CHAPTER 4EVALUATING A COMPANY’S RESOURCES, CAPABILITIES, AND

CHAPTER 4
EVALUATING A COMPANY’S RESOURCES,
CAPABILITIES, AND COMPETITIVENESS
Learn how to assess how well a company’s strategy is working.
Understand why a company’s resources and capabilities are
central to its strategic approach and how to evaluate their
potential for giving the company a competitive edge over rivals.
Discover how to assess the company’s strengths and weaknesses
in light of market opportunities and external threats.
Grasp how a company’s value chain activities can affect the
company’s cost structure and customer value proposition.
Understand how a comprehensive evaluation of a company’s
competitive situation can assist managers in making critical
decisions about their next strategic moves.
4–‹#›
EVALUATING A FIRM’S
INTERNAL SITUATION
How well is the firm’s present strategy working?
What are the firm’s competitively important resources and
capabilities?
Is the firm able to take advantage of market opportunities and
overcome external threats to its external well-being?
Are the firm’s prices and costs competitive with those of key
rivals, and does it have an appealing customer value
proposition?

Is the firm competitively stronger or weaker than key rivals?
What strategic issues and problems merit front-burner
managerial attention?
4–3
QUESTION 1: HOW WELL IS THE FIRM’S PRESENT
STRATEGY WORKING?
Best indicators of a well-conceived,
well-executed strategy:
The firm is achieving its stated financial and strategic
objectives.
The firm is an above-average industry performer.
4–4
FIGURE 4.1
Identifying the Components of a Single-Business Company’s
Strategy
4–5
SPECIFIC INDICATORS OF
STRATEGIC SUCCESS
Growth in firm’s sales and market share
Acquisition and retention of customers
Strengthening image and reputation with customers
Increasing profit margins, net profits and ROI

Growing financial strength and credit rating
Leadership in factors relevant to marketindustry success
Continuing improvement in key measures of operating
performance
4–6
Sluggish financial performance and second-rate market
accomplishments almost always signal weak strategy, weak
execution, or both.
4–7
STRATEGIC MANAGEMENT PRINCIPLE
Key Financial Ratios
TABLE 4.1
4–8
TABLE 4.1
4–9
TABLE 4.1

4–10
TABLE 4.1
4–11
QUESTION 2: WHAT ARE THE FIRM’S COMPETITIVELY
IMPORTANT RESOURCES AND CAPABILITIES?
Competitive Assets
Are the firm’s resources and capabilities.
Are the determinants of its competitiveness and ability to
succeed in the marketplace.
Are what a firm’s strategy depends on to develop sustainable
competitive advantage over its rivals.
4–12
A resource is a competitive asset that is owned or controlled by
a firm
A capability or competence is the capacity of a firm to perform
and internal activity competently through deployment of a
firm’s resources.
A firm’s resources and capabilities represent its competitive
assets and are big determinants of its competitiveness and
ability
to succeed in the marketplace.

4–13
CORE CONCEPTS
IDENTIFYING THE COMPANY’S RESOURCES AND
CAPABILITIES
A Resource
Is a productive input or competitive asset that is owned or
controlled by a firm (e.g., a fleet of oil tankers).
A Capability
Is the capacity of a firm to perform some activity proficiently
(e.g., superior skills in marketing).
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Resource and capability analysis is a powerful tool for sizing up
a company’s competitive assets and determining if they can
support a sustainable competitive advantage over market rivals.
4–15
Types of Company ResourcesTangible Resources Physical
resources Financial resources Technological assets
Organizational resourcesIntangible ResourcesHuman assets and
intellectual capitalBrands, company image, and reputational
assetsRelationships: alliances, joint ventures, or
partnershipsCompany culture and incentive system
TABLE 4.2
4–16

IDENTIFYING CAPABILITIES
An Organizational Capability
Is the intangible but observable capacity of a firm to perform a
critical activity proficiently using a related combination (cross -
functional bundle) of its resources.
Is knowledge-based, residing in people and in a firm’s
intellectual capital or in its organizational processes and
functional systems, which embody tacit knowledge.
4–17
A resource bundle is a linked and closely integrated set of
competitive assets centered around one or more cross-functional
capabilities.
The VRIN tests for sustainable competitive advantage ask if a
resource is Valuable, Rare, Inimitable, and Non-substitutable.
4–18
CORE CONCEPT
VRIN TESTING:
RESOURCES AND CAPABILITIES
Identifying the firm’s resources and capabilities by testing the
competitive power of its resources and capabilities:
Is the resource (or capability) competitively Valuable?
Is the resource Rare—is it something rivals lack?
Is the resource hard to copy (Inimitable)?
Is the resource invulnerable to the threat of substitution from

different types of resources and capabilities (Non-
substitutable)?
4–19
Social complexity (company culture, interpersonal relationships
among managers or R&D teams, trust-based relations with
customers or suppliers) and causal ambiguity are two factors
that inhibit the ability of rivals to imitate a firm’s most valuable
resources and capabilities.
Causal ambiguity makes it very hard to figure out how a
complex resource contributes to competitive advantage and
therefore
exactly what to imitate.
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CORE CONCEPTS
A company requires a dynamically evolving portfolio of
resources and capabilities to sustain its competitiveness and
help drive improvements in its performance.
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A dynamic capability is the ongoing capacity of a firm to
modify its existing resources and capabilities or create new ones
by:
Improving existing resources and capabilities incrementally
Adding new resources and capabilities

to the firm’s competitive asset portfolio
4–22
CORE CONCEPT
MANAGING RESOURCES AND CAPABILITIES
DYNAMICALLY
Threats to Resources and Capabilities:
Rivals providing better substitutes over time
Capabilities decaying from benign neglect
Disruptive competitive environment change
Managing Capabilities Dynamically
Attending to the ongoing modification
of existing competitive assets.
Taking advantage of any opportunities to develop totally new
kinds of capabilities.
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QUESTION 3: IS THE COMPANY ABLE TO SEIZE MARKET
OPPORTUNITIES AND NULLIFY EXTERNAL THREATS?
SWOT Analysis
Is a powerful tool for sizing up a firm’s:
Internal strengths (the basis for strategy)
Internal weaknesses (deficient capabilities)
Market opportunities (strategic objectives)
External threats (strategic defenses)
4–24

SWOT analysis is a simple but powerful tool for sizing up a
company’s strengths and weaknesses, its market opportunities,
and the external threats to its future well-being.
4–25
CORE CONCEPT
Basing a company’s strategy on its most competitively valuable
strengths gives the company its best chance for market success.
4–26
IDENTIFYING A COMPANY’S
INTERNAL STRENGTHS
A Competence
Is an activity that a firm has learned to perform with
proficiency—a capability.
A Core Competence
Is a proficiently performed internal activity that is central to a
firm’s strategy and competitiveness.
A Distinctive Competence
Is a competitively valuable activity that a firm performs better
than its rivals.
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A competence is an activity that a firm has learned to perform

with proficiency—a capability, in other words.
A core competence is an activity that a firm performs
proficiently that is also central to its strategy and competitive
success.
A distinctive competence is a competitively important activity
that a firm performs
better than its rivals—it thus represents
a competitively superior internal
strength.
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CORE CONCEPTS
IDENTIFYING A FIRM’S WEAKNESSES AND
COMPETITIVE DEFICIENCIES
A Weakness (Competitive Deficiency)
Is something a firm lacks or does poorly (in comparison to
others) or a condition that puts it
at a competitive disadvantage in the marketplace.
Types of Weaknesses:
Inferior skills, expertise, or intellectual capital
Deficiencies in physical, organizational, or intangible assets
Missing or competitively inferior capabilities
in key areas
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A firm’s strengths represent its competitive assets.
A firm’s weaknesses are shortcomings that constitute
competitive liabilities.
4–30

CORE CONCEPT
IDENTIFYING A COMPANY’S
MARKET OPPORTUNITIES
Characteristics of Market Opportunities:
An absolute “must pursue” market
Represents much potential but is hidden
in “fog of the future.”
A marginally interesting market
Presents high risk and questionable profit potential.
An unsuitablemismatched market
Is best avoided as the firm’s strengths are not matched to
market factors.
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A company is well advised to pass on a particular market
opportunity unless it has or can acquire the competencies
needed to capture it.
4–32
IDENTIFYING THE THREATS TO A FIRM’S FUTURE
PROFITABILITY
Types of Threats:
Normal course-of-business threats
Sudden-death (survival) threats
Considering Threats:
Identify the threats to the firm’s future prospects.

