Analyzing an Organization's Strategic Resource Base

advantage.

a

(4) 1s

the resource? Possessing a

it is quite

that has little value to one com-

for another. The

strategie

for competitive

it is for rivaIs to duplicate

it is to a company.

can be duplicated. The question is-at

asset

can be leveraged

the more valuable

a resource

to exploit

for

98

Strategy: A View from the Top

----

Physical Assets

A company's physical assets, such as state-of-the-art manufactur-

ing facilities and plant or service locations near important

competitiveness.

tomers, can materially affect a company's

airline companies,

the average age of their fleet of aircraft

important concern. Ttaffects customer perceptions,

bility, and operating and maintenance

key issue for telecommunications

geographical

reach and defines

they can provide.

tion, location,

cus-

For

is an

routing flexi-

is a

their

service

ln retailing and real estate, the old adage "loca-

costs. Infrastructure

companies. Ttdetermines

the types of customer

location" still applies.

Physical assets do not necessarily need to be owned. Judicious

leasing, franchising, and partnering can sub-

reach with a relatively modest

use of outsourcing,

stantially enhance a company's

commitment of resources.

Analyzing

a Company's Financial Resource Base

level, an evaluation

and position involves

financial

At the corporate

analysis of the

performance

company's

and cash

flows at the divisional or business unit level, with additional con-

sideration of the balance sheet at the corporate level.

and pro forma incarne statement

of a company's

a thorough

current

and a company's

Financial ratio analysis can provide

a quick overview of a

company's or business unit's current or Fast profitability,

liquid-

ity, leverage, and activity. Profitability ratios measure how weIl a

company is allocating its resources. Liquidity ratios focus on cash

its financial

flow generation

obligations. Leverage ratios may suggest potential

improvements

in the financing of operations. Activity ratios measure productivity

and efficiency. These ratios (Figure 5-1) can be used to assess

(2) the degree to which

(1) the business's position in the industry,

certain strategie objectives are being achieved,

(3) the business's

vulnerability

financial risk associated with the current or proposed strategy.

and cost swings, and (4) the level of

ability to meet

to revenue

The DuPont formula for analyzing a company or business unit' s

to financial

return on assets directly links operating variables

Charter 5 Analyzing an Organization's Strategie Resource Base

99

Figure 5-1

Ratio Analysis

Ratio

Definition

1. Profitability

a. Gross profit margin

sales - cost of goods sold

sales

b. Net profit margin

c. Return on assets

d. Retum on equity

2. Liquidity

a. Current

ratio

b. Quick ratio

profits after taxes

sales

eamings before interest

and taxes (EBIT)

Total assets

profits after taxes

total equity

current assets

liabilites

current

current assets - inventory Acid-test

liabilites

current

c. Inventory to net

working capital

inventory

current assest - current

liabilites

3. Leverage

a. Debt-to-assets

ratio

total debt

total assets

b. Debt-to-equity ratio

total debt

c. Long-term

debt-to-equity ratio

4. Activity

a. Inventory turnover

b. Fixed-asset turnover

total equity

long-term debt

total equity

sales

inventory

sales

fixed assets

Total margin available to

cover operating expenses

and yield a profit

Return on sales

Retum on the total investrnent

and

frOIDbath stockholders

creditors

Rate of return on stockholders'

investrnent

in the firm

The extent to which the daims

of short-term creditors are

covered by short-term assets

ratio; the firm's

ability to par off short-term

obligations without having

to sell its inventory

The extent

to which the

firm's working capital

is tied up in inventory

The extent to which borrowed

funds are used to finance the

firm's operations

Ratio of funds tram creditors

to funds frOIDstockholders

The balance between debt and

equity

The amount of inventory used

by the company to generate

its sales

Sales productivity and plant use

c. Average collection

accounts receivable

average daily sales

The average length of time

required to receive payment

100

Strategy: A View frOIDthe Top

,.

performance. For example, as shown in Figure 5-2, return on assets (

is computed by multiplYing eamings, expressed as a percentage of

sales,by asset turnover. Asset turnover,

is the ratio of sales

to total assets used. A careful analysis of such relationships allows

pointed questions about a strategy' s effectiveness and the quality of

its execution.

in turn,

Accounting-based measures have generally been found to be

value.

of a business unit's

economic

indicators

inadequate

Shareholdervalue analysis, in contrast,

focuses on cash flow gener-

ation, which is the principal determinant of shareholder wealth.

