GlobAl edition Strategic Management Concepts FIFTeenTh edition Fred R. David Forest R. David David David
Strategic ManageMent concepts A COMPETITIVE ADVANTAGE APPROACH
206 ChAPTER 6 ThE InTERnAL AUdIT TABLE 6-6 A Summary of Key Financial Ratios Ratio how Calculated what It Measures Liquidity Ratios current ratio uick ratio Leverage Ratios Debt-to-total-assets ratio Debt-to-equity ratio Long-term Debt-to-equity ratio times-interest-earned ratio Activity Ratios inventory turnover Fixed assets turnover total assets turnover accounts receivable turnover average collection Period Profitability Ratios gross Profit Margin Operating Profit Margin net Profit Margin return on total assets (roa) return on Stockholders equity (roe) earnings Per Share (eps) Price-earnings ratio Growth Ratios current assets current liabilities current assets minus inventory current liabilities total debt total assets total debt total stackholders equity Long-term debt total stackholders equity Profits before interest and taxes total interest charges inventory of finished goods Fixed assets total assets annual credit sales accounts receivable accounts receivable total credit sales/365 days minus cost of goods sold earnings before interest and taxes ebit net income net income total assets net income number of shares of common stock outstanding Market price per share earnings per share the extent to which a firm can meet its short-term obligations the extent to which a firm can meet its short-term obligations without relying on the sale of its inventories the percentage of total funds that are provided by creditors the percentage of total funds provided by creditors versus by owners the balance between debt and equity in a firm s long-term capital structure the extent to which earnings can decline without the firm becoming unable to meet its annual interest costs Whether a firm holds excessive stocks of inventories and whether a firm is slowly selling its inventories compared to the industry average productivity and plant and equipment utilization Whether a firm is generating a sufficient volume of business for the size of its asset investment the average length of time it takes a firm to collect credit sales (in percentage terms) the average length of time it takes a firm to collect on credit sales (in days) the total margin available to cover operating expenses and yield a profit Profitability without concern for taxes and interest after-tax profits per dollar of sales after-tax profits per dollar of assets; this ratio is also called return on investment (roi) after-tax profits per dollar of stockholders investment in the firm earnings available to the owners of common stock attractiveness of firm on equity markets annual percentage growth in total sales Firm s growth rate in sales net 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
ChAPTER 6 ThE InTERnAL AUdIT 207 3. How does each ratio compare with key competitors? Oftentimes competition is more intense between several competitors in a given industry or location than across all rival firms in the industry. When this is true, financial ratio analysis should include comparison to those key competitors. For example, if a firm s profitability ratio is trending up over time and compares favorably to the industry average, but it is trending down relative to its leading competitor, there may be reason for concern. 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, r&d 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. another limitation of financial ratios in terms of including them as key internal factors in the upcoming ife Matrix is that financial ratios are not very actionable in terms of revealing potential strategies needed, i.e. since they generally are based on performance of the overall firm. For example, to include as a key internal factor that the firm s current ratio increased from 1.8 to 2.1 is not as actionable as the firm s fragrance division revenues increased 18 percent in africa in 2013. chapter 7 discusses the importance of selecting actionable key factors, both externally and internally, upon which to formulate strategies. Selecting actionable key factors, both externally and internally, upon which to formulate strategies is important. a firm s financial condition depends not only on the functions of finance, but also on many other factors that include (1) management, marketing, management production and operations, r&d, and MiS; (2) actions by competitors, suppliers, distributors, creditors, customers, and shareholders; and (3) economic, social, cultural, demographic, environmental, political, governmental, legal, and technological trends. Breakeven analysis Because consumers remain price sensitive, many firms have lowered prices to compete. as a firm lowers prices, its breakeven () point in terms of units sold increases, as illustrated in Figure 6-4. the breakeven point can be defined as the quantity of units that a firm must sell for its total revenues (tr) to equal its total costs (tc). note that the before and after chart in Figure 6-4 reveals that the tr line rotates to the right with a decrease in price, thus increasing the quantity () that must be sold just to break even. increasing the breakeven point is thus a huge drawback of lowering prices. Of course when rivals are lowering prices, a firm may have to lower prices anyway to compete. However, the breakeven concept should be kept in mind because it is so important, especially in recessionary times. Before After FIGURE 6-4 A Before and After Breakeven Chart When Prices Are Lowered
208 ChAPTER 6 ThE InTERnAL AUdIT notice in Figure 6-5 that increasing fixed costs (Fc) also raises a firm s breakeven quantity. note the before and after chart in Figure 6-5 reveals that adding fixed costs such as more stores, or more plants, or even more advertising as part of a strategic plan raises the tc line, which makes the intersection of the tc and tr lines at a point farther down the uantity axis. increasing a firm s Fc thus significantly raises the quantity of goods that must be sold to break even. this is not just theory for the sake of theory. Firms with less fixed costs, such as apple and amazon.com, have lower breakeven points, which give them a decided competitive advantage in harsh economic times. Figure 6-5 reveals that adding fixed costs (), such as plant, equipment, stores, advertising, and land, may be detrimental whenever there is doubt that significantly more units can be sold to offset those expenditures. Firms must be cognizant of the fact that lowering prices and adding fixed costs could be a catastrophic double whammy because the firm s breakeven quantity needed to be sold is increased dramatically. Figure 6-6 illustrates this double whammy. note how far the breakeven point shifts with both a price decrease and an increase in fixed costs. if a firm does not breakeven, then it will of course incur losses, and losses are not good, especially sustained losses. Finally, note in Figures 6-4, 6-5, and 6-6 that variable costs (), such as labor and materials, when increased, have the effect of raising the breakeven point, too. raising Vc is reflected by the Vc line shifting left or becoming steeper. When the tr line remains constant, the effect of increasing Vc is to increase tc, which increases the point at which tr = tc = Be. the formula for calculating breakeven point is Be uantity = tfc divided by (price Vc). in other words, the quantity or units of product that need to be sold for a firm to breakeven is total fixed costs divided by (price per unit variable costs per unit). a breakeven problem is given in table 6-7. Suffice it to say here that various strategies can have dramatically beneficial or harmful effects on the firm s financial condition because of the concept of breakeven analysis. Before After FIGURE 6-5 A Before and After Breakeven Chart When Fixed Costs Are Increased Before After FIGURE 6-6 A Before and After Breakeven Chart When Prices Are Lowered and Fixed Costs Are Increased
