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Can someone take a look at this question and help me please? Prior to beginning work on this discussion forum, carefully read Chapters 5 and 6 of the course text. Strategic intent is an important aspect of maintaining or improving market position and market share. Week 3 looks closely at strategy and the concept of strategic alternatives and strategic alternative bundling. For this discussion, identify and define the various types of strategic alternatives and how the process of bundling might help or harm the strategic motivation of the organization. What is the goal of strategic bundling? Research the technology company Lenovo. Summarize the history of the organization. Define their current market position and market share. Describe what type of strategic alternative helped to facilitate their current market position. What strategic alternative might the organization use for future growth and improvement? Guided Response: Your initial post must be specific and significant. The initial post must be between 300 and 350 words. You must support your post with at least two scholarly resources in addition to the text to defend your positions and findings. Use the Scholarly, Peer-Reviewed, and Other Credible Sources (Links to an external site.)  document for additional guidance. Creating Strategic-Alternative Bundles Learning Objectives By the time you have completed this chapter, you should be able to do the following: • Develop strategic issues from having done a full situational analysis. • Understand what it means to develop strategic alternatives and why many companies don’t do it. • Develop strategic alternatives from the list of key strategic issues. • Create strategic-alternative bundles that meet certain criteria. • Understand why the key strategic issues and bundle elements should match. 6 © Image Source / SuperStock abr82381_06_c06_p159-184.indd 159 3/29/12 1:08 PM CHAPTER 6Section 6.1 Key Strategic Issues Chapter Outline 6.1 Key Strategic Issues 6.2 Strategic Alternatives 6.3 Creating Strategic Alternatives 6.4 Creating Strategic-Alternative Bundles 6.5 Closing the Loop with Strategic Issues This chapter shows how to develop a set of key strategic issues that summarize the most critical elements of the entire situation analysis, and from such issues create a small number of viable strategic alternatives, or bundles, for the company to seriously consider. 6.1 Key Strategic Issues Identifying key strategic issues is an act of synthesis, that is, taking what you know about the orga- nization and its changing environment (the situation analysis) and distilling the critical questions and issues the organization must address in its strategic plan. Strategic issues derive from both external and internal sources. The former includes the company’s industry, competitors, customers, suppliers, opportunities and threats, and other environmental forces. The latter includes key orga- nizational resources, culture, technology, or strategic decisions that the company must address. For example, consider a medium-sized private university based in the United States. Some critical external strategic issues may include the nature of private higher education in the United States; the attitude toward it of the surrounding community; legislation and policy governing higher edu- cation; the pool of graduating PhDs, which represents potential faculty; economic forces affecting education in general and private education in particular; the comparable universities that prospec- tive students consider; and the profile of students the university attracts. Some internal issues may include the size of the university’s financial endowment, scholarship monies available, aspects of the university’s history and culture, the relationship between faculty and administration, resources available for faculty research and teaching, and technologies available to students and faculty. Together, these strategic issues form the basis for generating the strategic alternatives. Too often, alternatives are generated from only a subset of these categories, which means leaving out a lot of information that is probably known and should be considered. External issues may take the form of a trend, for example, likely increases in the interest rate, price of a critical raw material, or the frequency and severity of terrorist acts. Another form of external issue is an impending event such as legislation that is about to be enacted or a large competitor about to enter the competitive arena, perhaps with strategic consequences for the firm. Internal issues may present as a strategic decision or choice, something that will have a dramatic impact on the firm and the way it does business. For example, a company may need to decide whether to merge or acquire another firm, go public, form strategic alliances, go international, vertically integrate, change its vision and core character, and so on. Even after identifying a strategic issue, determining whether it is really critical is still difficult. It is useful to think of a strategic issue as something that keeps the CEO up at night. abr82381_06_c06_p159-184.indd 160 3/29/12 1:08 PM CHAPTER 6Section 6.1 Key Strategic Issues Andy Grove, former chairman and CEO of Intel, wrote a book called Only the Paranoid Survive. In the preface, he described himself as quite a worrier. He said that he worried about everything from manufacturing problems to competitive threats to the failure to attract and retain the best talent. Many concerns kept him up at night. He believed fervently in the “value of paranoia.” So when reviewing a list of strategic issues, use this imagery as a way of pruning from the list those that do not merit such obsessive attention. Try also looking at a particular strategic issue in rela- tion to others on the list; is it as important or less important? Ultimately, the final decision is sub- jective; what one person might consider critical another might cross off the list. More to the point, a CEO or top manager should rely on gut instincts when creating the list of strategic issues: What are the real issues, problems, or dilemmas facing the firm (Roberto, 2009)? Case Study Riverbank University We have just described how the list of strategic issues used by an organization to formulate a plan may be either too limiting or too broad and that to inform strategy effectively, the issues must be thoughtfully generated and edited. The following brief case study summarizes how a recently hired university chancellor and her cabinet wrestled with the strategic issues needing to be faced by a small, private liberal arts college in the Northwest United States. (The identity of both the university and the individuals has been masked.) Riverbank University was situated in a metropolitan area with many public and private higher educa- tion institutions. It had a long tradition of excellent undergraduate teaching that primarily attracted local and in-state students. Professors were known for the long hours they spent advising students on both course-related and personal issues, and