College of Business and Economics

MSc Finance

Assignment 2

ACCT 610

Prof: Ali A. Alnodel

Students name and ID:

• Batool Alyahya - 421200496

• Amal Alsalloum - 421200442
• Maisoon Alwohaibi - 421200401
• Ahmad alotaibi - 411115997
1. Judith, an accounting major, states, “Strategy analysis seems to be an
unnecessary detour in doing financial statement analysis. Why can’t we just get
straight to the accounting issues?” Explain to Judith why she might be wrong.

Strategy analysis is a first step in analyzing financial statements, followed by accounting analysis
and then financial analysis, and it enables an understanding of the company's economics and the
industry in which the company competes. There are many benefits to developing this knowledge
before performing a financial statement analysis.

1. Profit drivers:

The strategy analysis sheds light on the company's profit drivers, and the main areas of risk, and
then the analyst uses this information to assess the company's current performance and evaluate
that the company will maintain or change this performance based on its business strategy.

2. Financial policies:

provides an understanding of the company's financial policies and whether they are logical,
because business economics in the company is an important driver of capital structure and
dividend policy decisions.

3. Accounting Policies:

Strategy analysis provides an understanding of the evaluation of the company's choice of

accounting policies, and then the information in the company's financial statements.
Understanding the company, the company's business success factors, and key risks is important
in analyzing effective financial statements.

2. What are the critical drivers of industry profitability?

There must be specific places for any industry to flourish, implying that doing business in
the particular industry is profitable.
The following are the sources of profitability in the industry:
Rivalry Among Existing Firms:

The average level of profitability is primarily influenced by rivalry among existing firms in
the industry. Due to enormous competition in the industry, then it will reduce the profit.
Conversely, a smaller number of firms will share the ultimate profit, and the profit per
head will be higher.
Factors affecting existing firm rivalry are the industry's growth rate, balanced
competitors and having concentration, switching costs and product differentiation level,
the excess of capacity and barriers exiting, economies of scale and learning, and fixed to
variable costs ratios.

The threat of New Entrants:

The strength of competition between existing companies would also affect profitability.
The ability to gain unusual earnings will draw new entrants to an industry. The threat of
new entry companies may force to set prices to keep industry profits down. In
economies of scale, the new entry threat can be mitigated, first-mover advantages to
incumbents, greater access to distribution channels and existing customer relationships,
and legal barriers to entry.

The Threat of Substitute Products:

The threat of substitute goods will cause companies to set lower prices and reduce the
profitability of the industry. The willingness of consumers to switch depends on the
performance and the relative price of the substitutes.

Bargaining Power of Buyers:

The power of buyers is based on two variables: price sensitivity and relative bargaining
power—the greater the buyers' bargaining power, the lower the industry's profitability.
Suppose a single buyer's amount of sales rises, its negotiating leverage with the supplier
increases.

Bargaining Power of Suppliers:

According to this factor, with a lack of suppliers, then it will be price makers. The higher
the bargaining power of suppliers, the lower the profitability of the industry. With lower
suppliers, the substitutes will become lower; thus, it will affect suppliers' bargaining
power to increase.
4. Rate the pharmaceutical and lumber industries as high, medium, or low on the
following

Dimensions of industry structure: Pharmaceutical Industry Lumber Industry

Rivalry medium high

Threat of new entrants low medium
Threat of substitute products low high
Bargaining power of buyers low high
Bargaining power of suppliers medium medium

Rivalry

Although Pharmaceutical Industry has many regulations to protect intellectual property when it
comes to any patented new drug that leads to a huge competition among a small number of
companies’ Research & Development departments in the industry, there is a possibility of
analyzing and create a substitutional drug that raises the industry’s rivalry. Sometimes, strong
conditions about information privacy and intellectual property lead to another phase of
competition leads to sort of merges or acquisitions to get the privilege. Concerning that not all
drugs are necessary, over-the-counter pharmaceutical products let companies compete by asking
for lower prices or use different marketing strategies. (Aitken, 2016)
On the other hand, the lumber industry where comparably has lower regulations and more
homogeneous products where is almost no differentiation. Exit or change the industry cost the
company in the Pharmaceutical industry more than the company in the Lumber industry.

