Business Strategy Explained Simply (With Real Examples)

What is strategy? How do you know if it's working and how do you apply it to your business?

I'm going to keep things really simple because there's a lot of garbage out there about strategy, especially from an academic perspective or from gurus who speak about strategy, but they've never been in the trenches, running companies, turning around businesses and investing in them so they can scale.

So I've been a CEO, I've been a CFO, I've been an investor and an advisor to many more, and I'm going to show you the exact framework that I use to drive value. Okay.

I also blend strategy and finance together. And that's something that's super rare out there because people will either talk about strategy from a pure pie in the sky perspective, or the nerds over here are talking about finance with spreadsheets and models that don't connect.

So I'm going to build the bridge for you and let's go ahead and get into it.

What is strategy? Okay. Think about it. In the world, you are running a business, okay? This is a terrible person, but this is a person running the business.

And there are so many things coming at them, right? So many decisions, so many different opportunities. And this person is left to wonder, okay, which direction should I pursue?

And with all these distractions and data points, this person has to make trade-offs, right? They have to make trade-offs about what they will do and what they won't do in order to win out there in the marketplace. Because if you try to pursue everything, guess what? You're going to fail.

Because think about it. Let's just say you have customers over here. You have customer A and you have customer B. And you were running a tea company and you can only sell one type of tea.

Okay. This customer over here likes hot tea. This customer over here likes cold tea.

So what do you do? You make warm tea. And you try to sell it to A and they're like, that's disgusting. You try to sell it to B and they're like, what the heck is this? Why is it warm? I like cold tea.

So you don't serve anybody well and you ultimately fail, right? Or if you are like the other CEOs out there, the flavor of the day CEOs, every time they see a new shiny object, they get excited. Then they realize, oh, this is much harder than I thought. And they start arriving in this valley of despair.

So then they start over again and they just repeat this cycle over and over again, instead of making it through this valley of despair and then really taking off because it takes a lot of work to scale a business.

So here's what happened in the whole strategy space somewhere. Somebody said planning is boring. So let's make it sexy. And so I'll add a little bit of red here. And they said, let's add the word strategic to it because it's fun is buzzwordy.

And now all of a sudden strategic planning is this new discipline and practice in business. The problem with this is that a lot of people don't know how to do this because they're coming at it from a planning perspective. So they'll go into a company and they're like, let's define your mission, vision, and values.

Or they'll take the Simon Sinek approach and say, let's start with why. And here's your why. And let's really define your purpose.

And I'm not poo-pooing these things. I think these are great. These are just not strategy in its entirety.

Or they'll say, here's your strengths, weaknesses, opportunities, and threats. Let's list them out. Or they'll say, let's define your rocks or whatever it may be so you can get traction.

So these are all the different frameworks that exist out there, but they all stem from this planning or this hypothetical standpoint. And they lead to this big list of goals. And goals turn into objectives. And objectives turn into initiatives. And initiatives turn into tasks. And tasks turn into actions.

And then there's rocks that are short-term and long-term. And there's all this stuff. And leaders are left to wonder what the heck is going on. And their heads explode. Okay. So let me just keep things really simple.

Michael Porter, the godfather of strategy, ultimately said there are three generic strategies to pursue. You have focus. You have differentiation. And you have cost leadership in no particular order.

Now, when you compete on differentiation, what it means is that you have some type of unique product or operating model or service or whatever it may be that allows you to earn higher margins because you're getting price premiums typically. Cost leadership is when you can take invested capital and you can be very efficient with your invested capital and operate at a lower cost structure compared to your rivals.

And focus is when you niche down and maybe you pursue differentiation and cost leadership, but you're doing it from a focus perspective. These are the three generic strategies that exist out there.

Now, in business, you have choices to make. So going back to the example, what I was saying with this person here, and they have all these things coming at them, and they have to make choices of what they're going to pursue and what they're not going to pursue.

The best strategies are ones where one choice connects to another choice, which connects to this choice and connects to that choice. And they're all interrelated. And when you have an interrelated set of choices about your market focus and position, your competitive behavior, and how you're going to win, then you have a really good strategy.

