What strategic issues and problems merit front burner managerial attention

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CHAPTER 4

Evaluating a Company’s Resources, Capabilities, and Competitiveness

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Learning Objectives THIS CHAPTER WILL HELP YOU UNDERSTAND:

LO 1 How to take stock of how well a company’s strategy is working.

LO 2 Why a company’s resources and capabilities are centrally important in giving the company a competitive edge over rivals.

LO 3 How to assess the company’s strengths and weaknesses in light of market opportunities and external threats.

LO 4 How a company’s value chain activities can affect the company’s cost structure and customer value proposition.

LO 5 How a comprehensive evaluation of a company’s competitive situation can assist managers in making critical decisions about their next strategic moves.

Crucial, of course, is having a difference that matters in the industry.

Cynthia Montgomery—Professor and author

If you don’t have a competitive advantage, don’t compete

Jack Welch—Former CEO of General Electric

Organizations succeed in a competitive marketplace over the long run because they can do certain things their customers value better than can their competitors.

Robert Hayes, Gary Pisano, and David Upton—-Professors and consultants

Chapter 3 described how to use the tools of industry and competitor analysis to assess a company’s external environment and lay the groundwork for matching a company’s strategy to its external situation. This chapter discusses techniques for evaluating a company’s internal situation, including its collection of resources and capabilities and the activities it performs along its value chain. Internal analysis enables managers to determine whether their strategy is likely to give the company a significant competitive edge over rival firms. Combined with external analysis, it facilitates an understanding of how to reposition a firm to take advantage of new opportunities and to cope with emerging competitive threats. The analytic spotlight will be trained on six questions:

1. How well is the company’s present strategy working? 2. What are the company’s most important resources and capabilities, and will they give the company a

lasting competitive advantage over rival companies? 3. What are the company’s strengths and weaknesses in relation to the market opportunities and

external threats? 4. How do a company’s value chain activities impact its cost structure and customer value proposition? 5. Is the company competitively stronger or weaker than key rivals? 6. What strategic issues and problems merit front-burner managerial attention?

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In probing for answers to these questions, five analytic tools—resource and capability analysis, SWOT analysis, value chain analysis, benchmarking, and competitive strength assessment—will be used. All five are valuable techniques for revealing a company’s competitiveness and for helping company managers match their strategy to the company’s particular circumstances.

QUESTION 1: HOW WELL IS THE COMPANY’S PRESENT STRATEGY WORKING?

LO 1 How to take stock of how well a company’s strategy is working.

In evaluating how well a company’s present strategy is working, the best way to start is with a clear view of what the strategy entails. Figure 4.1 shows the key components of a single-business company’s strategy. The first thing to examine is the company’s competitive approach. What moves has the company made recently to attract customers and improve its market position—for instance, has it cut prices, improved the design of its product, added new features, stepped up advertising, entered a new geographic market, or merged with a competitor? Is it striving for a competitive advantage based on low costs or a better product offering? Is it concentrating on serving a broad spectrum of customers or a narrow market niche? The company’s functional strategies in R&D, production, marketing, finance, human resources, information technology, and so on further characterize company strategy, as do any efforts to establish alliances with other enterprises.

FIGURE 4.1 Identifying the Components of a Single-Business Company’s Strategy

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The three best indicators of how well a company’s strategy is working are (1) whether the company is achieving its stated financial and strategic objectives, (2) whether its financial performance is above the industry average, and (3) whether it is gaining customers and gaining market share. Persistent shortfalls in meeting company performance targets and weak marketplace performance relative to rivals are reliable warning signs that the company has a weak strategy, suffers from poor strategy execution, or both. Specific indicators of how well a company’s strategy is working include:

• Trends in the company’s sales and earnings growth. • Trends in the company’s stock price. • The company’s overall financial strength. • The company’s customer retention rate. • The rate at which new customers are acquired. • Evidence of improvement in internal processes such as defect rate, order fulfillment,

delivery times, days of inventory, and employee productivity.

Sluggish financial performance and second-rate market accomplishments almost always signal weak strategy, weak execution, or both.

The stronger a company’s current overall performance, the more likely it has a well-conceived, well- executed strategy. The weaker a company’s financial performance and market standing, the more its current strategy must be questioned and the more likely the need for radical changes. Table 4.1 provides

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a compilation of the financial ratios most commonly used to evaluate a company’s financial performance and balance sheet strength.

TABLE 4.1 Key Financial Ratios: How to Calculate Them and What They Mean

Ratio How Calculated What It Shows

Profitability ratios

1.  Gross profit margin Shows the percentage of

revenues available to cover operating expenses and yield a profit.

2.  Operating profit margin (or return on sales)

Shows the profitability of current operations without regard to interest charges and income taxes. Earnings before interest and taxes is known as EBIT in financial and business accounting.

3.  Net profit margin (or net return on sales)

Shows after-tax profits per dollar of sales.

4.  Total return on assets A measure of the return on

total investment in the enterprise. Interest is added to after-tax profits to form the numerator, since total assets are

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Ratio How Calculated What It Shows

financed by creditors as well as by stockholders.

5.  Net return on total assets (ROA)

A measure of the return earned by stockholders on the firm’s total assets.

6.  Return on stockholders’ equity (ROE)

The return stockholders are earning on their capital investment in the enterprise. A return in the 12%–15% range is average.