for their strong mentoring skills. Research was not part of the landscape for either professors or students at this undergraduate-only institution. Fac- ulty at Riverdale regularly invited students to their homes for meals and participated in on-campus events that afforded them informal opportunities to meet and get to know students. Most Riverbank faculty had spent their entire careers there, and turnover among professors and administration was very low. In the late 1990s, as Riverbank’s board of trustees and administration designed a strategic plan for the new millennium, there was talk about the desire to become a nationally, rather than regionally, known and respected university. Officials reasoned that attracting a more diverse pool of students as well as benefactors would enhance the university’s profile and set the stage for continued growth and competitiveness into the 2000s. With this goal in motion, a search ensued for a qualified chancellor (chief academic officer) that had experience in leading the transformation from a regionally to nation- ally recognized institution and eventually, one was selected. When Dr. Irene Carson arrived on campus to begin assessing the climate and identifying the critical issues at hand, she quickly became overwhelmed with the internal and external factors that both inhibited and encouraged growth. Professor satisfaction and morale were huge issues: Faculty at Riv- erbank liked things the way they were and had no experience with an “outside” administrator being hired and setting the agenda for them. University relationships with key stakeholders—donors, board members, and other “friends” of the school—were delicate and needed to be carefully managed. The city where the school was located was resistant to growth of the physical size of the university. The structure of the university’s academic schools and departments seemed unbalanced and illogi- cal. Many professors were using outdated and outmoded teaching methods. The university offered no online courses in an era when all other schools did. Physical infrastructure, such as technology and (continued) abr82381_06_c06_p159-184.indd 161 3/29/12 1:08 PM CHAPTER 6Section 6.1 Key Strategic Issues The strategy development process is not a time to pull punches or shy away from the truth. As Dennis Rheault, former vice president responsible for corporate strategy and development at Motorola, wrote, “The purpose of an effective strategy-development process is not to avoid but to confront uncertainty: to pose the really tough questions that you do not have the answers to— the issues and opportunities that can make or break the business” (Rheault, 2003, p. 33). This is not a time to parrot what the CEO wants to hear. Unless these issues are real and phrased in plain terms, the resulting strategic alternatives that are designed will not likely be in the company’s best interest. Having strategic conversations with colleagues or outside experts over the course of a year will help to unearth the real issues that the company must confront. As has been emphasized earlier, this process is most fruitful if it is undertaken on an ongoing basis rather than as an annual exercise. lab space, was lacking. Moreover, Dr. Carson knew that universities don’t rise to national prominence based on excellent teaching. She knew that she needed the resources to attract some star researchers. So, Dr. Carson set about having strategic conversations with key constituents: members of fac- ulty senate, deans, board members, students, community members, and other university officials. Through these private meetings, informal conversations, and public town hall events, Dr. Carson and her team began to clarify, prune, and prioritize the list of strategic issues into manageable, realistic, and relevant order. This bundle of strategic issues allowed Riverbank to move forward toward its goal of national recognition. First, Dr. Carson identified structural problems and corrected them by moving some academic depart- ments to different schools within the university where they made more sense and stood a better chance of becoming accredited. For example, a School of Performing Arts was created to house the- atre and dance, because Riverbank’s dance department’s primary barrier to national accreditation was the lack of such a school. Next, the chancellor leveraged important and longstanding relationships with key benefactors and the board of trustees to gain commitments toward new facilities that would enhance the university’s goal of attracting high-profile, high-achieving research faculty. With these two critical strategic issues covered, the new chancellor and her team then focused on recruiting “stars.” Within five years, Riverbank was home to a growing number of graduate programs, a Nobel laure- ate, numerous prestigious faculty members recruited from well-known research universities, and a student body that, for the first time, represented all 50 states in the United States. All concerned acknowledged that the university’s strategy was working. Questions for Critical Thinking and Engagement: 1. When you consider Riverbank’s history and the case presented, do you believe that Dr. Carson’s eventual list of priorities (key strategic issues) was appropriate? Why or why not? (Note that the question uses the term “appropriate” rather than “successful.”) 2. Based on your reading and analysis of this brief case, was the list of critical issues thorough enough? Was anything left off the list that should have been there? 3. Without any additional personal knowledge of this institution, continue writing the case study. The case ends on a note of success, but what “fallout” might you expect based on the back- ground you were given? Be as specific as possible. 4. Comment on Dr. Carson’s practice of strategic conversations with key constituents. Based on your reading of this chapter to this point and your own experience, did she do the right thing? Why or why not? abr82381_06_c06_p159-184.indd 162 3/29/12 1:08 PM CHAPTER 6Section 6.1 Key Strategic Issues Comstock/Thinkstock One informal strategic planning process involves “HERs”—hallways, elevators and restrooms. These informal meetings can be where the most interesting conversations take place. Strategic Conversations A strategic conversation is a free-ranging discussion on a topic of strategic interest to an organiza- tion. Because of its characteristic “no-holds-barred” freedom to say whatever needs to be said, it invariably produces ideas and thinking that are ultimately useful in the strategic-planning process and that might not be captured in any formal process. All major strategic planning, according to Peter Schwartz, cofounder of the Global Business Network, does not, in fact, take place during the strategic- planning process (Abraham, 2003). What goes on in a formal process is almost always a ratification of what has already happened. A strategic conversation is an attempt to understand the real strategic-planning process and often takes place entirely informally. Schwartz’s colleagues at Bell South used to call it the HERs