But what a lot of people do is they engage in what I call straddling. So they're pursuing strategy number one over here, and they're pursuing another strategy number two over here. And this straddling is not good because they're trying to do this strategy, but they're also trying to do this strategy. Their attention is split, their focus is divided, and they're spreading the resources too thin.

And when you try to be all things to all people, once again, you're serving warm tea to the marketplace. So this does not work, but a lot of companies try to do this. They try to split test their strategy, which is not a good idea.

So how does this all fit back together? From a CFO's perspective, I have been driving home this point to the market for years. I've been speaking about strategic financial leadership across the country for a long time now.

And the way that I look at strategy is you have strategy over here, and this is how your company is going to compete, where it's going to compete, and ultimately how it's going to win. And then over here, you have finance because you want to drive value with finance.

And there's this bridge between the two. This bridge allows you to generate value, and value is generated from cash, cash flow. So a good strategy is not one that focuses on driving more cash flow.

Cash flow and good financial performance is the result of a good strategy. It's not the strategy in itself. Okay, you with me?

I know I kind of talked quickly here, but I have a lot to cover and I get really excited about this. So let me further explain strategy here.

So when it comes to strategy, and if you want to know if your strategy is working, there's a couple things you can do first. You can pull an income statement, all right? So if you pull an income statement for your company, you'll find your revenue all the way down to your operating profit.

This is how much profit you earn from the core operations of your business. And if you just look at your operating profit as a percentage of your revenue, and let's say it's 6% right now, and you compare that to the market, and let's just say the average for the market is 10%.

Well, guess what? You are not operating effectively. In other words, you do not have a competitive advantage because you're not even operating at market average. And a competitive advantage is defined and measured by your ability to earn above industry average profits. That's what the strategy allows you to do.

And so when I say strategy allows you to win, I'm talking about a strategy allows you to win because you're earning above industry average profits, but it goes even deeper than that. So let me explain this.

Profits are great, but let's just say you have company A and you have company B and company A makes a hundred grand in profit and company B makes 50 grand in profit, right? This is profit over here.

Which company is performing better? Now you may be tempted to say company A, because they're earning a hundred grand in profit. But what if I told you their invested capital, right? The amount of money they had to put into the business by investing in trucks, trailers, equipment, and floating working capital — what if this is $5 million?

Versus company B — they've only had to put in $10,000.

Which business is performing better? Company B is performing better because the amount of invested capital they put in compared to their profit is much lower than company A, right? Company A had to put in $5 million to squeeze out $100,000 in profit. So that's not good.

That's where this term of return on invested capital comes into play.

That's where this term of return on invested capital comes into play. I did this experiment with a group. I was just talking to them the other week and I said, look, does anybody know what return on invested capital is?

And they're like, we all know what it is. And this is a room full of managers, right? And I said, okay, well, let me illustrate this. I went over to one of the leaders and I said, Hey, do you have any money I could borrow?

And he's like, sure. So he gives me $5. And I was like, great. Cause I need to take my wife out on a date. And I was like, ha ha ha.

And I put in my pocket and then I walked away and he's probably thinking, what the heck? This guy just stole my $5. And I said, Oh, Oh, sorry. That was rude of me here.

And I reached into my pocket and I pulled out some coins and I gave him like, you know, 50 cents or something. I was like, here you go. There's a return on your money that you let me borrow.

And he's like, well, what the heck? And I said, exactly. That's return on invested capital. You gave me $5 because you wanted me to go do something with it, but I only gave you 50 cents.

This goes back to the Bible. Remember the whole parable of the talents, right? Where God is like, Hey, I'm going to give you 10 talents and five talents and one talent. And the guy with one talent, he just went and buried his one talent.

And then when the Lord returned, he gave him his one talent back. And the person who got 10 talents, like doubled it or whatever it was. That's the same point here is we're investing capital into these businesses.

We're putting in place a strategy to drive greater value, higher returns, right? And it's got to be relative to this return on invested capital. So return on invested capital is basically the amount of net operating profit after taxes.

So it's the amount of operating profit you're earning net of taxes divided by the amount of invested capital that goes into the business. And invested capital is not that complicated. It's really just your working capital and it's your net property plant and equipment.

Okay. Your net PP&E. These two items can be found on the balance sheet. This is found on your income statement.

