Financial Analysis

The proof of a strategy’s power or weakness is reflected in a company’s financial statements: particularly its balance sheet and income statement. Examination of the profitability ratios based on financial statement figures yields further insight about the strategy’s effectiveness.

FINANCIAL STATEMENTS. The balance sheet describes assets owned by the business and how those assets are financed—with the funds of creditors (liabilities) and the equity of owners. The income statement (sometimes referred to as the profit and loss statement) indicates the cumulative results of operations over a specified period. By comparing these results from one year to the next, is possible to gauge the effectiveness of both strategy and its implementation through operations—though separating the two is often difficult. Consider the case of Amalgamated Hat Rack Company, whose multiperiod income statement is represented in table 9-1. Amalgamated’s retail sales demonstrate steady growth even as its operating expenses have been held in check. Something is going well here. The company’s corporate sales, however, are flagging from one year to the next. If corporate sales is an important piece of Amalgamated’s strategy, then something is going wrong, either with the strategy or its execution. This piece of quantitative information should signal management to look closely at the problem.

TABLE 9-1

Amalgamated Hat Rack Multiperiod Income Statement

Source: Harvard Business Essentials: Finance for Managers (Boston: Harvard Business School Press, 2002), 15.

Managers can also gain insights by examining the ratios of key figures drawn from the balance sheet and income statement. Ratios help an analyst or decision maker piece together a story about where an organization has come from, its current condition, and its possible future. In most cases, the story told by these ratios is incomplete, but it’s a start.

PROFITABILITY RATIOS. Profitability ratios associate the amount of income earned with the resources used to generate it. Barring ineptness in operational implementation, the firm’s strategy should produce as much profit as possible from a given amount of resources. The profitability ratios to remember are return on assets (ROA); return on equity (ROE); return on investment (ROI); and operating margin, or earnings before interest and taxes (EBIT).

Return on assets relates net income to the company’s total asset base and is figured as follows:

ROA relates net income to the investment in all the financial resources at the command of management. It is a useful measure of effective resource utilization without regard to how those resources were obtained or financed—a factor that shouldn’t be considered in examining the effectiveness of strategy.

Return on equity relates net income to the financial resources invested by shareholders. It is a measure of how efficiently the shareholders’ stake in the business has been used. ROE is calculated as follows:

The term “return on investment” is often used in business discussions that involve profitability. For example, expressions like “We aim for an ROI of 12 percent” are common. Unfortunately, there is no standard definition of ROI, since “investment” may be construed from many perspectives. Investment might represent the assets committed to a particular activity, the shareholders’ equity involved, or invested assets minus any liabilities generated by a company’s taking on a project. ROI might also refer to the internal rate of return, a very specific calculation of return. So, when someone uses the term “return on investment,” always request a clarification. Ask, “How are you calculating investment?”

The earnings-before-interest-and-taxes margin, more generally known as the operating margin, is used by many to gauge the profitability of a company’s operating activities. The operating margin ignores the interest expenses and taxes over which current management may have no control, thus giving a clearer indicator of management performance. To calculate the operating margin, use this formula:

None of these ratios is a sure indicator of the strength or weakness of one’s strategy since each reflects both the strategy and its execution. Nevertheless, ratios that are weaker than those of peer companies, or ratios that are growing weaker from one year to the next, should set off alarm bells in the executive suite and encourage senior management to investigate the causes. Is it the strategy, or is the strategy being poorly executed?

From Financial Measures to a Balanced Scorecard

Financial ratios tell the tale of business performance, and generations of businesspeople have used them to manage their operations. But financial ratios aren’t buttons we can push to make things happen—instead, they are outcomes of dozens of other activities. And they are backward-looking, the products of past activities. Worse, traditional measures can send the wrong signals. For instance, profit measures that look very good this year may be the result of dramatic cuts in new-product development and reductions in employee training. On the surface, current high profitability can make the state of affairs look rosy, but cuts in project development and training jeopardize tomorrow’s profits. Nor do financial ratios directly measure things such as customer satisfaction and organizational learning, which assure long-term profitability.

Frustrated by the inadequacies of traditional performance measurement systems, some managers have shifted their focus to the operational activities that produce them. These managers follow the motto “Make operational improvements, and the performance numbers will follow.” But which improvements are the most important? Which are the true drivers of long-term, bottom-line performance? To answer these questions, Harvard Business School professor Robert Kaplan and his associate David Norton conducted research on a number of companies with leading-edge measures of performance. From this research, they developed what they call a balanced scorecard, a new performance measurement system that gives top managers a more comprehensive view of the business. The balanced scorecard includes financial measures that indicate the results of past actions. And it complements those financial measures with three sets of operational measures that relate directly to customer satisfaction, internal processes, and the organization’s ability to learn and improve—the activities that drive future financial performance. In this sense the scorecard assesses both the company’s strategy and its operational implementation.

