Womack Report

Class 2 of Business Strategy.  Lots of material has been placed up on WebCT now.A couple of sample cases have been put up.  Slightly different from the case studies we’ll be doing, but still helpful.  Some PDF files of Voelker’s slides and answers to last week’s in-class work.

Strategy is “The Art of the General”.  The general’s perspective.  Strategy is “The coordinated means by which an organization pursues its goals and objectives”.

Strategy takes place on a corporate level and a business level.  Corporate strategy involves what businesses to be involved in.  Strategy on the business level involves actual choices of how to compete.

Planning consists of Formulation, Implementation, and Execution.  Formulation is the process of developing a plan.  This is relatively easy.  Implementation is the process of putting the developed plan into action.  This is often hard.  Execution is the doing.  This is where you live or die.

Profit = Margin * Volume

You can increase profit by increasing margin, or increasing volume, or both.  However:

• Margin can be improved by increasing price OR reducing cost of goods
• Raising price reduces volume, cetaris paribus
• Margin is a function of price and cost
• Bottom line impacted needs to be taken into account before deciding on price policy
• Economic Logic must match with the rest of the strategy diamond.

Focusing on Margin or Volume informs your strategy.  Generally, you’ll have to play with both to some degree.

Epistemological Foundations

• External Perspective
  • Industrial Organizational (IO) – Economic (1940+)
  • Structure – Conduct – Performance linkage
  • Environmental Determinism -  The environment determines how your business will work
  • Profit via mobility barriers
• Internal Perspective
  • Resource Based View (1980+)
  • Internally Deterministic
  • VRINE – SCA Linkage
  • Profitability through capture of superior resources
• Dynamic Perspective
  • Emphasizes market-entrepeneur tension (1930 or 1990+)
  • Eschews sustainable advantage
  • Emphasizes leveraging today’s advantage for tomorrow’s advantageous positioning

Second part of the class:  Ratio Analysis & Firm Controls

What is Analysis?

Analysis is NOT:

• A laundry list of facts
• Presenting others’ research as your own
• Simply accepting the quality of the resource
• Fitting the facts to a predetermined conclusion

Analysis IS:

• The conclusions you draw after reviewing the facts  (The value-added clause)
• Thoroughly documenting sources to strengthen veracity of your conclusions
• Vetting your sources for integrity (The Onion Impact)
• Deliberate process of using facts on the ground to influence strategic choice

Ratio Analysis is a fundamental part of the control process.  It provides a basis of comparison for a firm’s performance to a standard.

A ratio on its own is meaningless.  The comparison of a ratio to a standard provides the entire basis for analysis and interpretation.

Standards for Comparison:

• Benchmarking – comparison to industry or functional leader, or firm to firm comparison
• Normative – comparison to industry averages or firm averages
• Historical – Comparison to previous data

Financial Statements – Balance sheets and Income statements will be needed.  Know them, be comfortable with them.

Liquidity Ratios measure a firm’s ability to make good on short-term liabilities.  Generally derived from the balance sheet.

• Current Ratio
  • Current Ratio = Total Current Assets / Total Current Liabilities
  • Most Commonly reported
  • Direct reflection of all current assets and all current liabilities
  • Higher number means more liquid
  • Liquid assets are generally non-performing, so more liquidity is not always desirable
  • Usually want enough to cover current liabilities with reasonable slack (1.0 < X < 2.0)
• Acid Test
  • Acid Test = (Total Current Assets – Inventory) / Total Current Liabilities
  • Primarily important in manufacturing
  • Virtually unused in pure service, because it’s identical to current ratio (No inventory)
  • Removes inventory from current ratio equation
  • Controls for slower moving and excess inventory
  • Also known as the “Quick Ratio”

Activity Ratios attempt to evaluate the operating performance of the firm.  They measure efficiency and effectiveness of the management

• Inventory Turnover
  • Inventory Turnover = Sales Revenue / Inventory
  • Number of times (per period) that a firm sells all its inventory (turns it over)
  • Higher numbers reflect more efficient processes
• Total Asset Turnover
  • Asset Turnover = Sales Revenue / Total Assets
• Accounts Receivable Turnover
  • AR Turnover = Credit Sales / Accounts Receivable
  • Number of times per year the firm turns over is accounts receivable
  • Lower numbers suggest less efficient collections
  • Bigger is better
• Accounts Payable Turnover
  • AP Turnover = Cost of Goods Sold / Account Payables
  • Number of times per year the firm turns over its accounts payable
  • Higher numbers mean the firm pays creditors quickly
  • There are times when it’s better to pay quickly or slowly.

Leverage Ratios depict the financial mix of the firm and the ability of a firm’s operations to meet its debt-servicing requirements

• Debt to Assets Ratio
  • Debt Percentage = Total Liabilities / Total Assets
  • Addresses what percentage of a firm’s asset value is owed to creditors (short and long term)
  • It represents the firm’s capital mix strategy
  • Too little or too much debt is problematic
  • The ratio varies substantially between industries, particularly service vs. manufacturing
• Times Interest Earned
  • TIE = EBIT / Interest
  • Addresses the ability of the firm’s operations to cover its capital commitments
  • A higher value is better
  • As this value approaches or falls below 1.0, the firm has the potential for bankruptcy

Financial Performance Ratios evaluate the profitability (net income) of the firm as a comparative to the level of capital invested.

• Return on Assets
  • ROA = Net Income / Total Assets
  • Evaluation of manager’s ability to generate profits from assets managed

Profitability Indicators

• Gross Margin
• Operating Margin
• Net Margin

Du Pont Analysis

• Net Profit Margin * Asset Turnover = Return on Assets
• Return on Assets * Equity Multiplier = Return on Equity

Strategic Ratios are not in the book.  These offer insight into the strategic choices firms make.  Display the extent to which a firm allocates resources to particular areas.  Generally only useful in comparison to direct competitors.  Relevant figures usually found only in detailed filings.

• Advertising Intensity
  • Advertising Intensity = Advertising / Sales
• R&D Intensity
  • R&D Expense / Sales

Environmental Impact Ratios

• Sustainable Growth Rate
  • SGR = ROE * (1 – ( Dividends / Net Income) )
  • How long can the firm continue its current growth vector
  • Number approaches zero when problematic.
• Operating Leverage
  • Operating Leverage = Gross Margin / Net Margin
  • Impact on profitability of revenue changes
  • Larger numbers indicate greater net income fluctuations for each change in revenue dollars
  • Reflects the impact of leverage on net income.