How business works

148 149HOW FINANCE WORKS
Measuring performance

WARNING 10–14%

Investors beware the minimum return on
investment (ROI) needed
Ratio analysis must be used over to fund a company’s future
time—at least four years—to
understand how a company
has reached its current position,
not just what the position is. For
instance, if debt has suddenly
gone up, it could be because the
company is branching out into new
areas of potential profit, or to limit
the damage of a poor past decision.

Liquidity ratios Solvency ratios Investment
valuation ratios
This group of ratios reveals While liquidity ratios look at a
whether or not a company company’s short-term ability Thes ratios are typically used
has enough cash or equivalent assets to meet loan repayments, solvency by investors to gauge the returns they
to meet its debt repayments. An ratios indicate the likelihood of a are likely to get if they buy shares in a
example is the working capital ratio company being able to continue company. An example is the dividend
(also a measure of efficiency), which indefinitely with enough cash or payout ratio. It indicates how well
indicates whether a company has current assets to pay its debts in the earnings support the dividend
enough short-term assets to cover long run. An example is the debt to payments—more mature companies
its short-term debt. equity ratio. tend to have a higher payout ratio.

WORKING CURRENT DEBT TO TOTAL DIVIDEND YEARLY
CAPITAL = ASSETS EQUITY SHAREHOLDERS’ PAYOUT DIVIDEND
RATIO = EQUITY RATIO = PER SHARE
CURRENT
LIABILITIES TOTAL EARNINGS
ASSETS PER SHARE

Other liquidity ratios Other solvency ratios Other investment valuation ratios

❯ Cash ratio is measured as total cash ❯ Interest coverage ratio is measured ❯ Net profit margin ratio is measured
(and equivalents) / current liabilities. as EBIT (earnings before interest and as profit after tax / revenue. Another
It shows whether a company’s short- tax) / interest expense. It indicates measure of a company’s profitability, it
term assets could repay its debts. A how easily a company can pay the is also useful for comparing a company
high ratio is seen as favorable. interest on its debts. The higher the with competitors. The higher the ratio,
ratio, the more easily they can pay. the more profitable the company.
❯ Quick ratio (acid-test ratio) is
measured as current assets minus ❯ Debt ratio is measured as total ❯ Price to earnings ratio is measured
inventories / current liabilities. It shows liabilities / total assets. It indicates as market value per share / earnings
how easily a company can repay short- the percentage of the company’s per share. It indicates the value of the
term debt from cash. The higher the assets that are financed by debt. A company’s share price. A high ratio
ratio, the more easily it can pay. low ratio is considered favorable. demonstrates good growth potential.

Forecasting

Predicting future business performance is necessary to estimate
probable sales, income, costs, and profitability and thus gain
investment and maintain confidence in the company.

How it works operation and can be tracked over time. The tracked
and monitored data can provide an early warning
Forecasting success or failure relies on historical system for potential problems. For small businesses
data—financial statements, financial ratios, and Key and start-ups, accurate forecasts provide a basis for
Performance Indicators—that reflect business

Forecasting with Z-score models Working capital / total assets
A measure of liquidity: the
Realizing that traditional financial ratios, such as the ratio of more working capital in a company,
costs to revenue, created only a partial picture of a business’s the more it is able to pay its bills.
financial performance, Altman devised a set formula that
combined four or five key ratios to give a Z score. The model
has proven 90 percent accurate in predicting business failure
over one year, and 80 percent accurate over two years.

Market value of equity / Retained earnings /
book value of total liabilities total assets
A measure of the market confidence A measure of leverage: a high ratio
in the company: a ratio of less than indicates profits are funding growth;
one means the firm is worth less a low ratio indicates growth is
than it owes—it is insolvent. financed by debt.

Corporate success Earnings before interest Sales / total assets
and taxes / total assets A measure of efficiency: the
Efficiently run companies with a A measure of return on assets: sales generated by the assets.
healthy balance between assets it gauges operating income
and liabilities, and profit and debt generated by assets.
inspire confidence in investors.

SS Success

Finding the Z score

Each of the above ratios is multiplied by
a specific value, to give them weighting;
results are added together to give Z score.

❯ A score of 0.2 or lower means the
company is highly likely to fail.

❯ A score of 0.3 or higher means the
company is unlikely to fail.

150 151HOW FINANCE WORKS
Measuring performance

raising external financing, while for larger companies, NEED TO KNOW
this information provides an indication of financial
strength for investors and markets. Predictions may ❯ Ohlson O score ❯ Undertrading When
range from conjectured costs and revenue to complex Alternative to Z score for a company trades at
financial models. One of the most frequently used predicting failure low levels compared
predictive models for forecasting business success to its finance levels
is the Z-score model, devised by Edward Altman, ❯ Overtrading When a
a New York University finance professor, in 1968. company’s sales grow ❯ Zeta analysis Second-
faster than its finance generation Z-score model

Signs of corporate failure 20%

There are many signs that a company is doing badly the predicted profitability
and perhaps sliding into insolvency. These signs make increase from 2013 to 2017
investors nervous, which is likely to lower share price for organizations using
if they start selling their shareholding. However, most performance measurement
companies that fail are in profit, but run out of cash. to make business forecasts

SS Failure Stoelplianygoaffssdeetbsts Cuts to employee
benefits

Bankruptcy to shadRrieevhpidoeeladnteedrdscuts
occurs if the
company cannot Top management
pay its debts resigning and taking
jobs elsewhere

on bLapolaawtntecceransshoheffledtoeowcvli,ensreeceinonncisnaescchouhntiotvilenduyineegdasrs and dhHwigiignhhdinlbintoegrrerreostvwepnianuygme, ents, oconnpsLrceooocfiwnutst-iipasvntreeodynfi-etltoadarsobsswisltniatstylei,dmseeeeinnntpsinrforofimt

Tracking fraud

For keen observers of financial statements, warning signs that
indicate fraudulent business activities may be detected in overly
optimistic statements and evasive attitudes of senior management.

How it works uncovered. It is the auditor’s job to NEED TO KNOW
ensure that business records and
Public companies are required statements are accurate and have ❯ Asset stripping Selling off the
to have their annual financial been honestly reported. Auditors assets of a company for a profit
statements audited (checked) carry out a systematic examination to raise funds, often resulting in
by an independent auditor. It of the company’s records and may the closure of the business
is typically during this process identify any irregularities that may
that any financial shenanigans— indicate fraud. If evidence of fraud ❯ Tunneling A particular type
creative accounting tricks used to is found, the next step is to involve of fraud in which assets and
manipulate the figures and improve forensic accountants and criminal funds are illicitly transferred to
the performance of a company in investigators, who may prosecute management or shareholders
its financial statements—and the perpetrators.
outright fraudulent activity is

Red flags Suspicious figures on financial statements
indicating fraud
❯ Cash flows that are negative ❯ Sales recorded before
Auditors may be alerted to fraud by a for three quarters, then they have been made
number of recognized warning signs or suddenly and dramatically
“red flags”; these may be either directly become positive ❯ Made-up, nonexistent
to do with the behavior of the CEO or sources of revenue
other top executives, or in the form of ❯ Sudden increase in gross
irregularities within the financial statements. margin, at odds with ❯ Expenses moved from one
industry average and company to another, or
89% company’s previous classified as assets
performance pattern
of US corporate ❯ Ongoing, long-term growth
fraud cases in ❯ Large sales to companies of earnings per share
2010 typically with dubious track records
involved the ❯ High payments to executives
company’s compared to base salary
CEO or CFO
How to detect fraud Applying ratio
analysis to
Procedures should be in place to reveal key
hold accountable anyone who handles long-term
expenses. When these fall short, trends (see
internal and external auditors need pp.148–149)
to take more drastic measures.

152 153HOW FINANCE WORKS
Measuring performance

LINE-UP: TOP FIVE NOTORIOUS FRAUDS

Some of the worst frauds stem from the most prestigious companies.
Enron was one of the top seven US companies, while JPMorgan Chase
& Co. was the largest American bank when measured by assets.

