© 2000 John Petroff

C- Understanding management decisions affecting earnings power

Earnings power comes first and foremost from the ability to generate sales. This is the all important marketing strategy which has been covered in Chapter 9 Section G-2. We will not repeat what was already presented, but link other aspects of operations to the sales strategy. Secondly, earnings power depends on the gross margin a company can secure by pricing its product wisely and keeping unit costs low. This also is the subject of Chapter 9, but naturally, operating decisions, capital budgeting, financial leverage and capital sourcing all have a bearing on gross and net margins, and should be part of the assessment. Finally, expenses are the by-product of the above decisions, and it is these expenses that an analyst must study to assess a company's earnings power.

In studying these expenses, the analyst gathers information about a range of management preoccupations:
- generating optimum sales revenues
- maximizing profits

- minimizing costs
- minimizing taxes
- maintaining stable profits

- avoiding financial distress

- securing resources

- attracting investors

Some of these motives conflict with each other. For instance, cutting on some expenses to increase profits will simultaneously increase tax liability as well. It was shown earlier, that aggressive sales strategies destabilize profits. Thus, the analyst has the difficult task of evaluating how desirable an expense strategy is in light of these conflicting objectives, and how effectively it is implemented.

Stating it one more time: earnings power comes from sales. Sales revenue is the goal of all expenses incurred and all resources put to use. One will recall from the analysis of sales in Chapter 9 that the approach to marketing and sales depends on the nature and age of the product, the type of industry, the position of the company within the industry, and the state of the economy. More will be said on the subject as part of industry and economic analysis in subsequent chapters. Aggressive or defensive sales strategies based on product technology or price will be compared on the basis of industry composition. These considerations should help predict the revenue of the company, as outlined in Chapter 9.

In this chapter, the focus will be put successively on each major type of expense in order to identify methods that can reveal management's strategy. In other words, the analyst starts from management stated sales strategy (as discussed in company's annual report), then puts that strategy to the test through analysis of company sales, industry and economy, and verifies that the strategy is in fact implemented by spending the necessary money.

See review questions Q-13C.1 through Q-13C.4.

See research assignment R-13C.1.

Previous: Measurement

Last modified: Jun/01/01

Next: 1-Major expenses