Kaplan and Norton have compared the balanced scorecard to the dials and indicators in an airplane cockpit:

Kaplan and Norton’s balanced scorecard uses four perspectives to link performance measures and to galvanize managerial action. Collectively, these perspectives give top management timely answers to four key questions:

• How do customers see us? (the customer perspective)
• What must we do to excel? (the internal perspective)
• Can we continue to improve and create value? (the innovation and learning perspective)
• How do we look to our shareholders? (the financial perspective)

Figure 9-1 indicates the linkages between the four perspectives. The advantage of the balanced scorecard over traditional measures is that three of the four perspectives (customer, innovation and learning, and internal) are more than results—they are levers that managers can manipulate to improve future results. For example, if the customer perspective indicator is in decline, management has a fairly clear idea where to intervene. Used together, the balanced scorecard and traditional ratio analysis can help managers understand the effectiveness of their strategy and identify areas where implementation needs work.

Market Analysis

Not too many years ago, a major publisher of college textbooks seemed pleased with its results. Revenue from sales was going up year after year, faster than expenses. There seemed like plenty of bonus money to go around—to shareholders, company managers, and the sales force. Only two disturbing facts intruded on this happy picture. First, the company’s unit sales were flat, and had been so for three years in a row. Revenue growth was simply the product of the company’s ability to increase its prices; a tactic that surely would not work forever. Second, revenues were dependent on the continued vitality of 5 books. Although the publisher actively promoted 180 current titles, these 5 accounted for 38 percent of total revenue. And each of them had been in the market for over fifteen years. Not one of the many other books this publisher had introduced during that fifteen-year period had even come close to establishing a strong position in the market.

FIGURE 9-1

The Balanced Scorecard Links Performance Measures

Source: Robert S. Kaplan and David P. Norton, “The Balanced Scorecard,” Harvard Business Review, (January–February 1992), 72.

On the surface, this publisher’s strategy appeared to be working. But market analysis revealed that it was simply treading water—going nowhere and being kept afloat by a handful of aging products. Although the sales force was earning annual bonuses for regularly hitting its expanding revenue quotas, it was making no gains in the marketplace. And though the publisher’s editors were developing and releasing new books every year, the company was living off past successes. Clearly, this company needed to examine its strategy through market analysis and find what was going wrong.

Market analysis is a big subject, too big to cover here. But you can capture many of its benefits if you focus your attention on just a few activities:

• Customer acquisition. Are you succeeding at acquiring new customers at an acceptable cost?
• Customer profitability. Are your current customers profitable to serve? Some companies focus solely on the number of new customers or accounts they corral, even though many of those customers are a drag on profits.
• Customer retention. Are you retaining your most valuable customers at a reasonable cost?
• New products/service. Are your new products/services successful and profitable?
• Market share. Are you gaining share in market segments that matter?

Negative answers to any questions on this short list should encourage you to reexamine you current business strategy.

The Appearance of New Competitors

Every successful and profitable strategy creates an unwelcome problem: It attracts competitors like bees to flowers. Unless hurdles are placed in their paths, the market will eventually become crowded, and competition and overcapacity will erode profits for everyone. And some of these new entrants may bring something different and superior to the market—for example, making their product or service more convenient to purchase.

Consider the example of the video rental stores that still populate many towns and urban neighborhoods. When movies were first made available on VHS cassettes (and Sony’s “Beta” format), smallscale entrepreneurs set up rental shops to serve local markets. And many did very well. This was a fairly easy business to enter, requiring little in the way of technical know-how or capital. When the profitability of the initial vendors became evident, others flocked to the market, driving down prices and cutting back sales for almost all players. Eventually, the U.S. market for videos was taken over (as always seems to happen in the United States) by big national chains such as Blockbuster and Hollywood Hits. These operators had advantages of scale that small, local competitors couldn’t match. Many of the original entrepreneurs went out of business.

The profitability of the big chains, in turn, has attracted innovative competitors, who are using pay-per-view, downloadable movies, and postal-based rentals to claim shares of the market.

If your business is successful, the reason for its success is that it provides something unique that customers value—or it sells/delivers its product or service in a manner they value (more quickly or conveniently). These qualities differentiate your company and give it a competitive advantage. The competitive advantage of that differentiation will disappear if new entrants begin doing the same thing.

Now ask yourself, “How easily can the unique qualities of our company or its products be copied by others?” If they can be easily copied, be prepared to share the market.