SECURITIES BARINGS BANK ENRON WORLDCOM JPMORGAN CHASE
EXCHANGE CO. The UK merchant Energy company US communications & CO.
In 1919, Charles Ponzi Enron declared company WorldCom
began a pyramid bank collapsed bankruptcy in 2001 declared bankruptcy For 10 years from
scheme in Boston, in 1995 after although it had 2002, the company
selling postal reply unauthorized never shown a loss in 2002 after it approved thousands
coupons. He pledged improperly accounted of home loans to
investors 50 percent trading by employee in its financial ineligible recipients.
return within 45 days, Nick Leeson racked statements. External for $3.8 billion in The employee who
which he paid from auditors were accused expenses. Auditors blew the whistle was
new investors’ funds. up losses of of failing to properly Arthur Andersen awarded $64 million.
$1.3 billion. He had
review accounts. were held liable
been allowed to for not noticing.
bypass internal audits.

CEO behavior Technicalities

❯ Evasive behavior by executives ❯ Late entry of sales or earnings
over important financial details adjustments

❯ Attempts by CEO to steer auditors ❯ Missing approvals or signatures
away from certain documents
❯ Photocopied documents presented
in place of originals

Setting up confidential Using element of Conducting a Data mining with
hotline for current and surprise, such as surprise cash count auditing software
past employees or others undertaking an to determine whether to detect any mismatch
with knowledge of the aggressive internal current cash flow between past patterns
company audit without prior matches statements and current statements
warning

Raising
financing

When a company needs additional funds, it can use either internal or external
sources, or both, depending on whether it seeks large amounts of funding for
long-term growth, such as an expansion, or smaller amounts for short-term
expenses, such as to cover operating costs. In addition, the number of external
sources available depends on whether the business is well established or
whether it is relatively new and without much of a track record.

Sources of financing and capital

When considering the prospect of raising financing, the financial directors will
first evaluate the financial health of the company. They will then decide what
proportion of the company will be funded by equity (the company’s own
reserves of cash and money raised from issuing shares) and what proportion
will be funded by borrowing money from an outside source, such as a bank,
so that the company takes on debt.

59% Debt and loans FUNDS IN THE
FORM OF A
of US financial $$ LOAN FROM
managers say AN OUTSIDE
financial flexibility Institutional lenders SOURCE
is the most
important factor Money loaned by large financial bodies, INTEREST
in deciding how such as banks. See pp.158–159. PAYMENTS
much debt the
company takes on

154 155HOW FINANCE WORKS
Raising financing

EVALUATING CAPITAL STRUCTURE

When investors consider buying shares in a ❯ A company with significantly more debt than
company, they look at its capital structure to equity has a high debt-to-equity ratio and is
assess the future prospects of the business. more risky as an investment.
The capital structure refers to the percentage
of a company’s finances made up of funds from ❯ Debt is not always bad. If interest rates are low
shares and earnings, called equity, and the
percentage made up from borrowed funds, a company could take on more debt to fund
or debt. When evaluating capital structure,
investors consider the following: expansion, as long as the revenue it makes

❯ As a general rule, companies with more equity from the borrowed funds is
than debt are considered less risky to invest in
because their assets outweigh their liabilities. greater than the interest
So a company with significantly more equity
than debt has a low debt-to-equity ratio and payable. So although this $$
is generally seen to be a low-risk investment. company may be more
risky, it may also have
greater potential for
growth—this is known as
“gearing.” See pp.174–175..

FUNDS FROM Equity $$
SHARE ISSUES
AND RETAINED $$
PROFIT

Profit from business Shareholders’ stake
activities in company

Proceeds of the core business. Payment received for shares in
See pp.156–157. the company. See pp.164–169.

Company DIVIDENDS—PAID ONLY WHEN A COMPANY
MAKES ENOUGH PROFIT

Bonds

FUNDS FROM $ Investor
BONDS BOUGHT lenders

INTEREST AND CAPITAL Payments made
SUM ON MATURITY by bondholders.
See pp.170–173.

Internal financing

Most companies prefer to secure funding from their own internal
resources, rather than either take on debt through borrowing or give
up a stake in the company by issuing shares, both of which cost more.

How it works Raising internal financing

When a business needs funds, or capital, to pay for Whether a company’s need for additional funds
expansion or investment in order to maintain its is long- or short-term, steps can be taken to
current operations, it is faced with two choices: either increase the level of funds within the company.
find the money from outside sources, or find the money
from within the organization itself. Since there are Short-term financing
costs attached to bringing in funds from external
sources, such as interest that has to be paid on a For businesses wishing to raise funds without
bank loan, the business managers must weigh up the recourse to external sources, there are three main
opportunity cost of using its own funds—the profit it strategies they can implement to maximize the
could earn by investing those funds—against the cost amount of cash available for day-to-day operations
of financing. and capital expenditure.

THE RECENCY BIAS Tighten credit control
Actions include chasing
When a company receives timely payments for its invoices, this debtors so that invoices are
helps maintain its levels of funds. Interestingly, invoices issued paid on time; ensuring new
right after completion of work tend to get paid sooner than customers are creditworthy
those invoices that are sent later. A theory called recency bias by conducting strict credit
explains this phenomenon: the brain prioritizes recent events checks; and setting a
over those that occurred longer ago. 30-day payment term.

10

DAYS IT 8 Delay payment
TAKES 6
CLIENT 4 Large suppliers may offer a
TO PAY discount for early payment,
but they may also allow a
2 $ company longer terms for
payment, boosting cash
levels in the short term.

01 2

WEEKS IT TAKES TO SEND INVOICE

156 157HOW FINANCE WORKS
Raising financing

Company USING PROFITS TO
FUND EXPANSION
Reduce inventory Long-term financing
A company seeking to grow may
It is expensive for a business For a business needing long-term choose to fund the expansion with
to retain a large inventory financial help, its own resources its profits. This option offers both
of unsold goods. Cutting should act as the primary support. advantages and disadvantages.
the inventory back reduces
storage costs, the cost of $$ Pros
production, and replacement
of goods that go out of date Retained profits ❯ The use of profits means that no
or become obsolete. A portion of profits may be interest payment has to be made,
pumped back into the business. unlike on money that is borrowed
A company may also decide to
sell assets to raise cash. ❯ Existing owners and directors are
able to retain full control over the
business, rather than sharing it
with new investors

❯ The company is able to keep a low
debt profile, which will appeal to
future investors and lenders

Cons

❯ Profits can take time to build up
sufficiently to fund expansion

❯ Withholding dividends may upset
some shareholders who prefer to
receive the profit as dividends

❯ Lost opportunity to earn funds
from investing profit rather than
spending it

Total intern al financing forthe business 44

the average
number of days
it takes a limited
company in the
UK to pay a
30-day invoice

External financing

When business growth or unforeseen expenses cannot be met using
internal sources of financing, such as retained profit, organizations
must rely on finding funds from lenders or investors.

How it works expansion is more challenging. NEED TO KNOW
A company that is either already
External financial support comes in listed on a stock exchange or is ❯ Term loan A bank debt repaid
various forms, including bank loans preparing to enlist will be able to over a set period of time
and issuing shares. The available raise the capital through the sale
sources of outside financing of shares. However, an unlisted ❯ Loan note A form promising
depend on the amount a company company may struggle to raise a payment to the holder at an
requires, and whether the money comparable amount. A company agreed future date
is needed to resolve a short-term with a large amount of debt will
issue, such as cash flow, or for the also find it hard to raise funds, ❯ Eurobond A bond issued in a
long-term growth of the business. since lenders or investors will currency other than the currency
While short-term financing is easier see the business as risky. of the country in which it is issued
to secure, finding larger sums for an

Raising external Short-term financing
financing
A range of financial agreements that help provide a
Generating funds from external company with immediate funds can be made with
sources can be a challenge, especially outside parties as a way of raising cash short-term.
when securing investors. However,
revenue does not necessarily need Bank line of credit
to take the form of a loan. There are $ Borrow from business checking
a number of strategies that can be
implemented through working with account up to an agreed limit, with
external parties in order to provide a interest typically at a high rate.
company with good working capital.
Debt factoring
80%
$ Sell unpaid invoices to an external
of external source for an agreed amount in order
corporate
financing is to receive immediate payment minus
provided by
domestic banks a commission fee.

Invoice discounting

Borrow money against sales invoices
customers are yet to pay (again, often
at a disadvantageous rate).