7.  Return on invested capital (ROIC) —sometimes referred to as return on capital employed (ROCE)

A measure of the return that shareholders are earning on the monetary capital invested in the enterprise. A higher return reflects greater bottom-line effectiveness in the use of long- term capital.

Liquidity ratios

1.  Current ratio Shows a firm’s ability to pay

current liabilities using assets that can be converted to

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Ratio How Calculated What It Shows

cash in the near term. Ratio should be higher than 1.0.

2.  Working capital

Current assets – Current liabilities The cash available for a firm’s day-to-day operations. Larger amounts mean the company has more internal funds to (1) pay its current liabilities on a timely basis and (2) finance inventory expansion, additional accounts receivable, and a larger base of operations without resorting to borrowing or raising more equity capital.

Leverage ratios

1.  Total debt- to-assets ratio

Measures the extent to which borrowed funds (both short-term loans and long- term debt) have been used to finance the firm’s operations. A low ratio is better—a high fraction indicates overuse of debt

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Ratio How Calculated What It Shows

and greater risk of bankruptcy.

2.  Long-term debt-to- capital ratio

A measure of creditworthiness and balance sheet strength. It indicates the percentage of capital investment that has been financed by both long-term lenders and stockholders. A ratio below 0.25 is preferable since the lower the ratio, the greater the capacity to borrow additional funds. Debt-to-capital ratios above 0.50 indicate an excessive reliance on long- term borrowing, lower creditworthiness, and weak balance sheet strength.

3.  Debt-to- equity ratio Shows the balance

between debt (funds borrowed both short term and long term) and the amount that stockholders have invested in the enterprise. The further the ratio is below 1.0, the greater

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Ratio How Calculated What It Shows

the firm’s ability to borrow additional funds. Ratios above 1.0 put creditors at greater risk, signal weaker balance sheet strength, and often result in lower credit ratings.

4.  Long-term debt-to- equity ratio

Shows the balance between long- term debt and stockholders’ equity in the firm’s long-term capital structure. Low ratios indicate a greater capacity to borrow additional funds if needed.

5.  Times- interest- earned (or coverage) ratio

Measures the ability to pay annual interest charges. Lenders usually insist on a minimum ratio of 2.0, but ratios above 3.0 signal progressively better creditworthiness.

Activity ratios

1.  Days of inventory Measures inventory

management efficiency. Fewer

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Ratio How Calculated What It Shows

days of inventory are better.

2.  Inventory turnover Measures the number of

inventory turns per year. Higher is better.

3.  Average collection period

Indicates the average length of time the firm must wait after making a sale to receive cash payment. A shorter collection time is better.

Other important measures of financial performance

1.  Dividend yield on common stock

A measure of the return that shareholders receive in the form of dividends. A “typical” dividend yield is 2%–3%. The dividend yield for fast-growth companies is often below 1%; the dividend yield for slow- growth companies can run 4%–5%.

2.  Price-to- earnings (P/E) ratio

P/E ratios above 20 indicate strong investor confidence in a firm’s outlook

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Ratio How Calculated What It Shows

and earnings growth; firms whose future earnings are at risk or likely to grow slowly typically have ratios below 12.

3.  Dividend payout ratio Indicates the percentage of

after-tax profits paid out as dividends.

4.  Internal cash flow

After-tax profits + Depreciation A rough estimate of the cash a company’s business is generating after payment of operating expenses, interest, and taxes. Such amounts can be used for dividend payments or funding capital expenditures.

5.  Free cash flow

After- tax profits + Depreciation – Capital expenditures – Dividends A rough

estimate of the cash a company’s business is generating after payment of operating expenses, interest, taxes, dividends, and desirable reinvestments in the business. The larger a company’s free

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Ratio How Calculated What It Shows

cash flow, the greater its ability to internally fund new strategic initiatives, repay debt, make new acquisitions, repurchase shares of stock, or increase dividend payments.

QUESTION 2: WHAT ARE THE COMPANY’S MOST IMPORTANT RESOURCES AND CAPABILITIES, AND WILL THEY GIVE THE COMPANY A LASTING COMPETITIVE ADVANTAGE OVER RIVAL COMPANIES?

An essential element of deciding whether a company’s overall situation is fundamentally healthy or unhealthy entails examining the attractiveness of its resources and capabilities. A company’s resources and capabilities are its competitive assets and determine whether its competitive power in the marketplace will be impressively strong or disappointingly weak. Companies with second-rate competitive assets nearly always are relegated to a trailing position in the industry.

CORE CONCEPT A company’s resources and capabilities represent its competitive assets and are determinants of its competitiveness and ability to succeed in the marketplace.

Resource and capability analysis provides managers with a powerful tool for sizing up the company’s competitive assets and determining whether they can provide the foundation necessary for competitive success in the marketplace. This is a two-step process. The first step is to identify the company’s resources and capabilities. The second step is to examine them more closely to ascertain which are the most competitively important and whether they can support a sustainable competitive advantage over rival firms.1 This second step involves applying the four tests of a resource’s competitive power.

Resource and capability analysis is a powerful tool for sizing up a company’s competitive assets and determining whether the assets can support a sustainable competitive advantage over market rivals.

Identifying the Company’s Resources and Capabilities

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A firm’s resources and capabilities are the fundamental building blocks of its competitive strategy. In crafting strategy, it is essential for managers to know how to take stock of the company’s full complement of resources and capabilities. But before they can do so, managers and strategists need a more precise definition of these terms.