Threat of new entrants

The entry barriers that face new entrants to the Pharmaceutical Industry are relatively higher
comparing to the Lumber Industry. One of the barriers that face the new entrants to the
Pharmaceutical field is loyalty and buyers' believes. The other barrier is the economies of scale
that are shown in the small number of huge to a large company that competes in the
Pharmaceutical Industry. The need for professional guilds is kind of The entry barriers that face
new entrants, tow. The holding of patents is a privilege that lowers the threat of new entrants as
well as the requirements like equity, license, or professional certificate. Regulators often legalize
some barriers to protect the industry or to give privileges to local Pharmaceutical companies.
(Jones, Mead, & Sorensen, 1978) The research phase of the industry has a lower barrier. While
the patent barrier depends on the regulator, the producers of the pharmaceutical product have
the distribution channels as a barrier.
New entrants to the Lumber Industry won’t face a lot of barriers compared with Pharmaceutical
Industry. They may be facing some regulations that are general and not strict. Both entrants and
exit are relatively easier. The exclusive contracts with large companies in the sector, the strong
brand name and loyalty represents barrier the new entrance faces.

Threat of substitute products

The substitute products do the purpose using other technology. In the Pharmaceutical Industry
and the case of a low patent, the substitution for original drugs/products will be available as a
generic one that has different price, delivery method, costs. Which is not the case in the patent
present. Generic and biosimilar pharmaceutical products, supplements, alternative therapies are
a special case of substitutes for original pharmaceutical products. (Austrian Health Institute, 2006)
On the contrary, the lumber industry products have many obvious substitutes that could be more
efficient for many uses.

Bargaining power of buyers

Patients have low Bargaining power when it comes to pharmaceutical products, and for the over-
the-counter pharmaceutical products, they get more power due to the multiple substitutions
where they have a different aspect to compare the products. The prescribing physicians, medical
centers, and hospitals are kind of buyers also, but with a higher bargaining power than patients.
(Maresova & Kuca, 2014)
Buyers of lumber products could be large developing or manufacturing companies that have the
bargaining power to make an effect in the market.

Bargaining power of suppliers

There are many stages of suppling on Pharmaceutical Industry. Starting with the qualified humans
that work on researches and innovations, who supplied by universities and researches centers.
Then, the clinical trials and exportations on the phases of the trial of the patent that supplied by
manufacturers of medical equipment that have strong bargaining power. Next, the
pharmaceutical product manufacturing that supplied by Manufacturers of chemical compounds
or chemical and other material suppliers who have low power of bargaining. Finally, the
distribution stage where suppliers have a variety of bargaining power from absolutely no power
to significant bargaining power depending on the sector, number of suppliers, and privileges.
(RocSearch, 2010)
As with any natural resources industry, the lumber industry faces limited supply that gives the
suppliers more power to bargain.

Given your ratings, which industry would you expect to earn the highest returns?
We expect that the pharmaceutical industry to earn a higher return than the lumber industry due
to the lower rivalry (power to raise prices), the threat of new entrants (bigger market share),
threat of substitute products (increase the demand elasticity) and Bargaining power of buyers
relatively (lower power to break prices). The revenue for the pharmaceutical industry for 2019
reached 1.25 trillion USD comparing with 144.67 billion USD for the lumber Industry. (Mikulic,
2020)

5. Joe Smith argues, “Your analysis of the five forces that affect industry
profitability is incomplete. For example, in the banking industry, I can think of at
least three other factors that are also important; namely, government regulation,
demographic trends, and cultural factors.” His classmate Jane Brown disagrees
and says, “These three factors are important only to the extent that they influence
one of the five forces.” Explain how, if at all, the three factors discussed by Joe
affect the five forces in the banking industry.

