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MGT603 - Strategic Management - Lecture Handout 15

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INTERNAL ASSESSMENT (FINANCE/ACCOUNTING)

Objectives:

Financial condition is often considered the single best measure of a firm's competitive position and overall attractiveness to investors. Determining an organization's financial strengths and weaknesses is essential to formulating strategies effectively. A firm's liquidity, leverage, working capital, profitability, asset utilization, cash flow, and equity can eliminate some strategies as being feasible alternatives. Financial factors often alter existing strategies and change implementation plans. After reading this lecture, you will be able to know that what are the basics types of ratios and who business measure its financial strength using these ratios analysis.

Finance/Accounting Functions

  • Determining financial strengths and weaknesses key to strategy formulation
  • Investment decision (Capital budgeting)
  • Financing decision
  • Dividend decision

According to James Van Horne, the functions of finance/accounting comprise three decisions: the investment decision, the financing decision, and the dividend decision.
Financial ratio analysis is the most widely used method for determining an organization's strengths and weaknesses in the investment, financing, and dividend areas. Because, the functional areas of business are so closely related, financial ratios can signal strengths or weaknesses in management, marketing, production, research and development, and computer information systems activities.
The investment decision, also called capital budgeting, is the allocation and reallocation of capital and resources to projects, products, assets, and divisions of an organization. Once strategies are formulated, capital budgeting decisions are required to implement strategies successfully. The financing decision concerns determining the best capital structure for the firm and includes examining various methods by which the firm can raise capital (for example, by issuing stock, increasing debt, selling assets, or using a combination of these approaches). The financing decision must consider both shortterm and long-term needs for working capital. Two key financial ratios that indicate whether a firm's financing decisions have been effective are the debt-to-equity ratio and the debt-to-total-assets ratio. Dividend decisions concern issues such as the percentage of earnings paid to stockholders, the stability of dividends paid over time, and the repurchase or issuance of stock. Dividend decisions determine the amount of funds that are retained in a firm compared to the amount paid out to stockholders.
Three financial ratios that are helpful in evaluating a firm's dividend decisions are the earnings-pershare ratio, the dividends-per-share ratio, and the price-earnings ratio. The benefits of paying dividends to investors must be balanced against the benefits of retaining funds internally, and there is no set formula on how to balance this trade-off. For the reasons listed here, dividends are sometimes paid out even when funds could be better reinvested in the business or when the firm has to obtain outside sources of capital:

  1. Paying cash dividends is customary. Failure to do so could be thought of as a stigma. A dividend change is considered a signal about the future.
  2. Dividends represent a sales point for investment bankers. Some institutional investors can buy only dividend-paying stocks.
  3. Shareholders often demand dividends, even in companies with great opportunities for reinvesting all available funds.
  4. A myth exists that paying dividends will result in a higher stock price.

Basic Types of Financial Ratios

Financial ratios are computed from an organization's income statement and balance sheet. Computing financial ratios is like taking a picture because the results reflect a situation at just one point in time. Comparing ratios over time and to industry averages is more likely to result in meaningful statistics that can be used to identify and evaluate strengths and weaknesses. Trend analysis, illustrated in Figure, is a useful technique that incorporates both the time and industry average dimensions of financial ratios.

Table provides a summary of key financial ratios showing how each ratio is calculated and what each ratio measures. However, all the ratios are not significant for all industries and companies. For example, accounts receivable turnover and average collection period are not very meaningful to a company that does primarily cash receipts business. Key financial ratios can be classified into the following five types:

Liquidity ratios measure a firm's ability to meet maturing short-term obligations. It includes:

  • Current ratio
  • Quick (or acid-test) ratio

Leverage ratios measure the extent to which a firm has been financed by debt.

  • Debt-to-total-assets ratio
  • Debt-to-equity ratio
  • Long-term debt-to-equity ratio
  • Times-interest-earned (or coverage) ratio

Activity ratios measure how effectively a firm is using its resources.

  • Inventory-turnover
  • Fixed assets turnover
  • Total assets turnover
  • Accounts receivable turnover
  • Average collection period

Profitability ratios measure management's overall effectiveness as shown by the returns generated on sales and investment.

  • Gross profit margin
  • Operating profit margin
  • Net profit margin
  • Return on total assets (ROA)
  • Return on stockholders' equity (ROE)
  • Earnings per share
  • Price-earnings ratio

Growth ratios measure the firm's ability to maintain its economic position in the growth of the economy and industry.

