Past columns in this space addressed aspects of strategic planning and financial management. Experience suggests that their close connection is not always recognized by managers. The intent of this column is to show how financial ratios can affect strategic direction and help focus on plans.
The Planning Model
We follow Harvard strategist, Michael Porter and his planning elements. (See Joan Magretta, Understanding Michael Porter).
- External Analysis: Examine your market environment to understand the things you don’t control, but must respond to. This includes understanding current and potential customers, as well as knowing the product characteristics and services they value that can offer you opportunities. What are competitors doing that threaten your position or provide additional opportunities? What changes in technology or other factors may have an impact on your position or opportunities? What changes in macro-social or economic factors threaten your current position or provide opportunity to improve it?
- Value Proposition: Articulate how you will respond to the external environment to provide value to your customers and, therefore, profits to your business. This defines:
- Products and/or services you will provide.
- Your target customers.
- The relative price you will charge.
For many commodity producers this is straightforward; you will produce high-quality products for intermediaries (e.g. elevators, feed mills and packers) at prevailing market prices. But for producers who want to differentiate, understanding who wants what (and why) is critical in focusing their businesses. It may result in one farm supplying consumers directly, while another focuses on wholesalers or processors. Nearly everyone has at least limited impact on pricing to the extent that they can negotiate a premium for extra value, or price under the prevailing market.
- Internal Analysis: Ask how well our internal supply chain delivers consistently on our value proposition, and what needs to be improved. This is similar to the strengths and weaknesses in a SWOT analysis, but done against the backdrop of delivering consistently on our value proposition. It examines all aspects of the operation to evaluate how effectively they deliver against the value proposition. Where is improvement necessary? Typical questions for each area from input purchasing through production, marketing, financing, or human resource management include: What can we leverage to improve our position? What needs to improve? What should we stop doing? What do we need to do that we’re not doing
- Strategic Intents: From the internal analysis, what four major things will we focus on achieving? These may include improved operations, acquiring new assets, improving or acquiring new human resource skills, or improving financing.
- Operational Plans: Turn each strategic intent (above) into operations. Define for each strategic intent what actions will be taken; by whom (who is accountable); timelines (deadlines for accountabilities); what resources are required; and how we will measure whether it was done correctly and how well, and whether it had the desired effect.
Role of Financial Analysis
Planning is not an event; it’s a process. It proceeds by deciding what to do, implementing the plan, and evaluating progress and effectiveness. It also includes tweaking — i.e. changing on the fly as new things are learned. Then you start over for the next planning period.
Financial analysis has at least two roles.
- Evaluation: This involves measuring performance. The plan should have goals or use benchmarks to determine effectiveness. Our most recent article noted a number of financial benchmarks. For example, gross margin should exceed 65 per cent of sales, while direct operating costs should be 15 to 20 per cent or lower.
- Internal Analysis: The evaluations also give insight into the internal analysis. If Gross Margin is less than 65 per cent, it reflects either a major production problem (yields too low), a marketing problem, or a fundamental question about whether the right products are being produced. If Direct Operating Costs are worse than the benchmark, it often reveals that there is too much labour for the size of operation, and it likely signifies the need to increase sales or manage labour more effectively. If better than the benchmark, it may signal potential to use the labour management processes in an expanded operation. Similarly, Debt/EBITDA over 6.5 is likely too risky to increase borrowings, thereby signaling to pay down debt, while a ratio under 2.0 shows there is plenty of room to borrow for expansion.
Recall the two farms from our last column. Farm A has Gross Margin of 63 per cent, Direct Operating Costs of 26 per cent and Debt/EBITDA of 8.3:1. The internal analysis for Farm A would focus on how operations can be improved to get more revenue out of its existing assets, and how to pay down debt.
Farm B has Gross Margin of 71 per cent, Direct Operating Cost of 23 per cent, Debt/EBITDA of 1.6:1, and a very high cost of land rental. While there will be some focus on improving operations, the major focus will be on reducing land rental cost and, perhaps, using some of the farm’s substantial borrowing power.
We find in CTEAM that using financial ratios as part of a disciplined strategic planning and management process gives powerful information and focus for operations to excel. This article contains the basic structure for a process that works.
Larry Martin is a principal of Agri-Food Management Excellence and is one of the instructors in AME’s Canadian Total Excellence in Agriculture Management program.