Value Chain Analysis Example

Step 1 - Firm's primary activities

Design and Purchasing Assembly Testing and Sales and Distribution

engineering materials quality marketing and dealer
and control support
components

Step 2 - Toal cost and importance

$164 M $410 M $524 M $10 M $384 M $230 M

less very very not important less
important important important important important

Step 3 - Cost drivers

 Number and  Order size  Scale of  Level of  Size of  Number of

frequency of  Average value plants quality targets advertising dealers
new models of purchases  Capacity  Frequency of budget  Sales per
 Sales per per supplier utilization defects  Strength of dealer
model  Location of  Location of existing  Frequency of
suppliers plants reputation defects
 Sales requiring repair
 Volume recalls

Step 4 - Links between activities

1. High-quality assembling process reduces defects and costs in quality control and dealer
support activities.
2. Locating plants near the cluster of suppliers or dealers reduces purchasing and
distribution costs.
3. Fewer model designs reduce assembling costs.
4. Higher order sizes increase warehousing costs.

Step 5 - Opportunities for reducing costs

1. Create just one model design for different regions to cut costs in designing and
engineering, to increase order sizes of the same materials, to simplify assembling and
quality control processes and to lower marketing costs.
2. Manufacture components inside the company to eliminate transaction costs of buying
them in the market and to optimize plant utilization. This would also lead to greater
economies of scale.

Turnover of Total Operating Assets

Net Sales
= Turnover of Total Operating Assets Ratio
Total Operating Assets1
Obviously, an increase in sales will necessitate more operating assets at some point (sales
may rise without additional investment within a given range, however); conversely, an
inadequate sales volume may call for reduced investment. Turnover of Total Operating Assets
or sales to investment in total operating assets tracks over-investment in operating assets.
Total operating assets = total assets - (long-term investments + intangible assets)
1

Note: This ratio does not measure profitability. Remember, over-investment may result in a
lack of adequate profits.

Net Sales to Tangible Net Worth

Net Sales
= Net Sales to Tangible Net Worth Ratio
Tangible Net Worth2
This ratio indicates whether your investment in the business is adequately proportionate to
your sales volume. It may also uncover potential credit or management problems, usually
called "overtrading" and "undertrading."
 Overtrading, or excessive sales volume transacted on a thin margin of investment, presents a
potential problem with creditors. Overtrading can come from considerable management skill,
but outside creditors must furnish more funds to carry on daily operations.
Undertrading is usually caused by management's poor use of investment money and their
general lack of ingenuity, skill or aggressiveness.
2
Tangible Net Worth = owner's equity - intangible assets

Gross Margin on Net Sales

Gross Margin3
= Gross Margin on Net Sales Ratio
Net Sales
By analyzing changes in this figure over several years, you can identify whether it is necessary
to examine company policies relating to credit extension, markups (or markdowns),
purchasing, or general merchandising (where applicable).
3
Gross Margin = net sales - cost of goods sold
Note: An increase in gross margin may result from higher sales, lower cost of goods sold, an
increase in the proportionate volume of higher margin products, or any combination of these
variables.

Operating Income to Net Sales Ratio

Operating Income
= Operating Income to Net Sales Ratio
Net Sales
This ratio reveals the profitability of sales resulting from regular business as well as buying,
selling, and manufacturing operations.
Note: Operating income derives from ordinary business operations and excludes other revenue
(losses), extraordinary items, interest on long-term obligations, and income taxes.

Acceptance Index

Applications Accepted
= Acceptance Index
Applications Submitted
Obviously, a high sales volume that comes from just two or three major accounts is much
riskier than the same volume coming from a large number of customers. Losing one out of
three major accounts is disastrous, while losing one out of 150 is routine. A growing firm
should try to spread this risk of dependency through active sales, promotion, and credit
departments. Although the quality of customers stems from your general management policy,
the quantity of newly opened accounts is a direct reflection on your sales and credit efforts.
Note: This index of effectiveness does not apply to every type of business.

Gross Profit on Net Sales

 Net Sales - Cost of Goods Sold =
Gross Profit on Net Sales Ratio
Net Sales
Does your average markup on goods normally cover your expenses, and therefore result in a
profit? This ratio will tell you. If your gross profit rate is continually lower than your average
margin, something is wrong! Be on the lookout for downward trends in your gross profit rate.
This is a sign of future problems for your bottom line.
Note: This percentage rate can—and will—vary greatly from business to business, even those
within the same industry. Sales, location, size of operations, and intensity of competition are
all factors that can affect the gross profit rate.