  • Sales
  • Net income
  • Earnings per share
  • Dividends per share
A Summary of Key Financial Ratios
Ratio How Calculated What It Measures
Liquidity Ratios
Current Ratio Current assets
Current liabilities
The extent to which a firm can meet its
short-term obligations
Quick Ratio Current assets
minus
inventory
Current liabilities
The extent to which a firm can meet its
short-term obligations without relying
upon the sale of its inventories
Leverage Ratios
Debt-to-Total-
Assets Ratio
Total debt
Total assets
The percentage of total funds that are
provided by creditors
Debt-to-Equity
Ratio
Total debt
Total stockholders'
equity
The percentage of total funds provided
by creditors versus by owners
Long-Term
Debt-to-Equity
Ratio
Long-term debt
Total stockholders'
equity
The balance between debt and equity
in a firm's long-term capital structure
Times-Interest-
Earned Ratio
Profits before
interest
and taxes
Total interest
charges
The extent to which earnings can
decline without the firm becoming
unable to meet its annual interest costs
Activity Ratios
Inventory
Turnover
Sales
Inventory of
finished goods
Whether a firm holds excessive stocks
of inventories and whether a firm is
selling its inventories slowly compared
to the industry average
Fixed Assets
Turnover
Sales
Fixed assets
Sales productivity and plant and
equipment utilization
Total Assets
Turnover
Sales
Total assets
Whether a firm is generating a
sufficient volume of business for the
size of its asset investment
Accounts
Receivable
Turnover
Annual credit
sales
Accounts
receivable
The average length of time it takes a
firm to collect credit sales (in
percentage terms)
Average
Collection
Period
Accounts
receivable
Total credit
sales/365 days
The average length of time it takes a
firm to collect on credit sales (in days)
Profitability Ratios
Gross Profit
Margin
Sales minus cost
of goods sold
Sales
The total margin available to cover
operating expenses and yield a profit
Operating
Profit Margin
Earnings before
interest and taxes
(EBIT)
Sales
Profitability without concern for taxes
and interest
Net Profit
Margin
Net income
Sales
After-tax profits per dollar of sales
Return on Total
Assets (ROA)
Net income
Total assets
After-tax profits per dollar of assets;
this ratio is also called return on
investment (ROI)
Return on
Stockholders'
Equity (ROE)
Net income
Total stockholders'
equity
After-tax profits per dollar of
stockholders' investment in the firm
Earning Per
Share (EPS)
Net income
Number of shares
of common stock
outstanding
Earnings available to the owners of
common stock
Price-Earnings
Ratio
Market price per
share
Earnings per share
Attractiveness of firm on equity
markets.
Growth Ratios
Sales Annual percentage
growth in total
sales
Firm's growth rate in sales
Income Annual percentage
growth in profits
Firm's growth rate in profits
Earnings Per
Share
Annual percentage
growth in EPS
Firm's growth rate in EPS
Dividends Per
Share
Annual percentage
growth
in dividends per
share
Firm's growth rate in dividends per
share

Limitations of Financial ratios:

Financial ratio analysis is not without some limitations. First of all, financial ratios are based on accounting data, and firms differ in their treatment of such items as depreciation, inventory valuation, research and development expenditures, pension plan costs, mergers, and taxes. Also, seasonal factors can influence comparative ratios. Therefore, conformity to industry composite ratios does not establish with certainty that a firm is performing normally or that it is well managed. Likewise, departures from industry averages do not always indicate that a firm is doing especially well or badly. For example, a high inventory turnover ratio could indicate efficient inventory management and a strong working capital position, but it also could indicate a serious inventory shortage and a weak working capital position.
It is important to recognize that a firm's financial condition depends not only on the functions of finance, but also on many other factors that include:

  • Management, marketing, production/operations, research and development, and computer information systems decisions;
  • Actions by competitors, suppliers, distributors, creditors, customers, and shareholders; and
  • Economic, social, cultural, demographic, environmental, political, governmental, legal, and technological trends.

So financial ratio analysis, like all other analytical tools, should be used wisely.

Finance/Accounting Audit Checklist of Questions

Similarly as provided earlier, the following finance/accounting questions should be examined:

  1. Where is the firm financially strong and weak as indicated by financial ratio analyses?
  2. Can the firm raise needed short-term capital?
  3. Can the firm raise needed long-term capital through debt and/or equity?
  4. Does the firm have sufficient working capital?
  5. Are capital budgeting procedures effective?
  6. Are dividend payout policies reasonable?
  7. Does the firm have good relations with its investors and stockholders?
  8. Are the firm's financial managers experienced and well trained?

Production/Operations

The production/operations function of a business consists of all those activities that transform inputs into goods and services. Production/operations management deals with inputs, transformations, and outputs that vary across industries and markets. A manufacturing operation transforms or converts inputs such as raw materials, labor, capital, machines, and facilities into finished goods and services. As indicated in Table, production/operations management comprises five functions or decision areas: process, capacity, inventory, workforce, and quality.