158 159HOW FINANCE WORKS
Raising financing

DEBT FACTORING PROCESS

To get money immediately, a company sells unpaid invoices (accounts receivable)
to a third party, known as a “factor.” The factor advances the company a major
portion of the amount, retains the rest until the account is paid, then charges a fee.

$$

Company negotiates Company sends invoices Factor pays company Customer pays Factor pays remaining
an agreement in which out to customers, and an agreed percentage factor the invoice invoice amount to
its unpaid receivables copies these to the of the invoices (typically amount after 30 days company, minus a fee
(invoices) are sold at a factor. Customer now 80–90 percent) within (or more if terms of (usually 2–5 percent of
discount to a “factor.” owes payment to factor. a few days of receipt. payment are longer). the invoice amount).

Company Long-term financing
al financing for
Putting effective measures in place to provide ongoing
revenue is essential for a company’s long-term growth.

Total extern the business $ Shares

$$ Raise capital by issuing shares to finance
$ growth. The company then retains less
profit, as it pays dividends to shareholders,
who also benefit from any capital gains in
the company’s value (see pp.164–165).

Borrowing

Secure long-term loans from banks and
other financial institutions, usually on
better terms than a bank line of credit.

Finance leases

Sell expensive assets such as computers to
finance companies to release capital, and
then lease them back.

Rent-to-own agreements

Pay for expensive assets, such as vehicles,
in installments. Overall cost may be higher,
but capital is not tied up.

Going public

When a company changes from private to public, it offers shares for
sale to members of the public. This process is known as going public
and enables the company to raise money for growth.

How it works Ways to list on a stock exchange

The process by which an There are three primary ways to take a company public,
organization goes public (also each of which has different associated costs. The type of
known as flotation) marks the end public offering that a company chooses will be determined by
of its life as a private company, after its size and how much capital it needs to raise.
which it is no longer owned by a
small number of shareholders or Introd uction A company joins a new stock exchange
company members. A company without raising capital, but by trading
may choose to go public when it its existing shares. To do this, over
needs capital to finance growth. 25 percent of the shares must already
Going public usually happens over be in public hands (on other stock
several months; the company exchanges) and no one shareholder
makes legal and financial can own a majority of shares.
preparations before the final stage,
when it releases company shares Placin Select groups of institutional investors
for sale, either to selected investors
or to the general public, or to a g are invited to buy shares. This involves
combination of both. Each share
represents a “stake” in the fewer costs than undertaking a full
company, and the money that public share offering (see below)
the company receives from the but the amount of capital that can
sale of shares becomes capital, potentially be raised is limited since
or wealth, which it now owns. there are fewer shareholders.

WARNING

❯ Underestimation If the Initial public of fering (IPO) Institutional and private investors are
initial valuation of shares by invited to subscribe to or buy from
the underwriters is too cautious, the first round of shares that the
then the company will fail to company issues. This is the most
realize the true value of its stock expensive way to go public, but
allows for a company to raise large
❯ Overestimation If underwriters amounts of capital.
overestimate the value of shares
newly on the market (new issue),
it may flop due to lack of demand

❯ Volatility Share prices in the first
few days of an IPO may fluctuate
dramatically due to political or
economic events

160 161HOW FINANCE WORKS
Raising financing

20% the typical minimum annual growth
potential of public companies in the US

TEN LARGEST IPOS IN HISTORY

When a well-known private company undertakes an IPO, there is fierce competition between
investors to buy its shares, and record-breaking activity can ensue. This graph shows the
largest IPOs until 2014, based on proceeds from shares sold on the first day they went public.

INITIAL PUBLIC OFFERING (IPO) Alibaba Group 2014, New York Stock Exchange $25BN
(Chinese e-commerce group)

Agricultural Bank of China 2010, $19.2BN
Shanghai Stock Exchange
(Chinese bank)

NTT Group 1998, Tokyo Stock Exchange $18.4BN
(Japanese telecoms group)

Stock exchange Visa 2008, New York Stock Exchange $17.9BN
(American financial services corp.)
A financial market
in which company Enel SpA 1999, New York and $16.58BN
securities (stocks and Milan stock exchanges
shares) are bought (Italian utility company)
and sold according to
current market rates. Facebook 2012, New York
See pp.170–171. Stock Exchange
(American social networking site)
$16BN

General Motors 2010, $15.8BN
New York Stock Exchange
(American car manufacturer)

$12.48BN Deutsche Telekom AG 1996, Frankfurt,
New York, and Tokyo stock exchanges
(German telecoms company)

$11.1BN Bank of China 2006, Hong
Kong Stock Exchange
(Chinese bank)

$10.65BN OAO Rosneft 2006, Moscow
and London stock exchanges
(Russian oil company)

$0 $10 BILLION (BN) $20 BILLION (BN)

VALUE (USD)

GOING PUBLIC

A closer look at IPOs WORLD’S TOP 10 STOCK EXCHANGES

An Initial Public Offering (IPO) The largest exchanges manage shares exchanges are listed in order of the
is the first time that shares in belonging to some of the world’s size of market capitalization—in other
the company are offered for public most lucrative businesses and, as a words, by the total monetary value of
sale. It is the most common way for result, substantial sums of money shares issued by the companies listed
a private company to go public if flow through them. The following on each exchange.
it needs a large injection of capital
to fund major expansion. There are 1. New York Stock Exchange 6. Shanghai Stock Exchange
other reasons for going public—for 2. NASDAQ OMX, New York 7. Hong Kong Stock Exchange
example if a government wants to 3. Tokyo Stock Exchange 8. Toronto Stock Exchange
privatize a state-owned company, 4. Euronext (Pan-European) 9. Deutsche Borse
such as a national railroad, or if the 5. London Stock Exchange 10. SIX Swiss Exchange
members of a large family-owned
enterprise want to sell their stake.

The IPO process 3

Before a company can issue shares, it has to File a prospectus
be listed on a stock exchange where trading
(the buying and selling of shares) can take This document contains information
place. The company must then fulfill the about the offering, the business, and its
criteria necessary to secure investors. This financial history, and proposed plans.
process is lengthy, subject to strict financial Details are still subject to change.
regulations, and is extremely expensive to
undertake. Only once all stages of the process
are complete can the share offering be
officially declared on a stock exchange.

1 Pretax earnings 2
above a certain
Meet the level Appoint underwriters
qualifications Three years of
audited financial These financial professionals will be
The specific statements responsible for buying and selling
requirements are set Ability to pay the the shares to the public.
by the stock exchange annual listing fee
where the company
plans to list. Listing
conditions vary
between exchanges,
but typically demand:

162 163HOW FINANCE WORKS
Raising financing

$16.6 trillion NEED TO KNOW

the total market capitalization ❯ Large cap Listed company with
of companies listed on the market capitalization of more
New York Stock Exchange* * as of October 2014 than $10 billion

❯ Mid cap Listed company with
market capitalization of between
$2 billion and $10 billion

❯ Small cap Listed company with
market capitalization of between
$250 million and $2 billion

4 6

Promote the share offering $
$
Company representatives, as well as $
the underwriters, visit national and $
international destinations to pitch $
to potential investors. $

5 Sell on the stock market

Set the final offer price The IPO is officially declared a few days
after potential investors receive the final
After ascertaining market conditions prospectus. The declaration is made on
and the anticipated demand, the a set day after the exchange has closed,
company decides the price and the and the shares are available for trading
number of shares to issue. It is then the following day.
ready to launch the offering.

7 8 9+

Shares and dividends

When a company goes public, it sells shares to investors, who become

part-owners in return for capital investment. The number and type of

shares bought by each investor determines the size of their ownership.

How it works be offered on the exchange. Upon Company shares
going public, a company issues
Before floating on a stock exchange, ordinary shares to investors as the
a company undergoes a valuation basic unit of ownership, commonly
process to set the initial price of its referred to as a stake in the
shares. This process involves the business. A company may also
directors, prospective investors, issue shares privately, rather
and an investment bank, which is than publicly to investors
appointed to assess the company’s via the stock exchange,
value. Together, they reach a to retain greater
decision on the most financially management control.
viable price for the shares that will

A share of the pie

Ordinary shares, issued by all companies when they go
public, are the most common type of shares. There are also
other share types, which give the company more flexibility
to control rights available to different shareholder groups.
Most shares are sold on the stock exchange, but non-voting
and management shares are issued directly to holders.
Different types of shares entitle the holder to different rights.