process—hallways, elevators, and restrooms— because that’s where the most interesting conversa- tions take place. While real decisions got made, real issues got confronted, real knowledge was developed, almost all of it took place in this conversational mode. And that is how real learning also takes place. If you are going to have good strategy, it involves good learn- ing—learning about new realities, new facts, new competition, new opportunities, new directions—and challenging old knowledge. Simply writing a strategic plan as an act of listing a set of new objectives for the coming year as if nothing had changed is pointless. The problem is that if everything has changed and you need to come up with a plan, how are you going to learn about those changes? Furthermore, again paraphrasing Schwartz, it is one thing to do this for an individual, but how do you get a group of decision makers, who almost always have to act together, to acquire that knowledge and to develop and implement strategic plans? He maintains that the only way you learn together is through conversations (Abraham, 2003). Whether formal or informal, a strategic conversation is the learning vehicle through which the group adjusts to a new worldview to enable strategic plans to be developed and implemented. The steps in the process often follow this sequence: shared conversations, shared learning, change one’s mental models, then develop better strategic plans. Tony Manning echoes Schwartz in endorsing the value of informal dialogue: Strategic conversation is far more than just an occasional practice that can be adopted or abandoned at will: it is without doubt the central and most important executive tool. . . . What senior managers talk about—clearly, passionately, and consistently—tells me what they pay attention to and how sure they are of what they must do. (Manning, 2002) abr82381_06_c06_p159-184.indd 163 3/29/12 1:08 PM CHAPTER 6Section 6.1 Key Strategic Issues © SOMOS / SuperStock When considering strategic issues, lists of 12 items or more should be reduced to 8–10 items by the CEO and/or the top management team. The viewpoint of most strategic analyses is assumed to be that of the CEO or leader of the orga- nization and may include the top-management team. When examined from the viewpoint of a board of directors, other variables could be added to the list of strategic issues, such as whether to go public, and even whether it is time to replace the CEO. There is one final check on whether you are dealing with the proper set of strategic issues. Because they constitute the critical questions and issues a company should address, they should all be taken into account explicitly when forming strategic alternatives. In the event that the alternatives fail to take into account one of the strategic issues, it could mean that either (a) the strategic alternatives have not been properly formulated and should be further modified to take it into account, or (b) the issue in question is not as impor- tant as was initially assumed, and thus could be deleted. While it is possible that a firm could have any number of strategic issues at a given point, the larger the num- ber of issues proposed, the higher the chances are that some of them are not as critical as others. Long lists of over 12 items should be pruned down, eliminating those that are not so critical or combining some of them. If the list cannot be reduced at this stage, another chance to do so will be when the strategic alter- natives have been created if it is found that they have still not taken into account every issue. Strategic issues are typically expressed in one of two forms: either as a statement or as a question. For example: • Whether the company should acquire XYZ Corporation. • Should the company acquire XYZ Corporation? The second is phrased as a question and is the recommended form because, if the outcome is known with certainty—”Yes, the company should acquire XYZ Corporation”—then the issue is not a strategic issue; it is a decision the company has already taken. It is not sufficient, however, that one simply pose a question on a matter of strategic concern. Consider the following: • Should the company try to lower costs? • How can the company lower its costs? The strategic issue is not whether to lower costs; the answer to that question is that of course it should. Rather, the strategic issue might be “How can the company lower its costs?” because that answer may be uncertain, so it could be included as a bona fide strategic issue. Thus, one criterion for a strategic issue is that the answer to the issue is uncertain. The way in which that uncertainty is resolved is through the design of strategic alternatives and choosing a abr82381_06_c06_p159-184.indd 164 3/29/12 1:09 PM CHAPTER 6Section 6.2 Strategic Alternatives preferred one. Given a strategic issue, “Should the company broaden its product line?” one alter- native could say, “Broaden it” and another, leave it out altogether (not broaden it). Thus, through deciding which alternative is preferred, the one that is chosen automatically “resolves” the uncer- tainty inherent in the issue. 6.2 Strategic Alternatives An ordinary alternative is one of several means by which a goal is attained or a problem solved. A strategic alternative is one of several ways by which a firm might compete in a marketplace, achieve its vision, or, if no vision has been articulated, decide where it might go and what it might achieve. Notice two things about the definition: (a) The designation “strategic” is necessary because alter- natives are fashioned in a competitive environment, where actions and retaliations of competitors must be taken into account; and (b) the alternatives are created at the level of the whole firm and not any one of its functions or units. In addition, they provide choices about marketplace strategy or about configuring the organization, address issues of central importance to the organization, have uncertain outcomes, and require resources to develop before action can be taken (Lyles, 1994). Alternatives are of three general types. “Obvious” alternatives arise from current strategies or simple extrapolations of what the organization is currently doing. For example, utilizing Facebook, Twitter, and a blog to communicate with consumers represents an obvious strategic alternative. “Creative” alternatives take different conceptual approaches than existing strategies do and break away, to some extent, from the assumptions and beliefs underlying current strategies. A training- and-development organization specializing in the creation and facilitation of live, face-to-face, trainer-led instruction might pursue a creative alternative by entering the e-learning market. “Unthinkable” alternatives reflect a radical departure from the organization’s historic mindset (Lyles, 1994). For instance, as a result of the organization’s organizational culture and values, alco- holic beverages have never been made available for sale within Disney theme parks. The idea that the sale of liquor could enhance profit or attract new customers would represent an unthinkable strategic alternative. As in the Disney example, an unthinkable alternative might be appropriately labeled as such because it violates some demonstrated, effective core value of the organization. However, sometimes alternatives are unthinkable simply because no one before has bothered to break the rules of what is appropriate for how an organization does business—even when experimenting with such alternatives might be the right move. Typically, such alternatives have little chance of being accepted by management unless arguments for their adoption are persua- sive and made by someone who commands respect in the organization. Unthinkable alternatives Discussion Questions 1. Having done a thorough situation analysis—both external and internal—do you agree that it makes sense to synthesize the results? Explain your answer. 