Article Review

gbr.pepperdine.edu/2010/08/the-role-of-finance-in-the-strategic-planning-and-decision-making-process/

2010 VOLUME 13 ISSUE 1

The Role of Finance in the Strategic-Planning and Decision-Making Process Financial Goals and Metrics Help Firms Implement Strategy and Track Success BY PEDRO M. KONO, DBA AND BARRY BARNES, PHD

The fundamental success of a strategy depends on

three critical factors: a firm’s alignment with the external environment, a realistic

internal view of its core competencies and sustainable competitive advantages,

and careful implementation and monitoring.[1] This article discusses the role of

finance in strategic planning, decision making, formulation, implementation, and

monitoring.

[powerpress: http://gsbm-

med.pepperdine.edu/gbr/audio/winter2010/PedroKono_article.mp3]

Any person, corporation, or nation should know who or

where they are, where they want to be, and how to get

there.[2] The strategic-planning process utilizes analytical models that provide a

realistic picture of the individual, corporation, or nation at its “consciously

incompetent” level, creating the necessary motivation for the development of a

strategic plan.[3] The process requires five distinct steps outlined below and the

selected strategy must be sufficiently robust to enable the firm to perform activities

differently from its rivals or to perform similar activities in a more efficient manner.[4]

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A good strategic plan includes metrics that translate the vision and mission into

specific end points.[5] This is critical because strategic planning is ultimately about

resource allocation and would not be relevant if resources were unlimited. This article

aims to explain how finance, financial goals, and financial performance can play a

more integral role in the strategic planning and decision-making process, particularly

in the implementation and monitoring stage.

The Strategic-Planning and Decision-Making Process 1. Vision Statement

The creation of a broad statement about the company’s values, purpose, and future

direction is the first step in the strategic-planning process.[6] The vision statement

must express the company’s core ideologies—what it stands for and why it exists—

and its vision for the future, that is, what it aspires to be, achieve, or create.[7]

2. Mission Statement

An effective mission statement conveys eight key components about the firm: target

customers and markets; main products and services; geographic domain; core

technologies; commitment to survival, growth, and profitability; philosophy; self-

concept; and desired public image.[8] The finance component is represented by the

company’s commitment to survival, growth, and profitability.[9] The company’s long-

term financial goals represent its commitment to a strategy that is innovative,

updated, unique, value-driven, and superior to those of competitors.[10]

3. Analysis

This third step is an analysis of the firm’s business trends, external opportunities,

internal resources, and core competencies. For external analysis, firms often utilize

Porter’s five forces model of industry competition,[11] which identifies the company’s

level of rivalry with existing competitors, the threat of substitute products, the

potential for new entrants, the bargaining power of suppliers, and the bargaining

power of customers.[12]

For internal analysis, companies can apply the industry evolution model, which

identifies takeoff (technology, product quality, and product performance features), 2/10

rapid growth (driving costs down and pursuing product innovation), early maturity

and slowing growth (cost reduction, value services, and aggressive tactics to maintain

or gain market share), market saturation (elimination of marginal products and

continuous improvement of value-chain activities), and stagnation or decline

(redirection to fastest-growing market segments and efforts to be a low-cost industry

leader).[13]

Another method, value-chain analysis clarifies a firm’s value-creation process based

on its primary and secondary activities.[14] This becomes a more insightful analytical

tool when used in conjunction with activity-based costing and benchmarking tools that

help the firm determine its major costs, resource strengths, and competencies, as well

as identify areas where productivity can be improved and where re-engineering may

produce a greater economic impact.[15]

SWOT (strengths, weaknesses, opportunities, and threats) is a classic model of internal

and external analysis providing management information to set priorities and fully

utilize the firm’s competencies and capabilities to exploit external opportunities,[16]

determine the critical weaknesses that need to be corrected, and counter existing

threats.[17]

4. Strategy Formulation

To formulate a long-term strategy, Porter’s generic strategies model [18] is useful as it

helps the firm aim for one of the following competitive advantages: a) low-cost

leadership (product is a commodity, buyers are price-sensitive, and there are few

opportunities for differentiation); b) differentiation (buyers’ needs and preferences are

diverse and there are opportunities for product differentiation); c) best-cost provider

(buyers expect superior value at a lower price); d) focused low-cost (market niches

with specific tastes and needs); or e) focused differentiation (market niches with

unique preferences and needs).[19]

5. Strategy Implementation and Management

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In the last ten years, the balanced scorecard (BSC)[20] has become one of the most

effective management instruments for implementing and monitoring strategy

execution as it helps to align strategy with expected performance and it stresses the

importance of establishing financial goals for employees, functional areas, and

business units. The BSC ensures that the strategy is translated into objectives,

operational actions, and financial goals and focuses on four key dimensions: financial

factors, employee learning and growth, customer satisfaction, and internal business

processes.[21]

