Strategic Management. Concepts and Cases. Strategic Management. Fred R. David Forest R. David

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1 Strategic Management Concepts and Cases For these Global Editions, the editorial team at Pearson has collaborated with educators across the world to address a wide range of subjects and requirements, equipping students with the best possible learning tools. This Global Edition preserves the cutting-edge approach and pedagogy of the original, but also features alterations, customization and adaptation from the North American version. Global edition Global edition Global edition Strategic Management Concepts and Cases Fifteenth edition Fred R. David Forest R. David Fifteenth edition David David This is a special edition of an established title widely used by colleges and universities throughout the world. Pearson published this exclusive edition for the benefit of students outside the United States and Canada. If you purchased this book within the United States or Canada you should be aware that it has been imported without the approval of the Publisher or Author. Pearson Global Edition DAVID_ _mech.indd 1 25/06/14 5:28 PM

2 Comprehensive Model of the Chapter 2: The Internal Audit Chapter 6 Types of Strategies Chapter 4 Vision and Mission Analysis Chapter 5 Strategy Generation and Selection Chapter 8 The External Audit Chapter 7 Chapter 3: Strategy Formulation used widely among businesses AND ACADEMIA WORLDWIDE

3 204 CHAPTER 6 The Internal Audit and Mexico, but RadioShack is struggling to compete with online-only rivals such as Amazon because customers increasingly order electronics online. Based in London, BP PLC recently boosted its quarterly dividend 13 percent to 0.09 a share. BP s board, in announcing the increase, said the company has a bright future with its recent 26.8 billion cash-and-shares deal to acquire a 20 percent stake in Russia s state-controlled OAO Rosneft. Despite not yet settling lawsuits related to the Gulf of Mexico Deepwater Horizons oil spill, BP posted a net profit for the three months ended September, 30, 2012, of 5.43 billion, up from 5.04 billion the prior year. Costco in late 2012 borrowed 3.5 billion just to pay its shareholders a 7 dividend per share, totaling 3 billion. The dividend payout, without the borrowing, would have depleted Costco s cash account. Many companies near the end of 2012 paid special dividends, 175 in November 2012 alone or firms paid dividends early, to avoid the expected 2013 substantial increase in taxes on dividends. 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 6-3, is a useful technique that incorporates both the time and industry average dimensions of financial ratios. Note that the dotted lines reveal projected ratios. Some websites, such as those provided in Table 6-5, calculate financial ratios and provide data with charts. Table 6-6 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 meaningful to a company that primarily does a cash receipts business. Key financial ratios can be classified into the following five types: Current ratio Industry average Company Profit margin (percent) 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0 Industry average Company Figure 6-3 A Financial Ratio Trend Analysis

4 CHAPTER 6 The Internal Audit Liquidity ratios measure a firm s ability to meet maturing short-term obligations. Current ratio uick (or acid-test) ratio 2. 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 3. 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 4. 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 (EPS) Price-earnings ratio 5. Growth ratios measure the firm s ability to maintain its economic position in the growth of the economy and industry. Earnings per share Dividends per share Financial ratio analysis must go beyond the actual calculation and interpretation of ratios. The analysis should be conducted on three separate fronts: 1. How has each ratio changed over time? This information provides a means of evaluating historical trends. It is important to note whether each ratio has been historically increasing, decreasing, or nearly constant. For example, a 10 percent profit margin could be bad if the trend has been down 20 percent each of the last three years. But a 10 percent profit margin could be excellent if the trend has been up, up, up. Therefore, calculate the percentage change in each ratio from one year to the next to assess historical financial performance on that dimension. Identify and examine large percent changes in a financial ratio from one year to the next. 2. How does each ratio compare to industry norms? A firm s inventory turnover ratio may appear impressive at first glance but may pale when compared to industry standards or norms. Industries can differ dramatically on certain ratios. For example grocery companies, such as Kroger, have a high inventory turnover whereas automobile dealerships have a lower turnover. Therefore, comparison of a firm s ratios within its particular industry can be essential in determining strength and weakness.

5 206 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 Total assets 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

6 CHAPTER 6 The Internal Audit 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 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 () to equal its total costs (). Note that the before and after chart in Figure 6-4 reveals that the 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

7 208 CHAPTER 6 The Internal Audit Notice in Figure 6-5 that increasing fixed costs () 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 line, which makes the intersection of the and lines at a point farther down the uantity axis. Increasing a firm s 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 is reflected by the line shifting left or becoming steeper. When the line remains constant, the effect of increasing is to increase, which increases the point at which = =. The formula for calculating breakeven point is uantity = T divided by (price ). 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