2. In your view, would the external analysis previously done be more useful in scenario planning than in forming strategic issues? Why or why not? 3. It’s possible that managers don’t go through a process of coming up with strategic issues because it involves phrasing questions to which the answers are unclear. Could there be any truth to such a view? 4. Suggest ways of shortening a list of 20 strategic issues to a more manageable number of about 12. abr82381_06_c06_p159-184.indd 165 3/29/12 1:09 PM CHAPTER 6Section 6.2 Strategic Alternatives Business Wire via Getty Images Pep Boys, an auto-service firm in Southern California, created a strategic alternative to their business strategy when they decided to start advertising on television. illuminate the current situation in a radically different light and inspire other managers to propose creative solutions. However, this typology, while insightful, is typically not advocated as a frame- work to generate alternatives. For some companies, the decision-making about their future may involve tweaking their present strategy slightly. This might be something as simple as adding a distribution channel or start- ing to advertise on television. Although the company might claim that this represents a change in strategy, it is, in fact, simply a change in implementation. Dutch digital-navigation-equipment developer TomTom recently announced that it would scale back the personal-navigation-device division that had made it famous and shift focus to its built-in automotive-navigation systems. TomTom had consistently lost profit on the small personal-navigation devices since consumers began relying on free or low cost mapping applications on smartphones and tablets. Conversely, financial reports suggested the strategy shift: The built-in-automotive systems is the fastest grow- ing division in the company (TomTom shares, 2011). For other companies, the strategy itself may remain unaltered, but the objectives may change, such as from 10% per year to 15% per year growth in revenues or profits. Companies may mis- takenly characterize this as a change in strategy; however, if the basic way in which the company competes has not changed, then this is not a change in strategy. Obstacles to Creating Strategic Alternatives What many companies do when planning ahead, it would appear, involves simpleminded extrapola- tions of past accomplishments involving no change in strategy, or they make the first change that occurs to them that makes sense at the time. Sometimes it works or works only for a short time, but more often it does not. As naïve as this analysis sounds, how else can we account for so many poor deci- sions made by various companies over the years? Even the best deci- sion made at a given time can lead to a poor result because of unforeseen events and actions. Poor results are notoriously the inevitable byprod- uct of poor execution, even with an otherwise sound strategy in place. In each of these cases, is the strat- egy the company chose the best one it could have adopted in the circumstances? The only way to tell, really, is to have analyzed the subset of all plausible alternative strategies and chosen one for very good, defensible reasons. If this is done, then any challenge or ques- tion about what else might have abr82381_06_c06_p159-184.indd 166 3/29/12 1:09 PM CHAPTER 6Section 6.2 Strategic Alternatives Comstock/Thinkstock Small groups of managers sometimes brainstorm ideas that later become strategic alternatives. This process must begin with framing a problem and identifying a list of alternatives. been done can be preempted because one can argue convincingly why the chosen strategy is superior or at least preferable to any other that might be proposed. Focus on Perceived Costs Why don’t companies develop alternative strategies routinely? Many companies forego developing strategic alternatives because they perceive obstacles, real or imagined. An excuse commonly heard is that it takes a lot of effort and time: “We’re in a hurry and can’t afford to wait.” In fact, to do some- thing well does require time and effort, so claiming to be in a hurry is just a convenient excuse. True, circumstances sometimes demand a quick decision, but even so, making a decision without consider- ing alternatives is foolhardy. Besides, to make any decision at all, one needs at least two alternatives. Another reason offered for not constructing strategic alternatives is that the exercise doesn’t guarantee the “right” answer, so it may be a waste of time and resources. It is true that no one can guarantee the correctness of a decision whose consequences play out in the future, but by considering the significant trends and impacts, including the relevant variables, assessing the fit with the company’s capabilities and resources, and considering plausible strategic alternatives, the chances of making the “right” decision for the company are substantially enhanced. Only when 3, 5, or even 10 years have passed, can you look back in hindsight and know whether a stra- tegic decision was good or not. Otherwise, one has to make the decision while not knowing how things will actually turn out. All one can do in the circumstances is one’s best. But companies that skip the process entirely for lack of certainty do not give themselves a fighting chance to make the best decision they can; they short-change themselves. Focus on the Past Many managers are more comfortable thinking about and analyzing the past than the future. They seem to find nothing wrong about examining past data and then making a decision that will play out in the future. The past is certain; the future is not. In these days of rapid, even discontinuous change, past data are often irrelevant. What we need to examine are trends about everything that is changing and likely future moves of competitors. How are industries changing? What will merging industries become? How will technology affect our lives, what we buy, how we use products, how we think, how we do business? People are less comfortable in the future because they are unable to predict or forecast it, unable to extrapolate, and unused to ambigu- ity and uncertainty. An oft-repeated joke is that people would rather be certainly wrong than not sure abr82381_06_c06_p159-184.indd 