Financial statement analysis exam notes

Chapter 2:
Strategy analysis also allows the identification of the firm’s profit drivers and key risks. Enables the analyst to assess the
sustainability of the firm’s current performance and make realistic forecasts of future performance.
A firm’s value is determined by its ability to earn a return on its capital in excess of the cost of capital.
Its profit potential is determined by its own strategic choices:
1. the choice of an industry or a set of industries in which the firm operates (industry choice),
2. the manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive
positioning), and
3. the way in which the firm expects to create and exploit synergies across the range of businesses in which it
operates (corporate strategy).
Strategy analysis, therefore, involves
1. industry analysis,
2. competitive strategy analysis, and
3. corporate strategy analysis.
INDUSTRY ANALYSIS
In analyzing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in which the
firm is competing as the profitability across industries has tended to differ systematically.
INDUSTRY STRUCTURE AND PROFITABILITY

average profitability of an industry is

influenced by the “five forces” shown
in Figure 2-1.
Degree of Actual and Potential Competition
One of the key determinants of the price is the degree to which there is competition among suppliers of the same or
similar products.
There are three potential sources of competition in an industry:
1. rivalry between existing firms,
2. threat of entry of new firms, and
3. threat of substitute products or services.
Competitive Force 1: Rivalry among Existing Firms
In most industries the average level of profitability is primarily influenced by the nature of rivalry among existing firms in
the industry.
Higher degrees of competition among firms:

 Push prices towards the marginal cost of production.

 Make non-price dimensions of products or services more important.
Determinants of the intensity of competition among firms:

 Industry growth rate.

If an industry is growing very rapidly, incumbent firms need not grab market share from each other to grow. In
this situation one can expect price wars among firms in the industry
 Concentration and balance of competitors.
The number of firms in an industry and their relative sizes determine the degree of concentration in an industry.
influences the extent to which firms in an industry can coordinate their pricing and other competitive moves.
 Degree of Differentiation and Switching Costs
The extent to which firms in an industry can avoid head-on competition depends on the extent to which they can
differentiate their products and services
 Scale/Learning Economies and the Ratio of Fixed to Variable Costs
If there is a steep learning curve or there are other types of scale economies in an industry, size becomes an
important factor for firms in the industry.
 Excess Capacity and Exit Barriers
If capacity in an industry is larger than customer demand, there is a strong incentive for firms to cut prices to fill
capacity.
Competitive Force 2: Threat of New Entrants
The potential for earning abnormal profits will attract new entrants to an industry. The ease with which a new firm can
enter an industry will affect the profitability of other firms within the industry.
Factors affecting the barriers to entry are:

 Economies of scale
When there are large economies of scale, new entrants face the choice of having either to invest in large capacity
which might not be utilized right away, or to enter with less than the optimum capacity.
 First mover advantage
Early entrants in an industry may deter future entrants if there are first mover advantages
 Relationships with suppliers and customers
Limited capacity in the existing distribution channels and high costs of developing new channels can act as
powerful barriers to entry
 Legal barriers
There are many industries in which legal barriers such as patents and copyrights in research-intensive industries
limit entry.
Competitive Force 3: Threat of Substitute Products
The third dimension of competition in an industry is the threat of substitute products or services.
 The degree to which substitute products or services exist affects the industry’s bargaining power with suppliers
and customers, and ultimately profitability.
 The degree to which substitutes exist depends upon the relative price and performance of competing products or
services, and the willingness of customers to accept substitutes.
Bargaining Power in Input and Output Markets
While the degree of competition in an industry determines whether there is potential to earn abnormal profits, the actual
profits are influenced by the industry’s bargaining power with its suppliers and customers.
Competitive Force 4: Bargaining Power of Buyers
Buyer bargaining power can exert downward pressure on prices. Factors that can affect this bargaining power are:
Two factors determine the power of buyers:
1. Buyer price sensitivity to product or service
Price sensitivity determines the extent to which buyers care to bargain on price; Buyers are more price sensitive
when the product is undifferentiated and there are few switching costs.
2. Relative bargaining power of buyers
Relative bargaining power determines the extent to which they will succeed in forcing the price down. Even if
buyers are price sensitive, they may not be able to achieve low prices unless they have a strong bargaining
position.
Competitive Force 5: Bargaining Power of Suppliers
The analysis of the relative power of suppliers is a mirror image of the analysis of the buyer’s power in an industry.
Suppliers are powerful when there are only a few companies and few substitutes available to their customers.
A mirror image of the bargaining power of buyers.
 Suppliers have bargaining power when there are few substitutes and/or few suppliers relative to the number of
customers demanding a product or service.