ChAPTER 6 ThE InTERnAL AUdIT 209 TABLE 6-7 Applying Breakeven Analysis for Joy s Day Care Seeing a need for childcare in her town, Joy is considering opening her own day-care service. Joy s Day care needs to be affordable, so Joy would like to care for each child for 12 a day. But Joy also wants to make money. Joy needs to know how many children she will have to watch per day to make money. Joy gathered the following information about her potential new business. the month of June has 20 workdays, Monday through Friday for 4 weeks. insurance and rent on her business will be 200 and 400, respectively, per month. expenses per student per day will be snacks (2 @ 1.00) + meals (2 @ 3.00). Joy s Analysis Breakeven = Operating expenses, (12.00 8.00) Breakeven = 600, 4.00 Breakeven = 150 units (children) in June. Because there are 20 days in June, Joy must watch 150, 20 = 7.5 kids, or 8 children every day to make a profit. Joy s Conclusion thanks to breakeven analysis, Joy is pondering whether or not she can care for 8 children daily. instead of abruptly opening the business, Joy is now considering adding a helper for 50 per day and charging 20 per student per day. How many students now would Joy have to care for to make a profit under this scenario? (answer 6.6 = 7) What do you think would be an ideal scenario for Joy in planning for her new business? there are some limitations of breakeven analysis, including the following points: 1. Breakeven analysis is only a supply side (i.e., costs only) analysis because it tells you nothing about what sales are likely to be for the product at various prices. 2. it assumes that fixed costs are constant. although this is true in the short run, an increase in the scale of production will cause fixed costs to rise. 3. it assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. 4. it assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in beginning or ending inventory). 5. in multiproduct companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant). 22 Finance and Accounting Audit Checklist the following finance and accounting questions, like the similar questions about marketing and management previously, 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 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? 9. is the firm s debt situation excellent? Production and Operations the extent to which a manufacturing plant s output reaches its potential output is called capacity utilization, a key strategic variable. the higher the capacity utilization the better because otherwise equipment may sit idle. the estimated plant capacity utilization in europe for the major auto producers is Volkswagen (84%), renault (77%), Peugeot (73%), Ford (66%), gm (60%), and Fiat (55%). 23 the production/operations function of a business consists of all those activities that transform inputs into goods and services. Production and 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 6-8, roger Schroeder suggested
210 ChAPTER 6 ThE InTERnAL AUdIT TABLE 6-8 The Basic Functions (Decisions) Within Production/Operations decision Areas Example decisions 1. Process these decisions include choice of technology, facility layout, process flow analysis, facility location, line balancing, process control, and transportation analysis. Distances from raw materials to production sites to customers are a major consideration. 2. capacity these decisions include forecasting, facilities planning, aggregate planning, scheduling, capacity planning, and queuing analysis. capacity utilization is a major consideration. 3. inventory these decisions involve managing the level of raw materials, work-in-process, and finished goods, especially considering what to order, when to order, how much to order, and materials handling. 4. Workforce these decisions involve managing the skilled, unskilled, clerical, and managerial employees by caring for job design, work measurement, job enrichment, work standards, and motivation techniques. 5. uality these decisions are aimed at ensuring that high-quality goods and services are produced by caring for quality control, sampling, testing, quality assurance, and cost control. Source: Based on r. Schroeder, Operations Management (new York: Mcgraw-Hill, 1981), 12. that production and operations management comprises five functions or decision areas: process, capacity, inventory, workforce, and quality. Production and 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 and 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 and operations managers are finding that cross-training of employees can help their firms respond faster to changing markets. cross-training of workers can increase efficiency, quality, productivity, and job satisfaction. For example, at general Motors Detroit gear and axle plant, costs related to product defects were reduced 400 percent in 2 years as a result of cross-training workers. as shown in table 6-9, James Dilworth outlined implications of several types of strategic decisions that a company might make. a magazine that had been printed since 1933, Newsweek, ended its print edition of the magazine on December 31, 2012, after suffering through years of declining profits and falling subscriptions. now only an all digital-tablet version, Newsweek Global, is available with a paid subscription. as a result of this strategic decision, Newsweek is laying off employees and closing production facilities both in the USa and abroad. among the USa s three icon weekly magazines, Time, Newsweek, and U.S. News and World Report, only Time now remains in print version. the weekly cost to publish and distribute the print version of Newsweek was 42 million. the top 10 print magazines by circulation in 2012 are: 1. AARP Magazine (22,528,478) 2. AARP Bulletin (22,283,411) 3. Game Informer (8,169,524) 4. Better Homes and Gardens (7,617,038) 5. Reader s Digest (5,577,717) 6. Good Housekeeping (4,346,757) 7. National Geographic (4,232,205) 8. Family Circle (4,100,977) 9. People (3,563,035) 10. Woman s Day (3,449,692) a current trend that is accelerating among U.S. manufacturers is to extend the payment term on monies owed to suppliers. Procter & gamble is leading the way on this trend, freeing