Management shares Issued directly

Issued (usually given not sold) to
owners and members of company
management, who have:
✓Extra voting rights, so control

of company stays in the same
hands

Non-voting shares

Issued to employees, who:
✓Receive a part of remuneration

in the form of dividends
✗ Have no voting rights
✗ Receive no invitation to attend

annual meeting

164 165HOW FINANCE WORKS
Raising financing

Sold via stock exchange Common stock NEED TO KNOW

Shareholders: ❯ Flipping Buying and quickly reselling IPOs
✓Share in the company dividends for a large profit
✓Share in the company’s assets
✓Have right to attend AGM ❯ Redeemable shares Shares that may be
✓Have right to vote on important later bought back by the issuing company for
a cash sum
company matters such as
appointment of directors 698%
✓Receive the company’s annual
report and financial statements the increase in share
price of IPO VA Linux
Preferred stock Systems in one day on
the New York Stock
Shareholders: Exchange, in 1999
✓Receive fixed dividend, paid
RAISING MORE SHARE
ahead of any dividends paid CAPITAL
out to ordinary shareholders
✓Take priority in receiving a share After the initial sale of shares, when a company
of any assets left after debts are goes from private to public, the business can
paid if company is insolvent raise additional funds by issuing more shares.
✗ Have fewer, if any, voting rights There are three main ways to do this:
❯ Rights issue entitles existing shareholders
Deferred stock
to buy additional shares from the company
✓Shareholders receive company within a set time frame, before they are
dividends and share of assets, but offered to other buyers.
only after all other shareholders ❯ Public issue is a process by which the
company issues a new allotment of shares
to sell to the public on the stock market.
❯ Private placement is a practice by which the
company sells its shares (or other securities)
directly to private investors, usually large
institutions, bypassing the stock exchange
all together.

SHARES AND DIVIDENDS

Establishing share value 25% SPLITTING SHARES

The forces of supply and demand the drop in A company occasionally carries
set the price of shares. Companies share value over out a “share split” to its existing
issue only a limited number of four days during shares. This increases the total
shares to the public, which can the Wall Street number of shares, although the
then be bought and sold on the Crash of 1929 combined value of shares stays
stock exchange. Demand for those the same. A share split allows a
shares is determined by whether company to lower the price of its
investors think the company has shares to bring them in line with
good future economic prospects. the price of competitor shares. The
If investors believe that the share split is usually a two-for-one
company is primed for substantial or three-for-one increase, whereby
growth, they will want to buy the shareholder sees the number
shares in it, which consequently of their shares double or triple.
drives up the share price.

Rising value of

shares

Financial market observers believe VALUE
that the emphasis on optimizing the (INDEX
POINT)

value of shares for shareholders began 1987MOOCNTODABYERC1R9A:SBHLACK

in 1976, when the idea of maximizing 4,000

profit for shareholders became a

priority. Since then, the market has 3,500
experienced a general upward trend

with occasional deep dips. The graph

tracks the average value of all shares 3,000
on London’s FTSE from 1964 to 2013.

2,500

NEED TO KNOW 2,000 CSRTA1OS9CHK7M2A–RK1E9T 74 1976MSATHHXAEIRMOERIHZYOINPLGRDOERPOVASELDUE
1,500
❯ Bear market Market that has 1,000 1970 1980
seen decline of 20 percent over a
period of 2 months or more 500
0
❯ Bull market Market where share
prices are rising and investor
confidence is high

❯ Market correction Short-term
decline in share prices to adjust
for an overvaluation

166 167HOW FINANCE WORKS
Raising financing

$ 3$3 1,000 $1.50
$1.50 2,000

SHARE PRICE TOO HIGH SHARES SPLIT SHARE CERTIFICATES ISSUED SHARE VALUE ALIGNED
A company listed on the stock The company decides on a share It issues new share certificates to The value of shares is now
exchange has seen its share price split. It halves the price of each holders, doubling shares held: a similar to that of competitors.
increase so that its shares now existing $3 share, so each share shareholder with 1,000 shares at The price encourages new
cost more than its competitors’. is now worth $1.50. $3 each now has 2,000 at $1.50 investors to make a purchase.
The high price puts off investors. each. Total worth is still $3,000.

1999DHOETI-GCHOTMOBFOTOHME 2007CRAEUDGITUCSTR:UGNLOCHBAL 2010DEFBETBRCURIASRISY: EUROZONE

1997

FJIUNLAY:NACSIIAALNCRISIS

DOT-2C0OM0 B0U–ST2002 2001

1990 IAN9T/N1T1AEWCTKEYRORORKRIST 2010 YEAR
2000

SHARES AND DIVIDENDS

What is a dividend? pay out dividends. In a good NEED TO KNOW
economic climate, they win
Shareholders in a company are twice—the dividend provides ❯ Dividend yield ratio Measure
usually entitled to a payment of income and the capital value of the of how much a company pays out
cash from its profits. The company shareholding increases. However, in dividends relative to the price
pays a dividend sum on every share there is always a risk that the of each share
it has issued, but it is up to the value of shares will go down,
company’s board to decide how and companies only pay dividends ❯ Dividend per share Sum paid
much profit to reinvest and pay out. if they have made a profit. on each share after retained
Investors may look at a company’s profits have been calculated
rate of dividend payout, along with Paying dividends is a good way
its capital growth, to gauge its for a company to attract investors. ❯ Dividend payout ratio
financial health and decide whether It is essentially a reward for putting Percentage of a company’s net
to invest in it. Investors who rely money into a company so that it income that is paid out in the
on shares for income are likely to can fund its existing output and form of dividends
invest in companies that reliably develop and expand the business.

How it works

Shareholders usually receive a dividend if the company in which they hold
shares has retained enough profit in that financial year to make the payment.
The decision to make a payment is made by the board of directors. The dividend
might be paid every quarter (four times a year), or in two parts—an interim
dividend may be made partway through the year, with the final dividend paid
just after the end of the financial year.

Announcing retained profits Making the decision for dividends

At the end of the financial year, the company The board of directors makes a decision on
announces its retained profits: the sum it intends whether there is enough to warrant a dividend
to keep for reinvesting or paying off debts rather payment, and if so, how much. It records details
than pay out as dividends. of each payment in dividend vouchers.

$$$$$$

168 169HOW FINANCE WORKS
Raising financing

INTEREST RATES AND DIVIDENDS HIGH Investors are Investors are LOW
INTEREST attracted to attracted to INTEREST
When interest rates are low, shares with high dividend buy shares as
payouts become extremely attractive to investors RATES pay into dividends give RATES
because they provide a better return than investments fixed-income a good return
that yield an interest payment. This economic climate assets, such as for their money.
encourages companies to pay out top-rate dividends deposit accounts.
and so attract as many investors as possible, which in
turn increases the share value. $$

Conversely, when interest rates are rising, investors
may prefer to put their money into fixed-income
assets, which will pay high rates as a result of the hike
without the risk attached to buying shares.

$ 1602
$
$ the year the Dutch East
India Company became
Keeping funds for growth the first company to
issue stocks and bonds
The company keeps some of its profit to put back into
the business. It needs to strike a balance between
pleasing investors and expanding its operation.

$ Paying taxes $

Making the payment Shareholders must
declare dividends on
Most dividends are cash dividends. Sometimes their tax return and
companies distribute stock dividends, issuing pay taxes on them.
more shares instead of cash to shareholders.

The capital market

The capital market is a global financial marketplace for trading long-term
securities—bonds with a maturity of at least a year, and shares. It is where
governments and businesses can raise funds and investors make money.

How it works to users of capital, such as businesses and government,
and capital is what enables goods and services to be
There are two types of product sold on the capital produced. The original issuers of the shares and bonds
market: shares (equity) and bonds (debt investments). do not gain from trading activity in the secondary
Shares and bonds are sold first on the primary market, market, which is purely for investors. However, share
where they are originally issued, and later traded on value and bond trading levels reflect confidence in a
the secondary market. The capital market is crucial company or institution, reinforcing its financial position.
to a functioning economy, because it channels funds

The structure Ca pital mark et

The capital market encompasses the debt capital market, $
where bonds are sold, and the stock exchange, where shares
are sold. Both have a primary and a secondary market.

Primary market

The market issues new bonds and shares, with
investment banks overseeing the trading. It is
also known as the new issue market (NIM).

