You can not hope to do strategic management work for an organization without understanding its financial condition, which requires analysis of the financial data available. You need to do financial analysis as part of your diagnosis. Your analysis and conclusions will be useful also when you proceed to formulation and implementation. However, don't panic, you do not need sophisticated, esoteric skills in financial analysis for this course, or even most applied strategic management.
There are two main aspects of financial analysis for strategic management: historical and future. Each requires some modest calculations plus, most importantly, comparisons and thought to develop conclusions from your numbers.
For cases, you start with the financial data provided, usually balance sheets and income statements for several years. You can learn some things by inspection, e.g., general trends. Pay particular attention to trends in sales, COGS (cost of goods sold), net profits, liabilities, shareholder equity, and total assets. It can be useful to convert the statements to common size statements by expressing the entries in the income statements as percentages of sales and the entries in the balance sheets as percentages of total assets; this makes it much easier to identify trends and compare with competitors.
Next, you should do some ratio analysis, looking at some of the key ratios in each of the four main categories (profitability, leverage, liquidity, activity) plus a few other ratios - all over several years. You should understand why it is important to look at each of these types of ratios (specifically, the first four). Ratios provide additional insight about trends in the financial condition of the company. Which ratios you choose may vary somewhat, depending on your preferences and, especially, what competitor/industry financial data you have for comparison. For the class, usually 1-2 ratios for each category will be sufficient. Here are some ratios I often like to consider:
1. Profitability Ratios:
All organizations should care about profits or the equivalent. Even non-profits must maintain a stable balance between revenue and costs, often setting goals to increase their reserves. Average profitability levels vary widely for different industries. In a good year, the average net profit margin for all U.S. manufacturing firms is in the range of 5 percent and the average ROI is in the range of 15 percent.
2. Leverage Ratios
Leverage refers to the use of debt in a firm's capital structure. A highly leveraged firm will have a large amount of debt relative to stockholders' equity. Higher leverage increases the potential return on equity during good times, but also increases the risk during bad times. Leverage is an important indicator of a firm's ability to obtain additional funds through debt financing.
3. Liquidity Ratios
This indicates the ability of a firm to meet its short-term financial obligations. Excessively low ratios indicate problems. Excessively high ratios indicate the firm is over-conservative in using its current assets wisely.
4. Activity Ratios
These are various indicators of how efficiently a firm is using its assets in its operations.
5. "Other" Ratios
If you have data, there are other ratios of interest, including the following.
An Additional Option
Sometimes it is useful to use Altman's Bankruptcy Formula (see W&H last chapter) in addition to the main analysis outlined above. Note that the text has an error in this formula (i.e., the coefficients as given are for all five variables as ratios, not as percentages). The equation and definitions should be:
|Z = 1.2a + 1.4b + 3.3c + 0.6d + 1.0e|
Now, What Do I Do With All These Numbers?
After computing selected ratios for the last several years, you need to do two things to extract meaning and conclusions from the ratios: (a) look at the trends over time, and (b) compare them with ratios from key competitors or industry averages. It is absolutely vital to go beyond computing ratios to look at the trends and compare both their ratios and the trends with those for typical competitors or industry averages during the same time periods. There are many sources of comparative information, both in the library and on the internet (see the Sources for Financial Data module plus the appendix in H&W for suggestions). It is necessary to make such comparisons to derive meaning from the numbers; otherwise, you have wasted your time. You need to reach and state a conclusion about the company's overall financial health, plus specifics - looking for significant strengths and/or weaknesses. Where there is a weakness or something seems off, dig deeper. This is important both in understanding where the company is, and later, in adding realism to your formulation and implementation. Such comparisons and conclusions can help you understand:
After analysis of the historical financial data, it also is important to look at the future, primarily to estimate needs and potential ability to raise strategic funds. This section outlines two ways to look at this issue: formulas for estimating sustainable growth, and forecast models.
Formulas for Estimating Sustainable Growth/
There is a variety of such formulas in the literature, giving sometimes quite different
estimates. Here are four from which you can choose:
(1) Index of sustainable growth (W&H, section 11.4) rewritten slightly:
|g = 100ra(1 + L)/[A - ra(1 + L)]|
(2) A second approach (Higgins, Analysis for Financial Management, 1992, p.119) is to
maintain that a company's sustainable growth rate is nothing more than its growth rate in owners'
|g = 100rb|
(3) The Boston Consulting Group starts with the premise that the rate of growth is equal to
the firm's return on equity, corrected for dividends paid:
|g = 100r[L(c - i) + c]|
(4) A similar equation is given by Rowe, et al. (Strategic Management, 1994, p.375), explaining that a company's sustainable growth rate is limited by (a) the rate at which it can generate the funds necessary to achieve its growth targets and (b) the return it can expect to earn on these funds:
|g = 100r[L(d - i) + d]|
g = the maximum sustainable growth rate (%) without external capital or changes in the current financial performance
A = total assets/sales [note: this & all following variables are as decimals, not percentages)
a = earnings before taxes/sales
b = net profit (after interest and taxes)/shareholders' equity (same as net worth or book value)
c = profit before taxes/total assets
d = profit before interest and taxes (EBIT)/total assets
i = average interest rate on total debt (as a decimal, not %)
L = total liabilities/shareholders' equity
r = earnings retention rate = 1 - dividends/net profit
Example of a Simple Strategic Cash Flow Forecast Model
A different way to gain perspective on a company's need to raise additional funds for strategic growth is to construct a model. Even a very simple one, such as that illustrated below, can provide an indication of a company's ability to support growth without additional sources of capital. The example projects future cash flows or sources and uses for strategic funds for the Maytag case over the five years following 1995. You could get much more sophisticated in modeling, with consideration of other accounts, nonlinear relationships, specific sales and capital plans, etc. You also can make use of a spreadsheet program to simplify the arithmetic and make it easy to consider various "what if" options.
This model considers five accounts, and makes assumptions that relate each to sales: sources are net earnings and depreciation; uses are dividends and increases in fixed assets (FA) and working capital (WC). The net requirement for additional strategic funds beyond what can be funded from operations in a particular year is:
|Increase from previous yr. in (FA + WC) + Dividends - Earnings - Depreciation|
If the requirement for additional funds turns out to be negative, this means that a surplus of funds is available from operations.
Assumptions for this specific situation:
Forecast/projection (in $millions):
|Requirement for add'l strategic funds||--||(63)||(48)||(50)||(49)||(52)||(262)|
The left column in the table contains the financial values from the case for the most recent year (note that working capital is Current Assets minus Current Liabilities); also the depreciation is that for the most recent year, NOT "accumulated depreciation" ...you can calculate this year's depreciation by subtracting last year's accumulated depreciation from this year's accumulated depreciation). The rest of the numbers in the table are calculated as follows:
|Requirement = Increase from previous yr. in (FA + WC) + Dividends - Earnings - Depreciation|
|Requirement = (1484-1455) + (574-563) + 59 - 97 - 52 = -50|
This means (within the assumptions of this simple model, and with a modest growth rate of 2%) that we would expect to have a surplus of about $63 million in strategic funds for 1996, and further surpluses during the following four years (1997-2000).
In cases where it appears that additional strategic funds will need to be obtained, there are a number of different possibilities, each with advantages and disadvantages which you should understand:
|Last modified June 30, 2008||Copyright 1992-2008 Rex Mitchell|