The Two Most Important Elements of Business
Kirjoittanut: Ella Muja - tiimistä FLIP Solutions.
Crafting and executing strategy. The quest for competitive advantage.
Fundamentals of Corporate Finance.
Arthur A Thompson JR
Written by: Ella Muja and Emilia Parikka
When establishing a company, one must prioritize the business’ strategy to increase competitive advantage and find a niche market position. After operations have begun, allotting more time for financial management and development should occur. The following essay will dive deeper into the theories behind both concepts and the importance of having a business strategy and strong financial management.
Creating a strategy is a key element of starting a company and it not only assists in setting the company apart from others competitively, but it also helps in determining objectives, opportunities, and strengths. Theoretically, it is defined as a pattern of actions and business approaches (Thompson et al. 2013). These actions and approaches are unique to each company and can be modified for various reasons, such as customers, experiences, changes in the market, or new objectives. The strategy is a way for companies to have a sense of direction and develop a purpose that drives them to achieve goals and seek new opportunities.
According to R. Edward Freeman, the creator of Stakeholder Theory, companies exist and operate to create value for all stakeholders, and not just the shareholders involved (McAbee 2022). Some examples of stakeholders are customers, surrounding communities, investors, and organizations. To stand out from other companies, the business strategy must clearly outline the purpose and value formed from the actions of the company. In today’s world, ethical companies that consider all factors or players (stakeholders) within their operations often have a better reputation and increased customer loyalty.
There are three main stages of coming up with a strategy for a company: crafting, executing, and monitoring. Each stage has the overall objective of helping the company succeed and increase their competitive advantage. Below is a diagram outlining the process of building a strategy.
FIGURE 1. The strategy making process (Thompson et al. 2013).
Crafting a strategy is a crucial part of the planning process, in other words, it is the foundation of the strategy as a whole. During this stage the company must consider or establish their vision, mission, and values to help with executing future actions and projects. The vision, mission, and values are what make each company unique and help them establish a purpose. Often, the most memorable companies are known for their rare and unique ideas that offer something new to the market. The next step is setting strategic objectives. Objectives provide direction for the company and outline the actions needed to achieve said goals. All of the goals set should be related to the strategy in some way, and all companies should consider the effect said strategic goals will have on their financial performance.
Following the development and planning of the strategy, the company will execute the strategy, or put it into action. At this point, companies will dedicate their resources and capabilities to the strategic objectives and do their best to succeed. When a strategy is thoroughly planned and risks are also taken into consideration, there is a better chance at succeeding and increasing financial performance (Thompson et al. 2013). However, it is also important not to be afraid of mistakes and failures, because it assists in learning and developing more finetuned strategies in the future.
The final stage of the strategy making process is monitoring. This includes evaluating the progress and success of the strategy as well as following data related to the outcome of the strategy (revenue, customer satisfaction, share price). While monitoring the strategy, executives or company managers can also look at specific parts of the strategy to see if modifications need to be made (Thompson et al. 2013). Another idea that touches more on developmental changes would be staffing departments differently to modify strategic outcomes. This could be temporarily assigning a worker skilled in marketing to come up with new ideas or objectives in a different department. These scenarios encourage the use of internal resources and strengths before outsourcing a service.
After a strategy has been implemented and monitored, changes can be made and revisions to certain parts of the process can be suggested (Thompson et al. 2013). A common example is if a new opportunity arises, adjusting the pre-existing strategy to accommodate the new opportunity. Sometimes companies also need to create a new budget or hire additional workers to ensure that there are enough resources and capabilities to handle the modifications.
When a strategy is planned or executed, there are both internal and external factors that influence strategic performance. External factors are influences that are out of the company’s control and are sometimes unpredictable. These can be either on the industrial level, such as market position, or on the macro-environmental level, which could be political or social factors (CFI Team 2022). Internal factors are influences found within the company, such as leadership, culture, and personnel, as well as unique strengths and weaknesses.
To understand the industrial factors and their impact on strategic performance, an analysis of the company’s specific industry should be completed (CFI Team 2022). This would look at the company’s competitive position in the market and answer questions like: will the position change under the new strategy? What changes could occur during the duration of the strategic plan? Companies looking to remain or grow competitively need to understand their competition within their industry and what actions should be taken to prevent drastic changes or threats.
An easy way to remember macro-environmental factors is by using the acronym PEST, which stands for Political, Economic, Socio-demographic, and Technological (CFI Team 2022). These four main categories have the highest levels of influence on companies as they create regulations, cause unforeseen circumstances, and are constantly changing. To prevent a company from falling behind competitively, they must keep an adaptive attitude and have the ability to modify their decisions under pressure. Completing a PEST analysis will help a company better understand which specific factors play the largest role in their success (The Economic Times N.d.). Some of the most prominent examples would be governmental regulations, market trends, new technological platforms or machinery, and changes in population.