So you can do the math and you can figure out what is your return on invested capital. And let's say you do the math and it's 12%. You may be wondering, well, is that good?

There's two ways to figure out whether this is good or not. First, I would look at the S&P 500 and in the United States over the last 50 years, it's returned around 10%. Okay. So let's just use that as a nice round number.

If you're earning above market returns, that means you may be in a good spot, right? Because otherwise, if you're at 6%, you can just liquidate the assets of your business, go invest it in an index fund, and then sit on the beach because you don't have to worry about managing employees and dealing with all the headaches of customers, et cetera.

Right? I'm kidding there, but you want to be earning a return on invested capital that exceeds the market. Okay.

Now, the second thing you got to consider is what is the cost of the capital that's in the business? And let's say your cost of capital is 10%. Well, here, your return on invested capital is greater than your cost of capital. So it means you are creating value, right? So value, yay.

If your return on invested capital over here was 6% and your cost of capital was 10%, that means you are destroying value. So value, and we'll add some color here, is negative.

So what I'm saying here is when your return on invested capital, and I just gave you the formula, exceeds your cost of capital, it means your business is generating value. So when it comes to strategy, when you're making an interrelated set of choices, and you're following one of these generic strategies, and you're combining principles of finance to create value because you're spinning off cashflow, things are working well.

Now, if this is too complicated, you could go back and you could watch this over and over again, or look at my other videos because I go deeper into these concepts. But this is really important.

This is a little bit more advanced, but it's really important to understand because otherwise you're just pursuing these dumb strategies that aren't really going to work. Okay. I hate to put it so bluntly, but I'm being direct because I've seen so many companies go down the wrong path and they make a ton of mistakes.

They waste a lot of money or they go bust because somebody is showing them a strategy model that doesn't work. So let me further illustrate this. And I'm going to tie back to the generic strategies from Michael Porter.

So you know how you can start to apply this to your business. Let's just take the longer definition of return on invested capital. So remember I said, it's Nopat divided by invested capital.

So if we just take this and we break it out, we have Nopat, which is Nopat divided by revenue here tells us our profitability. That's terrible. Okay. But you get the point.

So this tells us our profitability. Then over here, we have revenue divided by invested capital. And this tells us our capital efficiency.

So all I did is I took return on invested capital and I broke it out in its long form. Because remember from back in school, if you multiply Nopat divided by revenue times revenue divided by invested capital, remember revenue cancels out and you arrive at Nopat divided by invested capital.

That's what I just did right here. I just took the long form of this and I showed you two different ratios, Nopat divided by revenue, which measures your profit margin, your profitability and revenue divided by invested capital, which measures your capital turnover or your capital efficiency.

So then we could tie this all back to Michael Porter's differentiation, cost leadership, and focus. And I shouldn't have put a line here. This is his focus down below here.

Because if you are earning a higher return on invested capital and it's coming from this side of the equation, guess what? You are pursuing a differentiation strategy because you're earning higher profitability and higher profitability says you are differentiated, you're unique, which allows you to charge more and make more money.

Therefore you're pursuing this strategy effectively because your return on invested capital is high because of profitability.

Over here, if this side of the equation is driving a higher return on invested capital, it means you're really good with your capital efficiency, which means you're pursuing cost leadership effectively.

This is the type of strategy you're pursuing well. And if you're doing both really well, and these are both high, then that may mean that you are pursuing a focus strategy effectively.

And that's how it all ties back to Michael Porter's framework. And this is how you blend strategy and finance together to actually drive value.

No longer is strategy pie in the sky. Remember this mission vision values or begin with Y or SWOT or rocks or strategic planning. It's not a laundry list of things.

It's a roadmap to show you exactly where to compete, how to compete, and ultimately how to win. And when I say winning, I'm talking about driving real value in your company.

Okay. If your head's about to explode and you're like, wow, that was a lot. That's okay. You can watch this again.

And if you're interested in this with your business and you want to put in place a real path to profitability and higher cashflow, I'm always happy to take a free strategy call with you and your team.

So you can book that by going to Coltivar.com. No pressure whatsoever. It's just a strategy call to determine whether or not we can help and whether or not there's a fit, right?

That's what I have for you. And until next time, take care of yourself. Cheers.