Forces that Impact Business Decision Making

We already learned how to make basic financial analysis. However, financial analysis is only a means to an end; what we want to do is to apply the basic financial analysis to the process of our decision making. 

Before getting into this, let's think about another question: why do financial data demonstrate differently across different countries and different industries? 

We can easily realize that it is because the environment where the businesses reside will affect each business’ decision-making. And these decisions further affect its final performance.

If we think about how we make decisions, we will find the most important factor affecting our decisions is the environment we are in. This environment could be the whole world’s economic development, or it could be the economic situation of the country. We know that the economic developments in the world are drastically different from one another, and different industries are different as well. 

For example, for companies within the same industry, what competition are they facing? What kind of customers are they dealing with? Is their supply of raw materials in shortage or surplus? Where do their workforces come from? Where does the capital come from? How is their tax situation? Are there any special governmental restrictions? All of these things will influence an enterprise’s decision-making.

But, obviously, given the same environment, not all the enterprises will make the same decisions. For example, within the same country, the same industry, and even the same region, companies face similar environments. But we don’t see all companies doing the same thing. Why? It is because every company makes its own strategic choice. This strategy may include whether it wants to have a diversified business or to focus on only one area. It could also include how the company wants to compete with competitors on every business line. Because of this, companies vary widely even if they are in the same environment.

Let's dig a step deeper. Within the same industry, the same region, and a similar environment, we can find two companies which adopt similar strategies. However, when we come back to check these two companies a couple of years later, we may find that one company succeeded while the other failed. We see this happening all around the world. 

Why does it happen all the time? Well, even though the two companies choose the same strategy, their abilities to execute that strategy are not the same. Their differences in execution capabilities make the final difference.

This makes companies across the world differ. The differences are caused by at least three levels of factors: the first level is the external environment; the second level is the strategic positioning; and the last level is the strategic execution.

We've already known that environments can make big differences in a company's performance. However, let's not go all the way into the macros such as worldwide economy or even the macroeconomic development of a certain country. Let's focus on environment on the industry level first. After that, we can take a look at how strategy positioning affects a company’s financial data. And last, strategic execution.

Porter's Five Forces

To demonstrate how industry factors affect a company’s financial data, we need to first learn, in this industry as a whole, which factors are crucial for the company’s operations. 

Here we will use a famous model called Porter's Five Forces, created by the Harvard Business School's Michael Porter. In any industry, five forces determine an industry’s profitability. 

Existing and Potential Competitions

Let's look at the three forces at the top. 

The first is the competitive rivalry within an industry. The second is if there are new entrants threatening the industry. The last is if there are threats of substitute products or services in the industry. All three forces will create immense competition to industry incumbents.

Competitors may enter the industry in different ways. So, what will be the impact of intense competition on the company’s financial data?

We can think in this way. As we know, when competition we are facing becomes more and more intense, our company's profit might get competed out. For example, when originally only our company was selling a specific product, our customers don't even have another company to compare prices, leaving much more pricing power to us. However, as more and more companies enter the field with similar products, acquiring customers become more and more competitive. We will have to lower the price in order to sell more products. 

After dropping the price, will my cost of goods sold decrease proportionally? 

The truth is, not really. Why? 

Because among our costs, some of them are non-flexible, meaning that costs will not decrease with the decrease of the price at the same rate. In other words, at certain stages, you will find that your cost will basically stop changing, although prices may continue to decrease with intensified competition. As a result, the first thing to drop will be gross profit.

In general, gross profit is the most sensitive factor to changes in the external environment.

Bargaining Powers of Buyers and Suppliers

Now let's move on to the bottom half of the Five Forces, which are bargaining powers of buyers and suppliers. Normally, Buyers are called downstream because they purchase products from us, and suppliers are called upstream because we purchase products from them. In other words, it indicates the situation of the industrial chain where our company is involved. 

Let’s assume that our industry has really intense competition, and many companies are selling the same product. To acquire customers, not only do we have to ower our prices, but we also need to offer customers credits, i.e. grant them longer payment terms. This is where accounts receivables come in. Of course, if I don’t want to grant credits to customers, I probably will have to suffer longer inventory holding period. 

What determines who is in a stronger position, us or the customers?

It is related to how intense the competition is in my product’s market. The more intense competition my product is facing, the stronger bargaining power my customers have. The bargaining power not only brings them lower prices but also lets them hold my cash longer. Therefore, I will get more accounts receivable. Of course, from another aspect, the bargaining power between my customers and I may also be determined by how many customers I have. We can imagine the situations that I have only one customer versus that I have thousands of customers. The situations are very different. When I have thousands of customers, I will have more choices. If one customer threatens to stop buying my product, I can tell him to EFF OFF. But if I only have one customer, which means that my entire business relies on him, he will get strong bargaining power against me - he probably can do whatever he wants to do then. So customers’ bargaining power is not only determined by the competition in my product’s market but also related to the level of concentration of my customers.

Now let’s have a look at our upstream - the suppliers. One would assume that as a customer, you would always have more power over your supplier. 

But not so fast. Let’s look at what determines who is in a stronger position between a supplier and the company.

Similar to the relationship between our customer and our company, if my raw material market is a market where demand exceeds supply, it will be difficult to purchase the goods. For example, a company that commands over Microsoft, Google, Meta, and OpenAI these days is Nvidia, which is a supplier to all of them. How could some of the most valuable and powerful companies in the world bow down to Nvidia? Well, there is one thing that every single one of them trying to secure from Nvidia: their powerful chips. As all these companies are marching into the AI war, they all want to most powerful GPU chips from Nvidia. And there is no other company that can manufacture anything close to what Nvidia provides.

At this time, we can tell that a supplier such as Nvidia is going to have really strong power. What will he do when he gets to this strong position? He may raise the price, which will increase my costs. Depending on the competitiveness of my market, I may or may not be able to raise prices for my products, and if I don't, my gross profit ratio will decrease. 

On top of raising prices, a powerful supplier can also make other moves. He may not grant our company any credit on purchase, and may require cash payment to buy goods. He may even demand advance payment and send us the supplies later, occupying the cash that is supposed to be on our bank account for a couple of months. 

Similar to the customers' bargaininig power, suppliers' bargaining power is also determined by the demand and supply relation of my raw material market and how many suppliers I have, i.e. the level of concentration of my suppliersw. If I only have one supplier, I will be afraid of losing the supplier, which puts the supplier in a stronger position. On the contrary, if I have thousands of suppliers, I can always buy from someone else should one supplier makes excessive demands. 

Next, we are going to pick two completely different industries to see how the competitiveness affect financials.