Evaluate what strategic actions can be taken to neutralize or
lessen their impact.
4–33
TABLE 4.3
What to Look for in Identifying a Firm’s Strengths,
Weaknesses, Opportunities, and Threats
4–34
TABLE 4.3
What to Look for in Identifying a Firm’s Strengths,
Weaknesses, Opportunities, and Threats (cont’d)
4–35
Simply making lists of a company’s strengths, weaknesses,
opportunities, and threats is not enough; the payoff from SWOT
analysis comes from the conclusions about a company’s
situation and the implications for strategy improvement that
flow from the four lists.
4–36

WHAT DO SWOT LISTINGS REVEAL?
SWOT Analysis Involves:
Drawing conclusions from the SWOT listings
about the firm’s overall situation.
Translating these conclusions into
strategic actions by the firm that:
Match its strategy to its internal strengths and
to market opportunities.
Correct important weaknesses and defend it
against external threats.
4–37
The Steps Involved in SWOT Analysis: Identify the Four
Components of SWOT, Draw Conclusions, Translate
Implications into Strategic Actions
FIGURE 4.2
4–38
USING SWOT ANALYSIS
What are the attractive aspects of the firm’s situation?
What aspects are of the most concern?
Are the firm’s internal strengths and competitive assets
sufficiently strong to enable it to compete successfully?
Are the firm’s weaknesses and competitive deficiencies
correctable, or could they be fatal if not remedied soon?
Do the firm’s strengths outweigh its weaknesses by an attractive
margin?
Does the firm have attractive market opportunities

that are well suited to its internal strengths?
Does the firm lack the competitive assets (internal strengths) to
pursue the most attractive opportunities?
Where on a scale of 1 to 10 (1 = weak and 10 = strong)
do the firm’s overall situation and future prospects rank?
4–39
QUESTION 4: ARE THE COMPANY’S COST
STRUCTURE AND CUSTOMER VALUE
PROPOSITION COMPETITIVE?
Signs of A Firm’s Competitive Strength:
Its prices and costs are in line with rivals.
Its customer-value proposition is competitive
and cost effective.
Its bundled capabilities are yielding
a sustainable competitive advantage.
4–40
The higher a company’s costs are above those of close rivals,
the more competitively vulnerable it becomes.
Conversely, the greater the amount of customer value that a
company can offer profitably relative to close rivals, the less
competitively vulnerable it becomes.
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THE CONCEPT OF A COMPANY
VALUE CHAIN
The Value Chain

Identifies the primary internal activities that create
and deliver customer value and the requisite related support
activities.
Permits a deep look at the firm’s cost structure and ability to
offer low prices.
Reveals the emphasis that a firm places on activities that
enhance differentiation and support higher prices.
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A company’s value chain identifies the primary activities and
related support activities that create customer value.
4–43
CORE CONCEPT
A Representative Company Value Chain
FIGURE 4.3
4–44
COMPARING THE VALUE CHAINS
OF RIVAL FIRMS
Value Chain Analysis
Facilitates a comparison, activity-by-activity, of how
effectively and efficiently a firm delivers value to its customers,
relative to its competitors.
The Value Chain Analysis Process:

Segregate the firm’s operations into different types of primary
and secondary activities to identify the major components of its
internal cost structure.
Use activity-based costing to evaluate the activities.
Do the same for significant competitors.
4–45
A company’s cost competitiveness depends not only on the
costs of internally performed activities (its own value chain) but
also on costs in the value chains of its suppliers and distribution
channel allies.
4–46
VALUE CHAIN SYSTEM FOR
AN ENTIRE INDUSTRY
Industry Value Chain:
The firm’s internal value chain
The value chains of industry suppliers
The value chains of channel intermediaries
Effects of the Industry Value Chain:
Costs and margins of suppliers and channel partners can affect
prices to end consumers.
Activities of channel partners can affect industry sales volumes
and customer satisfaction.
4–47

A Representative Value Chain System
FIGURE 4.4
4–48
ILLUSTRATION CAPSULE 4.1
The Value Chain for KP MacLane,
a producer of Polo Shirts
4–49
Which activities in the value chain are primary activities?
Which are secondary activities?
Which activities are linked to the value chain for the entire
industry?
How could activity cost(s) could be reduced without harming
the competitive strength of KP MacLane?
The Value Chain for KP MacLane,
a producer of Polo Shirts
4–50
A company’s cost competitiveness depends not only on the
costs of internally performed activities (its own value chain) but
also on costs in the value chains of its suppliers and distribution

channel allies.
4–51
Benchmarking is a potent tool for improving a company’s own
internal activities that is based on learning how other companies
perform them and borrowing their “best practices.”
4–52
CORE CONCEPT
BENCHMARKING AND
VALUE CHAIN ACTIVITIES
Benchmarking:
Involves improving a firm’s internal activities based on learning
other companies’ “best practices.”
Assesses whether the cost competitiveness and effectiveness of
a firm’s value chain activities are
in line with its competitors’ activities.
Sources of Benchmarking Information
Reports, trade groups, analysts and customers
Visits to benchmark companies
Data from consulting firms
4–53
Benchmarking the costs of company activities against rivals
provides hard evidence of whether a company is cost-
competitive.

4–54
Benchmarking and Ethical Conduct
Avoid discussions or actions that could lead to or imply an
interest in restraint of trade, market and/or customer allocation
schemes, price fixing, dealing arrangements, bid rigging, or
bribery. Don’t discuss costs with competitors if costs are an
element of pricing.
Refrain from the acquisition of trade secrets from another by
any means that could be interpreted as improper, including the
breach of any duty to maintain secrecy. Do not disclose or use
any trade secret that may have been obtained through improper
means or that was disclosed by another in violation of duty to
maintain its secrecy or limit its use.
Be willing to provide to your benchmarking partner the same
type and level of information that you request from that partner.
Communicate fully and early in the relationship to clarify
expectations, avoid misunderstanding, and establish mutual
interest in the benchmarking exchange.
Be honest and complete with the information submitted.
The use or communication of a benchmarking partner’s name
with the data obtained or practices observed requires the prior
permission of the benchmarking partner.
Honor the wishes of benchmarking partners regarding how the
information that is provided will be handled and used.
In benchmarking with competitors, establish specific ground
rules up-front. For example, “We don’t want to talk about
things that will give either of us a competitive advantage, but
rather we want to see where we both can mutually improve or
gain benefit.”
Check with legal counsel if any information-gathering

procedure is in doubt. If uncomfortable, do not proceed.
Alternatively, negotiate and sign a specific nondisclosure
agreement that will satisfy the attorneys representing each
partner.
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STRATEGIC OPTIONS FOR REMEDYING
A COST OR VALUE DISADVANTAGE
Places in the total value chain system for a firm to look for
ways to improve its efficiency and effectiveness:
The firm’s own internal activity segments
The suppliers’ part of the overall value chain system
The forward channel portion of the value chain system.
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IMPROVING INTERNALLY PERFORMED VALUE CHAIN
ACTIVITIES
Implement best practices throughout the firm, particularly for
high-cost activities.
Eliminate some cost-producing activities altogether by
revamping the value chain.
Relocate high-cost activities to areas where they can be
performed more cheaply.
Outsource activities that can be performed by vendors or
contractors more cheaply than if done in-house.
Invest in productivity enhancing, cost-saving technological
improvements.
Find ways to detour around activities or items where costs are
high.
Redesign products and/or components to facilitate speedier and

more economical manufacture or assembly.
4–57
IMPROVING THE EFFECTIVENESS OF THE CUSTOMER
VALUE PROPOSITION AND ENHANCING
DIFFERENTIATION
Implement best practices for quality for high-value activities.
Adopt best practices and technologies that spur innovation,
improve design, and enhance creativity.
Implement the best practices in providing customer service.
Reallocate resources to activities having the most impact on
value for the customer and their most important purchase
criteria.
For intermediate buyers, gain an understanding of how the
activities the firm performs impact the buyer’s value chain.
Adopt best practices for marketing, brand management, and
enhancing customer perceptions.
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IMPROVING SUPPLIER-RELATED
VALUE CHAIN ACTIVITIES
Pressure suppliers for lower prices.
Switch to lower-priced substitute inputs.
Collaborate closely with suppliers to identify mutual cost-
saving opportunities.
Work with suppliers to enhance the firm’s differentiation.
Select and retain suppliers who meet higher-quality standards.
Coordinate with suppliers to enhance design or other features
desired by customers.
Provide incentives to suppliers to meet higher-quality standards,

and assist suppliers in their efforts to improve.
4–59
IMPROVING VALUE CHAIN ACTIVITIES OF FORWARD
CHANNEL ALLIES
Achieving Cost-Based Competitiveness:
Pressure forward channel allies to reduce their costs and
markups so as to make the final price to buyers more
competitive.
Collaborate with forward channel allies to identify win-win
opportunities to reduce costs.
Change to a more economical distribution strategy, including
switching to cheaper distribution channels.
4–60
ENHANCING DIFFERENTIATION THROUGH ACTIVITIES
AT THE FORWARD END OF THE VALUE CHAIN SYSTEM
Enhancing Differentiation:
Engage in cooperative advertising and promotions with forward
channel allies.
Use exclusive arrangements with downstream sellers or other
mechanisms that increase their incentives to enhance delivered
customer value.
Create and enforce standards for downstream activities and
assist in training channel partners in business practices.
4–61

Performing value chain activities with capabilities that permit
the company to either outmatch rivals on differentiation or beat
them on costs will give the company a competitive advantage.
4–62
Translating Company Performance of Value Chain Activities
into Competitive Advantage
FIGURE 4.5
4–63
Translating Company Performance of Value Chain Activities
into Competitive Advantage (cont’d)
FIGURE 4.5
4–64
QUESTION 5: IS THE FIRM COMPETITIVELY STRONGER
OR WEAKER THAN KEY RIVALS?
Assessing the firm’s overall competitive strength:
How does the firm rank relative to competitors on each of the
important factors that determine market success?
Does the firm have a net competitive advantage or disadvantage
versus major competitors?