The Role of Finance Financial metrics have long been the standard for

assessing a firm’s performance. The BSC supports the role of finance in establishing

and monitoring specific and measurable financial strategic goals on a coordinated,

integrated basis, thus enabling the firm to operate efficiently and effectively. Financial

goals and metrics are established based on benchmarking the “best-in-industry” and

include:

1. Free Cash Flow

This is a measure of the firm’s financial soundness and shows how efficiently its

financial resources are being utilized to generate additional cash for future

investments.[22] It represents the net cash available after deducting the investments

and working capital increases from the firm’s operating cash flow. Companies should

utilize this metric when they anticipate substantial capital expenditures in the near

future or follow-through for implemented projects.

2. Economic Value-Added

This is the bottom-line contribution on a risk-adjusted basis and helps management to

make effective, timely decisions to expand businesses that increase the firm’s

economic value and to implement corrective actions in those that are destroying its

value.[23] It is determined by deducting the operating capital cost from the net

income. Companies set economic value-added goals to effectively assess their

businesses’ value contributions and improve the resource allocation process.

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3. Asset Management

This calls for the efficient management of current assets (cash, receivables, inventory)

and current liabilities (payables, accruals) turnovers and the enhanced management

of its working capital and cash conversion cycle. Companies must utilize this practice

when their operating performance falls behind industry benchmarks or benchmarked

companies.

4. Financing Decisions and Capital Structure

Here, financing is limited to the optimal capital structure (debt ratio or leverage),

which is the level that minimizes the firm’s cost of capital. This optimal capital

structure determines the firm’s reserve borrowing capacity (short- and long-term) and

the risk of potential financial distress.[24] Companies establish this structure when

their cost of capital rises above that of direct competitors and there is a lack of new

investments.

5. Profitability Ratios

This is a measure of the operational efficiency of a firm. Profitability ratios also

indicate inefficient areas that require corrective actions by management; they

measure profit relationships with sales, total assets, and net worth. Companies must

set profitability ratio goals when they need to operate more effectively and pursue

improvements in their value-chain activities.

6. Growth Indices

Growth indices evaluate sales and market share growth and determine the acceptable

trade-off of growth with respect to reductions in cash flows, profit margins, and

returns on investment. Growth usually drains cash and reserve borrowing funds, and

sometimes, aggressive asset management is required to ensure sufficient cash and

limited borrowing.[25] Companies must set growth index goals when growth rates

have lagged behind the industry norms or when they have high operating leverage.

7. Risk Assessment and Management

A firm must address its key uncertainties by identifying, measuring, and controlling its 5/10

existing risks in corporate governance and regulatory compliance, the likelihood of

their occurrence, and their economic impact. Then, a process must be implemented to

mitigate the causes and effects of those risks.[26] Companies must make these

assessments when they anticipate greater uncertainty in their business or when there

is a need to enhance their risk culture.

8. Tax Optimization

Many functional areas and business units need to manage the level of tax liability

undertaken in conducting business and to understand that mitigating risk also

reduces expected taxes.[27] Moreover, new initiatives, acquisitions, and product

development projects must be weighed against their tax implications and net after-tax

contribution to the firm’s value. In general, performance must, whenever possible, be

measured on an after-tax basis. Global companies must adopt this measure when

operating in different tax environments, where they are able to take advantage of

inconsistencies in tax regulations.

Conclusion The introduction of the balanced scorecard emphasized financial performance as one

of the key indicators of a firm’s success and helped to link strategic goals to

performance and provide timely, useful information to facilitate strategic and

operational control decisions. This has led to the role of finance in the strategic

planning process becoming more relevant than ever.

Empirical studies have shown that a vast majority of corporate strategies fail during

execution. The above financial metrics help firms implement and monitor their

strategies with specific, industry-related, and measurable financial goals,

strengthening the organization’s capabilities with hard-to-imitate and non-

substitutable competencies. They create sustainable competitive advantages that

maximize a firm’s value, the main objective of all stakeholders.

[1] M.E. Porter, “What is Strategy?” Harvard Business Review, 74, no. 6 (1996). [purchase

required]

[2] D. Abell, Defining the Business: The Starting Point of Strategic Planning, (New Jersey: 6/10

Prentice-Hall, 1980).

[3] J.S. Bruner, The Process of Education: A Landmark in Education Theory, (hyperlink no

longer accessible). (Boston: Harvard University Press, 1977).

