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Strategic Management

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Strategic Management ­ MGT603
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Lesson 15
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 short-
term 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-per-
share 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.
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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
The extent to which a firm can meet its
Current liabilities
short-term obligations
Quick Ratio
Current
assets
The extent to which a firm can meet its
minus
short-term obligations without relying
inventory
upon the sale of its inventories
Current liabilities
Leverage Ratios
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Debt-to-Total-
Total debt
The percentage of total funds that are
Assets Ratio
Total assets
provided by creditors
Debt-to-Equity
Total debt
The percentage of total funds provided
Ratio
Total stockholders'
by creditors versus by owners
equity
Long-Term
Long-term debt
The balance between debt and equity
Debt-to-Equity
Total stockholders'
in a firm's long-term capital structure
Ratio
equity
Times-Interest-
Profits before
The extent to which earnings can
Earned Ratio
interest
decline without the firm becoming
and taxes
unable to meet its annual interest costs
Total interest
charges
Activity Ratios
Inventory
Sales
Whether a firm holds excessive stocks
Turnover
Inventory of
of inventories and whether a firm is
finished goods
selling its inventories slowly compared
to the industry average
Fixed Assets
Sales
Sales productivity and plant and
Turnover
Fixed assets
equipment utilization
Total Assets
Sales
Whether a firm is generating a
Turnover
Total assets
sufficient volume of business for the
size of its asset investment
The average length of time it takes a
Accounts
Annual credit
sales
firm to collect credit sales (in
Receivable
Accounts
percentage terms)
Turnover
receivable
The average length of time it takes a
Average
Accounts
receivable
firm to collect on credit sales (in days)
Collection
Total credit
Period
sales/365 days
Profitability Ratios
Sales minus cost
The total margin available to cover
Gross Profit
of goods sold
operating expenses and yield a profit
Margin
Sales
Earnings before
Operating
interest and taxes
Profitability without concern for taxes
Profit Margin
(EBIT)
and interest
Sales
Net Profit
Net income
After-tax profits per dollar of sales
Margin
Sales
After-tax profits per dollar of assets;
Net income
Return on Total
Total assets
this ratio is also called return on
Assets (ROA)
investment (ROI)
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Return on
Net income
After-tax profits per dollar of
Stockholders'
Total stockholders'
stockholders' investment in the firm
Equity (ROE)
equity
Net income
Earning Per
Number of shares
Earnings available to the owners of
Share (EPS)
of common stock
common stock
outstanding
Market price per
Attractiveness of firm on equity
Price-Earnings
share
markets.
Ratio
Earnings per share
Growth Ratios
Sales
Annual percentage
Firm's growth rate in sales
growth in total
sales
Income
Annual percentage
Firm's growth rate in profits
growth in profits
Earnings Per
Annual percentage
Firm's growth rate in EPS
Share
growth in EPS
Dividends Per
Annual percentage
Firm's growth rate in dividends per
Share
growth
share
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?
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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:
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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
Concomitant Conditions That May Affect the
Possible Elements of
Operations Function and Advantages and
Strategy
Disadvantages
1. Compete as low-cost
Discourages competition
provider of goods or
Broadens market
services
Requires longer production runs and fewer product
changes
Requires special-purpose equipment and facilities
2. Compete as high-quality
Often possible to obtain more profit per unit, and
provider
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
Requires versatile equipment and people
frequent introduction of
Has higher research and development costs
new products