4–65
High-weighted competitive strength ratings signal a strong
competitive position and possession of competitive advantage;
low ratings signal a weak position and competitive
disadvantage.
4–66
THE COMPETITIVE STRENGTH ASSESSMENT PROCESS
Step 1
Make a list of the industry’s key success factors and measures
of competitive strength or weakness (6 to 10 measures usually
suffice).
Step 2
Assign a weight to each competitive strength measure based on
its perceived importance.
Step 3
Rate the firm and its rivals on each competitive strength
measure and multiply by each measure by its corresponding
weight.
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A Representative Weighted Competitive Strength Assessment
TABLE 4.4
4–68

A company’s competitive strength scores pinpoint its strengths
and weaknesses against rivals and point directly to the kinds of
offensive/defensive actions it can use to exploit its competitive
strengths and reduce its competitive vulnerabilities.
4–69
STRATEGIC IMPLICATIONS OF COMPETITIVE STRENGTH
ASSESSMENT
The higher a firm’s overall weighted strength rating, the
stronger its overall competitiveness versus rivals.
The rating score indicates the total net competitive advantage
for a firm relative to other firms.
Firms with high competitive strength scores are targets for
benchmarking.
The ratings show how a firm compares against rivals, factor by
factor (or capability by capability).
Strength scores can be useful in deciding what strategic moves
to make.
4–70
A good strategy must contain ways to deal with all the strategic
issues and obstacles that stand in the way of the company’s
financial and competitive success in the years ahead.
4–71

QUESTION 6: WHAT STRATEGIC ISSUES
AND PROBLEMS MERIT FRONT-BURNER MANAGERIAL
ATTENTION?
Strategic “How To” Issues:
How to meet challenges of new foreign competitors.
How to combat the price discounting of rivals.
How to both reduce high costs and prepare for price reductions.
How to sustain growth as buyer demand slows.
How to adapt to the changing demographics of the firm’s
customer base.
4–72
QUESTION 6: WHAT STRATEGIC ISSUES
AND PROBLEMS MERIT FRONT-BURNER MANAGERIAL
ATTENTION?
Strategic “Should We” Issues:
Expand rapidly or cautiously into foreign markets.
Reposition the firm to move to a different strategic group.
Counter increasing buyer interest in substitute products.
Expand of the firm’s product line.
Correct the firm’s competitive deficiencies by acquiring a rival
firm with the missing strengths.
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Zeroing in on the strategic issues a company faces and
compiling a list of problems and roadblocks creates a strategic

agenda of problems that merit prompt managerial attention.
4–74
Principles of Research and Evidence-Based Practice
It is significant for nurses to keep in mind that the belief of a
patient and the circumstances are important, and they should
consider them as they offer treatment services to them.
Evidence-based practice ensures they incorporate the patient's
preferences (Saunders et al. 2019). The principle of evidence -
based practice is composed of six stages: to start, the nurse has
to develop the clinical question and then examine the suitable
indication resent. From this point, the nursing team will
critically analyze the identified evidence to determine its
validity and worth (Horntvedt et al., 2018). The nurses will
incorporate the clinical specialists together with the patient's
preferences. Individual performance evaluation will follow, and
finally, the team will convey the knowledge (Boswell & Cannon
2022). The nursing team also targets practical bases for more
research from medical practices through offering education
services.
The following are ways to implement evidence-based practices
effectively:
Nurses should develop patient-centered objectives. In executing
the evidence-based practices, health care nurses ought to outline
goals about the outcome for the patients. For instance, in a case
where the nurses want to minimize the period of inpatient, the
nurses should then come up with strategies to hasten the
patient's recovery instead of reducing the length of time the
patient is to spend in the hospital. Secondly, for the nurses to
implement evidence-based practices, they need to consider the
resources available in the healthcare organization (Boswell &
Cannon 2022). The EBP can only transform as long as the

healthcare organization can provide the necessary resources.
If the organization does not have the resources and does not
stand in a position to get the resources, the nurses may fail to
implement the EBP. The nurses should identify their
preferences before considering whether they will adopt a
specific evidence-based practice in their health center (Saunders
et al., 2019). Thus, after determining a certain EBP, the nurses
should then turn to their head provider of the program to
enquire if they also like the practice to be implemented. From
this kind of communication and understanding, the team will
develop strategies to offer evidence-based practice (Saunders et
al., 2019). Before implementing the EBP, the nursing practice
team should first look into the data in their record since the data
behind the EBP may not translate to the implementation in some
health centers.
References
Boswell, C., & Cannon, S. (2022). Introduction to nursing
research: Incorporating evidence-based practice. Jones &
Bartlett Learning.
Horntvedt, M. E. T., Nordsteien, A., Fermann, T., &
Severinsson, E. (2018). Strategies for teaching evidence-based
practice in nursing education: a thematic literature review. BMC
medical education, 18(1), 1-11.
Li, S. A., Jeffs, L., Barwick, M., & Stevens, B. (2018).
Organizational contextual features that influence the
implementation of evidence-based practices across healthcare
settings: a systematic integrative review. Systematic reviews,
7(1), 1-19.
Saunders, H., Gallagher‐ Ford, L., Kvist, T., &
Vehviläinen‐ Julkunen, K. (2019). Practicing healthcare
professionals’ evidence‐ based practice competencies: An
overview of systematic reviews. Worldviews on
Evidence‐ Based Nursing, 16(3), 176-185.

P U R D U E E XT E N S I O N
EC-722
Industry Analysis: The Five Forces
Cole Ehmke, Joan Fulton, and Jay Akridge
Department of Agricultural Economics
Kathleen Erickson, Erickson Communications
Sally Linton
Department of Food Science
Overview
Assessing Your Marketplace
The economic structure of an industry is not an accident.
Its complexities are the result of long-term social trends and
economic forces. But its effects on you as a business manager
are immediate because it determines the competitive rules
and strategies you are likely to use. Learning about that
structure will provide essential insight for your business
strategy.
Michael Porter has identified five forces that are widely used to
assess the structure of any industry. Porter’s five forces are the:
• Bargaining power of suppliers,
• Bargaining power of buyers,
• Threat of new entrants,
• Threat of substitutes, and

• Rivalry among competitors.
Together, the strength of the five forces determines the profit
potential in an industry by influencing the prices, costs, and
required investments of businesses—the elements of return
on investment. Stronger forces are associated with a more
challenging business environment. To identify the important
structural features of your industry via the five forces, you
conduct an industry analysis that answers the question,
“What are the key factors for competitive success?”
Using This Publication
This publication describes five forces that influence an
industry. The publication includes a set of application
questions that will help you evaluate the structure of the
industry you are in or are considering entering. The more you
understand about the strength of each force, the better able
you will be to respond.
The forces affecting profitability are often beyond your
control, so you must choose tactics to respond to the forces
rather than try to change the business environment. This
publication offers insight on specific tactics you need for
success when facing competitive situations. While you may
assess any one force individually, you will gain the most value
by assessing all five of the forces
With each force, a “Perspective” feature illustrates the force
for an Indiana wine entrepreneur by evaluating that market-
place. To avoid repetition, we use the word “product” to mean
either a product or a service. Read more about the five forces
in Porter’s book, Competitive Strategy.
Audience: Business managers seeking to assess
the nature of their marketplace

Content: Presents five forces that influence the
profitability of an industry
Outcome: Reader should understand the forces
and be able to counter them with appropriate
tactics
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2 Purdue Extension • Knowledge to Go
Bargaining Power of Suppliers
How Much Power Do Your
Suppliers Have Over You?
Any business requires inputs—labor, parts, raw materials,
and services. The cost of your inputs can have a significant
effect on your company’s profitability. Whether the strength of
suppliers represents a weak or a strong force hinges on the
amount of bargaining power they can exert and, ultimately,
on how they can influence the terms and conditions of
transactions in their favor. Suppliers would prefer to sell to
you at the highest price possible or provide you with no more
services than necessary. If the force is weak, then you may be
able to negotiate a favorable business deal for yourself.
Conversely, if the force is strong, then you are in a weak
position and may have to pay a higher price or accept a lower
level of quality or service.
Factors Affecting the
Bargaining Power of Suppliers

Suppliers have the most power when:
• The input(s) you require are available only from a
small number of suppliers. For instance, if you are
making computers and need microprocessors, you will
have little or no bargaining power with Intel, the
world’s dominant supplier.
• The inputs you require are unique, making it costly to
switch suppliers. If you use a certain enzyme in a food
manufacturing process, changing to another supplier
may require you to change your entire manufacturing
process. This may be very costly to you, thus you will
have less bargaining power with your supplier.
• Your input purchases don’t represent a significant
portion of the supplier’s business. If the supplier does
not depend on your business, you will have less power
to negotiate. Of course the opposite is true as well.
Wal-Mart has significant negotiating power over its
suppliers because it is such a large percentage of
suppliers’ business.
• Suppliers can sell directly to your customers,
bypassing the need for your business. For example, a
manufacturer could open its own retail outlet and
compete against you.
• It is difficult for you to switch to another supplier. For
example, if you recently invested in a unique
inventory and information management system to
work effectively with your supplier, it would be
expensive for you to switch suppliers.
• You do not have a full understanding of your
supplier’s market. You are less able to negotiate if you

have little information about market demand, prices,
and supplier’s costs.
Reducing the Bargaining Power of
Suppliers
Most businesses don’t have the resources to produce their own
inputs. If you are in this position, then you might consider
forming a partnership with your supplier. This can result in a
more even distribution of power. For instance, Dell Computer
uses partnering with its components suppliers as a key
strategy to be the low-cost/high-quality leader in the market.
This can be mutually beneficial for both supplier and buyer if
they can:
• Reduce inventory costs by providing just-in-time
deliveries,
• Enhance the value of goods and services supplied by
making effective use of information about customer
needs and preferences, and
• Speed the adoption of new technologies.
Another option may be to increase your power by forming a
buying group of small producers to buy as one large-volume
customer. If you have the resources, you may choose to
integrate back and produce your own inputs by purchasing
one of your key suppliers or doing the production yourself.
1. Are there a large number of potential input
suppliers? The greater number of suppliers of
your needed inputs, the more control you will

have.
2. Are the products that you need to purchase
for your business ordinary? You have more
control when the products you need from a
supplier are not unique.
3. Do your purchases from suppliers represent a
large portion of their business? If your
purchases are a relatively large portion of
your supplier’s business, you will have more
power to lower costs or improve product
features.
YES NOYES NO
YES NO
YES NO
YES NO
YES NO
4. Would it be difficult for your suppliers to
enter your business, sell directly to your
customers, and become your direct
competitor? The easier it is to start a new
business, the more likely it is that you will
have competitors.
5. Can you easily switch to substitute products
from other suppliers? If it is relatively easy to
switch to substitute products, you will have
more negotiating room with your suppliers.