167 3/29/12 1:09 PM CHAPTER 6Section 6.2 Strategic Alternatives whether they were right. The thought that they might even influence the outcome of future events even escapes them. Many people simply regard the future as something beyond their control. Complacency There are managers who don’t take the responsibility for strategic planning seriously enough, or they don’t devote enough time to ask themselves really tough questions that might put their com- panies on a stronger, albeit different course. It is much easier to keep doing what the company has been doing, particularly if the company is performing reasonably well. Setbacks can be blamed on a competitor, an unexpected piece of new legislation, a downturn in the economy, or a rise in sup- plier prices. True, the unexpected often happens, but in hindsight, many “unexpected’ occurrences could have been anticipated and taken into account had strategic planning been properly done. Insufficient … Assessing the Company Itself Learning Objectives By the time you have completed this chapter, you should be able to do the following: • Understand what is involved in a thorough financial analysis of a company and how to make sense of the data. • Perform an analysis of a company’s strengths, weaknesses, opportunities, and threats (SWOT analysis). • Determine whether a company has a core competence and a competitive advantage. • Understand a company’s internal and external value chains. • Determine the customer-value proposition and how strong it is. • Understand the significance of brand reputation, how strong it is, and how to manage it. 5 © Robert Harding Picture Library/SuperStock abr82381_05_c05_p129-158.indd 129 3/29/12 1:26 PM CHAPTER 5Section 5.1 Analysis of Financial Performance and Condition Chapter Outline 5.1 Analysis of Financial Performance and Condition 5.2 Conducting a SWOT Analysis 5.3 Core Competence and Competitive Advantage 5.4 Competitive Strength 5.5 Value-Chain Analysis 5.6 Brand Reputation, Equity, and Loyalty 5.7 Assessing Management and Leadership Analyzing and assessing the internal environment of the company is a key part of the strategic- planning process. The recent financial performance and current financial condition is an obvious place to start using quantitative data with which to reach an objective conclusion. There are also more subjective measures including an examination of a company’s competitive strengths and weaknesses, its capabilities, and determining which, if any of them, might be core competencies that would give the company a competitive advantage. The value of a company’s brand and the effectiveness of its management are also taken into consideration. 5.1 Analysis of Financial Performance and Condition Any analysis of an organization usually begins with careful evaluation of its financial position. To assess the recent financial performance and current financial condition of the company, you need three to five years of historical financial data—income statements and balance sheets (see box on financial state- ments for generic templates)—including the most recent year for which complete data are available. Financial statements: Generic templates Income-statement Balance sheet Total revenues (sales) Assets Cost of goods sold (COGS) Cash & cash equivalents Operating income (gross profit) Accounts receivable (A/R) Selling expenses Inventory General & administrative (G&A) Other current assets Earnings before interest & taxes & depreciation & amortization (EBITDA) Total current assets Total fixed assets Depreciation & amortization Total assets Earnings before interest & taxes (EBIT) Total liabilities and stockholders’ equity Net interest expense Accounts payable Other expense (income) Accrued liabilities abr82381_05_c05_p129-158.indd 130 3/29/12 1:26 PM CHAPTER 5Section 5.1 Analysis of Financial Performance and Condition An annual income statement presents a financial picture of a company’s operations over the pre- vious 12 months. A balance sheet is a “snapshot” at a point in time (usually at the close of a company’s fiscal year) that presents a financial picture of its assets and the pro- portion in which those assets are financed through debt and equity. In a balance sheet, the total assets equal the total liabilities (debt) and stockholders’ equity—the two sides must “balance.” A convenient way of analyzing sev- eral years’ worth of financial data is to create a spreadsheet and enter the data for each year in a different column (Tables 5.1 and 5.2). Doing so enables annual changes in line items and ratios to be computed. More specifi- cally, a thorough analysis of multiyear financial statements consists of the following elements (Bangs & Pellecchia, 1999): • Computing all liquidity, activity, leverage, and profitability ratios for all years. • Computing year-to-year changes for all line items (in both the income statement and bal- ance sheet) and all ratios for all years. • Computing average annual changes over all years for line items and financial ratios. Net income before taxes (NIBT) Other current liabilities Income tax expense Total current liabilities Net income after taxes (NIAT) Long-term debt Total liabilities Common stock Retained earnings Paid-in capital Other equity Total stockholders’ equity Total liabilities and stockholders’ equity Each subtotal in bold is equal to the Each subtotal is the sum of elements above it. previous bold subtotal minus the Total assets = current assets + fixed assets items in between. For example, Total liabilities = current liabilities + L-T debt NIAT = NIBT – income tax expense. Total assets = total liabilities + stockholders’ equity iStockphoto/Thinkstock To properly assess the financial state of a company, you need three to five years of historical financial data in the form of income statements and balance sheets. abr82381_05_c05_p129-158.indd 131 3/29/12 1:26 PM CHAPTER 5Section 5.1 Analysis of Financial Performance and Condition • Computing common-size income statements for all years (everything on the income statement expressed as a percent of revenues). • Computing a Z- or Z2-score for each year (Calandro, 2007). This computation involves financial ratios (see box on Z- and Z2-scores). • Forming a conclusion about how the company has been performing financially (from the income statements—revenue and NIAT performance) and about its current financial con- dition (from the balance sheets—financial structure, cash flow, degree of debt, liquidity), and its overall financial health (Z- or Z2-scores). Table 5.1: Multiyear income statements for Netflix In $ Thousands 2000 2001 2002 2003 2004 Subscriptions 35,894 74,255 150,818 270,410 500,611 Sales — 1,657 1,988 1,833 5,617 Total Revenues or Sales 35,894 75,912 152,806 272,243 506,228 Cost of Goods Sold 24,861 49,907 78,136 148,360 276,458 Operating Income 11,033 26,005 74,670 123,883 229,770 Operating Expenses 62,511 59,138 78,606 109,826 194,129 General & Administrative 6,990 4,658 6,737 9,585 16,287 Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA) (58,468) (37,791) (10,673) 4,472 19,354 Depreciation and Amortization — — — — — Earnings