[4] J.A. Pearce and R.B. Robinson, Formulation, Implementation, and Control of

Competitive Strategy, (New York: Irwin McGraw-Hill, 2000).

[5] C.S. Clark and S.E. Krentz, “Avoiding the Pitfalls of Strategic Planning,” Healthcare

Financial Management, 60, no. 11 (2004): 63–68.

[6] T. Jick and M. Peiperl, Managing Change: Cases and Concepts, (New York:

Irwin/McGraw-Hill, 2003).

[7] J.C. Collins and J.I. Porras, “Building Your Company’s Vision,” Harvard Business

Review, 74, no. 5 (1996). [purchase required]

[8] Pearce and Robinson.

[9] J.A. Pearce and F. David, “Corporate Mission Statement: The Bottom Line,” The

Academy of Management Executive, 1, no. 2 (1987): 109–116. [purchase required]

[10] R.K. Johnson, “Strategy, Success, a Dynamic Economy, and the 21st Century

Manager,” The Business Review, 5, no. 2 (2006).

[11] M.E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review,

57, no. 2 (1979).

[12] Ibid.

[13] A.A. Thompson, A.J. Strickland, and J.E. Gamble, Crafting and Executing Strategy,

(New York: McGraw-Hill/Irwin, 2009).

[14] Pearce and Robinson.

[15] Thompson, Strickland, and Gamble.

[16] B. Jovanovic and G.M. MacDonald, “The Life Cycle of a Competitive Industry,” The

Journal of Political Economy, 102, no. 2 (1994: 322–347).

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[17] C.A. Lai and J.C. Rivera, Jr., “Using a Strategic Planning Tool as a Framework for

Case Analysis,” Journal of College Science Teaching, 36, no. 2 (2006): 26–31.

[18] M.E. Porter, Competitive Advantage: Techniques for Analyzing Industries and

Competitors, (New York: The Free Press, 1980).

[19] Thompson, Strickland, and Gamble.

[20] R.S. Kaplan and D.P. Norton, “Using the Balanced Scorecard as a Strategic

Management System,” (hyperlink no longer accessible). Harvard Business Review, 74,

no. 1 (1996).

[21] Ibid.

[22] Peter Grant, “How Financial Targets Determine Your Strategy,” Global Finance, 11,

no. 3 (1997): 30–34

[23] Ibid.

[24] Sidney L. Barton and Paul J. Gordon, “Corporate Strategy: Useful Perspective for

the Study of Capital Structure?” The Academy of Management Review, 12, no. 1 (1987):

67–75.

[25] B.T. Gale and B. Branch, “Cash Flow Analysis: More Important Than Ever,” Harvard

Business Review, July–August (1981).

[26] H.D. Pforsich, B.K.P. Kramer, and G.R. Just, “Establishing an Effective Internal Audit

Department,” Strategic Finance, 87, no. 10 (2006): 22–29.

[27] Q. Lawrence, “Hedging in Perspective,” Corporate Finance, 115, no. 36 (1994).

Pedro M. Kono, DBA, is a professor of finance at Graziadio School of

AUTHORS OF THE ARTICLE

Pedro M. Kono, DBA

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Business and Management at Pepperdine University and Fox School of

Business at Temple University. He is also the president of Key Financing

Solutions, a company engaged in structuring vendor programs and

international financing. Dr. Kono worked for many years for Citigroup in

the U.S., U.K., Japan, and Brazil, and gained significant international and

diversified management experience at commercial banking, leasing, and

finance companies. He obtained his doctoral degree from Wayne

Huizenga School of Business and Entrepreneurship at Nova

Southeastern University and has conducted research in the fields of

corporate finance, specifically in the investment area, and corporate

strategy. He is currently researching the market efficiency hypothesis

and the performance of Exchange-Traded Funds (ETFs) in the U.S., Japan,

and Brazil.

Barry Barnes, PhD, is the Chair of Leadership at Nova Southeastern

University in Fort Lauderdale, Florida, where he teaches graduate-level

courses in leadership, strategic decision making, and organizational

behavior. In 2009, he received an Outstanding Research Award at the

Global Conference on Business and Finance; he received a Best Paper

Award at the International Global Academy of Business, and he was

selected as Faculty Member of the Year in 2000. Dr. Barnes has

published in the International Journal of Organizational Analysis, The

International Journal of Business Research, Review of Business Research,

the Journal of Applied Management and Entrepreneurship, and other

journals. His recent research and writing focus on the relationship

between leadership, organizational change, and strategy, as well as the

innovative and improvisational business practices of the legendary rock

band the Grateful Dead.

Barry Barnes, PhD

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