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
Requires accepting some projects or products with
growth
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
Provides ability to meet peak demands and quickly
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capacity for flexibility
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
Can result in economies of scale
(Centralize)
Can locate near one major customer or supplier
Vulnerability: one strike, fire, or flood can halt the
entire operation
9. Disperse processing of
Can be near several market territories
service (Decentralize)
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
Requires high capital investment
mechanization,
Reduces flexibility
automation, robots
May affect labor relations
Makes maintenance more crucial
11. Stress stability of
Serves the security needs of employees and may
employment
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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Table of Contents:
  1. NATURE OF STRATEGIC MANAGEMENT:Interpretation, Strategy evaluation
  2. KEY TERMS IN STRATEGIC MANAGEMENT:Adapting to change, Mission Statements
  3. INTERNAL FACTORS & LONG TERM GOALS:Strategies, Annual Objectives
  4. BENEFITS OF STRATEGIC MANAGEMENT:Non- financial Benefits, Nature of global competition
  5. COMPREHENSIVE STRATEGIC MODEL:Mission statement, Narrow Mission:
  6. CHARACTERISTICS OF A MISSION STATEMENT:A Declaration of Attitude
  7. EXTERNAL ASSESSMENT:The Nature of an External Audit, Economic Forces
  8. KEY EXTERNAL FACTORS:Economic Forces, Trends for the 2000ís USA
  9. EXTERNAL ASSESSMENT (KEY EXTERNAL FACTORS):Political, Governmental, and Legal Forces
  10. TECHNOLOGICAL FORCES:Technology-based issues
  11. INDUSTRY ANALYSIS:Global challenge, The Competitive Profile Matrix (CPM)
  12. IFE MATRIX:The Internal Factor Evaluation (IFE) Matrix, Internal Audit
  13. FUNCTIONS OF MANAGEMENT:Planning, Organizing, Motivating, Staffing
  14. FUNCTIONS OF MANAGEMENT:Customer Analysis, Product and Service Planning, Pricing
  15. INTERNAL ASSESSMENT (FINANCE/ACCOUNTING):Basic Types of Financial Ratios
  16. ANALYTICAL TOOLS:Research and Development, The functional support role
  17. THE INTERNAL FACTOR EVALUATION (IFE) MATRIX:Explanation
  18. TYPES OF STRATEGIES:The Nature of Long-Term Objectives, Integration Strategies
  19. TYPES OF STRATEGIES:Horizontal Integration, Michael Porterís Generic Strategies
  20. TYPES OF STRATEGIES:Intensive Strategies, Market Development, Product Development
  21. TYPES OF STRATEGIES:Diversification Strategies, Conglomerate Diversification
  22. TYPES OF STRATEGIES:Guidelines for Divestiture, Guidelines for Liquidation
  23. STRATEGY-FORMULATION FRAMEWORK:A Comprehensive Strategy-Formulation Framework
  24. THREATS-OPPORTUNITIES-WEAKNESSES-STRENGTHS (TOWS) MATRIX:WT Strategies
  25. THE STRATEGIC POSITION AND ACTION EVALUATION (SPACE) MATRIX
  26. THE STRATEGIC POSITION AND ACTION EVALUATION (SPACE) MATRIX
  27. BOSTON CONSULTING GROUP (BCG) MATRIX:Cash cows, Question marks
  28. BOSTON CONSULTING GROUP (BCG) MATRIX:Steps for the development of IE matrix
  29. GRAND STRATEGY MATRIX:RAPID MARKET GROWTH, SLOW MARKET GROWTH
  30. GRAND STRATEGY MATRIX:Preparation of matrix, Key External Factors
  31. THE NATURE OF STRATEGY IMPLEMENTATION:Management Perspectives, The SMART criteria
  32. RESOURCE ALLOCATION
  33. ORGANIZATIONAL STRUCTURE:Divisional Structure, The Matrix Structure
  34. RESTRUCTURING:Characteristics, Results, Reengineering
  35. PRODUCTION/OPERATIONS CONCERNS WHEN IMPLEMENTING STRATEGIES:Philosophy
  36. MARKET SEGMENTATION:Demographic Segmentation, Behavioralistic Segmentation
  37. MARKET SEGMENTATION:Product Decisions, Distribution (Place) Decisions, Product Positioning
  38. FINANCE/ACCOUNTING ISSUES:DEBIT, USES OF PRO FORMA STATEMENTS
  39. RESEARCH AND DEVELOPMENT ISSUES
  40. STRATEGY REVIEW, EVALUATION AND CONTROL:Evaluation, The threat of new entrants
  41. PORTER SUPPLY CHAIN MODEL:The activities of the Value Chain, Support activities
  42. STRATEGY EVALUATION:Consistency, The process of evaluating Strategies
  43. REVIEWING BASES OF STRATEGY:Measuring Organizational Performance
  44. MEASURING ORGANIZATIONAL PERFORMANCE
  45. CHARACTERISTICS OF AN EFFECTIVE EVALUATION SYSTEM:Contingency Planning