To evaluate a company’s internal influences, a SWOT analysis should be completed along with an outline of their culture and leadership style. A SWOT analysis helps an organization understand their competitive advantage through strengths and opportunities, and then where they can develop strategically by looking at weaknesses and threats (Kenton 2022). If a company can utilize their strengths and possible opportunities, it will increase their chance of success and help them overcome necessary challenges along the way. Below is an example of a SWOT analysis for the international food retailer brand Carrefour:
FIGURE 2. Carrefour SWOT Analysis 2018 (Munteanu 2022).
Regarding company culture and leadership styles, they vary between each organization and each person. Managers and leaders often use their own experiences to provide examples and try new techniques, which therefore prevents all leaders and cultures from being the same and makes it challenging to decide which leadership style will work best. A company’s culture is a shared set of attitudes, norms, and values that characterize the organization. However, instead of their being religion, history, or language involved, it is focused on common practices and understandings within the workplace and company as a whole. For example, the company’s relationship with time or customers plays a large role in both the strategy execution and daily routines.
After a desired strategy is formed and the company’s vision and mission are clear, it’s good to turn the focus into finances. Using these different analysis tools such as PEST and SWOT can already show some finance related issues or strengths the company might have. At this point the company could already be established, but of course it’s suggested to first figure out the first things about financial management, before jumping into it blindly. Even after the financial management is in order, it’s important not to forget the strategic part completely, but to return on both topics along the way helps to run the business smoothly and prepare for any changes or even crisis that may occur.
A company is a distinct, permanent legal entity that is owned by its shareholders. These shareholders have limited liability, as the company is legally distinct from them. This means the company has legal rights and obligations, and the shareholders can’t be personally held responsible for the debts of the company. (Brealey et al. 2018) If a company does not have its financial management in order, it will create problems with the operations and durability, which in the long term could lead to bankruptcy and an end to the company’s operations. Therefore, it’s important to look at the financial management of a company and the things affecting it. The topic is vast and thus we’ll not be able to go through everything in one essay, but we’ll highlight the key elements to get you started.
As mentioned in the introduction section to business strategy, the company exists to bring value to its shareholders. According to Brealey, the goal of the company is to maximize its value or otherwise add value. This raises a moral dilemma; could this be done without any concern for ethics? (Brealey et al. 2018) OfCourse not, but we’re not here to talk about ethics right now, we’re here to focus on the financial management of a company and its operations.
The corporate finances can be divided into two categories: Investment & Financing decisions, which are both managed by the financial manager. The investment decisions are about how to use the capital the company has. This includes both tangible assets, the ones you can touch and kick, such as machines or buildings, and the intangible assets, which you can’t touch, like advertising, patents or research. The Financing decision on the other hand focuses on how these investments and the company’s operations are to be funded. It could be done in multiple ways, like releasing new shares or taking out a loan or releasing bonds, that we’ll be learning more from later. (Brealey et al. 2018)
PIC 1: Financial Management roles
Cash flow inside the company starts with money being raised from investors by selling financial assets, such as shares. The financial manager will invest the cash in the company’s operations and that generates new cash, which will be either reinvested into the company’s operations to generate more cash or the cash is returned to investors as dividends. If the return offered by an investment project in the company’s own operations is higher than the rate of return expected from shareholders’ own investments, they will support the decision to reinvest the money in the company operations. This phenomenon is also called opportunity cost of capital. (Brealey et al. 2018)
PIC 2: How money moves in a company
Accounting & Finances
The Balance sheet shows the value of assets and liabilities, the company has at a certain time. Liabilities include the cash company owns to other and assets include the cash they have, get or things they could turn into cash. As intangible assets are often difficult to value in cash, they are rarely put on the balance sheet. It’s important to keep in mind that the balance sheet shows the book value of the company, instead of the market value, as the book value is based on the past according to generally accepted accounting principles, whereas market value focuses on the current and changes according to the market and can be lower or higher than the book value. (Brealey et al. 2018)
When looking at the income statement, Brealey shares that it shows how profitable the company has been over the course of the past year. As the income statement shows the inflows and outflows of cash, you can find the revenues, expenses and net income from it. When talking about accrual accounting, the accountant means matching the inflows and outflows of cash related to each sale. The net income is based on deducting all expenses, taxes and depreciation from the total revenue. (Brealey et al. 2018)
Corporate tax is what the company pays for its income and from which it’s possible to deduct expenses, such as depreciation and interest paid. However, it’s not possible to deduct dividends, which has created a concept called double taxation, as the dividends are taxed in corporate income taxation and then again at the taxation of personal income tax to shareholders. In case the company suffers a loss, it’s possible to get a tax return or use the losses ease the taxation in the following year. (Brealey et al. 2018)
