Business (9625) | Analysing the existing internal position of a business

Analysing the Existing Internal Position of a Business (Syllabus 3.3.2)

Hello future strategists! This chapter is where we take a deep dive inside the business to figure out exactly what we are good at, and where we need to improve. Before you can plan where you are going (strategy), you need an honest assessment of where you are now (internal position). Think of it like a doctor giving a patient a full health check before prescribing treatment.

Understanding the firm's current strengths and weaknesses is fundamental to setting realistic and effective strategies. Let's start with the hard numbers!

Section 1: Assessing Financial Performance – The Power of Ratios

Financial statements (like the Income Statement and Statement of Financial Position) contain vast amounts of data. Ratios are tools that simplify this data, allowing for meaningful analysis over time (trend analysis) or against competitors (comparative analysis).

1.1 Profitability Ratios: Are We Making Money Efficiently?

These ratios measure how effectively a business is turning its resources into profit.

Key Profitability Ratios:

• Gross Profit Margin (GPM): This shows the profit left over after paying for the goods sold (Cost of Sales).
  What it tells you: How efficient the core production process is. High GPM means effective sourcing or high pricing power.
• Operating Profit Margin (OPM): Shows profit after deducting all operating expenses (like wages, rent, utilities).
  What it tells you: How well the business is managing its day-to-day running costs. A gap between GPM and OPM suggests high operating expenses.
• Profit for the Year Margin (often called Net Profit Margin): Shows the final profit after deducting all expenses, including interest and taxes.
  What it tells you: The ultimate return available to owners/shareholders.
• Return on Capital Employed (ROCE): Arguably the most important profitability ratio for strategy.
  Analogy: If you invest $100 in a business, how much profit (return) do you get back?
  What it tells you: The efficiency with which the business uses all the long-term capital (equity plus long-term debt) invested in it. A high ROCE suggests excellent resource management.

1.2 Liquidity Ratios: Can We Pay Our Debts?

Liquidity measures the ability of a business to meet its short-term financial obligations. If liquidity is poor, the business risks bankruptcy, even if it is profitable on paper!

• Current Ratio: Compares current assets (cash, receivables, inventory) to current liabilities (payables, short-term debt).
  Rule of Thumb: Ideally, the ratio should be around 1.5:1 to 2:1. This means you have \$1.50 to \$2.00 of assets for every \$1.00 of immediate debt.
  A ratio of 0.8:1 is dangerous! You don't have enough liquid assets to cover your short-term bills.

1.3 Efficiency Ratios: How Quickly Does the Business Operate?

Efficiency ratios (often called working capital ratios) assess how effectively the firm manages its short-term resources.

• Inventory Turnover (Stock Turnover): How many times per year inventory is sold and replaced.
  High Turnover: Good! Stock isn't sitting around becoming obsolete (unless the business sells luxury/slow-moving items, like airplanes).
• Receivables Days (Debtor Days): The average time taken for customers to pay money owed to the business (Receivables).
  Strategic Goal: Keep this low! The faster customers pay, the better the business’s cash flow.
• Payables Days (Creditor Days): The average time the business takes to pay its suppliers (Payables).
  Strategic Trade-off: A longer payables period is good for the business's cash flow, but paying too slowly can damage relationships with vital suppliers.

1.4 Gearing Ratio: How Much Debt Do We Rely On?

Gearing (or Leverage) measures the proportion of a business's capital structure that is financed by external debt (loans, debentures) rather than equity (shares, retained profits).

• High Gearing (e.g., above 50%): The business relies heavily on borrowing.
  Benefit: Equity holders maintain control (no dilution of shares).
  Risk: High risk if interest rates rise or profits fall, as fixed interest payments must still be made.
• Low Gearing: The business is mainly financed by equity. Lower risk, but potentially less profitable for shareholders if borrowing could have funded successful growth projects.

Did you know? Companies with high gearing are often highly vulnerable during economic recessions, as falling revenue makes debt repayment very difficult.

1.5 Shareholder Ratios (PLCs Only)

These ratios are vital for PLCs (Public Limited Companies) as they communicate performance and value directly to investors.

• Dividend per Share (DPS): The amount of cash dividend paid for each ordinary share held.
• Dividend Yield: The dividend per share expressed as a percentage of the current market share price. Measures the rate of return from dividends.
• Price Earnings Ratio (P/E Ratio): The market price per share divided by the earnings per share.
  What it tells you: How many years it would take the business to earn back the current share price. A high P/E ratio suggests investors have high expectations for future growth.