Before Interest & Taxes (EBIT) (58,468) (37,791) (10,673) 4,472 19,354 Interest and other income (1,645) (461) (1,697) (2,457) (2,592) Interest and other expense 1,451 1,852 11,972 417 170 Net Income Before Taxes (NIBT) (58,274) (39,182) (20,948) 6,512 21,776 Provision for income taxes — — — — 181 Net Income After Taxes (NIAT) (58,274) (39,182) (20,948) 6,512 21,595 Source: Maddox, B., & Thompson, A. A., Jr. (2007). Netflix versus Blockbuster versus Video-on-Demand. A case in Thompson, A. A., Jr., Strickland III, A. J., & Gamble, J. E. (Eds.), Crafting and Executing Strategy: Concepts and Cases (15th ed.; pp. C-148 to C-161). New York, NY: McGraw-Hill. Table 5.2: Multiyear balance sheets for Netflix 2000 2001 2002 2003 2004 Assets Cash & cash equivalents 14,895 16,131 59,814 89,894 174,461 Short-term investments — — 43,796 45,297 — Other current assets — 3,421 3,465 3,755 12,885 Total Current Assets 14,895 19,552 107,075 138,946 187,346 abr82381_05_c05_p129-158.indd 132 3/29/12 1:26 PM CHAPTER 5Section 5.1 Analysis of Financial Performance and Condition Net investment in DVD library — 3,633 9,972 22,238 42,158 Other fixed assets 37,593 18,445 13,483 14,828 22,289 Total Fixed Assets 37,593 22,078 23,455 37,066 64,447 Total Assets 52,488 41,630 130,530 176,012 251,793 Liabilities & Stockholders’ Equity Liabilities Current liabilities 16,550 26,208 40,426 63,019 94,910 Total Current Liabilities 16,550 26,208 40,426 63,019 94,910 Notes & sub notes payable 1,843 2,799 — — — Other LT debt 107,362 103,127 748 285 600 Total Liabilities 125,755 132,134 41,174 63,304 95,510 Stockholders’ Equity Red. conv. preferred stock 101,830 101,830 — — — Other equity (175,097) (192,334) 89,356 112,708 156,283 Total Stockholders’ Equity (73,267) (90,504) 89,356 112,708 156,283 Total Liabilities & Stockholders’ Equity 52,488 41,630 130,530 176,012 251,793 Source: Maddox, B., & Thompson, A. A., Jr. (2007). Netflix versus Blockbuster versus Video-on-Demand. A case in Thompson, A. A., Jr., Strickland III, A. J., & Gamble, J. E. (Eds.), Crafting and Executing Strategy: Concepts and Cases (15th ed.; pp. C-148 to C-161). New York, NY: McGraw-Hill. Financial Ratios Liquidity Ratios Current ratio (CR) = Current assets / current liabilities (When this ratio > 1.0, working capital (current assets – current liabilities) is positive, which is desirable.) Quick ratio (QR) = (Current assets – inventory) / current liabilities Inventory-to-net-working-capital ratio (INV/NWC) = Inventory / (current assets – current liabilities) Activity Ratios Inventory turnover (INV Turns) = Revenues / inventory Total-asset turnover (TAT) = Revenues / total assets Average collection period (ACP) (days) = Accounts receivable (A/R) / average daily sales or revenues/365 abr82381_05_c05_p129-158.indd 133 3/29/12 1:26 PM CHAPTER 5Section 5.1 Analysis of Financial Performance and Condition Leverage Ratios Debt-to-equity ratio (D/E) = Total liabilities / total equity (When this ratio > 2.0, debt is too high and needs to be reduced; when it is negative, debt is so high as to exceed the assets of the firm and cause stockholders’ equity to go negative, a serious problem.) Debt-to-assets ratio (D/A) = Total liabilities / total assets (When this ratio > 0.67, debt is too high and needs to be reduced; when > 1.0, debt is so high as to exceed the assets of the firm and cause stockholders’ equity to go negative indicating a serious problem. Either D/E or D/A ratio is used, not both.) Times interest earned (TIE) or coverage ratio = EBIT / interest expense (When this ratio < 1.0, the company doesn’t have enough money to pay the interest on the debt, a serious condition only experienced with very high debt.) Profitability Ratios Net profit margin (NPM) or Net return on sales (NROS) = Net income after taxes (NIAT) / revenues Return on equity (ROE) = NIAT / total stockholders’ equity Return on assets (ROA) = NIAT / total assets Two ratios reveal how productive assets are—TAT and ROA; when these are declining, increasing one’s assets is problematical. Cash flow is made up of operational, financial, and investing cash flows; when overall cash is increasing from year to year, cash flow is positive, otherwise it is negative. Z- and Z2-Scores Z- and Z2-scores are bankruptcy predictors, or indicators, developed by Edward I. Altman, a profes- sor of finance at New York University. The Z-Score is based on data from manufacturing companies, while the Z2-score is based on data for nonmanufacturing companies. Each is a very important indicator of a company’s financial health or imminent bankruptcy. Both indicators take the form of a regression equation: Z-Score = 1.21X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 Z2-Score = 6.5X1 + 3.26X2 + 6.72X3 + 1.05X4 Where X1 = Net Working Capital / Total Assets X2 = Retained Earnings / Total Assets X3 = Earnings Before Interest & Taxes (EBIT) / Total Assets X4 = Total Stockholders’ Equity / Total Liabilities X5 = Sales / Total Assets abr82381_05_c05_p129-158.indd 134 3/29/12 1:26 PM CHAPTER 5Section 5.1 Analysis of Financial Performance and Condition Note that four of the financial ratios have total assets in the denominator and the other has total debt in the denominator. Thus, increasing assets through borrowing is not a good idea financially (unless performance improves), while one of the first things to do when a company is in financial trouble is to sell off some assets and use the proceeds to pay down debt. The final scores are com- pared to the following cutoffs to assess their significance: Criteria Safe Region Gray Region Bankrupt Region (Financially healthy) (In serious trouble) Z-Score > 2.99 1.81 – 2.99 < 1.81 Z2-Score > 2.59 1.11 – 2.59 < 1.11 The last step in the analysis is the most important. What sense can be made of the numbers? What picture do they paint of the company’s performance over the past several years and current condition? You could draw any one of the following conclusions: 1. The company is very well managed, has been performing extremely well, and is in strong financial condition and overall financial health (all key indicators are good and none is bad). 2. The company is very well managed, has been performing extremely well, and is in strong financial condition and overall financial health except for one major bad thing, for example, having very high debt or declining total-asset turnover (a predominance of good indicators with one or possibly two bad ones). 3. The company turned in a mixed performance over this period and is neither perform- ing well nor in serious trouble. The results are, in fact, inconclusive (an equal or roughly equal number of good and bad indicators). 4. The company’s performance and financial condition is poor and key result indicators were declining steadily (or precipitously) over time; the company is or should be in seri- ous financial trouble except for one major good thing, such as increasing revenues (a predominance of bad indicators with one or possibly two good ones). 