Each of the three factors that Smith listed, believing their importance, plays a role in influencing
the profitability of the banking industry based on the footprint that each factor places on the five
main factors, as follows:

Rivalry Among Existing Firms:

Government legislation is the basis that governs banks' business and competitive practices and
helps to stabilize the competitive environment, the governmental guidelines directives and
restrictions have led to more controlled banking practices and services. The clear effect of the
pricing restrictions on interest rates and service fees is seen through the reduction in switching
risk from the customer's point of view, thus increasing competition on the prices basis.

Also, the growth of the banking industry has been affected by “Branching Process” restrictions,
regulations on ownership linkages among financial institutions, the restrictions and requirements
placed on the type -or other features- of asset portfolio that the bank can hold, in addition to the
lending-to-deposit ratio restrictions, all these legislative government actions led in one way or
another to limit the growth of the banking industry, causing the competitive atmosphere to
stagnate at some point in the past.

However, the situation did not remain this way, as time passes, the general development of
governments regulations has made its mark in various industries, has befallen the banking
industry as well. In 1992 the restrictions related to the banking branching within the states - which
had prevailed in the United States - were abolished, followed by the Riegle-Neal Interstate
Banking and Branching Efficiency Act enacted in 1994 which gave banks the opportunity to launch
branches across the states (Board of Governors of the Federal Reserve System), so , therefore,
these facilities ultimately increased competition between the financial institutions existing in the
banking industry.

On the part of government regulations related to supporting competition between banks by

raising the ratio of lending to deposits, we explain the effect of this locally, such as what happened
in 2016 when the Saudi Central Bank “SAMA” raised this percentage to 90% which activated the
competitive atmosphere of banks by pursuing to expand customer base.

It is sufficient to consider the impact of government regulation on competition among existing

banks in the industry through what has happened recently, in the Covid-19 pandemic, when the
Saudi government prevents banks from applying any aspect of the financial burden of the citizen,
"such as imposing an exemption of transfer fees, raising the limit of electronic deposit…etc.",
Which led to the impact on banks through their tendency to compete in technology services
"competition by differentiation" more than price competition, hence, affecting the profitability of
the industry as a whole.

On the other hand, demographic trends play a role in influencing the industry through their
impact on the competition factor between existing banks, this effect can be seen most clearly in
European countries, where they experience a decline in the birth rate while increasing the
population aging, however, the shrinking customer base that took a place in the banking business
had less impact due to the partially offsetting of the aging customer base savings, consequently,
the profitability of the industry will be affected according to this scenario, where studies indicate
that until 2025 demographic shifts will have a greater impact on enhancing profitability, therefore,
competition among banks to attract this category “aging class” will increase with various
strategies. (Berlemann, Oestmann, & Thum, 2010)

The international demographic movement represented by the migration of young people and
their concentration in countries different from their parents affects the growth of the banking
industry, as existing banks expand and finance their assets in countries with younger populations
by means of liabilities in countries with aging societies, which leads to growth in banking services
followed by growth of the industry and the flourishing of competition between banks. (Schneider,
2007)

The cultural degree has an impact on competition, as banks in developing countries compete
differently for their competition in countries surrounded by a segment that is more in line with
scientific developments, where they compete to improve the level and quality of services that
they provide to customers compared to competition in low-income countries as it is only for the
main services, so the cultural level affects competition between banks and thus on profitability in
the industry.

Threat of New Entrants:

With the industrial boom, policymakers have become more thirsty to enact regulations that
reduce barriers to entry for new competitors and increase opportunities for expansion, growth
and profitability of the industry, as many countries -including Saudi Arabia- recently announced
regulations that facilitate entry into the banking industry, the most important of which are
licensing systems for new banks( SAMA issues additional guidelines and criteria for applying for
licensing digital banks)2020 ،, logically, these regulatory practices create a threat to the existing
banks, as the entry of new competitors brings about a change in the structure of the incumbent
banks’ market share, which forces them to adapt assessment processes, improve and bear more
expenses to keep up with and maintain customer bases and meet their needs.