6. Are you well informed about your supplier’s
product and market? If the market is
complicated or hard to understand, you have
less bargaining power with your suppliers.
Self Assessment—Bargaining Power of Suppliers
This i
“Yes” or “No” in the space provided. “Yes” indicates a
favorable competitive environment for your business. “No”
indicates a
negative situation. Use the insight you gain to develop effective
tactics for countering or taking advantage of the situation.
Perspective on Bargaining Power of Suppliers
For an Indiana winery, one of the main supply decisions lies
with the key product ingredients—winegrapes and juice.
Wineries have several options, including owning the
vineyard, purchasing grapes, or purchasing juice. An
overabundance of winegrapes and juice from the West Coast
of the U.S., for instance, enhances Indiana wineries’
negotiating power with grape and juice suppliers. However,
the bargaining power of Indiana wineries is generally
weakened due to lack of winegrape growing experience.
If the winery needs a specific grape variety for a particular
wine, then the manager needs to be concerned about the
supply and demand for the product. As supply becomes
short, the manager will find that suppliers have increasing
bargaining power.
Raw materials for wine production are commodity items that
are very cyclical in price, quality, and availability. There are
times when high-quality grapes can be bought for low prices
(over supply) and other times when particular grape varieties

or juice are almost non-existent. This can have a
significant effect on a winery. And it is something the
manager has no control over. For example, if a late spring
frost hits the New York vineyards, the tender varieties will
not produce enough grapes to satisfy demand for the year.
Small wineries are particularly challenged because they
do not have the leverage associated with volume that the
larger wineries have. As a result, the force of suppliers on
a small winery can be viewed as relatively strong.
However, a manager of an Indiana winery could decrease
the effect by cooperating with other small players to
make collective purchases.
Contracts and positive relationships with suppliers and
producers are another way a small winery can manage
the uncertainty and power of suppliers. Recognizing the
power of suppliers and the influence of outside factors
(e.g., knowledge and weather) is an important
consideration as a small winery finds a place in the market.
Many small customers acting as a group can create a strong
force. For instance, because of their size, health maintenance
organizations (HMOs) can purchase health care from
hospitals and doctors at much lower cost than can individual
patients.
Note that not all buyers will have the same degree of bargain-
ing power with you or be as sensitive to price, quantity, or
service. For example, apparel makers face significant buyer
power when selling to large retailers like Wal-Mart or
department stores, but face a much more favorable situation

when selling to smaller specialty shops.
Factors Influencing the
Bargaining Power of Buyers
Buyers have more power when:
• Your industry has many small companies supplying
the product and buyers are few and large. For
example, you may have little negotiating power if you
and several competing companies are trying to sell
similar products to one large buyer.
• The products represent a relatively large expense for
your customers. Customers may not price shop for a
quart of oil, but they will price shop if purchasing a
new vehicle.
Bargaining Power of Buyers
How Much Negotiating Power Do
Your Buyers Have?
The power of buyers describes the effect that your customers
have on the profitability of your business. The transaction
between the seller and the buyer creates value for both parties.
But if buyers (who may be distributors, consumers, or other
manufacturers) have more economic power, your ability to
capture a high proportion of the value created will decrease,
and you will earn lower profits.
How Much Power Do Your Buyers
Have Over You?
Buyers have the most power when they are large and purchase
much of your output. If your business sells to a few large
buyers, they will have significant leverage to negotiate lower
prices and other favorable terms because the threat of losing
an important buyer puts you in a weak position. Buyers also

have power if they can play suppliers against each other. In
the automotive supply industry, the large car manufacturers
have significant power. There are only a few large buyers, and
they buy in large quantities. But, when there are many
smaller buyers, you will have greater control because each
buyer is a small portion of your sales.
List the major inputs
needed for your business.
For each input,
list possible suppliers.
How can you best work with this supplier
to maximize your bargaining power?
1.
2.
3.
4.
5.
Further Assessment
Using a pencil and sheet of paper, examine in greater detail how
the bargaining power of suppliers will affect your business.
• Customers have access to and are able to evaluate
market information. You have less room for

negotiation if buyers know market demand, prices,
and your costs.
• Your product is not unique and can be purchased
from other suppliers. If your brand is homogenous or
similar to all of the others, buyers will base their
decision mainly on price.
• Customers could possibly make your product
themselves. Anheuser-Busch, Coors, and Heinz are
examples of companies that have integrated back into
metal can manufacturing to fill the balance of their
container needs.
• Customers can easily, and with little cost, switch to
another product. For example, IBM customers might
switch to Gateway or Dell, but it may be inconvenient
for them to consider Macintosh.
Reducing the Bargaining Power of
Buyers
You can reduce the bargaining power of your customers by
increasing their loyalty to your business through partnerships
or loyalty programs, selling directly to consumers, or increas-
ing the inherent or perceived value of a product by adding
features or branding. In addition, if you can select the
customers who have little knowledge of the market and have
less power, you can enhance your profitability.
Perspective on Bargaining Power of Buyers
Indiana wineries have three types of buyers—direct
consumers, wholesalers, and retail outlets. Direct
consumers are mostly tourists out for the day, weekend, or
even a weeklong vacation. In this situation, competition for
those buyers is actually any travel destination in the area

competing for their leisure time. Would the buyers rather
visit a state park or a museum than a winery? A winery
can reduce the bargaining power of these customers by
offering unique products and events that offer high value.
Wholesalers have a significant amount of bargaining power
because they are few in number and have a considerable
influence over the wines that are sold on the retail shelf.
Thus, the bargaining power of small wineries is weak
compared to that of the wholesalers. In Indiana,
counteracting legislation allows small wineries to sell
directly to retail outlets without using a wholesaler.
While the bargaining power of one of these wineries
with retail outlets is still weak, the winery has the
benefit of offering a local Indiana product that is in
demand with consumers.
Overall for Indiana wineries, buyers have more power
than the entrepreneurs. This is due to the fact that direct
consumers have multiple options for entertainment, and
wholesalers and retail outlets have thousands of wine
brands to choose from. Therefore, a small winery owner
must be creative in dealings with consumers, usually by
offering loyalty programs and increasing perceived value.
List the types of customers that
you have or expect to have.
What alternatives might these
customers have for your product?

How can you build loyalty for your product
or service to reduce customer bargaining power?
1.
2.
3.
4.
5.
Further Assessment
the bargaining power of buyers will affect your business.
Self Assessment—Bargaining Power of Buyers
Thi
respond with “Yes” or “No” in the space provided. “Yes”
indicates a favorable competitive environment for your
business. “No” indicates
a negative situation. Use the insight you gain to develop
effective tactics for countering or taking advantage of the
situation.
1. Do you have enough customers such that
losing one isn’t critical to your success? The
smaller the number of customers, the more
dependent you are on each one of them.
2. Does your product represent a small expense
for your customers? If your product is a
relatively large expense for your customers,
they’ll expend more effort negotiating with
you to lower price or improve product

features.
3. Are customers uninformed about your
product and market? If your market is
complicated or hard to understand, buyers
have less control.
YES NO
YES NO
YES NO
4. Is your product unique? If your product is
homogenous or the same as your competitors’,
buyers have more bargaining power.
5. Would it be difficult for buyers to integrate
backward in the supply chain, purchase a
competitor providing the products you provide,
and compete directly with you? The less likely
a customer will enter your industry, the more
bargaining power you have.
6. Is it difficult for customers to switch from
your product to your competitors’ products?
If it is relatively easy for your customers to
switch, you will have less negotiating power
with your customers.
YES NO
YES NO
YES NO

Threat of New Entrants
How Easy Is It for Businesses to
Enter Your Market?
You may have the market cornered with your product, but
your success may inspire others to enter the business and
challenge your position. The threat of new entrants is the
possibility that new firms will enter the industry. New entrants
bring a desire to gain market share and often have significant
resources. Their presence may force prices down and put
pressure on profits.
Analyzing the threat of new entrants involves examining the
barriers to entry and the expected reactions of existing firms
to a new competitor. Barriers to entry are the costs and/or
legal requirements needed to enter a market. These barriers
protect the companies already in business by being a hurdle
to those trying to enter the market. In addition to up-front
barriers, a new competitor may inspire established companies
to react with tactics to deter entry, such as lowering prices or
forming partnerships. The chance of reaction is high in
markets where firms have a history of retaliation, excess cash,
are committed to the industry (see Rivalry Among Competitors),
or the industry has slow growth.
Unique Barriers
Entry barriers are unique for each industry and situation,
and can change over time. Most barriers stem from irrevers-
ible resource commitments you must make in order to enter
a market. For example, if the existing businesses have well -
established brand names and fully differentiated products,
as a potential market entrant you will need to undertake an
expensive marketing campaign to introduce your products.

Barriers to entry are usually higher for companies involved
in manufacturing than for companies that provide a service
because there is often a significant expense in setting up a
production facility.
Another type of entry barrier is regulatory. To produce organic
food there is a three-year wait before land may be certified.
During the waiting period, producers must raise the crop as
organic, but may not market it as organic until the three-year
“cleansing process” of the land is completed.
Overcoming barriers to entry may involve expending signifi -
cant resources over an extended period of time. Industries
based on patentable technology may require an especially
long-term commitment, with years of research and testing,
before products can be introduced and compete.
Factors Affecting the Threat of
New Entrants
The threat of new entrants is greatest when:
• Processes are not protected by regulations or patents.
In contrast, when licenses and permits are required to
do business, such as with the liquor industry, existing
firms enjoy some protection from new entrants.
• Customers have little brand loyalty. Without strong
brand loyalty, a potential competitor has to spend
little to overcome the advertising and service
programs of existing firms and is more likely to enter
the industry.
• Start-up costs are low for new businesses entering the
industry. The less commitment needed in advertising,
research and development, and capital assets, the
greater the chance of new entrants to the industry.

