

where:
P = (Net profit before tax/Net sales) * 100
D = Target dividends/Profit after tax
L = Total liabilities/Net worth
T = (Total assets/Net sales) * 100

If the planned growth rate calls for a growth rate higher than its g*, external capital will
be needed to fund the growth unless management is able to find efficiencies, decrease
dividends, increase the debt-equity ratio, or reduce assets through renting or leasing
arrangements.5

Useful Economic Measures

If you are analyzing a company over many years, you may want to adjust sales and net
income for inflation to arrive at a “true” financial performance in constant dollars.
­Constant dollars are dollars adjusted for inflation to make them comparable over vari-
ous years. One way to adjust for inflation in the United States is to use the consumer
price index (CPI), as given in Table 13–2. Dividing sales and net income by the CPI
factor for that year will change the figures to 1982–1984 U.S. constant dollars (when the
CPI was 1.0). Adjusting for inflation is especially important for companies operating
in emerging economies like China and Russia. China’s inflation rate was just 1.8% in
2016; while the Russian inflation rate in 2016 was 9.8%.6
Another helpful analytical aid provided in Table 13–2 is the prime interest rate,
the rate of interest banks charge on their lowest-risk loans. For better assessments of
strategic decisions, it can be useful to note the level of the prime interest rate at the
time of the case. A decision to borrow money to build a new plant would have been a
difficult one in 2007 when the rate was at 8.05%, but far more practical just two years
later when the average rate fell to 3.25%.
In preparing a scenario for your pro forma financial statements, you may want to
use the gross domestic product (GDP) from Table 13–2. GDP is used worldwide and
measures the total output of goods and services within a country’s borders. The amount
of change from one year to the next indicates how much that country’s economy is grow-
ing. Remember that scenarios have to be adjusted for a country’s specific ­conditions.
For other economic information, see the resources for case research in Appendix 13.A.

Format for Case Analysis: The Strategic Audit

There is no one best way to analyze or present a case. Each instructor has personal
preferences for format and approach. Nevertheless, in Appendix 13.B we suggest
an approach for both written and oral reports that provides a systematic method for

M13B_WHEE5488_15_GE_C13.indd 386 6/21/17 7:01 AM