GOVERNMENTS SELL BONDS COMPANIES
SELL BONDS
AND SHARES

BONDS SHARES
Sold on debt capital Sold on stock
exchange (equity
market (bond capital market)
market)

INVESTORS

170 171HOW FINANCE WORKS
Raising financing

WHAT IS A BOND? $100
trillion
A bond is a debt security that time the interest is paid
a company issues to investors. to the investor annually. When the estimated value
By buying bonds, an investor the bond matures, the issuer of global debt markets
is effectively loaning money to repays the original sum of the
the issuers, who in return agree loan to the investor. Companies
to pay interest to the investor. or governments issue bonds to
A bond has a set term of raise money that can then be
maturity (a limited number of put back into the business or
years of validity) and until that used to fund government.

Bonds or shares: pros and cons

Secondary market Bonds (debt investments)

Investors buy bonds and shares from other investors, ✓Sellers are contractually obliged to pay interest
not from issuing companies. The cash proceeds go to
an investor, not to the underlying company or entity. ✓Bonds are less risky: debt capital markets are
less volatile than stock exchanges; if the issuing
company has trouble, bondholders are paid
before other expenses and before
compensation to shareholders

✗ Buyers of bonds have no stake in
the company

✗ Buyers cannot access principal sum
until bonds mature

BONDS SHARES Shares (equity)

✓Buyers of shares gain a stake in the company

✓Sellers of shares have to pay dividends,
although these can be reduced or suspended
if the company feels it is necessary

✗ Shares are more risky: changes in company
profits and in the economy as a whole can cause
share prices to rise and fall; if the company fails,
the shares become worthless

Individual investors buy and sell
shares and bonds previously issued

on the primary market

THE CAPITAL MARKET

How do bonds work? and sold. It attracts investors NEED TO KNOW
because bonds provide more
Bondholders effectively buy a slice protection from risk than shares. ❯ Debt instrument Official term
of a larger loan with each bond, for There are various types of bonds, for bond or other long-term debt
which they receive interest, along some safer than others—the risk
with the original sum on maturity. lies in whether the issuer will be ❯ Convertible bond Bond that
Issuing, buying, and selling able to pay the interest and repay can be converted into shares of
bonds takes place in the debt the principal sum on maturity. A the issuing company, or cash
capital market. The marketplace secured bond is backed by an asset,
has several functions: it offers such as property; an unsecured ❯ Warrant Security that allows
bonds and other types of loans to bond is not and so carries more risk. the holder to buy stock in a
investors; it operates as a fixed- company at a fixed price for
income market, because the issuer Both bonds and shares may be a certain period of time
is required to pay regular interest; referred to as securities. The term
and it enables companies and describes the share or bond itself, ❯ Callable bond Bond that gives
governments to raise long-term and the certificate of ownership or the issuer the right to redeem it
funds. Overall, the debt capital creditorship that gives the holder before maturity
market is much larger than the the right to receive a dividend,
stock exchange (equity capital in the case of shares, or interest ❯ Non-callable bond Bond that
market), where shares are bought payments, in the case of bonds. cannot be redeemed or sold back
to the issuer before maturity but
continues to provide interest

Investing in the debt capital market

A company wants to raise $100 million to finance growth but does not wish to
issue further shares. Instead, it raises the money by issuing bonds on the debt
capital market.

BOND
$100

BOND $100
$100
10 YEARS
Company issues bonds
The company issues 1 million bonds at $100 each. 7%
Each bond effectively acts as a loan between the
investor and the company. interest

Investors buy bonds

Each bond has a set maturity date of 10 years and
a 7 percent interest rate, with a face value of $100.
During the 10 years, the company can use the
money as capital.

172 173HOW FINANCE WORKS
Raising financing

TYPES OF BONDS Corporate bonds

Government bonds SECURED BONDS

GOVERNMENT Secured UNSECURED BONDS
BONDS
Secured bonds are secured by the Unsecured
Secured assets of a company, making them Unsecured bonds are not
a less risky investment than shares. backed by pledged collateral and are
Government bonds are the safest Examples include equipment, trust a riskier investment—if the company
type of bond since governments certificates, and mortgage bonds. fails, investors are paid only after
in developed capitalist economies secured bonds have been paid
are unlikely to default on interest out. Because they are more risky,
payments on the loan or on the investors expect a higher return
principal sum. (interest) on their investment.

INTEREST PAID (%) 100 $70
90 over 10
80 years
70
60 10 YEARS
50
40 $100
30
20 Mature bond is repaid
10 Once the bond reaches its date of maturity, in this
case 10 years, the original sum of money, $100, is
0 1 2 3 4 5 6 7 8 9 10 repaid to the investor. So the investor receives a
YEARS total of $170, including interest, over the full term,
in return for the original $100 investment.
$7

Investors receive annual interest

Each year, the company pays an investor $7
(7 percent of $100) for each bond bought, in
return for using the principal sum as capital to
fund its business. After 10 years, the investor has
received a total of $70 interest per bond.

Gearing ratio and
financial risk

Capital gearing is the balance between the capital a Low
company owns and its funding by short- or long-term gearing
loans. Investors and lenders use it to assess risk.
Company has
How it works Equity finance (shares) less debt

Most businesses operate on Pros Company has
some form of gearing (also called more equity
financial leverage). They partly ❯ Does not have to be repaid
fund their operations by borrowing ❯ Shareholders absorb loss Low proportion of
money, via loans and bonds, on the ❯ Good for start-ups, which may debt to equity, also
condition that they make regular described as a low
repayments of a fixed amount to take a while to become profitable degree of financial
the lender. If the level of gearing is ❯ Angel investors share expertise leverage. Equity
high (in other words, the business ❯ Low gearing seen as a measure comes from:
has taken on large debt), some ❯ Reserves (retained
investors will be concerned about of financial strength
its ability to repay and see this as ❯ Low risk attracts more investors profits)
an insolvency risk. However, if the ❯ Share capital
amount of operating profit is more and boosts credit rating
than enough to repay interest, high Cons
gearing can provide better returns
to shareholders. The optimum ❯ Shared ownership, so company
level of gearing for a company also has limited control of decisions
depends on how risky its business
sector is, how heavily geared its ❯ Shared profit in return for
competitors are, and what stage investors risking their funds
of its life cycle it is at.
❯ Legal obligation to act in the
interests of shareholders

❯ Heavy administrative load
❯ Complex to set up

Gearing ratio calculation Low gearing

Analysts and potential investors assess A software company is going public. Its ratio of 21.2 percent tells
the financial risk of a company with this investors that it has relatively low gearing and is well positioned
calculation, presented as a percentage. to weather economic downturns.

LONG-TERM DEBT × 100 $1.2 MILLION × 100 = 21.2%

SHARE CAPITAL + $2 MILLION + $2.455 MILLION +
RESERVES + $1.2 MILLION

LONG-TERM DEBT

174 175HOW FINANCE WORKS
Raising financing

High Debt finance (loans) NEED TO KNOW
gearing
Pros ❯ Interest cover ratio An
Company has alternative method of calculating
more debt ❯ If the company makes a profit, gearing—operating profit divided
it can reap a larger proportion by interest payable
High proportion of
debt to equity, also ❯ Paying interest is tax deductible ❯ Overleveraged A situation in
described as a high ❯ Does not dilute ownership which a business has too much
degree of financial ❯ Company retains control of debt to meet interest payments
leverage. Typical on loans
examples of debt are: decisions
❯ Loans ❯ Repayment is a known amount ❯ Deleverage Immediate payment
❯ Bonds of any existing debt in order to
that can be planned for reduce gearing
Company has ❯ Quicker and simpler to set up
less equity ❯ Small business loans at favorable 25%

rates may be available to start-ups the ratio at
Cons or below which
a company is
❯ Loan must be repaid traditionally
❯ Interest must be paid, even said to have
low gearing
if operating profit shrinks
❯ Debt may be secured on fixed

assets of company
❯ Unpaid lender can seize assets

and force bankruptcy
❯ Lenders first to be paid in the

event of insolvency
❯ High gearing considered a

measure of financial weakness
❯ High risk may put off investors

and adversely affect credit rating

High gearing

A water utility is the only water provider in the area, with several
million customers. The ratio of 64 percent is acceptable for a utility
company with a regional monopoly and a good reputation.

$360 MILLION × 100 = 64%

$82 MILLION + $120 MILLION +
$360 MILLION

$

HOW
SALES AND

MARKETING
WORKS

Marketing mix ❯ Marketing approaches
Outbound marketing ❯ Inbound marketing
Business development ❯ Information management

Marketing
mix

The successful marketing of a product depends on the consideration of four key
elements—the product itself, its price, how it is promoted, and where it is sold.
This combination is called the marketing mix, and it is used as a tool for planning
product launches and campaigns. Before focusing on the marketing mix, marketers
need to define the target market for their product by determining which groups of
customers are most likely to purchase it.