• The products provided are not unique. When the
products are commodities and the assets used to
produce them are common, firms are more willing to
enter an industry because they know they can easily
liquidate their inventory and assets if the venture fails.
• Switching costs are low. In situations where customers
do not face significant one-time costs from switching
suppliers, it is more attractive for new firms to enter
the industry and lure the customers away from their
previous suppliers.
• The production process is easily learned. Just as
competitors may be scared away when the learning
curve is steep, competitors will be attracted to an
industry where the production process is easily
learned.
• Access to inputs is easy. Entry by new firms is easier
when established firms do not have favorable access to
raw materials, locations, or government subsidies.
• Access to customers is easy. For instance, it may be
easy to rent space to sell produce at a farmer’s market,
but nearly impossible to get shelf space in a grocery store.
You are more likely to find new entrants in the food
business using the farmer’s market distribution system
over grocery stores.
• Economies of scale are minimal. If there is little
improvement in efficiency as scale (or size) increases,

a firm entering a market won’t be at a disadvantage if
it doesn’t produce the large volume that an existing
firm produces.
Reducing the Threat of
New Entrants
Enhancing your marketing/brand image, utilizing patents,
and creating alliances with associated products can minimize
the threat of new entrants. Important tactics you can follow
include demonstrating your ability and desire to retaliate to
potential entrants and setting a product price that deters entry.
Because competitors may enter the industry if there are excess
profits, setting a price that earns positive but not excessive
profits could lessen the threat of new entry in your industry.
Perspective on Threat of New Entrants
The threat of new entrants has a unique twist in the
winery business. A winery is not an easy business to start
because it is capital intensive and market entry can take
multiple years due to licensing requirements and initial
production time for vineyards and wine. A strong
knowledge base is also required in order to make high-
quality wine and understand the complexities of the
industry. Thus, there are significant barriers to entry.
However, in at least one respect, competitors are
complementary for Indiana wineries. When several
wineries exist in close proximity, it becomes beneficial
for all wineries involved. People may not travel an hour
from home to visit only one winery, but they would view
the trip as worthwhile if they had the opportunity to visit
four wineries. This clustering effect enhances the
attractiveness and profitability of all wineries involved.

Barriers to entry in the local wine market are high due to
capital investments, licensing, and knowledge
requirements. However, having competition close to a
business does not necessarily have a negative effect on
the bottom line. Therefore, some industries may actually
encourage and support new entrants up to a point.
1. How would a new entrant
affect your business?
Further Assessment
the threat of new entrants might affect your business.
2. What will your competitors
do if there is a new entrant
into your marketplace?
3. How will you respond to a
new competitor?
Self Assessment—Threat of New Entrants
Th
1. Do you have a unique process that has been
protected? For example, if you are a
technology-based company with patent
protection for your research investments, you

enjoy some barriers to entry.
2. Are customers loyal to your brand? If your
customers are loyal to your brand, a new
product, even if identical, would face a
formidable battle to win over loyal customers.
3. Are there high start-up costs for your
business? The greater the capital
requirements, the lower the threat of
new competition.
4. Are the assets needed to run your business
unique? Others will be more reluctant to
enter the market if the technology or
equipment cannot be converted into other
uses if the venture fails.
YES NO
YES NO
YES NO
5. Is there a process or procedure critical to your
business? The more difficult it is to learn the
business, the greater the entry barrier.
6. Will a new competitor have difficulty
acquiring/obtaining needed inputs? Current
distribution channels may make it difficult
for a new business to acquire/obtain inputs
as readily as existing businesses.
7. Will a new competitor have any difficulty
acquiring/obtaining customers? If current

distribution channels make it difficult for a
new business to acquire/obtain new customers,
you will enjoy a barrier to entry.
8. Would it be difficult for a new entrant to have
enough resources to compete efficiently? For
every product, there is a cost-efficient level of
production. If challengers can’t achieve that
level of production, they won’t be competitive
and therefore won’t enter the industry.
YES NO
YES NO
YES NO
YES NO
YES NO
Threat of Substitutes
What Products Could Your
Customers Buy Instead of Yours?
Products from one business can be replaced by products from
another. If you produce a commodity product that is undiffer -
entiated, customers can easily switch away from your product
to a competitor’s product with few consequences. In contrast,
there may be a distinct penalty for switching if your product is
unique or essential for your customer’s business. Substitute
products are those that can fulfill a similar need to the one

your product fills.
As an example, a family restaurant may prefer to buy the
packaged poultry produced at your plant, but if given a better
deal, they may go to another poultry supplier. If you grow
free-range organically grown chickens, though, and you are
selling to upscale restaurants, they may have few substitutes
for the product that you are providing.
Substitutes Can Come in
Many Forms
Be aware that substitute products can come in many shapes
and sizes, and do not always come from traditional competi-
tors. Pork and chicken can substitute in consumer diets for
beef or lamb. Aluminum beverage cans battle in the market
against glass bottles and plastic containers. Cotton competes
with polyester from the petroleum industry. Barnes and Noble
retail bookstores compete with Internet retailer Amazon.
Postal services compete with e-mail and fax machines.
When developing a business plan, it is critical to assess the
other options your customers have to satisfy their needs. To do
this, look for products that serve the same function as yours. A
threat exists if there are alternative products with lower prices
or better performance or both.
How Substitutes Affect the
Marketplace
Substitutes essentially place a price ceiling on products.
Market analysts often talk about “wheat capping corn.” This
occurs because wheat and corn are substitutes in animal feed.
If wheat prices are low, corn prices will also be low, because,
as corn prices rise, livestock feeders will quickly shift to wheat
to keep ration costs low. This reduces the demand and
ultimately the price of corn.

It’s more difficult for a firm to try to raise prices and make
greater profits if there are close substitutes and switching costs
are low. But, in some cases, customers may be reluctant to
switch to another product even if it offers an advantage.
Customers may consider it inconvenient or even risky to change
if they are accustomed to using a certain product in a certain
way, or they are used to the way certain services are delivered.
Factors Affecting the Threat of
Substitution
Substitutes are a greater threat when:
• Your product doesn’t offer any real benefit
compared to other products. What will hold your
customers if they can get an identical product from
your competitor?
• It is easy for customers to switch. A grocer can easily
switch from paper to plastic bags for its customers,
but a bottler may have to reconfigure its equipment
and retrain its workers if it switches from aluminum
cans to plastic bottles.
• Customers have little loyalty. When price is the
customer’s primary motivator, the threat of substitutes
is greater.
Reducing the Threat of Substitutes
You can reduce the threat of substitutes by using tactics such
as staying closely in tune with customer preferences and
differentiating your product by branding. In some cases, the
advertising required to differentiate is more than one firm can
bear. In that case, collective advertising for an industry may
be more effective.

Perspective on Threat of Substitutes
In the wine business, there’s a common misconception.
When considering substitutes, many would make the easy
assumption that the substitute for wine is beer. There are
many other options that need to be considered, however.
In addition to selling an alcoholic beverage, a winery is a
destination, an entertainment and educational source,
and a part of world history and culture.
There’s a saying in the wine-making business, “Taste the
experience of Indiana wine”—taste the wine, taste the
events, taste the education, etc.
Due to the diversification of offerings in addition to wine,
substitutes must be carefully considered and evaluated.
Competing against the other travel destinations for
limited customer leisure time is one of the biggest
challenges.
In order to decrease the threat of substitutes in the
market and encourage customers, managers of Indiana
wineries must carefully consider these alternatives and
strategically address all the other options facing a
prospective buyer.
Self Assessment—Threat of Substitutes
This is a short scorecard to help you assess your business’
position in your marketplace. Read each of the following
questions and

situation.
1. Does your product compare favorably to
possible substitutes? If another product offers
more features or benefits to customers, or if
their price is lower, customers may decide
that the other product is a better value.
2. Is it costly for your customers to switch to
another product? When customers experience
a loss of productivity if they switch to another
product, the threat of substitutes is weaker.
YES NO
YES NO
3. Are customers loyal to existing products?
Even if switching costs are low, customers
may have allegiance to a particular brand. If
your customers have high brand loyalty to
your product you enjoy a weak threat of
substitutes.
YES NO
Rivalry Among Competitors
How Intense Is Your Competition?

Competition is the foundation of the free enterprise system,
yet with small businesses even a little competition goes a long
way. Because companies in an industry are mutually depen-
dent, actions by one company usually invite competitive
retaliation. An analysis of rivalry looks at the extent to which
the value created in an industry will be dissipated through
head-to-head competition.
Intensity of Rivalry Among
Competitors
Rivalry among competitors is often the strongest of the five
competitive forces, but can vary widely among industries. If
the competitive force is weak, companies may be able to raise
prices, provide less product for the price, and earn more
profits. If competition is intense, it may be necessary to
enhance product offerings to keep customers, and prices may
fall below break-even levels.
Rivalries can occur on various “playing fields.” In some
industries, rivalries are centered on price competition—
especially companies that sell commodities such as paper,
gasoline, or plywood. In other industries, competition may be
about offering customers the most attractive combination of
performance features, introducing new products, offering
more after-sale services or warranties, or creating a stronger
brand image than competitors. In some cases the presence of
more rivals can actually be a positive—for instance in a
shopping area, where attracting customers may hinge on having
enough stores and attractions to make it a worthwhile stop.
Factors Influencing Rivalry Among
Competitors
The most intense rivalries occur when:
• One firm or a small number of firms have incentive to

try and become the market leader. In some cases, an
industry with two or three dominant firms may
experience intense rivalry when these firms are
battling to achieve market leader status. In other
situations, when competitors with diverse strategies
and relationships have different goals and the “rules
of the game” are not well established, rivalry will be
more intense.
• The market is growing slowly or shrinking. When the
potential to sell products is stagnant or declining,
List possible substitutes that your customers
could use in place of your product.
How easy would it be for your
customer to consider this alternative?
How can you differentiate your products or build
customer loyalty to manage the threat of substitutes?
1.
2.
3.
4.
5.
Further Assessment
the threat of substitutes will affect your business.

existing firms are unable to grow their market without
taking market away from competitors. In this
situation rivalry is more likely.
• There are high fixed costs of production. When a large
percentage of the cost to produce products is
independent of the number of units produced,
businesses are pressured to produce larger volumes.
This may tempt companies to drastically cut prices
when there is excess capacity in the industry in order
to sell greater volumes of product.
• Products are perishable and need to be sold quickly.
Sellers are more likely to price aggressively if they risk
losing inventory due to spoilage or if storage costs are
high.
• Products are not unique or homogenous.
Undifferentiated products (commodities) compete
mainly on price, because consumers receive the same
value from the products of different firms. Because
firms do not experience any insulation from price
competition, there is more likely to be active rivalry.
Perspective on Rivalry Among Competitors
Head-to-head competition is rivalry. For a winery, the
various interactions with competition create a dynamic,
multifaceted situation. It boils down to “how does a
winery compete for business.” Porter’s argument is that
the more businesses compete on price, the lower the
profit of the market.

