Internal Environment: Financial Analysis

Hitt, M.A., Ireland, R.D., Hoskisson, R.E.  2005.  Strategic Management: Competitiveness and Globalization: Concepts and Cases (6e).  Australia:  Thomson South-Western.

Organizational controls & balanced scorecard

  1. What are organizational controls? Why are strategic controls and financial controls important parts of the strategic management process?
  2. Organizational controls are basic to a capitalistic system and have long been viewed as an important part of strategy implementation processes. Controls are necessary to help ensure that firms achieve their desired outcomes.  Defined as the “formal, information-based…procedures used by managers to maintain or alter patterns in organizational activities,” controls help strategic leaders build credibility, demonstrate the value of strategies to the firm’s stakeholders, and promote and support strategic change (p. 394).
  3. Financial control focuses on short-term financial outcomes. In contrast, strategic control focuses on the content of strategic actions, rather than their outcomes (p. 394).
  4. The balanced scorecard is a framework that firms can use to verify that they have established both strategic and financial controls to assess their performance. This technique is most appropriate for use when dealing with business-level strategies, but can also apply to corporate-level strategies (p. 394).

The underlying premise of the balanced scorecard is that firms jeopardize their future performance possibilities when financial controls are emphasized at the expense of strategic controls, in that financial controls provide feedback about outcomes achieved from past actions, but do not communicate the drivers of the firm’s future performance.

Thus, an overemphasis on financial controls could promote organizational behavior that has a net effect of sacrificing the firm’s long-term value-creating potential for short-term performance gains.  An appropriate balance of strategic controls and financial controls, rather than an overemphasis on either, allows firms to effectively monitor their performance (pp. 394-395).

  1. Four perspectives are integrated to form the balanced scorecard framework:
    1. Financial (concerned with growth, profitability, and risk from the shareholders’ perspective).
    2. Customer (concerned with the amount of value customers perceive was created by the firm’s products).
    3. Internal Business Processes (with a focus on the priorities for various business processes that create customer and shareholder satisfaction).
    4. Learning and Growth (concerned with the firm’s efforts to create a climate that supports change, innovation, and growth). [p. 395]

 

BALANCED SCORECARD:  FAST FOOD RESTARUANT1

Perspective Goal

 

Measurement

 

FINANCIAL Firm Growth &
Profitability
Annual Sales Growth>5%
    Profit Margin > 10%
     
     
CUSTOMER Value Creation & Satisfaction Service Time < 5 minutes
    Repeat Business ≥ 50% of Sales
     
     
INTERNAL BUSINESS PROCESSES Organizational Efficiency Waste < ½% of Sales
    28% ≤COGS≤  30%
    Cash Over/Shorts < 1% of Sales
     
LEARNING & GROWTH Climate that Supports Change, Innovation, and Growth Intro 1 New Product per Quarter
    Into 2 new Profit Increasing Initiatives each year
    College Reimbursement Program=1% profits
     

1 Measures based on instructor’s management experience (i.e., not in Hitt et al. Textbook).

Google’s Financial Analysis: Sample Answers

Step 1:  Calculate each ratio.

Step 2:  Evaluate each ratio (or set of ratios).

Step 3:  Provide an overall assessment.

Category Historical: 2003-2004 Competitor: 2004
Liquidity Positive Strength
Asset Utilization Negative
(AR = Neutral)
Strength
Debt Management Positive Strength
Profitability Negative
(Margins = Neutral)
Strength
(Margins = Weakness)
Market Positive Strength

During the 2003-2004 period, Google experienced positive trends with respect to its liquidity, debt management, and market ratios; however, asset utilization and profitability declined.  Google maintained its competitive position relative to Yahoo, outperforming Yahoo in each category—liquidity, asset utilization, debt management, profitability, and market.  (Google’s profitability margins were weaker than Yahoo, however.)  Investor ratings suggest a vote of confidence in the company’s performance.  That is, investors believe that Google has more profit potential and/or is less risky than Yahoo.

Step 4:  Make a recommendation.

Although Google is strong financially overall, it needs to improve its performance in a few areas.  Google needs to focus on its asset utilization and profitability.  It should consider reducing its assets to sales ratio and streamlining its cost structure.

Note:

You were provided limited information for this exercise—ratios for the five primary financial categories.  In an actual analysis, you would have access to the company’s financial statements.  This information would allow you to provide a more detailed discussion of the company’s performance; for example, you could discuss the company’s sales and sales growth rates.  Additionally, you would have a better understanding of the company’s cost structure, and you could offer an explanation for the decreased asset utilization.