The 4Ps and 4Cs of Commodity Product
the marketing mix
❯ Has the product been specifically ❯ Is the product the right
First proposed in 1960, the classic engineered and designed to meet design, size, and color
marketing mix tool contains the 4Ps: and exceed customer expectations? to appeal to customers?
product, price, promotion, and place.
In the 1990s, these were recast as the ❯ What are its unique
4Cs, which emphasized the customer- features? How does it
oriented dimension of the tool. compare with competitors?

The 7Ps of the marketing mix Communication Promotion

Some marketers use a more detailed ❯ What is the most meaningful way ❯ What combination
model of the marketing mix, which to get marketing messages to of marketing and
has three additional elements. customers and provide them media channels will
with useful information? be most effective?
❯ Product See pp.180–183.
❯ When is the best time
❯ Price See pp.186–187. to run promotions?

❯ Place See pp.188–189.

❯ Promotion See pp.190–191.

❯ People Does the business
employ the right people to deliver
optimum service to customers?

❯ Process Are effective systems
in place for handling orders and
dealing with customer questions
and complaints?

❯ Physical environment Does the
design and layout of the business
premises appeal to customers?

178 179HOW SALES AND MARKETING WORKS
Marketing mix

“Product, DEFINING THE MARKET
promotion,
and place In order to establish a marketing strategy for the product they are introducing
create value. to the marketplace, businesses have to define the customers they aim to sell to
But price by researching and segmenting the market.
harvests
value.” ? Market research Market segmentation
See pp.192–193.
See pp.194–195.
❯ Identifies gaps in the market for the
launch of new products ❯ Breaks down the market into smaller
customer groups with similar needs
❯ Measures customer reactions to new
offers and campaign messages ❯ Allows more focused campaigns
with a greater chance of success

Price Cost

❯ What is the value of the product ❯ How much will the product cost
to prospective customers? the customer, and will it be seen
to represent a good buy?
❯ What is the usual price point
for this type of product?

Place Convenience The 7Cs of the marketing mix

❯ Where should the product be ❯ How easy is it for busy customers This model offers a customer-
sold—stores, online, or catalogs? to find and buy the product? focused variation of the 7Ps, adding
three more elements to the 4Cs.
❯ Where do competitors sell, and
is there a way to stand out in the ❯ Commodity
same place?
❯ Cost

❯ Convenience (or Channel)

❯ Communication

❯ Corporation How do company
structure, stakeholders, and other
competitors affect marketing?

❯ Consumer What are the
customer’s needs and wants?
Is the product safe? What product
information is available?

❯ Circumstances Can the business
deal with external factors, such as
laws, weather, economy, culture?

Product

The goods and services a company sells are its product. A product can be
defined in terms of features, design, size, packaging, service type, return
policies, and warranties, together intended to meet the customer’s needs.

How it works Marketers identify the goods and services they sell in
three or five product levels, with the benefit at the core.
Consumers can be said to buy benefits rather than The marketer’s job is to translate and communicate
products. For the marketer, the product itself is that each product level as an offer to the consumer.
benefit to the consumer, as packaged and presented.

Total product concept: Core product
three product levels
Product’s basic function and its
From a marketer’s perspective, a product core benefit to consumer
is more than the end commodity bought
by a customer. It is a total product concept
with several layers of benefit, and these
must be conveyed to the consumer.

Actual product

Packaging, brand name,
quality level, design, and
additional features that set
it apart from rival products

eco-friendly • trad Takes rider high-tech tires
free delivery • pay in from A to B free service

Augmented itional rs •
product installments 6 months’
design • 3 gea
Additional benefits, such • 2-year warranty•
as delivery and credit,
warranty, after-sales service

180 181HOW SALES AND MARKETING WORKS
Marketing mix

42% NEED TO KNOW

of new product ❯ Personal branding Promoting oneself
launches can be as a product with a distinct brand personality
expected to fail
❯ Fast-moving consumer goods (FMCGs)
Sold quickly and at relatively low unit cost,
such as food and household products

Variation: five product levels

This variation on the total product concept is more detailed.
It introduces two more levels by breaking down the actual
product level into a generic and an expected product, and
also includes an extra level of benefit—the potential product.

Core product Product’s
core benefit to consumer

Generic product Basic
functional benefits

2 wh Takesrakes Expected
st rider from product
de Additional
de A to B nd desirable
lighter frame n protection benefits
• austiognlo•cukrcdotyolo•preerrceelhslvoi•eainbc3etlgete•h•aewrsfsemtl•lo•-bokbtnhuoirwlit-ninbrcaollisio
Augmented
product
Extra features
and benefits

Potential
product
Future,
improved
version

Product positioning

A vital step in the process of deciding how to market a product is
defining how it is distinct from the competition—what is unique about
it and what are the qualities that make it better than rival products.

How it works of the product or brand, and clarify how it is different
from similar types of products offered by competitors.
Before a company launches a product, the marketing They also need to identify the criteria that customers
department has to decide how to position it in the are most likely to use when choosing a particular
marketplace compared to competitors’ products. To product or brand. With this information the marketers
determine the positioning of a product, marketers can then create a product positioning matrix or map.
must define the most important features and values

Product positioning maps HIGH QUALITY Ideal brand position

Marketers commonly create a perceptual “map,” Competitor Competitor Gap in the
using a product’s two most important attributes, brand brand market
presented as variables on an x and y axis, to work Competitor
out where to position it. Attributes may include LOW PRICE Competitor Competitor brand HIGH PRICE
price, quality, status, features, safety, and reliability. brand brand
Once the map is labeled, existing products are Competitor
placed on it to reveal the best position or gap for brand
the proposed launch.

FOUR POSITIONING
STRATEGIES

❯ Value positioning A product Brand’s
plotted on the map so that it has current
an attractive price while delivering position
good functional qualities.

❯ Quality positioning A product
that is located on the map on
the basis of its perceived quality
or superiority.

❯ Demographic positioning LOW QUALITY
A product mapped according to
its appeal to a specific population
segment, such as consumers with
a particular occupation.

❯ Competitive positioning Product positioning template
A product that is very similar to
those of competitors, relying on The map shows how marketers position competing products
correct pricing to find a viable in the marketplace according to the price/quality variables (the
position in the marketplace. most commonly used) to identify a gap for the new product.

182 183HOW SALES AND MARKETING WORKS
Marketing mix

EXPENSIVE

C roissant
C
ggs and bacon A breakfast dish An expensive
SLOW aimed at those breakfast food
with ample ideal for busy
P leisure time professionals
E and money.
in a hurry.
H
old cereal

Centrally QUICK
positioned,
cereal is the
most popular
breakfast food.

ancakes With a slow cook time,
pancakes occupy a
niche gap in the
market.

ot cereal In stant breakfast

Older people Students make
and children the ideal target
provide strong
market for
demand for instant breakfast
hot cereals.
products.

Breakfast positioning map INEXPENSIVE

The positioning of the various breakfast foods “Positioning is not what you do
has been determined by the speed at which to a product. (It) is what you do
the food is prepared, measured from slowest to to the mind of the prospect.”
fastest, and the price of each food type, from the
least expensive to the most expensive. Al Ries and Jack Trout

Product life cycle

Every successful product launched on the market experiences growth
followed by decline. To maximize profitability, business managers
must recognize and manage each stage of the product’s life span.

How it works different stages in the cycle is crucial to maintaining
business growth. The life of older products may be
There are typically six identifiable stages in a product prolonged by extension strategies, but if they are no
life cycle, with the product’s rate of growth measured longer grabbing new market share, the business must
by time and revenue. Most businesses have more than consider launching new products in order to continue
one product on the market at any time, and strategic generating revenue.
manipulation of the portfolio of products at their

Growth Saturation

Sales increase and the cost per Sales peak and the cost per
customer falls as profits rise. customer is at its lowest.
There are more customers—and Profits are now high and
more competitors. competition is intense.

Launch

Business outlay is high due to
product development costs
and marketing budget.
There is no return on
investment.

Introduction Decline

Sales are typically low and Profits fall as sales fall and the
cost per customer is high customer base contracts. The
as the market takes time to cost per customer remains low.
accept the new product. Marketing spend is now kept
at a minimum.