The Indiana wine industry is similar in scope to other
industries. There are a handful of large wineries with the
majority of market share and many smaller wineries
rounding out the industry. There are currently 31 wineries
in the state selling 1.8 million bottles of wine per year.
A small winery would sell approximately 7,500 bottles
per year.
On a global scope, the wine industry is very competitive.
Wineries compete for shelf space and “share of mouth”
with regard to consumer tastes. In the state, however,
competition at the local level is important to the
industry’s success. A small winery competes for customers
through the winery tasting room, rather than on the
external retail shelf. This means the winery competes
against all other tourism destinations in the state offering
similar entertainment, not just the other Indiana wineries.
As a result, the overall quality offered to customers is
very important. The first purchase is generally based on
the look of the wine package and customer service. To
retain these customers for the long-term, product quality
is essential. Future purchases are based on consumers’
perception of taste, not just how nice the bottle looks or
the friendliness of the staff. A winery manager needs to
offer a total package that goes above and beyond what
others in the state are offering.
The Indiana industry is not saturated at this point. There
is still room for wineries to grow without having to
capture customers from direct competitors. The demand
is growing, offering opportunities for industry growth
without extreme rivalry. However, staying ahead of the
game—the rivals—is the key for future success.

• Customers can easily switch between products. Intense
rivalry is likely when customers in a given industry
can easily switch to other suppliers. In these
situations, the businesses in the industry will be vying
for market share.
• There are high costs for exiting the business. If
liquidation would result in a loss, businesses that
invested heavily in their facilities will try hard to pay
for them and may resort to extreme methods of
competition.
Reducing the Threat of Rivals
Threats of rivals can be reduced by employing a variety of
tactics. To minimize price competition, distinguish your
product from your competitors’ by innovating or improving
features. Other tactics include focusing on a unique
segment of the market, distributing your product in a novel
channel, or trying to form stronger relationships and build
customer loyalty.
Self Assessment—Rivalry Among Competitors
This is a short scorecard to help you assess your business’
position in your marketplace. Read each of the following
questions and
situation.

1. Is there a small number of competitors?
Often the greater the number of players, the
more intense the rivalry. However, rivalry can
occasionally be intense when one or more
firms are vying for market leader positions.
2. Is there a clear leader in your market? Rivalry
intensifies if companies have similar shares
of the market, leading to a struggle for
market leadership.
3. Is your market growing? In a growing
market, firms are able to grow revenues
simply because of the expanding market. In a
stagnant or declining market, companies
often fight intensely for a smaller and smaller
market.
4. Do you have low fixed costs? With high fixed
costs, companies must sell more products to
cover these high costs.
5. Can you store your product to sell at the best
times? High storage costs or perishable
products result in a situation where firms
must sell product as soon as possible,
increasing rivalry among firms.
YES NO
YES NO
6. Are your competitors pursuing a low growth
strategy? You will have more intense rivalries
if your competitors are more aggressive. In
contrast, if your competitors are following a

strategy of milking profits in a mature
market, you will enjoy less rivalry.
7. Is your product unique? Firms that produce
products that are very similar will compete
mostly on price, so rivalry is expected to be
high.
8. Is it easy for competitors to abandon their
product? If exit costs are high, a company
may remain in business even if it is not
profitable.
9. Is it difficult for customers to switch between
your product and your competitors’? If
customers can easily switch, the market will
be more competitive and rivalry is expected to
be high as firms vie for each customer’s
business.
YES NO
YES NO
YES NO
YES NO
YES NO
YES NO
YES NO

Final Comment
Not all of these forces are equally important when assessing
the overall attractiveness of an industry. In some industries, it
is easy to gain entry, but very difficult to get out. Not surpris -
ingly, these industries tend to be mediocre investments.
A full-fledged industry analysis would require extensive
research, talking with customers, suppliers, competitors,
and industry experts. However, as a general overview, the
five forces concept provides entrepreneurs with an excellent
tool to examine the profit potential in a particular industry.
Gaining an understanding of the way in which each of the
five forces influences your profitability will provide you with
tactics for countering the strength of the forces.
Purdue Partners for Innovation in Indiana Agriculture
Agricultural Innovation & Commercialization Center
New Ventures Team
Center for Food & Agricultural Business
Visit Us on the Web
Agricultural Innovation and Commercialization Center
www.agecon.purdue.edu/planner
New Ventures Team
www.agecon.purdue.edu/newventures
Further Assessment
rivalry among competitors affects your business.

What business and growth
strategies does this competitor use?
How will this competitor affect
your business?
What actions will you take in response
to your competitors’ actions?
1.
2.
3.
4.
5.
6.
7.
8.
List your major competitors.
http://www.agecon.purdue.edu/planner/
http://www.agecon.purdue.edu/ newventures/
9/04
It is the policy of the Purdue University Cooperative Extension

Service, David C. Petritz, Director, that all persons shall have
equal opportunity and access
to the programs and facilities without regard to race, color, sex,
religion, national origin, age, marital status, parental status,
sexual orientation,
or disability. Purdue University is an Affirmative Action
institution. This material may be available in alternative
formats.
1-888-EXT-INFO
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PURDUE AGRICULTURE
Notes
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Crafting A Business
PORTER’S
Industry Ana

Bargaining Power
Suppliers are POWER
− There is a credibl
suppliers.
− Suppliers are con
− There is a signifi
− The customers ar
What does the bargai
SmallBizU
Plan http://www.smallbizu.org
FIVE FORCES WORKSHEET
lysis Model
of Suppliers
FUL if…
e forward integration threat by

centrated.
cant cost to switch suppliers.
e powerful.
Suppliers are WEAK if…
− The product is standardized. There are many
competitive suppliers.
− They are supplying commodity products.
− There is a credible backward integration threat by
purchasers.
− There are concentrated purchasers.
− The customers are weak.
ning power of suppliers in your industry look like?
Online eLearning Classroom
Crafting A Business Plan
http://www.smallbizu.org
Threat of New Entrants
Threat of new entrants is LOW if…
− There is patented or proprietary know-how.
− There is difficulty in brand switching.
− There are restricted distribution channels.

− There is a high scale threshold.
Threat of new entrants is HIGH if…
− There is common technology.
− There is little brand franchise.
− Distribution channels are easily accessible.
− There is a low scale threshold.
What does the threat of new entrants within your industry look
like?
Competitive Rivalry Within Industry
Competitive rivalry within an industry is LOW if…
− There are few players in the industry.
− Players have different strategies.
− Differentiation between competitors and their
products are high.
− There is little to no price competition
− There are high market growth rates.
− Barriers for exit are low.
Competitive rivalry within an industry is HIGH if…
− There are many players of about the same size.

− Players have similar strategies.
− There is not much differentiation between players
and their products.
− There is much price competition
− Low market growth rates (growth of a particular
company is possible only at the expense of a
competitor).
− Barriers for exit are high (e.g. expensive and
highly specialized equipment).
What does the bargaining power of customers in your industry
look like?
Crafting A Business Plan

http://www.smallbizu.org
Threat of Substitutes
Threat of substitutes will be LOW if…
− There is strong brand loyalty.
− There are tight or strong customer relationships.
− Switching costs for customers are high.
− The relative price compard to performance of
substitutes is high.
Threat of substitutes will be HIGH if…
− There is little to no brand loyalty.
− There are loose customer relationships.
− Switching costs for customers are low.
− The relative price compard to performance of
substitutes is low.
What does the bargaining threat of substitutes within your
industry look like?
Bargaining Power of Customers

Customers are POWERFUL if…
− There are a few buyers with significant market
share.
− Buyers purchase a significant proportion of the
output.
− Buyers possess a credible backward integration
threat.
Customers are WEAK if…
− Producers can threaten forward integration, taking
over customers’ position.
− There are significant buyer switching costs.
− There are many customers – significant influence
on a particular product or price is small.
− Producers supply critical portions of the
customers’ input.
What does the competitive rivalry within your industry look
like?

Financial ratio analysis
A reading prepared by Pamela Peterson Drake
O U T L I N E
1. Introduction
2. Liquidity ratios
3. Profitability ratios and activity ratios
4. Financial leverage ratios
5. Shareholder ratios
1. Introduction
As a manager, you may want to reward employees based on
their performance. How do you know
how well they have done? How can you determine what
departments or divisions have performed
well? As a lender, how do decide the borrower will be able to
pay back as promised? As a manager of
a corporation how do you know when existing capacity will be
exceeded and enlarged capacity will be
needed? As an investor, how do you predict how well the
securities of one company will perform
relative to that of another? How can you tell whether one
security is riskier than another? We can
address all of these questions through financial analysis.