As well, among the forms of government easing of banking industry barriers, permitting bank
mergers and generating a new bank with greater competition in the sector, as the merging of
branches leads to an increase in spread in new areas, which means accessing the new bank to a
new customer base and increasing the income of operations through increased rates of deposits
and loans and lower costs, consequently, the new entity enters into very strong competition with
the old banks, thus posing a threat to their survival and increasing concerns about their
profitability. (Alturki )2018 ،

In short, the government regulation impact scenario is as follows, with more mitigation actions
resulting in easing barriers to entry for new banks, which increases their threat in the banking
industry as a whole, thus, reducing the potential profit.

According to the results of the demographic changes that aforementioned, we find that the older
a person is, the greater desire for financial stability and a lower level of the willing to jeopardize.
So, despite the low regulatory restrictions, the new banks are having difficulty getting started in
the industry resulted from the concerns surrounding the largest segment of customers -the
elderly population in parallel to the increase of the young population migration in European
countries- the lack of confidence in the performance of these banks and the unwillingness to
insure them on the savings of the years they have worked hard on. Thus, from this standpoint,
new entrants’ threat and the competition in the banking industry are affected less by this
demographic profile than if the opposite occurred.

Besides that, in countries with a low demographic structure in numbers of working-age

individuals, this inhibits their drive to enter, thus reducing their threat, and vice versa.

The cultural level of the peoples may have a role in influencing the entry of new banks, either
positively or negatively, as it may lead to lowering the costs of entering banks, "such as by utilizing
technical knowledge to facilitate services at the lowest moral and financial costs", but on the other
hand, it may have a role in raising the ceiling for entering the market through the high aspirations
desired by individuals, which forces the banks to either compete at the required level or back off
the idea of entry.

Threat of Substitute Products:

The availability of a wide range of substitutes to the customer depends primarily on government
regulation, as aforementioned about the government's tendency to ease restrictions in the
banking industry and break the “oligopoly” in many countries recently, increasing substitutes in
the market is a commonsensical result.
As insurance companies, brokerage firms and savings and loan associations companies crowded
out the main services provided by banks "lending and borrowing", providing more attractive
substitutes with government regulations that are different from those of banks, affecting the
extent of similar services between them in the market and the extent of how the threat affects
the industry.
A vivid example of the impact, the Saudi government, represented by the Central Bank and the
Capital Market Authority, enacted regulations in 2018 to launch the so-called "Fintech Saudi” ,
Which has raised the scope of financial services tremendously by allowing local and international
financial technology companies to make their mark in the Saudi market, as it encouraged
innovation in the payments sector, stimulated companies by supporting their financial technology
research, and increased the issuance of licenses for new financial activities. All these put
customers in front of a wide range of services that they can implement Instantaneously, as a
result, Traditional banks are surrounded by the threat of attractive new substitutes, and the
competition between these fintech companies and banks in the market has intensified,
influencing the Saudi financial industry, banking industry and ultimately the potential profitability.
(Fintech Saudi, 2019,2020)

Demographic composition affects the range of alternatives in the financial industry. As European
countries with a high rate of aging, the options available by the non-bank entities that responsible
for planning, keeping and investing retirement savings are more than that in which the youth
prevail which the cultural expansion for them is exploited by providing more attractive and
modern substitutes that keep pace with their developments, which affects the potential
profitability of the banking industry as a whole in both types.

Bargaining Power of Buyers:

The effect of government regulations from reducing entry barriers and increasing financial
substitutes in the banking industry extends to affect the bargaining power of customers in the
market. As the scenario becomes as follows, the increase in the alternative banking services
coincides with the decrease in switching costs from one bank to another, ultimately lead to an
increase in the bargaining power of customers within the banking industry.