Figure 5-2

The DuPont Formula for Computing Return on Assets

Earnings belore

interest aJ-nd

taxes (EBIT)

Divided by

Sales

Sales

Divided by

Total assets

;}

Minus

Sales

Costs

Current assets

Plus

Fixed assets

Costol

goods sold

Plus

Qperating

expenses

Inventories

Plus

Plus

Plus

Accounts

receivable

Cash -

Prepaid

expenses

Earnings as

percent 01sales

Multiplied by

Return on

assets

Asset

turnover

Charter 5 Analyzing an Organization's Strategie Resource Base

101

1

l

,

~

Il

strategie plan create shareholdèr

in answering the following questions:

It is helpful

current

value, and,

much? (2) How does the business unit's performance

with the performance of others in the corporation?

alternative

current strategy?

(1) Does the

if so, how

compare

(3) Would an

value more than the

strategy increase shareholder

financial measures

The use of accounting-based

to assess cur-

(ROI), have been

such as return on investment

rent performance,

supplanted by the broader shareholder value-based measures of

economic value added (EVA) and market value added (MVA). EVAis a

value-based financial performance measure thaï focuses on eco-

based on

nomic value creation. Unlike traditional measures

thaï capital has two compo-

accounting profit, EVA recognizes

nents:

traditional

including return on assets (ROA) and return on equity

measures,

(ROE), focus on the cost of debt but

ignore the cost of equity.

The premise of EVA is thaï executives cannot know whether an

they assess the complete

operation is really creating value until

cost of capital.

the cost of debt and the cost of equity. Most

debt. Consider

ln mathematieal

terms, EVA = Profit - [(Cost of Capital)(Total

Capital)], where profit is after-tax operating profit, cost of capital is

cost of debt and equity, and total capital is book

the weighted

the following exam-

value plus interest-bearing

pIe. When buying an asset, executives

froID their

company and borrowed funds froID a lender. Both the stockhold-

ers and the lender require a return on their capital. This return is

and includes bath the cost of equity (the

the "cost of capital"

invest-

and the cost of debt (the lender's

company's

ment). The company does not generate any meaningful

profits

until returns generated by the investment

exceed the weighted

capital charge. Once this occurs, the assets are contributing a pos-

itive EVA. If, however,

the returns continue to lag the weighted

cost of capital, EVA is negative, and change may be needed.

invest capital

investment)

and reestablishing

Varity, Inc. used EVA as a basis for reinvigorating its corporate

its financial health. The company

culture

focused employees' attention on its negative $150 million EVA. It

established clear objectives to turn EVA positive within a 5-year

time frame. These objectives included revising the firm's capital

102

Strategy: A View from the Top

L..-

by initiating

a stock buyback program,

considering

structure

strategie opportunities with high EVA prospects, and efficiently

managing working capital. By establishing a 20 percent

internaI

cost of capital, managers

found attractive strategie opportunities,

facility, estab-

induding the construction of a new manufacturing

lishing an Asian presence through a joint venture, and divesting

ils door-Iock actuator business.1

Two additional benefits of EVA are that

(1) it caTIhelp align

incentive

to profits

programs,

employees

employee and owner

interests through employee compensation

plans and (2) it caTIbe the basis for a single competitive perfor-

mance measure called market value added (MVA). Under EVA-

based

for

contributing

through the efficient use of capital. As

employees become conscious of the results of their capital use

they become more selective in the ways they spend

decisions,

shareholder

legs

invested. Thus, EVA caTIbe used as a metrie for various

capital

employee perfor-

su ch as capital budgeting,

internaI

mance evaluation, and operational assessment.

ln contrast, exter-

nal shareholder value is measured through MVA, whieh is equal

to future discounted EVA streams.

investment. MVA is equal

to market value

functions,

rewarded

are

several

regarding

ln addition,

for competitors

that used EVA posted average annual

Although EVA offers attractive features, effective implemen-

independent

a relationship

firm performance.2 Fortune reported

tation has proven diffieult.

studies have produced mixed results

between EVA and superior

that companies

22 percent, versus 13 percent

Wall Street Journal, however,

University of Washington, whieh conduded

share is still a more reliable guide to stock performance

and other

companies

that EVA adopters

financial measures over quality and customer serviee.5 The find-

ings further suggest

gains are

tend to stall

realized by EVA adopters,

shortly after EVA is implemented.