1.6 The Value of Ratio Analysis and Potential Pitfalls

The Value of Ratio Analysis:

• Benchmarking: Compare current performance against historical data, budgeted figures, or industry competitors.
• Identifying Trends: Reveal whether the business is improving or deteriorating over time (e.g., is ROCE rising or falling?).
• Informing Strategy: Highlight areas of weakness (e.g., poor liquidity might mean a strategic focus on improving cash flow).

A Word of Warning: Window Dressing

Window Dressing is the manipulation of financial accounts to make the business appear financially stronger than it truly is, usually right before the reporting period ends.
Example: Delaying the payment of expenses or selling off old assets just before the year-end to temporarily boost liquidity or profit figures. Analysts must be cautious!

The Role of Profit Centres

A Profit Centre is a division or department within a business that is responsible for both revenues and costs, and therefore its own profit calculations.
Value: Analysing the performance of individual profit centres (e.g., the ‘North American’ division or the ‘Mobile Phones’ product line) allows management to identify which parts of the business are contributing most to overall success and which may need strategic restructuring or closure.

Section 2: Analysing Non-Financial Performance

Ratios tell us *what* happened financially, but they rarely tell us *why*. To get a complete picture of internal strengths and weaknesses, managers must look at data beyond the financial statements.

2.1 Data from Functional Areas

The performance of the three major functional areas (Operations, HR, and Marketing) provides insight into the strategic capability of the business.

• Operations Data (The Factory Floor):
  Focus: Efficiency, Quality, and Speed.
  Examples: Unit costs, defect rates, capacity utilisation, speed of response, customer satisfaction scores related to product performance.
  Weakness Example: High unit costs compared to competitors suggest an operational weakness that needs strategic attention (e.g., invest in Kaizen or new technology).
• Human Resources (HR) Data (The People):
  Focus: Productivity, Morale, and Stability.
  Examples: Labour turnover (how many employees leave), labour productivity, training costs, employee engagement scores.
  Weakness Example: High labour turnover and low productivity suggests a major weakness in human capital management, requiring strategic changes in motivation or recruitment.
• Marketing Data (The Customer Connection):
  Focus: Market Position and Customer Loyalty.
  Examples: Market share, sales volume/value trends, customer retention rates, brand awareness scores.
  Weakness Example: Falling market share indicates that current strategy is failing to compete effectively in the external environment.

2.2 Comprehensive Assessment Models

To prevent managers from becoming fixated only on profit, two strategic models help assess performance across multiple dimensions.

A. The Triple Bottom Line (TBL)

The TBL argues that businesses should not only measure Profit, but also their impact on People and the Planet. This model reflects the growing importance of social and environmental objectives in strategy.

Memory Aid: Remember the three P's!

1. Profit (Financial performance)
2. People (Social responsibility, fair wages, employee welfare, community impact)
3. Planet (Environmental responsibility, carbon footprint, sustainable resource use)

A strength in TBL terms might be having a low carbon footprint, even if this means slightly higher short-term costs.

B. Kaplan and Norton's Balanced Scorecard

The Balanced Scorecard is a framework that requires managers to assess the business across four critical perspectives, ensuring a holistic view of performance and strategy implementation.

Don't worry if this seems complicated; think of it as a strategic dashboard where all the key metrics are visible, not just the financial ones!

1. Financial Perspective: (Are we making money and adding shareholder value?)
   Measures: ROCE, Profit margins, Cash flow.
2. Customer Perspective: (Are customers satisfied and loyal?)
   Measures: Customer retention rates, market share, brand ranking.
3. Internal Process Perspective: (Are we executing our critical business processes efficiently?)
   Measures: Unit costs, efficiency ratios, product development cycle time, quality control scores.
4. Learning and Growth Perspective: (Are we adapting, improving, and ready for the future?)
   Measures: Employee satisfaction, labour turnover, training investment per employee, technological capability.

Value: This model forces managers to link non-financial measures (like training and process improvement) directly to strategic outcomes (like customer loyalty and financial success).

2.3 Contextual Assessment

When analysing any internal data, you must assess it within the context of the business.

• Start-up vs. Growing Business: A start-up might have very low profitability (even losses) as it invests heavily, but high market growth and excellent innovation (Learning & Growth perspective) may be considered a strategic strength.
• Market Conditions: A decline in market share during an industry-wide recession might not be a huge internal weakness if competitors are declining even faster.