Financial analysis for strategy: from ratio to strategic choice

An installation company has grown from 25 to 40 staff in three years. Revenue is up, the order book is full, and still the business needs a larger credit line every year. That is the moment for a financial analysis that looks past revenue. Revenue shows size; return on capital shows whether growth creates value or eats it.

Financial analysis for strategy asks a different question from the year-end check by your accountant. The point is not whether the figures are correct, but what they say about your choices: which activities earn their keep, how much risk the business can carry and what growth will cost. Set against industry figures, each ratio shows whether a gap is a strength, a weakness or the price of a deliberate choice.

Which financial ratios matter for strategy?

Working capital is the cash tied up in stock and unpaid invoices, minus what you owe suppliers. Look at several years rather than one, and read the ratios together: a high margin with slow-moving capital can earn less than a thin margin with fast-moving capital.

Return first or growth first?

Bing Cao and Bin Jiang of McKinsey (March 2006) found a simple pattern: when a company's ROIC is already high, growth typically adds value; when ROIC is low, raising it creates more value than growing. Jiang (September 2007) adds that companies in the middle band need both. The reference point is the cost of capital: the return lenders and shareholders require on the money in the business, usually expressed as the weighted average cost of capital (WACC).

A business whose ROIC is below its cost of capital can report a profit and still lose value, because every extra euro invested earns less than it costs. In a small business, the cost of capital includes a fair return on the owner's own money: at least what it could earn elsewhere at similar risk.

DuPont analysis: margin times turnover

The DuPont analysis, named after the chemical company where it was developed, splits return into parts you can steer.

• Margin: price, mix and cost per job. Improve it with better pricing, a different mix or lower costs.
• Turnover: how hard the capital works. Improve it with fewer debtor days, less stock or better use of equipment.
• Gearing: how much is financed with debt. It raises return on equity in good years and risk in bad ones, and never improves ROIC itself.

Financial analysis example: an installation company against its industry

Meridian Climate Services has 40 staff and €6 million revenue. It installs heating, ventilation and heat pumps in new buildings for contractors, and services installations for building owners.

Fictitious Firmfocus example. The industry column is illustrative; look up the averages for your own sector. The logic works in any currency.

• Gross margin: project prices for contractors are under pressure and price rises on materials are not passed on.
• Staff costs: Meridian employs its own technicians instead of subcontractors. That raises staff costs but should also raise the gross margin. Since the gross margin is lower, the choice is not yet paying off. Check the accounting too: in some legal forms the owner's pay is a staff cost, in others it comes out of profit.
• Other costs: a strength, provided Meridian is not postponing spending on vans, tools or IT.
• Debtor days: 22 days above the industry on €6 million of revenue ties up about €362,000 of extra cash, and every additional €1 million of revenue adds about €197,000 of receivables. That is why growth keeps needing more credit.

Per activity: where is value created?

Fictitious Firmfocus example. Before tax, against a pre-tax cost of capital of 10%; invested capital is fixed assets plus working capital; turnover rounded.

Service creates the value; projects destroy it. Projects tie up a lot of capital in work in progress, retentions and slow-paying contractors, and earn a thin margin, so their return of 5.0% stays below the cost of capital. Because most of the growth came from projects, Meridian has become bigger and poorer at the same time. The priorities follow: grow service and maintenance contracts, select projects on margin and payment terms, and bring debtor days down. Cutting them from 72 to 50 frees about €362,000 of cash and lowers the capital charge by about €36,000 a year. The value chain shows which activities drive these differences.

Why your industry matters so much

Porter showed in Harvard Business Review (January 2008) that five competitive forces govern how an industry's profits are divided. McKinsey's research on the world's 2,393 largest companies puts a number on it: about 50 percent of a company's position on the economic-profit curve is driven by its industry (source: McKinsey, February 2018). The same authors put the odds of a company in the middle of the curve reaching the top fifth within ten years at about 8 percent (source: McKinsey, February 2018). They also warn against the hockey stick: a plan with a dip next year followed by confident growth.

For strategy this means that where you play matters as much as how you play, and that the industry average is the right first benchmark: it shows what is normal before you claim a strength. Firmfocus industry figures give European Union averages per NACE sector, and the profit and cost benchmark sets your own figures next to them.

Pitfalls when comparing with industry figures

• Different legal forms: the owner's pay booked as a staff cost in a company and taken from profit in a sole proprietorship. Correct for it before you compare.
• Before and after tax mixed: compare pre-tax returns with a pre-tax cost of capital, or both after tax.
• The wrong sector: a broad sector average hides different business models. Pick the closest sector code and know what it includes.
• One year only: a single good or bad year says little; look at three to five.
• Leasing versus buying: leased vans and premises make invested capital look smaller and ROIC higher.
• Averages as targets: the industry average is a reference point, not an ambition.

Small business or larger organisation

Financial analysis puts money on the findings of your internal analysis. Repeat the comparison regularly with benchmarking, and test each strategic option on its return when you evaluate and choose. All analysis tools are in strategic analysis, and the full theme is under Strategy.