Market invasion by imitators is commonplace, and few market leaders can bar the door. Consider the case of Apple Computer and its popular iPod digital music player. Apple introduced the iPod in November 2001. It was not the first such device, but its design qualities and ability to store up to one thousand songs quickly made it a big success—the biggest for Apple since its Macintosh line of computers. The company sought to protect itself from direct imitators through a patented design and by farming out pieces of the iPod’s manufacture to a mix of suppliers operating under nondisclosure agreements. As of this writing, Apple still has a major chunk of the market and is maintaining it through new releases of improved models. However, this has not stopped others, including such formidable vendors as Hewlett-Packard, Dell, Sony, and Samsung, from entering the market and carving out pieces for themselves.

There are several possible defenses against the invasion by rivals seeking to enter your market:

1. Deliberately erect barriers to entry. For example, a fast-food restaurant owner in a small town might buy up the pieces of real estate most attractive to a potential rival.
2. Don’t maximize profits. If you are the market leader, seek market share dominance over profit maximization. This may sound like heresy, but it often makes sense. By establishing a pricing structure that produces only modest profits, fewer competitors will be drawn to your market.
3. Exploit the experience curve to establish yourself as the low-cost leader. This is particularly important in technology industries. If you can learn sooner and faster than competitors, you’ll maintain a cost advantage; that advantage may be large enough to drive competitors out of the business and keep others away.

If none of these antidotes is feasible, you must alter your strategy in a way that differentiates your offer and gives it a competitive advantage.

The Appearance of a New Technology

The fates of many businesses hinge on their core technologies. Just as those technologies account for their success, the eclipse of those technologies results in their failure. For example, during the nineteenth century, harvesting ice from lakes and ponds was a huge business, particularly in New England. Ice harvested in the Boston area was packed by the Tucker Ice Company and its emulators into specially insulated vessels and shipped to Gulf coast cities, England, and as far away as India and China. It was a wonderfully profitable business until mechanical refrigeration technology was developed and disseminated around the world. Because of that innovation, the fortunes of the big ice companies gradually melted away.

The rise of digital photography provides a more current example. Ever since the late 1830s, imaging was based on the exposure of light to a film or a glass plate coated with photosensitive chemicals. That technology was progressively improved over the years. Kodak built an empire on chemical-based photography and did the most to advance the field, producing film, processing chemicals, and photographic paper for both the amateur and professional markets. It also marketed consumer cameras.

The first substantial threat to chemical-based photography appeared in the early 1980s when Sony, an electronics company, introduced a camera using digital technology. The rapid rise of digital photography—which makes the use of film, chemicals, and most papers obsolete—directly threatened Kodak and its manufacturing infrastructure. Worse, Kodak lacked superior competencies in digital imaging, at least initially. The universe of competitors also shifted dramatically. Kodak’s main rival was no longer the film manufacturer Fuji; the explosive rise of digital imaging forced it into competition with Nikon, Canon, Leica, and other established camera makers. Even electronics firms such as Sony and Hewlett-Packard were in the game. By mid-2004, digital cameras had penetrated 40 percent of U.S. households and industry analysts were predicting another two years of rapid growth. Given this situation, Kodak had to undertake a huge strategic shift. To its credit, the company faced the facts and channeled its strategic resources into the technology of the future. How it will fare in the long run is anyone’s guess.

Situations like Kodak’s are common along fault lines created by technological progress. Business leaders must spot those disruptions in their very early stages and reformulate their strategies accordingly. When they spot them, they cannot bury their heads in the sand.

When faced with a new and disruptive technology, the impulse of many companies is to invest still further in the technologies that made them successful in the first place. This was observed when steamships challenged makers of sailing ships, when Edison’s electric lighting systems challenged the gas-illumination companies in the late 1800s, and when jet engines challenged piston-driven aircraft engines in the late 1940s. In each case, the companies threatened by these innovations continued to invest in and marginally improve their mature technologies even as the new ones were becoming better and cheaper by the month.

The only antidotes to the invasion of new technologies are:

1. Anticipate them. New, strategy-wrecking technologies do not appear fully formed. They emerge slowly, often from different sources. In their formative periods they reveal themselves in scientific papers and are discussed at technical conferences. An alert company—one that continually scans the external environment—can often detect the new technologies long before they have developed to the point of being serious threats. This gives the company time to adapt or get on board. You can anticipate emerging technologies through policies that open the windows of your organization to the outer world: by sending R&D and marketing personnel to technical conferences, by setting up a scanning unit to review technical literature, and so forth.
2. Go looking for trouble. Ask this question: What could kill our business? Create a team of your brightest people and give them the job of developing a business strategy capable of penetrating your markets and stealing your current customers.