returns of

that did not.3 The

referenced a study conducted at the

that "earnings Fer

than EVA

study of 88

'residual-income'

conduded

that although initial performance

measures."4 Another

these improvements

tend to emphasize

These reservations

the true

results of a company' s strength by considering the cost of debt

notwithstanding,

EVA portrays

Charter 5 Analyzing an Organization's Strategie Resource Base

103

but

financial performancè,

and equity. Tools, such as ROE, ROA, and EPS (earnings Fer

ignore the cost of

sharet measure

equity component

it is possible to

of cost of capital. Therefore,

have positive earnings and positive returns but a negative EVA.

a firm that

By encouraging an operation to manage indebtedness,

uses EVA maximizes

for

I(

example, a business can conserve its assets by improving collec-

tions of receivables and inventory turnover, EVA will fige.

of strategie

Cost analysis deals with the identification

capital efficiency and allocation.

cost

cost factors

in the value chain that determine

drivers-those

in the industry. Strategie cost drivers

long-term competitiveness

include variables

factor costs, scale,

score of operations, and capacity use. To assist in strategy devel-

op ment, cost analysis focuses on those costs and cost drivers that

are of strategie importance

by

strategie chaire.

because they can be influenced

such as product

design,

CC!stbenchmarkingis useful in assessing a firm's costs relative

against

five steps:

best-in-class

best-in-class

(1) selecting areas or operations

(2) identifying key performance measures

firms, or for comparing

competitors.

a company's

The process

to bench-

and practiees,

or key competitors,

to those of competing

performance

involves

mark,

(3) identifying

(4) collecting cost and performance

data, and (5) analyzing and

interpreting the results. This technique is extremely practieal and

It allows for direct comparisons of the efficiencies with

versatile.

It is dan-

whieh different

gerous, however,

for guidance,

because it focuses on similarities rather than differences between

rival firms' strategie designs and on proven, versus prospective,

bases of competitive advantage.

tasks in the value chain are performed.

to rely heavily Qn benchmarking

companies

That

financial

evaluation

A complete

of a company's

resources

should include a financial risk analysis. Most financial models

specify a single estimate

are deterministic.

are made

for each key variable. YetI many of these estimates

with the recognition

such uncertainties

about

true value. Together,

therefore,

high levels of risk. It is important,

itly considered. This involves determining

can mask

that risk be explic-

that

the variables

there is a great de al of uncertainty

is, managers

their

that

104

Strategy: A View from the Top

have the greatest

assessing different

commonly

priee trends,

lying technology.

effect on revenues

risk scenarios. Saille of the variables

and costs as a basis

considered

are market growth rate, market

the cost of capital, and the usefullife

for

that are

share,

of the under-

Human Capital: A Company's Most Valuable

Strategie Resouree

are fun by and for people. Although Saille strategie

the people who comprise an organi-

Companies

resources caTIbe duplicated,

zation or its immediate stakeholders

their concerns, aspirations,

determining a company's

are unique. Understanding

and capabilities

is, therefore, key to

strategie position and options.

that

returns,

Continuous

developing,

it concluded

training expenditures

on training had higher

examined 500 U.S.-based

good people is their greatest

A survey by Chie! Executive demonstrates

that more and more

and retaining

focus is being put on attracting,

43 percent believe that

human capital. Of the CEOs surveyed,

finding and retaining

challenge,

and 84 percent believe that "people issues" are far more impor-

tant than before. A study conducted by the Ameriean Society for

publicly

Training and Development

traded firms. By looking at annual

and

the top haIt of firms in

stockholder

returns

terms of spending

than did the bottom half.6

employee

and other. programs,

training

human capital. FedEx develops

puts 3

a commitment

to continuous

times the propor-

percent of its total expenses into training-six

attend

tion of the average company. Allline and staff managers

first year. More than

11 weeks of mandatory

and

Institute"

10,000 employees have been to the "Leadership

culture and

have attended weeklong courses on the company's

are adopting similar strate-

operations? Many other companies

gies and reaping the benefits. Motorola

that

their company receives $33 for every $1 invested in employee

education.

to the growth

talent

learning. The company

is critieal

its homegrown

of

through

training in their

development,

stockholder

executives

on-the-job

through

report

Charter 5 Analyzing an Organization's Strategie Resource Base

105