These activities extend from input markets involving

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vices. These activities extend from input markets involving suppliers of materials and labor to a company's output markets involving customers of prod- ucts and services. Input markets generate most expenses (or costs) such as inventory, salaries, materials, and logistics. Output markets generate revenues (or sales) to customers. Output markets also generate some expenses such as marketing and distributing products and services to customers. Net income arises when revenues exceed expenses. A loss occurs when expenses exceed revenues. Differences exist in the relative profitability of com- panies across industries. Although effective management can increase the profitability of a company, business models playa large part in determining company profit- ability. These differences are illustrated in the graph (to the side) of net income as a percentage of sales for several companies. Home Depot operates in a mature industry with little ability to differentiate its products from those of its com- petitors. Hence, its net income as a percentage of sales is low. Southwest Airlines faces a different kind of problem: having competitors that are desperate and trying to survive. Profitability will not return to the transportation industry until weaker com- petitors are no longer protected by bankruptcy courts. At the other end of the spectrum are Apple, Cisco Systems and Google. All three are dominant in their industries with products protected by patent laws. Their profitability levels are more akin to that of monopolists. 1-13 Module1 I Framework for Analysis and Valuation Net Income as a Percent of Sales 30% 25% 2()Ok 15% 10% 5% ~V-,-,-,-,-,-,-, I ( ~e ~ ~ ~ 0<:- ~e e~ ~~ ~e ~~£ ~v'IY <:::)e<Q° ~<:-Cj ~~ .~<::' ~e r~Oo~ (;1>-e (;0 e ,:>0 'b-0 ,"?' 0-s:. v r::f' 'b- t; _,ec; v O ~ 0<:- (;-.e ~' 1"1:3 ~Cj ,0 v ,:>CS' ~ BUSINESS INSIGHT Warren Buffett on Financial Reports "When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA [earnings before interest, taxes, depreciation and amortization] make us shudder-does management think the tooth fairy pays for capital expenditures? We're very suspi- cious of accounting methodology that is vague or unclear, since too often that means management wishes to hide something. And we don't want to read messages that a public relations department or consultant has turned out. Instead, we expect a company's CEO to explain in his or her own words what's happening." -Berkshire Hathaway annual report Statement of Stockholders' Equity The statement of stockholders' equity reports on changes in key types of equity over a period of time. For each type of equity, the statement reports the beginning balance, a summary of the activity in the account during the year, and the ending balance. Berkshire Hathaway's state- ment of stockholders' equity is in Exhibit 1.5. During the recent period, its equity changed due to share issuances and income reinvestment. Berkshire Hathaway classifies these changes into three categories: Contributed capital, the stockholders' net contributions to the company Retained earnings,
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