5. The company’s performance is poor, and key result indicators were declining steadily (or precipitously) over time; the company has not been managed well and is in seri- ous financial trouble (all indicators of performance and condition are bad and none is good). After completing the financial analysis, only one of the preceding five conclusions is possible. Whichever one is selected, it must be supported with selected statistics that summarize the cur- rent financial performance, condition, and health of the company, or the conclusion isn’t valid. Because the principal ways for a company to finance any strategic initiative are through cash or debt (or in the case of a public company, stock), the financial analysis provides essential informa- tion to top management as to the company’s ability to fund a proposed strategy. As an example, an analysis of the financial data for Netflix presented in the multiyear income statement (Table 5.1) and multiyear balance sheets (Table 5.2) produces the conclusion summarized in the follow- ing section. abr82381_05_c05_p129-158.indd 135 3/29/12 1:26 PM CHAPTER 5Section 5.2 Conducting a SWOT Analysis Example of a Financial-Analysis Conclusion Based on the income statements and balance sheets to 2004, Netflix has performed very well financially, is in strong financial condition, and financially healthy. In 2004: • Revenues increased 86% (for the fourth straight year) • NIAT increased 231.6% (also for the fourth straight year) • Current ratio is 1.97 (good working capital) • D/E ratio is 0.61 (low debt, excellent financial leverage) • Cash flow is positive, and increased 94.1% to $174.46 million. This conclusion is #1, where all the indicators are good and none are bad. When the conclusion is supported by data—particularly from the most recent year—it becomes hard to refute. 5.2 Conducting a SWOT Analysis Once a company has a firm understanding of where it stands financially, the next part of the internal assessment is conducting a SWOT analysis, which stands for a company’s strengths, weak- nesses, opportunities, and threats. To be sure, opportunities and threats are more appropriately part of an external analysis, but doing a SWOT analysis is so widespread as part of a strategic analysis that they are discussed together here for convenience. As was discussed in Section 3.2, the search for opportunities is an integral part of strategic thinking. Strengths Strengths and weaknesses are the “internal” aspects of the traditional SWOT analysis. Whenever something—or someone—is reviewed or assessed, it makes sense to point out the good points or Discussion Questions 1. What can you tell about a company’s operations from looking at the past few years of income statements? 2. How much profit a company makes after all its expenses are deducted (NIAT) is shown on the income statement. Yet, a company cannot “spend” the profits it makes—it can spend only cash, which is a balance-sheet item. How do you explain this? 3. In a balance sheet, total assets must equal or balance total liabilities + total stockholders’ equity. In what other ways is this principle of “balancing” useful? 4. In the newspapers, one often reads about companies that are “not managed well financially.” Given what you have learned in this section (and perhaps in a previous course on finance), what do you think this means? 5. The Z- and Z2-scores contain similar financial ratios as terms in their regression equations. From this, the two scores would go up with increasing working capital, retained earnings, EBIT, equity, and sales, and with decreasing assets and debt. However, all but EBIT and sales are balance-sheet items. Why do you think such bankruptcy indicators focus on balance-sheet items so heavily? abr82381_05_c05_p129-158.indd 136 3/29/12 1:26 PM CHAPTER 5Section 5.2 Conducting a SWOT Analysis iStockphoto/Thinkstock Evaluating an organization’s strengths based on its competitors can provide a more accurate assessment of the organization. what was done well, as well as the areas that need improvement. They are two sides of the same coin. This assessment is easy to do superficially, which is often the case, but difficult to do candidly and realistically. It is nearly always subjective, but less so if done by a group with multiple per- spectives, which is why companies sometimes hire outside consulting firms to help them analyze their strengths and weaknesses. Regardless of who conducts it, the strength analysis should compare the firm to itself at some previous point in its history, perhaps 2–4 years ago, and determine what it is doing better and what has not improved. It might also be useful to think of strengths as special capabilities or expertise. These are things a com- pany does well that have enabled it to be successful to this point, and how it has prepared itself to com- pete in the future. Comparing a company’s strengths against those of its competitors and identifying the industry’s critical success fac- tors (Section 4.1) also provides a useful assessment. Typical strengths that companies have might include the following: • Adequate financial resources to implement any likely strategy • Strong cash flow • Strong brand recognition • Effective differentiation • Effective advertising and promotion • Consistent high quality in products/services • Effective distribution • Economies of scale • Insulation from competition • Proprietary technology and patents • Low-cost leader • Product-innovation skills • Proven management • Visionary CEO, strong leader • Productive corporate culture that supports the strategy The problem is that it can be easy to classify what a company does “well,” but what exactly con- stitutes a “strength”? The answer is subjective; it depends on how high a company’s internal standards are and how widely they are shared. For this reason, it should also compare strengths (and weaknesses) with its closest competitors. In assessing whether their company’s brand is a strength or a weakness, executives at Wendy’s must compare the brand to those of McDon- ald’s and Burger King. Similarly, the athletic apparel offered by Adidas must be compared to the abr82381_05_c05_p129-158.indd 137 3/29/12 1:26 PM CHAPTER 5Section 5.2 Conducting a SWOT Analysis Stockbyte/Thinkstock When the top management of struggling companies meets, it is quite common for one department to blame the other for the company’s poor performance. products offered by Nike. Because Wendy’s and Adidas are established and successful companies, it is tempting to consider Wendy’s and Adidas to possess strengths in terms of brand and apparel. These firms’ standing relative to their closest rivals, however, would suggest that these areas are in fact weaknesses. Weaknesses Much like the strengths that a com- pany may possess, weaknesses are also internal. They include prob- lems that need to be corrected, deficiencies recognized through a comparison with competitors, or deficiencies relative to proposed strategies such as lacking the resources to grow. Whether or not what is identified is an actual weak- ness, it is the perception of a weak- ness that counts. Some managers have no problem admitting to weaknesses when they are self-evident, while others find them hard to own up to in the