 

Financial Statements—Analysis1
Chapter 4

 

Financial statements report both a firm’s position at a point in time and its operations over a specified period.  The REAL VALUE of financial statements, however is that they can be used to help predict future earnings as well as dividends!  There are 5 primary categories of financial ratios—Liquidity, Asset Management (Utilization), Debt Management (Leverage), Profitability, and Market Value.

As a general rule, financial analysts and management are concerned if a firm’s ratios are far removed from the averages for its industry; it is a signal to look further, to find out why the variance occurs.  Never forget that you must look at a number of ratios to see what each suggests, then look at the overall situation to judge the company’s performance with the goal of trying to figure out what the company should do to improve!

PLEASE NOTE:  A meaningful ratio analysis must go beyond calculation to interpretation.  A firm’s financial position cannot be analyzed in isolation; reference points are needed, such as historical comparisons, comparison with industry norms, and comparison with key competitors!

I.         Liquidity Ratios:
A.  The Current Ratio:
1. Formula: Current Ratio = Current Assets/Current Liabilities
2. Focus:     Will the firm be able to pay off its debts as they                               come due in the coming year?
3. Indication of Possible Trouble:  Current Liabilities are rising                                    faster than Current Assets!
4. Healthy Ratio (Rule of Thumb):  Current Ratio = 2
5. Abbreviations:
Current Assets = CA
Current Liabilities = CL

 

B.  The Quick Ratio:
1.  Formula:  Quick Ratio = (CA – Inventories)/CL
2.  Focus:    Firm’s ability to pay its bills without depending on                         inventory because inventories are typically the                                least liquid of firm’s current assets, which means                                they are the assets on which losses are most likely                                  to occur in the event of liquidation.

II.      Asset Management Ratios:  These ratios measure how effectively the firm is managing its assets.  Asset management ratios answer the question:  Does the amount of each type of asset seem reasonable, too high, or too low given current and projected sales?

A.  The Inventory Turnover Ratio:
1.  Formula:  Inventory Turnover Ratio = Sales/Inventories
2.  Focus: How many times the asset is turned over during year.
3.  Indication of Possible Trouble:  Extremely low inventory                                        turnovers relative to the industry suggest the firm                                                        is holding too much inventory; firms may be                                                          holding obsolete goods not worth their stated                                                         value!
4.  Days Sales in Inventory (DSI):  is used to appraise                                                  inventories, to find how many days’ sales are tied                                                        up in inventories.  Thus, it represents the average                                                    length of time that inventory sits before it is sold!                                                  Alternatively, it is the time it will take to work off                                                   the current inventory
a.  DSI = (365 days)/(Inventory Turnover)
= Inventory/average daily sales
= Inventory/(Sales/365)
5.  Note:      The inventory measures give us some indication of                                    how fast the firm can sell its products!

 

B.  The Accounts Receivable Turnover Ratio:

1.  Formula:  Accounts Receivable Turnover Ratio = Sales /AR
2.  Focus: How many times the asset is turned over during year.
3.  Indication of Possible Trouble:  low turnovers relative to the                                            industry.
4.  Days Sales Outstanding (DSO) or Average Collection                                                      Period (ACP):  is used to appraise accounts                                                              receivable, to find how many days’ sales are tied                                                    up in receivables.  Thus, it represents the average                                                        length of time that the company must wait after                                                     making a credit sale to receive cash!
a.  DSO = (365 days)/(AR turnover)
=  AR/average daily sales
=  AR/(Sales/365)
b.  DSO can also be evaluated by comparing it to                                                         the company’s credit terms
5.  Note:      Sales here refer to “Credit Sales.”
6.  Note:      The AR measures tell us how fast the firm can                                           collect on its sales (credit sales)!

  1. C. The Fixed Assets Turnover Ratio:
      Formula:  Fixed Assets Turnover = Sales/(Net fixed assets)
    2.  Focus:    How effectively the firm uses its plant and                                                 equipment.  (Does the firm use its fixed assets as                                       intensively as other firms in its industry?  If yes,                                       then it has about the right amount of fixed assets                                        relative to its sales.)
    3.  Note:      Large variances between market value and book                                        value (inflation) tend to inflate the Fixed Assets                               Turnover, which could cause an older company to                                  appear more efficient than a younger company, but                             these ratio differences would be more reflective of                                       when the assets were acquired rather than the                                  inefficiency of the younger firm!