Net Operating Profit Rate Return

EBIT
= Net Operating Profit Rate of Return Ratio
Tangible Net Worth
Your Net Operating Profit Rate of Return ratio is influenced by the methods of financing you
utilize. Notice that this ratio employs earnings before interest and taxes, not earnings after
taxes. Profits are taken after interest is paid to creditors. A fallacy of omission occurs when
creditors support total assets.
Note: If financial charges are great, compute a net operating profit rate of return instead of
return on assets ratio. This can provide an important means of comparison.

Net Profit on Net Sales

EAT4
= Net Profit on Net Sales Ratio
Net Sales
This ratio provides a primary appraisal of net profits related to investment. Once your basic
expenses are covered, profits will rise disproportionately greater than sales above the break-
even point of operations.
EAT= earnings after taxes
4

Note: Sales expenses may be substituted out of profits for other costs to generate even more
sales and profits.
Understanding financial ratios is a key business skill for any business owner or
entrepreneur. Financial ratios illustrate the strengths and weaknesses of a business. By
examining ratios over time, a business owner can notice any unusual fluctuations in
financial ratios and can note how the business is performing over time. Ratios are also
helpful tools in financial analysis and forecasting; ratios allow entrepreneurs to set
specific goals and to easily track progress toward those goals.
It is important to choose financial ratios that are applicable to the business at hand.
There are hundreds of financial ratios available, some of which apply to all businesses
and some of which are industry-specific. Below are explanations of some of the most
common financial ratios.
Operating Margin = Operating Income / Net Sales
This ratio shows how much of a company’s revenue is left after paying off all operating
expenses, such as employee salaries and raw material costs. A low operating margin is
a sign that a business might not have enough revenue to pay off debt and other non-
operating costs.
Gross Margin = (Revenue – Cost of Goods Sold) / Revenue
Gross margin is a representation of how much revenue remains after a company pays
all of the direct costs associated with generating that revenue. The higher this ratio is,
the more revenue the company has to pay off other expenses.
ROE (Return on Equity) = Net Income / Shareholder’s Equity.
This ratio measures how much profit the shareholder’s investment has generated. A
higher ROE percentage indicates that shareholders are receiving a better return on their
investment.
ROA (Return on Assets) = Net Income / Total Assets.
This ratio measures how profitable a company is relative to its total assets. A high ROA
indicates that management is effectively utilizing the company’s assets to generate
profit.
Quick Ratio = (Current Assets – Inventories) / Current Liabilities
The quick ratio measures the liquidity of a company. The higher this ratio, the more
liquid assets a company has to meet immediate financial obligations.
Current Ratio = (Current Assets / Current Liabilities)
The current ratio is another measure of liquidity. The current ratio is a bit more
forward-looking than the quick ratio; unlike the quick ratio, the current ratio includes
inventories in current assets, because inventories can be sold over a short period of
time to generate cash.
ISCR (Interest-Service Coverage Ratio) = Net Operating Income / Interest
Expense
ISCR indicates how much cash a company has to pay interest on its debt. A high ISCR
ratio means that a company is well-prepared to pay its upcoming interest expenses.
DSCR (Debt-Service Coverage Ratio) = Net Operating Income / Total Debt
Service
DSCR measures the cash available to meet debt payments, including principal and
interest payments. In some cases, Operating Cash Flow is substituted for Net Operating
Income in the formula. A high DSCR ratio indicates that a company has enough cash
flow to cover debt obligations.
Debt to Equity Ratio = (Total Liabilities / Shareholder’s Equity)
This ratio indicates how levered a company is. A high debt to equity ratio illustrates that
a company is highly levered, or that it carries a lot of debt relative to shareholder’s
equity. The appropriate debt to equity ratio depends on a company’s industry and
financial health.
Receivables Collection Period = (Days x Accounts Receivable) / Credit Sales.
This ratio provides the average number of days that it takes for a company to receive
payments from customers. A lower number of days receivable indicates that a company
is efficiently managing its accounts receivable process.
Days Payable Outstanding = Accounts Payable / Cost of Sales x Number of
Days
This ratio indicates how long a company takes to pay suppliers and vendors. The
optimum number of days payable varies by company and by industry. Each company
wants to have flexible payment terms to allow liquidity but does not want to incur past-
due invoices and fees.
Inventory Turnover = 365 / (Cost of Goods Sold / Average Inventory)
This ratio shows how many days inventory a company has on hand. A high inventory
turnover indicates excess inventory and perhaps low sales. A low ratio might indicate
strong sales or the need to increase inventory levels.
Using these ratios is the first step to taking a deep look into the financials of a business.
Also, ratios may help you to justify decisions when you are buying or selling a business.
These figures can illuminate unforeseen problems in a company and can highlight
unexpected successes. Adding financial ratios into the financial planning process can be
an invaluable tool to improving business performance.