Financial analysis is the selection, evaluation, and
interpretation of financial data, along with other
pertinent information, to assist in investment and financial
decision-making. Financial analysis may be
used internally to evaluate issues such as employee
performance, the efficiency of operations, and
credit policies, and externally to evaluate potential investments
and the credit-worthiness of
borrowers, among other things.
The analyst draws the financial data needed in financial analysis
from many sources. The primary
source is the data provided by the company itself in its annual
report and required disclosures. The
annual report comprises the income statement, the balance
sheet, and the statement of cash flows,
as well as footnotes to these statements. Certain businesses are
required by securities laws to
disclose additional information.
Besides information that companies are required to disclose
through financial statements, other
information is readily available for financial analysis. For
example, information such as the market
prices of securities of publicly-traded corporations can be found
in the financial press and the
electronic media daily. Similarly, information on stock price
indices for industries and for the market
as a whole is available in the financial press.
Another source of information is economic data, such as the
Gross Domestic Product and Consumer
Price Index, which may be useful in assessing the recent
performance or future prospects of a
company or industry. Suppose you are evaluating a company

that owns a chain of retail outlets.
What information do you need to judge the company's
performance and financial condition? You
need financial data, but it doesn't tell the whole story. You also
need information on consumer
Financial ratios, a reading prepared by Pamela Peterson Drake 1
spending, producer prices, consumer prices, and the
competition. This is economic data that is
readily available from government and private sources.
Besides financial statement data, market data, and economic
data, in financial analysis you also need
to examine events that may help explain the company's present
condition and may have a bearing on
its future prospects. For example, did the company recently
incur some extraordinary losses? Is the
company developing a new product? Or acquiring another
company? Is the company regulated?
Current events can provide information that may be
incorporated in financial analysis.
The financial analyst must select the pertinent information,
analyze it, and interpret the analysis,
enabling judgments on the current and future financial condition
and operating performance of the
company. In this reading, we introduce you to financial ratios --
the tool of financial analysis. In
financial ratio analysis we select the relevant information --
primarily the financial statement data --
and evaluate it. We show how to incorporate market data and
economic data in the analysis and
interpretation of financial ratios. And we show how to interpret

financial ratio analysis, warning you
of the pitfalls that occur when it's not used properly.
We use Microsoft Corporation's 2004 financial statements for
illustration purposes throughout this
reading. You can obtain the 2004 and any other year's
statements directly from Microsoft. Be sure to
save these statements for future reference.
Classification of ratios
A ratio is a mathematical relation between one quantity and
another. Suppose you have 200 apples
and 100 oranges. The ratio of apples to oranges is 200 / 100,
which we can more conveniently
express as 2:1 or 2. A financial ratio is a comparison between
one bit of financial information and
another. Consider the ratio of current assets to current
liabilities, which we refer to as the current
ratio. This ratio is a comparison between assets that can be
readily turned into cash -- current assets
-- and the obligations that are due in the near future -- current
liabilities. A current ratio of 2:1 or 2
means that we have twice as much in current assets as we need
to satisfy obligations due in the near
future.
Ratios can be classified according to the way they are
constructed and their general characteristics.
By construction, ratios can be classified as a coverage ratio, a
return ratio, a turnover ratio, or a
component percentage:
1. A coverage ratio is a measure of a company's ability to
satisfy (meet) particular obligations.

2. A return ratio is a measure of the net benefit, relative to the
resources expended.
3. A turnover ratio is a measure of the gross benefit, relative to
the resources expended.
4. A component percentage is the ratio of a component of an
item to the item.
When we assess a company's operating performance, we want to
know if it is applying its assets in
an efficient and profitable manner. When we assess a company's
financial condition, we want to
know if it is able to meet its financial obligations.
There are six aspects of operating performance and financial
condition we can evaluate from financial
ratios:
1. A liquidity ratio provides information on a company's ability
to meet its short−term,
immediate obligations.
2. A profitability ratio provides information on the amount of
income from each dollar of
sales.
http://www.microsoft.com/msft/ar.mspx
3. An activity ratio relates information on a company's ability to
manage its resources (that is,
its assets) efficiently.

4. A financial leverage ratio provides information on the degree
of a company's fixed
financing obligations and its ability to satisfy these financing
obligations.
5. A shareholder ratio describes the company's financial
condition in terms of amounts per
share of stock.
6. A return on investment ratio provides information on the
amount of profit, relative to the
assets employed to produce that profit.
We cover each type of ratio, providing examples of ratios that
fall into each of these classifications.
2. Liquidity Ratios
Liquidity reflects the ability of a company to meet its short-
term obligations using assets that are
most readily converted into cash. Assets that may be converted
into cash in a short period of time
are referred to as liquid assets; they are listed in financial
statements as current assets. Current
assets are often referred to as working capital because these
assets represent the resources needed
for the day-to-day operations of the company's long-term,
capital investments. Current assets are
used to satisfy short-term obligations, or current liabilities. The
amount by which current assets
exceed current liabilities is referred to as the net working
capital.1
The role of the operating cycle
How much liquidity a company needs depends on its operating
cycle. The operating cycle is the

duration between the time cash is invested in goods and services
to the time that investment
produces cash. For example, a company that produces and sells
goods has an operating cycle
comprising four phases:
(1) purchase raw material and produce goods, investing in
inventory;
(2) sell goods, generating sales, which may or may not be for
cash;
(3) extend credit, creating accounts receivables, and
(4) collect accounts receivables, generating cash.
The operating cycle is the length of time it takes to convert an
investment of cash in inventory
back into cash (through collections of sales). The net operating
cycle is the length of time it takes to
convert an investment of cash in inventory and back into cash
considering that some purchases are
made on credit.
The number of days a company ties up funds in inventory is
determine by:
(1) the total amount of money represented in inventory, and
(2) the average day's cost of goods sold.
The current investment in inventory -- that is, the money "tied
up" in inventory -- is the ending
balance of inventory on the balance sheet. The average day's
cost of goods sold is the cost of goods

1 You will see reference to the net working capital (i.e., current
assets – current liabilities) as simply working
capital, which may be confusing. Always check the definition
for the particular usage because both are common
uses of the term working capital.
sold on an average day in the year, which can be estimated by
dividing the cost of goods sold found
on the income statement by the number of days in the year.
We compute the number of days of inventory by calculating the
ratio of the amount of inventory on
hand (in dollars) to the average day's Cost of Goods Sold (in
dollars per day):
365 / sold goods ofCost
Inventory
sold goods ofcost sday' Average
Inventory
inventory days ofNumber ==
If the ending inventory is representative of the inventory
throughout the year, the number of days
inventory tells us the time it takes to convert the investment in
inventory into sold goods. Why worry
about whether the year-end inventory is representative of
inventory at any day throughout the year?
Well, if inventory at the end of the fiscal year-end is lower than
on any other day of the year, we

have understated the
number of days of
inventory.
Indeed, in practice most
companies try to choose
fiscal year-ends that
coincide with the slow
period of their business.
That means the ending
balance of inventory would
be lower than the typical
daily inventory of the year.
We could, for example,
look at quarterly financial
statements and take
averages of quarterly
inventory balances to get
a better idea of the typical
inventory. However, here
for simplicity in this and
other ratios, we will make
a note of this problem and
deal with it later in the
discussion of financial
ratios.
We can extend the same
logic for calculating the
number of days between a
sale -- when an account
receivable is created -- to
the time it is collected in
cash. If the ending
balance of receivables at
the end of the year is

representative of the
receivables on any day throughout the year, then it takes, on
average, approximately the "number of
days credit" to collect the accounts receivable, or the number of
days receivables:
Try it!
Wal-Mart Stores, Inc., had cost of revenue of $219,793 million
for the fiscal
year ended January 31, 2005. It had an inventory balance of
$29,447 million
at the end of this fiscal year. Using the quarterly information,
Wal-Mart’s
average inventory balance during the fiscal year is $29,769.25:
Inventory balance, in millions
$28,320 $27,963
$33,347
$29,447
$24,000
$26,000
$28,000
$30,000
$32,000
$34,000

April July October January
Source: Wal-Mart Stores 10-K and 10-Q filings
Based on this information, what is Wal-Mart’s inventory
turnover for fiscal year
2004 (ending January 31, 2005)?
Solution
:
Using the fiscal year end balance of inventory:
= =
$29,447 $29, 447
Number of days inventory = 48.9 days
$219,793/365 $602.173
Using the average of the quarterly balances:
= =

$29,769.25 $29, 769.25
$219,793/365 $602.173
In other words, it takes Wal-Mart approximately 50 days to sell
its
merchandise from the time it acquires it.
= =
Accounts receivable Accounts receivable
Number of days receivables
Average day's sales on credit Sales on credit / 365
What does the operating cycle have to do with liquidity? The
longer the operating cycle, the more
current assets needed (relative to current liabilities) because it
takes longer to convert inventories

and receivables into cash. In other words, the longer the
operating cycle, the more net working
capital required.
We also need to look at the liabilities on the balance sheet to
see how long it takes a company to pay
its short-term obligations. We can apply the same logic to
accounts payable as we did to accounts
receivable and inventories. How long does it take a company, on
average, to go from creating a
payable (buying on credit) to paying for it in cash?
= =
Accounts payable Accounts payable
Number of days payables
Average day's purchases Purchases / 365
First, we need to determine the amount of an average day's
purchases on credit. If we assume all
purchases are made on credit, then the total purchases for the
year would be the Cost of Goods Sold,
less any amounts included in this Cost of Goods Sold that are
not purchases.2