Limitations of Industry Analysis

A potential limitation of the industry analysis framework discussed in this chapter is the assumption that industries have
clear boundaries. In reality, it is often not easy to demarcate industry boundaries.

COMPETITIVE STRATEGY ANALYSIS

The profitability of a firm is influenced not only by its industry structure but also by the strategic choices it makes in
positioning itself in the industry. Individual firms must choose appropriate strategies to succeed within their industry
segment. Two generic competitive strategies that can potentially allow a firm to build a sustainable competitive advantage.
Sources of Competitive Advantage
Competitive Strategy 1: Cost Leadership
Cost leadership is often the clearest way to achieve competitive advantage. In industries where the basic product or
service is a commodity, cost leadership might be the only way to achieve superior performance. There are many ways to
achieve cost leadership, including economies of scale and scope, economies of learning, efficient production, simpler
product design, better sourcing and lower input costs, and efficient organizational processes. Cost leadership enables a
firm to supply the same product or service offered by its competitors at a lower cost.
Competitive Strategy 2: Differentiation

Differentiation strategy involves providing a product or service that is distinct in some important respect valued by the
customer. To be successful, the firm has to accomplish three things.
First, it needs to identify one or more attributes of a product or service that customers value.
Second, it has to position itself to meet the chosen customer need in a unique manner.
Finally, the firm has to achieve differentiation at a cost that is lower than the price the customer is willing to pay for the
differentiated product or service.
Drivers include:
 providing superior intrinsic value via product quality,
 product variety, bundled services, or
 delivery timing.
STRATEGIES FOR CREATING COMPETITIVE ADVANTAGE

ACHIEVING AND SUSTAINING COMPETITIVE ADVANTAGE

Choice of strategy is an important first step for a firm. The likelihood of achieving and sustaining competitive advantage
must be evaluated.
Factors to evaluate include:

 Unique core competencies

 A system of activities that fits with the strategy and potentially reinforce each other
 Strategic positioning
Achieving Competitive Advantage
The choice of competitive strategy does not automatically lead to the achievement of competitive advantage. To achieve
competitive advantage, the firm has to have the capabilities needed to implement and sustain the chosen strategy.
To evaluate whether a firm is likely to achieve its intended competitive advantage, the analyst should ask the following
questions:

 What is the customer need that the company is focusing on?

 How does the company distinguish its customer value proposition from the alternative propositions available to
the customers from its competitors?
 Does the firm currently have the key capabilities and processes to deliver its value proposition?

Sustaining Competitive Advantage

The uniqueness of a firm’s core competencies and its value chain and the extent to which it is difficult for competitors to
imitate them determine the sustainability of a firm’s competitive advantage.
To evaluate whether or not a firm is likely to sustain its competitive advantage, an analyst should ask the following
questions:

 Are there any barriers to imitation in this company’s strategy? If so, what are they? How long are they likely to
last?
 Are there any changes that potentially affect this company’s industry and its strategic position in that industry?
What are they? In what way are these changes likely to lead to lead to changes in the competitive dynamics in this
industry?
 What actions, if any, can this company take to address these changes, and renew its competitive advantage? How
likely is it that the company will be able to renew itself successfully?

CORPORATE STRATEGY ANALYSIS

When analyzing a multi-business organization, an analyst has to evaluate not only the industries and strategies of the
individual business units but also the economic consequences—either positive or negative—of managing all the different
businesses under one corporate umbrella.
Companies with multiple business segments require an analysis how the separate segments are managed within the
corporate governance structure.
Factors to analyze include:

 Transaction costs
 Specific benefits to operating under one corporate umbrella
Porter’s “five forces” framework is valuable in evaluating the strategy and actions of firms within an industry