In our last post we covered the market environment and emphasized how important it is for lenders to understand the position that a business has in its market.
As part of that analysis we should also be thinking about the competitive aspect of the market since that can have a significantly positive or negative effect on the business’s sustainability in the future.
In the market environment, a tool that can be used to assess some of the potential threats and opportunities for the business is called the Porter’s Five Forces Model. This model, created by Michael Porter at Harvard Business School, considers the effect on a business of what he called the five forces of competition. Although the model was not developed from a risk analysis perspective, applying it to an individual business’s environment does give insight into the forces that might positively or negatively affect the business’s revenue and profitability in the future.
Let’s take a look at what these five forces are and how they play a role in credit assessment.
- Industry Competitors; These are competitors that exist already and basically provide the same product or service as the business being assessed. The fact that these competitors exist generally tends to have a deflating effect on profits. However, it is the intensity of competitive activity that is important – the higher the intensity, the more important it is for the business to have a sustainable competitive advantage to protect its market share and its profits.
- Potential Entrants; These are future competitors that may yet come into the market. They are attracted to a market when they see that there are profits to be made. Their arrival tends to have a deflating effect on profits for businesses that are already in the market. The possibility of new entrants coming into an industry is determined largely by the entry barriers of the industry.
- Substitutes; These are products or services that are not exactly the same as those produced by the business being assessed but are so similar in nature that they will attract all or some of the business’ market away. Examples would be butter and margarine, TV and home video/DVD etc. The existence or arrival of substitute products or services will tend to have a deflating effect on profits for businesses already in the market.
- Bargaining Power of Suppliers; When suppliers are more powerful than the business being assessed, they tend to have more bargaining power and can dictate terms of business, delivery, quantities, price, quality etc. If the business being assessed is making significant profits, the supplier could seek to increase the supply price which would have a deflating effect on the profits of the business being assessed.
- Bargaining Power of Buyers; When buyers (customers) are more powerful than the business being assessed, they tend to have more bargaining power and dictate terms of business, price, delivery, quality etc. If the business being assessed is making significant profits, the buyer could insist on better prices which would have a deflating effect on the profits of the business being assessed.