The operating cycle tells us how long it takes to convert an
investment in cash back into cash (by
way of inventory and accounts receivable):
Number of days Number of days
Operating cycle
of inventory of receivables
= +
The number of days of purchases tells us how long it takes use
to pay on purchases made to create
the inventory. If we put these two pieces of information
together, we can see how long, on net, we
tie up cash. The difference between the operating cycle and the
number of days of payables is the
net operating cycle:
Net operating cycle = Operating Cycle - Number of days of
purchases
or, substituting for the operating cycle,
purchases of

days ofNumber
sreceivable of
daysofNumber
inventory of
daysofNumber
cycle operatingNet −+=
The net
operating cycle
therefore tells
us how long it
takes for the
company to get
cash back from
its investment
in inventory
and accounts
receivable,
considering that
purchases may be made on credit. By not paying for purchases
immediately (that is, using trade
credit), the company reduces its liquidity needs. Therefore, the

longer the net operating cycle, the
greater the company’s need for liquidity.
Microsoft's Number of Days Receivables
2004:
Average day's receivables = $36,835 million / 365 = $100.9178
million
Number of days receivables = $5,890 million / $100.9178
million = 58.3643 days
Now try it for 2005 using the 2005 data from Microsoft’s
financial statements.
Answer: 65.9400 days
Source of data: Income Statement and Balance Sheet, Microsoft
Corporation Annual Report 2005
2 For example, depreciation is included in the Cost of Goods
Sold, yet it not a purchase. However, as a quite
proxy for purchases, we can use the accounting relationship:

beginning inventory + purchases = COGS + ending
inventory.
Measures of liquidity
Liquidity ratios provide a measure of a company’s ability to
generate cash to meet its immediate
needs. There are three commonly used liquidity ratios:
1. The current ratio is the ratio of current assets to current
liabilities; Indicates a company's
ability to satisfy its current liabilities with its current assets:
sliabilitieCurrent
assetsCurrent
ratioCurrent =
2. The quick ratio is the ratio of quick assets (generally current
assets less inventory) to
current liabilities; Indicates a company's ability to satisfy

current liabilities with its most
liquid assets
sliabilitieCurrent
Inventory - assetsCurrent
ratio Quick =
3. The net working capital to sales ratio is the ratio of net
working capital (current assets
minus current liabilities) to sales; Indicates a company's liquid
assets (after meeting
short−term obligations) relative to its need for liquidity
(represented by sales)
Sales
sliabilitieCurrent - assetsCurrent
ratio sales to capital workingNet =
Generally, the larger these liquidity ratios, the better the ability
of the company to satisfy its
immediate obligations. Is there a magic number that defines
good or bad? Not really.

Consider the current ratio. A large amount of current assets
relative to current liabilities provides
assurance that the company will be able to satisfy its immediate
obligations. However, if there are
more current assets than the company needs to provide this
assurance, the company may be
investing too heavily in these non- or low-earning assets and
therefore not putting the assets to the
most productive use.
Another consideration is the
operating cycle. A company
with a long operating cycle
may have more need to
liquid assets than a
company with a short
operating cycle. That’s
because a long operating
cycle indicate that money is
tied up in inventory (and then receivables) for a longer length of
time.
Microsoft Liquidity Ratios -- 2004

Current ratio = $70,566 million / $14,696 million = 4.8017
Quick ratio = ($70,566-421) / $14,696 = 4.7731
Net working capital-to-sales = ($70,566-14,969) / $36,835 =
1.5515
Source of data: Balance Sheet and Income Statement, Microsoft
Corporation Annual
Report 2005
3. Profitability ratios
Profitability ratios (also referred to as profit margin ratios)
compare components of income with sales.
They give us an idea of what makes up a company's income and
are usually expressed as a portion
of each dollar of sales. The profit margin ratios we discuss here
differ only by the numerator. It's in
the numerator that we reflect and thus evaluate performance for
different aspects of the business:

The gross profit margin is the ratio of gross income or profit to
sales. This ratio indicates how
much of every dollar of sales is left after costs of goods sold:
Gross income
Gross profit margin
Sales
=
The operating profit margin is the
ratio of operating profit (a.k.a. EBIT,
operating income, income before
interest and taxes) to sales. This is a
ratio that indicates how much of each
dollar of sales is left over after operating
expenses:
Microsoft's 1998 Profit Margins
Gross profit margin = ($14,484 - 1,197)/$14,484 = 91.736%
Operating profit margin = $6,414 / $14,484 = 44.283%
Net profit margin = $4,490 / $14,484 = 31%

Source of data: Microsoft Corporation Annual Report 1998
___
Microsoft's 2004 Profit Margins
Gross profit margin = ($36,835 – 6,716)/$36,835 = 81.767%
Operating profit margin = $9,034 / $36,835 = 24.526%
Net profit margin = $8,168 / $36,835 = 22.175%
Source of data: Income Statement, Microsoft Corporation
Annual Report
2005
Operating income
Operating profit margin =
Sales
The net profit margin is the ratio of
net income (a.k.a. net profit) to sales,
and indicates how much of each dollar
of sales is left over after all expenses:

Net income
Net profit margin
Sales
= .
4. Activity ratios
Activity ratios are measures of how well assets are used.
Activity ratios -- which are, for the most
part, turnover ratios -- can be used to evaluate the benefits
produced by specific assets, such as
inventory or accounts receivable. Or they can be use to evaluate
the benefits produced by all a
company's assets collectively.
These measures help us gauge how effectively the company is at
putting its investment to work. A
company will invest in assets – e.g., inventory or plant and
equipment – and then use these assets to
generate revenues. The greater the turnover, the more
effectively the company is at producing a
benefit from its investment in assets.
The most common turnover ratios are the following:

1. Inventory turnover is the ratio of cost of goods sold to
inventory. This ratio indicates how
many times inventory is created and sold during the period:
Inventory
sold goods ofCost
turnover Inventory =
2. Accounts receivable turnover is the ratio of net credit sales to
accounts receivable. This
ratio indicates how many times in the period credit sales have
been created and collected on:
receivable Accounts
credit on Sales
turnover receivable Accounts =
3. Total asset turnover is the ratio of sales to total assets. This

ratio indicates the extent that
the investment in total assets results in sales.
assets Total
Sales
turnover asset Total =
4. Fixed asset turnover is the ratio of sales to fixed assets. This
ratio indicates the ability of
the company’s management to put the fixed assets to work to
generate sales:
assets Fixed
Sales
turnover asset Fixed =
Microsoft’s Activity Ratios – 2004
Accounts receivable turnover = $36,835 / $5,890 = 6.2538 times
Total asset turnover = $36,835 / $92,389 = 0.3987 times
Source of data: Income Statement and Balance Sheet, Microsoft

Corporation Annual
Report 2005
Turnovers and numbers of days
You may have noticed that there is a relation between the
measures of the operating cycle and
activity ratios. This is because they use the same information
and look at this information from
different angles. Consider the number of days inventory and the
inventory turnover:
=
Inventory
Number of days inventory
Average day's cost of goods sold
Inventory
sold goods ofCost
turnover Inventory =

The number of days inventory is how long the inventory stays
with the company, whereas the
inventory turnover is the number of times that the inventory
comes and leaves – the complete cycle
– within a period. So if the number of days inventory is 30 days,
this means that the turnover within
the year is 365 / 30 = 12.167 times. In other words,
= =
365 365 Cost of goods sold
Inventory turnover =
InventoryNumber of days inventory Inventory
Cost of goods sold / 365
Try it!
Wal-Mart Stores, Inc., had cost of revenue of $219,793 million

for the fiscal year ended January 31, 2005. It
had an inventory balance of $29,447 million at the end of this
fiscal year.
Source: Wal-Mart Stores 10-K
Wal-Mart’s number of days inventory for fiscal year 2004
(ending January 31, 2005) is
= =
$29,447 $29, 447
$219,793/365 $602.173
Wal-Mart’s inventory turnover is:
=
$219,793
Inventory turnover = 7.464 times
$29,447

And the number of days and turnover are related as follows:
Inventory turnover = 365 / 48.9 = 7.464 times
Number of days inventory = 365 / 7.464 = 48.9 days
5. Financial leverage ratios
A company can finance its assets either with equity or debt.
Financing through debt involves risk
because debt legally obligates the company to pay interest and
to repay the principal as promised.
Equity financing does not obligate the company to pay anything
-- dividends are paid at the
discretion of the board of directors. There is always some risk,
which we refer to as business risk,
inherent in any operating segment of a business. But how a
company chooses to finance its
operations -- the particular mix of debt and equity -- may add
financial risk on top of business risk
Financial risk is the extent that debt financing is used relative
to equity.
Financial leverage ratios are used to assess how much financial
risk the company has taken on. There
are two types of financial leverage ratios: component

percentages and coverage ratios. Component
percentages compare a company's debt with either its total
capital (debt plus equity) or its equity
capital. Coverage ratios reflect a company's ability to satisfy
fixed obligations, such as interest,
principal repayment, or lease payments.
Component-percentage financial leverage ratios
The component-percentage financial leverage ratios convey how
reliant a company is on debt
financing. These ratios compare the amount of debt to either the
total capital of the company or to
the equity capital.
1. The total debt to assets ratio indicates the proportion of
assets that are financed with
debt (both short−term and long−term debt):
assets Total
debt Total
ratio assets todebt Total =
Remember from your study of accounting that total assets are

equal to the sum of total debt
and equity. This is the familiar accounting identity: assets =
liabilities + equity.
2. The long−term debt to assets ratio indicates the proportion of
the company's assets that
are financed with long−term debt.
assets Total
debt term-Long
ratio assets todebt term-Long =
3. The debt to equity ratio (a.k.a. debt-equity ratio) indicates
the relative uses of debt and
equity as sources of capital to finance the company's assets,
evaluated using book values of
the capital sources:
equity rs'shareholde Total
debt Total

ratioequity todebt Total =
One problem (as we shall see)
with looking at risk through a
financial ratio that uses the book
value of equity (the stock) is that
most often there is little relation
between the book value and its
market value. The book value of
equity consists of:
• the proceeds to the
company of all the stock
issued since it was first
incorporated, less any
treasury stock (stock
repurchased by the
company); and
• the accumulation of all
the earnings of the
company, less any
dividends, since it was

CHAPTER 4EVALUATING A COMPANY’S RESOURCES, CAPABILITIES, AND

CHAPTER 4EVALUATING A COMPANY’S RESOURCES, CAPABILITIES, AND

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CHAPTER 4EVALUATING A COMPANY’S RESOURCES, CAPABILITIES, AND