Bonds are a way for a company to collect cash for funding their operations and development. They are obligations, which bind the issuer to a set of payments for the person purchasing the bond, (also known as the bondholder). Companies issue bonds when they are in need of a loan as a long-term investment. Some bonds have coupons, which the bondholder can cash in every year, getting an interest payment based on the face value of the bond. Face value is the payment received when the bond comes to maturity or otherwise put the agreed date of final payment has arrived. Bonds that have a zero-coupon rate means, the coupon does not have an interest payment every year. The price of the bond can be calculated by discounting the required rate of return from all the cash flows the bond will generate. You can see the formula for this in the picture below, note that R is the coupon rate and T is the time in years. When thinking about the value of a bond compared to other bonds, it’s easiest to measure Yield to Maturity, which is a percentage demonstrating the price. (Brealey et al. 2018)
PIC 3: Present Value of a Bond Calculation
Measuring corporate performance
Now that you have made your business strategy and established your financial management, you OfCourse want to know how it’s performing or if you’re getting your money’s worth as an investor. There are a few things you can measure; the market value, economic value and efficiency. Measuring the market value shows you if the company has been successful at generating value for its shareholders. If you calculate economic value, it reveals the economic value of the company. Calculating efficiency shows how effectively the company is using its assets. The efficiency of the company can be calculated by using asset turnover ratio, inventory turnover or receivables turnover. The asset turnover ratios demonstrate how many sales have been generated by each dollar of total assets. (Hayes 2022) While the Inventory turnover ratio shows the number of days it takes for a company to turn its inventory into profit, (Jenkins 2022) the Receivables turnover ratio measures how well the company can collect money for its credit. (Murphy 2022)
PIC 4: Asset turnover ratio calculation
PIC 5: Inventory turnover ratio calculation
PIC 6: Receivables turnover ratio calculation
Calculations to help you with Market Value are market capitalization, market value added and market-to-book ratio. Market capitalization, also known as market cap, shows the total value of the company’s equity. You can calculate it by multiplying the price of a share with the total number of outstanding shares. Market value added measures the cumulative investment of shareholders has done for the company. To calculate it you should deduct the book value of equity from the market capitalization. The market-to-book ratio shows how much value had been added per dollar invested and calculation for this happens by dividing the market value of equity with the book value of equity. (Brealey et al. 2018)
PIC 7: Market Capitalization Calculation
PIC 8: Market value added calculation
PIC 9: Market-to-book ratio calculation
According to Brealey finding out the economic value of a company is best done by using calculations the accountants such as EVA, ROC, ROE and ROA. Economic Value Added, EVA for short, shows the profit after all costs, including the cost of capital, have been deducted. (Brealey et al. 2018)
PIC 10: Economic Value-Added calculation
Return on Capital (ROC), Return on Equity (ROE) and Return on Assets (ROA) are easy to get mixed up as they all measure profitability and look a lot alike. Where return on capital measures the profitability based on capital the company had to work with, return on equity shows profitability based on how much income has been generated to shareholders per dollar invested. Return on assets on the other hand demonstrates the company’s profitability based on the total assets it has. (Brealey et al. 2018)
PIC 11: Return on capital calculation
PIC 12: Return on equity calculation
PIC 13: Return on assets calculation
When establishing and running a company, there is a lot to do and consider. It’s easy to get lost in all the calculations of financial management and terminology of business strategy. We want to highlight that even when getting help from a professional it’s important to know and understand the way your company operates and generates revenue, which is why learning at least some of these calculations will be very useful for you. Planning a strategy or reviewing finances can be complicated, and many things will reveal themselves once the plan has been executed, which is why we hope it was clear how business strategy and financial management go together. We would like to hear if you are familiar with some of these tools we’ve shared, and if they have helped with managing your company?
Brealey, R., Myers, S. & Marcus, A. 2018. Fundamentals of Corporate Finance. 9th edition. New York: McGraw-Hill Education
CFI Team. 2022. External Analysis. Updated on 04.12.2022. Read on 06.01.2023. https://corporatefinanceinstitute.com/resources/management/external-analysis/
Hayes, A. 2022. Asset Turnover Ratio Definition. Updated: 15.06.2022. Read: 06.01.2023. https://www.investopedia.com/terms/a/assetturnover.asp
Jenkins, A. 2022. Inventory Turnover Ratio Defined: Formula, Tips & Examples. Written: 09.08.2022. Read on 06.01.2023. https://www.netsuite.com/portal/resource/articles/inventory-management/inventory-turnover-ratio.shtml
Kenton, W. 2022. SWOT Analysis: How To With Table and Example. Updated on 10.08.2022. Read on 08.01.2023. https://www.investopedia.com/terms/s/swot.asp
McAbee, J. 2022. Understanding Stakeholder Theory. Read on 03.01.2023. https://www.wrike.com/blog/understanding-stakeholder-theory/
Murphy, C. 2022. Receivables Turnover Ratio Defined: Formula, Importance, Examples, Limitations. Updated on 31.08.2022. Read on 08.01.2023. https://www.investopedia.com/terms/r/receivableturnoverratio.asp
The Economic Times. N.d. What is a ‘PEST Analysis’. Read on 06.01.2023. https://economictimes.indiatimes.com/definition/pest-analysis
Thompson, A., Strickland, AJ., Gamble, J., Peteraf, M., Janes, A. & Sutton, C. 2013. Crafting and executing strategy. The quest for competitive advantage. European edition. London: McGraw-Hill Higher Education.