Despite the effect of government regulations that aforementioned, the matter is not as simple as
it seems, as the demographic structure of the population influences the banking industry through
its adverse effect on the bargaining power of customers, as when there is a population density
that significantly exceeds the available banking options, the bargaining position of individuals
there will be weaken, and vice versa.

The customer's cultural background reinforces the role that has the largest footprint in the
bargaining position with banks, as the importance of their bargaining ability increases by create a
greater understanding of the bank’s buyer and successfully meet its needs, in order to raise their
level of satisfaction to the point that leads to raising their buyback practices.

Bargaining Power of Suppliers:

Since the analysis of this factor is a mirror image of the buyers’ bargaining power analysis, the
effect of the sub-factors “government regulations, demographic trends and cultural level” will be
as follow, regulations reduce the bargaining power of banks as a result of the entry restrictions
into the banking industry which have been relaxed recently, therefore, the role of banks in
determining profitability became less important with providing more freedom of competition and
the non-banking institutions entrance with more available alternatives. With respect to
demographic and cultural factors, the same way of the reflection of the “governmental
regulation” factor that aforediscussed applies here as well.
6. Coca-Cola and Pepsi are both very profitable soft drinks. Inputs for these
products include corn syrup, bottles/cans, and soft drink syrup. Coca-Cola and
Pepsi produce the syrup themselves and purchase the other inputs. They then
enter into exclusive contracts with independent bottlers to produce their products.
Use the five forces framework and your knowledge of the soft drink industry to
explain how Coca- Cola and Pepsi are able to retain most of the profits in this
industry.

Coca-Cola and Pepsi built their businesses and retained profits by focusing operations in less
competitive sectors, with intense competition between the two companies. These two companies
divided the soft drinks industry into two industries (production and manufacture of soft drinks -
distribution of soft drinks).

These two companies compete on the brand level more than they are competitive on prices, and
they sell their products to independent bottlers who have exclusive contracts to distribute soft
drinks and other products to these companies in a specific geographical area. (And because the
other producers are present and are usually regional, they have small shares of the market. ).
Coca-Cola and Pepsi are writing exclusive contracts with bottlers to prevent them from packing in
favor of a competitor, because bottlers are hard to earn more than the normal return on their
investment.

It is difficult for independent bottlers around the world to switch from one company to another,
and it is possible that a bottling company of one company is located in the same geographical
area of another company, so independent bottlers have little bargaining power, and it is possible
for Pepsi and Coca-Cola to charge prices. High on drinks too.

Newcomers to the beverage industry are prevented or restricted through limited access to
appropriate distribution channels and valuable brands created by Coca-Cola and Pepsi, while the
soft drink is relatively inexpensive and easy to manufacture, so the new manufacturer will have
difficulty finding distributors who can distribute Its products are sold to retail stores, and
advertisements from Coca-Cola and Pepsi have led to the creation of high-value brands that are
internationally recognized, so it is difficult for other competitors to replicate.

PepsiCo and Coca-Cola have direct influence over their suppliers, a major component, through
the ability to retain profits rather than pay them to suppliers.

It is possible that the production and distribution of soft drinks is less profitable than the
production of the drink, for several reasons:

1- Many see that the drinks are relatively similar and the conversion costs for consumers are very
low. Therefore, it is difficult to price one soft drink higher than the other, despite the massive
advertisements designed to create differentiated products.

2- There are many alternatives to soft drinks, which consumers can switch to if the price of soft
drinks increases.
3- Consumers can be price sensitive, and they can exercise bargaining power over independent
bottling companies, due to lower transfer prices.

The relationship between Coca-Cola and Pepsi and independent bottlers gives Coca-Cola and
Pepsi greater bargaining power over bottlers, which limits the ability of independent bottlers to
hold a larger share of their profits.

NOTES
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