The Basic Functions of Production Management
Function Description
1. Process Process decisions concern the design of the physical production
system. Specific decisions include choice of technology, facility
layout, process flow analysis, facility location, line balancing,
process control, and transportation analysis.
2. Capacity Capacity decisions concern determination of optimal output levels
for the organization—not too much and not too little. Specific
decisions include forecasting, facilities planning, aggregate
planning, scheduling, capacity planning, and queuing analysis.
3. Inventory Inventory decisions involve managing the level of raw materials,
work in process, and finished goods. Specific decisions include
what to order, when to order, how much to order, and materials
handling.
4. Workforce Workforce decisions are concerned with managing the skilled,
unskilled, clerical, and managerial employees. Specific decisions
include job design, work measurement, job enrichment, work
standards, and motivation techniques.
5. Quality Quality decisions are aimed at ensuring that high-quality goods and
services are produced. Specific decisions include quality control,
sampling, testing, quality assurance, and cost control.
Source: Adapted from R. Schroeder, Operations Management (New York: McGraw-Hill Book
Co., 1981): 12.

Production/operations activities often represent the largest part of an organization's human and capital assets. In most industries, the major costs of producing a product or service are incurred within operations, so production/operations can have great value as a competitive weapon in a company's overall strategy. Strengths and weaknesses in the five functions of production can mean the success or failure of an enterprise.
Many production/operations managers are finding that cross-training of employees can help their firms respond to changing markets faster. Cross-training of workers can increase efficiency, quality, productivity, and job satisfaction.
There is much reason for concern that many organizations have not taken sufficient account of the capabilities and limitations of the production/operations function in formulating strategies. Scholars contend that this neglect has had unfavorable consequences on corporate performance in America. As shown in Table, James Dilworth outlined several types of strategic decisions that a company might make with production/operations implications of those decisions. Production capabilities and policies can also greatly affect strategies:

Given today's decision-making environment with shortages, inflation, technological booms, and government intervention, a company's production/operations capabilities and policies may not be able to fulfill the demands dictated by strategies. In fact, they may dictate corporate strategies. It is hard to imagine that an organization can formulate strategies today without first considering the constraints and limitations imposed by its existing production/operations structure

Impact of Strategy Elements on Production Management
Possible Elements of
Strategy
Concomitant Conditions That May Affect the
Operations Function and Advantages and
Disadvantages
1. Compete as low-cost
provider of goods or
services
Discourages competition
Broadens market
Requires longer production runs and fewer product
changes
Requires special-purpose equipment and facilities
2. Compete as high-quality
provider
Often possible to obtain more profit per unit, and
perhaps more total profit from a smaller volume of
sales
Requires more quality-assurance effort and higher
operating cost
Requires more precise equipment, which is more
expensive
Requires highly skilled workers, necessitating higher
wages and greater training efforts
3. Stress customer service Requires broader development of service people and
service parts and equipment
Requires rapid response to customer needs or
changes in customer tastes, rapid and accurate
information system, careful coordination
Requires a higher inventory investment
4. Provide rapid and
frequent introduction of
new products
Requires versatile equipment and people
Has higher research and development costs
Has high retraining costs and high tooling and
changeover in manufacturing
Provides lower volumes for each product and fewer
opportunities for improvements due to the learning
curve
5. Strive for absolute
growth
Requires accepting some projects or products with
lower marginal value, which reduces ROI
Diverts talents to areas of weakness instead of
concentrating on strengths
6. Seek vertical integration Enables company to control more of the process
May not have economies of scale at some stages of
process
May require high capital investment as well as
technology and skills beyond those currently
available within the organization
7. Maintain reserve capacity for flexibility Provides ability to meet peak demands and quickly implement some contingency plans if forecasts are
too low
Requires capital investment in idle capacity
Provides capability to grow during the lead time
normally required for expansion
8. Consolidate processing
(Centralize)
Can result in economies of scale
Can locate near one major customer or supplier
Vulnerability: one strike, fire, or flood can halt the
entire operation
9. Disperse processing of
service (Decentralize)
Can be near several market territories
Requires more complex coordination network:
perhaps expensive data transmission and duplication
of some personnel and equipment at each location
If each location produces one product in the line,
then other products still must be transported to be
available at all locations
If each location specializes in a type of component
for all products, the company is vulnerable to strike,
fire, flood, etc.
If each location provides total product line, then
economies of scale may not be realized
10. Stress the use of
mechanization,
automation, robots
Requires high capital investment
Reduces flexibility
May affect labor relations
Makes maintenance more crucial
11. Stress stability of
employment
Serves the security needs of employees and may
develop employee loyalty
Helps to attract and retain highly skilled employees
May require revisions of make-or-buy decisions, use
of idle time, inventory, and subcontractors as
demand fluctuates
Source: Production and Operations Management: Manufacturing and Nonmanufacturing, Second
Edition, by J. Dilworth. Copyright © 1983 by Random House, Inc. Reprinted by
permission of Random House, Inc.

Production/Operations Audit Checklist of Questions

Questions such as the following should be examined:

  1. Are suppliers of raw materials, parts, and subassemblies reliable and reasonable?
  2. Are facilities, equipment, machinery, and offices in good condition?
  3. Are inventory-control policies and procedures effective?
  4. Are quality-control policies and procedures effective?
  5. Are facilities, resources, and markets strategically located?
  6. Does the firm have technological competencies?

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