belief that doing so casts them in a bad light as an ineffective manager. Sometimes, if a company is having problems and the top man- agement team is meeting to discuss them, it is not unheard of for one department to find a way of blaming another department for the company’s problems. The production manager might blame human resources for inadequate training resulting in low quality. Marketing might complain that engineering and R&D failed to act on its good market intelligence to create new products. Or R&D could complain about a cut in its budget for something far less important. In all these examples, grappling with weaknesses is not about finding who is at fault or who is to blame. It is about gain- ing a realistic understanding of the company’s weaknesses so that steps can be taken to alleviate or correct them. Weaknesses can take many forms, including the following: • Obsolete facilities • Key skills and competences missing or obsolete • No core competence, hence no competitive advantage • Internal operating problems and inefficiencies • Too narrow a product line • Long cycle time to get product out • Poor marketing skills • A culture that hasn’t changed with the strategy • Weak or eroding brand image • Poor or negative cash flow from operations, including low or negative profits, resulting in an inability to service debt or fund needed programs abr82381_05_c05_p129-158.indd 138 3/29/12 1:26 PM CHAPTER 5Section 5.2 Conducting a SWOT Analysis Bill Pugliano/Getty Images When Ford Motor Company bought Jaguar, Ford’s company executives found multiple weaknesses and wondered how Jaguar had survived. Weaknesses become real when compared to other companies in the industry. For example, you might think your company has low costs and believe that to be a strength only to discover that your costs are among the highest in the industry. Suddenly, that supposed strength becomes a weakness. A new CEO participating in a SWOT analysis with his or her new management for the first time will have a different frame of reference and a different set of standards from the managers, so the CEO might have difficulty agreeing with them on what strengths and weak- nesses the company has. As noted previously, it is the perception that is important. These illustrations show that when making any assess- ment, even a seemingly casual one like identifying a strength or weakness, you are using an implicit stan- dard or reference in making it. More experienced people will tend to be more critical because they may once have worked in organizations where they have observed things done better, thus raising their own standards. Again, the goal here is not to be “right” at the expense of someone else being “wrong.” Rather, it is to reach consensus on what is real and problem- atic so that it can be attended to and the firm’s future prospects improved. Opportunities An analysis of strengths and weaknesses covers what is internal to the firm, but that is only half the story as it pertains to assessing a company’s potential success or failure. In order to stay competitive in an industry, one has to go looking for opportunities that would improve the company’s situation. An opportunity has a specific technical definition; it is a product-market issue. It must include a product or service the firm offers, including the existing ones, and a defined customer group at which that product or service is targeted, including the existing ones. The following are examples of real opportunities (and concentration strategies): • Staying with an existing product and existing market and penetrating the market further. • Improving the product for an existing market; that is, implementing a product-development strategy. Examples include automobile companies producing new models annually, and software companies releasing upgraded versions of their software. • Creating a new product for an existing market, which is also a product-development strat- egy. Examples include Nike offering athletic apparel in addition to athletic shoes for the same market, Microsoft creating application software for users of its Windows operating system, and Calvin Klein selling perfumes as well as clothes. • Expanding the market for an existing product by implementing a market-development strategy, such as promoting the product to appeal to young adults in addition to teenagers abr82381_05_c05_p129-158.indd 139 3/29/12 1:26 PM CHAPTER 5Section 5.2 Conducting a SWOT Analysis or lowering the price so that more people can afford to buy the product. Facebook, for example, has gradually expanded its market from young people to people of all ages. • Finding a new market for an existing product, which is another market-development strat- egy. Examples abound of companies going regional from being just local or a regional company going national or entering a new country, all without changing the product or service. For example, Indian automobile manufacturer Mahindra & Mahindra is planning to start selling pick-up trucks in the United States by 2016 (Hamprecht, 2011). If a company goes to the trouble of identifying opportunities, it does so only when doing strategic planning, usually once a year. But why not have an opportunity-finding mechanism operating all the time? Why not formalize it and use it to generate ideas and feasible proposals on an ongoing basis? This is what is truly meant by “being opportunistic.” Many companies have new-product-development committees through which they screen new- product proposals. They encourage promising ones by asking for more detailed information or requiring a prototype demonstration, and giving increasing support as needed at each stage of development to those ideas that show potential for commercial success (Cooper, 1993). While such new products could form the basis for a future revenue stream, the probabilities for most companies are distressingly small. By its very nature, the process can be likened to a funnel, where a large number of items are successively narrowed to a small number: only a few of the many ideas for new projects are researched further, even fewer are found to be feasible, fewer in turn are finally adopted, and fewer still achieve success. Indeed, many fields experience a similar, narrowing effect. Consider the example of the game of baseball. Each year more than 2 million youngsters worldwide play on Little League teams, many with dreams of one day making it to the “big leagues.” Players who actually reach the minor league level number a few thousand while the active rosters in Major League Baseball include only 750 players. Contrast such a system to another where the number of ideas vastly increases, and sifting through them becomes a fulltime job for several people. Why not ask customers for their suggestions? Few companies do. Why not have everyone in the company participate, instead of just the engi- neers? And why not broaden the suggestions to embrace any kind of improvement or innovation, not just new product ideas? This way, the ongoing focus of the company would be opportunity- recognition, and its revenue model continually refreshed. …