human resource management

Lecture Notes

You will receive the greatest benefit from the following Lecture and Research Update if you first read this narrative, review the lesson, study the Required Readings, then come back to this section and carefully re-read this Lecture and Research Update. The “lecture” portion of this narrative focuses on issues from the textbook that need further explanation, while the “research update” portion integrates supportive information from recent professional academic and trade articles with the textbook information.

At this point, we have devoted most of our effort to the assessment of internal and external conditions affecting a firm and its strategy. Now as we turn our focus to the firm's financial performance, we will attempt to understand which financial policies and financial conditions are conducive to which strategy. This is essential because it enables us as future managers to make sound decisions that move us towards our goal of value maximization. We have explored external analysis, both in general terms as well as from the firm’s perspective, using Porter’s Five Forces model. From that technique, we know that if we understand threats posed by the environment, we can position ourselves better to overcome those threats. Then, we focused on the firm’s internal strengths and on gaining and sustaining a competitive advantage. In order for a firm to outperform its competitors, it must hold unique and valuable resources that cannot be immediately replicated by others.

Resource-Based View and the VRIO Approach

The Resource-Based View of the firm and the VRIO approach provided us with the theoretical and practical tools to identify a firm’s competitive advantage. At this point, you should understand the complementarities of external and internal analysis. It would be of little benefit to a firm to have a firm grasp of the overall economy, its industry, and its competitive environment, but possess little understanding of how its own resources and capabilities can be employed toward a competitive advantage. For example, a firm may develop a strategy to become the largest producer of its product, but that strategy is meaningless unless that firm possesses the financial strength and capability to raise the capital necessary to attain and retain that size. Likewise, a firm may hold valuable, rare, and inimitable resources, but it may not be able to employ them effectively if it fails to understand its environment or if it lacks the requisite financial capability.

Effectiveness of Strategy

Once you have determined a strategy for a firm based on its competitive position and its resources, you must monitor the effectiveness of that strategy. While there are several methods to measure the performance and financial condition of a firm, analysis of financial statements is a logical place to begin in assessing a corporation’s overall financial position and competitiveness, as manifested in its financial performance. Financial statements are used by the corporation's directors as one tool for evaluating management and for decision-making, by taxation authorities to determine the firm's tax liability, and by investors to determine the quality of the firm's securities. Publicly held firms, in addition to sending periodic reports to their stockholders, also are required to submit audited financial statements in a specified format, as well as other information about their operations and strategy, to the Securities and Exchange Commission (SEC). The SEC requirements are to protect existing and prospective investors and to gain and maintain confidence in publicly-issued securities, and, consequently, the financial markets.

By studying SEC reports, investors are able to make informed decisions about their investments. Earlier, we saw how internal governance can sometimes create problems with the transparency of the reporting process. The regulatory system, while flawed, still enabled such cases as Enron and Global Crossing to be exposed and allowed both the government and the accounting profession to take action. We have already covered governance issues, a discussion that we do not need to duplicate here, but it is essential to understand the reporting obligations imposed on traded firms as part of the system to protect investors and maintain the integrity of financial markets.

Managers and directors must be aware of the SEC regulations and reporting requirements for public firms and fully comply with them. The passage of the Sarbanes-Oxley Act in 2002, charging directors and management with more direct responsibility for financial controls and for the accuracy of financial reports, has added another costly burden to businesses. In addition, the accounting profession has established the Public Company Accounting Oversight Board (PCAOB), subjecting firms to more rigorous scrutiny. Awareness and understanding of the more stringent requirements is an integral part of the operating environment of all firms in the contemporary environment.

Balance Sheet and Income Statement

Two major accounting statements report the financial position of a company: the balance sheet and the income statement. The balance sheet reports the assets and liabilities of the firm as of a given date. The income statement (once called profit and loss statement) reports all revenues and expenses for the firm for a given accounting period, resulting in a bottom line of net income or loss for that period. While this information is useful, analysis of these statements enables greater insight to be gained on the financial performance and on the broader financial and competitive position of a company.

Statement of Cash Flows

An important step is to determine the sources and applications of cash for the firm for a particular period by constructing the statement of cash flows, sometimes called the summary of net changes in financial position. As you will learn, the balance sheet reports, among other accounts, the cash on hand as of a certain date, but does not trace how that cash position changed or came about since the previous reporting period. The importance of cash inflows and outflows of the firm is that it enables decision makers to detect possible problems in both the finances and operations of the firm. If you need a review of the various accounts in financial statements, consult a basic accounting textbook.

Financial and Nonfinancial Ratios

Another way the balance sheet and income statement can be analyzed is by the calculation of financial ratios. Financial ratios help to evaluate a firm’s performance because they provide a normalized indication of the company’s financial condition and current operating results. Possibly more important, however, is analysis over several periods to determine trends, either favorable or unfavorable, and to enable comparisons with competing or comparable firms, or even with the entire industry.

Financial Ratio Analysis consists of:

1. Liquidity Ratio

2. Profitability Ratios

3. Activity Ratios

4. Leverage Ratios

5. Other Ratios

Ratios for most firms and industries are publicly available. As one example, let us say we have calculated the Inventory Turnover Ratio (ITR) for BestBuy and find that their average turnover is 20 days in 2015 (The ITR provides a measure of the effectiveness of the company’s logistics, as each extra day of inventory can add significantly to the firm’s costs.). That number means little in isolation, but if we calculate the same ratio for the previous five years and find that the ITR had improved from 60 days to 20 days, we will be inclined to think positively about the current figure. Now, let us say we determine the ITRs for BestBuy’s competitors and find that their average ratio was 35 days. At this point, we might begin to believe that BestBuy holds a competitive advantage in its inventory management operations, which in turn may provide some indicators about BestBuy's strategy.

Every time a question arises or a trend is indicated, you should attempt to dig further into these ratios so that you understand the reasons for your observation. Equally important, you will learn that mastery of financial analysis techniques enables you to make realistic projections about future operations.

Finally, there are nonfinancial indicators that also influence a firm's long-term profitability and ultimately its competitiveness. These include such factors as customer loyalty, brand recognition, and employee satisfaction (low employee turnover). Such measures have a major influence on a company's strategy and must be considered in addition to those techniques used for assessing financial strength. Again, a caution is offered for thought: no single factor can be used to draw a conclusion about the firm’s overall condition. All ratios and indicators must be integrated into a whole.

Financial Analysis

From this background and with the mastery of ratio techniques, it becomes possible to employ financial analysis in the determination of a firm's strategy and in the assessment of the firm’s ability to support its strategy. The key point about the field of financial analysis is that it must be undertaken for a purpose. No analyst can conduct a meaningful ratio analysis without being told what the purpose is. Accordingly, there must be some indication of how much that strategy will require in financial resources, integrated with the other, nonfinancial indicators listed above. While objective financial calculations are useful, it should be understood that human judgment is also essential. You should feel free to incorporate your own judgments into any analysis to implement and support a strategy.

Lecture and Research Update Bibliography

Wheelen, T. L., Hunger, J. D., Hoffman, A. N. And Bamford, C. E. (2016). Strategic Management and Business Policy (14th ed.). NJ: Prentice Hall.

PowerPoint Lecture Notes

Use the lecture notes available in PowerPoint as you study this chapter by CLICKING THE LINK BELOW. These notes will help you identify main concepts and ideas presented in this chapter.

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Chapter 7