$
SALES

TIME

184 185HOW SALES AND MARKETING WORK
Marketing mix

6 Diffusion of innovationINNOVATORS NEED TO KNOW
months (consumer uptake) %EARLY ADOPTERS
EARLY MAJORITY ❯ Extension strategy Revival
the length of time Marketers identify five distinct LATE MAJORITY of a product by rebranding, or
a product can be customer types according to LAGGARDS repackaging, repricing it, or
labelled as “new” how quickly they pick up on finding new markets
a new product.
❯ Portfolio analysis Each of
34% 34% a company’s products measured
by growth rate and market share
Withdrawal to determine marketing spend

The product is phased out ❯ Product life cycle management
as sales stall or continue to (PLM) Tracking of product data
fall. The business introduces from inception to withdrawal
a replacement product before
the old one is withdrawn. PORTFOLIO ANALYSIS

16% Rising stars
Products with a high
13.5% market share in a
high-growth market;
2.5% they require a big
marketing spend to
keep them growing.

Cash cows
Products with a high
market share in a
low-growth market;
they generate money
to support rising stars.

Problem children
Products with a low
market share in a
high-growth market;
they need a big
marketing spend.

Dogs
Products with low
market share and low
growth; they may stay
in portfolio to keep
customers happy.

Price

Price is a crucial variable of the marketing mix: it generates revenue,
while product, promotion, and place yield costs. Pricing may also be the
marketer’s most potent tool because even minor tweaks affect returns.

How it works of the product is low they will NEED TO KNOW
look for the cheapest price among
To set the price of a product, competing products. ❯ Price, value, and cost
marketers adopt a pricing strategy Price refers to the amount
based not only on the actual cost A business must also take into a product sells for; value refers
of production but also on the account the price charged by rival to the product’s actual worth;
perceived attractiveness of the organizations, particularly in cost is the amount that has been
product to consumers. If consumers competitive markets. Setting spent to manufacture the product
think a product has a high value, a price above that charged by
they will be prepared to pay more competitors can only work if the
for it, but if they believe the value product is superior to others.

Pricing strategies Low price Low quality $
$$$$
A number of different strategies can be Economy
used to determine the price of a product. High price
Cost-plus pricing is a retail markup used ❯ High prevalence Manufacture
by many companies to ensure a profit is a product that is very similar
made. For example, adding a markup of to others in the same category.
50 percent to a product that costs $2 to
make means that every unit will sell for ❯ Low price Undercut competitors’
$3, generating a $1 profit. pricing and gain a larger share
of the market.
Pricing matrix: price vs. quality
❯ Minimal marketing Keep the
A product’s quality affects its price tag— marketing and branding spend
the higher the quality, the more money as low as possible.
consumers will pay for it—but marketers
use strategies that play on the interaction Skimming
between price and perceived quality.
❯ High launch price Charge more
5% than usual in the short term while a
product is seen as unique.
increase in price
is worth more ❯ Correct timing Set a higher price
than a 5% increase when the business has a temporary
in market share advantage in the marketplace,
before competing products appear.

❯ Price adjustment Reduce the
price once competitors enter the
market, or to draw more customers.

186 187HOW SALES AND MARKETING WORKS
Marketing mix

PRICING MARKUP COMPARISON

Different industries adopt 400% DESSERT GLASS COCKTAIL
different approaches to 300% WINE OF WINE 350–400%
markups. A markup of 300–400%
two to five times the cost 200–250% of cost
is typically applied to of cost of cost
drinks served in bars and
restaurants. The highest 200% CARAFE OTHER
markup is usually applied OF WINE LIQUOR
to the second-cheapest BEER 250–300% 400–500%
bottle of wine on the 250–300% of cost
wine list, as people tend of cost
to avoid the cheapest item. COST of cost
(100%)

$ High quality Other pricing strategies
$$$$
Market Psychological
penetration pricing

❯ Low price Charge the lowest price $ Manipulate a
possible in order to lure customers customer’s emotions,
away from competitors. appealing to their thrifty
side or desire for prestige.
❯ Price adjustment Increase the
price to a normal level once the $$$$ Bundle pricing
product has a loyal following.
Offer several products
❯ Pricing flexibility Reassess pricing; for an overall price,
initial high-volume sales lower cost providing better value
of production, allowing price tweaks. than buying separately.

Premium Geographic pricing

❯ High price Charge as much as $ Charge different prices
the market will pay for an item. for the same product
in different locations.
❯ Unique value Apply premium
prices to products that have no ? Non-pricing
comparable substitute, such as strategies
famous brand-name goods.
Avoid adjusting the
❯ High production cost Charge price to attract sales,
a premium price because a product promoting superiority
is customized and offers no savings of product instead.
through volume manufacturing.

Place

Knowing where customers shop, where a product is sold, and how
efficiently goods can be delivered to the consumer—called “place”
in marketing terms—is essential to sales success.

How it works A sales outlet is the place 70.5%
where a product is sold, suchas
Whether a company sells goods stores, catalogs, or e-commerce
or services, customers must be sites. Sales channels are the
able to find and buy those products
as easily as possible. Businesses merchants, agents, and distributors
have to decide on the best sales
outlet and sales channel to get of device sales bywho take a product from the seller
their products to customers in a
way that benefits both parties. and bring it to the consumer. 2017 are forecast

to be smartphones

Main distribution channels Selling direct to consumers

A product reaches the marketplace through one of four main types of Product is sold directly by the
distribution channels. The most suitable distribution channel is usually producer, online, or through a
dictated by where customers prefer to buy the product. mail-order catalog, and delivered to
customer without intermediary.
Producer
Selling through retailers
A producer chooses the distribution channel, or a combination
of channels, that will maximize the number of customers it can Goods are delivered by producer
reach while keeping costs as low as possible. directly to retail outlets; retailer
adds a markup onto the price they
pay to producer.

Selling through
wholesalers and retailers

Products are distributed in two
stages: by producer to wholesaler
and then wholesaler to retailer.

Selling through an agent

Products are distributed in three
stages: from producer to agent,
from agent to wholesaler, and then
on to retailer.

188 189HOW SALES AND MARKETING WORKS
Marketing mix

PROS AND CONS OF USING INTERMEDIARIES NEED TO KNOW

Pros Cons ❯ Channel margin The cost
intermediary adds to producer’s
❯ Allows wider market coverage so ❯ Raises difficulty of making direct selling price, which is added to
producer can reach more customers, communication with customers price paid by customer
especially those in distant areas. to learn about their preferences.
❯ Push strategy Method in which
❯ Minimizes distribution cost for ❯ Increases the risk of slow, inefficient producer promotes products
producer as intermediaries are delivery, especially if several to wholesalers, wholesalers to
responsible for this service. intermediaries are involved. retailers, and retailers to customer

❯ Provides producer with specialized ❯ Takes away control over how ❯ Pull strategy Use of advertising
knowledge of customer buying products are handled and displayed and promotion to sell to customer
habits, as well as delivery logistics. at point of sale.

Example Consumer
E-commerce site selling
vitamins; they are sent
to customer by mail
or delivery service.

Example
Electronics company
distributes its television
sets to a chain of
retail stores.

Retailer Consumer

Example

Farmer sells apples to
wholesaler, who sells
them on to supermarkets.

Wholesaler Retailer Consumer

Example Agent Wholesaler Retailer Consumer

Chocolatier in France
uses import agent in
Japan to sell its products
to wholesalers and on
to retailers.

Promotion

Promotion is necessary for generating interest in and sales of a product
or service. A complex and expensive part of the marketing mix, it involves
communicating to customers and influencers such as peer groups.

How it works Consumer bee Personal
selling
The primary purpose of promotion
is to boost sales by attracting new Interact with customers
customers, while enticing existing face to face and tailor
ones to try out something new.
Most companies use a number of sales messages to
communication activities to inform their needs.
and remind their target audience of
a product’s benefits (see pp.196–231).

One of the long-term benefits of
communicating with customers is
that it helps to build brand loyalty.