 

  1. The Total Assets Turnover Ratio:
    1.  Formula:  Total Assets Turnover = Sales/(Total Assets)
    2.  Focus:    How effectively the firm uses all its assets.
    3.  Note:      It measures the turnover of all the firm’s assets, the                         company’s ability to generate sales based on its                              assets.
  • Debt Management Ratios: used to determine the extent to which a firm uses debt financing or financial leverage.
    Implications (motivations behind financial leveraging):
    1.  Stockholders prefer higher debt ratios because it allows                                 them to control a firm with a limited amount of                               equity investment.
    2. Creditors prefer lower debt ratios (higher proportion of                                  total capital supplied by stockholders) because it                                      reduces their risk!  Creditors look to equity to                                     provide a margin of safety.
    3.  The advantage of Financial Leverage:  If the firm earns more                         on its assets than the interest rate it pays on debt,                                then using debt “leverages,” or magnifies, the                               return on equity (ROE)!  There are 2 reasons for                              the leveraging effect:
    1.  The Tax Shield increases pre-tax income.
    2.  When EBIT as a percentage of assets exceeds                                                the interest rate on debt, as it generally is                                         expected to do, then a firm can use the debt                                          to acquire assets, pay the interest on the                                             debt, and have money left over as a “bonus”                                                 for its stockholders!
    4.  The double-edge sword of leveraging:  Firms with high debt                                    ratios have higher expected returns when the                                   economy is good (or normal) but enhanced or                                 greater losses when the economy is bad (i.e.,                               recession)!

 

  1. The Debt Ratio:
  2. Formula:  Debt Ratio = Total debt/Total assets
    2.  Focus:    It measures the percentage of funds provided by                                        creditors!
    3.  Red Flag:  High debt ratios make it relatively costly to                                   borrow additional funds, if creditors are willing to                                    make loans!
    C.  The Times-Interest-Earned Ratio:
              1.  Formula:  TIE = EBIT/(interest charges)
    2.  Focus:  TIE measures the extent to which operating income                                     can decline before the firm is unable to meet its                                annual interest costs.
  3. The EBITDA Coverage Ratio:
                       1.  EBITDA = (EBITDA + lease pmts)/(Int + Prin + lease pmts)
    2. All cash flow available for pmts & all required financial pmts
    3.  Note:  If EBIT declines, the coverage will fall!

 

IV.  Profitability Ratios:  The liquidity, asset management, and debt ratios covered thus far tell us something about the firm’s policies and operations, but profitability ratios reflect the net result of all the financing policies and operating decisions!
A.  Profit Margin on Sales Ratio:
1.  Formula:  Profit Margin on sales = Net Income/Sales
2.  Focus:  Measures the profit per dollar of sales
3.  Note:  Sub-par results generally occur because costs are too                                    high or inefficient operations!  It can also be a                                 result of the financing strategy.
4.  Note:  While high return on sales is good, we must also be                                      concerned with turnover!  (If a firm sets a very                                high price on its products, it may get a high return                                      on each sale but not make many sales.)
B.  Return on Total Assets:
          1.  Formula:  ROA = Net Income/ (Total Assets)
2.  Note:  Sub-par results may reflect financing strategy.

 

C.  Basic Earning Power Ratio:

1.  Formula:  BEP = EBIT/(Total Assets)
2.  Focus:  BEP shows the raw earning power of the firm’s                       assets, before the influence of taxes and leverage, and it                              is useful when comparing firms with different degrees of                     financial leverage and tax situations!
D.  Return on Common Equity:
          1.  Formula:  ROE = Net Income/(Common Equity)
2.  Focus:  Stockholders expect to earn a return on their money,                         and this ratio tells how well they are doing in an                                        accounting sense!  It is considered the “bottom-line”                        accounting ratio!

  1. Market Value Ratios: relate the firm’s stock price to its earnings, cash        flow, and book value per share.  These ratios give management an       indication of what investor think about the firm’s risk and future        prospects!
    A.  The Price/Earnings Ratio:
    1.  Formula:  P/E = (Price per share)/(Earnings per share)
    2.  Focus:    It shows how much investors are willing to pay per                                   dollar of reported profits.
    3.  Note:      P/E ratios are higher for firms with strong growth                                              prospects and relatively little risk!
    B.  The Price/Cash Flow Ratio:
                       1.  Formula:  Price/cash flow = (Price per share)/(CF per share)
    2.  Focus:    It shows the dollar amount investors will pay for                                               $1 of cash flow.
    3.  Note:      P/CF ratios tend to be higher for firms with strong                                             growth prospects and relatively little risk!
    C.  The Market/Book Ratio:
                       1.  Book Value/share = Common equity /(# shares outstanding)
    2.  Market/Book Ratio = (Market price per share)/(BV/share)
    3.  Focus:    shows the dollar amount investors will pay for $1                                              of book value.
    4.  Note:      Companies that are well regarded by investors sell                                             at higher multiples of book value.

Last Updated on September 16, 2018 by Essay Pro