NEED TO KNOW Customer
service
❯ Integrated Marketing
Communication (IMC) Provides customers with
Promotion of the same brand information about the
message across all media channels product; offers updates
and special deals.
❯ MarCom (Marketing
Communication) Full range
of promotional activities used
to reach out to the market

25% Below the line (BTL)
Describes promotional
the percentage of activities a business carries
digital promotion out in-house, such as direct
budgets spent on mail or telemarketing, to
mobile advertising reach customers directly.
in 2013

190 191HOW SALES AND MARKETING WORKS
Marketing mix

Advertising Direct Interactive
marketing marketing
Run ad campaigns
through media channels Send product offers and Build long-term
most likely to reach target information directly to relationships with
the potential consumer, customers using two-
market, and stick to way communication,
budget appropriate via mail or email. especially online.

for the product.

Sales Public
promotion relations

Entice customer with Generate positive interest
offers, free samples, gifts, in the company by
competitions, packaging,
sponsoring events and
and point-of-sale charities, or pitching
displays.
news content
Above the line (ATL) to media.
Refers to online and
offline advertising
a business pays for
to target customers.

Market research

Asking customers what they think about a product is a vital part of the
decision-making process for marketers. Research offers insights into how
a product might perform and lowers the risk of marketing campaigns.

How it works asked of a large group of people—and qualitative
(in-depth) research—into how a consumer uses and
Market research is used during product development feels about a potential new product. The marketing
and then to monitor customer satisfaction and department’s research budget is usually split between
competitor activity. Researchers draw on existing the two types of surveys. Quantitative research is often
data, observations, and their own research. New used when developing a new product, followed by
research is broken down into quantitative (number- qualitative research to help refine the product.
based) research—closed (multiple choice) questions

“Research + Intuition
= Decision”

Primary data
collection

New research to answer
specific question

Observations Quantitative surveys Qualitative surveys

❯ Researchers may watch from ❯ Researchers question many ❯ Researchers probe small
a distance as customer people for a broad view groups or individuals for
interacts with product, or (numerical data). in-depth view.
identify themselves and talk
to customer. ❯ They carry out online surveys to ❯ They conduct focus group
obtain a quick result from a discussions.
❯ They observe customer using large sample.
equipment such as eye tracking
analysis and checkout scanners.

❯ They study credit card records
or computer history to observe
past consumer behavior.

192 193HOW SALES AND MARKETING WORKS
Marketing mix

? Marketer CASE STUDY
reaches a
Marketer decision Coca-Cola launch
has a
In 1985, Coca-Cola launched a new kind of cola.
question The launch followed two years of taste tests, costing
$4 million, to refine the product. However, the drink
DATA REQUESTED DATA RETURNED failed and had to be withdrawn in the face of
overwhelming disapproval from the public. In the
marketing postmortem, analysts concluded that the
company’s researchers had failed to ask customers
a very important question: “Do you want a new Coke?”

Secondary data
collection

Published material
on a subject

Agency

Carries out original
research and organizes

research data into
meaningful results

32% Internal sources External sources

the projected ❯ Web usage data (for example ❯ Industry reports by trade
increase in the browser logs and online bodies, institutions, and private
hiring of market sales records) research companies
research analysts
in the US by 2022 ❯ Customer profiles with buying ❯ Reports by broadcast, print,
history and demographic data and internet media

❯ Accounting records, such as ❯ Academic papers, university
statements and balance sheets think tank reports, and
research library holdings
❯ Original data from past
market research reports ❯ Government surveys, reports,
and statistics

Market segmentation

In order to make decisions about who to sell their product to,
marketers try to identify distinct groups of consumers with similar
wants and habits who together form a “segment” of the market.

How it works narrows down a potentially huge
market into segments, allowing
Marketing departments use marketers to identify the ones more
a strategy of market segmentation inclined to buy a given product.
to find the potential customers who For example, after applying this
are most likely to buy a particular strategy, a company trying to launch
product, thereby increasing the premium-price organic baby food
chances of a successful product realizes that instead of marketing to
launch. They divide a broad group all women who have young children,
of consumers into subgroups based it should aim its product at working
on many factors, including age, mothers with children under six
lifestyle preferences, location, months, above-average incomes,
family structure, household income, and an interest in healthy eating.
and occupation. This process

NEED TO KNOW Defining market groups Behavioral

❯ Baby Boomers Section of To establish different consumer groups, Focuses on behavioral
population born between marketers create five segments and focus patterns when it comes to
1946 and 1964 on each individually. Besides identifying shopping. Understanding
groups by geography and demographics, this helps marketers adapt
❯ Generation X People born marketers also explore psychology to campaigns to target
between 1966 and 1980 ascertain how consumers behave, so that specific groups. Potential
they gain a better idea of which products focus areas include:
❯ Millennials Section of might appeal to which consumer groups.
population born between See also pp.258–261. ❯ Brand loyalty
1980 and the early 2000s
❯ Regularity of purchases

❯ Credit card usage

❯ Typical expenditure

❯ On- or offline shopping

❯ Heavy product user

“Market segmentation
is a natural result of
the vast differences
among people.”

Donald Norman

194 195

Sociographic Psychographic

Identifies individuals’ connections Focuses on consumer’s interests, values,
on social media, or membership of and opinions to help marketers develop
political and other groups, helping relevant messages and find the right
marketers learn about consumers’ media channels to target a segment.
passions and interests. Potential Potential focus areas include:
focus areas include:
❯ Risk taker
❯ Group memberships
❯ Charitable
❯ Number of friends on social
media ❯ High achiever

❯ A tendency towards
expensive tastes

❯ A preference for
email contact

Demographic Geographic

Uses basic consumer Concentrates on a
data, such as gender or customer’s place of
age, to accurately categorize residence, so that any
needs and target products product launched is
appropriately. Potential made relevant to their
focus areas include: environment. Potential
focus areas include:
❯ Income
❯ Post code
❯ Nationality
❯ Continent
❯ Family size and age
❯ City
❯ Ethnic background
❯ Neighbourhood
❯ Occupation
❯ Population density
❯ Religion
❯ Climate

Marketing
approaches

Every product launch requires strategic planning to make sure messages about
a new product reach the right types of consumers, are communicated through
the most effective combination of channels, and have the most relevant content
and style. Once marketers have researched the market and defined their target
audience, they face several key decisions on how to make their approach.

Types of approaches Rather than sending the same message via different media,
they usually adjust the tone and style of the marketing
Whom to target and how to go about it are crucial to pitch to suit the channel as well as the target consumer.
success. Marketers may use several complementary
approaches to different groups of potential consumers.

Niche marketing Mass marketing
“I only have eyes for you.” “I love you all.”

The big choice

The first decision is whether to go for a narrow, specialized market or to
appeal to as large an audience as possible. See pp.198–199.

196 197HOW SALES AND MARKETING WORKS
Marketing approaches

85% Engagement
marketing
of all purchasing “Come dance
decisons in the US are with me.”
made or influenced It entices the
by women customer to
collude in
Traditional product sales.
channel allied See pp.204–205.
with a dominating
style. “Let me tell Sensory marketing
you,” it blares. “Wake up and smell
See pp.200–201. the roses.”
It seduces the
customer with sights,
sounds, and smells.

See pp.206–207.

Digital channel allied with a Relationship marketing
soft approach. “Let me woo you,” “Let’s be friends.” It builds a rapport with its
it whispers. audience of consumers. See pp.208–209.
See pp.202–203.
Making a move
How to tell the customer
Turning the buying transaction into an experience
Marketers often get the best of both worlds by using the consumer enjoys can help sell a product.
traditional and online channels in varying styles.

Niche vs. mass
marketing

Two fundamental choices traditionally face marketers: whether to
try to sell a product with broad appeal to as many people as possible,
or to focus on selling a tailored product to a defined group.

How it works use internet channels to promote
the same product to different
Both niche and mass marketing groups of customers within a
strategies offer businesses the mass audience.
potential to make a high return
on investment. A niche approach 20%
generally works on the basis of low-
volume sales at a premium price to of sales can
a specific group of consumers, while make up to
a mass approach tends to use heavy 80% of profit
promotion to a wider audience and
aims to achieve high-volume sales.

In reality, businesses tend to mix
up both approaches, launching a
niche product and then expanding
it to a mass market. Marketers also

NEED TO KNOW

Long-tail marketing

Coined by Wired magazine editor Chris Anderson, the term “long-tail
marketing” takes its name from a demand curve (see below) depicting
products with low demand or sales volume—niche products—that
continue to sell and make profit over time.

POPULARITY Head Popular products with Long tail Products
high demand and sales volume with low demand
that sell steadily
Withdraw The point at
which retailers typically
stop selling a product

PRODUCTS